Spotlight on property funds' tactics

As it stands, a number of listed property funds are using non-traditional sources of revenue to increase the income they distribute to shareholders, while the rental return growth may be less than spectacular.

The financial engineering methods include breaking interest rate contracts, and accounting for commission and consulting fees as distributable income. The breaking of interest-rate contracts is used to lower the cost of debt.

Property groups are able to break their fixed interest rate contracts at relatively low cost. They may contract with a bank to pay at 8% interest for example. But then if they find they can get 7% later in the year, they can break the first contract at a relatively low cost.

They then run the financial gain on the difference in the rates through their income statement and increase distributable income, says Norbert Sasse, CEO of Growthpoint Properties, the largest South African-based listed property fund with a market capitalisation of close to R70bn.

He says that while strong distribution growth inflated by financial engineering is beneficial to shareholders, it is not sustainable in the long run if it is not based on the income property owners generate from their tenants.

Sasse also says that property funds may run commission or consulting income through their income statements, boosting their distribution income.

Most of the listed property real estate investment trusts reporting interim or final results for the period to end December recorded average distribution growth of 9% with a number of counters achieving double-digit growth for the first time in their history.

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Distribution growth is a key performance indicator for real estate investment trust (Reit) investors as each South African Reit must pay at least 75% of its taxable earnings available for distribution to its investors each year. Growthpoint's distributions grew 7.5% in the six months to December, short of the sector average.

But Sasse says most of Growthpoint's distribution growth came from rental returns from the tenants at their properties. Given Growthpoint's size, it is difficult to obtain double digit rental growth. "I think people must just be aware of where returns are coming from.

"There is nothing illegal about using nontraditional income sources such as fees for consulting but we must not get carried away with the distribution returns we are seeing."

Reits in other countries have come under strain as they focused on tools to restructure debt instead of managing their underlying property portfolios. This was evident in Australia during the 2008-10 crisis where Reits there lost about 80% of their value, according to Sasse. Many of them were overgeared. Debt engineering was a tool used by many of them to boost income distributions.

SA's market is quite conservative when it comes to gearing but nevertheless some funds are using tools to boost their returns and Growthpoint had done this in the past.

"When we restructured and listed Growthpoint more than a decade ago the company had used various methods to boost income but we shifted the focus more to rental income generation," Sasse says.

But analysts are becoming aware of financial engineering in the sector.

An analyst who declined to be named says: "I believe there is some validity to Sasse's comments. There have been a few firms breaking swaps to boost distribution growth and aid their rating. The days of lowering debt costs are coming to an end though - in terms of sustainability of growth one would have to assess each counter on its merits."

Old Mutual Investment portfolio manager Evan Robins says: "In my view some companies have done financial engineering but the significance of this is modest in the big picture. Some of this financial engineering destroys value."

Ma'alot Investments portfolio manager Maurice Shapiro, says higher interest in the sector has meant that more investors who did not focus on the sector, need to be aware of how it generates its returns.

"Essentially there are four parts of a listed property business. These are property management, property asset management, debt management, which is where the financial engineering tends to come in, and raising capital."

Some firms have done financial engineering but the significance of this is modest in the big picture.