European Sovereign Debt Crisis: Up Next, German Real Estate Bubble?

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Includes: DRR, ERO, EUFX, EUO, EWG, FGM, FXE, ULE, URR
by: CFA Institute Contributors

By Ron Rimkus, CFA

Where there's one cockroach, there's fire! Wait, that's not quite right. Where there's smoke, there's a lot more cockroaches! No, that's not it either. Let's see . . . ah, yes . . . where there's smoke, there's fire! And when you see one cockroach you can bet there are more lurking out of sight. So which analogy - smoke or cockroaches - best describes German real estate? It may well be both. Real estate prices in Germany suggest that trouble is afoot. Pay attention: This should worry every investor in the world.

As the European sovereign debt crisis drags on, I have begun to focus my attention on Germany. Recently, I came across a table of German real estate price changes. Consider the quarterly price changes of the following seven-city index of real estate prices:


Germany: Real Estate Prices for Seven Cities

Click to enlarge

Sources: Bundesbank, BulwienGesa AG, CFA Institute.


First thought? Is a real-estate bubble in the offing? If so. . . . Oh my! Germany is considered the bulwark of the European Union. While everyone discusses Germany's fiscal strength and probity, fewer investors may realize that the German dream might well be structurally unsound.

How could Germany be experiencing a real estate bubble in the midst of the euro crisis? It's quite simple, actually: the European Central Bank has lowered rates in response to the global financial crisis that began in 2008, and then dropped rates dramatically in response to the euro crisis, which didn't gain steam until late 2009, and then pushed rates near zero in late 2011 - where they have remained. As illustrated in the chart below, real estate prices have risen in conjunction with falling rates for the same seven-city index (the data are quarterly figures through June 2012).


Germany: Seven-Cities Real Estate Prices vs. Five-Year Bond Yields

Click to enlarge

Sources: Bundesbank, BulwienGesa AG, CFA Institute.


Now, just in case you think that this seven-city index is an anomaly, consider the Bundesbank's 125-city index through 2011 (the data are annual figures through December 2011).


Germany: Real Estate Prices for 125 Cities

Click to enlarge

Sources: Bundesbank, BulwienGesa AG, CFA Institute.


And all this growth in real estate is happening even though the German population is declining. That's right: Germany has a population in decline.


Germany: Population in Decline

Click to enlargeSources: Statistiches Bundesamt, Haver, CFA Institute.

So, where is all the new real estate demand coming from? In part, the periphery of the European Union. As noted in a recent piece in Der Spiegel, many Italians are now investing in German real estate as a way to protect their money against the backdrop of the euro crisis. In a worst-case scenario - if the euro were to break up, then the German deutschmark would be reintroduced, and it is widely believed that the currency would gain materially against the remaining euro member currencies (to balance trade deficits). So in a eurozone breakup scenario, a German real estate investor would pick up a substantial currency gain. And shy of that (unlikely) scenario, investors in the European periphery can avoid the instability of their homeland.

Demand is also coming from institutional investors. As noted in this clip from Press TV, institutional real estate investors are snapping up German real estate and driving up prices and rents. The underlying momentum for the creation of a real estate bubble is now established. However, we can't simply look at real estate prices in isolation as purely a monetary phenomenon without acknowledging the structural flaws at work within the eurozone. For starters, because it is a monetary union only, trade imbalances within the eurozone will persist. Since Germany has maintained a persistent trade surplus within the eurozone, Germans have strengthened their household income, employment, and the overall economy at the expense of weaker eurozone neighbors. Currencies in a "free exchange rate" regime normally offset these imbalances by adjusting until trade approaches balance. However, Germany has entered a fixed exchange-rate system within the euro zone and, as such, it works to Germany's advantage by preventing its trading partners from revaluing or devaluing their currencies.

This faulty structure has led the eurozone straight into crisis. Germany is now left with two choices: First, the country can unwind the euro and go back to the deutschmark. This would force the value of the deutschmark to rise relative to the remaining euro area currencies and correct the imbalances - thereby reducing exports, employment, and income. When employment and income decline, what do you think happens to the housing market? Hold that thought.

Second, and more likely, Germany and the EU will forge ahead with some form of fiscal union. Some think that there is already a covert fiscal union as the ECB is buying sovereign bonds of select peripheral nations. As such, it is the mechanism to engage in transfers from the stable, northern eurozone economies to the weaker, peripheral nations which, in effect, is somewhat similar to what would happen in a formal fiscal union. By way of example, the United States was born with a monetary union, fiscal union, and political union. As such, people in Wisconsin regularly fund people in Illinois. Also, people in Utah regularly fund people in Colorado. And so on. This occurs through nationalized programs such as welfare and housing in which money is taxed from all tax-paying citizens nationally and redistributed in wide variety of ways that differ from natural geographic boundaries of states.

Likewise, in whatever form a fiscal union takes, if money goes from country A (Germany) to country B (say, Spain), then it is a fiscal union. The only issue is how efficient or dysfunctional it is. In any event, to the degree there is a fiscal union (or quasi-fiscal union), then the Germany economy will be harmed on the margin - meaning that the country will face less income and less employment than it otherwise might.

And when employment and income decline, what do you think happens to the housing market? Deja vu!

Now, in all fairness, Germany does have a more flexible real estate market than many other European economies, so creating additional supply is much easier in Germany than it is in, say, the UK. Yet prices are escalating despite this flexibility. All things considered, does it now make a little more sense why the EU just wants to kick the can down the road?

My personal view: This won't end well.

Disclaimer: Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.