Property against shares – how does performance stack up?
By Neale Petersen
Owning your own home can be the ultimate investment but it is not necessarily an asset that is putting money into your pocket
The debate on whether property is a better asset class than shares is a debate that will probably go on for decades. The question should be, which asset class can give you the best returns and match your investment style. Both asset classes have their distinct advantages and disadvantages. Property pundits would always say that there is no safer investment than bricks and mortar. Share pundits will tell you that shares have made more millionaires in a shorter space of time than any other asset class. Both have their diehard supporters and promoters who each have their own set of statistics to prove that one asset is better than the other. Both asset classes are pushed by vested interests in each. There are a number of people that feed off property investments from agents, banks, brokers, auctioneers, attorneys and government for example.
The question is, which asset class is best for you and why? We look at all the options and seek to find answers for yield seeking investors. The soft argument is to keep all of your eggs in one basket and keep a balance between property, shares and cash. Listed property is probably one way you can get the best of both worlds, ie: investing in shares which own multiple property portfolios in commercial and residential sectors both locally and abroad.
Why investing in shares is better
Stock market investors will tell you that the time to invest in stocks is now. If you have enough cash then all you need to do is learn the ropes and invest directly in the market, which can be very rewarding for an investor. With a stock you receive ownership in a company. When times are good you profit and when they are bad you lose.
Here are the big reasons why shares are good:
- High rates of returns over a long period of time – real returns for stocks are around 8% per year while real estate is around 4 – 6% average for international investment. It all depends on share selection.
- More liquidity – you can easily sell your shares and cash out within 24 hours. Real estate can take anything from a month to six months to cash out which can drain cash flow for an investor.
- Low transactional costs – share costs vary from 0,32% – 1,7 % brokerage fees value of transaction, small admin fees, Securities Transfer Tax (STT) of 0,25%. Real Estate can be anything from 5 – 7,5% agents commission, 10% deposit, transfer fees, stamp duties, plus other fees.
- Less work and passive income – if you have bought properly shares can generally be left alone for a long period of time. Real estate takes constant management of tenant and maintenance issues.
- More variety making it easy to diversify with multiple shares – In stocks you can invest in any category, sector or country. In property you can only invest as to what you can afford. Properties in New York, London, Marbella, Sydney, San Francisco, etc. tend to be too overpriced for the average investor.
- Tax benefits – it is easier to lower your marginal tax rate with shares and not as easy with property
- Hedging can be easier – you can buy ETF’s to reduce risk while with property you need to have insurance.
Why investing in direct property is better
Owning your own home can be the ultimate investment but as Rich Dad author Robert Kiyosaki says your house is not necessarily an asset as it is not putting money into your pocket but taking money out. You are at the mercy of the economic cycles, interest rates, getting finance, raising deposits, however there are many ways to overcome that and the medium to long-term benefits outweigh the short-term ones. As an investor you need to understand what the drivers of real estate return fundamentals, leverage, currency, equity and debt are?
Here are the reasons why property is such a great asset to invest:
- More control over your investments – You can renovate the property, refinance, rent it out, sell it, rezone it but still remain in control of wealth optimizing decisions
- Use other people’s money – banks, financiers or investors love to finance real estate or use real estate as collateral or security. Unlike a business you can raise finance against the value of a property.
- Leverage your debt – a 10% cash on cash return can be redeemed in a year and the benefits of compounding the capital value and get a rental income.
- Tax benefits – you can deduct all expenses against the property mean more tax-free profit depending on which entity you use.
- Tangible asset – unlike shares which you cannot see it where real estate is made of bricks and mortar which you can see.
- Easy to analyse and quantify income and expenses – rental income is based on specific location, quality of accommodation, type of accommodation and value of the property. If you can borrow at 8% and rent out at 10% you are already cash flow positive.
- It builds long-term wealth – the underlying equity growth and capital component with the additional rental cash flow generation component makes it a perfect wealth builder. With shares you have to trust what the company reports and numbers can be manipulated to make it look better using amortization strategies, depreciation or adjusting account receivables.
- Utility value of the property – you can use your home or property as a shelter or rental even during bad times there is always a demand for property and for people to live.
There are two main categories in property: Residential and Commercial. Residential can be split into flats, town houses, semi-detached houses, free standing houses, estate living and can be sectional title, freehold or leasehold properties. Commercial is split into the 3 main categories of retail, industrial, office and hospitality. It can be split up into more sub sectors such as parking, airports, hospitals, schools, etc.
We can choose listed or non-listed property or public versus private investments. REITS are different to direct investment but both have their own unique benefits.
Investing into Listed property
The fundamentals of listed property are generally the same as direct investment although direct is a more active investment process while listed is more passive as you can work through a broker network. They both offer great dividend yields, rental income growth, and capital growth. The JSE-listed Real Estate Investment Trust (REITS) is a tried and tested vehicle, which has performed way above investor expectations for the last 15 years.
Indicators to look for performance in a listed property fund or REIT as an investor are:
- Listed price and performance
- Return on assets – profits divided by asset value
- Return on equity or Net Asset Value (NAV) – equity is assets less liabilities
- Gearing ratios – are they low at around 35% loan to value or high from around 70% loan to value?
- Interest rate exposure fixed or fluctuating at what rate?
Income growth, distribution and dividend per share
- Cap rates
- Tenant mix and retention
- Portfolio mix – retail, office, industrial, hospitality, etc.
- Quality of assets – A, B or C grade assets
- Ability to raise capital for future projects
The main reason why South African listed property sector has delivered great returns over time in a declining yield environment is mainly due to predictable and growing income streams. Distribution growths of around 8% per annum since 2002 since listed property inception are not uncommon.
Mohammed Kalla, founder of Sesfikile Capital, says that it is important to continually recycle assets to enhance rental growth. The income growth element of property is simply a function of a number of factors. This includes rental growth achieved through revising rentals when leases are renewed; ensuring rental escalations are built into lease agreements, cost controls to protect margins and balance sheet gearing.
The listed environment gives an investor great exposure to commercial property specifically retail, industrial and offices sectors. It is important to understand rental income drivers in the various categories. According to Kalla, ‘Retail listed funds have much lower vacancies compared to offices for example, which is quite volatile at the moment. Industrial is steady. With a diversified portfolio you are not always clear as to the vacancies between the categories.’ Natasha O’Reilly asset manager head of Eris Property Group says, ‘ that currently there is definitely a more depressed offices sector market at the moment with higher vacancies. Retail for example has a diversity of tenants with more secure national tenants which gives more secure income.’
Anton de Goede, property specialist and manager at Coronation Fund Managers agrees that the office sector is more risky at the moment and it needs to ride the poor economic cycle. He says that lawyers in particular are big clients of large A-Class office space but even that is limited and the potential for vacancies is high if you are reliant on one tenant for bespoke properties. ‘That can be a risk as there is not much new interest out there. ‘
If you look at SA GDP growth in 2015 it averaged at 1,4% whereas 2016 GDP growth is expected to average around 0.5%, which affects investor returns. The slow growth does not support good rental income growth, which has previously been responsible for excess inflation distribution growth. Operating margins have also come under pressure due to above-inflation cost increases in admin services, which in most cases is beyond a property manager’s control. Increases are normally passed on to the tenants but in the current economic environment, some increases have had to be absorbed by the property companies themselves.
Gearing, has always been the major tool to accelerate distribution growth, but it too has its challenges going forward. According to Kalla the cost of funding is getting higher which is the reason why many funds are looking offshore. A local listed property counters gearing of about 29% on average and the funding cost of hedging of about 94% which are metrics considered as conservative. With a recent 20 – 25% currency improvement in the rand, low interest rates make offshore funding cheaper according to Kalla.
Most SA listed property companies also have the benefit of offshore exposure without having to move your funds offshore. The reality is that the local economic landscape is deteriorating. Given the lacklustre local fundamental backdrop, listed property funds are increasingly looking elsewhere to generate better returns. The advent of relatively newly established funds like New European Property Investment (NEPI), Redefine International, Stenprop, New Frontier, Rockcastle, Hyprop and Redefine, have all made investments into Eastern Europe and UK. They are buying properties at around 7% yields, funded with Euro-denominated debt of around 4% where you immediately have positive results. The focus is mostly on ramping up earnings first and property fundamentals second.
Real estate is one of the strongholds in the South African economy and is a large and important sector of our economy and the growth trend is growing. According to the Property Charter the real estate market in South Africa is valued at R5, 9 trillion. Residential is valued at R3, 9 trillion, Commercial is valued at R1, 3 trillion and the rest hospitality. In property terms South Africa has the sixth 6th most mall space in the world with over 200 shopping centres. This makes real estate a strong investment candidate before anything else.
What is CAP RATES?
The cap rate or capitalization rate is the rate of return on a real estate investment property based on the income that the property is expected to generate. The capitalization rate is used to estimate the investor’s potential return on his or her investment.
The capitalization rate of an investment may be calculated by dividing the investment’s net operating income (NOI) by the current market value of the property, where NOI is the annual return on the property minus all operating costs.
Capitalization Rate = Net Operating Income / Current Market Value
So, for example, if a property was listed for R10, 000, 000 and generated an NOI of R1,000,000, then the cap rate would be R1,000 000/R10, 000 000, or 10% cap rate