In our previous commentary we mentioned that either property yields or bond yields must give in opposite directions to warrant the trading levels experienced at the quarter ending June 2010. For the first time in recent quarters, the listed property sector showed its true hybrid colours, taking its cue from both the strong momentum in the equity market as well as following bond yields lower. In terms of risk and return, listed property was positioned between equities and bonds, as one would traditionally expect, with a total return of 13.7%. These strong returns were driven by capital markets despite only tentative recovery signs continuing to come from the underlying commercial property market as well as the macro-economic environment. When the speculated interest rate cut eventually took place in September, against our initial anticipation, both bond and property yields had already priced it in. While listed property did partially de-rate against bond yields as expected, the nearly 1% movement lower in the 10-year rolling bond yield to 7.9% provided the impetus to restart the momentum gained in the first quarter and resulted in the weighted average forward yield of the sector to move from 8.6% to 8.2%.

The fund underperformed the SA Listed Property Index (SAPY) for the quarter, but for the 12 months to September, it remains one of the top performing funds in its sector. The past quarter's positive performance contributions came from our overweight positions in Fortress A, Resilient and Pangbourne as well as our exposure to the non-benchmark constituents Capital Shopping Centers (CSC) and Capital & Counties (CapCo), the demerged entities from Liberty International. Underperformance came mostly from our underweight positions in Growthpoint and Redefine, the two sector heavyweights making up 44% of SAPY, as well as our exposure to the non-benchmark constituent Foord Compass. In a rising market, as was experienced this past quarter, any cash exposure also detracts. We however remain comfortable with our current cash exposure.

We have increased our exposure to Emira (through a beneficial capital raising), Hyprop and again Redefine during the quarter. This was funded from the fund's cash position as well as our decreased exposure to Growthpoint, Fountainhead and Vukile. Although the fund's investment philosophy is not thematic, but rather based on individual share valuation metrics, the increased exposure to these companies should give the fund more exposure to the current momentum in GDP growth. There is a strong correlation between commercial property returns and GDP growth, albeit at a 6 to 12 month lag, making it important to have some exposure to more cyclical sectors within the broader market.

We continue to remain comfortable about our exposure to CapCo and CSC. The investment merits have been explained in the past. We visited some of the companies' assets recently and can confirm that the investment merits are still intact. For CapCo momentum continues to gather for the value unlock from the Earls Court site, while the repositioning of Covent Garden is going well with further leases being bought out and buildings purchased to improve the retail mix. For CSC the four centers visited remain strong within their catchment areas and their target markets clearly identified with retailers and offerings specifically for those markets enhanced. UK consumers are traveling further for their retail experience, therefore bigger centers will continue to have the upper hand - in 1971 50% retail market share was achieved from 200 trading locations, in 2008 that number was 90 and estimates are that this will settle at 75. CSC should benefit from the trend in the long term.

Ten companies reported results or declared distributions during the quarter. Excluding the quarterly distribution announcement of Redefine and maiden full year results of Fortress, the year-on-year distribution growth average reported was 6.8%, which was generally perceived as rather positive. The average disguises the 10% distribution growth by Pangbourne, Resilient and Capital compared to negative year-on-year distribution growth by SA Corporate and Hospitality. Most of the guidance pointed to better growth from this base, but worrying trends remain. The biggest by far is the impact of substantial increases in electricity tariffs and rates and taxes valuations, impacting the gross versus net rental levels when leases expire. In addition, more and more tenants are rolling leases into shorter-term contracts making lease expiry profiles less defensive. The operating environment remains tough for landlords albeit bad debts write offs and provisions are improving.

Are we at a cyclical turning point for both listed property and direct property? It could be that we are close to both, but at opposite ends of the spectrum. In terms of the listed sector, the number of listings being mooted for the next 12 months could be an early indicator of the yield cycle being close to its bottom. Approximately R25 billion worth of listings could be coming to the sector, which accounts for 20% of the current market cap. This has the potential to take local listed property from 2.5% to 3.5% of the All Share Index, improving liquidity, specialization and diversification. In addition, the turn in the inflation cycle should put pressure on the interest rate cycle, thereby putting pressure on the sector's yield. From a revenue point of view the sector is gradually improving by filling vacancies and sourcing alternative funding arrangements to benefit from the interest rate cycle (despite margins being structurally higher). The underlying rental market should improve in the next 6 to 12 months, led by the retail sector. Vacancies in the retail sector are also stabilizing, which will further support revenue growth. We remain selective in office and industrial exposure as it continues to lag the retail sector. Expect the listed property sector to closely follow bond yields in the short term.

Portfolio manager
Anton de Goede

Listed property took a breather after a very strong start to the year. Initially, it continued on its upward path into April but retraced mid-quarter as risk aversion returned to investment markets on concerns about the eurozone crisis, with Greece at the centre of the storm. Some positive momentum towards quarter-end resulted in the sector delivering a positive total return of 0.6% for the past three months. In addition to the negative return momentum following weaker than expected guidance from Redefine at its interim results, the sector received little support from longer dated bonds as the 10- year rolling bond yield moved 24bps higher to 8.86%. With little movement relative to bonds on a yield perspective the result was an increase from 8.6% to 8.9% from a weighted average forward yield perspective.

The fund underperformed the SA Listed Property Index (SAPY) for the quarter, but for the 12 months to June, it remains one of the top performing funds in its sector. While the past quarter's positive performance contributions came from our overweight positions in Foord, Hospitality A, Fortress A, Resilient and Acucap, underperformance came mostly from a combination of many of our underweight positions as well as our exposure to the non-benchmark constituents Capital Shopping Centers (CSC) and Capital & Counties (CapCo), the demerged entities from Liberty International. As was mentioned in our previous commentary, we remain positive on both demerged entities, henceforth the increase in exposure to the two companies during the quarter. The long-term investment case for both companies remains intact despite the austerity measures introduced by the UK Government in June. The upside for CSC lies within the conversion of short-term rentals signed during the last 18 months to fill vacancies left by retailers going into administration as well as further positive yield movements from December 2009 levels. In turn, the upside for CapCo lies within the repositioning of Covent Garden as a premier Central London retail destination as well as potential in the redevelopment of the Earls Court site.

Beside the dealings in CSC and CapCo, we have increased exposure to Capital, Fortress A and especially Redefine during the quarter. This was mostly funded from the decrease in exposure to Fountainhead and Emira. The exposure to Emira was decreased into strength. We still believe that the market does not truly appreciate the potential dilutionary impact of the Blue Route Mall development within Fountainhead's earnings profile for the next two to three years. In addition to these transactions, we have regained exposure to Hyprop. The sale of Hyprop to Redefine concluded during March was finalised at a clean forward yield of 7.0%, while we initiated exposure during the past few weeks at 7.5% - 7.6% levels. Due to the unforeseen resignation of Wolf Cesman as joint-CEO of Redefine, Hyprop exercised its right to cancel the consulting agreement with Redefine. Although it is uncertain in what form a future agreement will be signed, if at all, the potential increase in distribution levels makes the share attractive at current levels. Despite the general sense that vacancies and lease renewal rates are under pressure within the broader property sector, signs of improvement are gradually coming through. This is despite the sense that the private sector has not yet started to really reap the benefits of the economic recovery over the last few quarters. This has been confirmed by various management interactions and results released during the quarter. In general, vacancies are stabilising, even in the more volatile office sector, as confirmed by SAPOA in its second quarter vacancy report for 2010 (office vacancies decreased from 9.1% to 8.8%). It seems that developers are still cautious to commit to new developments. However, we remain apprehensive about too much speculative development in the immediate surroundings of the Gautrain stations as speculators may become 'gung ho' once funding becomes easier.

In addition, retail sales growth has returned which should provide some reprieve for landlords in terms of the pressure on total occupation costs for tenants. Successful retail offerings should still be able to attract higher rentals as illustrated by anecdotal evidence from major shopping center landlords. Location, tenant mix and ease of shopping remain key in a center's success. This will ensure that vacancies remain low, retail sales growth is sufficient to ensure that rental increases can be absorbed by the tenants, and shoppers keep coming back for the shopping experience which the center is positioned for. Therefore landlords across all the retail subsectors can operate a successful center, and success is not necessarily size dependant. The risks however, do exist that the negative impact of the 2010 FIFA World Cup is not being fully considered. Leasing activity has come to a standstill since the beginning of June, while consumer spend may be stifled in the months immediately following the event due to a too large spend on event activities.

Current trading levels suggest that the market continues to price in either very strong distribution growth or additional credit for the growth to be achieved over the next 12 months. Our initial sense along with the movement during the quarter was that the market is looking two years out, beyond the initial economic recovery as the growth profile for year two looks more promising. But the strong recovery towards quarter-end led us to believe that the growth the sector is being compensated for does not warrant the current forward yield relative to the rolling 10-year bond yield, especially since the expected earnings outlook for the sector has reduced during the quarter with the lowered guidance from both Redefine and Fountainhead. Thus either bond yields or property yields must give in opposite directions. Therefore, expect volatile trading conditions in the short term as, although things may surprise in a positive manner on the macro economic front, the current levels may be pricing in a rate cut of which the likelihood remains uncertain.

Portfolio manager
Anton de Goede

Listed property experienced a very strong quarter on the back of much lower bond yields as well as a results season which did not spring too many negative surprises. The sector delivered a total return of 9.9% as both the 50bps interest rate cut (and the accompanying downward movement in the rolling 10-year bond) as well as less bearish guidance from management teams in their results releases. From a forward yield perspective the sector rerated strongly from 9.2% to 8.6% on a weighted average basis, reflecting both strong share price movement and the impact of large index constituents like Growthpoint moving out of lower distribution growth reporting periods.

The fund marginally underperformed the SA Listed Property Index (SAPY) for the quarter, but continues to outperform the spliced benchmark over one year. However, it marginally underperformed the benchmark over three years. The underperformance for the quarter can mainly be attributed to the limited exposure to stocks like Sycom, SA Corporate, Redefine and Vukile, while the relative positioning in Liberty International, Acucap and Hospitality A further detracted from performance. Positive relative return contribution occurred through the exposure to Hyprop and Foord Compass.

The main activity within the fund during the quarter was the disposal of its entire holding in Hyprop. This disposal does not reflect a potential derating in retail assets within the property sector or a weakness in Hyprop's portfolio. At the time when the negotiations started regarding the sale of Coronation's entire stake in Hyprop, the 7.0% clean forward yield achieved with the sale compared very well with the sector clean forward yield at that stage of 9.0%, as well as the underlying valuation yield within Hyprop's portfolio of 7.3%.

This disposal resulted in the cash position of the fund increasing substantially to 20%. However, with only a few days between the effective date of the transaction being 19 March and the end of the quarter, the cash position was decreased to 8.3% into a rapidly rising market. This was achieved by increasing exposure to Capital, Pangbourne, Resilient, Growthpoint, Redefine, Acucap and Liberty International. In addition, the fund participated in a private placement of NEPI at a discount price to the market trading levels. NEPI was established to invest primarily in the high quality office, retail and industrial property market in Romania and has a secondary inward listing in South Africa since April 2009. NEPI has the strong support of the Resilient group of companies with direct and indirect shareholdings and access to management skills. The portfolio has a retail bias with 66% exposure to this sector. The prospects of these properties seem positive with strong international and national Romanian tenants as well as a gradually improving consumer base.

Liberty International released full year results in March. The focus of the results fell less on the actual underlying performance of the company and more on the announcement regarding the demerger into Capital Shopping Centres (CSC) and Capital & Counties (CapCo). CSC will remain dual listed (similar to Liberty International at present) and contain the shopping centre assets, while CapCo will be an inward listed company on the JSE housing all the Central London assets, which include Covent Garden, Earls Court & Olympia, the Great Capital Partnership and the Empress State building. Despite the anomalies with the new listing structure we remain positive on both the demerged entities. The upside for CSC lies within the conversion of short-term rentals signed during the last 18 months to fill vacancies left by retailers going into administration as well as further positive yield movements. In turn, the upside for CapCo lies within the repositioning of Covent Garden as a premier Central London retail destination as well as the potential in the redevelopment of the Earls Court site.

Many local companies also reported during the quarter. Excluding Redefine, which delivered a year-on-year increase of 28% in its quarterly distribution, the weighted average distribution growth delivered by the sector was 6.5%. This ranged from -36.1% in the case of the combined Hospitality unit through to the 14.4% delivered by Capital. Key themes which came through with the results released were the defensiveness of industrial and regional retail assets. The cyclicality of the office sector has started to rear its head and could continue to put pressure on rental reversion, specifically in nodes where an oversupply is gradually being created. In addition, developers have hopefully learned the importance of quality line shops in smaller retail developments and that, despite having a food retailer as anchor tenant, consumers are sophisticated enough to differentiate between good and bad tenant mix. Tenants remain under pressure, with an increase in vacancies and subsequent vacancies taking longer to fill given increased incentives (either broker commission or subsidies to tenant installations). From an operating point of view, I expect the next 6 months (at least) to remain tough for tenants. The lower interest rate cycle should by then have had sufficient time to filter through the system. Tenants will however continue to experience headwinds with electricity costs and municipal rates increases. Going forward the key for operating success within the listed sector will be the successful managing of costs and vacancies and negotiating favourable funding margins when funding facilities need to be renewed. From a landlord perspective knowing tour tenant is very important.

The sector seems to have run ahead of itself early in the quarter. However, with the subsequent movement in bond yields the strong quarter seems justified, although a bit unexpected taking the underlying property risks into account. Things seem to be improving on the ground, but commercial property is not entirely out of the woods yet (although the 2009 Investment Property Databank numbers point to the momentum turning positive in the second quarter of 2009 for direct commercial property). In the short-term inflation may surprise on the downside as the currency remains strong, government borrowing may be less than anticipated and GDP growth may surprise on the upside. This leads me to believe that the positive momentum in the sector should remain, although this call is marginal as there are so many variables that could impact the macro economic environment.

Portfolio manager
Anton de Goede

The sector capitalised on the strong momentum of the previous quarter, with the SA Listed Property Index (SAPY) delivering a total return of 4.0%. This was mainly due to a rerating relative to bond yields as, despite bond yields ending the quarter higher, listed property yields drifted lower. Results released during the quarter generally remained fairly intact with distribution growth in line with lease escalation rates. This is defying the trend of a continued increase in vacancies and pressure on rentals.

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 exposure to Hyprop, Acucap and Pangbourne, while the relative positioning in Redefine and Growthpoint also added to performance. Some relative return retraction occurred through the limited exposure to SA Corporate, Sycom and Emira relative to SAPY.

The cash position in the fund nearly halved over the three months. This decrease can mainly be attributed to the utilisation of favourable share placement opportunities. The first thereof was that of Fortress Income Fund. This new listing emerged from the Resilient stable and listed at a combined market capitalisation of R1.8 billion. The listing structure is that of an A and B unit where the A unit should receive the lower of 5% or CPI distribution growth, while the B unit takes on most of the risk of the volatility of the underlying property earnings stream. Most of the properties in the underlying portfolio have been assembled from Resilient, Pangbourne and Capital. The largest 15 properties are mostly retail in rural and semi-rural areas linked to Shoprite or Pick n Pay leases. The fund participated in a placement of the A unit at listing at low double-digit yield levels, which is favourable taking into account the more secure distribution growth prospects due to the unit structure. The second opportunity was to participate in a placement of Acucap units at a discount to market levels to fund the acquisition of the 50% share in Bayside Shopping Centre which it did not already own. In addition to these trades, the fund decreased exposure to Capital, Fountainhead, Liberty International and Pangbourne in favour of sector heavyweights - Growthpoint and Redefine.

An interesting trend has emerged within the listed property sector. With the recent slump in global real estate the relative attractiveness of international property exposure, either listed or direct, has increased. With limited distressed selling or debt funding issues, local commercial property valuations have kept up well compared to global property prices. This has resulted in higher-yielding acquisition opportunities for local listed property companies available internationally rather than locally. Besides Growthpoint's entry into the Australian property market, Redefine increased its stake in Ciref, the UK-listed property company, to 55%. Subsequently Ciref acquired 13% of Cromwell, an Australian-based listed property company involved in both property ownership and property asset management. In addition, Emira has been investigating potential opportunities in Australia. Despite being in favour of value enhancing acquisitions, an increase in offshore exposure opens companies up to an additional layer of risks. Ironically, going global was one of the major factors impacting the Australian listed property market negatively over the last two years. Local companies just need to be cognisant of the risks involved.

The current challenging market conditions have led to many advocating that commercial property is in for a difficult next few years. The commercial property cycle tends to run in an eight- to ten-year cycle. With the current cycle already two years in the making since the high reached end-2007, it can easily be assumed that the negative momentum should continue. However, commercial property returns are closely correlated with GDP growth. With positive GDP growth already coming through in the third quarter of 2009, and a continued economic recovery in 2010, the current commercial property cycle could be much shorter than in the past. In the past positive economic growth corresponded with an increase in speculative building activity. Into the current cycle the local commercial market escaped much of the speculation as seen in the past due to various factors, from an initial high building cost base, electricity constraints through to the current challenging funding market. This should result in the current cycle being shorter, with commercial property returns picking up from late 2010 into 2011 in line with positive economic growth.

However, the next 6 to 12 months are pivotal for risks in the occupier market from a landlord's point of view. Increased occupancy costs driven by higher electricity tariffs and local government costs may stifle the willingness of tenants to accept high reversion rates and even in the weaker trading environment, be the final catalyst for tenant failures. Although relative value remains the key determinant in deciding which stocks to have exposure to, we remain cognisant of these risks in the current fund composition.

It is with mixed feelings that we also use this opportunity to thank Edwin Schultz for the enormous contribution he has made to this fund. As has been communicated to the market over some time, Edwin and his family have decided to emigrate to Australia. We wish him well in his future career.

Portfolio manager
Anton de Goede