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Book your seat at the Allan Gray Investment Summit taking place on 22 July at the Cape Town International Convention Centre and 23 July at the Sandton Convention Centre.

Investing in property? Tread carefully, warn experts
by Kundayi Munzara, Director & Portfolio Manager at Sesfikile

An active investing strategy can help determine long-term investment opportunities in property.

The performance of the property sector in the previous 18 months has been less than desirable. The FTSE/JSE SA listed property index fell by a whopping 28% late last year since peaking in April 2016. According to experts, while there are pockets of opportunity currently, investors should proceed with caution.

Kundayi Munzara, director and portfolio manager at Sesfikile Capital - who will be presenting on opportunities in the listed property sector at the upcoming Allan Gray Investment Summit - says that listed property is likely to deliver a total return of between 11 and 13% in the medium term.

"The sector's outlook is currently being impaired by weakening growth prospects coupled with a lack of confidence in corporate governance. Considering the earnings downgrades, some of the recent fallout may be justified especially considering the headwinds the sector still faces in the year ahead," he says. "However, given our expected return for the sector, together with the correlation to equities and bonds, listed property should form part of a balanced portfolio."

He explains that the domestic and retail sectors are struggling due to a state of oversupply of property and anaemic demand from tenants.

"While companies are recording trading density growth in the low single digits, most retailers have reduced expansion plans and negotiated lower rentals and escalation rates to combat lower growth in sales. The impact of Edcon reducing its footprint has also been felt on the market, with the brand returning between 20% and 40% of its space. This will come at a cost as landlords must reconfigure and re-let the space in a weak-demand environment."

Mark Dunley-Owen, portfolio manager at Allan Gray, says that the current state of listed property is not surprising when looking at how the country's economic growth has declined due to structural deficiencies.

"South Africa has experienced a property construction boom for much of the last two decades, most notably in retail shopping centres and office nodes such as Sandton. But the weakened economic climate has impacted the demand for space. We expect this combination of rising supply and weak demand to result in lower rentals to keep space occupied."

Despite the weakened environment, Munzara is seeing value in companies in the listed property sector that have focused specialist strategies, defensive portfolios, high-quality earnings and strong balance sheets.

"The preference for defensive portfolios and strong balance sheets emanates from the weak state of the economic environment, where rental growth and asset valuations are under pressure."

Dunley-Owen says that Allan Gray is now seeing value in property companies that are priced below the company's assessment of intrinsic value, especially after last year's correction in share prices.

"We are seeing opportunity particularly in companies that are run by management teams that are aligned with shareholders, use appropriate financial gearing, focus on cash flow rather than accounting earnings, and prioritise long-term value over short-term metrics," says Dunley-Owen.

For investors who are contemplating investing in listed property amidst this background, Munzara and Dunley-Owen say that there are few things to know about getting it right.

"A high initial yield may seem attractive at face value, but inherent tenant risk and financial risks in the companies may be masked by this," says Munzara. "Back strong management teams that have a track record and experience to deal with the constantly changing dynamics of the property industry, as well as those that don't underplay corporate governance."

Dunley-Owen, however, says that investors should look out for cases where management teams are misaligned with long-term shareholders.

"Investing in listed property to earn an income encourages management to make decisions that target short-term distribution expectations at the expense of long-term value, for example, refusing to sell low-quality assets because they are high-yielding.

"Also, watch for cases where management pays out more than business generates. In the quest to grow distributions, some listed property companies pay out more in dividends than their free cash flow, funding the deficit by issuing shares, taking on more debt or underinvesting in their assets. This strategy works when share prices are high and debt is readily available, but is unlikely to generate value through the cycle."

Munzara echoes this, saying that leverage can lead to strong distribution growth but can place a business under strain as asset valuations come under pressure. Importantly, he adds, stock picking is crucial to get the mix of companies right. "While the sector valuation seems cheap, be very weary of index tracking strategies as stock picking is very important at this part of the cycle."

Dunley-Owen says that one mistake investors make is to assume that any equity investment, including listed property, has a low risk of capital loss. "In an environment of rising property prices and acquisitive growth, listed property is essentially a subordinated claim on highly priced assets funded by a lot of debt; capital loss is probable for such investments."

Munzara suggests that the best strategy for investors who are looking at listed property, is to take a slow and steady approach that includes active invest management.

"It is prudent to have a cautious approach and invest gradually as fundamentals improve. For this, an active investment strategy is best suited to determine the right long-term opportunities," he concludes.

Kundayi Munzara will be presenting at the Allan Gray Investment Summit in Johannesburg and Cape Town in July 2019. www.investmentsummit.co.za

Book your seat at the Allan Gray Investment Summit taking place on 22 July at the Cape Town International Convention Centre and 23 July at the Sandton Convention Centre.

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