It has been a particularly bad six months for the JSE Securities Exchange's real estate sector. Many now say it is only for the brave. But investors who avoid it could miss out on one of the best-performing safe havens in these troubled times.
Problems in the sector started with overdevelopment of office space 18 months ago and falling rents on even the best buildings. This has started to flow through as lower income to funds.
Then came the rand's plunge, spurring on rising inflation, interest rates and yields on government long bonds. Property yields, joined at the hip to long bonds, automatically followed.
Property loan stocks (PLSs) - they are funds that can borrow - were capitalised at an average yield of 13,5% near this survey's publication date , resulting in a 30% drop in value compared with September last year. The ungeared property unit trusts (PUTs), with yields at 13,8%, had lost 14% of their value. Like listed bonds, prices fall when interest rates rise, because properties pay out a fixed income that is less attractive if money in the bank earns you more.
PLSs were damaged the most. Because they are geared, higher interest rates mean investors get less of the pie; the bank claims far more of the PLS's income. With an average 45% gearing, investors are taking a double hit - on the value of the stock, and on the income distributed.
Despite its size and reputation for good management and performance, Grayprop, the sector's domestic giant at R1,8bn, has a capitalisation rate of 14%, 2,8 percentage points above the RSA 150.
And there could be worse to come. Interest rates are climbing, and property investors could face further pain. At the time of going to press, the market had already discounted another percentage point rise in the bank rate sooner rather than later. A further fall in property sector market caps seemed likely.
But the good news is that prices will rise with falling interest rates. Short-term capital gains are a racing certainty when that happens.
In October, listed property was flying. Portfolios worth R7,5bn were added to the sector and more were on the way. It was the third year of a property renaissance after decades of languishing as SA's forgotten asset class. PLSs at 34,1% total return outperformed equities and bonds over this period and PUTs at 27,2% were just below equities' 29,4%.
After September 11, property, with its steady, predictable income flows and attractive, risk-weighted dividend yields, had "safe haven" written all over it. As stock exchanges plunged and the debt market became even more volatile, investors moved into property worldwide. In the first two months of this year, Germans ploughed euro1bn into their listed properties and capitalisation rates were at record lows.
The rand has taken SA capitalisation rates the other way, but Corpcapital's Marc Wainer points out that most of the sellers were small investors. "The institutions are holding and even buying good counters on weakness."
Corovest director and property asset manager Mike Aitken and his Marriott counterpart, Ian Anderson, both say property fundamentals have not changed.
Aitken says the current decline offers an opportunity for outstanding capital growth to investors who take a view that rates will drop in the next 12-18 months.
Barnard Jacobs Mellet property analyst James Templeton is a more cautious independent voice. "The property fundamentals have worsened and the listed property sector is expected to weaken further before it strengthens again," he says. "On this basis we would only expect the sector to recover within 12-18 months."
Do not rush to buy until rates have risen again, he warns.
But others are optimistic. "Property is a safe investment and the sector is giving wonderful yields right now," says Property Finance Solutions director Lisa Forshey, another independent. "Buyers today also have an excellent chance of big capital growth if inflation falls back and government long bonds come back."
Grayprop CEO John Rainier points out that few financial advisers direct their clients towards the sector, often citing the low liquidity and market cap of the PUTs and PLSs. Both size and liquidity are improving now. Four domestic funds - Grayprop, Sycom, Growthpoint and Martprop - have market caps over R1bn and nine are over R500m (see main table). A number of funds are breaking through the liquidity threshold of 30% annual turnover of issued shares (see table).
"There may not be enough stock for the large appetites of some institutions, but there is more than enough action for individual investors," says Aitken. Other observers are less polite, noting that financial advisers do not get commissions on PUTs and PLSs, as they do from the general unit trust sector. For them there are three units trusts that invest in listed property: Coronation, Marriott and Oasis.
Marriott property equity and property income could be bought at an initial yield of 13,6% and 13,9% respectively at the time of going to press and Marriott CEO Simon Pearse was forecasting a 20%/year total return over the next five years. The other two funds have slightly lower yields, mainly because they are more heavily invested offshore.
These units trusts and PLS Redefine, which is 50% invested in listed property funds, can take advantage of the high yields to build their own income. But fixed property yields, averaging 10,5% according to the latest SA Property Index, are lower than the fund's yields of 16%. So most funds cannot buy property with paper because it will dilute their earnings. This means few property deals will be done until interest rates and yields fall back.
But why invest in what, given the size of the sector, are in effect sector indices when you can mix your own portfolio at historic yields from 20,5% for ApexHi B to 12,4% for Hyprop? Hyprop, Grayprop (14%), Sycom (12,3%), Growthpoint (19,4% historic but 15% forward since it bought the Mines Pension Fund portfolio late last year) and Martprop (14%) are favoured by all the pundits. Anderson also likes Atlas (12,1%). Aitken adds teeny cap Paraprop (17%) because of management and ApexHi (A 15,3%, B 20,4%) because of its upside potential.
These funds pass two main criteria for performance in the short and medium terms. They have good asset management that will protect income through the current softness. And their portfolios are diversified sectorally and geographically to reduce risk.
"Investors should look for good management and good lease expiry profiles," says Forshey. "A mix of A and B grade funds, say Hyprop and Grayprop, with C and D grade high-yield funds like ApexHi, can give a combined 16% or 17% initial yield and excellent growth in the future."
So a R250 000 investment could yield R40 000/year before tax with a fair chance of keeping your capital intact or even growing it.
Marriott's Anderson forecasts income growth of 4%-6% over the next five years. But that could be as low as 3%-4% for the top quartile of performers over the next 12 months, says Aitken. After that he sees 6%. They both expect inflation and interest rates to have peaked before year-end and for yields to fall steadily from then. "I would like to see yields at 12% by December 2003," says Aitken.
That would translate to 24% capital growth over 18 months, along with annual yields close to 16% if you buy now - a total return of around 32% in 12 months.
But interest rates may not fall. Even the income return on property will be, at worst, slightly lower than now, but steady, as property always is.
The writer indirectly holds ApexHi B units.