A-REITs find favour – but what about those vacancies rates?

The listed property trusts sector continues to outperform the general market, yet prime CBD office vacancy rates are high.

Summary: The listed property trusts sector continues to outperform the general market, yet prime CBD office vacancy rates (where A-REITs tend to focus) are high. However experts do not see a significant negative outlook for the commercial property market.
Key take-out: Stockbroker Morgan Stanley says despite its cautious view on demand and rental growth fundamentals, especially for Australian retail and office, it expects the sector will outperform in a weak macro-environment.
Key beneficiaries: General investors. Category: Commercial property.

The property market may be ‘coming alive’, or at least returning to some form of normality, with house prices gaining a respectable 4% in the last 12 months.

But investors who have been pouring funds into Australian real estate investment trusts (A-REITs) that focus on the bigger end of town might take a harder look at the weakness in vacancy rates, certainly in the office sector.

At first glance it would seem like the A-REIT sector has been a winner, having outpaced the broader index in recent months (see the graph below).

But the big question is whether investors are chasing the actual underlying performance of the property market – especially in commercial property – or whether they are blindly chasing yields, which at a highly attractive average of 5.8%.

Earlier this week a report from real estate agents Knight Frank said Australia’s CBD markets continue to languish, with a high vacancy rate of 10.1%. Moreover, most of Australia’s property markets (CBD and non-CBD) have recorded negative net absorption over the past six months, driven by an increase in sub-lease availability and tenant contraction.

These negative absorption rates were broad based across all geographic and industry sectors. Separately, the total vacancy rate including non-CBD markets is also 10.1%.

But it is in the CBD office sector – which is dominated by A-REITs – where the figures are least impressive. In fact, vacancy rates have actually been increasing to 10.1% from 8.1% in the past six months – historically 6% to 7% would be expected in Australian CBDs.

The gap in vacancy rates between primary and secondary markets is wider for markets not in the capital cities. In CBDs, prime grade vacancies hover at 9.2% compared to 11.2% for secondary properties. But in non-CBD markets prime vacancies are at 7.2%, while secondary vacancies are at 12.1%.

So, is there anything to worry about for investors who have invested in A-REITs searching for higher dividend yields? An industry report from stockbroker Morgan Stanley on July 29 gives a cautious recommendation on the sector, with several provisos:

“Despite our cautious view on demand and rental growth fundamentals, especially for Australian retail and office, we believe the sector will outperform in a weak macro-environment.”

Ken Atchison from Atchison Consultants says that while reports are beginning to show emerging problems in the office A-REIT space, he doesn’t see a significant negative outlook for the market.

“I have concerns with Melbourne because of excess supply at the Docklands, but elsewhere around the country I don’t see significant supply issues,” he said.

“I have the A-REITs at fair value. They definitely got expensive back in March but not now.”

Whether the optimism from inside the industry is justified remains to be seen: Certainly with vacancy rates going the wrong way in recent months a turnaround will be needed in the months ahead to fully justify the sector’s new found popularity.