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This article appeared in the May 2012 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.

Higher-grade office and industrial assets in favour, while retail property lags.

Photo of Ken Howard By Ken Howard, RBS Morgans

It has been a relatively quiet start to the year for Australian Real Estate Investment Trusts (A-REITs). The February profit-reporting season did not hold many surprises, with the sector posting 3 per cent growth in earnings per share.

We believe the sector is entering a relatively stable period in which A-REITs sharemarket values are predominantly based on operating earnings, and swings in capital values likely to be more based on fundamentals rather than sentiment. We expect mergers and acquisitions activity, in addition to capital management initiatives, to remain key themes for A-REITs throughout 2012.

Despite concerns about a potential slowdown in Chinese economic growth and the high Australian dollar, the S&P/ASX 200 index finished the March quarter up around 7 per cent compared to the A-REITs index at around 5.5 per cent. Nevertheless, this was one of the best quarterly performances by A-REITs for some time.

The worst performer

Not surprisingly, the worst performer among A-REITs during the quarter was Stockland (the nation's largest residential developer) with a fall of around 7 per cent. This followed the group issuing a profit downgrade at the end of March, citing deterioration in the residential market affecting sales.

Consequently, the group expects earnings per security for 2011-12 to be around 3.5 per cent lower than last year, but distribution guidance of 24 cents per security is unchanged. Management said it expects the residential market to find a floor in the next six to 12 months. But the recovery is likely to be slow unless there is a reduction in bank interest rates.

The residential sector remains tough, and outlook comments overall during the reporting season were very cautious, given the lower sales and longer settlement times. This seems to have been compounded by purchasers experiencing further difficulty in accessing bank funding.

In April, unit holders almost unanimously backed Goodman Group's plans to create a new company in Hong Kong and its price rallied after management flagged a 10 per cent uplift in active earnings. Investors also approved a 5-for-1 security consolidation, which the chairman said would create a more appropriate security price for a group of Goodman's size, improve market perception and reduce price volatility.

It was expected the new structure would allow the continued flow-through of taxation benefits, regulatory and tax efficiency, a corporate presence in the markets in which the group operated, and facilitate growth through the Hong Kong company. Goodman Group aims to be the world's leading owner, developer and manager of industrial property.

One of Australia's largest REITs, Charter Hall Office, was delisted in April following the successful privatisation bid by a consortium of investors including Singaporean sovereign wealth fund GIC and the Canadian Public Sector Pension Investment Board. Investors who held units on the record date (April 20) will be entitled to receive the scheme implementation distributions ($2.49 per unit) and the contingent consideration (up to $0.15 per unit). The bulk of the cash proceeds will be received on April 30; however the earliest date on which contingent consideration will be paid is October 30, 2012.

Conservative balance sheets

While the macro environment remains challenging, most A-REITs continue to focus on retaining a conservative balance sheet, although capital management in the form of share buybacks are likely to continue to feature in 2012. Many groups continue to undertake buybacks in order to close the discount-to-NTA (net tangible assets) gap.

During the quarter, Westfield, Dexus Property Group and CFS Retail Property Trust joined the long list of groups undertaking buybacks and Stockland announced it would extend its buyback, funded by asset sales.

Given the large cash holdings and many A-REITs trading at low valuations, we continue to expect further M&A activity in 2012. We also expect some groups may have to consider acquisition opportunities in order to assist earnings growth.

Our preferred property exposures are higher-grade office and industrial assets with blue-chip tenants, on longer-than-average lease terms incorporating annual rent increases (that is, better security of cash flow, which underpins distributions and with lower vacancy risks).

We expect retail A-REITs and residential developers to lag, particularly given the lack of a near-term catalyst to turn around weak consumer sentiment and/or the declining appetite for debt. The trend towards online retailing continues to gather momentum as the strong Australian dollar creates significant pricing differentials between Australia and, in particular, the US. None of this is new news, but these themes are likely to continue for some time.

The recent announcement by Woolworths to close up to 100 of its 260 Dick Smith electronics stores and look to sell the business, coupled with Specialty Fashion indicating it plans to close up to 120 stores and seek rent reductions of 15 to 20 per cent, creates further headaches for mall owners.

According to Morningstar, the office sector will play out in two parts. Prime office property is expected to continue to perform solidly, underpinned by falling vacancy rates and declining incentives. Morningstar is less positive on lower-grade office space, which, following the significant upgrades by corporate and government departments, will need expensive refits to re-let.

With the premium end of the market now in a period of undersupply, Morningstar expects further declines in vacancy rates during 2012, supporting growth in effective rents. In addition, the current structural shortage combined with continued tight lending by the banks, will support cap-rate contraction during 2012.

External factors

No doubt key issues for the sharemarket include the ongoing uncertainty around European debt and deterioration in the near-term global growth outlook. These external factors, combined with the increased likelihood of a slowing momentum in the Australian commodity sector in the near term, have dampened the growth prospects of some property sub-sectors.

Although we do not expect a material downside risk to earnings, nonetheless property values are expected to track sideways, particularly for the retail and residential property sectors, reflecting lower retail profit margins and low housing affordability.

In summary, since the end of last year the domestic economic backdrop has not changed significantly. We forecast the Australian economy to grow at 3.2 per cent in 2012 and 2013 (compared with 2.7 per cent in 2011), which is at trend growth. We expect interest rates to be on hold for the immediate term and continue to believe investors should maintain a core exposure to quality, high-yielding shares.

With an average yield of around 6.5 to 7 per cent A-REITs can continue to be regarded as a defensive asset. We believe A-REITs with solid balance sheets and cash flow will continue to see growth opportunities through acquisition.

About the author

Ken Howard is a stockbroker and financial planner. He has worked with RBS Morgans since 2001 and in the financial services industry since 1996. He has adopted a fundamental approach to investing, looking for value and quality in long-term investments. The strategy is biased towards investments with a long history of paying dividends and distributions. To find out more on the outlook for A-REITs in 2012, email Ken Howard or phone on 07-3334 4856.

Ken Howard, LLB, BEcon, CFA, GAICD, is an Authorised Representative of RBS Morgans. RBS Morgans Limited (ABN 49 010 669 726 AFSL 235410) is a Participant of the ASX Group and a Professional Partner of the Financial Planning Association of Australia.

From ASX

Investors who are new to A-REITs should watch the ASX A-REITs video, which features ASX business development manager Jonathan Morgan.

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