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Views on the Listed Property Sector from a Macro and Interest Rate perspective

Posted On Wednesday, 28 November 2007 02:00 Published by eProp Commercial Property News
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A number of comentators present their outlook on the listed property sector amidst a local rising inetrest rate and a global inflationary environment

Leon AllisonLeon Allison, Macquarie Securities

When inflationary fears increase, bond yields increase as well. As listed property is, like bonds -- an income generating asset -- property yields and bond yields tend to move in tandem.

So, as inflationary fears increase, property yields are also inclined to rise.

Increasing interest rates and bond yields lead to more expensive cost of debt for property companies. This only really applies to new debt, as most of the existing debt of listed property companies is fixed for periods of between three and 10 years.

Higher interest rates also have the potential to slow economic growth and retail spending in particular, impacting property companies' tenants.

Rising interest rates and bond yields directly impact listed property pricing (through yield shifts) and cost of debt.
Indirectly, listed property can be impacted by a slowing economy affecting the sector's tenants.
However, so far the rising interest rate cycle and inflationary pressures have had a limited impact on listed property. The sector is up around 30% year to date.

The main reasons for this are the strong property fundamentals resulting in robust income growth and strong demand from investors, particularly the government pension fund, the PIC.

Pieter Prinsloo, Hyprop Investment Limited

While continued strong consumer spend has been recently announced, which may justify the latest interest rate increase, many commentators believe it is one step too far and a further increase this year would be excessive.
Hopefully there will be no more increases for the immediate future, with rate decreases to be implemented in 12 to 18 months time.

Higher interest rates will certainly impact negatively on residential property values. The effect on commercial property is to some extent still unquantified at this stage. However as large institutional players are currently very active in the commercial property sector, it is unlikely that interest rates increases will have a material negative impact on commercial property values.

In addition international investors are expressing increasing interest in the South African property market in a bid to diversify their investment profile and as a result of the attractiveness of our property yields, which will also contribute to strong property values.

Inflationary pressure is an inevitable consequence of high economic growth and something many developing countries are experiencing at the moment. In order to combat high inflation, economic growth will have to be sacrificed, which in turn can slow new property developments. This will increase pressure on the already short supply of commercial property space available for letting, as South Africa is in the unique position of continuing to experience strong demand for space, especially in offices. Currently, average lease escalation is still in excess of inflation which will further support real future income growth for investors.

One negative is that higher interest rates will increase the cost of funding for cash acquisitions. Also, interest rates are higher than the average income yields at which listed property is currently trading, which makes cash acquisitions dilutionary on immediate income distributions. As a result more listed property companies are settling acquisitions by issuing paper, which in the short term can be income enhancing but will have a negative impact on long-term distribution growth.

In conclusion, if higher interest rates are effective in controlling high inflation, any negative effect will be short-lived with improved economic prospects expected to be realised in roughly two years time.

Evan Jankelowitz, Stanlib

Before discussing the impact of the macroeconomic forces on listed property, it would be wise to first set the scene. Our economy is still in the midst of a boom. There is significantly more money in the hands of a substantially larger economically active population. The result of this being a spirited consumer sustaining an elated retailer. As our economics 101 textbooks tell us 'excess demand for any asset results in price appreciation, i.e. inflation'.

In response to this wave of liquidity chasing prices ever higher, comes the opposing Reserve Bank set to put things straight, wielding the weapons monetary policy makes available. One of the supposedly more effective tools is the ability to manipulate the short rate of borrowing, with the hiking of rates having the effect of creating a stronger incentive to invest and deterrent to borrow, hence slowing down consumer spending.

Weaker spending levels ultimately lead to lower corporate profitability and thus higher rate of tenant defaults, increased vacancies and effectively a weaker bargaining position for the landlord. While this is correct in theory, the reality contains far more moving parts. This said, the current mismatch between supply and demand can take on a lot more pressure before rentals are materially impacted. An expected GDP growth of 4% should lead to healthy corporate growth; while soaring building costs as well as higher funding expenses as a result of interest rate hikes is stunting excessive development.

Furthermore, this proposed unravelling of events will not happen over night. Assuming the average lease is five years, only twenty percent of the revenue will be up for renewal under these weaker conditions in the first year and, by the time the latter rentals are up for review, economic conditions could be in a completely new space. Ultimately tightening the consumer will impact the rental market, but there's no need to panic just yet...

Where there is cause for concern is the opportunity-cost a higher rate environment presents listed property shareholders. Due to property stocks' attractive/consistent annuity attributes it is often valued relative to the long bond. The key differences between these two asset classes are risk (the additional risk a company exhibits above that of a government issued bond), and income growth (the growth potential of a rental linked distribution as opposed to a static coupon).

Assuming the market has found a balance in the relative yield (income divided by price) between the two, this difference should remain constant unless the market rating changes. In this case, if the rate the long bond offers increases, rational investors would sell property (pushing prices down) and pick up a higher yielding bond. Over the past few months, despite inflation on the rise and a 3.5% top up on the prime interest rate the long bond has been robust. Government funding through the bond market has been timid as collections by SARS have surprised on the upside, and this has kept yields artificially low. However, recent data has shown that this phenomenon may soon turn in light of signs of a shortfall in the budget coupled with inflated price tags on several state projects.

Whereas this isn't a doomsday call for the listed property sector, as there are several other underpins to prices, it is an area in which any property investor should be well versed. So while increasing long bond yields/rates will weigh down on property prices; in the short term this will be primarily as a result of relative valuations rather than a slowdown in the nuts and bolts, on the ground business operations.
Craig Hallowes, Fortress Asset Managers

Generally (and in terms of traditional thinking), an increasing interest rate environment is not generally considered positive for commercial real estate. As interest rates increase, the cost of debt increases, making financing transactions more costly, and less likely. This has the overall effect of depressing real estate markets and eventually asset prices. The listed real estate sector on the JSE Limited, for example, is the securitised reflection of the hard assets transacting on the ground, and acts similarly.

At the same time, listed property tends to behave in a similar way to bonds when it comes to a more bearish market where interest rates are rising. Thus, the yields, or cap rates, of property tend to move out when interest rates rise, depressing property values. This has not occurred, however, in South Africa where other economic principles of supply and demand seem to be counteracting the effect of higher interest rates. These economic fundamentals include lack of supply of both properties and shares in property counters, increasing demand for space as the economy grows and increasing interest in, and demand for, both properties and listed shares and units.

However, increased interest rates can have the positive impact of enhancing foreign investment. Foreigners looking for higher yielding investments may, in theory, place cash into a country as its interest rates increase, in the search for higher yielding assets (assuming sovereign risk parameters are acceptable). This will have a positive effect on the local real estate market, as foreigners become interested in acquiring local assets, thereby raising prices. This assumes that the foreign investors still have the liquidity to invest beyond their borders.
Global inflationary pressures have the effect of making goods more expensive, and inadvertently, raising real estate values as well. This is not good in the local market for those looking to purchase real estate assets, but excellent for those who already own the assets. Listed real estate companies in SA are currently benefitting from this phenomenon, enjoying strong total growth rates of between 7% and 20% into 2008.

Having said this, central banks generally combat inflation by raising interest rates which has the effect alluded to above of ultimately deflating property values.

Government has the problem of balancing interest rates with inflation, increasing the one to offset the other, respectively. This balancing act is kept in place to ensure that inflation does not rise too quickly, and is maintained between a certain band to ensure that the publics' purchasing power is not depreciated too quickly over time. But the rate of growth economically needs to be assessed with inflation in mind, to ensure that containing inflation does not come at the cost of economic growth. Similarly, the rate of inflation needs to be kept in check in order to alleviate further interest rate hikes, which could negatively affect local real estate owners making new transactions more expensive and consequently depressing prices.

So, in conclusion:

- Global uncertainty in investment means that there is a flight to 'quality' and a divestment from emerging markets, effecting SA;
- Rising rates globally to combat inflation should negatively affect direct property and the listed sector in SA,but this is being counteracted by the supply and demand dynamics of the SA market (e.g. PIC buying
-The net result is that our real estate sector generally, including the listed sector, has to date shrugged off the global woes and continues to rise reaching new highs every month.

As can be seen, the 'moving parts' in any sector or asset class can be innumerable, and investing is made more difficult because of all these influences.

Last modified on Tuesday, 22 April 2014 16:42

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