In the middle of the so-called lost decade, South African institutional investors were desperate for more offshore exposure. South Africa was clearly in a lot of trouble and regulations put a cap on local pension funds in terms of investing offshore, so innovative ways were being found to get around this. Pressure was put on local management teams to find international opportunities if they wanted any hope of raising equity capital on the local market.
Those management teams were highly incentivised to find swashbuckling opportunities in faraway lands, so you didn’t need to be active in the market in that period to guess what happened next. Lured by the promise of hard currency earnings and “low forever” interest rates, South African property funds raised equity capital at an extraordinary rate from local institutions and shipped that capital offshore to countries such as the UK, Germany and Poland.
I’ll never forget those days of watching Java Capital earn more fees over their morning coffee than many other corporate finance houses were earning in six months of work. These were heady times in the market and especially in property, with Java topping the deal tables over and over again as each property acquisition was treated as a separate deal.
The thesis was to acquire a stream of rental cash flows and fund them at a lower cost of debt, effectively locking in a net yield
The thesis was to acquire a stream of rental cash flows and fund them at a lower cost of debt, effectively locking in a net yield. The problem is that the offshore rentals were often in markets with practically no inflation, so the net cash flow from the property wouldn’t grow. The first year of the deal would achieve some growth in the rand dividend thanks to the net cash flows being locked in with each deal, but then growth would disappear unless the rand kept depreciating.
The good news for the funds (and bad news for South Africans) is that the rand did exactly that. This only encouraged more of the same behaviour, with the market putting premium valuations on funds that showed an ability to find deals overseas and execute on them. Combined with a desire to keep locking in a net yield on new offshore deals to achieve a growing dividend locally, the wheels kept spinning until problems set in.
Like all great hype bubbles, it eventually burst. In my view, there is no reason whatsoever to buy a property fund at a premium to NAV, as you’re effectively putting management on a pedestal instead of discounting the value of the portfolio to account for the costs of managing the thing.
Still, the market never learns, as evidenced by the premium to NAV that Sirius Real Estate traded at during the pandemic. It’s a good business, yet investors are nearly 40% off the peak in December 2021. The peak-to-trough capitulation was a drop of more than 55% in the space of nine months. Every time I tried to warn people, I was given a speech about how great the management team is at unlocking the value in the properties. That’s great, but if you’re paying for this outcome on the day that you buy the shares, then there’s no room for the share price to reward you for taking the risk.
The market certainly doesn’t have an enviable history of behaving sensibly in response to corporate behaviour
The point of this history lesson is that the local property sector doesn’t have a great track record of capital allocation. And the market certainly doesn’t have a history of behaving sensibly in response to corporate behaviour. This creates the opportunity for another round of questionable corporate activity in the sector, with a few signs starting to show that we need to keep our wits about us.
One of the things to watch out for, particularly given the high cost of debt, is acquisitions priced at a low yield. If the yield is low, it means that the price is high. Hyprop has agreed to acquire Table Bay Mall on a forward yield of around 7.7%, taking its group loan-to-value ratio to 40.3%. This yield is well below the cost of debt, so it isn’t an earnings-accretive transaction until the mall benefits from growth in the Sunningdale area. Hyprop is paying for that growth upfront, which is dangerous.
Also look out for accelerated bookbuilds that bring favoured institutional investors onto the share register, usually at a discounted price. This means that minorities effectively get diluted at a discount. Exemplar REITail is a good current example, but probably won’t be the last.
In this low-growth, high-rate environment, most property funds are not a good choice.
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