The listed property sector reversed the losses experienced during the previous quarter. Its strong correlation with bonds broke down as the sector ignored the outward movement in the bond market towards the end of the quarter. Instead, the sector found support in a strong results season and continued mixed signals on prospective interest rate increases globally, which lured some yield-seeking investors back to listed property. This resulted in a total return of 6.2% for the three months, which coincided with another large trading quarter.

The fund underperformed the SA Listed Property Index (SAPY) for the quarter and the last 12 months, but continues to outperform the benchmark over 3 and 5 years. Value-add during the quarter came from the fund's relative exposure to Capital and Counties, Intu, Fortress A, Equites, Hyprop and Growthpoint. Relative positioning in Fortress B, Resilient, Capital, Redefine, Rockcastle and Pivotal all detracted value. Exposure to offshore currency, either direct or indirect, seems to continue to fuel individual stock returns, while little differentiation is given to the source of underlying earnings in stock ratings or the see-through gearing associated with these earnings. The fund reduced exposure to Hyprop, Resilient and Capital among others. In turn, it increased exposure to companies including Octodec, Pivotal and Rockcastle. The sector remains rife with corporate events. Despite the market uncertainty, investors continue to support capital raisings. Close to R8bn was raised during the quarter, 50% of which was raised by Redefine, Rockcastle and Texton. Redefine utilised the demand for its shares following inclusion in the Top 40 Index (only the second SA REIT to be included), late in the quarter. Redefine International announced a substantial R10bn portfolio acquisition, while Investec Property announced its potential acquisition of a R7bn portfolio from Zenprop, one of the larger portfolio transactions ever in the local market.

On the corporate action front, Redefine concluded its takeover of Fountainhead, Ascension B shareholders received Rebosis shares, while the takeover of Capital by Fortress (in a revised format compared with the original indicative offer) should be concluded soon. In addition, Vukile is expanding its reach and model of strategic stakes in a few companies by injecting R350m of capital into Atlantic Leaf, thereby increasing the number of companies in which it has a strategic stake to three. With the previous quarter already delivered some executive changes within the sector, the past quarter's announcements came as a surprise - the biggest being that of the departure of Nepi's CEO and COO. In addition, it was announced that Dipula's FD resigned, while Emira announced that current FD, Geoff Jennett, will be replacing the soon departing CEO James Templeton. Vincent Joyner was furthermore announced as new CEO of Hospitality. Companies representing close to two thirds of the sector's total market capitalisation reported results this quarter. Excluding the pure rand hedges, the sector delivered 12.4% dividend growth, an improvement from the 11.3% delivered by the same group of companies in both the six and twelve months prior.

A few noticeable trends are coming through within the sector. There has been a general improvement in like-on-like net income growth. Not only are most companies achieving overall positive reversions, vacancies in general have been well managed. In addition, operating costs continue to be well managed, with cost ratios net of recoveries mostly decreasing. Unfortunately this comes at the cost of more cost pressure being passed on to tenants rather than being absorbed by the landlord. Funding rates have remained surprisingly flat with traditional bank funding still very competitive. Hedging debt has however become more expensive. This could lead to more equity raisings in the market, which is already around R25bn year to date, or to companies utilising interest rate caps, instead of swaps, whereby the initial premium paid is capitalised. Companies are gradually aligning themselves closer to either development platforms (to ensure pipeline) or management platforms associated with new sector endeavours. This is leading to an increase in companies cementing positions in previously untested markets for the specific management teams. These markets range from student to residential accommodation to hospitals, and include new geographies with some preference for Europe while others prefer to stay closer to home (looking at Mozambique, Zambia and/or Kenya). Offshore exposure, either direct or indirect, now makes up 26% of the underlying property exposure within SAPY.

According to SAPOA, office vacancies decreased from 11.4% to 10.6% over the last quarter; the largest quarter-on-quarter decrease since 2008. The 10.6% compares to a low of 4.9% in 2008 and a high of 15% in 2003. Asking rents are 5.1% higher over the last 12 months compared with an increase of 6.0% in the previous quarter. All the metropolitan areas except Durban experienced a decrease in vacancies during the quarter. New space committed to increased by 0.3% to 4.8% of current total office space, with 46% of this development space being concentrated in Sandton (24.3% of the current Sandton market).

IPD released the results of the South Africa Biannual Property Indicator. For the six months to 30 June 2015, the South African direct property market generated a total return of 6.5% (versus 7.4% for the comparative six-month period in 2014. The retail sector was the best performing subasset class with a total return of 7.4%.

The current sector rating is dependent on the gradual tapering off of continued strong dividend growth; not on any negative surprises. Unfortunately some slower growth guidance for the next financial year from the sector's bellwether, Growthpoint, came as a negative surprise to the market. Although its projected growth number includes a few negative once-offs, it does point to potentially slower growth momentum for the broader sector. However, with all the uncertainties currently surrounding SA's economic growth outlook and balancing this with the prospects for inflation and interest rate increases as well as the normalisation of growth and interest rates globally, the SARB may be reluctant to continue with its interest rate hiking cycle in the short term. With interest rates being an important input for the sector's dividend growth prospects, it may be able to defy the risk of negative guidance surprises and therefore maintain its current rating.

Portfolio manager
Anton de Goede

The strong correlation between the property sector and the bond market made its return this quarter. While the sector was well supported in the prior three-month period as it enjoyed some assistance from global index inclusion, pushing the international shareholding of a few companies to above 20%, it followed bonds more closely in the three months to end June. As a result, the sector recorded its weakest quarter since 2008. As the local rhetoric from the Reserve Bank became more hawkish in recent months, the sector (and the rest of the income-yielding asset basket) was hit by the realisation that interest rates might be increasing sooner rather than later. The rolling 10-year bond yield moved from 7.71% to 8.20% over the quarter, while the sector's clean forward yield moved from 7.0% to 7.1%. This resulted in a total return of -6.2% for the three-month period, coinciding with the sector's largest trading quarter on record.

The fund outperformed the SA Listed Property Index (SAPY) for the quarter, thereby improving its relative performance over all meaningful time periods. Value-add during the three-month period came from the fund's relative exposure to Capital and Counties, Pivotal, Fortress B, Rockcastle, Redefine, Fountainhead and Dipula A. Relative positioning in Hyprop, Attacq, Texton, Equites, Capital and Nepi all detracted value. The fund reduced exposure to Hyprop, Emira, Capital and Ascension A, in turn increasing exposure to companies including Growthpoint, Nepi and Octodec. The fund participated in a Tower, Investec Property and Vukile book build and initiated exposure to Rockcastle. Individual property companies continue to utilise the sector's rating relative to bonds through the issuing of more equity. Besides primary capital raisings from the likes of Delta International, Vukile and Tower, Resilient launched a R2.8bn rights issue - the largest of its kind in the sector's history. Larger secondary placements in Redefine, Emira and Investec Property also occurred. Indluplace became the third property listing for the year as Arrowhead unbundled its residential assets into a separate listing, while remaining as a 77% shareholder of the new listing. This resulted in only R400m being raised as part of the R1.9bn listing market capitalisation.

The quarter also saw the delisting of Acucap following its successful takeover by Growthpoint. We should see the delisting of Sycom as well in the near future once Growthpoint has secured the final minority shareholdings. Further potential corporate action include Fortress's announcement of its intention to acquire Capital, while Capital (independent from the Fortress announcement) stated its intention to unbundle its office portfolio. Redefine moved another step closer to owning 100% of Fountainhead with the deal likely to be concluded during the third quarter. In turn, Rebosis was unsuccessful in its bid to acquire 100% of Ascension, only securing 100% of the Ascension B shareholding. It was an interesting quarter in terms of management movements. Three companies announced that their chief executives will be leaving their respective positions: Rob Kane announced his departure from Texton; James Templeton will be leaving Emira; and following an internal disciplinary hearing relating to procurement irregularities Andrew Rogers was dismissed as CEO of Hospitality. Gerald Nelson, who preceded Rogers as CEO, was appointed in the interim. Companies comprising approximately one third of the sector's market capitalisation published results during the quarter. The weighted average distribution growth for the reporting companies came in at 7.5%. If one excludes the once-off Vukile special distribution of sales commission in the base, this figure comes in at 8.5%. Excluding Redefine International and Investec Australia, the growth came in at 7.6% and 8.8% respectively on a similar basis, which was in line with the 9.2% distribution growth delivered by the same group of companies six months prior and the 8.9% distribution growth achieved 12 months prior.

Some definite trends are clear from the recent results releases. By far the biggest trend is that nearly all management teams indicated a desire to move either offshore or into property subsectors, which they did not previously naturally operate in. Europe and the UK appear to be the most popular destinations being investigated. Africa is being shied away from by most, as the risk/return profile from the rest of the continent is not that favourable taking into account funding rates versus the asking prices for established income streams. Development opportunities, however, still make sense for those who are prepared to move up the risk curve. The attraction for most in gaining exposure to the UK and Europe seems to lie in the positive jaw in initial acquisition yields versus offshore funding rates, where many believe that positive gaps of at least 200bps - 300bps are easily achievable. The jury is still out on how successful all the investigations and already announced ventures into these markets will be.

The movement of property in response to weaker bond markets proves that the sector remains vulnerable to movements in the broader interest rate market. We believe it is good that the sector has released some steam following the strong start to the year, partly driven by foreigners buying into the index in March, making the sector one of the bigger net foreign purchase beneficiaries YTD. It is clear that against the current economic and inflation backdrop, trading volatility will persist. Up to now, the stronger dividend growth of the last 12 - 18 months has supported the relative rating of the sector. This growth could come under pressure as the impact of load shedding starts to meaningfully reflect in vacancy numbers and operating costs. In addition, higher interest rates will impact longer-term funding rates, making yield enhancing acquisitions difficult and the positive effect of gearing less effective. However, we anticipate dividend growth to be at least high single-digit on average for the next year, which should support the sector in the medium term.

Portfolio manager
Anton de Goede

The first quarter of the year started with a strong push in January as the local bond market found support in global bonds, especially after the ECB announced its quantitative easing programme, but also from lower inflation expectations in South Africa, driven by lower oil and food prices. However, the rest of the quarter experienced a breakdown in the strong correlation between listed property and bond yields. While bonds reversed most of their gains achieved in January, listed property continued to follow an upward trajectory, driven by a positive results season. In addition, FTSE index changes had a material positive impact on the sector towards the end of the quarter, not only in terms of share price spikes but also in terms of trading volumes, with the sector experiencing its highest quarterly trading volumes on record. The sector remained active on the portfolio repositioning front, with the most sizeable being Redefine's acquisition of the Leaf Capital portfolio for R4.1 billion.

The rolling 10-year bond yield moved from 7.87% to 7.71% over the quarter, while the sector's clean forward yield moved from 7.0% to 6.4%. This resulted in a total return of 13.7% for the sector over the quarter. Within this strong return environment, additional capital raisings continued with close to R8 billion being raised via accelerated book builds or through investor presentation led appetite. The quarter already delivered this year's first new listings. Lodestone listed out of the Resilient stable with a small portfolio of 22 properties, valued at just below R1 billion, while New Frontier Properties listed as an inward-listed company on the AltX out of Mauritius. The company is a UK REIT, with a focus on retail in secondary towns and cities in the UK. It has already secured two town centre shopping centres in the UK, both with redevelopment opportunities.

The fund underperformed the SA Listed Property Index (SAPY) for the quarter and for the last 12 months, but continues to perform in line with the benchmark over the three- and five-year periods. Some results releases assisted stock prices during the quarter, as did the index changes implemented at the end of the quarter. Value-add during the quarter came from the fund's relative exposure to Growthpoint, Capital, Texton, Attacq, Synergy A and Hospitality. Relative positioning in Resilient, Fortress B, Fountainhead, Redefine, Intu and Capital & Counties all detracted from performance over the period. Having no exposure to Fortress B, representing just over 1% of the benchmark, resulted in close to two thirds of the fund's relative underperformance as it delivered a total return of 80% for the three months alone. We believe the associated risks within Fortress B are not correctly priced by the market with its forward yield at 3% versus the sector's 6.4%. We therefore remain comfortable having no exposure. The fund reduced exposure to Intu and Redefine into strength, in turn increasing exposure to companies including SA Corporate, Vukile, Nepi, Growthpoint and Hyprop. The fund participated in the Rebosis book build and once more initiated exposure to Octodec. Some conclusions on pending/anticipated corporate actions came through during the past quarter. Vukile's offer to acquire all the Synergy A and B units it did not own previously was partially successful, with Vukile being able to secure a final shareholding of 11.9% in Synergy A and 87.6% in Synergy B. Rebosis made a similar type of offer to Ascension shareholders, with the difference that the Ascension A structure will be replicated through a similar Rebosis A share. Redefine seems to be a step closer to having 100% of Fountainhead. It reached an agreement with the minority shareholders who previously voted against an offer to increase the swap ratio of Redefine shares being offered for Fountainhead shares.

Companies representing 60% of the sector's total market capitalisation reported results during the quarter. The sector delivered 11.3% dividend growth (excluding Nepi and Rockcastle, which are pure rand hedges), which was in line with the 11.3% delivered by the same group of companies six months prior and slightly ahead of the 10.0% delivered 12 months prior. Some interesting operational trends are noticeable within the sector. Landlords with a retail bias continue to achieve the highest reversions when leases are renewed, on average between 5% - 8%, while despite the continued low vacancies it seems that industrial reversions have overtaken office as the weakest subsector due to the natural cap that seems to currently exist on industrial rentals (due to viability rentals for new product). Vacancies have marginally increased over the last six months, although much of it can be explained by the failure of Ellerines. Landlords have increasingly become more discerning when it comes to gaining additional exposure to the Edcon group, with stores being categorized in terms of performance and risk of closure. Landlords continue to aggressively manage their cost base with most of them now achieving lower property operating cost ratios. It seems they continue to improve their cost recoveries from tenants, but this could put pressure on future rental reversions. In addition, landlords are increasingly using their portfolio footprints to achieve lower costing for outsourced contracts.

There is a continued appetite for companies to gain offshore exposure. Some companies who previously never showed interest in offshore exposure are buying in the UK and Europe, and while Australia is the other region which remains a firm favourite, management teams are enquiring how investors will feel about exposure outside of these three regions. Despite initial excitement for exposure to Africa ex South Africa, the traction remains slow, with only a few companies prepared to enter markets on the continent. The offshore element within the sector has increased substantially over the last few years, with an estimated 20% - 25% of the sector's income coming from offshore.

The current large yield gap between property and bond yields is supported by continued strong dividend growth. Going forward, the quality of the dividend growth is important to gauge as it should rather be driven by improved portfolio efficiencies than necessarily the positive impact of rand weakness, which was a driver of dividend growth over the last 12 months. Barring a surprise interest rate hike, which can't be ignored taking into account the hawkish nature of the recent Monetary Policy Committee statement, the sector seems fairly valued relative to bonds. An interest rate increase should have a minimal impact on dividend growth; however, the impact on investor sentiment should be more negative.

Portfolio manager
Anton de Goede

The strong run in the listed property sector during 2014 surprised many investors. Despite a very poor January (down 7%), the sector recovered strongly to deliver a return of 26.6% for the year. These polarised movements in the fortunes of the sector have mostly been associated with either actual interest rate movements or market sentiment regarding potential interest rate movements. For most of the past quarter, the sector took its lead from the local bond market, which in turn was supported by lower US treasury yields. With the continued pressure on the oil price, lower inflation expectations are starting to be projected, which seems to provide some base support for current bond yields. The rolling 10-year bond yield moved to 7.87% from 8.22% over the quarter. With the relationship between bond and listed property yields remaining strong - accompanied by a rerating - the sector's clean forward yield moved from 7.5% to 7.0%. This resulted in a total return of 11.1% for the quarter. Within this strong return environment additional capital raisings continued in the sector. During the period under review Fortress, Nepi, Texton, Attacq, Redefine, Resilient and Investec Property all raised capital via accelerated book builds.

The fund marginally underperformed the SA Listed Property Index (SAPY) for the quarter and for the year, but continued to perform in line with its benchmark over the three- and fiveyear periods. Some results releases assisted stock prices during the quarter, as did the index changes implemented at the end of the quarter. Value-add during the quarter came from the fund's relative exposure to Accelerate, Investec Australia, Nepi and SA Corporate. However, our relative positioning in Hospitality A, Synergy A, Fortress A, Intu, Resilient and Hyprop detracted value. The fund reduced exposure to a cross section of stocks, mostly SA Corporate and Capital, due to cash management. During the quarter, the fund participated in a few equity placements, including Attacq, Fortress, Investec Property and Redefine; increased exposure to Emira; and initiated a position in Investec Australia. The lower interest rate cycle and introduction of Real Estate Investment Trust (REIT) legislation in South Africa during 2013 continue to encourage new listings within the listed property sector such as Pivotal, Sirius and Acsion during December 2014. Our participation in the listing of Pivotal, a development focused fund out of the Abland stable, was the largest trade for the fund during the quarter.

Companies consisting approximately a third of the sector's market capitalisation reported their results this quarter. The weighted average dividend growth for these companies came in at 9.0%. If one excludes the once-off Vukile special dividend of sales commission in the base, the weighted average dividend growth totalled 10.7%. Dividend growth has been driven by companies with offshore exposure, receiving a yield pick-up due to the weaker rand. In turn, management teams performed well operationally, extracting good growth from the underlying local property portfolios. Throughout the year, forward guidance has also looked better than anticipated. Some interesting operational trends are noticeable within the sector. In general, positive reversions are being maintained, mostly within the retail sector, while negative office reversions are being contained to the minimum. Industrial reversions continue to be a bit haphazard as longer leases (10yr+) coming up for renewals revert to normalised levels. Vacancies are also being contained despite little support from the economy for tenant demand. Management teams continue to impress with a general containment of property operating cost increases relative to income growth. Besides the filling of vacancies supporting the relative movement, it seems the sector has come to grips with administrative pricing increases and how to manage it in a broader portfolio context. This has in part been achieved through new property management contract agreements or negotiating services contracts on a more national level. The tightening of the corporate credit market has led to property companies gradually being priced out of this source of funding. Some companies have made abrupt u-turns in their approach to funding, moving back to source more funding from the banks than from the debt market. Even without the resetting of the corporate credit market, bank funding has become more competitive again.

Although the relative value proposition against other asset classes have reduced over the recent months due to the sector's strong performance, long-term value in the listed property sector prevails with continued double-digit medium to long-term IRR (internal rate of return) expectations. Shareholders have benefited from good operational discipline exhibited by management teams in a tough environment through the strong dividend growth delivered in 2014. The sector remains finely balanced between dividend growth expectations and the yield relative to long bonds. Expectations of interest rate normalisation taking longer and in smaller increments continue to provide some support for the sector and the correlation with bond yields remain fairly intact. With dividend growth prospects remaining relatively positive, the sector's performance should be driven by the overall fixed income market, which we will follow closely, rather than sector specific issues.

Portfolio manager
Anton de Goede Client