OPINION | Unloved and undervalued – why SA property shares may finally deserve attention | Business

There is evidence of improving fundamentals across the SA listed property sector, writes Shane Packman.

South African investors
have a love-hate relationship with listed property, with significant shifts in
sentiment and demand evident over the last 10 years. Before 2017, it was quite
common for multi-asset funds to have healthy allocations to the SA listed
opportunity set mostly due to the appeal of property companies offering
relatively stable dividends.

The SA property market
demonstrated strong performance between 2013 and 2017, attracting significant
investment flows into the sector, as depicted in the chart below.

Sentiment towards the
sector began to weaken in early 2018 as market participants became concerned
about the overuse of debt, possible financial engineering, as well as corporate
governance problems. The sector was further hindered by expensive valuations,
unsustainable earnings and deteriorating local conditions. The FTSE/JSE SA
Listed Property Index lost 62.6% of its value between 1 January 2018 and 31
October 2020 with most of the drawdown occurring during the outbreak of the
Covid-19 pandemic.

While the asset class has
recovered somewhat from pandemic lows, industry flows have remained relatively
muted. The question for investors is whether the sector still provides
opportunity during times of uncertainty.

While market sentiment
continues to deteriorate, there have been some improvements in fundamentals to
suggest that investors should not ignore the sector altogether.

Diversified
revenue streams

Similar to SA equities, the SA property sector’s revenue
decomposition has changed over the years to be slightly less reliant on the
local economy for driving earnings.

As can be seen in the below graph, approximately 43% of the revenue of
the FTSE/JSE SA Listed Property Index is generated from outside South Africa.
Therefore, it is important to emphasize that the sector’s dividend yield and
return are derived from both local and offshore revenue streams.

The largest constituent in the FTSE/JSE SA Listed Property Index is Nepi Rockcastle (which accounts for 21.5% of the index) and
almost 100% of its revenue is derived from central and eastern Europe. While
global property has faced its own challenges, Nepi
Rockcastle has reported strong distributable earnings, reflecting resilience
from the latter regions.

While the quality of earnings is not as high as in the SA equity
universe, there is evidence that management teams have attempted to tilt
underlying property portfolios towards more global exposure. Most importantly,
companies are no longer paying out 90% to 100% of their earnings which
significantly improves the robustness of their business models.

Balance
sheet strength

The Covid-19 lockdown allowed many property companies to pay down their
debt while holding back payouts, reducing their holdings in non-core assets and
cleaning up their balance sheets.

This improvement can be observed in loan-to-value (LTV) ratios, that
measure a company’s nominal debt against the value of its underlying
properties. The graph below shows that, while current LTV ratios are still
above the long-term average, there has been a noticeable decline – to levels of
around 37% over the last three years. The spike in 2020 was due to write-downs
in asset values negatively impacting LTV and interest coverage ratios.

A higher interest rate and lower growth environment is likely to test
the resilience of company balance sheets. Nonetheless, the fixed-rate nature of
the sector’s debt maturities does provide a buffer in the short term. On
average, the sector has 75% to 80% of its debt fixed for an average tenure of
between two and a half to three years. We are, however, cognisant that the
interest impact of debt on these companies will likely increase as these fixed
obligations roll over at higher rates.

Diversified underlying property portfolios

The three segments making up the SA Listed Property Index (SAPY) –
namely retail, industrial and office – have differing landscapes, opportunities, and headwinds.

The largest segment, from a
South African perspective, is retail which makes up more than 60% of the
index by market capitalisation. Overall, national retail vacancies have shown
resilience coming in at 5.4% at the end of the first quarter of 2023, which is
below the peak of 7% recorded in 2021.

Recent results in the retail space show signs of resilience and some
green shoots, as rental reversions have turned upward. The outlook remains
cautious given the health of the consumer, however, there continues to be a
reasonable demand for good quality and well-located retail space.

The second largest segment within the SA Listed Property Index is the industrial
property sector, which makes up just under 20% of the index. It has continued
to be the outperformer among the three major sectors in South Africa, with low
vacancy rates (currently at 4.4%) and the highest base rental growth. It is
important to note that there are various sub-sectors within the industrial
sector and, while manufacturing still faces headwinds, logistics and storage
have been buoyed by good demand.

Office space (making up less than 15% of the index) remains
tough as work-from-home pressures and weak business confidence continues to
hamper vacancy levels. The segment is experiencing a significant demand and
supply imbalance (occurring since before the COVID-19 pandemic) which has
resulted in national vacancies of 15.6% at the end of quarter one of 2023.

Despite the grim outlook, office vacancies appeared to have plateaued
and have slowly declined from their all-time high of 16.7% in the second
quarter of 2022. Importantly, the construction of new offices remains low. New
office supply is likely to remain muted and be tenant-driven over the short to
medium term, given the amount of space readily available and the high costs
associated with building.

Discounted valuation

The property sector continues to trade at a significant discount to net
asset value (NAV), which falls below its 10-year average.

South African-focused property companies’ NAV growth is expected to be
weak on the back of a tough local economic environment. While South African
property companies have been battling low economic growth, high-interest rates
and a tough trading environment, current valuations do indicate, for some, a
particularly gloomy downside. At a current discount to NAV of around 30% – 40%,
property valuations would need to fall significantly for investors to suffer
permanent losses on capital.

Recent results have also come in better than expected, with global
property counters such as NEPI Rockcastle, MAS, and Hystead
(wholly owned by Hyprop) reporting excellent distributable earnings growth,
reflecting stronger-than-expected regional fundamentals. Driven by strong
occupier demand and constrained supply, property valuations have been stable
despite higher bond yields in the central European region.

Cheap?

While the market is pricing in particularly poor outcomes, there is
evidence of improving fundamentals across the SA listed property opportunity
set.

The shift in revenue exposure to global markets provides access to a
diversified revenue stream, reducing reliance solely on the local economy.
Balance sheets are less leveraged with lower LTV ratios and a higher percentage
of retained income. Many property companies have also been investing heavily in
becoming less reliant on the national power grid, which could potentially
improve the long-term sustainability and resilience of their operations.
Valuations in the market appear cheap and positive rental reversions and
better-than-expected earnings could see a rerating
in the sector.

There are, however, significant challenges and negative factors to
consider. Local economic headwinds continue to hamper growth, and higher
interest rates could become problematic in the future. The weakness in the
South African consumer base might also dampen sentiment towards the property
sector. The outlook for different segments of the property market is also
likely to become an important driver of prospective returns from the sector.
Given the difficult headwinds facing businesses and consumers in South Africa,
caution remains essential for investors.

Shane Packman is an associate investment analyst at Morningstar South Africa.

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