The German housing market has been remarkably strong for decades, but it faces a serious downturn in prices over the next couple of years, according to analysts.

Mortgage rates have soared, with a 10-year fixed rate up from 1% to 3.9% since the start of the year, according to Interhyp data, which typically causes demand to cool as fewer people can afford to take out loans.

House prices have already declined around 5% since March, according to Deutsche Bank data, and they will drop between 20% and 25% in total from peak to trough, forecasts Jochen Moebert, a macroeconomic analyst at the German lender.

“If you think about mortgage rates of 3.5% or 4% then you need higher rental yields for investors and given that rents are relatively fixed, it’s clear prices have to fall,” Moebert said.

Rental income is a priority for German investors, with approximately 5 million people in Germany receiving revenue from renting, according to The Cologne Institute for Economic Research, and the country having the second-lowest share of homeowners of all the OECD countries, according to the Bundesbank.

While Deutsche Bank doesn’t have specific data for when the bottom will be reached, Moebert said he wouldn’t be surprised if it was over the next six months.

“We already saw the steepest price declines if you look month-over-month — this was in June and July … In August, September and October the price declines are already below 1% … So there is some positive momentum here if you look from an investor’s perspective.”

Holger Schmieding, chief economist at Berenberg, anticipates a house price decline of “at least 5% if not a bit more” in the next year.

“The housing market is softening significantly,” he said, citing a strong decrease in demand for loans and a drop in housing construction.

And while the language used may vary, many analysts are forecasting a dip in Germany’s housing market.

“We expected if there was no energy crisis, no recession, prices would increase further. Now we have a situation where we face a very dramatic adjustment of conditions,” Michael Voigtländer from The Cologne Institute for Economic Research told CNBC.

A recent UBS report went as far as to place two German cities — Frankfurt and Munich — in the top four of its Global Real Estate Bubble Index for 2022, as locations with “pronounced bubble characteristics.” 

UBS defines “bubble” qualities as a decoupling of housing prices from local incomes and rents and imbalances in the local economy, including excessive lending and construction activity. 

The definition doesn’t suit the German property market as a whole though, UBS Real Estate Strategist Thomas Veraguth told CNBC.

The situation in Germany is “not going to be a typical bubble burst as we experienced in the financial crisis … but rather it will be a correction,” Veraguth said.

“In real terms a bubble burst would be more than 15% decrease in prices and that would be a very, very bad scenario, a very strong, high risk scenario that is not the base case at the moment,” he added.

A Reuters poll of property market experts last month anticipated German house prices would fall by 3.5% next year.

A ‘vulnerable’ market

But not all financial institutions agree that Germany’s property market is set for a large fall in value.

“We do see a slowdown in the price growth for residential real estate but it’s not that the overall dynamic has reversed,” Bundesbank Vice President Claudia Buch said in an interview with CNBC’s Joumanna Bercetche last month.

“On balance, house prices are still rising, albeit at a slower pace,” Buch said. “That said, there are no signs of a severe slump in real estate prices or of overvaluations receding.”

The Bundesbank will continue to monitor the housing market closely because it is “vulnerable,” according to Buch.

Analysts at S&P Global have also rejected the idea of a “severe slump” in the market. In fact, the financial analytics company said the outlook is stronger than its most recent forecast, published in July.

“It’s likely we will have to revise up our price forecasts for Germany for this year,” Sylvain Broyer, EMEA chief economist at S&P Global Ratings, told CNBC.

“We still have very strong demand,” he said.

Broyer also said it will take time for a change in financial conditions and fiscal tightening to trickle down and affect the housing demand.

“More than 80% of mortgages in Germany are financed with fixed rates, so many households have locked [in] the very favourable financing conditions we had until very recently for five to 10 years,” he said.

The Association of German Pfandbrief Banks (VDP) uses information from more than 700 banks to produce its property price index, and data from the latest quarter shows prices were up by 6.1% compared to the previous quarter.

The organization anticipates we have already seen the peak in Germany property prices “for the time being” but the fundamentals of the market are still working well, according to VDP CEO Jens Tolckmitt.

The scarcity of housing, increasing rental prices and a strong labor market will continue to support the market, Tolckmitt said, and even if house prices dropped, it wouldn’t necessarily be a bad thing.

“If house prices reduced by 20%, which we do not expect at the moment, then we would be on the price level of 2020. Is this a problem? Maybe not,” Tolckmitt said.

“That was the price level we reached after 10 years of price increase,” he added.

The labor market is key

Moves in the labor market will determine how the property market shifts, according to some analysts.

“Should the labor market prove resilient to the technical recession we will have at the end of this year into the next, that is a strong positive for the housing market,” Broyer said. 

Schmieding made similar comments but over a longer timeframe, saying the medium- to long-term outlook for the German property market “will be good, as long as the country has a buoyant labor market.”

Employment in Germany is at a record high at 75.8%, but with the country likely to slip into “mild recession” in the coming months, that figure could be impacted.

German GDP figures released last month raised hopes of a milder recession than expected, with the economy having grown slightly more than expected in the third quarter.

The German economy grew by 0.4% compared to the second quarter and by 1.3% year-on-year, according to the Federal Statistics Office.