The year 2022 has been extremely difficult for many developers,” marked by great uncertainty and investor buying restraint, says Pepijn Morshuis, CEO of residential and commercial property developer Trei Real Estate. Unfortunately, the prospects for 2023 look little better.

As Union Investment Real Estate CEO Michael Bütter highlighted in a speech at the Handelsblatt Annual Conference 2022, the development market is at a turning point. Already rising construction costs are being forced higher by soaring material and energy prices, supply chain disruptions and a growing skills shortage. Interest rates have shot up to combat inflation. And tighter sustainability and construction requirements are upping the pressure on developments.

Land prices and municipal restrictions are causing developers to shift to the suburbs.

The demand picture is adding to the challenges. UK office occupancy rates, at 30 percent, are half pre-pandemic levels. Retail, already wrestling with online competition, has been hit by Covid and the cost of living crisis. And with increased finance costs and living expenses making homeownership unaffordable for many households, whole groups of buyers are leaving the apartment market, observed a recent BF.direct note.

Geopolitics is a further factor, especially in the residential sector. “In some markets where governments are more active and introducing rent controls, development becomes much tougher,” notes Paddy Allen, Head of Operational Capital Markets, Colliers. “In others where governments provide support with land supply or financing, development can be encouraged.”

The risk-reward ratio has fundamentally changed, says Bent Mühlena, Head of Project Management at Union Investment, with fewer speculative developments likely to be implemented in particular: “Future forward deals will likely require developers to prove they have sufficient financial resources or equity cover, or have otherwise made adequate provision to implement projects independently even in times of crisis.”

New build activity declining across the board

In Germany’s A-cities (Berlin, Hamburg, Cologne, Düsseldorf, Stuttgart, Frankfurt and Munich), project development volume fell 3.6 percent between 2021 and 2022, with residential construction – the biggest segment – tumbling 7.6 percent, according to analysis by consultant bulwiengesa.

A combination of high land prices and construction costs, interest rates four times higher than in January 2022, tough regulation and poor administrative processes are weighing on the industry, notes bulwiengesa Chief Representative Andreas Schulten. This is most apparent in the residential sector, where land prices and municipal restrictions are causing developers to shift to the suburbs. Offices are also struggling, with vacancy rates rising due to recessionary and other pressures, although rents on grade A offices are still trending upwards, he says.

Limited incentive at present for constructing new buildings

UK residential faces similar headwinds. “We are seeing significant challenges in making development projects viable, especially across lower rental tone markets as the cost of building outweighs the end development valuation,” says Colliers’ Allen. “Currently, in many situations there is limited incentive for developers to start projects unless they are taking a longer-term view i.e. building a platform, have access to cheaper financing or are working in partnership with public bodies.”

Trei is using its international reach to spread risk. The US has become a particular target in recent months, as rents there are rising even faster than costs and interest rates, says Morshuis. And while Western European markets are now saturated, Poland offers expansion opportunities for investors, he argues.

Future forward deals will likely require developers to prove they have sufficient financial resources or equity cover.

For Union Investment, portfolio deve­lop­ment – with its value-adding potential – remains a key focus. “For example, we have recently invested in our Intercon­tinental and Luc hotels in Berlin and the Steigenberger Hotel in Hamburg, extensively refurbishing them and making them marketable,” Mühlena notes. “We are also doing this in the commercial sector, as with the K7 project in Wiesbaden, where a new building was added for the tenant, credit reference agency Schufa.”

Ingredients for future developer success

One feature all projects must now share is an onus on sustainability. Buildings and construction account for almost 40 percent of energy-related CO2 emissions according to the World Green Building Council. Decarbonising the built environment will require new buildings, infrastructure and renovations to have net zero embodied carbon by 2050, with all buildings, including existing ones, operating at net zero carbon.

For institutional investors and tenants, sustainability aspects are increasingly important, making competence in sustainable new construction essential for developers, says Morshuis. “Residential properties that are not ESG-compliant, for example, will soon no longer be saleable to institutional investors, as these in turn are subject to strict ESG regulations.” Trei uses CO2-friendly building materials such as wood and modular construction methods in its projects, with its new residential buildings in Germany each meeting the highest possible KfW energy efficiency standard.

Competence in sustainable new construction is essential for developers.

Office demand is likewise skewing towards buildings with high sustainability standards. Recent European analysis by advisor CBRE found office buildings with sustainability certifications command a 6 percent rental premium to non-certified stock. The premium is driven by a reduction in negative environmental impact, lower operational and maintenance costs, greater appeal to tenants, and increased occupant comfort, well-being and productivity.

Satisfying investors’ sustainability requirements is just one precondition project developers must meet though. Today’s heightened risks mean Union Investment increasingly demands high-quality building and location standards, with guarantees that construction is completed on time and budget, Bütter noted. Developer creditworthiness, to ensure investor protection against financial risk, is of growing importance too.

“We don’t expect the current market environment to ease in the short term, so developers who can react flexibly to changing circumstances and have a long-term rather than short-term focus are in demand,” concludes Morshuis.

By Paul Allen