Free market flogs property

The latest increase in interest rates was harsh on the prices of listed properties over the past two months. Prices fell by 20%-30%.

Fortunately, the private owners of ordinary office buildings don't see what their property is worth in the paper every day, otherwise they would also lie awake at night worrying about falling prices.

It's the job of the board and management of a company to make a profit. After all, that's the shareholders' mandate to the board. And that's what the board and management are paid for. Somewhere along the line, the "market" attaches a value to this profit. If, for example, the company earns a profit of R2/share, the market can then decide it likes that and give it a price:earnings (p:e) ratio of 12. That means the company's shares will trade at 12x2, or R24 each.

However, if the market decides it doesn't like the company's profit or if something else is troubling it, it could attach a p:e or valuation of only eight to the profit. Then the share would trade at only R16 (2x8).

Investors, the board and the management, of course, are not at all taken with the vagaries of the market, especially if the market rating suddenly weakens and the share price drops.

Investors, especially in local listed shares, were probably much inclined to describe the market in more colourful terms over the past month or so. Just look at the unreasonably sharp fall of 24% in the prices of the SA PUT index in the second quarter of the year. It's quite unrealistic and is in fact the sharpest quarterly fall in 30 years - with the exception of the dark days of 1998 during the crisis in the emerging markets. At that time, this index collapsed by 29%, but that was after local interest rates on Government bonds had shot up by as much as 24%.

However, Stanlib's latest weekly survey shows that the market is not the culprit. It only sometimes seems to be.

The prices at which property shares were trading on the JSE were simply too high, because the valuations used to determine the prices were far too optimistic.

The price of a property, and therefore the price of the shares of a property trust, is determined by the future cash stream that the property can produce over the next few years at a rate discounted to the current value. Easy - there are scores of little models on computers to work it out.

The critical question or problem, however, is which rate to use for discounting the cash flow. That's determined by the market.

The Stanlib graph shows that early in May investors were prepared to discount the future cash flow at as little as about 6%. But suddenly the market looked surly and decided to push up the rate to the current 8,2%, which in fact is as high as 9,2% if the following year's income is used.

But what really frightened the market? Nothing - or nothing much. The SA Reserve Bank recently increased interest rates by as little as 0,5 percentage points. That's not enough to justify the surge from 6% to 8,2%, or perhaps 9,2%.

Relax. The market hasn't started fiddling the figures. It has merely corrected what was excessive. For years, listed properties have been trading at a return rate of a percentage point or so higher than the rate on Government bonds. Remember, a country's Government bonds are the safest investment in the country itself. Others, like property investments, should trade at a slightly higher rate.

However, after the past four years of solid increases in the prices of these listed property shares, investors became somewhat too excited, and from about April the return rate on these shares fell to just over 6%, while Government bonds were still trading at 7,15% - on the same angry market.

When it became clear in May that the four-year-long fall in local interest rates had ended, the yield on Government bonds rose from 7,15% to the current 8,35%. The return rate on property trusts therefore inevitably also had to rise. In fact, the one-year forward return rate of 9,2% on the shares that Stanlib shows in its graph looks very realistic. As already mentioned, the return on the property trusts in the past was always at least one percentage point more than the rate on 10-year Government bonds.

"But my property down the road is now worth 25% less than it was two months ago," the same unhappy investor says. "The bricks, the roof, the floor and even the tenants and the rental they pay are still the same as two months ago," he continues. "The property can't be worth 25% less now."

Unfortunately, it is. That's how the free market works, and it's not an amorphous market. Two months ago, investors were prepared to buy properties with an initial return of 6%; now they want an initial return of 8% or more. To satisfy the need or the desire of the market, the prices of properties had to fall.

Source: Finweek, Vic de Klerk

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