Most of the property funds listed on the JSE are diversified across office, industrial, retail, residential and offshore property investments.
The Futuregrowth Community Property Fund, on the other hand, offers a rare opportunity to invest in a specialist property fund that focuses predominantly on investments in unlisted shopping centres in townships and rural areas in South Africa.
Is the South African listed property sector entering a new era?
The South African (SA) listed property sector has produced phenomenal returns to investors over the past 10 years, delivering a return of 15.8% per annum and outperforming equities, bonds and cash. Many investors, however, have questioned the sustainability of these returns and whether we can expect the same kind of performance in the future.
J253 vs Equities vs ALBI vs STEFI over 10 years annualised up to Dec 2014 and Dec 2016
If we look at the 10 year annualised returns up to the end of 2014, returns were at 21.5% p.a. The sector cooled off over the past two years, which resulted in a more normalised return.
To understand one of the greatest bull runs in the history of South African financial markets and the likelihood of a repetition we have to turn back the clock and unpack the distinct contributing factors.
1) In 1998, prime interest rates reached an all-time high of 25.5%, while long bond yields reached an all-time high of 19.7%. These high interest rates effectively killed the direct property market and the lack of liquidity made it more difficult for investors to exit. The SA listed property sector weakened in line with the direct property market and as a result property yields pushed as high as 22.9% in 1998. From 1998 to 2014, the prime interest rate fell from 25.5% to 9.25% and long bond yields fell from 20% to 7.9%.
10 year bond yields and Prime lending rate chart between 1998 and 2014
The decline in interest rates and falling long bond yields were the primary drivers for the bull market returns and we believe that this phenomenon will not be repeated for a very long time.
2) While interest rates were on a downward trend, property companies were able to borrow at rates that were well below the acquisition yields of properties. This resulted in phenomenal income growth for many years, but this has slowed down as the gap between borrowing rates and acquisition yields has narrowed.
During this period, we believe that even the weakest property companies would have performed well as it was these market factors, rather than good management, that pushed up property valuations. The opportunity to refinance at cheaper interest rates has, however, disappeared in the current market environment.
3) In 2010 there was a boom of new property companies listing on the JSE, which resulted in many mergers and acquisitions. This, in turn, resulted in the creation of yield enhancements as property companies with lower yields bought out property companies with higher yields.
These opportunities have now declined, with some mergers and acquisitions done purely for the sake of growing the size of the company and not for the purpose of adding any long-term value to investors. JSE listing is also seen by some property owners as a way of creating liquidity and an exit for themselves.
4) During the boom, the SA listed property market provided investors with income certainty and a growing income stream. Demand from investors for this type of asset in a low growth environment was another key factor in driving the returns. Some of the SA listed property companies were added to the TOP 40 Index and also entered global property indices due to their size. This drove up prices further as passive tracker funds as well as traditional equity funds, which are benchmark cognizant, were required to buy these stocks. Prices became inflated and the SA listed property companies traded at a 30-40% premium to their NAV at the height in 2014.
In 2015 and 2016, annual returns came in at around 8% and 10% respectively. We believe that the idiosyncratic factors that produced the astounding returns between 2000 and 2014 have dissipated and that the weaker returns over the past two years have helped normalise the long term returns.
Why are SA listed property companies heading offshore? Is the grass greener on the other side?
Most property companies that have invested in offshore property have cited that there are few opportunities in South Africa and that they see better value offshore. In 2008, only about 5% to 6% of the earnings of SA listed property companies were derived from offshore assets. Today, this portion sits at approximately 40%. This situation introduces a range of new risks and increased volatility for investors, which we feel has not been adequately priced into the value of the shares.
It appears that many investors in the market are placing a high rating on property companies that can deliver double digit income growth and not placing much emphasis on the sustainability of the income growth or the effective management of their current properties. This results in some property companies taking on additional risk through financial engineering and buying offshore properties in order to sustain their ratings.
We believe that investors would be wise to ask their fund managers how much exposure they have to offshore property via SA listed property companies, as a percentage of their total portfolio value, and to assess whether they are comfortable with the amount of risk being taken. They should also bear in mind that there are additional country specific risks and currency risks for investors, many of which did not exist in 2008.
Why is SA property uniquely suited to investment by South African pension funds?
The South African property industry has a unique advantage in its leasing conventions. Here, leases tend to have an annual rental income escalation rate of between 7% and 10%, which is above the South African inflation rate. This enables local pension funds to match their investment to their liabilities. On the other hand, properties in the United Kingdom (UK) and Europe have leases that are linked to their respective inflation rates, which are considerably lower than the SA inflation rate. This means that if one invests in properties in these regions, the income growth is mismatched for a pensioner living in South Africa. Currency fluctuations add an additional layer of risk and can wipe out the prospect of positive returns for a South African pension fund. Brexit was a prime example of how political risk caused the British Pound to weaken considerably against the South African Rand. SA listed property companies exposed to the UK faced very weak returns as a result.
What does the Futuregrowth Community Property Fund offer investors?
The Futuregrowth Community Property Fund is focused on providing retail facilities to previously disadvantaged communities, especially in areas characterised by a lack of infrastructure and services, throughout South Africa. It targets a niche market of low to middle income groups and forms part of Futuregrowth’s suite of developmental investments.
The objectives of the Fund are both commercial and social. Properties are selected for their potential for strong income growth. A key strength of the Fund is that 87% of the tenants are large and listed national tenants, which enhances income certainty. The Fund has also proven to be relatively defensive through economic cycles, as the tenants that occupy space in the retail centres provide the community with essential goods and services that one cannot live without. The convenient location of the shopping centres results in significant savings in transport costs for the consumers, which increases their buying power.
The success of the Fund stems from the fact that it values the communities in which it operates and delivers the following benefits:
- Job creation during the construction phase, employing artisans and labourers from the local community, and, in some cases, providing training in these activities.
- Creating permanent/long-term jobs during the life cycle of the centre. On average, 80% of all employees that work in the shopping centre live in the area.
- Providing a wider range of choices to consumers, of a higher quality and at lower prices than previously available.
- Bringing key services such as social grant payout points and affordable clinic services to the local community.
- Each shopping centre is a catalyst for the development of municipal infrastructure in the area and enhancement of the local transport infrastructure.
Futuregrowth Asset Management (Pty) Ltd is the Fund Manager. The property management component, such as the leasing, marketing, refurbishment and expansion of the properties is managed by Capital Land Property Asset Management, a specialist property manager that has an established track record in delivering value enhancing performance to investors though the direct active management of property portfolios.
We believe that our specialist focus gives us a competitive advantage, as the barriers to entry in the market that we operate in are relatively high due to the intensive nature of managing these types of assets.
Furthermore, having the asset and property manager situated in the country in which the properties are held is pivotal to the long-term success of the model. A manager who knows the market that surrounds its property investment will deliver the best results for its investors.
Click here for more information about the Community Property Fund.