THE CONTRARIAN CASE
FOR PROPERTY STOCKS

JSE-listed property stocks have had a hard time over the past four years, delivering a total return of negative 31% (-9% per year) – a whopping 77% behind the 46% (10% per year) that the South African equity market as a whole achieved over the period. The industry’s substantial capital losses in 2020, coupled with skipped or significantly reduced dividends, have shown that property should not be viewed as a proxy for fixed-income securities like bonds, where returns are contracted.

Since the start of 2020, the SA Property Index’s total return of -21% was certainly disappointing for those invested in this sector. At Sanlam Private Wealth, we’ve been underweight in property stocks in our multi-asset portfolios for more than five years, and we haven’t owned any in our houseview equity portfolio over the period.

THE BEAR CASE

In the face of the generally negative market sentiment toward listed property, why have we decided to up our exposure to the sector? The bear case for property stocks is well known:

• Given that most South African property companies’ assets are primarily retail and office property, the structural shift towards working from home is negative for the demand outlook. Large corporates are more willing than ever to allow remote working, which of course reduces their office space requirements.
• The acceleration in online retail is evident across the globe, with adoption and acceptance rates increasing substantially through 2020. Comments from e-commerce leaders suggest that the industry made three to five years’ worth of progress in a single year.
• With lower demand for space, the balance of power has shifted towards tenants, meaning that lease renewals will likely continue to see prices come down.
• The balance sheets of many local property companies were stretched in 2020, creating uncertainty for investors, particularly around distributions. Given the contractual nature of their revenue streams, these companies typically have higher levels of debt than industrial businesses. Throughout 2020, this drove concerns about the sustainability of these businesses – a situation not helped by the requirement to pay out at least 75% of earnings in order to retain their REIT status and thus not pay tax (instead, the distributions are taxed in the hands of the recipients). However, through a combination of skipping and delaying dividends, disposing of assets and some capital raises, most of the constituents of the SA Property Index now have materially stronger balance sheets than they did a year ago.
• Dividend payout ratios will likely stabilise at around 80% of distributable earnings, below the near-100% of the pre-pandemic years. A key reason for our being underweight in property over the past five years is that we viewed the valuations as too demanding. Our analysis suggested that these companies would not be able to sustain both high growth and the near-100% dividend payout ratios that the market was baking into stock prices. This has now changed, with the market seemingly factoring in more sustainable dividend payouts going forward.

‘NEW NORMAL’ OPPORTUNITIES

Most of the above was already obvious in late 2020 and was thus reflected in prices. When the general sentiment towards a sector is negative, it can create opportunities. In particular, our investment philosophy at Sanlam Private Wealth focuses less on the short term than on what the ‘new normal’ in a post-pandemic world might be.

While we’re fully aware that office vacancies across South Africa are at their highest levels since 2004, the other side of the coin is that new office space under development is even lower than it was at that time. Therefore, while it will take some time for the existing vacancy rate to normalise, this will be helped by the lack of new inventory coming onto the market.

Our analysis suggests that distributable profits from the JSE-listed property sector as a whole will return to their 2019 levels only in 2024 or thereabouts, and we value these businesses accordingly.

Having factored into our valuations all the negative views above, as well as the likely higher required returns from property given the volatility of recent years, our numbers suggest that even the larger, more liquid locally listed companies are being priced as though they’ll either not grow at all from 2024 onwards (for example, Nepi Rockcastle) or grow well below inflation (for example, Growthpoint). While we don’t expect a repeat of the double-digit growth rates that the industry delivered in the eight years post the financial crisis, property companies should be able to grow distributions at or near inflation after 2024.

ATTRACTIVE YIELDS

Yields are starting to look attractive again. Growthpoint now trades at a yield of around 11% two years out, while Nepi Rockcastle, which generates its income in hard currency, should deliver around 8% when looking 18 months forward.

As the world normalises over the coming years, we expect JSE-listed property companies’ earnings to recover and return to growth. With company balance sheets now stabilised and the market still nervous, we see this as the appropriate time to increase the property exposure in our multi-asset portfolios.