Inflation Bites: Action vs. Acceptance

Image: Consumer prices in Germany broken out by sector, from Destatis

When I woke up this morning, it really hit me for the first time: we aren't in total control of our expenses. I kind of freaked.

Electricity

In the past month, we've been hit with two disturbing price increases. First, we were hit with a price increase for our electricity. It's gone from 31.345 cents/kWh to 39.827 cents/kWh, which is a 27% jump. It would be even worse if we changed contracts, since existing customers get slightly better deals than new customers, so there's nowhere to run.

Right now, we're trying to get our electricity use under control; shorter more precise showers, bulk food prep, and turning electronics off and unplugging them are some of the steps we're taking. So far, it's only made a slight difference.

I've considered buying more efficient electronics (a new stove or refrigerator), but would these new objects actually pay for themselves fast enough to be worth it? I doubt it.

Rent

Even worse, our rent was raised by 17%. Back when we signed our lease, we agreed to have our rent tied to the Verbraucherpreisindex (the German consumer price index). The landlord explained this to us, and I even remember him telling us, but I didn't totally understand what it meant because, well, not understanding everything you're hearing is just part of the immigrant experience¹.

However, I didn't really understand what I was signing. I feel both like an idiot and like I'm sitting on a time bomb. If inflation continues rising in Germany, we could not only be priced out of our existing apartment, but we could be priced out of our neighborhood entirely, forcing us to downsize our living space and move much further from my employer.

German housing sucks right now. I looked around the city to see what prices are like for buying apartments and houses, and it's all bad news. From an American perspective, houses are laughably small and are often comparable to apartments in terms of actual living space. However, they are still expensive and often situated away from good public transport.

Apartments are probably a better option, but they come with mandatory building expenses and neighbors. To be fair, both apartments and houses are often joined to a neighbor's structure, and although I'd like to have some real privacy, privacy is out of our budget.

Let's not forget that mortgages have also gotten more expensive, so previously affordable mortgages are now priced out. Naturally, my German savings account still pays me nothing.

Running the Numbers

As I mentioned in a previous article, you take a huge loss up front when you buy property here. If we saved up €50,000 for a down payment on a place, it's likely that most of that would just go to the Grundsteuer, the Makler, the registration costs and so on. It's a pure loss up front, and it's the kind of thing that leads to sunk cost fallacies: no matter how much I'd want to make a life change, I'd always have this huge expense in the back of my mind.

So I'm trying to look at the numbers rationally and chill out. The rent increase is about 112 EUR. Divide €50,000 by €112, and that's 446 months or 36.16 years. So does it make sense to spend €50,000 to save myself from 36 years of this rent increase?

No, damn it, it doesn't make sense².

Remodeling as Further Disincentive

Another number to consider: if we moved, we'd likely have to remodel in some fashion. German houses and apartments often come without floors, for example, or toilets or kitchens. All of that costs money. So let's say we moved and remodeled, and it cost us €20,000 on top of the €50k we already spent on taxes and fees. That another 178.57 months of this rent increase or just under 15 years.

The risk, of course, is that this isn't the only rent increase. The German CPI jumped by 17% year over year in May, so let's extrapolate into the future. If rent increased again by 17% from our new level, that would be a €129.61 increase. Combined with the previous raise that's a €242 additional payment. So €70,000/242 = 289 months or 24 years. So would it make sense to save and then spend €70,000 up front in order to spare myself 24 years of a worst case scenario rent increase?

I don't think so. But now I'm less certain. And if it happened for a third and fourth year in a row, the numbers start to get worrying very fast. I have to remind myself however, that even if we owned a place, a world in which prices are rising by 17% every year is a world where we're still on the hook to buy things that are increasing 17% every year. If a water heater breaks or if the roof needs repairs or whatever, that would be on us.

I don't have a good answer, and I think I'll have to live with that. My hope is that our incomes will also rise to meet this new challenge, but I can't guarantee it.

Accepting a Loss of Control

Image: various price changes from Destatis

I'm not happy with it, but I have to live with being out of control to some extent. Otherwise I'll drive myself crazy. We do have control over some things, such as our groceries, which have also gone up in price. In that realm, we still have some maneuverability, so we'll have to do what we can there to feel like we have some power.

Hopefully, this doesn't go on forever. And hopefully, I won't be writing a similar article a year from now, chastising myself for not seeing the signs of impending doom via inflation and taking decision action. I'm not sure what action is best besides trying to earn more and spend less.

I'm sure you're feeling some pain from inflation. This is a difficult period for everyone. Just make sure you look at the numbers before taking some kind of drastic action to save yourself from it. It might not be worth it.

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1. This is a relatively new method for German landlords to extract higher rents since the default method is for rent increases to be determined by the city. ↩︎

2. I would like to own property one day, but the upfront costs continue to dissuade me from going too far down this path. ↩︎

Why This Expat Isn't Buying German Real Estate

As I recently mentioned, I just took out a loan to buy stocks. Right now, interest rates are temptingly low, and while the U.S. market overall is expensive, there are still undervalued companies there and elsewhere that can overcome the loan's interest rate cost.

My impression is that few people do this. Stocks are risky, and those who lever up can flame out hard. Stocks, in addition to being volatile, are nearly always available to be traded. I could get drunk, get scared at falling prices on my iPhone, and close every position in my portfolio at a giant loss with six or seven taps. Applying leverage to that is risky, no doubt, and buying stocks on leverage attracts a certain amount of skepticism and disdain.

Real estate leverage attracts much less scrutiny.

Stating the obvious, the high price of a single real estate unit usually requires a buyer to finance the purchase through a mortgage or other lending structure. That's naturally as true in Germany as in the US. And that leverage means, theoretically, that you can turn your down payment into a much more potent force, where you can reap the levered gains from rent and from the price appreciation.

For those who do this, it's possible that rental income more than covers the monthly cost of the mortgage. Indeed, one of the oft-repeated strikes against renting is, "You're paying someone else's mortgage." For a landlord who accomplishes this repeatedly, they can create an empire of rental units paying off his or her debts all while accumulating value through appreciation.

It sounds like a dream.

Expensive

In Germany however, it looks much less dream-like. To be fair, there are serious real estate investors here. I know two of them personally, and their wealth is absolutely real. But recently, both have said the same thing: everything's too expensive.

For all the complaints about costs in the US, German real estate feels increasingly out of reach. Yes, if you live in the hot American cities, purchasing real estate can be nigh impossible. But even in the not-so-hot German cities, buying an apartment can be a ludicrous amount of money for what you get.

Prices in many cases have outstripped the possible rental income you can get from the property. I sometimes see properties listed with a renter in place. That means the rental income starts immediately without having to go through the hassle of finding a tenant and doing all the necessary background checks.

But if you do the math it stops seeming so nice. I've gone through the listings and priced out mortgages for given down payments to see what kind of cash flow can come from these properties, and it doesn't work. In general, the down payment would have to be enormous for the property to have positive cash flow from the rental income. But having an enormous down payment cancels out the benefits from the low interest rates in the first place.

Tenant Protections

For an American, you might ask, "Why not just raise rents?" But we're not in Kansas anymore, and there are legal and cultural realities you have to adapt to. In general, German renter protections are much higher. And, as a renter, they're great.

Leases are continuous, and the renter can leave at any point if they notify the landlord 90 days in advance. So there's no new lease signing event to hike rents. Instead, there are prescribed rules about when and by how much a landlord can raise rent on an existing tenant, and it's biased in favor of the tenant. For the ambitious landlord, there are ways to force it, such as by doing a large Modernisierung of the unit where it's materially nicer and more energy efficient and therefore deserving of higher rents. But that's yet another cost, and do you really want to spend your time doing that?

Dealing with tenants, by all accounts, is hard in Germany. One of my landlord friends says that you basically can't raise rents once a tenant is in place. Kicking tenants out who don't pay rent is, by all accounts, difficult and lengthy. In addition, tenants are allowed to lower their rent payments for cause, such as loud construction nearby. German renters have non-profit organizations that can go to fight for them for nominal membership fees.

High Taxes and Fees

If you're versed in basic investing wisdom, you know that keeping fees low is a primary requirement of the wise investment. But for the German real estate investor, taxes and fees are deadly. When you buy an Immobilien in Germany, you pay a series of up-front fees that are an immediate loss.

If you visit a site like ImmobilienScout24, they list fee estimates for a given property. For example, the estimated fees for an apartment in Stuttgart is around 10-11%. That includes the following:

• Maklerprovision (3.57%, broker fee, and the one fee that can be avoided)
• Grunderwerbsteuer (5%, property transfer tax)
• Notarkosten (1.5%, lawyer fees)
• Grundbucheintrag (.5%, registration fee)

So in my Stuttgart example, according to Sparkasse's calculator, we get an estimate of €50,350 in Nebenkosten.

Here's an actual example in Stuttgart from a 56m² (about 603 sq. ft) Maisonette apartment with slanted walls with a property price of €298,000 where the Nebenkosten add up to €27,952, which equals a total cost of €325,952. And that's with a slightly lower Maklerprovision.

To be sure, the fees vary depending on location. The Maklerprovision and the relevant taxes depend on the local government rules. But they're all high, and the fees are purchase price dependent. The Maklerprovision gets a lot of hate despite it being the one fee that is sometimes avoidable, but the Grunderwerbsteuer by itself will bite you hard. With property values at high levels, you're getting hit twice: you're at higher risk of a fall in property values, and you're hit by the upfront fees attached to that price¹.

You're also guaranteeing yourself high opportunity cost. You'll have to save up those fees since banks generally won't finance them for you. To save up, you'll likely stick the money in a savings account earning nothing, and it might take years. You have to ask yourself if the lost potential gains in the stock market are worth it. If it takes you two years, those are two years of compounding you never get back. And when you eventually buy, your down payment might go entirely to the fees and not towards the property, leaving you financing 100% of the property value.

Those fees mean that there's never a guarantee that you earn any money from the purchase. It's an immediate hit of ~6-12% up front of the levered cost, and if you're compelled to sell for any reason before compounding has overcome that hurdle, then it's a shocking loss of potentially more than your entire down payment. That's the two-edged sword of leverage.

At the very least, it means that you'd better be damned sure that this is the best use of your money or that you have some special insight or strategy that makes those costs worth it. And you'd better be able to hold on.

Property Tax

There is property tax (Grundsteuer) here in Germany, but trying to estimate it in advance is hard. Just know this: you will have ongoing property taxes. They are not particularly onerous, which is one advantage compared to the US.

What I've divined from the online literature is this: the tax varies based on the type of dwelling and depends on an official value assessment (Einheitswert) by the state (Bundesland) you're in. This number is much lower than the purchase price and gets adjusted every six years. That number is multiplied by a small percentage (Steuermesszahl). This value is then multiplied by several hundred percent (Hebesatz) - depending on the state - to equal your yearly tax. Clear?

Expat Issues

I haven't even talked about the potential challenges of being a U.S. expat doing this. For one example, Robert Kiyosaki likes to extol the virtues of not owning anything yourself to protect yourself from liability issues and lawsuits. That would likely mean putting your properties into a corporation or other such entity. But you, the American expat, have to consider the implications back in the States and what the IRS will make of your German arrangements. Controlled foreign corporations require extra compliance and paperwork.

There's also the rule that the IRS can declare that you have capital income from your mortgage if the exchange rate changes in your favor.

Lastly, there are the normal challenges of being a real estate investor that exist everywhere. All the stuff listed above is layered on top of that already substantial levered risk burden.

High Prices, Lots of Rules, High Fees, the IRS... What's Not to Like?

If you're excited by real estate, and other options won't do, then more power to you. There are likely unexplored riches because the hurdles are so high, and there are likely strategies that can work for those geniuses who recognize and execute on them. If you're actually receiving cash from your purchase in excess of your outflows, it dulls - but doesn't eliminate - the impact of the up front fees, especially compared to owning a home as a residence.

But at this moment, I can type some numbers into my computer, get an appropriately-sized loan relative to my income, buy a diversified basket of stocks, and go on with my life. If that sounds irresponsible to you, you have to ask if losing potentially tens or hundreds of thousands of euros up front guaranteed for a likely overpriced asset to service tenants whom you can't kick out sounds responsible.

Maybe neither sounds responsible, and that, at least, would be consistent. But I want to use low interest rates to my advantage, and although I'm attracted to real estate, I look at the reality of it and am turned off in comparison to other options.

Does that mean never for this oft confused expat? Of course not. I've moderated my opinions often, even after writing negative articles. Buying stuff is fun, and property captures my imagination. I know all this because I regularly stare at property listings, after all. But there's a lot of friction in buying real estate, and I assume that I'd bail before putting my name on the dotted line.

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1. In comparison to the US, Bank of America estimates the closing costs for a $500,000 property in Charlotte, NC with a 5% down payment at $12,921. In New York City, it'd be $21,547.↩︎