Property exposure needs to be weighted carefully in portfolios

While property experts want investors to believe property is a stable asset class, and rental increases continue into perpetuity, short-term capital fluctuations of listed property can be hard for investors to swallow.

The returns of the FTSE/Johannesburg Stock Exchange (JSE) SA Listed Property Index (SAPY) over the past five years ended 30 June 2011, show that listed property outperformed the FTSE/JSE All Share Index (ALSI) by an astounding 7.6% per annum.

Regarding the inception of the Listed Property Index in March 2002, the outperformance is more pronounced at 11.2% per annum.

While this history may argue for an overweight exposure to listed property within a portfolio, there are times when exposure to listed property should be underweighted.

This is confirmed by a recent study in which Plexus Asset Management looked at listed property, taking into account the changes in interest rates (the South African repo rate) and comparing them to equity returns.

For the study, periods of returns were divided between increasing, flat and decreasing interest rate cycles. The monthly total returns (including dividends and interest) of the SAPY and the FTSE/JSE ALSI were then analysed over these three cycles.

The graph above shows the interest rate cycles as well as the SAPY and ALSI performance indexed to 100 in March 2002.

It is not immediately clear from the graph whether there is any correlation between the interest rate cycle and the performance of listed property.

However, by isolating and summarising the average returns for each stage of the interest rate cycle (see accompanying table on the left), a clearer picture emerges.

The table further indicates that while the average monthly return for both property and the All Share Index is positive – regardless of the interest rate cycle – the minimum return over a single month can be significantly large.

It is interesting to note that listed property’s biggest down-month at -13.9% was greater than the biggest down-month for the ALSI.

It is somewhat surprising that the best period of average monthly returns for property is when the interest rate cycle is flat.

Conventional wisdom would have one believe that property would do best when interest rates are decreasing.

The flat interest rate cycle provides the largest outperformance of property over the ALSI.

It is clear that the up-cycle in interest rates is the most difficult period for property.

The average monthly performance is the lowest, the Property Index underperforms equities, and the monthly standard deviation is greatest during this cycle.

Another interesting statistic is the correlation between the monthly returns of the Property Index and the ALSI. It is relatively low over all interest rate cycles, and makes a good case for having both property and equity exposure in a diversified portfolio.

Despite the fact that the interest rate cycle is still flat, concerns regarding increasing inflation could prove to be ominous for the property sector. While one would not want to lose the upside potential of property returns during the flat interest rate period, having an overweight property exposure at this stage could be detrimental to portfolio performance when the interest rate up-cycle starts.

Paul Stewart is managing director of Plexus Asset Management.