Residential property from an investor perspective
There are plenty of statistics to help us interpret trends in residential property prices. Each quarter we receive updated house price statistics from the big banks (Absa Bank, First National Bank and Standard Bank) as well as mortgage originator ooba, pr
Enter an opinion piece by Wilhelm Hertzog, Portfolio Manager at RE: CM. He tests the case for residential property from a value investor’s perspective. “As with any asset, the question foremost in our minds when it comes to residential property, is whether it is a good time to buy,” he begins. To answer this question we have to determine what the intrinsic value of residential property is before comparing this intrinsic value to current market prices. Armed with this information the buy or sell decision becomes easy. If house prices are below our intrinsic calculated value, we buy. If house prices are above this fair value level we proceed with utmost caution.
Using bank research to determine the market value
How do you determine fair value for a house? We’ve often argued with home owners that the value of their property is not what they “ask” for it when listing it on the market, but the price they would realistically achieve once the sale successfully beds down. In other words – you don’t know what your house is worth until the cash is in your pocket. Hertzog relied on the Absa House Price Index as a proxy for residential property values. This makes sense because Absa bases this index on its mortgage loan activity – where loan values are based on the actual selling price of houses. To flesh out his valuation model Hertzog also considered measures of South African household disposable income and GDP per capita.
This information was collated in three charts. The first chart plotted the inflation adjusted ABSA House Price Index going back to 1966. For the economists and statisticians among you the chart included the long term exponential trend for this data and one standard deviation above and below the trend. The second chart portrayed the index relative to South African household disposable income per capita to the end of 2010 and the third illustrated the index relative to South African GDP per capita. Graphs two and three are quite similar. What can we conclude from these graphs?
According to Hertzog these charts prove that South African residential property is no longer wildly overpriced, as it was between 2005 and 2007. But on the same evidence residential property cannot be said to be cheap!
On buy-to-let and rental yields
Investment analysts seldom value an asset without considering the income generated by it. The best way to assess the income generated by residential property is to look at rentals. “Working with data available to us, we can make certain inferences about residential property rental yields,” says Hertzog. The starting point is to estimate a fair rental yield, which he achieves by positioning direct property ownership on the risk return curve. An investment in a house is considered somewhat less risky than owning a business and more risky than lending money to a credit worth borrower… In other words, a “fair” rental yield should be somewhere between that of equities and government bonds.
“Calculating a real return trend from data sourced from Rode & Associates, suggests that South African investment property has on average returned a bit more than 5% real since 1962,” he says. “This fits nicely in between the real return of about 7% achieved by listed equities and the 2% or so real return delivered by bonds in South Africa over 111 years to the end of 2010!” He continues: “If we accept that rentals as well as property maintenance, repair and refurbishment expenditures grow broadly in line with inflation over time, it must mean that the sustainable net rental income (after all maintenance, repairs and refurbishment expenditures as well as direct property taxes) expressed as a percentage of the price of the property should equal the required real return – in this case about 5%.”
Residential property is a poor investment
A fair rental yield at inception therefore comes to 8% per annum, allowing for the 5% required return (to compensate for the risk of investment) and 3% for general repairs and capital maintenance. Hertzog split the maintenance component into 1% each year on ongoing maintenance and repairs and a 2% annual contribution to build up reserves to refurbish or rebuild the property comprehensively at the end of its life. We wonder how many buy-to-let investors actually make this provision!
The trouble is the average rental property is generating nowhere near this yield. “Rode & Associates conducts a survey of rental yields, and their data suggests that residential rental yields in South Africa are currently in the vicinity of 6%,” says Hertzog. “We have been unable to find good long term data on this, but 6% strikes us as well below what anyone would realistically consider a long term fair rental yield for this investment class.”
His conclusion: “While residential property is no longer as wildly overpriced as was the case a few years ago, our research suggests that the asset class is still far from cheap and offers rental yields well below what investors would consider a fair return.” The duration of the typical domestic property cycle – from trough to trough – is 16 years. And we have some way to go before we reach the bottom turning point.
Editor’s thoughts: The valuation argument by RE: CM ignores the benefits afforded property investors by leverage. Certainly, if you had R1 million cash it makes more sense to invest in equities or bonds over buy-to-let property… But if you only need R100, 000 down, the investment dynamic changes significantly. Would you agree that the leverage argument makes investment in residential property (in addition to your primary residence) more attractive? Please add your comment below, or send it to gareth@fanews.co.za
Comments