Real Estates -
important benchmark data of 1998

 

Catchwords of this article

The right property for your needs
Never buy only because of tax advantages
Take bargains below market value
Include additional costs of the purchase into the calculation
Time’s trend: attractive apartment buildings
Without one’s own funds (almost) nothing is possible
Really win by partitioning
Forecast of the market

 

The right property for your needs

It is not much being talked about that an investment into a real property is one of the securest investments of our time. But only as long as two factors apply:

  1. The long-term profitability of the property is confirmed
  2. The relation of the sales price compared to the rental income results in a proper yield

Looking at the current real estate market in Germany (January 1998) one will notice that by far not everything that is being offered on the market is a secure investment.

Example:

A recent inspection of several properties in the new federal states showed that e.g. the m² price of a studio apartment was 2.900 DM. That apartment did not even render an actual view outside the window; one of the existing windows led to the light well and the other one merely rendered a view onto a dull wall! The apartment was rented out, however the person renting was an elderly, very sick woman – paying a m² rent of about 11,30 DM!

 

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Never buy only because of tax advantages

Of course the chief attraction was that the buyer was still able to save some taxes before the end of the year (special depreciation); but the buyer wisely reserved a right to cancel until he has seen the property and went to see the property based on an expert’s advice. If he would have bought it without seeing it then there would have been a rude awakening sooner or later – and the saved taxes would backfire very quickly.

So what do the two mentioned prerequisites to buying a property mean? Well, on one hand the apartment, the house or the commercial space needs to be on such an attractive location that it can be rented out on a long term.

These are in general easy-to-reach, central locations with public transport nearby and a constant demand potential. Here we have the oldest of all real estate rules again: location, location, location.

The second point says that the relation sales price to rental income should result in a proper yield. But what does “proper” mean in this case?

For freehold flats within the realm of old buildings, a yield of about 5% should be attainable. That means that the sales price should not be higher than 20X of the annual net rent. But there are exceptions: sometimes the current rental income is clearly below the average of the market and can either be raised bit by bit or in one go when the tenant changes. Here of course one has the possibility to acquire such a property for a price which is below the current market price for an average flat – meaning a so-called bargain.

 

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Take bargains below the market value

But also the other situation can be given: the rent lies quite a bit above the current market level – this can lead to a rude awakening in case one changes tenant. For then the rent now attainable is so much lower that it hurts.

So the rule of thumb can look like this:

The usual net monthly market-rent (without added costs) multiplied by 12 multiplied by 20 minus the appropriate deductions on long-term rental contracts with low rents= the sales price. Bear in mind: do never take a too high rent as a determination base for the sales price.

 

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Include additional costs
of the purchase into the calculation

If one is really ready to negotiate then one should even include the added costs of the purchase into the formula for the sales price. This includes the property acquisition tax (3,5%), the notary and the court (about 2%), financing costs (1-2%) as well as the agent as applicable (3-6%). Altogether one easily gets 10% of added costs, which of course lessen the yield of a property. So in order to get the needed margin of a 5% the above formula actually should be:

Annual net rent multiplied by 20 = sales price including the added costs.

Of course this cannot always be attained, but it is definitely worth to negotiate.

If you don’t have the needed market knowledge in order to judge these factors yourself then you should get advice from a specialist who traces the real estate market year after year and knows the trend and developments at the different locations. He will be able to advise you in taking a decision.

The trend of the coming years:

Residential buildings as a second pension plan.

We want to point out another peculiarity of the market of 1998 in this information letter. While the classical rented out freehold flat remains the ideal investment property for the “average earner”, the trend for higher income levels is more and more going towards acquiring one or two residential buildings which practically write off their own debts themselves. Such properties are also called apartment buildings (in German: “Zinshaus” or “Rentenhaus”).

 

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 Time’s trend:
attractive apartment buildings

Of course acquiring such a property depends on the income of the customer, i.e. of his creditworthiness as the bankers call it. This simply means that the customer, in the eyes of the bank, is “good” for such a purchase. For it makes a large difference to the monthly interest charge whether he purchases a freehold flat at a price of 100.000 up to 300.000 DM and finances it with a credit, or whether he buys a whole house for a price ranging between one and several millions DM. After all a credit above 1,5 million DM “costs” 7.500,- DM per month, at an interest rate of 5% and an amortization of 1% per month; the rental income from the property should be accordingly high. If the property holds 14 apartments for instance then an average net rent of 535,- DM per apartment needs to be attainable.

The taxable annual income should thus be accordingly high in order to be able to cover a vacation of two or three apartments for several months if needed. We can put as a basis a minimum income of 150.000,- DM per year – of course no limits are set to how high it can go.

 

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Without one’s own funds
(almost) nothing is possible

Additionally to the income solvency of the customer also the existing own funds play a role when doing such a purchase. Financing a freehold flat is also possible with no own funds sometimes or can be done with an existing life insurance or a building loan contract.

However the criteria for buying an apartment building are usually different:

The bank evaluates the property based on the so-called lowest value principle, meaning the lowest valuation rate. To give an example of this: one expert opinion on a 14-apartment building brought about an asset value of 1,9 million DM, but a capitalized earning power of only 1,3 million DM. The asset value is the value which the property has based on its size, building structure, location, land size, age, condition, etc. The capitalized earning power, in the case of multiple dwellings, usually is that value which comes about when the annual net rent is multiplied with the factor 12 up to 15 – depending on the location of the property. Since even well-kept and, in terms of the building structure, immaculate buildings often do not even bring in the rent according to the market due to old and long-term rental contracts, there will often be such a grand difference.

Now it is within the discretion of the financing bank how it evaluates the property and the customer in regards to the amount of the loan to finance the property. Based on the lowest value principle it would finance 90% of 1,3 million DM in case of the above property, meaning 1,170 million DM. So in case of a contractually agreed upon sales price of 1,5 million DM (as in case of this property) the customer would need to pay 330.000 DM plus the added costs (about 80.000 DM without the agency fee) out of his own pocket. But whether he has such a grand reserve fund at all is questionable in most cases.

If the bank evaluates based on an average between the capitalized earning power and the asset value then it would come to a sum of 1,6 million DM. The financing sum in case of 90% financing would then be 1,440 million DM; then shareholder’s equity remains 60.000 DM plus added costs (around 80.000 DM).

Of course it becomes really suspenseful if a 100% financing is supposed to get done including the added costs or – even better – is also supposed to include a renovation or modernization. But these are financings of the fine art which need to be prepared by an expert hand.

But why is buying an entire residential building worthy doing compared to buying several freehold flats? Very simple: such a house can be partitioned into single freehold flats as needed.

The chief attraction is:

While the evaluation of the capitalized earning power of a house from side of the bank is being done by the factor 12- to 15X of the annual net rent, the evaluation of a freehold flat is practically always done based on the (usually higher) asset value. This means that when selling the property later on a tremendous gain can be gotten – tax free (currently after at least two years, in which one must have owned the property).

In case of the above example the house, partitioned into single flats, could be sold for 1,8 up to 1,9 million DM already today, at the time of the purchase – so an immediate gain of at least 300.000 DM! if one deducts the added costs of about 80.000 DM one still has a tax-free gain of 220.000 DM – elsewhere this money would take some time being earned after taxes, wouldn’t it?

 

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Really win by partitioning

Aside from this attractive resell-possibility residential buildings also hold another advantage: they are a secure reserve fund for one’s pension. If one buys a property at the age of e.g. 35 or 40 years then this house can “finance itself” in the next 25-30 years. Interest and amortization are getting financed by the rental income and by regular rental adjustments, so that one basically doesn’t need to pay anything on top except for the originally invested own funds. In case of the mentioned property the rent, in case of an annual increase of 2%, would be 165.000 DM in 30 years – a considerable sum against which the pension paid by the state would look like alms.

And: in case of a high income also the tax advantage is to be considered. For it can easily sum up to the needed added costs for the purchase, meaning that one actually can get such a house practically for “free admission”!

If is needless to say that the location also (and especially) plays a vital role in case of purchasing a residential building. But it is interesting that especially in large cities one finds tremendous bargains in this category, and when we tell you now that the gross price of the above example (including the added costs) is only 1.600 DM per m² of living space then you will really start pricking your ears. For at an average rent of 9 DM per m² of living space one gets a yield of 6,75% before taxes! The rent adjustments of the next years and decades could even easily let the yields go above 10%.

With a financing of 6% including amortization one quickly realizes that as an investor one even attains a gain of 0,75% annually. This surplus should then be invested into the maintenance of the building or be used as a set aside for possible vacancies.

 

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Forecast of the market

The year 1998 is being evaluated as the last year of the real bargains. Not only because the interest rates have remained quite low; also the real estate prices are still sitting at a low level – but have become ready to take off. It remains to be seen if the coming year 1999 will hold such chances again; but what is certain is that the introduction of the euro causes more and more people to attain asset values – meaning rented out residential spaces with a high value appreciation on a long term.

 

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Important note: Any evaluations, advices and indications on our information and internet pages are mostly subjective evaluations and solely have the purpose of giving real estate investors a general orientation. They make no claim to be complete, right or constantly valid. Most real estate information is founded on conditions or legal regulations (taxes, regulations about apartment ownership, tenant’s rights and more) which might have been current or of interest for real estate buyers at the time the text was written. These conditions and legal foundations – especially also fiscal aspects – possibly have changed by now. Thus we recommend, before one does any property purchase, to get the current data on the real estate markets, tax- and other legal regulations and innovations, as far as these could be of importance to the objective and subjective success of the investment.