The beginning of the quarter was characterised by the ongoing downward trend of the South African Property Index (J253) from its highs in May, brought about by the expectation of and the actual increase in interest rates by the central bank.

In August, the Reserve Bank hiked interest rates further by 50 basis points (0.5%), leading to a repo rate of 8.0%. At the same time, the current account deficit, currency weakness, higher inflation expectations and unabated private sector credit extension continued to bring uncertainty to the market. This was exacerbated by international concerns relating to emerging markets.

Consequently, the sector came under pressure towards the end of the quarter to September 2006 due to the above factors. It delivered a negative total return of 1.5% for the month of September, but a positive return of 9.2% for the quarter. The recovery was driven by higher than expected distribution growth from those companies that reported results to the end of June.
From the sector's low on 17 July 2006 to the end of September, the sector rose by 16.3%. The average distribution growth for those companies that reported was a market cap weighted 11.9%, with income distribution growth ranging between 3.8% and 21%. We have been overweight those companies that delivered stellar results.

However, with increasing concerns regarding the amount that the South African Reserve Bank would be hiking interest rates at its 12 October meeting and the possibility of further hikes in future meetings, the volatility returned to the market, especially towards the latter part of September. This pushed yields weaker in anticipation of the increase in interest rates and into buying territory.

In light of our view of a 50bp increase in October 2006 we believe that the sector was oversold. We have not seen, nor are we expecting any meaningful adverse impact of these interest rate increases on property fundamentals. Our earnings growth prospects of 12% in 2006 and 10% in 2007 remain largely unchanged.

The SA listed property sector continued to come under enormous pressure in June as a result of ongoing global and local market jitters. The weakness in the sector was further compounded by the largely unexpected 50 basis point (bpt) increase in the SA repo rate in the second week of June. There was a significant outflow of cash from all equities, including SA quoted real estate, as retail and institutional, local and global investors "ducked for cover" by moving into cash. Fortunately, at the end of June, the US Federal Open Markets Committee (FOMC) raised interest rates in line with consensus expectations, with an increase of 25 bpts. In addition, the message from the FOMC, albeit vague and generally non-committal, indicated that the series of interest rate hikes might have finally come to an end.

This message provided the market with a degree of clarity and direction that it required in order to at least stabilise, if not recover, from the prior downward movements. Before the FOMC meeting, SA markets had priced in a "worse-case scenario". The markets were expecting more negative news out of the US in the form of higher interest rates and the possibility of a long-term bear market. This filtered directly through to emerging markets and SA, softening the rand and weakening JSE share prices across all sectors with yields on interest-income generating assets also moving sharply upwards. The classic saying "when the US sneezes, SA [the rest of the world] catches a cold" was entirely appropriate in describing what was experienced in the local markets over this period. However, encouraging signals received out of the US at the end of the quarter implied that the aggressive sell-off in most asset classes, in particular listed property, was largely "overdone".

Our opinion is that listed property share prices have adjusted downwards to take into account the 50 bpt June 2006 increase and possible further increases in interest rates. The market has priced in a possible further 50 bpt rate in the second half of 2006, and an additional 50 bpts in 2007. We believe that further interest rate hikes in SA are probable. The market continues to discount the robust earnings growth that we are anticipating out of the SA listed property sector. We are not expecting a significant adverse effect from the recent (and possible further) increase in interest rates on distributable earnings. Gearing levels in the listed property sector have declined from 33.4% in 2004 to 30.1% at 1 June 2006. On a "see-through" basis, 75% of total long-term liability within the SA listed property sector is fixed.

The impact of the interest rate increase is therefore limited in terms of our short to medium-term distributable earnings forecasts. Any increases in financing costs as a result of interest rate hikes are being more than counter-balanced by the ongoing reduction in lower lending rate margins and securitisation initiatives. The fundamental drivers of direct property investment have not changed, and remain strong. These include lower vacancies and upward rental reversions, driven by supply / demand disequilibrium. We believe a correction in share prices is likely, although unlikely to be "overnight".

This is based on ongoing global market nervousness (investors still rather shell-shocked after the exceptional volatility and rapid downward pressures of the past few weeks) and concerns on the growing SA current account deficit. It cannot be ignored that an increase in interest rates should, in theory, weaken the rand and, therefore, have a positive impact on the deficit. The current account deficit continues to be the remaining threat in terms of the Monetary Policy Committee adopting a more aggressive approach to interest rate management, as opposed to the series of increases in interest rates that have already been referred to. While our view is that this risk is limited, investors should be reminded that listed property stocks are subject to market fluctuations and short-term volatilities. Long term, it is the predictable and growing income streams that drives capital values.

Listed property performed well in the first quarter of 2006, returning 21.87%, compared with equity returns of only 13.25%. This performance was underpinned by a number of factors. Fourteen out of the 30 Property Unit Trusts (PUTs) and Property Loan Stocks (PLSs) declared interim or final results in the quarter. Seven of these declared distributable earnings growth of more than 10% relative to the same comparable reporting period in 2005. This supported the strengthening in share prices as the market surprised analysts and asset managers on the upside.

Secondly, the tax on retirement funds was halved, from 18% to 9%, in the F2006 budget. This means that all interest-producing assets, such as bonds, cash and listed property, could have higher after-tax contributions to portfolios due to the tax break. However, as a result of listed property's growth in distributions, there will be an additional alpha generated by investing in listed property than anticipated.

South Africa's economic growth continued to provide the base for the continued out-performance of the listed property sector. Rentals were revised upwards due to demand for space across all commercial sectors, particularly industrial. Buoyant consumer spending led to suppliers requiring more space as they attempt to use warehouse space to bring products closer to customers.

Factors contributing to the demand-supply disequilibrium in the physical property market include the pace of the process of rezoning land and increasing building costs (e.g. from the skills shortage and the prices of materials). The SA Reserve Bank has noted that, according to the Bureau of Economic Research, the cost of newly completed buildings for the client, known as the tender price, has risen by 85% since 2000.

According to the Reserve Bank, factors accounting for this increase compared to that of headline consumer inflation include the degree of competition in the tendering process, the availability of labour and material inputs, which are strongly related to the stance of the business cycle. All these point to the ongoing increase in the take up of previously unoccupied space and lead to lower vacancies.

A significant rise in interest rates could spoil the party in part because of the negative sentiment this could bring to the market. Capital values could come under pressure however distribution growth will continue as most of the property companies have hedged their interest rate exposure, with most of the fixes extending between three and five years.

The South African commercial real estate sector still has some legs as property fundamentals have continued to improve and are not showing signs of abating in the medium term.