South Africa real estate tops the IPD performance index and the economic outlook is good but a shortage of prime real estate, building materials and a severe brain drain are clouding the horizon, as Lynn Strongin Dodds reports
After the V&A Waterfront, one of South Africa's prime properties, was sold to a British and Dubai consortium for $1bn (€700m), there was hope that other foreign investors would be scouting around for direct opportunities.
While interest has been sparked, supply constraints and relatively high prices are acting as a deterrent not only to international fund managers but also to their local counterparts. For now, market observers believe that fund managers are most likely to follow the listed route. Gary Hardisty, fund performance manager at Old Mutual Property Group, one of the largest real estate investors in the country, notes, "Although we have seen more interest in South African property after the V&A deal on the direct side, it is mainly from private equity firms. However, they are more interested in acquiring listed property companies rather than making direct investments."
It is no wonder, though, that market participants as well as property developers were hopeful. The V&A deal rated as the first property transaction of any significant size by a foreign investor. The mixed-use development, which is located near Cape Town's central business district (CBD), is considered one of the country's prize assets and was priced more in line with international than local valuations. Istithmar, the private equity arm of government-owned Dubai World, and UK-based London and Regional Properties, along with a local black empowerment grouping, snapped it up for $1bn. All eyes are currently on the fate of the landmark Carlton Centre, which as the country's tallest building is generating a buzz. The property is valued at around ZAR500m (€53m), and there are rumours that London & Regional as well as investors from the Middle East might express interest again. However, there is also a view that many investors might be dissuaded by the location - Johannesburg -which has a reputation for high levels of crime. Although the city council is committed to regeneration, some institutions might not be that adventurous.
For those investors interested in taking the plunge, the South African property market looks attractive and continues to produce strong returns on the back of healthy economic fundamentals. According to Investment Property Databank's latest figures, the commercial sector recorded a 26.7% gain in 2006, the second highest annual return since the inception of the index in 1995. Industrials were the strongest performer for the second year running, at 31.1%, while retail, which came off its 2005 highs of 32%, still yielded a noteworthy 27.4%. Offices remained the laggards, repeating the same pattern seen over the past five years. Total returns were 24.5% but there are encouraging signs of growth due to solid income growth of 10.2% - second to industrials at 10.9% - and capital growth of 3.0%.
As with many countries, typically it is only the larger pension funds endowed with significant assets under management that are able to invest directly while the smaller to medium-sized institutions opt for listed funds, which are commonly known as property unit trusts or property loan stock companies. According to Estienne de Klerk, executive at Growthpoint, the country's largest listed property company with a market capitalisation of ZAR17bn, both are designed to offer investors a pre-tax yield, with most entities distributing all their profit, after expenses and interest, on a semi-annual or quarterly basis. De Klerk explains that PUTS are the most similar to the real estate investment trusts structure in that they are limited by law to raise debt. PLS firms, on the other hand, are typically regulated by the Companies Act and have more flexibility when it comes to leverage.
The general consensus is that for now the listed market would offer investors the best opportunities in terms of liquidity and returns. While there would be no legal hurdles to overcome in the direct space - overseas investors, like their local counterparts, are entitled to obtain the full right and title to land - South Africa may be trickier than most to navigate. As Professor Francois Viruly, a property economist who started his own property consulting company, notes, "Institutions have to choose their property carefully. As always, location is critical, but in South Africa, the location can change.
This is why it is important to work with a local partner who understands the culture and knows the property market. Every town offers new and different opportunities."
Craig Hallowes, executive director of Fortress Asset Managers, concurs, adding, "One of the biggest challenges is to find a partner who has all the core competencies. You want someone who is credible, has experience as well as a strong track record."
The disadvantage of the listed property market, of course, is that it is subject to the vagaries of the stock market. Len van Niekerk, head of quoted property for Old Mutual, recommends taking a long-term view because rising interest and inflation rates have taken their toll. In the second quarter, the market returned only 0.3% compared with 4.3% for the All Share Index although its year-to-date total return of 16% was slightly higher than the 15% generated by the index.
As for the additional 50 basis point rise that is on the horizon, van Niekerk believes the market has already factored it in and does not expect any further weakness if the hike does materialise. As he notes, "the listed property returns are being pulled by opposing forces. Short-term capital movements are volatile and have been negative, but the underlying income streams from property companies is stable and growing. Listed property is a long-term asset and return expectations should be shaped accordingly.
Those with a short-term outlook could be disappointed, but patient investors have the ability to buy secure growing income streams at lower prices."
Industry participants also believe that overseas investors should not be put off by the relatively small size of the quoted market. Evan Jankelowitz, property analyst at Stanlib, the asset management arm of Standard Bank, explains, "although the listed market is only ZAR100bn, it has turned out double-digit growth of 12-13% over the past couple of years and we expect the same for the future. In 2002, the market was trading at a discount and today it is at a premium of about 7%."
De Klerk also points out that the size of the market needs to be put into context. "The growth has been significant if you look back to 1998 when the market capitalisation of the listed property market was just ZAR5bn. The economic fundamentals today are positive, with the economy growing at 4% to 5%. Although interest and inflation rates have risen, they are still relatively low historically while rentals are increasing and vacancy rates are falling across the board, even in the office sector."
In general, the governing African National Congress has followed a fiscally conservative path aimed at keeping the country on a stable and even course. Growth has been steady at 5% over the past three years and the country enjoyed its first ever budget surplus in its history. It reached 0.3% - or about ZAR5bn - in 2006-7 and it is expected to double to 0.6% the following year. There is no doubt that South Africa has greatly profited from China's voracious appetite for its natural resources. Revenues from the commodity boom are helping to diversify the economy as they feed through to the banks, retailers, construction companies and financial service companies. Equally as important, the government is ploughing the money back into the country's dilapidated infrastructure and has embarked on a much needed ZAR415bn three-year programme comprising water, sanitation, solid waste management, roads, airports, ports, rail, electricity distribution, and hospitals and clinics.
Not surprisingly, the money has also been earmarked for the 2010 World Cup in terms of stadia, hotels and transportation facilities. Although some might cast doubts on whether the country will actually be ready, the general view among industry participants is that the events will take place. Although there are concerns about a general slowdown and a drop in commodity prices, Viruly believes that the South African economy is in much better shape than in the past to weather a storm. "People focus on the 5% growth but there has been a real significant and structural shift in our economy. We have a growing black middle class that we call the ‘black diamonds' and this has triggered strong consumer spending across the board. We are now seeing retail shopping centres in townships such as Soweto, which was unheard of in the past.
Two years ago there was one, today there are four to five." According to industry statistics, there are currently 2.6m people who are labelled as "black diamonds". This represents 12% of the employed workforce, which is a significant jump from the 2% figure five years ago. They are the driving force behind consumer spending rising to 7% last year and soaring sales of consumer goods, financial services, property, cars and tourism.
This explains why the retail end of the property market has boomed, although industry participants believe that the higher interest rates are beginning to bite and returns could dip in the short term. Hardisty compares the real estate market to a clock "where the retail sector is at 12 or the peak with industrials behind at 10 or 11.
The office sector is at 9 o'clock and is the last sector to recover. It has plenty of room to grow and we are seeing total returns in prime areas such as Sandton and Cape Town in excess of 25%, although they are coming from a low base."
Kgaogelo Mamabolo, research manager of IPD South Africa, agrees, adding, "The office property market is the fastest growing. It is happening across the board and not just in major areas such as Sandton. This is because companies are expanding and are looking for space. There has also been a lot of development in CBDs such as Johannesburg where we are seeing the first new office block in ten years. Due to our transportation problems, people also want to live near their work and we are seeing more mixed-use development which combines both office and residential properties."
Despite the optimistic long-term forecasts for both the economy and property market, industry participants all agree that there are inherent challenges to investing in South Africa. The main hurdles are tied to capacity constraints in terms of people, materials and quality properties. The South African government continues to be the largest owner of commercial property, while many of the larger pension funds, such as insurance companies, are sitting on prime real estate. Neither is in any hurry to sell.
As for new developments, there is a dearth of building materials and cement because they are being sucked into the large scale infrastructure projects. Also an under-invested infrastructure has meant that a country that once exported large quantities of electricity is now suffering from power outages. "It makes it very difficult to develop a new shopping centre or office block if you do not have the roads in place or a sufficient energy supply," notes Hardisty.
Perhaps, the most challenging issue is the skills shortages that is adversely affecting the economy. Over the past 12 years, South Africa has suffered a brain drain. According to the South African Institute of Race Relations, about 850,000 whites have left the country, reducing the most skilled segment of the population to about 4.3m from more than 5m a decade ago. The vast majority of those that have left the country were skilled people in the 20-40 age range.
Moreover, as research from ABSA Bank reveals, the country has witnessed the rising emigration of mixed race, Asian and black professionals, particularly from the public sector, with medical, technical and engineering expertise. Although the government has made a big push on the education front and companies, particularly in the construction sector are trying to repatriate people from the UK, Australia, Dubai and other parts of the world, it will take time for the country to rebuild its skills base.
As van Niekerk put it, "Independence was gained in 1994 and we cannot expect to fix these problems overnight. Many of these issues are generational and it will take time to sort them through."