Since the start of the year, the South African Listed Property Index has declined by 22% on a total return basis. The appropriate question to ask now is: are local property stocks starting to offer value as a result of recent price corrections? Or is it too early to start viewing them in a more positive light?
As an asset class, listed property remains relevant as it allows investors to beat inflation through capital investment growth and contractual rental income distribution. It also provides good diversification within a traditional portfolio containing stocks and bonds.
We previously held the view that listed property looked expensive on a risk-adjusted basis. More recently, however, a number of local funds have reported negative distribution growth, with difficult trading conditions cited as reason for the poor performance.
The poor performance of domestic counters has resulted in price corrections across the sector. Our investment philosophy has always held price as the focal point for making a good investment – so is it time to start buying local listed property counters, even amid all the negative news flow?
To answer this question, let’s look at what would be required for listed property funds to achieve positive distribution growth. We’d need to see:
Escalating positive rentals in terms of leases with new tenants
Satisfactory renewal of leases with existing tenants
Renting of vacant space within the property portfolio
Management and reduction of costs associated with the portfolio
Acquisition or development of revenue-enhancing properties.
Building on this checklist, the contractual nature of the property management business should also be considered when looking at listed property as an asset class. Put simply, new or existing tenants enter into contracts to rent space from landlords. When looking at property stocks, contractual agreements allow for greater predictability and visibility of future earnings. Contracts are renewed as and when required and are renewed at positive, flat or negative reversions depending on prevailing economic conditions on both macro and micro levels.
As a landlord, you ideally want long-term contracts during poor economic times, when the negotiating power switches to existing or prospective tenants keen to secure lower rentals. Conversely, you want shorter-term contracts during stronger economic periods. Management teams must strike the correct balance between length of lease and rents achieved.
In our view, due to the contractual nature of the business, the financials of local listed firms are lagging the current operating environment. The weakened local fundamentals will still wash through company financials for some time. Our economy is struggling to grow and there’s an oversupply of office, retail and industrial properties relative to demand.
FOCUS ON TENANT RETENTION
Given this operating environment, domestic listed funds will continue to focus on tenant retention, albeit at lower, if not negative, rental growth. Reduced rental is better than no rental resulting from a vacancy. However, reduced rentals will continue to hamper distribution growth going forward.
Another factor that will continue to hamper distribution growth is the spread between the cost of debt and the available yields at which funds can invest locally. In South Africa, we’re seeing a negative spread, as the cost of debt continues to be greater than investment yields. In the local economy, pricing for assets remains sticky at elevated levels, making accretive acquisitions difficult. This has been a major driver for offshore expansion, as one is able to borrow money at extremely cheap rates to fund accretive acquisitions or developments.
While we do see value appearing in the local listed space, we still think there’s a disconnect between the fundamentals and the price, due to the contractual lag and other factors. An attractive entry point for us would be when the market extrapolates a weak environment into perpetuity – simply put, when the market price of stocks reflect that the operating environment isn’t likely to improve. This will give us the opportunity to invest at the correct price. Until then, we remain patient and vigilant.
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