Currently no margin of safety in listed property: Regarding Capital Management

The RECM Investment Team have looked into investing in listed property and concluded that although there have been spectacular returns over the past ten years, right now they do not consider property to be low risk from an investment perspective.

The fact that Trump has suffered numerous bouts of bankruptcy seems to be lost on the optimistic promoters of property as an ‘all weather’ investment. Many investors don’t need encouragement either and often do not even consider the alternatives. Logically, property can’t always be the most rational choice, yet it is the preferred investment. The reason: property is tangible. Psychologically human beings prefer an investment that they can see and feel over one they cannot.

For the same reason real estate is perceived to be a safe investment, regardless of the circumstances. Ultimately, safety depends on the price paid in relation to the value received.

In South Africa property as an investment has protected and grown the real wealth of investors at a very attractive rate over the long-term. This is true for both privately owned- or unlisted property as well as property companies listed on the JSE. But, does that mean that investors could simply buy property at any point and expect to earn a satisfactory real return going forward?

In this article, we consider how the South African listed property sector stacks up in terms of valuation and consider the likelihood for investors of earning an adequate real returns, if they buy at current prices.

Table 1 shows the total return for cash, bonds, equities and listed property over the last 10 years. The exceptional performance of listed property companies can be explained by four dynamics that were in place 10 years ago.

First of all, property companies traded below their underlying value or Net Asset Value (NAV) and subsequently re-rated to a premium to NAV. Because the official listed property indices in South Africa have a very limited history we created our own index from the listed property companies that do have long histories as listed entities namely Growthpoint, Hyprop, Octodec, Pangbourne, Fountainhead, Sycom and Premium Properties. Together, they make up about 40% of the combined market capitalization of all listed property companies. Although this index is not fully representative it provides us with a useful reference to illustrate our reasoning. Chart 1 shows the Price / Net Asset Value (P/NAV) for the index. NAV is a good measure of the worth of a property company when the true value of its real estate assets is shown on the balance sheet. If it is the case that the real estate assets for the sector as a whole is shown at true value then NAV will reflect true underlying value and we can conclude from the chart that today investors are willing to pay more for the same amount of property value compared to the past. The fact is that almost everyone hated property 10 years ago and today almost everyone loves it.

Secondly, new accounting rules led to higher NAVs. When observing the history of the chart one has to keep in mind that property companies in South Africa only started valuing real estate for accounting purposes on an annual ‘fair value’ basis from around 2002 and before this it was effectively recorded at cost. ‘At cost’ is typically lower than ‘at fair value’.

This means that before 2002 the NAV is understated and the PINAV is even lower during that period. Consequently, the current PINAV is even higher in relation to history than the chart suggests.

Thirdly, growth in underlying value or NAV was significant over the past few years due to declining interest rates which had a major impact on property valuation both in terms of higher profitability and the higher value of discounted future cash flows.

Lastly, strong economic conditions led to above average growth in cash flows and NAV due to substantial tenant demand.

But that’s history. Prospective returns are determined by the price you pay today, not by what happened in the past.

Besides, the four variables considered are at opposite ends of the spectrum today compared to 10 years ago. Firstly, investors will not continue paying a premium for property indefinitely. Characteristically they will be guided by the recent past and it will only take a few years of relatively meager performance for property to trade at a discount to NAV again.

Secondly, new accounting rules are unlikely to have a once-off benefit on NAVs as it did over the last few years. Thirdly, low interest rates will also not last forever and will have an adverse effect on NAV growth when the interest rate cycle turns. Lastly, economic conditions are inherently cyclical and we have already started witnessing the negative impact of slowing economic growth on vacancy rates and the rate of new property developments.

We can gauge potential future returns by examining its components. The total return earned from any investment consist of the cash or dividend yield received plus the percentage change in the price, which in turn is equal to the growth rate in the cash flow or dividends if measured over a long time period.

Chart 2 shows the historical nominal returns for our composite listed property index, Chart 3 shows the components of the historical nominal returns split between dividend yields and share price gains and Chart 4 shows the components of those returns split between the real return and inflation.

In Chart 3 the cash flows returned to shareholders at particular points in time can be observed and it is clear that current dividend yields are rather low compared to history. Preferably investors want to earn a large portion of the total return from less risky current dividend yields and therefore will favour higher dividend yields. To earn a sufficient total return from the starting point of a low dividend yield requires a great amount of growth. Currently therefore, with dividend yields at low levels, growth becomes crucial which is not ideal as the only thing that is certain about growth is investors’ inability to forecast it. This holds true even for property companies which normally have fairly visible cash flows over shorter periods of time. Over the long-term, growth in cash flows for property companies and therefore growth in NAV is closely linked to inflation in building costs. However, one also needs to take account of leakages from the system. After all, properties representing A-grade space today can only be A-grade space and therefore command similar rents in 10 years time if it is maintained in pristine condition. This once-off maintenance spending does not occur year after year. Given the short history of the South African listed property sector it may well be that we have not seen the full impact on overall distribution growth for the sector. Time will tell.

Similarly, value dilutive capital allocation by management, the result of inappropriate incentives, also work their way into the Income Statement and therefore distributable income eventually. Over time, it therefore comes as no surprise that property value grows at inflation, or slightly less than inflation. This is not true for certain properties in prime positions, but on average it holds true. Also, the portfolios of most listed property companies consist of a diverse range of properties. The good ones tend to subsidise the bad ones, leading to an average outcome.

For the next 12 months nominal dividend growth of about 8% is expected for the listed property sector as a whole. This dividend growth is nothing to write home about in the first place but more importantly, what happens to growth after year one? Given the evidence presented below it seems that growth is at risk.

Chart 5 shows the long-term trend in the vacancy rate for both listed and unlisted property and includes retail, office and industrial space. Although listed property on average reflects higher quality property portfolios than unlisted property and have lower vacancy rates, similar trends are evident for both types of property. In 2009 vacancy rates have continued to rise. Chart 6 shows the large amount of new developments initiated while the going was good. These developments are still coming on stream and do not bode well for overall vacancy rates and therefore growth in cash flows.

Ultimately one needs to compare price with an estimate of value. To do this, it helps to compare the return one expects to earn and the return required from the investment.

What return do we require from listed property?

The return investors should demand from a particular asset depends on their assessment of the risks inherent in the asset. In this context risk relates to the strength of the company’s competitive position and the predictability of its cash flows. The higher the risk the higher the required return. For the listed property sector as a whole we can provide an estimate required return figure of about 14%. This consists of an expected 10YR SA Government bond yield, which we use as a proxy for a risk free rate, plus a risk premium to compensate for the fact that it is more risky than government bonds.

Are the odds of the listed property sector earning this return favourable?

To answer this question, we can examine the two components of returns again. As a sector, property is currently giving an investor close to an 8% dividend yield. This has to grow by 6% into perpetuity to meet our return requirement. As property grows distributions by inflation or slightly less than inflation over the long-term, it seems that 6% growth will be hard to achieve given that inflation is also assumed to grow at 6%. Although it is expected that distributions will grow by 8% for the next 12 months and it appears that we will beat our required return over the short-term, the market is a forward-looking mechanism and will price in any future slowing cash distribution growth accordingly. From the evidence on hand, we believe that a prevailing low dividend yield together with distribution growth of 6% into perpetuity from the current base, in other words expecting a nominal return of 14% into perpetuity, is a bit of a stretch.

More importantly, this expected return must be higher than the 14% required return for there to be any margin of safety, which is a requirement for investment to take place as opposed to speculation.

With the JSE rallying again in leaps and bounds many local fund managers are finding more selling- than buying ideas in general equities. Relatively ‘safe’ listed property with a relatively respectable short-term return outlook may now be viewed as the sensible alternative or middle ground between holding low yielding cash and fairly valued general equities.

Although property is not a very risky asset class in general, we do not consider property to be low risk from an investment perspective currently. There does not seem to be a margin of safety in any form. The low cash flow yields at which properties are currently changing hands seem to suggest that NAVs may be on the high side. The outlook for growth in yields, our least preferred source of margin of safety, is not great.

With average gearing levels for the sector close to 30%, measured as debt to real estate assets, the impact of property devaluations on their net worth is not as significant as is currently the case for many global property companies. A 10% decrease in valuations for properties will only lead to a 15% reduction in net worth.

However, the risks that we have highlighted are not reflected in the prices at which listed property companies are currently on offer. In short, the low prospective returns on offer do not compensate for the fairly large risks. If things turn out fine, returns will not be stellar, and if valuations are impaired, returns will be very poor!

Our clients’ portfolios currently have no direct exposure to this asset class but we are waiting patiently for value to emerge in the sector.