The ugly duckling asset class fluffs up its feathers

04 November 2022

The listed property asset class in South Africa has underperformed most major asset classes, from equities and bonds to cash, over the past few years.

Following the deep Covid-19 lockdowns of 2020, the sector has gained +103.87% on a total return basis from the trough in 2020 to the peak at the beginning of 2022.

Covid-19 and its lingering implications, such as retail and office occupancies and the repurposing of office space into residential units, isn’t alone in affecting the sector. Other challenges that were faced by South African listed property over this period include the July 2021 civil unrest and the extensive flooding in KwaZulu-Natal in April 2022, both of which resulted in a number of assets being damaged.

It is encouraging that while issues still persist, there is evidence of some green shoots. This is particularly true of the local retail sector.

What cannot be discounted, however, is the fact that headwinds in the current economic environment abound. Offshore markets, including Central and Eastern Europe, Spain and the UK, account for just under 50% of the overall South African listed property sector exposure by asset value and are facing arguably even bigger macro challenges than South Africa currently.

KEEP AN EYE ON…

Some of these challenges, to single out just a few, include high inflation and the resulting increase in the cost of funding as interest rates continue rising globally in line with central bank intentions to cool high inflation levels. This is highly relevant since the sector’s gearing or loan-to-value levels are just under 40%, a somewhat improved level relative to the situation pre-Covid. The cost of funding for real estate companies tends to be among the most material cost-related items.

Property-related costs are also escalating at rates exceeding top-line rental growth levels, which is compounded by administered costs such as electricity and rates that have been increasing at rates higher than inflation. Elevated inflation levels and interest rate increases will also likely have a negative impact on consumer spending which means retail turnover and trading densities will come under pressure. Higher bond yields could have negative implications for underlying property asset valuation yields, especially if they remain elevated for some time and in the absence of good rental growth.

BUT IT'S NOT ALL NEGATIVE

On the positive side, top-line rental income has shown good improvement having normalised after being negatively impacted during the throes of Covid-19. Certainly, rental concession are a thing of the past.

During the pandemic, the sector provided rental relief to various tenants totalling R3.5 billion. Since then, the retail sector has experienced a positive improvement in rental turnover figures with most centres generating figures above pre-Covid levels. This, to a large extent, implies that tenants are healthy, a development that could well manifest into a positive rental trend as the market's cost of occupancy continues to improve.

The deep negative reversions that have been experienced over the past two years could well mean that rentals have rebased to far more palatable levels. Retail vacancies have also showed signs of improvement as certain retailers have taken the opportunity to expand at a time when rentals are being rebased lower. Most of the resizing and former department store excess space has largely been absorbed. This is evidenced by the reduction in vacancies in retail.

A LONG-TERM HORIZON ASSET

Having a glance at valuation metrics such as forward dividend yields and price to book, an argument can be made that listed property does offer value at current levels and especially if one has a long-term investment horizon.

The sector is currently trading on a forward yield of about 11% and a 31% discount to historic net asset value. Especially considering that rentals have largely rebased to more sustainable levels and underlying property values have faced varying degrees of write downs since Covid-19, it appears that the sector is now turning the corner. Despite these green shoots, a more defensive stance within portfolios is still, however, warranted given the macro headwinds.