International property stocks have contributed meaningfully to the returns of our global asset allocation funds since inception. Over the past five years, property indices have outperformed global equities, which themselves have doubled. Nevertheless, we continue to hold a number of global property stocks in our portfolios.
Although we evaluate each stock on its individual merits, our holdings can be grouped into four themes:
- High-quality yield: From office properties in Australia, to Singapore industrial and US retail assets, we’ve scoured the globe to build a broadly diversified, high-quality portfolio that currently yields 7% with growth prospects that we expect to exceed inflation.
- Residential property: As discussed later in the article, we believe German and Japanese residential prices are anomalously low in a world full of generally overvalued residential stock.
- Emerging market (EM) assets: We bought into selected EM property stocks as currencies and prices dropped (sometimes by more than 50%) in the contagion that swept across these markets earlier this year. We expect these assets will compound at higher rates than our investments in more stable developed economies. Our entry prices more than compensate for generally higher levels of risk in these markets.
- Large discounts to net asset value: Value can sometimes be obscured because a portfolio is ‘under-earning’, much like a business at a low point in its cycle. This can happen, for example, when redevelopment activity temporarily depresses rental income. Yield-seeking investors who find this unattractive can create opportunities for those investors (like us) with a fundamental approach and longer-term mindset. Our collection of these investments is currently priced 25% below what we consider to be fair value.
Furthermore, listed property stocks are yielding more than sovereign long bonds in virtually every market in which we are invested. This positive yield gap means companies can fund value-enhancing acquisitions with low-cost debt. It is a fundamental attraction that hasn’t been enjoyed in the South African market for some time.
The chart below compares the yield gap in our two favoured residential markets (Germany and Japan) to South African real estate investment trusts (REITs).
Prospective homeowners, when applying for a mortgage, will know that a bank typically assesses two factors to determine affordability:
- the total mortgage amount relative to annual income (price-to-income ratio); and
- the mortgage repayment relative to income.
Combining such affordability criteria (low price-to-income ratios) with those that determine ‘cheapness’ (such as high rental yields) provides a starting point in the hunt for value. The following charts, using data from the IMF’s Global Property Outlook, show current levels of these ratios compared to long-term averages. A negative figure indicates discounted property prices.
Taking the charts at face value, we might conclude that:
- Canada, Australia and New Zealand, parts of Scandinavia and Europe are expensive, and are therefore to be avoided.
- The PIIGS (Portugal, Ireland, Italy, Greece and Spain) are fairly valued to cheap. However, these countries have structural issues to work through, so the risk-reward trade-off may not skew favourably, i.e. they’re cheap for a reason.
- Japan, Germany and the US are inexpensive and thus warrant more work.
Not coincidentally, Japan and Germany account for all our listed residential property investments. (We do have indirect exposure to US housing via our investment in Blackstone, which through its real estate funds is the largest owner of single-family homes in the US.)
Just how cheap is Germany?
German house prices are currently 10% below the levels of 40 years ago (in real terms), and today you can buy an apartment for only slightly more than it cost 20 years ago (in nominal terms).
Moreover, Germany has not stagnated over this period; both population and household incomes have steadily grown. For perspective, house prices in the UK and Australia have more than tripled over the same period. So if Herr Schmidt and Mr Smithers both bought a house 20 years ago for 100 units of their local currency, the German’s property is now worth approximately 115 to 120 units, whereas the Brit is sitting on a property ‘investment’ worth 330 to 340 units.
But while German residential property is cheap relative to historic levels and to other countries, it isn’t necessarily cheap in absolute terms. Income, as mentioned before, is one way of measuring value and we consider gross rental yields above 7% to be highly attractive. Another way to assess value is by comparing prices to replacement cost. In Germany, the cost of developing a property from scratch is about double that of purchasing one in the secondary market (i.e. price is half the replacement cost). With no financial incentive to develop, supply remains constrained, yet the economy continues to forge ahead. Our view is that higher capital values and/or rentals are the escape valve for this unsustainable pressure cooker… Something has to give. In the meantime we are content to earn our share of the high rental yields currently on offer.
The case for Japan
Japan’s journey to ‘cheapness’ could not be more different than the multi-decade flatlining in Germany. The country saw a massive property bubble which finally burst in 1990, when the 3.4 km² of land around Tokyo’s Imperial Palace was famously said to be worth more than the entire real estate stock in California. Subsequently, Japanese land and house prices have been deflating for the past quarter century. Residential prices are now at levels last seen 30 years ago:
Despite awful demographic prospects for the country as a whole, Tokyo and Osaka (where our residential exposure is concentrated) continue to see net immigration. Rents have stabilised and prices are beginning to rise.
The attraction of Japanese residential property is perhaps best summed up by comparing the cost of renting to owning. Gross rental yields are between 6.5% and 7%. In contrast, our investees can borrow at 1.5% (fixed for seven years, largely negating the risk of rising interest rates) to buy residential property at 30-year-low prices. With a materially lower carrying cost (even after factoring in maintenance and insurance expenses) and the opportunity to build equity in an attractively priced asset, buying rather than renting seems like the economically rational course of action in Japan.
If rationality remains absent, we’re once again paid (and happy) to wait.