Growing income stream will drive SA listed property returns

Key points:

• Property fundamentals in South Africa remain solid and distribution growth is set to accelerate this year

• Income and distribution growth will likely be the main drivers of return over the medium term

• Careful stock selection will become an important return differentiator in the current macroeconomic environment

 

The South African listed property sector has certainly experienced a volatile past 18 months, but despite these price fluctuations, the listed property sector continues to offer a predictable and growing income stream.

 

After a robust 2012, with returns of 35%, the sector made a fairly strong start to 2013 as well, delivering returns of 17.5% in the first four months of the year. However, a significant part of these early 2013 gains were reversed in the second quarter, after the US Federal Reserve (Fed) announced its intention to taper its quantitative easing programme. Uncertainty around the exact timing and extent of tapering saw both fixed income markets as well as the listed property sector continue on a volatile path for the rest of the year.

 

This volatility has continued into 2014, and was exacerbated by emerging market concerns which flowed through into rand weakness and ultimately a surprise interest rate hike in late January. Similar to what has been witnessed at the commencement of previous rate hiking cycles in 2002 and 2006, the sector initially sold off aggressively before recovering strongly in February and March to eventually end the quarter in positive territory.

 

Given these sharp, short-term movements in share prices on the back of global and local monetary policy shifts, investors are encouraged to focus on the dependability of the sector’s income stream as well as its growth over time. Underlying direct property fundamentals remain stable and distribution growth is underpinned by a high proportion of underlying contractual lease escalations (roughly 8% p.a.) and fixed debt (roughly 70% of gearing).

 

 

Historically, the sector’s combination of income (or yield) and income growth has been a strong driver of real returns for investors, even in years where there was some de-rating due to higher yields in the bond market. The sector’s ability to grow income over time differentiates listed property from other asset classes such as cash and bonds, where income is largely fixed. This was evident in 2013 when, despite the volatility, listed property still returned more than 8% for the year, ahead of cash (5.3%) and bonds (0.6%).

 

We believe it is unlikely that the exceptional returns of 2010 and 2012 will be repeated in the short to medium term, as this was partly thanks to the sector’s re-rating on the back of lower bond yields. From current levels, realistic return expectations for the medium term range between 10% and 12% per annum, which is considerably ahead of inflation expectations.

 

We expect distribution growth for the sector to accelerate slightly to approximately 8.2% this year before moderating to approximately 8% in 2015. The benefit of a weaker rand from the foreign real estate component – that some of the property sector’s management teams have prudently introduced in recent years – is part of the reason for the acceleration in growth.

 

 

The sector’s valuation has become more attractive of late, as share prices have largely tracked sideways since the middle of 2013 whilst underlying cash flows (distributions) have continued to grow over that time. The sector’s forward yield of approximately 8%, or roughly 2% real, is at the upper end of the range of the past two years. On a price to net asset value basis, the sector is now also trading below its long-term average.

 

 

While the underlying fundamentals of the listed property sector remain solid, the recent price volatility highlights the sector’s sensitivity to yield movements in the domestic bond market. Therefore, we see the biggest risks to short-term price movements in listed property as likely coming from two sources. Firstly, pressure on local bonds if future surprise interest rate hikes were to materialise, and secondly if global bond yields were to move higher on the back of a change in monetary conditions.

 

While these concerns have largely been discounted by the rise in local bond yields over the last ten months, continued uncertainty about emerging markets could limit upside in the short term. Therefore prudent stock selection will become increasingly important.

 

 

From a direct real estate perspective, the broader retail market has become more challenging over the past year. Consumers have felt the pinch from the rising cost of living and reduced access to credit, especially with regards to unsecured lending. Given this dynamic, we still prefer exposure to dominant regional and super-regional shopping centres, as this sub-sector has historically been the most defensive through the economic cycle. This is due to high levels of exposure to national tenants, which are generally backed by strong balance sheets. In this context, we prefer the retail landlords Hyprop and Resilient – these continue to enjoy strong growth in trading densities and hence positive rent renewals.

 

Other stock preferences include Capital and Vunani within the industrial and office segments respectively. New Europe Property Investments (NEPI) remains the preferred offshore exposure.

 

 

Given the volatile macro environment, significant emphasis is placed on creating a well-diversified portfolio of shares with a preference for those counters with sustainable, superior distribution growth at reasonable valuations While the future returns of the sector might not be as robust as seen in the past decade, the sector can still deliver attractive real returns and remains an important component of an investor’s broader balanced portfolio.