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A rosy future for non-residential property

Thursday, October 18, 2007

The rising star among property portfolios for the foreseeable future is the non-residential market. This has been revealed in the latest Rode’s Report, which consolidates the findings of research conducted by property valuers and economists, Rode & Associates, for the second quarter of 2007.

Commenting in particular on the industrial property market, Erwin Rode notes: “Robust growth in building costs and land values, coupled with low vacancy rates and ravenous demand, have pushed industrial rentals even higher during the second quarter of 2007.”

Industrial rentals have enjoyed substantial growth over the same period of a year earlier, with Port Elizabeth leading (at 28%), followed by Durban (19%), and the Cape Peninsula and the Central Witwatersrand (both 17%).

Robust real — building-cost inflation adjusted — rental growth has resulted in industrial stand values more than doubling in the Cape Peninsula (103%) and Durban (112%) over the last year. In other regions, stand values grew at a rate more than double that of rental growth over the same period, with Port Elizabeth showing an increase of 85% and Central Witwatersrand one of 75%.

Office property is also experiencing an upswing, led by Johannesburg decentralized, where rents in the second quarter of 2007 were up by 20% on the same period the previous year — much higher than the projected building-cost inflation of 12% over the same period. With Durban decentralized following at 10% and Cape Town decentralized 9%, only Pretoria decentralized disappointed, showing hardly any upward movement.

In spite of the much talked-about movement of office rentals in CBDs, most centres showed nominal rentals moving sideways, with real rentals declining. The only exception was the Cape Town CBD, which jumped by 20% year on year during the second quarter of 2007.

Capitalization rates — the property equivalent of the forward earnings yield of shares — continued to strengthen during the second quarter. The strengthening occurred in spite of a deterioration in the inflation outlook and the concomitant rise in short-term interest rates, which reflect investors’ continued optimism about the income-growth prospects for directly-held property. Reflecting their relatively more stable income streams (and, therefore, lower risk), regional shopping centres still had the lowest capitalization rates. On the other end of the scale, offices — specifically those in the more derelict CBDs — still had the highest capitalization rates due to their weaker income-growth prospects.

Turning its attention to escalation rates, the Report revealed that leaseback escalation rates continue to stay close to the 8% mark. The leaseback escalation rate is the rate by which a rental on a long lease (10-years-plus) is hiked once a year. Says Rode: “Given our forecasts of robust market-rental growth over the next few years, many landlords currently signing lease agreements at market escalation rates may find their properties being under-rented in the next few years.”

Moving onto the listed property market, the Report notes that listed income yields, just like capitalization rates, held up well despite JSE volatility. This is indicative of the market’s rosy prognosis for income streams over the next year or more.

On the residential front, the Report notes that over the past 10 years the compound growth in flat rentals was about double that of consumer-price inflation. More specifically, flat rentals in metros around South Africa recorded annual compound growth rates ranging from 10 to 11%, while consumer inflation measured around 5% per annum over the same period. However, with building-cost inflation over the past 10 years also at around 11% per annum, developers did not have sufficient incentive to build flats-to-rent.

As far as the house market is concerned, buyers continue to feel the pinch from the combined effect of extraordinary house-price growth relative to disposable-income growth of the last few years, which has now been compounded by the upswing in the interest-rate cycle. These forces are set to maintain the downswing in real (building-cost-inflation adjusted) house prices across all house-price categories over the next few years.

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