Chapter 10: Equity and property markets Flashcards
What are the characteristics of ordinary shares i.e. equities?
Characteristics of ordinary shares (equities)
- Ordinary shares (equities) are securities held by the owners of an organisation
- Small company all equity shares may be held by few individuals or institutions
- In large organisations may be many thousands of shareholders
- Ordinary/equity shareholders have right to receive all distributable profits of a company after debtholders and preference shareholders have been paid
- Right to attend and vote at general meeting of company
Cashflows
- Distribution of profits to shareholders takes form of regular payments of dividends
- Dividends are related to company profits that are unknown, divided rates are variable
- Company profit increases then dividends per share increases
- THUS, to construct cashflow schedule for equity it is necessary to make
assumption about growth of future dividend - AND, entries in cashflow schedule are uncertain – estimates not known quantities
- Sometimes, companies hold back some profits to provide funds for new projects or expansion
- May also hold profits in good years to subsidies dividends in years with worse profits.
- Payout ratio (proportion of profits distributed as dividends) = dividend per share / earnings per share
- Companies may distribute profits in manner other than dividends – buying back shares issued to investors
- Equities do not have fixed redemption date – can be assumed to continue indefinitely UNLESS investor sells shares or company buys back
- Important to bear in mind risk that company will fail
- Dividend income will cease, and shareholders will only be entitled to any assets remaining after creditors are paid
- Dividend income is highly uncertain
- Directors try pay steadily increasing stream of dividends
- Dividend policy will specify how annual dividends are determined
- If wound up may result in investor losing initial capital investment
What are the investment and risk characteristics of equities - SYSTEM T
Investment and risk characteristics
- Security
Depend on company issuing shares
Depend on stability of company’s profits and ratio of earnings to dividends
If wound up – shareholders will receive the residual assets after all creditors have been paid
- Yield – real vs nominal
Equities provide real yield over long term – because profits tend to rise with inflation and economic growth and hence so do dividends
BUT hedge is a loose one – no guarantee of inflation protection
- Yield – expected return relative to other assets
Equities perceived as riskier than bonds – expected to give higher return to compensate
Depend on company issuing shares/ bonds
- Spread – volatility of capital values
Equity prices and dividends can be volatile
Price of individual equity shares is determined by interaction of supply and demand
Most important basis when deciding price for a share is an assessment of its value based on the present value of future dividends
- Term
Held perpetuity
- Expenses
Costs of dealing in equites are closely linked to marketability
Dealing expenses generally greater than for bonds – depends on marketability of stocks being compared
- Exchange rate – currency risk
Equities are available in many overseas countries
Will be currency risk for investor investing in equities denominated in one currency but who has liabilities denominated in another
- Marketability
Varies enormously between companies
The larger the company – better the marketability
BUT if few investors hold large proportion of the shares in a company the marketability could be low
- Tax
Income and capital gains from quoted and unquoted shares may be taxed differently
Different investors will often pay differing tax rates upon income and CG
What are quoted or listed share?
Quoted/ listed shares
- Most equity investment is in shares that are listed on a stock exchange
- To obtain listing, companies have to comply with the stock exchange’s regulations – which give investors measure of protection
- Regulations usually relate to financial reporting and disclosure of info
- Equities not listed on a stock exchange not subject to same degree of regulation – may be considered less secure and more risky investment
- Listed shares generally more marketable than unlisted ones – easier to value because meaningful market value can usually be ascertained
- Quoted shares are bought and sold in easily divisible chunks-divisibility
How is equity categorised and why?
Equity categorisation
Shares may be classified by size of company, expected profits growth or industrial sector
Categorisation by industry
- Equity analysts often specialise in an industry and confine their research and advice to the relative merits of companies within that group for:
Practicality
Correlation of investment performance
Practicality
- Investment analysts specialise within particular investment sectors because:
Factors affecting one company within an industry likely to be relevant to other companies in same industry
Much of the information for companies in same industry will come from common source and presented in similar way
No single analyst can expect to be an expert in all areas – so specialisation is appropriate
Grouping of equities according to commo factor gives structure to decision-making process – assists in portfolio classification and management
Correlation of investment performance
After adjusting for overall market movements – share price movements of companies within industrial groupings tend to correlate with each other than with companies in other industries
Share price movements reflect changes that have occurred in operating environment
These changes affect companies in individual industries in similar ways
For this reason, listings of share prices are often sub-divided by business sector
Major markets have separate indices for different sectors
- Factors affecting one company in a sector that are relevant to other companies in the same sector include:
Resources- companies in same sector use similar resources and therefore have similar input costs
Markets – companies in same sector supply same markets and therefore be similarly affected by changes in demand
Structure – companies in same sector have similar financial structures and therefore be similarly affected by changes in interest rates
What is prime property?
Property investment – a prime property
- Property that is most attractive to investors is called prime
- Prime property would score highly on all of the following factors
Location
Age and condition
Quality of tenant
Number of comparable properties available to determine the rent at rent review and for valuation purposes
Lease structure
Size
What are the characteristics of direct property investment - SYSTEM T
Characteristic of direct property investment
Nature of return
Real asset – expected to provide a hedge against inflation
Real means property returns move broadly in line with changes in inflation
Owners of property should be able to increase rent in line with inflation – so real value of rent is not compromised
Cashflow pattern
Leases are for fixed terms with relatively infrequent rent reviews
These may be upward only
Therefore, income stream might increase in steps every few years
For property that is rented at level above current market rents – income stream may be fixed for many years
Lease agreement will have periodic reviews of the rent
Upward only rent review – level of rent cannot be reduced at any review
Running yield (rental yield) on property varies with the type of property – tells us how much of the return is given though income as opposed to through capital growth
Running yield = rental income (net all management exp) / cost of purchase (gross of all purchase costs)
Different types of property exhibit different risk characteristics
Predictability of future rental income and expenses will vary depending on type of property and occupying tenant
More risky types of property will generally offer higher running yield
Marketability
Direct property may be very unmarketable
Can take long time to buy and sell and dealing costs are high
This is because of following characteristics of property:
- Unit size – unit size of most investment property is large and, generally single properties are indivisible – may prevent smaller investment funds from investing in property or lead to them investing in property indirectly
- Uniqueness – each property is unique – makes it harder to value individual properties and reduce marketability
- Valuation – property valuation is matter of professional judgement and there is no central market with quoted property prices – valuations may be significantly different by different or same valuator
Security
Security of income depends very much on the quality of tenant
Rent payable by company is a prior charge on its profits BUT costs of recovery from tenants in arrears can be high
Risk of voids – periods when the property is not let thus no income received
Possibility of void periods must be allowed for in estimated expected return on a property
Other risks which compromise security – obsolescence and intervention
Obsolescence – land is virtual indestructible, and buildings normally have long life if maintained in good condition, but
buildings can suffer from obsolescence – slowdown in relative rate of growth in value between old and new buildings
Expenditure on modernisation becomes necessary
The cost of refurbishment is major expense of property management
Obsolescence arises when building becomes out of date and is no longer of use to potential tenets
So even if average property values rise in line with inflation, value of particular building may fall in real terms
Property is susceptible to government intervention such as rent and planning controls – may limit supply of property
Spread
Capital values of buildings can be volatile over longer term – but frequent valuations and stable valuation methods reduce short-term volatility
Because land is indestructible – good site will always have value
Property values tend to move in cycles -lagging behind general economic cycle as supply is slow to respond to changing economic conditions
Usually determined by reference to expected flow of rental income – which is relatively stable
Stability may enhance attractiveness of property (for investors who prefer stable asset values)
Yield
In comparison with index-linked government bonds property is less marketable and less secure
Investors expect higher return from property
Expenses
Property management costs are high – although tenant is often responsible for building maintenance and insurance
High expenses involved with buying, selling and ongoing management mean that for most investors property is long-term commitment
Investment characteristics can be changed by owner
Possible for investment characteristics of individual property assets to be substantially changed by owner
Example: redevelopment of an existing property or re-negotiation of a lease with a tenant
How can indirect property investment avoid disadvantages of direct property investment?
Indirect property investment
- Many disadvantages of direct property can be avoided by investing in indirect property arrangements
- Disadvantages of direct property investment include:
Size – too big for most investors to afford
Diversification – many properties needed to create well-diversifies property portfolio – the size of each investment might make this impractical for smaller funds and individual investors
Lack of marketability – time taken, and costs associated with buying and selling make properties unmarketable
Valuation – property values are never known until sale – estimating values can be expensive
Expertise needed – much of the profit to be made through property investment comes through detailed local knowledge – many investors don’t have this
What are pooled property funds and property company shares?
Pooled property funds
Many vehicles exist for pooled property investment
These vehicles normally have constitutions that specify types of property that they can invest in, limits on liquidity, management charges
Property company shares
Exposure to real property can be gained by investment in shares of a property company
Property companies can be property developers or investors
What are listed JSE REITS?
Listed JSE REITS
The JSE lists real estate investment trusts, which are companies that manage, operate and own a real estate portfolio consisting of income-producing property
Largest property companies can invest in very large properties which may even be beyond the scope of many smaller pooled funds
Property company has no restriction on the investments it can make or management expenses it can incur
Larger property companies also invest in property developments – which carry greater risk than investing in existing building with existing tenants
Investing in property development adds risks associated with building and establishing a new property, like:
- Delays in time to completion
- Over-run in estimated building costs
- Ability to find tenants at expected rental income
For this reason, investors in property development require higher yield on investment when compared to established, existing buildings
Hence investment in property VIA property company shares provides investor with access to properties that they would not otherwise be able to invest in, either directly or via pooled funds
Examples: very large properties and property developments
Normally property shares stand at discount to their underlying estimated current net asset value
The discount to NPV reflects:
- Any difference between way in which investors value shares and way they value property
- Risk of loss on forced sale
What are listed JSE REITS?
Listed JSE REITS
The JSE lists real estate investment trusts, which are companies that manage, operate and own a real estate portfolio consisting of income-producing property
Largest property companies can invest in very large properties which may even be beyond the scope of many smaller pooled funds
Property company has no restriction on the investments it can make or management expenses it can incur
Larger property companies also invest in property developments – which carry greater risk than investing in existing building with existing tenants
Investing in property development adds risks associated with building and establishing a new property, like:
- Delays in time to completion
- Over-run in estimated building costs
- Ability to find tenants at expected rental income
For this reason, investors in property development require higher yield on investment when compared to established, existing buildings
Hence investment in property VIA property company shares provides investor with access to properties that they would not otherwise be able to invest in, either directly or via pooled funds
Examples: very large properties and property developments
Normally property shares stand at discount to their underlying estimated current net asset value
The discount to NAV reflects: (net liabilities and net intangible assets)
- Any difference between way in which investors value shares and way they value property
- Risk of loss on forced sale
