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20 October 2011

Special Report
AREITs A quarter better forgotten
the foundation for capital value growth. We like Dexus Property Group (DXS) and Commonwealth Property Ofce Fund (CPA) due to substantial discounts to NTA, conservative gearing and good exposure to domestic ofce properties. Several retail AREITs appear cheap but this not a preferred sector for long-term investment due to concerns about the impact of falling discretionary spending on super-regional and regional shopping centres, particularly given the increase in specialty store occupancy costs over recent years.
Dismal -9.5% performance for the quarter Having gone sideways for most of FY201011, the AREIT index trended downwards for the rst quarter of FY12, as shown in the graph below, nishing the quarter down 9.5%. While this was marginally better than the All Ords Index, which nished the quarter down 12.8%, the result was disappointing.

David Parker Property Consultant

While the AREIT sector outperformed the All Ords Index for the September quarter 2011, the performance was still a dismal -9.5%. There was signicant divergence within the sector with higher risk property developers falling up to 20% while conservatively geared, plain vanilla AREITs fell only marginally. Condence towards riskier parts of the AREIT sector remains fragile and ongoing volatility is likely. A continued stock market rally could see beaten down stocks rebound strongly but long term income investors are encouraged to focus on good quality, conservatively geared AREITs. Australian ofce remains our preferred sector with falling vacancy rates and growing effective rents building

Adrian Atkins Senior Research Analyst

Of particular concern was the sudden plunge in AREIT index in August, following news of the Continued on page 2

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AREIT index marginally beats the All Ords


AREIT
105 100 95 90 85 80 30-Jun 07-Jul 14-Jul 21-Jul 28-Jul 04-Aug 11-Aug 18-Aug 25-Aug 01-Sep 08-Sep 15-Sep 22-Sep 29-Sep

AOI

Source: Morningstar

Wide divergence within sector


GMG
110 105 100 95 90 85 80 75 30-Jun 07-Jul 14-Jul 21-Jul 28-Jul 04-Aug 11-Aug 18-Aug 25-Aug 01-Sep 08-Sep 15-Sep 22-Sep 29-Sep

WDC

SGP

GPT

CFX

DXS

CPA

situation or needs. Before acting on any advice, you should consider the appropriateness of the advice and we recommend you obtain financial, legal and taxation advice before making any financial investment decision. If applicable, investors should obtain the relevant product disclosure statement and consider it before making any decision to invest. Some material is copyright and published under licence from ASX Operations Pty Limited ACN 004 523 782 ("ASXO"). DISCLOSURE: Employees may have an interest in the securities discussed in this report. Please refer to our Financial Services Guide (FSG) for more information at www.morningstar.com.au/s/fsg.pdf

Source: Morningstar

20 October 2011

PCA ofce vacancy rate September 2011 (%)


14 12 10 8 6 4 2 0 Melbourne Brisbane Perth Adelaide Sydney Canberra

Melbourne Docklands continues to undergo development and will contribute the majority of the 100,000sqm plus of ofce space coming onto the Melbourne CBD market in the rst half of calendar 2012. However, with around half of this space pre-committed, the upward impact on the vacancy rate may be limited to just 100bps. Reecting the greater exposure to nancial services and lesser exposure to resources, white collar employment growth in Sydney and Melbourne is more subdued leading to lower levels of demand. But limited supply will keep these markets tight over the near term. We expect solid effective rental growth mostly stemming from lower leasing incentives. Conversely, demand for ofce space in Brisbane and Perth could be strong as white collar employment growth in legal, accounting services, engineering and mining support services is further strengthened by the resources boom. The combined effect of moderate supply and increasing demand could lead to double digit effective rental growth in the Brisbane and Perth ofce markets over the next year if the resources sector remains strong. The retail sector is parting into two halves, with the outlook for the discretionary spending based super-regional and regional shopping centres deteriorating while the outlook for nondiscretionary spending based neighbourhood centres remains stable. The combination of sub-15% occupancy costs, as shown in the table, in the sub-regional and neighbourhood shopping centre portfolios of SGP, MGR and Charter Hall Retail (CQR) combine with their heavy emphasis on food and everyday shopping to underwrite security of income streams. The outlook is not so rosy for the super-regional and regional shopping centres of Westeld Retail Trust (WRT), Westeld Group (WDC) and CFS Retail Property Trust (CFX), though occupancy levels remain in the high ninety percent region. The heavy dependence on fashion and other discretionary spending coupled with already very high occupancy costs suggest signicant risk to revenue growth. Retailers are becoming more vocal about unsustainable rental levels in super-regional and regional shopping centres with Premier Investments, who have 161 outlets in Westeld centres (including Just Jeans, Jay Jays, Portmans

Source: Property Council of Australia

Super-regional and regional centres


AREIT Occ Cost

WRT Westeld Retail WDC Westeld Group CFX CFS Retail Property

18.5% 18.4% 17.1%

Sub-regional and neighbourhood centres


AREIT Occ Cost

SGP CQR

Stockland Group

13.7% 13.2%

MGR Mirvac Group


Source: Morningstar

deepening US and European debt crises. This hit the residential developers particularly hard with Australand (ALZ), Stockland (SGP) and Mirvac (MGR) all falling heavily, then not recovering nearly as well as other AREITs before the end of the quarter. AREITs with international exposure and higher gearing were also hit hard. With condence in the AREIT sector fragile, bad news from around the world is capable of driving further falls in the index providing buying opportunities.
Income stability The ofce sector stands out as the growth sector for AREIT revenue, with improving occupancy rates and moderating incentives driving effective rental growth. The most recent Property Council of Australia data shows vacancy rates are below the equilibrium 10% level in all cities except Canberra, where the Federal Governments policy shift to preferring green buildings for occupancy may mean that some non-green buildings remain vacant, even with discounted rents, for considerable time.

Charter Hall Retail REIT 8.4%

As a result of the GFC and the difculty in raising debt funding, speculative ofce development has been rare across Australian capital cities over the last few years, leading to modest current supply levels which are now resulting in relatively strong ofce market fundamentals. Sydney is particularly well positioned as a result of constrained supply. A few major ofce developments are underway but have signicant pre-commitments. We expect the market to be favourably balanced until the extensive Barangaroo development starts adding to supply from 2015. The prospect of Barangaroo should keep speculative ofce development under control, with the willingness of banks to fund other major ofce projects limited unless there is substantial tenant pre-commitment.

20 October 2011

and Peter Alexander), publicly canvassing the closure of non-performing stores. Such possible closures, when coupled with the potential for other retailer collapses following those of Borders and Colorado Group, is unlikely to be offset by the much publicised new store openings by international retailers such as Zara, Top Shop, Abercrombie & Fitch and H&M leading to pressure on revenue growth of super-regional and regional shopping centres. Despite their focus on smaller, defensive shopping centres, both SGP and MGR, together with ALZ, continue to be buffeted by the uncertain outlook in the residential development sector as prospective homeowners are concerned about rising costs and interest rate uncertainty. As Federal and State Government home owner assistance diminishes, it only takes a perception of the potential for a possible rise in interest rates to slow demand for residential land and new homes. Generally, house prices appear to be falling across the country with new borrowing down and mortgage delinquencies rising on the Gold Coast, Sunshine Coast and across greater western Sydney. While anecdotal evidence suggests signicant price falls at the very top of the residential market, exactly what is happening in the mid and lower tiers of the market is harder to judge due to the smoothing nature of residential sales data. However, house prices appear to be down and in the magnitude of around 3% overall for the year, but may now be stabilising at least in the near term.

ALZ and SGP both commented that inquiry has increased, though ALZ added that converting inquiries into sales is taking around twice as long in the present environment. ALZ, SGP and MGR should rene product offerings both sectorally and geographically to meet the pockets of demand that exist, with the second half of 2011 expected to be an improvement on the rst half.
Balance sheet stability With gearing levels now generally in the manageable range of 2030%, the dark days of the global debt crisis appear well behind most AREITs and the focus has moved to buybacks for some. SGP, GPT, Investa Ofce Fund (IOF) and CQR have each announced buybacks with DXS, MGR and CPA canvassing the possibility. As trading prices remain stubbornly at a discount to NTA, as shown in the graph, buybacks are a better use of excess funds than buying property at market value plus transaction costs.

Though the more traditional property owning AREITs like Bunnings Warehouse Property (BWP), Charter Hall Ofce (CQO), CQR and CFX are progressively closing the gap between trading price and NTA, those with residential development businesses (ALZ, SGP and MGR) continue to trade at a hefty discount to NTA of 20% to 35%. The discount to NTA would appear to be driven primarily by a lack of investor condence. Property values have stabilised and are now strengthening with transaction activity at healthy levels. With the AREITs effectively net sellers of property, the active buyers driving the direct market are Australian super funds and an increasing number of offshore investors. Local super funds such as SunSuper, REST and Telstra Super have been active in the direct property market, with offshore investors from Singapore, China and the USA also buyers. Singapores Tay Family purchased 259 George Street, Sydney from CPA for $395m, at a 15% premium to book value, while the Singapore listed K-REIT Asia bought half of MGRs Chiey Square ofce development in Sydney. Goodman Group (GMG) continues to partner with China Investment Corporation and the Canada Pension Plan Investment Board for local investment, with acquisition interest announced by Bouwinvest (Holland), SachsenFonds (Germany), Heitman (US), South Korea Pension Board and global investors including Deutsche Banks RREEF.

NTA discount/premium 18 October 2011 (%)


30 20 10 0 -10 -20 -30 -40 ALZ ABP MGR WRT CHC DXS IOF SGP CPA GPT BWP CFX CQR CQO WDC GMG

Source: Morningstar

20 October 2011

Numerous AREITs have listed substantial direct property assets for sale, which will test the depth and quality of such buyer demand. SGPs 52 Martin Place in Sydney and Riverside Plaza on Melbournes Flinders Street, together with GPTs 50% interest in Sydneys iconic MLC Centre and MGRs hotel business are just some of the more substantial assets announced for sale during the quarter. Following the privatisation of Valad Property Group and ING Industrial Trust, together with the merger and acquisition activity surrounding EDT Retail, attention has now turned to a bid by a consortium comprising Macquarie (being the vendor of the AREITs management to Charter Hall Group (CHC)), Singapores GIC and the Canadian Public Sector Pension Investments Fund for CQO. While independent directors consider the current bid too low, this may be increased by the consortium placing the goodwill paid by CHC to Macquarie on acquisition in jeopardy. SGP continues to hold a strategic stake in FKP, whose retirement assets t well with SGPs 3Rs strategy, but has not agged any strategic movement for the holding to the market. With both local super funds and offshore investors keen to acquire Australian direct property, a period of sustained discounts to NTA only serves to increase the prospect of further merger and acquisition activity unless AREITs, such as Abacus, choose to privatise rst. With manageable gearing levels and a strengthening direct property market, the balance sheet fundamentals for AREITs are looking good with buying opportunities where the markets lack of condence has overshot.
Home goals Two key issues further dampened investor condence during the quarter, being executive remuneration and the incredible outcome of the ASIC litigation against the Centro Board.

performance for security holders would go a long way towards rebuilding investor condence and support for the AREIT sector. Despite a unit price fall of over 99% in Centro Properties between February 2007 and September 2011, CEO Andrew Scott got to keep 99% of his reported $3.0m termination payment by only receiving a penalty of $30,000 following the Court action by ASIC. Andrew Scott suffered more than his fellow directors who only received a declaration of wrongdoing without ne or ban, causing the callers to talk back radio to go ballistic. Despite misallocating $2.0bn in liabilities and not disclosing $1.75bn in guarantees in the 2006/07 accounts, which contributed to wiping out the savings of many small investors, the CEO and Board received little more than a slap on the wrist. From an investors viewpoint, this sent a very disappointing message to Boards of other AREITs and gave little condence to investors that highly paid CEOs would be punished for inappropriately managing unitholder funds. Sadly, the opportunity for demonstrably punitive penalties as a warning to errant CEOs and Boards was lost and the market is left to levy punishment on the sector as a whole. The outcome of the class action against the Centro directors, auditors and others by unitholders is awaited with interest.
Outlook The AREITs are generally continuing to deliver on the strategies put in place during the GFC. While DXS completed its No 1 Bligh Street ofce development in Sydney and WDC completed the massive Stratford East shopping centre adjacent to the London Olympics site, the DXS sale of US industrial assets and the WDC sale of US retail assets is now starting to drag. Similarly, while CQOs sale of US ofce assets is progressing glacially, it is at least progressing whereas CQRs sale of European retail assets has now been given a three year timeframe.

Unrest has been brewing for some time now about the level of executive remuneration in the AREIT sector, with attention focused mainly on the reported CEO packages of $5.7m at SGP, $4.8m at DXS, $3.4m at CHC and $3.3m at MGR. Despite extensive coverage in the nancial press and the risk of unitholder votes against the packages, AREIT Boards have been remarkably slow to do anything about the issue. Moving to more closely align senior management remuneration with

Standing apart from the disposal stories during the quarter was WDCs acquisition announcements of a $440m 50% joint venture with Almeida Junior Shopping Centres in Brazil and a $160m investment in Milan, when many commentators were expecting their next big move to be in Asia. Looking forward, manageable debt levels coupled with a strengthening ofce property market, a stabilising industrial property market and a retail

20 October 2011

property market that is good in parts provide a broadly positive outlook for the AREIT sector over FY12 and FY13. Our preference remains for good quality traditional AREITs, particularly those with high exposure to domestic ofce markets such as CPA and DXS. Meanwhile, uncertainty in the residential development market appears to have caused

over-reaction by investors in SGP and MGR, so providing buying opportunities for risk tolerant investors. Retail property trusts look cheap and could rally if cyclical factors currently depressing spending improve but the long term outlook is relatively unfavourable with ongoing household de-leveraging and migration to online shopping. K

ASX Code

AREIT Name

Sector

Geo Spread

2012E Yield

Gearing 1H11

Business Risk

Recommendation

ALZ GMG SGP WDC MGR CHC ABP CPA DXS WRT BWP GPT CQR IOF CQO CFX

Australand Goodman Group Stockland Group Westeld Group Mirvac Group Charter Hall Group Abacus Group Cwlth Prop Ofce Fund Dexus Westeld Retail Bunnings Warehouse Prop. GPT Group Charter Hall Retail REIT Investa Ofce Fund Charter Hall Ofce REIT CFS Retail Property

Ofce, Industrial, Residential Industrial Retail, Residential, Retirement Retail Retail, Ofce, Industrial, Hotels, Residential Retail, Ofce, Industrial, Residential Retail, Ofce, Industrial Ofce Ofce, Industrial Retail Industrial Retail, Ofce, Industrial Retail Ofce Ofce Retail

Aus Aus, Euro, Asia Aus Aus, US, UK Aus Aus Aus Aus Aus, US Aus, NZ Aus Aus Aus, NZ, Euro Aus, US, Euro Aus, US Aus

9.9% 6.1% 7.7% 6.7% 6.8% 9.1% 8.7% 6.1% 6.6% 6.9% 7.9% 6.3% 8.5% 6.4% 4.2% 7.2%

30.7% 23.0% 22.0% 36.1% 26.3% 8.1% 25.8% 26.4% 28.4% 20.0% 17.0% 21.0% 39.1% 20.5% 33.3% 27.0%

High High Medium Low Med-High Medium Med-High Low Medium Low Low Medium Med-High Medium Med-High Medum

Buy Buy Buy Buy Accumulate Accumulate Accumulate Accumulate Accumulate Accumulate Accumulate Accumulate Hold Hold Hold Hold

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