Diworsification: The process of putting additional assets into a portfolio that diworsifies, rather than diversifies, future returns.
The South African listed property sector has been a huge winner over the last decade, returning 17.65% per year compared with the 11.98% for the JSE All Share Index. However, South Africa’s slow economic growth and high borrowing costs have made it extremely difficult for local property companies (Propcos) to sustain the rapid growth of the previous decade. It was therefore only a matter of time before these Propcos looked offshore in an attempt to enhance their growth potential.
This begs the question – will these offshore acquisitions create real value or have local management teams fallen into the trap of diworsification?
Offshore acquisitions enhance earnings, initially
Due to the low borrowing costs of around 3% in Central and Eastern Europe (CEE), local management teams have predominantly focussed on acquisitions in that region. The cost of funding in CEE is far lower than the rental yields on property acquisitions and the transaction immediately enhances the earnings of the acquirer. A good example is the acquisition by Redefine of Echo Prime Properties in Poland. The initial rental yield on the assets are roughly 6% and was funded with a cost of debt of around 3%.
The problem is that these offshore transactions may turn out to be financial transactions as opposed to property transactions, with the focus more on the initial increase in earnings (due to favourable acquisition spreads and the assumed depreciation of the rand) as opposed to the longer-term impact on overall portfolio quality and growth potential.
Value created through tangible synergies
A sound justification for an offshore acquisition cites strong market fundamentals and/or significant redevelopment opportunities. The presence of these tangible synergies will add to the rental growth and asset value of the acquirer’s total portfolio over many years to come, not only the first year.
According to local property fund managers Sesfikile Capital, the Redefine-Echo Prime deal “was not only about initial earnings accretion. The secured pipeline of refurbishments and acquisitions can generate growth beyond the first year”. While Redefine has likely created real value with this transaction, Sesfikile aptly states that there are still those “running away from the rand into another set of problems.”
One only needs to look across the Atlantic to the US for evidence of how unsuccessful US Propcos have been on the merger and acquisition front. Since 1992, acquiring companies have typically delivered total returns that lag those of their peers and provide scant evidence of real value creation.
The jury is still out on offshore expansion. Local investors will do well to judge each offshore acquisition on its own merit, with a focus on identifying its tangible synergies beyond the first year.