As safe as houses, or maybe not?

Over the past few weeks this writer has spoken to countless individual investors who have tied up large sums of money in residential real estate as part of their retirement plan. Such plans involve investing and paying for a handful of rental properties in the run-up to retirement, and then ‘living it large’ on the proceeds from the monthly rental income. Of course, this form of investment is not without its risks, not least of which that you are tied to the country and, more specifically, geographic location of each investment.

A range of uncertain risks

Investors in this type of retirement funding activity are also subject to a range of uncertain risks, including being invested in poorly performing areas; dysfunctional local municipalities; and tenant default risk, to name a few. In fact, many smaller investors have simply dumped their properties as the costs and risks associated with smaller portfolios dwarf the potential long-term returns on offer. A popular alternative to direct investments into residential properties has been for investors, often at the behest of their financial advisers, to pour money into listed property, either directly on the JSE or through one of dozens of collective investments scheme (CIS) funds. 

Alas, the listed property sector has been a minefield for investors, delivering terrible multi-year returns due to constrained economic growth and, more recently, the debilitating impact of the 2020-21 COVID-19 pandemic. Is it time to reconsider the sector? To find out, this newsletter considers the latest Property Insights note derived from the Q2 2022 FNB Property Broker Survey. The survey, said John Loos, Property Sector Strategist at FNB Commercial Property Finance, points to an ongoing decline in vacancy rates in all three commercial property markets… Do not despair, dear reader, because vacancy rates are one of a handful of areas where investors actually relish a declining trend! 

According to Loos, the turnaround in each of the industrial, office and retail property categories, reflects a “normalisation in economic activity following the harsh COVID-19 lockdowns, with those lockdown regulations having been scaled back dramatically through 2021, resulting in greater rates of new business formation and perhaps expansion”. The good news contained in the Q2 broker perception survey is that the office and retail property categories have finally caught up with the industrial category insofar as perceptions. This contrasts with the surveys carried out in the last two quarters of 2021 and the first quarter of this year, which showed industrial properties contributing disproportionately to the recovery. 

Industrial still in favour

Industrial property was the stand-out category in Q2 2022, with that sector’s Index for Direction of Change in Vacancy Rate returning negative 60 for the period, implying that 60% more respondents pointed to a declining vacancy rate compared with those pointing to an increase. In fact, industrial properties have been in a declining vacancy rate for six consecutive quarters. The retail property sector’s index level remained strongly in improving territory too, with a -62.1 reading, which was slightly less in magnitude than the prior quarter’s -72.8. “This still reflects a widespread broker perception of declining retail vacancy rates, stronger even than the industrial property reading in the latest quarter,” said Loos, adding that the office sector’s -32.5 score is the weakest of the three. 

At first glance, investors will be champing at the bit to plough into listed property funds with an industrial and retail property ‘skew’; but caution is indicated. Because even as South Africa shakes off the last vestiges of pandemic, a new monster looms. Loos explained: “As inflation and interest rates rise, and the economy comes under renewed pressure, the question is how long can this declining trend in vacancies last?” The fear is that rising cost pressures could undo the fragile recovery, especially in the national office vacancy rate, which reported surged to 18.2% during 2021, continuing a multi-year rise in vacancies in the category from 9.6% in 2015. 

Three reasons plus a counter…

The latest Property Insights note offered three reasons why vacancies in the office property category were declining, before warning that it was too early to conclude that South Africa had reached a sustainable declining office vacancy trend. The first was that there was a decline in available stock. “The new development of office space is weak, and a portion of existing stock is being converted into residential space, so we may have experienced some decline in the total available office space in the office rental market of late,” said Loos. 

The second, is that more realistic office rentals should curb the declining demand for office space. In other words, landlords were finally realising that their extortionate rentals were part of the problem. “Office rentals have been getting more realistic over time, and this can help to stabilise demand for space at some new lower equilibrium level,” he said. And thirdly, the sharp decline in employment numbers in the finance, real estate and business services sector has shown signs of ending. The assumption here being that a higher number of employed people translates into higher demand for office space. In reality, the hybrid work models spawned by pandemic render this assumption moot. 

“There are still big questions around the potential downscaling in office requirements by many companies; we know that greater levels of work-from-home compared to pre-lockdown days, along with improved use of desk space through the hoteling of space, has been leading to a reduction of office space requirements for many,” admitted Loos. “This may have significantly influenced the rising vacancy trend of recent years and we have no way of knowing when this trend process ends or slows down”. 

We cannot expect SMMEs to do all the heavy lifting!

It seems that property brokers are pinning their hopes on South Africa’s small, medium and micro-enterprises (SMMEs) to carry the industrial, office and retail property categories to new heights. It turns out that 24% of brokers made mention of  “growth in the small business segment” and “entrepreneurs opening new businesses” as reasons for their confidence in the retail property category. And just over 15% of respondents cited “growth in the small business segment” as their reason for remaining upbeat about industrial properties. Sadly, only 2.5% felt that small business growth would underpin demand for office space. 

“We would actually be cautious to say that we have reached a sustainable declining vacancy trend in any of the three sectors yet, given renewed economic pressures mounting,” concluded Loos. “In addition, the global economy is also showing signs of pressure from high energy prices and inflation in general, and resultant widespread interest rate hiking, and this can also dampen the domestic economy and business confidence”. The bottom line is that the declining vacancy trend in the office and retail property sectors are likely to fizzle out, leaving listed property investors to seek out funds that specialise in carefully selected industrial property assets. 

Writer’s thoughts:
Investing in domestic property has always been risky business, with today’s prime residence being prone to massive value destruction if it ends up being next to tomorrow’s informal settlement, rail development or sinkhole. What advice do you give to clients who are invested in, or considering investing in, small residential units to supplement their retirement incomes? Please comment below, interact with us on Twitter at @fanews_online or email us your thoughts editor@fanews.co.za.