How Russia’s invasion of Ukraine will impact South Africa’s property market: FNB

 ·7 Mar 2022

While it is too early to say how Russia’s invasion of Ukraine will impact South Africa’s property market in the long term, analysts at FNB have warned that the sector is likely to be hit by the obvious short-term economic factors, such as higher inflation rates and interest rate hikes.

The conflict appears likely to add to already troublesome global inflationary pressures, notably energy prices, said John Loos, property strategist at FNB Commercial Property Finance.

Potential energy supply disruptions in the region, in part as a result of the conflict but also due to potential sanctions and boycotts against Russia, a key oil and gas producer, have sent energy prices rising significantly.

In short, the Ukraine war impact remains highly uncertain, with much depending on how long it continues, its final outcome result, and what happens in terms of global sanctions, boycotts and reaction to them, Loos said.

“For property, the main potential impact points are via upward pressure on cap rates, upward pressure on vacancy rates, downward pressure on rentals and thus property incomes, as well as possible additional upward pressure on operating costs.

“For the residential rental market, the recovery can continue should the war impact be mild at worst, but this market’s tenant population cannot handle too big an economic impact before tenant rental payment performance starts to suffer again.”

Capitalisation (Cap) Rates

Given the partial link between short term interest rate and long bond yields on the one hand, and property capitalization (Cap) rates on the other, some negativity around inflation prospects as a result of the Ukraine conflict led to some sell-off of South African government bonds.

The average yield for 10-year bonds have risen from 9.26% as of the 25th of February to 9.665% as of the time of 4 March, Loos said.

“While this is not a major sell-off in bonds to date, it does suggest that the Ukraine crisis’ fueling of heightened inflation and interest rate fears would likely exert upward pressure on local property capitalization rates, and thus be a negative for property valuations.”

Vacancy rates

After recent years of rising average vacancy rates in all three major commercial property markets (Industrial, Retail and Office), the recent FNB Property Broker Surveys late in 2021 were pointing towards a possible stabilization in retail and office vacancy rates and a decline in industrial property vacancy rates, supported by some recovery in the economy following the sharp 2020 GDP contraction.

“South Africa’s economic situation is fragile at best, however, so any major global recessionary impact on the domestic economy could quite easily see vacancy rates rising once more,” said Loos.

“While industrial property may weather an economic storm of moderate proportions, the fragile retail and office sectors, challenged by increasing online retail and greater remote working respectively, could quite easily see renewed weakness that could return them to rising vacancy rates and further downward pressure on rentalsm.”

He added that all three sectors could see economic pressures greater than would otherwise be the case, as a result of the Ukraine Crisis’ potential global economic impact.

“Industrial property’s link to the global economy is quite strong via warehousing and logistics space used for imports and exports, as well as the local manufacturing sector’s strong trade links to the rest of the world.”

“The retail sector’s links to the global economy are more indirect, rand weakness and higher global inflation partially bringing imported inflation into consumer goods prices, notably in the area of food prices given their global pricing link, and especially petrol prices.”

Apart from higher inflation eating into consumer incomes that are already under pressure from a weak economy, rising interest rates lift the cost of servicing debt, further eating into incomes. The war could potentially add to these pressures that have already been mounting, he said.

The office market is arguably the least directly exposed to the potential global economic impact from the Ukraine War, although it does house certain tenants who trade with the world.

But its potential impact is more indirect, via the slowing economy impacting on the number of office worker jobs, in turn exerting pressure on office space demand. Higher interest rates, too, would exert additional pressure on both the landlord and tenant population.

Property valuations

With risks of additional upward pressure on capitalization rates via long and short interest rates, and on vacancy rates via the economic impact translating into downward pressure on rentals, the Ukraine conflict looks to be a source of negative pressure on property valuations, said Loos.

“However, it is too early and uncertain to tell if the magnitude of the potential economic and interest rate impact will be sufficient to delay our expected return in the All Property Average Capital Value (MSCI data) to positive nominal growth this year.

“The negative impact of the Ukraine War will be pushing against the lagged positive impact of normalization in economic activity, and some economic recovery, following the deep 2020 lockdown recession.”

Property operating costs

He added that the indirect impact of the Ukraine War, via the economic impact on South Africa, can conceivably indirectly impact on operating costs, via the inflationary impact feeding through to service provider costs.

“In addition, should electricity sales revenues be dampened by economic weakness, Eskom can attempt to claw it back through tariff increases, as can councils with rates and other tariff increases should economic pressure cause rate payer payment performance to weaken.”

Residential market 

The potential war impact on the domestic residential rental market is tough to call, depending on how big the magnitude is, Loos said.

“Mild additional upward pressure on interest rates, over and above what would have been the case in the absence of war, could see additional impetus provided to the expected rental market recovery.

“We have expected that the rental market will strengthen as interest rates rise, with the economy and tenant payment performance both recovering after the hard lockdowns, and a greater group of would-be home buyers postponing their home buying to remain in the rental market for longer while rates rise.”

But for this to continue, the negative economic impact of rising interest rates, and any additional Ukraine impact, must be mild at worst, he said.

“Too big an inflationary and interest rate impact exerts financial pressure on tenants, and then all bets of recovery in this market are off. Therefore, it’s a fine balance.”

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