South African Listed Property – Better Value, but the Growth has Disappeared

SA Property has been a consistently high performing asset class for the last two decades, with returns only briefly interrupted by the financial crisis of 2008. SA property investors have experienced annual dividend growth of 8% since 2005 and this has driven capital growth in the sector.

This year the property sector has experience a significant draw-down with a fall of close to 30% year to date. The first quarter saw the collapse in value of the Resilient stable of companies. The extent of fraudulent activity within these companies remains to be seen, but the price fall is largely due to the fact that these stocks were trading at large premiums to their Net Asset Value. We avoided all the Resilient related stocks as they were extremely expensive, and we believed that the growth reported was unsustainable.

Once the Resilient story had played out, the rest of the sector came under pressure as the market began to realise that growth had vanished.

The Quality of Earnings Growth has Fallen Sharply

The reality is that most companies in the sector have been struggling to grow earnings for a number of years due a lack of economic growth and low business confidence. Lower rent escalations and negative reversions (lower rent) on expired leases have become the norm. Property companies have been under pressure to continue showing high dividend growth and they have engaged in a number of financial “shenanigans” in order to report a higher growth number to investors. These financial engineering strategies include:

• Highly leveraged offshore acquisitions
• Debt/Swap Restructurings
• Cross Currency Swaps
• Distributing Fees and Once off gains (at expense of property values)

Property companies have also increased the concessions they have been willing to give tenants for both new leases and renewals. They are giving longer rent-free periods and have increased their contribution to tenant installation costs. The effect of these concessions has been to overstate rental levels and hide some of the weakness in the sector.
We have been cautious on the property sector for the last three years given the deteriorated letting prospects in a poorly performing economy. The market has finally realised that much of the growth in recent years has been an illusion.

Valuations are Beginning to Catch Up with Reality

The decline in growth prospects for the sector is finally being reflected in valuations as the starting yield on the sector has increased significantly. Since the beginning of 2017, the trailing yield on the JSE REIT Index has increased from 6,5% to its current level of over 9%. While this is partially attributed to the derating of the Resilient stable, the yield on all stocks has shifted higher to compensate for the diminished growth prospects.

JSE REIT Yield

With the headwind of lower, or even negative growth from property companies, we continue to remain cautious on the sector. SA investors have been spoilt with very attractive returns for a long time, and the adjustment to a lower growth environment will take time. However, much cheaper valuations warrant some additional exposure and we have been adding SA property to our funds at these cheaper levels.

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