Please note that the commentary is for the retail class of the fund.

The volatility experienced in the SA listed property sector in the second quarter of 2016 continued throughout the third quarter, with the sector delivering a return of -0.73% (after its second-quarter return of -0.43%). This lagged the performance of bonds, which saw another bumper quarter (+3.4%), and general equities, which were able to eke out modest gains (the CAPI Index returned 0.50%). The divergence between bonds and listed property continued during the quarter: bonds received support from CPI data that pointed to a moderating inflation profile over the next year (suggesting a rate hiking cycle that is at or close to its peak) while a cautious tone coming out of the results season saw the property sector remaining relatively subdued. The SA 10-year government bond yield decreased to 8.66% at the end of the third quarter (from 8.78% at the end of June), while the clean forward yield of the listed property sector saw an increase to 7.7% by end September (20 bps wider than the closing level of the second quarter).

The fund's return of -0.31% during the quarter was better than the -0.73% delivered by its benchmark, with the fund gaining momentum over one and five years, but losing it marginally over three years. The outperformance during the quarter was due to value-add from the fund's relative positioning in Hyprop, Resilient, NEPI, Fortress B, Redefine and Investec Property Fund. These were enough to offset the value detraction from the fund's relative exposure to Capco, Intu, Attacq, Growthpoint and Rockcastle. During the period, the fund increased its exposure to NEPI, Sirius, MAS Real Estate and Redefine, while trimming exposure to a handful of counters including Growthpoint, Hyprop, SA Corporate and Fortress A.

The trend of capital raises within the sector continued during the quarter, with six companies raising just over R9.5 billion between them. Greenbay (R2.25 billion), Redefine (R1.5 billion), NEPI (R2.5 billion), Hyprop (R700 million), MAS Real Estate (R500 million) and Sirius (R480 million) all undertook accelerated bookbuilds, while the new Polish listing, Echo Polska Properties (EPP), raised the equivalent of R1.6 billion in a private placement as part of its JSE listing. Another Polish company, Globe Trade Centres (GTC), also listed on the SA bourse during the quarter. In addition to these two listings, the quarter saw a secondary listing on the JSE from Hammerson (the UK-listed owner of prime retail assets in the UK and on the European continent), joining its UK peers Intu and Capco. Going forward, it was announced that a new REIT will come out of the Liberty portfolio. Dubbed Liberty Two Degrees, the company will bring R6 billion in property assets, and will look to raise R4 billion in equity capital before the end of the year.

Characteristic of the sector, corporate action ensued during the quarter. Pivotal revealed that Redefine has made an offer to acquire the company, which has the support of 25% of Pivotal shareholders. Meanwhile, following months of discussions, Arrowhead, Vukile and Synergy jointly announced a transaction that will see the Synergy structure being used to house Vukile and Arrowhead's high-yielding assets, while the retail component within the current Synergy portfolio will be transferred into Vukile. Under this deal, Arrowhead will own the majority of the new Synergy structure, which will be renamed Gemgro. In other activity, the majority of Lodestone's shareholders approved a takeover offer from Fortress, while Arrowhead looked to take advantage of the recent fall in Emira's share price (following its profit warning), offering to take over the company with support from 22% of the shareholder base (this was subsequently rejected by the Emira board). After announcing revised transaction terms, Rebosis saw its acquisition of the privately held Billion Group approved by shareholders.

The South African Property Owners Association released its office vacancy survey for the second quarter of 2016 during the third quarter. The survey showed that office vacancies decreased to 10.5% in June 2016, from 10.9% in March. Of the four office grades, A-grade space was the only category to see a decline in vacancies (falling to 8.2%), while C-grade space saw vacancies remain flat at 16.2%. P- and B-grade space saw slight upticks in vacancy levels to 4.9% and 13.1% respectively. Of the five metropolitan areas surveyed, Cape Town was the only one to see an increase in vacancies during the quarter, with the other four (Johannesburg, Pretoria, Durban and Port Elizabeth) seeing an improvement in occupancies. Asking rents were 9.1% higher over the last 12 months, compared to the 8.6% increase noted in the previous quarter. In terms of office space under development, a high degree of concentration remains, with 10 out of 53 nodes accounting for 85% of all developments. 42% of this space is in the Sandton node (representing 22.2% of existing Sandton space).

The group of companies with June and December year-ends (representing just under two thirds of the sector's market capitalisation) reported results during the course of the past quarter. Taken together with the group of companies with February and August year-ends, which reported earlier in the year, distribution growth of 14.5% was delivered (excluding the fully offshore-focused counters). The core message coming out of the results is that conditions on the ground remain tough, with this past year having been among the most challenging in the past decade or so. Most companies reported growth in distributions that was in line with previous guidance, though outlook statements remain cautious. Within the underlying portfolio metrics vacancies were generally mixed, with prime retail seeing further improvement from already low levels, while industrial and office portfolios are reflecting the challenging macro environment. In the same vein, office rentals are under pressure, with intense competition amongst landlords seeing a drive for increasing incentives and negative reversions. The industrial market continues to see a cap on rentals, though logistics tenants still appear to be faring better than traditional manufacturing tenants. On the other hand, although still positive, reversions in retail are seeing a downward trend, with isolated cases of nationals pushing back on the level of contractual escalations.
The softness in the broader economy remains a headwind for property fundamentals, as reflected in the cautious outlook adopted by a number of companies. While a few of these outlook statements indicate some slowdown in earnings growth into the next year, the quantum is not indicative of a wheels-off scenario (save for Emira) and the sector looks set to achieve real growth in distributions. On the positive side, the local rate-hiking cycle appears to be close to an end and should be supportive of earnings going forward. Following two consecutive quarters of underperformance relative to bonds, the listed property sector's rating has cheapened somewhat, and we are of the view that at current levels, SA listed property offers value over the medium term.

Portfolio manager
Anton de Goede
as at 30 September 2016

Please note that the commentary is for the retail class of the fund.

Following a challenging end to the final quarter of 2015, SA listed property started the year on the back foot in January, but recovered emphatically to deliver a return of 10.1% for the first quarter of 2016. This performance was ahead of that of the broader equity market, as well as government bonds, which had also seen a tumultuous time in December 2015. With the SA 10- year government bond yield decreasing to 9.03% from 9.69% over the quarter, the positive correlation between bonds and listed property was again reinforced, with the sector’s clean forward yield falling to 7.3% at quarter-end (from 7.7% at end-December). This was despite a 75bps hike in the policy rate by the South African Reserve Bank (SARB) during the quarter, as inflation climbed to 7% in February (and expected to persist above the SARB’s target over the next year).

The fund’s 7.60% return for the quarter was behind the SA Listed Property Index’s (SAPY’s), with the 12-month performance also slightly below that of the benchmark. However, the fund continues to outperform the benchmark over three years, while being in line over five years. Value-add during the quarter came from the fund’s relative exposure to Attacq, Fortress A, Vukile, Emira, Stenprop and MAS Real Estate. Relative positioning in Capital & Counties, Intu, Growthpoint, Redefine, Hyprop, Nepi, Rockcastle, Fortress B and Resilient detracted from performance. With the UK Real Estate market showing pronounced weakness during the quarter in anticipation of possible Brexit, the fund increased exposure to Capital & Counties, while adding to its Fortress B holdings. Following the sector’s recovery, especially amongst the larger, more liquid stocks, the fund trimmed exposure to a handful of counters, including Growthpoint, Redefine, Nepi and Resilient.

Right off the bat, the year started with companies looking to continue the sector’s trend of equity raises. However, given the state of the markets in January, things did not go as expected; International Hotel Group did not garner enough support for its intended capital raise, while Atlantic Leaf was able to raise only half of its targeted amount. However, a few other companies (Redefine International, Fortress, Schroders, Investec Australia and Delta Africa) were able to raise capital following the recovery in February and March, bringing the total amount of capital raised in the year thus far to R6.4bn.

In line with the rest of the sector’s foray into Central and Eastern Europe (CEE), Redefine acquired a stake in a portfolio of retail and office properties in Poland, while Hyprop acquired two shopping centres in Serbia and Montenegro, adding Eastern European exposure to its existing African (ex- SA) presence. MAS Real Estate, which had up to now focused on Western Europe, also moved into CEE, setting up a 40/60 joint venture with Prime Kapital, a vehicle owned by former Nepi executives. And last, Tower Property Fund is seeking to increase its exposure to Croatia with an acquisition of four retail centres in the country (the transaction will require shareholder approval). On the corporate action front, Growthpoint announced that it will be acquiring the remaining 1% it does not own in Sycom, while Vukile and Arrowhead are looking to use the Synergy structure to house both funds’ higher yielding office and industrial properties. Meanwhile, Arrowhead continues with its strategy of holding small equity stakes in higher yielding funds, with their latest acquisition being a 9.8% stake in Rebosis.

The first reporting season of the year took place during the quarter, with companies representing just over 62% of the sector’s market cap announcing results. Average distribution growth of 23.7% was reported, with the weaker rand supporting earnings; distribution growth excluding offshore counters averaged 18.8%. This compares to a figure of 12.4% for the same group of companies six months ago, and 11.3% twelve months ago. The remaining local stocks also have varying degrees of offshore earnings, with the Resilient group of companies having the highest offshore exposure - excluding this group of companies, distribution growth recorded 8.8%, which is respectable given the economic backdrop.

Despite the slower tempo in the macro environment, vacancies generally held up well across the group of companies reporting - with flat or marginal improvements compared to six months ago save for one or two counters. However, reversions are coming under pressure; management teams continue to report seeing stress in the office sector, with tenants pushing back on rental increases at lease expiry, especially in the B-grade office space. Landlords are finding themselves having to strike a balance between retaining tenants and managing rental increases, with most preferring to keep tenants at lower rental levels than risk losing them completely. Tenant retention ratios for the companies that reported them remained strong in the mid-80s bar one or two. On the other hand, retail sector reversions are still relatively strong, especially at dominant malls in metropolitan areas, though there is anecdotal evidence suggesting that line shops are beginning to experience strain. In this environment of headwinds to the top line, management focus on costs remains key: operating cost-to-income ratios were predominantly flat during the period, with landlords able to recover most municipal costs from tenants.

Despite the strong showing during this past quarter, the sector’s valuation has only returned to levels seen prior to the dismissal of the SA finance minister in December. As shown by the underlying metrics from the reporting season, the fundamentals are holding up- the sector appears to be weathering the slow economic environment fairly well up to this point and we do not expect a material deterioration in its earnings. However, a still likely sovereign credit rating downgrade remains a potential headwind to the sector’s rating. Given the historical positive correlation between the 10-year government bond and listed property (as illustrated during December 2015), a downgrade would likely have an adverse impact on listed property. Balancing this risk against the sector’s fundamentals, we view the domestic listed property sector as fairly valued at current levels.

Portfolio manager
Anton de Goede

Up to November, the local listed property sector looked poised for a relatively good 2015. However, the positive correlation between listed property and bonds was reinforced during the quarter, as the sell-off in government bonds - following changes in the ministry of finance portfolio - saw property lose 6.1% in the month of December to end the year up 8.0%. The bond market weakness is in part due to a weaker currency (which is negative for inflation) in an environment where the SARB is already in hiking mode. This could see a more aggressive policy stance from the central bank, especially after the US Federal Reserve lifted interest rates for the first time in nine years as it moves towards rate normalisation. The SA 10-year government bond yield increased to 9.69% from 8.37% over the quarter, while the property sector’s clean forward yield moved to 7.7% from 6.9% - resulting in a total return of -4.7% for the quarter.

With a return of -3.4%, the fund outperformed the SA Listed Property Index (SAPY) for the quarter and for the year (8.5% fund return vs. 8.0% for the SAPY). The fund continues to outperform the benchmark over three and five years. Value-add during the quarter came from the fund’s relative exposure to Capital and Counties, Intu, Growthpoint, Hyprop, Redefine and Equites. Relative positioning in Nepi, Rockcastle, Fortress B, Attacq and Pivotal detracted value. Given the pronounced currency weakness during the quarter, inward-listed counters showed good gains. The fund increased exposure to Hyprop, Redefine and Growthpoint, while gaining exposure for the first time to Indluplace and participating in Stor-Age’s listing. Meanwhile, exposure was reduced to Arrowhead, Fortress B, Nepi and Resilient.

Investors continued to support capital raises during the quarter. A total of R9.9bn was raised between nine companies, of which R7.3bn was raised by Investec Property Fund, Nepi, SA Corporate and Equites alone. For 2015 as a whole, R30.4bn in new capital was raised by companies in the sector (R32.6bn of secondary placements are included). The last quarter of the year also saw four new listings – Stor-Age, the self-storage company; Capital and Regional, owner of dominant convenience community shopping centres in the UK; and Schroder European REIT, a fund aiming to invest in top Continental European cities. Green Flash, which has a primary listing in Mauritius, listed on the AltX during the quarter. The company will invest in European Property.

Corporate action within the sector continued well into the final quarter of the year. Fortress’s takeover of Capital was concluded during the period, resulting in the delisting of Capital, and the inclusion of the larger Fortress into the JSE Top 40 Index (bringing the number of SA-focused property counters in the Top 40 to three). Tsogo and Hospitality announced details of the deal that will see Tsogo inject a number of hotels into Hospitality in return for a 50.6% shareholding. On the rest of the continent, Delta Africa and Pivotal announced a tie-up that will see Pivotal sell its Nigerian and Kenyan interest into Delta Africa in return for a shareholding, which will see Delta Africa grow its presence on the continent to six countries. The African expedition was joined by Attacq and Hyprop acquiring Ikeja Mall in Lagos, while Growthpoint and Investec Asset Management have set up a joint venture that will be a platform for forays into the rest of continent. The trend of entry into Europe also continued, with Texton expanding further in the UK, while Attacq and Atterbury jointly gained exposure to Serbia. Executive changes taking place during the quarter included the appointment of former Dipula FD, Brigitte de Bruyn to the same role at Texton. At Delta, Shanil Maharaj replaced Greg Booyens (who moved across to Emira) as CFO.

Companies making up just over a third of the sector’s market capitalisation reported results during the quarter. The SA-focused companies that released results reported average distribution of 8.5%, slightly less than the 8.8% reported by the same group of companies six months ago. This compares to distribution per share (DPS) growth of 12.4% for the group of companies with June year-ends. Taking all companies that reported since June, DPS growth of 11.4% was registered, compared to 10.4% in the prior six months. Trends coming out of the sector show that despite the macroeconomic environment, companies managed vacancies well, with some even experiencing a decrease in vacancies, partly due the overhang from the failure of Ellerines working itself out (in retail and industrial). Tenant retention has become a key focus for landlords with most being prepared to take cuts in rentals to retain tenants (negative reversions have a much smaller impact on earnings than an increase in vacancies). Costs are being well-managed, with greening efficiencies becoming more prevalent. Unfortunately, this is coinciding with landlords taking on the responsibility of electricity and water infrastructure and metering as some councils show unwillingness to provide landlords with the wholesale/retail differential despite being responsible for the infrastructure.

Avenues for external growth in SA are diminishing (acquisition yields are dilutionary in general, while larger portfolio deals are drying up). Those external growth avenues being pursued are focused on expanding/redeveloping existing assets, tenant-driven warehouse/logistic developments or previously underrepresented sectors in the SA listed space such as residential, student accommodation and medical. Growth into the rest of the world has been embraced with most companies having some or other offshore exposure or showing aspirations to do so.

Going forward, a number of headwinds face the listed property sector. In addition to those we have flagged in the past - the weaker economic environment and the hiking cycle - there appears to be additional stress points materialising. A deteriorating position in government finances, combined with the downgrade of SA’s sovereign credit rating towards the end of 2015 (and the potential for more downgrades over the next year or two) pose material risks to SA government bonds, and as a result, listed property. Given the muted economic environment, we expect distribution growth to gradually ease to levels closer to inflation over time.

Portfolio manager
Anton de Goede