Should investors buy REITs that have exposure to the office sector?
Over the past five years, the office property sector has suffered from a mixture of negative factors, led by the oversupply of gross lettable space. According to the South African Property Owners Association, in December 2019 the office vacancy rate was 12.7% and deteriorated to 18% in December 2021. It improved marginally to 16% in Q322. Rising office vacancies were exacerbated by the COVID-19 lockdowns and an exponential increase in the adoption of remote working. Post the COVID pandemic, some companies have embraced a hybrid working model which, in most cases, allows employees to work onsite for two to three days a week. This has resulted in workspace optimisation and contributed to the downsizing of office space by tenants, especially at lease expiry. According to our research, more than 60% of listed property companies in South Africa have exposure to the office property sector. Given the low vacancy rates in retail (5%) and industrial (4%), it is prudent to conclude that high office vacancy rates have made a significant contribution to the de-rating of the listed property sector, which currently trades at a 40% discount to NAV.
High vacancy rates do not bode well for rental growth as property owners experience negative rental reversions at lease expiry. When rental growth rates decelerate, property valuers write down property values. According to MSCI, in December 2021, the office property sector valuation declined by 10.2%. According to the Property Sector Charter Council, the total South African office market was worth ZAR437bn in December 2020, which means write-downs were around ZAR45bn a year later. However, in recent months, property valuations seem to have stabilised against the backdrop of declining vacancy rates. Most REITs have reported marginal decreases in office property valuations.
According to property research company Rode & Associates, gross nominal rentals for decentralised grade A office space rose by 2% year-on-year in Q322. In real terms, rentals decreased by 8% due to the 10% increase in building costs. Furthermore, it is noteworthy that gross rents do not factor in tenant installation allowances, rent discounts and free months’ rent to attract tenants. The net rentals (revenues) received by property owners are, to a large degree, still in a depressed state. In Sandton, Johannesburg, some office landlords are offering six to 12 months of free rent to prospective tenants, according to billboards and anecdotal evidence.
According to Rode & Associates, Cape Town’s grade A office rentals increased by 7.6% year-on-year in Q322, which was lower than the Bureau for Economic Research’s building cost index of 10%. In Durban, Johannesburg and Pretoria, nominal rentals rose by 1%, 3.8%, and 3.3%, respectively. In real terms, rental growth rates for all the big metropolitan areas were in negative territory. In a nutshell, rising building costs are putting a squeeze on property owners’ income in the face of a struggling office market. The building cost index is used by maintenance contractors for pricing purposes.
According to MSCI, approved office building plans declined by 50.1% year-on-year in June 2022. Between June 2019 and June 2022, building plans plunged by 74.2%. There is a muted development pipeline of office buildings. It is difficult to believe that there will be a quick recovery in the office construction market given the current glut of office space. Total South African office space is 19m sqm, and 3m sqm of office buildings were unoccupied in Q421, according to MSCI. Forgone rental income due to this high vacant space is negative for revenue and net property income, the key variables used to value properties. Some property owners are repurposing their buildings, converting them into residential buildings, but this is still on a small scale.
The South African National Treasury expects GDP growth to remain below 2% in 2023 and 2024. The combination of weak economic growth and high unemployment does not provide a conducive environment for the office property segment to recover. The official unemployment rate remains above 30%, and the expanded definition of the unemployment rate is above 40%. Similarly, youth unemployment is around 70%. Together with severe energy problems, this remains a major constraint on economic activity and the demand for office space.
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