The immediate focus for many REITs is now survival and attention has squarely shifted to shoring up balance sheets and maintaining adequate liquidity. To this end, many property companies have either cancelled, postponed or withdrawn guidance on dividend payments given the uncertainty of what lies ahead – removing one of the primary motivations behind investing in property shares. The industry has been quick to respond to jointly confront the issues it faces for the foreseeable future by forming the Property Industry Group (PI Group), a coalition including the SA REIT Association, the SA Property Owners Association (SAPOA) and the SA Council of Shopping Centres. On the issue of distributions, REITs are required by regulation to pay out 75% of distributable income as dividends to maintain their tax-free status. Given the fall in earnings that is expected in the months to come and the associated cut in dividends, the PI Group has engaged with the JSE and National Treasury for a special dispensation that would allow REITs to withhold dividends for up to two years without losing their tax status. Early indications from the JSE are that they are supportive of the property sector due to the extra-ordinary circumstances we find ourselves in and will work with the sector to find solutions to possible breaches of JSE listing requirements which may be unavoidable going forward.

The other big role players who are intertwined with the fate of the property sector are the banks and the financial sector. To minimise the risk of financial contagion, the banking sector would rather support property companies through this time, and active discussions are ongoing between the two sectors to provide additional liquidity or refinancing facilities for near-term debt expiration. Loan-to value (LTV) ratios have increased in recent years to elevated levels, and asset values, which some investors have argued were overvalued given the pre-crisis weakness in the sector, could finally catch up with the economic reality we currently face. This would effectively raise LTVs to a level that could be in breach of bank covenants for certain counters. However, indications are that banks would prefer that property companies continue to service their interest payments rather than focus on LTVs in the short term. The more important metric then is the interest coverage ratio (ICR) of the sector, which is on average above covenant levels. Despite the higher levels of leverage in the sector, the good news is that there is headroom for most companies to absorb a drop in their earnings, up to c.50% in some cases, and asset values and remain above covenant levels. Sector covenant levels for LTVs range between 45-70% and around 2x for ICRs. In the medium to longer term, it will be expected that property companies will deleverage to more comfortable levels.

Source: Sesfikile Capital

Given the sharp fall in value we have seen, many investors will have questions about the merits of including listed property investments in their portfolios. Traditionally, listed property has usually been regarded as more defensive in weaker market environments, however the nature of the current crisis has turned that notion on its head. Against the weak economic backdrop that is expected to persist for some time, landlords are likely to absorb the pain going forward as negative rental reversions continue and bad debt and arrears tick up. In the short term with the prospect of reduced or no distributions from REITs, investors focused on income could do well to look at alternatives, such as government bonds which are trading at attractive yields given the risks. As we emerge from the crisis, and certainly not letting a crisis go to waste, the sector should find itself in a better position over the long term by clearing out some of the excesses and unsustainable practices of the past. The introduction of the Best Practices Framework by the SA REIT Association supporting more transparent and robust reporting, and the introduction of pay-out ratios and the move to the Adjusted Funds From Operations (AFFO) model, should see a more sustainable earnings profile emerge. In the scenario where growth returns to meaningful levels, investors taking a long-term view could do well to benefit from capital appreciation from such depressed levels as the environment normalises further, although a high-risk appetite would be necessary to stomach the volatility expected to persist in markets.

In summary, the listed property sector will see itself through this period, and while it is too soon to fully quantify the damage, most property counters are expected to come through the crisis. Markets remain volatile and to the extent that property shares have sold off, they are now trading around an unprecedented c.50% discount to NAV. At current levels, many fund managers are seeing value in selective counters, given more conservative earnings and return expectations going forward. The current focus on balance sheet strength, rather than dividends, and the eventual deleveraging across the sector should eventually see property companies emerging stronger in a post-crisis world. Of course, a broader recovery hinges on the government’s ability to enact meaningful economic reforms and spark growth. Investors, however, will need to remain patient as the situation unfolds as the road ahead remains long.

References:

Anchor Capital, Catalyst Fund Managers, Coronation Fund Managers, Ninety One, SA REIT Association, SAPOA, Sesfikile Capital, Stanlib