Weaknesses in Fortress

Fortress is under the spotlight after it announced that it would not be able to meet the minimum distribution requirements to be classified as a real estate investment trust (REIT).

Fortress is a real estate investment trust listed on the Johannesburg Stock Exchange (JSE) that specialises in logistics and retail properties. It also has office and industrial segments.

A REIT aims to create an income-producing property portfolio that can give investors a reoccurring income stream through dividends while having the upside of capital appreciation.

For a company to be classified as a REIT, the JSE has criteria that need to be met. The following are some of the listing requirements specific to REITs:

• Own property with a gross value of at least R300 million.

• Maintain its debt below 60% of its gross asset value.

• Generate at least 75% of its revenue from rental income.

• Distribute at least 75% of its total distributable income to its shareholders.

Fortress has recently come under the spotlight when it announced that it would not be able to meet the minimum distribution requirements of the JSE.

The company explained that its memorandum of incorporation (MOI), a document stipulating the rights and responsibilities of all parties involved in the structure, prevented the company from paying dividends.

Group CEO Steven Brown said in the group’s annual results presentation that they don’t have a liquidity or solvency problem.

Instead, they are held back by a hindrance in the MOI caused by the dual share structure. Brown said that once the group has a single share structure, Fortress would be able to pay dividends.

It raises the question of how the MOI prevent Fortress from paying dividends.

The problem is related to Fortress’ two share classes – Class A (FFA) and Class B (FFB).

The MOI states that both share classes have equal voting rights. However, they differ in their entitlements to capital participation (in the event of group liquidation) and distributions (dividend payouts).

The A share class has a dividend benchmark equal to the prior year’s dividend plus the lower of CPI or 5%.

If Fortress generates distributable income greater than the benchmark, the A class receives a dividend payment equal to the benchmark. The B class receives any residual distributable income.

However, if the group cannot generate distributable income above the A class benchmark, the board of directors is not authorised to distribute dividends to either of the share classes as per the MOI.

The company could not generate distributable income in excess of the class A benchmark, preventing it from paying dividends.

Fortress’s board of directors presented a proposal to shareholders where Fortress would repurchase all issued class A shares in exchange for class B shares.

The repurchase and exchange will happen as an exchange ratio of 3 class B shares per class A share.

If this scheme was successful, it would eliminate the dual share structure and the restrictions on dividends imposed by the MOI.

However, the proposal did not achieve the necessary 75% approval from shareholders, as there were differences in opinion regarding the exchange ratio between class A and B shareholders.

Fortress is now at serious risk of losing its REIT status for the 2022 financial year as shareholders could not reach a consensus regarding the exchange ratio.

As such, the group announced that it would engage with the JSE regarding this matter to manage the process.

Considering Fortress’ REIT status and strict dividend policy in the MOI, one should expect steady recurring dividend increases.

However, it is not the first time Fortress has been in its current situation.

The graph below shows Fortress’ dividends over the past ten years and indicates periods of significant dividend deterioration.

Fortress’ revenue has been downward sloping since 2017. The group stated that leasing vacancy had been an important consideration in its latest financial period.

Fortress also has R1.41 billion of non-core properties they want to sell and invest the proceeds in higher-yielding properties.

When working with real estate, an important measure is a loan-to-value ratio – the size of a loan relative to the value of the property it financed. It is a good measure of the lender’s credit risk should the borrower default.

The graph below shows that Fortress has slowly increased its loan-to-value ratio since 2018 to 40% of its total property value.

It is still well below the 60% REIT requirement, and the group needs to monitor these levels.

Fortress seems to be in a difficult position with its MOI restricting its dividend payout.

However, the main cause for the dividends issue is the group’s inability to generate the required distributable income.

Fortress has seen its revenue pulling back and has been unable to sustain dividend increases over the past ten years.

Fortress has been able to improve its property vacancy rates since 2020.

The vacancy rates in the group’s specialist areas – the retail and logistics segments – are at 3.6% and 1.2%, respectively.

The improved vacancy may be a combination of disposing of low vacancy properties and increased demand for property space.

The office segment has the highest vacancy rate at 28.6%. It is not surprising as more businesses operate from home.

Many investors are hoping that after the group disposed of its non-core properties, it will invest the proceeds into high-yielding logistics and retail properties where vacancy rates are low.