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Listed Property – Are the Foundations Solid Enough to Endure the Storm?

By Mansoor Narker, 9 July 2020

There was a time in our recent history when the property sector could do no wrong, attracting investors with its steady and growing dividends and providing a dependable source of income, particularly in pension funds. Indeed, the asset class led the way by outperforming all others on a total return basis from 2009 until 2017.

However, the sector has fallen out of favour with investors as distribution growth notably slowed from its highs, given a structurally weak economy, and concerns around capital structures and as company fundamentals came to the fore. The controversy around the Resilient group of companies at the beginning of 2018, with allegations of share price manipulation and questionable corporate governance practices aimed at the group, saw investors pay closer scrutiny to the sector as whole and many did not like what they found – accelerating the sell-off from the peak. In the wake of the COVID-19 pandemic and associated market volatility, the property sector has been the worst hit – the FTSE/JSE All Property Index (ALPI) has plunged 45.41% year-to-date (to end May 2020) and has lost 46.27% over one year and 23% over three years. With the imposition of the national lockdown and the prevention of non-essential businesses from trading, the situation has gone from bad to critical. The question then becomes can the sector endure this perfect storm?

Multi-Asset Graph

The immediate focus for many REITs is now survival and attention has squarely shifted to shoring up balance sheets and maintaining adequate liquidity. To this end, many property companies have either cancelled, postponed or withdrawn guidance on dividend payments given the uncertainty of what lies ahead – removing one of the primary motivations behind investing in property shares. The industry has been quick to respond to jointly confront the issues it faces for the foreseeable future by forming the Property Industry Group (PI Group), a coalition including the SA REIT Association, the SA Property Owners Association (SAPOA) and the SA Council of Shopping Centres. On the issue of distributions, REITs are required by regulation to pay out 75% of distributable income as dividends to maintain their tax-free status. Given the fall in earnings that is expected in the months to come and the associated cut in dividends, the PI Group has engaged with the JSE and National Treasury for a special dispensation that would allow REITs to withhold dividends for up to two years without losing their tax status. Early indications from the JSE are that they are supportive of the property sector due to the extra-ordinary circumstances we find ourselves in and will work with the sector to find solutions to possible breaches of JSE listing requirements which may be unavoidable going forward.

SA REIT exposure, as shown in the chart below, is mostly concentrated in the retail sector. While the impact of the lockdown and the subsequent economic damage will eventually be felt in all sectors, with such a large weighting toward retail, collaboration between tenants and landlords will be key to mutual survival. To facilitate this, the PI Group launched a retail tenant assistance and relief package primarily targeted at SMME retailers (with annual turnover up to R80m) whereby rentals will be discounted around 60-100% in April, up to 55% in May, and up to 45% rental deferment in June. Larger retailers are also to participate with lower discounts being offered. With the aim of sustaining retailers through the lockdown period by freeing up cashflow in order to preserve jobs, property companies will also want to ensure that many of these businesses survive until normal operations can resume to provide sustainable rental income. While there is no doubt that some weaker tenants will fail and vacancies will rise, landlords will also have little ability to grow earnings through rental increases against the backdrop of weaker consumer demand and constrained finances, thus the focus is now on tenant retention. Encouragingly, around 30% of retail space is occupied by essential retailers who have continued to trade and pay rent.

Multi-Asset Graph

Source: Catalyst Fund Managers, April 2020

The other big role players who are intertwined with the fate of the property sector are the banks and the financial sector. To minimise the risk of financial contagion, the banking sector would rather support property companies through this time, and active discussions are ongoing between the two sectors to provide additional liquidity or refinancing facilities for near-term debt expiration. Loan-to value (LTV) ratios have increased in recent years to elevated levels, and asset values, which some investors have argued were overvalued given the pre-crisis weakness in the sector, could finally catch up with the economic reality we currently face. This would effectively raise LTVs to a level that could be in breach of bank covenants for certain counters. However, indications are that banks would prefer that property companies continue to service their interest payments rather than focus on LTVs in the short term. The more important metric then is the interest coverage ratio (ICR) of the sector, which is on average above covenant levels. Despite the higher levels of leverage in the sector, the good news is that there is headroom for most companies to absorb a drop in their earnings, up to c.50% in some cases, and asset values and remain above covenant levels. Sector covenant levels for LTVs range between 45-70% and around 2x for ICRs. In the medium to longer term, it will be expected that property companies will deleverage to more comfortable levels.

Multi-Asset Graph

Source: Sesfikile Capital

Another factor that could benefit local investors is the growing component of earnings derived from offshore exposure, currently at c.50% of the sector on a look-through basis. Weaker fundamentals in the South African market has led many REITs to diversify offshore, with foreign markets seen to provide better return prospects, while others are purely offshore companies that are merely listed in South Africa. Given the constrained financial position of the South African government and its limited ability to provide financial stimulus, foreign economies are expected to recover quicker than the local market, particularly around Central and Eastern Europe which has seen good growth in recent years.

The longer lasting effects of the pandemic will be with us for some time, and changes in consumer behaviour are to be expected. Growth in secular trends, such as online shopping and working from home, will have been accelerated by the lockdown and will leave its mark on the property sector as well as others. Demand for warehousing and distribution properties could see an increase as more retailers move their offering online. Office space demand, already suffering from an oversupply and relatively high vacancies rates (11.6% nationally at Q1 2020) before the crisis, will continue its downward trend as companies reconfigure their floor space and vacancies increase until we see a turn-around in the economy.

Given the sharp fall in value we have seen, many investors will have questions about the merits of including listed property investments in their portfolios. Traditionally, listed property has usually been regarded as more defensive in weaker market environments, however the nature of the current crisis has turned that notion on its head. Against the weak economic backdrop that is expected to persist for some time, landlords are likely to absorb the pain going forward as negative rental reversions continue and bad debt and arrears tick up. In the short term with the prospect of reduced or no distributions from REITs, investors focused on income could do well to look at alternatives, such as government bonds which are trading at attractive yields given the risks. As we emerge from the crisis, and certainly not letting a crisis go to waste, the sector should find itself in a better position over the long term by clearing out some of the excesses and unsustainable practices of the past. The introduction of the Best Practices Framework by the SA REIT Association supporting more transparent and robust reporting, and the introduction of pay-out ratios and the move to the Adjusted Funds From Operations (AFFO) model, should see a more sustainable earnings profile emerge. In the scenario where growth returns to meaningful levels, investors taking a long-term view could do well to benefit from capital appreciation from such depressed levels as the environment normalises further, although a high-risk appetite would be necessary to stomach the volatility expected to persist in markets.

In summary, the listed property sector will see itself through this period, and while it is too soon to fully quantify the damage, most property counters are expected to come through the crisis. Markets remain volatile and to the extent that property shares have sold off, they are now trading around an unprecedented c.50% discount to NAV. At current levels, many fund managers are seeing value in selective counters, given more conservative earnings and return expectations going forward. The current focus on balance sheet strength, rather than dividends, and the eventual deleveraging across the sector should eventually see property companies emerging stronger in a post-crisis world. Of course, a broader recovery hinges on the government’s ability to enact meaningful economic reforms and spark growth. Investors, however, will need to remain patient as the situation unfolds as the road ahead remains long.

References:

Anchor Capital, Catalyst Fund Managers, Coronation Fund Managers, Ninety One, SA REIT Association, SAPOA, Sesfikile Capital, Stanlib

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