Australian Real Estate Investment Trusts (Listed Property or "AREITs")

The ASX 200 AREIT Accumulation index rose by 7.01% over the quarter ending 31 March 2012.

The reporting season was broadly positive for the sector with a number of earnings upgrades (GPT, Dexus, CFS Retail, Commonwealth Property Office Fund and Goodman Group) the highlight. Overall we are expecting earnings growth of about 6% for FY12 and around 5% for FY13.

Debt levels in the sector remain relatively low at around 27% of total assets and debt serviceability ratios have also improved, with earnings covering interest expense by around 4 times.

With the sector trading at an average discount to net tangible assets of around 12% (excluding Westfield Group), buybacks remain popular (Stockland, Westfield Group, Commonwealth Property and GPT are currently running on-market buybacks).

Turning to the respective sectors:

As at the end of December office sector vacancy rates fell slightly in Brisbane (+6.3%), Melbourne (+5.8%) and Perth (+2.5%), while Sydney remained unchanged (+8.4%). We expect vacancy rates could rise in Sydney and Melbourne as employment demand in financial services moderates but demand in the resource exposed office markets of Perth and Brisbane CBD may firm (although this will be partially offset by new supply, particularly in Brisbane). As noted in previous commentaries Sydney also faces a potential oversupply issue in coming years once Barangaroo space becomes available.

In the retail sector vacancy rates remain low overall. Evidence to date suggests that retail landlords are maintaining rent and occupancy levels but more recent anecdotal evidence points to a marginal fall in recent lease renewals. In our view this trend is likely to continue given the difficult retail environment. We maintain our view that the structural trend towards on-line shopping is likely to suppress any rental and price growth over the coming year.

In the industrial sector, prime grade vacancy rates are running at about 3-4%. Manufacturing conditions remain challenging which is suppressing any rental income growth but equally supply constraints should support property values, at least in the medium term.

Residential Conditions remain challenging for the residential sector. High levels of household debt and economic uncertainty continue to impact demand. The expiry of government subsidies such as the First Home Buyers Grant will also limit near term activity. Notwithstanding, developers are responding to these challenges by increasingly focusing on lower value products where pent up demand remains high.

The sector continues to provide a reasonable income stream (average dividend yield of about 6.8%), modest earnings growth and a price discount to net tangible assets of about 12%. Nevertheless, the outlook is not compelling and in our view Australian Equities provide greater upside over the medium term. As a consequence we continue to recommend a mild underweight exposure to this asset class.

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