Why listed property firms are still a good bet in the long term
Sector has been on the back foot in 2019 but investors can look forward to better returns when the economy bounces back
SA’s listed property sector has been treading water in 2019 as it faces a number of short- and medium-term challenges.
Fortunately, investors have been partly cushioned by the offshore diversification strategy adopted by most of the large SA-based property companies. There is also potential for merger and acquisition activity, and some discussions have been initiated that could result in consolidation.
The biggest influence on driving a comeback in property returns would be a turnaround in local economic growth. Some of the more specific challenges facing the local sector in a low-growth environment include weakening distributions, rising loan-to-value ratios, falling property valuations, shrinking payout ratios and questions over corporate governance.
Listed property companies have expanded outside SA, with exposure to offshore markets now about 47%, from virtually 0% more than 10 years ago.
For the first time in decades listed property companies and funds are now delivering distribution or income growth below inflation. Growth has slowed 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%. Listed property companies have expanded outside SA, with exposure to offshore markets now about 47%, from virtually 0% more than 10 years ago.
The fall in property companies’ share valuations has altered how these businesses are able to manage and fund growth. Listed property companies are now trading at a discount of more than 10% to their net asset values. This makes it difficult for them to fund any acquisitions using equity given the dilutive effect as well as the fact there is limited investor appetite for property shares. Most companies are therefore funding acquisitions and developments with debt, resulting in increased loan-to-value ratios.
The debt levels or loan-to-value ratios for most local property companies have risen to their highest level, at about 40% from a low of about 27%, making rating agencies such as Moody’s Investors Service uneasy. However, most banks have debt covenant or limit levels of anywhere between 50% and 60%.
It is important to highlight that while loan-to-value ratios 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 two is considered healthy. Most listed property companies are in a good position, but the market will be closely watching for deterioration in these numbers.
The valuations of physical properties have largely held up (capitalisation rates have been stable) despite a challenging economy, oversupply coupled with weak demand and slowing or declining rental growth. Valuers tend to look through the cycle and use the SA 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%. That is still well below the 25% decline that would cause property companies to breach debt covenants with the banks.
SA’s listed property companies (real estate investment trusts, or Reits) have typically paid out 100% of their earnings to investors as distributions. However, payout ratios globally range from 75% to 90%, meaning Reits retain some of the earnings to fund a portion of their operations or service interest costs. We may see local payout ratios come down, which would lead to declining distribution growth as companies look to restructure their balance sheets.
As far as corporate governance is concerned, the market would welcome an end to the investigation into the former Resilient stable of companies by the Financial Sector Conduct Authority. 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, which we believe indicates the investigations are nearing an end.
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 SA we see these as medium-term positive catalysts, with the current economic challenges facing the listed property sector anticipated to continue into 2020, though we believe the economy will slowly recover.
As a result, the listed property sector’s returns will be primarily driven by double-digit dividend yields for many counters, rendering the shares more attractive than the SA 10-year bond yield. We encourage investors to take at least a three-year view on the sector.
• Ndlovu is Stanlib head of listed property.