Listed property share prices were volatile in the third quarter as the market came to grips with a deteriorating and uncertain interest rate outlook. Macroeconomic, rather than company factors, have been the primary driver of market sentiment over the quarter. Overall, listed property is in fair value territory relative to bonds. It offers little re-rating potential, but also little downside risk relative to bonds in the immediate short term. The risk, however, lies with worse than expected short term capital performance, given the current capital market dynamics.
Investors must realise that property is a medium to longer term asset class. Those investors who buy property for its longer term capital gains (based on income growth) will be rewarded because property companies' earnings growth remains very healthy. Average distribution growth has risen from around 1% year on year at the beginning of 2004 to 10%. It is forecast to accelerate to about 11% year on year in the next 12 months. Furthermore, the positive earnings cycle is sustainable for at least another three years as supply and demand dynamics increasingly favour landlords.
The fund has comparatively low cash holdings and no holding in Liberty International, which has benefited from the weaker rand. Fund performance was further negatively affected by its historically low holding in ApexHi B units. The holding in ApexHi B has been increased, but it is still underweight relative to the benchmark. The fund has increased its over- and underweight positions relative to the benchmark in various stocks and we believe that these "bets" will generate alpha over the next year.

As a result of a combination of factors, listed property share prices fell 21% from their 11 May peak. Investors can expect continued capital volatility from listed propoerty over the next three to six months. However, distribution growth from property remains well intact, underpinned by strong property fundamentals. Average distribution growth has risen from around 1% year-on-year at the beginning of 2004 to 10% currently and is forecast to accelerate to about 11% year-on-year during the next 12 months.

Most of the listed property sector is well positioned to absorb the impact of higher interest rates - for two reasons. Firstly, virtually all listed property companies fix the cost of around 70% to 80% of their debt. Secondly, given the high level at which they are expiring, maturing fixes are still likely to be refixed at lower rates notwithstanding the rise in rates.

Demand for all categories of space (office, industrial and retail) as the economy grows ensures that vacancies remain low or continue to decline. Constrained increases in the supply of office and industrial space because of rising land prices and building costs, as well as slow and tighter rezoning of land, supports a sustainable rise in rental income. The recent and expected further rise in interest rates poses some threat to the rate of household consumption growth. But, ultimately, economic growth and still healthy increases in disposable income will support income growth in the retail property sector, albeit at a lower rate.

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Listed property is an attractive investment for those seeking stable growth and a reliable income stream. The property sector's strong earnings growth is expected to continue during 2006 and we believe the positive earnings cycle is sustainable for at least another three years thereafter. Listed property is expected to outperform cash and bonds over the long term.

Capital returns over the next few months could continue to be volatile but we expect consistent growth in company distributions over the next few years to translate into positive capital returns over time.

Property share prices rose 18.8% during the first quarter of 2006. The average year-on-year distribution growth of companies that released interim or final results during the quarter equated to 12.1%, with forecast distribution growth about 9%. The sector continues to grow through acquisitions and proposed mergers. Companies are still pursuing alternative sources of finance, such as securitisation, a benefit that falls straight to the bottom line.

Consumer price inflation excluding mortgages (CPIX) increased to 4.5% in February 2006 and producer price inflation (PPI) remained stable at 5.5%. Consumer inflation was slightly below market consensus of 4.6%. Inflation data is still positive and the outlook for interest rates remains flat, which is positive for property income statements and yields.

Property fundamentals continue to strengthen. The latest Rode Report predicted double-digit rental growth, relatively low and stable interest rates and declining capitalisation rates across all three sectors of the industry. These forecasts re-enforce the fact that the commercial property industry is on a positive growth path. Demand for space is strong and a decrease in available space, reducing vacancies, is dictating an increase in rentals across all commercial property sectors. Property remains a good diversifier in any portfolio and should outperform bonds and cash in the medium term.

Property share prices continue to gain on the back of excellent distribution results. Share prices rose more than 9% during the fourth quarter of 2005. The prospect of further growth in distributions remains strong and this will be positive for the sector going forward. Many companies with interest rate fixes are unwinding these for more beneficial rates and are also pursuing alternative sources of finance, for instance securitisation. This benefit falls straight to the bottom line. The listed property sector continues to grow, with three new listings since August 2005.

Consumer price inflation excluding mortgages (CPIX) fell to 3.7% in November 2005 and producer price inflation increased to 4.5%. The continued decrease in inflation from the high of 4.8% in August 2005 was a relief to a market expecting interest rates to firm. The outlook for interest rates remains flat, which is positive for property income statements and yields.

Current property fundamentals continue to improve. Reports from the market continue to confirm that the commercial property market is responding well to current fundamentals. The industrial and retail property sectors, in particular, have benefited the most so far, as both property types benefit from a strong consumer and low interest rates. Confidence among listed companies and managing agents in the local office sector has also increased significantly. According to the latest report released by property economists Rode and Associates, office rentals in decentralised areas increased 5% on a year earlier, while rentals in central business districts were almost 12% higher than at the same time in 2004. The likelihood of further sector earnings and distribution growth remains strong.

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The SA listed property sector's strong earnings growth is expected to continue. The property cycle remains positive as a result of relatively low inflation, 24-year low interest rates, a strong retail supply chain and improving demand for space. However, much of this good news has already been priced into share prices, so the likelihood of strong capital gains similar to 2005 appears unlikely.