The All Property Index (ALPI) delivered a total return of -4.2% in the third quarter of 2019 (Q3-19). Although this resulted in an outperformance of the FTSE/JSE All Share Index (-4.6%), it continues to lag the performance of the All Bond Index (0.7%). As has been increasingly the case in recent months, the correlation between bonds and listed property continues to weaken, with the increased offshore exposure in the sector. The South African 10- year government bond yield moved 20 basis points (bps) out to 8.9% over the quarter, while the forward yield of the ALPI saw an increase to 9.4% from 8.9% as at end-June 2019, despite some support for UK property stocks late in the quarter as rotation into value property stocks occurred globally. The historical yield of the bellwether index (comprising Growthpoint, Redefine, Hyprop, Vukile, SA Corporate and Investec Property Fund) increased to 10.8% at the end of Q3-19, up from 9.9% three months earlier. This saw the historical yield gap relative to bonds move out to 181bps at the end of September from 126bps as at end-June 2019.

The fund’s return of -4.2% during Q3-19 was in-line with the benchmark, while performance over periods between three and 10 years compares favourably to peers and the benchmark. The fund’s relative positioning in Redefine, Hammerson, Nepi Rockcastle and Capital & Counties added value during Q3-19, while value detraction came from the relative positioning in Resilient, Investec Australia, Hospitality and Accelerate. During the period, the fund increased exposure to MAS Real Estate, Equites Property Fund and Redefine, while reducing exposure to Nepi Rockcastle, Resilient and Fortress A.

Post completion of Q3-19 reporting, the underlying local operational performance continues to be reflective of the broader challenging economic backdrop. Reported year-on-year (y/y) dividend growth came in at 0.8% compared to 0.9% in the first half of 2019 (H1-19). Excluding the black economic empowerment deal rebasing of Resilient and Fortress, y/y dividend growth was 2.7% compared to 2.3% in H1-19. Including offshore counters, dividend growth averaged 3.6% y/y compared to 4.3% in H1-19, supported by Nepi Rockcastle and MAS. Operationally, pressure on net property income (NPI) growth remains, as reversions weigh on top line growth while cost pressures increase. Operating cost increases are driven by higher municipal rates and tenant incentives, although this is partially offset by improved general service cost management and the benefit of more greening initiatives, especially solar. Landlords continue to manage for occupancies rather than rental growth, although this is becoming more difficult due to the poaching of tenants, especially within the office sector, putting even more pressure on reversions. Balance sheet strain is starting to visibly show with a high probability that this will continue in the short to medium term. Property values should come under pressure, while degearing through sales is difficult in a buyer’s market, with few buyers actually able to raise funding.

Within the retail sector, trading density growth continues to be under pressure at low single-digit growth. Retailer cost of occupancy is increasing due to escalations and higher municipal rates and taxes outpacing trading performance. Reversions are trending down to low single-digits and even negative growth rates, while escalation rates of national retailers are moving closer to 5%- 6.5%. With this as a backdrop, vacancies actually remain fairly well managed. Despite attention-grabbing headlines, we have seen limited space rationalisation of banks in shopping centres thus far, although this could pick up in future. In turn, there seems to be sufficient appetite to accommodate Edcon space rationalisation. National fashion retailers are, however, using the Edcon deal as bargaining tool for lease negotiations despite landlords stating no actual rental reduction (as per the lease agreement) has taken place. Each landlord is treating the equity investment differently, with most either writing value partially down or to zero. Massmart is starting to become a concern, and although it pays a lower rental relative to percentage gross leasable area occupied, box format and size will make it difficult to release, especially post the Edcon space absorption.

Offices remain under pressure, especially in certain nodes in Johannesburg. The national office vacancy of 11.3% is masking underlying challenges in the sector, as no new tenant demand exists to absorb vacant space coming about from space consolidation and backfill space. Landlords are not only experiencing pressure on reversions, but also higher leasing commissions and incentives – there is evidence of up to 12 months’ rent-free on three-year leases for challenging properties, although market practise remains one month for every one year of lease length. One promising fact is that development activity has slowed to a 13-year low to 2% of existing stock. Activity is still concentrated in Sandton, with a quarter of all development activity in the country – the development is led by proximity to the Gautrain station rather than the historic Sandton core. Flexible office space has gained in popularity, with WeWork coming to South Africa (three leases) and landlords’ own initiatives, but the mode does challenge traditional office space lease structures.

Despite positive market dynamics for industrial properties, limited market rental growth continues as space consolidation and development activity are keeping a cap on rentals. There is a continued trend of large negative reversions on long-term 10-year leases coming up for renewal, which will likely take another three to five years to work out of the system. Big box tenants are pushing hard for contractual escalations closer to consumer price inflation – we are seeing this especially for logistics space users, who are also demanding shorter lease lengths.

The state of the economy remains the biggest challenge for the sector. The interest rate cut this past quarter will likely be insufficient to kickstart the economy. The lacklustre economy remains the biggest challenge for the sector, together with an increasing cost base, which is becoming more difficult to recover from tenants, resulting in property operating margin erosion. The most recent reporting season mostly cemented the trends landlords have experienced the last 12-18 months. An issue coming more to the fore is how real estate investment trusts (REITs) will treat dividend pay-out ratios going forward. REITs may choose not to pay out 100% of profits to shareholders to mainly preserve balance sheets in the current cycle. With these uncertainties still being the backdrop, the current lacklustre sector performance may continue in the short to medium term.

The listed property sector (ALPI) delivered a total return of 1.3% in the first quarter of 2019 (Q1-19), following a strong performance in January but subsequent reversal in February and March. This return lagged that of the FTSE/JSE All Share Index (+8.0%) and the All Bond Index (+3.8%). The correlation between bonds and listed property held up for the better part of the quarter, though dissipating somewhat in the latter part. The South African 10-year government bond yield compressed to 9.0% from 9.2% a quarter earlier, while the forward yield of the ALPI saw a decrease to 8.8% from 9.4% as at end-December 2018 (including index changes).

The historical yield of the bellwether index1 decreased to 9.5% at the end of Q1-19, from 9.6% three months earlier. This saw the historical yield gap relative to bonds widen to 51 basis points (bps) at the end of March from 38bps as at end-December 2018.

The fund's return of 1.5% during Q1-19 was ahead of the 1.3% delivered by the benchmark, while performance over periods between three and 10 years compares favourably to peers and the benchmark. The fundfs relative positioning in Hyprop, Investec Property Fund, Hammerson and Nepi Rockcastle added value during Q1-19 . enough to offset the value detraction coming from the relative positioning in Liberty Two Degrees, Redefine, Resilient and Growthpoint. During the period, the fund increased exposure to Vukile, Hyprop, MAS and SA Corporate while reducing exposure to Growthpoint, Redefine, Investec Australia Property Fund and Investec Property Fund.

Companies with June/December year ends, representing just under 60% of the sectorfs market capitalisation, reported financial results during Q1-19, with dividend growth coming in at 1.1% for the domestic names. When including offshore-focused but locally-listed counters, dividend growth sat at 8.3%. This was supported by the weaker rand over the 12 months to end- March 2019. As was to be expected given the challenged macroeconomic environment, underlying operational results generally reflected strain, manifesting in pressure on rental growth even as vacancies for now remain generally stable. With this being a tenantsf market, retailers are pressing for larger reversions and lower escalations, while on the office side, a limited pool of occupiers continues to see landlords use various avenues to compete. Following on from last year, an increase in municipal rates remain a key driver of cost growth, offsetting growth in gross rental income which is already under pressure.

Just under R1.3 billion of equity was raised in accelerated bookbuilds during the quarter. Equites was the first company to come to market for the year, raising R710 million. Stor-Age followed with a R585 million bookbuild following small acquisitions of self-storage assets in the UK. Meanwhile, in corporate activity announced during the period, Safari and Fairvest said that the parties had agreed to engage with each other regarding a potential friendly merger, though the expression of interest signed remains nonbinding. After announcing an asset swap deal that would have seen Fortress acquire various shopping centres from Resilient in return for Resilient shares owned by Fortress, a stake in Lighthouse Capital and a minority stake in two shopping centres, Fortress announced that the proposed deal had been pulled, citing limited prospects of reaching consensus on all aspects of the proposed transaction. Redefine announced that it had increased its stake in listed Polish retail landlord, Echo Polska Properties, from 39% to 44%. This latest transaction will see Redefine’s Polish exposure tick even higher following the acquisition of the direct logistics platform into the country during 2018.

Following limited information at the beginning of the year, Edcon finally made public its recapitalisation deal with stakeholders that will reportedly allow it a few years of breathing room. Of relevance to landlords, a handful of options are on the table. Of these, the most prevalent include a straightforward 41% rental cut for two years, with the cut accruing monthly into a trust account which will then be used to subscribe for equity in Edcon every six months. The other option is an upfront equity contribution by the landlord equal to the present value of the rental holiday, with the rental payable unchanged. It will be up to individual landlords as to how this latter option will be treated for distributable income purposes: some have indicated they would only distribute the circa 59% of rental after the ‘cut’, while others plan to pay out the entire amount, with the distribution adjusted by interest costs related to the debt used to subscribe for the equity.

In management changes during the month, former Hyprop CFO, Laurence Cohen was appointed as the new CFO for Vukile Property Fund. Meanwhile, Resilient announced the appointment of former Mr Price CEO Stuart Bird to its board as a non-executive director following the retirement of longserving director, Bryan Hopkins. In sector news during the month, the Financial Services Conduct Authority announced that it had closed its investigation into allegations of insider trading against Resilient, Fortress and Nepi Rockcastle, though investigations into share price manipulation remain ongoing.

SAPOA released its quarterly office vacancy survey for the fourth quarter of 2018 during Q1-19. The release showed that office vacancies were down 17 basis points (bps) to 11.1% in December 2018 from a quarter earlier. Of the four office grades, A-grade space was the only one to show a deterioration, climbing 30 bps to 9.1%; P-, B- and C-grade space recorded declines of 60 bps, 40 bps and 70 bps respectively from the prior quarter, to end the quarter at vacancy rates of 6.1%, 13.8% and 14.7% respectively. Of the five metropolitan areas, three (Durban, Port Elizabeth and Cape Town) saw a deterioration in occupancies, while two recorded an improvement (Pretoria and Johannesburg). Growth in asking rents over the last 12 months recorded a slowdown to 4.4% (versus 5.3% in the previous quarter). Office space under development amounts to 2.3% of existing stock (with 53.2% of this pre-let). As has been the case for some time now, a high degree of concentration remains, with 10 out of 53 nodes accounting for 91% of all developments, with Sandton, Waterfall and Rosebank accounting for a combined 58% of total office development.

As illustrated by the recently concluded results season, numerous headwinds to organic rental growth remain in place, stemming from broadbased weakness in underlying domestic fundamentals. Across the major sub-sectors, negotiating power has tilted in tenants’ favour, with the result that landlords are managing for occupancies rather than rental growth. Some uncertainty will likely remain until after this year’s National Elections in May; however, a sustained rebound in the economy will be needed before fundamentals return in favour of landlords. Against this backdrop, we see selective opportunities within the domestic listed property universe, where the headwinds from muted dividend growth are sufficiently priced into initial yields.