In the five-year period from 2013 to 2018, many South African investors also became “yield pigs”. The vehicle of choice with which to express this form of greed was a security called a “REIT”, which is an acronym for Real Estate Investment Trust. Apart from appealing to unsophisticated investors’ insatiable appetite for investing in “Easy Acronyms” – remember BRICs, FAANG’s, SPAC’s etc – REITs had many attributes which reinforced the emotional response. Here are a few:
- Property. Remember, they don’t make more of it. It’s tangible, you can touch it. Look how beautiful it is, stunning architecture. I’m sure you have heard these platitudes many times. As a result, property as an asset class can evoke emotional responses from investors, which are often not always backed up by cold hard numbers.
- REITs are tax efficient. Nothing gets investors going like a perceived tax break. They will willingly overpay for an asset because it is “tax efficient”.
- Growth. In markets, the word growth is like a red rag to a bull. Investors will pay any price to get hold of growth, especially if the dominant narrative is that growth is scarce. It’s the oldest trick in the salespersons’ book – create a sense of scarcity, push up the price, and watch a queue form.
So, it came as no surprise that the combination of “property”, “tax efficiency” and “growth” created a lollapalooza effect. Many investors were prepared to pay just about anything to get hold of this trifecta. Even the so-called smart money – large institutions – fell prey to this avarice. Given the boundless opportunity, it presented for increasing their AuM this was perhaps not so surprising.
None of this went unnoticed by smart management. Very quickly, REITs with variable capital structures were formed. Most were variations on a theme with the following characteristics: a class of share that paid a “secure” income stream, and a class of share which had the right to the excess income after the secure income has been paid out. So, you ended up with an income class and a growth class, each appealing to different types of shareholders. And the beauty was that each class of shareholder would pay a premium for the characteristic they valued.
If the income stream from the properties was secure and growing, management had created a situation where 1 plus 1 turned out to equal 3 or more. The results of such alchemy is not easily resisted, so the next step was to issue these highly rated instruments to acquire more properties, thereby increasing both assets under management (AuM) and the welfare of… yes, you guessed it… management. The ability to issue shares at a significant premium, allowed these companies to temporarily inject a shot of steroids, juicing short-term earnings and create the illusion of aboveaverage growth, thereby extending the cycle by attracting even more capital at a premium.
Shareholders benefitted in the short term, but in the long term, the quality of the portfolio was being undermined by the acquisition of incrementally worse properties. Institutional shareholders, often a voice of reason when it comes to management overstepping, were also drinking the KoolAid. After all, “when the ducks quack you must feed them” goes the old saying in the various business development rooms of our great institutional investment houses.
But the best was still to come. Fortress B shares went up by a factor of 5 times from 2014 to 2017. It reached the point where the combined A and B units of Fortress capitalized the firm at almost two times its book value. Bearing in mind that property firms are required to do independent valuations of their properties on a regular basis, a market value of twice book value strikes one as being egregious, at a minimum. The fact that most of the “excess income” accruing to the B shareholders was capitalised interest, capitalised costs and the conversion of capital into income via controlled entities (“educational trusts”) meant that there was actually never much property-related income for the B’s in the first place.
As they say in the classics, never let the truth get in the way of a good story, so – at least for a few years – institutional investors thoughtlessly gorged themselves on the easy income and manufactured growth, wholly earning the derogatory description of “yield pig”.
But when the emperor has no clothes, it is a charade that can only carry on for so long. Eventually, as always happens in markets where management and shareholders overreach, the so-called secure income stream turned out to be less than secure, and the growth was nothing more than a set of make-believe gowns for the emperor.
Fast forward five years and Fortress management are in a tight position. The slow poison of poor acquisitions, a capital-hungry development pipeline and Covid-related behavioural change led to a shortfall of income. Income which needs to be paid to shareholders to retain the tax-efficient REIT status.
Exacerbating management’s poor property acquisitions, their hubris at the time lead to the drafting of a deficient memorandum of understanding MoI – the document that sets out the rights, duties and responsibilities of shareholders, directors and other persons involved in a company. The MoI never envisaged a circumstance in which the income generated by the business was too low to satisfy the different interests of the different shareholders. In an effort to resolve the impasse, an offer was made to unify the shareholding structure by swapping B shares for A shares, in a specific ratio.
At the time of the announcement of the mooted transaction, A shares traded at a (slight) premium to NAV since the “yield pigs” placed irrationally high confidence on the safety of the income stream. B shares, suffering from a lack of growth, traded at a large discount to NAV. As a result, both sets of shareholders voted against the scheme. Objectively, both sets of shareholders are using incorrect value judgements to form their preferences. A property is only worth the discounted value of its cashflows to the owners. It can’t be worth more than that if you have a subordinated claim on a portion of the income stream. And it can’t be worth less because you have a subordinated claim on the growth of that income stream. It is what it is – a property investment. No more and no less.
The final irony in this twisted tale of skewed incentives is that management is predominantly invested in B shares, which trade at a 70% discount to NAV. Their incentive thus lies in extracting the most overall value for the business, not maximising the value of the income stream – which is what the A shareholders insist upon. They don’t care about the income stream, they just care about getting the right value. The differing interests of the classes of shareholders thus lead directly to an inability to get a transaction done which can clean up the capital structure. In turn, this leads to a realistic possibility of Fortress being de-REIT’ed, losing its tax-advantaged status. So, the yield-pigs not only face a lower income, but they also face being taxed on that income. And the B shareholders just don’t care..
Management is now effectively holding the knife to the yield pig’s throat.
In investing, one should not only understand valuations but also understand incentives. And the sad story of the Fortress Yield Pigs holds many lessons in both regards. But the main takeaway from this sad story is, as always, Caveat Emptor.
It’s safe to say that Fortress epitomises the excesses of the past for SA’s listed property sector and those ghosts continue to haunt the management team. They certainly weren’t the only REIT trying to lower their cost of capital by inflating short-term earnings to get a better rating from the market. They are however one of the few management teams still grappling with the consequences of those excesses.
Across the sector, management teams have started to focus on long-term value creation and net asset value accretion, rather than short-term earnings enhancement. Balance sheets have been right-sized and debt and assets have been currency matched.
Capital is being recycled within most of the REITs, with a focus on improving the overall relevance of the portfolio given some of the dynamic changes impacting the sector right now.
From an investor’s perspective, several companies are trading at significant discounts to net asset value and yields at least comparable to longer-dated SA government bonds. This is presenting stock-pickers with an opportunity to construct a portfolio with a yield close to 12% and mediumterm income growth prospects of between 4% and 6% per annum, with the growth mainly driven by incrementally higher payout ratios and a recovery from the rental discounting offered during lockdowns.
Out of the ashes, a phoenix sometimes arises. In the property sector, that might just be happening.
