Argosy Property Limited (ARG) Earnings Call Transcript & Summary

Thank you for standing by, and welcome to the Argosy Property Limited 2023 interim financial results for the 6 months to 30 September 2022. [Operator Instructions] I would now like to hand the conference over to Mr. Peter Mence. Please go ahead.

Good morning, and thanks for joining us for the Argosy Property half year results presentation. Looking at where we're sitting with the -- building a better future and the vision and the strategy. We're obviously looking at an environment of rising interest rates, seeing some softening capitalization rates for property values, looking at a potential recession, we're seeing at the occupancy side of strong flights to green assets, and we're getting some good rental growth for the right properties if they're in the right location. So in that context, looking at some of the key results highlights. Net property income, good results there with solid rental growth remaining available and the distribution looking -- fairly solid and giving us fairly nice return at today's share price too, modest gearing level at the bottom end of the range and an asset backing that is reduced to NZD 0.02 on a reduction of the asset values on assessment. With the portfolio, the portfolio looks to be in good shape. Occupancy is solid. Weighted average lease term remains good, and the makeup of that as we'll see a bit later on, pretty solid. Rent reviews and expect some good results in the second half of the year as well. The arrears is actually at an extremely low level at the moment. And going into what looks likely to be a more constrained year, calendar year, the portfolio is in good shape to take that on. Looking at the sector summary and where that's sitting where we've got a scenario where with the industrial assets, we're obviously seeing some good rental growth in the Auckland market. The Wellington market has been slower to show signs of life but is starting to do that now. Still characterized by land constraint in Auckland and in Wellington. We're not yet bumping into affordability thresholds. No pushback from that yet, and still seeing some solid rental growth coming through. Added to that, we're seeing continued inquiry from reshoring or onshoring of industrial manufacturing and assembly activity. In commercial office space, if we've got a property that is green, if we've got property that is well located, particularly in Wellington, we're seeing very good rental growth down there and expect it to continue. In Auckland, the inquiry is very solidly into the green space. The vacancy rate in green space is about 1/3 of the vacancy rate in non-green space. Hence what we're seeing across our portfolio with actual transactions is some modest rental growth sitting in that sector but rental growth nonetheless, which is working against the market, where in general terms across the market the projections are for a decline. So some reasonably good results if you've got green space there. Large Format Retail for us, predominantly that is the Albany Mega Center. We're seeing, again, very good rental growth, where we're able to put new leases in place at higher rentals than we can justify with rent reviews -- and we see the opportunity over the next 12 months. And so -- and forward to improve the quality of tenants again through that site. So overall, pretty positive there. The remainder of our Large Format is principally with the warehouse, and we do know that they tend to do reasonably well in a recessionary environment. And as a consequence, that sector is looking reasonably solid, albeit quite small for us. I'll leave the portfolio weightings as I said and drop through to valuations, where we did an internal assessment of valuations and got that reviewed by an independent valuer to come up with what is effectively a director's valuation, showing a reasonably small loss. But what we've seen through that obviously is softer cap rates offset to a degree by market rental growth. Leasing has been a positive life, not just in the market, but for Argosy, but only for green space. And our inquiry for both industrial and office is almost exclusively for green space. And within that, we're seeing an increased focus from tenants on embodied carbon. So I think there's increasing divergence coming through there. It's worth noting that there is very little evidence in the market. Assets that are for sale in the market at the moment are generally of poorer quality and the reality is that we're not expecting to see significant activity between now and March either. So we're going to be dealing with the paucity of evidence and the valuers are going to have to put their thinking hats on. But the cap rates that are -- and rental rates that are being adopted are largely projected and expected rather than anything that's clearly evident in the market. For us, that's given us a NZD 23.5 million loss or reduction in value. And clearly, that's driven by the softer cap rates coming through. The value-add properties, the projects that are underway, 12-20 Bell Avenue is well underway now, and that's on program and on budget. 105 Carlton Gore Road again on budget and on program, leasing is going well. We've got a conditional heads of agreement with an international tenant for a further floor in that building. And the reality is we expect to have that fully committed on completion. 1-3 Unity Drive and 5 Allens Road are both nearing completion, pretty well tidy; and again, on budget and on program. The planning phases, 224 Nielson and 8-14 Mt Richmond. Both those projects remain on program. If you're aware, we don't get those back yet. That's still delivering as a rental income. So that's progressing as expected. But 101 Carlton Gore Road, we've moved from planning into future with what is probably a fairly logical, maybe expected deferral of that green project there. So we expect to see some -- during the year, some continued easing of construction costs. We've seen those peg back a couple of percent already. Expectation from the construction market is that we will see softer construction costs to the tune of 8% to 10% during 2023, going in hand with the reduced pressure on the supply chain. And leasing inquiry remains very strong. Rental growth continues, especially in well-located Wellington offices that are over 80% and in the industrial sector. What we're seeing with industrial is, as I mentioned, Wellington has been slow to respond as has, to a degree, the North Shore of Auckland, but we're starting to see signs of life with both those projects now. There's a couple of case studies there with 8-14 Willis Street, yield on cost slightly improved. Obviously, that project is completed. We're going through the commissioning stages at this point. Initial commissioning data is encouragingly on target for us there. Obviously, if we're targeting a 6-star rating, commissioning data is very important to us, and it's good to see that coming through. The 105 Carlton Gore Road on the next slide, some good results there. Remains on time and on budget. To mention, the leasing is going very well, and we expect to see that to be fully committed on completion. Over to Dave to talk through the financials, and then I'll talk a bit more about leasing at the other end.

Thanks, Peter, and hello, everyone. First slide from me is the gross property income waterfall. Gross profit income was NZD 60.4 million for the period compared to NZD 56.4 million last year, up 7%. Rent reviews contributed NZD 700,000, and there's more detail on that in the appendix. It was a NZD 1.3 million net contribution from leasing up this vacancy with 7 Waterloo Quay being the main contributor with positive NZD 1.1 million. We had a NZD 600,000 contribution from our acquisition of 100 Maui Street in Hamilton and a net gain of NZD 1.5 million from developments. That's made up of NZD 2.6 million from 8-14 Willis Street, less NZD 1.1 million from the withdrawal of 105 Carlton Gore Road. The impact from disposals was NZD 800,000, and that relates to sales last year of the Albany Lifestyle Centre in Omahu Road and Hastings. There was no COVID-19 progressing this year, which is great. So on to the next slide, the profit and loss. Net property income was up by NZD 1.9 million, largely driven by the increase in the gross property line, but offset by increased property expenses at Willis Street, which is a gross lease, and non-recoverable ground rent at 39 Market Place on vacancy. Admin expenses were down partly due to the capitalization of development, team salaries, projects as well as reduction in the doubtful debt provision. And as Peter said, our arrears is very, very low at the moment. MER ratio was 46 basis points and the percentage of corporate expenses to NPI is 9.44% compared to 11.2% at March year-end. Interest expense was up by NZD 3.2 million on last year. About NZD 2.2 million of this is due to the increase in floating rates over the period, and there was a NZD 1 million negative volume variance. Peter has covered the revaluation loss booked in the period, and there was a NZD 3 million payment received in respect to the March 2020 final settlement by the default in purchase review of the Albany Lifestyle Centre. Profit after tax was NZD 10.7 million compared to NZD 127 million last year, which included a NZD 92 million valuation gain. Next slide covers net distributable income. After all the usual adjustments, gross distributable income was up by NZD 2.4 million to NZD 36.5 million. Tax, net of depreciation recoveries was up to NZD 3.6 million compared to NZD 1.2 million last year. Last year included an NZD 820,000 prior period adjustment, and that was largely related to insurance washups and a significant reduction in respect to facade cost of 7 Waterloo Quay. The tax impact of the facade reduction was approximately NZD 2 million. So overall, net distributable income was NZD 32.9 million compared to NZD 33 million last year. Per share basis, NDI was NZD 0.0388 per share compared to NZD 0.0392 per share. On to adjusted funds from operations or AFFO. Firstly, we are looking at maintenance CapEx here. Main items of maintenance CapEx this year relate to fit-out and lobby works at Citibank, a new roof at 39 Randwick Road in Wellington and an electrical upgrade in [indiscernible] at 7 Waterloo Quay. AFFO was NZD 32 million compared to NZD 25.5 million last year. Facade last year was NZD 7.2 million, and that certainly dampened the result last year. Per share basis, AFFO was NZD 0.0379 per share. And with dividends paid and payable at NZD 0.033 per share, the payout ratio was 88% compared to 108% in the previous period. The next slide covers the movement in investment properties. We ended the half year about the same place we started the year. We purchased 100 Maui Street in May this year for NZD 33 million. We spent NZD 27 million on projects in the interim period. The biggest expense was NZD 10.4 million for 105 Carlton Gore Road, it's NZD 5.7 million for 8-14 Willis Street and NZD 3.4 million for our development at Bell Ave. We've covered revaluation loss of NZD 23.5 million. After deduction of the value of the right-of-use asset of 39 Market Place, NZD 40 million, the portfolio is worth NZD 2.24 billion at 30 September 2022. Next slide is NTA per share. Our NTA is also very similar to March '22. More revaluation loss booked at the half year has resulted in a movement down from NZD 1.74 per share to NZD 1.72 per share. To the next slide, gearing. Balance sheet is in good shape with our debt to total assets ratio sitting at 32.5%, marginally up at March and towards the bottom end of our target ratio of 30% to 40%. Next slide covers interest rate management. Weighted average interest rate increased to 5% from 4.1% of March '22, and this was caused mainly by movements in the 90-day rate over the period. Turn -- interest rate cover, interest cover ratio was a solid 3.1x at 30 September, the same as March. Percentage of fixed rate borrowing slightly down on year-end, and we provided some further detail on our hedging profile and also the weighted margins on our drawn bank debt and bonds in the appendix for your information. Level of hedging is fairly static until early March 2025 with some of our older swaps roll off and the average base rate of these older swaps is 4.8%. Next slide covers our debt profile. We refinanced our debt during the period, pushing out tenure. There was a small increase in the facility, and we added ICBC to the fold. You should note that when we refinance, the margins and line fees were fairly similar to the previous refinance. Nearest expiry is now 1 April 2025 and the weighted average deterioration is 3.7 years. The last slide for me on dividends. We declared our second quarter dividend this morning. It will be NZD 0.016625 per share with NZD 0.0159398 per share of imputation credit attached. The record date is 7 December and the payment date will be 21 December. We reiterate our guidance for a full year dividend of NZD 0.0665 per share, a 1.5% increase over last year. Now I'll pass you back to Peter for leasing update.

Thanks, Dave. As I mentioned earlier on, the leasing progress has actually been quite good for us during the year with some decent chunks of space put away and some good results coming from that. Again, the drive towards green space cannot be overemphasized. It's very, very infrequent to see an inquiry to space in industrial or commercial that is not for green space. If we look at the expiry and rent review profile going forward, lease expiries for the next 2 years are relatively modest. And as you'd expect, already well in hand and we expect that we'll keep very high retention rates for those 2 years in particular. Obviously, there's the potential for us to be in a recessionary environment next year and the team have been working for the last 12 months to make sure that we're not overly exposed to expiries or unexpected changes during that year. Again, with -- as you'd expect, we've been through the tenancy profiles across the portfolio again, and there's nothing particularly significant that we're concerned about at this point. So we don't know what's ahead, but I'm saying that we expect to be fairly well in control during that period. So if we're going into a difficult year, going into it in the best possible shape. The largest expiry at 9.4% at Stout Street in '27. We're already working on that and we're expecting a renewal of that lease to come through early. So I've covered off a lot of these market insights already, but industrial sector, where -- we're continuing to see good rental growth without pressure from affordability ratios. Green space is definitely the norm and the inquiry levels. Land supply remains scarce. We're seeing that reshoring or onshoring of manufacturing and interestingly, staff concerns impact location discussions to a significant degree with industrial tenants. The Wellington rents have been slow to respond, but we're starting to see some life in that sector at the moment. Moving to the office space. In Wellington, if you've got well located, well serviced and seismically sound property, you should be expecting to see some good rental growth, and we've got some results that we're working on at the moment that are surprising, if anything, on the upside. In Auckland, also where the CBRE suggested a 5% decline in rental rates across the market, net effective rentals that is, with our actual leasing evident, in many cases we're seeing some increases of 3% to 5% in those. I'd argue that that is probably only because it's green space, where the vacancy rate is 1/3 the level of non-green space. And as mentioned, for Large Format Retail for us, that's principally the Albany Mega Centre, which is going extremely well and for the warehouse that we expect to do reasonably well in a recession. So in that environment, it may well be a challenging year, but we're going into that in the best possible shape. So we do expect to see a recession during the next year, but the portfolio and the market and the business really well positioned to be able to deal with that. Importantly, we're not seeing any oversupply issues in the market, nor any that are potentially pending. There is certainly a flight to green going on, and we expect to see that continue. And the pathways, both at evaluation and a leasing level are increasingly divergent between green and non-green space. So that's a reasonably short and sharp presentation in an environment where we continue to see increased interest rates, softening cap rates, potential recession, flight to green, but really good rental growth for the right properties. Happy to take any questions.

[Operator Instructions] Your first question comes from Arie Dekker from Jarden.

I mean just following on from those concluding comments and the environment you face, I guess the decision on 101 is understandable. Can you just talk about the tenant status there?

Yes, sure. Thanks, Arie. The tenant is obviously Vector. They are going to be unable to move out of the building longtime in any event in totality. So they'll end up taking a renewal for 3 years over 1 floor. We will be probably replacing light settings and then looking to extend the -- put the building back into the market. We've got some leasing inquiry on for the rest of the building at the moment. And yes, it seems that it's actually going to be a better answer for us to defer that project and push ahead in spite of the good leasing inquiry we're getting for 105.

Yes. So have you got options within that Vector renewal on the floor for 3 years to get access to the property in advance for the 3 years?

Yes, we have. It's a question -- obviously, we've got a lot of scenarios running on at the moment, and if we are successful with the current leasing initiatives that are kind of strapped to change the strategy. But we've got quite a bit of flexibility in how we deal with it.

Yes. And in parallel, you're working through at the moment and getting other short-term leasing in place for 101 on those other floors?

Yes, that's exactly right. The building is actually presenting really, really well. Even the carpets are in good condition. So all the 3 assets we've had down the, the best one to be looking at deferring anyway, albeit that it was the only one that timing allowed us.

Yes. And then just on Mt Richmond, I guess just an update on, I guess, expected sort of phasing there when you might move on -- move into the first stage, what that's looking like at present?

It's a bit of a guess at the moment in terms of when resource consents and bits and pieces drop out. But the expectation is that by the beginning of next construction season, so August next year, we'll be -- we'll have enough space available for us on that site to commence the first of what will probably be a NZD 5,000 a meter building on that side.

Great. And then just on divestments. Have you had much inquiry? Is there anything you are sort of looking to bring into active marketing or are you happy to just sort of sit and wait in current market environment?

Well, obviously, we're trading at a bit of a discount at the moment, but -- so that has a bearing on it. There's nothing that's active in the market. But as always, I guess, you'd look at us as an opportunist seller should the asset and market be right to do something there.

The next question is from Nick Mar from Macquarie.

Just in terms of where the valuations washed up. It's probably around the other way is what you'd expect in terms of the ranking between sort of industrial, office and LFR. Could you talk through some of your kind of perspectives on what's happened there? And particularly within office, was there anything around profit recognition on Willis Street?

No, I think Willis Street is pretty much as you'd expect with the building nearing completion, but risk level remains in there. I guess it was -- you might be pointing to a bit of an unwinding of what was possibly an overreaction last year in some of the retail space. I think it's probably fair to say that with retail -- and indeed with bulk retail, no 2 assets are going to be equal. We're fortunate with the Albany Mega Centre that has always held good tenancy demand and gross rentals for us there now are poking over the NZD 5,000 meter, which is ahead of what we had expected. And what's been a reasonably difficult time for retailers, it has been quite rewarding to see that we have a continual supply of people who are interested in taking space over there. If we look at what might be a difficult environment, then obviously, you could start looking at your retail tenants, but there are a few in that center that would cause us concern. And in all the cases, we've identified, we think we have a good opportunity to trade up on the way through. You might have noticed that tenants are pretty slow to leave the location. And even if they've been in for a tough time with lockdowns and other sorts of things, they don't really want to leave, but it does give us an opportunity to look at being able to trade up on tenant quality is always a focus, of course.

And then just on the sort weighing the rental growth by sector. Industrial was sort of weaker than office and LFR. What's sort of reasoning behind that? I know it's sort of a smaller subset and will be timing of various types of reviews. But just any color on that you can provide?

Yes. You probably put your finger on it. Some of the rentals held down by timing of reviews, formula reviews. Interestingly enough, no one really wants the CPI review anymore. But it's timing and when those things come through. So I expect you see some leveling out through the next half of the year.

Yes. And the comment that FY '23 is NZD 83 million of income subject to review, is that including what's been seen in the first half? And does the NZD 27 million to market include the expiries remaining in the year?

So an expiry is classified as a review, yes, and we've only given you the 1/2 year numbers there.

Okay, cool. And then lastly, just on the development pipeline more broadly, so now Richmond and Neilson Street. Can you talk through your, I guess, return benchmarks or thresholds that you need to push go on those projects and whether or not those have sort of, I guess, increase given where interest rate go to?

Yes. Well, clearly, that increased state gives us certain -- different hurdle rate every week at the moment. And we have to be cognizant of where things are trading at the moment. But looking through over the long-term, it's important to try and make the long-term decisions. So it's very much a balancing act of what holding return can you get out of it, what security can you get out of that holding return, what's the development pipeline required to be over the 10-year period and what hurdle rates do we need to achieve it? It's very much a challenging scenario and somewhat of a moving piece it's just important we're able to evaluate all the benchmarks and make the best decision at the time. If you've got a tenant who wants to keep there -- stay there and pay you, what's a reasonable holding return then -- you've got to take that into account as well.

So if you had to put a number on a minimum IRR for spending the money on those sites, what would it be?

Yes, we're still looking at just over 7%, Nick. But like I say, numbers change all the time at the moment.

The next question is from Nicholas Hill from Craigs.

Just following on from Nick Mar's question around rent reviews. Will it be possible to talk about the lease structures for each subsector? Does industrial have a much -- larger degree of focus rent reviews in, say, like office or Large Format Retail?

So much larger proportion, I'm not sure. Actually, I might have to come back to you on that one, Nick, as to what the proportions are. Dave's got...

Well, there's information in the appendix, Nicholas. If you haven't looked at that, there's quite a bit of detail and we can add to that later on, if you like.

Okay. And with regards to leasing for the Citibank Center in Auckland office, are you experiencing sort of like a large degree of lease inquiry? And sort of are you considering sort of petitioning some of the areas in the smaller floor plates?

Have you been reading my mail, Nick? Yes, we are. I'll take the second question first. We're seeing quite a bit of demand for smaller space. That is benefiting the building. And in some ways, one, a lot of people who were previously looking at 1,000 meter floor plates are now looking for 600 meter floor plates, and we've got some really good leasing success with that building and some rental growth as a result of that. We've also managed to retain more tenants in the building than we thought we would over the 1/2, and we are in the process of subdividing 1 floor unto 3 because we can lease it at a much higher rental rate doing that than getting some good results. So you're right on song with that question. It's almost a taxi question. I'll get you with that later.

The next question is from Rohan Koreman-Smit from Goldman Sachs (sic) [ Forsyth Barr ].

Seem to have returned to my previous employer. First question from me, just on the cap rate expansion you put in for industrial. Can you give us an idea of what you've kind of got in your valuations?

Yes, we've got a softening of 55 points on Auckland industrial -- that's not even across when we sat down and went through all the assets with the valuers. There was a drive to reprice or to price or to price risk where that had been slipped in the past, but it's not completely even. But as you'd be aware, for the last few years, the market has been pricing risk at a fairly generous level and the value is around winding that to a reasonable degree.

Perfect. And then maybe just with your interest rate hedging coming to an end, you had that 8-year swap, I think it was from memory in there or maybe it was 6. Anyway, you're kind of coming to the end of that long period. Can you give us an idea on the hedging policy kind of going forward, given you had a bit of a departure from, I guess, industry norms?

Unfortunately, that loan coverage still got another 2.5 years to go. Most of it has come off until March '25. So we've still got at least 2.5 years to veer that unfortunately. But we -- going forward, we've got obviously normal policy bands that we stuck with. We're expecting there to be some headwinds next year in respect of the increase in floating rates, and we'll navigate through those pretty well, I think. And then after that tailwinds with some of these older swaps rolling off and hopefully floating rates starting to return back to the neutral rate.

Perfect. And then I guess just given the comments around 101 and you do have a bit of a tail of value-add assets. Is it much harder to kind of convert those non-green assets to green and therefore, you'll have a bit of a bifurcated portfolio yourself in terms of the part that's green goes well and the part that isn't is harder to kind of get up to those green levels near term? Is that kind of a bit of the…

Yes, not really kind of what you'd expect to see, I guess, but because we started well over a decade ago with moving the office part of the portfolio into green. There's been a fairly strong and consistent strategy over the last decade to put those building blocks in place. And net result of that, we got a 4.5-star rating at the Citibank building, just in the last couple of months on a NABERS basis that gets most tenants over the line, and that's a pretty good rating for an existing building you haven't spent a lot of money on. And at the same time, the Wyndham Street property, we got an upgrade to a 6-star rating out of our last work on that on a NABERS basis. So with most of our office buildings, they're either green or easily green a ball because the career path for those assets over the last decade has taken us in the right direction. So it's actually easier for us to green assets now than it has been because we've got a great deal more knowledge, a lot more data and our flight path has been consistent on the way through. So that's really working for us at the moment.

[Operator Instructions] Your next question comes from Bianca Fledderus from UBS.

Just with regards to the drive towards green space, so it's obviously pleasing that there's high demand for that in your portfolio. I'm just wondering, is there a risk there in your view that as we move to a potential recessionary environment, as I guess, companies may be more focused on cost savings and we may see increasing vacancies. Do you expect that there's -- just that flight to green assets may slow?

Look, it's always a possibility, Bianca, but we're actually seeing the reverse of that at the moment. And I've got nothing to back this up, but I'm of the view that what we're seeing is as businesses are relocating, taking potentially pure desk spaces, they've got a little bit more up their sleeve. But the drive to getting people back in the office and creating a better environment for their staff is driving them solidly into that more desirable green space, particularly with employees' demands and what they want to see. So I think probably the positives are outweighing the negatives because it's certainly the reverse of what we're seeing.

Okay. And then just the net property income increase was partly driven by lower COVID-19 rent rebates. Were there any coverage rebates during the 1/2 or was it just 0 and can we expect 0 going forward?

Yes, 0.

There wasn't a lot in the last half, was there?

It was about NZD 800 million, I think in the second half of last year.

Thank you. There are no further questions at this time. That does conclude our conference for today. Thank you for participating. You may now disconnect.