It may not be the time to wet toes
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.