The current global financial woes have hit property around the world as hard as any other sector. Weak export markets, a sluggish local economy, as well as poor business and consumer sentiment have all hindered the performance of local property activity in many markets, including South Africa.
However, compared to international markets, local real estate has performed relatively well. Returns, both in terms of capital and income, have on the whole stalled and flattened rather than slipped fully into negative growth. Certain elements of the sector, depending on location and class, continue to present attractive opportunities, especially commercial office property. While there is little sign of a rapid turnaround, there are some positive longer-term indicators, including potential income growth.
However, while long-term horizons are more robust, a whole host of indices and indicators pointed to the challenging environment in the country’s property sector in the second half of 2012, a trend that parallels the general weakening of the overall economic performance. According to Neil Gopal, CEO of the South African Property Owners Association (SAPOA), a nongovernmental body that represents the commercial property sector, “2013 won’t see the same returns as we have had in the past. Investor confidence is not at the same high levels due to a number of internal and external factors.”
The First National Bank’s (FNB) fourth-quarter 2012 estate agent survey, a barometer of market sentiment, saw a minor decline in the fourth quarter but still finished the year with a positive change. According to the survey, residential demand, measured on a scale of 1 to 10 (with 10 being the strongest) was down slightly from 6.11 in the third quarter to 5.89 in the fourth quarter. Despite the decrease, the overall rating for 2012 registered an improvement on the previous year, from 5.8 in 2011 to 5.98 in 2012. Additional research from FNB suggests residential property, in line with the economy, is facing a challenging period. The average house price inflation reached 5.1% in 2012, following growth of 3.3% in 2011; however, the real house price growth ( adjusted for Consumer Price Index growth) was negative, contracting by 0.6% (following a drop of 1.7% in 2011).
The FNB’s Valuers’ Market Strength Index, a measure of housing demand vs. supply, fell from a growth peak of 2.7% in September 2012 to 1.5% in January 2013. Furthermore, Gopal has suggested that external economic conditions and the local property cycle are likely to lead to a tougher 2013. “The UK and the EU are our biggest trading partners. If these economies move onto even shakier ground, we won’t be able to escape being affected. I do think there’s a little saturation in the urban areas. I think we’ve reached the top end of the cycle,” Gopal told OBG.
Despite the somewhat gloomy indicators, FNB remains sanguine about the current dip in the market, asserting that the conditions in the residential market are “comfortable” and predicting nominal house price growth in the region of 2.5% for 2013.
Indeed, while it was a tough second half of 2012 for the South African property market, it should be taken into consideration that this is relative.
In global terms, the country outperformed many of its peers. The latest comparative figures for 2011, compiled by Investment Property Databank (IPD) for SAPOA, show South Africa near the top of the global rankings for property returns. In that year, South Africa achieved a total return (capital and income) of 10.4%, third globally behind Canada (15.9%) and the US (14.5%). Most of this average property return in the country was generated by income (8.9%), with capital growth averaging a lowly 1.4%. Nonetheless, even here, South Africa outperformed a number of international markets, most notably those that were suffering as a result of the eurozone crisis.
The last two years’ performance suggests that South Africa should have strong and resilient fundamentals moving forward. The longer-term demand indicators for the sector look reasonably healthy. Although the population increase is not going to generate the same demand as in some emerging markets (with a growth rate of 1.2% in 2011), the rise of the middle class and income in general is expected to whet the appetite of real estate developers and property investors. The long-term trend shows a sizeable increase in incomes in the country. Between 1993 and 2011, gross national income per capita increased in real terms from R27,521 ($3355) per person to R38,734 ($4722) per person, according to the South African Reserve Bank (SARB).
Measuring Living Standards
Furthermore, the Living Standard Measures (LSM) of the South African Advertising Research Foundation (SAARF) illustrates significant social mobility with strong growth into the middle class. The LSM measures the standard of living through a variety of measures and each category has an average income, with LSM 1 being the lowest, earning R1493 ($182) per month or less, and LSM 10 being the highest, earning 30,323 ($3696) or more.
In 2011 LSM 5 (R3832 [$467]), LSM 6 (R6398 [$780]) and LSM 7 (R10,824 [$1319]) showed the strongest growth, while LSM 1 to LSM 4 all showed decline, illustrating a strong trend of people migrating to middle-income status. LSM 6 was the most populous group in 2011, accounting for 9.6m adults, followed by LSM 5 and LSM 7, each counting approximately 7.1m adults.
Such figures should be encouraging for the property industry, as they suggest strong demand for both residential and commercial real estate in the coming years. Incomes in the country have been growing substantially faster than property prices. FNB measures of affordability all point to a more positive market for buyers. The average house price to average employee remuneration ratio had fallen by 25.5% by the second quarter of 2012 from the peak of unaffordability in the first quarter of 2008. Even more dramatically, the instalment repayment value of a housing loan against the above ratio dropped by 47.6% in the same period, largely as a result of a dramatic reduction in interest rates during this same time period.
This has had a positive impact on demand and market activity, citing the jump in first-time buyers in the past two years. According to real estate agent surveys, the percentage of first-time buyers to total buyers reached 23% in 2011 and 2012, up from 15.8% and 17% in 2009 and 2010, respectively.
However, affordability is not just a function of growing incomes. House prices have stalled on the back of muted demand, a trend that has been exacerbated by a markedly different credit environment since 2008. According to John Loos, household and property sector strategist at FNB, banks began rapidly scaling back mortgage lending prior to 2008, as interest rates climbed and default rates began to grow.
Mortgage growth has slowed considerably since 2008. According to Loos, the mortgage books of commercial banks are growing at just over 1%. Official October 2012 figures from local financial institution Absa Group showed that outstanding mortgage balances across all financial institutions were growing at a low rate of 3.3% year-on-year (y-oy). As such, this rate has had a notable impact on property demand and pricing.
Although financial institutions still remain somewhat overextended as a result of the substantial lending before 2008, non-performing loans (NPL) ratios have been kept in check, to a large degree as a result of low interest rates. According to François Viruly, associate professor in the Department of Construction Economics and Management at the University of Cape Town, “You have seen a 700 basis point decline in interest rates [since mid-2008] and this has insulated borrowers from default to some extent. You haven’t seen many distressed sales in the market. But the yields on houses in Cape Town are down to 3% to 4%.”
Indeed, both consumer loan and mortgage portfolios appear to have held up reasonably well. In a January 2013 report by Fitch Ratings, “South African Banks: Peer Review”, the ratings agency says that the banking sector’s NPL ratios have been improving since 2010 and that the home loans NPL ratio has been rehabilitated. The issue for the formal banking sector is now only the residual effects from poor loans that were extended prior to 2008.
Household indebtedness could have a potential spill over effect into the property market. “Overall debt can often go up to 50% or 60% of income,” Loos told OBG. Household credit growth moved above 10% in November 2012, the first double-digit y-o-y growth since 2008, according to Loos.
Sector returns, 2011 “It is not only unsecured lending that’s an issue but also secured lending. It is not just about these personal loans but also about instalment vehicle loans and credit card debt. If these things do not slow, we could have problems,” Loos told OBG.
The overall debt to disposable income ratio is now at 76% (as of November 2012). Loos suggests that this rate could creep back up towards the record high of 82.7% experienced in 2008 and that if interest rates rise, the sector could experience some difficulties. This is certainly not beyond the realm of possibility. With inflation beginning to increase (moving up from 4.9% in August 2012 to 5.9% in March 2013, closer to the top-end of SARB’s target range of 3% to 6%), prospects of an interest rate hike are strong in 2013. “We might see a couple of hikes this year, as slowly domestic inflation rates are rising,” said Loos.
Viruly told OBG, “If you look at the balance sheet of banks, I would not be convinced that we have the risk of a South African subprime crisis. If there is any risk, it’s with the unsecured loans environment, but I don’t think they would flow into the formal banking sector.” There has not been any securitisation of unsecured home loans that could lead to the contamination of the formal sector, according to Viruly.
Units In Demand
Irrespective of the extent of the use of unsecured lending in the home financing segment, it is clear that the emerging middle class, those people falling in the LSM 5 to LSM 7 categories on the SAARF index, are finding it difficult to access formal financing to get on the property ladder. Indeed, despite an observable shift towards affordability noted by FNB, there is still an affordability gap between income and repayment levels for the most populous income brackets in the country. Viruly told OBG, “The biggest issue is not the R3500 ($427) per month and below Integrated Development Plan or social housing. The most significant problem is the market just above that. The major proportion of South Africans is no longer on the lowest rung of the ladder. But there is a whole group that is unable to obtain a mortgage, in the monthly income range of R3500 ($427) up to R10,000 ($1219). It is a gap market and there is a shortfall of 600,000 to 1m units in this sector.”
With such a potential shortfall, the private sector is unlikely to be able to cater to this demand in the medium term. “I think this sector will go one of two ways. Either they will move from shanty towns to high-rise, high-density housing like in China, but this will require the state to play a role, or we will go down the Latin American favela (shanty town) route, where people don’t go into the formal market,” said Viruly. “We’re already beginning to see this with a trend for bricking shanty houses and investing in renovations and improvements.” While it is difficult to get a clear picture on the end-use of unsecured loans, it seems evident that home improvements play a substantial part.
Filling The Gap
This suggests a unique demand scenario for the residential real estate segment. There is certainly latent demand, and while the demographic growth rate of the country alone is not expected to generate significant demand for property, the general trends of urbanisation in the country certainly will. Viruly told OBG, “If you look at Gauteng, there will be another 10m people by 2035. So financing can’t be on a house-by-house basis. It means major funding for large housing developments. The question is whether we can create these developments.”
In certain areas of the country, the medium-term supply-demand balance looks like it will put additional pressure on property demand. “The metropolitan areas that will outperform the rest are Gauteng and Cape Town. The economy is increasingly centred on these places,” said Loos. He also said that such trends will lead to pressure to build greater density, something that has so far not been a market preference. “We’re moving into a situation where urban land is scarce because infrastructure investment has been scarce. The trend has been to build smaller and smaller houses and I think these units will outperform the growth of larger-sized houses,” Loos told OBG.
Given current trends in the country, there are significant opportunities in the more affordable segment of the market. In a January 2013 report, FNB noted, “We appear to have seen relatively healthier transaction volumes on the lower-priced end of the market, which has translated into something of a shift in relative transaction volumes in favour of the lower end. This is not entirely unexpected, as tough economic conditions drive the search for affordability.” Viruly suggested that the potential returns in the affordable market are currently higher by a substantial margin than in the upmarket segment. “I think there are some developers who are finding their specific niche in these markets. Yields on these flats are better than at the higher end of the market. You can still point to yields of 8% in this segment but when you move upmarket, it falls apart to 4% to 6%,” said Viruly.
It would appear, given the difficulty of getting on the housing ladder for those with an income below R10,000 per month ($1219), that there should be significant potential in the rental market and buy-to-let. “A lot of the gap market [which he defines as between R3500 ($427) and R10,000 ($1219) per month] is probably in the rental market,” Viruly said. While rental data is not readily available in South Africa, existing indications suggest that buy-to-let is still a relatively small and unrewarding market. According to the FNB’s fourth-quarter 2012 estate agent survey, only 7% of purchases in that period were for buy-to-let purposes, down from a peak of 25% in 2004.
Rental inflation has outperformed house price growth. Michelle Dickens, the managing director of Tenant Profile Network (TPN) Credit Bureau told the Business Report in December 2012 that y-o-y rental inflation had been 3.6% in November. Despite flattening house prices and increasing rental costs, rental yields are still not particularly attractive. Loos estimated in the local press a net yield of 7.08%, below the cost of financing, with the prime rate at 8.5%.
Furthermore, there are still risks associated with buy-to-let, given that 17% of tenants were not in good standing in terms of rental payments in the third quarter of 2012, according to Dickens. “So an investor Average nominal house prices, 2000-11 would probably be looking for a yield that compensates for the still-significant risk associated with buying to let property,” Dickens said.
While residential property suffered a little at the end of 2012 and beginning of 2013, the commercial property sector was faring somewhat better. Indeed, certain segments of the market, such as office (see analysis), stood out with returns of 11.2% in 2012, above the sector average of 10.4%. Furthermore, certain parts of the retail sector performed well. Although regional shopping centres saw negative capital growth of 1%, other retail registered capital growth of 4.2%, while community shopping centres experienced capital growth of 2.7%. According to a report by IPD for SAPOA, most of the basic indicators of the retail sector, including footfall, gross rentals, trading density and money spent per capita, were all up in the fourth quarter of 2012 in comparison to the same period of 2011.
Although regional shopping centres showed negative capital growth, trading densities, which are measured as rand per sq metre per month, recorded 4.7% y-o-y growth in the fourth quarter, with a rate hovering around R2500 ($305) per sq metre per month for regional shopping centres. This was, however, still below the rate of inflation, at 5.7%, over the same period. Gross rentals also recorded marginal growth, but again, this was below the rate of inflation. While such figures suggest that the sector is far from being in distress, they are coming from a low base in 2011, showing that growth is still sluggish.
Indeed, the retail property sector is being affected by some of the same influences as the residential segment. With GDP growth slowing considerably in the second half of 2012 and industrial action challenging the economy, sentiment in the sector has been hit. In the fourth quarter of the year, the FNB/BER (Bureau of Economic Research) consumer confidence index dropped 2 points to -3, hovering around the low levels of 2008 and well below the 2010 peak of 15. In the third quarter of the year an FNB/BER statement presented a gloomy prognosis for the consumer sector, “Consumer confidence remains weak and not supportive of robust growth in consumer spending. Moderating wage inflation, lacklustre job creation and rising household tax burdens will continue to erode household income growth.”
It is hard to break away from the assumption that all facets of the property industry are going to feel some pain in the shorter term. With both global and domestic economic conditions presenting difficulties, demand and sentiment are likely to remain bruised for some time. In the longer term, there should be potential for significant growth for residential and retail real estate in particular. With strong urbanisation rates and growing income, underlying demand for property is expected to grow.
However, while the emerging middle class should drive investment over the coming years, policymakers and investors alike will need to occupy themselves with how this market can be accommodated ahead.
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