How to make property perform
The first quarter of 2024 has been more of the same in the local property sector, with only dividends for shareholders to enjoy and no share price upside. The two major exchange traded funds (Satrix Property ETF and 1nvest SA Property ETF) are both flat for the year excluding dividends. They are trading at similar levels to three years ago, so the post-pandemic period for the sector has been one of treading water. Though dividends certainly help, yield alone isn’t enough to justify the equity risk for investors.
At a time when inflation has been running rampant, these property funds haven’t given investors sufficient protection. The silver lining is that dividends from real estate investment trusts (Reits) at least offer positive real returns (the yields exceed inflation), but real returns are also available at your friendly local bank on a reasonable notice account (and with zero equity risk).
It seems as though the right strategy with these funds has been to hold the ETFs in a tax-free savings account. Reit dividends are usually fully taxable as income, but using a tax-free savings account basically turns those dividends into a miniature pension fund, with rentals flowing through the Reit without much tax leakage in that structure, before landing in your tax-free savings account without any leakage either. This is the way I hold my property exposure. I would just love it if there was some capital growth as well.
If property is supposed to be a great inflation hedge, then what’s going wrong? There are a few factors to understand that really get to the heart of what drives returns in property.
First, a property can only earn revenue by having tenants. It can’t magically pivot into something else. To make things worse, each property type can only have specific tenants. Shoprite isn’t about to open a distribution centre in a shopping mall and TFG isn’t going to open a range of shops in a warehouse somewhere. As for offices, the drop in demand for space as a result of Covid has turned out to be a structural problem. Hybrid working arrangements work better for everyone and most companies have continued to recognise this to some extent. Some office buildings have been converted into residential properties, but most are still running at subpar occupancy rates.
Still, the post-pandemic winner has been industrial property, thanks to strong demand from tenants. There are a few reasons for this, the most striking being the shift in demand from retailers. In an omnichannel world of online shopping and in-store fulfilment or even deliveries to people’s homes, retail space can be reduced in favour of larger warehouses that hold stock and promise short delivery times. It’s a whole lot cheaper per square metre to have a warehouse in an industrial area than a larger store in a premium mall. When you factor in the supply-demand dynamics of warehouse space and the relatively long build time to react to increased demand, you have a scenario of positive rental reversions in logistics and negative reversions in retail.
Rates and reversions
The reversions tell us just about everything, really. This is a measure of the rate on the renewed lease vs the expired lease. A positive reversion means a higher rental on the new lease. A negative reversion tells us that demand was so poor for the space that the landlord had to accept a lower rental to fill it. When operating costs for properties are climbing with inflation, a negative move on the income line is a tough situation for net operating income.
The biggest problem has been happening below the net operating income line. To make the return on equity appealing, Reits operate at very high levels of debt. A typical loan-to-value ratio for a healthy Reit is 35%-40%. This places a substantial interest burden on the funds, which becomes an even bigger challenge when interest rates shoot up. Combine that with pressure on net operating income and there’s only one outcome: banks have received a relatively larger share of the economic pie of Reits over the past few years than before.
As a property investor, if you’re wondering where your returns went, the answer is the banks.
For this scenario to change, rates need to come down and reversions need to turn positive. There are signs of this happening, but I’m not getting my hopes up for meaningful returns from this sector in 2024.