© PLSA 2011
With listed property delivering returns of 24% per annum over the last 3 years, thereby outperforming most other asset classes, many investors may have focused solely on the capital return potential of the asset class. Buying decisions were made based on these returns and the 30% – 50% returns achieved during the mid 2000’s, without fully appreciating the increased risks associated with these higher returns and the attendant return volatility in excess of the broader equity market.
Property, whether listed or direct, remains primarily an income yielding asset and accordingly fits into the asset allocation process of a multi asset class portfolio. Listed property yields therefore tend to track long bond yields and are exposed to macro economic variables which could impact interest rates. At the beginning of the year inflationary risks had a detrimental impact on all interest rate sensitive asset classes, with the listed property sector losing 7% in total return by mid March 2011. This placed upward pressure on yields with the clean forward yield of the sector moving from 8.2% to 9.0% at that time. Besides the negative impact of the bond market, the sector lagged on largely disappointing results released in the first two months. The majority of distribution growth reported was either as management had guided or between 1% and 2% lower than expected. Average distribution growth came in at 7.5%, with only Hyprop and Growthpoint marginally surprising on the upside. This is in direct contrast to 12 months prior, when the sector experienced a positive burst in share price movement. At that time management teams delivered guidance statements exhibiting a more positive stance. This time around guidance statements were much more muted reflecting the very challenging operating environment. Since March the sector has come back strongly by more than 12%. However, most of this was as a result of strong movements in the bond market as global bond yields moved lower. Subsequent results releases have not provided any comfort with regards to the operating environment. Operating cost ratios are under pressure due to higher than inflation increases in municipal charges and electricity, with municipal valuation back-charges another recent sting in the tail. Municipal and electricity tariff increases are placing pressure across the entire property sector, from tenant to landlord, while service delivery standards are ostensibly decreasing, in many instances resulting in additional cost layers for landlords.
Where to from here? Looking forward it has become clear that, from a direct market point of view, the retail sector has been the first subsector to move into a recovery phase, with industrial and then the office sector pulling its respective weights. The office sector is very weak and should stay like this for another 12 to 18 months. Prospective tenants do show interest, but is very reluctant to commit as they are seeing no visibility in the economy. The current weakness seems much more a demand problem than a supply issue. Corporate South Africa is not yet prepared to commit to additional or new space despite the rebound in the economy. Tenants seem to roll leases into much shorter term leases as leases expire. In addition, landlords are accepting lower rentals than expiry rental to secure tenant continuity and avoid tenant installation costs or broker commissions. In summary, landlords would rather ensure the continuity of rental income than run the risk of losing an entire income stream and the potential of additional operating costs.
Industrial properties linked to distribution and warehousing seems to be the strongest as many retailers are positioning its logistics for a potential Walmart entry while two retail subsectors on the opposite sides of the spectrum (regional and commuter) remain the most defensive while also rebounding the quickest at present.
In terms of the listed space, the number of listings which were mooted 12 months ago may have been an early indicator of the yield cycle being close to its bottom. Approximately R4.5bn of new equity has entered the sector in terms of new listings with Vividend, Investec and Rebosis already listed. An additional R15bn of new equity could be added to the current R133bn of the sector if the bulk of the prospective equity placements and new listings to be concluded before the end of 2011 transpire. This is very important for improving liquidity, specialisation and diversification.
What we have actually experienced seems to be a disconnect between the yield cycle and the operating environment. With many generalists still within the sector as short-term yield play and renewed interest from international investors, the sector’s volatility has increased on talks of the next move and timing in interest rates. This seems to have been the main driver of the sector’s performance since the start of the year. There is definitely still some inflationary risk in the system that could impact local bond yields, but it seems the local market is just focusing on the trends being set by global bonds. Locally economic growth has surprised on the upside, which could actually lead to an earlier increase in interest rates than anticipated. The tone at the most recent MPC meeting turned gradually hawkish, letting us to believe that operating risks of inflationary cost pressures and weak demand for the sector remain intact. For the listed sector we expect things to remain volatile and closely follow the bond market into August when we see the next big wave of results releases. As yield play selective entry into the sector, especially retail exposed companies, may be prudent to benefit from the improvement in operating environment for retail related properties. The uncertainty in the sector is leading to those stocks with limited liquidity to remain very volatile and if there is some weakness in yields when generalists exit the sector, should create further opportunity to enter the sector.