Listed property still attractive despite headwinds
With South Africa’s economy stagnating and further interest rate increases still possible, SA listed property sector returns have, of late, disappointed investors. However, looking ahead, in the absence of a material de-rating of property, prospective total returns are likely to remain above 10% per year over the medium term, well above inflation. Should investors be heading for the hills or staying the course?
Looking at the results of the listed property companies for the most recent financial periods to the end of August 2016, as shown in Graph 1, the average distribution per share growth came to a healthy 15.9% y/y. However, this good level of distribution growth has not translated into favourable returns for investors over the past year, with listed property’s 12-month return of 3.5% (to 31 August 2016) lagging all of the major domestic asset classes.
So what is the investment case going forward? Examining market fundamentals, the outlook for the sector is somewhat mixed across the retail, industrial and office property sectors. The retail property sector has posted above-inflation growth in sales per square meter, a positive factor for potential base rental growth, and retail vacancy rates have been broadly flat.
In industrial property, rental growth has been above inflation and the vacancy rate flat, leaving it in good shape. In the office space, however, base rental statistics reflecting above-inflation growth are somewhat misleading, being distorted by a number of newly completed high-spec developments that have skewed asking rentals, without any actual underlying shift in demand. Meanwhile, office vacancy rates continue to persist above 10%, with an elevated level of development activity adding to new supply in certain areas. We continue to see the office sector as weak.
The above factors, when combined with a lack of growth in the South African economy, mean that the earnings outlook for property companies is on balance somewhat weaker. However, current consensus distribution growth forecasts for SA listed property (excluding non-yield paying developer stocks) are still healthy at 7.8% on a two-year forward view, as Graph 1 also shows.
If you take into account the sector’s forward distribution yield of 7.4% at the beginning of August (excluding non-yield paying developer stocks), together with a fair estimate of the long-term potential distribution growth of 5%–8%, then in the absence of a material de-rating in the market’s valuation, listed property is priced to deliver a total return in the region of 12%-15% (roughly 7.4% + 5% to 8%) over the medium term. This range of low double-digit total returns is attractive for South African investors, given that it should comfortably beat expected consumer inflation of around 6%.
However, investors should be aware that there are a few de-rating (or downside) risks to the valuation of listed property. At 7.4%, its forward distribution yield is significantly lower than the average over the past decade of around 8%. A move back towards the average would hurt returns. The prospect of global higher interest rates would also pose a threat to valuations. Heightened political risks as experienced in December 2015, and again in late August 2016, could also manifest in a de-rating of property, as could a downgrade of South Africa’s sovereign credit rating.
Despite these headwinds, we do consider listed property to be an important building block of our multi-asset unit trusts like the Prudential Inflation Plus and Balanced Funds, and are currently slightly overweight in this asset class compared to our benchmarks.
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