By Dirk Jooste
THE South African listed property sector has had a torrid time of late.
After being a darling of local investors for several years, the local listed property sector has more recently been the worst-performing asset class since 2018. Listed property has seen a yearto-date return of -42.37 percent till the end of November.
The sector was facing headwinds even before the onset of the Covid-19 pandemic, which has raised further uncertainty about future returns. However, the dangers in focusing on sector numbers only is that investors miss out on the potential return opportunities that arise when extreme negative sentiment overshadows fair valuations.
Pre- pandemic concerns have been amplified
Even before the pandemic, investors were concerned about the outlook for the sector. The South African economy has not created an environment that supports the growth of either the retail or office property sectors over the past few years. Above-inflation increases in rates and taxes and electricity tariffs have been reducing tenant affordability, and an oversupply of rental property in certain nodes has meant that tenants could shop around for lower rentals.
Management of the real estate investment trusts (Reits) have not all run businesses in a way to withstand severe stress. Legislation states that 75 percent of distributable income must be paid out, and limits tax deductible expenditure to maintenance only. Capital expenditure (aimed at improvements) cannot be deducted for tax purposes, and since any retained distributable income is also taxable, the majority of management teams have elected to pay out 100 percent of distributable income as dividends, limiting the organic funding options available to Reits for expansionary purposes.
Presented with a choice to fund capital expenditure from rights issues or through debt, many Reits have more recently opted for debt. As a result, their overall level of indebtedness has been steadily creeping up over time, even as the economy has cooled.
While the preceding factors have gradually been souring sentiment against the sector, Reits have been slow to lower their portfolio valuations in response to tighter market conditions. This has created uncertainty about the discount rates that should be applied to future income streams, leading to increased risk premiums and share prices trending sharply lower in response.
The Covid-19 curveball
Once the pandemic hit, the impact of the poor economic environment and the level of uncertainty were amplified. While larger retailers may have the reserves to survive temporary restrictions on trading, smaller format stores and offices, which typically have a higher rental per square meter, were considered far less likely to survive lockdown. With the bond-like income stream often associated with Reits called into question, share prices have become deeply distressed, with some of them trading at a discount to net asset value (NAV) as high as 90 percent.
Searching for opportunity in the midst of distress
The negative conditions dogging the listed property sector are very real, and are a large part of the reason why PSG Asset Management has largely avoided the sector over the past few years. To our minds, there were better opportunities to be exploited at lower risk until now, such as those on offer in the longer-dated government bond sector. However, our interest is piqued when extremely negative narratives become conventionally accepted wisdom, even as valuations are driven lower. While the concerns about the listed property sector are indeed real and founded, one has to ask what scenarios could cause the extremely pessimistic forecasts implied by current share prices and wide discounts to NAV to materialise.
Discernment is called for
Accepting risk in return for potential reward is part and parcel of the investment process. We do not consider the existence of risks in themselves to be a deterrent, but rather ask what the likelihood is of the investor being rewarded in the long run – everything considered. Being cheap has never been a sufficient criterion, to our minds, to prompt investment either. However, when low valuations and a sound business strategy are combined with superior management, our process requires that we seriously consider whether the dominant market narrative is overlooking some fundamental quality of the company in question.
Has the negative narrative gone too far?
Looking at the listed property sector, we believe market participants are not differentiating enough between companies. While some are likely to breach loan covenants and are likely to be forced to a rights issue as a last resort, others are far more likely to weather the short-term storm, and reward investors in the long run. The devil is, however, in the detail.
We also believe there are many value traps in the sector, and that selectivity is key. With the listed property sector having languished at the bottom of the asset class returns table over the past several years, it may be time for the discerning investor to relook the value proposition of this sector. As it is a hybrid asset class, and with interest rate returns likely to remain low for an extended period, diversifying your sources of return could prove more valuable than ever, provided you apply a judicious and patient approach.
Dirk Jooste is a Fund Manager, and Ané Craig, Analyst, at PSG Asset Management
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