SA listed property – more juice in the tank

SA listed property has delivered a total return of 30.1% year-to-date, outperforming bonds (+15.9%) and equities (+10.6%). The level of outperformance has understandably sparked scepticism, with many investors asking whether the rally, which began in November 2023, has run its course. Some are asking if it’s time to “take profits”. In our view, the re-rating seen in the property sector is justified, and several tailwinds remain to support further upside.

The encouraging outcome from the elections and formation of the Government of National Unity (GNU) removed the risk premium that was priced into SA in general, resulting in a 1.8% compression in the 10-year bond yield since May 2024 to c.10% today. SA bonds started the year at 11.1% and touched 9.9% this week. This bond rally has led to a re-rating in the sector as listed property is often seen as a fixed-income instrument with growth characteristics.

The local property market is showing signs of improvement. Retail rental rates have started to increase in most shopping centers, and leasing retail space has become more affordable than it has been in the past decade. This presents an opportunity for growth in distributable income. Industrial rentals have gone up significantly due to higher construction costs, leading to an increase in market rentals over the past year. Office vacancies have decreased by 1.9% over the last 12 months to 13.6%, with prime-grade office vacancies now at 7.5%, which is lower than the levels before the Covid-19 pandemic.

Thanks to sizable demand from the call centre sector, some markets like Cape Town and Umhlanga (Durban) are ‘virtually full’ with limited space for any large users. Net operating income (NOI) growth is likely to be at least in line with inflation over the next two years. Several companies that have reported results in the past month beat consensus forecasts and raised earnings guidance. We believe consensus growth estimates will still undergo an upward revision over the coming months.

The improvement in electricity supply is growth-enhancing to both tenants and landlords. Landlords historically recovered around 65% of the diesel costs, with the remaining 35% ‘leakage’ directly affecting REIT operational costs. This saving and lower generator maintenance costs will continue to filter to earnings, thus boosting growth. In addition, investments into solar projects, which currently account for the bulk of capital expenditure, yield approximately 15%, enhancing the bottom line.

Balance sheet leverage (debt-to-asset ratio) has fallen to 37%, providing debt capacity-funded acquisitions at a time when the cost of funding has started to drop. In the last few weeks, Vukile Property Fund (via its Spanish subsidiary Castellana) announced the acquisition of three malls in Portugal for €176 million at a 9% yield. The following day Vukile raised R1.5 billion in an oversubscribed accelerated book build (ABB) to fund the acquisitions. JSE listed European retail property company Lighthouse also raised R1 billion via an ABB last Friday. Earlier in the same week Western Cape-focused Spear REIT announced a R457 million vendor placement (issuing shares to new & existing shareholders) to shore up its balance sheet. The recent capital-raising activity demonstrates that capital markets are open again. In our view, inorganic growth, which has generally eluded the sector for some time, will return and provide further impetus to distribution growth in the medium term.

Lastly, we believe we are on the cusp of a protracted interest-rate-cutting cycle that could last 12-18 months. The US Federal Reserve Bank (“Fed”) cut rates by a deeper than-expected 0.5% and signaled a further 2% in total interest rate cuts in the next 24 months. With SA inflation falling below 4.5%, the Fed’s decision paved the way for our SARB to cut rates by 0.25% on 19 September 2024. The Forward Rate Agreement (FRA) curve, which is the market’s indication of future interest rates, is currently pricing in 1.25% pts of interest rate cuts over the next 12 months.

Turning to valuations, the sector trades at a 23% discount to net asset value (NAV), there are 13.6%9.1% distributable income yield, and around 8% dividend yield. Distributable income growth is expected to be in the region of 6% per annum over the next two years, which we believe will be significantly higher than local inflation, which continues to trend downward. In our view, we have merely seen a normalisation in an oversold sector – we believe there is more ‘juice in the tank’ with total returns of 13-14% per annum are expected over the next 3-5 years.