A bit about property…

For many of us, investing in property refers to the purchase of a home to live in, or for the more fortunate, a second or third property to rent out or use as holiday accommodation. Purchasing property is an integral part of wealth creation. Yet owning physical property is only one means of gaining exposure to this unique asset class, and essentially only exposes the homeowner (or the investor) to a specific area of the property investment spectrum i.e. the residential property market. Moreover, the returns derived from owning a home, which presumably is appreciating in value over time, are unrealized unless the property is sold, and even then, usually the return derived from selling one’s primary property is used to finance a new primary residence. Few people sell their only home and move into a rented flat simply to realize a capital gain!

For those who purchase secondary properties or speculate in residential property, the costs of financing the property together with the general illiquidity associated with physical property can make this type of investing particularly daunting. The buy to rent strategy also has its own difficulties, not least of which is the fact that residential rental rates can be influenced by numerous exogenous factors. Despite the fact that real estate agents usually facilitate the managing of the property on the owner’s behalf, it is the owner who ultimately remains responsible for the upkeep and maintenance of the property, and also shoulders the burden of any unrecoverable damage which may be incurred.

Like with all other markets, prices of residential properties fluctuate depending on the supply. That said, residential property has been kind to investors with decent returns over the past decade and a bit. Between the beginning of 1997 and the middle of 2007 median property prices as measured according to Standard Bank’s mortgage book increased by 330% in nominal terms. Median house prices according to ABSA’s mortgage book over the same period increased by 415%.
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Figure 1: Median House Prices (source INET)

The performance of the residential property market is to a large degree a function of the interest rate environment, the financial health of personal balance sheets as well as the confidence which the average person has in the local economy. When individual balance sheets are strong and there are expectations of strong economic growth going forward, individuals are more inclined to take on extra debt which translates into extra demand for residential property and higher prices. Similarly, when interest rates are low or there are expectations of declining interest rates going forward, individuals will be more inclined to take on debt in order to purchase new or more expensive homes.

Albeit that investing in residential property is implicit to most of us who aspire to owning our own homes, investing in listed property does provide another means of getting exposure to the property market. The listed property universe may be divided into 3 broad categories, namely PUTs (Property Unit Trusts), PLSs (Property Loan Stocks) and Property Companies.

PUTs, like all other local unit trusts, are registered under CISCA – the Collective Investment Schemes Controls Act of 2002. Where they differ from ordinary unit trusts is that they are listed on the JSE. There are currently 5 PUTs which jointly have a market cap of approximately R30bn. Since inception in 1969, the legislation surrounding PUTs has become more relaxed, especially with regards to gearing levels. Gearing levels in a PUT are dictated by its trust deed which specifies the amount of borrowing as a proportion of the fund’s holdings. The gearing levels in local property unit trusts are much lower than their international counterparts. Initially, PUTs were only allowed to invest in fixed property, however with the loosening of the legislation surrounding PUTs, they are now being allowed to invest in non-fixed property (listed property) as well. Only retained income is taxed inside the PUT, the income which is distributed to the investor is only taxed in the hands of the unit holder. As a consequence of this tax legislation, all income is paid out to the investor either biannually or quarterly. Income distributions from PUTs are regarded as interest – and taxed accordingly.

PLSs were born during an era when PUT legislation was still fairly restrictive. Unlike PUTs at this time (early 1980s), PLSs were allowed to borrow funds, and could also invest in listed property. PLSs are companies which invest exclusively in property. Like all other companies, they are subject to the Companies Act of 1973. There are 13 PLSs which jointly comprise a market cap of approximately R90bn. Each unit of a PLS is essentially comprised of a portion of equity in the underlying property portfolio together with a portion of debt (a loan to the company). The investor earns interest on his / her loan to the company which is funded from the rental collections on the property portfolio net of the administration, maintenance and other running costs. Dividends paid out on the equity portion of the unit are usually small in comparison to the debenture (loan) interest payments. Similar tax rules apply to PLSs as to PUTs, and as such, the interest earned on the investment is taxed in the hands of the investor and not the company.

Listed Property companies differ from PUTs and PLSs in a number of ways. Firstly, they are taxed on both their profits and their distributions. Secondly, listed property companies are not compelled to distribute all their net income. Lastly, listed property companies are allowed to buy shares in other listed property companies and are not forced to invest directly in physical assets. Listed property companies are also subject to the Companies Act of 1973. Listed property has distinct advantages over residential property when used purely for investing purposes. Listed property companies are listed on the JSE, and trade similarly to ordinary equities. As with equities, one is able to gain exposure to a property portfolio without purchasing the properties in their entirety. This means that the investor does not need to lay out large amounts of capital (as in the case of purchasing a residential property) nor does the investor need to raise a mortgage bond in order to finance the property.

Since there is an active market for listed property shares, they are a lot more liquid than physical property and may be disposed of a lot quicker without incurring large transaction costs or paying high sales commissions. Listed property also has diversification benefits over physical property, in so much as the property portfolios are usually comprised of a mixture of property types (retail, industrial and commercial) and also provide geographic diversification – i.e. may be spread out over a fairly large area unlike a residential property which is usually confined to a single geographic area.

Historic performance is usually a poor indicator of future performance. That said, listed property has historically provided investors with handsome rewards. Since inception (April 2002) till the end of September 2010, the listed property index has delivered a return of 726% (28.3% annualized) compared to the ALSi which delivered a return of 238% (15.4% annualized) and the ALBi which delivered a return of 168% (12.3% annualized).
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Figure 2: Listed property performance versus equities and bonds. (source INET)

The returns derived from listed property are twofold. Like shares, the value of the underlying property portfolio may appreciate (or depreciate) over time. This increased (decreased) value in the underlying portfolio in turn contributes to an increase (decrease) in the value of the property units. It’s important to note that like with equities, there may be irrational periods of over and under pricing of the units. The second source of the return on listed property is the yield which is derived from the portfolio. This yield is essentially funded by the rental stream derived on the properties as well as interest earnings. A major advantage which listed property has over other asset classes is the relative stability of the yields which they provide. (see the graph below)

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Figure 3: Listed property returns broken down into capital and income. (source: Catalyst)

This stability results out of the fact that the rental incomes are usually tied down by lease agreements which lock in tenants over a period of time. Moreover, these lease agreements usually have a built in escalation clause which ensures that the collected rental stream escalates at a minimum of inflation. The onus of managing tenant contracts and maintenance of the property portfolios are delegated to specialized property management companies, which means that the listed property investor is not burdened with the administration and maintenance of the properties.

Another significant characteristic of listed property is best illustrated by looking at its correlation to other asset classes – specifically equities and bonds (see the table below). Over the period from the inception of the listed property index (April 2002) till the end of September 2010, the correlation of the listed property total return index with the ALSi and the ALBi was 30% and 60% respectively. This speaks to the usefulness of listed property as a means of portfolio diversification. Also, it’s interesting to note that the volatility of listed property over the same period was marginally less than the ALSi, despite having outperformed both equities and bonds.

Table 1: Comparison of standard deviation across asset classes. (source MoneyMate)

This observation is by no means attempting to make the case for listed property as an alternative to investing in other asset classes, since the results of such analysis are usually subject to end point bias. Rather, what does become apparent, is the importance of this unique asset class when constructing a diversified portfolio.

References

1) Moodley-Isaacs, N., 2009. How to invest in listed property, [online] Available at: http://www.persfin.co.za/index.php?fSectionId=&fArticleId=5152692 [Accessed 22 September 2010].

2) Brown, M. 2010. Listed property: The fourth asset class, [online] Available at: < http://www.mg.co.za/article/2010-05-07-listed-property-the-fourth-asset-class> [Accessed 20 September 2010].

3) Catalyst, 2010. Listed property sector monthly overview, [online] Available at: < http://www.catalyst.co.za/domestic/reports/reports2010/monthlyreportSep2010.pdf> [Accessed 30 September 2010]

4) Botha, J., 2010. South Africa: Residential Property Report, [online] Available at: < http://ws9.standardbank.co.za/sbrp/LatestResearch.do> [Accessed 20 September 2010]

5) Association of Property Unit Trusts, 2010. Property Unit Trusts, [online] Available at: http://www.put.co.za/ [Accessed 20 September 2010]

Association of Property Loan Stocks, 2010. Property Loan Stocks & Tax Information, [online] Available at: http://www.propertyloanstock.co.za/ [Accessed 20 September 2010]