After a horrible three years characterised by unpredictable share price swings and dwindling dividends, analysts expect a somewhat more stable and profitable year ahead for real estate investment trusts (Reits).
Property stocks’ multiyear underperformance continued last year as the sector again lagged behind the other three major asset classes. The South African listed property index (Sapy) ended 2022 barely in the black, with a total return of just 0.5%.
Share prices of the index’s 20 constituents were down an average 7.3%. But total returns were propped up by a decent 7.8% dividend yield.
Listed property’s 0.5% total return compares with 3.6% for general equities, 4.2% for bonds and 5.2% for cash.
While most property stocks were still reeling from pandemic-related losses incurred from relief granted to struggling tenants, falling rentals and higher vacancies, the earnings of many South Africa-focused Reits suffered a fresh blow last year due to aggressive interest rate hikes and surging operating costs on the back of rising utility costs and relentless load-shedding.
Then rand hedge property stocks, UK- and Europe-focused ones in particular, were severely hit in the first half of 2022 by the Russia-Ukraine war and subsequent spike in energy and food costs.
However, a handful of property stocks (mostly South African-biased), nevertheless delivered double-digit returns in 2022. These include Fortress Reit, Octodec Investments, Dipula Income Fund, Emira Property Fund and Vukile Property Fund.
Corporate action was no doubt the prime driver behind Fortress and Dipula’s rally, while exposure to the resilient US and Spanish real estate markets provided a strong underpin for Emira and Vukile respectively.
The good news is that analysts are fairly upbeat about the sector’s prospects for the year ahead as interest rates and inflation start to peak.
Nesi Chetty, head of property at Stanlib, highlights an improved rental growth outlook as a key positive. It should provide an important underpin for earnings — and dividend — growth.
Chetty says: “We have started to see rental reversions on lease renewals stabilise in some parts of the retail sector and to some extent also in office markets. In addition, we expect in-force rental escalations on existing leases to reflect real growth as inflation moderates into the second half of the year.”
Chetty adds that in some subsectors, most notably residential, logistics and parts of the retail market, a lack of new development has created a shortage of supply. “This is likely to keep rentals firm.”
Naeem Tilly, portfolio manager and head of research at Sesfikile Capital, shares the sentiment: “We believe the sector’s fundamentals have improved to a position where rental growth will be slightly positive, driven by stable vacancies, healthy escalations and improving rental reversions.”
What’s more, he says balance sheets are now in a healthier position after most companies retained income during the pandemic by cutting or halting dividends.
Many companies have also sold off noncore assets over the past two to three years and used the proceeds to pay down debt. “Loan-to-values are now at 37% on average, down from 42% at the pre-Covid peak,” Tilly says.
Still, the sector faces challenges as the local and global economy continues to stutter. Chetty refers to the rising cost of capital, especially for companies with exposure to debt in offshore markets, as a key worry.
We expect in-force rental escalations on existing leases to reflect real growth as inflation moderates into the second half of the year
— Nesi Chetty
He says another risk that could slow the property sector’s rebound is higher rates starting to erode consumer spending, which could dampen demand for retail space.
Tilly cites as major threats a worse-than-expected year ahead for load-shedding and heightened political risk. Rising operating and municipal costs could also be a drag on income.
“Elevated interest rates will be a significant headache for Reits as they manage the repricing of interest rate swaps from historically low levels to current market rates,” he says.
But Chetty and Tilly believe value chasers could return this year, given that the sector still trades at a healthy 30% discount to NAV.
Chetty says the sector is poised for a rerating on the back of a more stable distribution growth outlook, which could narrow the discount to NAV to about 10%.
Tilly expects the listed property sector to deliver a “fair” total return of 13.4% in 2023, made up of an income yield of 8.6% and a modest capital gain of 4.8%. The latter will be largely driven by earnings growth, he says.
Ridwaan Loonat, senior property analyst at Nedbank CIB, forecasts a slightly lower total return of 10%-12% for listed property in 2023. He says that incorporates earnings growth of about 4% and an average dividend payout ratio of 85%-90%.
It’s also possible that general equity fund managers, who exited the listed property sector in droves over the past three years, could start to trickle back in 2023
Analysts believe property share prices could be supported by a drop in long-bond yields this year. Listed property yields (and their inverse price movements) have historically had a close correlation with government bond yields. The latter tested record highs last year.
It’s also possible that general equity fund managers, who had exited the listed property sector in droves over the past three years, could start to trickle back in 2023.
Among them is PSG Wealth, which, in a recent report on the real estate sector, suggested listed property is worth a second glance again.
According to the report, fiscal factors indicate that the nominal yield on the 10-year South African bond should come down this year, “possibly providing an uplifting effect on the listed property sector at large’’.
Using the South African 10-year bond yield of 9.6% (one-year forward) as a benchmark, PSG Wealth says a 9% uplift in the Sapy (capital values) can be implied — based on the historical relationship between the two asset classes.
Vaughan Henkel, head of equity research at PSG Wealth, says other macro tailwinds for the property sector include the fact that rental reversions, retail in particular, are now at an inflection point.
“That should transition into positive territory within the next year, providing a solid basis for upward property valuations,” he says.
“In the office market, we see signs of decreasing new supply and troughing valuations, which should allow sales into the owner-occupier market at or above book values. This should allow for capital recycling and should limit the negative contributions to earnings.”
Henkel notes the sector is also a good rand hedge proposition, given the large exposure that many stocks have to offshore real estate markets.
Though PSG hasn’t “pulled the trigger’’ yet to re-enter the listed property market, Henkel says the sector is certainly starting to look more interesting.
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