News Article: First National Bank - Property Economics

SUMMARY: Unlike residential property, in the area of commercial (or non-residential) property it would be premature to be talking about the probability of a “Soft landing versus a hard landing? Rather, some are talking about the boom that is still coming, and I anticipate that speculation in 2006 may revolve around how long the upswing may last.

Commercial property fixed investment appears to take more to get going than its residential counterpart. This is to be expected, with households' decision-making and planning processes being far more swift than their commercial counterparts whose projects are often quite sizeable.

Nevertheless, there are some strong signs that a prolonged period of fixed investment in commercial property may ensue in the coming years Certainly the fixed investment environment has been improving for some time. Real economic growth has been on a long term path of acceleration since the mid-1990s, after about 2 decades of stagnation. Furthermore, ironically to some, faster economic growth has not halted a 2-decade-long decline in domestic inflation, and in what could be described as a lagged response by the SARB to lower inflation, interest rates have declined sharply since their high peak in 1998.

What is still perhaps necessary to unleash stronger fixed investment in the sector, however, is a greater degree of confidence by investors in the possibility that stronger economic growth is here to stay in the long term, and that the structural adjustments that have taken inflation lower, resulting in major interest rate reductions are also of a more “permanent nature”. A shortage of such “long term” confidence is to be expected given the weak and volatile economic past which spanned from around the mid-1970s to the mid-to-late-1990s. Ultimately, as our economic history continues to improve, so will longer term business confidence, but this takes time, and in the meantime this feature may be containing the pace of the non-residential building fixed investment upswing. The positive side is that this constraint should reduce the probability of a massive oversupply of commercial property (which could have caused a “boom and bust” cycle).

The real value of buildings completed has been rising over the past 3 years, but has yet to be spectacular, with the levels still below the real peaks in the previous 4 cycles. However, looking at the real value of building plans passed, the indications are that the pace in growth could be stepped up a gear or two. From 37% growth in 2004, near 70% growth looks to have materialised in 2005, taking the real value of building plans passed back up to a level last seen about 2 decades ago.

Split into retail, industrial and warehouse, and office space, all three categories show significant increases in building plans passed on a square metre basis, which should not be surprising given that capitalisation rates have declined significantly in recent years in all 3 categories.

Some may argue that slowdowns in retail sales growth, manufacturing output growth, and indeed in overall economic growth may stop the building expansion in its tracks. However, this would be to forget the leads and lags. Furthermore, slowdowns aren't what they used to be. Real GDP growth looks set to have been near to 5% for 2005, and a slowdown could still see the figure above 4% in 2006. This should limit any downturn in manufacturing, while its positive contribution to household disposable income should see the now sharply higher levels (not growth) of real consumption expenditure being sustained. Spare capacity in building space may, therefore, not improve in the near term. During 2005, manufacturing capacity utilisation reached its highest rate in over three decades according to the SARB series, while office vacancies have been declining steadily since 2003 according to SAPOA.

Therefore, after recording an estimated 7% real growth in 2005, real non-residential property fixed investment growth is forecast to pick up to 9% in 2006, and grow positively all the way through to 2010.

Is this just wishful thinking to expect the longest non-residential fixed investment upswing in decades? No. If you're going through the longest business cycle upswing on record, and have been through the most impressive residential property and consumer growth booms in decades, a next logical step is to expect fixed investment to blossom for a prolonged period of time, especially given the prospect of the solid GDP growth continuing for some years and interest rates remaining favourable. Commercial property investors may take it a bit slower perhaps than their residential counterparts, with this boom being more like a marathon compared with the “sprint” of residential property, but the upswing may continue for a good number of years as a result.

COMMERCIAL PROPERTY FIXED INVESTMENT – YOU AIN'T SEEN NOTHIN' YET

It would seem that it takes a bit more to get commercial property investment and development off the ground than it does to get residential property investment booms into gear.

Therefore, as the residential property boom appears to be tapering off, the next property boom could be gathering steam. It probably won't take place with the speed of the residential property fixed investment boom, but it may have significant staying power, spanning over the rest of the current decade and being the longest upswing in a few decades.

The economic conditions over the past few years have been increasingly supportive of a commercial, or non-residential, property price and fixed investment boom.

Examining real non-residential property fixed investment from way back to 1946, one sees that after a very impressive rise from the early-1960s to the mid-1970s, and then after some decline one “last push” to an all-time peak in 1982 (thanks to the gold boom), it has been in the doldrums ever since.

Real non-residential fixed investment at its peak in 1982 was 213% higher than 20 years prior in 1962.

However, 22 years on, in 1984, after two years of what South Africans would consider strong growth of 10.5% for 2004 and 7.1% year-on-year for the first three quarters of 2005 respectively, real non-residential fixed investment in Q3 2005 remained 18.7% below the all-time high reached in Q3 1982. This is in spite of the size of the economy having grown by 60% over the corresponding period.

It is plausible, given the help of technology and labour productivity improvements over the years, that floor space is utilised far better than a few decades ago especially in the area of retail and offices, which would imply that fixed investment need not keep up with economic growth over the years.

However, the macro fixed investment environment can also be seen as a major factor that may have contributed first to a relative “oversupply” of non-residential property by the early-1980s, and now to diminishing spare capacity.

South Africa's real economic growth was on a long term stagnating path from the early-1970s, ignoring the brief spike in the early-1980s spike driven by the gold boom at the time. This long-term stagnation continued until the early-1990s, just prior to the advent of democracy in 1994.

Increasing economic isolation due to the political situation domestically was a key cause of the stagnation. However, less talked about was a two-decade long slide in the real value of commodity prices, which had a significant impact on what is a major commodity exporting economy.

On top of stagnating growth, the late-1970s and early-1980s saw a dramatic increase in inflation and interest rates, and from the mid-1980s through the 1990s there was a broad rise in interest rates in real terms too. This was a reflection of the SARB's need to keep a tight reign on domestic demand in order to maintain a reasonable current account balance in the face of a lack of foreign capital inflows. This was due to sanctions and boycotts in the late-1980s, and later due to a rampant dollar coupled with emerging markets becoming less attractive as the 1990s progressed.

Since early this decade, the situation has turned for the better in most aspects. Admittedly, real economic growth had begun to turn the corner in the mid-1990s already. However, fixed investment which is both growth and interest rate driven, still had the high levels of real interest rates to contend with as well as their volatility. Post-1998, however, the SARB has been addressing this issue, opting for a far more stable interest rate policy since 2000, and reducing interest rates dramatically in lagged response to two decades of structural change that have brought consumer price inflation down from high-double-digit figures.

With growth on its way up, and real interest rates on their way down, the fixed investment environment is improving dramatically. Why then does the growth in fixed investment in commercial property seem to be so slow compared to its residential counterpart?

It is important to remember two factors:

Firstly, commercial property investments often require significant planning periods.
Secondly, given the relatively large size and capital requirements of many commercial property developments, the stakeholders involved often require “convincing” that the project is sustainable, i.e. that the lower cost of capital is not just of a short term temporary nature and that the demand for the facility will be sustained.

When one examines the 3 previous non-residential building upswings (1989-1991, 1995-1997 and 1999-2001), one can see that they were relatively short because just as the fixed investment was starting to resp ond to an improved economic growth and interest rate environment from a few years prior, the interest rate cycle turned and interest rates rose significantly. We therefore often witnessed the seemingly strange phenomenon of rising building activity coinciding with rising interest rates.

The current upward cycle in building activity looks to be somewhat different. We are three years into the upswing with no end in sight, and interest rates still arguably in a (albeit sl ow) downtrend.

What signals a possible rapid increase in building activity in 2006 and beyond is the huge gap that has opened up between the real value of building plans passed versus buildings completed. Building plans passed in real terms for 2005 should turn out to be the highest in about two decades, with a rate of increase in the region of 70% compared with buildings completed estimated to have run at about 20%.

A high level of building plans passed will not necessarily translate into building activity. Economic conditions need to remain favourable. In 1981, when the data started, plans passed were far higher than plans completed, and while building activity increased until 1985, it never got near the level of plans passed in 1981 because of the deterioration in the economic and interest rate environment following the gold boom.

The current cycle promises to be more favourable. The interest rate environment could remain benign for some years due to a benign inflationary environment, supported by a rand that is in a longer term period of relative strength. The last hike in interest rates was in September 2002, over three years ago.

However, the extent of interest rate cuts, the current low levels, and the length of time over which we may see no hikes, may be difficult for many SA investors to swallow, having been used to far higher and more volatile rates in the 1990s.

Therefore, periodic interest rate hike talk, such as late in 2005 when oil prices were misbehaving, quickly serves to instil a cautious approach in many.

The same goes for economic growth. SA is no China yet, and by comparison its growth remains mediocre. But compared with the past two decades we are going through a “golden era” and this for many is also almost too good to be true.

Expectations are driven by past experience, and past experience was not very good. This has an upside and a downside. On the upside, it should serve to reduce the chances of a huge oversupply of building stock which could result in a “boom and bust” fixed investment cycle in non-residential building, making positive real growth sustainable for the rest of the decade. On the downside, expectations drive economies, and more modest expectations are often a “self-fulfilling prophecy” containing economic growth at lower levels compared to what it could be.

Important is that interest rates play the game, and fortunately our economics team anticipates sideways movement in interest rates through 2006, which will increasingly make investors comfortable with the idea that lower interest rates (compared with a few years ago) could be a more permanent fixture. Important is to remember the leads and lags between economic activity, interest rates and fixed investment due to the length of the planning and preparations involved. Therefore, while real economic growth, consumer demand growth, and manufacturing are all expected to taper off in 2006, provided the slowdown is mild and given the growth of recent years in these variables, the scene should still be set for solid growth in non-residential building fixed investment.

RETAIL PROPERTY INVESTMENT – STRENGTH ON THE BACK OF THE 2003-2005 CONSUMER BOOM?

It would not come as a surprise if shopping space building growth strengthened significantly in either 2006 or 2007 despite slowing growth in retail sales.

Rode and Associates suggest that 2006 may experience a bit of a lull in building completions, with their figures showing some decline in the expected completions of shopping centres larger than 5000 square metres. However, a rapid rise in building plans passed suggests a significant increase in fixed investment in this sector, even though it may only translate into many projects being completed in 2007 or 2008, and this bodes well for the rest of the decade.

After a massive boom, growth in retail sales is showing signs of a gradual slowdown. Growth in real household consumption expenditure is starting to taper off gradually on the back of the softening real household disposable income growth and a gradually rising household debt service ratio.

The softening in disposable income growth is not extreme, with real disposable income growth still in excess of 6% on a quarter-on-quarter annualised rate in Q3 of last year, but a mild

expected slowing in real economic growth in 2006 is expected to lead to a continuation of slowing growth.

The debt service ratio, the debt servicing cost (interest plus capital) of households expressed as a percentage of disposable income and indexed, has risen since its low reached at the end of 2003. This rise is on the back of a rising household debt to disposable income ratio which is offsetting the positive effect of declining interest rates (now at a very slow pace) on debt servicing costs.

The net result is a gradual, but not troublesome, slowdown in real household consumption expenditure,

with the growth in the more volatile and interest rate-sensitive durable and semi-durable goods consumption components tapering off more significantly.

Important, though, is that it is only real consumption growth that is declining and not the absolute level. The relatively high level of consumer confidence at the end of 2005 continues to support the view that there are no nasty extreme deteriorations awaiting us in 2006.

IndexGiven my view that the sharply higher levels of consumption are sustainable, based on the view of solid economic growth continuing, and that no recession or fall in real disposable income is at hand, it would appear quite possible that the building of retail space could still rise significantly in the 2006-2007 in lagged response to the past few boom years.

If the rise in shopping space building plans passed expressed in square metres are anything to go by, i.e. year-on-year growth above 77% for the first 10 months of 2005, this should be the case.

INDUSTRIAL SPACE – SUPPORTED BY RECORD INDUSTRIAL CAPACITY UTILISATION

South Africa has had something of a manufacturing boom in recent years, aided by strong domestic consumption and fixed investment growth.

In recent months, the signals emanating from the Investec Purchasing Managers Index are that growth in the sector is slowing.

Renewed rand strength could exert some near term pressure on manufacturing due to the negative impact on exports as well as making imports more competitive locally. Furthermore, growth in domestic real consumption expenditure is tapering off mildly.

However, the prospect of overall real economic growth continuing at between 3% and 5% for the rest of the decade, and given my belief that the levels of household consumption are sustainable, there should be sufficient domestic demand for the manufacturing sector to broadly sustain its levels of output. Admittedly, we anticipate some slowdown in real economic growth in 2006, but slowdowns these days are not what they used to be, and from GDP growth of near to 5%, a decline to say 4.5% or slightly less would still reflect significant growth in domestic final and intermediate demand, containing the magnitude of manufacturing output's possible downturn in the initial stages of 2006.

Furthermore, in 2005 manufacturing capacity utilisation reached a level of 85.7%, a rate not witnessed since the SARB seasonally-adjusted capacity utilisation series started in 1971.

Therefore, even with some softening in 2006, utilisation rates would probably remain high. and I suspect that capacity expansions will take some time to catch up with demand. In addition, a larger economy requires an increasing volume of inventories, boosting the warehousing side of industrial space.

Given the supporting factors mentioned above, and given the that building plans passed appear to still be on an upward trend, the future appears bright for fixed investment and building activity in the area of industrial and warehousing space.

OFFICE SPACE –SUPPORTED BY DECLINING VACANCIES

Unlike industrial and warehouse space which needs to increase very much in line with industrial output and inventory volumes, building of office space has shown little long term increase, with short cyclical fluctuations influenced by short term economic and interest rate cycles. Technological advancements have arguably allowed the improved utilisation of office space, and perhaps increases in space have not been as essential as in the industrial and warehouse component.

However, ultimately improvements in space utilisation can only go so far, and office vacancies have been declining since early-2003, from a peak of 15% in Q1 2003 to 8.9% by Q3 2005 according to SAPOA.

While the building activity that has taken place does translate into an increase in office stock, this may not be keeping pace with an acceleration in real economic growth, with SA appearing to have turned from a labour-shedding economy to a job-creating one.

The logical outcome? An increase in the pace of new office space provision, along with improvements and alterations to unsuitable space. I expect, therefore, that the real increase both in plans passed and buildings completed will continue in 2006 and beyond.

OUTLOOK – MORE A MARATHON THAN A SPRINT

While a mild real GDP growth slowdown, including tapering manufacturing and retail growth, is expected, the pace of overall economic growth in 2006 is still expected to be above 4%. At such a pace we should not see a major drop in the already-high rate of manufacturing capacity utilisation, while real retail sales growth is expected to remain in positive territory. At this pace of economic growth, along with stable interest rates throughout 2006, it is believed that solid growth in non-residential fixed investment and in building will be the order of the day. Real non-residential fixed investment is forecast to grow at a stronger 9% in 2006, compared with 7% in 2005.

Furthermore, this positive growth is expected to endure by-and-large for the rest of the decade, adjusting to the increased long term economic growth momentum of SA, and could be the longest non-residential fixed investment upswing in decades.

However, several factors lead me to believe that positive growth in non-residential fixed investment and building will be slower and steadier perhaps than the residential property one:

Firstly, I believe that the long term average level of SA's interest rates is declining on a more permanent basis, in lagged response to the economy moving towards being a lower inflation country compared with the 1980s and 1990s. On the positive side, a longer downward cycle in interest rates and a decline in real interest rates should sustain a far longer upswing. On the negative side, South African business can be expected to proceed with caution, taking a while to get comfortable with the concept that lower interest rates may be here to stay. This caution is the result of many shocks, and poor economic performance for the two previous decades, with the memories of the 1960 and 70s' high growth and low real interest rates too distant to have an impact.
Secondly, economic growth is on a long term rising trend, but it is not a rapidly rising trend. Once again, too, many believe that it is almost “too good to be true” and are wary of getting “overoptimistic”. This can contain investment growth.
Skills shortages are reported to be a constraint on the building industry. While more rapid growth normally leads to an increased supply of skills in an industry, there is normally a considerable time lag.
Building cost inflation, as measured by the BER's Building Cost Index, was running at 17% y/y in Q3 2005. While there was a mild tapering in this inflation rate from early-2005, it remains high and reflects the scarcity in supply of building services relative to demand.

Is it wishful thinking to expect the longest non-residential fixed investment upswing in decades? If you've gone through the longest business cycle upswing on record, and the most impressive residential property and consumer booms in decades, a next logical step could be to expect fixed investment to blossom for a prolonged period of time, especially given the prospect of the GDP upswing continuing for some years and interest rates remaining favourable.

JOHN LOOS: PROPERTY ECONOMIST
Commercial Property Finance
011-3718109
john.loos@fnbcommercial.co.za

The information in this publication is derived from sources which are regarded as accurate and reliable, is of a general nature only, does not constitute advice an may not be applicable to all circumstances. Detailed advice should be obtained in individual cases. No responsibility for any error, omission or loss sustained by any person acting or refraining from acting as a result of this publication is accepted by Firstrand Group Limited and / or the authors of the material.

News Article First National Bank - Property Economics 9 January 2006

News Article
First National Bank - Property Economics
9 January 2006