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REVIEW OF OPERATIONS
THE BOARD REQUESTED THAT MANAGEMENT "PROGRESS KEY PROJECTS, WHILE CAREFULLY REVIEWING ALL OTHER CAPITAL EXPENDITURE". MANAGEMENT REDUCED ITS CAPITAL BUDGET BY R250 MILLION BY DELAYING SOME REPLACEMENT AND LESS URGENT CAPITAL EXPENDITURE PROJECTS. OF THE R1,2 BILLION SPENT ON CAPITAL EXPENDITURE, R738 MILLION WAS INVESTED IN THE STRATEGIC CAPITAL PROGRAMME. |
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REVIEW OF OPERATIONS: HEARTLAND
Land development activities focus on projects to develop and sell land. Land that has become surplus to the operational requirements of AECI's businesses is converted to zoned residential, commercial or industrial land for sale. The property investment activities relate to letting 342 000m² of available space and managing about 500 tenants. The vision is to define the portfolio into investment-grade buildings and opportunities for redevelopment, with the objective of achieving a critical mass for the portfolio. Facilities management activities relate to the provision of a range of services to mainly chemical-based manufacturers at the AECI-owned Umbogintwini Industrial Complex (UIC), south of Durban. MARKET CONDITIONS The year provided many challenges for the South African property industry in general and for Heartland in particular. Independent research shows that the average annual total return from real estate over the last 40 years has been 14%, with total return being the sum of income return and capital growth. The investment property database (IPD), which comprises property investment data collated from participating property portfolios valued at some R80 billion, indicates that total returns from 2004 to 2007 were in excess of 22%. By the end of 2008, total returns had declined to about 12% a level last seen in 2002 as shown in the graph below. The trend did not reverse in 2009. During the same 2004 to 2007 period new rental stock, where construction had commenced prior to the market decline, came onto the market and created a surplus of lettable space.
Simultaneously, infrastructure and building costs increased by 60%. New development is difficult to finance while existing space remains vacant and the return from property is below the cost of capital. Higher infrastructure costs and the scarcity of appropriately zoned land have resulted in an increase in the value of land of about 150%. Land input costs also impact on rental; rental rates are declining and vacancies are escalating both in South Africa and globally. A reversal of this is required to create any meaningful prospects of another property boom. PERFORMANCE
Revenue for the combined property activities for the year was R211 million (2008: R432 million), net income was R33 million (2008: R45 million) and a trading cash outflow of R57 million was incurred. The global financial crisis caused South African banks to re-evaluate their exposure to property risk. When assessing credit applications by developers, banks are seeking to reduce the development risk and, therefore, are applying rigorous credit criteria and are stringently enforcing pre-loan conditions where facilities are approved. These pre-loan conditions are a function of covenants to which potential tenants are prepared to commit and, in the prevailing economic conditions, tenants are re-evaluating the risks associated with commitments to lease agreements. Developers in turn are unable to satisfy the banks' stipulated pre-loan conditions, resulting in credit facilities being withdrawn. As a consequence of this environment, two transactions which had been recognised in 2008 were adversely affected and resulted in a profit reversal of R52 million in 2009. Included in the trading cash flow is R86 million spent on infrastructure development. A large portion of this was invested in three bulk infrastructure projects, in line with Heartland's strategy of creating a sustainable pipeline of land available for sale and development. These projects included the London Link Road construction and the Westfield substation upgrade, at Modderfontein, and the Helderberg Coastal Sewer construction in association with the City of Cape Town, at Somerset West. R13 million was spent on remediation and environmental projects. FULFILLING A GROUP ROLE In line with the AECI Group's objectives for 2009, Heartland focused aggressively on working capital management. Specifically: CONTROLLING TOWN PLANNING The conversion of a portion of agricultural land to a proclaimed, serviced and zoned township stand is the essence of Heartland's business. This requires the identification of the quantum and sequence of land to be planned as well as its zoning. The process is a function of supply and demand and the cost of services. Heartland aims to plan the correct portions of land and to service them for sale on a just-in-time basis. In addition, compliance with the National Environmental Management Act, No. 107 of 1998, is a critical success factor in the conversion process. The challenge in 2009 was implementing rigid controls on a process that typically takes in excess of three years. A Gate Review process was established to formalise decision making at key intervals in the land development process. This review includes adherence to a system that improves understanding of the quantum of capital exposure and its measurement. The greatest expenditure in township development is infrastructure installation. The Gate Review has enabled Heartland to adopt a more flexible yet disciplined planning regime. It has also allowed planning to proceed or be stopped at any key interval. In this way, the town planning approval process can be delayed for a period without incurring expenditure on infrastructure. Gate Reviews are conducted regularly and are now standard practice in the business. CONTROLLING INFRASTRUCTURE DESIGN Bulk infrastructure design includes identifying input costs and designing to local authority standards. Most often, the local authority provides bulk infrastructure services and receives bulk services contributions from developers as part of the granting of land use rights. Since the objectives of local authorities and those of Heartland sometimes differ, and given the lack of capacity in some local authority structures, it has always been in Heartland's interest to install services and offset their cost against bulk service obligations. This gives the business an advantage in terms of the allocation and timing of expenditure. The company has established a track record in terms of its ability to deliver bulk services consistently and to the standards required. Capital costs are managed aggressively to achieve maximum efficiencies in terms of land use rights received per rand of infrastructure spend. Failure to meet project timelines is a major reason for capital over-runs. Although the business has succeeded in controlling services installation costs, it has been less successful in controlling timelines for project approvals by metropolitan authorities and obtaining timeous decisions on environmental approvals from provincial authorities. Fortunately, these delays did not result in financial loss, owing to prevailing market conditions, but could become a real risk in a more buoyant environment. To offset this risk Heartland is building up an inventory of zoned land which will be ready for sale when market conditions improve. From the second quarter of 2010, continuous real time communication of Heartland's development intentions for its entire landholding will become available to all interested and affected parties via the Heartland website (www.heartland.co.za) and an exhibition centre at Modderfontein, Gauteng. CONTROLLING THE TIMING OF REVENUE WITH INFRASTRUCTURE COST The immediate benefit of having implemented a formal Gate Review process is that matching revenue from the sale of a portion of land with expenditure incurred in bringing it to a saleable state has become more predictable. It has also allowed land release to be planned further into the future without incurring excessive costs. The fact remains, however, that the sale of land is subject to the vagaries of the market and a small customer base. Accordingly, flexibility in planning will remain key. REDEFINING THE PROPERTY STRATEGY Research conducted by independent consultants in the year confirmed that unbundling Heartland in its current form and in current market conditions is not in the interests of AECI's shareholders. Typically, property companies concentrate primarily on revenue-producing assets and restrict their exposure to non-revenue producing land holdings. Only 20% of Heartland's assets consist of a revenue-producing property portfolio. A cash purchaser is unlikely to be found and the criteria and implications of a non-cash transaction and the final price would be a critical issue. Historically, Heartland's business plan focused primarily on township development and the systematic disposal of proclaimed and serviced parcels of undeveloped land to developers. This approach is fairly low risk but also yields low returns. Scope exists for the business to move further up the real estate value chain and to act as a developer for re-sale or for retention, or both, resulting in a business model more in line with that of development companies but with the advantage of already owning well located land, the holding cost of which is negligible. Heartland has thus adopted a new vision as follows: to optimise the value of the property holdings surplus to AECI's operational requirements by selling land and by selectively investing in revenue-producing buildings in order to grow a portfolio of properties. INVESTMENT IN TOP STRUCTURES This will be done selectively to act as a catalyst for further land sales and should have the additional benefit of accelerating the rate of sales. At the same time, it will help to identify potential joint venture partners or merger opportunities with other portfolios to mutual advantage. FILLING THE PIPELINE The table below indicates that a total of about
500 hectares of land will be made available for sale over the next few years, for residential, commercial
Prior to the economic crisis, Heartland sold all its available zoned serviced land and in 2009 it concentrated on strategic planning, or filling the pipeline of serviced and zoned land, in anticipation of the next property up cycle. In the year, 57 hectares of zoned land were prepared and made ready for sale.
MAINTAINING AND ENHANCING THE PORTFOLIO'S REVENUE STREAM The leasing component of the portfolio is in the following geographical areas:
Rental income is generated from three sectors: offices, industrial and land. Net income of R62 million was achieved in 2009. The lease expiry profile shown above illustrates that the mean length of leases is three years and, with annual lease escalations of between 8% and 10%, indicates stable income for that period with the opportunity to increase rentals as the market improves.
The graph above illustrates the regional monthly net rental achieved from the portfolio. It also indicates the opportunity cost of the space not let at average achieved rentals. The bulk of this space could be classified as unlettable without capital expenditure on refurbishment. This expenditure would only be incurred for a specific tenant requirement. The portfolio of revenue-producing properties incurred minimal capital expenditure in 2009 and focused on maintaining occupancy levels in difficult market conditions, with small tenants being challenged by liquidations and insolvencies. The office vacancy is mainly B and C Grade space (the South African Property Owners Association's classification for C grade is buildings that are 20 to 30 years old but are well-located and are generally in good condition although the finishes do not meet modern standards). Of this, 6 000m2 in Gauteng was let in January 2010. Almost all of the remaining balance would require substantial capital expenditure and structural alterations to render it lettable in current market conditions. Vacancies in the industrial portfolio are due to two main reasons: firstly, an 11 000m2 portion of warehousing at Potchefstroom is currently unlettable owing to adjacent demolition activities; and secondly, at Modderfontein, an additional 5 000m2 of space has been brought into the portfolio. VALUATION As part of a strategy to identify a consistent value for the entire property holding managed by Heartland, a valuation of the UIC was commissioned in 2009. The Valuation Division of Old Mutual Investment Group Property Investments determined a valuation of R461 million for the portfolio of buildings, inclusive of leased and vacant land. This valuation is conservative since it is based on the mainly short-term leases in place. In July 2008, the same division of Old Mutual valued that portion of surplus AECI Group-owned property located at Modderfontein and Somerset West at Utilities and services such as steam, water, electricity and effluent treatment are provided and controlled by Heartland's facilities management activities at the UIC. This allows the site's manufacturing companies to focus on their core businesses. OUTLOOK The current business environment is characterised by onerous lending conditions, an oversupply of rental space and risk-averse capital financing models. While this environment prevails Heartland is concentrating on filling the pipeline of land available for sale to developers and maintaining net income from its investment activities through tenant retention and strict debtor control. In this manner Heartland will be well placed to take advantage of any upturn in the property cycle.
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