Despite a fair amount of upheaval, the SA Listed Property sector survived the Covid-19 pandemic, only to emerge into a world of intensified loadshedding and higher global interest rates. Many moving variables remain, which makes it timely to take stock of South African Real Estate Investment Trusts (REIT) as we explore the good, the bad and the ugly of the challenges and opportunities facing the sector.
The good news
During Covid-19 and the largescale non-payment of rental, concerns surfaced that some SA REITs would not survive. However, this has not transpired – bar some small counters already in danger before C-19. In hindsight we take this outcome for granted, but it is worth remembering that, at the height of the pandemic, many REITs were priced for bankruptcy.
Important fundamental measures have stopped deteriorating. Still negative overall, rental reversions are progressively turning positive. Market rents have reset lower to reflect the new economic reality and some, above market, legacy leases still need to expire, which will impact the numbers when they do. This dynamic is most evident in the retail sector, where tenant affordability ratios (the ratio between sales/income and rent) – already overstretched before C-19 – are now at much more affordable and sustainable levels. Modern warehouses remain in demand and this, together with elevated construction cost inflation, should feed through to higher rentals on existing stock.
Planned construction of offices and shopping centres (except in underserviced areas) has, in recent years, slowed dramatically. Less new supply is good news for existing assets as it removes a driver of higher vacancies on existing space and allows any increase in demand for space to benefit existing buildings.
Many REITs did not allow a ‘good crisis go to waste’ following the pandemic and used the opportunity to become more conservative regarding the extent to which they pay dividends. In the heady days, REITs maximised their dividends, often paying out more cash flow than they generated as they did not retain the cash required to fund capex in the ordinary course of business – relying instead on rising asset values to cover overpayment. Today, many funds do not pay everything out as a dividend. Furthermore, the industry is now more conservative in how it calculates earnings, with fewer funds engaging in practices which boost short-term earnings (hence the dividend), often at the expense of the balance sheet and dividend level sustainability. Consequently, one cannot compare the dividend yield today to that of a few years ago. The forward dividend yield for a basket of SA REITS at time of writing is around 10.5%. The spread between this yield and that of the government benchmark bond yield is close to the average spread over history, despite the dividend now reflecting less than 100% of earnings. In our process we concentrate on the sustainability and expected trajectory of earnings and the risk-adjusted fair value of these earnings, not the dividend yield per se.
Based on the market-implied value of its buildings per square metre, SA listed property is very cheap. They are trading at a fraction of replacement costs. A residence is likely worth many times more per metre squared than the implied value of SA REITs, which include the bulk of the country’s prime investment grade assets. Unfortunately, you cannot live in a share certificate.
The bad news
We know that interest rates have risen. This is cyclical and a bad environment for property as it lowers the value of properties, due to the opportunity cost of capital being higher, and also reduces earnings due to higher interest costs. This may undermine what otherwise could have been a stabilisation or slight growth in earnings.
The office market, especially in Gauteng, is heavily oversupplied. Although this is old news, it is hard to call the bottom. Offices are only a small component of overall SA REIT exposure and the wider impact of this should not be over-estimated.
In our view, direct property values are overstated, resulting in direct property valuation yields (as determined by professional property valuators) being too low relative to those of SA bonds given the current environment. For listed property investors this is less of an issue as the stock market does not imply these Direct Property valuations. SA REITs trade at well-below book value so investors are not paying ‘book’ price as determined by the valuators. Nonetheless, if direct property valuations were to come down to what we regard as a more appropriate level, gearing ratios would look less healthy requiring some funds to have to take dilutive remedial action.
The ugly news
Exit Covid, enter loadshedding – some properties being more impacted than others.. For example, the efficacy of solar installation as a solution for loadshedding, depends on the size and structure of a building’s roof area. Large and wide horizontal dimensions like warehouses can potentially benefit by selling off the excess solar power they generate. High and narrow roof dimensions, such as tower block offices and multi-level shopping centres have more of a challenge. In addition, having many common areas – such as in the case of multi-let offices and enclosed malls – is a problem as these structures make it difficult to recover solar installation costs from tenants. Buildings with few common areas like single-tenanted offices and strip malls are less likely to face this issue. Solar still requires the grid to operate and doesn’t negate the need for expensive generators or batteries.
Then there is the issue of mitigation costs. It's not just the cost of diesel that needs to be considered, but also the cost of maintaining generators, which are designed for emergencies and not repeated use. It can be difficult to pass on this maintenance cost, as opposed to the variable cost. There are also secondary costs, with the distress caused to businesses compromising their ability to trade and pay rent, and consumers likely channelling income to devices to counter loadshedding that may have otherwise been spent in the mall. This weakens the entire economy. The secondary effect could be more severe than the primary effect.
The collapse of municipal service delivery in many areas is well known. Property companies are having to pay for services otherwise provided by the municipality or state. Rates and taxes to fund this non-delivery have been rising at a rate well-above inflation over the past decade and this has compounded. As tenants ultimately pay these costs, it pushes up occupancy costs, significantly reducing the rent that landlords can charge and pricing otherwise viable small-business (and larger business) tenants out of the market. In many cases a shopping centre is one of the major entrenched enterprises in a district and can’t just pick up and leave. It therefore becomes an obvious target for revenue collection in financially distressed councils who can dictate rate tariffs.
Chill winds are also blowing in from the rest of the world. The sharp rises in developed market interest rates, combined with jitters in banking, have caused concern around the ability and cost of property debt refinancing in the US and Europe. This could result in property repossession, distressed sales, equity raises, dividend cuts and falling prices, as potential buyers can’t get finance and banks try to offload unwanted collateral. The South African property market is fortunately sheltered from the direct impact of this dynamic because our interest rates have not proportionally increased by as much and our banks are solid with no banking jitters. However, SA REITs are invested offshore, and some contagion is possible were this scenario to develop globally.
The crux of the matter
What do we make of all of this? Outlooks are rarely clear and easy. At OMIG, our investment team evaluates each asset class using a consistent investment methodology which we call Theme & Price. Based on this, we believe that had interest rates not increased, the global environment remained benign and there was no loadshedding, we could have seen a clear roadmap to a general SA commercial property operational recovery post the Covid pandemic (subject to the fate of the domestic economy). These are not the cards we have been dealt. Property is a long-term asset, and one needs to look beyond the medium term. Interest rates fall as well as rise, loadshedding may end (and/or SA and companies invest in mitigation and adaptation), and global credit markets will eventually normalise. Despite still being at the mercy of the domestic economy and factors beyond its control, many SA listed Property fundamentals are healthier than they were before Covid-19 and therefore the sector is well positioned for improvement when it arrives.
Against this bumpy backdrop, the Old Mutual Listed Property Fund continues to hold its own. The Fund outperformed its benchmark over the past 10 years, five -years, three years and 12-months, having been positioned conservatively for economic and consumer stress, avoiding high gearing, financing and operational risk, and holding quality companies. As always, we are focused on the long-term and by taking account of the team’s Theme & Price input mentioned above, we managed to avoid a number of ‘value-traps’ during the pandemic. The fund’s longer-term annualised performance is testament to this approach. Despite the challenges the current environment presents, the fund remains invested in meaningful positions in a diversified selection of property shares that we believe offer the most long-term value, as we continue to be mindful of the relative outlook, risk and changing environment for the listed property sector.