South African listed property sector
The South African listed property index has posted poor returns in the past three years, as evidenced by the -25.3%, 1.9% and -34.5% total returns in 2018, 2019 and 2020, respectively. Driving these lacklustre returns are weak domestic economic growth, oversupply of lettable area in the office and retail sectors (regional malls), coronavirus pandemic lockdowns, rising loan-to-value ratios and firm bond yields. Based on our calculations, the sector is trading at a c 30% discount to NAV. We believe this could narrow, mainly due to the anticipated dissipation in risk aversion, as a result of the coronavirus vaccine rollouts, the projected economic recovery in South Africa, the UK and Central and Eastern Europe (CEE), and the US and EU fiscal stimulus packages. We expect an improvement in global and domestic property fundamentals such as rent collections, net operating income, balance sheets restructuring and dividend growth to bolster total returns in 2021.
CEE and UK economic recovery to support the sector
We believe the South African listed property sector will benefit considerably from its global diversification, which, arguably, reduces its reliance on the domestic economy’s pedestrian growth. According to our analysis, 47% of the South African listed property sector’s revenue and distributable earnings come from CEE, Western Europe, United Kingdom (UK) and Australia. The IMF expects the CEE region and the UK economy to rebound significantly in 2021, posting 4% and 4.5% GDP growth, respectively. This recovery, post coronavirus lockdowns, should support property companies’ operational performance indicators – footfall, trading density growth rates, rental income, net operating income, distributable earnings, and loan-to-value ratios (LTVs).
Industrial/retail exposure to bolster shareholder returns
At the same time, we believe property companies that have strong balance sheets (below 35% LTV) and less exposure to the domestic office sector should generate strong shareholder and NAV returns in 2021. The office sector’s vacancy rate is 12%, significantly higher than the 5.5% 20-year average, although there is a glut of office building and limited demand for office space in most domestic nodes. By contrast, the industrial and retail sectors’ vacancy rates have recorded marginal deviations from their long-term averages.
Companies we believe should benefit from this theme
- Stenprop: benefiting from a multi-let industrial strategy.
- Stor-Age: a pioneer of the big-box storage property in South Africa.
- Nepi Rockcastle: well positioned to benefit from a resurgence in CEE.
- Sirius Real Estate: focused on Germany, strong growth and balance sheet.
- Equites: a specialist logistics focus with a strong balance sheet and strong management team.
The companies shown above do not translate into buys and sells as other themes (and valuation parameters) may conflict with this one.
Over the past few years, the office sector has faced momentous headwinds due to rising vacancy rates, caused by the oversupply of office buildings in traditionally lucrative nodes (Johannesburg North, for example). The tectonic shift in the demand for office space, caused by remote working, as a result of COVID-19, has undoubtedly worsened vacancy rates for the office sector, contributing to the stronger de-rating for those companies with high exposure to the office market. The office vacancy rates have increased across all segments in the past four years (see chart below). Overall, sector’s vacancy rate at 12% in Q420 was significantly higher than the 5.5% long-term average. The sector’s asking rental growth has turned negative, noticeably below the 5% long-term average.
Exhibit 1: Office vacancy rates
The retail sector has recovered somewhat from the severe coronavirus-induced collapse in the first half of 2020. Neighbourhood (less than 10,000sqm) and community shopping centres (12,000–25,000sqm) have fared better than regional (50,000–100,000sqm) and super regional (more than 100,000sqm) malls during the coronavirus pandemic, measured by trading density growth rates and vacancy rates. It is a convenience phenomenon. We expect the retail sector’s trading densities to grow by 3.3% in 2021. Also, the 5% sector vacancy rate in Q420 was not meaningfully higher than the 2.9% long-term average.
It is important to highlight that South African government social grants have been a pillar of support for retail sales. As a result, according to Stats SA retail sales declined only 4% year-on-year in November 2020, not disastrous in this environment. On the downside, however, rising unemployment, together with declining personal disposable income, remains a big risk for retail sale growth.
We also note that South Africa is expected to be mildly affected by the shift to online shopping, which currently accounts for 3% of total retail sales. In Europe, e-commerce sales contributed 15% to total retail sales in 2020. The internet penetration rate in South Africa’s low-income areas is insignificant; property companies that own community and neighbourhood shopping centres in these areas will almost certainly continue to see stable trading density growth rates, despite the upward trajectory in global online shopping.
Exhibit 2: Year-on-year trading density growth
In early Q120, before the coronavirus pandemic, the industrial sector was largely untroubled, trading at a 3% vacancy rate and recording around 4% rental escalations. Even at the height of the coronavirus lockdowns, the industrial sector did not experience financial calamity. The predicted increase in consumer spending and international trade should support the industrial sector in the months ahead. For this sector to deliver strong performance, the manufacturing sector’s capacity utilisation rate would have to rise to 85% and is currently around 80% on a normalised basis. It is worth noting the industrial sector is well diversified (manufacturing production, warehousing and distribution, and industrial multi-parks), which supports its performance and stability.
Exhibit 3: Industrial vacancy rates
Source: SAPOA and TMGI Property Investments
Offshore exposure: we estimate that some 47% of South African listed property sector’s investment earnings come from CEE, Western Europe, the UK and Australia. While the global diversification has reduced property companies’ reliance on South Africa’s pedestrian economic growth, CEE countries recorded strong GDP growth rates before the coronavirus pandemic. The vaccine rollouts and somewhat lenient lockdown regulations, combined with global economic stimulus policies, should lead to a speedy economic recovery in the CEE region.
More importantly, we expect the property sector to gain support from the improvement in net operating income. The chart below shows the evolution of net operating income of the top 10 stocks in the sector, which we forecast to post 3% growth in 2021, underpinned by firmer offshore property revenues and distributable earnings; we also expect improvement in domestic property companies that have high exposure to the industrial and retail sectors. It is worth noting that if valuation yields do not expand as expected, physical property valuations will stabilise or increase in 2021 and 2022 property valuations will be supported by growth in net operating income.
Exhibit 4: Top 10 South African property companies’ net operating income
Source: Company data, Stanlib Asset Management and TMGI Property Investments
However, property expenses have been adversely affected by strong increases in municipal charges in the past few years. Since 2006, rates and taxes and electricity charges have registered compound annual growth rates of 9.5% and 9.2%, respectively. Aggressive escalations in property expenses put pressure on net operating income and, invariably, distributable earnings and dividends.
In the past three years, the South African listed property sector has significantly underperformed other asset classes, eroding the superb 20-year performance that was a beneficiary of strong economic growth, government infrastructure spending, the emerging middle class, new property developments across different sub-sectors, offshore acquisitions and new listings of property companies.
Exhibit 5: South African listed property index returns
Source: Stanlib Asset Management, TMGI Property Investments
Most property companies are trading at significant discounts to NAV and some of the smaller stocks are arguably priced for bankruptcy. Before the COVID-19 lockdowns, the property sector was trading at c 20% discount to NAV. The vaccine rollouts, together with the US and EU fiscal stimulus packages and a persistent glut in global liquidity, could be supportive of the sector in 2021.
Exhibit 6: Top 20 South African property companies by market capitalisation and their valuation metrics
|Code||Company||Market cap (Rbn)||2020 total return %||Dividend yield %||P/NAV||LTV %|
|MSP||MAS Real Estate||8710||-0.36||0.11||0.59||0.33|
|IPF||Investec Propety Fund||7166||-0.432||0.0775||0.53||0.4|
Source: Company data, Sharedata, TMGI Property Investments. Note: Priced at 10 March 2021.
South African listed property sector is globally diversified, with almost 50% of the sector’s investment properties in offshore markets: CEE, the UK, Germany and Australia. Most of the companies listed in the table above have either an entire or significant presence in offshore markets. However, some do not have earnings exposure and investment properties in South Africa: Nepi Rockcastle, Sirius, EPP, Stenprop, Lightcap and MAS Real Estate. Their investment properties are in CEE, continental Europe and the UK. From a sector diversification perspective, most companies own shopping malls in CEE and UK and there is little exposure to UK industrial and office markets.
The consensus is that the CEE region will post strong economic performance in 2021 and 2022, benefiting from low inflation and accommodative monetary policy. The IMF projects 4% economic growth in 2021 and 2022, respectively. The improvement in property drivers – vacancy rates, rent collections, net operating income, distributable earnings and LTVs – strongly buttress the outlook for the property companies.
The UK economy has been adversely affected by the coronavirus pandemic, recording a severe contraction in 2020. Despite the coronavirus and vaccine rollout challenges, the IMF expects GDP to increase by 4.5% in 2021, which is a weighty rebound although lower than the Office for Budget Responsibility’s initial forecast of 5.5%.
Exhibit 7: Top 20 South African property companies’ balance sheets are overextended
Source: TMGI Property Investments and company reports
South African property companies’ LTVs have demonstrably worsened in the past three years as a result of the devaluation of physical properties, largely due to declining rent collections and net operating income. By contrast, valuation yields have not expanded in recent months despite the coronavirus pandemic and negative rent reversions. It is important to note that only 35% of the top 20 companies have recorded LTVs above 40% (see Exhibit 6 above).
Companies are frantically restructuring their balance sheets by selling non-core investment properties. Unfortunately, there is a noticeable glut of property stock in the market, which unfavourably affects bid prices. Property companies will, in some cases, be forced to sell properties below NAV. This could arguably be a more viable solution than bankruptcy filings or abrupt de-listings. In the medium term, we expect the sector’s LTV to fall to the long-term average of 34%, bolstering a momentous sector re-rating.
Limited risk from property valuations and refinancing
Property valuers have been conservative in their property valuations, resulting in write-downs and rising LTVs. In the months ahead, there will be limited downside risk in property valuations due, largely, to the expected rebound in net operating income growth and stable valuation yields (capitalisation rates).
On refinancing risk, corporate investment grade yields have declined considerably since May 2020; the US BBB investment grade equivalent yield is trading at 2.1%, from 5.6% around mid-2020. Equally important, global sovereign bond yields are not expected to increase significantly this year. Furthermore, commercial banks are generally not punitive when funding high quality property companies. In contrast, small and illiquid companies – already trading at huge discounts to NAV with stretched balance sheets – could struggle to refinance debt at favourable terms.
Exhibit 8: South African property sector price/NAV evolution
Source: TMGI Property Investments and company reports
The listed property sector is trading at 0.7x price/NAV (P/NAV), significantly below the long-term average of 1.2x. This reflects the sector’s massive de-rating over the past three years, recently heightened by the coronavirus pandemic. The likely improvement in physical property fundamentals could be a catalyst in closing the valuation gap. The economic recovery driven by the reopening of the economy, together with the coronavirus vaccine rollout, should strongly support the property sector in the future.
Exhibit 9: Dividend distribution growth
Source: Stanlib Asset Management, TMGI Property Investments
The South African property sector’s distribution growth profile underpins the valuation in the short to medium term. Johannesburg Stock Exchange guidelines require real estate investment trusts (REITs) to distribute 75% of their distributable earnings and retain the remaining 25%. In 2020, REITs deferred dividend payments as a result of the collapse in rent collections and the foggy economic outlook caused by the coronavirus lockdowns. We expect the increase in 2021 net operating income (operating profits after property expenses) to have a positive impact on distributable earnings. The property sector is trading at a forward dividend yield of 10.3%, a superior yield relative to bonds and cash. Bond yields have increased by 77bp over the past month, from 8.5% in early February 2021 to 9.27% in March 2021, narrowing the gap.
We believe our top pick of companies – Stenprop, Stor-Age, Nepi Rockcastle, Equites and Sirius Real Estate – have solid fundamentals: high offshore earnings contribution, low LTVs, projected growth in net operating income and distributable earnings. Additionally, these companies have specialist sub-sector focus that we believe should support their re-rating and shareholder returns in 2021.
Stenprop is a South Africa-listed property company with investment properties in UK and Germany. In recent years, the company has adjusted its strategy to focus on building a UK multi-let industrial portfolio; management has been aggressively divesting from Germany and noncore subsectors. Management invests in assets and locations that offer growth opportunities in rent and values. The company has acquired multi-let industrial income-producing assets, at value-enhancing net income yields. Consequently, the company marginally de-rated during the coronavirus pandemic, a reflection of investors’ confidence in the multi-let industrial strategy, rent collections, net operating income and management. Stenprop has a strong balance sheet (30% LTV) and is trading at 0.8x P/NAV and a 5% forward dividend yield.
Stor-Age is the largest specialist self-storage company in South Africa, a pioneer of big-box self-storage properties. The 2021 interim results posted 13.3% growth in net operating income and close to 100% collection of rentals due. It has investment properties in South Africa and the UK. Stor-Age has a strong balance sheet with 27% LTV. From a valuation perspective, it is trading at a forward dividend yield of 8% and 0.8x P/NAV. In addition, the valuation of investment property increased by 18% to R7.3bn in 2020.
Nepi Rockcastle owns and operates premium retail assets in the CEE region and is a strategic partner of many retail players there. Tenant sales and footfall recovered well in late 2020, following the strict coronavirus lockdowns in H120. The EPRA occupancy rate was 95.8% in June 2020, supporting the investment view that Rockcastle could deliver solid net operating income growth in 2021, despite the 19% collapse in 2020. The company is well positioned to benefit from the improvement in the CEE region’s economic activity. The balance sheet is strong with 32% LTV. The stock is attractively priced, trading at a forward dividend yield of 9% and 0.7x P/NAV.
Sirius Real Estate is the leading owner and operator of business parks, offices and industrial complexes in Germany. It posted 11% like-for-like two-year revenue compound growth in 2020; management has also executed yield enhancing acquisitions. Sirius has implemented a good strategy, manifested in impressive acquisition and organic growth. The stock is trading at a 3.9% forward dividend yield, in line with most European real estate peers. In addition, its LTV is 32%, which indicates a strong balance sheet in this environment and the stock is trading at 1x P/NAV, not expensive relative to the four-year historical average.
Equites is the specialist logistics company with investment properties in South Africa (55%) and the UK (45%). It was recently awarded the Amazon distribution deal in the UK. Management has built a decent portfolio of assets in the past few years. Equities has a decent balance sheet with 30% LTV. The stock is trading at 8.7% forward dividend yield and 1x P/NAV, a 12% discount to its four-year average of 1.12x.
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