Top property firms offer good value, but delayed dividends pose a risk
SA banks, which are well-placed to tackle the crisis, will play a role in determining the fate of these companies
Many conservative SA and global investors squirrelled away their savings in property shares in recent years to earn an attractive, growing income. This bubble has burst over the past few months and the value of even the highest-quality property companies has plunged. The steep share price drops of counters such as Growthpoint, Redefine, Resilient, Nepi Rockcastle, Vukile, Attacq and Hyprop follow the already steep falls across the board in 2019. These shares are now trading at 40%-80% discounts to their respective book net asset values.
So what happened and is the loss in value permanent? We have concluded that in a basecase scenario, these values are well below current book values, but higher than the share prices. In the quality counters, the companies are fundamentally worth 50%-100% more than their share prices (unless Armageddon prevails!). But there is a high risk of shareholders not getting dividends for one, or even two, years.
The dire local economic outlook had already hit share prices hard when the novel coronavirus hit, and the sector is now in crisis. These are unprecedented times and the world has changed in the last few weeks. Some tenants, especially in the retail sector, will soon earn little or no turnover for some time, and we have no doubt they will want to renegotiate rentals with landlords. Some smaller tenants will go bankrupt.
A typical current scenario, even for a highquality property company, is as follows: Panic in the boardroom.
Gearing of 30%-45% with a realisable property value of 20%-40% below book values. In many cases, debt covenants are certain to be broken.
No chance of material short-term property sales to tackle loan-to-value equations.
Future rentals are uncertain (despite rental contracts) and sustainable rentals are, in many cases, 10%-30% below current levels. Apart from essential-services providers (pharmacies, food retailers and so on) malls are closed during lockdown.
Property company management teams are doing scenario planning to assess the worst case and sustainability.
The property sector will be reset after panic about the virus has subsided. These big property companies generally have excellent management teams to navigate this change.
The fate of the companies largely depends on SA banks, which have very strong balance sheets and we believe will be co-operative to navigate the way through the crisis. Focus will turn from loan-to-value ratios to interest cover, cash flow and sustainability. It is not in the interest of the banks to “pull the plug” on some of their biggest clients, and if they did, the income statement impact for banks would be damaging. They have a vested interest.
Property management companies have no idea where rentals will settle, and they will largely depend on the health of the economy and their tenants.
About 30% of retail turnover is from “safe” companies such as food retailers, cellphone companies and banks. Many office tenants will remain robust, and industrial and logistics rentals will depend on tenant quality. It is thus not a disaster across the board, but months of hard negotiations will follow. Property management teams have expressed a realistic approach to rental negotiations and we are comfortable that a reasonable middle ground between landlords, tenants and banks will be found.
Loan-to-value is nevertheless a big issue. Picture a typical property company with R100 of book value and R40 of debt — that 40% loan-tovalue ratio is usually comfortable. If the book value is written down by 25%, the ratio goes up to a delicate 53%. Ironically, interest cover is probably still palatable in this scenario, but the equation needs to be addressed.
ASSET SALES
We do not expect banks to become obsessed with loan-to-value ratios in the current setting, but they will want property companies to have a plan to reduce this. Asset sales are usually a partial solution, but this looks increasingly unachievable. Withholding dividends payments becomes the next, and most likely, scenario. If a company can generate an 8% yield on book value, ploughing this back into debt repayments (as opposed to dividends), with a two-year dividend holiday, this can reduce the loan-to-value ratio from 53% to 37% — back into the comfort zone.
Not all listed property companies will be forced into this situation. Redefine and Hyprop have already delayed their interim dividend payments.
On its March 25 conference call, Vukile made no commitment concerning the payment of the next dividend. A big issue with withholding dividends is taxation. Real estate investment trust (Reit) legislation allows companies designated as such to not pay taxation and distribute income to shareholders who receive the distribution as taxable income.
If Reits do not distribute 75% of their income, the rules say they must pay tax on their income. We believe the property sector is in the process of negotiating with the Treasury to waive this rule, even if a one-off.
So where does that leave valuations and prospects for share price recovery?
We are in the eye of the storm and much uncertainty is ahead. But ultimately these big property companies have quality assets and as a default we expect them to work with banks and landlords to get through the crisis.
As a generalisation, fair gross property values are probably 20%-25% below book values. After taking debt into account, net fair share values are probably 30%-40% below published book values, but share prices reflect far worse scenarios than this. Growthpoint was trading at a 51% discount to book value on March 25 and Vukile at a 64% discount. Unless the lockdown prevails for an extended period, we believe share prices are generally offering good value.
We acknowledge the risk of being overly negative in our assessment, which is no doubt influenced by us being in a 21-day lockdown. Many companies will argue that they are in better shape than we have sketched, and those with low loan-to-value ratios have a bigger ability to see through the current scenario without equity value being damaged as much.
Interest rates have also declined, and could decline further, which is usually a big positive driver for property company fundamentals and share prices.
Share prices are factoring in a far worse scenario than our base case. However, we believe investors should stick with quality firms with a focus on the balance sheet and factor in a full or partial decrease in distributions for some time.
We sense a positive attitude from all the roleplayers in working through the crisis. But a long road is ahead. For shareholders who have taken pain already, we would recommend seeing it through.