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Jun 30, 2008:
Commercial and residential property investments react differently to interest rate changes.
"When interest rates go up, people buy less and the tenants in shopping centres (the shopkeepers) suffer. If the downturn in the economy is severe, one may see a reduction in rentals and even increasing vacancies in shopping centres," says Jurie Wessels, managing director of Capital Investments.
"The service industries that generally occupy office blocks don't feel the effect of interest rates changes as directly, but they nevertheless feel the effects in the long run and it is important to have in your portfolio the right buildings, in high-demand areas, that you can always let.
"But the effect on factories is interesting. Higher interest rates are usually preceded by higher inflation and accompanied by a weakening of the rand – as is indeed the case currently. A weaker rand is stimulating for exports. So, provided you have the right tenant mix in your industrial properties, namely that your buildings house export oriented factories, your tenants should be doing very well. Rentals may even increase."
Wessels says investors in a distributed property portfolio are well-positioned to be buffered against the immediate effects of the change in interest rates.
"The second part of the analysis is a little technical," he says.
"Higher interest rates result in higher yields on commercial properties. What I mean is that an investor in a commercial property is really buying an income stream and when the yield is higher, it means that the price one pays for a particular income stream, is lower. In other words, commercial properties start becoming slightly cheaper, over the longer term, when interest rates rise."
This does mean reduced growth is achieved on the buildings that are already in a portfolio, but it also means that one can buy additional buildings for cheaper.
In turn, that means that a bigger portion of the purchase price of a building can be financed via a bond from a bank – because the investor has a relatively bigger income stream with which to pay back the bond.
"If you can finance a bigger percentage of your new investments with bank money and a smaller percentage with your clients' money, it means that you can buy more properties with the money your clients invest. In other words, your clients end up with a bigger portfolio of properties and they therefore receive capital growth on more properties and also receive rental income from more properties.
"This long second part of the answer really just means that the various other economic changes that accompany a change in interest rates, have a neutralising effect in a portfolio of commercial properties and investors end up with very much the same net result they would have had, had interest rates not changed," says Wessels.
"In the short term, just as interest rates are adjusted, the various factors are indeed out of kilter but over the longer term the different factors neutralise one another.
"Similarly, of course, things are temporarily awry when interest rates start coming down again but normalise over the longer term. The Reserve Bank's focus is to make minor adjustments and avoid major shocks while keeping the country's economic growth within the bounds of what is achievable over the long term. In recent years, the Bank has been very successful at doing just."
