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Listed property in 2015

Despite good performance, sector faces headwinds.

JOHANNESBURG – Following a relatively muted performance in 2013, the listed property sector surprised on the upside.

The SA Listed Property Index (Sapy) delivered a return of 14% in the first nine months of this year, compared to a return of roughly 9% for the JSE All Share index during the same period.

But can the sector continue on this trajectory in the year to come?

Tsana Ramatswi, investment analyst at Meago Asset Managers, says although the sector faces headwinds in the form of a revised growth forecast and muted demand, going forward listed property will likely continue to deliver positive total returns because of the defensive nature of the asset class.

With the South African economy forecasted to grow at just 2.5% next year, listed property returns will be supported by the income return with the forward yield in excess of 7%, she notes.

Ramatswi expects the downward revision of growth rates to cause uncertainty in the direction of interest rates, which will discourage developers to increase supply of commercial properties in the market and encourage the absorption of the current vacancies.

Decreased vacancies will benefit the landlords, as they will be able to negotiate higher rentals, which could translate into increased distributions for listed properties, she says.

But caution is advised.

Zwelakhe Mnguni, chief investment officer at Benguela Global Fund Managers, says at current market valuation levels, they believe the sector is expensive.

He says the property sector has delivered a capital gain of roughly 8.3% in the year to date while equities returned 4.2% and bonds are down 3%.

“We believe that the outperformance of the property sector is a function of technicalities rather than an asset class that is substantially attractive relative to others.”

Mnguni says in their opinion these technicalities include investors’ hunger for higher yield relative to for example the money market, growth in income and stability of income even given a possible tough economic environment.

In their pursuit for simultaneous stability and growth of future income, investors have bid the property stock valuations to levels that have substantially raised the level of price risk in the sector, he says.

“In a ‘normal investment environment’ where rationality prevails, one would expect long-term government bonds to trade at a premium to dividends listed property given the relatively low credit risk (it takes a lot of ‘political doing’ for a country to default on its bond payments).

“We use dividend yields because property stocks paid out virtually all the attributable profits. However for the past five years, at least, we’ve observed investors overprice the additional benefits of a predictable growth in their expected income stream well beyond reasonable levels [as can be seen in the figure below],” Mnguni says.

Source: Thomson Reuters, Benguela Global Research

Mnguni says despite the relationship being anomalous in the context of long-term historic data, the property sector premium of 89 basis points against government bonds has not only been maintained in the past five years, but has widened substantially to 145 basis points in the last 16 months.

In theory, investors appear to be so confident about the prospects of the property sector that they price them at a substantial premium to government bonds that are backed up by legislated taxes, he says.

“We believe that this is not normal and it is a matter of time before the situation corrects,” Mnguni says.

He says while it is not yet clear what could trigger the normalisation process, there are at least four possibilities.

The first is that the economic challenges facing the South African and global economies may put pressure on businesses to a point where a substantial rise in property sector vacancy rates occur, which could in turn threaten the stability and growth of the income streams from the property sector, he notes.

Mnguni says a sovereign risk downgrade may also trigger a sell-off in bonds, which would in turn set off a process to reassess the valuation risk of assets like property stocks.

“The 1.4% real growth forecast for South Africa will do very little to assuage foreign investors’ concerns around our debt levels and anemic growth.”

A third possibility is that looming rate hikes may force investors to impute the effect of higher funding costs on underlying property loans and therefore force them to reconsider their property allocations.

However, the correction may also be gradual in that as the sector delivers earnings and distributions, prices remain around the current levels with no meaningful re-ratings.

Mgnuni says in a nutshell Benguela believes that the risk of further “normalisation” between bonds and property yields remain quite high going forward.

“For that reason we believe that property allocations require a healthy dose of caution,” he says.

However, certain individual companies could outperform the sector as a whole in the medium to long-term.

Ramatswi says Hyprop Investments has niched itself as a dominant retail player.

“The International Data Bank research have revealed that super regional and regional shopping centres in excess of 50 000 m2 perform well in contracting economic cycles,” she says.

Hyprop has a concentration of such centres and is expected to perform well relative to its peers during the trying economic times forecasted for the next three years.

Ramatswi says prime retail has attracted better ratings than other retail types and this should support Hyprop well into the 2015 financial year.

“New Europe Properties is also one to look out for. The company has a longer lease expiry profile and is a rand hedge,” she says.

Mnguni says Delta Property Fund is their preferred counter in the sector.

Amongst other factors, the company trades at a significant dividend yield discount to industry peers and management recently reiterated their 2015 distribution growth target of 14% to 15%, he says.

Mnguni says Delta is also trading on a forward yield of 10% notwithstanding a small financial drag coming through from Delta International.

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