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Caution rules in property funds

Posted On Monday, 20 May 2002 10:01 Published by
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Look for yield and quality, now that a sure thing is less reliable You cant go wrong with property

Look for yield and quality, now that a sure thing is less reliable

You cant go wrong with property. Advice that lived up to its claim between 1998 and 2001, when property unit trusts (PUTs) and property loan stocks (PLSs) generated total returns of around 200%.

More of the same appeared in the offing until late last year: SAs economy was strengthening, inflation was heading lower and interest rates were sure to follow. The rands collapse brought this happy scenario to an abrupt halt, highlighting the reality that, as with any investment, timing and fundamentals count.

Inflation moved upwards and long-term interest rates rebounded to 13% from lows of around 10%. Added to this gloom, property groups began reporting increased vacancy levels and difficulties in maintaining rental levels when renewing leases.

PUT and PLS prices fell by about 20% and sent average income yields rocketing from about 10,5% in September 2001 to over 15% by April this year.

The rebound in PUT and PLS yields also normalised the relationship between them and bond yields. With the property funds average income yields at their 2001 price peaks on a par with the benchmark government R153s yield, the risk premium for investing in property had become too low.

Experience over the past few years indicates a normal risk premium on quality PUTs of about 150-200 basis points above the yield on the R153. Any move out of this range means property investments are becoming over- or undervalued.

Declining interest rates over the past six weeks brought relief, boosting PUT and PLS prices by around 10%. Notably, PUT yields have fallen by 180 points to a 13,4% average but the R153 by only 130 points to 11,9%. The result is a narrowing of the differential between average property fund yields and the R153 yield to 150 points.

PUTs have thus moved from offering high value to what may be regarded as fair value. Big improvements in average property fund valuations appear limited without further strong declines in bond yields and improving property market fundamentals.

On the bond yield front, the news is good. Institutional investors are concerned that a shortage of bonds is looming in the market. Government, the dominant supplier of new issues, will be a net purchaser of its own stock this year and issues from other sectors are at a low ebb.

With the added factor of a curtailment of offshore asset swaps, cash is finding its way back into the bond market, despite rising inflation. Thus rising bond yields do not appear to present any big immediate threat to PUT and PLS valuations.

But other property market fundamentals are not as rosy and should preclude conservative investors from buying lower-quality funds offering 20%-plus yields. These yields could prove difficult to sustain.

Its tough in the property market, says Allan Gray property division MD John Rainier. Income distributions will remain flat and, in some cases, go backwards until the economy picks up, he says.

A sobering change from 3%-5%/year sustainable income growth forecasts of less than a year ago. Rainier also cautions that the property market lags behind the economy by 18-24 months. On this basis, improved property market fundamentals cannot be expected until well into the future.

In the absence of strong income growth, investors should assess risk and the need for an adequate risk premium, the reward for accepting risk not present when you invest in government bonds.

Future income growth must be factored in to an acceptable risk premium. For example, buying on 13% yields when income growth of 3%/year is expected should justify a lower risk premium than when only marginal growth is forecast.

At present, conservative investors seeking income should be mindful of this and stick with big-cap, quality funds offering a solid risk premium.

Allan Gray Property Trust (Grayprop), with a highly diversified portfolio, is an attractive option. Excluding a 15c/unit income distribution (applicable to unit holders until May 17), Grayprop yields 14,4%, a 240-point premium over the R153 which provides a good cushion against adverse moves in bond yields.

Over five years, with income growth averaging 1%/year, an unchanged 14,4% exit income yield in year five will produce a 15,7%/year return. A 13,4% exit yield improves returns to 17,2%/year while a 15,4% exit yield would cut returns to 13,7%/year.

Conservative assumptions. But reassuring, given current uncertainty.

Financial Mail

Publisher: Financial Mail
Source: Financial Mail
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