Will you win or lose with listed property going forward?
South African listed property delivered exceptional returns over the last ten years, outperforming both the FTSE/JSE All Share Index (ALSI) and BESA All Bond Index (ALBI), which both had an excellent decade in their own right. With the bar set so high, where to from here for listed property?
Gazing into the future requires us to understand what drove returns over the past decade and then establish how many of these tailwinds will still be evident in the next couple of years. Firstly, however, we need to understand listed property as an asset class.
Owning a house is very different to investing in listed property
For many of us, property is the house we live in and our return is calculated from the purchase price, maintenance and renovations during the years, as well as the eventual selling price. House prices usually rise sharply when the economy is booming and interest rates are low. Shopping malls, office parks or industrial developments, typically owned by listed property companies, should do well under similar economic conditions. However, from a return perspective, the experience of a house owner compared to an investor in listed property shares is very different.
As JSE-listed securities, the prices of these property companies are determined daily by the market. Investors take views on rental growth, vacancies, funding cost and the value of each property to determine what shares are worth. Future acquisitions or developments and concepts like ‘balance sheet gearing’ also drive prices. Importantly, however, investors look at other asset classes like cash, bonds or shares to determine where they will achieve the best future returns.
Chart 1: Listed property had an exceptional ten years (no costs or taxes taken into account)
Sources: Citadel Asset Management, DataStream
Property returns driven by falling interest rates
Listed property is predominantly bought for the income distributions (dividends) paid by these companies, and the dividend yield relative to bond yields is an important valuation measure. The fall in interest rates over the last ten years saw property yields declining from above 11% to around 6%. This reduction in yield had a massive positive impact on prices; in fact, this was the largest driver of returns. An important point, which we will get back to, is the question of what lies ahead for bond yields.
Property spreads had a positive impact on price as well
The reduction in property yields is partly due to a large contraction in the property spread, that is, the difference between the property yield and the government bond yield. As investor sentiment towards listed property improved during the past decade, property yields went from higher than bond yields to lower than bond yields; in other words, the spread became negative.
This change provided a further kicker to price returns. In fact, the combination of falling bond yields and contracting spreads caused prices to rise by 14% per year. This is double the 7% per year distributions growth rate. Once again we pose the question, whereto from here for property spreads?
Dividend distributions growth kept pace with inflation
The single best aspect of listed property is that over time, dividend distributions grow roughly in line with inflation. Chart 2 shows that sometimes the growth is faster and sometimes it’s slower, but fact of the matter is that there is a correlation. This is because shopping mall or office rentals typically escalate in line with inflation and, depending on cost control and funding costs (interest rates), this increase is passed through to investors.
This differentiates listed property from a normal government bond where the income (coupon) is fixed. In theory, property can be described as a ‘real’ asset and is more comparable to inflation-linked government bonds. These bonds currently yield around 2%, making listed property yields of more than 6% very attractive. A 6% real return is however only realisable if dividend distributions keep track with inflation going forward.
Chart 2: Distributions increase over time (roughly in line with inflation)
Sources: Citadel Asset Management, DataStream
Our view is that some of the tailwinds are turning into headwinds
Of the three supporting factors we touched on above, we see only one persisting: distributions growing roughly in line with inflation. Interest rates globally are still close to historical lows and are likely to rise in future. If sentiment towards listed property changes in this environment and spreads rise, prices will fall sharply.
It is not difficult to paint a scenario where bond yields rise by 1% and spreads close by 1% (for those that follow the financial press, think tapering by the US Fed faster than currently expected). This 2% change in the yield will instantly knock around 25% off the price of property. The opposite scenario, where yields fall a further 2% from current levels, is however difficult to imagine at this point in time.
In Table 1 we share a summary of our investment views. The remaining tailwind for listed property, distribution growth, is however extremely powerful. If distributions grow roughly in line with inflation and you have a long (say ten-year) investment horizon, attractive real returns is achievable even in a rising interest rate environment.
Table 1: Our investment view summarised
|Bond yields||Positive||Likely negative||Interest rates to rise|
|Property spreads||Positive||Possibly negative||Spreads to normalise|
|Distribution growth||Positive||Continued positive||Roughly in line with inflation|
|Short-term outlook||Volatility to continue, with likely price declines as interest rates rise|
|Long-term outlook||Distribution growth makes listed property an attractive long-term investment|
It is all about your investment horizon
Our investment conclusion is clear: Investors with a short-term investment horizon that cannot handle volatility should refrain from investing in listed property. The volatility of listed property is almost on par with that of the FTSE/JSE ALSI. We don’t advise anyone who does not have a long-term investment horizon and cannot sit through sharp price falls to invest in shares.
We believe listed property is an important component of a long-term growth portfolio. Even though listed property has different characteristics to shares, you need a similar investment approach. Currently, we do not hold property in any of our portfolios and prefer to be overweight shares. If our short-term investment view plays out and yields rise to attractive levels, we will definitely be actively looking for an entry point into this market.
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DISCLAIMER: A member of the Peregrine Group. Citadel Investment Services Proprietary Limited is licensed as a financial services provider in terms of the Financial Advisory and Intermediary Services Act, 2002. Kindly note that this article does not constitute financial advice. All information and opinions provided are of a general nature and are not intended to address the circumstances of any individual.
By Harold Strydom: Investment Analyst at Citadel Wealth Management