Centuria Office REIT (COF.XA) Earnings Call Transcript & Summary

Thank you for standing by, and welcome to the Centuria Office REIT FY '25 Results. [Operator Instructions] I would now like to hand the conference over to Mr. Jesse Curtis, Head of Funds Management. Please go ahead.

Thank you, operator, and good morning, everybody. Thank you for joining Centuria Office REIT's 2025 Financial Year Results Presentation. My name is Jesse Curtis, Head of Funds Management for Centuria Capital. Presenting today with me is Belinda Cheung, Fund Manager of the Centuria Office REIT, and Cameron Mullen, Senior Fund Analyst. Also in the room with us is Grant Nichols, Head of Listed Funds; Tim Mitchell, Head of Investor Relations; and Jason Huljich, Joint CEO of Centuria Capital Group. Starting on Slide 3. I would like to commence today's presentation with an acknowledgment of country. We are joining you from the lands of the Gadigal people of the Eora Nation. Centuria manages property throughout Australia and New Zealand and pays its respects to the traditional owners in each country, to their unique culture and to their elders, past and present. The outlook for the office sector is showing stronger indicators of market improvement. Diminishing new office supply and a reduction in existing office stock is providing a backdrop to normalized vacancy and signs of improved tenant demand. This is particularly the case for metropolitan office where supply is becoming extremely constrained as office development feasibilities remained challenging, which we anticipate will drive market rents in the medium-term. Office supply is further reduced with the rising trend of secondary assets being withdrawn for conversion to alternative uses, creating additional demand for displaced tenants. These trends bode well for existing A-grade office landlords and reaffirm our optimism for the future of metropolitan office markets. In today's presentation, Belinda and Cameron will cover an overview of COF's full year performance, COF's financial results, COF's portfolio and conclude with a market overview and guidance. Moving to Slide 4. Centuria Office REIT is managed by Centuria Capital Group, which has over $20 billion of assets under management. COF unitholders benefit from Centuria's deep real estate expertise, including a fully integrated property, facilities and asset management platform. Synergies across the group's wider office portfolio and strong alignment as Centuria is COF's largest unitholder and the manager's interests are strongly aligned with yours as unitholders. Moving now to Slide 6. COF's long-standing strategy and vision remains unchanged. We aspire to be Australia's leading pure-play office REIT with a focus on generating sustainable and quality income streams and executing initiatives to create value across our portfolio of quality office assets within metropolitan and near city markets that are differentiated by sustainability, amenity and connectivity. The results that Belinda and Cameron present today reflect the execution of this strategy, supported by the deep real estate capability of the broader Centuria team to drive value for unitholders. I will now pass over to Belinda.

Thank you, Jesse, and good morning, everyone. Starting on Slide 7. COF had a solid performance during the 2025 financial year and delivered funds from operations of $0.118 per unit and distributions of $0.101 per unit, in line with guidance. Key highlights for the year include an $18 million property valuation gain in the second half, supported by market rental growth across most office markets, which marks the first period of portfolio growth since peak valuations were recorded in June 2022. Leasing terms were agreed for more than 24,000 square meters or 9% of the portfolio net lettable area across 44 separate deals, bringing occupancy to 91.2%, well above the National Metropolitan office occupancy level of 82%. All facilities financed with renegotiated covenants, allowing greater headroom to LVR and ICR covenant requirements and extending expiry to FY '28, and completion of a 1.1-megawatt edge data center, which has contributed to a 19% uplift in asset valuation and further diversifies the rental income streams in the REIT. COF continues to execute its strategy as well as asset and capital management initiatives. Despite this, leasing Centuria markets are challenging and continue to weigh on earnings in FY '26, which is detailed on Slide 8. We provide FY '26 FFO guidance of $0.111 to $0.115 per unit and distribution guidance of $0.101 per unit. Key drivers of this outlook on earnings include forecast downtime associated with current vacancy and FY '26 expiries. We have conservative downtime assumptions, including no income for full floor vacancies and expiries in FY '26. Should we complete any incremental leasing, there will be potential upside to earnings. Interest rate cuts are another factor to the range. We anticipate COF's all-in cost of debt will be about 5.2%, which remains relatively consistent with a marginal cost of debt. There may be potential earnings upside should interest rate cuts be made beyond what is forecasted today. As always, leasing is a major focus, and we are well progressed on multiple leasing negotiations for the upcoming expiries, and we'll provide further updates in the first quarter update. Let's look more broadly at the Australian metropolitan office markets on Slide 9. Higher replacement costs continue to impact office development feasibilities, and we are seeing the strain on supply play out in the current market, including a growing number of muted or delayed projects. The future pipeline in metropolitan markets is meager compared to what was delivered during the past 5 years. And COF's portfolio will have minimal exposure to these buildings with less than 8% of the new stock built in directly competing markets. Costs are escalating economic rents, widening in metro and fringe markets compared to CBDs. This discourages tenants from pre-committing to new builds and instead shifts that demand to existing office buildings like COF's assets, which re-offer high-quality office spaces accessible to amenity and transport and by comparison, can offer more compelling value. On to Slide 10. Replacement costs have increased by at least 40% since 2020, driven by escalations in material pricing and financing costs, labor as well as leasing-related incentives. The hypothetical cost to build an A-grade office in Metro Sydney has grown by our estimate from $11,000 a square meter to over $15,000 a square meter since 2020. At $15,000 a square meter, replacement costs are more than 2x COF's current average valuation at $6,900 per square meter, and this is 2.5x its implied value based on the recent trading price. Moving to Slide 11. Further adding to the supply stream is the significant shift in office withdrawal strategies of landlords from office redevelopment to conversion to alternate use. Looking back at the last 5 years, 3/4 of all withdrawn office stock was refurbished and reintroduced to the market as office stock. Looking forward to the next 5 years, we expect this to change significantly to over 90% of forecast future withdrawals converted to other uses. The driver for these drastic changes includes population growth outpacing housing supply and the introduction of government housing policies such as transport-oriented development or the Housing Development Authority, which are focused on metro markets due to its proximity to public transport, entertainment and civic precincts. Metropolitan markets have experienced higher levels of vacancy to date due to it having a higher concentration of low-grade underutilized office, which now presents an attractive case for conversion as the higher and better use shifts to other sectors like living, data center and life sciences and underpins the land value of metro office. In more detail on Slide 12, it's estimated that by 2030, 10% of total office stock in Metro Sydney will be withdrawn and converted to non-office uses, displacing existing tenants of those buildings. Colliers expects over 100,000 square meters of office demand from these displaced tenants. Adding this to the forecast absorption numbers meaningfully improves the forecast vacancy in Metro Sydney to 8.7% by the end of 2030. I will now hand over to Cameron to take you through the financial results and portfolio overview.

Thank you, Belinda. Moving to our financial results on Slide 14. COF delivered funds from operations of $70.4 million or $0.118 per unit. Gross property income decreased primarily due to asset divestments executed during FY '24 and higher portfolio vacancy. The average all-in cost of debt incurred for FY '25 was 5.4%. COF declared and paid distributions of $0.101 per unit across the period in quarterly installments, representing a payout ratio of 85.7%. Slide 15 details COF's capital management. At the beginning of the year, COF completed an $862 million loan refinance with existing lenders, resulting in beneficial outcomes such as renegotiated debt covenants, extended debt duration and no change to margin. COF maintains sufficient liquidity and debt covenant headroom with no debt expiring until FY '28. Now turning our attention to COF's portfolio, starting on Slide 17. The COF portfolio provides quality, highly connected and affordable office space that is consistent with the style of workspace that both occupiers and investors increasingly seek. That is new generation buildings that provide high-quality accommodation with healthy lifestyle-orientated work environments, efficient floor plates and improved amenity while being competitively priced. Furthermore, there is increased demand to be located in areas that provide efficient commutes to improve employee satisfaction and attract the best talent. When looking specifically at the COF portfolio, it has been positioned to deliver on many of these qualities by offering a young portfolio with an average of 18 years, high-quality assets with 93% meeting an A-grade specification, highly efficient buildings with 5-star average NABERS energy rating, significant geographic diversification, providing exposure to Australia's high-performing office markets and locations that are easily accessible by both public and private transport with generous car parking availability. Moving to the portfolio overview on Slide 18. COF's portfolio comprises young quality assets position in Australian metropolitan and near city office markets. COF's portfolio of 19 assets is truly diversified with no single state exposure greater than 26%. Importantly, the portfolio is underpinned by quality tenants, posting over 75% of portfolio income being derived from government, multinational corporations and listed entities. The ability to attract quality tenants is reinforced by a large proportion with 62% of our tenant base being larger corporates, occupying space exceeding 2,000 square meters. I will now hand back to Belinda to take you through the leasing summary for the period.

Thanks, Cam. Turning to Slide 19. During the period, lease terms were agreed for over 24,000 square meters across 44 deals, representing 8.9% of COF's total portfolio NLA. Average rents increased by 4.5%, and we have reached full occupancy in WA. We continue to focus on leasing existing vacancies and upcoming expiries across the portfolio, particularly in Docklands and St. Leonards. Despite having faced a challenging leasing environment with higher market vacancy rates during the period, terms agreed for over 6,000 square meters in these markets. Achieving high portfolio occupancy is a key management focus, and we are actively seeking outcomes to further improve COF's lease expiry profile, focusing on improving tenant amenity, aligning asset strategies with market conditions and finding cost-effective solutions for tenants. Moving to valuations on Slide 20. Pleasingly, COF's portfolio reported an $18 million valuation gain in the second half, marking the first period of valuation growth for the COF portfolio since FY '22. Further to that, 66% of the portfolio increased in value or had stable valuations, indicating that metro market valuations are stabilizing and potentially at an inflection point. The portfolio's weighted average capitalization rate further expanded to 6.89%. However, this softening has been offset in some valuations by market rent growth at an average of 4% across the portfolio. Now turning to sustainability on Slide 21. COF continued to demonstrate its commitment to environmental, social and governance initiatives. COF achieved a 5-star NABERS Sustainability Portfolio Index rating and is targeting 0 Scope 2 emissions by 2028. More than half of COF's portfolio is now electrified, including 100% of our Queensland assets. Continuing on Slide 23. Looking ahead to the medium-term, there are a growing number of drivers supporting the Australian office markets. We touched on some of these earlier in the presentation, including high replacement cost supply, and office withdrawals significantly restricting future supply and improving vacancy levels in metro markets, transport infrastructure being at the center of conversion feasibilities and rental growth potential resulting from the supply and demand dynamics. We also believe Australia will benefit from high population growth forecasts, driving a larger contingent of white-collar workers and the shift in occupier sentiment towards office-centric workforces increasing demand for office space. This has also contributed to increased levels of interest in the office sector from investors looking beyond the short-term volatility. We saw improvement in transaction volumes resulting from the narrowing price gap between buyer and seller expectations, which demonstrated the growing positive sentiment to the sector and returning investor appetite, both domestically and globally. COF's FY '25 priorities are outlined on Slide 24. From here, we continue to focus on maintaining high portfolio occupancy, improve portfolio quality and preserve a solid balance sheet, maintaining sufficient liquidity and debt covenant headroom. I draw this presentation to a close on Slide 25 with the FY '26 FFO and distribution guidance. Thank you for your continued interest in Centuria Office REIT. I will now hand back to the operator and welcome any questions you may have.

[Operator Instructions] Your first question comes from Daniel Lees of Jarden.

I was just wondering if you can provide some color on the lease terms agreed over the period. Maybe if you can comment on incentive levels, contractual rent increases and re-leasing spreads, that would be great.

Yes. No problem, Daniel. The average incentives for the year, we noted for new leases, it was 34% and incentives for renewals on average were 25%. In terms of leasing spreads, for the year, we noticed that the average leasing spread was 3.9% positive. We have excluded the reset data deal from these statistics given that reset data is a data center rent and would significantly skew these numbers. And in terms of -- across the portfolio, yes, it's pretty in line with market at the moment.

Okay. And I appreciate it's tough in some of the markets like Docklands, but what do you think needs to happen to get this space away? What are you seeing there?

Sorry, can you repeat the question?

I was just saying, I appreciate it's tough in some of the markets you're exposed to, such as Docklands. What do you think needs to happen to get that space away?

Docklands is a pretty tough market. But in recent times, we've actually seen net absorption increase in that Docklands market with Coles moving into that market. I think what it takes is a bit of time. We need to see further demand in that Melbourne market. Outside of Melbourne, net absorption is actually increasing across most Australian markets, and I think this has been spurred on by population growth and some of the other trends that we were talking about in the presentation earlier.

And just one more for me, if I could. If you could make a comment on what you're seeing liquidity like in the metro transaction markets, just noting recent media commentary around ISPT at 100 Pack Highway, the Maple Tree portfolio and 475 Victoria Avenue and Chatswood. Just wondering what you're seeing in transaction markets.

We're definitely noticing a lot more activity in the metro markets compared to the last few years, which is -- it's pretty good. It means that the landlords are demonstrating a bit more conviction in selling in this current market. So, I think it's a really positive sign that there's more liquidity and just a higher level of transaction volumes. And this has really been spurred on by, I guess, increased interest from global markets. We've seen some global capital looking around, not just in the CBD markets, but metro markets also.

Your next question comes from Tom Bodor with UBS.

Just looking at your FFO per unit since 2021 or FY '21, it's gone 19.9,18.2, 15.6, 13.8, 11.8. And then next year, it's going lower again. And I appreciate the conditions have been challenging. But I'm just interested in when do you think you can return to FFO growth?

Tom, great question. We actually think FY '26 is at the bottom in terms of FFO. We've got pretty good conviction going into the future that there will be improvements in leasing as well as costs. If you look back over the last years, debt costs have been a significant contributor to the decrease in FFO. In the past, we've also been affected by sales, or we chose to sell a number of assets that were noncore to the portfolio, which would have also contributed to the decrease in FFO.

Okay. And then I guess if I look at the other side of the equation, your gearing has consistently gone up. I think a year ago, it was 41%. It's now 44.4% and you're paying up more of your FFO in your distribution and distribution isn't covered by free cash flow or AFFO. Do you see that as an issue? Or are you comfortable with leverage in the mid-40s?

We're pretty comfortable with the level of debt that we have at the moment and where gearing sits given the level of debt covenants or debt covenant headroom we currently have. We also believe like valves have a big impact to gearing. And given that we think the valve market is stabilizing and potentially an inflection point from here on, we'll see a natural recovery through that, too. In terms of --

Is the payout ratio sustainable though, over free cash flow?

We remain pretty cognizant of our long-term payout ratio aspirations. It's likely that going forward, that FFO growth will exceed the distribution growth into the future until we reach our long-term payout ratio target of 80%. But based on our strong conviction that FY '26 will be the low point, and that's driven by better leasing inquiry into the future, but also debt costs coming down. We're pretty comfortable with where that sits.

Okay. Sure. And then just a final one for me. I think you've talked in the past a lot about replacement costs, and I can see that slide is still there. But there's also, I guess, some new thoughts around change of use or conversions as a concept. I guess the thing to think about there is that would imply that the asset value needs to be written down to land value less demolition costs. Like how many of your assets would be close to that level that they could be repurposed?

Tom, to make it very clear, we're not saying that any of the COF assets are in that class. We reference secondary assets; low-grade stock that have seen valuations go down to that point where alternate uses are becoming attractive. For us, how this would impact us would be the tenants that are displaced from these secondary assets, they need to go somewhere. And it's really likely that tenants move within the same market and the COF assets sitting in that market will benefit from these displaced tenants needing office space.

Your next question comes from Murray Connellan with Moelis Australia.

I was wondering whether you could just talk through a couple of your assumptions that went into your guidance. Just in terms of the expiry that's coming through this year, would you be able to speak to, I guess, just an average vacancy number and whether you would expect vacancy to be ticking up over the course of the year off the back of the expiries that come through and whether that's in guidance?

We've been fairly conservative in our guidance assumptions. I mentioned during the speech that vacancies and expiries will have no income associated with it in FY '26 guidance. In terms of other downtime assumptions, it's actually pretty similar to what we've assumed over the last year.

Got it. And then maybe just touching on some of the more material expiries. I assume that the precincts of Docklands and St. Leonards still remain relatively challenging given the amount of vacancy and competition in those markets. But maybe just touching on some of the others for a second, like Evely, there's a big expiry coming through there and some of the Docklands and Brisbane -- sorry, some of the South Melbourne and Brisbane ones as well.

Yes, definitely. So just to touch on Docklands and St. Leonards, to be very clear, those vacancies at the moment actually make up more than half of the total current vacancy in the COF portfolio. So those are -- those are quite challenging, as you mentioned. In terms of the expiries, we're a lot more positive about 8 Central Avenue being in that Sydney fringe market, also South Melbourne, 101 Moray Street. That's in a very active precinct as well as 825 Ann Street. These are very -- these are really vibrant markets at the moment. And these are the buildings where we are well progressed on leasing discussions. So, I hope to have more to report as part of our first quarter update.

Your next question comes from Simon Chan with Morgan Stanley.

Payment for investment properties in your cash flow statement, I see that's coming in at $41 million this year. The bulk of the outflows were in the second half. Can you just tell me what you spend the $30 million on in the second half, please?

So, the majority of that spend is actually relating to the data center build for 818 Bourke Street as well as improvement projects across the rest of the portfolio.

Right. And that 818 Bourke Street lease deal, can you confirm the reset, can you confirm that's actually a full year contribution in FY '26 as per, I guess, previous guidance of about $5,000 per square meter?

So, for 818 Bourke Street, that data center lease, we don't calculate rent per square meter because by nature, it's a data center lease. But if you think about it in dollar terms per year, it's still as we disclosed at half year, face rents are $3.9 million a year. And yes, in FY '26, we are reporting a full year of face rent through reset data.

You made comments earlier about whole floor vacancies expected to remain vacant -- how floor vacancies and expiries expected to remain vacant in your F '26 guidance. So, if I look at Slide 19, current vacancy plus expiries, it works out to be about over 50,000 -- close to 60,000 square meters. How many square meters of that whole floor vacancies that you're not assuming income from?

It will be a few of these buildings. So, these numbers include both full floor vacancies and part floor vacancies. Most of these will sit in 818 Bourke Street, 201 Pacific Highway, 203 Pacific Highway and 825 Ann Street.

Yes, I guess. So, will that be like, say, 30% of the 56,000 meters? Is that fair that we're assuming 0 income but potential upside?

That would be a fair assumption.

Right. Okay. Just one last one. You mentioned your comfort that FY '26 is going to be the trough, et cetera. But I just feel like you've gone a little bit like one step forward, 2 steps back. Your payout ratio was trending down was about 85% of FFO in FY '25. Yet based on your guidance, it's actually gone back up to close to 90% for FY '26. Did you and the Board consider not doing that? You've gone down to 85% and you've checked back up to 90% again. What's the reason for that?

Yes, Simon. This is definitely a major consideration with our Board, and we remain really cognizant of what the long-term payout ratios are. And going forward, the FFO growth will exceed the distribution per unit growth until we achieve that long-term target of 80%.

So basically, you say you just didn't want to cut your dividend.

We've got a pretty high conviction that FY '26 is going to be the low point for FFO, and just judging by where debt costs are going to be going. And in the past, debt cost is what has affected us the most. It's affected the DPU the most. And so, we're pretty confident with FY '26 FFO and DPU guidance.

Right. Just to reiterate, '26, you were guiding to 5.2% weighted average cost of debt, right, down from 5.4%.

That's correct.

Your next question comes from Liam Schofield with Morgans Financial.

Just on Slide 19, those FY '25 leasing transactions, did they contribute significantly to '25?

Liam, no, a lot of these are forward leases. So, they wouldn't have made much contribution to FY '25, more to FY '26.

Are they a full year for '26?

Some of them will be full year, some of them won't be.

Fair enough. And I know that this has been discussed already, but I'll just sort of cross it off again. Obviously, that FFO at $70 million, distributions at $60 million and CapEx at $18 million. Is it safe to say that distributions are going to trend fairly flatly until such time as that sort of distributions plus CapEx is in line with FFO?

Yes. It's likely that DPU will trail behind FFO growth.

[Operator Instructions] Your next question comes from Connor Eldridge with Bell Potter Securities.

Just one from me today, following on from Murray's question around the guidance. Just given where gearing is and conscious you are starting to see some valuation growth, but are you assuming any divestments in terms of FY '26 guidance?

In FY '26 guidance, we haven't factored in any divestments.

There are no further phone questions at this time. I'll now hand back to Belinda Cheung for closing remarks.

Thank you for your continued interest in Centuria Office REIT. If you have any follow-up questions, please contact Tim Mitchell or me. Thank you, and have a lovely day.

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