Listed property benefited from a fairly positive results season this past quarter as a majority of the sector's reported results were in line with expectations. In addition, it was supported by a much stronger equity market, lower bond yields and a partially unexpected interest rate cut in August. A rerating relative to bonds also worked in the sector's favour. This led the sector to deliver a 12.2% total return for the quarter. Over one and three years, it continues to compare favourably with equities and bonds, outperforming both asset classes as well as cash.

The merger between Redefine, ApexHi and Madison was concluded during the period. This resulted in Redefine being included in the MSCI Emerging Market Index as well as the GPR Global and GPR 250 property indices. In turn, it was confirmed that Redefine would not be included in the FTSE/JSE Top 40 Index at the September quarterly rebalancing. It was however included in the reserve list for future potential inclusion. Growthpoint, already a Top 40 Index constituent, and Redefine now constitute 45% of the SA Listed Property Index (SAPY).

One advantage of the weaker operating environment is the shaking out of weaker portfolios and management teams, thereby increasing the gap between the various stocks' distribution growth. The average year-on-year distribution growth was between 7% and 8%, but as an illustration of the quality gap opening up ranged from marginally negative to double-digit growth. The fund is well positioned to benefit from a move towards more defensive and quality growth properties. The sector's results, however, confirmed signs of an increase in vacancies across all sectors (SAPOA office vacancies increased from 6.1% to 6.8% in the second quarter), an increase in arrears as well as bad debts and higher bad debt provisions. Not only retail, but also industrial and office tenants are now experiencing the pain of weaker trading conditions.

The fund outperformed SAPY for the quarter, as well as the spliced benchmark over one year. However, it marginally underperformed the benchmark over three years. The outperformance for the quarter can be attributed to the relative positioning in stocks like Pangbourne, Hospitality A, Hyprop and Resilient versus SAPY as well as the exposure to Liberty International. Some relative return retraction occurred through the limited exposure to Redefine, Vukile and Sycom relative to that of SAPY.

Reducing exposure to Acucap, Liberty International and Redefine in favour of an increased holding in Pangbourne were the major changes to the fund positioning during the quarter. Pangbourne released its full year results in August which showed that distribution growth continued to be above 10% and management indicated a similar growth trend for the coming financial year. Positives include the improvement in general operating efficiencies and potential in under-rented industrial properties, while a recent visit to its largest asset, the Boardwalk Shopping Centre in Richards Bay, confirmed the growth prospects in this asset.

The strong movement of Liberty International during the quarter was in line with the rest of the UK Real Estate sector. The company released its interim results at the end of July, which were in line with market expectations. The results were characterized by more positive than negative take-away features. Positive features mostly relate to an improvement in letting of vacant space as well as the early signs of the opening of the lending market. The company did however surprise the market in September with a second capital raising of £280 million on the back of this sector rerating. Management indicated that the capital raised will be used to reposition the company for future growth by improving some current shopping centres and Central London assets. We did not participate in the capital raising this time due to its format and relative price level.

Growthpoint finalised the part acquisition of Growthpoint Properties Australia (previously named OIF). The acquisition was eventually not cash funded by means of the cash raised in the earlier rights issue, but by a second capital raising of R1.26 billion via a vendor placement in September. In addition, nearly two thirds of unitholders elected the dividend reinvestment plan as proposed in the final results announcement in August, making another R540 million of cash available. All of this bodes well for Growthpoint and the refinancing of its securitizations coming up later this year. The fund should benefit from this improved refinancing prospect as the exposure to Growthpoint was marginally increased during the quarter. However, the exposure remains a bit lower than Growthpoint's weighting in the benchmark as some concerns around the company's vacancies related to its development pipeline remain.

The IPD South Africa Property Bi-Annual Indicator - the 6-monthly return of SA direct property to June 2009 - was released at quarterend. All Property delivered a negative capital return of 0.8%, but with an income return of 4.2%, still came through positive at 3.4% on a total return basis. This set of results is a reflection of the inherent risk profile associated with each sector. The cyclical nature of office property, closely linked to the underlying economic growth and business confidence, came through strongly, underperforming both retail and industrial property. Retail properties have proven its more resilient nature, being the only sector delivering a positive capital return. This just reinforces the current fund positioning towards more defensive retail properties, mostly regional and super regional shopping centres.

Moving into the final stretch of the year, most of the listed property sector's movement will probably come from the interplay between the rand, bond yields and interest rate decisions. The sector should receive some of its lead from the few results announcements and the guidance from the underlying direct property market. While retail tenants should enjoy the pick-up of improved trading conditions towards Christmas, which will benefit larger regional shopping centres, industrial and office tenants may look for more reasonably priced space, decrease space usage, or consolidate space usage. In terms of funding margins, banks continue to increase the cost of capital, making any refinancing probably more expensive, unless a favourably priced interest rate swap overlay can be entered into. Also, higher funding margins and a decrease in liquidity are making the likelihood of any big developments within the sector, and even outside the sector, smaller and smaller. This should act as a buffer for vacancies in the current property cycle, compared to the late 1990's into 2002/2003 cycle.

Portfolio managers
Edwin Schultz and Anton de Goede

Local listed property took a backseat during the past quarter as sentiment towards equities improved globally on the back of gradually increasing risk appetite. Despite an upward movement in bond yields, listed property underperformed bonds as positive sentiment on potential further interest rate cuts at the beginning of the quarter provided some price buffer. Property stocks were not impacted as positively by the 4.5% cut in interest rates since the start of the easing cycle as one would have expected. This is mainly due to funding rates within the sector that should remain fairly stable due to the prevalence of long-term fixed interest rate contracts. All of these factors resulted in local listed property returning -0.9% for the quarter. Over one and three years it continues to compare favourably with equities and bonds, outperforming both of these asset classes as well as cash.

As of 1 May the fund's benchmark has been changed to the FTSE/JSE SA Listed Property Index (SAPY). This index, representing 20 domestic property stocks, is viewed as the benchmark domestic listed property index. The fund outperformed the spliced benchmark for the quarter, as well as one and three years, with outperformance for the quarter attributed to the relative positioning in stocks like Fountainhead, Acucap, Growthpoint and Resilient versus those in the broader peer group and the SAPY Index. Some relative return retraction occurred through the positions in Hyprop and Hospitality-A as well as the zero exposure to SA Corporate.

The inclusion of Pangbourne as well as increased exposure to Liberty International were the major changes to the fund positioning during the quarter. This was funded with sales across most of the portfolio. Pangbourne moved onto the radar screen as the progress of its portfolio as well as operational alignment with the goals set by the new management team (that came on board via Resilient as major shareholder) seems to be on track. This should result in a much more transparent income stream and improved operational efficiency. With regards to Liberty International, the uncertainty regarding a potential capital raising was eliminated. The company raised £620m during this past quarter to minimise the risk of loan covenant breaches. We participated in the capital raising as the price level was very favourable compared to the then trading levels. In addition, the trend of a slower decline in UK property capital values continues as yields seem to start bottoming out. May and June marked a relative stabilisation in investment yields. This does not necessarily mark a turning point in the market yet, but suggests investor sentiment towards the direct property market is becoming more favourable. In addition, UK property derivative pricing continues to improve, implying a current peak-to-trough capital value return of -51% versus - 59% in January. This implies another 16% drop to the trough levels. This improved derivative pricing reflects a more optimistic look at the market as transactional evidence and the listing of new property funds to capitalise on the current market are coming through.

The fund's most pronounced differentiating conviction remains Hyprop, with the investment case still intact. The appointment of a replacement CEO in Mike Rodel was recently finalised. Prior to his most recent position, Rodel was responsible for the management of the Gateway Theatre of Shopping in Durban, one of the largest shopping centres in the country. In addition, the day-to-day management of Hyprop should be internalised as from 1 January 2010, with The Glen Shopping Centre already being internalised from 1 June 2009. As for the asset management, Hyprop's board is very cognisant of the Redefine merger and it seems likely that the asset management contract will be terminated in its current form and Redefine will be paid a consultation fee. Despite the retail pods at Canal Walk Shopping Centre being behind schedule, the income upside in 2010 should come from the additional 19 000m² retail space at The Glen, the completion of the Hyde Park Southern Sun as well as the cost savings on asset management fees.

Other sector news includes Growthpoint's potential acquisition of the Australian listed Orchard Industrial Fund. Management has already indicated its desire to enter the Australian market with the rights issue at the end of 2008. The potential acquisition requires Australian shareholder approval and, if successful, would result in an R1.2bn investment for Growthpoint. Although management highlighted that the acquisition should be yield neutral, the potential of a limited dividend payment for the first year as well as difficulty in letting of new developed space in South Africa will in all likelihood lead to lower-than-sector-average distribution growth for Growhtpoint over the next 12 to 18 months.

Besides Hyprop, SA Corporate also experienced a management reshuffle. Mariette Warner, who replaced the executive team that has managed the fund since the merger between Marriot and SA Retail, resigned as CEO after one month due to personal reasons, and was replaced by Len van Niekerk. These management changes, however, increase the risks pertaining to SA Corporate and, although offering potential price upside, the portfolio risks within the current economic environment may impact earnings more than anticipated. We are cognisant of portfolio risks across the sector, preferring a long-term stability in income streams, as sector revenues may come under pressure.

Surprisingly, recently released company results point to a fairly positive outlook for retail rentals, while the outlook for A-grade office rentals seem to be on the downside. It seems that these office rentals may remain fairly constant in a range of between R100 - R130/m2 in the medium term (node dependant) despite feasibility rentals still much higher than current market rentals. This illustrates the cyclical nature of the office market, which is much more cyclical than the retail market. What also emerged is the continued risk in the current market for speculative developments (either for sale or for rent) versus the upside of an internal focus on working with existing space.

The market still seems not to differentiate between tenant and property type risk profiles of the various companies. This is probably due to limited evidence in results announcements thus far. However, the likelihood of such stress, and the resultant negative impact on general sector distribution growth, should start to gain prominence in the next round of results announcements.

Portfolio managers
Edwin Schultz and Anton de Goede

Compared to other asset classes, local listed property has exhibited its defensive qualities since the start of the year. Given the stellar total return of 33.5% in the second half of 2008, one could easily forgive returns for losing some momentum. While underperforming the FTSE/JSE All Share Index in March, the -1.4% return on listed property for the first three months of the year compares favourably with the -4.2% returned on equities. In addition, taking into account the 96bps upward movement in the yield of the benchmark R157 government bond, listed property investors can be relatively satisfied with what the sector has delivered in the past quarter.

One major supporting factor for the sector was the continued strong distribution growth reported by many companies during the period. Most of the results met market expectations, with the average year-on-year distribution growth still coming in above 10%. There was, however, a rather big disparity between distribution growth, from as high as 19% to close to zero. Pressures from both a funding and tenant perspective are weighing on future distribution growth prospects resulting in guidance for future results being muted, in line with the global and local economic environment.

The potential of corporate activity within the sector caused for some excitement as Redefine announced its firm intention to acquire fellow Madison-managed ApexHi as well as Madison itself. Redefine rerated strongly on the back of the announcement as it will serve as vehicle for the margin unlock in the Madison fee margins and resultant strong once-off distribution growth.

The fund underperformed the benchmark domestic property funds mean return for the quarter. In addition, it also underperformed the domestic listed property index. Positions in stocks like Liberty International, Growthpoint, Fountainhead and Hyprop vs those in the broader peer group, led the fund to underperform the benchmark domestic property funds mean return. The substantial exposure to especially Hyprop and Fountainhead differentiate the fund from the peer group and although the short-term performance has been hampered due to this exposure, the long-term strength of the underlying property portfolios bode well in the current economic environment. In addition, the long-term stability in the income streams of these two funds should bode well for the immediate future as sector revenues may come under pressure.

Growthpoint continues to be important in the life of the sector. Thus, despite being marginally underweight relative to the domestic listed property index, the 20% holding in the fund remains important. The volatility of Growthpoint's share price has increased substantially since it's inclusion in the FTSE/JSE Top 40 Index, and is resulting in the share being much more closely correlated with the performance of general equities due the broader shareholder base.

Liberty International remains under pressure. With the risk within the broader UK listed property market of breaching debt terms, many firms announced capital raisings through rights issues.

The fund marginally increased exposure to Liberty International in the subsequent weakness of the sector as many of the sector's main companies announced dilutive rights issues to strengthen balance sheets. Unfortunately this increase was too early as, the uncertainty created by Liberty International's absence of a capital raising announcement and continued risk of covenant breach weighed the share price down a further 23%. This was despite releasing results that were relatively in line with market expectations.

Notwithstanding the prospects of lower interest rates, funding rates within the sector should remain fairly stable. Counter to lower interest rates, any newly negotiated borrowing would be granted at higher margins than that of the last two to three years, with margins having shifted out by between 100bps and 150bps. The viability of the securitisation market as alternative funding source has also decreased substantially, with limited capacity at higher spreads. For any new development, bank requirements for an equity capital portion and percentage preleasing have also increased, making speculative development (which is mostly debt funded) unlikely. Fortunately, the favourable swap curve at the end of 2008 has made it possible for many funds to refinance expiring swaps at rates very similar to fixes achieved at the previous bottom of the interest rate cycle.

At present, occupancy costs seem to be the single biggest issue for many landlords, specifically among smaller retailers taking strain due to higher electricity costs and rates. Second to smaller retailers, smaller industrial tenants, followed by office tenants, are taking strain. Therefore, rentals have probably peaked for the next year or two. In addition, retailers may have reached trading densities plateaus as well. Trends surfacing in the recent results of both landlords and retailers include that value retailers are gaining market share, with increased spend on basic goods, resulting in specifically rural retail holding up its own. In terms of the industrial market, the demand for greater than 20 000m² warehouse boxes has dried up, while pressure has started to come through in the mini-industrial market. Office tenants have remained fairly resilient, although SAPOA vacancy numbers point to upside risk in increased vacancies.

Landlords have become much more risk averse during the last few months. The focus has shifted to tenant retention rather than portfolio expansion. Retaining tenants is key for landlords who want to limit the foreseeable increase in vacancies, thereby also sidestepping the payment of letting commissions to acquire new tenants or tenant installation costs.

The current weakness in listed property prices, closely correlated to the performance of the equity market, has created the opportunity for income seeking investors to increase their exposure relative to other income yielding asset classes. Locking in yields of above 10% for the next 12 months is possible and despite guidance being muted, the potential for growth in these income streams remains in place. To manage the prevailing economic risks, the key is to be positioned in quality portfolios, management teams and transparency in conjunction with more certain cash flows. The fund is positioned to benefit from such an anticipated flight to quality.

The domestic listed property sector consolidated during the fourth quarter of 2008 despite an initial increase in bond yields and much weaker equity markets in October. During this period, the sector delivered a total return of 8.5%, This strong performance was partially on the back of stronger bond yields being led by aggressive cuts in global interest rates. Local market participants took the gradual change in the Reserve Bank rhetoric to heart by starting to price in the potential of interest rate cuts being moved forward, with the 50bps rate cut in December 2008 being the proof in the pudding. Leading to further strong sector movement was the inclusion of Growthpoint in both the MSCI Global Emerging Markets Index and FTSE/JSE Top 40 Index, with the resultant price movement coming from buying support pushing property index levels higher. The significance of the inclusion in these indices is that many investors use index tracker funds against these indices to gain exposure to either Emerging Markets or South African equities as a whole. In addition to the benefits of inclusion in the indeces comes the risk of heavily increased share price volatility as investors easily move in and out of these types of funds. The fund marginally underperformed the benchmark domestic property funds mean return for the quarter. In addition, it also underperformed the domestic listed property index. The strong price movement in Growthpoint prior to the respective index inclusions in November and December was used to decrease exposure into favourable pricing levels. Concerns regarding weak UK consumer spending leading to potential retailer bankruptcies resulted in the reduction of exposure to Liberty International. Despite this decrease, the remaining exposure to the share was one of the major value detractors during the quarter. Not only do UK retail landlords face the risk of shops standing empty, but also that of its own bank debt terms being breached. This may lead to forced property sales in an already weak UK commercial property market. These risks, assisted by rand strength during the last few weeks of the year, have led the share to loose nearly 50% of its value during the quarter. The cash made available by the decrease in exposure to Liberty International as well as the trimming of exposure to ApexHi A was mostly used to initiate exposure to Capital Property Fund. A number of companies, including Acucap, Sycom and Fountainhead, released results during the quarter. These results confirmed that the strong growth in market rentals experienced over the last two years in the underlying commercial property market is slowing down, resulting in a gradual movement to more normalised distribution growth in the next two to three years as lease expiries work through the system. Based on the results of the first ever SAPOA/IPD South Africa Biannual Property Indicator for the local commercial property market released during the quarter, physical commercial property returns remain healthy. The indicator, based on capital growth and income receivable recorded for the six months (January to June), showed a total return of 7.3%. Reduced capital growth was the primary driver behind the tail-off in the recent record overall returns. Despite the weaker economic environment vacancies did not come under pressure while rental growth, albeit at lower levels, continues. This should support revenue levels of listed property companies while distribution growth normalises. In the next few months the sector will be impacted by interest rate decisions; even more so by the urgency or lack thereof by which it is implemented. Despite the strong moves during November and December, the relative value movement vs. long bonds has been muted. Potential upside relative to bonds should support the sector if bond yields retrace. The benefit of an early interest rate cut may not immediately flow through into higher distribution growth, and in anticipation of a cut a large portion of the repricing has probably already taken place. The biggest immediate benefit is likely to be some relief in the occupier market, rather than the investment market.

Edwin Schultz & Anton de Goede
Portfolio Managers