Rising rentals, declining cap rates fuel notion of imminent non-residential boom

Rising rentals, declining cap rates fuel notion of imminent non-residential boom

30-03-2006

Double-digit rental growth in the non-residential market over the next few years, is one of the predictions made in the latest Rode’s Report, which contains surveys and an analysis of property-market data from the fourth quarter of 2005.

The capitalization rates of office and industrial buildings continued to decline during the fourth quarter of last year, and were joined on the downward path by shopping-centre capitalization rates after they had taken a breather during the previous quarter. Capitalization rates — the non-listed property sector’s equivalent of the forward earnings yield of shares — decline when prices rise. The lower capitalization rates and expectations of relatively low and stable interest rates are adding fuel to the widely expressed notion that the non-residential property market is on the brink of a major upswing.

Rode & Associates’ CEO Erwin Rode says regional shopping centre investors currently require a hurdle rate – the minimum total return that investors require to induce them to buy a property − of about 14%, which, given current regional shopping centre capitalization rates, implies that they expect capital growth of about 7% to 8% per annum over the next few years.

The average leaseback escalation rate, which is the escalation rate applicable to 10-year-plus leases, was 8,4% during the reported quarter. “This sounds reasonable given the likely prospect of double-digit market-rental growth in the next few years”, says Rode.

On the industrial front, real rentals in most of the major industrial conurbations were notably up on the same period a year earlier. That is to say, nominal industrial rentals grew much faster than building-cost inflation over the last year. Although nominal rentals appeared to be losing some steam during the last quarter of 2005, low vacancies, coupled with a robust economy, are likely to keep real rentals on the up.

Amazingly, nominal grade-A decentralized office rentals took a slight dip nationally, while nominal grade-A CBD office rentals climbed further during the fourth quarter of 2005. However, decentralized rentals were still 5% up on a year earlier, whereas CBD rentals managed 15% year-on-year growth. Given the expectation of 10% building-cost inflation, this implies that real decentralized rentals continued to decline. The good news is that vacancy rates are currently at normalized levels, which means that if the economy keeps on growing as economists predict, rentals will take a huge leap to reach the levels required to make new developments economically feasible.

Listed property yields edged further south during the latter part of 2005. This was probably owing to the growing perception that interest rates would stay put, coupled with expectations of strong income-stream growth. Over the next few years, capital growth will be driven by income-stream growth rather than declining income yields.

The continued strength of building activity has resulted in building-construction input costs (as represented by the Haylett index) growing at a steady rate of approximately 7% during 2005. In contrast, the BER Building Cost Index, which includes input costs as well as the profit margins of contractors, has been losing steam during the course of the year. Rode does not expect building-cost inflation to decelerate much further, however, as the current non-residential property boom is sure to keep it under pressure.

Turning to the residential property market, the report says that although national middle-segment house prices during the last quarter of 2005 (as tracked by Absa) were still 15,7% higher then they were a year earlier, house prices in January 2006 were only 1% higher than the month before − that is, annualized month-on-month house price growth was 12,4%. Given the already overheated status of much of the house market, the forecast is that national house-price growth is unlikely to exceed 12% in the next year. In fact, says Rode, it is more likely to lose further steam and end up growing by anywhere from 5% to 10% in the next 12 months. “The lower-priced market may be the exception, especially in light of the recent transfer duty concessions. Middle-priced and upper-priced houses, however, are already over-heated and therefore we do not expect their prices to react noticeably to the decrease in transfer duty.”

Over the last two years, flat rentals in Pretoria put in the best performance, growing at a compounded 11,5% p.a. Although impressive when compared to consumer inflation, this growth rate barely matched building-cost inflation over the same period. In the Durban, Cape Town, Port Elizabeth and Johannesburg metros, flat rentals grew at a compound rate of 7% to 9% p.a. The upshot of all of this is that building-cost deflated flat rentals in all of the major metros are still well below the highs of the 2000—2002 period. Moreover, given Rode’s expectation of strong building-cost inflation coupled with lowish rentals growth over the next two years, it is questionable whether these levels can be reached again any time soon.

As far as residential building costs are concerned, Absa’s figures suggest that residential building-cost inflation has been declining for the last two years. This makes sense in the light of this period representing the mature stage of the residential boom, says Rode. “However, the fact that residential building-cost inflation still remained high at around 13% during the last quarter of 2005 — much higher than the input costs as represented by the Haylett index — implies that residential building contractors are still stretching their profit margins.” Enquiries: Garth Johnson at 021 946 2480