April 2021

Inflation is back in Germany: The consumer price index’s annual rate of change climbed to 1.7% in March, up from December 2020 when the inflation still stood at –0.3% year on year. The strongest price driver to date have been special effects. After the temporary reduction in 2020, VAT was raised again in January 2021 to its original level of 19%. Moreover, the newly introduced CO₂ levy in Germany is sending up heating oil and fuel prices. According to BayernLB Research forecasts, the inflation rate could rise to more than 3% over the course of 2021 before settling again at a good 2% in 2022. The market consensus expressed as an average of the forecasts of many economists from banks and economic research institutes also expects inflation rates of “only” 2.1% and 1.6% for Germany in 2021 and 2022 respectively. The current debate about inflation is therefore possibly merely a storm in a teacup. If, however, inflation rates were to rise more sharply and permanently than assumptions suggest, what would be the impact on the real estate markets, above all specifically on rents, in this scenario?

The following factors could cause prices to accelerate more swiftly:

1. Domestic price pressure: Gastronomy, retail, hotels and travel agents, companies and sectors who were especially impacted by the restrictions of the Covid-19 pandemic might attempt to claw back part of past losses by raising their prices step by step as the economy and private life resume at normal levels. Things could develop this way particularly if economic growth, as anticipated by the majority of market players, proved to be very dynamic in the current year and next year. Market consensus estimates real GDP growth in Germany at 3.3% this year and 4.1% next year. 

2. Price pressure from abroad: Higher inflation rates abroad, for instance in the US and Eastern Europe, could put greater pressure on prices through imports. An increase in commodity prices would have a similar effect, this is at least already visible with oil and metal prices, for instance. In the same way, growing price pressure may also emanate from Brexit as logistics companies are faced with higher costs from customs declarations and greater efforts involved in goods clearing customs. Companies may pass these cost increases on to the consumer.

The impact of higher inflation rates on the real estate markets are manifold, with an important transmission mechanism being the influence of inflation on the level of interest rates. The European Central Bank (ECB) is committed to the pursuit of medium-term price stability. A permanent and significant increase in the inflation rate in Germany and in the euro area above the 2% mark would force the ECB to tighten its monetary policy. Higher key rates and markets expectations of these higher rates would cause bond yields to rise in tandem. This would result in higher financing costs for property development and for acquiring real estate, which would pare down the supply of new developments and lead to dwindling demand for real estate in the investment market. Moreover, higher interest rates would reduce the risk premium, meaning the yield mark-up of property relative to long-term government bonds. This would make investing in government bonds more attractive relative to real estate, which would ultimately reduce demand for real estate in the investment market.

So far the ECB does not expect prices to rise permanently above the 2% mark. Consequently, key rate hikes this year and next year are unlikely from today’s standpoint. In addition, the ECB is keeping bond yields low through its programme of purchasing government bonds issued by eurozone countries. The benchmark yield of 10-year German Bunds, for instance, has risen by “only” just under 40 basis points to currently -0.2% since year-end 2020. For comparison purposes, the yields of US 10-year treasuries advanced by around 70 basis points over the same period. The costs of financing real estate in Germany and in the euro area therefore remain low while the risk premium stays high. This scenario is an important precondition for Germany’s real estate boom to continue.

But if inflation rates remained permanently high how would this impact rent progression? An analysis of the complexities is multi-layered. If prices should rise on the back of favourable economic market conditions, as is expected both this year and in 2022, this is generally associated with higher levels of employment, which would boost demand from companies requiring more space. This should then positively impact the rents quoted in the leasing market. 

Figure 1 illustrates the correlation between economic growth and the inflation trend. The chart plots the development of real GDP growth and the rate of price increases in Germany. There were four phases in the last 50 years when the inflation rate was permanently above the 2% mark. The two phases of high inflation at the start of the 70s and 80s were essentially triggered by the two oil crises, and therefore by special factors from abroad. The high inflation period at the start of the 90s was prompted by the economic boom following Germany’s reunification, and the last high inflation phase in 2007/08 by the flourishing economy prior to the onset of the financial market crisis. In terms of analysing rental trends, the last two high inflation phases are therefore of primary interest. Figure 2 shows the development of office and residential rents in Germany’s A cities as an (unweighted) average for the period from 1990 to 2020 (minus Berlin, as data is biased due to German reunification). 

Both phases of high inflation sent quoted rents spiralling up although this was comparatively more moderate for the residential property usage type in the 2007/08 high inflation phase.

In the next step, it is interesting to see how rents developed when adjusted for the rise in inflation. Figure 3 maps this real rental development for the residential and office property usage types. 

Real housing rents rose by around 11% on an aggregated level during the 1991/92 phase of high inflation and moved sideways in the second high inflation period (at this point, real rental growth started to accelerate surprisingly enough with the onset of the financial crisis as from 2009). Real office rents climbed by around 4% in the first high inflation phase and by around 6% in the second phase. The extent of the real rent increases in the respective period of high inflation hinges on how strong the surge in demand was (real GDP growth), along with growth in new space and space availability (existing vacant stock). In conclusion, rents basically rise faster than the inflation rate in phases of high inflation triggered by dynamic economic developments, which ultimately filters through as significant growth in real rents. 

Inflation in Germany and in the euro area has recently picked up significantly. This trend is set to continue in the short term. In the medium term, the rate at which prices rise will be more moderate again, however. If inflation rates were to remain permanently above the 2% mark, and these developments were driven by demand on the back of an economic recovery, nominal and real rents for office and residential real estate would see significant growth in this phase. This would then especially be the case if the ECB continues to prevent bond yields from any substantial increase through its asset purchase programme. In a nutshell: Inflation without rising interest rates would be the Goldilocks scenario for the real estate markets.