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Property development as opportunity – how big are the risks?

Residential properties seem a safe bet for investors. In Germany in particular, rental demand is strong and continues to rise in many places, while supply is scarce. But there is a shortage of construction capacity, which raises the question if investors should become involved in property development.

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Residential sector has increasing appeal to investors 

International investors are becoming increasingly focused on residential properties in Europe. Used broadly, the category includes retirement homes and student dormitories. The past twelve months alone have seen one out of every five invested euros going to this segment. That is the conclusion drawn in the latest PATRIZIA study, “European Residential Markets”. The report also concludes that the appeal of this asset class is likely to increase in the medium term. This is not only due to megatrends, such as demographic change and urbanisation, but also to investors seeking options that promise stable income.

But investors need to be careful. For example, by 2025 only one-third of all regions in Europe will see an increase in working-age population. Over the long term, demographic change and urbanisation will produce distinct winners and losers on the continent. The number of “winning” cities will be small, but the magnetic appeal of Europe’s metropolitan regions such as Berlin and Paris will remain undiminished. For many people, these cities promise employment, a high quality of life, and good infrastructure.

Investors taking property development into their own hands

Risk-averse investors should look to existing residential properties in these cities. In principle, the residential sector has the advantage over options like commercial properties because the tenant supply is virtually inexhaustible, management is relatively uncomplicated, and expected returns are high. Demand has also significantly exceeded the supply of existing and new buildings for many years. 

The situation is made more acute by massive bottlenecks in the construction industry. “That in turn leads to soaring construction costs,” says Johannes Haug, Head of European Real Estate Development at PATRIZIA Immobilien AG.

In addition, new properties arrive on the market after a time lag. This means managers of large investment assets can get involved in property development by taking over the role of the general contractor. However, completing complex construction projects needs partners and local expertise, as well as capital. This level of involvement is inadvisable for return-driven investors who might, for example, want to build condominiums, keep them vacant, and sell later at a substantial profit.

Not a suitable strategy for return-driven investors 

Expanding the supply of affordable housing has become a priority for cities in Europe, so they have stopped offering property to “condo flippers”. In fact, cities often require residential construction projects to include a percentage of publicly subsidised units even when financing has been raised by the investors themselves. 

Such requirements increase the complexity of investments, but Haug remains convinced that the residential sector is “the safest investment category, because demand is so immense.” Only continuous new construction will keep megacities in particular from a growth collapse.

Investors who become involved in property development should limit this segment to 15 to 20 per cent of their portfolio, Haug advises. “The other four-fifths will ensure stable asset value,” he explains, as it takes time until development costs are amortised. 

Increasingly, it also requires developing in-house expertise for such projects, otherwise investors will rely on an outside general contractor to provide the required services. Finding and recruiting contractors is becoming more difficult in a market plagued by bottlenecks and “cherry-picking”.

“Finding affordable housing will become a growing problem for many segments of the population.”

Johannes Haug, Head of European Real Estate Development, PATRIZIA Immobilien AG

Geopolitics and market cycle determine involvement 

PATRIZIA is currently acting as a property developer in Denmark. As part of that involvement, by mid-2019 it will build 16 apartment buildings in Copenhagen’s Sydhavnen district with a total of 120 units, as well as 56 row houses. In parallel, it has it has ambitions in Germany. 

“Finding affordable housing will become a growing problem for many segments of the population all over the country,” says Haug. He explains the company is focused on ley locations, such as Germany’s “Top 7”: Berlin, Cologne, Dusseldorf, Frankfurt am Main, Hamburg, Munich, and Stuttgart.

However, not all big cities or metropolises are automatically good places to invest. The storm clouds of Brexit, for example, hang over London. Europe generally could suffer from the ongoing trade conflict between China and the United States, while political decisions in Italy or Turkey could also create turbulence. 

Investors should assess investment locations in terms of geopolitical risk as well as the business cycle. It may be advisable to invest anti-cyclically in markets that have seen little development to date. In the same way, entering mature markets – which describes a growing number of Europe cities – increases risk. But unlike office or commercial properties, residential properties in such locations should still hold potential even in event of a market downturn.

 

Photos: Westend 61, Getty

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