The question that many investors are asking right now is how commercial real estate prices will react to a renewed recession, increased inflationary pressures and low medium-term interest rates.
Based on property prices of well-let properties, as well as the outstanding performance of listed property, local commercial real estate has performed well, even in a distressed economic environment. This would suggest that real estate is more of a stagnation hedge rather than an inflation hedge.
Many commercial property sector experts are remarkably uniform in their assessments. Upticks in inflation and increased vacancies will likely cause cap rates to increase slightly, a negative effect that will be more or less offset by better fundamentals and therefore higher cash flows. The net expected effect is that property prices will hold firm in the short term, and may even increase in certain sectors such as well positioned retail and industrial properties.
Recent activity on the auction floors shows that investors are now chasing yields. Commercial real estate is seen as one of the safest investments to park capital during volatile equity and exchange rate environments.
We believe that there are seven main reasons why commercial real estate prices will hold for now, and certain sectors will see price increases:
Reason #1—A Reserve Bank bias towards low interest rates: Over recent months, interest rates have held steady. Investors know that in this environment interest rates will remain low and fixed-rate mortgage debt remains reasonably priced.
Reason #2—Urbanisation and the influx of people from other African states: Although urbanisation certainly has its critics, the upside is that economic development and open borders have bolstered the growth and development of South African cities. Moreover, South Africa’s main metropolitan areas continue to attract entrepreneurially minded migrants from neighbouring countries and smaller provinces.
Reason #3—Uncertainty overhangs in the equities market: The broader equities market has been unpredictable. Corporate profits have been stable and governance is strong. However, price-earnings (P/E) ratios have fallen and the market is generally moving sideways. A large amount of uncertainty originates from three major sources: commodity prices, the Rand and domestic politics.
Reason #4—The supply side has slowed: At one stage, there was great concern that we were building too many new shopping centres, office blocks and industrial centres. However, with localised exceptions, supply has moderated and has slowed down in the medium term.
Reason #5—Momentum in listed properties flow: Looking at the strength of listed real estate, capital is starting to flow towards selected commercial property.
Reason #6—Improved risk management: We believe that cap rate compression may be coming to commercial real estate. It has previously come in the form of higher P/E ratios to the broader equities, so why not real estate? In fact, there are very good financial economic reasons for lower long-run cap rates (and they are not just related to lower interest rates).
Reason #7-South African corporations are doing well: Despite the occasional bad results from certain listed companies involved in construction and property development, our local companies have done really well. Notwithstanding a recessionary environment since late 2008, we have not seen one listed company go bust – as we did a decade ago.