Australian Unity Office Fund (AOF) Earnings Call Transcript & Summary

Thank you for standing by, and welcome to the Australian Unity Office Fund Half Year Results. [Operator Instructions] I would now like to hand the conference over to Mr. Mark Lumby, Fund Manager. Please go ahead.

Thank you, and good morning, everyone, and welcome to the 2020 half year results announcement for the Australian Unity Office Fund. My name is Mark Lumby, and I'm AOF Fund Manager. Joining me today is Simon Beake, the Portfolio Manager for AOF. Today, I will discuss the performance of the fund for the half year ended December 31, 2019. The outlook and guidance for the remainder of the financial year FY '20, including the proposal from Starwood, and provide you with an opportunity to ask any questions you may have. Earlier today, we published various documents on the ASX, including the interim report for year ended 30 -- sorry, for the half year ended 31 December 2019, Appendix 4D, AOF property book and investor presentation, which we'll go through this morning. We anticipate the call will take around 25 minutes. Before we start, on Slide 2, it's important to note that the information in this presentation is general information only and should be read in conjunction with the interim report lodged with the ASX earlier today. So starting on Slide 4, I'm pleased to report that we continue to deliver on the key fund objectives for investors of delivering sustainable income returns, with a potential for capital growth over the long term. Occupancy in the portfolio remained strong at 95.2%, which is close to the high point since the fund listed 3.5 years ago. This solid leasing activity, combined with strong institutional investment demand and market rental growth, which is brought by affordability, infrastructure and accessibility in metropolitan markets, drove a $16 million increase in AOF's total assets to $693 million and increased the NTA per unit by $0.06 to $2.85. Our capital management position remains conservative. Gearing has increased slightly to 29.9%, reflecting capital expenditure and the $1.9 million in additional costs associated with the CHAB proposal which ultimately did not proceed following the unitholder vote in November last year. Despite the management distraction of corporate activity during the last 18 months, which resurfaced again last week with the Starwood proposal, we have delivered an 82% total return to investors since the IPO compared to the A-REIT 300 Index of 39%. We reaffirm our FFO guidance subject to no material change in current market conditions and no unforeseen events of $0.173 to $0.177 per unit for the full year to 30 June 2020, and distribution guidance of $0.16 per unit. We are at the last stage of the approval process relating to the proposed 28,000-square meter Parramatta development. We have previously disclosed our target fully let yield on cost relating to this proposed development, including tenant incentives, of between 7% and 8%. To assist investors with understanding the potential impact of the proposed Parramatta development on the fund's performance, we estimate that the NTA per unit will increase by between $0.20 and $0.40 per unit. This assumes the development is built with 100% occupancy and is based on property market assumptions that are publicly available. It also assumes that additional units are only issued to fund the development to maintain gearing at approximately 30%. While we are yet to receive development consent and yet to secure a tenant, the upside from the proposed Parramatta development is potentially quite significant. I'll now hand over to Simon Beake to present the half year financial results.

Thank you, Mark. Turning to Slide 6 and in 6 months to 31st of December 2019, the statutory net profit was $23.02 million, which is nearly $10 million higher than the FY '19 half year results. The principal reason for the increase in net profit was the higher growth in asset revaluations in the first half of FY '20 compared to the first half of FY '19. To put this into context, the cap rate tightened 8 basis points in the last 6 months with no change in cap rates for the prior half year. Mark will explain the property valuations in more detail later in the presentation. The net profit number also includes $1.9 million of costs relating to the CHAB proposal which reversed out in the FFO calculation. FFO increased marginally, driven by increased rental income of approximately 3.5%, which was offset by an increase in responsible entity fees following higher valuations, nonrecoverable outgoings and other trust expenses. Distributions increased by $0.001 per unit to $0.08 per unit, in line with the guidance we provided at the start of the year. Investors may recall that this distribution was not paid according to our usual quarterly timetable given the CHAB transaction was in progress. However, we sought to effectively rebalance this by paying the distribution to investors soon after the unitholder meeting, at which the resolutions to implement the CHAB transaction were not passed by the requisite majorities in November last year. We have also provided another perspective on FFO to ensure consistency of disclosure with some other A-REITs. Incentives paid to tenants generally take 3 forms: rental abatement incentives, rent-free incentives and fit-out incentives. Funds from operations has been assessed by adding back amortization of rent-free and fit-out incentives, but not rental abatements incentives as these are expensed. As a result, different incentives provided to a tenant may result in a different FFO outcome, which is why we have provided additional disclosure to investors. Turning to capital management on Slide 7. During the half year, total borrowings increased by $6 million, which was used to fund capital expenditure, fit-out incentives and costs associated with the CHAB transaction. Gearing increased marginally to 29.9%, driven by costs associated with the CHAB transaction. Gearing remains well below our target range of below 40%. There was no change to the debt facility of $220 million. However, we are currently seeking to refinance a $70 million tranche which expires in June 2021. This is in line with our standard practice of refinancing debt approximately 1 year ahead of its expiry. The interest cover ratio reduced slightly to 4.41x due to costs associated with the CHAB transaction. The interest cover ratio remains well above the debt covenant of 2x. Borrowings were 81% hedged as at 31st of December 2019. I'll now hand back to Mark.

Thanks, Simon. Moving on to the portfolio highlights in Slide 9. We've had a good period leasing up vacant space, which has contributed to the portfolio occupancy remaining consistently high at 95.2%. Market rental growth associated with this leasing has also contributed to an increase in the portfolio's value by $17.4 million to $685.8 million as well as cap rate compression and capital expenditure. Overall, AOF's earnings profile continues to be underpinned by high-quality tenants, including Telstra, New South Wales Federal Government, Boeing and GE. These 5 investment-grade tenants account for approximately 60% of the portfolio's income. We also made further progress with the planning requirements of the proposed development of 2 Valentine Avenue, Parramatta, which I'll discuss soon. Looking at the leasing activity in more detail on Slide 10. A significant portion of the leasing occurred at our multitenanted properties at 468 St Kilda Road in Melbourne, 2 Eden Park Drive in North Ryde and 241 Adelaide Street in Brisbane. We are witnessing a higher level of tenant inquiry in North Ryde following the opening of the Northwest Rapid Transit line in May. In addition, Brisbane continues to surprise on the upside with strong tenant demand for sub-500 square meter suites. This is clearly evident at 241 Adelaide Street in Brisbane which caters to small tenants with a -- sorry, with a 500-square meter floor plate and where occupancy is now nearly 95%. The property at 468 St Kilda Road continues to be almost fully occupied and is experiencing good rental growth. Market rents at this property, for example, were $340 net per square meter 18 months ago. Now they are $390 per square meter net, representing an increase of almost 15% in a space of 1.5 years. Overall, we struck leasing deals on approximately 6% of the portfolio in the half year, comprising almost 6,500 square meters of completed leases across 19 different tenants. Looking forward, AOF has a relatively favorable lease expiry profile with no significant single lease expiry until June 2022. In this regard, we're starting to actively engage with upcoming major lease expiries in FY '22 and FY '23. However, I won't discuss this further as I don't want to prejudice any discussions with those tenants. Needless to say, leasing and increasing portfolio occupancy remains a key management focus. Turning to valuations on Slide 11. Four properties were revalued as at December 31, 2019, in line with our valuation policy. Overall, the portfolio increased by $17.4 million during the last 6 months as a result of cap rate compression and market rental growth. On average, cap rates compressed 18 basis points during the last 6 months for the -- all properties revalued, which resulted in an overall 8 basis points compression across the portfolio. In the last 6 months since all properties were revalued in June 2019, cap rates reduced 25 basis points in Brisbane, Parramatta and North Ryde markets, reflecting the institutional demand in these areas. Market rental growth also contributed to the strong capital increase, particularly in the St. Kilda Road market, which has been performing well for a number of years, given the decrease in office stock for residential conversion over the last few years, combined with relatively affordability compared to other metro markets. The new metro rail line under construction is also benefiting this market. Net face rents also increased modestly in the Brisbane, Parramatta and North Ryde markets. And overall, the capital value of the portfolio is $6,372 per square meter which, to us, represents good value. While the property at 10 Valentine Avenue was not revalued in this 6-month period, it should be noted that a $122 million book value does not take into account any development potential associated with the proposed 28,000-square meter office building, which might have a significant impact on the valuation and which I discussed earlier on in the presentation. This leads me into Slide 12. You will be aware that we are pursuing a development scheme for a commercial office building with net lettable area of approximately 28,000 square meters at 2 Valentine Avenue, Parramatta, and this is on the same title as AOF's existing property at 10 Valentine Avenue. In the last 6 months, we have progressed the site-specific planning proposal which is almost at its final stage. Following a period of community consultation, Parramatta Council endorsed the planning proposal in October 2019 and submitted it to the New South Wales government Department of Planning and Environment just before Christmas. The local environment plan has now been prepared by the New South Wales Parliamentary Counsel and is now awaiting the Minister's approval. Once approved, the local environment plan is published on the New South Wales legislation website and becomes law. The Gateway Determination received in May 2019 states that the site-specific local environment plan is to be finalized and gazetted by 29 of February 2020. Running in parallel, we also launched a development application in August to -- seeking to add a further 20,000 square meters to the development consent already received relating to the 8,000-square meter building. Parramatta Council has advised that they intend to be in a position, provided they consent to the DA, to approve the development in the weeks following gazettal of the site-specific planning proposal. We are working actively with leasing briefs currently in, and about to come to, the market with significant state and federal government requirements included in those briefs. Commencement of the development is subject to a number of conditions being satisfied, including Board approval, securing a tenant to pre-commit part or all of the building, signing a major works contract with a builder and obtaining finance. As discussed earlier in the presentation, including the assumptions I discussed, once all of these conditions are satisfied and the building is complete, we estimate that the development will increase the NTA per unit by between $0.20 and $0.40 per unit. Turning to Slide 14. We announced last week that Australian Unity Limited, the headstock of AOF's responsible entity, will transfer all of the issued capital in the responsible entity to a joint venture company owned equally by wholly owned subsidiaries of Australian Unity Limited and Keppel Capital. This is expected to settle on or before 28 February 2020. While the ownership of the responsible entity will change, it will not impact AOF's strategy of providing sustainable income returns with the potential for capital growth over the long term by investing in a portfolio of Australian office assets. It's important to note 4 things associated with this announcement. Number one, Australian Unity Funds Management Limited and Australian Unity Property Management Pty Limited remain as AOF's investment manager and property manager, respectively, under the existing arrangements with the responsible entity, which is AUIREL. Number two, each of Australian Unity and Keppel Capital will be entitled to have one director on the responsible entity Board. However, the composition of the responsible entity Board will continue to be a majority of independent directors, continuing AOF's strong corporate governance principles. Number three, Australian Unity's existing policy dealing with potential conflicts of interest will continue to apply to this new joint venture company in the same way that AOF deals with potential conflicts with the Australian Unity's other property funds. And number four, we understand from Australian Unity Limited that this announcement is a result of a number of months of confidential detailed discussions and the negotiations between Australian Unity Limited and Keppel Capital. Given the timing of this announcement relative to Starwood's announcement about their intended takeover proposal, one of Starwood's conditions relating to the change of control will not be satisfied, noting, however, that Starwood has subsequently said it will not rely on this change in ownership of the responsible entity to lapse their intended offer. I'll discuss the Starwood proposal in more detail soon. Turning to Slide 15. I'm really pleased to announce that James Freeman commences as Fund Manager for AOF on 24 February 2020. James has over 20 years of experience across the property and financial markets, with experience in both listed and wholesale funds management platforms, including Mirvac and Investa Property Group, where he has been involved in asset management and capital transactions. James also brings valuable funds management experience to AOF, having worked as the Assistant Fund Manager for the Investa Commercial Property Fund, growing funds under management in that fund to over $3 billion. It's been a great year for me leading this fund, which has consistently delivered returns for investors in line with its objectives. I'll be taking a broader business leadership role within Australian Unity once James has been embedded into the team. This leads me to the first of a corporate -- sorry, the corporate actions on Slide 16. Given CHAB has no current intention of making a further offer for all of the units in AOF, I won't spend much time on what has been well documented, other than to say that we now have greater clarity on investors' expectations and what's important to them. This was demonstrated in the results of the unitholder meeting, where 19% of investors by issued capital voted against the 2 resolutions associated with the CHAB proposal, with only 33% of investors by issued capital voting for the proposal. This ultimately meant that the requisite majority of unitholders did not vote in favor of the scheme when assessed by those unitholders voting. Turning to Slide 17. Last week, Starwood announced its intention to make, itself or through an affiliate, an unsolicited all-cash, off-market takeover offer for all outstanding units in AOF for $2.98 per unit reduced by any distributions received by unitholders after 29 of January 2020. An independent board committee comprising the independent directors of the responsible entity, being Mr. Peter Day, Mr. Don Marples and Ms. Eve Crestani, was established to consider the intended offer. To provide some context to the Starwood offer, investors should note that the offer consideration is $0.06 per unit lower than the consideration offered under the CHAB scheme. Unitholders voted not to proceed with the CHAB scheme on 18 November 2019, with unitholders representing approximately 19% of AOF units on issue voting against the resolutions to approve a CHAB scheme. This is important given the 90% minimum acceptance condition of the intended offer from Starwood. Furthermore, and as discussed earlier in this presentation, we have since announced an increase in AOF's NTA of $0.06 per unit as a result of revaluations of 4 properties within the portfolio, resulting in an NTA of $2.85 per unit as at 31 December 2019. There are also a number of operational conditions which the independent board committee believes overly restrict AOF's ability to manage its portfolio effectively in the ordinary course of business in light of its growth strategy. This includes significant restrictions on leasing, development, refinancing and acquisitions and disposals. In the normal course of its business, AOF continues to be currently active across each of these operational and strategic elements. The independent board committee accordingly believes that it is in the best interest of all unitholders of AOF to continue to focus on managing its portfolio and executing on its growth strategy, including exploring potential acquisitions that meet the strategic objectives of AOF, including the negotiation of leases across the portfolio and further progressing the development opportunity at 2 Valentine Avenue, Parramatta, where AOF is in the final stages of receiving a development consent for a 28,000-square meter building. Given AOF will continue to be managed in the ordinary course of business, the independent board committee notes that this will highly likely result in some of the conditions of the intended offer not being satisfied. Given Starwood's proposal is very recent, no action is required by unitholders at this time, and the independent board committee will keep investors fully informed of any material developments. In closing, on Slide 19, we believe AOF is well placed to deliver on its objective of providing unitholders with sustainable income returns with the portfolio underpinned by 95.2% occupancy, with no single significant lease expiry until June 2022 and approximately 60% of the portfolio leased to investment-grade tenants, such as Telstra, state and commonwealth government, Boeing and GE. To that end, subject to no material change in current market conditions and no unforeseen events, we reaffirm AOF's FFO guidance for the 2020 financial year of between $0.173 and $0.177 per unit and distribution guidance of $0.16 per unit for the same period. This, of course, is based on operating AOF as business as usual, which includes refinancing a tranche of AOF's debt facility and continuing to focus on our key objectives, particularly as it relates to leasing any vacant space and upcoming expiries. Our focus also remains on progressing the proposed Parramatta development and exploring potential acquisitions that meet the strategic objectives of the fund. Australian Unity Limited is committed to AOF, as evidenced by the appointment of James Freeman as AOF's Fund Manager and the introduction of Keppel Capital. And this should provide further support -- sorry, should provide further support for AOF leveraging of Keppel Capital's access to capital sources and its origination capability. I would like to thank you for providing us with stewardship of your investment in AOF. We've delivered some exceptional results for investors over the last few years that the team and I are very proud of. To this end, liquidity in the fund has increased over the last 6-or-so months, which might also result in the potential admission of AOF to the S&P ASX 300 Index in March. That concludes the formal part of the presentation.

[Operator Instructions] There are no questions at this time. I'll now hand back to Mr. Lumby for closing remarks.

Okay. Thank you, everyone, for your time today. That completes the presentation, and we'll make this webcast and audio call available on AOF's website, australianunityofficefund.com.au, as soon as possible. Thank you, and good morning.