Research and Insights

The case for listed property in an index-tracking vehicle

| 6 December 2018

More than just a diversifier; the appeal is in the attractive yield.

By Jason Swartz, Head of Portfolio Solutions at Satrix

Listed property has often suffered from an existential identity crisis. Is it an asset class all on its own, or is it a distinctive sub-sector within equity? Or could it even be seen as a high duration bond? Most seasoned investment professionals consider listed property as a stand-alone asset class given its unique character where the return drivers are linked to both equities AND bonds. As an example, a share in a listed property company produces returns through the change in its share price which is linked to earnings/rental growth prospects (equity return driver), but also offers a regular income in the form of dividends (derived from rental incomes), which is linked to inflation (the driver of bond returns). This combination of both capital gains and income provide a distinguishing character that can be accessed by investors.

As such, listed property has become an increasingly popular and accessible asset class globally over the last fifteen years, in large part due to the proliferation and success of real estate investment trusts (REITs). These products gives investors access to the same cash flow characteristics that previously were only available to direct property investors. While the REIT model is largely a global investment structure, property loan stock companies and property unit trusts listed on the JSE have been steadily converting into REIT structures over the prior five years, providing investors with effective exposure to this asset class. REITs offer the benefits of real estate ownership without the challenges of being a landlord, and unlike direct property ownership, these shares can be quickly and easily traded.

The role of listed property

A critical question around investing in listed property however is: what role does this asset class play within your portfolio?

Traditional asset classes such as equities, bonds and cash each have a clear case for inclusion within a balanced portfolio, typically revolving around improving the risk-adjusted return characteristics of a strategic asset allocation. This is no different with listed property. Since January 2004, this asset class presented the best risk-adjusted outcomes (as measured by the Sharpe Ratio) across a broad range of asset classes for South African investors. This long-term result is in spite of the correction seen earlier this year in listed property, as the asset class fell some 23.5% year-to-date. On the upside, however, this sell-off presents an attractive opportunity for investors looking to gain exposure to this asset class.

Risk and return summary of asset classes (Jan 2004 to Oct 2018)

Intuitively, one would reason that due to listed property distributions generally being based on rental incomes that increase over time, the reliability of these distributions would make listed property stocks less risky than other equities. The reality is that property companies are exposed to interest rate changes due to the leveraged nature of their balance sheets, and this manifests through this asset class’s return volatility which can be seen to be the highest among competing asset classes since 2004. Notwithstanding the high volatility, listed property has still produced a strong compensating premium to deliver meaningful risk-adjusted returns.

Yield – not diversification – makes for an appealing income stream

An argument typically given for the consideration of listed property within a balanced fund is its diversification benefits, seen through its generally low correlations to other asset classes. Based on our analysis (calculating monthly return correlations since 2004) we find this argument lacking empirical evidence, as listed property has a correlation of 0.56 to domestic bonds and 0.44 to domestic equities – which is hardly appealing. A far better diversifier (with lower correlations to domestic equities and bonds) would be inflation-linked bonds, for example.

What listed property does offer, however, that no other asset class can, is its mouth-watering yields.

Figure 1: 12-month rolling yields of South African listed property, equities and bonds

12-month rolling yields of South African listed property, equities and bonds

These high yields are generated through long-term rental agreements with tenants, and are typically diversified across segments, sectors and regions. This produces fairly reliable income streams for investors relative to traditional equities.

Globally, the appeal of high yields has grown as sovereign bond yields have struggled to normalise, given years of financial repression and low inflation expectations. As such, the search for alternative sources of yield among global asset allocators has intensified. Domestically, nominal bond yields have not experienced the same pressure, and investors should continue to compare listed property yields to what is offered from nominal bonds. Relative to listed equities however, listed property yields have delivered been between two and three multiples that of listed equities – a very appealing income proposition.

Choosing the correct property index

For investors in South African listed property, the choice of benchmarks has significantly improved with the new range of FTSE/JSE property indices. These indices aim to give market participants access to a range of property baskets covering the spectrum of the asset class. The new FTSE/JSE All Property Index provides broad coverage of all listed property companies in South Africa (not just the primary listings) and has additional benefits of capping constituents at 15% and employing a shareholder weighting to better reflect investability. A liquid subset of this index is the new FTSE/JSE Tradable Property Index which excludes small caps stocks, while the FTSE/JSE SA REIT index is intended as a benchmark for the SA REIT industry, providing benchmark users with a real estate index with both an SA-bias and an increased yield-bias. Relative to the other two new indices, the SA REIT index presents the most challenges from a liquidity perspective versus the Tradable Index which is very liquid.

Investors can now pick the index that is best suited to their own investment needs, but need to be mindful of each indices’ construction, yield prospects and liquidity before deciding. For now – warts and all – a de facto benchmark for domestic listed property remains the SA Listed Property Index, otherwise known as SAPY.

Satrix’s Property Index capability

We believe that the benchmark choice and the resulting returns is what forms the most important elements of any investment. By investing in an index-tracking vehicle, the returns for investment strategies are well established. Particularly for an asset class which presents relatively less dispersion between stocks with similar macro drivers, index tracking is a strong choice.

The Satrix Property Index strategy is a specialist index tracking capability which tracks the performance of the FTSE/JSE SA Listed Property Index. By applying a full replication strategy (i.e. we match the exact constituents and weights of the relevant index) there is no risk of deviation from the chosen benchmark and tracking error can be minimized. The fund also engages in scrip lending activities to reduce costs, and is rebalanced on a quarterly basis.

Why choose this capability? This property index tracking investment strategy by Satrix would be appropriate for investors wanting simple and transparent exposure to SA Listed Property stocks at a compelling cost. The fund would also appeal to investors who require an enhanced overall yield and income generation in their portfolio, but not at the cost of long-term capital appreciation.

Conclusion

Many investors still favour investing in real estate directly or in unlisted investment vehicles, despite the worldwide growth and advantages in listed property products as well as real estate investment trusts (REITs). We are confident that the adoption of this unique asset class will continue to grow in understanding and acceptance, particularly with the expanded choice of domestic listed property indices now available to meet the needs of more investors. Please speak to us should you have any questions in this regard.

Satrix Managers (RF) (Pty) Ltd (Satrix) a registered and approved Manager in Collective Investment Schemes in Securities and an authorised financial services provider in terms of the FAIS. Collective investment schemes are generally medium- to long-term investments. Unit Trusts and ETFs the investor essentially owns a “proportionate share” (in proportion to the participatory interest held in the fund) of the underlying investments held by the fund. With Unit Trusts, the investor holds participatory units issued by the fund while in the case of an ETF, the participatory interest, while issued by the fund, comprises a listed security traded on the stock exchange. ETFs are index tracking funds, registered as a Collective Investment and can be traded by any stockbroker on the stock exchange or via Investment Plans and online trading platforms. ETFs may incur additional costs due to it being listed on the JSE. Past performance is not necessarily a guide to future performance and the value of investments / units may go up or down. A schedule of fees and charges, and maximum commissions are available on the Minimum Disclosure Document or upon request from the Manager. Collective investments are traded at ruling prices and can engage in borrowing and scrip lending. Should the respective portfolio engage in scrip lending, the utility percentage and related counterparties can be viewed on the ETF Minimum Disclosure Document. The Manager does not provide any guarantee either with respect to the capital or the return of a portfolio. The index, the applicable tracking error and the portfolio performance relative to the index can be viewed on the ETF Minimum Disclosure Document and/or on the Satrix website. Performance is based on NAV to NAV calculations of the portfolio. Individual performance may differ to that of the portfolio as a result of initial fees, actual investment date, dividend withholding tax and income reinvestment date. The reinvestment of income is calculated based on actual distributed amount and factors such as payment date and reinvestment date must be considered. If the fund holds assets in foreign countries it could be exposed to the following risks regarding potential constraints on liquidity and the repatriation of funds: macro-economic, political, foreign exchange, tax, settlement and potential limitations on the availability of market information.
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