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Tuesday, May 1, 2007
PUTS in perspective

Property Unit Trusts (PUTs) give investors the opportunity to buy units in a portfolio of properties, which are traded on the JSE Securities Exchange. But just how are their prices determined and what should investors consider when making a decision to buy or sell them?
There are essentially three factors that drive the prices of listed property vehicles:
• Expected earnings;
• Expected performance of short dated bonds; and,
• Short-term interest rates.

Expected earnings

A PUT’s earnings are derived from rental income. There are two factors to examine when forecasting rental income:
• expected rental growth, and
• expected vacancy rates

The higher rental growth is, particularly relative to inflation, the better this will be for the unit trusts. However, any vacancies will offset this and consequently the higher the vacancy level, the lower the expected earnings will be. Both these aspects need to be considered in forecasting earnings.

Expected performance of short dated bonds

In general, the yield on listed property mimics that of long-bond yields. PUTs do not retain income; it is passed on to the unit holders in the form of a distribution. The property portfolio can be considered as a collection of contracts for the payment of rental. When an investor buys a PUT, he is effectively buying that income stream (as opposed to buying the physical properties). In this regard, the investment is similar to the bond market, where an investor is buying the interest income stream on a bond.
There is a strong degree of predictability to the income flow and to future earnings in a PUT. Bonds have a constant distribution based on the effective yield at which the bond was purchased. Hence PUTs and bonds are seen as having a degree of substitutability as investments. The yield on short dated bonds will therefore be an influencing factor in determining the valuations of PUTs.
Bond prices move inversely to their yields and so, too, do PUTs. If one is trading at R10 and it yields an income of 70c, it is said to be trading on a yield of 7%. If yield falls, say, to 6.5%, investors would be prepared to pay R10.77c for the same 70c income. In other words, they would now demand a yield of 6.5% on their investment, so the price of the units would rise.
If investors expect short dated bond yields to fall, they would expect PUT prices to rise and vice-versa.

Short-term interest rates

Most PUTs have some borrowings but this is limited to 30% of their value. An interest rate hike or cut could therefore impact on earnings. Higher rates increase the cost of debt and reduce distributions. When yields on safe, fixed interest investments rise bonds are relatively more appealing than PUTs. Interest rate movements are therefore a critical component in any assessment of the outlook for the listed property market.
In contrast, lower interest rates will usually result in a positive re-rating in share and unit prices. In other words, investors will settle for a lower yield on PUTs as they compare this to the lower rate they would get for money in the bank.
Anyone following the listed property market recently will have seen several listed entities reporting good rental growth, as well as expectations of further growth to come. Vacancies are generally falling at this stage, so expected earnings should have a positive impact on PUT prices.
The 2007/08 budget tabled in February provided a very bullish outlook for bond rates. As government is budgeting for a surplus, net borrowing requirements will fall and thus a shortage of bonds can be expected, leading to lower yields. This, too, will be positive for the PUT market.
Finally, the latest inflation figures indicate that the upper limit of the target range is unlikely to be breached, which would point to no further short-term interest rate hikes for the time being, another suggested positive trend for PUT prices.

Copyright © Insurance Times and Investments® Vol:20.4 1st May, 2007
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