Attractive Yields but Headwinds Remain
By Simbarashe Mangwiro
Associate Investment Analyst
The South African Listed Property market’s success and troubles are well documented, with the asset class going from being the darling of the market to being completely unloved. At Morningstar, we follow a valuation-driven investment approach and therefore believe it’s extremely important to look beyond the noise and objectively understand the underlying economics of any asset class within our investment universe.
Most investors access the South African Listed Property market by investing in Real Estate Investment Trusts, better known as REITs. REITs are companies that own or finance income-producing real estate across a range of property sectors.
A REIT is a hybrid asset class which falls somewhere between the stocks and bonds spectrum. This, by construction, implies that the asset class should exhibit stock and bond-like characteristics in terms of risk and return. Like any other asset, investors would generally expect the total returns to be driven by a combination of earnings growth, yield and capital growth.
Due to the extreme sell-off we have witnessed within the listed property sector over the past few years, one would have expected attractive returns going forward given the current undemanding share prices and attractive yields. The time old saying remains true – there is no free lunch in investing. Investors need to take the time to do their homework and look beyond share prices and yields to understand the qualitative aspects of this investment opportunity before considering including it in an investment portfolio.
Before the Covid-19 outbreak, a conservative approach to the asset class would have been to expect yields to be a significant driver of returns in the short to medium term, modelling in;
1. Zero growth in earnings – to reflect both a stagnant South African economy and the supply/demand dynamics within the sector; and
2. No positive ratings change – to factor in a prolonged period of negative investor sentiment towards the sector.
Even if the REITs market failed to grow and just managed to maintain current distributions, the yield would be attractive given the low prices an investor would be paying for the asset class.
Key to this approach would therefore be comfort levels around the certainty of cashflows (i.e. to earn the implied yields as tenants continue to pay their rent) and balance sheet strength which one could get via a quality approach to the sector. Under normal economic conditions, it wouldn’t be unreasonable for high-quality counters to maintain distributions, however, the short-term certainty of these cashflows is now under question given the disruption in economic activity due to the Covid-19 outbreak.
Covid-19 has indeed proven to be a black swan event like no other. Whilst necessary to stem the spread of the virus, social distancing brings about a disruption to economic activity. In the context of REITs, this translates to a disruption to revenue streams such as loss of rental income (which is the main source of income for REITs) when, for example, shopping malls close in the short term.
Whilst some landlords have rental insurance in place in such instances, this is not a given for all. As many tenants will be unable to pay rent, it will no doubt, have an impact on expected property distributions in the short to medium term. This would mean that investors run the risk of not earning the implied yields as property company’s cut their distributions. It is, however, important for investors to note that this phenomenon is not unique to property and applies to the rest of the sectors in the equity market.
It’s not unusual for companies to withhold or reduce dividends in economic downturns, and it won’t be surprising to see companies in other sectors also not matching the current implied dividend yields with actual dividend payments. Morningstar’s preferred approach here would be to look beyond the Covid-19 crisis and maintain a disciplined long-term approach to investing.
Net Asset Value (NAV) and leverage
Underlying property valuations for REITs have also come under scrutiny from investors. Simply put, investors are concerned that the reported property valuations are too high in the context of the current sector fundamentals. The implication of this would be that the current discount to NAVs are not reflective of the true underlying value of REIT assets.
Given that the REIT business model is reliant on leverage, a decrease in property values could affect the ‘’value component” of the key Loan to Value (LTV) metric that is commonly used in setting debt covenants by banks and other creditors. A decrease in LTV could result in REITs breaching debt covenants, thereby forcing creditors to call back their loans. Whilst this is true and could play out for highly leveraged companies, exposure to quality counters with strong balance sheets should give investors a reasonable level of comfort. Revenue and property prices would have to decline significantly before quality counters breach their covenants
Although current pricing would suggest that a lot of these issues are discounted in market pricing, investment is an exercise of relative selection, and attractive valuations alone do not warrant positions in portfolios. Recalling that we highlighted that Property is a hybrid between stocks and bonds earlier, it is useful to think about the relativities in expected yield between REITs and bonds as well as the expected capital appreciation between REITs and stocks.
In the context of the current market construct, South African Government bonds are currently offering attractive yields with little risk of non-payment of coupons and principal amounts by the government. With regards to stocks, South African stocks have also been aggressively sold and opportunities have emerged within even the large-cap counters that have resilient earnings streams and strong balance sheets. Further to this, it’s worth mentioning that stocks have less refinancing risk given that they have the flexibility to retain earnings – which is a very valuable option in a period where capital markets can dry-up.
Whilst we acknowledge the fundamental risks within the sector, we also believe that the market has over-reacted in certain counters and believe that the REIT sector still holds opportunities in the long run for disciplined and diligent investors.
Morningstar continues to express this view with sensible allocations to quality property counters in our higher risk mandates that have longer time horizons. In the more conservative lower risk mandates, the certainty of South African government bond cashflows is an attractive characteristic and is our preferred access point to yields.
More than ever, we stress that investors should avoid rash decisions and stay focused on fundamentals with a long-term view. No one knows what the future holds, but if the world pulls through this crisis – as it has done numerous times before – it’s best to be positioned to benefit from the recovery and the compounding effects of the market.