By Shane Packman

South African investors have a love-hate relationship with listed property, with significant shifts in sentiment and demand evident over the past 10 years. Before 2017, it was common for multi-asset funds to have healthy allocations to the SA listed opportunity set mostly due to the appeal of property companies offering relatively stable dividends.

The SA property market demonstrated strong performance between 2013 and 2017, attracting significant investment flows into the sector.

Sentiment towards the sector began to weaken in early 2018 as market participants became concerned about the overuse of debt, possible financial engineering, as well as corporate governance problems. The sector was further hindered by expensive valuations, unsustainable earnings and deteriorating local conditions.

The FTSE/JSE SA Listed Property Index lost 62.6% of its value between January 1, 2018 and October 31, 2020 with most of the drawdown occurring during the outbreak of the Covid-19 pandemic.

While the asset class has recovered somewhat from pandemic lows, industry flows have remained relatively muted. The question for investors is whether the sector provides opportunity during times of uncertainty.

While market sentiment continues to deteriorate, there have been some improvements in fundamentals to suggest that investors should not ignore the sector altogether.

Different factors impacting the SA property:

Diversified revenue streams

The SA property sector’s revenue decomposition has changed over the years to be slightly less reliant on the local economy for driving earnings.

Approximately 43% of the revenue of the FTSE/JSE SA Listed Property Index is generated from outside South Africa. The sector’s dividend yield and return are derived from local and offshore revenue streams.

The largest constituent in the Property Index is Nepi Rockcastle, which accounts for 21.5% of the index, and almost 100% of its revenue is derived from central and eastern Europe. While global property has faced its own challenges, Nepi Rockcastle has reported strong distributable earnings, reflecting resilience from the latter regions.

While the quality of earnings is not as high as in the SA equity universe, there is evidence that management teams have attempted to tilt underlying property portfolios towards more global exposure. Most importantly, companies are no longer paying out 90% to 100% of their earnings, which significantly improves the robustness of their business models.

Balance sheet strength

The Covid-19 lockdown allowed many property companies to pay down their debt while holding back payouts, reducing their holdings in non-core assets and cleaning their balance sheets.

The improvement can be observed in loan-to-value (LTV) ratios, which measure a company’s nominal debt against the value of its underlying properties. While LTV ratios are above the long-term average, there has been a noticeable decline – to levels of around 37% over the past three years. The spike in 2020 was due to write-downs in asset values negatively impacting LTV and interest coverage ratios.

A higher interest rate and lower growth environment is likely to test the resilience of company balance sheets. Nonetheless, the fixed-rate nature of the sector’s debt maturities does provide a buffer in the short term.

On average, the sector has between 75 and 80% of its debt fixed for an average tenure of between two-and-a-half to three years. We are, however, cognisant that the interest impact of debt on the companies will probably increase as the fixed obligations roll over at higher rates.

Diversified underlying property portfolios

The three segments making up the SA Listed Property Index – retail, industrial and office – have differing landscapes, opportunities and headwinds.

The largest segment, from a South African perspective, is retail which makes up more than 60% of the index by market capitalisation. Overall, national retail vacancies have shown resilience coming in at 5.4% at the end of the first quarter of 2023, which is below the peak of 7% recorded in 2021.

Recent results in the retail space show signs of resilience and some green shoots, as rental reversions have turned upward. The outlook remains cautious given the health of the consumer, however, there continues to be a reasonable demand for good quality and well-located retail space.

The second largest segment within the Property Index is the industrial property sector, which makes up just under 20% of the index. It has continued to be the outperformer among the three major sectors in South Africa, with low vacancy rates (currently at 4.4%) and the highest base rental growth. It is important to note that there are various sub-sectors within the industrial sector and, while manufacturing faces headwinds, logistics and storage have been buoyed by good demand.

Office space, making up less than 15% of the index, remains tough as work-from-home pressures and weak business confidence continues to hamper vacancy levels. The segment is experiencing a significant demand and supply imbalance (occurring since before the Covid-19 pandemic) which has resulted in national vacancies of 15.6% at the end of quarter one of 2023.

Despite the grim outlook, office vacancies appeared to have plateaued and have slowly declined from their all-time high of 16.7% in the second quarter of 2022. Importantly, the construction of new offices remains low. New office supply is likely to remain muted and be tenant-driven over the short to medium term, given the amount of space readily available and the high costs associated with building.

Discounted valuation

The property sector continues to trade at a significant discount to net asset value (NAV), which falls below its 10-year average.

South African-focused property companies’ NAV growth is expected to be weak on the back of a tough local economic environment. While South African property companies have been battling low economic growth, high-interest rates and a tough trading environment, valuations do indicate, for some, a particularly gloomy downside. At a current discount to NAV of around 30 to 40%, property valuations would need to fall significantly for investors to suffer permanent losses on capital.

Recent results have also come in better than expected, with global property counters such as NEPI Rockcastle, MAS, and Hystead (wholly owned by Hyprop) reporting excellent distributable earnings growth, reflecting stronger-than-expected regional fundamentals. Driven by strong occupier demand and constrained supply, property valuations have been stable despite higher bond yields in the central European region.

Outlook

While the market is pricing in particularly poor outcomes, there is evidence of improving fundamentals across the SA listed property opportunity set.

The shift in revenue exposure to global markets provides access to a diversified revenue stream, reducing reliance solely on the local economy. Balance sheets are less leveraged with lower LTV ratios and a higher percentage of retained income. Many property companies have also been investing heavily in becoming less reliant on the national power grid, which could potentially improve the long-term sustainability and resilience of their operations. Valuations in the market appear cheap and positive rental reversions and better-than-expected earnings could see a re[1]rating in the sector.

There are, however, significant challenges and negative factors to consider.

Local economic headwinds continue to hamper growth, and higher interest rates could become problematic in the future. The weakness in the South African consumer base might also dampen sentiment towards the property sector.

The outlook for various segments of the property market will probably become an important driver of prospective returns from the sector. Given the difficult headwinds facing businesses and consumers in South Africa, caution remains essential for investors.

By Shane Packman, associate investment analyst at Morningstar South Africa

BUSINESS REPORT