The beleaguered SA Property sector is starting to show sign of life

The South African (SA) property asset class has been in the doldrums for longer than most investors would care to remember. The sector has been at the sharp end of SA’s tepid macro environment and then to add insult to injury, Covid exacerbated - the situation. But things are starting to look up, the sector is beginning to pick up off this low base.

In this note, we will consider the sub-sectors we believe offer the best potential for out-performance. We will also discuss two of our larger holdings, NEPI Rockcastle and Stor-age, and show our fund’s performance against the benchmark and peer group.

Our investment approach | Sub-sectors on a look-through basis

Given that several listed property counters are themselves a combination of various sub-sectors and to complicate matters, also have crossholdings in other property companies, we thought that an interesting starting point would be to show our major sub-sector exposures – on an estimated, look-through basis.

From an SA perspective, our largest exposure is to retail as we see this sub-sector recovering now that the downward rebasing of rentals is mostly completed. We anticipate landlords being able to, once again, participate in any sales growth achieved by their tenants. This is typically achieved in two ways, either via turnover clauses in the leases which ensure a direct pass-through of sales growth into rental increases or upon lease renewal, the new rental negotiated will, to a major extent, be a function of their tenants’ turnover.

Regarding the office sector, the fundamentals remain relatively depressed, but we continue to hold exposure given that any recovery would be off a very low base. From a regional perspective, we are far more positive on the Western Cape, via our holding in Spear – a REIT which is only exposed to this region. Our Industrial exposure is mainly via the storage sub-sector and it is discussed below, where we unpack the investment case for the Stor-age REIT.

First, we will share the investment case for NEPI Rockcastle, our largest holding. It is worth pointing out that our fund has strong rand hedge qualities with an estimated 56% exposure to predominantly global retail.

NEPI found an opportunity and capitalised on it – an undersupply of modern retail centres in rapidly growing post-communist CEE countries. Two factors were behind this; first was the strong catch-up economic growth in these countries off a low base, much more rapid than in developed Europe and second was the accompanying convergence of consumer habits and aspirations towards Western European living standards – preferences which resulted in strong retail sales. In many post-communist countries, there was little attractive retail space and no ‘high street’ to compete with, meaning that modern shopping centres faced little formal competition. What set NEPI apart was that it became a major developer and did this profitably. These modern developments attracted a queue of retail tenants looking to penetrate these untapped regions. As a result, NEPI tends to own the best and most dominant shopping centre in a large catchment area.

Macro picture

These macro trends continue to hold albeit at a slower pace as there is now far less scope for new retail developments. For example, 2024 gross domestic product (GDP) growth in CEE is forecast by the European Commission to be in the order of 2.6% compared to the much more pedestrian 1% expected across the broader European Union.  NEPI’s last reported like-on-like net operating income growth was a respectable 13% (in Euros) with base rentals increasing by 18%. This was in the context of tenant sales increasing by 13% which is unusually high given the post-Covid base effect and elevated inflation over the period.  That said, NEPI has typically reported tenant sales growth of around 5% historically which we believe is a more realistic but robust, long-term forecast.  It is also worth pointing out that the region has demonstrated real resilience despite the Ukraine conflict.

Investment case

Valuation has always been the cornerstone of our philosophy and based on this approach, NEPI is attractive, especially on a risk-adjusted basis. According to our calculations, the business currently trades on a forward euro distributable income yield of 8.4%. NEPI’s current policy is to pay out 90% of this as a dividend – from an SA investor’s perspective, this yield will tend to increase should the rand devalue against the euro. We believe that this yield is sustainable as leases are generally indexed to inflation given that the business operates in an environment of proven sales growth – furthermore, the counter currently trades below its net asset value – albeit at a smaller discount than its European peers.

Looking forward

NEPI has a development pipeline of €652 million which is likely to provide additional earnings and value enhancement. That said, we do anticipate that higher European interest rates will negatively impact earnings as debt expires over the coming year which will require rolling into more expensive loan facilities. Online retail continues to be a structural threat to all brick-and-mortar operators, but reassuringly, the business has historically shown decent sales growth through periods of rapid increases in online shopping. In conclusion, NEPI is guiding for 4% growth in euro distributions in 2024 off the high base of 2023.

Looking at chart 1 below, it is pleasing to see that NEPI’s total return and earnings per share are now well ahead of pre-Covid levels, producing calendar returns of 11.4% and 39.6% in 2022 and 2023, respectively.

Achievements post listing

Through greenfield developments and some acquisitions, Stor-age has grown into SA’s undisputed dominant storage brand with an unrivalled digital platform. Scale advantages are everything in this business as there is considerable churn among customers given the nature of these small individual value leases.  Stor-age has managed to create a highly competitive moat in this fragmented market by offering state-of-the-art, secure facilities, in convenient urban locations, whereas most of the competition tends to be ‘low-spec’ operators in far flung areas.

Management’s initial claim that this sub-sector would be economically defensive has proven accurate, given their resilient performance during Covid. As an aside, we were sceptical of this listing claim, but we are happy to be proven wrong.

Investment case

Relative to the currently elevated SA government bond levels, Stor-age is not cheap at a forward yield of 9.7% and price to book of 0.88. However, we are prepared to pay up for quality opportunities, especially given that management has been able to progressively increase rentals comfortably above inflation. More recently Stor-age has also expanded into the United Kingdom (UK) where they bought a storage company and platform from a private equity company.

From our calculations, we estimate that the UK business now contributes a substantial 42% to earnings before interest and tax. This has established a good base for continued growth which they are further supplementing via the marketing of their digital platform expertise to third-party operators.

Chart 2 below illustrates how important stable dividend distributions are to property counters. On a price return basis, the return post the 2015 listing appears pedestrian, from R10 to R14. Nevertheless, on a total return basis, R100 invested at listing would now be worth approximately R227, a cumulative return of 127%.

Performance 

Over the last decade, our fund has consistently beaten the FTSE JSE benchmark and is ahead of the peer group top quartile (25^th percentile), as shown in chart 3 below. There has also been pleasing persistence to the peer group outperformance over the ten-year period given that our rolling five-year return has never been below the median and 77% of the rolling five-year returns were 1^st quartile.