Market review
Despite a positive start to the year, the SA Property Index (SAPY) delivered a
modest total return of 2.2% in the first half of 2017, underperforming bonds, equities
and cash. The Cabinet reshuffle and subsequent credit downgrades did little to
derail bond yields, which benefited from capital flows into emerging market debt.
Nonetheless, the sector derated owing in part to the flurry of negative news in the
retail sector, which led to a deterioration in distribution growth prospects.
The best-performing shares in the SAPY for the year so far included the likes of
Fortress B, Octodec, Resilient and MAS PLC. By contrast, some of the worstperforming
shares for the first half of 2017 included Accelerate Property Fund (-
20%) due to poor dividend growth outlook, and the large-cap heavyweights
Growthpoint (-2%) and Redefine (-2%), which were hurt most likely from the
country’s downgrade to junk status, given that they are most likely to be the largest
and most liquid counters owned by foreign shareholders.
While local REITs have been affected by the lacklustre economic environment,
companies have thus far been able to protect distribution growth. Some of the
methods used to enhance the bottom line are non-recurring in nature, which is
increasing forecast risk, artificially inflating the base period and reducing the quality
of earnings across the sector. We see the potential for negative earnings surprises
as the year unfolds, although most REIT managers generally provide conservative
guidance. The market forecasts dividends per share growth of more than 7.5% over
the next 12 months.
Interest rate-sensitive stocks may benefit from a rate cut later this year, but should
not translate into upside for listed property, due largely to fixed-debt books and the
lag between rate cuts and demand-side improvements. There may be some upside
through debt restructuring and accretive local deals, but this will not be meaningful
in our view.
Portfolio performance and changes
During the last three months corporate actions in the SAPY Index included shares in
issue changes for Echo-Polska and MAS PLC. During the June quarterly rebalance,
Greenbay Properties replaced Delta Properties in the index. Your fund performed in line with the index.
The year ahead
The yield spread between the SAPY and the long bond narrowed to -160 basis
points (bps) in the first half of 2017. At these levels, the sector seems to be
inexpensive compared to the historical average. This conclusion is not evident when
comparing the sector to the long-term average spread as the increase in offshore
exposure has made the South African 10-year bond as a benchmark rate less
relevant. Nonetheless, slowing distribution growth should keep spreads at current
levels, although further compression is unlikely due to REITs’ defensive
characteristics.
The SAPY is currently on a 7.3% 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
5% p.a. This yield is now a 160 bps premium to (i.e. below) the long-bond yield. This
5% p.a. This yield is now a 160 bps premium to (i.e. below) the long-bond yield. This
spread versus bonds has narrowed from as high as 260 bps in the first quarter of
2016, on account of local bonds outperforming the SAPY, with the SAPY derating
over that 15-month period from 6.6%. The implied average yield of just SA-specific
counters is higher, at 8.5%.
A total return of about 15% over the next 12 months seems reasonable, assuming a
constant 10-year bond yield of 8.9% and the implied market risk premium of close to
4.9%.
Rand volatility could persist into year-end, as political turbulence gathers momentum
in the lead-up to the ANC’s National Conference in December 2017.