REITs a huge game-changer for property stocks?

The South African listed property market is changing. On April 1 next year South Africa will implement a local Real Estate Investment Trust (REIT) regime that will begin a new chapter for the sector.

The coming REIT legislation is important because it brings the sector into line with the latest international standards. It will also exempt REITs from capital gains tax (CGT), which has been a contentious issue for some time.

Most local property loan stocks currently carry significant deferred tax on their balance sheets, which has built up as their property assets have increased in value. Listed companies that convert to the REIT structure will free themselves from that particular mess.

The talk from the sector itself is that the introduction of a REIT regime will also lead to a boost in foreign interest in JSE-listed property companies. This is because although local property loan stocks have effectively acted like REITs, they have done so synthetically and so haven't enjoyed the full confidence of offshore investors. They have also been avoided by certain institutions and indices that are mandated to only consider formal REIT companies.

If all the property companies currently listed on the JSE adopt the REIT structure, South Africa will boast the eighth largest REIT market in the world. The biggest counter, Growthpoint, could become the largest emerging market REIT and the 40th largest overall.

This certainly sounds encouraging, but how much of an increase in foreign interest can we realistically expect? Is this the moment that our property stocks will take off like our retail counters did when foreigners developed an appetite for them?

Evan Jankelowitz, a fund manager at Sesfikile SCI Property Fund, is of the opinion that a formal REIT regime will sit more comfortably with foreign investors, but it's not going to cause an overnight sensation.

“I don't think this is going to be a huge game-changer,” he says. “The counters that already have large foreign exposure are Growthpoint and Redefine and that is primarily because of their size and liquidity. The small, illiquid players aren't suddenly going to become more attractive. The truth is that there might be a little more interest, but I don't think it's going to change the whole share register.”

The table below shows the current levels of foreign ownership in a selection of the larger JSE-listed property stocks:
CounterForeign unit holding at 30 Sept 2012
SA Corp5.09%

These are well below the following counters of not dissimilar size:
CounterForeign shareholding
Life Healthcare48.00%
Group Five13.50%
Super Group12.20%

Overall, the JSE is between 35% and 40% foreign owned. Listed property is closer to 10%.
So clearly local real estate stocks are not as popular with international investors as some others on the bourse. The lack of a formal REIT regime might be one reason for this, but are there others?

Certainly eyebrows have been raised in the past about some messy cross-holdings and the large interests some industry players have in other counters. For instance, Redefine currently owns 31.2% of Hyprop and 33.8% of Arrowhead. For its part, Hyprop owns 33.9% of Sycom and 1.5% of Acucap. Acucap, in turn, owns 17.2% of Sycom. Resilient owns 13.5% of Capital, while Capital owns 5.8% of Resilient.

However, this is not necessarily unique to South Africa's listed property sector, and nor is it a huge turn-off for foreigners. Investec Asset Management's Neil Stuart-Findlay also believes that the REIT legislation might lead to a few of these stakes being exited.

“Some of these holdings were taken on a passive basis, while others were made more strategically,” he says. “But if a company took a position in the past and wanted to sell it down for whatever reason, they currently run the risk of incurring CGT on that listed shareholding. That liability will however fall away in the new REIT legislation, so it might actually unlock opportunities for some of these cumbersome positions to be unwound.”

The issues that really sit uncomfortably with foreigners are liquidity and valuation.

“Liquidity constraints and rather 'full' valuations with regards to net asset values (NAVs) may be potential deterrents to future foreign shareholding growth,” says Efficient Select analyst, Stuart Sinclair.

While counters such as Growthpoint and Redefine have outgrown liquidity problems, the same is certainly not true for many others in the sector. Some of the smaller counters remain highly illiquid and their conversion to REITs is not suddenly going to change that.

“Certainly the larger companies are set to benefit more in the short term, but this is a stepping stone,” says Stuart-Findlay. “The smaller players are currently off the radar entirely, and while I don't think it's going to be transformational overnight, it could be a catalyst over time for increased foreign interest.”

In terms of valuations, South Africans also see these companies in a very different light to offshore investors. Stuart-Findlay believes this will come into play.

“South African investors place a strong emphasis on yield as a valuation basis, comparing a real estate counter's yield to those seen in the bond market as well as its listed peers,” he says. “Foreigners, on the other hand, tend to be more familiar with NAV as a valuation methodology. While local yields are quite healthy compared to global markets, we look quite expensive from a price to NAV perspective.”

Sesfikile's Jankelowitz agrees:

“Locally, our assessments of property stocks relies on cash flow,” he says. “So we might get a bit of a shock as to how we are perceived by foreigners when REIT comes into play.”

There is, however, an upside. The REIT legislation is going to have an impact on the NAVs of these companies as it will allow many of them to get rid of large deferred tax liabilities.

“The CGT tax liability falling away on the balance sheets of our property loan stocks will, on average, cause about a 10% uptick in NAV across the board,” explains Stuart-Findlay. “So NAVs will go up, and price-to-NAV valuations will come down, bringing these counters more in line with their global peers.”

Where local property stocks will definitely benefit is the position they will occupy in the global REIT market. The sector is growing relatively quickly in South Africa, and will be a serious emerging market play in this space.

“There are not many emerging market opportunities in the REIT space outside of Asia,” Jankelowitz explains,” and we are one of the only viable African opportunities. We also offer a pure rental earnings offering here that you don't get in most emerging markets.”

Overall, the legislation will cast the sector in a new light for international investors. And that is what the industry is excited about.

“Following global best practices will have a positive impact on the market,” Sinclair says. “Foreign shareholding has already risen significantly over the past few years, albeit off a low base, but for foreigners looking for diversification into quality assets with relatively high yields, the new REIT structure will certainly have additional appeal.”

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