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The scale of monetary policy tightening since early 2022 has brought the cost of money across many advanced economies to levels not seen before the global financial crisis. As inflation has remained stubborn above central banks targets, monetary policy has responded by being restrictive and looks to remain so for an extended period. On the back of this, the tailwinds from low-interest rates for the better part of the 2010’s enjoyed by real estate owners across the globe via low finance costs turned into headwinds in this new higher-for-longer regime. Not only has this normalisation in interest rates directly affected company earnings due to a higher interest rate bill, but valuations have come under pressure as capitalisation rates have also increased. In response, the share prices of listed real estate companies globally and in South Africa have undergone strain, with returns from real estate as an asset class firmly lagging those of other classes over the past 18-24 months. But with the bad news now in the price, how should investors think about the return prospects offered by the asset class over the coming phase of the cycle, considering where current valuations sit?
The inherent appeal of property as an asset class is two-fold. Firstly, it produces a steady stream of income from rental collections, with this stream contractually growing broadly in line with inflation annually (save for a few markets with their own rental adjustment idiosyncrasies). In addition to this, real estate also offers investors an opportunity for capital growth. This hybrid nature of the asset class makes it an appealing investment for both income-focused investors as well as those looking for long-term capital appreciation. Current yields on offer across the SA listed property counters (in the double digits) makes this income element appealing, while the potential narrowing of the deep discounts to Net Asset Values (NAV) offer capital growth upside.
Looking at the SA real estate sector, fundamentals have been improving steadily since the gradual emergence from the tough Covid-induced lockdown years. Vacancy rates in the retail and industrial sectors have stabilised at low levels, reversions are incrementally on the mend, and normalised net property income growth is showing encouraging trends in the mid-single digit range, even after factoring in the cost impact from diesel spend as a result of heightened levels of power outages. And while the SA sector has taken a prudent stance via hedging 75%-80% of interest rate exposure, the extent and duration of monetary policy at these levels has meant that the small variable portion of interest exposure, as well as higher rates on refinancing, have come to hurt companies’ bottom lines. As a result, the outlook over the coming year to eighteen months is for earnings to be weighed down by this once-in-a-generation stance of global monetary policy, despite a reasonably healthy set of operating conditions on the ground.
Coming as it did on the heels of Covid, company earnings which were already low have seen even more pressure from these interest rates. For select counters, their earnings base has returned to multi-year lows, implying limited further downside potential from this point onwards. As investors, we need to take cognisance of this and take a view going forward of where the skew is from a risk-reward perspective. Our assessment is that over the medium term, we are likely to see a recovery in underlying earnings as the monetary policy cycle eventually turns and the prolonged tightness gives way to policy easing. While earnings won’t necessarily respond immediately, we anticipate that the forward-looking nature of the stock market will start pricing in this normalisation, at which point the sector’s rating will show meaningful improvement from current levels.
Offshore diversification is a key feature of the SA-listed property landscape, with around half of the asset value exposure of the All Property Index (ALPI) sitting offshore either directly through inward-listed counters or indirectly through foreign exposure in South African property companies. In the current phase of the cycle, we have seen limited diversification benefits as synchronised policy tightening has weighed on sentiment towards listed real estate globally. A weaker Rand exchange rate against the major developed market (DM) currencies has not seen much mitigation against the sector’s lagging return performance; however, as we look forward to the next phase of the cycle, the same overarching macro drivers which hurt the sector over the past year and a half stand to work in the opposite direction.
Through the cycle, fundamentals at the individual company level are vital in determining each company’s fortunes in delivering shareholder returns. But there are crucial points in the macro cycle that can override most company-level differences and have an outsized impact on sentiment and company earnings across the board. Stock picking remains paramount; however, the macro cannot be ignored in periods where it influences sentiment towards a sector almost indiscriminately across geographies. At Terebinth Capital, our top-down approach and detailed bottom-up analysis place us in a favourable position to take cognisance of key opportunities presented by moments such as the one we find ourselves in today. We believe that exposure to listed property will be a key differentiator in underlying return drivers within multi-asset funds over the coming phase of the cycle.