The Finance Ghost: How to Redefine Your Yield Strategy

As exciting as government bonds are in terms of the yields currently on offer, do some property funds offer more compelling opportunities?

On the spectrum of fixed income (government bonds) to equity instruments, we find REITs (Real Estate Investment Trusts) somewhere in the middle. This is because they have elements that are similar to bonds, yet they certainly can’t be called fixed income.

As the pandemic taught investors, there’s a big difference between fixed income and having to fix a broken income.

Using the example of Redefine Properties, let’s take a closer look at the property sector and why investors might consider exposure here.

Is it still broken?

A long-term chart of Redefine Properties shows that it traded sideways for a few years leading up to the pandemic, before being absolutely slashed by the dreaded COVID. After bottoming out at around R1.90 per share, the price has clawed its way back to R3.79.

At the start of 2020, it traded at R7.50. Ouch.

Clearly, the share prices in this sector are still broken, even if the dividends have come a long way since the bottom of the pandemic. This isn’t unique to Redefine. Just as things were coming right in terms of occupancies and rental reversions (the rate at which a new lease is signed vs. the old leases) for most REITs, rapidly rising interest rates put the squeeze on the balance sheet.

And on top of that, the environment of higher yields and heightened risks in South Africa leads to lower property valuations. Properties are valued based on net operating income and a suitable cap rate. Even if operating income recovers, an increase in the cap rate leads to a flat or potentially lower valuation for the portfolio.

This isn’t helpful for a share price recovery.

So, why would someone invest in Redefine?

Firstly, the dividend. Redefine paid a dividend of 43.8 cents a share for the year ended August. Based on the share price at time of writing, this puts the stock on a trailing yield of 11.56%. This is more than you’ll get from a bank account or the typical government bond for that matter, with the added benefit of liquidity. A fixed deposit at a bank locks your money in for years. A government bond or a share in a REIT can be sold if you need the funds.

You must keep in mind that this dividend is taxed in your hands as normal income (like rentals you would earn from a property), not as a dividend. This means that it isn’t directly comparable to dividends paid by companies other than REITs, which are taxed as dividends at a lower rate than income tax.

The dividend from a REIT is only one part of the potential return. A further source of return is the discount to net asset value (NAV), which is a feature of almost every property fund on the JSE at the moment. Redefine’s NAV per share is 765.96 cents, so the current share price is a discount of 50% to the NAV.

We need to separate this into two components.

The first one is simpler: the actual NAV. If the value of the property portfolio increases and the discount of 50% remains steady, then the share price should increase in line with the NAV. It’s never quite that simple for the reason given below, but it’s a good starting point for understanding the components of the return.

The second component is the extent of the discount. If the discount of 50% “closes” i.e. decreases, then the share price moves higher even if the NAV doesn’t. Of course, if the discount widens, then the share price drops even if the NAV is steady.

This should make you ask the question: what affects the discount to NAV of a REIT?

Let’s explore this.

REITs on sale

This Black Friday sale on REITs relative to their NAV per share is arguably because of the yield. South African investors see REITs as yield-focused vehicles with the potential for the share price to grow over time, thereby taking the total return beyond what is on offer in government bonds (if things go well). Of course, there are no guarantees of that.

The focus on yield means that investors look at the property portfolio of a group like Redefine and figure out what yield they want, an assessment that is always made with reference to what government bonds are yielding. In very rare cases for only the most loved property funds, investors might be willing to accept a yield below government bonds. This implies that the fund is less risky than the country in which it operates, which is a slippery slope. In most cases, the required yield is higher than the bond rate.

The market is telling us that investors in Redefine are happy with a yield of around 11.5%. If for some reason they were happy to accept 11%, then the share price would ratchet higher in response. If conditions worsened and they need 12%, the price will drop. This assumes that in both cases, the dividend is kept steady.

Although views on this may differ in the market, the right way to think about REITs is arguably to focus on the dividend rather than the NAV. After all, the dividend is cash in your pocket and the NAV is based on valuations of the properties, which is always a topic of debate.

Look at the earnings guidance

When results were announced, Redefine noted that distributable income per share in the next financial year is expected to be between 48 and 52 cents. This year, it was 51.53 cents. In the prior year, it was 53.71 cents. Can you spot the trend? It’s tough out there.

The dividend payout ratio is also very important, as Redefine doesn’t pay out all its distributable income as a dividend. The ratio was 85% in 2023, up from 80% in 2022. This is why the dividend actually increased from 42.97 cents to 43.80 cents in 2023, despite distributable income per share decreasing.

The guidance for the next financial year is a payout ratio of between 80% and 90%.

This suggests that the guided worst case is 80% of 48 cents, which is a dividend of 38.4 cents. The guided best case would be 90% of 52 cents, which is 46.8 cents.

The 2023 dividend was 43.80 cents, which is higher than the mid-point of the guided range (42.6 cents). This suggests that the likeliest outcome is a decrease in the dividend in 2024.

What does this mean for investors in Redefine?

The forward dividend yield, based on the mid-point of the guidance, is 11.2%. This means that if they achieve the mid-point and you buy the shares today, that’s the best available estimate of the yield you’ll receive in the next 12 months.

This is a premium to the South African 10-year government bond yield, which has come down to 9.985%. Whether it’s enough of a premium is debatable. Remember, as discussed in a previous article, the total return on a bond isn’t the same as its yield, as the price of the bond will change in the next 12 months (and beyond). Similarly, the price of Redefine will change.

It’s also very important to remember that Redefine is about more than just the South African economy. The group has substantial exposure to Poland. It unfortunately also has a lot of exposure to South African office space, so any excitement around the Polish economy needs to be tempered by a reality check on the prospects for South African office space.

In asking yourself whether you want to hold shares in Redefine, you need to decide whether you would rather take a riskier punt on a stock like this, or look at a fund that has a more promising recent trajectory. Vukile springs to mind, but the trailing yield on that stock is only 8.5%. The market isn’t blind to the good news coming out of Vukile, nor is it blind to the risks in Redefine. The yield is priced accordingly.

The correct approach, in my opinion, is to hold a basket of property funds rather than trying to bet the farm on a single fund. When researching these REITs, you need to dig into the underlying portfolio to understand the exposures. You need to consider the current yield and the future earnings guidance. You then need to take a view on whether the yield is compensating you for the risk.

Finally, give some thought to the NAV and whether you think the portfolio can go up or down in value from here. This is an important driver of returns, although not as important as dividends.

REITs are complicated animals, but they can be rewarding. Like with all things on the market, it’s important not to pay too much for them.

Want to know more about the latest research?

Should You Invest in Defence Stocks?

Space Exploration Stocks: Are They Worth Investing In? 🚀

Can You Invest Like Warren Buffett? 🎩

Any opinions, news, research, reports, analyses, prices, or other information contained within this research is provided by an external contributor as general market commentary and does not constitute investment advice for the purposes of the Financial Advisory and Intermediary Services Act, 2002. First World Trader (Pty) Ltd t/a EasyEquities (“EasyEquities”) does not warrant the correctness, accuracy, timeliness, reliability or completeness of any information (i) contained within this research and (ii) received from third party data providers. You must rely solely upon your own judgment in all aspects of your investment and/or trading decisions and all investments and/or trades are made at your own risk. EasyEquities (including any of their employees) will not accept any liability for any direct or indirect loss or damage, including without limitation, any loss of profit, which may arise directly or indirectly from use of or reliance on the market commentary. The content contained within is subject to change at any time without notice.