It may not be the time to wet toes

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WHILE res­i­den­tial prop­erty is no longer as wildly over­priced as was the case a few years ago, re­search con­ducted by RE:CM sug­gests that the as­set class is still far from cheap and cur­rently of­fers rental yields well be­low what in­vestors would con­sider a fair re­turn.

As with any as­set, the ques­tion fore­most in most peo­ple’s minds is whether it is a “good time to buy”. We ap­proach this ques­tion as we do for all as­sets: by try­ing to de­ter­mine what the in­trin­sic value of the as­set in ques­tion is, and com­par­ing mar­ket prices to in­trin­sic val­ues. Mar­ket prices well be­low in­trin­sic val­ues sug­gests a good time to buy, while the op­po­site sug­gests cau­tion.

To de­ter­mine how SA’S res­i­den­tial prop­erty mar­ket mea­sures up cur­rently, we make use of the ABSA House Price In­dex as well as mea­sures of South African house­hold dis­pos­able in­come and GDP per capita which al­lows us to draw some con­clu­sions.

Chart 1, top right, shows the in­fla­tion­ad­justed ABSA House Price In­dex since 1966, as well as its long term ex­po­nen­tial trend, and one stan­dard de­vi­a­tion above and be­low the trend. Chart 2 shows the ABSA House Price In­dex rel­a­tive to South African house­hold dis­pos­able in­come per capita to the end of 2010. And fi­nally, Chart 3, right, shows the ABSA House Price In­dex rel­a­tive to South African GDP per capita — which (not to­tally un­ex­pect­edly, one must add) cor­re­lates very closely to the shape of Chart 2 above it.

Ev­i­dence from the charts no longer con­clu­sively sug­gests that South African res­i­den­tial prop­erty is wildly over­priced (as was un­equiv­o­cally the case from 2005 to 2007), but it def­i­nitely sug­gests that the as­set class is far from cheap.

What about res­i­den­tial prop­erty rental yields?

Work­ing with data avail­able to us, we can make cer­tain in­fer­ences. To us, di­rect prop­erty own­er­ship comes across as some­what less risky than own­ing eq­uity in a busi­ness, but some­what more risky than lend­ing money to a cred­it­wor­thy bor­rower. This sug­gests that over time, prop­erty should de­liver in­vest­ment re­turns some­where in be­tween that of eq­uity and that of bonds. The data seems to sup­port this sug­ges­tion. 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 (the data for listed prop­erty is not as com­pre­hen­sive, on ac­count of the rel­a­tive youth of the listed prop­erty sec­tor). This fits be­tween the real re­turn of about 7% achieved by listed eq­ui­ties and the 2% or so real re­turn de­liv­ered by bonds in SA to the end of 2010.

Armed with that knowl­edge, we can draw some broad con­clu­sions. If we ac­cept that rentals as well as prop­erty main­te­nance, re­pair and re­fur­bish­ment ex­pen­di­tures grow broadly in line with in­fla­tion, it must mean that the sus­tain­able net rental in­come (ie 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%.

The ques­tion then “sim­ply” be­comes how much an­nu­alised main­te­nance, re­pairs and re­fur­bish­ments will be over the life of the prop­erty in or­der to main­tain the con­stant real rental stream. We have not seen hard numbers, but given that prop­er­ties age, and prob­a­bly have to be fully ren­o­vated/re­fur­bished af­ter at most 50 years, an an­nu­alised main­te­nance and cap­i­tal re­pair bud­get of 3% does not strike us as un­rea­son­able. Roughly speak­ing this al­lows for a 1% an­nual spend on on­go­ing main­te­nance and 2% to­wards build­ing of re­serves to re­fur­bish/re­build the prop­erty com­pre­hen­sively at the end of its life.

This sug­gests a fair prop­erty yield of about 8% at in­cep­tion. Rode & As­so­ci­ates con­ducts a sur­vey of rental yields, and their data sug­gests that res­i­den­tial rental yields in SA are cur­rently on av­er­age in the vicin­ity of 6%. We have been un­able to find good long-term data on this, but 6% strikes us as well be­low a long-term fair rental yield.

So, un­for­tu­nately, it does not look to us as though now is a good time to buy South African res­i­den­tial prop­erty yet. Given the du­ra­tion of the typ­i­cal prop­erty cy­cle (Er­win Rode reck­ons the cy­cle in SA, trough to trough, stretches for about 16 years), it seems as though there may still be some wait­ing to do.

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