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26 October 2004 Angelo Coppola

There is now little doubt that 2003 marked a major turning point in investors’ perceptions of directly-held property as an asset class, say property economists Rode & Associates in their third-quarter publication Rode's Report on the SA Property Market.

This continued rerating of non-residential property has led to a further increase in market values on the back of decreasing capitalization rates.

Capitalization rates — the non-listed property sector’s equivalent of the forward earnings yield of shares — decline when prices rise, holding constant market rentals.

Further, the gap between listed property’s income yields and capitalization rates has continued to narrow, even closing recently. This means that property investors now have less of an incentive to invest in listed property than in directly-held property.

Rode's Report editor Garth Johnson says that given the good fortune of retailers, it is not surprising that shopping centre capitalization rates were the first to drop.

"In fact, regional shopping centres are so highly rated that some investors are happy with yields close to those offered by government bonds."

Decentralized-office capitalization rates also declined further, showing that investors regard the recent oversupply in certain nodes as cyclical and not long-term in nature.

The big surprise on the office front came from CBDs, whose capitalization rates dropped sharply.

"Given the general decline in capitalization rates, caused by a downward adjustment in investors’ long-term inflation expectations and an insatiable demand for property by listed funds and syndicators, we expected a small decline, but not to the extent that we have witnessed.

"Sapoa’s most recent vacancy survey shows that there has not been an increase in the demand for office space in most CBDs. We can only conclude that the hype surrounding office-to-residential conversions has created this substantial strengthening of capitalization rates in the CBDs," Johnson says.

Turning to office rentals and demand, he says that Rode & Associates expect that rentals will bottom out soon, as above-normal vacancy rates are being eroded. A growing economy has seen office take-up increase nicely over the last twelve months, which bodes well for rental growth sooner rather than later.

Real industrial rentals continued to rise in the second quarter of 2004 in the wake of a steady climb in manufacturing activity since the second quarter of last year. This turnaround in the industrial market is significant because real industrial market values have been on a secular decline for over two decades.

Turning to the residential market, Johnson says house-price growth for all price classes continued to accelerate faster than building-input cost growth in the last quarter of 2003. Middle- and upper-priced suburbs are consequently at real levels last seen in 1984.

These are dangerously high levels, but Rode does not expect an implosion any time soon in the absence of an external shock to the economy.

Lower-priced homes, however, have not had such good luck and real values are still lower than their levels in the early 1990s. Hence, if the past is anything to go by, lower-priced houses still have ample space for upward movement.

For once, prospects look slightly better for the building-construction industry. With office vacancies in the decentralized nodes being mopped up, an increase in office-building activity could be on the cards. Industrial building activity should also increase, given the resurgence of real rentals.

Input-cost increases have been decelerating since the start of 2003 and continued to do so in the second quarter of this year.

This downward trend in underlying building-cost inflation comes on the back of a strong rand, which impacted positively on building-material costs, and moderate labour cost increases.

Strengthening building activity has, however, allowed contractors to stretch their profit margins.

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