Urban properties are now overpriced by 10-20 percent, the bank said, adding that "in major cities the prices for residential property deviate by about 25 percent." It added that apartment prices have gone up by 9 percent in Germany's seven largest cities.
The bank already warned of big jumps in residential property prices in October last year. However this marks its most severe warning.
"Prices for residential property have risen faster than the economic and demographic fundamentals suggest," the bank said.
(Read more: German house prices could be overvalued by 20%: Bundesbank)
As the European Central Bank's interest rates are at record lows, Germany worries that easy access to money and spending could push prices of everyday goods and services to unhealthy levels.
However, the Organisation for Economic Co-operation and Development (OECD) warned Germany it must accept higher inflation on Monday, or large parts of the euro zone could get stuck in deflationary territory, potentially putting the bloc's single currency at risk.
(Read more: Germany will send bond-buying program to European court)
Germans have long feared the threat of rising prices ever since the nation experienced hyper-inflation in the Weimar Republic after World War One.
—By CNBC's Jenny Cosgrave: Follow her on Twitter @jenny_cosgrave