Metope Investment Managers CEO Liliane Barnard (pictured) believes that the extreme challenges facing the local real estate sector over the past 18 months have revealed underestimated strength in the sector.
“It seemed like we were at the bottom in January of last year, and then the pandemic hit,” said Barnard, who co-manages the Metope Property Prescient fund. ‘Property was one of the sectors most affected.
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“But when we stress tests on balance sheets, readjusted earnings and devalued properties last year in the wake of Covid, we saw a strength that was not seen by the market. This is now beginning to be seen in the latest financial results. Rents in the physical market are still under pressure and will be for some time, but there are changes in the listed real estate sector that have actually improved its quality. ‘
This is perhaps most evident in how Reits distributions are now much ‘cleaner’.
“A couple of years ago, there were companies where rental income was only 80% to 90% of the base,” Barnard said. “The other 10% to 20% were things that were more exceptional, such as underwriting transaction fees, margins earned on cross-currency interest rate swaps, and capitalized interest. All those elements have been removed from the numbers.
‘You now have almost all income from the property listed as rental income, and of that, they are only paying 80% of distributable income. So you’re really getting pure property income on your dividend. ‘
The fact that real estate transactions continue to take place in the market and that companies obtain book value of assets also shows how the sector has not simply collapsed.
“The fear was that NAV would just disappear because the South African property was worthless. That has not materialized. ‘
Barnard added that while the impact of the lockdowns on real estate businesses was severe, this is not the first major drop in the real estate market. The sector came under extreme pressure in the late 1980s and 1990s, for example.
“I’ve been in real estate for a long time and I’ve seen the cycles,” Barnard said. “This cycle feels extreme, but it doesn’t really outgrow previous cycles yet. Although I would say that the future is more difficult. I don’t see the kind of recovery we saw previously from the pent-up base after the sanctions were lifted, for example.
“But I think the overall economy can still be considered bigger than it was 20 years ago. As things recover, the economy will naturally be larger and space occupation will continue. ‘
Metope’s head of research Kelly Ward added that it is important not to extrapolate too much from recent past experience.
‘At the beginning of 2020, the fundamentals of the sector were weak and in decline, and then there was Covid that accelerated some of that decline. In a total blockade, 70% of the shopping centers were not operating. You cannot carry that drop in income in perpetuity. That was largely unique. He will get over. There may be some casualties along the way, with some stores having closed permanently, but the April 2020 level five lockdown is not the normalized basis. ‘
The companies also provided a significant amount of relief to tenants last year, which will not be repeated to the same extent. As this relief subsides, it will drive earnings and returns, which must be taken into account as well.
“You have to see that for what it is,” Ward said. “You need to be able to know if an increase in revenue is a sign of a long-term path to recovery or a decline in discounts from the previous year.”
The good and the bad
Understanding the sustainability of earnings and distributions is a key part of how Metope distinguishes between opportunities in the industry. The use of ESG metrics is also vital.
“Governance covers the quality of management, the quality of the portfolio, the quality of the business strategy and the quality of earnings,” said Barnard. ‘Green buildings attract tenants who pay more with longer leases and have lower operating costs. All of them will also contribute to the quality of the earnings ”.
Another key factor is the maturity profiles of the leases. Businesses with a high lease maturity profile in today’s environment will be more exposed to current rental weakness than those with leases that expire within three to five years, when the economy is expected to improve.
Looking ahead, Barnard expects there is still more room for stock prices to improve, even after the positive returns of the past 12 months. This will be supported by improved dividend payment rates.
“As confidence returns, companies can go from paying 75% or 85% of profits to 95%,” Barnard said. ‘It will have a spike in distributions just to close the gap in payment rates. So while negative rent reversals will remain a feature of the market that puts earnings under some pressure, it will have that boost to dividends, which should help stock price valuations. ”
This is part of the reason you still see material on the upside for listed properties from current levels.
“I still think there is a good 20% rise in prices as of today,” Barnard said. “Within a year, if a little economic growth materializes, maybe that could be 30%. The industry offers value, performance and there is a 27% discount on NAV for convenience. ‘
Patrick Cairns is a South African editor at Citywire, providing knowledge and information for professional investors around the world.
This article was first published on Citywire South Africa hereand republished with permission.