Listed South African Property had to face up to the challenge of a severe recession over the past 18 months. That the sector has met this challenge very successfully is very clear from both reported financial statements and valuations in the asset markets. The Property Loan Stock Index (PLS) and Acucap continued to deliver positive growth in cash distributions and very satisfactory total returns to its unitholders over the past twelve months when the SA economy came under considerable strain. 

The recent approval registered by portfolio investors in the performance of PLS companies in general and of Acucap in particular has been very gratifying and is a testament to the strong defensive qualities of listed commercial property in South Africa. In the thirteen months between 1 May 2009 and 30 May 2010 Acucap delivered a total return to its unitholders of nearly 27%, well in excess of the returns realised by the PLS Index of an impressive almost 19% (see below) The JSE All Share Index (ALSI) over the same period returned 28.91% and the All Bond Index (ALBI) 8.81%.

 

 

 

 

 

 

 

These recent returns have reinforced the exceptional performance of the PLS Index over the past ten years and more. Since Jan 2000 R100 invested in the PLS Index, with distributions reinvested in the Index, would have grown to about R1 000 by early June 2010. By the same measure, R100 invested in the JSE would now be worth about R380 while R100 invested in the ALBI with interest reinvested would have grown to about R360.

Over this period 2000 - 2010, the average annual total return, calculated monthly, in the form of capital gains plus distributions provided by the PLS Index, was as much as 24.5% per annum. Acucap, since its listing in 2002, has delivered an average compound rate of return of over 24% pa. These well diversified returns may be very favourably compared to the JSE ALSI that delivered average annual returns of 16%, the ALBI 12.24% pa average and 9.3% p.a. from the money market. These returns may be compared to an average inflation rate of 6% pa over the period indicating that all these asset classes gave highly satisfactory real returns over the decade. SA listed property provided truly extraordinary benefits to its shareholders.

We discuss further the reasons for these high returns that have so exceeded what might be regarded as expected returns, from what is a relatively low risk and liquid asset class.

 

 

 

 

 

 

 

 

 

 

When these cumulative benefits are converted into compound annual returns and compared, it may be seen in the following graph that investors in the PLS Index have suffered but one period of negative returns over the last eleven years and more. That was in the aftermath of the Global Financial Crisis and that was in 2008-09. It should be noticed that the JSE PLS Index, with the bond market, escaped the bear market of 2002-03 completely. It should also be noticed from the figure that the bond market held up very well in 2008-09 and that the property market, as represented by the PLS Index, held up much better than the share market in 2008-09 and recovered sooner from the global financial crisis.

These statistics help make a very important point about the SA property market. That is that the influence of interest rates on property valuations has been much more important than that of the share market, including those of banks and insurance companies,  that are themselves directly affected by interest rates.

 

 

 

 

 

 

 

 

We have calculated the sensitivity of monthly percentage movements in the PLS Index to monthly moves in the ALBI and the stock market, as represented by the Index of Financial shares on the JSE or the ALSI. The results are striking. Monthly property returns have been highly sensitive to the direction of the bond market and in a statistically very significant way. Moreover, the influence of the bond market on property returns has been growing in recent years as has the goodness of the fit of the model that links monthly property returns to monthly bond market and Financial Index returns. As we show below, what financial analysts refer to as the bond market beta, has been rising, while the goodness of fit of the model, measured by its R squared, has been rising.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

The figure above indicates that for every one percent move up (lower interest rates) or down (higher rates)  in the ALBI, the PLS Index consistently increases or decreases by about two percent in the same direction, while every one percent move  in the share market would move the PLS Index by only about 0.4%. In other words, the property market has a very high interest rate beta, is highly exposed to the bond market and has a low equity market beta. This means that listed property has provided very good defence against moves in the equity market,  especially when interest rates recede as they are likely to do under recessionary conditions. Thus any weakness in the top rental line of the property owner can be well countered by lower interest rates when property assets are valued. The recent close connection between the behaviour of the bond market and the property market is testimony to the importance of interest rates on property valuations and the defensive qualities of listed property.

 

 

 

 

 

 

 

 

 

 

 

 

The influence of interest rates on valuations is twofold. Most important,interest rates represented by the ALBI with an average duration to maturity of three years, indicates the opportunity cost in terms of interest foregone of holding claims on real estate. Thus net rental income is present valued or capitalised at market rates of interest. Furthermore, lower or higher borrowing charges can feed through to the bottom line of property companies depending on the duration of their own borrowings. This direct influence of interest rates on Acucap’s reported financial results is plain to see. Interest paid to Acucap creditors fell by R23m from R228m in 2008-09 to R205m in 2009-10.

But it was more than lower interest rates that helped the bottom line and the ability of Acucap and other PLS companies to grow the cash distributed to its unitholders. Despite the recession, the demand for trading, office and industrial space held up well and the ability to collect rents and benefit from escalation clauses in rental contracts was exercised in large measure.

The economic health of the major retail chains that are so important in the letting life of Acucap has been very well sustained despite the weakness of household spending. Major retailers who generate outstandingly good returns on the capital they invest showed no lack of appetite to maintain, and indeed to add to their trading space.

And so while growth in the top revenue line of Acucap and its peers was minimal or marginally negative over the past twelve months, given the recessionary state of the economy, the growth in cash distributed to shareholders despite the recession was mostly very well maintained, Acucap has also proved able to exercise good control over its cost of managing its assets partly through realising economies of scale in asset management.

The acquisition of management control of Sycom has proved very helpful in controlling the costs of managing the Acucap portfolio.  This success is well reflected in what may be regarded as a critical ratio – that of net costs to income. This very encouragingly has declined from 12.7% of Acucap income in 2005 to 11.1% in 2010. The search for economies of scale, the careful attention to costs, as well as the ability to focus the skills of our management team on a few large buildings and centres, has been a consistent feature of the Acucap business model. The declining cost to income ratio informs that our strategy is working well and that the focus on containing costs is being maintained, despite inflationary pressures.

In the figure below we compare the annual growth in dividends distributed by the companies included in the PLS and the JSE ALSI over two difficult periods for the JSE and the SA economy (2002-03 and 2008-10). As may be seen on the dividend, line PLS companies underperformed the ALSI in 2002-03 and have greatly outperformed in 2008-10.

 

 

 

 

 

 

 

 

 

 

 

 

Measured on the basis of daily returns since 2005, the Property Loan Stocks have been much less risky than the ALSI and more risky that the ALBI as may be seen below. That is less volatile as measured by the 30-day moving average of the standard deviation of daily returns. The standard deviation of daily returns over the entire period 2005-2010 is 0.3% for PLS, 0.6%  for the ALSI and 0.1% for the ALBI. The PLS has been about half as risky as the ALSI and three times as risky as the ALBI.

 

 

 

 

 

 

 

 

 

The JSE listed PLS Index has held up very well in 2008-2010 on their good economic fundamentals. These fundamentals, in the form of very good dividend yields and strong average growth in dividends, have been excellent for many years. The average annual internal rate of return calculated monthly for the PLS Index has been 18.36% pa. This is the sum of the initial dividend yield, twelve months before to which the average growth in dividends distributed of 7.5% pa is added to measure the internal rate of return.

However, the very high average annual returns realised by investors in this sector of the JSE suggest that the good underlying performance of the Property Loan Stocks came as something of a large surprise to the market place. Had these internal rates of return, or more generally the high rate of return on capital employed been well anticipated, higher values would have been placed on the shares traded at an earlier point in time and so the realised rates of return would have been lower and more normal. That is to say starting values would have been higher and returns lower for the same very good underlying performance. It remains something of a puzzle that the sector has not come to enjoy a higher standing by investors, and that will be addressed below. That the sector can perform well through recessionary conditions should provide further justification for improved values and lower realised returns.

We have suggested before that an appropriate expected rate of return for an investment in well diversified and liquid listed property assets on the JSE would be about two per cent per annum above the yield on government bonds. As indicated, actual returns have been far higher than this.

One of the features of the scepticism with which investors have accorded the growth prospects of the Property Loan Stocks, has been the emphasis placed by investors on the value of high initial dividend yields from the PLS companies. Were faster growth expected, investors would presumably be much more tolerant of initial yield dilution. This conservative approach to investing in JSE listed property however, stood the sector very well in the recession of 2008-09. It had made the boards and managers of the typical Property Loan Stock reluctant to take on projects and debt that would have diluted yields in the short run, even when the prospect of very good long term shareholder value adding returns were high. This requirement of high initial yields from new developments helped restrain the rate of development itself. The sector was thus not encumbered with a large increase in space coming on to the market as the economy deteriorated.

There has, however, been something of a tendency to underestimate the internal rates of return realised by the average Loan Stock company. This may well have contributed to the lack of market appreciation given to the representative Loan Stock company. For example, the published returns on book capital realised and expected of Acucap by the leading SA property analyst are of the order of a rather sedate 10% per annum. Such estimates do not  accord well with the much higher internal rates or external rates of return referred to earlier.

What appears not to be fully appreciated in such estimates of the return on capital employed in the sector, is that the value of equity capital registered in the books of JSE listed Loan Stock companies is regularly revalued by independent appraisers in the light of property market developments. Unlike the ordinary company, where capital employed is recognised  at historical cost – and depreciated further to reduce equity capital employed – the principal assets of a Loan Stock company are included in their books at market values that can be significantly higher than their book values. The difference between book and market value is then credited to a non-distributable equity reserve. This increased capital then has the effect of reducing the estimated returns on the capital invested.

The positive revaluation of property assets owned by shareholders can surely be regarded as part of the benefits of ownership and added to the income received by providers of capital. We have undertaken an exercise for Acucap, shown below, whereby the revaluation reserve is deducted from the capital employed and added to the income received by unitholders. The returns on capital employed are thereby significantly enhanced when we deduct the revaluation reserve from equity capital as per the Annual Financial Statements. Such returns, based on the revenues generated and the cash capital employed by shareholders, help make better sense of the extraordinarily good market returns realised by investors in the units issued by the Loan Stock companies to which we have referred. It is to be expected that in the long run the external and internal rates of return on capital employed would converge.

ESTIMATING RETURNS ON CAPITAL EMPLOYED

 

 

 

 

 

 

 

 

 

It is my view that the market place has still to catch up with the property realities in the values it attaches to Property Loan Stock companies for the excellent real performances realised by these companies over many years. The sector has proved its ability to generate good long term growth in distributions and its resilience to harsh economic conditions. The market place has consistently failed to fully appreciate the achievements and prospects of the Property Loan Stocks, hence the exceptional, well above what might be regarded as expected or normal risk adjusted returns realised.

We at Acucap are determined to maintain our excellent track record in this regard. We have a board of directors and a group of excellent senior managers of proven worth. I would, as chairman, like to record my appreciation of and thanks for the excellent service they provide to our unitholders and creditors. We are confident that, provided macro economic conditions in SA remain stable – or more particularly that long term interest rates remain reasonably stable – which we expect to be the case, Acucap will continue to increase its distributions and so continue to fully satisfy the expectations of its shareholders. I am confident that the strategies and the skills to achieve this are in place.  The fact that there is little excess built capacity and the reality that rentals that would justify adding to office or retail mall capacity are well above current rentals, with but a fair wind blowing from the broad economy, Acucap is very well placed to continue to provide very good internal returns for its unitholders. Hopefully this can translate into very good external returns.