The South African property market was particularly tough for investors during the last 18 months. The best performing SA asset class over the last decade perhaps lulled investors into a false sense of security. Higher returns come with higher risk, a truism often forgotten in good times but a financial reality that nonetheless proved true in 2018. Price corrections of some overvalued stocks, corporate governance concerns and concurrent deterioration in property fundamentals led the sector to a 25% decline.
Current valuation levels for the sector show investors are extremely bearish on the growth outlook. The SA property sector dividend yield is higher than the SA government bond yield for the first time since the financial crisis, where on average over time it traded at a slight discount because of implicit dividend growth. The income component of property investment is largely still intact; however, investors are questioning the growth in dividends and the valuations of physical property assets. Factors that impact negatively on the growth and valuation outlook are: low GDP growth; above inflation increases in electricity, rates and taxes; Eskom load-shedding woes; the Edcon issues and subsequent recapitalisation; land expropriation policy talks; and lower business and consumer confidence levels.
In such a weak environment, property supply outstrips demands and vacancies inevitably creep up. Low job creation and retail sales growth eventually also lead to existing rental contracts escalating to above market rental rates. In current leasing negotiations, tenants end up having more bargaining power than their landlords, as landlords want to retain tenants at almost any cost. The net effect is that new rental agreements are now often being struck at lower than previous rental rates and with lower future contractual escalations, placing further pressure on property income growth, and hence dividend growth.
We expect this situation to continue in the foreseeable future as demand growth for property space tends to lag economic growth. The South African economy will need to see growth return before we turn bullish on SA property in general.
That said, Laurium Capital still believes property makes sense as part of a prudent asset allocation process. The five-year correlation of SA REITs to the JSE All Share is only 0.28, even lower against the Top 40 at 0.19. For superior results, however, investors need to filter through the noise to find the property companies that will continue to deliver in a tough environment. Certain property sub-sectors, like high-end logistics and self-storage, offer some respite from the weakening office and retail property fundamentals.
There are also some attractive opportunities in offshore property for those with longer time horizons. Laurium Capital prefers to get most of its exposure from companies in these sub-sectors.
We advise investors to practice patient opportunism. Investors can still find good opportunities within the property sector, but they must remain cognisant of where we are in the cycle.