Risks remain in struggling listed property market

For most of the past 15 years, listed property was the best performing local asset class. To the end of 2017, investors in leading property unit trusts had enjoyed annualised returns of over 15% for a decade.

More recently, however, returns from this sector have fallen heavily. According to figures from Morningstar, the three-year returns for the majority of funds in the South Africa real estate general category are currently negative. Only four have delivered positive performance over this period, with the best eking out just 2.48% per year.

Across the board, local real estate investment trusts (Reits) have struggled. As the table below shows, a handful have done well, but others – particularly some of the smaller cap Reits – have come off dramatically.

As a result, the fundamentals of the sector have also changed significantly over the last few years. Back in 2015, domestic Reits as a whole were offering a forward dividend yield of around 6.5%. Today, yields are over 10%.

The price-to-book-value multiple at which the sector is trading has also reversed substantially. In 2013, domestic Reits were commanding a multiple of as high as 2 times. That fell to around 1.1 times for most of 2015, 2016 and 2017, but has since fallen to 0.8 times.

In other words, local Reits can be bought at a 20% discount to their net asset value.

Cheap, but nasty?

As Evan Robbins, listed property manager within Old Mutual’s MacroSolutions boutique, points out, this makes the sector appear very cheap.

“It’s very much unloved,” Robbins notes. “A lot of bad news is priced in.”

There is no question that the environment is tough. The high and persistent growth in rentals that property companies enjoyed a few years ago are no longer available, and when rental agreements expire they are mostly having to offer the same space at lower prices.

Robbins acknowledges these risks, but nevertheless believes that there is value.

“If you think about it clinically, we are now talking about a market with 10% yield,” he points out. “Even with no growth, compare that to a few years ago when you had 7% yield. While that was growing, it would have to grow a lot to just catch up with the 10% you’re getting now.

“So you’re buying a sector where you can’t expect much growth for quite a few years, but you’re compensated with higher income.”

However, that doesn’t mean that local property is a screaming buy. It just means that there is some margin of safety for investors at these prices.

Risk remains

Robbins says that in that regard it is worth considering where concerns still lie.

Firstly, even though local Reits are trading at a 20% discount to their book value, he believes this is justifiable as direct property is overvalued. The market is therefore simply pricing in the fact that asset valuations are probably too high.

“And even if it’s in the price, it still means that if companies have to write down the value of their properties, their loan to values go up, which makes their balance sheets look much worse,” Robbins adds. “They may have to sell properties to get their loan to value down, and that’s very dilutive.”

There is also still excess supply in a low growth environment. The amount of new space being built has dropped noticeably, but it hasn’t disappeared and that means there is still an overhang, particularly in the retail market.

Robbins also believes that some earnings growth and therefore distribution growth has been due to non-sustainable drivers. In particular, many companies have bought international assets that have given them once-off improvements.

“They have bought property assets in Europe yielding 6% but that can be funded at 2%,” Robbins explains. “But they can only do that as long as they have balance sheet capacity. Eventually they won’t be able to do it anymore and growth will flatline.”

The lag

This preference for offshore assets also raises concerns around capital allocation.

“Almost all South African property companies are going offshore, not because they have expertise, but because they want to diversify away from South Africa,” Robbins says. “But local companies, across sectors, don’t have a great reputation in terms of success offshore.”

There are always inherent risks in going into international markets where local companies have no obvious advantage.

“We have had a few disasters offshore already, although it has been among the smaller companies,” Robbins points out. “The larger companies have been more responsible. However they are buying in hot markets, where prices are high already, so disasters could happen.”

Finally, he notes that the performance of property stocks does lag the economic cycle. This has two potential consequences.

“What concerns me is that a lot of shops are struggling,” says Robbins. “Even if things recover, they may not recover in time for them to remain insolvent.”

Secondly, any recovery that does happen will take time to filter through to Reit performance. This is because long-term leases that are being signed now will reflect the current conditions. Rentals will therefore be lower, and with smaller annual increases.

“So even if things improve in a year or two, it is still going to take some time for the fundamentals to improve,” he says.

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