Real Estate Company Rating Outlook for German office market Price (EUR) PT (EUR) Potential (%) What’s ahead for the office market in Germany? alstria office REIT Buy 12.20 16.10 32.0% The COVID-19 crisis has changed our lives profoundly in many ways. While some parts of the economy have fared well, others faced tremendous difficulties with a sudden DIC Asset Buy decline in demand leading to zero revenue generation – a crisis impact not seen before. 10.24 19.00 85.5% For the real estate market, the consequences of such changes vary across sectors and UBM Development Buy in the degree of visibility and thus, in terms of future outcomes. While the residential 31.00 47.00 51.6% sector developed very well, the distressed retail sector remains under pressure. The office sector however, has not provided a very clear picture of the future and after taking a closer look at the prevailing driving forces, we share our insights and expectations in this report. Investment market: The different stimulus packages should ensure that investor confidence in the German investment market, and particularly in the office market, continues to strengthen. With this, the transaction market is expected to pick up again. Rental market: The incipient economic recovery should have a positive effect on the rental market and, despite all the uncertainties, we expect a moderate recovery in the coming months. Vacancy: As tenants are expected to remain cautions, with many adopting a “wait-and- see” approach as the pandemic continues, vacancies should increase slightly towards the end of the year as new office space comes onto market. Rent levels: The pressure on rents could intensify as the year progresses if there is an increase in attempts to push through rent-free periods or expansion cost subsidies . Financing: We expect a decline in new business volume of commercial real estate financing in Germany in 2020. The financing volume of offices should be stable as demand for core office properties (LT-lease, fully let, strong tenants) from equity-rich investors should remain strong. COVID-19 should not have had much of an impact on the conditions for the financing of core properties owing to banks' focus and strong liquidity from the ECB's TLTRO programme. The financing of other categories (core+, value add, development) will deteriorate. For this reason we expect opportunities in these asset categories for investors with strong equity and liquidity positions or access to financing. Covenants: The possible lower LTV requirement in new business could lead to lower demand for higher-risk assets as investors with a strong equity position prefer core assets (insurers, pension funds) to secure a stable cash flow. Credit quality: NPL-volume should rise due to negative cash-flow developments due to tenant insolvencies. This could offer attractive investment opportunities across categories core+, value add and developments due to forced selling. Remote work: The share of office workers working from home will increase and impact office market by between 10–20%. However, the transition will be gradual and will occur over the medium term and therefore should not impact yields profoundly. To conclude our report, we applied our assumptions to different business models within the office sector, such as alstria as a portfolio holder, DIC with its hybrid business model (portfolio holder and asset manager) and UBM Development as a developer of office real estate. We believe all those businesses provide different but attractive exposure to the recovery of the office sector. However, we are convinced the current environment offers opportunities for those with sufficient liquidity and low risk of revaluations leading to write-offs. Authors Analyst Analyst Analyst Andreas Pläsier Simon Stippig Philipp Kaiser [email protected] [email protected] [email protected] +49 40 309537-246 +49 40 309537-265 +49 40 309537-260 S E C T O R N OTE Published 05.10.2020 09:00 1 Real Estate Outlook for German office market 1 What to look for in the German office market 1 Different risk categories in real estate 3 Commercial real estate market in Germany 4 Investment market 4 Rental market 5 COVID-related decline in demand for office space 5 Flexible office space 6 Vacancy rates still on a very low level 7 Volume of completions still at previous year’s level – pre-letting down 8 Rents unchanged – two cities even showing a slight increase 10 Financing of commercial properties 11 Financing of commercial properties – COVID-19 poses extra challenges but normalisation possible with recovery of domestic economy 11 Remote office as new trend 14 COVID-19 disrupting conventional office real estate? 14 Remote work across sectors 14 Higher flexibility and company-specific factors 15 Cost savings by reducing office-based workers 15 Legal framework for remote work 16 Personal interest of employees 16 Potential future scenarios for the office real estate market 17 S E C T O R N OTE Published 05.10.2020 2 Real Estate Different risk categories in real estate Core, Core Plus, Value add and Opportunistic Our considerations of the office market are preceded by a general definition of the various risk classes. In the real estate sector there are different investment styles; and in order to be able to assign suitable properties to these styles, the so-called risk classes or risk categories have become established in the real estate sector. The risk classes provide information on how the risks relate to the yield opportunities of the respective property. A distinction is usually made between the risk classes Core, Core Plus, Value add and Opportunistic. In order to classify a property, key figures are used to allow an objective risk assessment. Criteria for risk assessment include location, tenant structure, value potential, vacancy rate, solvency of the tenants, debt ratio and expected return Core and Core Plus assets: . High-quality existing properties and new developments . Very high asset quality . No, or only minor, maintenance investments . Good to very good location . Low vacancy rate . Long-term leases . Very high solvency of tenants The aim of Core and Core Plus properties is maintenance, renovation and refurbishment. Value add and Opportunistic assets: . Higher vacancy . Higher maintenance investments required . Higher value increase potential The aim of Value add and Opportunisitc assets are to privatise or re-let the properties after renovation, redensification or new construction. Once a property has been upgraded, it should be sold at profit. Different risk categories in real estate Holding Risk period Opportunistic Value add Core + Core Return Source: Colliers, bulwiengesa, Warburg Research S E C T O R N OTE Published 05.10.2020 3 Real Estate Commercial real estate market in Germany Investment market RE market defies COVID – impact of lockdown visible in Q2 In the first half of 2020, a total of EUR 41.8bn was invested in the German real estate investment market, of which EUR 29.3bn was in commercial property. Compared to the first half of 2019, this represents an increase of 21%. As in recent years, the office sector was the main driver of this increase, accounting for more than 40% of transaction volume in the commercial real estate sector. Commercial real estate investment market overview 2019 H1 2019 H1 2020 % Change yoy (in EUR m) (in EUR m) (in EUR m) Total investment volume 89,500 34,550 41,800 21.0% Commercial properties total 71,600 23,600 29,300 24.2% Transaction Type Portfolios 21,053 4,248 13,190 210.5% Single Assets 50,576 19,352 16,110 -16.8% Type of use Office 40,500 12,040 12,600 4.7% Residential 17,900 10,950 12,500 14.2% Retail 10,000 4,840 6,740 39.3% Industrial & Logistics 6,500 2,360 3,810 61.4% Hotel 5,000 1,650 1,170 -29.1% Development Site - 1,770 3,220 81.9% Other - 940 1,760 87.2% Source: CBRE, JLL, Warburg Research That it was still possible to achieve an increase in transaction volume compared to the previous period despite the current corona crisis is predominantly explained by a very strong first quarter. Driven by large portfolio transactions (17 portfolio transactions in excess of EUR 100m, totaling EUR 14.7bn), the transaction volume increased by 97% to EUR 27.8m compared to the previous year (Q1 2019: EUR 14.1bn). Thereof, EUR 18.4bn was attributable to commercial real estate and EUR 9.4bn to “living” (residential properties). But even the property market was not left untouched by the pandemic. Mainly as a result of the lockdown during the second quarter, the transaction volume fell by 20% compared to previous year’s Q2. Office properties remain the most popular asset class among investors and reflect the confidence in the stability of the German office market. Even during the lockdown, transactions for core assets in prime locations were observed, such as the sale of Patrizia’s Ericus-Contor office building in Hamburg to Union Investment Transaction35 volume in Germany (EUR bn) 30 25 20 15 10 5 0 2014 2015 2016 2017 2018 2019 2020 Q1 Q2 Q3 Q4 Average Q1 14 - Q2 20 Source: CBRE, JLL, Warburg Research S E C T O R N OTE Published 05.10.2020 4 Real Estate For the moment it looks as if the German economy is slowly recovering after the massive slump in spring. Two arguments support this thesis: . Short-term real-time indicators: According to CBRE, short-term (sometimes daily) real- time indicators such as the truck toll index, the weekly activity index of the Bundesbank or the mobility data of mobile phone users indicate that the German economy is on the upswing again .