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Simon Brown: I'm speaking with Daniel King, head of fixed income at Merchant West Investments. Daniel, welcome to the show. I caught part of a presentation you gave earlier talking about his REITs, which are publicly traded real estate stocks. The discount to net asset value is certainly attractive, in some cases as much as 30%, and the yield looks good.
But you point out that the yield is probably somewhat so-so compared to bank rates and bonds, which are probably risk-free.
Daniel King: Yes, exactly. The bottom line is that when you buy a REIT, you're not just buying the underlying real estate. Actually he ends up buying 4 things. You will be purchasing the underlying property. You're buying management and the ability to allocate capital. You will be purchasing a portfolio that will be the basis of the lease signed by the tenant. And perhaps most importantly, it's buying a ton of operational and financial leverage within that system. The biggest one is the financial liability that exists within the REIT. So you actually have to work a lot harder to get a yield comparable to a bond yield in the first place.
That was the gist of that part of the webinar we did. There are two problems with this 30% discount to NAV. The first is that it is distorted by the amount of LTV debt within the REIT sector. [loans to value] About 40%. And secondly, as you say, the so-called independent value system in the South African market is very slow in adjusting the capitalization rate, which measures the value of real estate in line with bond yields, so NAV itself could potentially That means it's outdated.
So, very simply, when bond yields rise, the capitalization yields of all assets have to rise to reflect that higher base rate, but we don't see that to a significant degree in the real estate sector. did not. And a 30% discount to book value for the publicly traded REIT sector is more or less appropriate, due to the fact that adjusting for this underlying leverage should, firstly, increase cap rates for all assets. We found that there is a bias between “appropriate” and “appropriate.” Considering other factors within the REIT sector also results in a potential “moderate overvaluation.”
So I don't think there's much to get excited about there, and even if you don't need to touch listed properties in South Africa, I don't think there's a strong reason to do so.
Simon Brown: I understand your opinion. While that 30% number sounds appealing, it's certainly an old-fashioned methodology. But valuations are probably a little slow. Then there's yield. Sure, you'll get a nice yield around 8% or 9%. He can get 10% by going to buy government bonds. This is frankly a much less risky investment for better returns.
Daniel King: yes. Its yield should always be viewed in terms of potential growth. This isn't his mid-2000s to mid-decade era, when the commercial real estate sector was delivering near-double-digit, and in some cases double-digit, net real estate income growth.
This is the situation in which the South African market currently faces a severe glut of office real estate. Some might argue that the sudden surplus of large commercial facilities is similar. So what this means is that the situation will be quite deflationary for some time. And currently, a huge over-rent situation in retail and office real estate exists, not just everywhere, but in certain key nodes of the country. [but] in most of the country's urban areas.
In other words, in order for the listed real estate market to grow organically, growth expectations need to be significantly reduced. Naturally, that means yields need to increase. Because, as you say, on bonds he gets a 12% yield. So, if you're going to keep the organic growth rate of listed real estate to probably 3.5% to 4.5% over the long term, how high should your real estate yield be? Over normal periods, you need to earn an equity risk premium over bonds. So naturally, it has to reach 12%, 13%.
Again, this is true, the yield looks high in absolute terms, but once you control the growth dynamics and control the leverage and oversupply conditions, it's very easy to justify the valuation. This shows the fact that it is easy to do.
Simon Brown: Gotcha. You mentioned LTV. As you were saying, I was remembering 2017/2018 when the sector was at its peak prior to the pandemic, with high LTVs, high premiums to NAV and low yields.
LTV is approximately 40%. There are two tips. One is, of course, loans to value, but is that value – from your point of view – outdated? Is 40% because intuitively it looks good? Do you think that's enough? ?
Daniel King: No, I don't think it's enough. I think it's not enough in certain areas. Please note that the banking sector often lends to listed real estate companies with terms and conditions. Therefore, in some cases, these covenants are as low as 50% LTV or 55% LTV, effectively stating that “exceeding this threshold would result in us controlling cash flows into and out of the business.'' means.
So if your LTV stays at 40% to 45%, as some REITs do, you're actually very vulnerable to real estate value impairment. A 20% or 30% impairment, which I have argued is not out of the realm of possibility, is actually quite possible.
Doing so would bring you very uncomfortably close to, if not breach, the existing contract. Therefore, it is insufficient as a safety net. If your LTV repeats his 40%-45% cycle enough times, you will end up breaking these contracts at some point, creating a liquidity crisis for your business and eventually being abandoned by the market. . Stock market – what we saw. Therefore, it is flying too close to the sun. For me, closer to 30% is more sustainable, especially in the current situation.
However, this is not to say that there are sub-sectors of the real estate industry that do not struggle with this type of deflationary situation. Of course, there are also areas like storage. Generally speaking, there are some fields, such as logistics, where there is no oversupply. Since we are generally in a state of inflation, a higher LTV may give you peace of mind.
But in office and retail, I think as an equity investor you need to be very careful about making sure that the underlying business you're investing in has a very conservative balance sheet.
Simon Brown: I understand your opinion. absolutely. 40% LTV is better, but maybe the point is “not good”.
I'll leave that aside. Daniel King, Head of Fixed Income Merchant West Investments, thank you for this early morning.
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