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The sad story of Fortress REIT and the Yield Pigs

Read time: 3 Mins

“There is always a tension in the financial markets between greed and fear. During the 1980s investor greed frequently got the better of fear, with the result that yield-seeking investors, known among Wall Streeters as “yield pigs,” were susceptible to any investment product that promised a high current rate of return, the associated risk notwithstanding. Naturally, Wall Street responded by introducing a variety of new instruments- junk bonds, option-income mutual funds, international money market funds, preferred equity return certificates (PERCS)–anything that promised high current yields to investors.”

– Seth Klarman

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. 

"Bulls make money, bears make money, pigs get slaughtered"

Comfortably accommodating two-way liquidity shocks

Unlike retail bank deposits, collective investment scheme (CIS) funds do not benefit from an explicit government guarantee. It is therefore incumbent on portfolio managers to ensure that the liquidity of underlying investment holdings is appropriately matched to that of the CIS. In practice, however, it can be tempting for portfolio managers to sacrifice investment liquidity in pursuit of a higher return.

In the fixed income universe, ostensibly wide yield-spreads sometimes entice investment in sub-investment grade or speculative credit instruments. But the South African credit markets are not very actively traded (compared to government bonds or equities) and often lack comparable secondary-market transparency. Thus, when general market volatility is high and returns are down, ‘high-yield’ credit instruments can become notoriously difficult to liquidate at carrying value. The portfolio manager may lose the ability to comfortably provide liquidity in the event of large fund redemptions and may even have to sell the illiquid investments at a significant loss. Similarly, when sizable inflows are received, the manager may find it difficult to deploy the surplus cash profitably and in proportion to existing holdings, as secondary market opportunities sometimes need to be induced by offering inflated prices.

For these reasons, Counterpoint’s Enhanced Income Fund is managed with an explicit focus on liquidity and is predominantly invested in government and bank-issued notes as a by-product (where liquidity is relatively ample). Investment in high-yield, junior, or speculative corporate paper is naturally limited, as these instruments often cannot be comfortably liquidated in periods of market turmoil.

Being intolerant of existential or default risks

Liquidity concerns are not the only factor preventing Counterpoint’s wholesale investment in speculative credit. Successful fixed income investing requires a fundamentally different mindset to equities. Most debt investment opportunities offer a contractual yield to maturity, which is invariable to any improvement in the value of the underlying borrower’s assets.

By contrast, equity returns enjoy theoretically unlimited upside potential (while downside is capped at 100%). This positively skewed distribution of returns means that, in stocks, it pays handsomely to take diversified risks and embrace uncertainty over the long-term. The value of a call option, after all, increases as expected volatility rises. By contrast, the capped upside potential of fixed income investment returns can be easily outweighed by the emergence of any meaningful default risks, where they do occur from time to time. Debt investors therefore need to be extremely vigilant of credit risk and properly consider the impact of extreme events (both upside and downside) on the expected return profile of the instrument.

Junior corporate credit instruments often provide a spread (in the order of 300 to 500 basis points) over the yield on senior debt. However, in extremely positive scenarios, it is the equity investors who are entitled to most of the investment spoils. In a similar vein, junior creditors do not benefit from the same protection as senior and secured debt investors in extremely negative scenarios. Junior credit is clearly neither robust (like senior debt) nor anti-fragile (like equities), and we believe that human biases limit the ability of investors to properly calibrate the likelihood of these kinds of extreme shocks. As a result, speculative credit spreads are often quite severely mispriced relative to the other levels of the capital structure.

Within Counterpoint’s Enhanced Income Fund, we are taking several measures to minimise the existence of meaningful default risk in the portfolio. We are passively reducing the Fund’s exposure to state-owned enterprises (by re-investing maturing debt elsewhere in the market) and actively lowering the Fund’s exposure to certain categories of commercial property, in an orderly fashion.

Diversifying the risk of being wrong

The fluctuation of global interest rates is commonly the most important determinant of short-term fixed income returns. However, consistently forecasting macro-market outcomes (like future interest rates) with any useful accuracy is impossible due to the complexity of the global economic and market system. Counterpoint’s fixed income team therefore always considers several scenarios in conducting our top-down interest rate analysis, with due regard for a wide range of possible outcomes. Acknowledging what we cannot know constrains how concentrated our strategic positioning can be, as significant probability weights are always applied to very different potential outcomes.

Nevertheless, where our analysis suggests that excess returns are available at specific points along the yield curve (on a probability-weighted basis), we will incorporate bias in the Enhanced Income Fund’s positioning. This active positioning will, however, be tempered by some investment in instruments which outperform in different macroeconomic situations, limiting the extent of possible capital downside which the Fund is exposed to in any scenario.

Picking our poison

In an efficient market, there cannot be excess returns without risk, and our aversion to liquidity and credit risks clearly does not preclude the Fund from taking measured exposures to other types of risk. Active yield curve positioning has resulted in a significant investment in very long-dated South African government bonds, which has introduced some capital volatility (duration risk) to the portfolio. As interest rate gyrations reverberate through the global system, the Fund has, as a result, experienced some capital fluctuations in the year to date. However, in the absence of default, there are no permanent unexpected capital losses in fixed income.

We believe that in the fullness of time, South African government bond yields, which are exceptionally high by global standards, will likely decline, The resultant capital gains would benefit our position greatly. So, rather than taking unseen liquidity risks in lightly traded and speculative credit, we take comfort in the view that the Counterpoint SCI Enhanced Income Fund’s disclosed NAV is always a fair reflection of its realisable liquidation value.

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Merchant West Investments
6th Floor, The Terraces, 25 Protea Road
Claremont, Cape Town, 7708
+27 21 492 0200 |  invest@merchantwest.co.za

Merchant West Investments  FSP 44508

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