Investments at secondary locations promise stability and returns. However, the narrowness of the market is often a problem.

Germany’s most famous real estate locations have disappointed investors in the past: office rents decreased, values fell, and leasing was often extremely difficult. Thus, investors and developers focused their attention more on cities in the second tier – so-called class B locations. The term creates the impression that the location is of less quality. This is deceiving: the markets in class B locations are smaller than those in the most important cities, but they are not worse and even have qualities that class A cities do not have: they offer more stability and often higher returns.

No Clearly Defined Boundaries
Which locations are class A or class B locations often depends on the eye of the beholder. Global companies naturally tend to keep their class A category relatively small. For office space, this is limited to Berlin, Düsseldorf, Frankfurt am Main, Hamburg and Munich. That category is larger for market players more strongly focused on Germany; they include at least Cologne and Stuttgart as well. As for the boundary between class A and class B markets there are neither binding quantitative values nor qualitative criteria.

Investment or leasing sales, top rents or available space is a possibility here – or a combination of all of these. One thing is clear: there is no correlation between the number of a city’s residents and their designation into one or the other category: the undisputed class A city Düsseldorf, Germany is ranked ninth, and the cities Cologne and Stuttgart, which are sometimes categorized as class A and sometimes as class B cities, the number of residents puts them at fourth and eighth place, respectively. The sixth and seventh-largest cities, Dortmund and Essen, are unanimously ranked in the class B category.

The evaluation of various market segments is even more complicated: a city can be in several different categories for its office, retail, residential and commercial segments. The most comprehensive definitions have been developed by BulwienGesa AG in their regional information system RIWIS. The table “Class A and B in Rotation” shows that if RIWIS ranks a particular market in a city as class A, then other submarkets can get another A or also a B – see Dresden, Essen and Leipzig. Or, a class B city for office and residential space is not even represented in the retail category – see Magdeburg and Mainz.

More Balanced and Stable
What attracts real estate players to class B cities? The first reason sounds paradoxical: They come here because their colleagues avoided these locations in earlier years. In boom times, the industry concentrated on the big markets. This was particularly true for developers – and the market took vengeance in a subsequent downturn: while demand fell, supply grew rapidly. Class A locations were characterized by extremely negative values, for example, Frankfurt am Main with an office vacancy rate of 17 percent.

A psychiatrist would say that at class A locations, the markets tend to shift between a manic and depressive mood. The class B character is, on the other hand, much more stable. Even in good times, only pre-leased buildings are built, and there are hardly any speculative developments. Thus, such cities have vacancy rates of up to just five percent, even in times of crisis – at least in Western Germany. In Eastern Germany they are still suffering from delayed consequences of the depreciation mania of the 1990’s.

Higher Returns
Higher stability and more balance in the market is one reason for the tendency towards class B locations. Another reason is the good returns, as Claudius A. Meyer, Director for Corporate Finance at Ernst & Young Real Estate GmbH explains. “At class B locations there is a deficit in real estate buyers. That means, in the past years and even today, the purchase prices in relation to obtainable rents are clearly lower.” Ernst & Young empirically researched this phenomenon in a long-term study from 1986 to 1999. “Within this time period, office properties brought in returns of more than seven percent in class B cities. In class A cities, this figure only reached 5.5 percent,” summarizes Claudius A. Meyer. And because in the following crisis years the rents did not crash significantly, the return advantage continued to increase for property owners.

Since 2003, the conditions in class A and class B cities have become more alike for new investors. In Germany’s class A markets, the demand weakness put pressure on the prices; the returns for pure office buildings of the highest quality increased from an average of five to roughly six percent. At class B locations, stronger buyer interest pushed the prices up so that earlier returns of eight percent in prime locations were no longer attainable for buyers.

Sources: BulwienGesa AG, Federal Statistical Office Germany

The Flipside of the Coin
However, there were differences, and they will indeed remain. The causes for these differences are the specific disadvantages of the class B locations: their markets are smaller and less transparent. The small size led to very few options for those willing to invest. Properties that are appropriate for open and closed funds are particularly scarce, especially safe and low maintenance real estate with one renter with good credit. And, if something like this is found at a class B location, there is a special risk that comes with it: if this ideal renter moves out, there will hardly be an appropriate successor. The property that was considered particularly profitable today risks drastically dropping in value tomorrow.

If a good property is found, the negative flipside of the high stability of class B locations appears in the long term. Here, the growth dynamics and growth potential is usually lower than in economic centres with strong international integration that significantly profit from globalization. Thus, a strong increase in property value is unlikely until it is sold. Besides that, the small market size reveals its special disadvantage in this situation. Often no one is willing to buy, and only seldom can the transferor push the price up per bidder competition.

Low Transparency
Another deficit of a narrow market is its low transparency. In class A locations, prices are made in a number of transactions and less influenced by single deals. Here, international and regional agents and consulting companies are active and compete with market reports for the attention of the players. In class B locations, on the other hand, it is possible for only a few business deals to influence an entire market – and possibly to skew it. Furthermore, there is less information flow. Often, only one single office market report exists, which was created or commissioned by the local business promoters, who would rather not highlight the possible downsides of the location. In smaller class B cities, there is often not even this type of expertise. A narrow market is often a reason enough for investors to go back to class A cities after taking a quick look at the class B markets.

No Clear Recommendation
Market observers, such as Professor Matthias Thomas, Managing Partner of Deutsche Immobilien-Datenbank, are abstaining from a clear recommendation towards class A or class B locations, and are focusing on the characteristics of both city types. The advantage of class B locations, according to Matthias Thomas, is the “slightly higher returns.” On the other hand, the larger cities have a “higher market transparency, an international buyer clientele, lower pre-sales period, and high volume of real estate.”

In more positive terms, the various characteristics in class A and class B locations have one key amenity for investors: they can combine the best of both worlds into their portfolios.