Listed Property in 2010: Positives and Negatives from Prudential

Listed property has already notched up decent returns in 2010. In the first two months of the year, the South Africa Listed Property index returned 5.5%, outperforming the FTSE/JSE All Share index by 8.6%. Property has also produced higher returns than cash and bonds. During this period the BESA ALL Bond Index returned 2.3% while cash returned 1.2%.

If you consider adding listed property to your investment portfolio, you may wonder if it will yield enough gains to warrant the shift from a ‘direct investment in property.’ You may even be unsure about what listed property is.

Listed property refers to the securitised interest in underlying physical property, in other words, you can invest along with other investors in a vehicle such as a unit trust, and have exposure to the property investments that underpin this. This interest is listed on stock exchanges, which makes it easy to trade. In South Africa, the underlying assets of listed property are largely commercial rather than residential properties. These assets include industrial warehouses, shopping malls, and both high and low rise offices.

Albert Arntz, Portfolio Manager of the Prudential Enhanced SA Property Tracker Fund says that there are several key drivers of listed property returns. These include the inflation expectations embedded in long bond yields, GDP growth - particularly growth in consumer spending as retail property makes up the bulk of listed fund portfolios - building activity and building cost inflation, and corporate credit spreads.

To help you weigh up the pro’s and con’s of investing in listed property Arntz suggests considering the following for 2010:

Regarding market rental declines, Arntz explains that this decrease does not mean that listed property earnings will decline in the short-term. “Property funds are only exposed to market rental declines on the portion of leases that expire annually. For a typical listed property fund, on average, only around 20% of leases expire annually. The remaining 80% of leases have rentals that escalate contractually by 8-9% per annum. ”

“In our view it is unlikely that we will suffer the same level of overbuild of commercial property in the current cycle that we experienced in the late 1990s and early 2000s. This is largely due to lack of credit from banks. In many cases market rentals are also still below feasibility rentals for new developments. Although national vacancy factors have risen, they are now only approaching long-run averages. This suggests simplistically that the commercial property market has not reached a position of oversupply yet. There are exceptions to this within individual property nodes. For example, excessive office property development appears to have occurred in Century City in Cape Town. ” says Arntz.

So what could happen in the year ahead?

According to Arntz, “One positive scenario for listed property in 2010 is that the SARB keeps interest rates on hold or even reduces them. The economic outlook continues improving and analysts expect vacancy factors to stabilise or decline. Listed property re-rates to distribution yields below, or in other words, more expensive than long-run averages. In this scenario property may deliver a total return higher than 15%.”

 “In a negative scenario the SARB raises interest rates. Listed property sold off more than 20% at the time of the first rate hike in the 2006 tightening cycle. Such a severe sell off is, in our view, less likely now because valuations are cheaper than 2006. In 2006, property yields were low making it expensive and hence vulnerable to a sell off as we entered the tightening cycle. Despite lower current valuation risk, interest rate hikes may lead to a decline in listed property capital values in 2010.”