Market Review

The SA Listed Property Index (SAPY) returned a total of -1% in Q3’18, actually outperforming equities (-3.3%) but still lagging cash, which obviously still delivers positive nominal returns even as risk assets have declined in absolute terms. Year to date (YTD), the SAPY has materially underperformed all other domestic asset classes, returning -22.2% YTD versus -8% for general equities and about +5% for cash.

The best performing shares in the SAPY for the quarter included Echo Polska (+18%); Equites (+13.6%), Fortress A (+10%) and MAS Real Estate (+9%). In contrast, the worst performers were Accelerate (-16%), Growthpoint (-13%), Rebosis (-13%) and Hyprop (-10%). However, some of the negative moves in the worst performers were exacerbated by them paying out dividends in the quarter.

Contributing to the negative returns for these shares were a number of SA-focused mid- and smaller caps reporting weak distribution growth and even weaker (declining in some cases) forecast distributions, such as Accelerate, Rebosis and SA Corporate, while even larger caps like Growthpoint and Hyprop reported and are targeting low single-digit growth rates.

What SIM did

Before fees, the SIM Property Fund outperformed the SAPY by 0.12% for the quarter, and YTD, the fund has materially outperformed the SAPY by 2.45%, somewhat cushioning the large negative return experienced by the sector this year.

The main action of the fund in Q3’18 was to trim overweight positions in pure Rand hedges Echo Polska and Investec Australia during a period of Rand weakness, as these shares actually went up even as the index, and in particular, SA-focused stocks, actually fell in absolute terms. The proceeds were mainly used to add to a basket of high-yield large-cap SAfocused REITS such as Growthpoint, Redefine, Hyprop and Attacq, as well as a basket of even higher-yielding mid-cap SA-focused REITS such as SA Corporate, Rebosis and Investec Property Fund.

These SA REITS the fund added to in the quarter are anywhere from 15% to 30% lower from their Ramaphoria highs, and offer attractive dividend yields of about 9% for the larger caps (Growthpoint, Redefine, Hyprop), and 10% or more for the mid-caps (SA Corporate, Rebosis, Investec Property Fund).

Outlook

Following the weak YTD returns, the SAPY has derated from a 6.8% clean forward yield at end Q4’17 to an attractive 8.6% trailing income yield and about a 9% clean forward yield. The forward yield is a slight premium to the SA long-bond yield of 9.1%, which itself derated this year as Ramaphoria faded and amid general emerging market weakness on account of an impending trade war.

We consider these levels to now be very cheap on average, in absolute terms, and certainly relative to SA cash. The income yield alone is over 3% higher than inflation expectations, and over 1% higher than cash rates. With the SAPY also likely giving growth in dividends (unlike cash and bonds) of CPI in the long run (4% to 6% p.a.), buying at the current price levels may make for a total medium- to long-term (three- to five-year horizon) expected return of 13% to 15% p.a. from here. Further, given the sharp sell-off this year, it is also possible that investors at these levels also benefit from a rerating of the sector back to an 8% or, best case, 7% or so yield. If the sector does indeed rerate back to, say, the midpoint, or a 7.5% yield from current levels, investors from current price levels could benefit from an additional once-off capital rerating return of c.15%, which, when amortised over five years, leads to an expected five-year total return of 16% to 18% p.a. compounded.

This can be roughly broken up into an entry forward yield of 9%, plus dividend growth of 4% to 6% plus the potential capital rerating benefit of c.3% p.a. The first two components we have a fair degree of certainty of receiving. However, the third component ? capital rerating ? is the most uncertain and speculative and certainly non-linear given the volatility of financial markets. Indeed, in the short term this capital rerating component can continue to be negative as it has been so far YTD, before it reverses. This is especially given our current interesting times ? anything from local politics, or international politics where potential trade wars between the US and China could continue to have an adverse shorter-term impact on financial markets’ price levels worldwide.

There are also some fundamental headwinds that could take time for the abovementioned expected return to be realised. As previously mentioned, some of the smaller REITS have cut their distribution outlooks, in some cases to negative growth. In terms of how this weaker outlook for property distributions may have materialised, even supermarkets like Shoprite are struggling to grow earnings (earnings down 3%), highlighting a tough SA economy - as a tenant, them or clothing retailers like Foschini or Truworths struggling to themselves grow ultimately filters into the REITS as lower rental growth or even worse, vacancies as they cut space in a bid to trim their own cost base in an environment of weak revenue growth.

Further, because the REITS are priced cheaply at the moment, it makes it difficult for them to do accretive acquisitions, which has in the past added to dividend growth rates. It is difficult for a company trading on 9% or 10% yields to raise capital and then buy an asset yielding more than that in order to create acquisitive growth; whereas not too long ago, they were able to raise capital at a 6% or 7% yield to buy something at a 9% or 10% yield, thus creating some excess earnings growth per share. In other words, now they have to rely almost entirely on organic growth, which is unlikely to exceed CPI, or at the very best contractual escalations, which may be 7% p.a. at this stage.

However, the sharp derating to the high-income yields of 9% to 10% for SA-focused shares hopefully provides an adequate cushion for the above considerations; and hopefully with dividends now largely rebased, growth from the current earnings base resumes in the CPI range, more or less in from the current earnings base resumes in the CPI range, more or less in line with contractual rental escalations of 7% p.a. less some allowance for vacancies, defaults, rental resets, maintenance capex, etc.

Market Review

The SA Listed Property Index (SAPY) returned a total of -19.6% in Q1’18, materially underperforming all other domestic asset classes such as cash, bonds and equities.

The best performing shares in the SAPY for the quarter and hence year to date included the likes of higher-yielding domestic mid-caps such as Accelerate, Arrowhead and Emira, as well as larger caps such as Growthpoint and Redefine, all materially outperforming the index with returns of c.5 - 15% versus the -20% for the index. The rallies in these domestic names were driven largely by the change in SA presidency from Zuma to Ramaphosa, which in turn drove our local bond yields lower and rand stronger. Of the rand hedges, Echo Polska also rebounded this year (+c.10%) after its sell-off in 2017 on news of a director being arrested.

In contrast, the worst performing shares in the quarter (which drove the average index down 20%) were the shares which were by far the best performers in 2017. Their sell-off was incredibly dramatic, offsetting all their prior year gains and more. These included Fortress B and Resilient (both down c.60 - 70%), NEPI Rockcastle and Greenbay (down c.50 - 60%) and MASS Real Estate (down c.30%). The sell-off in these counters were driven by them being very overvalued for one thing after their 2017 gains, being rand hedges (the rand strengthened sharply) and finally, concerns over this grouping having similarities to Steinhoff, which fell c.90% in December on confirmation of accounting fraud in that group. The concerns in these property counters relate to off-balance sheet loans, cross-holdings whereby they own each other’s shares, possible insider trading to push up share prices, aggressive capital raising at loft multiples, and offshore acquisitions, all of which do in fact have some similarities to Steinhoff.

So, while there may be merit to the above concerns and hence a sell-off in these was justified, perhaps it has taken these particular shares, but also the average index with it, from one extreme (overvaluation) to the other (undervaluation) as discussed below.

What SIM did

Before fees, the SIM Property Fund outperformed the SAPY by c.2% for the quarter, somewhat cushioning the large negative return experienced by the sector in the quarter. This outperformance was driven largely by being underweight in the Resilient group of shares and MAS Real Estate, which sold off dramatically, as well as overweight positions in some of the SA-focused stocks and Echo Polska.

On account of the relative price moves in the quarter, and the fund outperformance, the bulk of the trading activity related to firstly closing the underweight positions in the Resilient group of companies (Resilient, Fortress B, Greenbay, NEPI Rockcastle) and MAS Real Estate, and ultimately introducing a net overweight position at attractive prices in this grouping of shares. This was financed largely by sales of Echo Polska and the SA-focused stocks which were up strongly in the quarter, such as Growthpoint, Emira and Arrowhead.

While we do believe there is some merit to the accusations made against the Resilient group, the share prices had fallen too far in our opinion even given these risks, falling 40 - 70% in quick time. Resilient, for example, went from trading at an expensive 4% yield, double book value, to as high as a 12% yield and a 0.7x book value. Likewise, Fortress B went from trading at a 4.5% yield to as high as a 16% yield. Or NEPI Rockcastle from a 4% yield to over a 7% euro-denominated yield despite a track record of double-digit growth in dividends. The funds thus traded accordingly, progressively adding to these shares as they fell, firstly to a reduced underweight, then to neutral weight and ultimately up to a small, cumulative overweight, spread across those shares at these attractive yields.

Outlook

Following the weak Q1’18 returns, the SAPY derated from a 6.8% clean forward yield at end Q4’17, to well over an 8% clean forward yield, with two-year expected growth in dividends of about 7% p.a. and, in our view, longer-run growth in the CPI range of 4 - 6% p.a. This yield is now, for the first time in a long while, at a discount (i.e. above) the SA long bond yield, which had rerated to c.8%.

We consider these levels to now be cheap on average, in absolute terms, and certainly relative to SA bonds and SA cash. This is given that the SAPY entry yield alone is now above the spot yields on bonds and cash for the first time in a long while. On top of that, the SAPY gives you growth in dividends, while bonds and cash simply provide a flat income yield. Finally, given the sharp sell-off in Q1’18, it is possible that investors at these levels also benefit from a rerating of the sector back to a 7% or so yield, which we consider to be fair. Thus, over the medium to longer term, e.g. five or more years, we would expect an absolute total nominal return from listed property in the c.12 - 14% p.a. range compounded from current price levels, comfortably expected to beat all of inflation (5.25%), cash (7.25%) and bonds (8%), and possibly on par with even general equities. This expected total return is comprised of the c.8% average entry yield plus conservatively assumed long-run CPI-like growth in distributions in the 4 - 6% band. If the sector does indeed rerate back to a 7% yield from current levels, investors from current price levels will benefit from an additional once-off capital return of c.12%, which when amortised over five years, leads to an expected five-year total return of 14 - 16% p.a. compounded.

The bulk of the value or cheapness does now admittedly lie in the riskier section of the SAPY, namely the Resilient group, given the reasons and yields mentioned earlier. The cumulative weighting of these shares in the index is currently 25 - 30%, with the SIM Property Fund now slightly overweight in the grouping. The position sizing does try to account for the probability of further downside or fraud being a reality. Or put another way, the overweight is smaller than what the raw upside and high yields would suggest. And the risk is then rather spread across other shares that also offer value including Delta and Rebosis, which trade above 15% yields despite lower-risk government tenants. In terms of rand hedges, yields despite lower-risk government tenants. In terms of rand hedges, the fund has overweight positions in Intu and Capco, which still trade at depressed ratings post Brexit, below net asset value and c.7% yields, and Investec Australia, which trades at an attractive c.8% Aussie dollar yield plus growth of 3 - 4%, and at a more expensive rand level.

At the macroeconomic level, a further 25 basis points cut (50 basis points over the past year) in domestic interest rates also helps the sector, given their borrowing levels of about 35% debt to assets on average. This directly lowers their finance costs, thus increasing net income for dividend distribution. Further, it lowers their weighted average cost of capital, possibly allowing them to invest in accretive acquisitions and developments. The other indirect benefit is that it makes other competing asset classes such as cash and bonds less attractive for investors, leading to increased demand for riskier assets such as property and general equities.

Market review

The SA Listed Property Index (SAPY) returned a total of 8.3% in the fourth quarter of 2017 and 17.2% for the calendar year 2017. Over the 2017 calendar year, the SAPY outperformed bonds (10.2%) and cash (7.5%), but only marginally underperformed equities or the FTSE/JSE All Share Index (ALSI), which returned a total of 21% in 2017.

Interestingly, for investors with a longer-term mindset, over a trailing fiveand 15-year period, SA listed property is still the best performing major SA asset class, even ahead of general equities.

For the year, the best performing shares in the SAPY included the shares with 100% foreign exposure, such as MAS PLC (35%), Sirius (41%) and Greenbay Properties (60%), and locally, Equities Property Fund (32%). The last three companies only recently entered the SAPY index, which in itself could have also aided their share price growth due to forced index tracker buying.

However, in the fourth quarter itself, and in particular December 2017, following the outcome of a new leading party president in Cyril Ramaphosa, it was actually the more pure play SA stocks that delivered superior returns, re-rating somewhat from depressed yields of 7-9% along with SA government bonds re-rating from 9.5% to 8.6%. The rand hedge stocks, such as GRT, RDF and HYP, fell from intra-year highs on the back of sharp rand strength in December.

What SIM did
As highlighted in a previous commentary, the fund had maintained a balanced currency exposure with healthy benchmark type weightings to both SA type (+/-65%) and rand hedge property stocks (+/-35%). As a result, it did benefit nicely in absolute terms from the fourth quarter and in particular December rally that was driven by SA type exposures in the likes of GRT, RDF and HYP. In December alone, the SAPY rallied 4.2% with the SIM Property Fund returning 4.8%.

Before fees, the SIM Property Fund returned 7.5% for the quarter, unfortunately underperforming the benchmark by about 0.8%. For the calendar year 2017 the fund returned 16%, underperforming the SAPY by 110bps. The underperformance arose mainly from underweight exposures in some of the year’s best performing stocks mentioned above, such as MAS PLC, Greenbay and Equities, with our offsetting overweights unfortunately not performing as strongly.

We trimmed some of our Intu exposure, which rallied sharply after Hammerson offered to buy the company at a substantial premium to the prevailing share price. Both shares are cheap relative to history and we remain overweight. However, we used the rebalancing proceeds to buy back certain rand hedge underweights like MAS PLC and Greenbay, which fell off their highest levels on rand strength and de-rating. We also aggressively increased our overweight in EPP as it fell sharply on news ofa non-executive director being held for a certain crime. As a nonexecutive, this has no effect on the company operations, yet the share de -rated to a euro yield of over 10%.

Among the SA-focused REITs, we remain benchmark weighted Equities, which entered the SAPY, as it trades at a premium rating of 6% dividend yield (DY) and 140% net asset value (NAV), versus the likes of GRT and Redefine (above 8% DY and at book), or DLT and REB (above 12% DY and well below their book values). ATT signalled its intention to convert to a REIT, but only guided to being able to pay a 4% forward DY, a sharp premium to its SA peers. We thus also sold ATT to an underweight position, which together with Equities funded our material overweights in much higher yielding, lower price/book GRT, RDF, DLT and REB. We also now run an overweight in high quality HYP, which owns Canal Walk, at an attractive 6.5% DY. We also carry smaller offsetting overweights in a high yielding mid-caps basket, including Emira, Octodec, Arrowhead, Accelerate Property Fund and Tower Properties, yielding about 11% on average.

We did use the strength in the SA dominant shares post Cyril Rampahosa’s victory to trim shares like GRT and HYP, as a rebalancing opportunity to add to pure rand hedge property counters due to the rand strengthening to levels below even its PPP value of R12.75/$. (The rand is arguably now expensive following the December rally). However, the fund still remains balanced in terms of its absolute exposures to SA/offshore income streams, split roughly into 65% SA and 35% offshore.

Outlook
Following the strong fourth quarter returns, the SAPY re-rated from a 7.2% clean forward yield at the end of the third quarter of 2017 to a 6.8% clean forward yield, with two-year expected growth in dividends of about 7% p.a. In our view, longer-run growth is in the CPI range of 4-6% p.a. This yield is now a 170bps premium (i.e. below) to the long bond yield. The implied average yield of just SA specific counters is much higher, over 8% and hence a smaller premium to the SA government bond yield, which trades at 8.5% currently.

We consider these levels to be fair value on average, in absolute terms, but still attractive on a relative basis, for the longer-term investor, when compared to bonds and SA cash. Over the longer term, e.g. three or more years, we would still conservatively expect an inflation beating absolute total return from listed property of around 11-13% p.a. compounded from current price levels, comfortably expected to beat all of inflation (5%), cash (7.5%) and bonds (8.5%), and possibly on par with even general equities. This expected total return is comprised of the around 6.8% average entry yield plus conservatively assumed long run CPI like growth in distributions in the 4-6% band, even though shorter-term growth for the sector and the SIM Property Fund will likely even exceed CPI.

Further, unlike in the past (five or more years ago), the property sector is not 100% exposed to SA or rand income streams. The fund is more balanced or diversified in terms of currency exposures, with about 65% SA income streams and the balance 35% is offshore income streams (Australia, UK, Eastern Europe and the USA), which helps smooth thereturn profile for the sector/fund over time. For example, the 35% rand hedge exposures may help cushion the sector and the fund’s returns against adverse political/sovereign events (such as downgrades and minister dismissals), which could cause a double whammy of rand weakening coupled with a sell-off in SA focused stocks (as experienced in December 2015 or March/April 2017). Or, alternatively, as we experienced in December 2017 when we actually had a positive political outcome, the 65% SA focused exposures rallied aggressively contributing to the abovementioned healthy absolute returns of the sector/fund in December 2017 and the fourth quarter of 2017, despite the effective 35% rand hedge exposures falling materially in this time with the stronger rand, which strengthened from weak levels of R14.40/$ in October to R12.30/$ currently.