Throughout the past quarter, equity markets remained volatile, earnings continued to disappoint and the risk of a double-dip recession in the US and Europe increased. Locally, we have had two further dynamics with which to content - the draft Mineral Rights Bill and the Community Reinvestment Act that was leaked in July, and the Reserve Bank reaffirming its commitment to inflation targeting by raising interest rates for a fourth time this year.

The property market has been impacted by these events. However, it has managed to remain steady despite the blood bath on the stock market. Conditions in the direct property market remain difficult: vacancies continue to rise; there is a massive downward pressure on rentals, and competition amongst landlords has intensified. This is the trend in all sectors, but the most affected has been the office market.

Furthermore, South Africa is quickly reaching a stage where we are at risk of becoming over-retailed with far too much shopping centre development taking place, or scheduled to take place in the near term. This requires investors to be far more selective in terms of the properties they are willing to have exposure to. It's a tenants market and will in all likelihood remain so for the next two years. Only then do the fund managers expect the cycle to normalise.

Based on these fundamentals, the property sector looks fairly valued. There is limited scope for capital growth over the next 12 months. However, current yields look very attractive relative to bonds, offering an enhancement of 2.5% (which is above the long-term average of 1.75%). The fund managers continue to recommend that income-seeking investors maintain a selected exposure to property and lock-in these higher yields for the long term.

The two key highlights of the past quarter were the strengthening of the rand, and the rally in the bond market, both of which were driven by foreign investor interest in the South African markets.
On the back of the rally in bonds, the listed property sector recovered some of the losses incurred in the first quarter of the year, and the index managed to stage an 8% capital gain. In addition, we have seen the return of securitisations to the market, after being delayed earlier this year. Overall, investor appetite for the sector is improving.
The local direct property market remains under pressure. Vacancy rates remain high and rentals continue to be under pressure. Taking these fundamentals into account, the fund manager's believe that the listed property sector is fairly valued on a 12-month view. Thus, while the fund manager's do not expect to see any capital appreciation over the next year, yields in excess of 13% should be achievable. Furthermore, at these levels, listed property is looking attractive relative to bonds. However, simply buying and holding the index will not produce superior returns. Stock selection is key, and within the sector there will be distinct under and over performers.
The fund manager's have continued to trade our position in Liberty International based on the share's price movements on the London market. Through these activities the fund manager's have managed to enhance the portfolio's return. Liberty International will remain a core holding, and the fund manager's will look to increase the fund's exposure on any price weakness.

In January 2002, the Reserve Bank surprised the market with a 1% hike in interest rates. This was largely driven by the impact on inflation caused by last year's Rand depreciation, and more importantly the impact on inflation expectations. These expectations had increased substantially and have to moderate if the Reserve Bank is to meet its 2003 target. Already it is clear that the 2002 target will not be achieved. Again in March, the Reserve Bank raised rates, citing identical reasons.
On the back of these hikes, the fund manager continued to see selling pressure in the listed property market over the quarter, with the sector losing a total of 8%. Activity within the sector has slowed, and we have only seen one new listing and a scattering of acquisitions by existing funds. Furthermore, the fundamentals within the property market have deteriorated. Vacancies and costs have increased, while rentals have been under significant downward pressure. This has resulted in major downward revisions to earnings forecasts. Despite these downgrades, yields in both absolute terms and relative bond yields look very attractive. Currently, the sector is averaging 15.5%.
The fund manger believes that inflation will continue to trend upwards, and anticipate a further 1% hike in June (already this appears to be priced into the market). As before, the fund manager will continue to preserve capital as much as possible, but will use this opportunity to lock in some of the high yields currently available. On a total return basis, he believes that the listed property market offers goods value at present.