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

Thank you for standing by and welcome to the Australian Unity Office Fund 2020 Full Year Results Conference Call. [Operator Instructions] I would now like to hand the conference over to Mr. James Freeman, Fund Manager. Please go ahead.

Thank you. Good morning, everyone. Thank you for joining us, and welcome to the 2020 Full Year Results Announcement for the Australian Unity Office Fund. My name is James Freeman, and I'm the Fund Manager for AOF. Today, I am joined by Simon Beake, the Portfolio Manager for AOF. Today, we'll discuss AOF's performance for the full year ended 30 June 2020; the outlook for the fund, including guidance for FY '21; and provide you with the opportunity to ask questions. Earlier today, we published various documents on the ASX, including the report for the full year ended 30 June 2020, Appendix 4E, AOF's property book and the investor presentation, which we'll go through this morning. We anticipate the presentation will take about 25 minutes, followed by Q&A. Before we start, I'd like to take this opportunity to acknowledge the traditional custodians of the land our properties are on and pay my respects to elders past, present and emerging. I also hope that you and your family and friends are well in these extraordinary times. Moving to 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 report lodged with the ASX earlier today. Turning to Slide 4. I'm pleased to announce that despite the challenging economic environment we're all facing, the fund is resilient and continues to deliver a solid income stream, which is in line with its strategy of providing sustainable income returns with the potential for long-term capital growth by holding a diversified portfolio of Australian office assets. Given the current environment, we felt it was appropriate to independently revalue the full portfolio as at 30 June 2020. Total asset values have remained broadly in line with the 30 June 2019 position. The fund has enjoyed an active period of leasing, with almost 15% of the portfolio by NLA leased or under offer since July 2019. The portfolio is well positioned as we enter FY '21 due to its high concentration to the metro office markets and smaller CBDs across Australia, which provide a price competitive proposition compared to the Sydney and Melbourne CBDs while still providing solid amenity and accessibility. During the year, we improved the capital structure of the fund, increasing the debt capacity by $30 million, extending the debt maturity with no debt now expiring until October 2022. Gearing remains within our target range at 31.2%. Full year FFO of $0.17 per unit was impacted by COVID, which Simon will touch on later in the presentation. Collections have averaged 92% during the June quarter, which I will speak to shortly. We enter FY '21 in a strong position, with 64% of the income of the fund coming from our largest 5 high-quality investment-grade tenants, being State and Federal Governments, Telstra, Boeing Defence and General Electric. During the year, the fund made significant advancements on our Valentine Avenue development opportunity, which upon completion delivers a forecast yield on cost of over 7%. Turning to Slide 5. AOF has not been immune to the current economic uncertainty and disruption that the COVID pandemic as created. In saying that, we have been proactive in supporting our tenants, mitigating the impact for our shareholders and positioning the fund to come out of the pandemic in a strong position. We have been in regular dialogue with our tenants as we seek to support them and establish their entitlements under the National Cabinet Mandatory Code of Conduct for commercial tenancies. As at 30 June, approximately 11% of the portfolio by gross monthly income had requested proportionate rental relief under the code. This increased to approximately 15% as at 31 July as the second wave impacted Victoria in particular. Each tenant is being assessed on a case-by-case basis. Our approach has been to bill tenants in line with their existing lease arrangements and agree appropriate payments on account. Once their actual reduction in turnover for the full legislated rent relief period is known, a reconciliation will be undertaken and adjustments made. Collections as a proportion of the full rent roll remain robust, averaging 92% during the June quarter. It should be noted that the 92% is prior to any rent waivers being provided. Moving to valuations. And the full portfolio was independently revalued as at 30 June 2020. Whilst capitalization rates were broadly in line with the prior year, external valuers softened key metrics such as growth rates, downtimes and incentive assumptions to account for the current environment. I will now hand over to Simon Beake to present the full year financial results.

Thank you, James. I am now on Slide 7. The profit for the year reduced to $13.2 million due to the impact of revaluations, which were stronger during FY '19. The FFO of $0.17 per unit includes a $0.007 per unit doubtful debt provision associated with expected rent waivers to be granted under the code. If this COVID-related provision is backed out of our earnings, AOF would have been at the top of the previously stated and then withdrawn guidance range of $0.173 to $0.177 per unit for FY '20. Distributions for FY '20 were $0.15 per unit, representing a payout ratio of 88%, well within our 80% to 100% payout range. Net tangible assets per unit reduced by $0.07 during the year, driven by mark-to-market movements in the swaps and revaluations. I should note that in future periods, the add back of rental abatement incentives will be included in the Directors' assessment of FFO to ensure consistency of treatment of all incentives. This treatment is in line with a number of our peers. Moving to Slide 8. The fund remains in a strong capital position with significant debt covenant headroom and debt diversified by 3 separate tranches and 2 major banks. There are no debt expiries until October 2022. One of the debt tranches was refinanced during the year, increasing the available headroom by $30 million. A number of swaps were blended and extended at 0 cost. Overall, the weighted average interest rate reduced to 3.1%. I note that since listing, we have not spent any capital restructuring swaps. I will now hand back to James.

Thank you, Simon, and turning to Slide 10. As we enter FY '21, the AOF portfolio is well positioned. We believe our underlying allocation of 59% of the portfolio to metropolitan markets and 41% to the smaller CBDs is likely to create outperformance in the current environment given the attractive price point our rents have relative to the major CBDs of Sydney and Melbourne while still offering excellent amenity and accessibility. Only 4% of the portfolio expires during FY '21, with all of the larger expiries during the year located in Macquarie Park, one of the best-performing markets at present. Macquarie Park is showing solid levels of inquiry with several recent agreements reached across the portfolio. This is due to a range of factors, including its attractive price point, with gross effective rents 62% lower than Sydney CBD, and its high concentration of firms in the pharmaceutical, logistics and technology industries, which are typically performing well in the current environment. While we are on Macquarie Park, we are pleased to announce a major leasing transaction of 5 Eden Park Drive. More about this on Slide 13. During the year, we have made excellent progress on the Valentine Avenue development, achieving development approval for a 28,000-square meter building and completing a competitive tender process to identify the preferred builder, Buildcorp. Turning to Slide 11. The AOF portfolio is located in major office markets, which provide an attractive price point relative to the CBD markets of Sydney and Melbourne. On a gross effective basis, market rents across AOF's markets are between 29% to 49% of Sydney CBD. The decentralization theme was already evident before the COVID pandemic. For example, according to Jones Lang LaSalle, the New South Wales government had taken up approximately 116,000 square meters in Parramatta over the past 5 years. Other major corporates such as Westpac, NAB, QBE, Link Market Services and some major universities such as Western Sydney University, have established significant tenancies in the marketplace. We expect COVID will accelerate this trend with businesses reassessing their cost bases and employees seeking to work closer to home. Metro and smaller CBDs should outperform given their compelling advantage to the larger CBDs of Sydney and Melbourne. Tenants will also require proximity to a residential area serviced by good infrastructure. Most metro markets where AOF's assets are located are benefiting from major infrastructure spending, be it the light rail at Parramatta, metro rail in Melbourne and Macquarie Park or road infrastructure enhancements such as the WestConnex in Sydney. Our Sydney assets are also located near where the population lives. For example, more than half of Sydney's population lives in or west of Parramatta. Moving to Slide 12. As we enter FY '21, the AOF portfolio is in good shape. 64% of gross income is from the largest 5 major investment-grade tenants. There is only 4% of the portfolio expiring in FY '21, and over 95% of the portfolio has fixed increases of between 3% and 4%, providing income growth. Finally, the portfolio only has 3% exposure by gross income attributed to tenants in retail, hospitality and recruitment sectors. Turning to Slide 13. Since July 2019, there has been almost 16,000 square meters of leasing activity across the portfolio, representing close to 15% of the portfolio's NLA. It's pleasing that this activity has been spread across the portfolio and is not concentrated to any particular market. The most notable transaction is a major lease restructure at 5 Eden Park Drive. CPSA had a lease just over 6,400 square meters over a warehouse production lab and level 1 of 5 Eden Park Drive. This lease has recently been restructured with level 1 surrendered to Saluda Medical, a global medical device company. As part of the transaction, the level 1 lease term has been increased by 3 years to now expire in June 2029. The CPSA business has been acquired by a biotech company known as Aegros, who have taken over the remainder of the leased space. Overall, the transaction diversifies the existing CPSA lease into 2 separate leases, introducing new medical and biotech companies to the portfolio, both with significant future growth potential, while maintaining broadly the same annual tenancy income and extending 1 lease by a further 3 years. Given the above, we have commissioned a new valuation. Turning to Slide 14 and the portfolio's current vacancies and upcoming expiries. There's only 1 vacancy over 1,000 square meters, being level 5 at 64 Northbourne Avenue, Canberra, where we're actively seeking tenants. To minimize downtime, we may split the floor to accommodate smaller tenants. The portfolio has limited expiry in FY '21, sitting at just 4.3%. There are 4 tenancies over 400 square meters, all located at 2 Eden Park Drive, which is one of the best-performing markets at present. We've already made good progress on these expiries. On Slide 15, we outline the expiry profile for the fund. A key focus is the upcoming major expiries. The next major expiry is Property New South Wales at 10 Valentine Avenue in June 2022. We are in regular dialogue with Property New South Wales as we seek to understand their intentions going forward. As with most occupiers, Property New South Wales is assessing their business, the impact of the current environment and working out their footprint going forward. 10 Valentine is one of the best located buildings in Parramatta, next to Parramatta Station and close to the Westfield shopping center. It also provides an attractive rent proposition. We know these are key drivers for the government as they consider their occupancy needs. Given the strong performance of the Parramatta office market, there is solid rental reversion potential with the passing rental 20% below market in the most recent valuation. Moving to Telstra at 30 Pirie Street in Adelaide. Their tenancy expires in February 2023. Telstra are currently reviewing their business to ascertain what their office space requirements are going forward. We believe that 30 Pirie Street provides attractive accommodation for Telstra as it is well located A-grade asset, provides an attractive price point, particularly compared to Telstra's occupancy costs in some other markets. Telstra do not need all the space they currently lease, and as such, they have sublet 5 of the lower floors to 3 separate tenants, including Boeing Defence, who we have an existing relationship with at 150 Charlotte Street, Brisbane. We are seeking to retain Telstra over their required area and convert the subtenants into direct tenants well ahead of the Feb 2023 expiry. At 32 Phillip Street in Parramatta, GE is the sole office tenant expiring in June 2023. The asset is positioned in a part of Parramatta undergoing a significant transformation. There is the nearby light rail under construction, the proposed civic walk which would adjoin our property, and the proposed Powerhouse Museum. Given the upcoming expiry and the potential transformation in the area, we're reviewing options to improve the appeal and amenity of the ground plane and seek to integrate it with the wider precinct. We will shortly engage with GE and the subtenants. Given 6 floors are currently sublet, there is an opportunity to create a diversified tenancy profile going forward. Again, given recent market rent growth, the building is approximately 13% under-rented in the most recent valuation, providing some potential rental reversion. There is still 4 years to run on Boeing Defence's lease over the majority of 150 Charlotte Street in Brisbane. Our focus is on providing the best possible tenancy experience for Boeing to maximize the likelihood of a renewal in the future. Over recent years, Boeing have moved staff from surrounding buildings into 150 Charlotte Street. We are spending targeted CapEx to enhance the overall appeal of the asset for Boeing. Slide 16. We now move to Slide 16 and 2 Valentine Avenue. Over the course of FY '20, substantial progress has been made on this development opportunity. During the year, following site-specific planning approval, Parramatta Council approved our 28,000-square meter development application. A competitive tender for the construction of the building has been completed with the preferred builder, Buildcorp, selected. The contract has been structured to allow minor early works to commence shortly, which will reduce program delivery risks. The second phase, being the actual construction of the building, is subject to a range of conditions precedent. We are actively working with our appointed leasing agent to seek tenant precommitments. The DA has added value, and our development feasibility is showing a return on cost of over 7%. The building will substantially improve AOF's portfolio metrics, such as asset quality and environmental credentials, when it is built. It is worth noting that the commencement of the development is subject to a number of conditions being satisfied, including Board approval, securing a tenant to precommit part or all of the building, commencing stage 2 of the works contract and obtaining finance. Turning to Slide 17. As noted, the portfolio was independently revalued as at 30 June 2020. Portfolio capitalization rates were broadly in line, while market rentals have increased approximately 1.4% across the portfolio. Given the current environment, valuers have lowered their growth rates and increased downtimes and incentive allowances. I note that in the current low yield environment, prime yields in AOF's markets are at a significant premium to the 10-year bond yield. In the appendix, we highlight Parramatta's prime yield of 5.5% is approximately a 4.6% premium to the 10-year bond rate on a historic basis. Moving to Slide 19. Given the uncertain current environment, AOF will not be providing FY '21 earnings guidance at this point in time. As an income-based fund, we know distributions are important to our unitholders. We are pleased to advise that due to the resilience of the fund's income stream, FY '21 distribution guidance is $0.15 per unit, in line with FY '20 distributions. This guidance is subject to no material change in market conditions, no material change to the portfolio and no unforeseen events. The $0.15 per unit represents a distribution yield of over 7% on the 30 June 2020 closing price. Looking forward, management's focus is on managing the portfolio through COVID-19 and finalizing rent relief negotiations, maintaining a strong capital structure with gearing well within our target of below 40%. From the September quarter onwards, the distribution reinvestment plan will be operational, providing the opportunity for investors to increase their holding of AOF in a cost-effective manner. Over time, this is likely to increase AOF's equity base and market liquidity. Addressing current vacancy and upcoming expiries with a particular focus on major expiries. Completing early works and seeking a precommitment for 2 Valentine Avenue. And of note, we have just started a sales campaign to divest 241 Adelaide Street, Brisbane. In closing, I would like to thank you for your investment in AOF. We look forward to continuing to drive the portfolio to provide a sustainable income return for investors with the potential for capital growth over the longer term. This concludes the formal part of our presentation.

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

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

That does conclude our conference for today. Thank you for participating. You may now disconnect.