currencies and rents commodity impact on ssa real estate 2016
TRANSCRIPT
Currencies and Rents: The Commodity Impact on Sub Saharan Africa Real Estate
May 2016
ACTIVATING INSIGHT
THIS IS THE EDGE
Executive summaryIn this paper we identify Sub-Saharan Africa (SSA) countries which are the most exposed to currency pressures as a result of recent commodity price volatility and consider the implications for their real estate leasing markets based on our experiences in other developing economies.
Nigeria, Angola and Zambia have been the most exposed countries, given that they are large exporters of commodities and possess developed real estate markets. Ghana is less vulnerable from a commodity perspective but has experienced major devaluation, also due to its current account deficit.
The countries in our study have all allowed their currencies to depreciate to a greater or lesser extent. Zambia has done the most to align itself with market pressures. Nigeria, arguably, has not done enough.
We also look at the experience of Russia, another transitioning economy that is heavily reliant on the price of exported commodities, and consider how pressures on the ruble have impacted real estate markets in SSA, which largely function in USD.
The Russian experience suggests that sentiment and USD funding issues will put upward pressure on yields, though to a comparatively limited extent.
In the SSA countries’ office markets there will be pressure on landlords to switch to local currency lease agreements, though again this may either be impractical or short-lived. Landlords (and tenants too) may prefer instead to remain in USD though with a slightly discounted rate or with greater incentives.
If the experience of Russia is a blueprint and rents have to be renegotiated, the impact is short term and in a market of limited supply of quality stock they can rebound surprisingly quickly. The window for renegotiation can be surprisingly narrow.
That said, the retail market is likely to stay under pressure for longer than the office market as the consumer has to digest the impact of higher-priced imported goods and falling real wages.
Oil Rig, Nigeria
Currency LTM Currency Commodity GDP per Current account Population Unemployment Gov Balance, FX reserves, Months of Depreciation Exports, % capita US$ balance, % GDP (mn) % GDP US$ Import vs US$ of GDP (ppp) Cover Equatorial Guinea CFA 3.7 75.8 34,827.2 -10.0 0.8 4.3 n/a 1.4 n/aGabon CFA 3.7 34.9 19,497.2 8.3 1.6 1.7 -3.74 1.9 9.4 Angola Kwanza 49.1 53.8 7,316.5 -1.5 24.4 7.5 -4.64 23.6 13.6Nigeria Naira -1.2 34.5 5,932.9 0.2 173.9 7.9 -3.11 29.3 6.9 Ghana Cedi 4 12.7 4,048.9 -9.6 26.2 17.0 -7.52 3.9 4.2Zambia Kwacha 57.6 25.0 3,905.1 -1.4 15.0 7.9 -8.18 2.5 4.2 Chad CFA 3.7 34.7 2,178.1 8.9 11.3 3.7 -3.68 0.2 2.4
1. Kenya and South African are excluded from this report as the former is a net importer of commodities (6.2% of GDP) and this (in theory at least) should benefit from weaker commodity prices. South Africa is a net exporter of commodities (2.2% of GDP) though has a larger more diversified economy. Mozambique, similarly, is a net export of commodities, though at 5.5% of GDP falls outside of our scope.
Table 1: Macro Indicators
Source: Economist, Oxford Economics, Bloomberg, IMFData as of end March 2016
The impact of falling currencies on real estate markets in commodity-dependent Sub-Saharan Africa countriesThe fall in oil prices from over USD110/bbl to below USD30/bbl by January 2016 has had important implications for the economies of commodity-exporting markets. Those economies, particularly in developing markets that are struggling to fund state budgets as export earnings dry up, have suffered from major speculative pressure on their local currencies. In turn, this build-up of pressure has had significant repercussions for commercial real estate markets, where leases are quoted in FX terms (typically USD) and in most instances paid in local currency.
In this paper we draw on our experiences in other developing markets with large commodity exposure, notably Russia, to come to some broad conclusions as to what the impact of this dislocation could be for those commercial real estate leasing markets in Sub-Saharan Africa (SSA) that share some similar macroeconomic characteristics and how the complex issues that arise from it might be navigated.
As a caveat we understand that any analysis should be cautious when comparing apples with oranges, and we acknowledge that the extent of homogeneity between SSA countries, let alone with economies on other continents, is limited. Nonetheless, in this research
it is our aim to identify unifying features between their economies and real estate markets, which means that the experiences of Russia in the last decade or so can provide constructive guidance for countries which share similar characteristics. This is namely a heavy reliance on the export of commodities to support budget revenues and a developing real estate market which is largely supported by USD financing and lease terms.
Selecting marketsAs stated before, since we are primarily interested in the impact of weakening currency dynamics due to lower commodity prices in selected countries in SSA, our first task is to identify those countries that are most vulnerable to falling commodity prices. Therefore, we have decided on those that are large net exports of commodities (where commodity exports >10% of GDP). This yields us a broad focus group of seven SSA countries: Equatorial Guinea, Gabon, Angola, Nigeria, Ghana, Zambia and Chad.1
Within that group, we are focused on those economies that have meaningful consumer spending power; we therefore screen according to GDP per capita. The very small oil-exporting countries of Equatorial Guinea and Gabon are clear outliers here, with GDP per capita levels well in excess of the SSA average. However, with a combined population of below 2.5 million people, we include them in our analysis for comparison only.
Furthermore, since we are mainly interested in the impact of currency depreciation, the CFA franc peg makes analysis rather a moot point, since the currency is tied to the euro rather than influenced by local central banks. As such given its currency and relatively low GDP per capita, we also exclude Chad.
Therefore, we narrow our attention to Angola and Nigeria, which are the two SSA countries where commodity exports comprise more than one-third of GDP, and which both have meaningfully powerful domestic consumers (GDP per capita above USD6,000) and sizeable populations. Importantly, they also have central banks which have control over monetary policy.
We also consider Zambia and Ghana which are both heavily reliant on commodity exports (25% and 13% respectively) and have active and relatively developed real estate markets. Significantly, as the region’s second largest copper producer, Zambia has been heavily impacted by greatly depressed copper prices (though the kwacha has enjoyed some recent gains). Ghana, while also dependent on commodity prices, is likewise under pressure due to its large fiscal deficits, which have left it particularly vulnerable to external shocks. Its 2016 budget aims to narrow the deficit to 5.75% of GDP. However, many analysts would acknowledge this looks a little optimistic.
Currency pressures The main reason for choosing Russia for comparison is that the common characteristic of all the countries in Table 1 is that their currencies import volatility through commodity price movements. Generally speaking, when faced with the pressure of falling commodity prices, central banks can take one of two routes.
They can spend their foreign currency reserves to defend the currency and keep it artificially competitive. This can prove expensive and is risky when the country is also suffering from budget and current account deficits caused by falling FX revenue streams. Furthermore, as foreign currency reserves are depleted, so too is the credit rating of the country put under pressure, further pulling up the cost of debt and hindering inward investment, thereby undermining the benefits of maintaining an artificially strong currency.
Alternatively, central banks can let the currency respond to market pressures, deciding instead not to defend it and to let it float freely. In developing markets this step into the unknown also carries considerable risks, including more volatility and the danger that consumer spending power will be significantly eroded, particularly in countries which import large amounts of consumer goods. Inflation feedthrough from FX depreciation can also be aggressive and can present a major threat, particularly as it constrains the central bank’s ability to keep policy rates loose to encourage growth further down the line. It also implies a major hike in policy rates at some point in the future in order to contain inflation.
These are issues that Russia has faced twice in the last decade, and has responded to by using both routes. In 2008 the central bank defended the Russian ruble when the oil price fell to USD35/bbl.
This led to Russia spending some USD150 billion of its USD500 billion foreign exchange reserves before finally giving up. These reserves were not replaced until the oil price recovered through 2009-2014. In 2014, understanding the expense and limitations of intervention, the central bank chose the alternative route in order to keep their reserves powder dry, and it let the currency trade in line with market pressures as dictated by the oil price. In doing so, the Russian ruble weakened from some RUB 35/USD to over RUB 80/USD. Though the central bank has retained its foreign currency firepower, it has come at the cost of major societal disruption. Salaries in USD terms have effectively halved and inflation is eroding real wage growth which stood at almost -10% in 2015. Imported goods are a luxury for the wealthy and the rest of the country has had to rely on a process of faltering import substitution.
Graph 1: Russian ruble vs Oil
Ruble Brent, US$/barrel
Feb 1
4
Apr 1
4
Jun 1
4
Aug 1
4
Oct 1
4
Dec 1
4
Feb 1
4
Apr 1
5
Jun 1
5
Aug 1
5
Oct 1
5
Dec 1
5
Feb 1
6
90
80
70
60
50
40
30
20
0
20
40
60
80
100
120
140
Source: Central Bank of Russia
The two largest economies in our scope of study, Nigeria and Angola, face the same issues. Indeed, given that both are larger exporters of commodities, 35% and 54% of GDP respectively (versus 17.4% for Russia), and have far smaller foreign exchange reserves (Russia, unlike Nigeria,
saved up in the good times to create a war chest to help defend itself against future commodity price falls – currently some USD380 billion), the impact of falling commodity prices is likely to be even more acute. The Central Bank of Nigeria (CBN) responded to these pressures by allowing
the naira to weaken in a one-off step in March 2015 to trade in a band between NGN 197-199/USD. As the oil price has stayed in the USD30-40/bbl range, the continued pressure on the country’s economy has led to growing calls that the CBN should let the naira weaken further.
Graph 2: Nigerian Naira vs Oil
Nigeria Naira Brent, US$/barrel
Mar 1
1
Sep 1
1
Mar 1
2
Sep 1
2
Mar 1
3
Sep 1
3
Mar 1
4
Sep 1
4
Mar 1
5
Sep 1
5
210
200
190
180
170
160
150
0
20
40
60
80
100
120
140
Source: Bloomberg, IEA
Parallel rate, 23/03/16 = 323/US$weaker
stronger
It is difficult to argue against this given that the Nigerian government expects to see earnings from oil exports fall from USD19 billion in 2015 to USD4 billion in 2016, and even admits to facing a USD11 billion budget deficit in 2016, which greatly increases its vulnerability to external shocks.
The current parallel market rate, which is a reasonable (although illiquid and inaccessible) reflection of the true oil-price implied value of the naira, is some 60% above the official central bank rate. This puts it broadly in line with the movement in the country’s real effective
exchange rate which is currently trading at some 28% above its 10-year average. In the absence of a stronger oil price, as the widening gap between the spot price and the futures market suggests, pressure on the naira appears inexorable.
Graph 3: Nigerian Naira/US$ spot vs 3M FWD.
Naria 3M FWD Naira Spot
Jun 1
4 Au
g 14
Oct 1
4
Dec 1
4
Feb 1
5
Apr 1
5
Jun 1
5
Aug 1
4
Oct 1
5
Dec 1
5
Feb 1
6
220
210
200
190
180
170
160
150
Source: Bloomberg
weaker
stronger
Graph 4: Current Real Effective Exchange Rate vs 10 year average
30%
25%
20%
15%
10%
5%
0%
-5%
-10%
-15%
-20%
Source: breugel
undervalued
28%
Nigeria
6%
Angola
5%
CFA
-13%
Ghana
-16%
Zambia
overvalued
It’s a similar story for Angola, which has been one of Africa’s fastest-growing economies over the last decade, but is now likely to see revenues from oil exports almost half in 2015 from USD60 billion in 2014 and, like Nigeria, is facing a major USD liquidity crunch. With GDP forecast to come in at 3.4%, its lowest growth rate in 16 years and less than half the 10-year average GDP growth rate of 8.7%, there is a comparable level of pressure on the kwanza. The government has slashed its spending, has been relatively successful in raising external funding, the kwanza has been devalued a number of times from AOA 98/USD to AOA 158/USD. However, with parallel market rates well above this, there is likely to continue to be considerable pressure on the authorities to let the currency weaken further.
Zambia has similarly faced major USD liquidity constraints, though the pressure that has been building on the economy has to an extent been tapped by the largest currency devaluation in Africa. Aggressive rate hikes to contain rampant inflation have done much to keep further devaluation under control, but the government’s budget still faces huge challenges, largely due to its continued policy of fuel subsidisation and expensively contracted electricity imports. Saying that, since the start of the year, the kwacha has experienced a sudden burst of energy. From being the worst performing currency in the world last year, it is the strongest so far this year ahead of potential IMF support in August and on the back of supportive metals prices.
Ghana, which is one of the few SSA countries to be a net exporter of foods (7.2% of GDP), has been hurt by poor cocoa production as well as the broader impact of weaker commodity prices, being a net exporter of both oil and metals. However, the currency has held up reasonably well, supported by inflows of external debt. Nevertheless, with policy rates already at 26%, the scope for the central bank to use monetary policy tools any further may be somewhat constrained.
Graph 5: Angolan Kwanza vs Oil
Mar 1
1
Sep 1
1
Mar 1
2
Sep 1
2
Mar 1
3
Sep 1
3
Mar 1
4
Sep 1
4
Mar 1
5
Sep 1
5
170
160
150
140
130
120
110
100
90
80
0
20
40
60
80
100
120
140
Graph 6: Zambian Kwacha vs Copper
Mar 1
1
Sep 1
1
Mar 1
2
Sep 1
2
Mar 1
3
Sep 1
3
Mar 1
4
14
13
12
11
10
9
8
7
6
5
4
100
150
200
250
300
350
400
weaker
stronger
Parallel rate, 23/03/16 = 400/US$
stronger
weaker
Angolan Kwanza Brent, US$/barrelSource: Bloomberg, IEA
Zambian Kwacha US$ Copper (1M)Source: Bloomberg, LME
Graph 7: Ghanaian Cedi vs Oil
Ghana Cedi Brent, US$/barrel
Mar 1
1
Sep 1
1
Mar 1
2
Sep 1
2
Mar 1
3
Sep 1
3
Mar 1
4
Sep 1
4
Mar 1
5
Sep 1
5
5.0
4.5
4.0
3.5
3.0
2.5
2.0
1.5
1.0
0
20
40
60
80
100
120
140
Source: Bloomberg, IEA
weaker
stronger
Graph 8: Real Effective Exchange Rates (Jan 1, 2008 = 100)
Angola CFA Ghana Nigeria Zambia
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
180
160
140
120
100
80
60
40
20
0
Source: breugel
Appreciating
Depreciating
Since central bank policy rates are already pretty tight, the options available for the central banks in both Angola and Nigeria are limited, which has added pressure to devalue their currencies. This is even more so the case for Zambia and Ghana, which have been aggressively hiking rates through the recent commodity price weakness.
Impact of currency weakness on real estate marketsIf we look in more detail at the direct impact of local currency devaluation in markets where deals are often fixed in USD, the recent exchange rate weakness has, generally speaking, caused concern among tenants who generate revenue in local currency and have costs in USD, and who expect to see margins come under pressure in light of the economic downturn.
On the other hand, landlords are worried that the costs borne by tenants will ultimately be passed on to them through rental negotiations, either to reduce the USD rental rate or to introduce a cap on the local currency rate, protecting the tenant from further currency weakness. In the following sections we consider how we expect the relationship between the landlord and tenant to develop in the occupier market, and also the likely impact of currency devaluation on the transactional market.
Graph 9: Nigeria, Angola, Ghana and Zambia Policy Rates
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
30
25
20
15
10
5
0
Angola Ghana Nigeria ZambiaSource: Bloomberg, IEA
Capital markets
The impact of a weaker currency clearly has important implications for transactional activity and is transmitted in two ways. The first is through sentiment - investors are less likely to be reassured by a market which is experiencing current account and budget deficits slide into the red and for whom GDP is contracting. As Graphs 10-13 show, Nigeria, Angola, Zambia and Ghana are expecting GDP rates well below their historic 10-year average, which is likely to remain a headwind for investment in the short term. However, it is worth noting that despite the current pressure on their economies, in both Zambia and Ghana the medium term forecast growth rate remains well above the developed and emerging markets average of 4.8%.
“The recent exchange weakness has caused concern among tenants who generate revenue in local currency but have costs in USD, and who expect to see margins come under pressure in light of the economic downturn”
Graph 10: Nigerian GDP Growth, %
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
2020
9
8
7
6
5
4
3
2
1
0
Source: Oxford Economics
2006 - 2015 average
7.8
4.94.3
5.4
6.3
2.73.1
3.84.4 4.6 4.3
Graph 11: Angola GDP Growth, %
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
2020
9
8
7
6
5
4
3
2
1
0
Source: Oxford Economics
2006 - 2015 average
3.43.9
5.2
6.8
4.4
3.5 3.43.9
4.34.7
5.4
Graph 12: Zambia GDP Growth, %
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
2020
12
10
8
6
4
2
0
Source: Oxford Economics
2006 - 2015 average
10.3
6.36.7 6.7
5.6
3.7 3.4
5.36.0 6.2
6.9
Graph 13: Ghana GDP Growth, %
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
2020
16
14
12
10
8
6
4
2
0
Source: Oxford Economics
2006 - 2015 average7.9
14.0
9.3
7.3
4.0 3.74.4
5.3 5.86.4 6.6
Graph 14: SSA Long Term US$ Eurobond yields
Aug 1
3
Nov 1
3
Feb 1
4
May 1
4
Aug 1
4
Nov 1
4
Feb 1
5
May 1
5
Aug 1
5
Nov 1
5
Feb 1
6
16
14
12
10
8
6
4
Angola Ghana Nigeria ZambiaSource: Bloomberg
The second is through the availability (rather than the cost) of USD debt. Russia saw a major decline in direct real estate investment volumes in 2015 to USD2.3 billion from USD8.2 billion in 2013, though it is difficult to attribute this entirely to the fall in the price of oil, rather that sentiment for Russia was largely also defined by its foreign policy agenda at the time (and continues to be). Instead, we think it is the availability of USD funding which is the primary concern. It is interesting that in both Angola and Nigeria (rather like in Russia), long-term sovereign Eurobond yields have remained comparatively tight. Angola, for example, was able to raise some USD10 billion in external financing in 2015 and some USD14.5 billion for 2016. Similarly for Russia, long-term Eurobond yields have remained below 6.5%, even at the peak of its recent crisis.
The situation in Russia has meant that capitalisation rates which are calculated on the basis of USD funding (and that assume a prime asset in a CBD location) have not moved out as much as the dislocation in the economy might suggest. However, again, the question is one of liquidity. So far the main Russian state lenders have been quite flexible in their refinancing terms, which has meant that up to now there has been relatively little distress in the market. Rather, assets have simply not been trading, which has meant that office prime yields have moved out only from 8.75% to 10.5%. In short, good-quality assets in good-quality locations with debt in place have remained competitively priced but relatively inaccessible. Importantly, the lesson from the Global Financial Crisis (GFC) is that though market dislocation can be brutal in commodity-exporting countries when commodity prices fall - certainly in terms of economic output and there can be a sharp painful correction in real estate markets - it does not necessarily have to be protracted. In Moscow, with a nascent market and tight supply, yields had returned close to pre-GFC levels within 18 months of reaching their peak.
Graph 15: Russia Long Term US$ Eurobond yields
May 1
4
Aug 1
4
Nov 1
4
Feb 1
5
May 1
5
Aug 1
5
Nov 1
5
Feb 1
6
8%
7%
6%
5%
4%
3%
2%
1%
0%
Russian, 30-Year Bond Yield, US$
Current financing issues in SSAIn the case of SSA, the majority of developers and investors similarly prefer to secure USD funding, due to more favourable interest rates to support IRRs. The acute shortage of USD in Nigeria and Angola, Sub-Saharan Africa’s first and third largest economies, along with the significant currency devaluation, has resulted in two significant financing challenges. First, landlords cannot in general convert their local currency earnings into the hard currency which is required to repay their debt obligations. Second, the volatility in local currency markets makes the debt repayment amounts unpredictable and creates difficulty from a cash flow perspective. This is a very recent phenomenon that banks have been faced with, and it is putting pressure on the way real estate has traditionally been financed in these markets. In the short term the reality is that banks need to be flexible by dealing with each case individually and they may have to accept part of their loan repayments in local currencies; as a result, necessary innovations on how projects are financed are needed.
This may prompt project promoters to start obtaining funding locally or through a combination of local and hard currencies which will bring about higher blended finance costs. Furthermore, it also means that real estate developers will be required to deliver higher-quality projects; that is to say functional and efficient buildings situated in prime locations with the ability to attract quality tenants over the long term, thereby creating sustainable income streams in order to attract and service favourable loan terms. The future dependency on commercial bank debt may also come into question. Banks will have to be more cautious on the type of projects they finance and may well require a higher proportion of equity funding as they become more conservative on LTVs. If funding issues are inhibiting the roll-out of good real estate projects, alternative sources of funding should be explored. Pension funds, which are typically under-allocated to real estate in emerging markets, have long-term investment horizons and no currency challenges, and this makes them an ideal capital provider. The added advantage is that it gives pension funds the ability to deliver quality assets to serve the local communities in which they have a vested interest.
At this stage it is probably fair to say that no one has a clear, co-ordinated medium to long-term solution to these funding issues, though interestingly a leading bank in SSA has made efforts in addressing the issue by introducing, in the interim, a ‘dual currency structure’ whereby debt is accessed through a combination of USD and local currency. The mechanism allows for a local currency facility to be accessed in periods of economic uncertainty and currency devaluation, and once the market stabilises the local currency exposure can be refinanced back into USD currency. (An overall blended interest rate of local and hard currencies is charged.) Uncertainties exist around some of the practicalities of the funding model; however, it seems to be the only solution that a bank with local retail presence can offer at present.
“The future dependency on commercial bank debt may also come into question. Banks will have to be more cautious on the type of projects they finance”
Source: Bloomberg
Impact on the office marketIn Lagos and Luanda, like Moscow, most high-quality office rents are fixed in USD and are leased for typically five or more years. Where the contract is fixed, the tenant may find that they have little recourse to force a decrease in rents in FX terms. As a consequence, the fall in the local currency and the subsequent necessary increase in local currency payments to the landlord will have a significant impact on the tenant’s margins. Of course, businesses that generate the majority of their revenues through exports are more likely to able to absorb the impact of these extra costs, putting them in a far stronger position than tenants like FMCGs who generate their revenue in local currencies and who rely heavily on imports.
In efficient markets, and assuming the supply/ demand equation is in balance, tenants should react quickly to currency pressures. In the case of Russia in 2014, when the oil price started to fall, we were generally less surprised at the pace at which the market reacted (since occupier sentiment merely reflected the movements in the local currency) and rather more by the pace at which rents switched to local currency as tenants sought to reduce their FX liability. Assuming that banks are able to accept a degree of flexibility in local currency funding, broadly speaking we see two types of discussion between landlords and tenants - stay in USD or switch to local currency rents:
Graph 17: Moscow Class A office rents
Class A rent GDP growth, YoY
Q1 20
07Q3
2007
Q1 20
08Q3
2008
Q1 20
09Q3
2009
Q1 20
10Q3
2010
Q1
2011
Q3 20
11Q1
2012
Q3 20
12
Q1 20
13Q3
2013
Q1 20
14Q3
2014
Q1
2015
Q3 20
15Q1
2016
Q3 20
16Q1
2017
1,400
1,200
1,000
800
600
400
15%
12%
9%
6%
3%
0%
-3%
-6%
-9%
-12%
-15%
US$/sq m/yearGraph 16: Moscow prime yields
Q4 20
02
Q4 20
03
Q4 20
04
Q4 20
05
Q4 20
06
Q4 20
07
Q4 20
08
Q4 20
09
Q4 20
10
Q4 20
11
Q4 20
12
Q4 20
13
Q4 20
14
Q4 20
15
18%
16%
14%
12%
10%
8%
6%
Shopping centre Office
10.75%
10.5%
Stick in USD - Renegotiating an existing lease but keeping it in USD terms has some major advantages for both parties. Most importantly, landlords ordinarily have FX denominated debt and have assets that are valued in FX, which means they want USD. Landlords may be willing to accept a local currency lease in the short term to boost occupancy rates and cover their liabilities; however, by doing so they will feel an impact on their NOIs and thus on the valuation of their assets. In our view, occupiers therefore have a far stronger negotiating position, both in terms of rates and in terms of length of lease, if they are willing to accept lower USD terms now. Markets do, after all, settle over time and the funding constraints of today imply that there will be an even more constrained supply response tomorrow when the broader market has recovered. Renegotiating a long-term, USD-based lease on favourable terms (as well as probably supporting a good relationship
with the landlord in the short term) may well put the tenant in a favourable position for when the market and vacancy rates have recovered and the advantage is no longer with the tenant.
Switch to local currency - Switching to local currency leases has some attractive short-term benefits for the tenant, though at the expense of the owner who has to defend NOIs. In the Russian experience, most local currency deals that are struck hold for only two years, so the short-term solution looks favourable; on the other hand, when the economy has recovered in a few years and the market is tight, the tenant could find themselves at a big disadvantage when renegotiating the lease. It is unlikely that the market will be as favourable in two years as it is now and the negotiating power of the tenant will be
significantly reduced. Another consideration is that currency movement is not a one-way street and occupiers who are negotiating for local currency leases should be aware that currencies can oversell and then strengthen again, particularly in economies that are based on the export of commodities. This has certainly been the case in Zambia where the kwacha, after being the worst performing currency in 2015, has been the best performing so far in 2016. Occupiers should therefore be cautious in their assumption that it necessarily makes sense to fix lease terms in local currency. Moreover, local currency leases imply local currency indexation. Inflation will remain elevated (in the case of Nigeria, given that the currency could well devalue markedly, inflation could well climb sharply) for the foreseeable future and tying a lease to this uncertainty could erode a lot of the short-term gains associated with the lease.
Source: JLL Source: JLL
Graph 18: Russia retail turnover vs real income growth
Retail turover growth, YoY Real income growth, YoY
Dec 0
8
Jun 0
9
Dec 0
9
Jun 1
0
Dec 1
0
Jun 1
1
Dec 1
1
Jun 1
2
Dec 1
2
Jun 1
3
Dec 1
3
Jun 1
4
Dec 1
4
Jun 1
5
Dec 1
5
18%
12%
6%
0%
-6%
-12%
-18%
Graph 19: Moscow shopping centre rents vs retail sales growth
Prime Rent Retail sales growth, YoY
Q1 20
08Q2
2008
Q3 20
08Q4
2008
Q1 20
09Q2
2009
Q3 20
09Q4
2009
Q1 20
10Q2
2010
Q3 20
10Q4
2010
Q1 20
11Q2
2011
Q3 20
11Q4
2011
Q1 20
12Q2
2012
Q3 20
12Q4
2012
Q1 20
13Q2
2013
Q3 20
13Q4
2013
Q1 20
14Q2
2014
Q3 20
14Q4
2014
Q1 20
15Q2
2015
Q3 20
15Q4
2015
Q1 20
16
6000
5500
5000
4500
4000
3500
3000
2500
2000
1500
20%
15%
10%
5%
0%
-5%
-10%
-15%
-20%
US$/sq m/year
Depreciation has a direct effect on retailers who buy imported goods in foreign currency and then sell on in local currency. As retail margins suffer, the impact is passed on to landlords as soon as retailers ask for a rental discount. This is clearly a threat to those landlords who already have a large amount of foreign currency debt which they have to service, but it is one that landlords are likely to have to endure if they wish to retain occupancy rates.
Given that the relationship between tenants and landlords is somewhat symbiotic, landlords are far more likely to agree to share retailers’ losses and look for ways to negotiate with each other in order to protect margins. Retailers, for example, may not want to increase sales prices in order to maintain volumes at the expense of their margins. In doing so, they are de-facto trying to share their losses with the landlord by asking them to decrease the rents.
With imports increasing in cost in local currency terms, an environment is being created in which it is very difficult for the landlord to maintain current rental rates; indeed, with retail sales coming under pressure, the risks are heavily to the downside. In Moscow, the fall in shopping centre rents has lagged that of offices by some six months, and is likely to take longer to recover.
Impact on the market - In this environment we would typically expect a widening division between prime and non-prime or the best-quality and lesser-quality assets. Prime assets in prime locations have retained, in Moscow at least, much stronger pricing power and have been generally more capable of retaining leases in USD terms. To provide an idea of the extent of the impact, in USD terms average rents for quality offices in Moscow between 2014 and 2016 slid from USD850/sq m/year to USD600/sq m/year with new deals largely in local currency terms. Within that period, prime rents have slipped from USD1,100 to USD800-900/sq m/year, though importantly have still been negotiated in USD terms.
Importantly, we would expect that with the slowdown in completions the market can quickly recover to favour the landlord once again. Even in Russia, we think rents will start to recover by the first quarter of 2017. It is perhaps a little too early to predict when rents in Lagos and Luanda will start to recover, though there are some similarities with the Russian experience. For offices on Victoria Island in Lagos, which is to all intents and purposes solely a prime market, new leases have remained in USD with expectations of around a 25% haircut on previous levels. Landlords are willing to accommodate new tenants’ demands to the extent that they may offer better incentives (longer rent-free periods, quarterly payments rather than annual, and/or free parking),
however there is little evidence of a shift to a local currency market.
In the absence of a truly effective arbitration process, the most active negotiations between landlord and tenant are on which naira rate a lease should be pegged: either the central bank rate (as has been typical) which favours the tenant, or the black-market rate which favours the landlord. Anecdotally at least, it appears that landlords and tenants are meeting somewhere in the middle.
Outside of prime though, where rents have historically been much more likely to be negotiated in naira and where there is still considerable oversupply with rents very low, there has been little change to the status quo. Rather like the Moscow market, the trend has been towards increasingly divergent, fragmented segments within the market where prime assets in the main defend USD rents at a slightly discounted level, and anything outside of prime struggles to break out of the cycle of being low rent and under-occupied.
In terms of occupier activity, it appears that the majority of tenants are in ‘wait and see’ mode. With the macroeconomic instability, there is little argument for increasing floor space and, arguably, prime rents have not necessarily fallen enough to encourage tenants to use the current market conditions to upgrade or consolidate space. However, if the experience of Russia is anything
to go by, the window of opportunity to renegotiate or move to new space can close quite quickly, so tenants may prefer to wait for some stability in the economy or in commodity prices before starting negotiations.
Shopping centresShopping centre rents are also heavily impacted by local currency weakness. The market is not developed enough yet for leases to be determined by turnover volume, as is the case in Russia; nonetheless, rental levels will be strongly tied to retail sales and the broader economic health of the consumer.
This means that inflation feedthrough from a sharp devaluation, which is typically very aggressive in developing economies, is a major risk. This has been particularly apparent in Zambia, but is also a feature of all the countries in the SSA region. A spike in inflation will put further pressure on consumer spending power which will be transferred directly through to retailers’ margins. Initially we would expect retail sales to hold up as consumers spend local currency to buy white goods before the impending devaluation. This can create the impression that the retail sector is more robust than it is in reality. The Russian case shows that strength in consumer behaviour at the end of 2014 was then followed by one of the weakest quarters on record.
Source: JLL Source: JLL
ConclusionsThe major challenge for the countries discussed in this paper is that until they can diversify their economies away from a reliance on the revenues generated from the export of commodities, they will remain importers of volatility through commodity price fluctuations which they cannot control. Allowing a floating exchange rate does provide a cushion, but the longer-term solution is to alter the balance of trade by promoting a local manufacturing base and reducing the dependence on imports of consumer goods.
Until that can happen, inflation and interest rate policy will remain too uncertain for real estate developers to fund themselves in anything other than FX terms, at least until a country’s structural inefficiencies have been resolved. Over the longer term, therefore, and in the absence of predictable
monetary policy, capitalisation rates are likely to continue to reflect FX lending which will require FX denominated leases. The implication for capital markets is that we would expect the market to consolidate around developers who have either external funding sources and or favoured status among local lenders.
All things being equal, in a tight market with a lagged supply response to demand (which is typical in developing markets), the advantage is usually with the developer, who can pass these currency risks on to the tenant. This advantage for the landlord breaks down when commodity prices crash, but recovers quickly once they recover.
Therefore, in the office market in particular, though we may see a short-term push towards local currency leases, for offices outside of prime locations where supply is less tight, we would not expect it to become
the norm in the longer term, specifically if their economies remain largely dependent on commodity exports. Given the impact on consumer spending power, it is likely that it will take longer for the retail market to recover. Until that point, retailers and especially smaller retailers are likely to continue to push for local currency leases with an emphasis on turnover rent in order to balance the losses that they incur from the increased cost of imports.
Of course, each occupier will be driven by the subtleties of their business model and the balance they strike between their revenues and their costs. Whether a tenant believes that the right approach is to adopt a shorter-term local currency lease or a longer-term USD lease, it is clear that now is the time, at the very least, to be having the discussion.
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Tom Mundy Director Research EuropeanCapital [email protected]
COPYRIGHT © JONES LANG LASALLE IP, INC. 2015. This report has been prepared solely for information purposes and does not necessarily purport to be a complete analysis of the topics discussed, which are inherently unpredictable. It has been based on sources we believe to be reliable, but we have not independently verified those sources and we do not guarantee that the information in the report is accurate or complete. Any views expressed in the report reflect our judgment at this date and are subject to change without notice. Statements that are forward-looking involve known and unknown risks and uncertainties that may cause future realities to be materially different from those implied by such forward-looking statements. Advice we give to clients in particular situations may differ from the views expressed in this report. No investment or other business decisions should be made based solely on the views expressed in this report.
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