Buying a property in Germany vs investing into MSCI World

[chris1974]

Hi everyone, Happy New Year!

I am comparing two investment opportunities which I have right now:

• buying an apartment to rent in one of German cities with 3-4% rental yield (e.g. Frankfurt, Nürnberg, Karlsruhe)
  
• investing into broad world index (e.g. MSCI World)

From the first glance buying RE in Germany with very low interest rates and letting tenants pay it off looked very sexy.
But the more I think about it and analyse, the more it looks like a very risky deal.
Apart from being a part-time job and being very undiversified and illiquid, I have 2 more concerns:

• according to Bundesbank, properties in big German cities are now 15-30% overvalued (I don't want to buy high)
  
• growth of property prices in Germany might decline a lot (I don't want to sell low)

According to this investopedia article there are 4 factors that have a big impact on property prices:

• demographics
• interest rates
• economy
• government policies

I tried to evaluate each factor separately and so far all of them look grimmy for Germany.
Please verify if my understanding is correct and share your thoughts.
And thank you for your time!

Demographics​

According to Destatis:

• total population is projected to stay the same, decline by 4% or decline by 7% (depending on immigration, fertility, etc) till 2050.
• working age population (20-67 y.o.) is projected to decline by 11%, 17% or 23% till 2050.
• old age population (67+) is projected to increase by around 30%
  

Taking above projections into consideration, the demand for housing in big cities has a potential to decrease due to:

• a huge decrease in a working age population, which needs to live closer to work
• a huge increase in old age population, which will have less reasons to stay in big cities (e.g. closer to work) and more reasons to move to a more affordable locations (e.g. decreasing pensions due to a demographic shift)

Projections for population of biggest cities suggest that growth will remain (probably due to urbanization) but slow down significantly.

Interest rates​

Interest rates are harder to predict, but it looks like they already hit the (psychological) bottom and furter decrease will unlikely drive many people to buy their own property.
There is very little room to go down, but a big potential to go up, which will lower the demand and prices.

Economy​

It is hard to predict how innovations and productivity will drive the economy till 2050, but rapid decline of working-age population and rapid growth of old age population suggests that the economy as a whole will probably stagnate.
PWC projections suggest that emerging markets will grow and dominate the world economy by 2050, so investments might shift more from developed (e.g. Germany) to emerging markets.

Goverment Policies​

It looks like rent cap in Berlin is only a beginning and other cities will follow the trend due to a rapidly growing rents.
So, this factor is also likely to slow down RE price growth.

 

[resjudicata]

@chris1974 My guess is: you won't find property in the big cities for which you won't have to pay $$$ each and every month due to low yield. Calculate the opportunity cost of an ETF investment - I did it for multiple properties in my city, and none of them turned out to be superior to an ETF investment (even without leverage - just by investing the amount I would have to pay every month for the rented apartment).

 

[craig01]

@resjudicata What do you mean « even without » leverage? Leverage that is possible only with real estate is what makes it a so specific asset class.

 

[resjudicata]

@craig01 Yes, leverage is the only reason real estate can make sense. But people forget that they can also take out debt to invest in stocks and ETFs - not quite as much obviously, but investing 50-100k on margin is easily gonna outperform gains from a 300k rental property, all costs considered.

 

[craig01]

@resjudicata Except I can get a loan for 100% of these 300k for real estate.

Nobody is going to grant you margin from scratch for stocks/ETFs.

 

[resjudicata]

@craig01 You gotta have the 10% for fees anyway, which is 30k. Furthermore, banks currently might wanna see 10-20% equity, which would be another 30-60k.

Margin on those 60-90k would already get you above 100k invested.

 

[craig01]

@resjudicata These can be included as well. Last loan I signed was for 110% of the asset value.

 

[gogogo]

@resjudicata You don't have to have the 10%, you're getting even these things financed now.

 

[chris1974]

@resjudicata Hey, thanks for your answer! I programmed a simulator to compare RE vs ETF scenarios over 30 years and the problem is that the outcome depends a lot on the rate at which property price will grow. For example, if property price will grow 5% a year (which was the case for the previous 5-10 years) it will greatly outperform ETF that is growing 6% a year.
This is why I am trying to understand what are the prospects for German RE market.

Edit: taxes for the rental income are also included in my simulation. I set them to 33% as my current tax rate.

 

[resjudicata]

@chris1974 Don't calculate with anything above inflation for property price increases - that would be pure gambling. People think that prices will continue to rise just because they only now the development of the last 10 years (check historic data before 2010, you will be amazed). It's more than likely that at some point, prices might stagnate or even drop (once baby boomers die out, starting around 2030).

Also, consider tax implications. Tax is the key factor that fucks up most favorable calculations due to insane rates that apply to rent income.

I ended up investing in ETFs with leverage, and this is near certainly gonna outperform any rental investment. Because why would it be OK to take out debt to purchase overpriced apartments but not ETFs?

 

[lightwriter]

@resjudicata Would you not consider ETFs equally uncertain, based on the last few years of bull market determining the superior outcome you describe compared to RE?

 

[resjudicata]

@lightwriter Stocks always went up in the long run, property in Germany did not beat inflation in the long run.

 

[lightwriter]

@resjudicata RE in the long run I would assume is the same all though might not be correlated over an equal timespan. I don’t know the Germany RE market, but would bet that most western societies, after all the QE easing are bound to see inflation in which care RE values and your leverages will be positively impacted. Furthermore, large metropolitan cities will always continue to grow as its were the businesses and universities are.

I’m not arguing for RE, as I would do both strategies and not either or.

 

[exsoldier]

@lightwriter I think there is a misunderstanding. RE in 13 different markets almost always has a real return of 0-1%. The noble prize winner Schiller after which the Schiller CAPE indicator is named, concludes that long-term house and appartement prices converge to the cost of materials and labour. It wouldn't make sense that they had a meaningful real return. Were it the case with a 4% real return the prices would double every 18 years or so. That would mean that within the lifetime of a person in real terms the prices would quadruple. Within two or three generations almost nobody would be able to afford it. However we see the opposite over the last half a century. It's getting cheaper and more efficient to produce housing.

Another issue I have with your remark is with QE being inflationary. QE by it's nature neutral. It extracts interest bearing assets from the market and creates bank reserves which in turn should favor lending. Some would argue that in case of tightened credit conditions it actually is deflationary, as can be seen with Japan. However inflationary effect can be seen on assets.

 

[lightwriter]

@exsoldier Great point of view regarding real returns on RE. One point that is missed in this equation is that access to leverage. As mortgages are easier and cheaper for most investors as you have hard collateral - again I’m comparing to other passive investment strategies for most retail/common investors.

It is the first time I heard that QE is intended neutral or even deflationary. Japanification of an economy is not the intention of QE and was not in Japan either. Lending is meant to stimulate consumption and thus the increase of real prices to the CB targets of 2%.

My comment around it was that real prices (for any asset) based on excessive QE is likely to result in much higher inflationary pressure in the future diluting most asset prices.

 

[exsoldier]

@lightwriter

Great point of view regarding real returns on RE. One point that is missed in this equation is that access to leverage. As mortgages are easier and cheaper for most investors as you have hard collateral - again I’m comparing to other passive investment strategies for most retail/common investors.

Leverage cuts both ways. These numbers are adjusted for inflation without transaction costs, rental yields, borrowing costs and taxes :

1. Average real return is 0.9%
2. Adjusted for supercity bias to 0.4%. This is to eliminate cities such as Paris or London and have more relevant real returns
3. Insurance and maintenance costs drop return to - 0.6%
4. Adjusting for quality improvements devaluing older real-estate gives us - 2.1%

The average debt to equity ratio used to be around 1 to 4. So you're using 5x leverage. I'd say annually you lose around 10.5% of your purchasing power for the money invested. If you account for all costs real estate reveals itself as a commodity that it is. To get positive on real-estate you need to rent it out. Where the commodity becomes a service.

There is a reason why home ownership and rental comes about even for sunk costs.

It is the first time I heard that QE is intended neutral or even deflationary. Japanification of an economy is not the intention of QE and was not in Japan either. Lending is meant to stimulate consumption and thus the increase of real prices to the CB targets of 2%.

Probably because QE is often referred to as money printing, which it isn't. Also don't misquote me ; never did I say that Japanification is the aim of QE. QE has the aim to maintain liquidity during crisis where traditional banking systems tend to lock up. There is a slight mix up with the 2% target, which is auxiliary for inflation monitoring independant of QE. However QE is deployed when credit conditions are tightening as well so it's effects are quite muted. As I said QE exchanges bonds for bank reserves. As you see it is by itself neutral. What is the inflationary effect due to it?

My comment around it was that real prices (for any asset) based on excessive QE is likely to result in much higher inflationary pressure in the future diluting most asset prices.

I disagree with this premise. QE is bidding up price of sovereign bonds high enough to make them unattractive which in turn forces investors to move to more risky assets in turn increasing their prices. I'm not sure I'd qualify it as inflation but rather as a reallocation of assets in sea ch of returns.

A more efficient bottom up approach would be required to favor inflation, but that is for governments to decide and beyond the scope of the mandate for central banks. I would be more concerned with deflation than with inflation. HCPI is showing deflationary signs.

 

[resjudicata]

@lightwriter I think it's dangerous to believe that cities will always grow.
1) what if Work from Home is gonna stay a big thing? People might move out of the city. What if selfdriving cars are going to facilitate commuting within 10 years? Another catalyst for moving out of the cities.
2) what if population in the country decreases as a whole? this is actually common thought right now - 1,4 children per woman will simply not keep us growing, even despite immigration.

 

[chris1974]

@resjudicata There is a nice book by Geoffrey West called "Scale". There he explores the effects of scale on different things: organisms, cities, etc. One of the things he has found is that the bigger the city, the more it is driving innovation and economy in general and the more well-off are the citizens. Now it is interesting if physical presence is mandatory for that effect or we still can do the same thing over zoom

 

[gogogo]

@chris1974 One thing to consider is that a lot of the authors write under heavy US influence. Cities are born and cities die there - there's simply so much space so this can happen (Apart from metropolises). Europe and specifically Germany is full and condensed.
This screws the numbers in multiple ways. For one, as people mentioned, commute is not that big of a deal as everything is close anyway, in addition to the work-from-home trends. On the other hand there is not much space to go to so space in cities will remain in high demand. Three are many more considerations, but the pop density is sometimes overlooked.

 

[lightwriter]

@gogogo Great input. How do you see Asia’s in this perspective where many of the larger metropolises are more recently developed