What is next for SA listed property?

South Africa’s (SA) listed property has made a tremendous comeback in 2024, delivering a 52% total return over one year to 30 September.

This performance has outpaced both SA bonds and SA equities, which returned 26% and 25%, respectively. For investors who were initially skeptical and missed the rally, the question now is whether it’s too late to re-enter the listed property market. We believe it still offers a compelling opportunity to invest.

Listed property has fundamentally transformed itself and is set to benefit from anticipated tailwinds that will drive sustainable earnings growth.

Battle hardened
Once the best-performing South African asset class, listed property entered a ‘period of fear’ in 2018 when the fallout from the Resilient stable shook the market. This incident unmasked the aggressive accounting practices and financial engineering that allowed REITs to produce unsustainably high dividend growth fueled by cheap offshore debt. Then, in October 2023, a comeback rally began.

To survive the period of fear, the sector required a drastic transformation, entailing:

- Debt reduction: Overleveraged companies were compelled to repay debt as property values came under pressure. Funds were raised through asset disposals, equity issuances and earnings retention.
- Earnings quality improvement: To rebuild market trust, companies improved earnings quality by adopting a conservative cash-backed distribution policy combined with implementing a pay-out ratio to ensure capital expenditure was sustainably self-funded.
- Improving resilience: Significant investment into solar power and water supply resilience to bolster self-sufficiency in the face of poor public service delivery.

As a result, listed property companies have rebased earnings and net asset values to sustainable levels, positioning themselves to grow as anticipated tailwinds materialize.

Anticipated tailwinds
The listed property sector has endured several years of headwinds, including negative reversions, rising vacancies, ballooning property expenses and higher interest rates. However, we believe we are now at the bottom of the property earnings cycle and look forward to a period of growth as previous headwinds begin to turn into tailwinds. This includes:

- Declining interest rates
We are in the early stages of an interest rate cutting cycle, where SA interest rates are down 25bps and are expected to fall another 125bps over the next 12 months. Lower interest rates boost profits and stimulate transactional activity, which bodes well for asset pricing (property valuations).

- Property expenses expected to decline
SA property companies have absorbed excessive costs relating to loadshedding, such as diesel, generators and extra repairs and maintenance caused by intermittent power supply. These excessive costs no longer weigh on these companies. Significant investment in alternative power sources, like solar, reduce the reliance on expensive Eskom supplied power, further reducing energy expenses.

- Improving SA property fundamentals supportive of future net rental growth
Retail property rentals have rebased as the reversionary cycle saw occupancy cost ratios fall to decade lows. Shopping centers are now well-positioned to deliver rental growth.
Elevated office vacancy rates have peaked and have started to decline. Development activity is limited to pre-leased developments only, keeping the supply of new space in check.
Industrial property has benefitted from strong demand, limited supply and rising construction costs, which has been a key driver of rental growth. We anticipate this trend may continue.

- Attractive offshore exposure in the SA listed property sector
Approximately 60% of the SA listed property stock assets are located offshore, including high growth regions, such as Central Eastern Europe and Spain, where property fundamentals are robust. This diversification helps to mitigate the impact of South Africa’s underwhelming economic performance.

Is it still worth getting back into listed property?
The sharp rerating came off a very depressed base and, therefore, post-rally valuations still look reasonable. The SA All Property Index trades at an 8% dividend yield (on an 85% pay-out ratio) and 0.7 times price-to-book ratio. The yield spread relative to the SA 10-year government bond (government bond yield – listed property dividend yield) has stabilised around historical averages of about 200 basis points. We estimate that SA listed property is priced to deliver 5% nominal growth – an achievable target given the low earnings base and growth tailwinds previously mentioned.

The expected dividend yield and growth equates to a total return package of around 13%, a fair return for equity investors. For income-seeking investors, listed property has re-emerged as a reliable source of income yield with inflation hedge potential.

The widespread rerating of listed property stocks led to a convergence in valuations across the sector. The earnings yield differential between high-risk and low-risk property companies has narrowed, indicating that we are no longer sufficiently compensated for risk. Consequently, we have adopted a more cautious stance on stock selection, concentrating on high-quality companies that are trading at fair valuations. These companies typically exhibit strong free cash flow, healthy balance sheets, and portfolios that are well-positioned for growth in income and net asset value.

In summary, we believe it is a good time to re-enter the listed property market. This asset class is reinvigorated and possesses a unique risk-return profile reflective of both bonds and equity – worthy of inclusion in any diversified portfolio.