The impact

of the world and South African economy

on the SA property market

Client: Estate Agency Affairs Board

Erwin Rode

29 Feb 2016

No man is an island By John Donne

(First written by him as prose in 1624)

No man is an island, Entire of itself,

Every man is a piece of the continent, A part of the main.

If a clod* be washed away by the sea, Europe is the less.

As well as if a promontory were. As well as if a manor of thy friend's

Or of thine own were: Any man's death diminishes me,

Because I am involved in mankind, And, therefore, never send to know for whom the bell tolls;

It tolls for thee.

*Lump of earth or clay. Cf. kluit (A)(D)

1. The world economy

Ever since human communities began warring and trading – the latter maybe 10 millennia

ago – they started influencing one another. Our ancestors traded not only goods, weapons

and skills, but also passed on ideas. Initially (primitive) jewellery, pottery, stone tools,

later bronze tools and weapons, food like olive oil, even later iron tools and weapons.

Now let’s jump a few millennia.

The first truly multi-national corporation – the Vereenigde Oost-Indische Compagnie or VOC1

– opened its doors in 1602 in Amsterdam, and was listed on the world’s first modern

bourse, the Amsterdamse Effectenbeurs (stock exchange). The Dutch, and the Portuguese

before them, started trading with Asia with

their tiny ships and nasty canons (instead

of trekking overland), bringing spices,

Asian cuisine and ‘china’ to Western Eu-

rope. Close on their heels came the Eng-

lish and the French.

Figure 1 Courtyard of the Amsterdam Effectenbeurs, c. 1670

In the West, the ages of discovery (from

the 15th century onwards) and enlighten-

ment (18th century), were quickly fol-

lowed by the industrial revolution, which

started in the late 18th century in England. As a consequence of industrial-age ‘machine

tools’ like the steam engine, the standard of living (and inequality within and between

nations2) started growing at an exponential rate, and with it, knowledge and trade between

nations. Actually, coming to think about it, knowledge and trade preceded wealth, but

surely there must have been (and still is) quite a bit of feedback, creating a virtuous circle.

The next big leap in ‘getting to know thy neighbour’ came about through the information

technology and telecommunications (ITC) revolution in the second half of the 20th century.

Now we can buy and sell assets, and transfer capital, to and from anywhere on the planet

by pressing a button. Price movements early in the morning on the Asian stock exchanges

affect prices on the bourses in the West and vice versa. Thus, price movements on the

JSE are to a great extent determined by global forces. Ditto the exchange rate of the ZAR.

This means countries’ economic policies are now to a large extent subject to global market

discipline. Tiny South Africa has always been − and still is − a price taker. In fact, South

Africa is a bit like a farmer who cannot choose the weather but can manage his cash flow,

the crops he plants, and so on.

So, politicians, please take note: we are one village now, and there is no place to hide;

the all-seeing Argus-like3 markets and credit-rating agencies observe and punish sinners

relentlessly. This is the new god.

1 Yes, the United East-India Company that sent Jan van Riebeeck to the Cape to start a victualling station in

1652 2 From this we can learn that when a nation’s economy ‘takes off’, inequality within the population inevitably grows; in a free-market economy, you cannot have strong growth without worsening inequality – at least ini-tially 3 Argus Panoptes was a primordial giant in Greek mythology whose epithet, "Panoptes", "all-seeing", led to his being described with multiple − often one hundred − eyes. Source: Wikipedia

2

60

80

100

120

140

160

50 55 60 65 70 75 80 85 90 95 00 05 10 15

House prices

Real U.S. home values

Index

(2000=

100)

Compound growth rate of trendline: 0,7% p.a.

Source of data: Irrational Exuberance, Robert Shiller

With the above as a big-canvas background, let us now dwell for a while on the state of

the world economy.

Economists generally assume that economic agents (that’s you and I) act rationally. While

this may be true most of the time, it is not true all the time. A good example of irrational

behaviour was the exuberance in the run-up to the Great Recession. In a feeding frenzy,

house prices in secondary markets4 in many countries eventually surpassed replacement

costs by a wide margin, and in the wake of booming house prices, the USA became over-

supplied with houses. All that was required was a prick – the collapse of Lehman Brothers

– to eventually pierce the bubble in 2008.

The accompanying graph shows real house prices in the USA from 1950. By ‘real’ we mean

we have taken out inflation (viz. replacement costs). As one would expect, real prices

stayed in a channel (between 80 and 100 on the y-scale) until 2000, after which they shot

through the ceiling in the run-up to the Great Recession.

I define a property bubble as a situation where real prices generally exceed replacement

costs (like after 2000 in the USA). In theory, one would expect the trend line in this graph

to move sideways, assuming properties do not age (which of course is not true); instead,

it grew at a compound rate of 0,7% per year during the period 1950–2015. We posit the

following explanation:

Reasons for growth in the trend line: (1) Owners continually improve or renovate their

properties, thereby partially negating obsolescence caused by ageing (2) new proper-

ties are continually being added to the stock (3) newer properties are of a higher qual-

ity compared with older stock (as a result of rising affluence).

Reasons for an expected decline in the trend line: (1) In the absence of renovations,

properties in the USA age at about 1% point per year relative to new.

4 In other words, prices of existing houses (in contrast to new-build)

3

Evidently, the reasons for growth in the trend line are stronger than the reasons for a

decline through ageing. However, to me the graph depicts a house market that is still

over-valued, and if real prices were to drop to pre-2000 levels again (not impossible!) the

trend line will become horizontal again. Thus, this graph could also be interpreted to mean

that the second leg of the big crash is still to come.

Of course, the real estate market is only one cog in the economic machine. This machine

had before the crash been running at unsustainable revs for more than a decade in a

country like the USA. More specifically, in many countries, consumers and polities had

been living way beyond their means by piling up debt (see the graph depicting world debt).

They were able to do this on the back of unheard-of low interest rates. These low interest

rates were made possible by negligible inflation, which in turn was made possible through

cheap imports from China. In fact, there is another explanation for the very low interest

rates in the run-up to the crash, and I quote Morgan Stanley chief economist Stephen

Roach at the Davos summit in 2005: 5

US consumers ‘suck money’ out of their homes to fuel imports from Asia while gov-

ernments there buy dollars, keeping interest rates low and allowing consumers to

borrow more. This is an utterly insane way to run the world economy.

The story of China is a once-in-500-years phenomenon. In a (so far successful) attempt

to stabilise the world economies after the crash of 2007-08, monetary authorities in the

major economies followed a zero-interest-rate policy combined with the large-scale print-

ing of money (technically called quantitative easing). However, these measures were like

giving the patient an analgesic; the underlying debt problem still needs to be solved.

5 Business Day, 27 January 2005, ex Sapa-AFP

4

A consumer or a national treasury can for a while get away with excessive debt levels,

especially while interest rates are very low, provided the consumer’s income or, in the

case of a country, the treasury’s revenue stream, is robust. And herein lies the greatest

risk to the world economy: the moment the world economy starts accelerating, interest

rates will have to start rising to more realistic levels to combat inflation, thereby retarding

economic growth and governments’ tax take. It is, therefore, not impossible that the world

economy faces another 5−10 years of stagnation, similar to the Japanese economy since

1990 (and counting). An alternative strategy would be to allow inflation to rise because

that would be a less painful way of reducing sovereign debt.6 In history, debasement of

the currency was often used by sovereigns to solve their indebtedness problem.

In the world at large, the fallout of the financial crash has been contained until now through

a booming Chinese economy, where the government quite rightly went on an infrastruc-

ture-investment spree as a counter-cyclical measure. However, at the time of writing this,

it has become clear that the Chinese economy is now also stuttering as it is suffering from

over-capacity, combined with struggling exports into a stagnating world economy. As a

consequence, the authorities there are trying to morph the capital-investment oriented

economy7 into a more consumption-driven society, which in the short run is easier said

than done.

For South Africa, the critical result of this development is the collapse in the demand for,

and the prices of, hard commodities.

2. The South African economy

We first deal with ‘structural’ characteristics of the SA economy.

South Africa, or what was to become the Union of South Africa in 1910, was historically

an agrarian society. This only started changing after the discovery of diamonds at Kim-

berley (1866) and gold on the Witwatersrand (1884). Fortunately, these territories already

had well-developed governance institutions at the time, which meant that the commodity

windfall kick-started the industrialisation of South Africa (the mines had to be serviced)

rather than disappearing into the Swiss bank accounts of a few well-connected people (as

is wont to happen in so many third-world countries8). Nevertheless, the serious industri-

alisation trend only gained pace during and after World War II on the back of the need

for self-sufficiency. This trend was tragically reversed after 1994, when the SA economy

was opened up to competition from low-wage (Asian) countries. To illustrate this point, in

the early 1990s manufacturing constituted about 30% of GDP compared with the current

12%.9

However, the de-industrialisation of SA did not impact industrial property10 at all, and the

explanation for this phenomenon is that (1) SA’s booming private consumption requires

6Say in 2016, a pension fund lends R100 for 10 years to the national treasury. Lo and behold, 10 years later the fund gets refunded its R100 – but in the meantime the inflation rate was, say, 15% per year. This means the real refund is only R28 in 2025. Thus inflation is in effect a tax on investors (in this case, pensioners) but it does solve the treasury’s debt problem. 7 In economics, ‘capital investment’ refers to investments in real estate (including infrastructure like bridges and roads), plant and equipment 8 This phenomenon even has a name: the resource curse. Another complicating factor is that a resource-rich country’s currency tends to be too strong to make the large-scale manufacture and exporting of manufactured good viable. 9 Source: Chris Barron, ‘State companies are killing local manufacturing’, Business Times, 28 Feb 2016 10 Industrial property includes warehousing

5

warehousing and distribution centres (see below) and (2) the industrial property market

is not speculative like the office property market; thus, supply is typically only added to

stock where there is concrete demand.

On the other hand, starting in the 1970s, and following a world trend, the tertiary sec-

tor11 or services sector of the economy started growing in importance (growing faster than

the total economy). This sector is of world-class stature and is an important pillar of the

SA economy – but it cannot by its very nature mop up die low-skilled unemployables. This

is the sector that typically employs office workers, so it is of crucial importance to the

landlords and developers of office buildings. However, it should be noted that it does

not follow that where the demand for a certain property category is high that such a

category will as an investment perform better than the rest. The reason for this is that in

a free market, supply quickly catches up with demand. In fact, in popular locations, supply

often anticipates demand, as in the Sandton and Cape Town CBDs at present12 – resulting

in uncomfortably high vacancies.

In spite of the structural changes in the economy, commodities still form the mainstay

of South Africa’s exports. Both the quantum demanded and the prices achieved are de-

termined by international markets. As a result, SA’s rather open economy13 tends to be

volatile. A volatile economy inevitably results in volatile interest rates and unstable for-

eign-exchange rates, which make planning by businesses more difficult than in more

stable economies.

Another important weakness is that SA’s economy is consumption driven. In fact, about

60% of GDP is constituted of consumption expenditure – which is high for a developing

country. As we have seen above, this is in stark contrast to the Chinese situation. It means

South Africans live for the ‘now’, and they do not invest enough for the ‘tomorrow’. As a

consequence of the predilection to consume, the country’s savings ratio is dismal, and

consumer debt is close to its historic peak at about 65% of disposable income. This in turn

is about 20 percentage points higher than 20 years ago.

The implication for property developers and landlords is that shopping centres are the

best performing and the most popular property type in South Africa (more than 60% by

value of properties listed on the JSE are retail). The reason that shopping centres are doing

better than office properties is that malls typically serve a circumscribed geographical

catchment area, thereby in a way limiting direct competition from new competitors.14 This

can be compared with office buildings that are generic, resulting in cut-throat competition

for tenants within a circumscribed node like a CBD.

SA’s shopping malls are truly world-class.

Because of a lack of domestic savings, South Africa is dependent on the confidence of

foreign investors for capital inflows, which is another source of risk and volatility. Foreign

investors can be divided into two categories, viz. portfolio investors (who have a short-

term horizon) and foreign direct investors, who invest for the long haul (in, for instance,

factories or real estate). The problem with the first category (on which the country is

largely dependent) is that they can leave SA at the drop of a hat (e.g. should the country’s

11 Finance, insurance, real estate, government services 12 See the date on the front page of this précis 13 In an open economy, a large proportion of the country’s GDP is imported and exported. In SA, this was so even before 1994. 14 No developer would be foolish enough to erect a second super-regional centre a block away from an existing one

6

sovereign debt be de-rated to junk status by the credit-rating agencies). This is another

major risk to the outlook for the SA economy and, therefore, the property market.

The last structural handicap facing South Africa that I would like to deal with here, is

demographics and education.

About 50% of SA’s population is below 25 years of age (see Table 1). Add to this ingredient

the deficient SA education system,

that low-skill workers are overpaid relative to Asia,

an insufficient number of educated entrepreneurs,

the brain-drain, and

the swiftly-changing knowledge and skills demanded by a fast-changing world,

and we can see that SA is heading for serious social and political upheaval in years to

come.15 This is so because there is no chance that the majority of this wave of young

people could ever be employed in formal jobs. In fact, the current (Feb 2016) riots at the

universities (and the continuing service-delivery riots all over SA) are arguably part of this

age of discontent, which has its roots in an economy that is under-powered and cannot

satisfy high expectations. Thus inequalities between the well-educated and the unemploy-

able will grow – as in the rest of the world, just more so.

Table 1:

National population breakdown by population group and age category

Age group 0-24

% of total population

Age group 25-120

% of total population

Grand total

Black African 21 353 623 41,2% 19 647 315 38,0% 41 000 937

Coloured 2 171 233 4,2% 2 444 168 4,7% 4 615 401

Indian or Asian 473 106 0,9% 813 823 1,6% 1 286 930

White 1 369 700 2,6% 3 217 138 6,2% 4 586 838

Other 110 447 0,2% 170 007 0,3% 280 454

Grand total 25 478 109 49,2% 26 292 452 50,8% 51 770 560

Source: Stats SA (Population Census 2011)

The implication of this demographic wave, plus the continuing migration to the cities, is

that there is no way that the SA economy will be able to deliver give-away houses to all.

Site-and-services schemes will become the order of the day as it is the only realistic option

government can exercise. The town-planning and transportation-planning implications are

huge.

A last word on demographics. In the developed world, the catchphrase among property

developers is to ‘follow the roofs’ (i.e. go to locations where population growth takes

place). In a country like SA, one must interpret this mantra with care, as so often these

population shifts are represented by unemployed people. Granted, the unemployed must

buy food, so there is a need for basic food outlets of a sort and some community facilities,

but that is more or less where it ends.

Until now we have been discussing structural characteristics of the SA economy. We now

turn to more recent government policy.

15 It should be noted that, even if SA had a good education system, it wouldn’t have changed the following sce-nario by much. This is so because it takes generations to produce educated entrepreneurs. The Afrikaners’ so-cio-economic history since 1902 could serve as a pertinent case study for this statement.

7

As I have noted before, the Chinese government reacted to the Great Recession by coun-

ter-cyclically boosting government expenditure. This is the classic Keynesian remedy pre-

scribed by renowned economist John Maynard Keynes in 1936.16 The Chinese decided to

accelerate investment in infrastructure, which, if wisely done, will facilitate economic

growth in later years. The SA government, in contrast, decided to spend on expanding the

civil service and giving the civil servants extraordinary salary increases (to levels that are

allegedly about 20-30% above those of the private sector17). SA thus opted for consump-

tion rather than fixed investment. The SA ‘government did this by increasing sovereign

debt – to levels that are now threatening the country’s fiscal health.18

South Africa’s current fiscal predicament vividly illustrates the limits of Keynesian pump-

priming. If the increase in government expenditure does not succeed the first time around

to put the country on a renewed growth path, then the authorities have in a manner of

speaking shot all their ammunition away. This is where SA is now, and the country has

nothing to show for the government’s consumption spree and the collateral increase in

sovereign debt. Thus, SA is inevitably heading for a prolonged period of economic stagna-

tion, which will spill over to the property market, because the property market is not an

island.

It is noteworthy that economic growth is one of the important metrics used by credit-

rating agencies, and the reason is not difficult to find: strong economic growth could im-

prove the fiscal position within a couple of years.

16 Keynes argued that monetary policy (reducing interest rates) wouldn’t help much to increase aggregate de-mand in the economy. How right he was! 17 Informal communication by well-placed consultant, as well as economist Dawie Roodt, ‘Staatsdiens is oorgewig en kos te veel’, Sake-Rapport, 28 Feb 2016 18 SA borrowed its way out of the recession by doubling the public-debt ratio. Source: Hilary Joffe, ‘Gordhan must juggle growth, fiscal metrics and confidence’, Business Day, 22 Feb 2016

8

To illustrate SA’s integration into the world economy: the accompanying graph shows the

amazing correlation between SA’s composite leading business-cycle indicator and the

equivalent indicator of SA’s trading-partner countries.

The reader will note that in the period starting 2003, SA outperformed the trading partners

in 2004 (beginning of the commodity boom), and also in 2010 (SA stimulated its economy

more than its trading partners through a huge growth in the public-sector salary bill, which

was made possible through a prudent public-debt ratio at the time). However, and this is

the disconcerting news, since 2013 SA has been underperforming its trading partners

(mainly because of the collapse of the demand for, and prices of, commodities). However,

domestic economic policy that undermined business confidence cannot be ruled out as an

additional contributing factor.

3. The SA property market follows the SA economy

How does all this affect the property market in SA?

3.1 What drives house prices? Our analyses over the years have shown that it is

mainly construction-cost inflation (long-term determinant), and interest rates (cy-

clical). Construction-cost inflation in turn is driven by construction input costs

(wages and building materials as measured by the Haylett index) as well as the

workload of contractors (contract prices become keener when there is less work,

and vice versa).

Don’t expect much growth in house prices in 2016.

-20

-10

0

10

20

30

03 04 05 06 07 08 09 10 11 12 13 14 15

South AfricaSA trading partner countries

Growth composite-leading business cycle indicatorsSA vs SA trading partner countries

Gro

wth

(%

; y

-o-y)

Source of data: SARB

9

3.2 Estate agents’ income is inextricably linked to the number and value of property

sales, so let’s start with this.

A good proxy for the value of residential sales is changes in the nominal value

of new mortgage loans and re-advances for residential dwellings and flats. Our

analysis shows the major drivers of sales are

the prime interest rate (which has a negative relationship), and

nominal house prices (positive relationship).

Rising interest rates make home ownership less affordable (and vice versa), so

this is easy to explain.

But why are more houses and flats sold when house prices accelerate? My expla-

nation for this phenomenon is not a feeding frenzy (that is, behavioural), but ra-

ther that the underlying reasons that make house prices accelerate in the first

place are also the drivers of the number and value of sales. For instance, declin-

ing interest rates and accelerating building costs.

It is common knowledge that SA is facing about two years of low growth and

rising interest rates. Thus I expect the value of property sales to decline in

2016 by at least 10%. However, our model shows sales could rebound by an

equal amount in 2017.

3.3 Retail sales largely determine the rentals that retailers can pay. Sales in turn are

determined by changes in disposable incomes and credit extended to households.

This explains why shopping centres have been doing so well after the financial

crash: the government has been boosting the number of civil servants and their

-60

-40

-20

0

20

40

60

80

100

1985 1990 1995 2000 2005 2010 2015 2020

ActualFitted

Growth in nominal value of new loans and re-advances grantedfor residential dwellings and flats

Actual vs Fitted

Gro

wth

(%

; y

-o-y)

Source of data: SARB; Rode forecasts

R²=0,7

Fo

re

ca

st

10

salaries (as discussed above). However, on the negative side, over the past two

years credit extension has declined sharply and still is in negative territory.

Expect retail sales in aggregate to show little real growth in 2016. This would

put huge pressure on market rentals of retail space. Especially as retailers’

operating expenses in shopping malls are still a serious concern (exorbitant

increases in rates & taxes and electricity, which are passed on to tenants).

3.4 Demand for office space is determined by growth in the number of employees

in the tertiary sector. With the economy tanking, and low business confidence,

there is overall no growth in staff complements.

So property brokers will in 2016 typically play musical chairs with landlords.

3.5 Office rentals are determined by vacancies (cyclical) and building-construction

costs (long run).

Don’t expect much growth in building costs (because of brutal tender competi-

tion) and vacancies are not going to come down by much – if at all – because of a

lack of growth in demand (via low economic growth) and some misplaced new

supply that have come on stream in recent times, or is still in the pipeline.

Hence there will be little growth in office rentals in 2016.

3.6 Capitalization rates are moved by changes in long-bond yields (positive relation-

ship), vacancy rates of properties (positive) and growth in the economy (negative

relationship). Long-bond yields are in turn moved by international confidence in

SA (or the lack thereof) and inflation risk. A de-rating of SA’s sovereign bonds to

junk status could play a crucial role here, although it can be argued that a possi-

ble de-rating is already (29 Feb 2016) priced into SA sovereign bonds.

Expect capitalization rates to rise in 2016 on the back of rising long-bond

yields (the lag is about one year). This would depress market values of in-

come-producing properties, ceteris paribus.19●

19 This is a fancy Latin tag for ‘holding all other factors constant’

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THE SECOND COMING

By William Butler Yeats (1865-1939)

Turning and turning in the widening gyre

The falcon cannot hear the falconer;

Things fall apart; the centre cannot hold;

Mere anarchy is loosed upon the world,

The blood-dimmed tide is loosed, and everywhere

The ceremony of innocence is drowned;

The best lack all conviction, while the worst

Are full of passionate intensity.

Surely some revelation is at hand;

Surely the Second Coming is at hand.

The Second Coming! Hardly are those words out

When a vast image out of Spiritus Mundi

Troubles my sight: a waste of desert sand;

A shape with lion body and the head of a man,

A gaze blank and pitiless as the sun,

Is moving its slow thighs, while all about it

Wind shadows of the indignant desert birds.

The darkness drops again but now I know

That twenty centuries of stony sleep

Were vexed to nightmare by a rocking cradle,

And what rough beast, its hour come round at last,

Slouches towards Bethlehem to be born?

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