This article is part of a two-part series, read article 1 here.

Geopolitics and instability are making this an unusual and challenging investing environment. In part 1 , we set the scene for the attributes we want from AREITs in the Dexus AREIT Fund that will assist us to deliver to our investors our goals of not only income but, also the potential for capital growth.

Here, we’re going examine the property sectors set to perform in this environment and three AREITs we’ve identified as core portfolio holdings.

The retail sector

Even before the war, retail was the Dexus AREIT Fund’s largest, look through property sector exposure. Our analysis has only reinforced this view.

Retail is benefitting from occupancy cost ratios below pre pandemic levels, enabling retailers to absorb rising costs. The sector is in rude financial health. Vacancy rates are negligible, additional space is desperately sought, and the predominance of inflation linked rent reviews is an additional growth driver.

History offers additional comfort. Even during Australia’s last major recession in the early ‘90’s and the onset of online retailing a decade later, retail sales growth has remained positive over the long term. We expect this period to conform to the historical pattern.

Retail sales

Convenience based retail is of particular interest, being a beneficiary of non-discretionary spending. Malls with strong experiential offerings also stand to capture redirected spending, especially as households become more cost conscious.

In addition, we expect the redistribution of spending earmarked for overseas travel to offset any short term impact to discretionary spending, at least initially. Rising fuel costs should also accelerate the shift towards click and collect, a model that benefits retailers and landlords by increasing foot traffic, maximising sales and reducing last mile delivery costs for the retailers. As if to make the point, online only offerings are now charging higher delivery fees to offset fuel prices rises.

Service stations with high quality retail offerings all also benefiting from the current environment. With fuel costs rising, drivers are making more visits to manage overall costs, leading to more (higher margin) in store purchases. The transition to improved retail outlets at service stations was well underway but the war should accelerate the transition. 

The industrial sector

While industrial property may benefit from a renewed focus on just in case onshoring inventory, sharply higher transport and operating costs for tenants are likely to offset this. We expect infill located assets to relatively outperform as these are typically closer to end markets. Higher overall costs are likely to mean less developments of newer, automated, facilities.

Data centres are booming due to the investment in AI but costs are increasing and key equipment supply is tightening. We expect reduced development margins and longer construction times.

The office sector

The bifurcation in office markets, so evident since the pandemic, will continue. Core CBD assets with great amenity, connectivity and sustainability credentials should remain highly attractive to tenants and, increasingly, capital. Such is the demand; incentives are becoming a less important aspect in attracting tenants.

Secondary suburban stock is facing increasing obsolescence risk. Flexible work trends are being reinforced by higher commuting costs, making car dependent locations increasingly vulnerable. Whilst some fringe/suburban office markets may benefit from their lower rents, investors must be highly selective. The price conscious nature of tenants limits the ability of landlords to derive material net effective rental growth.

The residential sector

In residential, higher interest rates, fuel costs and inflation are weighing on confidence. We expect this to limit transaction volumes and pricing, with developer margins likely to be lower.

Historically, the higher price points suffer the biggest falls in economic downturns, a trend that is already evident. Affordable product, particularly in master planned communities (MPCs), is better positioned, given the developers’ ability to control rollouts and amend lot sizes/specifications to deliver affordable properties.

The strong residential markets in south-east Queensland, Perth and Adelaide should continue to outperform Melbourne and Sydney. MPC performance in the stronger markets are limited only by the ability to meet demand.

Land Lease stands out due to CPI linked rent escalations, residents access to government support, mortgage free residents and affordability. We do however forecast an initial near term softness in sales volumes, as prospective residents readjust their pricing expectations on existing homes. 

Other sectors

Self-Storage is really a play on residential. Inertia usually sees a large cohort keep their forgotten belongings in the unit but the jump in costs, combined with a potential reduction in residential turnover, may see operators struggle near term.

Childcare is financially supported by the federal government. Historically, low occupancy cost ratios support those operators in absorbing regulatory cost increases, along with any potential drop in daily attendance from an economic slowdown.

Agriculture operations look set to experience a material jump in the cost of doing business, given diesel and fertiliser availability and pricing. This may impact crop yields, but the pass through of higher prices for goods produced could more than compensate, supporting the farmers and their ability to pay rent.

Whilst healthcare landlords are not directly impacted, elective procedures may start to be deferred as households reassess their spending.

As for fund managers, they are likely to find it harder to raise capital as higher rates of return are required. Potential transactions for lower yielding assets (under 6% capitalisation rate) have already seen institutions back off, given the (potential for further) interest rate rises. Higher interest rates translating into higher capitalisation rates in some instances, should also pressure assets under management, further negatively impacting the ability to generate fees.

Portfolio positioning

Given these factors, we have further positioned the Fund towards AREITs that combine income resilience, inflation linked growth and conservative capital management, especially where the supply–demand dynamic is favourable. This means retail and select alternative exposures.

Examples of key holdings in the Fund include:  

• Arena REIT: Enjoying about ~90% exposure to childcare and CPI linked rent reviews, Arena REIT is modestly geared, with conservative capital management and a sector well supported by government.
• Vicinity Centres: With exposure to discretionary and non‑discretionary retail, this AREIT has strong capital management and a proactive refurbishment led growth strategy.
• Stockland: Not only does Stockland have the largest exposure to retail, it is also the largest player in affordable residential (MPCs and land lease). Its residential land bank is held at historical cost, providing long dated and accretive optionality. Trading at a discount to its net tangible assets, it offers access to the best residential development business in Australia and retail exposure at an attractive price.

Conclusion

Investing success in this environment will not be driven by leverage or multiple expansion, but by growing income durability, pricing power and capital discipline.

By leaning into sectors and AREITs where rents can grow organically, linked to inflation, with minimal leakage via maintenance capital and tenant incentives, constrained supply via rising replacement costs and conservative capital management, we believe the Dexus AREIT Fund is well positioned to continue to deliver on its objective of reliable income and capital growth.