What’s the Growth-point of property REITs?
The property sector on the JSE was once a hive of activity. A few years back, investment bankers literally rode the property wave all the way to their favourite sportscar dealership, raising money in the market on practically a daily basis and earning delectable fees along the way.
The property sector was literally dripping with honey, as pension funds and institutional investors plowed money into property funds with seemingly endless enthusiasm. The JSE was welcoming new listings on a regular basis and existing funds were constantly either raising money for yet more South African malls, or for adventures in Eastern Europe or the UK.
Before we touch on Growthpoint’s capital raise this week, let’s take a look at some interesting features of the JSE property sector.
The pursuit of Rand diversification hasn’t been easy.
It was the UK that unravelled first. Brexit caused havoc for funds like Texton Property Fund. Far more recently of course, lockdown put JSE-listed Intu Properties into ICU and ultimately into bankruptcy, as one of the largest mall owners in the UK became a high-profile corporate failure. Against a backdrop of political turmoil and significant disruption from online shopping, malls in the UK haven’t been a great investment choice.
But why was Eastern Europe a favourite?
As a developing region, Eastern Europe offered local property funds an attractive mix of development opportunities and a higher growth environment vs. developed markets in Europe.
South African pension funds, who are the primary funders of property companies, seek growth in dividends, as their pensioners are living in South Africa with living expenses growing at 3 – 6% per year. If a lease in a developed market (like the UK) barely has any inflation escalations and achieves limited growth, the local fund relies on Rand depreciation to show any growth in earnings.
That’s not a sustainable position, so the fund ends up doing new deals continuously to lock in a margin between rental income and finance costs overseas, thereby growing income each year. It works, at least for a while. It’s a bit like running on a treadmill. You simply can’t do it forever.
At least in Eastern European countries, the economic growth rate is higher and in several markets the inflation rate is a helpful underpin too. Through the use of so-called “triple net leases” that basically lock in a minimum net return, local funds achieved Rand diversification and a bit of growth in foreign earnings to go with it.
These foreign structures created all sorts of structured finance opportunities for funds. Structured financiers love nothing more than regular cash flows that need to flow cross-border. That’s when the fun really starts with debt structuring, managing currency risks alongside complicated tax rules.
Why might you want to invest in these companies?
Almost all the property companies are structured as Real Estate Investment Trusts (REITs), which is a tax framework that turns the company into a conduit that typically pays very little tax, transferring the tax burden on profits to the shareholders instead. In return for being in this framework, the REITs must pay out most of their profits as dividends each year, “guaranteeing” a flow-through of income to shareholders (but of course nothing is guaranteed as profits do fluctuate).
Pension funds don’t pay tax either, so they love REITs because there is practically no tax leakage in the structure whatsoever. That 7% dividend yield lands squarely in the hands of pensioners (less significant asset management fees from the investment houses, naturally …).
Individuals and companies pay income tax on the dividends, which is a lot higher than dividends withholding tax (20%) like on dividends from companies other than REITs. Although REITs offer high yields, you need to subtract the full tax rate (28% if you are a company and up to 45% if you are an individual) to calculate the net yield you would receive.
So, REITs are clearly designed with pension funds in mind. In theory, they are the perfect investment for a pensioner: regular dividends combined with inflationary growth thanks to the underlying leases.
That theory has fallen over this year. Lockdown hurt the REITs so badly that a special ruling was given that allowed them to defer paying dividends. The very reason that REITs exist was called into question and pensioners suffered along the way.
As malls shut down and office leases were cancelled, property valuations plummeted, and investors prepared for the inevitable: property funds would need to raise money to survive.
Growthpoint: leading from the front
This week, Growthpoint announced that it would raise around R4bn, representing 10% of the shares in issue. Note: this is not a rights issue!
A rights issue entails the company raising cash from existing shareholders. Growthpoint’s capital raise is under a general authority by shareholders for the company to raise money. The raise is done through an accelerated bookbuild, a process through which interested investors apply for shares and the book is closed when the target has been reached.
Allocations are then made to applicants, taking into account the institutions that the company wants to have on the register.
Shareholders will be thrilled to note that proceeds will be used for repaying debt as well as “general corporate purposes” which is an incredibly nice way to say that the company needs the money badly. In addition, Growthpoint will execute a cost savings plan, reduce its dividend payout ratio and dispose of between R1bn and R1.5bn of non-core assets within the South African portfolio.
The banks had to dust off their old capital raising specialists, who were presumably cryogenically frozen with practically nothing to do on the JSE property sector for the last while. Having thawed sufficiently, a raft of banks including Absa, Goldman Sachs, JP Morgan, Morgan Stanley and RMB all got their place at the trough to act as “joint bookrunners” – this means that they would market the shares to institutional clients to convince them to subscribe for shares.
In the end, the shares sold out faster than tickets to a Bieber concert. Growthpoint raised R4.3bn (more than planned), at a price of R12 per share.
Remarkably, the share price closed at R11.51 on the day the bookbuild was closed. It would’ve been 4% cheaper to just buy the shares on the open market. To be fair, the share price closed at R13.70 on Wednesday before the capital raise, so investors did think they were getting a good deal.
Growthpoint may be the first REIT to tap the markets after lockdown, but it almost certainly won’t be the last.