Announcements Corporate Rating Alerts

GCR places Octodec Investments Limited’s Issuer rating of A-(ZA) on Negative Outlook due to elevated industry risk

Rating Action

Johannesburg, 03 July 2020 – GCR Ratings (“GCR”) has placed the long and short term national scale Issuer ratings assigned to Octodec Investments Limited of A-(ZA) and A2(ZA) respectively on Negative Outlook.

Rated Entity / Issue Rating class Rating scale Rating Outlook / Watch
Octodec Investments Limited Long Term Issuer National A-(ZA) Negative Outlook
Short Term Issuer National A2(ZA)

Rating Rationale

Octodec Investments Limited (“Octodec” or “the REIT”) continues to depict asset and property management rigour that have historically supported reasonable earnings resilience. That said, the Negative Outlook reflects the REIT and the industry’s susceptibility to elevated covenant and funding risk, lately exacerbated by COVID-19 related disruptions.

The property sector is viewed to be vulnerable to short-term pressure on gearing metrics and reduced headroom on debt covenants until profitability normalises. With respect to Octodec, this mainly applies to interest cover, which at 1H FY20 registered at 2.2x (corporate covenant: 2.0x), ahead of the COVID-19-driven earnings reduction that GCR expects in 2H FY20. That said, we have positively noted the REIT’s initiatives to manage this risk, and GCR expects proactive covenant management to be sustained over the outlook period, including securing waivers in advance where necessary.

Net debt to EBITDA, which has historically trended between 5.0x and 5.5x, is also expected to deteriorate in FY20, although we anticipate this pressure to be relatively short-lived. The REIT’s net LTV registered at 39% at 1H FY20, while management remains committed to stabilise the ratio at/below 40%, and continues to implement initiatives to ensure stability of the metric over the outlook period. Octodec’s annual asset write-downs have remained low, trending below 2.5% of the total property portfolio, although, as with other funds, there is risk for sharper downward market repricing over the outlook period due to the recessionary climate.

While funding shows relative concentration, we have considered the positive efforts to diversify, including the recent addition of Absa to the REIT’s funding counterparties. GCR has noted the slowdown in the disposal of non-core properties to reduce debt due to market uncertainty. As with most domestic REIT’s, Octodec’s intention to withhold distributions as an alternative source of liquidity bodes positively. We have noted that several funds have taken similar precautions, and that there is ongoing industry engagement with National Treasury and the JSE, with a view to securing concessions on taxation and REIT status requirements related to withholding distributions.

Retention of distributions and other cash preservation measures, including reducing capex to essential requirements, and the increase in secured, undrawn facilities to R600m is positively noted, and is supportive of comfortable liquidity coverage for the next 12 months. The relatively low refinancing risk over the outlook period also serves to support reasonable liquidity headroom, with the weighted average maturity profile expected to remain above 2.5 years. In this regard, GCR estimates a liquidity ratio of at least 1.5x, thereafter easing towards 1.0x-1.3x due to debt maturities falling between June 2021-2022. Although the high asset encumbrance continues to constrain the liquidity assessment somewhat, Octodec’s conservative treasury management is a strong underpin to the ratings.

Octodec’s portfolio quality assessment is constrained by high concentration to properties in the inner cities of Pretoria and Johannesburg, although this is counterbalanced by a very granular asset and tenant profile. We also note that despite the largely short-dated weighted average expiry profile, high core vacancies (1H FY20: 11.7%) and exposure to SMMEs, Octodec continues to achieve sound tenant retention and asset performance, with the relatively short lease profile helping to effectively manage bad debts and leasing. This is underpinned by strong processes and systems, which until recently, contained arrears at/below 3.5% of rental income. Due to tenant relief support measures, especially on commercial property, we expect a spike in arrears in the short term, albeit with a comparatively quick pick up as the year progresses.

The constrained operating environment, as well as rising utility costs and property rates, continue to place pressure on the industry’s cost base. Octodec’s cost ratios have shown some compression due to pressure on rental rates, although the variability has been better managed than similar-scale peers. Overall, we expect constrained industry dynamics to persist until the broader South African economy reverts to reasonable growth levels. As such, and looking beyond the market-wide underperformance expected in FY20, Octodec’s rental rates remain susceptible to negative reversions, with strong growth only likely to be achieved from development opportunities Octodec will undertake once hurdle yield rates become attractive. As such, we expect the REIT’s operating margin to trend within the 45%-50% range over the outlook period.

GCR has sustained a positive peer adjustment to reflect the impact of the REIT’s strong internal protocols on its earnings. That said, protracted earnings underperformance or unremedied covenant risk could see us remove this adjustment.

Outlook Statement

The Negative Outlook reflects GCR’s view that earnings and funding pressure will persist in the industry beyond the COVID-19 disruptions due to constrained demand, while debt reduction initiatives will take longer to materialise. We also view covenant risk to be rising, although we expect South African banks to remain supportive of REITs with stronger long-term fundamentals.

Rating Triggers

Negative rating action could result from 1) earnings pressure that persists beyond the COVID-19 crisis 2) a sustained deterioration in leverage metrics 3) a deterioration in the debt maturity profile and 4) unremedied covenant pressure arising from a decline in valuations and/or earnings underperformance.

Upward rating progression is not expected over the rating horizon, although a strong market turnaround in the medium term that supports sustained growth and more conservative leverage, especially interest coverage above 3.0x and LTV below 35% would bode positively.

Analytical Contacts

Primary analyst Patricia Zvarayi Deputy Sector Head: Corporate Ratings
Johannesburg, ZA Patricia@GCRratings.com +27 11 784 1771
Committee chair Matthew Pirnie Group Head of Ratings
Johannesburg, ZA MatthewP@GCRratings.com +27 11 784 1771

Related Criteria and Research

Criteria for the GCR Ratings Framework, May 2019
GCR Rating Scales, Symbols and Definitions, May 2019
Criteria for Rating Real Estate Investment Trusts and Other Commercial Property Companies, May 2019
GCR Country Risk Scores, May 2020
GCR Corporate Sector Risk Scores, July 2020

Ratings History

Octodec Investments Limited

Rating class Review Rating scale Rating class Outlook Date
Long Term Issuer Initial National A-(ZA) Stable Outlook November 2014
Short Term Issuer Initial National A1-(ZA)
Long Term Issuer Last National A-(ZA) Stable Outlook September 2019
Short term Issuer Last National A2(ZA)

Risk Score Summary

Rating Factors and Sub-factors Risk scores
Operating environment 13.00
Country risk score 7.00
Sector risk score 6.00
Business profile (1.00)
Portfolio quality (1.00)
Management and governance 0.00
Financial profile (1.50)
Leverage and capital structure (1.00)
Liquidity (0.50)
Comparative profile 1.00
Group support 1.00
Peer analysis 0.00
Total Risk Score 11.50

Glossary

Cash Flow The inflow and outflow of cash and cash equivalents. Such flows arise from operating, investing and financing activities.
Concentrations A high degree of positive correlation between factors or excessive exposure to a single factor that share similar demographics or financial instrument or specific sector or specific industry or specific markets.
Debt An obligation to repay a sum of money. More specifically, it is funds passed from a creditor to a debtor in exchange for interest and a commitment to repay the principal in full on a specified date or over a specified period.
Debt Service Ratio A measure of a company’s ability to service its interest and principal redemption costs, expressed as the ratio of earnings or cash flows over a period to the sum of interest and principal payments over the same timeframe.
Diversification Spreading risk by constructing a portfolio that contains different exposures whose returns are relatively uncorrelated. The term also refers to companies which move into markets or products that bear little relation to ones they already operate in.
Exposure Exposure is the amount of risk the holder of an asset or security is faced with as a consequence of holding the security or asset. For a company, its exposure may relate to a particular product class or customer grouping. Exposure may also arise from an overreliance on one source of funding. In insurance, it refers to an individual or company’s vulnerability to various risks
Interest Cover Interest cover is a measure of a company’s interest payments relative to its profits. It is calculated by dividing a company’s operating profit by its interest payments for a given period.
Interest Scheduled payments made to a creditor in return for the use of borrowed money. The size of the payments will be determined by the interest rate, the amount borrowed or principal and the duration of the loan.
Issuer The party indebted or the person making repayments for its borrowings.
Leverage With regard to corporate analysis, leverage (or gearing) refers to the extent to which a company is funded by debt.
Liquidity The speed at which assets can be converted to cash. It can also refer to the ability of a company to service its debt obligations due to the presence of liquid assets such as cash and its equivalents. Market liquidity refers to the ease with which a security can be bought or sold quickly and in large volumes without substantially affecting the market price.
Long Term Rating See GCR Rating Scales, Symbols and Definitions.
Margin A term whose meaning depends on the context. In the widest sense, it means the difference between two values.
Maturity The length of time between the issue of a bond or other security and the date on which it becomes payable in full.
Portfolio A collection of investments held by an individual investor or financial institution. They may include stocks, bonds, futures contracts, options, real estate investments or any item that the holder believes will retain its value.
Rating Outlook See GCR Rating Scales, Symbols and Definitions.
REIT Real Estate Investment Trust. A company that owns, operates or finances income-producing real estate.
Renewal The re-establishment of the in-force status of a policy, the term of which has expired or will expire unless it is renewed.
Rent Payment from a lessee to the lessor for the temporary use of an asset.
Risk The chance of future uncertainty (i.e. deviation from expected earnings or an expected outcome) that will have an impact on objectives.
Short Term Rating See GCR Rating Scales, Symbols and Definitions.
Weighted Average An average resulting from the multiplication of each component by a factor reflecting its importance or, relative size to a pool of assets or liabilities.

Salient Points of Accorded Ratings

GCR affirms that a.) no part of the ratings process was influenced by any other business activities of the credit rating agency; b.) the ratings were based solely on the merits of the rated entity, security or financial instrument being rated; and c.) such ratings were an independent evaluation of the risks and merits of the rated entity, security or financial instrument.

The credit ratings have been disclosed to Octodec Investments Limited. The ratings above were solicited by, or on behalf of, the rated entity, and therefore, GCR has been compensated for the provision of the ratings.

Octodec Investments Limited participated in the rating process via face-to-face management meetings, teleconferences and other written correspondence. Furthermore, the quality of information received was considered adequate and has been independently verified where possible. The information received from Octodec Investments Limited and other reliable third parties to accord the credit ratings included:

  • the 2019 audited annual financial statements (plus four years of audited comparative numbers);
  • unaudited financial results for the six months to February 2020;
  • results presentations;
  • a breakdown of debt facilities, security schedules, and related counterparties at 31 March 2020.
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