Extracts from Property Innovation: Madison Property Fund Managers

Edwin Schultz

Coronation Fund Managers

Listed property probably fits somewhere between a bond and an equity. It has many bond-like characteristics, but also will have, in certain environments, equity-like characteristics.

Ultimately all financial assets can be valued as a series of cashflows discounted at a particular rate. Given that both listed property and equities are long duration assets, the rate at which these underlying cashflows are discounted is typically referenced from the long bond rate. Given that equity cashflows are typically more risky than property cashflows, which have fixed rental agreements with escalations in place, the rate at which you would discount equity cashflows would be higher. But equity holders will be compensated by a higher growth rate in underlying income over the long run.

Over the past sixty years equity would have delivered growth in earnings of around 3% above inflation. Although we don’t have data going back that far for listed property, an average listed property would be expected to show distribution growth below inflation, and this has been borne out by international experience. The result is that over the long term, the direction of listed property returns are dominated more by the direction of bond returns, as evidenced by a correlation of 80% to 90% between bond and property yields over the long term. The correlation with equity is much lower.

Having said this, listed property is currently delivering distribution growth well above inflation, and is expected to do so for at least the new two to three years. In this kind of environment, listed property assumes more equity-like characteristics, which will continue as long as growth in distributions remains strong.

There is an important difference between domestic listed property and domestic equity relating to the currency though. A weak rand environment is more likely to benefit equity, through a large portion of our market being exposed to exports and dollar based commodity earnings, while it is likely to be a negative environment for domestic listed property. Hence a bit of foreign property exposure is unlikely to do much damage in a well constructed property portfolio.

Evan Robins

BOE

It depends on the time horizon. In the short-term listed property is de facto equity. As the chart below shows, the SAPY listed property index has moved in lock-step with the JSE mid-cap index. Statistically the mid-cap index explained 98% of variation in listed property. Correlation does not imply causation and third factors may be driving both. Nonetheless, property has behaved indistinguishably from equities.

Internationally listed property is more influenced by the equity than the property market. Investors hold listed property as a competitive substitute to equities and fixed income assets. In mid-2006 local listed property fell sharply unrelated to changes in the underlying physical property market. It was the result of retail investors selling en-mass. Institutional investors and hedge funds too have their own reasons for trading that will be more related to equity and bond dynamics than to the physical property market. Listed property does not trade on NAV.

In the longer term, listed property will behave like physical property. Valuations are ultimately anchored on distribution prospects. Listed property can be taken private or physical property listed to restore equilibrium.

To enhance distribution growth, some listed property companies globally are engaging in more risky undertakings. This results in a more equity like profile. Property development is equity risk.

The implication as the chart below shows, is that the volatility of listed property has been well above that of bonds, close to that of the ALSI index and in line with, and often greater than, mid-caps. Listed property does not possess physical property’s traditional attribute of low risk and little correlation with equity markets. As physical property is less liquid, prices are more sticky in the short-term and it may display illusionary price stability.

The equity like behaviour of listed property lowers its attractiveness to investors seeking to reduce or diversify risk in the short-term. The excess returns from listed property however, have more than made up for this disadvantage.

Leon Allison

Macquarie First South Securities

From a different angle this question asks: does listed property represent direct property? No. Listed property is more closely correlated with bonds and equities than with direct property. From 1996 to 2005, the correlation between direct and listed property was only 0.42 versus 0.72 between listed property and equities. Bear in mind though, that correlations are dynamic and thus change over time.

Figure 1: Correlation between asset classes in SA

Listed property’s risk profile, as measured by standard deviation of returns, has been lower than general equities’, but much higher than direct property. Its risk profile has ranged between equities and bonds, but closer to equities. It is therefore questionable whether listed property is a good proxy for direct property.

Figure 2: Performance of asset classes in SA 1996-2005

The problem with direct property is that valuations tend to be smoothed and to lag macro economic and property fundamental factors. Changes in valuations are slow and small and therefore artificially lower the standard deviation, or volatility. In high growth periods, listed property’s behaviour is more akin to equities than bonds or direct property, whereas in periods of low growth, it is closer to bonds. We would argue that listed property is part equity, due to its growth characteristic and its equity stake that is quoted daily on the JSE Limited. Nonetheless, it shares with bonds the characteristic of a relatively high and secure income stream. In this sense therefore, listed property is a hybrid security, sharing the growth characteristic of general equities as well as the higher, more secure income characteristic of bonds, and has its own attributes, whether one calls it the fourth or simply an alternative asset class.