Indluplace Convinces Investors of the Rental Residential Opportunity

Published: Tuesday, April 19th, 2016 by Lenora

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Source: Indluplace Properties Ltd.

Indluplace Properties Ltd, the first residential REIT in South Africa, wants investors to know that investing in rental housing across income segments is appropriate and profitable. Indluplace CEO Carel de Wit emphasizes this in DevelopingSmartCities.org’s interview with Financial Director Terry Kaplan and de Wit. Apparently, it was initially tough to convince investors. The Indluplace team had to tackle fundamental misperceptions about the rental residential opportunity.

Although some of the team, including de Wit, has its roots at the Johannesburg Housing Company, the social housing pioneer, they view their goal as capitalist not social, profits not prophets. Indluplace was established by Arrowhead Properties Ltd, a REIT invested in commercial, retail and industrial properties, which remains a substantial shareholder in Indluplace. The institutionalization is good for increasing affordable housing and a beacon for responsible investment in well-located, transit accessible and professionally managed urban housing.

Listed residential property comprises less than 2% of SA’s listed property market, compared with more than 13% in developed economies, which shows the opportunity for growth. As this interview shows, there is room to build, adapt and deploy the REITs model for affordable rental housing.

DevelopingSmartCities.org: How was it explaining to investors your investment thesis about housing, rental housing in particular, as an attractive opportunity?

Indluplace: There have been formal rental residential markets for years but not in the public listed space. REITs are about three years old in South Africa. Prior to that there were property loan stock companies and property unit trusts. As a result, there is already information about the historical performance of these assets. The team also have many years of experience with rental residential housing. So there was some understanding in the market, but we also feel we have a big responsibility to make this first residential REIT work.

Raising capital was harder than we expected. It’s been a tremendous amount of work educating investors that rental housing can be a low risk asset class. Bankers and investors have been working with incorrect and uninformed assumptions and are generally surprised at the good fundamentals of the asset class. One of the major differences is that cash flows are essentially uncontracted compared with the long term leases that are more common in commercial real estate.

Our investment objective is novel for the market. As a result, it took a couple of years to structure the Indluplace vehicle. Being able to illustrate the size and viability of the opportunity right out of the gate was key to the success of the launch. The fund also needed to get to a certain scale in order to launch. That added another layer of complexity.

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Source: Indluplace Properties Ltd.

DSC: How were you able to manage that and Indluplace’s ongoing growth given South Africa’s challenging market circumstances in recent years? That in itself seems like a feat.

Indluplace: At the beginning when we were establishing our pipeline, we were able to acquire a sizable portfolio from a private investor who saw an opportunity to invest in the growing housing opportunity. That acquisition gave us the scale we needed to bring the opportunity to the market. Since then, we have grown to more than 116 properties with more than 5,400 residential units and a ZAR 2.4 billion market capitalization. We need to grow as quickly as possible. Being small and illiquid is a problem, so responsible growth has to be our priority at this stage.

DSC: Fortunately, it seems like there is a huge gap in housing, so does this help with sourcing deals and growth?

Indluplace: It does in the sense that rental housing in general has very low vacancies and low arrears because of high unmet demand. The biggest gaps are in the affordable segment. We do lean toward the affordable end, especially for inner city portfolios. However, we can’t solely focus on the affordable end of the market. The average rental of the units in our portfolio is ZAR 3,800/mo with a range of ZAR 1,000 to ZAR 7,500. That means household income is about ZAR 3,500 to ZAR 20,000. (See author’s note on incomes in South Africa below). We also have a small portfolio of student specific properties but although there is huge demand for this, it is not our focus.

DSC: Does the Johannesburg Housing Company experience play a role?

Indluplace: Several members of the team were involved with the Johannesburg Housing Company, but Indluplace was set up to earn above market returns for its investors not to achieve social housing goals. What we bring from that experience is that the assets have to be managed carefully and with financial discipline.

As the first residential REIT in South Africa, we feel a big responsibility to make this work. We have to illustrate our capabilities to our investors and to the marketplace.

DSC: What kinds of misperceptions do investors have that you must address?

Indluplace: First of all, most REITs focused on commercial or retail property are looking at long contracts of 5-10 years as the norm. Rental housing isn’t like that. It’s essentially uncontracted income. That is challenging to explain. While some tenants stay in buildings for many years it remains a short term contract.

The second issue is that tenancy laws in South Africa are favorable to tenants. It’s difficult to evict if necessary. We have to explain the eviction process to investors and highlight to them that evictions in this market is extremely rare.
Investors are generally surprised at the low vacancy and high payment levels achieved in the residential market. Just in terms of perception, people simply don’t think about what goes into a well-run residential building because when management works well, people take it for granted and don’t see the skill set.

DSC: What competitive advantages enables help Indluplace respond to these misperceptions?

Indluplace: Property management is crucial to our success. We have outsourced property management to four specialist managers, of which two manage most of the portfolio. This helps us manage rapid growth. We have good relationships with our property managers, who bring the right capacities to each property types. Good student housing managers know it’s a completely different world. They’re established managers.

We’re in the process of moving the property managers on to our back office systems. That means we will have operating data across all our properties regardless of the manager. This will make it easier for us to monitor performance and be more strategic investors.

Diversification is also a critical advantage. We are focused on building a diverse portfolio across income levels, nationally. We are investing across inner city and suburban, high rises, townhouses and blocks, and across income segments. We need a diversified portfolio to lower risk.

Finally, Indluplace makes quarterly income distributions. It’s an income fund so the fund needs to have stable rental income.

DSC: What are the big challenges?

Indluplace: We are buying income streams from stabilized, tenanted properties. We don’t take development risk. So, the supply of deals is an issue, but more importantly, this is a difficult market for financing at the moment. We are currently ungeared. We need to secure capital at the right cost to buy deals.

DSC: Is there enough stabilized residential stock out there?

Indluplace: There’s plenty of stock, as well as massive shortages in certain segments and cities. Student housing, for instance, makes excellent investment sense. We estimate that market is significantly undersupplied.

DSC: What’s the significance of the REIT structure for housing in South Africa?

Indluplace: To the extent that REITs can help developers exit from their projects, they help recycle capital so that developers can get on with what they do best, which is building new projects.

DSC: What about sustainability? Have Eskom’s issues affected your portfolio management?

Indluplace: The Eskom debacle has been a wake-up call for many of us. We have seen 9% energy inflation this year with inflation at 7%. Also over the last three years electricity price increases have been substantially higher than inflation. With energy shortages, we have been looking more at solar. We have a couple of properties that use solar, but we recognize we need to do more on sustainability.

One thing that we see as an advantage in moving in that direction is that we meter individual units as much as possible. This way, tenants can benefit from their own conservation efforts. We need to help people manage consumption as best they can. It’s more of a behavioral challenge, but we can do more to help. Given that this is also the worst drought in 50 years, we know we need to pay more attention to water efficiency. As we grow, we’ll be able to do more.

DSC: How does Indluplace think about urban regeneration and renewed interest in South Africa’s inner cities?

Indluplace: We follow the market and seek market-driven opportunities. We aren’t focused primarily on social purpose. That said, it only makes sense to invest resources on both buildings and the areas around them. We get involved in improvement districts. We definitely see some more suburban areas that are ripe for proper urban management and regeneration.

This is about investing for the long run. We are not speculative property buyers. We buy to own. People want to enjoy the whole area where they live. It’s just good business sense.

Author’s note: Average gross monthly income in South Africa is approximately ZAR 17,700, according to the Center for Affordable Housing Finance in Africa’s 2015 Yearbook.