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The case for listed property in an index-tracking vehicle

04 December 2018Jason Swartz, Head of Portfolio Solutions at Satrix
Jason Swartz, Head of Portfolio Solutions at Satrix

Jason Swartz, Head of Portfolio Solutions at Satrix

More than just a diversifier; the appeal is in the attractive yield

Listed property has often suffered from an existential identity crisis. Is it an asset class all on its own, or is it a distinctive sub-sector within equity? Or could it even be seen as a high duration bond? Most seasoned investment professionals consider listed property as a stand-alone asset class given its unique character where the return drivers are linked to both equities AND bonds. As an example, a share in a listed property company produces returns through the change in its share price, which is linked to earnings/rental growth prospects (equity return driver). But also offers a regular income in the form of dividends (derived from rental incomes), which is linked to inflation (the driver of bond returns). This combination of both capital gains and income provide a distinguishing character that can be accessed by investors.

As such, listed property has become an increasingly popular and accessible asset class globally over the last fifteen years, in large part due to the proliferation and success of real estate investment trusts (REITs). These products gives investors access to the same cash flow characteristics previously available only to direct property investors. While the REIT model is largely a global investment structure, property loan stock companies and property unit trusts listed on the JSE have been steadily converting into REIT structures over the prior five years, providing investors with effective exposure to this asset class. REITs offer the benefits of real estate ownership without the challenges of being a landlord, and unlike direct property ownership, these shares can be quickly and easily traded.

The role of listed property


A critical question around investing in listed property however is: what role does this asset class play within your portfolio?

Traditional asset classes such as equities, bonds and cash each have a clear case for inclusion within a balanced portfolio, typically revolving around improving the risk-adjusted return characteristics of a strategic asset allocation. This is no different with listed property. Since January 2004, this asset class presented the best risk-adjusted outcomes (as measured by the Sharpe Ratio) across a broad range of asset classes for South African investors. This long-term result is in spite of the correction seen earlier this year in listed property, as the asset class fell some 23.5% year-to-date. On the upside, however, this sell-off presents an attractive opportunity for investors looking to gain exposure to this asset class.

Risk and return summary of asset classes (Jan 2004 to Oct 2018)

Intuitively, one would reason that due to listed property distributions generally being based on rental incomes that increase over time, the reliability of these distributions would make listed property stocks less risky than other equities. The reality is that property companies are exposed to interest rate changes due to the leveraged nature of their balance sheets, and this manifests through this asset class’s return volatility which can be seen to be the highest among competing asset classes since 2004. Notwithstanding the high volatility, listed property has still produced a strong compensating premium to deliver meaningful risk-adjusted returns.

Yield – not diversification – makes for an appealing income stream


An argument typically given for the consideration of listed property within a balanced fund is its diversification benefits, seen through its generally low correlations to other asset classes. Based on our analysis (calculating monthly return correlations since 2004) we find this argument lacking empirical evidence, as listed property has a correlation of 0.56 to domestic bonds and 0.44 to domestic equities – which is hardly appealing. A far better diversifier (with lower correlations to domestic equities and bonds) would be inflation-linked bonds, for example.

What listed property does offer, however, that no other asset class can, is its mouth-watering yields.

Figure 1: 12-month rolling yields of South African listed property, equities and bonds

 

Source: Bloomberg, 2018

These high yields are generated through long-term rental agreements with tenants, and are typically diversified across segments, sectors and regions. This produces fairly reliable income streams for investors relative to traditional equities.

Globally, the appeal of high yields has grown as sovereign bond yields have struggled to normalise, given years of financial repression and low inflation expectations. As such, the search for alternative sources of yield among global asset allocators has intensified. Domestically, nominal bond yields have not experienced the same pressure, and investors should continue to compare listed property yields to what is offered from nominal bonds. Relative to listed equities however, listed property yields have delivered between two and three multiples of that of listed equities – a very appealing income proposition.

Choosing the correct property index


For investors in South African listed property, the choice of benchmarks has significantly improved with the new range of FTSE/JSE property indices. These indices aim to give market participants access to a range of property baskets covering the spectrum of the asset class. The new FTSE/JSE All Property Index provides broad coverage of all listed property companies in South Africa (not just the primary listings) and has additional benefits of capping constituents at 15% and employing a shareholder weighting to better reflect investability. A liquid subset of this index is the new FTSE/JSE Tradable Property Index, which excludes small caps stocks, while the FTSE/JSE SA REIT index is intended as a benchmark for the SA REIT industry, providing benchmark users with a real estate index with both an SA-bias and an increased yield-bias. Relative to the other two new indices, the SA REIT index presents the most challenges from a liquidity perspective versus the Tradable Index, which is very liquid.

Investors can now pick the index that is best suited to their own investment needs, but should be mindful of each index’s construction, yield prospects and liquidity before deciding. For now – warts and all – a de facto benchmark for domestic listed property remains the SA Listed Property Index, otherwise known as SAPY.

Satrix’s Property Index capability


We believe that the benchmark choice and the resulting returns are what form the most important elements of any investment. By investing in an index-tracking vehicle, the returns for investment strategies are well established. Particularly for an asset class that presents relatively less dispersion between stocks with similar macro drivers – index tracking is a strong choice.

The Satrix Property Index strategy is a specialist index tracking capability that tracks the performance of the FTSE/JSE SA Listed Property Index. By applying a full replication strategy (i.e. we match the exact constituents and weights of the relevant index) there is no risk of deviation from the chosen benchmark and tracking error can be minimized. The fund also engages in scrip lending activities to reduce costs, and is rebalanced on a quarterly basis.

Why choose this capability? This property index tracking investment strategy by Satrix would be appropriate for investors wanting simple and transparent exposure to SA Listed Property stocks at a compelling cost. The fund would also appeal to investors who require an enhanced overall yield and income generation in their portfolio, but not at the cost of long-term capital appreciation.

Conclusion


Many investors still favour investing in real estate directly or in unlisted investment vehicles, despite the worldwide growth and advantages in listed property products as well as real estate investment trusts (REITs). We are confident that the adoption of this unique asset class will continue to grow in understanding and acceptance, particularly with the expanded choice of domestic listed property indices now available to meet the needs of more investors.


We began our analysis in 2004 due to South African inflation-linked bond return data only being available from this date.

 

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