Property is one of the most discussed and debated topics when it comes to an investment strategy. As South Africans, we are probably more biased towards property than most international investors due to historic property ownership and wealth creation opportunities that many SA citizens experienced [or were denied].
Investors grapple with the choices available to them. Should you invest in the residential space or commercial space, should you own property directly (bricks and mortar) or via ETFs or funds like real estate investment trusts (Reits), and to gear or not to gear, the list goes on and on.
As with any asset class, one must understand the fundamentals of property and know what drives the price, what economic factors influence valuations, and what sectors are likely to outperform under certain economic and market conditions.
Another factor to consider is what the main purpose of including property in a portfolio will be. Is capital growth your main objective or do you want to create an income-paying investment portfolio? All these factors will determine how much property exposure must be held in a portfolio at a given time.
Listed commercial property is a bit like Jekyll and Hyde. On the surface, you see value in the bricks-and-mortar, consistent income streams, glamorous shopping centres and more. As soon as inflation picks up and interest rates start going up, leases are cancelled and the nasty side of commercial property starts raising its head …
Before I put a figure to the optimal property exposure let’s look at some of the fundamentals of listed commercial property.
The following factors apply to commercial property demand and valuations:
- Rental income. The higher the rental income stream is, the higher the property value will trend due to the demand for income-paying assets. This holds hands with the occupancy rate of a given property. Investors don’t like half-empty shopping centres and office blocks.
- The percentage yield determines the quality of the property. This can work in two ways. High yield (where the % of the rental is in relation to the property value) can mean there is a high demand for shopping centres or office space, which pushes up the rental in quality centres. However, an even higher yield can mean there is risk in a property. For example, in a ‘C’ market segment shopping centre where the property valuation by market demand could be dropping (due to, for instance, concern about land invasions) but rentals remaining at the same level will increase the yield. Lesson (same as bonds): If the yield of property suddenly increases, it means the property valuation has decreased! A rising yield is not a good thing for property valuations. It does, however, provide buying opportunities for the right property. In this case, buying high and selling low makes sense, quite unlike shares where you buy low and sell high (confused now?). The same rule, however, applies to all investments: be sure of the quality of the underlying asset before you buy.
- Where income is required from an investment, the three main contenders are cash, bonds and property or a combination of the three as we see in many income funds.
- All three asset classes are taxed in a similar way. The rental income component referred to as distributions within property funds (Reits) is taxed as income and will be taxed at your marginal tax rate irrespective of whether you receive the ‘distribution’ or not. Investments within retirement annuities (RAs) and tax-free investments are obviously tax-exempt.
- Since these three assets compete, the main driving factor that will influence their preference is which one offers the highest net return after tax. In this instance, commercial property acts very similarly to a 10-year government bond as far as yield and valuation trends are concerned. Property does, however, also have a component of capital growth due to valuation which bonds do not have.
- Inflation and interest rates, therefore, have an impact on all three of these asset classes.
- Gearing can work in favour of capital growth in bull markets, but during bear markets gearing has an adverse effect on the capital value and breaching bank covenants leads to disastrous outcomes! Be sure you know what the gearing limits are within the funds you use.
Considering the limited number of listed property companies on the JSE, many of the SA Reits perform in a similar manner. Some Reits also invest in offshore properties. It is therefore important to take note of the underlying investments and sectors the Reit holds before investing in it.
The graph below illustrates the growth and volatility characteristics of a prominent property fund’s local (blue line) and global (red line) funds over the past 10 years. This trend is universal across the sector. Property in any form is by no means a stable, predictable investment. It acts and reacts the same as a normal company listed share and can turn quite nasty once fundamentals turn against it. One does, however, expect it to deliver decent returns over extended periods.
From the above, we can conclude that Covid-19 had an adverse effect on both local as well as global property values.
During Covid-19 there was also a structural shift away from office and shopping centres to data centres and warehousing to accommodate the massive demand in home deliveries and online working. Funds/fund managers who identified the trend and adjusted their portfolios early fared better than those who didn’t.
Where to from here? Three answers …
I am going to provide you with three answers (I am after all a confessed ‘draadsitter’ [fence-sitter], often answering: ‘Well it depends.’).
1. Not many multi-asset fund managers currently have more than 5% property exposure in their portfolios. This is based on current fundamentals and a concern about a possible global recession. Property values err on the fair value side depending on the sector you look at. If you currently have property exposure of around 10% I would probably leave it as is but not add to it if your investment objective is to achieve capital growth. The horse has bucked and getting out now will cement your losses. If you have substantially more than 10% exposure it may be a good idea to trim exposure to a more acceptable level.
2. If you are building wealth by way of monthly contributions and you like property, allocate a maximum of 10% of your monthly contribution to property. If you are not too keen on property, then keep your allocation to 5%.
Within the retirement space, property is one way you can increase your exposure to growth assets beyond the Regulation 28 limitation of 75% placed on equities. Regulation 28 allows 25% exposure to property which means you can bump up your exposure to growth assets to 100%. Bear in mind the heightened volatility risk that you will experience, but if you have 15 or more years to retirement, being a bit more bullish may work in your favour …
3. If you are investing with the intention of deriving an income, property offers good qualities as far as yield and potential capital appreciation are concerned. Remember that listed commercial property has both bond and equity characteristics, so don’t get caught on the wrong side of the yield curve! Capital losses can occur often, and they can be aggressive. In my opinion, if you keep your overall property exposure below 10% it may be a good idea to allocate the property exposure to an income-paying investment combined with cash and bonds. Some administrators can pay out the rental yield component on a quarterly basis, but it will probably make more sense investing directly with one or two property funds and instructing them to distribute the distributable rental component to you.
In figures, the structure will be as follows:
- Overall investment value = R10 million
- Property portion = R1 million
- Structure: Income-paying investment (depends on your income requirement):
- Property: R1 million
- Bonds/cash/income funds: R4 million
- Total yield as income = approximately 8% or R400 000 per year
- Capital growth investment: 100% equities with offshore exposure depending on your risk appetite and income requirement.
The above is for individuals who favour property. For the Average Jo, keep it simple. Invest in a suite of multi-asset funds, risk-adjusted according to your risk appetite with adequate offshore exposure, and you should achieve acceptable results over time.