Embattled Reits eye their options as property fortunes wane
The volatile equity market may often overshoot, but it gets the direction right. After almost six months of economic lockdown, backward-looking property valuations should continue to fall. This has been compounded by tenants struggling to survive, the coronavirus worsening existing structural challenges such as internet shopping and flexible working, irresponsible property oversupply, few buyers but many potential sellers, exorbitant increases in municipal charges and the level and yield of government debt. Listed property real estate investment trusts (Reits) are, understandably, in crisis.
Share prices have more than halved in 2020 and Reits are trading at a similar discount to net asset values (NAVs).
However, Reits have primarily a forward-looking balance sheet problem, not an income statement problem. Indeed, they were even able to make distributable profits over the six months to end-June, which incorporated the lockdown. This includes shopping centre owners, who were the worst affected.
Those with lower debt have outperformed starkly. Market prices imply that aggregate property balance sheet values will fall about 40% from already reduced levels. This is more than double what public commentators suggest and implies that many Reits could eventually breach their debt covenants. Few funds are in immediate danger, but gearing levels are too close for comfort and the market is pricing for a self-reinforcing downward cycle.
Remedying this situation is a quandary. The following options all have their own challenges:
- Sell properties — This may not be feasible in size as only a small pool of investors can afford the big-ticket prices of SA’s premier assets. If all Reits concurrently sold, a vicious cycle will be created as prices fall further, resulting in even worse gearing levels and so necessitating even more disposals. (Reits benefited from this virtuous cycle in the good times). Some funds are rather looking at reducing offshore holdings.
- Raise equity — This is an option that is now feared and loathed by the market and very dilutive in size. Raising capital in an unflavoured sector and with specialist investors themselves cash strapped (property funds have seen outflows) necessitates large discounts. This too creates a vicious cycle. Fear of a possible capital raise pushes down share prices, requiring an even lower raising price, which further pushes down the price. Hammerson recently raised more than its market capitalisation just to reduce debt by a fifth, and did so at a 95% discount.
- Retain earnings — This involves reducing or withholding the dividend to shareholders and rather repaying debt. If Reits were “normal” companies, this would have been standard practice already. But Reits are not “normal” and ill-suited for this environment. Their tax status passes the tax burden from the Reit to the individual investors. If a Reit distributes less than 75% of earnings, it forfeits the coveted Reit status. What a Reit does not distribute is taxed, leaking the earnings it wants to retain for balance sheet repair.
The best option of a bad bunch to get out of this quandary, in conjunction with sales and limited raises if still necessary, is a regular dividend reinvestment plan (Drip) issued at a deep discount. No Reit has done this yet. In a Drip, shareholders can elect to receive additional shares rather than a cash dividend. This is an allowable Reit distribution and not taxed in the Reit. As Reits are cash generative, their balance sheet will be repaired over time, even with expected falling property values and rentals. Thereafter they can resume normal cash dividends off a stronger earnings base as there is less debt.
The elective shares must be issued at a sizeable discount to discourage election of the cash dividend. There are those only invested for the cash distributions, but sustainability, long-term value and strategic imperatives must be the priority. Shareholders can always smoothly sell shares to cover any tax liability or cash-flow requirement. This is superior to funding large, unpredictable rights issues. What is suggested will dilute accounting NAV per share, but shareholders are not put at a disadvantage if they elect the shares as their ownership does not decline.
The market is pricing in the draconian side-effects of the medicine that will eventually be necessary to remedy the balance sheet situation if not decisively addressed. Prices may recover if investors get comfortable that balance sheets can be repaired without any nasty surprises. Enticing value can thus be unlocked and a virtuous cycle can be created. This far outweighs the temporary loss of a cash dividend. The upside is clear. The implied value of some of SA’s best commercial real estate is well less than half of replacement cost and, per square metre, is worth much less than the homes in your street.
These are not normal times. Reits and investors cannot play by the old rules and expectations. The management must do what makes economic sense, taking a long-term sustainable view, not what is expedient or allows strategy to follow tax structure — don’t kill the Reit cash cow by milking it while it is ailing.
• Robins is listed property manager at Old Mutual Investment Group.
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