DealMakers - Q1 2023 (released May 2023)
Considering JSE-listed property companies
by Calvin Craig
South African listed property struggled last year and ended 2022 as the worst performing sector on the JSE, delivering a negative total return of circa 2%. This was largely due to rapidly rising inflation (exacerbated by the Russia-Ukraine war), followed by interest rate increases by the South African Reserve Bank and international central banks, aimed at curbing inflation.
Europe’s reliance on Russia for gas led to an energy crunch during the Northern hemisphere winter months, which caused heightened concern for global investors regarding the ability of companies to withstand escalating energy costs and economic pressure. Geographically, South African listed property was shielded from direct war exposure, but nevertheless suffered from the broad-brush effects of the resulting capital reallocations.
Higher interest rates caused concern for investors in respect of property valuations, especially those properties that were already valued at lower than industry average discount rates/yields. Any expansion in these yields due to higher interest rates, which are not offset by increasing net income, result in a depressed valuation of the underlying properties. Companies with higher loan-to-value (LTV) ratios have been dealt a particularly hard blow, as investors expected these LTVs to increase off the back of reduced property valuations, combined with higher interest on loans. As a result, investors have priced in significant additional risk, which has led to the sell-off of listed property stocks.
A major difference between South African property companies and developed market global property companies is that South African businesses are accustomed to operating in a low growth environment, with elevated inflation levels and high interest rates, whereas many developed market global peers have traditionally benefited from higher economic growth, low inflation and very low interest rates. While significant economic growth in the South African economy appears a distant mirage at present, local property companies could benefit from the expected peaking of inflation and subsequent slow-down in interest rate hikes.
The three key performance metrics for listed property investors are total return, total return and total return (much like location). Investors usually gauge total return from expected increases in the property stock’s net asset value (NAV) and/or dividend yield/income. Many locally listed property companies trade at deep discounts to their underlying NAV, which may seem like a bargain to investors at face value, but which could also result in a value-trap scenario. When hunting for bargain property stocks in the market, the value trap is unlike a bear trap in that the gap between price and value does not always close (or may take a very long time to close), which poses risk for these value investors.
Due to ongoing loadshedding, many South African property businesses are allocating capital investment to alternative energy solutions, like solar, to ensure that their operations are better equipped for disruptions and to keep tenants incentivised to stay locked into medium-to-long term rental agreements.
Many South African property stocks that pay high dividend yields are compared directly to “risk-free” government bonds and/or risk-adjusted corporate bonds. But in the current high interest rate environment, it is anything but plain sailing for these listed property stocks that compete with bonds for capital in the market, and potentially also with safer bets, such as cash investments. Earnings growth will be key for South African property stocks to continue growing their dividends, and hopefully their NAV too. In the absence of earnings growth, investors may opt to be risk averse and stick with bonds and cash investments at the peak of the interest rate cycle.
Portfolio managers and analysts often regard certain Real Estate Investment Trust (REIT) sectors as resilient investment vehicles during times of recession, which can outperform general equities during high-inflationary periods. Experts note that REITs also outperform when bond yields continue to increase, and especially when a slow-down or pause in interest rate hikes are imminent. Whatever the environment, listed property companies benefit from having a strong balance sheet. A South African REIT is obliged to pay out at least 75% of its earnings to shareholders as dividends on an annual basis and, given that REITs receive the benefit of only being taxed on the portion of earnings that do not get distributed to shareholders as dividends, this translates into a larger pool of capital that can be allocated to dividends for shareholders, which can, in the right circumstances, provide good income opportunities for investors.
When considering capital allocation and, more specifically, returning capital to shareholders, several strategies are available to listed property companies, ranging from paying cash dividends to share buy-backs and scrip dividends. Listed companies typically consider share buy-backs in the open market where they believe that their share price is undervalued. In terms of the JSE Listings Requirements, a listed company may not buy back its own shares in terms of a general repurchase authority at a price greater than 10% above its trailing five-day volume weighted average price, which provides protection to shareholders from a capital allocation perspective. Strategic share buy-backs, followed by the cancelling of the repurchased shares, could attribute tangible value on a per share basis to shareholders, especially where earnings grow. Scrip dividends are usually offered to shareholders as a mechanism to preserve cash reserves for the company and/or to provide shareholders with an opportunity to receive additional shares on a pro-rata basis relative to their current shareholding, without incurring transaction costs that would ordinarily need to be spent in buying shares on the open market. Scrip dividends are, however, not viewed favourably by shareholders if implemented when the share price of a listed property company trades at a substantial discount to its NAV, as issuing cheap equity is not value accretive.
Depending on how the remainder of 2023 unfolds from an inflation and interest rate perspective, the result is expected to drive and/or change investor risk appetite in the markets, which could benefit well-positioned JSE-listed property companies.
Craig is a Corporate Financier | PSG Capital.