Getting the house in order: Listed property headwinds are reducing going into 2024
Listed property fell substantially during the Covid-19 pandemic and has been subsequently weaker over the past two years
Rising interest rates, a moribund economy, rentals reverting downwards and the load-shedding crisis, have not been kind to the sector. However, the risks facing the sector relative to other domestic sectors are likely to subside in 2024, and, while property conditions will remain challenging, negativity around the sector is somewhat overdone.
Tough environment is troughing
Looking forward to the more immediate future, there are not yet any tailwinds on the horizon, but the headwinds are reducing. Among the risks facing the sector, there are two key headwinds to unpack as we move into 2024: interest rates and the local operating environment.
A high interest rate environment is not good for listed property given that it lowers the asset value of properties and reduces earnings as interest costs are higher. However, this challenging environment may subside with the interest rate environment gradually improving and with the market expecting interest rates to go down during next year. This provides a more positive backdrop.
Additionally, while local operating conditions have been very tough on the ground for commercial property owners for years, the operating environment may have troughed and appears to be improving. This has been reflected in recent forward-looking commentary from a number of large listed property companies.
Many domestic property fundamentals stopped deteriorating some time ago, but these were not an event in company earnings as their improvements were drowned out by the impact of higher interest expenses and load-shedding costs. Consequently, some large property companies have provided double digit negative earnings guidance for next year despite an improved backdrop in their operational businesses.
If interest rates reduce as the market expects this headwind should start to subside and we may see distributable earnings recover somewhat.
Tenants sign contractual leases for a number of years. Once these expire, they are renegotiated to the prevailing market rental level. The extent that this new rental will be higher or lower is based on how different the rental paid by expiry is from the market’s current rental level. For example, if a lease was signed five years ago, and rentals since then have declined substantially, there would be a large negative reversion. Over time, however, most of the rental book has been signed at the new lower rentals, which is reflected in the rental base and reduces the level of negative rental reversions. This is beginning to occur now with reversions starting to get less negative, and in some cases positive.
This dynamic is most evident in the retail sector, where tenant affordability ratios (the ratio between sales/income and rent) – already overstretched before Covid-19 – are now at much more affordable and sustainable levels with most leases already reflecting the new (lower) base. If tenant sales grow, there is now the potential for commensurate rental growth to come through.
Load-shedding in the base
Load-shedding is another headwind that is already in the base (unless it worsens further). Property companies have taken the hit and their earnings reflect the additional costs of load-shedding (e.g. diesel, generator maintenance, loss of trading where no backup exists etc). In addition, they have improved their recovery of load-shedding costs from tenants and may turn a crisis into a long-term opportunity to the extent they can roll out solar with electricity self-generation, which property companies are aggressively pursuing. Interestingly, load-shedding has been good for larger shopping centres with backup power, as when there is no power at home people are more likely to go eat at a mall.
While the risks are receding for domestic listed property, there is still a significant risk facing the sector globally. Many listed property companies have exposure to global property holdings. The companies have borrowed at foreign interest rates to fund these holdings. The South African debt capital market is healthy, but this is not the same in Europe, especially for commercial real estate. Not only will it be much more expensive to refinance these loans when they (and their interest rate hedges) expire, given that interest rates overseas have increased substantially since these deals were financed, but the availability of funding to do so is a challenge. Ironically this offshore dynamic could be the next headwind that the listed property sector faces, which could overwhelm the domestic improvements we have discussed. However, should interest rates in Europe decline and funding pressures improve, this issue would be less pronounced.
Slow and steady
As we’ve learnt over the past few years, economic conditions can change at any time. However, barring a deterioration of current economic conditions and the anticipated political risk in South Africa in 2024 which is relevant to all sectors, we are expecting a modest uptick in the listed property sector domestic earnings, which will reflect in published earnings with a lag. We are not talking about a boom story here, but the fading of a bad cycle – with pricing reflecting this negativity.
While the risk has moved to the offshore portfolio, negativity around the domestic property market compared to other equity sectors has become stale. Property is a long-term investment and investors need to be forward looking. We are not expecting a return to levels remotely close to pre-Covid performance, but it is time for investors to start realising that forward domestic property fundamentals (relative to other domestic asset classes) are not as dire as they previously believed. DM/BM
Author: Evan Robin, Listed Property Portfolio Manager, Old Mutual Investment Group