MARKET OVERVIEW

After a relatively shaky start to the quarter, the SA Listed Property Sector (“SAPY”) delivered a positive total return of +0.91% in 2Q17, underperforming Cash (+1.8%) and Bonds (+1.5%) but ahead of Equities (-0.4%). The cabinet reshuffle and subsequent credit ratings downgrades by S&P and Fitch early in the quarter saw the SA 10-year bond yield spike from a low of 8.34% in March to a high of 9.03% in early April. However, the market seemed to have shaken off much of the bad news as the months progressed with bond yields ending the quarter stronger at 8.85%. Some of the positive momentum was broken in the latter part of June as Mineral Resources Minister Mosebenzi Zwane released the new mining charter, which was extremely poorly received by investors and then yet another ‘own goal’ in the form of Public Protector Mkhwebane’s conclusion that Parliament amends the Constitution to change the SARB’s primary mandate from price stability and sustainable growth to focus more on social transformation. Perhaps all of this gives some credence to President Zuma’s comments that his actions are not driving the markets… it does seem that the FED and the European Central Bank are having a greater impact of late. Nevertheless, all asset classes delivered positive returns for the first half of 2017 - we summarise the returns below:

Table 1: Asset class total returns to 30 June 2017 SAPY Bonds Equities Cash 2Q17 0.91% 1.49% -0.39% 1.81% 1H17 2.29% 4.02% 3.37% 3.72% 1 year 2.82% 7.93% 1.69% 7.63% Source: Bloomberg

Income returns continued to hold up the SAPY’s total return with the sector recording a negative capital return of -0.80% in 1H17 and an income yield of +3.09% resulting in a total return of +2.29%. Bonds were the star performer in 1H17, in spite of the ratings downgrades and ‘own goals’ on the political front, as the market benefitted from net foreign inflows into emerging market debt. Over the last 18 months, the SAPY has shown a consistent de-rating relative to bonds, the result of a surprisingly resilient bond market and weaker share prices in anticipation of 1) slowing fundamentals for SA-Inc focused counters and 2) lower ZAR share prices for dual listed counters as the currency strengthened.

In Chart 1 below, we illustrate the relative rating of the SAPY vs. Bonds. We also show our in-house COMPOSITE where we adjust the SAPY for any ‘noise’ created by the inclusion of lower yielding offshore counters, non- yielding developers as well as distortions from index inclusions/exclusions. On this basis, we remain of the view that SA-Inc counters are fairly valued relative to bonds with much of the bad news already priced in.

Chart 1: SAPY dividend yield vs. SA 10-year bond yield

1.2

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1 0.96 0.9 0.88 0.8

0.7 0.71

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0.5 Jul-07 Apr-08 Jan-09 Oct-09 Jul-10 Apr-11 Jan-12 Oct-12 Jul-13 Apr-14 Jan-15 Oct-15 Jul-16 Apr-17 COMPOSITE vs. SA 10-year bond yield SAPY vs. SA 10-year bond yield Source: I-Net BFA

RETAIL IN FOCUS

We continue to see more caution from management teams with SA exposure. Concern around retail – something we wrote about a few months back – seems to be more prominent as store closures in many shopping centres start to ramp up. Edcon poses the biggest risk to the sector as it rationalizes its footprint and closes underperforming stores – a much needed remedy for the ailing retailer. Some of the brands that will be closed include River Island, Tom Tailor, Geox, Jack Jones and Lucky Brand. Stuttafords has entered business rescue and will cease operations by 1 August 2017. Hyprop will replace Stuttafords at with H&M, and are currently in negotiations with two larger national retailers for the space at Rosebank Mall and Clearwater Mall. While Liberty 2 Degrees had previously stated that it too had large national tenants lined up (H&M at Eastgate & Dischem at City) although we find it hard to see all the space being taken up. More and more there is a view that centres above 110,000m2 may be too big for the South African market with the optimal size being around 80,000m2. With that said, many centres above this threshold, such as Canal Walk, continue to trade well with very low vacancies. In June 2017, SAPOA released its Retail Trends Report for 1Q17, we summarise some of the key findings from the report below:  Trading density growth slowed to 2.7% year-on-year (down from 5.5% in previous quarter).  Super regional malls lagged other categories, with -4.6% year-on-year trading density growth. (-1.1% in previous quarter).  Community shopping centres continue to outperform the larger centres.  The department store category continues to lose market share (with apparel and health & beauty gaining market share across all retail formats).  Retail vacancies are above the long term average (although still low vs Office and Industrial).

RECENT RESULTS June was a relatively quiet month on the result front with only two companies reporting. We provide a brief summary of the results below.

DISTRIBUTION COMMENT COMPANY GROWTH (CENTS)

2017 distribution growth was strong considering tough trading conditions. Like-for-like NPI was 7.8% higher, driven by a slight compression of core vacancies from 7.1% to 6.9%, in-force escalations of 7.8% and slightly positive rental uptick on renewals. Considering the decent operating metrics coupled with the R6 million capital payment and the benefit from the accretive offshore acquisition we must question why the growth wasn’t better. The 2016 base was inflated, in our view primarily from over-stated anti-cadent interest income; with this the once-off income mentioned above were used to ‘fill the gap’. Unfortunately, this still results in an inflated base, and while 2017 provided once-off tailwinds, 2018 and 2019 have several earnings headwinds instore. Amongst these are the impact from dilutionary acquisitions, refinancing low interest swaps, modest escalations on offshore assets and a once-off R20 million lease cancellation fee to accommodate a drawcard tenant for Fourways Mall, KidZania. Accelerate acquired R2.8 billion of assets through the year at an average yield of 7.3%. Accelerate 57.6 7.3% The yield was diluted through the R450 million (at 6.5%) spent on the CitiBank office in Sandton and the Murray & Roberts office in . These two assets are positioned to deliver value through further development, but will create earnings uncertainty. The biggest transaction of the period was the OBI Portfolio (being their offshore venture into Europe). Despite the relatively modest yield of 7% on the R1.2 billion spent, the lower Euro denominated debt funding allows for significant earnings accretion on acquisition. A combination of the scale of acquisitions coupled with a weak share price has resulted in the LTV pushing higher to 41.9% of which 77.9% is fixed for 2.4 years. With the cost of equity weakening further (due to the market disappointment with earnings forecasts) and capital requirements still material (most notably for the equalisation payment for Fourways Mall), we expect the gearing levels to rise further. Management have guided flat distribution growth for the next two years as a result of what we have stated above as well as softer operating metrics expected as the economic activity remains under pressure.

The first full financial year saw the company beat distribution expectations by 3.5%. Operationally the company has hit their key markers. Occupancies are up for the like- for-like portfolio at 85% (which is a level indicative of a stabilised asset, but still leaves room for improvement); similarly, the comparative rental levels are up 9.4%. We expected the fund to drive earnings through acquisitive opportunities, which they have done. The fund has 18 pipeline assets totalling R1.3 billion through their managed portfolio, which now have 12 properties operational and in the lease up phase. In addition, the recent period saw six properties and one development opportunity acquired 10.0% through the acquisition of the Storage RSA portfolio for R475 million. Post year end Stor- (ahead age made two further acquisitions; A single property from Unit Self Storage and six of Stor-age 88.05 properties in KZN from StorTown. While these acquisitions are not necessarily accretive annualise at the outset, they offer potential through synergies and further active management. d 2016 This takes the total number of properties to 37 versus 24 at the end of the previous result) financial year. The balance sheet ended the period in good shape, with the LTV at 11.9% of which 79% is fixed for just over two years. The R400 million equity raise in February helped keep debt levels low, however the StorTown transaction post year end will see gearing levels normalise towards the 25 – 35% band. Management have guided distribution growth towards a 9 – 10% range for the year ahead. If achieved, this would be testament to the defensive quality and diversification of storage as a sub-sector of listed property.

LOOKING FORWARD We were somewhat surprised by the resilience in the currency and bond markets although much of this can be explained by general emerging market strength. Either way, we had anticipated a much greater fallout as the respective ratings agencies downgraded SA’s foreign currency rating effectively moving us into junk status. Sovereign spreads did not adjust materially as it appears much of the bad news had already been priced in.

With SA fundamentals starting to show signs of weakness, we still see opportunities for active stock selection in both the SA and offshore counters. On balance, we believe much of the bad news around slowing SA fundamentals has been priced in, as the sector has had a steady de-rating relative to bonds over the past 18 months. However, as we’ve seen with Accelerate, the market has a low tolerance for negative surprises. We continue to expect distributions to carry the sector through the short term as capital growth stumbles along. The key short-term risks lie in global bond yields driven by the trajectory of US growth and inflation as well as the ability for to hold the credit rating of its local bond issuances above sub-investment grade. Medium term valuation prospects continue to hold, albeit in a rational political climate, and should still deliver low double-digit returns.

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