It has undoubtedly been the decade of the SA housing market. With the seemingly never ending surge in house prices, since the late 1990s, the attention of financial services firms has been focused on the residential property market.
But over the past two years the attention has gradually shifted to the commercial property market with its exposure to office, retail and industrial property.
Fundamentally linked to the economy's solid growth performance, commercial property finance has offered the players in the market strong returns of late with plenty more to come.
WHAT IT MEANS
 Commercial property offers high returns
Absa CPF is one of the market leaders
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SA's leading banks in particular have benefited from their lending exposure to the market and commercial property finance is becoming an increasingly significant element in their corporate banking activities.
Until about 2000 commercial property funding was often an add-on to the home loans division. This has changed markedly, as illustrated by the history of SA's largest bank Absa.
It only set up its commercial property division - Absa Commercial Property Finance (Absa CPF) - as a subsidiary of Absa Corporate & Business Bank in 2000, when it realised the full potential of the market. It's a decision that has paid big dividends for the banks.
Commercial property finance now contributes an estimated 11% to banks' combined headline earnings, according to a recent analysis by stockbroking firm Nedcor Securities.
In Absa CPF's case, says its GM Rob Jeffery, it is a major contributor to the profits to Absa Corporate & Business Bank and, with a R29,3bn book, accounts for almost half of its assets.
Starting out with a handful of people, including Jeffery, it now has 380 staff and is the second-largest player operating in the market, after Nedbank.
But Nedbank's share has been declining, from 40% to 33% at the end of last year, according to the Nedcor Securities analysis, and Absa CPF is seriously challenging for the top position, building on its 22% share at the end of last year.
Jeffery notes that the market is becoming more competitive as all the banks are vying for greater market share, which has put some pressure on margins.
Still, commercial property generates high returns on equity varying between 25% and 30%, well above those returned in other areas of banking, where returns average around 20%. The home loan divisions of SA's banks, for example, are currently returning 13%-18%, returns that are coming under further pressure from rising interest rates.
Jeffery says Absa CPF has achieved a steady return on equity of about 26% over the past few years, but that this could come under "a bit of pressure" given the more competitive market environment.
The outlook for growth from commercial property activities still remains sound, given that they are less sensitive to the rising interest rate environment than residential property and are less commoditised than home loans.
Nedcor forecasts 15%-20% growth for the sector over the next two years as commercial property finance, despite the rising interest rate environment, has lower upfront costs and often generates fee income from investment and deal structuring activities.
Most importantly though, as fixed investment gradually takes over from consumer spending as the driving force behind economic growth, the commercial property finance divisions should benefit through strong performances in industrial, office and warehouse space in particular.
These trends are already evident. Office vacancies are at 10-year lows on the back of strong economic growth and the steady demand for new space.
Property economist Erwin Rode recently stated that the industrial boom is coming into its own "as industrial rentals are showing double digit year-on-year growth, with vacancies in major cities having fallen to below 3%".
On the retail front rental growth has slowed down slightly, but that is off a very high base - in 2005 capital and income growth from retail investments yielded an impressive 33% total return according to the international Investment Property Databook (IPD).
Though these growth rates have fallen, Rode says "landlords are still gaining the benefits from turnover rental in the solid economic and retail conditions". He expects retail vacancies to remain at about 10% for this year.
Even the commercial property division's investments in residential property developments are somewhat shielded from the current slowdown in home prices: the bulk of their lending goes to sectional title developments, which are still showing relatively strong growth being underpinned by the demand for secure housing and from strong demand from the black middle class.
Of the major banks, Absa is recognised as having the most diversified approach to commercial property and operates in all areas of the market, with perhaps a slight bias towards the residential market.
Of its R29,4bn book in June, R9,2bn represents development loans with the balance being investments loans split as follows: R0,5bn in residential projects; R7,5bn in retail; R7,5bn in industrial; and R4,7bn in office projects.
A key strategy applied by Absa CPF has been the segmentation of its market by both size of clients and segments.
At the top end of the market this has led to the establishment of two divisions that look after the listed property sector and key accounts - the bank's top 50 clients.
Both these divisions are staffed by consultants who ensure that these customers get a devoted service and that products and services are tailored to their unique requirements. One consultant looks after no more than seven or eight clients.
"We have found that the one-size-fits-all approach doesn't work for these customers. They operate in niche areas that require a hands-on approach; it is vital that our consultants know the business almost as well as their clients do," says Jeffery.
Structured finance products are more common in this area and the fee income as a portion of total income is higher, given that the services are also more specialised.
Apart from lending to listed companies, Absa CPF also funds black economic empowerment transactions - these include some high-profile deals over the past few years, headed by the BEE equity deals for Growthpoint and Pangbourne.
In the midmarket Absa CPF has segmented its market by client size with divisions looking after large and medium-sized customers.
This is determined by the amount of business they do with the bank on a regular basis, irrespective of whether the clients operate in the office, retail or industrial arena.
For these customers Absa offers a range of debt products that are common across all customers. Its medium-sized client base - where loans average around R2m - is about 10 000 strong and, unlike many of its competitors, Absa CPF has a strong nationwide footprint thanks to its links with Absa Corporate & Business Bank.
With lending to the residential property market accounting for almost 40% of its book, Absa CPF runs a specialised division catering for this market, which comprises primarily lending to sectional title projects such as townhouse and cluster home developments, but also includes leisure developments such as golf estates.
Absa CPF is also viewed as a leader in funding affordable housing with developments such as Cosmo City in northern Johannesburg and Brickfields in Newtown cementing its reputation as the pioneer in this fast growing segment of the market.
"We have developed a specialist development finance team that has proven to government that we are able to deliver viable low-income housing products," says Jeffery.
Performing in the affordable housing market is crucial for Absa: not only because it's an expanding market but also because it helps meet the bank's obligation under the financial sector charter. Of the R42bn the commercial banks have committed to low-income housing under the charter, Absa is responsible for 32%. Apart from Absa CPF, the retail bank's DevCo division also operates in that area.
Income growth by Absa CPF is split roughly two to one between lending and fee income. Lending in the commercial property sector normally takes the form of debt secured against the underlying property, or may be structured and include fee portions.
Off balance sheet lending (such as securitisation) does arise as banks manage the size of debt on their balance sheets. Absa CPF is recognised as the market leader in mortgage-backed securitisation for listed property stocks, having been involved in five issues since 2004.
The bank also derives interest and dividend income from its sizeable property investments in listed property stock and equity exposure to a number of strategic unlisted investments and joint ventures with selected developers.
Turning to cost management, Jeffery says Absa CPF's cost to income ratio is running at about 12% - the lowest in the sector - and is improving as a result of better efficiencies on the back of higher advances and profits per staff.
"As margins are coming under pressure from higher interest rates and more aggressive strategies by our competitors it is crucial that we continue to focus on our cost and productivity ratios," he says.
A more aggressive competitive landscape is only one of the many risks facing the commercial property market. Higher interest rates inevitably put a squeeze on margins but they also have an indirect impact in that they curtail economic activity in general.
As it is, other buyers are entering the market - the Public Investment Corporation and institutional investors - putting a further squeeze on the demand for physical properties.
Banks are also facing stricter regulations with the introduction of the Basel 2 capital adequacy requirements, which will force them to allocate appropriate assets to match the risk of lending liabilities.
"We have recently completed our grading model," Jeffery says. But he adds: "Our book is of a good quality and the level of risk applicable could actually result in reduced capital requirements." The quality of the book is underlined by Absa CPF's low bad-debt levels.
Like other banks Absa CPF is feeling the skills shortage, particularly of suitably qualified black professionals, which limits the amount of business it can take on. "There is a lot of poaching of staff at present and it requires that we spend a lot of time making our staff feel comfortable and rewarding them appropriately," says Jeffery.
There is also a lot of emphasis on training to ensure that more skills are entering the market.
Absa's acquisition by Barclays in 2004 has afforded Absa CPF the opportunity to expand into Africa.
It is already providing consulting services to Barclays on a number of transactions, but Jeffery believes that Absa CPF's role will grow with Absa's expansion into Africa. Absa already has offices in Tanzania, Angola and Mozambique and, combined with Barclays, has a footprint in 17 countries on the continent.
Kelly Clinton, who heads Absa CPF's African operation, says the bank has about US$150m of debt invested in Africa with a further $300m in the pipeline for next year.
Because of the risk and the high costs involved, he says, projects are "conservatively geared" and the group works closely with the developers. Its largest project on the continent is the Eden Island resort in the Seychelles, in which an SA developer is involved.
