In 2017, the SA listed property sector had enjoyed 15 years of a super bull run, returning 18 times your money and outperforming local equities and bonds.
Since the beginning of 2018, these returns have been unwinding and have tainted people’s perception of this universe. Ian Anderson of Bridge Fund Managers, Portfolio Manager for the Nedgroup Investments Property Fund, sheds some light on this and the case for SA listed property as a credible asset class and a good component of a diversified investment portfolio going forward.
The dynamics of SA listed property relative to the global market
The key difference between the local and global real estate market is the choice you have globally. 75% of the SA listed property index is dominated by retail and office with retail dominated by super regional and regional malls, which are under tremendous pressure right now. When investors look at the overall SA market, they predominantly see the property types that are under pressure. While there is a growing industrial/warehousing component, residential and self-storage exposure is very low and we don’t have many data centres or other property types that have benefitted from the pandemic. The SA property market has suffered significantly more than other global markets because of the make up at an index level. There are, however, specialist REITs outside the largest companies in the index that offer compelling long-term value for investors because they will remain relevant.
The drivers of the super bull run prior to 2018 and the current position
There was a tremendous rally in the SA listed property market after the global financial crisis (GFC) from 2010-2017 driven primarily by strong distribution growth built on strong rental growth and little to no supply. This was followed by sudden, strong demand that drove up market rentals, an increase in consumer spending in South Africa and slightly stronger economic growth. From 2015-2017, a number of SA property companies took advantage of very cheap debt in Europe, buying properties particularly in Central and Eastern Europe. This allocation is now almost 30% of the SA listed property market, with the bulk of that exposure in retail property such as large shopping centres.
The distribution growth generated between 2015 and 2017 was primarily driven by being able to borrow money at 2% and acquire property at 7%. A growth of 30%-40% in dividends became almost the norm. In the meanwhile, the capital and corporate structures of these businesses were becoming increasingly more risky. However, this was exposed at the start of 2018 with the Resilient Group of companies and their negative cash flows, which led to almost R1 billion worth of market capitalization wiped off that group. A few months later, very poor economic growth in South Africa had a very negative impact on property fundamentals. From the second half of 2018 to 2020, we saw a decline in property values in South Africa, an increase in vacancies and a drop in market rentals across most property types, except for warehousing and self-storage. We went into the pandemic in far worse shape than the global property market, which is why the SA property market is down over 50% for 2020.
Are there pockets that are not under pressure?
There has been a lot of success in non-urban stores with 20% growth reported during the pandemic. Globally, we’ve seen strong growth in self-storage rentals and although we haven’t seen that growth here, we shouldn’t see any decline in values. The inner city is a huge opportunity as it’s the one area where office accommodation is affordable enough for developers to convert it into student accommodation and low-cost housing. The government has already indicated a willingness to provide very cheap funding and tax breaks to developers. This is probably supporting some of the value that we see in the inner city.
Work from home and the impact on the property sector
This impact will be felt in the decentralized office market which costs R20 000 – R30 000 per square metre. Residential developers are looking to buy properties at between R6 000 and R8 000 per square metre, which you’re not going to find in the decentralized nodes, but you may find it in the inner cities. I think we’re going to continue to see a significant increase in vacancies and pressure on market rentals in decentralized office nodes. People working from home now will eventually go back to the office, but clearly utilization rates will not be the same.
Who are the big constituents of the SA listed property index?
Almost half of the index is made up by four companies. NEPI Rockcastle is the second largest constituent at 15%, but has no assets in South Africa. It is 100% exposed to Central and Eastern European retail, which is currently experiencing a far worse second wave. Growthpoint is the largest constituent at 22% with investments all over the world. Many of these buildings are predominantly in high end, fashion dominated retail and offices. Fairvest and Safari are two of the top performing REITs in South Africa, but are typically not held by other investors as they’re not a large part of the SA listed property index. Analysing the sector from a South African investor perspective is difficult because you need to know what’s going on in each one of these markets.
What about the levels of debt in property businesses?
Some of the companies expanded their balance sheets by borrowing at lower rates overseas and using cross currency interest rate swaps. As the Rand weakens, these positions become worse, creating cash flow problems. Most of these businesses have put a significant amount of their property portfolio up as collateral. During the height of the pandemic, when prices had dropped 30% - 50%, values were falling and the Rand had blown out completely, only a few of these businesses were required to put up any cash. These cross currency interest rate swaps are currently being unwound with the debt being brought back to South Africa, creating more drag on incomes and cash flow.
Why major private equity players are looking at SA property
Listed property companies were trading at a discount of between 20% - 30% relative to the underlying values of their portfolios before the pandemic. The average discount today is well over 50% because of the capital structures of these businesses. A private equity player is able to take the business private, taking pressure off the banks and other lenders. They can offer shareholders 40% - 50% above the current share price, but still have a substantial discount to the underlying value of the portfolio. The extreme level of valuation as a result of the extreme levels of negative investor sentiment towards listed property in South Africa has created a huge opportunity for private equity players to make good money. The sweet spot seems to be the R2 billion and less market cap segment of the market and given what’s happened to prices, there are a lot of South African REITs that fit that bill today.
Are REITs still a viable asset class?
REITs are definitely still a viable asset class, but you need to be selective as to the types of properties you own. They need to be relevant to the changing needs of consumers and businesses. You can’t just own the market in South Africa as you will own a lot of properties that are becoming increasingly irrelevant. South Africa’s economic growth challenges over the next few years will not result in a substantial increase in the demand for space and therefore not a substantial increase in rental levels. The bulk of your return over the next three years is going to be derived from income yields. The current yields on South African property are well in excess of 10%, which is meaningful relative to other asset classes that are returning 4% - 8%. If we can return to 90%-100% of rental collection, we should see a rerating of the South African property market given where interest rates and bond yields are currently.