South African investors with the fortitude to withstand some significant bouts of market volatility have been rewarded with generous returns above inflation over the last decade. A simple buy and hold strategy in any of the major asset classes would have earned investors annualised real returns of 4%, 15% and 19% in bonds, equity and listed property respectively over a 10-year period to the end of May.
The return on listed property in particular has been nothing short of spectacular, with investors perhaps becoming overly sanguine after the sector delivered a staggering 36% during 2012. The property bull run continued unabated into 2013, with the sector delivering a further 17% in the first four months of the year. May, however, came as a rude awakening to many investors with the sector clawing back 15% of 2013’s returns in a matter of weeks and posting the biggest decline since January 2008.
Drivers of recent returns
Between the end of May last year and the end of April this year, South Africa’s listed property sector returned 43.7%. The one year forward income yield on the sector was below 6% for the first time at the end of April. Although the sector produced inflation-beating distribution growth despite weaker property fundamentals and a slowing economy, this doesn’t fully explain the strong rally in the listed property sector, although it certainly contributed to an improvement in sentiment.
The rally was sparked by a surprise cut in interest rates in July 2012 which led to a drop in bond yields and made the higher yields of the listed property sector even more attractive.
Listed property prices started rising to restore the spread in yields. Bond yields have continued to decline since then and listed property yields have followed. However, by the end of April this year, the one-year forward yield on listed property was more than 50 basis points below the yield on a ten-year government bond. This suggests there was a further factor influencing the recent rally.
The Real Estate Investment Trust (REIT) legislation became effective on 1 May 2013, but was announced to the market in July last year. REITs are the de facto standard for listed property vehicles throughout the world. They were first introduced in the United States during the 1960s to allow the man in the street access to the benefits of commercial and industrial property in a tax-efficient manner.
The introduction of REIT legislation in South Africa has opened up opportunities to raise capital in international markets. Foreign ownership of South Africa’s two largest listed property companies, Growthpoint Properties and Redefine Properties, has increased tenfold since 2008, with US yield-hungry investors now making up the lion’s share of foreign ownership.
The combination of inflation-beating distribution growth despite a weaker economic backdrop, lower bond yields, and an increase in foreign ownership, all contributed to the sector’s stellar performance between May last year and April this year.
During May this year, the sector lost more than 10% of its value, as a combination of higher bond yields, a weaker Rand and foreign investor selling drove listed property yields higher. Notwithstanding sharply lower prices at the end of May, the sector remains vulnerable to further foreign selling and rising bond yields.
The case for listed property
A move back to more normalised yields in sovereign and corporate bonds represents the single biggest risk to listed property returns in the short-term. However, on a longer-term view, listed property remains attractively priced relative to other asset classes.
An investment in listed property offers investors three key benefits:
- A high starting income yield
- Inflation-hedged income growth
- Inflation-hedged capital growth over longer investment horizons
The relationship between income growth and capital growth is important and has often been overlooked by investors when assessing the merits of an investment in listed property.
If an investor only focussed on initial income yields when comparing the attractiveness of South Africa’s higher yielding asset classes, the small pick-up in initial income yield from listed property would appear insufficient when compared to the risks associated with an investment in property. But the income an investor receives from their listed property investment will grow over time (see chart below) and as a result, the capital value of their investment will show a similar level of growth.
Listed property therefore offers investors the best of both worlds: a high income yield comparable to bonds, and long-term income and capital growth, similar to equities. As official interest rates and the yields on bonds and listed property have reduced to historically low levels, the growth characteristic has taken on more significant proportions.
The current one year forward yield on South Africa’s listed property sector is 6.7%. Given the significant changes that have occurred in the sector over the past decade, most companies are capable of growing their incomes above inflation. Those changes include higher gearing levels, access to multiple sources of capital, improved property portfolios and internalised management teams. With capital growth a function of income growth, that suggests that investors today should expect a higher contribution from price increases than from income yield in the years ahead.
In the short-term, South Africa’s listed property sector may be vulnerable to increasing bond yields if inflation remains elevated and the South African Reserve Bank doesn’t cut official interest rates, or worse still, talks about increasing interest rates early in 2014. This would result in short-term capital losses and would probably wipe out most of the past year’s impressive price gains.
However, for long-term investors, listed property continues to offer an attractive income yield (relative to other asset classes in South Africa), and the potential for long-term capital gains in excess of inflation. It’s the ideal asset class for investors saving for retirement as well as those already in retirement. Prior to retirement, investors are able to reinvest the income into an asset class with growth characteristics, thereby growing their capital base. During retirement, investors are able to enjoy a high level of income (relative to other asset classes) and growth in that income stream in excess of inflation.