SA listed property:

is it a value trap?

Read an abridged version of the webinar transcript below, and watch a recording here:

Alwyn: After around 16 years of quietly outperforming other asset classes, the South African Listed Property Index has pulled back dramatically since the start of 2018, the rapid decline exacerbated by the events of 2020. Estienne, could you give us an overview of the current state of listed property stocks? Is there still an investment case to be made for the sector?

Estienne: Clearly, we’re not in the seven fat years in terms of real estate at the moment, and if you look at what’s happening on the stock exchanges, the sector has taken a huge amount of pain. But while there’s not a lot of love for the industry right now, I do believe there is still some value to be had. Why do I think this? Well, look at the current yield environment – if you invest in global bonds, you actually have to chip in, in certain areas. If you’ve got cash in a euro account, bizarrely, you have to pay the bank to keep it for you. As an investment class, listed property is diversified away from these asset classes, so it will always provide good diversification within a traditional portfolio containing stocks and bonds. In my view, it should certainly form part of a properly constructed investment portfolio.

The biggest single factor affecting real estate at the moment is South Africa’s struggling economy, which is impacting demand. Generally, if you look across markets for the past nine years or so, our economy has taken strain, and as a result, listed property companies haven’t grown materially in terms of their value. Overlay COVID-19 onto this, and of course you’ve got an absolute nightmare. In my entire career, from an operational management perspective, I’ve never encountered a situation like we had in March where government literally closes down an entire sector, while all the usual expenses, such as rates and taxes, and bonds on properties, remain in place. And then of course a client base which cannot pay rent since they can’t operate.

We did manage to pull the industry together fairly quickly, however, and I think as a country, we’ve done pretty well to work through the challenges reasonably fast. Looking at Growthpoint in particular, while we have by no means emerged unscathed, we’ve done well compared to some of our peers, mainly since our business is highly diversified – we’re invested in a broad range of sectors, including retail, office, industrial, even hospital exposure. Each of the sectors we’re in has its own unique trends, and the sectors aren’t necessarily correlated. However, our sluggish economy has impacted all property sectors.

Let’s look at the various sectors in more detail. With regard to retail, we’ve seen quite a lot of expansion in terms of big malls in South Africa, which has led to oversupply. Ironically, this has been driven by the retailers themselves committing to every guy with two bricks and the rights to build retail. I think this movie is over, to be honest. Interestingly enough, what we have seen with COVID-19 is that while footfalls dropped during the lockdown, people quickly came back to shopping centres, although not as often as before. However, they seem to be spending much more than they used to, especially on things like home goods, leisure and athletic wear, and so on. Much less on suits and ties, of course! The bottom line is we certainly don’t see shopping centres disappearing any time soon in South Africa.

From an investment perspective, for real estate owners, shopping centres do require significant capital to maintain them, and to keep them attractive for not only tenants but also shoppers, who want an environment in which they feel safe, and where they have a good offering. And capital is rather expensive for the sector in this specific area. So I do think that globally there’s a big amount of capital looking to move away, out of retail, at the moment. The worst country in this regard must surely be the UK, where there is a government-endorsed rental strike, and we’ve seen valuations tumble dramatically in retail.

In terms of office space, the sector has naturally been impacted by people working from home over the past few months. However, we don’t see this as a long-term trend. Our ailing economy has had a much larger impact on office space over the past five years than any other short-term factor or trend, including the concept of collaborative workspaces.

On the industrial side, this sector seems to be defying gravity in many respects. While there is weakness in retail, we are certainly seeing a lot of money flowing into industrial. The big investment themes in listed property are currently playing out in this sector, which is seeing significant growth. In fact, of the three sectors – retail, office and industrial – industrial is now performing the best.

We’ve also seen strong growth in healthcare, mainly because of the long leases in this sector, and there is good demand from the operators to expand their footprint in a country that needs additional healthcare space. We also foresee good growth in sectors like student accommodation and telecoms infrastructure over the long term in South Africa.

One positive trend that is emerging in real estate in South Africa is the strong growth in sustainability and green building initiatives across the sector. This is not only bringing down the cost of occupation for our tenants, but it’s also ‘doing the right thing’ in terms of the actual bricks and mortar. The technology going into new buildings is much improved – for example, most large real estate companies today generate quite a lot of money from solar power on their roofs. In fact, I would argue if it wasn’t for the current regulations around electricity generation, the sector could be a significant power producer – certainly for their own properties.

So looking at the bigger picture in the property sector, there is clearly bad news, but there is also good news, not least of which is the current low interest rate environment, which we hope will see our economy move forward. In addition, if the global economy picks up a bit, this will also play out into the South African economy, which will certainly support listed real estate.

David: How has the COVID-19 pandemic changed both the retail and the office environment over the long term, i.e. over five to 10 years? Has it structurally changed the way we should view property?

Estienne: Let’s start with retail. In developed markets, the online shopping trend is playing out differently in different jurisdictions. As to the future, well, if I had a crystal ball, I would have polished it and given you an exact answer, but in truth none of us really knows what will happen. But, disregarding COVID-19 for a moment, what we’ve seen in the US and the UK, for example, is that the online trend has topped out. In the UK, online has topped out at about 25% of total retail. In South Africa, this figure was only about 1.8% a year ago (it has now gone up to around 5.5%). Of the 1.8%, half was for services such as airplane and movie tickets, so it wasn’t really retail. Over the past couple of months, we’ve seen a big uptick in online shopping, especially for groceries, but this is predominantly in the sophisticated, middle-market sector and doesn’t apply to all retail clients.

Investors need to take into account that the retail environment is rather inconsistent at the moment. For example, there’s been a skew in trade as some people have returned to rural areas, where we’ve seen good retail performance, aided by additional grant money. While online will likely continue to grow, we do believe we’re likely to see retail ultimately circle back to some kind of normality going forward.

In the office space, vacancies had already been ticking up for the past five years due to economic pressures. However, there is still a demand for quality, top-end office space, so we are still seeing development in this area. For example, Growthpoint recently completed a 35 000m2 office complex in Rosebank, and this building is fully let. But there is definitely oversupply, and older office buildings may have a limited lifespan since they are uncompetitive from a cost perspective, and they don’t have new technology, which rather limits their prospects in our present economy.

One thing we do know is that people do want to return to work. There are a lot of things you can’t do from home, and many people want the interaction with their colleagues. Also, it’s very difficult to mentor younger or newer staff members remotely. And in the South African context, many people don’t have good connectivity or the type of residential set-up which enables them to work from home. For us as real estate players, we’re going to have to step up and provide more services and more amenities in our office buildings for people returning to work – I think this will be a major theme in the office space in future.

Dave: Investors typically invest in property companies for the income, for the dividends. Local real estate investment trusts (REITs) like Growthpoint are required to pay out 75% of distributable earnings to shareholders, but we’ve seen cases in the past where REITs have paid close to 100%. Is the industry likely to now go back to 75% in order to nurse their balance sheets back to health?

Estienne: The retention of capital by a REIT is certainly a way to strengthen the balance sheet, but it’s also a way to ensure sustainability of the company. To stay in business, you need to upgrade your shopping centres and keep refurbishing your office spaces, especially those nearing the end of their lifecycle. In the current environment, most boards have had to err on the conservative side, especially if rental income is insecure or there is the threat of your entire business being closed down by government.

I do believe, however, that when things normalise – which they in all likelihood will over time – paying out a reasonable level of distribution will certainly be the order of the day. That’s the way the REIT model is designed – it’s effectively the cheapest and most liquid way for investors to get real estate exposure. And the REITs generally have paid distributions. Even today, I do think most of them will pay at least the 75% because otherwise they’ll run into regulatory difficulties. What we will probably try and do from a sector perspective is negotiate around 10% that REITs can withhold for maintenance capital expenditure, since in this environment, it is important that they retain some capital to reinvest into their properties.

Alwyn: A last question – how would you respond to your own mother if she told you she’s keen on buying listed property shares?

Estienne: Well, there’s no doubt there is tremendous uncertainty in the sector at the moment, and we don’t know what will happen with our economy. If the current policies continue to be followed at government level, we’ll probably continue to have problems. However, changes in some of those policies, the introduction of austerity measures, investment into infrastructure, and more privatisation will be strong growth drivers for our economy.

On this basis, I would argue that it’s not a bad bet to put a couple of listed property shares in Mom’s box. While this year she may not have received the same distribution that she did last year, she will be getting distributions. Also, relative to other asset classes such as cash, where she’s seeing only half the interest she did last year, I do believe that there is some upside in listed property which, over the longer term, could be quite generous.