146 | Page The interaction between property returns and the macroeconomy: Evidence from South Africa Mabutho Sibanda Lecturer- School of Accounting, Economics and Finance University of KwaZulu-Natal, Durban, South Africa E-mail: sibandam@ukzn.ac.za Dr. Richard Mhlanga Director - Graduate School of Business National University of Science & Technology Bulawayo, Zimbabwe ABSTRACT A study on the interactions between property returns and the macro-economy in the UK provides contrasting results with those based on the American economy which forms the basis for this research (Brooks and Tsolacos 1999). This study therefore employs a vector autoregressive models to establish the interactions between macroeconomic and financial variables on the South African economy, a proxy for developing and transitional economies. Property assets have generally been viewed as value-growth assets due to their inflation tracking nature. Values of property-based assets may be measured through direct measures and/or equity-based measures. The two different methods of measuring the value of property-based assets available are shrouded with drawbacks although equity-based measures are theoretically preferred. This study uses direct measures to determine the impulse response functions and variance decompositions on the rate of short-term nominal rates, long-term and short-term interest differentials, inflation rate and household debt/ disposable income in South Africa. Key words: property returns; macroeconomic; vector autoregressive; granger causality; impulse responses 1. Introduction and background Real estate investment and finance has traditionally been classified as an illiquid asset class by portfolio managers. With the evident of innovation and architecture in financial markets however, real estate investments have become more liquid and popular in modern financial economics with the Real Estate Investment Trusts (REITs) and Property Unit Trusts (PUTs) leading the pack. Real estate investments may take different forms such as agriculture, commercial, industrial and residential portfolios. Due to the traditional illiquid nature, it has become axiomatic in financial economics to regard any form of real estate investment as a hedge against inflation. As such, we observe the overinvestment in residential houses by financial institutions on subprime clients in the US prior to 2007. Such investments led to the housing bubble which cascaded to the subprime crisis that was subsequently termed the ‘Great Recession’(Krugman 2009). The trend in financial markets, in particular deposit taking banks, in financing housing projects in the economy drives the academic need to investigate the interconnections between the housing market and the macroeconomic and financial factors. Obviously, we know that financing real estate is part of financial intermediation which entails channeling savers deposits to other participants in the financial system including individuals, businesses, institutions, and governments that want to finance real-estate investments (Melicher and Norton 2011). Financing real estate investments entails the capital formation process which drives the neoclassical economic theory of financial intermediation. Now, South Africa has a well regulated financial market but is not insulated from macroeconomic and financial shocks which have serious repercussions on the housing market. These shocks may emanate from changes in monetary and foreign exchange policies, real per capita GDP, fiscal policy shifts, employment, affordability, political changes etc. We observe that the housing market in South Africa suffered a dip during the 2008-9 recessions, a period when global financial markets suffered a huge slump in investment returns.