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

[Operator Instructions] I would now like to hand the conference over to Ms. Nikki Panagopoulos, Fund Manager. Please go ahead.

Good morning, everyone. Thank you for joining us, and welcome to the Annual Results Announcement of the Australian Unity Office Fund for Financial Year 2021. My name is Nikki Panagopoulos, and I'm the Fund Manager for AOF. And I'm joining you from Melbourne. I'm also joined by Simon Beake, the Portfolio Manager for AOF, who is in Sydney. I was appointed as the AOF Fund Manager in July, having spent more than 30 years in the property industry in both listed and unlisted markets, including the last 17 years at Australian Unity. I'm very excited about the opportunity to lead AOF into the next phase of its journey, and I look forward to working with our unitholders and tenants to drive mutually beneficial outcomes. Earlier today, we published various documents on the ASX, including the annual financial report, Appendix 4E, AOF property book and the investor presentation, which we'll go through this morning. Following the presentation, we will have time for Q&A. Let's now turn to Slide 2. Today, Simon and I will take you through the portfolio highlights for financial year '21, provide detail on the outcome of the strategic assessment that we completed, update the key financial results and provide a property update and financial year '22 guidance and outlook. We will also highlight how AOF portfolio is well positioned, offering affordable accommodation with excellent accessibility and amenity. Let's now turn to Slide 3. Before I 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. Slide 5. It is pleasing to advise that AOF had an excellent year with funds from operations at the top end of guidance at $0.187 per unit and occupancy increasing by 2% to approximately 96%. The increase in occupancy was driven by strong leasing outcomes with approximately 16,500 square meters completed during the year. This equates to 15% of the portfolio and was largely driven by small-to-medium enterprise tenants looking for affordable accommodation closer to home with good amenities and easily accessible by car and public transport or staff convenience. The fund provided approximately $0.5 million of rent relief support to tenants impacted by COVID. This equates to about 1% of rental income. Pleasingly, collections remained robust during the year at 98% of financial year '21 billings, and over $1 million of financial year '20 arrears were also collected. This highlights the resilience of AOF's tenants and the benefits of having a diversified and quality tenant base. Most importantly, a high collection demonstrates how we worked constructively with our tenants to ensure they could navigate through a very challenging period to continue their businesses. While we are by no means through this COVID pandemic, we do believe that we have the right framework in place to continue to support our tenants while ensuring returns to investors. At AOF's half year results, it was announced that the Board had initiated a strategic assessment to challenge the existing strategy and examine all options to enhance value and generate returns for unitholders. The assessment, including obtaining feedback from unitholders, was completed during the year. Later in the presentation, I will provide details of the scenario, which were considered; the strategic priorities, which were identified; and the conclusion reached. For now, I will talk to AOF's refined strategy. Let's turn to Slide 6. In July, we announced the conclusion of the strategic assessment. And I am pleased to provide the outcome, which presents the refined strategy that delivers on the existing AOF strategy, that is, its focus on owning Australian office properties in metropolitan and CBD markets but complemented by a targeted and diversified portfolio of Australian real estate assets. Maintaining an office focus while investing in other asset classes helps to deliver a diversified income profile which can withstand economic shocks while maintaining sustainable distributions. Together with active management strategies, including refurbishments, asset recycling and a balanced lease expiry profile, investor returns can be maximized. We believe that a well-constructed portfolio with assets focused on affordability, amenity and accessibility will be well positioned to outperform. Let's now turn to Slide 7. AOF's active management has been approximately 16,500 square meters of leasing during the year, which equates to 15% of the portfolio NLA. This leasing has driven 2% in occupancy to 95.7% from 93.7% as of June 2020. This is an exceptional result, considering it was delivered during periods of extended COVID-related lockdowns. There was a good level of leasing activity, particularly at 468 St Kilda Road and at 5 Eden Park Drive with approximately 67% of the 16,500 square meters of leasing completed at these properties, resulting in the occupancy for 5 Eden Park increasing by 3% to 96%. And for 468 St Kilda Road, the weighted average rate expiry increased to 3.9 years from 2.3 years as of June 2020. I'm also pleased to announce that the last vacant suite of 5 Eden Park Drive has just been leased, delivering 100% occupancy. Pleasingly, across the transaction, rents were typically at or above independent valuations with consensus in line with prior periods. Turning our attention to the major expiries at 10 Valentine Avenue and 30 Pirie Street. The tenants continue to assess their accommodation needs, but their requirements have been delayed impacted by COVID lockdowns in New South Wales and Victoria. We expect them to make decisions as their accommodations [ becomes zero ] and their expiries approach. At 10 Valentine Avenue, Parramatta, Property New South Wales is the major tenant which lease expires in June 2022. As previously communicated, they did not exercise their 5-year option. We've been in regular dialogue with the Property New South Wales team, meeting with them as recently as last week to discuss their occupancy requirements. Property New South Wales is liaising with a number of New South Wales government departments to finalize their future occupancy requirements. Parramatta remains the core market for Property New South Wales due to the affordable nature of the market while also providing excellent transport feasibility and staff amenity. At 30 Pirie Street Adelaide, Telstra has recently come to the market with a circa 4,500 to 7,000 square meter occupancy requirements. We have been in active dialogue with Telstra's team working through their future requirements and service needs. It is important to note that Telstra does have a lease of 21 levels but does not occupy all of its floors, having sublet 5 to a range of tenants. We have refurbishment strategies underway at 10 Valentine Avenue and 30 Pirie to reposition these assets with sustainable features, including enhancing amenity to maximize the wellness experience. We believe this will position the assets well to capture future leasing opportunities. Let's now turn to Slide 8. Our active asset management extends to recycling assets and enhancing portfolio construction. We successfully sold 241 Adelaide Street, Brisbane, an aging leasehold asset requiring significant capital expenditure, and will redeploy the funds to 96 York Street, Beenleigh in the City of Logan in Brisbane. The Beenleigh asset is leased to the City of Logan and will be occupied by the Department of Water for a 10-year term with 2 5-year options. Being newly constructed with sustainable green start and energy rating, the property is well positioned to deliver sustainable income strategy. We're also considering divesting 32 Phillip Street, Parramatta to maintain a balanced portfolio of construction in the Parramatta market as we commenced the refurbishment strategy on 10 Valentine Avenue and, possibly, 2 Valentine Avenue development, providing a precommitment is achieved. Let's turn to Slide 10. As discussed earlier, the purpose of the strategic assessment was to challenge the existing strategy and examine options to maximize returns and realize value for unitholders. We identified 3 broad categories to assess a range of scenarios. They were: grow and enhance the portfolio, maintain the current portfolio and divest the portfolio and return capital. We established a comprehensive framework to assess the scenarios, including engagement with many of AOF's investors, including institutional, high net worth and retail investors; an assessment of the strengths, weaknesses, opportunities and threats for AOF; consideration of the future of office; evaluation of AOF's portfolio construction, including a detailed assessment of AOF's properties, tenants and future cash flow; and an analysis of AOF's position within the listed real estate investment trust universe. Turning to Slide 11. The outcome of the strategic assessment refines the existing strategy, complementing AOF's continuing core focus on office with an expanded asset ownership mandate, allowing AOF to own commercial real estate that aligns with the key asset attributes of affordability, accessibility and amenity. Core to achieving this strategy is the focus on enhancing the current portfolio, enhancing through acquisitions and divestments, enhancing through asset repositioning and development and enhancing through potential large-scale portfolio combinations. We have already started to deliver on our portfolio enhancement in a number of ways, including the divestment of 241 Adelaide Street in Brisbane; the acquisition of 96 York Street, Beenleigh; the potential divestment of 32 Phillip Street in Parramatta; the initiatives being considered at 30 Pirie Street Adelaide and Valentine Avenue, Parramatta; and the ongoing assessment of the potential merger with the Diversified Property Fund. Specifically, on the investigation of the merger with DPF, we continue to believe this opportunity has financial and strategic merit. Over the last several weeks, management had been focused on finalizing year-end accounts and preparing the results presentation. We continue our assessment of the merger and expect to update the market over the coming weeks. Various other initiatives were considered as part of the strategic assessment, including maintaining the current portfolio in various structures and divesting the current portfolio. These options didn't achieve strategic priorities. In particular, a full portfolio divestment presents a significant uncertainty around what proceeds could actually be returned to unitholders and when. Further detail regarding value uncertainty are included in the appendix. Finally, I would note that whilst strategic assessment has been completed, our focus will remain on maximizing returns and realizing value for unitholders. I'll now hand over to Simon who will provide an update on AOF's annual results.

Thank you, Nikki. And turning to Slide 13. As Nikki discussed, AOF had a strong FY '21 with FFO of $0.187 per unit at the top end of guidance. Distributions of $0.15 per unit were in line with guidance. The profit for the year increased by $10 million to $23.3 million. The increase was due to a combination of low borrowing costs, low cost expenses, improved valuation outcomes and a gain on the mark-to-market valuation of interest rate swaps. The NTA for the year was $2.71 per unit. Turning to Slide 14. All assets were independently revalued during the year with an overall increase from 30th of June 2020 independent valuations of $5.95 million. The portfolio capitalization rate firmed by 25 basis points to 5.84%. The 2 Macquarie Park assets experienced strong valuation growth driven by strong leasing outcomes and cap rate compression. 2 to 10 Valentine Avenue, Parramatta also increased in value driven by an increase in the valuation of the development site. The valuation of 30 Pirie Street, Adelaide reduced due to an increase in the capital expenditure refurbishment allowances. Turning to Slide 15. The capital structure of AOF remains robust. Gearing is 28.4%, with $190.8 million of debt drawn against $250 million of debt facilities. The drawn debt will increase post assessment of 96 York Street, Beenleigh in December this year. The cost of debt has reduced to 2.9% as of today and it is expected to reduce further once an interest rate swap expires later in June [ 2020 ]. There remains significant headwind to the debt covenants. I'll now hand back to Nikki who will provide an update on AOF's portfolio positioning.

Thank you, Simon. Now let's turn to Slide 17, our portfolio positioning. As discussed, the AOF portfolio is built around 3 key themes: affordability, amenity and accessibility. AOF seeks to hold assets that are positioned in markets that offer great amenity with retail or open space convenience and are highly accessible with existing infrastructure or will benefit from future infrastructure investment. AOF's underlying allocation of 6% to 7% by book value to metropolitan markets and 33% of the smaller Australian CBD with affordable rents positions it well. Turning to Slide 18. The markets where AOF assets are located, which I highlighted in orange on the table, have gross effective rents between 53% and 68% discount to 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 a distinct cost advantage while typically having greater flexibility and amenity of staff. AOF's average stabilization rates of approximately 5.8% is at the top end of the yield range for these markets and provide an opportunity for valuation growth. Turning to Slide 19. The environmental credentials of AOF's portfolio are a key focus. An important objective of the upcoming refurbishment program will be to improve the environmental potential and implementing initiatives to enhance the occupancy experience and wellness. Enhancing the portfolio's NABERS ratings and collaborating with tenants to implement ESG initiatives in lease agreements is also a key focus. From a social and governance perspective, AOF aligns with the Australian Unity Group more broadly and benefits from the group's broader expertise and builds on the group's framework of community focus, connection and diversity, reconciliation and the modern slavery assessment criteria, importantly, AOF as a majority independent board. Turning to Slide 20. I'm pleased to provide FFO guidance of $0.18 to $0.185 per unit and distribution guidance of $0.152 per unit for financial year 2022. FFO guidance includes an allowance for the disposal of 241 Adelaide Street, Brisbane; the acquisition of 96 York Street, Beenleigh; additional rent relief support to tenants impacted by the COVID pandemic, noting the recent lockdown in Sydney and Melbourne; and for the potential sale of 32 Phillip Street, Parramatta. Our focus remains on enhancing value and delivering the best possible returns to unitholders. To achieve this, the near-term priorities are: to drive the active management strategy and deliver leasing outcomes to maintain and improve sustainable distribution; to execute on the asset refurbishment initiatives, to improve occupancy levels, rents and capital values; deliver on portfolio repositioning priorities and including the settlement of 96 York Street, Beenleigh, and exploring the divestment of 32 Phillip Street, Parramatta; and finally, maximize value for unitholders by implementing the refined strategy. In closing, I thank you for your time today and for your investment in AOF. We look forward to continuing to advance the priorities listed and providing an update to investors in due course with a focus on delivering the best possible returns. This concludes the formal part of our presentation. I will now pass you back to the moderator for Q&A.

[Operator Instructions] The first question we have comes from Leanne Truong from Ord Minnett.

Just some questions from me. The first one regarding the financial year 2022 guidance. It looks like it's below financial year '21. You did touch a bit on it. Can you just explain, I guess, or talk about what assumptions in terms of rental relief and the divestment of 32 Phillip that you've assumed in there?

Leanne, thanks very much for your question. Yes, I'll hand over to Simon with regards to -- to discuss on the rent relief assumptions because they have been modeled to a degree on what we witnessed in 2021, but he can provide more detail on that. And really from the 32 Phillip Street assumption, we've assumed that if we take the asset to market, noting the recent lockdowns now in New South Wales, appetite might be difficult to sell that asset this side of '21 calendar year. But our assumptions assume that possibly in quarter 1, there may be the possibility of that asset transacting. But I will just hand over to Simon because he has had -- within the financials, he has sort of allowed for a period of downtime for both the rent-free and the sale. So Simon, just handing over to you.

Leanne, so the main differences between the FY '21 and FY '22 financial year will be -- I mean 241 Adelaide Street was obviously owned for pretty much the whole of FY '21 where it's been disposed of [ and won't be owned at all ] during FY '22. 241 Adelaide Street, as we mentioned, we have recycled the cash to the 96 York Street where 96 York Street the time and settlement of that will not be until December. So effectively, we're miss 6 months' worth of income in relation to that. As Nikki previously mentioned, and we are seeing the disposal of the 32 Phillip Street, but that won't be until probably after the second half of the year. And in terms of COVID rent relief, we are assuming a similar level of COVID rent relief will have to be provided to support tenants compared to the FY '21 level. So in FY '21, we had about $350,000, and we're assuming a similar level into FY '22. Thanks, unless you have any more queries.

Yes. Just on 32 Phillip Street, I'm wondering what the strategy is there. There's a few lease expiries coming up there or a major lease expiry coming up, are you going to look to sell it with that lease expiry or, I guess, renew or do some leasing activity before you sell that asset?

So I'll answer. So I mean we are in discussions with GE Finance as well as some of the subtenants at the moment. Ideally, we would like to finalize those discussions prior to sale. But yes, I mean, it will all depend upon a timing shift. So I can't provide certainty either way. So we will test the market's appetite. But ideally, we will finalize those discussions and the extensions.

If I can jump in there as well, Leanne. I think the reality is that we are looking on embarking -- as Simon said, to add to Simon, we're actively engaging with GE, but their expiry is in 2023. So it still got a couple of years before it expires. But we are looking at embarking on our refurbishment projects. So if we can dispose of 32 Phillip with still a 2-year lease term, then that would be an attractive proposition. I think that would provide also an opportunity for someone who is acquiring it, the opportunity to determine how they want to proceed with GE and the subtenants that currently exist in the property.

And just a final question from me. What's the timing in terms of the proposed merger?