The CEO of Metope Investment Managers, Liliane Barnard (pictured), believes that the extreme challenges faced by the local property sector over the past 18 months have revealed an under-appreciated strength in the sector.
‘It seemed we were at a bottom in January last year, and then the pandemic hit,’ said Barnard, who co-manages the Metope Property Prescient fund. ‘Property was one of the worst affected sectors.
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‘But when we stress-tested the balance sheets, rebased earnings and devalued properties last year in the wake of Covid, we saw robustness that wasn’t seen by the market. This is now starting to be seen in the latest financial results. Rentals in the physical market are still under pressure and will be for some time, but there are changes in the listed property sector that have actually improved its quality.’
This is perhaps most evident in how distributions from Reits are now much ‘cleaner’.
‘A couple of years ago you had companies where rental income formed only 80% to 90% of the base,’ Barnard said. ‘The other 10% to 20% were things that were more once-off, like fees on underwriting transactions, margins earned on cross-currency interest rate swaps and capitalised interest. Those elements have all been stripped out of the numbers.
‘Now you have almost all income from the listed property being rental income, and of that, they are only paying out 80% of distributable income. So you are really getting pure property income in your dividend.’
The fact that property transactions are still taking place in the market and that companies are getting book value for assets also shows how the sector has not simply fallen over.
‘The fear was that NAV would just fall away because South African property was worth nothing. That hasn’t materialised.’
Barnard added that while the impact of lockdowns on property companies was harsh, this is not the first major downturn in the property market. The sector was under extreme pressure in the late 1980s and 1990s, for example.
‘I’ve been in the property sector a long time and seen the cycles,’ Barnard said. ‘This cycle feels extreme, but it actually doesn’t yet surpass previous cycles. Although I would say that the future is more difficult. I don’t see the kind of recovery we saw previously from the repressed base after sanctions were lifted, for example.
‘But I think you can still consider that the general economy is bigger than it was 20 years ago. As things recover, the economy will naturally be larger, and takeup of space will follow.’
Metope’s head of research, Kelly Ward, added that it is important not to extrapolate too much from recent past experience.
‘At the start of 2020, the fundamentals for the sector were weak and declining, and then you had Covid that accelerated some of that decline. In a full lockdown, 70% of shopping centres weren’t trading. You can’t carry that drop in income into perpetuity. That was largely a one-off. It will recover. There may be some casualties along the way, with some stores having permanently closed, but April 2020 level five lockdown is not the normalised base.’
Companies also provided a significant amount of relief to tenants last year, which won’t be repeated to the same extent. As this relief winds down, it will boost earnings and yields, which also has to be considered.
‘You need to see that for what it is,’ Ward said. ‘You need to be able to tell whether a boost in income is a sign of a long-term path to recovery or a clawing back of discounts from the previous year.’
The good and the bad
Understanding the sustainability of earnings and distributions is a key part of how Metope is distinguishing between opportunities in the sector. Using ESG metrics is also vital.
‘Governance covers the quality of management, the quality of the portfolio, the quality of the strategy of the business, and the quality of earnings,’ Barnard said. ‘Green buildings attract higher-paying tenants on longer leases and have lower operating costs. All of those will also feed into the quality of earnings.’
Another key factor is lease expiry profiles. Companies with a high lease expiry profile in the current environment will be more exposed to the current weakness in rentals than those holding leases that expire in three to five years’ time when the economy is expected to improve.
Looking ahead, Barnard expects that there is still more room for share prices to improve, even after the positive returns of the past 12 months. This will be supported by improving dividend payout ratios.
‘As confidence returns, companies can move from paying out 75% or 85% of earnings to 95%,’ Barnard said. ‘You’ll have an uptick in distributions just from closing the gap in payout ratios. So, even whilst negative rental reversions will continue to be a feature of the market placing earnings under some pressure, you’ll have that boost to dividends, which should help share price valuations.’
This is part of why she still sees material upside for listed property from current levels.
‘I still think there’s a good 20% in upside in prices from today,’ Barnard said. ‘In a year’s time, if a little bit of economic growth materialises, maybe that could be 30%. The sector offers value, a yield, and there is a 27% discount to NAV to give you comfort.’
Patrick Cairns is South Africa editor at Citywire, which provides insight and information for professional investors globally.
This article was first published on Citywire South Africa here, and republished with permission.
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