There is a further downside risk to listed real estate investment trust (Reit) values over the next few financial reporting periods because demand and supply dynamics in the sector remain out of balance, according to Momentum Investments.
However, Lawrence Koikoi, a listed property portfolio manager at Momentum Investments, stressed that not all property companies will experience the same decline in value.
In addition, Koikoi said values do recover when economic activity and real estate fundamentals improve but the pace of the recovery depends on the supply and demand fundamentals.
“This remains a key anchor of Momentum Investments’ view on this sector,” he said during a webinar last week.
Koikoi said the global real estate sector as an asset class suffered its worst year in 2020 due to the outbreak of the Covid-19 pandemic and the restrictions that were imposed to curb the spread of the virus.
He said the South African listed property market was not spared in this sell-off, with share prices of property companies and Reits collapsing “to levels not seen in the history of the asset class in South Africa”.
This collapse stemmed from market concern about the impact of the Covid-19 pandemic on the economy, the financial impact of trading restrictions that were imposed on shopping centres, and the impact of corporates not physically occupying spaces.
Koikoi said the devaluation cycles of the listed property sector can be protracted, taking up to five years to reach the trough but the recovery back to peak levels has historically been shorter, taking up to three years to get back to historic peaks.
To test whether markets are rational in their pricing of Reits, Momentum Investments used spot share prices to work out the extent to which the market expected property values to decline.
Koikoi said the share prices of Reits at the height of the Covid-19 lockdown traded at a 50% discount to the net asset value reported on their balance sheet.
“Based on this pricing, market participants expected property values to fall by 30% from peak to trough.
“We disagreed with the pricing expectation throughout the course of last year, as our work suggested the market was too bearish in its expectations.
“The progress made on finding vaccines in November led to a strong rebound in the share prices of Reits,” said Koikoi.
“The sector has rallied about 30% since November 2020, bringing total returns since its lowest levels in March 2020 to about 55%.
“When we look at pricing expectations, we agree broadly with the aggregate property decline that the market is pricing in,” he said.
Koikoi said the Covid-19 pandemic served as a catalyst for property value write-downs in the sector since last year and, based on calculations by Momentum Investments, the value of Reits has dropped by 8% on an accumulative basis since June 2020.
He added that the property values of Reits will have to fall by another 25% before they breach their loan-to-value covenants.
On the income side, the net operating income of Reits, including income already lost from concessions offered to tenants because of the impact of the Covid-19 pandemic, will have to fall by an additional 40% for the interest cover ratio to be breached, he said.
“So barring two Reits which had to request covenant relaxation for last year, Reits have largely complied with their debt metrics and have reasonable headroom before covenants are breached,” he said.
Craig Smith, head of Anchor Stockbrokers, told Moneyweb earlier this month it is very probable that the listed property sector will end this year “in the green” given that it is already up close to 20% year-to-date.
Smith said their base case at the beginning of the year included estimated total returns for the full year of between 20% and 15% for 2021 and “year-to-date the sector has outperformed relative to our expectations”.
TPN Credit Bureau reported last week that the recovery in the non-payment tenant category in the commercial property sector appears to have stalled at about 12%.
TPN said commercial tenants in good standing nationally improved to 62.5% in the first quarter of 2021 from 61.62% in the fourth quarter of 2020 but is still significantly lower than the 77.85% pre-Covid-19 lockdown level in the first quarter of 2020.
The classification of tenants in good standing is that the tenant’s account balance is fully settled and no arrears balance is carried forward.
TPN Credit Bureau CEO Michelle Dickens stressed that a commercial real estate recovery relies on a business recovery.
Despite the financial stress being experienced by tenants, which is negatively impacting landlords, and the 6.6% decline last week in South Africa’s Reit or listed property sector following damage to commercial properties in KwaZulu-Natal and Gauteng during widespread unrest and looting, the sector is still about 14% up since the start of 2021.
Koikoi said the amount of office space that developers are introducing to the market came to a halt in 2020 and there is to date only 43 739m2 of development currently on the ground.
“This represents the lowest level of supply we have seen in the market in over 30 years.
“We do not expect to see any supply coming through in the market over the next few years, which will be positive for absorption and rental income growth should demand come back on stream,” he said.
Despite the supply of offices being constrained “at all-time lows”, Koikoi said vacancies in the office sector have deteriorated and are approaching 2003 peak levels.
He said it will be important to monitor tenant intentions going forward.
“We think that the emergence of trends such as hybrid working and sub-letting of space will exacerbate the deterioration, making this picture worse before we see an improvement,” he said.
Turning to the retail property sector, Koikoi said vacancy rates have continued to rise over the past 12 months, a trend that has been ongoing for several years.
“Again tenant intentions are generally more focused on consolidation than on expanding,” he said.
Koikoi added that Woolworths, for example, is planning to cut about 15% of its apparel space between now and June 2023.
On the food side, the business is doing relatively well and the company plans to add space on that front over the next two years, he said.
However, on a net basis, the Woolworths group will shed space over the next few years on its non-discretionary offering, he said.
Koikoi said against the backdrop of a relatively challenging operating environment and the weakness anticipated over the next few months, Momentum Investments’ daily focus remains on ensuring it has positioned its portfolio towards companies that can withstand pressures in the market and on investing in companies that will continue to grow earnings higher than real estate fundamentals.
“We believe there are good investment opportunities in the sector with Reits that can continue to provide the yield underpin that investors require in a portfolio, with added diversification benefit expected from the asset class.”
Listen to Suren Naidoo’s interview with Craig Smith of Anchor Stockbrokers (or read the highlights here):