How did SA's housing growth become a world beater?

08-02-2005

In spite of the current low inflation rate, leaseback escalation rates, as surveyed in Rode's Report 2004:4, continue to be high at an average of 9,1%.

While escalation rates have been on a steady decline since the mid-1990s, they have not kept pace with the downward trend in inflation over the last few years. This significant lag behind inflation implies that escalation rates should continue to fall for some time to come.

The discrepancy between escalation rates and market-rental growth is nothing new and shows once again how inaccurate a forecaster the rental market actually is, says Rode & Associates CEO Erwin Rode. "A market escalation rate is nothing but an attempt by the market to forecast where market rentals will be when the lease expires. Just how inaccurate the market can be as a forecaster, was recently demonstrated by the fact that escalation rates remained at 10% p.a. amidst falling market rentals for decentralized offices.

In a non-inflationary environment there should be no need for rental escalation rates, while in a hyper-inflation environment, on the other hand, inflation-linked monthly increases may be the order of the day. In general, the practice is to sign industrial, office and retail lease contracts for periods of between two and five years with a fixed annual rate of increase.

It is not so far-fetched, as most people think, for a very low inflation environment to be reached again, says Rode. That is the environment that existed in 1957, when the first leaseback agreement — a rental contract spanning 10 years or more — was signed by Sanlam for a 30-year period, with no escalation clause.

An industrial-market study conducted by Rode back in 2000 shows that during the 1994-1997 period, market rentals grew faster than escalation rates. However, leases with inception dates 1995 to 1998 were negotiated at escalation rates higher than the subsequent market-rental growth achieved. For instance, in 1998, new leases were signed at an average escalation rate of 11,6%, while industrial market rentals showed no growth over the subsequent four-year period. Rode concluded that the market escalation rate is not a good predictor of the future movement in market rentals in periods where there is a change in the direction or pace of market-rental growth.

Rode's comparisons between the leaseback escalation rate and the rate of inflation between 1982 and 2002 showed the escalation rate decline lagging the inflation decline by five to six years — the inflation rate peaked in 1986, while the escalation rate peaked in 1992. "The reason for the long lag is that there is no direct link between escalation rates and consumer inflation", says Rode. "Rather, the direct link — albeit a weak one — is between escalation rates and expected market rental growth via inflation. Put another way, escalation rates are largely determined by expectations regarding market-rental growth, which in turn is, in the long run, driven by inflation expectations."

* The Rode team has built a regression model that uses this lagged relationship to explain and forecast market escalation rates. Subscribers to RR's sister publication Rode's SA Property Trends get the benefit of this forecasting model.