Property has always been viewed as a defensive asset class, a hybrid between bonds and equities, however the pandemic known as COVID-19, has dispelled this theory – or is the market mispricing this asset?
COVID-19 sent shock waves through the global financial system as the world was essentially forced to shut down. Global equities, listed property and bonds all reacted in the same way – falling sharply.
While the world is beginning to adapt to social distancing and national lock downs, the overwhelming impact it is having on our lives, health and business, is being felt profoundly. Businesses are scrambling to respond to the disruption and seeking ways to adapt to the new normal.
Very few industries are being left unscathed by the COVID-19 pandemic, and the property sector is certainly no exception. The economic ramifications will affect all stakeholders, having long term consequences. Certain property sectors, such as retail and hospitality, felt the impact immediately and are likely to be affected more severely than other sectors. However, over time, the contagion will no doubt bleed into most sectors in one way or another.
Real Estate Investment Trust’s (REIT’s)
Financial markets are influenced by consumer confidence and sentiment. REIT’s generate returns for shareholders in two different ways, namely; through income distributions (yield) and capital gains (value). Prior to the outbreak of COVID-19, the South African REIT sector had been under pressure for some years. Many South African REIT’s struggled to grow distributions due to poor economic fundamentals, coupled with persistent challenging trading conditions in South Africa. The latter lead to many South African REIT’s looking offshore for improved returns predominately in retail real estate investments. The COVID-19 impact has had a double negative effect on those REIT’s, as malls and the global economy shut down.
According to Gita Gopinah of the International Monetary Fund (IMF) it is anticipated that for the first time since the great depression “both advanced economies and emerging markets will be in recession”. The COVID-19 impact has been seen by many as the great reset of the global economic system.
REIT’s share prices plummeted as the rapid spread and severity of the COVID-19 pandemic caused worldwide panic. Investors reacted quickly, indicating their concern around the impact that the virus would have on the property sector. Specifically, the uncertainty of tenants’ ability (and in some cases unwillingness) to service their rental obligations during the national lock down period, and the potential consequences of business failure in the aftermath. SA REIT’s were particularly hard-hit due to their heavy exposure to the retail sector, with a weighting of around 55%, which has subsequently fallen to 50%, due to this sector being most affected.
The sector was further strained by the dramatic sell off of government bonds on the back of the Moody’s downgrade to South Africa’s international long-term credit rating. This downward spiral was muted, to some degree, with the South African Reserve Bank intervening in the bond market, followed by a surprise meeting on the 14th of April to cut rates once again. Listed property rallied off its low, but it is unlikely the volatility is over. Retail centric Landlords will be in for a roller coaster year as footfall and rental revenue looks to decline.
There is little doubt that capital values have been affected. The value of a portfolio is ultimately determined by the level of sustainable income it can produce and its ability to grow that income stream – both of which will be impacted as a result of COVID-19, placing pressure on the property sector as a whole.
Despite these immediate valid concerns, property remains an investment backed by ‘bricks and mortar’. Property forms part of a network of basic societal needs. It provides society with a place to reside, a place of work, a place of industry and production, a place for consumer spending and social recreation, amongst others. As an investment, property has proven to be resilient.
Once the air clears, proverbially speaking, it is likely that share prices will recover accordingly.
Investment Strategies for REIT’s post COVID-19
COVID-19 has changed the world forever. A crisis not only magnifies weaknesses but accelerates change. We believe going forward REIT’s investment strategies will include a closer look at the following areas:
Protecting bank covenants at all costs. Balance sheet strength has and always will remain paramount. A strong balance sheet allows businesses to maintain dividend payments, operate at full capacity and take advantage of opportunities. Going forward there will be further emphasis on Interest Cover Ratio (ICR) and Loan to Value (LTV), which will continually be stress-tested for the next black swan event.
B) Property Portfolio
- Stricter investment criteria, deeper and more thorough analysis in procurement of properties;
- Diversification of properties within portfolios will be key. This mitigates the risk of a particular sector being affected by a crisis or cyclical sector challenges; For example: SA REIT’s large exposure to the retail sector must be reconsidered in the wake of COVID-19, to create a more defensive sector;
- Continual organic improvement in the quality of assets by reinvesting surplus capital into the upkeep and enhancement of buildings and continual focus on premium locations. Both quality of assets and location are key factors in the defence against elastic demand and downward pressure on rentals;
- Procurement of assets, which are adaptable in nature to changing tenant profiles and user needs will attract more attention. Assessing alternative uses of properties, to adapt to changing circumstances and trends will need to come in focus. For example: COVID-19 will accelerate consumers tendency to buy on-line and office users to provide flexibility for their staff in terms of working from home, both of which will impact on users space requirements;
- Attention to ensuring all properties provide safe and secure environments, with increased levels of hygiene and sanitation, now in addition to water saving and electrical back-up initiatives!
Attract and retain good tenants by building and maintaining relationships. Focusing on the strength of covenants to ensure a resilient and sustainable cash flow.
There will be a balancing act between income distribution and net asset value growth. We are likely to see REIT’s hold back on distributable earnings. Firstly, and most importantly to ensure all working capital requirements are met. Secondly, to reinvest funds into existing properties to protect their defensiveness against market conditions and thirdly to take advantage of investment opportunities that typically present themselves in challenging times like these. The fact that full dividends may not be distributed should not make the investment case less attractive but in fact the opposite.
One measure that the SA REIT Association has petitioned for, is a 24-month dispensation to relax the REIT legislation whereby REIT’s must distribute a minimum of 75% of rental income received, LTV’s must be maintained below 60% and 75% of income must be rental income. If this is approved by SARS and the National Treasury, REIT’s will have the opportunity to strengthen their balance sheets and navigate through this crisis ensuring their immediate survival and their long-term sustainability after the COVID-19 pandemic.
There is a saying in investment markets, don’t waste a good crisis. COVID-19 has thrown us all out of our comfort zone providing us with the opportunity to learn and grow. As Gary Player says: “Change is the price of survival”.
About the author:
Kim Pfaff-Karg, (BSc Property Studies (Honours) is the Chief Investment Officer at Spear REIT Limited, a Real Estate Investment Trust (REIT) listed on the Johannesburg Stock Exchange (JSE). The company is the only regionally focused REIT listed on the JSE. Spear is a diversified property investment company investing in high-quality income-generating real estate across all sectors within the Western Cape, predominantly in the Cape Town region, with assets under ownership of R4.3 billion.