Should investors buy South African retail property funds in the face of global economic turmoil?
Over the past five years, the South African listed property sector has suffered from a confluence of adverse factors, which have resulted in poor shareholder returns. Overall, the real estate investment trust (REIT) sector is trading at a 30% discount to net asset value, a marked de-rating from the 10% premium that was recorded in 2017. Pre-COVID-19, property developers aggressively expanded gross lettable area. This, combined with exogenous factors such as COVID-19 lockdowns and the KwaZulu-Natal (KZN) and Gauteng riots in July 2021, contributed to deteriorating fundamentals for the commercial property sector. On a positive front, the retail and industrial property segments have fared much better relative to the office market, which, unfortunately, continues to face declining occupancy rates as there is still a glut in lettable space. The specialist retail property funds, however, have reported decent recovery in occupancy rates, footfall, collection rates and trading density growth rates. In turn, specialist retail funds have outperformed the property sector year-to-date. From a valuation perspective, these retail REITs are trading at 8% dividend yields, higher than yields in the UK (5%) and the United States (2.9%).
Is the improvement in trading density growth rates underpinning the retail property segment’s performance?
The MSCI Trading Density Index posted a 9.8% increase in Q222, which means that tenant sales are performing well in the face of rising inflation and interest rates. It is noteworthy that the trading density growth rates are still below pre-pandemic levels. In addition, footfall has recovered from the COVID-19 lockdowns, bolstering sales for tenants and improving collection rates.
South African REITs that recently reported financial results have posted impressive collection rates, around 97%. It is also encouraging to see positive rent reversions as property owners manage to achieve positive rental growth at the expiry of old leases. Low vacancy rates and strong trading density growth rates are driving positive rental reversions.
New retail building plans have collapsed
There has been a massive decline in the supply of new retail developments across South Africa over the past two years. According to MSCI, in June 2022 the number of retail property building plans that were passed plunged by 39% on a year-on-year basis. There is little appetite to add retail developments as the prognosis for personal disposable income and consumer spending growth does not paint a glowing picture in the medium term. Property is a cyclical sector and is dependent on the performance of the economy. First National Bank’s broker survey noted that retail property vacancies decreased in the first half of 2022, but rising inflation and interest rates will add pressure on consumers in the months ahead. This could, potentially, adversely affect the demand for new retail trading space and provide support for the retail property sector as the limited supply of new stock keeps vacancy rates low and improves rental growth rates. Rental lease escalations are linked to consumer price inflation.
Rising inflation and interest rates have an adverse impact on tenants
Tenant turnover and profit margins certainly suffer from the impact of rising inflation and interest rates. Over the past few months, the South African Reserve Bank has joined global central banks in hiking interest rates to contain rising consumer price inflation. Global and domestic inflation is currently driven by rising oil prices, food prices, global supply-side constraints and the weak rand against trading partners’ currencies. In August 2022, South African consumer price inflation increased by 7.6%, slightly below the 13-year high of 7.8% posted in July 2022. Inflation is currently outside the government inflation target band of between 3% and 6%. The central bank’s interest rate decision is based on the mid-point inflation target of 4.5%. Interestingly, domestic bond yields have not reacted dramatically to the recent upward trajectory in inflation and administered interest rates. This signals that bond investors expect the trend to reverse in 2023; inflation is not a permanent blemish spot that could eventually erode real returns. In developed markets (the UK and United States), bond yields have responded extremely negatively to rising inflation, increasing by more than 300 basis points since the beginning of 2022. This clearly puts pressure on REITs’ borrowing costs and valuations.
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