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Mischievous rumblings or grains of truth? - by M N Ingham

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Reit-Strategy-note-Real-Estate-Investment-Trusts

The now infamous Viceroy have a cloak-and-dagger modus operandi within a guise of anonymity that disregards common professional scruple. It’s enough to turn a Cold War KGB agent squeamish. Institutional analysts wouldn’t get away with a fraction of what Viceroy trumpet, as a strict code of conduct and legal considerations binds them. Viceroy enjoys rather more believability than they perhaps deserve, with investors quaking at the slightest rumour of a Viceroy investigation, seemingly to divulge alleged nefarious or dubious corporate dealings. Even Property stocks, often literally perceived as safe as houses, were not immune from this jittery behaviour as investors at the margin recently stampeded for the exits. Within a kernel of truth may lie the source of exaggeration to flourish for possible profit, via short selling off borrowed stock, or there may be substance but within a proportionate context. Markets are not necessarily rational; the efficient market hypothesis has as many supporters as detractors. Real Estate Investment Trusts have much to recommend them but, as with any sector, some are more equal than others. Be careful about the increasing offshore investment by REITs, particularly in Eastern Europe, which I am on record as calling a crowded property play for South Africans and, arguably, rather too much of a beguiling one for perceived currency hedge reasons. Choose your exposure carefully and have an understanding for what drives prices. Don’t get taken in by higher yield at face value, it may be for a reason that should give you pause for thought, and be aware of where true value lies, such as the price you pay relative to the book value of the assets. Play it cautiously and you’ll be rewarded. This is not the wild west that allows management to get away with insane debt levels or to be cavalier with distributions; REITs exist within strict listing requirements and best practice industry benchmarks.                

“Mischievous rumblings or grains of truth?”

Real Estate Investment Trusts

Strategy Note

What you need to know:   

Real Estate Investment Trusts have become one of the larger asset classes on the JSE and an attractive source of income yield whilst still giving capital growth over time. Listed property has been in existence for almost 50 years but the REIT as we know it today came in to existence in 2013. There is no minimum, you can buy as little as one share. There is a plethora of choice abroad too for those seeking international currency and risk diversification.  

This strategic update on the REIT sector is not meant to be stock specific and avoids mention of any REIT by name; this is deliberate, as there is enough unsubstantiated rumour doing the rounds and the mere mention of a name can get speculation ramped up.

I would observe in passing that a rich rating of a stock may precipitate a derating, as could occur from a Viceroy type insinuation of shady practices, but it is not the same thing.

As an example, a locally listed REIT is around 15% lower following Viceroy speculation but that has been a healthy correction and the stock, arguably, remains overvalued. The price was 60% higher than book value, including investments in listed property locally and abroad. The stock is now 35% above book and remains expensive. If the stock fell another 15% it may start to look nearer to reasonability, but it still wouldn’t be one of my preferred.

My preference would rather be a particularly large cap REIT on a 10% premium to book and offering a 7,6% forward gross yield. 

 

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Several JSE listed REITs I would be cautious of exposure to in any event because of, inter alia, the following reasons:

  • exposure of their portfolio, such as mix of retail or office and tenancies within that;
  • geography external to South Africa;
  • risk of future yield compression as a market or sector matures or saturates;
  • lease expiry profile;
  • lease concessions rather than occupancy in isolation;
  • stock price in relation to book value;
  • sustainability of distribution yield.       

For investors, there are certain tax aspects to be aware of. The transfer of shares in a REIT is exempt from securities transfer tax, distributions don’t have dividend withholding tax levied at 20%, as with a normal share, but you do include it as taxable income. However, dividends received by non-resident shareholder will not be taxable as income and instead will be treated as an ordinary dividend. A capital gain or loss on the disposal is required to be included but if REITs are in a bona fide retirement vehicle there is no tax on capital gains or distributions.

As with other interest rate sensitive stocks, there is a linkage to trends in the long bond yield. There is an inverse relationship between capital values and yield.  Forward yields on a Real Estate Investment Trust would trend in line with the government long bonds. Since 2014, bond yields have trended upward and remain vulnerable to changes in investor sentiment. Of late, yields have eased back.

In this regard, REITs have both an equity and bond aspect. On the income front, you can typically expect 7% or 8% income growth, even if the capital value falls because interest rates have gone up.

 

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REITs tend to be capital intensive, not least because most of the income is distributed to shareholders so growth of the asset base has to be funded from new equity, debt, or sale of assets. REITs have recently tended to favour book builds to raise equity capital, but distribution reinvestment plans also provide additional capital, as much as 20%. However, quite a lot of capital being raised in recent years has been orientated to offshore, particularly Eastern Europe, so be careful as to whose is raising and where it is going.

There are best practice guidelines that REITs adhere to. These are provided in the context of International Financial Reporting Standards, the JSE Listing Requirements, typical financial and operating ratios, and accounting and financial reporting germane to REITs.

The JSE has a separate section of the listing requirements devoted to property. Here are some of the key requirements to be aware of:

  • An issuer must have gross assets of at least R300 million;
  • There must be a committee to monitor risk;
  • At least 75% of revenue as reflected in the statement of comprehensive income must be derived from rental revenue;
  • Importantly, total consolidated liabilities, cannot be more than 60% of the total consolidated assets as reflected in the audited or reviewed consolidated IFRS financial statements;
  • The directors must provide an undertaking to the JSE and ensure that at the time that they authorise any new borrowings that the total consolidated liabilities less any capital repayments made on those liabilities after the statement of financial position date, plus the nominal value of the new debt, divided by gross asset value will not be more than 60%;
  • There are criteria for what constitutes gross asset value as reflected in the issuers published results prepared in terms of IFRS;
  • What the 60% debt threshold means is that a REIT cannot have debt more than 60% of gross asset value and therefore cannot be overgeared – in fact the average loan to value ratio in South Africa is typically 35%;
  • A REIT must distribute at least 75% of its total distributable profits as a distribution to the holders of its listed securities by no later than four months after its financial year end, subject to the relevant solvency and liquidity test, and that interim distributions may occur before the end of a financial year end;
  • The JSE has to be satisfied that the asset manager or management company and/or the executive directors responsible for managing the property portfolio have adequate, appropriate, and satisfactory experience in the management of investments of the type in which the property entity invests;
  • At least 75% of rental revenue must be derived from contracted and near-contracted rental revenue. The term “contracted rental revenue” means rental revenue that is derived from a legally binding agreement for the lease of property for the period specified, including rental derived from lease agreements that are subject to automatic renewal (unless notice of termination was provided) and rental revenue from lease guarantees provided by a vendor; it excludes rental revenue for legally binding agreements that have expired;
  • The term “rental revenue” means revenue that is derived from the owning or leasing of immovable property which is let or sub-let to tenants plus dividends received from another REIT where the investment in that REIT is not consolidated in the group accounts;
  • The term “revenue” is the revenue as determined in accordance with IFRS disclosed in the statement of comprehensive income;
  • The term “property” can only include immovable freehold or leasehold property;
  • The tenant profile, based on existing leases, is graded as “A, for large national tenants, large listed tenants, government and major franchisees, or “B”, for national tenants, listed tenants, franchisees, medium to large professional firms, and “C” for other;
  • The REIT has to provide a vacancy profile, by sector by rentable area, a lease expiry profile, based on existing leases, by revenue and by rentable area per sector, weighted average rental per square metre by rentable area per sector, a weighted average rental escalation profile, based on existing leases, by rentable area and by sector, and an annualised property yield;
  • The JSE wants to know location, rentable area of the property, by sector, the weighted average rental per square metre for the rentable area (in the case of single-tenant buildings, the issuer may present this figure as the weighted average rental per square metre for the total rentable area);
  • Any increase in value of existing properties is to be supported by a valuation report prepared by an independent registered valuer whose independence is to be justified in accordance with disclosure to the JSE;
  • The term “market value” is the amount, as determined by an external valuer, that a property would realise if sold on the date of valuation in the open market by a willing seller to a willing buyer;
  • A definition of “operational net income”, being rental income less any expenses directly attributable to that building (including property management fees) but before interest, head office costs, any general management fees or taxation;
  • The term “property yield” is defined as operational net income divided by the purchase or disposal price of the property, for the twelve months commencing on the acquisition/listing date or prior to the disposal;
  • The term “rentable area” is the rentable area as determined in accordance with the guidelines set out by the South Africa Property Owners Association;
  • There are various continuing obligations, inter alia, even if a REIT has not adopted the fair value model for its property in terms of IFRS, it must obtain a valuation from a registered valuer for its property portfolio.

In conclusion, Real Estate Investment Trusts have much to recommend them but, as with any equity or bond investment, you should do your homework and decide what works best for you and be cognizant of the risks. In addition to the local offerings, there is a wealth of opportunity in overseas property REITs, including exchange traded funds.

Wishing you profitable investing, until next time.

Mark N Ingham     

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