Last year was a tough year for the property industry overall. Increased vacancies and reduced demand for commercial space were some of the challenges facing the sector. Significant increases in administered costs, such as electricity prices, rates and taxes, also impacted negatively on the commercial industry.

Estienne de Klerk, executive director of South Africa’s largest listed property company, Growthpoint Properties, says that the company has seen a dramatic rise in administered costs that is set to continue. This will place pressure on property investors’ ability to grow their net income.

“Electricity increases have had a negative impact as the increased cost of occupation for tenants has impacted on landlords’ ability to increase rentals,” says De Klerk.

Growthpoint has invested resources to optimise and effectively measure the electricity consumption at its buildings and has further implemented energy efficiency technologies, where feasible.

“We believe these cost increases are set to continue into the next two to three years.”

First National Bank property strategist John Loos agrees that electricity costs, along with municipal rates and other utility tariffs, are putting significant upward pressure on costs, “and 2011 should bring more of the same as we come close to Eskom’s next big tariff hike”.

In 2010, the attention of property investors in the South African commercial property sector was primarily focused on controlling vacancy rates and managing operating costs, says property economist and University of Cape Town Department of Construction Economics and Management professor Francois Viruly.

Green Shoots?
However, it is not all gloom and doom as there is consensus that the South African commercial property market is facing a gradual and varied recovery in 2011, with specific areas of the sector showing promise beyond the norm.

“As the performance of the sector improves in the next 12 months, the focus will shift to the timing of potential development opportunities,” avers Viruly.

He states that the gradual correction in market fundamentals will largely be driven by an improvement in economic growth and, to a lesser degree, by a further decline in interest rates.

Consensus forecasts suggest that gross domestic product (GDP) growth will gradually rise, from 3,6% in the first quarter of 2011 to 4,3% in the fourth quarter of 2011. Research into the South African commercial property returns indicates that a 1% rise in GDP growth results, on average, in a 3% increase in total returns.

Measured rental growth, which is starting to come through in select areas, has been viewed as good news as there seems to be renewed confidence that the commercial property market will continue to offer investors sound future returns.

The South African Property Owners Association’s ‘Investment Property Databank Office Vacancy Survey’ for the last quarter of 2010 indicated that prime office properties in areas such as Sandton, Cresta and the Johannesburg central business district (CBD), in Gauteng, and Bellville, the Waterfront and the Cape Town CBD, in the Western Cape, are either fully let or have minimal vacancies.

Mergence Africa Property Fund’s Izak Petersen notes that, in addition to a cautiously positive outlook in general, commercial property investment in South Africa is diverse as, within the sector, there are a number of bright spots offering the potential of higher-than-average returns for the informed investor.
While the sector adjusts to a prolonged journey to stable growth, Petersen believes that property owners with the necessary black economic-empowerment credentials for government tenancies, which represent lower risk in a testing economic climate, are positioned to reap benefits.

Lower-risk occupants, such as government and national corporate tenants, are an essential part of a property portfolio as they improve the reliability of cash flow, which is essential to the performance of a property investment, and, as such, leases from such tenants represent a strong covenant.

“Further, portfolios with a good component of government tenancies are in the beneficial position of being default free,” notes Petersen.

Development Activity
Viruly says that, in 2011, development activity in the commercial property sector will remain subdued as developers and financiers remain nervous of a possible market oversupply.

Building activity data released in December 2010 show that, while the real value of building plans passed in the residential sector increased by 1,5% in the first 11 months of 2010 (compared with figures for the corresponding period in 2009), plans passed in the commercial property sector declined by a substantial 38,5%.

“While this illustrates the weakness of development activity, the expected decline in this activity should assist in the reduction of vacancy rates. In addition, it should place downward pressure on building cost increases,” explains Viruly.

Loos believes that the outlook for commercial building activity in 2011 is not promising, with lower building activity for the year than in 2010.

He states that this is expected to be the case for all three major commercial categories, namely office, industrial and retail.

He says that building activity in 2010 and so far this year has declined dramatically from 2009, with square metres of office space completed down about 45% year-on-year for the first and third quarters of 2010, industrial space down about 26%, and retail down 36% for the same period.

Loos adds that the country is still witnessing relatively high vacancy rates compared with the boom-time lows of a few years ago; and it would seem that a further period of weak building activity is required to cause vacancy rates to start noticeably declining.

Nedbank Corporate Property Finance managing executive Frank Berkeley says that the outlook for property development in 2011 is fairly flat, relative to 2010, which essentially means that there will not be many new developments until the number of current vacancies has been substantially reduced.

He adds that the increase in electricity tariffs will negatively impact on the increase in operating costs, resulting in lower net income and lower property values, assuming that capitalisation rates or yields remain unchanged.

Berkeley expects activity to pick up towards the end of 2011, and 2012 should be busier, provided that interest rates do not increase too much or too quickly.

Building Costs
Viruly emphasises that the rise in building costs will remain close to the inflation rate.

“Two issues will have an important effect on the level of development activity. Firstly, developers and financiers need to be convinced that global and domestic financial uncertainties have been brought under control. And, secondly, the banking sector will need to be convinced that market fundamentals justify an increase in supply.”

He says that, as economic growth will largely be driven by consumption expenditure, it is likely that investors and developers will pay particular attention to the retail sector.

This will largely take the form of renovations and the expansion of existing properties. Although the manufacturing sector is restocking, exporters will continue to feel the brunt of the strengthening rand and prospects for the sector will remain subdued.

Retail Revival?
Multidisciplinary property services company Broll Property Group says that South Africa’s retail sector is demonstrating a cautiously optimistic trend.

“Retail sales are following a similar trend to that of 2009, which leads us to conclude that festive-season trade will be similar to last year’s but at a slightly higher growth rate of between 10% and 12%,” cautions Broll Group research and marketing manager Sanett Uys, following a detailed study of Broll-managed shopping centres larger than 20 000 m2.

The company’s latest research, published in the Broll Retail Barometer Review of the third quarter of 2010, indicates that the South African retail property market is entering a recovery phase, reflecting improved retail performance.
“Globally, the retail market has entered the recovery phase and South Africa is no exception,” says Uys.

Highlights of the current market include nominal retail sales figures that show year-on-year growth of about 7% in September 2010, declining retail vacancy rates in prime areas, increased consumer confidence levels and modest growth in gross retail rentals.
“Demand for retail property has started to increase, but at a slow pace, and the existing oversupply of retail space is being absorbed gradually. Owing to little or no new stock coming on line in most major areas, this trend is likely to continue.”

Uys reiterates that research indicates that new supply of about 287 000 m2 is expected to come on line in 2011 and 120 000 m2 in 2012.
She reveals that declining high street rentals for prime space in Cape Town, Durban and Johannesburg all stabilised during the first three quarters of 2010 and are now moving up slightly.

“Prime regional shopping centres are likely to follow this pattern during the first six months of 2011, correcting the downward trend that has prevailed since early 2009.”

De Klerk outlines that demand for new office and retail developments remains subdued.

“We have seen a pick-up in the demand for industrial space and we see that continuing throughout 2011. Generally, the fundamental business environment continues to improve and growth in the economy will result in improved demand for property across retail, office and industrial sectors,” he avers.

De Klerk cites economic growth and the reduction in vacancy rates as the key drivers of commercial property this year.

Tenant Retention in Focus
Viruly reiterates that, by the end of 2011, office vacancies will most likely be back to where they were in 2008. In decentralised nodes in Cape Town, Johannesburg and Durban, the take-up of space will have reduced office vacancies to below 10%.

“It is unlikely that rentals in the office sector will rise in real terms until vacancy rates have moved below the sector’s natural vacancy rate, estimated at about 8%.”

De Klerk says that Growthpoint has a dedicated focus on reducing vacancies and ensuring tenant retention through improving the client/tenant experience and efficient management of administered expenses.

“We also have broader sources of capital that we can optimise for our debt and equity funding requirements. The industrial sector remains an opportunity for us and, internationally, we are making positive headway in Australia.

“Growthpoint will continue to oppor- tunistically seek transactions that add value to the company and to improve our development capability to offer our clients a holistic service.”

Although access to debt capital for Growthpoint remained good, the margins required by debt providers have increased. The company also completed several developments during the past year, some of which are not fully let. These additional development vacancies are taking longer than expected to let.

Quantum Property Group executive chairperson Chaim Cohen believes that the industry will be seeing an increase in demand for offices and escalating rentals.

He sees an increase in foreign investors in the African emerging market as a driver of commercial property in 2011.

“Further, we expect growth in business tourism in the next three to five years. This will generate substantial growth in employment and foreign currency earnings. “This will add huge benefit to the South Africa economy, especially with South Africa being the financial hub of Africa and the gateway to the continent,” Cohen assures.
He adds that costs have stabilised, and good margins have been achieved and will continue to be achieved.

Absa Commercial Property Finance Lending head Michael Mortimer explains that the economic outlook for 2011 is expected to remain “fairly flat”, and the bank does not expect to see a significant improvement in the outlook during the year.

“Development activity in 2010 was well off the levels seen in previous years. There is still some mopping up of vacancies that need to occur, but reduced building activity over the last year in the different sectors should follow through to a reduction in vacancies over the year. The past year was characterised by a reasonable degree of portfolio activity, with a number of property portfolios changing hands, rather than excessive quantities of new stock coming to market” says Mortimer.

He adds that the stabilisation of the overall economic environment will be the driver of commercial property in 2011 and the government’s infrastructure spend will remain the key contributor, with significant activity in the industrial market focused on areas providing good visibility and transport infrastructure. The Gautrain in Gauteng is proving to be a catalyst for new development activity, particularly in the nodes and the routes around the various stations,

“The banking institutions have a major role to play but credit will remain tight, with the banks seeking to use their capital as effectively as possible in order to secure a broader range of banking opportunities. Last year, banks placed increased focus on managing their books, looking at their margins and tightening the lending criteria.

“We don’t expect to see the lending activities experienced in 2007/8 returning any time soon.”

Slow Recovery As for a significant turnaround, Loos says that the sector will have to wait until after the next interest rate hiking cycle, which could be three to four years from now.

“By that time, I think that a prolonged period of slow commercial building activity will gradually bring vacancy rates down and drive a rental growth recovery, and this, along with the next interest-rate cutting cycle, could bring capitalisation rates down once again. But, as mentioned, I think that is some years away. This is the nature of property cycles – they are very long and turn very slowly.”

Cohen predicts that the turnaround is expected in the first quarter 2012.
Loos adds that the picture lacks clarity in terms of strong drivers for the property market in 2011. Interest rates look set to stay flat for some time, with some commentators expecting increases late in the year.

“The FirstRand view is that rate hikes will only start early in 2012. On the economic growth front, another mediocre year of economic growth promises little in the way of commercial space demand growth.”
Viruly states that, in seeking new market opportunities, South African developers will be following potential tenants who are targeting markets across the African continent.

Countries such as Ghana, Nigeria, Angola and Mozambique will be high on this list and investors will be considering the retailing opportunities that a rapidly growing middle class offers in these countries.

The next 12 months will, therefore, see conditions in the South African commercial property market improve, with the retail sector taking the lead. The office and industrial property sectors are expected to lag the market and only show stronger fundamentals in the second half of 2011. Investors will also start thinking about the longer-term possibilities that an upswing in the property cycle offers, concludes Viruly.