Uncertainty and volatility have been the hallmarks of recent times. Aside from global unpredictability, the downgrade of South Africa’s sovereign debt ratings by Standard & Poor’s and Fitch, local political shenanigans and a volatile rand have weighed on SA’s listed property sector.
Despite these challenges, the sector is
expected to post total returns of between 8% and 10% this year, says Keillen
Ndlovu, head of listed property funds at Stanlib.
It has long been an attractive sector for investors, outperforming other asset classes over the past 20 years. Over this period, listed property yielded an average return of 19% annually against the 16% delivered by equities, 12% by bonds and 9% from cash. In 2016, SA’s real estate investment trusts (REITs) returned 14.7% to investors, only marginally outperformed by bonds at 15.4%, and well ahead of cash at 7.4% and equities at 2.6%, according to SA REIT Association research.
At the time of writing on 16 May, the FTSE/JSE SA Listed Property Index (SAPY) was up 1.1% since the start of the year, underperforming the FTSE/JSE All Share Index, which was up 6.7%. In the first quarter of 2017, non-SA JSE-listed REIT stocks with UK or EU exposure like that of Capital & Counties, Nepi and Rockcastle, were mostly outperformed by SA REITs, with Rebosis and Delta topping the sector’s performance. Much of that had to do with the strengthening of the rand.
Predictably, there was a U-turn in that scenario after President Jacob Zuma’s firing of former finance minister Pravin Gordhan at the end of March, and the subsequent credit ratings downgrades.“Post the country’s downgrading, 100% offshore-focused companies like Hammerson, Capital & Counties, and Intu did well mainly on the back of a weaker rand,” says Ndlovu. “But larger [SA] REITs like Growthpoint Properties and Redefine Properties, despite their sizeable offshore exposure of over 25%, were sold off more after the downgrades.” This, explains Ndlovu, was mainly attributable to liquidity, the REITs not deriving the benefit of their offshore exposure when the rand weakened. Yet the impact was a short-term one, the stocks starting to come back as the market normalised, he says. “It’s likely the market mostly expected the downgrade, because there has been no panic disinvesting.”
Junk status though is certainly not supportive
of investment generally. It also reduces the potential horizon of foreign
investors that have the mandates to invest in the SA REITs – a sector that
represents nearly R400bn worth of real estate assets and boasts a market
capitalisation of around R360bn.
“The downgrade affects the SA foreign currency
debt rating, as well as that of Growthpoint or any other SA company/corporate
or SOE [state-owned enterprise] that has foreign currency debt,” says Estienne
de Klerk, managing director of Growthpoint Properties. The same holds true for
those that might wish to issue such debt if they haven’t got any yet, such as
Growthpoint.
“The rating downgrade is not likely to have any
real impact on equity investors, as opposed to debt investors, safe to say that
as the economy and growth prospects deteriorate, so will our ability to grow
our earnings and that would be negative for equity investors, as opposed to the
debt downgrade itself.”
Downgrading has brought with it a rise in bond
yields and simultaneous rising property yields that have meant a fall in
capital values. It also brings with it risks associated with higher funding
costs and debt ratios.
Debt hedging will mitigate effects of the
downgrade in the short term, but the REITs now face increased cost of capital
over the medium and long term that will directly impact the valuation of direct
property and the valuation of the REIT share prices.
The bulk of the REITs have hedged 80% to 90% of
their debt for three to four years, and debt ratios are around 30% to 35%. “In
fact, most REITs have been funding most of their acquisitions through equity
compared to debt,” Ndlovu tells finweek.
“Generally the SA REITs have low LTV
[loan-to-value] ratios and thus we don’t foresee this becoming a major issue,”
says Growthpoint’s De Klerk. However, interest cover ratio covenants will be
negatively impacted if the rental levels drop, he adds.
While the downgrade is not good news, likely to
affect not only the property industry but also the economy as a whole, it came
as no surprise, says Mark Stevens, CEO of Fortress Income Fund.
“Most property funds had prepared for an event
like this. It’s been hanging over us for the last year and a bit. From an
operational point of view, most expect that with junk status will come the
inevitable interest rate increases and the majority are reasonably well-positioned
from an interest rate hedging point of view.
“Those not hedged and with high gearing are
going to be hit by interest rates,” Stevens says.
Challenges
Given the greater uncertainty surrounding SA
after junk status, SA’s REITs might be more circumspect when it comes to making
local acquisitions and pursuing their development pipelines in SA. Disposal
programmes too could be affected.
“Interest rates will go up. Acquisitions of
property will be more difficult because it will be more expensive to gear,”
says Stevens.
“There will be some impact on funding costs
because bank funding base rates and spreads will rise. That means REIT funding
base rates and margins will become higher too,” says Emira Property Fund CEO
Geoff Jennett. “And, if there is a general tightening of credit conditions,
then potential buyers will be affected, which will also slow down disposal
programmes.”
A downgrade means less money coming into the
country, and less money for spending and circulating. It exerts even more
pressure on an already weakening economic environment that had already begun to
impact property sectors like retail, where trading densities are down.
“While good and dominant assets continue to do
well and deliver positive rental growth, a weakening economy has seen the local
market becoming extremely competitive across most of the sectors, especially
office and retail. This continues to put pressure on rental growth. Vacancies
are also increasing in the industrial space but they are not out of control,”
explains Stanlib’s Ndlovu.
Says Growthpoint’s De Klerk: “A reduction in
market confidence will result in a further weakening of demand which in turn is
negative for rental levels.” He adds that a decline in retail spend is
generally bad for the economy which the SA REITs trade in.
Even so, Ndlovu expects the trend of expansion
to offshore markets to continue, albeit at a slower pace. The silver liningOn the bright side for the sector, the rating
downgrades were foreseen and factored in through offshore expansion, debt
hedging and low gearing, mitigating its effe cts.“From an offshore diversification perspective, the
move to junk status certainly highlights why offshore diversification is so
important and this is something that has been receiving much more attention
recently,” says Emira’s Jennett.SA REITs are somewhat cushioned from local
events by offshore hedging. “Most SA REITs have some sort of offshore exposure.
On average the REITs have about 30% of their investments offshore. So while
there might be negatives locally, the REITs derive the concomitant positives
from that offshore exposure,” says Fortress’s Stevens.Despite income growth slowing down in the local
markets, this too is being cushioned by offshore exposure or expansion. In 2009, SA REIT offshore earnings were a
paltry 1%. Today 40% of earnings come from outside SA, partially hedging the
sector from local events. SA’s REITs are attractive not only for their
ability to identify assets that generate returns for shareholders and where
sustainable growth on those returns can be made in the future, they are
attractive for another reason, especially for international investors, and it
has to do with compliance. The REITs’ level of compliance, which includes
auditing standards, REIT standards, stock exchange requirements and the King
Code, surpasses that of even some countries within Europe. It’s a big tick, and that, together with the
sector’s inflation-beating returns, could prove to be a big carrot on the stick
for investors willing to set aside downgrade risk in the chase for yields. In 2016, SA REITs raised over R26bn in new
equity, coming from new listings, dividend reinvestment plans, mergers and
acquisitions, and secondary placements. A strong appetite for offshore exposure
from local investors has also seen JSE listing proving attractive for offshore
REITs, the likes of Eastern European property funds Global Trade Centre (GTC)
and Echo Polska Properties, and UK-based Hammerson plc (now the largest listed
property stock on the JSE) tapping into the local market and providing
investors with access to hard currency income.We may see more offshore companies coming to
list in SA. “We continue to have frequent visits or enquiries from offshore
companies looking at the prospects of listing in SA, or attracting SA
investors,” Ndlovu tells finweek. Despite the downgrade and a low-growth domestic
environment, rating agency Moody’s expects the performance of rated SA REITs
Growthpoint Properties, Redefine Properties, Fortress Income Fund and Hyprop
Investments to remain resilient courtesy of quality properties in prime
locations, broad sector/tenant diversification and offshore property exposures.Property is a long-term game, with analysts
often encouraging investors to hold a long-term view and to ride out
volatility.“Coming out of junk status and a return to
normality can take as long as five to seven years. But REITs who have hedged
their businesses, those who have offshore exposure, will weather the storm and
go forward,” says Stevens.
This is a shortened
version of the cover story that originally appeared in the 25 May edition
of finweek. Buy and download the magazine here.