This article was first published in the latest issue of the Moneyweb Investor. To read the magazine click here.
You just need to drive through Sandton and count the cranes to feel justified in thinking that property development has remained robust in the midst of an economic slump.
But the signs of development are misleading. Big companies, including Sasol and Discovery, have been building massive new headquarters, but they have moved out of other buildings, which may now be sitting empty or let at a discount as oversupply continues to be a feature in the sector.
In fact, as Catalyst Fund Managers investment manager Paul Duncan puts it, the signs of development are “more musical chairs than net new demand.”
The past few years have been a daunting time for property companies, with a slowing economy, declining demand for new space and oversupply. With few exceptions, they have acted to offset lower earnings expectations by expanding offshore.
Over the past ten years the contribution of foreign assets to South African listed property companies’ earnings has increased from almost nothing to 35%.
As recently as 2009, the international exposure of the property companies listed on the JSE was limited to the likes of what was then called Liberty International, since split into Capco and Intu.
With the rest focused locally, property fundamentals became challenging, says Duncan. “It has become difficult to deliver the earnings growth investors had become used to, so as they sought earnings growth, they have had to look at other markets.”
An increasing offshore focus is evident across most sectors, but in the case of property, has been one of the reasons driving the JSE to consider dumping the benchmark FTSE/JSE South African Listed Property Index to create three indices – South African Reit, All Property and Tradable Property.
The details, at this stage, are unknown, making it difficult to predict if or how this will affect individual shares in the sector and institutional index tracking.
“At this stage nobody knows,” says Duncan. “The JSE won’t want to create massive volatility, obviously there are property companies with big weightings in the existing index and it will want similar weightings,” he says, adding that the changes could create opportunities for active managers.
Anton de Goede, portfolio manager at Coronation, says some of the smaller stocks which may be included in a wider index will become more closely watched, but the changes should not materially change investment strategies. “With new index inclusions, there may be a price jump on the day or week but then things should normalise.”
What the proposed changes illustrate, though, is that there are very few South Africa-focused property companies left on the JSE.
De Goede says around 35% to 40% of listed property earnings sits offshore, ranging from exposure to Australia, the UK, Romania, Germany and Spain with other geographies in between. This brings rand hedge thinking into the equation, but it depends very much on the specific share as the extent of foreign exposure differs, as does the particular currency.
Duncan says the cost of borrowing is attractive offshore and yields appear quite attractive too. “The risk is that property and understanding real estate dynamics is a specialised skill, so there are concerns about whether companies are buying at the right prices in the right markets.
“When investors demand certain levels of performance, companies may feel forced to move up the risk curve. Unfortunately we believe not all of these companies will be rewarded adequately for the additional risk,” he says.
There have, however, been a number of established property platforms offshore, where companies have spent a number of years building local market intelligence and they have been successful, like Resilient through Nepi and Rockcastle, and Growthpoint in Australia. However, some companies that have gone offshore more recently “are late to the party and are probably at most risk moving offshore at wrong time.”
The increasing percentage of offshore exposure has changed the nature of the property sector. Once considered a stable asset class based on yields and closely correlating with SA bonds, there is now much more volatility.
The relationship with bonds is still very strong, says Duncan, “but what has changed is the influence of offshore earnings on their earnings as global real estate is lowly correlated to SA bonds and once you overlay currency the correlation is even less. The yield on the index relative to the SA government bond is the lowest it has ever been – but the comparison should, in fact, be to a blended local offshore bond.”
“Investors have always focused on the yield,” says De Goede, “but nowadays, the underlying yield component is a smaller portion and over the last three to five years, property has been more volatile than equities.”
Nevertheless, local conditions illustrate why offshore expansion became a priority for property companies.
Building activity in Sandton reflects its status at the epicentre of development in South Africa. De Goede says 40% to 50% of all office development in the country is taking place in Sandton, placing it and broader nodes at risk in terms of increasing vacancy. “Although a lot of the development is pre-let, there is a risk of backfill space coming to market,” De Goede says.
Duncan says a lot of the office development reflects big companies consolidating space and leaving pockets of vacancies elsewhere.
“When there is oversupply, landlords become price takers, giving up more upside on their developments, diluting the return they anticipated to attract new tenants.”
He says while people say retail is a more resilient asset class, “there are many different types of retail which all behave differently. Dominant mall centres will have periods of relative weakness, but tend to have the most resilience with strong tenancies.
Retail development continues apace, and there are about 100 shopping centres in development in the country ranging in size, “with a lot of the focus on the rural, semi-rural or commuter-size centres,” says De Goede.
While increased offshore exposure comes with its own risks, it has provided property companies with the opportunity to offset local challenges and keep the earnings stream flowing.
The performance of property shares may more closely resemble general equities than previously, but investors must not forget that property remains a specialist investment, requiring different valuation methods and an understanding of yields, inflation, interest rates, currency and exposure to debt.
Duncan says property is a specialist asset class, but some of the fundamental investment priorities are not dissimilar to other investments. “We prefer specialist focused operators – over time they deliver relative to their peers. We invest in companies with specialist focus, great assets, sustainable earnings streams and intelligent management whose interests are aligned and who have integrity.”