/ 22 January 2024

Hedging your debts: Smoothing out the impact of high interest rates on the listed property sector

Evan Robins038
Evan Robins, Listed Property Portfolio Manager, Old Mutual Investment Group.

Risk is not something to be shunned, but rather to be respected and, where possible, softened

With speculation escalating around the rolling over of the global and local interest rate cycle, the listed property sector is keeping a closer eye on this horizon than most. It is widely acknowledged that a high interest rates environment is bad for property companies, as it reduces both the capital value of the buildings, as well as the free cash flows the company generates as the interest bill increases. 

Relief ahead from the interest rate cycle?

With the higher interest rate cycle continuing to hit home over the coming months, despite easing towards the end of last year, growth in the US and Europe is ultimately likely to slow, which will feed through to weaker demand and less pressure on prices. This should pave the way for a more dovish shift among central bankers in 2024. 

This means we are at the peak of the current global interest rate cycle, and once growth and inflation slows more decisively, it is not unreasonable to expect lower global rates towards the mid-point of this year. 

For South Africa, weak growth and some inflationary pressures abating should set the groundwork for easier policy. A peak and decline in global rates in 2024 would add impetus for the Monetary Policy Committee to implement modest rate cuts, provided inflation remains well anchored within the target range. Speculation is currently intensifying around the timing of these cuts.

Navigating the uncertainty

Nobody can predict with certainty future interest rates as the environment is a moving target. There is little management can do about the impact of sudden unexpected increases in interest rates on valuations. There are, however, ways of slowing the impact of interest rate volatility on interest costs and thus earnings. 

One way to do so is for property companies to fix their interest rates for a set period, either directly with banks or by using interest rate derivatives like swaps and caps which effectively do the same thing. This is often termed hedging the debt. The norm among South African Real Estate Investment Trusts (REIT) is to hedge the interest rates on at least 70% of their debt — typically over a staggered period of some years.  Consequently, when interest rates begin to rise, the cost of only 30% of debt would be immediately impacted. The remaining 70% would gradually ratchet up as these fixes and swaps expire.

When interest rates are perceived to be close to their expected peak, there is an incentive to reduce hedging to immediately get the benefit of any rate cuts that occur and to avoid “locking in” high current rates. A significant number of REIT management teams have recently flagged that, considering this is the current outlook, they are reviewing their interest rates hedging policy or are delaying re-hedging debt on hedges that have expired.  

To hedge or not to hedge

As beguiling as it sounds to hedge less debt at prevailing levels, if you expect rates to have peaked, doing so on this basis would be a mistake. Listed property management, under increasing pressure to stabilise earnings, should continue to place risk management at the forefront of these approaches.

REITs have no forecasting edge in the interest rate market and no management team has (thankfully) ever claimed this ability. The interest rate market is already priced for forward rate expectations (albeit with a reputation for overexuberance in overshooting the direction of change). These can turn out to be right or wrong, but nonetheless reflect market expectations. 

Boards put a hedge policy in place as a risk management tool, not a lever to pull in the hope of boosting distributions.  The integrity of a risk management tool requires that it is not treated as merely an expediency.

It is key to note that institutional investors can structure their own interest rate and currency positioning. We invest in property companies to get access to the property assets and the companies’ specific skills and expertise to add value to these now and into the future. We don’t want a property-cum-interest-rates-cum-foreign-currency-cum-stock-picking “quasi-hedge fund”.  If we wished to try and make money trading interest rates, we would invest in a team with this focused expertise.  

Investment risk is inherent

As a risk management tool, hedging is not only about delaying the full impact of higher interest rates. The higher rates eventually catch up, unless rates happen to fortuitously fall in the interim. Rather, an additional benefit of hedges is that, by delaying the full impact, they provide time and therefore optionality to take remedial action when this is necessitated by the new rate regime. This may entail simply allowing revenue to catch up with the higher interest costs (escalating rentals, inflation etcetera) or direct interventions like cutting the dividend or capex, raising capital, disposals, negotiating with banks or corporate action. 

Before recommending to the board the scaling back of the hedging policy, it would be prudent to first engage in a “what could go wrong” analysis — a “pre-mortem” of sorts. What would be the impact if, for a totally unpredictable reason, interest rates go sharply up instead. Would the interest cover ratio still be within bank covenant levels? How would the fund navigate a subsequently devalued portfolio, higher gearing levels and elevated interest costs with little time or free cash in which to adjust? Value could be destroyed when REIT is forced to act in haste and, as a result, has to engage in “bad deals”. The potential value destruction could vastly outweigh the benefit of lower interest rates over a period.

There is an asymmetric downside to all of this. If rates fall as expected, the company will be better off for the period they would have hedged for. However, if rates rise sufficiently, the damage could be permanent capital loss. 

As in life, risk is inherent in investment. It is not something to be shunned, but rather to be respected and, where possible, softened. Companies and investors should be wary of deliberate exposure to risk where they have no edge and there is asymmetric downside. Ultimately, quality businesses that do not increase risk for a short-term non-operational income boost are preferred and should form the focus of the listed property strategy.

Evan Robins, Portfolio Manager, Old Mutual Investment Group