Property Fund – Thoughts on SA listed property

By Nedgroup Investments

Despite a Q4 rebound of 23% for the local property sector, the SA Listed Property Index is still down 35% for 2020. Ian Anderson from Bridge Fund Managers, Portfolio Manager for the Nedgroup Investments Property Fund, illustrates the differentiated proposition within the Fund and how it is positioned to take advantage of the current environment.

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What happened in 2020?
Last year represented the lowest annual income return from SA REITs, not just the yield, but also the benefit, or lack thereof, of reinvesting the income as it’s declared. Last year’s annual income return was below 6% for the first time in the history of the sector. The yield expectation at the start of 2020 was for that return to be at least 10%.

Not only did the sector produce the lowest annual income return, but also the worst capital return in the history of the sector. On a total return basis, the sector lost about 35% of its value. Not only was 2020 a difficult year for listed property, but so was 2018 and 2019. This shows that the sector wasn’t derating or correcting previous inflated levels. We’d already started to see a period of significant underperformance with most of the sector trading at substantial discounts to net asset value at the start of 2020. One of the reasons we had such a strong return in Q4 was because a lot of the selling had been overdone.

There was a tremendous amount of volatility in 2020 as well. If you’d only been invested in Q2 and Q4 of 2020 and were sitting in cash in Q1 and Q3, your return from listed property would have been close to 50%. The big negative moves happened in both Q1 and Q3, with the Q1 move down over 50% with the sector unable to make that up during the remainder of the year.

Big issues in 2020 that impacted the sector
The most pertinent issue was the strength of the balance sheets or quality of the businesses with regard to their capital structures. It was incredibly difficult to raise capital in 2020 as had been the case for the last few years when prices were falling. Valuers started taking a harder look at what future rents and future vacancy rates were likely to be, so there was a devaluation of properties, which pushed loan to value ratios to much higher levels. In some cases, companies were in breach of their debt covenants with their banks and needed to preserve cash.

They couldn’t raise cash through additional debt or equity so had to lower their dividend payout ratios. There is a minimum dividend payout threshold of 75%, so although the payout ratios reduced, they have not gone below 75%. Most REITs took advantage of this opportunity including those who delayed dividend payments. The JSE gave companies, REITs in particular, dispensations to delay the payment of their dividends by up to 2 months. A couple of REITs in the Nedgroup Investments Property Fund like Octodec and Dipula didn’t declare any dividends in 2020 but expect to in 2021.

Another big issue was their ability to collect rent, particularly during the height of level 4 and 5 lockdown, where many tenants were unable to generate revenue and weren’t in a position to pay rent. Rental collection rates dropped from 95% - 100% to between 40% and 60% in April/May. This has since improved and collections are now closer to 80% and 90%.

SA REIT dividends fall 40% in 2020
The combination of lower payout ratios applied to lower distributable earnings meant that the sector saw just more than a 40% reduction in dividends. People will say this if the dividends were down 40% that justifies the price being down 40%. But remember that this is just the dividends that are being applied to 75% of distributable earnings. So, the earnings from these businesses didn’t fall anywhere near as much. Many of the companies didn’t actually pay any dividends, which is included in the umbrella 40% reduction. This probably highlights the reason why we saw a strong recovery in prices in Q4 because again share prices fell substantially more than the fundamentals warranted. The companies were still generating reasonable earnings albeit that dividends were much lower.

2020 Performance of SA REITs
Within the REIT universe, not every company generated a negative return. The two biggest companies that we own in the Fund, Safari and Fairvest, were both able to generate positive returns in 2020. Some of the other businesses we own and where we have fairly substantial positions like Stor-Age, Equites and Indluplace, also did well despite producing negative returns. Safari, Fairvest, Stor-Age, Equites and Indluplace make up almost 45% of the Nedgroup Investments Property Fund today and play into the themes that are relevant not just in 2020, but into 2021. 
Fund performance in 2020
One of the Fund’s objectives is to provide an income return significantly above that of the market and we were able to do that returning 9.5% against SA REITs at 5.3%. This is not the yield of the portfolio, but the yield together with the reinvestment of that income. As a result of the very strong run in Q4, all of the income that had been invested in Q2 and Q3 benefitted from a strong capital increase. Importantly, from a capital return perspective we were able to deliver a better capital return albeit a very negative return (-39.1%), meaning that from a total returns perspective we outperformed the market by about 8.5% in 2020. A big chunk of that came from the fact that we produce a much higher level of income and the benefits of reinvesting that income.

Current positioning vs SAPY
The Fund was able to differentiate itself in 2020 by playing to the themes that were not just pertinent in 2020 but will be relevant for the next 2-3 years. We have much lower retail exposure than the market and importantly the retail exposure is very different. Our office exposure is a lot lower than the market and is predominantly in government tenanted offices. We know that the government is not thinking about working from home or reducing office space whereas the rest of the sector is. We also have very high exposure to storage through our investment in Stor-Age and high exposure to residential, which will also be a beneficiary of more people working from home. This certainly helped the share price of Indluplace in 2020. We believe there is still significant upside potential from this point for residential and we have therefore maintained a reasonably high weighting in this area.

One of the big problems with South Africa’s listed property sector is just how much exposure there is to the two sectors that were most impacted by the pandemic, namely large format retail (regional shopping malls and super regional shopping malls) and office. 77% of the SA listed property market is in those two sectors. Unfortunately, this means if you are going to hug the benchmark, most of your exposure is going to be in the two most at risk sectors over the next 2-3 years. The Fund’s portfolio therefore continues to look very different to the overall market.

Current Retail positioning vs SAPY
The exposure in the Nedgroup fund is dominated by small, rural and community shopping centres where the bulk of the tenants are considered essential services or sell essential products and most have remained operational throughout lockdown. That exposure is mainly through the two businesses that produced positive returns in 2020, being Fairvest and Safari, and they continue to do well in 2021. In January, the Fund is outperforming the market by another 6%, mainly on the back of this particular exposure. 42% of the SAPY retail exposure is in regional and super regional malls, which is under huge pressure.

Outlook for 2021 and beyond
Working from home is unfortunately continuing to gather momentum with a larger portion of people moving to working from home since Q3 2020. This is a global trend affecting South Africa, which will continue past the pandemic with people wanting to work from home for at least 3 days a week.

In terms of valuations, the share price declines that we’ve seen over the last three years have been overdone. We know there are tremendous headwinds for this sector, but while property prices have fallen, share prices have fallen by significantly more with significant discounts to net asset value. We believe that those discounts are likely to narrow in 2021 and 2022 as the economic recovery gathers momentum and will be as a result of share prices moving up.

In terms of the outlook for income from the sector and the portfolio, we anticipate a strong recovery from a very low base in 2021. The forecast risk remains elevated and we cannot predict payout ratios, but they are likely to remain low for at least 2021 and possibly 2022. Some companies may opt to forego their REIT status, but think the probability is very low. Our outlook for 2021 and beyond is reasonably positive, not because of a significant change in fund fundamentals, but because the valuations look so attractive and the yield on the portfolio is well in excess of 10% today.