OLD ARTICLE – Original posted on November 24, 2016
See Part 1 over here: Warning Signs: Retailers, Shopping Centres & Retail REITs (Part 1 of 2).
There are three harmonious parts to a Real Estate Investment Trust (REIT):
- Income: These are predominantly rentals from tenant renting space from the REIT. The lower the vacancy rate and the faster rentals are being escalated, the better the income flowing into the REIT.
- Assets: These are predominantly the properties that the REIT owns. If the rentals are growing, the vacancies are falling and the assets are in good repair with positive fundamentals, then property valuators tend to revalue these properties (and, hence, the REITs NAV) upwards over time.
- Liabilities: REIT tend to be funded with a fair amount of debt. A key ratio here is their Loan-to-Value (LTV) ratio (which is pretty much a Debt:Assets ratio for REITs), though Debt:Equity I believe is also relevant. The trick is that debt is fixed while the rentals and underlying property values can change over time…
The last point in (3) is a key one.
We have been through a long period (roughly 10 to 20 years) of declining interest rates, expanding shopping centres and booming retail. This has led to a growing number of shopping centres, lowering vacancies, high rental escalations being passed and the resulting property valuations steadily rising for these shopping centre assets (as a broad generalisation).
What if this period of shopping center and retail growth is over? What if the retail industry has over-reached (at least in the short-term), and retailers and the shopping centres that host them begin to struggle? What if (shock and horror) this market actually contracts?
Well, then point (1) above begins to unwind and impacts quite negatively on point (2) and point (3).
Let me explain why REITs can be risky when (1) to (3) work against you:
- Income flatlines or begins falling: If retailers are struggling, then they will not accept rental escalations. At best, shopping centres will keep rentals flat for their major key customers so that they can keep vacancies minimal. At worse, vacancies begin to rise as retailers consolidate marginal and unprofitable stores. Likewise with the smaller stores in a shopping centre. Don’t forget that anchor tenants in shopping centres are there to generate foot traffic and are sometimes paying minimal rental anyway. It is often the last c.20% of the small, independent stores that rent from a shopping centre that can make the shopping centre c.80% of its profits. These stores are often independent, unaligned, and quite marginal. If these go, the asset’s bottom line goes as well. I.e. Retail REITs income can start to become static (at best) or even decline, thus negatively affecting their distributions.
- Instead of steadily growing, assets drop in value: Property valuators tend to use key metrics in valuing REITs underlying properties. The most important of these metrics are the rentals that the property generates. If gross/net rentals drop, then it is likely that (at least some) REITs will see their properties values fall, thus lowering their underlying asset base.
- Debt remains fixed, which causes problems: The problem with fixed debt is that when your asset base (as in (2) above) falls, your ratios all go out of whack. In the context of both financial gearing and debt covenants, there could well be a scenario where post-devaluation drive a REITs LTV upwards significantly injecting risk into their sustainability. Interestingly, debt is something that you can borrow quite easily and cheaply if you do not need it. As African Bank found out, it is when you do desperately need debt (in order to roll your other debt) that the credit markets suddenly retreat from you and you hit a liquidity crisis. Not that I think it will get to this, but REITs are highly geared instruments and a 5% to 15% devaluation in some of their NAVs would seriously dent some of these structures ability to borrow at reasonable rates. So you borrow at unreasonable rates, this makes your capital structure more expensive, thus your distributable income drops even further, and so the cycle amplifies…
OK, the above is a lot to digest, but the point I am trying to get across is that if retail is in trouble, then retail REITs are also in trouble.
Now allow me to show you the South African Property Index (SAPY) Return on Equity (ROE) over time. (Note: While the SAPY includes non-retail and non-domestic REITs, it was utterly dominated by these domestic retail REITs historically. Even today, the SAPY has over 66% of it as domestic assets with an estimated two-thirds of this being retail exposure.):
Now here is the SAPY’s Debt-to-Assets (near enough to index-wide LTV) and Debt-to-Equity (i.e. gearing):
Here are a couple observations I can make here:
- Although debt in the listed property space has been trending down, so have the returns within these REIT structures (i.e. ROE has been falling recently).
- Despite this downwards trend, debt still remains quite high with D:E at c.45% (imagine that this was not property, but just a normal business and suddenly a D:E of 45% looks dangerous).
- Likewise, the sector’s current ROE appears quite marginal at c.8.4%, which I would argue is well below the sector’s Cost of Equity (COE).
- Given the gearing in the REIT structures, if assets are written down by, say, 5%, then Debt:Equity does not rise 5%, it actually rises about 5.5% to breach c.50% D:E (this is the nature of ratios when assets are floating and debt is fixed).
Finally, here is a graph tracking the SAPY as indexed against the General Retailer’s index on the JSE. It is worth noting that if you run a correlation between the two indices, the correlation comes out at 0.97x. Given that a 1.0x correlation is perfectly correlated, this means that these two index are very closely related. Correlation does not imply causation, but I strongly suspect that it is not Growthpoint driving Shoprite’s share price, but probably the other way around (with a healthy dash of interest rate sensitivity thrown in there, which drives both sectors). Given yield is a major portion of REITs returns, the total return correlations of these indices is likely even stronger…
Another way of putting this is: if you are negative on domestic retail, you have to be negative on domestic retail REITs. These two are so closely linked that the same drivers in one market bleed directly into the other one.
Once again, I ask: If South African retail and South African shopping centers were such great investments, why is nearly every retail REIT taking its capital offshore by buying assets in Europe and the UK (or elsewhere)?
It is simple, it is because SA Inc’s shopping center boom is over and these property businesses can get better returns elsewhere.
So why not you as well?
So, in conclusion, here is my thought process:
- First Degree Thinking: South African retailers are in trouble, sell South African retailer shares.
- Second Degree Thinking: South African retailer shares have begun pricing this in (in my opinion, but come to your own conclusion). Simply avoid South African retail shares for now.
- Third Degree Thinking: The listed retail REITs with direct and material exposure into this shopping center market does not appear to have priced into their unit prices the deterioration of their fundamentals (go check this out for yourself, as it is beyond the scope of this article). Sell retail REITs, short them and/or avoid them…for now. There could well be some coming tragedies in this sector, particularly given the highly geared natures of these REIT capital structures.
And that is my two part retail view for domestic South African retailers and their key suppliers of space.