With strong performance and transparency, investors have good reasons to strongly consider the South African real estate market. Christine Senior reports

It may be a cliché but the description of South Africa as an emerging market with first world infrastructure is fairly accurate. The country's real estate market conforms to this formula - performance is more in line with emerging markets, while the top-end building quality and legal infrastructure is in line with Europe.

Figures from Investment Property Databank (IPD) show that annualised returns from South African property were 14.5% over five years and 17.6% over 10 years. The top performing sector over the 10-year period has been industrial at 20.1%, followed by retail at 18.2% and office, 15.6%. While this is against a background of relatively high inflation, it is still impressive.

"The most striking thing about South Africa property returns over the past decade is they have been one of the best, if not the best country as measured by IPD," says Jess Cleland, research director at IPD South Africa. "A lot of people counter that, saying South Africa has higher inflation compared to the UK or European markets. Inflation is just over 6%. If you look at it on a real basis instead of nominal, South African property is still right up there."

But emerging markets investors are conscious of risk. South Africa's economic base has changed since the 1990s, its traditional reliance on minerals and agriculture now diversified by expanding manufacturing and service sectors. Major trading partners are Asia, the EU and the US, with Asia taking 36% of the export market, and 12.5% of exports going to China. A slowing Chinese economy inevitably takes its toll on the resources sector. And Europe's ongoing crisis dampens demand for South Africa's manufactured goods.

Foreign investors are particularly vulnerable to the volatility of the foreign exchange market, and any global crisis hits the value of the rand. Marc Wainer, CEO of Redefine, one of South Africa's biggest listed property companies, says: "The biggest risk for offshore investors is the currency. The rand was stable for 12 or 18 months vis a vis the pound or euro. But with what's been happening in Europe now, emerging markets are taking a pounding on their currency."

The other concern of foreign investors is political risk, something insiders believe is more a matter of perception than reality. "Democracy is getting healthier and healthier, but there's a lot of bad publicity," says Henry Playne of the capital markets team at JLL in South Africa. "The emergence of a black middle class is beginning to happen. As that happens, there is less and less chance of instability because then that black middle class has too much to lose. But it's not happening as fast as one would like." High unemployment at 25% is also a concern.

But there are good reasons to consider investing in South Africa's real estate market. For one thing, market transparency is high. It ranks 23rd in JLL's transparency index for 2011 (and will have moved up when this year's index is published). The ownership of properties bought and sold is open to public scrutiny. For the listed sector, the listing requirements are based on what happens on the London Stock Exchange.

"On our accounting we have to apply IFRS," says Wainer. "There's integrated reporting on our annual financial statements. With listed companies, some more than others, there is total transparency. At Redefine we continually try to improve transparency."

Other pluses are the strong, independent legal system and property rights that are protected as part of the constitution.

A major attraction to property investors is the lease system which provides for escalating rental rates of around 8% per annum, on leases which are usually for five-year terms, but sometimes 10.

"Investors like the fact we have built-in growth," says Wainer. "With an average lease of five years, every year, approximately, you renegotiate 20% of leases. Hopefully you're getting upward reversion, but 80% of the portfolio will automatically escalate by 8%. That's the big attraction."

Foreign investors have two ways to access the market, either via listed property funds or direct. Direct investment is the more difficult. There's a lack of good-quality stock available and the listed funds usually snap up whatever comes to market. Liquidity is also poor, with property transactions taking three to nine months from when a sale agreement is made to ownership being transferred.

The listed side, on the other hand, makes South African real estate investment easily accessible. Mark Bradford, managing director of JLL South Africa, says: "Investors don't have to invest though an emerging market fund. Our listed sector is very public. Everything is very open. Bringing money in and out is no problem at all. It's very well governed, very well regulated. They generally hold prime South African real estate."

The top three listed companies by size are Growthpoint, Redefine and Hyprop, the latter a retail-focused fund with assets worth R20bn (€1.9bn). Redefine, which launched in 2001, is currently worth R22bn. It's set to acquire another listed fund, Fountainhead, if the transaction passes the regulatory approval process.

Foreign investors are dramatically expanding their presence. Overseas equity ownership in Growthpoint doubled over the year, from 7% to 14.5%, and Redefine experienced a similar rise in investment from offshore investors. Some 6.5% of its equity was foreign-owned this time last year; now it's 15%.

Distribution yield from funds look attractive to foreign investors. Bradford says: "Average distribution yields of 7.8% are quite attractive to American investors who can raise capital at 2% or 3%. Listed funds don't declare dividends, they declare distributions, so you would get no withholding tax on that 7.8%. You can take the full amount out of the country and get taxed at the source of origin."

If Redefine's bid for Fountainhead is successful, the structure of the portfolio will become 50% retail, 35% office and 15% industrial (from its current 47% office, 20% industrial, 33% retail content).

In the last couple of years, distribution growth for Redefine has lagged due to a repositioning of the fund. A large part of the portfolio was previously in B-grade offices, many leased to government or local government which have drawbacks as tenants. These were not performing well, and so the decision was taken to sell them and invest instead in a smaller number of more valuable A-grade buildings.

Wainer is very enthusiastic about the retail sector which is doing well. He says: "One of the reasons is the South African government a few years ago started giving social grants to poor people. That's now something like R120bn a year, and a lot goes to rural areas. Now there's very strong demand for shopping centres in those areas. Our retail focus has always been the commuter areas and rural areas. That is doing better than traditional urban shopping centres. We're nicely positioned and looking to grow that part of the business."

For any UK institution looking to invest in South African property, Towers Watson's advice is quite cautious. It doesn't currently research the market: "At present we consider there to be plenty of suitable opportunities elsewhere on a risk-adjusted basis," says Douglas Crawshaw, senior investment consultant at Towers Watson.

"Our view would be that global diversification is important for the real estate investor, but for those regions where there are no suitable products we would consider gaining access through the real estate securities market."