Office Cap Rates Remain Headline Story
The performance of capitalization rates of prime office property remains the headline story. This as the upward trend in office capitalization rates seems now to be firmly entrenched. The outlook for capital returns from office property has been, and continues to be, marred by vacancy rates that are heading in the wrong direction, and the concomitant adverse impact that this has on market rentals. Naturally, poorer capital return prospects could lead to investors requiring even higher income returns - capitalization rates - to induce them to invest in directly-held office property. For now, some assistance to office capitalization rates (and those of industrial and retail properties) must be the better-than-expected consumer inflation numbers, and the recent decision by the MPC to keep short-term interest rates steady. Interest rates can affect the hurdle returns that investors expect on property through three channels, viz. (1) through the substitution principle (alternative, long-term investments like 10-year bonds now yield a higher or lower return), (2) through the cost of financial gearing (shorter-term interest rates), and (3) through the market's rating of listed property funds like REITs that can affect the profitability of purchasing directly held property. A look at office capitalization rates at the nodal level, shows that in the first quarter of 2017, capitalization rates on prime office property in most of the Johannesburg decentralized office nodes were also slightly up when compared to the previous-quarter levels. What's more, in most of these nodes capitalization rates are now also up by roughly 100 basis points when compared considered together with the fact that market rentals in Johannesburg decentralized have performed poorly overthe past year, implies market values must surely have come under pressure in the Johannesburg suburban office nodes. Prime office capitalization rates in Johannesburg decentralized now range from as low as 9,6% in Sandton to as high as 11,7% in Randburg. Naturally, the difference in capitalization rates between Sandton CBD and Randburg Ferndale, for example, can be used as a rough guide to the state of the property markets in these two suburbs. The higher the capitalization rates, the worse the expected growth in income streams and/or the higher the perceived risk of the location. During the reporting quarter, Centurion was the only Pretoria decentralized office node where capitalization rates weakened (increased) notably when compared to the previous quarter. This is in contrast to Hatfield, where capitalization rates firmed (decreased) slightly. In the first quarter of 2017, capitalization rates in the Pretoria decentralized nodes of Brooklyn, Hatfield, Centurion and Midrand ranged between 10,1% (Brooklyn) and 10,9% (Hatfield). In the Durban decentralized office nodes of Umhlanga Ridge and Westway, capitalization rates on prime office property remained at about their previous-quarter levels, while in Essex Terrace and Berea they edged up slightly. Our panellists were of the opinion that capitalization rates for prime office properties in Durban decentralized, ranged between 9,2% and 10,0% in the first quarter of 2017 Capitalization rates in the Cape Town decentralized office nodes of Claremont and Westlake increased ever so slightly, while in Tyger Valley and Century City they remained at roughly their previous quarter levels. In these four popular Cape Town suburban office nodes, capitalization rates on prime office property stood at just below 9%. Interestingly, prime office capitalization rates in Cape Town decentralized are now ─ on average ─ lower than those on prime office properties in Johannesburg and Pretoria decentralized. This implies that investors are seemingly prepared to pay more for the same year-1 net market income when the property is located in Cape Town, as opposed to Johannesburg and Pretoria. Investors evidently expect a better cash-flow growth rate from Cape properties, a notion with which one can agree given vacancy rates that are higher in Johannesburg and Pretoria. With regard to industrial property, capitalization rates of prime industrial properties with a leaseback covenant in the country's main industrial regions generally speaking remained at roughly previous-quarter levels. In the main industrial conurbations, like the Central Witwatersrand, the Cape Peninsula and Durban, industrial leaseback capitalization rates stood steady at about 9%, compared to 9,6% in Pretoria. In the reporting quarter, Durban was the only major city where an increase (albeit marginal) in regional-shopping-centre capitalization rates was observed. On the Central Witwatersrand they remained at previous-quarter levels, while in Pretoria and Cape Town they firmed slightly. In the first quarter of 2017, our panellists were of the opinion that capitalization rates for regional shopping centres in these cities should range between 7,6% and 8,5%. For now, the prospects for income stream growth from shoppingcentres remain weak. The outcome of this could mean investors eventually requiring higher returns when investing in shopping centers, and consequently, higher market capitalization rates.
Author: Rode Report 2017