Construction in Germany: What are the risks?
So, how can you make money on real estate in Europe? The most intuitive option is to rent it out to local residents, tourists or students for example. But now the analysts are talking about a new pan-European trend - a decrease in the profitability of the rental business (according to PwC's calculations, it fell from 6% in 2009 all the way to 4% in 2017).
In an effort to increase profitability, buyers are beginning to look closely in the direction of the value-added projects - mostly the construction and reconstruction of real estate abroad. The results of an analytical study by an international real estate broker Tranio shows that every tenth Russian-speaking real estate investor is interested in construction projects overseas.
Value-added projects bring investors 8–15% per annum, but they are considered the most risky among other types of investments. Ekaterina Raznikova, Tranio Senior Project Manager for Germany, explains how an investor may protect themselves when dealing with construction projects in the most stable European economy.
The essential risks of development projects are the same in all countries: banks may refuse to grant financial backing, public authorities my delay planning permissions, building materials rise in price, new properties are not selling as quickly as planned, etc. However, the investment climate in all countries varies and it is especially attractive in Germany. Setting aside this country from the rest is its economic power and stability, German GDP growth accelerated from 0.4% in 2013 to 4.2% in 2018, and unemployment during this period decreased from 5.8 to 3.4%.
Any legislation changes in Germany are announced in advance, the rights of investors are protected by law, and all processes relating to the purchase, maintenance and sale of real estate are strictly regulated. For the most part, Tranio customers that are interested in value-added projects and have an intended budget of €1 to 5 million consider building housing blocks for 10–20 apartments.
Why do we usually point our customers towards Germany? The simple fact is, most of the risks associated with the construction of residential buildings are levelled by the German law. Competent technical consultants, lawyers and taxation specialists can break down how to avoid all the other pitfalls that potential investors may come across.
Minimizing the risks!
1. Failure to obtain financing
First of all, not all German banks are willing to work with foreign customers when it comes to loans, (due to a number of additional procedures that complicate the preparation and execution of transactions for banks). Those banks that are willing to cooperate with foreign investors (Sparkasse, Volksbank, and others) may have adopted requirements that differ vastly from one organisation to another. Reasons for why banks may refuse to provide financing vary, but these are the most common:
- Lack of credit history in Germany (if the borrower is a newly formed GmbH (LLC), registered in Germany);
- An unknown team behind the project (the bank analyses the experience of its participants in the implementation of similar projects);
- Incomplete set of documents (if a company is implementing a development project which is registered through an investor, that person must obtain certain licenses to satisfy the law);
- Problems with compliance and KYC (Know Your Customer) procedures. In accordance with the law, banks do check all the data on legal entities, studying the legality of their business as a whole and the project for which the loan is being taken out.
Banks are aiming to combat money laundering among other things like the financing of terrorist activity and tax evasion. A potential borrower must provide documents confirming the sources of funds used for the project. In turn, a good consultant should advise their clients on all the potential issues.
2. Risk of failing to obtain a construction permit
The building process in Germany can get underway once the two main documents are obtained, a construction plan and a building permit (baugenehmigung). The urban development plan (bebauungsplan) contains all the information relating to the development of a land plot (the area, development density, types of objects available for construction, etc.). Most land is sold with an urban development plan!
A document is prepared by the architect to obtain a building permit based on the data specified in the urban plan. Gaining approval usually takes from three to six months (the larger the city, the longer it takes). It will take more time to obtain an urban construction plan, in case of its absence, in some cases the procedure may take several years. That is why the plots that lack an urban plan are sold much cheaper.
Nevertheless, the sites requiring a ‘bebauungsplan’, can yield higher profits. Arguably, such real estate transactions are in fact the most profitable. However, when making a choice, a client should understand that it would be rather difficult to define an exact time scale for the project. In order to provide the investor with additional guarantees, in some cases, we try to strike a deal with the site owner that the investor will pay the full amount only upon the receipt of the building permit.
3. Risks of overspending, delaying the due date
Frequent problems that real estate investors face are: going over the budget and suffering from a delay in construction end date. In Germany, the corresponding risks are reduced due to special regulations provided by the state. Thus, special laws govern how an architect generates the budget, as does the price for each stage of the work on a project. When compiling the estimated outlay, the architect relies on DIN 276, a document developed by the German Institute for Standardisation.
The development costs per square meter are recorded in an agreement between the investor and the developer for each specific property. In a document, parties will determine whom and in what volume will assume responsibility for unforeseen expenses. Practice shows that the investor does not always benefit from a complete refusal to incur any additional costs, since it is ultimately in their interest that the construction does not drag on.
The act of federal legislation of Germany (Honorarordnung für Architekten und Ingenieure, HOAI) details out nine stages for the architect to undergo, while also fixing the procedures and payment volume.
Let’s take a close look:
- The base estimation stage is 2% of the total cost of architect’s services: the architect should compare the wishes of a developer to the type of site and existing building norms and contact the local administration.
- The preliminary plan (7%): the architect prepares a sketch and a preliminary plan of the project, presents a budget.
- Design (15%): the architect develops the final draft of the project with all the necessary drawings and sketches.
- Obtaining the permits (3%): completion, coordination and approval of the plan, taking account of the requirements that must be met in order to obtain a building permit.
- Construction project (25%): the architect develops an implementation plan, prepares the technical documentation for contractors.
- Holding a construction tender (10%): the architect comes up with a list of tasks, describes their scope, and organises a tender.
- Participate in project delivery (4%): the architect evaluates the results of the tender, takes part in negotiations with contractors, and helps to procure building materials.
- Supervision (32%): the architect controls the process of construction and compliance with technical standards, draws up inspection reports, warranty documents.
- Development of documentation and elimination of deficiencies (2%): the architect prepares executive documentation and guarantees for the maintenance of the property.
The investor can always resort to the services of an independent expert who will check the adequacy of the calculations by the developer and how they correspond with the going market rates.
German law presumes that the developer or an insurance company will guarantee the maintenance of the building during the first five years or its use. Investor ceases to be responsible for the condition of the property immediately after the sale goes through. Responsibilities to eliminate any deficiencies are then assigned to the developer or a specialised insurance company.
4. Risk of unsold flats
Modern Germany is a seller’s market. Apartments and houses in major cities are usually sold within just a few weeks. According to the estimates from the Deutsche Bank, the current shortage of residential, individual apartments in Germany comes to about 1 million units. When it comes to the larger cities, prices have increased by 80% from 2009 to 2017, and by 50–60% for smaller geographical areas, such as towns.
Despite the fact that construction volumes are growing (in 2016, 280 thousand residential units were completed, in 2017 - 305 thousand), demand is still significantly ahead of supply. According to various estimates, Germany needs around 350 to 400 thousand new residential units to appear each year.
In order to minimise the risk of non-realisation of an object, the investor should focus on local buyers - Germans who buy apartments for themselves or as assets, so as not to keep money in banks which offer too low of an interest rate. Such buyers quickly decide on the acquisition of real estate since it is easier for them to get a loan (banks cover up to 90% of the value for 1–1.5% per annum).
Residents of large cities choose real estate located closer to the outskirts: there, a square meter is cheaper. For example, investors in Berlin that hope to land a local buyer should consider the districts of Pankow, Steglitz-Zehlendorf, Tempelhof-Schöneberg and Neukölln, in Munich - Schwabing, Perlach, Trudering.
5. Risk associated with a wrong choice by the developer
When thinking about choosing a developer, the investor should understand that the largest German developers, in principle, do not seek to attract investment. Availability of sufficient equity capital, cheap financing from the banks and a developed market of forward contracts mean they do not need to borrow capital.
As we consult our clients, Tranio offers to cooperate with proven local teams: they know their region well, have extensive experience working with local municipalities (which simplifies procedures to obtain permits, coordinate projects, etc.), are well-versed in the socio-demographic situation and can predict the demand for housing created in the local market, maintain links with brokers who can help with the implementation.
Tranio team works alongside both developers and investors on project completion throughout the whole development process. This includes aiding the developer in assessing the plot, offering it to the investors, guiding the purchase/sale process, helping to secure financial backing, takes charge of the documentation flow and the coordination process between project participants: developer, bank, lawyers, external technical experts and the broker that will end up marketing the property towards the end of the project.
Today, we are witnessing a construction boom in Germany and the builders are taking advantage of the situation as demand exceeds supply. They significantly inflate prices for their work, and it's only the local developers who can successfully find contractors whose involvement will be as economically feasible as possible.
Upon analysing the risks of a potential development project in Germany, an investor can be confident not only in the stability of the economic situation in the country, but also in the favourable investment climate guaranteed at the legislative level. Furthermore, project risks can be managed with the help of experienced local consultants and technical experts with a good reputation and act in a conservative and thoughtful fashion without promising heaps of gold.
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