You can also listen to this podcast on iono.fm here.
SIMON BROWN: I’m chatting with Evan Robins, listed property portfolio manager, Old Mutual Investment Group. Evan, appreciate the time today. Probably in the last quarter, properties had a fairly tough time, a bad run. Some people will categorise it as permanent losses, some argue it started pre-Covid. Certainly we saw the indices peaking late 2019, 2018. Have we seen the bottom of the sector, and what kind of rebound could we expect going forward?
EVAN ROBINS: I think in terms of the fundamentals, we are getting to the bottom. Things are stabilising.
Property was a net loser with Covid. So, in the other sectors, where earnings are well above Covid levels, property is not there at all, and rents have reduced materially, which means the rental levels are below pre-Covid levels. Therefore, the share price and everything is below pre-Covid, and so rebased there.
What has happened is things have now stabilised and they’re rebased, which means rental levels are now at sort of the new lower-base level on which things can grow. Up to now, things have been falling, falling, falling. Now we’re getting to the stage where things have equivalised and we can start seeing some growth off the space in the next year or so.
SIMON BROWN: I take your point on that because rent reversions that we’ve been seeing coming through, that number has been getting smaller and smaller and smaller and, at some point, it stops going down – and that’s really, I suppose, going to be that bottom, and then the opportunity for maybe even sub-inflation, but some increases coming through.
EVAN ROBINS: Exactly. Remember, those reversions are leases that were signed some years ago, so as they expire, they reset to the new rental level, which is lower. So there are always going to be some negative reversion leases. The longer back they were signed, the more the reversions. But after a while almost [all] of your leases in the company are leases that were signed at a much lower level, and that’s where the base sets and where you can start seeing growth.
SIMON BROWN: Certainly, a sector that’s had a lot of headwinds, they certainly seem to be reducing. We’ve just mentioned the leases and the rentals there. Are there others that are looking to reduce that could give some tailwinds rather than the headwinds?
EVAN ROBINS: I think another factor which is going to turn into a tailwind is interest rates. That was the reason why we’re actually not seeing some of these improvements already there. To some extent we’re not seeing them in the numbers because the interest rate rise has just totally taken over that and drowned it out.
With rates likely to reduce this year, that’s going to become a bit of a tailwind.
Another one is load shedding. Load shedding also muted numbers, or the extra costs [associated with load shedding]. I would argue those are in the base and companies are probably charging for the debt and recovering more of that. So that’s also something that’s in the base now. It attracted, now it’s there; it has happened, [and] it’s unlikely to track further unless you have far worse load shedding, which isn’t an outlook we expect.
SIMON BROWN: I take your point. It’s not that load shedding is going to disappear, just that the landlords are better positioned for it. They’ve got their generators or their renewable [energry] on the roof, whatever the case may be, some reason for investors to continue to stick out with the asset class. What makes it an attractive asset class? One, of course, is distributions which, if you look at them as a percentage, are very attractive.
EVAN ROBINS: Distributions are attractive. Not as attractive as it appears because bond yields are so high. The government’s sort of crowding out property, but still it’s not expensive. You’re talking about a sector that investors shied away from; it’s been, like, unloved because fundamentals were deteriorating and deteriorating.
Now you’ve got a sector from which we hopefully can start seeing some growth. It comes to a stable sector with stable performance, giving a dividend.
Earnings quotas are much higher – not talking about any fantastic form or shooting the lights out. You need economic growth for that. You need interest rates coming down a lot. Doing what property is supposed to do – be a sort of boring yield, providing a diversifier in a portfolio which should be a bit more defensive – which hasn’t been more defensive. As I mentioned, it did worse in Covid than other sectors, which you wouldn’t have thought – it probably should be more defensive. But the nature of what happened during Covid didn’t play out in that way.
SIMON BROWN: We’ve also seen, for one thing, again looking at the results that have been coming through over the years, listed companies [have] been getting rid of some of their non-core assets and loan-to-values certainly improving markedly over the last couple of years.
EVAN ROBINS: Yes. During Covid companies went into emergency mode to try and get their balance sheets in shape. They did what they could do. Selling was difficult. So those values are not very extreme levels. Personally, the valuation yields in the market where things trade just seem quite expensive to me compared to where bond yields are and what you can find listed property for.
So those assets on those property balance sheets I would think are worth less just if you look at the whole market. In the property market, they’re worth what they’re worth. But that’s in the share price. The property shares are trading well below the NAV [net asset value], so they’re not valued at what those valuations are. They are valued at deep discounts to those, and that’s been the case for some time even though, as you mentioned, values have stabilised, the actual physical values that the companies are producing – the valuations – have stopped falling.
SIMON BROWN: I get you. And it’s a case that the market is perhaps taking a better view on those valuations, but it’s been reflected in the price, which removes any risk there.
If you could wave a magic wand, what would be those ideal economic conditions for this sector to really, really shine again?
EVAN ROBINS: We need economic growth. Property at the end of the day is demand and supply. So you need more demand, which is in the shopping centres, which is jobs for offices and the offices are a small part of the sector. You need that. We still have certainly got offices [with] high vacancies.
In retail we don’t have such high vacancies, we still have a bit of vacancy factor. The moment there’s enough demand and vacancies start going to a certain level, there is now price pressure because the landlord is now [the] price setter because there’s someone else who wants the space, and that sets a pricing friction and that’s when rents grow. So we need a pricing friction. We are far from there.
But eventually, if we have some growth, we get that because not much is being built. And not only that, but it’s also very expensive to build.
So, if you look at the implied valuation of properties in listed property companies and what it costs to be building, it’s a fraction of that; they can’t build something and rent it and get a return because building costs are so high versus what they [are] valued [at] within listed property companies.
So again, to reduce those vacancies, to increase supply, if we ever get enough demand it’s going to be very expensive. So rents are going to have to go up, but for that you need the demand and you need economic growth.
And the second factor is interest rates. If the government gets its act together, interest rates go [up], bond yields come down, then investors will pay more for property because [what] the government bonds are providing is so much less. So there’s less competition for yields, you can say.
SIMON BROWN: Gotcha. And interest rates coming down – that is everyone’s expectation for this year. The debate is when do they start and [what] cuts will we get from the MPC [Monetary Policy Committee]. Let’s park that aside.
The economic growth is not coming through. When could we hope/expect a sort of recovery to those pre-Covid levels? Is this going to take some time, notwithstanding we could get an uplift in the sector without necessarily getting back to those pre-pandemic levels?
EVAN ROBINS: Those pre-pandemic levels were too high, even pre-Covid. So it’s easy to blame Covid, but if you actually look at the sector, have a hard look; even before Covid, those rental levels were too high, certainly with shopping centres.
If you think of shopping centres, rent is basically a rent-to-sales ratio. So the landlord works out how much shops get in trade, you know how much turnover is in that shop, and sort of agree a percentage of the turnover goes into rent, very roughly.
But that was only up, it got to a level that was too high for the retailer and it just didn’t make sense. So even pre-Covid the retailers were pushing back and things were tough. Now they’re reset. So if you were paying – I’m making up numbers – 10% of sales before, now you’re paying 5% of sales before.
That’s now 5%. I don’t see it going back to 10% unless you have a whole lot of pressure or boom. So that’s set. Now still from that 5% you can, as sales grow, get growth in your rental. But that rebasing I think has taken place, but that I don’t expect to go to pre-Covid levels. I think those were just too high unless you’ve got a property boom. Who knows, looking at that at the moment?
Offices are a different sector; I don’t know where the floor is with offices – there’s so much vacancy and [there are] all the well-known office problems. But, like, 10% of the listed property’s exposure is to SA offices, and that’s done particularly badly. So maybe that’s also reached a bottom. I don’t know where you draw the line, where this knife ends.
SIMON BROWN: Yes. But I take your point around that rebasing. One of the things that has come through a couple of times in this chat is that we have had some rebasing in the property sector, which does bode well for it.
Final question – exposure to property in a balanced portfolio? It adds quality; it enhances not just the profile but also its downside protection as well to a degree. I appreciate some listeners are going to say, hang on, what happened in the pandemic? But with that phrase you’ve been using, the rebasing, it gives you some yield, it gives you some downside. It’s an integral part of a diversified portfolio.
EVAN ROBINS: Exactly. And property as an asset class is the biggest asset class in the world. So, to not be exposed to that asset class is leaving yourself open to risk that you can diversify in its exposure. It’s less leverage to operational leverage. It’s got financial leverage. So because it’s all contractual rental, it has that effect where things are much slower to behave.
It does reduce risk in the short term, and that’s why it’s always been an integral part of all portfolios. It has just gone through a rough patch.
It’s not going back to boom times, but certainly going back to the normal patch, I would argue, where it’s certainly a core around portfolios.
I think in the good times, many investors made the mistake of looking at property like bonds and saying: ‘Oh, it’s like a bond, but it’s giving us 10 times the return.’ They forgot that it’s not like a bond; it’s risky, it’s a bit more like an equity, and that’s a mistake.
And having too much property, I think many people were caught. It’s that part of diversification. But to have too much property and be too aggressive there – given that its risk is closer to equity than to bonds – is a mistake; it needs to be an adequate holding in a portfolio.
SIMON BROWN: Absolutely. And an important part of a portfolio. Perhaps we got caught up in the good times and now in some sense we’re getting caught up in the bad times.
But we’ll leave it there. Evan Robins, listed property portfolio manager at Old Mutual Investment Group, I appreciate the insights.
This podcast series, Investment Alchemy, is brought to you by the Old Mutual Investment Group. In relentless pursuit of investment excellence.
Moneyweb does not endorse any product or service being advertised in sponsored articles on our platform.
#Investment #Alchemy #series #property #investors #stick
