Listed property: A good investment in volatile markets?

A decade ago listed property was unpopular as an investment vehicle, for various reasons. But this asset class has since undergone a revival, writes Richard Anderson, senior portfolio manager: Sanlam Investment Management (SIM). Both younger and older investors can add this asset class to their portfolios for long- term benefits.

Listed property has performed exceptionally well for the past eight years and was virtually untouched by the global credit crisis other than an initial panic-induced meltdown.

However, as a value manager we are cautious in our immediate outlook for the asset class because it will prove difficult to achieve the rates of growth experienced since early this decade – and there is a possibility the sector could derate if the economy remains under pressure.

The property market tends to lag a pickup in the general economy by about 12 months because businesses need to see firm evidence of better economic conditions before they will look for more   space. So the longer the downturn, the more likely property will be negatively affected.

For now, however, conditions in the industry have generally stabilised, with vacancies and rental arrears reaching a plateau and bad debts never a real issue for the industry. (See graph 1)

A solid survivor

SA listed property held up remarkably well during and after the sub-prime crisis because listed property companies generally had much sturdier business models and didn’t fall prey to the same over-development and gearing experienced elsewhere.

The industry has also benefited from a structural change that has boosted demand for the asset class. A decade ago most investors ignored listed property for a variety of reasons.

There was a lack of demand for listed property for these reasons:

* Up to 1998 listed property performed extremely poorly owing to rising interest rates.

* The city centres of Johannesburg and Durban were abandoned, leaving vacancies and redundant properties within the funds.

* Investors preferred offshore investments as foreign exchange controls relaxed, so listed property was sold to fund offshore investments.

* IT or “new economy” stocks were preferred over property or “old economy” stocks during the run-up to the new millennium.

Since then, however, investors have recognised the benefits of the asset class and thus have been removing their underweight exposure to the sector. Against this backdrop, investors in the SIM Property Fund and in the SIM Balanced, Inflation Plus and Active Income Funds, which all have exposure to this asset class, have benefited from listed property’s exceptional returns and its hybrid nature in that it has both bond- and equity-like characteristics.

In relation to bonds, listed property offers relatively high – and growing – yields. While property yields tend to be somewhat lower than yields of bond funds, they do offer investors annual growth in income as a result of contractual rental escalations, which currently range between 6% and 10%. (See graph 2.)

Future development

The industry is also likely to undergo various changes going forward, which could further boost demand for the asset class. For instance, the listed property sector is working towards adopting global standards and structures. Offshore listed property is available for investment in structures called Real Estate Investment Trusts (REITs).

In South Africa, investors can opt for either a property unit trust (PUT) or Property Loan Stock (PLS) – investment vehicles that are largely unknown to international investors. So to attract more foreign investment into this South African asset class, the local listed property industry is planning to amalgamate the two different instruments into a REIT structure.

A REIT is not itself subject to CGT or company tax. However, distributions to investors are deemed to be interest and thus investors are taxed at their own marginal income tax rate, which encourages people in the lower tax bands to invest.

Thus the asset class is particularly well suited to elderly investors and charities reliant on income and who want their income stream to keep pace with inflation. Investors need to be aware that their capital values will still be subject to stock market volatility though.

For younger investors, the equity-like characteristics of the asset class are attractive, namely that listed property offers capital growth albeit at a rate that is likely to be lower than equities, given that income in listed property funds is fully distributed rather than reinvested.

Managing the risk

Property risk is managed within listed property funds by owning a number of properties, in most cases across the property sectors (retail, commercial and industrial), and diversifying across a large range of tenants.

Interest rate risk is managed by fixing interest rates on the bulk of debt in most cases. So not-withstanding prevailing market conditions, it is worth having long-term exposure to listed property because of its diversifying qualities and its yield. Listed property exposure is also asset-backed, with physical assets underlying the holdings.

The industry’s recent resilience to adverse global economic conditions further highlights that the listed property funds are well-managed and fundamentally sound investments.