Slow-down in passing of non-residential building plans
While the slow-down in building activity in the residential sector has been expected, recent statistics for non-residential property have surprisingly shown that this sector is also now beginning to weaken.
According to property economists Rode & Associates, there has in particular been a slow-down in building plans being passed for the development of office and industrial properties – the two boom sectors — whereas the stagnant retail sector still sees lots of developments in the pipeline.
Says Erwin Rode: ‘At first glance, this deceleration would seem to be an anomaly when one considers how strong the fundamentals for office and industrial properties are what with low vacancies and rising rentals, clearly the demand is still there.’
The reasons, believes Rode, can be explained as follows:
The high volume of new shopping centres still in the pipeline is the lagged effect of the past consumer boom. Shopping centre development has a long gestation period and strong momentum – just like a ship, that cannot be turned around on a tiekie.
Office and industrial properties have a shorter gestation period, and are more quickly affected by outside factors like uncertainty around electricity supply and politics (the two big negatives of the first half of 2008).
And then there’s the impact of higher interest rates. Explains Rode: ‘Twenty years ago, the major players in the non-residential market were the pension and life-office institutions, who were largely unaffected by fluctuations in the interest rate because they were not dependent on any debt finance. Hence, they could afford to take a longerterm view of three to five years.’
However, notes Rode, two things have happened since the second half of the 1990s: ‘Firstly, listed funds have taken over from the institutions – and these funds are typically dependent on loan capital, which has become very expensive.
‘Secondly, as a result of the low interest-rate regime of up to two years ago, the listed funds now have a pretty strong market rating (low income yields) relative to the cost of debt and relative to market rentals and building-construction costs. This makes the acquisition (buying or development) of new properties difficult, unless they are prepared to dilute their earnings, which property analysts generally frown upon. The reason property analysts frown upon earnings dilution is because they regard short-term cash flows as all important, in contrast to total returns in the medium term. ‘One can argue that this approach by analysts is short-sighted, but that is the real world for you.’ Thus, according to Rode, to make new developments, or the purchase of existing properties, for listed funds viable again, the following, or some of the following, need to happen:
- The market rating of listed funds must change for the worse (income yields must rise to bring them closer to interest-rate levels and capitalization rates of existing properties)
- The market rating of existing unlisted properties (their capitalization rates) must rise to make them more affordable to listed funds
- Interest rates must decline substantially (which will have the bonus that funding will become cheaper)
- Market rentals must accelerate faster relative to building-construction costs, thereby improving the developer’s profit
Says Rode: ‘If the first three do not happen, then number 4 becomes highly likely.’
On top of this, Rode continues, has been the rise of the private developer: ‘Like listed funds, they are similarly interest-rate sensitive.’
Thus the entire market has become more sensitive to changes in interest rates, and so proposed new office developments are now lagging in spite of the strong fundamentals. ‘A sobering thought is the possibility that – structurally, in contrast to cyclically – high interest rates are going to stay with us for some time.’
The question, then, is whether this is the time for institutions to re-establish their territory in the non-residential market place. Comments Rode: ‘This certainly puts those who are not dependent on loan capital or a listed-market rating into a stronger position to accumulate stock and take on new developments with a longer-term view.
In fact, notes Rode, a number of institutions are already back on track – among them Old Mutual, as well as companies such as Pareto Ltd. It has been reported in the media that the latter, owned jointly by Eskom Pension and Provident Fund (EPPF) and the Public Investment Corporation (PIC); recently saw the addition of Mimosa Mall in Bloemfontein to its portfolio. This gives Pareto (an unlisted property-loan-stock company) a significant stake in seven major shopping centres across the country.
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