Meyrick Barker – Investment Analyst
Fortress Real Estate Investment Trust (REIT) originally listed on the JSE Securities Exchange in October 2009, with a market capitalisation of R1.8 billion and a primary focus on South African retail assets. We discuss how the property portfolio has been reconfigured over the years and why we believe that it is well positioned today to deliver shareholder value.
The portfolio has been refocused
As the Fortress board and management team have changed, so too has the strategic focus of the property portfolio. Supported by multiple capital raises, the asset base has increased 15-fold since listing.
The period leading up to 2016 was characterised by much investor optimism and some questionable earnings recognition policies within the South African property sector. The previous Fortress management team actively traded in various listed property stocks and made use of complex financial transactions to temporarily and unsustainably inflate earnings and thus, “income” distributions. This eventually resulted in the failure of numerous company BEE deals and destroyed value.
Since then, the primary focus has also shifted from directly owning rural and CBD retail properties, to owning large-scale, modern logistics warehouses. Directly held South African retail assets and an indirect stake in Central and Eastern European shopping centres are a secondary focus – with the day-to-day management of the properties being outsourced to external property managers. The chart below demonstrates how the portfolio composition has changed over time.
Capitalising on the shift to centralised distribution and e-commerce
Over the last decade, retailers have transitioned their supply chains from direct-to-store delivery by their suppliers to their own distribution of products from large, centralised, modern warehouses. These technologically advanced warehouses reduce the need for expensive inventory storage space at the shopping centre, provide efficiencies of scale, improve stock availability and ultimately enable lower prices if these savings are shared with consumers. The ongoing shift towards e-commerce is adding to the need for efficient, low-cost, centralised distribution networks.
To benefit from the evolving retail landscape and ongoing centralisation of supply chains, Fortress began purchasing land tracts in 2016. In the same year, Capital Property Fund was acquired, significantly shifting their property exposure by end use – diluting retail assets and increasing industrial property holdings.
The acquisition of strategically located land parcels in Gauteng, Durban and Cape Town favourably positioned Fortress to develop logistics warehouses. Subsequently, the company has grown into the largest owner and developer of premium-grade logistics real estate in South Africa. They recently signed on a 36-hectare modern distribution facility for Pick n Pay – their largest warehouse development to date (see below rendering). This will be developed at their Eastport Logistics Park in Gauteng and will be the fifth largest distribution centre in the world. Due for completion in 2023, it will encompass 165 000 m² under roof and span 27 rugby fields in length.
At present, about R3 billion worth of Fortress-owned land is effectively a drag on earnings, absorbing debt funding costs and generating no cash flow until it is developed. The continued rollout of their development pipeline is therefore accretive to earnings and, once the existing land is fully developed, approximately two thirds of directly held property will be in logistics. The balance will comprise convenience and commuter retail centres. Management continues to sell down their smaller office and old industrial property portfolio, recycling this capital into the development of logistics warehouses.
Laying the groundwork in Eastern Europe
The Central and Eastern European (CEE) region remains a low-cost manufacturing and servicing hub for Western Europe. Ongoing development of the CEE region’s infrastructure, funded by European Union contributions, is enhancing its integration with wealthier neighbours. Growth in this region is bolstered by nearshoring1 from China into the EU. This strong growth background, together with the evolving retail use of centralised distribution, is generating strong warehouse demand.
By applying their South African expertise, Fortress have established a local team to acquire and develop logistics warehouses in the CEE region, having made their first acquisitions in Poland and Romania last year. While still in the early stages, this organic approach appears to be a sensible allocation of capital, especially in contrast with other South African property companies that are acquiring pre-existing properties at reasonably full prices.
1The transferring of business operations closer to the customer market that they serve, with the aim of improving service levels.
NEPI ROCKCASTLE: dominant CEE mall owner
NEPI Rockcastle (NEPI) is Fortress’ sole remaining listed equity investment, having originally acquired a stake in New Europe Property Investment (which subsequently merged with Rockcastle Global Real Estate).
NEPI comprises approximately a third of Fortress’ total property assets, with a €5.8 billion portfolio of high-quality, dominant shopping centres and convenient retail parks across nine countries in the CEE region, concentrated in Romania, Poland and Hungary. In addition, it has the potential to develop a further €1.2 billion of property assets, which should ultimately translate into higher earnings for Fortress.
COVID-19 and the ensuing lockdowns have temporarily suppressed NEPI’s earnings, however, both the property portfolio and balance sheet are resilient. Growing employment levels and strong economic growth resulted in buoyant demand for CEE retail space in the period leading up to the pandemic. New global consumer brands entering the CEE region support positive rental growth and high occupancy levels. Disposable income in the region is likely to grow more strongly than in both Western Europe and South Africa over the coming years, which should translate into robust retail spending growth.
While increasing e-commerce penetration will no doubt slow retail landlords’ ability to grow rentals, the shopping centre installed base is comparatively low and NEPI is taking actions to mitigate this by positioning their malls to accommodate an evolving interactive omnichannel-based shopping experience and sustain a loyal shopping base.
Trading levels maintained at South African retail centres
Fortunately, Fortress do not own any of the large super-regional shopping centres that have been particularly hard hit by the COVID-induced change in shopping behaviour towards more local shopping venues. Instead, they own smaller centres situated mainly in rural, township and CBD areas – close to transport nodes with high volumes of pedestrian traffic. While these commuter-orientated centres undoubtedly came under pressure, trading levels have bounced back quickly and are already generating higher sales than pre-pandemic.
Their catchment areas benefit from increased government social support initiatives, which offset some of the pressure from South Africa’s low-growth economy. Given the target market of Fortress’ centres and their predominantly non-metropolitan location, e-commerce is unlikely to materially disrupt sales.
Value beyond uncertainty
Fortress has A- and B-shares, offering investors two very different risk and reward propositions. A-shares receive a preferred dividend that grows at the lower of inflation or 5% per annum. Any remaining distributable income accrues to B shareholders. The two share classes’ claims on the assets of the company on dissolution also differ. If a minimum earnings level is not met, all earnings are retained by Fortress, unless their shareholders grant a special concession to do otherwise.
Over the last two years, Fortress have taken actions that enable the business to better navigate a weak economic environment and more closely align their dividend payouts to the cash they earn. Compounded by the pressures of COVID-19, this has reduced their distributable income and introduced uncertainty as to whether their minimum earnings thresholds (for payouts to A-shares) will be met.
Corporate tax becomes payable if a REIT retains any earnings. If more than 25% of its earnings are retained in a year, the tax concessions granted to a REIT can temporarily be removed. Retained earnings can, however, be put to many long-term value-enhancing uses, including accelerating the roll-out of new logistics warehouses or repurchasing shares when appropriate. Given that a large portion of Fortress’s earnings is generated by way of dividend income from NEPI, their effective tax rate would be lower than that of the average corporate if they lose their REIT status.
By adopting a long-term outlook, being cognisant of the property development pipeline in both NEPI and Fortress and aware of the value-enhancing capital allocation decisions management can take with retained capital – we believe Fortress (particularly the B-shares) make for an undervalued investment proposition.