International property craze is tears waiting to happen

STELLENBOSCH – Over the last couple of years, there has been a big move by South African real estate investment trusts (Reits) to buy overseas assets. A number of locally listed companies have found properties in Europe, the UK and Australia to add to their portfolios.

Many investors have welcomed this. On the face of it, the exposure to international currencies and markets seems like an excellent idea given the current weakness in the rand and the South African economy.

However, speaking at the BCI Global Investment Conference in Stellenbosch this week, some of South Africa’s top real estate fund managers raised serious concerns about this desire by local Reits to buy up international properties.

Evan Jankelowitz of Sesfekile Capital said that investors have to ask whether these companies are moving towards something worthwhile, or merely running away from something.

“Given the state of the currency, local politics and the general South African economy, it can be a justifiable reason to look overseas to more investor-friendly markets,” he said. “But with that said, what kind of opportunities are they finding?”

He made the point that companies like Growthpoint, Redefine, Fortress and Emira all invested offshore a few years ago when the rand was much stronger.

“They had a justification and a strategy,” he said. “But recently we’ve seen many others buying internationally. Are they being proactive or reactive?”

The manager of the Absa Property Equity Fund, Fayyaz Mottiar, expressed a similar sentiment.

“It looks like there’s some sense of FOMO here,” he said. “Companies think they are missing out, so they follow the herd.”

This is particularly evident in the number of South African Reits buying assets in Eastern Europe. This follows from the extraordinary success enjoyed by New Europe Property Investments in Romania.

“But you have to ask, if they want to go offshore why don’t they go to developed markets?” said Jankelowitz. “Even those that are investing in the UK are not going to central London, they are going to the outskirts.”

While the quality of these assets may appear high, their location is not. And that raises questions about the expected returns.

“Local companies head to Europe and come back bragging that they have found 8% yield in a first world currency,” said Greg Rawlins, CEO of Reitway Global. “I say beware! There are going to be tears.”

He cautions that these kinds of yields in pounds or euros are not sustainable.

“Some of these are B or C grade properties where there is no business edge and no comparative advantage,” he said. “You are going to wake up with low capital growth, low liquidity and little or no income growth within two years.”

Jankelowitz argued that what is driving these acquisitions in many cases is not the assets themselves, but the balance sheet opportunity. This is because in an extremely low interest rate environment in Europe, local companies are getting a significant positive carry.

“But that is a problem because interest rates are a function of expected inflation,” he warned. “So, yes, you get the carry in year one, but later you get inflationary increases in rentals that lag the rest of the market. The initial kicker doesn’t last into perpetuity.”

Mottiar said that investors therefore have to be very cautious about being seduced by these initial gains.

“Chasing after deals just for the initial pick up is not the place to be,” said Mottiar. “There is a lot of engineering going on just to boost short term earnings.”

The concern is that management teams are chasing these deals because of the way they are being incentivised by their boards.

“Too many CEOs in the local property sector believe that they have to continually be buying,” Jankelowitz argued. “But that’s not where they should be incentivised. They need to grow sustainable earnings. Yes, there are a lot of headwinds in South Africa, but if you back the right management teams, then I would still back a strategy to stay local.”

Mottiar agreed.

“South African real estate has always given you a great return because you can get initial yields on quality properties of 6% to 7% and lease escalations of 7% to 8%,” he said. “In developed markets yields are much lower and there is no growth.

“In absolute terms these companies don’t need to do anything and they will give you a double digit return over three years,” Mottiar added. “But the incentive is for them to do risky things to boost short term earnings.”

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