After offering South African investors phenomenal returns over the past 10 years, the SA Listed Property Index plummeted 11% in May 2013 to record the index’s third worst monthly decline since its 2002 launch. And it extended its losses over the first three weeks of June before posting a remarkable turnaround to end that month 4.4% to the good.

The question now is should investors take advantage of the hiccup in the SA Listed Property Index and increase their exposure to this asset class? Sanlam Multi Manager International (SMMI) currently holds on average about 2% in listed property across its multi-asset balanced funds and is in no rush to increase this exposure.

Rafiq Taylor, a portfolio manager at SMMI says, “The volatility can largely be attributed to movements in bond yields and the rand. We expect listed property to remain volatile in the short term due to its strong correlation with the bond market.

“We are prepared to wait out this market volatility before reassessing the weighting of listed property in our various portfolios. SMMI is waiting for certain valuation metrics to turn favourable before committing additional funds to this asset class – if yields move nearer 8.5% from the current 7.93% on the All Bond Index we would definitely look to buy more nominal bonds and in that vein also look to increase our allocation to property.”

He points out that the total return generated from the asset class over the past decade has been substantially above the long term average. “In the search for yield, foreign investors inflated domestic property prices in a market where there was already a shortage of domestic listed property paper. In addition, a rise in nominal bond prices also made property look more attractive on a relative basis,  adding more impetus to the rise in property prices.”

Against this backdrop the excess volatility exhibited in the listed property index over May and June is a red flag for property investors. Taylor suggests a cautious approach until the market volatility settles and the fundamentals driving the market can be assessed more soberly to determine if the sector offers value.

Listed property is a unique asset class in that it exhibits certain characteristic of both equity and bond markets. Investors in a listed property fund benefit from the capital growth in the underlying property portfolio – an equity trait – as well as their share of the income (or yield) generated by these properties. Unfortunately, the listed property is not as liquid as the bond market and consequently some fund managers shy away from the sector in favour of more liquid counters.

There are also two fundamental principles that asset managers consider when investing in listed property. Firstly, the current interest rate cycle, as bond yields and property yields are highly correlated. And secondly, what the potential growth in distributions is for listed property over the coming economic environment.

So why the sudden decline in property prices in May? “The rand has weakened significantly of late due to a combination of factors,” says Taylor. “These include growing sovereign risk concerns, labour unrest (and the expectation of lower domestic productivity), poorer than excepted GDP growth figures and a growing budget deficit.”

The weaker rand combined with increasingly negative foreign investor sentiment towards emerging markets to create a “perfect storm” over the local bond and property markets. As a result more than R3.7 billion of foreign investor capital exited our bond markets in May and a further R10.5bn in June this year. The mild recovery of listed property in the last week of June was supported by net inflows of R6 billion to  equity markets compared with just R630 million out of bonds.

Taylor believes that the soft property market could persist through the remainder of 2013 and that bond yields could be softer from here on out. And while bonds and listed property are already showing some positive signs a prudent asset manager should not ignore the risk of yields pushing higher from current levels.

Another potential red flag is that South Africa is nearing another rising interest rate cycle. Taylor says that SMMI does not expect an interest rate hike in the next year despite the bond market pricing in a 100 basis point move in the next six to eight months: “We cannot totally discount the chance of a rate hike nor ignore the impact this would have on property yields and prices.”