For years the property sector in South Africa was the star performer in our market, handily outperforming other domestic sectors over long periods of time on a total return basis. The tide has recently (2018) turned, and we have seen a big reversal of this outperformance. The question now is: where to from here?
To answer the question, we need to first see how we got here. Historically, South African property counters were rewarded for growth in distributions. This had two consequences: property companies distributed 100% and sometimes more of their true distributable cash income; and companies used creative ways of growing distributable earnings. By distributing all their distributable income, they had to fund capex (maintenance and expansion) through either equity raises or debt. Since the asset class was performing so well, capital was readily available and increases in debt were covered by increases in underlying property values.
As a result of the amount of capital that went into the sector, significant capacity was added – especially in the office and retail space. As growth in South Africa slowed, the additional capacity outpaced demand and the result has been increased vacancies. This trend in office space was seen before Covid-19 hit. The retail sector however held up slightly better until Covid-19, but in certain retail categories the increases in rental started outpacing turnover growth of retailers, putting the profitability of these retail businesses under pressure.
When Covid-19 hit, a large portion of the sector had high debt to asset ratios (or loan to values), with very little room for error should asset prices fall. We have now seen these asset prices starting to fall and this has put many property companies’ balance sheets under pressure. The prospects of asset values increasing again soon has also diminished. Not only is rent going backwards on renewals due to an oversupply of space, but there are affordability issues for tenants as well. Capital has also become harder to access, and many of these companies now have few options to repair their balance sheets.
The main avenues available to repair balance sheets are capital raises, retention of earnings and sales of assets. Capital raises are problematic as companies are trading at big discounts to net asset value, with any capital raise severely diluting the net asset value per share. Earnings retention is also challenging as property companies need to distribute 75% of earnings to maintain REIT status and hence not pay tax on earnings. Asset sales are possible to private buyers where assets are smaller, but bigger assets are difficult to sell as there are few buyers with access to sufficient capital and the pricing gap between buyers and sellers is large.
The most likely route is a combination of these measures, but the net effect is that the cash yield the average investor can expect from these companies has either disappeared or has been severely impaired. The road to a healthy property sector will be a long one as long as overcapacity exists. With our low growth prospects, it will take time before many of these companies pay cash distributions, and hence one should be very selective in choosing an appropriate property investment.