PROPERTY unit trust prices – especially the listed loan stock of these companies – have climbed 40% or so over the past few months. However, a number of asset managers – especially those who missed the opportunity – are now crying wolf and warning that a property bubble is about to burst.

Of interest is that the prices of these shares and loan stocks increased in anticipation of a better interest rate for SA. They’ll probably rise even further without any increase whatsoever in underlying property prices or net rental income. Ignorance about the effect of interest rates has some observers looking for the bear in the wrong cave.

The example (below) of how a reduction in SA’s interest rates – and the market’s rating in the light of future rates – can affect the price of a listed loan stock is based roughly on the financial statements of Premium Properties (PMM).

A reduction in prime from 17% to 13% causes the loan stock price in the model to increase from 156c to 270c – or 70% – without any increase in the value of properties or improvements in net rental incomes. Incidentally, this is exactly what’s happening with PMM’s price.

In the example we assume that the property portfolio is worth R510m and that R250m of this is financed by short-term loans from the market at the current 17% prime. We show the effect of a reduction in prime to 13%.

The Effect of a 400 point reduction in prime rate on property loan stock

Balance sheet

Value of property                                             R 510m

Financed by means of

- interest-bearing borrowed capital                    R 250m

- listed loan stock 100m @ 250c each               R 250m

- linked shares 100m at 10c each                      R   10m

Income statement                                              17% prime                   13% prime

Gross Rental Income                                        R 100m                        R 100m

Cost                                                                 R 30m                          R 30m

Income before interest                                      R 70m                          R 70m

Interest on borrowed money                             R 42m                          R 32m

Available for own loans                                     R 34m                          R 28m

Distribution to linked unit                                   34c                              28c

Market Rating                                                  18%                             14%

Priced of linked unit                                          156c                            270c

The listed loan stock finances roughly 50% of its assets by means of short-term borrowed money and therefore benefits twice from an interest rate reduction. The direct accounting benefit, without any improvement in property prices or rental income, is a 36% increase in distributable income, from 28c to 38c/linked unit. (Note: As interest income, this is fully taxable.)

The second factor causing an increase in the price is a better market rating. With prime at 17%, an investor demands a return of at least 18% – when the price was only 156c on the strength of the annual distribution of 28c. With prime cut from 17% to 13%, a new investor is satisfied with a return of, say, 14%, on a listed loan stock such as PMM.
He’ll therefore be prepared to pay 270c for an annual income of 38c – 70% more than for the listed linked share/loan stock. This has everything to do with a reduction in interest rates and nothing to do with the property market.

With problems regarding SA’s inflation and prospects for a drop in prime, investors could still go for the loan stock of choice property trusts. We’re not really dealing with a property bubble about to burst.