SA REITs’ governance standards could be improved

Since the Covid pandemic, South African REITs have made considerable progress in strengthening their balance sheets and streamlining their operations. However, we believe that by improving corporate governance they can further increase shareholder value through the economic cycle.

Governance is the responsibility of the board of directors and the large investors who dominate the vote to re-elect them every year. These institutions have the influence to impose best global practice on behalf of their own fund investors and minorities and therefore should promote higher standards of environmental stewardship, social impact and corporate governance.

One of the most telling symptoms of historic governance failures is that, according to MSCI Real Estate, REITs own 25% of all institutional-grade property in SA. This compares with an average of 5-10% in most developed markets, where REITs tend to own only the highest quality segments in niche property markets. The obvious inference is that domestic REITs have raised more investor capital than they have been able to deploy into the very best property assets. The quality of their portfolios suffered during their decade of rapid expansion from 2008 to 2018 as they were obliged to acquire non-strategic assets in SA and offshore.

The following are some examples of governance shortcomings (and therefore opportunities) among the domestic REITs:

• Lack of specialisation: Growthpoint, Redefine, Fortress, Burstone, Attacq, Fairvest and SAC have pursued diversification without keeping a sufficient eye on risk, in our view, damaging earnings quality and missing the opportunity to become sector specialists like their most highly valued global peers. A generalist approach also incurs the risk of increased operating costs as management structures are often duplicated across portfolios.
• Excessive dividend payouts: it was not uncommon for South African REITs to pay out 100% of earnings in dividends until capital preservation became a priority during the Covid pandemic. Paying dividends is a REIT’s raison d’etre to some extent; retaining earnings and paying 27% corporate tax instead seems wasteful by comparison.. The US REITs pay out far less of their earnings as dividends, 70% on average. We think this is a prudent approach, building a cash buffer for rainy days and strategic expansion opportunities. We see the tax paid as the cost of a robust balance sheet which can react quickly to changes in the environment. A lower payout ratio also avoids the need to raise capital or sell the most prized assets if earnings are insufficient to cover the dividend.
• Dual share structures: until early this year, Fortress operated a dual A/B share structure: B shareholders would only participate in profits once A shareholders had received a specified level of return. The level of the REIT’s performance required for B shares to have any value in this arrangement created conflict between A and B shareholders, leading to Fortress losing its REIT status in 2022 and the suspension of its dividend in 2023. This conflict has now been resolved by holders of A shares making, in our view, a significant financial concession to holders of B shares (who included Fortress’ management team).
• Investments in other listed entities: Resilient’s ownership of interests in Lighthouse and Hammerson, Fortress’s holdings in Nepi Rockcastle and Attaq’s holding of MAS lack strategic merit, in our view.
• Relationship concentration risk: MAS Real Estate’s dependence on developer, JV partner and investor PKM for growth has forced MAS to unexpectedly suspend its 2023 dividend as the interest rate cycle has turned.
• Misalignment of incentives:
  • For many years, the Burstone Group (formerly Investec Property Fund) had an external management structure which created a misalignment of incentives. After years of advocacy by STANLIB and others, Burstone finally brought management of the fund in-house in 2023 but this required several negotiations over the costs and value to be released in that process. To this day, Burstone’s purported expansion opportunities in Australia reflect legacy relationships and we believe they should be re-examined.
  • Some South African REITs still have remuneration policies that do not serve the interests of minority shareholders. Examples include geared equity schemes and management performance metrics which incentivise balance sheet growth over growth in free cash flow per share.
• Sub-optimal capital allocation:
  • South African REITs’ offshore acquisition spree over the last 15 years has generally been disappointing, as it relied on upward property price revaluations to achieve the required returns. Notable missteps include:
  • Growthpoint’s acquisition of Capital & Regional in 2019 was not only poorly timed but it also lacked strategic value.
  • Equites’ relatively weak capital structure forced it to sell prized UK assets in 2023, near the bottom of the market, and its majority stake in UK ENGL, the market-leading logistics property development platform that it acquired in 2019 as a strategic growth engine.
  • Resilient’s botched attempt to take control of Hammerson distracted management from the core portfolio.
  • Hyprop and Burstone’s recently acquired retail properties at yields below their cost of borrowing, let alone their cost of capital.
  • Burstone’s opportunistic acquisition of what we consider to be a mixed-grade Pan European Logistics portfolio which owns assets across seven countries. It offers neither scale nor potential synergies.
  • Emira’s diversification into low-LSM open-air shopping centres in the US through a joint venture in which Emira has a minority stake. Under the control of Emira’s partner, a private equity investor, the JV is investing across various property types, on a tactical basis, all over the US without achieving scale or strategic focus in any of them.
  • Redefine’s acquisition of Echo Polska Properties, a portfolio of ageing retail centres in Poland, and subsequent dilution of existing shareholders when forced to raise capital (through joint venture structures) near the bottom of the cycle.
  • Spear REIT’s share buyback in 2023 was technically accretive to earnings but net negative for shareholders due to the erosion of the stock’s already narrow liquidity. This was a poor trade-off, given the importance of liquidity for a small cap REIT that is off-index and trying to attract more institutional investors. We believe that shareholders would have been better served by using the cash to fund strategic acquisitions.
  • There is a handful of small cap REITs listed in SA that could present interesting long-term opportunities. But they are handicapped by similar dynamics that do not fully align their interests with those of minority shareholders (Exemplar, Dipula, Octodec, Heriot, Safari etc.)

Two SA-based REITs are exceptions to this pattern. They have achieved success overseas by maintaining strategic focus and allocating capital in a disciplined fashion. In Spain, Vukile bought Castellana and a stake in LAR at valuations which allowed for a positive return on invested capital without the need for revaluations. With these acquisitions, Vukile maintained its focus on retail and achieved scale in Spain, thereby increasing its relevance to the country’s largest retailers. Another success was NEPI Rockcastle’s dominant position in grade A shopping malls in Romania, Poland and neighbouring countries during a period of economic growth in those countries. NEPI has generated the highest total shareholder returns in the sector over almost any time horizon during the last 10 years.