September 27, 2004

By Graham Norris

Property investors seeking a better income return should be looking to diversify their portfolios into the commercial sector, says Tony Bales, managing director of ChurchillMurray Properties.

"Income returns on residential properties are declining, particularly in the buy-to-let market, whereas returns on commercial properties are improving as demand increases."

Bales has 15 years' experience in the commercial property market and has concluded some of Cape Town's biggest deals - including the sale in 1997 of the BP Centre to German businessman Dieter Bock for R94 million, then a new record.

"With the residential market at its peak, investors - as opposed to home-seekers - face the question: where do I buy my next property? Traditionally, residential has produced lower income returns (7.5% to 8% of market value net after expenses) but currently has the attraction of capital growth exceeding 20% a year.

"Values in the commercial sector have been nowhere near that, and so we have the current phenomenon of huge CBD office blocks being stripped out and turned into apartments. In time these will further inflate the buy-to-rent market.

"Moreover, these office block conversions, in the central city and Claremont will reduce available office space, putting pressure on the supply-and-demand cycle."

Bales, who heads ChurchillMurray's recently launched commercial property division, estimates that the current rental return on residential property has fallen to the 5% range, depending on size and location. "In general the lower the value the higher the rental return."

Some rental agencies in Cape Town report that house rentals are down as much as 20% compared with a year ago. Many former tenants have now become property owners due to low interest rates, putting further pressure on rental occupancy rates and returns.

Historically, income yields have been higher in commercial property, Bales says. "They are currently in the region of 11.5% (net after expenses, expressed as a percentage of the capital value). Due to an over-supply of commercial space and a proliferation of shopping centres, tenants have been able to negotiate good terms and rentals with commercial landlords.

"During the last five years growth in values of commercial property has lagged that of other classes.

"Now, due to better business conditions, higher confidence levels and increasing consumer spending, tenants are currently trading at good levels and are able to commit to better business premises at higher rentals. Supply and demand pressures have already started to push up rentals and this trend will accelerate."

Looking at the two sectors, says Bales, the astute property investor should be considering diversification into commercial property.

But many investors and potential investors are unfamiliar with the commercial market and feel uncomfortable with it. "It is a very different world," says Bales. "Then rather than buy into commercial property directly, investors should look at the listed sector of the JSE, which has been performing extremely well over the past two years and will continue to do so.

"Investors can buy Property Unit Trusts (PUTs) or Property Loan Stock companies (PLS), most of which have been trading at a premium to directly-held property."

In addition to the listed companies, there are a number of institutional mutual funds which invest in PUTs and PLS stocks.

The listed Property Unit Trusts are not really unit trusts. They are called property unit trusts because they are trusts rather than companies and are set up in terms of the same laws which govern a normal unit trust fund. A normal fund-of-funds unit trust invests directly in listed shares on the JSE, but PUTs invest directly in physical property and may not invest in other listed shares.

The real estate sector is one of the JSE's largest, so it is not easy to pick a share or shares. "One way of getting some professional direction is to look up the portfolios of the property mutual funds - Old Mutual, Stanlib, Marriott, Sanlam etc - and see what their major holdings are. Easier still is to invest in the funds themselves.

"Like anything else," cautions Bales, "do your homework and get good advice before you invest."