FINANCE
environmental and tenant requirements. Over time, a
property will typically suffer from physical, functional
and economic obsolescence. These drivers affect
the economic life and expected returns of a property
investment. Physical obsolescence refers to the
observation that as building ages, building maintenance
and operating costs rise, reducing total returns.
Moreover, changing tenant requirements result in
the functional obsolescence of a building. Typical
examples of functional obsolescence include the
inability of a factory to deliver modern warehousing
space. The demand for space which reflects modern
work practices can also affect the desirability of office
space. Economic obsolescence primarily reflects the
fact that a decline in rentals caused by urban decay or
poor economic growth prospects may reduce rental
income and total returns. While physical, functional
and economic obsolescence can be managed to a
degree, the challenge for the investor is to ensure
that an appropriate balance is maintained between
risk and return.
Property returns in South Africa have reflected a
600-basis point premium over the long bond rate.
Therefore with a long bond rate of 8%, property
investors would, on average, require a return of
14%. Invariably this return differs depending on
the sector and geographic position of a property. In
the commercial sector a property with “blue chip”
tenants will secure a more stable return to a property
that is reliant on riskier tenants. In the case of a
property development, the expected return will be
in excess of 20%.
Once the expected return has been established,
the investor must decide on the expected balance
between the yield and capital return of the property.
The income yield reflects the net operating income
which the property provides. It is measured as a
ratio between the annual net operating income of
the property and its market value. The net operating
income is a function of the rental income that the
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Commercial Handbook 2013
property secures minus operating costs. The value of
the property will be determined by overall market
conditions, economic growth prospects, the position
of the property cycle and interest rates.
Investors focused on capital growth will tend to
acquire properties that are expected to increase
in value. This may include properties that can be
redeveloped or which have the potential to be let at
higher rentals. It may also mean acquiring a property
at the bottom of the property cycle, or placing a focus
on properties that are located in a part of town that
is expected to benefit from an urban regeneration
programme. At the height of the 2004-2008 property
boom investors saw residential property values were
rising at a rate of 20% per annum. The speculator will
hold a property for a relatively short period with the
intention of securing a significant capital growth.
The investor in the commercial property market
tends to focus on the capitalisation rate, or expected
discounted value of the cash flow of the property to
determine the value of a property. The capitalisation
rate for different types of property is published by
estate agents, valuers and industry sources such
as SAPOA. The higher the risk associated with a
property, the higher the capitalisation rate and the
lower the value that will be paid for the property.
In the case of a residential property investment, a
comparative method or the value of comparative
properties is used to assess property values.
For the investor, the objective is to secure a return
that reflects the risks associated with the investment.
The perceived risk will be a function of the experience
that an investor has in a specific sector of the market.
But before entering an investment, it is important to
decide on the emphasis that will be placed on income
or capital growth and the conditions under which the
investment will be exited.
RESOURCES
Viruly Consulting
www.reimag.co.za