Market and portfolio review
Listed property in a global context had a stellar third quarter. Over this period the US dollar global listed property returns came in at 26.8%, primarily driven by Oceania (41.9%), Europe (39.2%) and the Americas (34.3%) (Source: Global Property Research, Market Update - September 2009). Despite being one of the most resilient markets during the peak of the financial crisis, the local listed property sector delivered currency adjusted total returns of 13% over the quarter. Furthermore, local listed property outperformed bonds (3%) and cash (1.9%), but underperformed equities (13.9%), in rand terms. The South African Listed Property Index (SAPY) continued to be the top performer over the past 12 months. This can mainly be attributed to a lower interest rate environment and government's expected budget deficit for this fiscal year. Listed property is expected to deliver better returns when compared with bonds and cash over the medium term. Nine companies reported interim and full year results to June 2009. Weighted average distribution growth of 8.4% was reported. A common theme in recent listed property company earnings has been the growth in vacancies from 4.9% to 6.1% and the escalation in arrears and bad debts as tenants face operational challenges. Landlords have highlighted the need to move towards tenant retention with specific focus on smaller companies, line shops and industrial mini unit tenants who are usually the first to default in a difficult economic environment. To achieve this, some landlords have moved to incentives such as rent-free periods which may have negative income implications in the short term.

Portfolio activity
Although capital returns were in excess of 10% between 2004 and 2007, property has delivered income returns of approximately 9.7% over the last 12 years. Our view is that income will again form a greater portion of total returns to investors over the medium term. As a result, the investment strategy employed has been to restructure the portfolio in order to increase exposure to companies with attractive entry yields and relatively good distribution growth prospects over the next 18 months. Over the last quarter, the portfolio significantly decreased its weighting in Hyprop and Sycom. Reducing the portfolio positions in these stocks increased the overall cash position. However, the cash position was recently reduced through participation in the partial rights offer and book-build by Growthpoint Properties at a discount to market. Other stocks the portfolio increased exposure to over the quarter are Capital, Acucap, Resilient and Pangbourne. Over the past few years, Investec Property Investments has had limited investment into Pangbourne. Since the reconstitution of the board in 2007, the company has gone through major restructuring, moving away from the reliance on non-annuity income. Greater exposure to annuity and more sustainable income allowed an improvement in organic distribution growth for the results to June 2009. Going forward, distributable earnings are forecast to be above the sector for the next two years. Over the quarter to the end of September, Redefine, now the second largest company by market capitalisation in the sector, has underperformed the market by delivering returns of 10.8%, and continues to look well valued on a relative basis. This may be one of the stocks that could deliver substantial capital returns over the short to medium term. We continue to buy selectively into share price weakness, favouring those counters that show value.

Portfolio positioning Our view is that listed property continues to look attractive, given sustainable distribution growth. However, the outlook is more modest compared with the last three years based on the slowdown in distributable income growth. The yield gap is a long way off its premium reached during 2007, even if it has recovered since March 2009. The change in investment strategy towards a lower cash target of between 2% and 5% coincided with the high yield gap point between listed property and bonds in March 2009. Research from Macquarie First South, based on data compiled over the past 12 years, concludes that for every 7% growth in distributable income, listed property justifies a 1% yield premium relative to bonds. At the current yield gap, the market is implying flat to slight negative income growth while Investec Property Investments is forecasting distribution growth of between 7% and 9%. Therefore, even if the current yield gap accounts for the weakening fundamentals, the sector remains attractively priced relative to cash and bonds, and is likely to outperform these two asset classes with the recovery in the economy over the next 24 months.

Market and portfolio review
The domestic economy continues to show signs of stress in the wake of the global economic downturn. However, there are signs that the downturn - both globally and locally - may be nearing the bottom. Despite an additional 200 basis point decline in the prime interest rate in April and May, the consensus view is that the economic recovery could be slow and protracted. A recent survey by the Bureau of Economic Research revealed that consumer confidence fell significantly during the course of 2008, but managed to rebound during the first half of 2009, led by an improvement in equity markets. Output growth remains negative and consumers are under pressure. This has translated into a slowdown in consumer spending, increased arrears and bad debts for tenants and lower renewal rentals for commercial property owners such as the listed property sector. We believe that the recent approval by the National Energy Regulator of South Africa to hike electricity tariffs by 31.3% may have a slightly negative impact on earnings growth. The hike is likely to have a detrimental effect on high energy users such as general manufacturers, mines and call centres. Although companies in the listed property sector recover around 90% of operating expenses from tenants, this hike will increase tenants' cost of occupancy and may in turn lower landlords' bargaining power when leases are up for renewal. During the second quarter to the end of June 2009, the SA Listed Property Index (SAPY) underperformed equities, cash and bonds, on the back of revised earnings expectations over the next two years. The SAPY returned -0.9% while equities, cash and bonds delivered 8.6%, 2.2% and 0.3% respectively. However, over 12 months, the SAPY was the top performer by a large margin over other asset classes, while equities delivered negative returns.

Portfolio activity
Over the past year the Investec Property Equity portfolio's investment strategy was to retain a relatively high cash exposure and to take advantage of the buying opportunities presented by the weakness in the market. During the first quarter of 2009 the strategy changed and we entered the market more aggressively, thus lowering the cash position substantially. We will continue to buy selectively into share price weakness. Growthpoint underperformed the benchmark over the three months to the end of June and we took the opportunity to increase the portfolio's holding in the counter. Over the medium term we believe that Growthpoint shows value and is better geared towards the recovery of the overall market. The counter has a relatively higher correlation with equities as a result of its increased liquidity and inclusion in the FTSE/JSE Top 40 Index and Morgan Stanley Capital International Emerging Market Index (MSCI EMI). The accompanying table shows the two top and bottom performing stocks held in the portfolio relative to Growthpoint, ranked over 12 months. The underweight position in Growthpoint and overweight exposure to Resilient and Capital, relative to the benchmark over the past 12 months, was the correct strategy to adopt. The portfolio also has a relatively high exposure to Redefine, ApexHi and Madison, which are expected to merge in the second half of the year. These shares have not shown strong performance over the last month; investors started to lower their exposure to prevent a significant overweighting in the combined Redefine. We have largely retained the overweight position, but have traded out of the most expensive shares as per the merger swap ratios. Once merged, the new entity is likely to have a market cap of around R18 billion. This could result in Redefine being included in the FTSE/JSE Top 40 Index and MSCI EMI, thereby re-rating similarly to Growthpoint when it was included in the indices.

Portfolio positioning
Our view is that listed property continues to look attractive, given sustainable distribution growth. However, the outlook is more modest compared to the last three years. There is also the possibility of a repricing on the back of a decreased interest rate environment, which should benefit asset classes with strong correlations to interest rates. However, the re-pricing of listed property and other sectors will, in part, be influenced by how quickly the economy recovers. Investec Property Investments continues to monitor each of the underlying property stocks. We hold meetings with management and tenants and visit properties to get a better sense of the impact of the slowdown and which stocks are well structured to weather the storm.

Market and portfolio review
In the first quarter of 2009 the local economy began to show signs of a significant slowdown. Gross domestic product (GDP) for the fourth quarter of 2008 was at a worse than expected -1.8% and manufacturing data showed a similar trend at -11.1% for January 2009. As a result, the Monetary Policy Committee(MPC) responded by cutting interest rates in February and again in March by 100 basis points on both occasions. The forecast is for further monetary easing of 100 basis points in April and 50 basis points at both the May and June meetings, culminating in a 400 point cut in the first half of 2009.

For the three month period to 31 March 2009 some of the gains achieved in the second half of 2008 were reversed with the SA Listed Property Index(SAPY) delivering total returns of -1.4%. Following the MPC announcement to meet more frequently, the SAPY reported total returns of 2.6% in March 2009, recovering some of the losses of January and February 2009.

The SAPY has maintained its strong return history. Returns have been surpassed by cash over the last three months and by bonds and cash in the 12 months to 31 March 2009.

Ten listed property stocks recently declared interim and year end results with distribution growth largely in line with or ahead of forecasts. Resilient Properties Limited (overweight) led the sector with 18.3% growth and SA Corporate Real Estate Fund (underweight) was the laggard at -7%. Despite mostly strong performances, management teams have tempered medium-term growth expectations on the back of weakening economic fundamentals, particularly in the office and retail sectors. As arrears and bad debts rise, vacancies have shown an upward trend, averaging 4.9% across all sectors.

The Investec Property Equity Fund outperformed the SAPY during the quarter.

Portfolio activity
The strategy of maintaining an overweight cash exposure contributed favourably towards the performance of the portfolio in the period under review. Market weakness was used to reduce cash exposure ahead of possible aggressive cuts in interest rates. Amid volatile market conditions, the high cash position benefited performance, moderating risk and acting as a buffer against share price weakness.

The high cash exposure and good stock selection contributed to returns over the quarter. The high cash position was, in part exploited in the weak markets in January and February 2009. Weightings in stocks such as Growthpoint, Capital, Octodec, Premium, Resilient and Acucap were increased.

Acucap, which had a zero weighting previously, was recently introduced into the portfolio following a year of restructuring and integration. The outlook for sustained income growth at or near double digits seems likely.

The portfolio currently has an overweight position in Resilient mainly because of the company's sector-leading operational performance. In 2008, the fund declared 18.3% distribution growth mainly led by the strong operational income growth, additional income from newly developed and refurbished projects and the yield-enhancing acquisition of associated Diversified Properties. Dominance in outlying regions has proven successful even in this difficult environment. Resilient recently undertook a capital raising exercise, which the portfolios were happy to participate in as it was correctly priced. It also assisted in reducing the cash holding, whilst increasing exposure to a preferred share which is likely to continue being a top quartile distribution growth stock in the medium term. Weightings in stocks such as Emira, Sycom and Vukile are likely to be reviewed over the next three months.

Portfolio positioning
The strategy is to further reduce the cash holding, taking advantage of current market weakness and volatility. Our view is that, listed property continues to look attractive given sustainable distribution growth and a possible re-pricing on the back of further cuts in the repo rate.

Investec Property Investments' 2009 strategy is to actively manage the portfolio, buying into weakness, seeking attractively priced stock and aiming to deliver attractive, top quartile total return performance relative to peers and outperforming the SAPY benchmark.

Market review
The South African Reserve Bank cut the repo rate by 50 basis points to 11.5% in December 2008. This was the first cut since June 2006, with the prime lending rate dropping to 15%. The Governor, Tito Mboweni, cited a much improved consumer inflation outlook and a significant slowdown in consumption as the main reasons for the interest rate relief. Aggressive interest rate cuts are anticipated during the course of 2009. We expect interest rate sensitive sectors, including property, retailers and bonds to outperform as a result of this.

One of the motivations for investing in property unit trusts and property loan stocks in the past has been their low correlation to the rest of the financial markets as well as their lower relative volatility, which results in better risk-adjusted returns. In other words, property shares have tended not to move in tandem with most stocks and bonds, thus providing benefits of portfolio diversification with lower relative volatility.

This theory was tested in particular in the first half of 2008 amid the deepening credit crisis and the financial market meltdown. As global markets came under significant pressure, so too did global and local property stocks. However, investor sentiment reversed in the latter half of the year. There was a return to higher, more certain and growing income yields that the listed property sector provides, away from the more uncertain earnings' prospects from industrial companies.

The SA Listed Property Index (SAPY) had a roller coaster ride over the past three months, resulting in a quarterly performance of 8.5%. The inclusion of mega cap Growthpoint Properties Limited in the MSCI Emerging Markets Index and improved economic data boosted the sector in the fourth quarter.

The SAPY earned total returns of -4.5% for the 12 months to December 2008. The SA Listed Property Index outperformed the All Share Index, which produced returns of -23.2% over the same period. The last six months have been positive for the listed property sector, delivering 33.5% and outperforming all other asset classes.

Portfolio review
The Investec property equity portfolios were managed on a conservative basis during 2008. The cash allocation was generally kept at close to the maximum acceptable level, in order to decrease the volatility of the portfolios and take advantage of any investment opportunities. We continue to manage the portfolios with caution as the underlying global market volatility remains high.

Portfolio activity
The volatility in the market afforded the management team the opportunity to reposition portfolios, selling overvalued shares and increasing positions in the historically more untradable core stocks. Exposure to ApexHi-A, B and C units, Hyprop, Madison, Octodec, Redefine and Sycom was increased over the quarter with the intention of taking advantage of the potential recovery in these shares, some of which may be the subject of corporate action in the short term. Exposure to Acucap (taken to zero), Capital, Emira and Fountainhead shares was reduced due to their weaker income growth prospects for the coming year and unfavourable outlook relative to their peers.

The portfolios have recently been underweight Growthpoint (GRT). In the quarter under review this counter outperformed its peers, aided by its inclusion in the MSCI Emerging Markets Index and the FTSE JSE All Share Top 40 Index. The investment team considers GRT to be a trading stock due to its high liquidity and significant market capitalisation relative to the sector.

Towards the end of the quarter Investec Property Investments (IPI) secured an option to acquire up to R1 billion of GRT shares at R13.60. Settlement for this transaction took place on 31 December 2008 and the full stock allocation is reflected in the portfolio valuation. In addition to the substantial market discount, the GRT units will be entitled to the full six months interim distribution to end December 2008, which is payable in February or March 2009. IPI's current forecast is a distribution of 56.5 cents per units. In addition, the portfolios will receive an approximate interest rate of 12% per annum on the settlement cash until the allocation date of around 6 February 2009. This is a sizable transaction that will be highly beneficial to the overall performance of all the portfolios.

As this transaction is an option (as opposed to an outright purchase) the portfolios may not receive the full allocation. However, we are confident that the portfolios will be allocated a substantial portion. In the event of being awarded a smaller amount, the funds will be returned to the portfolios having earned interest. The portfolios are precluded from trading in these GRT-linked units until the rights issue allocation is finalised on 6 February 2009. The team is very pleased with this transaction and the value it adds to the portfolios.

Portfolio positioning
The South African property market is expected to face some challenging market conditions in 2009, along with most other sectors of the economy. Tenant defaults are likely to increase, leading to higher vacancies. However, vacancies remain at ten-year lows. South African listed property continues to look cheap relative to bonds, which delivered superior returns in 2008. The earnings growth story of South African listed property is still very positive, but somewhat muted relative to the double digit growth achieved in the past two years.

The historical yield spread between listed property and bonds indicates that the current spreads only reflect growth of around 5% from the listed property sector. We remain confident that high single digit growth of 9.6% is achievable in the next 12 months. Our view is that on a forward yield basis, listed property is offering more value than bonds and equities. Investec Property Investments' strategy for 2009 is to continue taking a cautious approach, although the stimulus of the interest rate cuts will be beneficial for listed property stocks.