July 31, 2019
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By Keillen Ndlovu, Head of STANLIB Listed Property
South Africa’s listed property sector has been a consistent top performing asset class over many years. Investors had become accustomed to double digit annual returns and continued growth. The tide turned last year when the sector lost over 25% of its value. Since then SA listed property has been struggling to regain these losses. There are a number of challenges that continue to face the sector over the short to medium term.
1. Weaker distribution growth
For the first time in decades, listed property companies and funds are now delivering distribution or income growth below inflation. Growth has slowed down to between 2% and 3%. This has largely been driven by weak economic growth and an oversupply of properties, particularly in the office and retail space.
Without diversifying exposure to offshore markets, distribution growth would be negative 3% to 4%. This basically reflects the current state of the South African economy. Listed property companies have expanded outside South Africa with about 47% exposure to offshore markets at the time of writing. This has grown from virtually 0% over 10 years ago.
2. Loan-to-value ratios
The fall in property company share valuations shifted how these businesses are able to manage and fund growth. Listed property companies are now trading at a discount of over 10% to their net asset values. This makes it difficult for property companies to fund any acquisitions using equity given the dilutive impact as well as the fact that there is limited investor appetite for property shares. Most companies are therefore funding acquisitions and developments with debt resulting in increased the loan-to-value ratios (LTVs).
The debt levels or LTVs for the majority of local property companies are at their highest levels. They are now approaching 40% from a low of about 27%. These higher debt levels in relation to the property value are now at the level where rating agencies like Moody’s become uncomfortable. However, most banks have debt covenant or limit levels of anywhere between 50% and 60%. It is important to highlight that while LTVs provide a measure of a company’s balance sheet risk, interest cover ratios are a more important measure. These basically highlight how easily a company is able to service its debt. A ratio of above 2 is considered healthy.
Most listed property companies are in a good position but the market will be closely watching for deterioration in these numbers.
A further challenge, however, is that on a relative basis, the local portfolios have lower debt levels than the offshore portfolios. Despite offering better growth prospects, the market would love to see offshore debt levels come down.
3. Property valuations
The valuations of physical properties have largely held up (i.e. capitalisation rates have been stable) despite a challenging economy, oversupply as well as weak demand and slowing or declining rental growth. Valuers tend to look through the cycle and use the South African 10-year bond yield as one of their valuation inputs. They argue that yields have not gone up. When capitalisation rates, just like bond yields, go up then capital values fall. The market is anticipating that we may see capitalisation rates increase by as much as 50 basis points on average in the next year and this could lead to physical property values declining by as much as 5%. To breach debt covenants with the banks, property values, other things being constant, would have to decline by as much as 25%.
South Shopping Centre Capitalisation Rates or valuations have been stable despite a weak and oversupplied environment
4. Earnings pay-out ratios
Listed property companies or Real Estate Investment Trusts (REITs) in South Africa have typically paid out 100% of their earnings to investors as distributions. However, globally this is not the norm. Pay-out ratios range anywhere between 75% and 90%, meaning that REITs retain some of the earnings to fund a portion of their operations or service interest costs. We may see pay-out ratios come down in South Africa aligning with their global counterparts. We have seen early signs of this but largely from distressed funds. Delta Property Fund reduced its pay-out ratio to 75%, the minimum allowed by the REIT legislation. Rebosis Property Fund skipped paying out its interim distribution and will only pay the final distribution. It’s important to note that earnings that are not paid are subject to corporate tax. To maintain its REIT status, a REIT has to pay out its final distribution. Lower pay-out ratios could lead to declining distribution growth as companies look to restructure their balance sheets.
5. Corporate governance
The market would welcome an end to the investigation around the former Resilient stable of companies by the Financial Sector Conduct Authority (FSCA. To recap, the stable included Resilient Property Income Fund, NEPI Rockcastle, Fortress Income Fund and Greenbay Properties (now Lighthouse Capital. To date: NEPI Rockcastle has been cleared of all the allegations. We believe that the investigations are nearing an end given the progress made around NEPI Rockcastle.
FSCA investigation progress on the Resilient stable of companies
The SA REIT Association has released a draft Best Practice Recommendations (BPR) and the investment community was given a chance to provide feedback. The BPR will help to create more consistent reporting framework that facilitates comparisons between, and better represents the financial position of South African REITS. The adoption of this will not be mandatory but will hold our REITs accountable and will help to improve the image of our tarnished sector.
Exposure to the offshore market, more so central and Eastern Europe as well as Australia, is helping to cushion the listed property sector against a relatively weaker SA economy. There will likely be more comfort or clarity in the SA property market valuations once we see some upward movement in capitalisation rates due to weak property fundamentals and the full impact of rental reduction feeds through the sector.
On the debt side, loan-to-value ratios remain sticky at marginally inflated levels with higher offshore debt levels being used by property companies to assist in driving overall distribution growth. Closure of the FSCA investigations on the former Resilient stable of companies as well as application of best business practices in the sector are expected to feed through positively into the sector over 2019-2020, resulting in more sector transparency and better governance standards.
The potential for improved economic growth, business confidence and reduction in interest rates could be major boosts for the sector. Indeed, this is driving share price performance for those counters that have overseas portfolios. However, in South Africa we see these as medium-term positive catalysts, with the current economic challenges facing the listed property sector anticipated to continue into 2020, albeit at a slower rate.
As a result, the listed property sector’s returns will be primarily driven with double digit dividend. Yields for many counters, above the South African 10-year bond yield. The significant discounts to reported Net Asset Values for South African focused REITs, we feel, fairly reflect the economic headwinds facing the listed sector.