Look beyond bricks and mortar for real gains

The demand for housing and property investments continues to grow on the back of solid economic growth, but the supply of developed property is limited and supply costs are high and rising, forcing up prices to unaffordable levels, André Stadler says.

The higher prices and interest rates will create affordability constraints for investors. This means the buoyant markets can be expected to cool off. He says the short-term uncertainty over interest rates could create high volatility in property markets.

To get above-ordinary returns from property investments, you need to look beyond the existing bricks and mortar to other opportunities, such as different usage.

Stadler says if you want to invest in property, you first need to understand some of the basics of where you will make your profits.

An investment in property consists of two parts:

  • Real estate, which is the land and the buildings on that land (also known as immovable property; and
  • Realty, which is the real estate plus the ownership rights over the real estate. In other words, what rights you have and do not have. The value in a property investment can lie in the rights rather than the existing buildings or the improvements you make on them.

Realty rights include:

* The right to inhabit a property;
* The right to improve the property - for example, by building a structure or adding equipment (for example, factory machinery) to the property;
* The right to lease the property;
* The right to extract the fruits of the property; and
* The right to sell the property.

Stadler says, in the broadest sense, you can do what you want with a property, but there are limitations that can affect the value of your investment.

These limitations include:

  • The law of the land.
  • Sovereign property rights. Every country has different laws on property rights. For example, Cuba has different property ownership rights to South Africa.

Your ownership rights can be removed by things such as expropriation by the state.

  • Title deed restrictions. These can limit the use to which you can put the property, such as building a block of flats.
  • Town planning restrictions. These can limit the use of the property (for example, business rights) and/or the type of improvements on property (for example, not being allowed to build a factory in a residential area).
  • Servitudes. These include a public right of way or water reticulation across your property.

There are two main reasons to purchase a property. These are:

  • Shelter for a residence or a business; or
  • Investment, where the benefits are derived from the utility rights you have on the property. The benefits are rent and capital growth.

Evaluate each chance

Stadler says to derive the maximum returns you need to evaluate each investment opportunity thoroughly. This includes:

  • Identifying the land. You cannot move the property once you have bought it, so you must be sure it is in the correct place.
  • Evaluating the location of the property and what is happening in the area. For example, is the area decaying or improving?
  • Establishing the rights and limitations on the property;
  • Taking account of the existing improvements to the property, such as the age and appropriateness of any buildings; and
  • Maximising the use of your real estate rights to get the highest possible returns.

Stadler says an example of poor use of real estate rights is the sea-edge parking lot of the Cape Town Hotel School, which looks across Table Bay and is surrounded by luxury apartment blocks.

Stadler says that when you actively manage property as an investment, you must understand that there are also risks. To avoid the risks, you must:

  • Understand the development exposure and sensitivity. For example, there can be unforeseen costs to renovating, demolishing and rebuilding, or making improvements that require additional capital outlay while you may be caught out by a lower than anticipated resale price.
  • Allow a realistic timeframe for the extraction of value. In other words, property is normally a medium- to long-term investment.
  • Realise that without a tenant your cash flow can be negative. This will be exacerbated if you have a large loan.
  • Understand that if the current lease charged is higher than the market average, this can result in a decline in income yield when the lease period expires.

Golden opportunities

Examples of getting the best from property investments include:

1. South Seas, Mouille Point, Cape Town. This office block was purchased for R46 million at R5 000 a square metre. This could be considered expensive as at the time it would have provided a yield of 10 percent a year. The building was converted to residential use and sold for R17 000 a square metre and a profit of R20 million.

2. Canal Walk, Cape Town. This shopping centre, which was built on what was swamp land, was acquired and developed by Monex, which was forced into liquidation before the development could really take off. The property was subsequently acquired by a listed property company for R1.16 billion in 2003. In its first year, the shopper spend was about R1.75 billion, which produced a net income of R143.8 million for the owners. In 2006, the shopper spend had increased to about R2.8 billion and net income of R195.6 million. The complex is now valued at R3.25 billion.
3. An industrial property, Epping, Cape Town. The property was bought in 2004 for R14.6 million and it was then immediately resold for R21 million. The first purchase was made on the basis of the income yield. But the second purchaser, who paid R1 000 a square metre, was attracted by the effective land value and longer-term cash flow.
4. Johnnic headquarters, Rosebank, Johannesburg. This building was bought for R139 million in 2002.

The cash flow, backed by a R20-million surety, was sold to a bank for R137 million. Today, the building is valued at R500 million and there is potential to add 25 000 square metres of floor space. The value of the building can be expected to improve because it is close to one of the Gautrain stations and is in a sought-after retail area.

5. John Ross House, Durban. A developer acquired 100 sectional title units for R5.5 million in April 2004 in what was becoming a rundown residential block. By February 2006, the revitalised units had been sold for a total of R22.1 million.

How various property sectors shape up:

Residential property. After an average return of 20 percent a year for the past five years (according to the ABSA House Price Index), returns are expected to slow due to affordability pressure, André Stadler of Catalyst Fund Managers, says.

He says Erwin Rode's most recent survey shows that gross rental yields for houses and town houses are below 10 percent of the value of the property. The situation is worse in the main metropolitan areas, where gross yields are between four and six percent.

Office space. The office space for leasing has been declining over the past six years in the decentralised business centres of Sandton in Gauteng, Claremont in Cape Town, Umhlanga/La Lucia in KwaZulu-Natal and Brooklyn in Pretoria.

At the same time, rentals have been increasing.

Top of the list for rentals is Brooklyn, where there is a vacancy rate of only 0.4 percent (that is, 99.6 percent of the available property is tenanted) and rentals average R88 a square metre. Sandton is next, with rentals of R85 a square metre and a vacancy of 5.8 percent.

In Claremont, tenants pay R80 a square metre and the vacancy rate is 1.1 percent. In Umhlanga, rentals are a comparatively low R65 a square metre and the vacancy rate is two percent.

Stadler says based on vacancy rates and on land and building costs, there is significant scope for an increase in office rentals.

Industrial property. Stadler says industrial property has the best prospects for growth.

He says that over the past 10 years, the average compound growth in industrial land prices has ranged from three percent for Durban to eight percent for the Cape Peninsula. In 2006, the returns soared to 21 percent for Durban and 77 percent for the East Rand in Gauteng.

Stadler says based on land and construction costs, rents should be in the region of R56 a square metre. Different rental surveys average rental income between R18 and R26 a square metre for industrial use.

This means that rentals can be expected to increase significantly to bridge the gap between current rentals and viability rentals for new property developments.

Other property investment options

André Stadler of Catalyst Fund Managers says directly owning a property is not the only way you can invest in property. Buying into property that is listed on a stock exchange should also be seen as a property investment.

There are 38 companies listed on the real estate board of the JSE.

Over the past 11 years, the sector has provided a relatively stable but increasing average income return (rental): 10 percent in 1995 and 19 percent in 2006.

Capital value has, however, been a lot more volatile. Between 1995 and 2006, there were three years when you may have made negative returns because of capital losses. However, these were outweighed by the positive returns of the past eight years. For some, these returns totalled more than 50 percent in 2005 - 60 percent came from income returns (rentals) and 40 percent from capital returns.

Stadler says the listed property sector is producing sound income returns and there are good prospects for further growth, but capital growth (property values) will be affected by higher interest rates.

Article by: Bruce Cameron - www.persfin.co.za