Even though the validity of an index to the small investor is questioned in its normal application, it is believed that the index still provides a credible reflection of the behaviour and the general trends of property returns on the macro-level and because asset-specific risk is reduced to relatively small proportions at this level, they may thus still be of use when relationships between the macro-economy and the general property market are sought. Logically, the smaller the scale at which the investment is to function, the more specialised the market will be, but if total returns of an index are considered, the general market behaviour may be brought in comparison with the macro-economy and in particular with its main indicators.
It must be noted that the information of the index for application to the small investment being referred to, refers to figures specific to a particular region and sector, as would be needed to perform the calculations on variance and standard deviation for inclusion in escalation rates in the DCF. It was however suggested in Chapter 3 that asset-specific risk relating to the individual components be managed through the application of risk premiums to such rates and that the external risk considered to be market related (predominantly relating to PGI and ESP), be transferred the overall expected return or discount rate, in the form of a single market risk premium. It is therefore possible to limit the information obtained from the index to only general indicators, which would enable the quantification of market risk.
Essentially property indices function as a necessary link between the property investment and its relevant market. The index therefore should be a reflection of supply meeting demand at equilibrium price, an aspect that was discussed in Chapter 3 as the basis for determining risk from a theoretical point of view. Therefore, if property indices are irrelevant to small investors, the alternative link to be developed must fulfil the same
function in representing a reliable link between the market and the investment and be reflective of supply meeting demand. Property demand is thus hereby identified as a determinant of equilibrium price and market behaviour and the first step towards a possible alternative link between the property investment and its market. In order to justify this statement, the links between the property market and the property investment will now serve as a point of departure on a discussion of the relevance of property demand as a possible alternative means of quantifying market behaviour for property returns for the small investor. The discussion will be a theoretical examined form within the framework of a property market model (Four Quadrant model).
5.3 LINKS BETWEEN THE PROPERTY MARKET AND THE
INVESTMENT
Ball et al (1998) lists a distinctly identifiable property cycle as presenting possible problems to the small investor from an investment strategy formulation-, as well as a risk management point of view. The very nature of the property market seen through the Four Quadrant Model (as was discussed in Chapter 3) of the market implies that the market as a whole will have a delayed reaction to changes in the macro-economic climate.
Briefly, the Four Quadrant Model of the commercial property market comprises the following sub-markets:
• The Rental Market, which is driven by the demand for space by business.
• The Asset Market, which responds to an increase in rentals and the associated investment opportunity that it represents.
• The Development Market responding to an increase in demand for income producing property as an investment.
• The Land Market that is driven by a need for vacant space to develop further, as supply is outstripped by demand.
All the components are inter-linked and respond to one another until equilibrium is reached between their respective supply and demand curves.
From the above structure it can be seen that the financial asset market, development market and the urban land market respond in a logical knock-on manner to one another, with the rental market responding to external influences from the macro-economy through the demand for space by business. The capital value for property as a financial asset should also logically be derived from rental or income stream as per the income approach to valuation (Ball et al, 1998).
Deriving capital value from income also finds application in the DCF when feasibility models are constructed. In applying this approach in the determination of value, ESP is directly related to the income characteristics and potential of the property itself. Logically therefore, any potential variation in income with the resultant variation in capital value, is regarded as being specific to the property and is regarded as asset-specific risk.
Thus, by not making use of specific index values on rental and capital value, the contentious point discussed under point 5.2.1 earlier on in this chapter, may avoided. The only impact that the market would have on the investment would thus be related to demand in the form of market risk. Since specific risk is either avoided or accounted for through active management, the relationship between the market and the investment through the cash flow is thus limited to general indicator of the behaviour of the market at the macro-scale – rental escalation rates (as demand is met by supply) and capitalisation rates (used in determining capital value as per the income approach to valuation).
Therefore, in terms of the Four Quadrant model, the primary interface between the property market and the investment is the rental market. The need for space in the user- or rental market is however driven by the demand for business. Business activity in turn is driven by the general demand for business.
Therefore, the demand for business can therefore be regarded as an evolution of the initial identified link of property demand between the property market and the investment. The demand for property is thus not direct, but a derived demand from the demand for business. A critical question arises from this deduction: What is the means of measurement that may be used to quantify the demand for business? This indicator must be tested for relevance to both income (rental) and overall return, in order to justify the argument that rental is a preferred indicator from an index to be used in the determination of general market behaviour. If income shows a stronger relationship to the business demand indicator than overall return does, it may be used as a valid substitute and indicator of general market behaviour at the macro-scale.
What follows is a discussion on the relationship between the macro-economy and the demand for business.
5.4 MACRO-ECONOMIC THEORY AND THE DEMAND FOR BUSINESS
In order to determine the relationship between the demand for business and the macro- economy, the theoretical management framework of the macro-economy in South Africa must be clarified, since the logical movement of the macro-economic indicators is largely determined by it. In the development of an alternative benchmark for property returns, the relationships between property index values and the macro-economic indicators will be established.