The law of relativity applied to investments
15-04-2009
The first law of investment is that returns are relative.
Over the past year or so, equity values worldwide have more or less halved, yet the latest available capital returns on directly-held property in South Africa are still positive. This illustrates the truism that property’s returns are less volatile than those of equity, even though property will never outperform equity in the long run.
The recently released IPD return statistics for property illustrate the classic trade-off between risk and return, and non-residential property investors can congratulate themselves on having been invested in property during these uncertain times.
During 2008 capital returns on directly-held non-residential property deteriorated significantly from their 2007 levels, but were still decent, considering what could have been. Industrial property showed the strongest capital growth (+8,4%) followed by office (+4,6%) and retail (+3,1%). However, none of them could outperform consumer inflation, which averaged 11,5% in 2008.
Nevertheless, a word of caution would not be amiss: These capital returns are based on estimated market values, which in turn are based on a very thin market, in that little trading takes place. The reasons for this are twofold:
Firstly, the major players in the market, the listed funds, need to gear new acquisitions, and loan finance has been too expensive relative to the income yields at which potential sellers of prime properties are prepared to trade.
Secondly, the income yields at which the listed funds have been trading have been off their lows of two years ago (their market ratings have deteriorated); this implies that they require higher income yields (lower prices) when acquiring property in order to avoid ‘diluting’ their earnings.
However, potential sellers have not been prepared to do the funds this favour. This implies that potential sellers of prime properties in South Africa are not desperate, as in some other countries. Consequently, the market is still in a process of price discovery, and has ground to a standstill.
One of the reasons why vendors in South Africa are not as desperate as elsewhere is that South Africa’s lending institutions have always had a conservative loan-to-value (LTV) policy (think 60% rather than 90%). Another reason is that this business-cycle recession has caught the non-residential property market in the upswing phase of its long, very long, cycle. Thus, market rentals are still rising (based on fundamentals, but do expect growth rates to decelerate sharply); thereby offsetting the moderate rise in capitalization rates of the past year or two. So, all in all, prime property’s values have not tumbled. Note that this analysis does not apply to secondary-quality property, which is more dependent on the private investor, who is dependent on financial leverage.
An interesting structural change compared to twenty years ago has occurred in the market for prime property. At the time, the life offices and pension funds, which required no financial gearing, ruled the roost. Thus rising gearing costs did not affect the directly-held market at the time, nor did deteriorating JSE-listed market ratings, because these behemoths were unlisted. Now there are few unlisted capital-rich funds operating in the marketplace, the unlisted market is driven by the listed funds, and they in turn are driven by their need to please JSE analysts, who think short-term cash flow (dilution of earnings is a sin).
Despite all of this, when income returns are added to the capital returns to derive total returns for direct-property in 2008, the picture does not look bleak at all: both industrial (at 18%) and office (14%) property achieved total returns in excess of consumer inflation. However, retail property had not fared as well, as this sector could only muster total returns of 11% not good news for investors heavily exposed to retail property. But then, compared to the halving of equity values, investors can surely live with this.
