Just a few months ago, 2007 looked like it could be one of the best years ever for German real estate. Big deals were as popular as mugs in a beer garden — roughly $36 billion in sales in the first half of the year. But in July, the foam stopped flying, as the depressing chords of America's subprime mortgage blues began to drown out the jolly oompah of an improving German economy.

Foreign investors, who bought 75% of everything sold before July, have been particularly hard hit by the global trend toward tighter credit, says Hendrik Broeker, national director of corporate finance for Jones Lang LaSalle in Germany. “Most of those players were very much leverage-driven.”

German market-watchers are focused on the effects of the credit crunch, trying to determine how much subprime paper German banks hold. The extent of the banks' exposure, much of which is reportedly off-balance-sheet, may not be known for some time.

“I believe that it will take until the end of the first quarter next year when all banks have then published their audited annual reports,” says Broeker.

Even before the crisis broke, sales may have hit their peak. The rich yields Germany enjoyed in the past few years, roughly 100 basis points higher than yields in France and the United Kingdom, were being whittled down to a less attractive 4.4% for office and 4.5% for shopping centers, reports Jones Lang LaSalle.

At the same time, a shift in interest rates upward by 60-70 basis points over the year began to reduce demand. Leveraged buyers no longer had a positive yield compared with the 10-year swap rates they enjoyed in the previous years.

Since July, tighter lending has further discouraged buying. Requirements have gone up, Broeker says, with no more 90% to 95% loan-to-value ratios available. Concern about bank risks have also pushed interbank lending rates up, making large deals out of the question. There's almost no funding for loans larger than €500 million or €600 million, he says.

For the moment, Broeker expects leverage-fueled private equity funds will be replaced by folks with big checkbooks, including large Middle East investors and wealthy families.

Frugality attracts buyers

To many cash buyers, the German market is still attractive. It is poised for growth, driven by increasing rents and declining vacancies, the kind absent between 2005 and 2007, says Thomas Beyerle, director of research and strategy for DEGI, a major German real estate investment firm.

The frugal German consumer may suddenly seem more appealing now. Joe Sixpack's German cousin, Otto Normalverbraucher, doesn't spend or borrow money. He doesn't carry much debt because, by law, credit cards must be paid off at the end of the month. He may not even have a mortgage. In short, Otto exhibits attractive traits in a world awash in bad debt.

“They are renters, not people who borrow money,” says Michael Topham, executive vice president with Hines, who is based in Europe. The developer is building a shopping center in Berlin near a new center that opened to record crowds last month, perhaps indicating that retail sales in Germany will be less negatively affected than in other countries, he says.

Some observers believe investors have already factored continued economic growth into current prices. “The problem is that German yields more than discount that upside,” says Paul Kennedy, director of European research for Invesco Real Estate in London.

“So even though we have a strong outlook for the German economy, we believe that you are paying quite a high price for that upside when you enter the market.”

Expect smaller deals

Even if growth continues, some market features may change. The massive multi-billion-dollar portfolios assembled by major private equity players such as Cerberus and Terra Firma, for instance, are likely to go by the wayside. “There is really no market for these €500 million to €2 billion portfolios,” says Beyerle.

Financing limits and market demand will dictate smaller, focused deals. Massive portfolios with a pan-German story, created in part to sell property to foreign investors, will be replaced by smaller portfolios with local stories, Beyerle predicts.

Bennett Voyles is a veteran commercial real estate reporter and National Real Estate Investor's Paris correspondent. For questions or comments, e-mail benvoyles@yahoo.com.