Decisions, Decisions, Decisions

Posted On Monday, 28 July 2003 02:00 Published by
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Colin Young explains what to look for if you're planning to invest in the JSE's real estate sector.
The real estate sector has enjoyed great returns over the past year compared
with other sectors on the JSE.
The All Share Index lost 18.4% in the 12 months to June while the Property
Unit Trust Index returned 46.2% and the Property Loan Stock Index returned
39.2% (see graph).
This has created keen interest from investors seeking a "safe haven" from
the troubled equity market. But be careful - historical performance is not
always a good indicator of future performance.
The most fundamental principle is that investing in a listed property
company is a long-term investment which earns taxable interest income. It
also offers the potential for capital growth.
Income return is received from the company in the form of interest. When the
current share price is divided by the interest amount, it gives a figure
known as the income yield. The lower the yield, the more highly rated the
share and the less risk attached to the company.
The capital return is derived from the share price movement over a period of
time. Both capital return and yield are important to consider in evaluating
your potential total return.
While a normal unit trust fund invests directly in listed company shares on
the JSE, property unit trusts invest directly in physical property and may
not invest in other listed shares. Investors in a property unit trust buy
units in the listed company.
In the case of a property loan stock, an investor purchases what is called a
"linked unit", which is simply a mechanism that translates dividend income
into interest income.
A cash payout from a listed property company is pre-tax interest income - as
opposed to a dividend from other listed companies ( post-tax payment).
Also note that a listed property company receives rental income as its main
source of revenue. This is protected by lease contracts negotiated with
tenants - most of which contain escalation clauses.
Therefore, unlike bonds where the interest received is set at the time of
issuing the instrument, a listed property company has the potential to grow
its rental income.
Assuming a listed property company achieves the rental growth (and contains
its costs), it should increase its distributions to shareholders and
outperform bonds over the long term.
But, unfortunately, listed property companies are not always able to achieve
this. It explains why bonds enjoy a "premium" risk rating and often trade at
a lower income yield.
There are two major aspects to consider when evaluating a listed property
company: income return and capital return.
Income return
Use the following key points to assess which companies have the potential to
grow their earnings, achieve good returns and survive the tough times:
The historical record of earnings growth.
The company's structure. A property unit trust will suit a more conservative
investment strategy, whereas a property loan stock is more risky due to its
use of higher gearing (borrowing).
Management's ability to maximise the property portfolio's income return.
Quality of their property portfolio - the more diversified it is, the more
likely the chance of achieving solid performance over the longer term.
Strong balance sheet. Note, particularly, how much capital is invested in
the company.
Gearing should not exceed 45% of assets. But highly geared companies benefit
more in terms of earnings growth when interest rates are low.
Timing. Bear in mind the strength of the current share price and its
historical trend.
Also look for the company's income yield relative to the average property
unit trust or property loan stock yield and the R153 bond yield.
Note the net asset value per unit and whether the current price is at a
premium or discount.
Compare the current and historic share price rating against the R153 bond.
This is called the bond yield differential.
Liquidity of the share. Shares that don't trade due to lack of institutional
investor support normally have poor liquidity and should be avoided.
Capital return
The capital return is what you derive from the share's price movement. It is
not a "real" return until you sell the share, and it is taxable.
The two major forces that affect capital return are the economic cycle and
the direct property cycle.
The economic cycle affects listed property companies mainly through interest
rates and the demand for space.
It is important to note that property income yields tend to track long-bond
yields. A property income yield should be higher than a bond yield to
compensate for the additional risk.
The direct property cycle is driven by market dynamics, and affects the
supply of space.
As long as the expectation is that interest rates continue to fall,
investors in listed property should enjoy further capital returns.
Young is responsible for the fund management of Old Mutual's SA-listed
property funds.

Publisher: Business Times
Source: Business Times

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