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

Thank you for standing by, and welcome to the Australian Unity Office Fund HY results. [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 FY '21 Half 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. Earlier today, we published various documents on the ASX, including the interim report for the half year ended December 31, 2020, Appendix 4D, AOF's property book and the investor presentation, which we'll go through this morning. We anticipate the presentation will take about 20 to 25 minutes, followed by Q&A. Before we start, I would like to take this opportunity to acknowledge the traditional custodians of the land our properties are located on and pay my respects to elders, past, present and emerging. Turning to Slide 2. It is 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. Today, Simon and I will take you through the AOF half year results. AOF has performed well with increasing occupancy levels, robust collections and minimal future FY '21 expiries, enabling FY '21 FFO guidance to be provided. We will discuss what we are seeing in the marketplace and the focus by tenants on cost-effective accommodation, working closer to home with an increased preference to drive and the need for staff amenity. The AOF portfolio is well-constructed to meet these demands with a focus on affordability, amenity and accessibility, which we believe positions the portfolio well to outperform in the current environment. The operating environment is improving, with key economic indicators turning positive, such as business confidence, sentiment, forecast GDP and employment levels. COVID-19 is well under control in most states and the vaccination program has commenced. It is no surprise that office utilization rates are showing an upward trend. Across our portfolio, we are seeing good levels of activity from the SMEs, assisting increasing our occupancy rate. While larger tenants to date have been assessing their requirements, we expect them to make decisions in the near future as their accommodation requirements become clearer and their expiries approach. Turning to Slide 5. For the half year to December 31, 2020, the funds from operation or FFO were $0.092 per unit and distributions were $0.075 per unit. Leases or heads of agreement have been reached for approximately 12,000 square meters equating to 11.1% of the portfolio NLA, driving a 1.6% increase in occupancy to 95.3% and a reduction in FY '21 expiries to 2.7%. The full portfolio was independently revalued, resulting in an $11.4 million increase since June 2020. The Fund's NTA increased by $0.05 per unit and gearing reduced by 0.5% to 30.7%. Given the underlying strength of the portfolio with limited vacancy, minimal FY '21 expiries and strong collections, earnings guidance of $0.183 to $0.187 per unit for the full year is provided. Distribution guidance of $0.15 per unit is reaffirmed, which based on the closing price last Friday, equates to a yield of 7.1%, attractive in the current low yield environment. This guidance is subject to no material change in market conditions, no material change to the portfolio and no unforeseen events. Turning to Slide 6. Throughout the pandemic, AOF's collections have remained robust, with collections of billings, including payment of arrears, averaging 98.3% for the 6-month period to December 31, 2020. Significant progress has been made on finalizing rent relief negotiations with tenants under the National Code of Conduct on commercial leases. As at December 31, 2020, outstanding tenant requests for proportionate rent relief have reduced by approximately 2/3 from 16% to 5% of tenants by average monthly gross income. Rent waivers totaling $451,000 were granted during the half year, with a further $298,000 of rent deferred. Turning to Slide 8. The profit for the half year is $20.1 million, down slightly on the prior corresponding period due to lower revaluation increases and the impacts of straight-lining of rental income. The half year profit and FFO includes a $473,000 doubtful and bad debts provision equivalent to approximately $0.003 per unit. FFO was $0.092 per unit and distributions of $0.075 per unit were payable for the period. As previously announced, the full portfolio is independently revalued which contributed to an increase of $0.05 per unit in net tangible assets. Turning to Slide 9. The capital structure of AOF remains robust. Net borrowings of $209.5 million provides significant headroom to the $250 million facility limit. Gearing slightly reduced over the period to 30.7%, and the interest coverage ratio increased to 4.5x, providing adequate headroom to AOF's target gearing range of less than 40% and 2x ICR covenant. Debt is diversified across 3 tranches and 2 major banks with the next maturity in October 2022. The dividend reinvestment plan was activated for the September quarter distribution, allowing unitholders to reinvest their distributions into new units. Positively, we saw a 22% participation rate for the September quarter, increasing to 32% for the December quarter. Combined, this raised approximately $3.3 million, further strengthening the balance sheet. Turning to Slide 11 and portfolio positioning. The AOF portfolio is built around 3 key themes: affordability, amenity and accessibility. The Fund seeks to hold assets that are positioned in markets that have affordable rents, offer great amenity for staff and are highly accessible or will benefit from future infrastructure investment. AOF's underlying allocation of 62% by book value to metropolitan markets, and 38% to the smaller Australian CBDs, positions it well for the future. The markets where AOF's assets are located have gross effective rents between 31% to 49% of Sydney CBD. In a cost-conscious environment, where employees are seeking to work closer to home, we believe these markets are well positioned as they offer distinct cost advantage while typically having great amenity and accessibility for staff. Turning to Slide 12 and portfolio highlights. The well positioned nature of the AOF portfolio has driven an excellent period of leasing in a challenging environment. Over 12,000 square meters of leasing and heads of agreement have been reached, driving a 1.6% increase in occupancy to 95.3% as at December 31, 2020. Renewal activity has been positive, reducing FY '21 expiries down to 2.7%, which is projected to fall to 2% once the current heads of agreement are finalized. As previously announced, the 7,000 square meter CPSA lease restructure occurred during the period, derisking the tenancy by introducing 2 new medical and biotech companies to the portfolio, while maintaining broadly the same annual tenancy income, and extending 1 lease by a further 3 years. This resulted in an independent valuation increase of $4 million to $70 million, a 6% increase. It is worth noting that all portfolio leases typically have fixed annual rent increases of 3% to 4%. Turning to Slide 13 and leasing. As mentioned, over 12,000 square meters of leasing and heads of agreement were agreed, comprising 11,200 square meters of leases and a further approximately 800 square meters of heads of agreement combined equating to 11.1% of the portfolio NLA. Macquarie Park was active at 5 Eden Park Drive, in addition to the CPSA lease structure, we subdivided and spec fitted a tenancy on Level 3. And pleasingly, 1 suite has been leased, leaving just 1 suite left to lease in the property. At the full year results, it was noted that all of the Fund's FY '21 expiries, over 400 square meters, were at 2 Eden Park Drive. I'm pleased to announce that 3 of the 4 expiries, over 400 square meters, have been let or under heads of agreement, leaving just unit 5 to be let up, which expires in June 2021. The asset is currently 100% occupied. In Brisbane, 241 Adelaide Street saw a particularly busy period of leasing with 8 transactions, 4 on vacant areas, with occupancy increasing by 9.5% to 95.2%. Pleasingly, across the transactions, face rents were typically at or above independent valuations with some increasing incentives on prior periods. Turning to Slide 14. Vacancy across the portfolio now sits at 4.7%. Management is focused on letting up the existing vacancy. And to date, there are several offers out over existing vacancy, which we are seeking to close out. FY '21 expiries are down to 2.7%, which will fall further to 2% if existing heads of agreement are converted to leases. Turning to Slide 15. Turning our attention now to the major expiries across the AOF portfolio. At 10 Valentine Avenue in Parramatta, Property New South Wales is the major tenant. They expire in June 2022 and have a 5-year option to be exercised by June 30 of this year. We have been in regular dialogue with Property New South Wales, meeting with them as recently as last week. Property New South Wales are currently assessing their required footprint and overall space accommodation requirements. One of the challenges they face is they have many different agencies with a range of different requirements, which they are working through to determine where their staff will be based, how they will work and how much space they need. Parramatta remains a core market for them due to the affordable nature of the market, while providing excellent transport amenity and staff amenity with Westfield, cafés, restaurants and gyms. We have tabled various terms for renewal for them, and we are awaiting further the guidance on their intended approach. We are working on a proposed reversion program for 10 Valentine Avenue to ensure it presents well and offers an A grade attractive proposition to Property New South Wales or any other potential future tenants. At 30 Pirie Street, Adelaide, Telstra have been busy working through their space requirement. Telstra do not currently occupy all their floors. Of the 21-day lease, they have sublet 5 to a range of tenants. We're in regular dialogue with Telstra and expect discussions around their future requirements will ramp up shortly. Of note, Telstra have a series of 5-year options over various tranches of the building, exercisable within 12 months of notice. We're currently working on a refurbishment program for the building to ensure the asset provides solid amenity to tenants ahead of the upcoming expiry. At 32 Phillip Street, Parramatta, the area will undergo a substantial transformation with the Powerhouse Museum achieving state significant planning approval. We have been working on schemes to revitalize the ground floor, to offer greater amenity and connectivity to the Powerhouse Precinct. This will be important to attract and retain tenants. GE currently leased the full building until June 2023 and have a 5-year option to extend. They have currently sublet 6 of the 8 floors to a range of sub tenants. We are in active dialogue with GE, and we'll seek to renew them and go direct with the various subtenants. At 150 Charlotte Street Brisbane, Boeing's expiries are over 3 years away, and it's too early for them to engage in meaningful renewal discussions. Our focus there is on enhancing the building experience to position the building well for future discussions. All the proposed refurbishments will include a suitable response to the COVID environment with elements such as touchless tapware, dispensers, doors and digital connectivity to lifts and speed styles all considered. Turning to Slide 16. As noted, all assets were independently revalued as at December 31, 2020, resulting in an increase of $11.4 million above the June 30, 2020, independent valuations. The portfolio capitalization rate firmed by 7 basis points to 6.02%. The valuers have had regard to the current environment, and valuations typically have lower growth rates, higher incentives and longer downtime allowances compared to pre-COVID. For example, the average 5-year compound annual growth rate reduced 0.7% at the June revaluations and a further 0.1% in December. Market downtime allowances have been included for all future expiries, including the major expiries. Turning to Slide 17. At 2 Valentine Avenue, more progress has been made with Buildcorp, completing the first stage of early works. The asset has been revalued and the combined 2 to 10 Valentine Avenue asset has increased by $18.15 million since June 2020. Recently, we have been working with fitzpatrick+partners, our architect, to develop a combined building offering, linking 2 and 10 Valentine together. The initial concept utilizes the entrance of 10 Valentine Avenue for 2 Valentine Avenue, providing a direct undercover entrance to 2 Valentine Avenue. It also provides the ability to have a grand entry to both 2 and 10 Valentine Avenue and a full floor on Level 5 in 2 Valentine Avenue as the arrival experience to provide tenant amenity, better café, third space, tenancy area, concierge and/or security gates. Market feedback has been very positive, and we expect to lodge a development approval in the next quarter. If this DA should have been received, would be complementary to our existing DA. So we could deliver the stand-alone 2 Valentine Avenue, which is currently approved or the combined building offering. Overall, the forecast yield on cost is 6.5% plus as we have reassessed our feasibilities in line with recent market conditions and costs associated with the link should it proceed. To maximize our market coverage and give us the best opportunity to achieve a precommitment, Resonate Partners have been appointed as a joint agent with Colliers. Turning to Slide 18. This slide shows the architectural drawings of the potential link between 2 and 10 Valentine Avenue. Moving from the right, tenants walk out of the train station into 10 Valentine Avenue proceeding through the lobby and a café or other amenity space and up the escalators to the level 5 garden lobby of 2 Valentine Avenue. This provides an enhanced tenant experience compared to walking along the pavement outside 10 Valentine Avenue, and allows for maximum flexibility on Level 5 of 2 Valentine avenue. Turning to Slide 19. Turning to other portfolio opportunities. As evident within the presentation, our Macquarie Park assets are performing well, with occupancy increasing, solid rents being achieved and incentives remaining fairly low on a relative basis. Key drivers for this are: the affordability of accommodation in the marketplace with gross effective rents, approximately 41% of Sydney CBD. The high accessibility to the market with the market well serviced by Metro Rail, buses and the M2 nearby and high car parking availability. And the amenity the market offers with various gyms, cafés and the major Macquarie shopping center nearby. The tenant composition of Macquarie Park consists of tenants typically in the logistics, health care and IT sectors, which are less affected and, in some cases, benefiting in this current environment. As part of this, we are looking at future opportunities and 2 Eden Park Drive currently has significant potential upside in terms of developable area. The current zoning allows an FSR of up to 3:1 for this site, which is currently developed to close to 1:1. There is also a strategic alliance, including the Department of Planning, Environment and Infrastructure and the Greater Sydney Commission, looking at the long-term zoning for the precinct, which may provide future opportunity. We will continue to participate in this alliance and also align the lease expiry to take advantage of future potential changes in the medium to long-term should they arise. In Parramatta, the Powerhouse Museum has recently achieved state significant planning approval. So the precinct around 32 Phillip Street will transform significantly. The light rail due in 2023 and the proposed civic link also served to enhance the appeal of the precinct. As previously flagged, we're developing a scheme to revitalize the ground plan of 32 Phillip Street to enhance the amenity of the asset and leverage off the improving Powerhouse Precinct going forward. As previously announced to the market, 241 Adelaide Street has been deemed a noncore asset due to the diminishing leasehold structure, and we have been actively seeking to divest the asset. We are pleased to announce we have a party in exclusive due diligence. Should a binding agreement be reached, we will update the market in due course. The proceeds would provide an opportunity to recycle the capital. Turning to Slide 20. The environmental credentials of the AOF portfolio are a key management focus. An important objective of the upcoming refurbishment programs will be improving the environmental credentials, such as neighbors ratings. At 2 and 5 Eden Park, we have recently commissioned a total of 150-kilowatt of solar to lower net energy consumption and improve the assets environmental credentials. I will now hand over to Simon to talk through the outlook.

Thank you, James. And turning to Slide 22 and the outlook. As we emerge out of the COVID-19 pandemic, economic indicators are positive. Real GDP is forecast to bounce in calendar year '21 at 3.7% versus minus 2.8% for the prior year. [ Maps ] business confidence hit plus 10% for January, above the long-term average and business conditions sit at plus 7% after reaching a multiyear high of plus 16% in December. Employment is trending upwards at plus 3% for January with finance, business and property, the highest sectors in January, a key driver of office demand. Turning to Slide 23, 2 COVID Vaccines have been approved and have been rolled out. As more people are vaccinated, we expect concerns, particularly around public transport to reduce. The Property Council of Australia is monitoring office utilization rates across the various states. It is pleasing to see utilization is typically trending upwards with the [ smaller rates ] typically above 60% and some as high as 80%. Across the AOF portfolio, our property management teams estimate office utilization rates are between 50% and 80% with the exception of Melbourne due to the recent lockdowns. Finally, with the official CapEx rate of record low to 0.1%, that appears to be substantial support for asset valuations as evidenced in recent market sales. With the AOF market midpoint yield according to JLL in the range of 5.26% to 6%, these markets offer a significantly high significantly -- a significant yield premium to cash in 10-year bond rates. Turning to Slide 24. I am pleased to advise that due to the resilience of the underlying income stream, strong tenant covenants, robust collections, recent leasing success and the limited near term expiry profile, AOF provides FY '21 FFO guidance of $0.183 to $0.187 per unit and reaffirms the FY '21 distribution guidance of $0.15 per unit, subject to no material change to market conditions, no material change to the portfolio and no unforeseen events. Despite the well positioned portfolio, and underlying resilience it is demonstrating, the stock continues to track at a significant discount to NTA. Today, we are also announcing that a strategic assessment is underway for AOF. Directors and management are focused on enhancing value and delivering the best possible outcomes to unitholders. And the strategic assessment will provide a framework to challenge the current strategy of AOF. The Board has engaged Highbury Partnership to assist with the strategic assessment. We expect to communicate outcomes and conclusions to the market over the coming months. Turning to Slide 25. Our focus remains on enhancing value and delivering the best possible outcomes to unitholders. To achieve this, the near-term priorities are to: continue to less up vacant space and derisk upcoming expiries, in particular, the major expiries; close out the sale of 241 Adelaide Street and recycle the capital; finalize the design and lodge the DA for the combined building up at 2 Valentine Avenue and to seek to lock in a tenant precommitment; progress the strategic assessment; finalized rent related discussions with eligible tenants and advanced value-add investigations and opportunities at 32 Phillip Street and 2 Eden Park Drive. In closing, we thank you for your time today and for your investments in AOF. We look forward to continuing to advance the Fund's priorities and providing an update to investors in due course with a focus on delivering the best possible outcomes. This concludes the formal part of our presentation. I will now hand you back to the moderator.

[Operator Instructions] Your first question comes from Leanne Truong from Ord Minnett.

I was just wondering if you could provide or maybe comment on 241 Adelaide Street in terms of, I guess, potentially expectations. Should it -- you expecting around book value for that asset? Or can you provide an update on that or some comments?

Okay. Thank you for your question, Leanne. 241 Adelaide Street, so we can't specifically comment on the price that's been set with the party that's in exclusive due diligence. I guess the best indication of value as at December 31 is the current independent valuation, which is at $31.5 million.

Okay. And just, I guess, the next question, just noticed that the tenants that are requesting rental relief has gone up from 11% to 16%. I'm just wondering why that's gone up, given the environment's getting a bit better or opening up a bit more?

So Leanne, the total number of tenants requesting rent relief did increase from 11% at 30th of June. A number of tenants between July and September actually then became eligible. So the total number of tenants applying for rent -- proportion of rent relief increased up to 16%. But in terms of the number of outstanding tenants because we have finalized a number of those negotiations. So the number of outstanding is now down to 5%.

Okay. And just one final question. I guess, can you discuss what you're seeing in terms of leasing spreads or incentives basically on some of your leases that you've renewed or agreed -- has an agreement with?