Many people who invested in companies like Masterbond and Owen Wiggins (who offered high returns) for example, lost a lot of money and now the provisional liquidation of City Capital SA Property Holdings Ltd and Financial Mail Cover Story, 12 June 2009, "Exposed: SA's Madoff.

The higher the return, the higher the risk. With prime overdraft rates at 11% and expectations of further reductions, property investors are once again appreciating the long term benefits of direct property investment.

A fixed deposit for a year with one of our major banks can be considered a “blue chip” investment with zero possibility of any capital loss (recent global events lead us to believe that we should adopt a more cynical approach). Fixed interest investments, however, do not protect hard earned capital from the eroding effects of inflation, whereas an investment in an income earning property can provide an investor with income and the prospects of capital appreciation.

When assessing a property investment, the same criteria have to apply. Risk is related to return, this is one of the fundamentals that must be considered when assessing the return or capitalization rate that is used in arriving at a value for the investment.
 
If Standard & Poor, Moody’s or Fitch downgrade a countries credit rating, every notch down the scale means the cost of that countries borrowing increases. We must surely apply the same rule to property investment.

In the case of a single tenant property, condition, location of the property, length of the lease, financial stability of the tenant and the cost of borrowing are risk elements that must be considered in arriving at an appropriate capitalization rate.

When assessing the value of a multi-tenanted property the same principles are usually applied – and an overall capitalization rate is applied to the entire investment. We believe that this is wrong.
 
A shopping centre with a prime national anchor tenant occupying, say 34% of the lettable area, applying a low capitalization may be justified but applying the same rate to the remaining 66%, mom and pop tenant mix is inappropriate.
 
For example if the net income on a property is R 1 000 000, applying a 9% capitalisation rate gives a value of approximately R11 100 000.
If the national tenant contributed R 340 000 to the net income at 9% the value of that income would be approximately R 3 800 000.
 
Applying a 10% capitalisation rate to the balance of R 660 000 the value would be approximately R 6 600 000 a total of R 10 400 000. The correct application of the “risk is related to return” test means a significant, 6.31% drop in value.

In multi-tenanted properties, the national tenant may occupy 34% of the lettable area at a lower rent per square metre, the other, perhaps more risky tenants contribute a bigger share of income as they pay a higher square metre rate.

MARKET COMMENTARY

In October 2003 prime was 12%, declined marginally through 2004/2006 and reached 12% again in October 2006. Property values were driven upwards by two major fundamentals - lower interest rates and steadily increasing rentals. With rising interest rates in 2008, capitalisation rates increased and values dropped.

The market in May 2009 is diametric. With prime down to 11%, capitalization rates have started to drop, but unlike 2006/2007, rentals are under pressure and are declining. As a consequence, where value should have increased dramatically, it may not have changed at all, in fact, may have even come down.
 
The perceived increase in value as a result of lower capitalization rates is negated by lower market rentals, any lease renewals in the next 18 months may result in revenue actually dropping. When assessing value check lease expiry dates carefully, and make sure that renewals are projected at market rentals.