A Perspective On Property
Category Property Industry Reports
To understand where the listed property market is going in 2018, we need to consider what happened last year. It was the year of outperformance from Europe, with real estate investment across the continent at very high levels. The EU economy is in good shape, led strongly by policy and directives from Germany, and with recoveries in the Southern European economies of Spain and Portugal. The Central Eastern Europe (CEE) region offers investors stronger GDP growth prospects, but with elevated risks in the form of fiscal policies, geopolitical uncertainty and domestic political risk.
The UK remains an unknown, as concerns over Brexit continue to plague investors.
The SA economy is in a lacklustre state, with rising debt levels and a seeming lack of commitment within government to address this. Threats of further credit ratings downgrades loom, with Fitch and S&P having downgraded SA’s foreign and local currency rating in November 2017. Moody’s has SA on a negative watch, with the strong possibly of a downgrade. In addition, a severe liquidity crisis is facing power utility Eskom.
These factors are expected to result in capital outflows and rand weakness, depending on the extent to which the downgrade is already priced in.
Given the moderation in inflation, the South African Reserve Bank (Sarb) lowered interest rates by 25bps in July 2017. Further rate cuts may be possible given the lower inflation forecasts and rand strength following the election of Cyril Ramaphosa as ANC president. However, that would put South Africa out of line with developed markets, which are raising rates, resulting in SA’s bonds losing their appeal to yield-seeking investors. The US should continue to raise rates gradually but consistently in 2018, which will influence Europe, although there will be a lag effect.
Property fundamentals have deteriorated throughout 2017 along with the growth expectations of local listed property counters. Despite the weak operating environment, forward yields of domestically-focused counters look increasingly attractive at almost 9%. We expect investment in Europe to continue to dominate the South African property landscape.
Listed property market
Quality of earnings
In 2017 there was a decline in the quality of earnings of several listed property companies. While managing to maintain their growth trajectories, income was boosted in many cases from once-off sources, such as trading and capital profits, and foreign exchange gains. Poorer quality income, even if sustainable, dilutes the investment case, and we expect to see a derating in
stocks that are diverging away from offering pure property income.
Cross-currency swaps and interest income are making up a larger portion of companies’ financials. Several funds took the opportunity in 2017 to ‘rebase’ their dividends, setting themselves up for future sustained growth at the expense of low short-term dividend growth.
As local property fundamentals weaken, counters offering offshore exposure in high-growth regions continue to outperform those Reits with greater
exposure to South African assets. We expect this trend to continue into 2018. It must be noted however that indiscriminate investment offshore for the sake of a currency play is not sustainable. There are many companies that have executed well thought-out strategic offshore plays, which both complement their local strategy and enhance it. Equally, there may be some offshore investments by South African Reits which could prove to be unsuccessful and difficult to sustain in the months or years to come.
The Sapy offered a 9.9% price return and 7.2% income return, delivering a total return of 17.2% for 2017.
Review of top-performing stocks in 2017
In January 2017, our top picks for the year were the high-growth companies, namely Resilient, Fortress B, Nepi Rockcastle and Greenbay, as well as Equites, MAS and Delta.
Offshore and hybrid funds, making up about one third of the Sapy, contributed more than two thirds of the Sapy’s total return. Top performers in 2017 included offshore funds such as Greenbay, Sirius, MAS and Nepi Rockcastle, which all delivered strong distribution and capital growth in their local currencies. The top performing SA-focused fund was Equites, which delivered 14% distribution growth for the 2017 financial year and a further 12% for the half year to August, and is expected to deliver around 10% growth per annum over the medium term. Hybrid funds Fortress B and Resilient, with about 50% exposure to offshore assets, were also in the top funds for 2017.
Stocks such as Octodec and Arrowhead, which reported negative earnings surprises and significantly lower growth forecasts, were among the worst-performing stocks for the year, while pure retail funds such as Hyprop and Liberty 2 Degrees were hit due to their exposure to a weak consumer and the closure of Stuttafords across several of their malls.
Current market fundamentals
Trends in retail over the past year have shown a divergence away from super-regional shopping centres, with consumers preferring to visit community and neighbourhood centres. Globally, the attractiveness of retail assets has begun to wane as the threat of online shopping spooks investors. We see this as the spark of new retail trends, with a much larger shift towards leisure and entertainment. Food is the new fashion and shopping malls will have to reinvent themselves as community centres, collection points for online orders, social recreation places and even charging stations for hybrid and electrical cars. In SA, we favour centres with a higher exposure to non discretionary spend as money provided through social grants is recycled back into the malls.
As the market evolves, it becomes increasingly important to distinguish between true industrial, and the new modern logistics facilities and distribution warehouses. Globally, prime logistics facilities with blue-chip tenants are fetching record low yields and provide stable earnings for income-focused Reits.
Flexible working solutions and shared spaces are mopping up some of the excess supply in office space. Given South Africa’s stagnant economy, office is our least preferred sector as funds struggle with the costs of attracting and retaining tenants, coupled with increasing municipal charges, higher vacancies and negative renewal growth.
Despite a continued structural shortage in residential stock throughout SA, Reit landlords are struggling to force through annual rental increases to tenants, as tenants are increasingly under financial pressure from all sides and costs associated with tenant retention eat away at the escalations. We continue to favour the sector for its defensive qualities but forecast subdued growth going forward.
Other: infrastructure, storage
New asset classes have come to the fore in recent years, offering investors diversification away from office, retail and industrial. These include infrastructure, which can serve as a complementary investment, and self-storage, which requires good strong management in order to extract maximum value.
Total return outlook
While the strength in the rand in recent weeks following the ANC’s December conference, and into January, is encouraging, it puts pressure on distributions from the foreign-listed companies and income streams from foreign direct property investments held by SA listed property companies. As always, we are subject to political volatility and, in a year where the ANC sits with two seats of power divided between the party president and state president, we expect a fair bit of that.
If South Africa muddles through these political and economic headwinds and delivers on the forecasted GDP growth of ~1%, we expect a total return of around 14% for the SAPY index. The income generated by the sector will provide a yield of around 6.6%, while the capital return can vary in this volatile market to produce a capital return of between 6% - 9%, and will depend on a number of factors, including news around our bond market rating, currency and political events.
Author: Liliane Barnard