Centuria Office REIT (COF) Earnings Call Transcript & Summary

Ladies and gentlemen, thank you for standing by and welcome to the Centuria Office REIT Half Year '21 Results Conference Call. [Operator Instructions] Please be advised that today's conference is being recorded. I would now like to hand the conference over to your first speaker today, Mr. Grant Nichols, fund Manager of COF. Thank you. Please go ahead.

Good morning and thank you for dialing in to the Centuria Office REIT Half Year '21 Financial Results and Fund Update. I am Grant Nichols, COF's Fund Manager. Earlier today, we published various documents on the ASX relating to the half year results, including a results presentation, which we will go through this morning. I am very pleased to share COF's results. COF provides a quality portfolio of highly connected commercial property that has delivered a strong performance through the first half of FY '21. Starting on Slide 4 with a short overview of COF's management. Centuria Capital Group is an established specialist investment manager that operates under the ASX code CNI. With around $10.2 billion of assets under management, Centuria Capital Group provides its investors with exposure to quality office, industrial and health care real estate investments across Australia and New Zealand and investment bonds through the Centuria Life business. COF accounts for around 21% of Centuria Capital Group's total assets under management. Slide 5 further highlights the alignment between the broader Centuria business and COF. The advantages of being managed by Centuria is that the group has over a 20-year successful track record in property funds management and a substantial commercial property platform. With in-house property and facilities management, Centuria provides deep leasing capability and hands-on management of the COF portfolio. Centuria Capital Group also remains COF's largest unitholder with 19.9% of the register. The capability of Centuria Capital Group and the strong alignment with COF also provides various opportunities to undertake joint venture initiatives, including potential access to pipeline opportunities for future transactions. Turning to COF specifically on Slide 6. COF delivered a solid performance in the first half of FY '21, completing a significant amount of leasing while maintaining high rent collections. COF also reduced gearing through challenging or recovering operating conditions. COF's resilient operating performance enabled us to reinstate an FY '21 FFO guidance range of between $0.194 to $0.199 per unit. FY '21 distribution guidance of $0.165 per unit is also reaffirmed, which equates to a strong distribution yield of 8.5% based off yesterday's close and a projected FFO payout ratio of around 85%. As Australia's largest pure-play listed office REIT, we believe COF provides a quality, highly diversified portfolio leased to excellent tenant covenants. When combined with a solid weighted average lease expiry profile, an average building age of around 16 years and ample undrawn debt and debt covenant headroom, COF remains well placed to continue delivering attractive income returns to unitholders. Looking at the results summary in more detail on Slide 7. The COF portfolio performed well throughout the first half FY '21, generating solid leasing activity, strong cash receipts while maintaining WALE. The portfolio is underpinned by high-quality tenants and assets offering affordable rents in locations that resonate well with tenants, especially those scrutinizing operating costs and when workforces' preferences show a trend towards working close to home. Additionally, COF benefits from a relatively young portfolio with an average building age of around 16 years. Younger-generation stock will assist in attracting and retaining tenants while providing limited overall capital expenditure and maintenance requirements. COF's portfolio is balanced -- is a geographic -- COF portfolio's balanced geographic diversification means no single market exposure is greater than around 16%, which is beneficial as we have seen significant variation in the performance of the various Australian office markets. By and large, COF's exposed markets generally outperform the Australian CBD office markets. Looking specifically at leasing, the Centuria team executed a significant amount with over 28,000 square meters leased during the half. This equates to over 9% of the portfolio, and it still maintained a 4.5-year WALE. We've also improved our debt position, with debt being sourced from 5 quality lenders at a very low all-in cost of 2.3%. Following settlement of 465 Victoria Avenue, Chatswood on Monday, which sold at a healthy premium to book value, gearing reduced to 33.2% and undrawn debt capacity increased significantly to $175.5 million, which comfortably satisfies future liquidity requirements. Turning to the portfolio composition on Slide 8. We believe COF is well positioned to not only meet challenging tenant demands that may be accelerated by COVID-19 but also continue delivering sustainable, quality income returns to our investors. Owning a geographically diversified portfolio without single-market concentration enhances the sustainability of COF's income returns. Geographic diversification reduces risk to a specific market slowdown whilst also allowing greater exposure to various industries contributing to Australia's economic positive outlook. In the 12 months to 31 December '21, some of the COF exposed office markets, such as Canberra and Sydney Fringe, experienced positive net absorption, which starkly contrasts to Melbourne City's CBD, which had significant negative net absorption. These are markets where COF has little to no exposure. Over the longer term, we believe there will be a strong employee preference towards working close to home. For some time, we've said a key contributor to employee satisfaction is the length and quality of their work commute. This thinking certainly influenced our decision to acquire buildings in locations like South Eveleigh and Fortitude Valley, with both providing excellent and improving connectivity. While there remains significant concern about productivity related to working from home, there is almost universal acceptance that the most efficient thing in relation to working from home is reducing time lost commuting to the workplace. Consequently, we believe businesses will more actively seek a combination of solutions that provide staff with workplaces closer to their home, providing better commutability. This workplace change will directly benefit metropolitan fringe office markets that COF is exposed to. We also believe in hub and spoke-style accommodation solutions that enhance employee flexibility. However, in contrast to the context in which it is often discussed, we believe it is possible, even preferable, for the hubs to be located in metropolitan or fringe locations with the spoke located in a CBD. This would provide tenants with cost-effective, efficient hub accommodation solutions due to the large floorplate options available in metropolitan locations, while it is easy to spoke in a CBD due to the abundance of small suite accommodation already available in CBD locations. We also believe, particularly in times when some markets have elevated vacancy, that there will be a flight to quality office accommodation. Some [ lazy ] industry bias may assume a flight to quality when, say, metropolitan and fringe tenants seek alternate CBD accommodation. While this may have happened in the past, current market data indicates the reverse, with large CBD markets presently recording the weakest levels of tenant demand. In the medium term, we believe tenants will seek improved standards of accommodation and a building amenity, with an increased focus on sustainability, health and cleanliness, including a building's capacity to provide adequate social distancing, particularly in regard to lift usage. As such, we believe there will be a preference towards new-generation office stock, which should benefit the COF portfolio as the average building age is around 16 years. Additionally, the portfolio average NABERS energy and water ratings are 4.8 and 4 stars, indicating excellent building efficiency. Affordability will also become a key consideration over the medium term as economic circumstances force tenants to focus on their operating costs. Again, we believe COF is well-placed, as the portfolio provides consistently high-quality office accommodation at an affordable cost. COF's exposed markets average a discount between 44% and 67% compared to the Sydney CBD market rents. This relative affordability also makes COF market rents a lot more sustainable compared to our CBD peers. Moving back to the half year FY '20 results on Slide 10. COF produced funds from operations of $57.7 million or $0.112 per unit and paid distributions of $0.083 per unit. FFO increased in comparison to half year '20 due to prior acquisitions and the Foxtel surrender payment received in July 2020. However, FFO was adversely impacted by COVID-19 due to rent relief claims and other provisions, reducing FFO by $1.2 million. Provided rent relief relating to COVID-19 more than halved during half year '21 compared to Q4 FY '20. COF's resilient operating performance and the improving outlook for operating conditions enabled us to reinstate FY '21 FFO guidance with a range of $0.194 to $0.199 per unit. We also reaffirmed COF's FY '21 distribution guidance of $0.165 per unit, which equates to a strong distribution yield of 8.5% based off yesterday's close and a projected FFO payout ratio of around 85%. Turning to capital management on Slide 11. During the half, COF exchanged contract to sell its 25% interest in 456 (sic) [ 465 ] Victoria Avenue, Chatswood, for $44.7 million. The sale achieved a premium to book value and eradicated any minority interest within the COF portfolio. Proceeds from the sale, which settled on the 1st of February, were used to retire debt. As a consequence, gearing reduced to 33.2% and undrawn debt capacity increased significantly to $175.5 million, which easily satisfies future liquidity requirements. The interest cover ratio at 7.6x substantially exceeds the debt covenant of 2x. With sufficient undrawn debt, a very competitive all-in cost of debt of 2.3%, significant debt covenant headroom and a diversified debt maturity profile to 5 quality lenders, COF is well placed with a robust capital structure. Moving on to the portfolio on Slide 13. COF has a truly geographically diversified portfolio of 22 assets without any single market concentration and exposure to most of Australia's major office markets. So for those investors seeking access to Australian commercial property, COF provides an attractive option due to its young portfolio age, geographic diversification, quality tenant profile and an appealing distribution yield of 8.5%. Despite the challenging operating conditions, COF completed a significant amount of leasing during half year '21, securing 31 separate lease transactions across 28,000 square meters, representing over 9% of the portfolio NLA. Of the agreed deals, about 10,700 related to new tenants across 17 separate leasing deals. The balance related to tenant renewals. Occupancy at 31 December 2020 was 91.5%. Occupancy decreased by about 6.5% compared to 30 June 2020 due to the Infosys expiry at 818 Bourke Street, Melbourne and Foxtel surrendering its lease at 35 Robina Town Centre Drive, Robina, as previously announced. Under this agreement, COF received a surrender payment equivalent to the rent payable for the remainder of Foxtel's lease term, discounted to June 2020. This surrender provides an opportunity to utilize Centuria's strong leasing capabilities to reposition the asset, maximizing the benefit of the surrender payment received. Pleasingly, and due to leasing completed, occupancy at 35 Robina Town Centre has already increased to 36.1% during half year '21. As I mentioned, the average building age across the portfolio is around 16 years, which further highlights the quality of the COF portfolio. New buildings generally have lower capital expenditure requirements, lower operating costs and tend to be more attractive to tenants, offering greater building efficiencies and generally better building amenity. During the 2020 calendar year, we actively sought to enhance COF's energy and water efficiency, delivering improved 2020 NABERS energy and water ratings and expanding the adoption of renewable energy sources with the rollout of solar projects across the portfolio such that 26% of assets now produce solar electricity. We are particularly proud of the average NABERS energy rating across the COF portfolio, which is an excellent 4.8 stars. COF's portfolio provides a very staggered expiry profile with 57% of leases expiring at or beyond FY '25. This diversified expiry profile is another reason why COF is able to generate sustainable income returns, as no single tenancy represents more than 7% of portfolio income. Notably, and as indicated on Slide 14, COF's portfolio income is derived from high-quality tenant covenants, with more than 80% of income coming from government, listed or multinational tenants. More than 25% of income is derived from government tenants, with the federal government representing almost 15% of the portfolio income across a number of different tenancies and government departments. Turning to portfolio valuations on Slide 15. As of 31 December 2020, 13 of the 23 assets representing 59% by value were independently revalued, resulting in a marginal decreased portfolio value of approximately $17 million or 0.8% compared to the preceding book value. As a result, COF's NTA as at 31 December 2020 slightly reduced to $2.45. The decrease in value was primarily the result of valuers adopting lower growth rates with increased downtime and incentives. The weighted average capitalization across the portfolio was broadly unchanged at 5.9%. Consistent with valuations completed as at 30 June 2020, ongoing rent relief claims were accounted for where relevant. Significantly, the entire COF portfolio has been independently revalued since 30 June 2020, and these values have occurred with softer near-term income assumptions made from the valuers resulting from impacts of COVID-19. As many recent transactions continue to support COF cap rates, if the leasing market were to surprise on the upside, there could be positive future valuation implication, as much of the potential downside has already been factored into COF's independent valuation. Moving to Slide 16 and the continuing impact of COVID-19. Portfolio rent collections have continued to improve, averaging 96.7% for the half. By comparison, COF reported rent collections at 92% for Q4 FY '20. In the FY '20 results, our collections for this period subsequently rose to levels consistent with half year '21. Rent relief claims, both waivers and deferrals, totaled about $2.6 million for the half year. This represents more than 50% reduction on the relief provided in Q4 FY '20. Going forward, as rent relief provisions related to the National Code of Conduct on Commercial Leases taper, we expect the level of rent relief provided to reduce accordingly. Centuria Property Services and the COF management team continue to focus on the preparedness and rapid response to challenges arising from COVID-19, providing safety and well-being to our tenant community. Looking ahead on Slide 18. The outlook for the Australian economy is positive and has materially improved since the full impact of COVID-19 became apparent in mid-2020. Underpinned by significant fiscal and monetary support, the economic recovery is well underway. There's been strong growth in employment with 50,000 jobs created during December 2020 and the highest level of job advertisements in Australia for the last 18 months. Of the $172 billion in fiscal stimulus committed by the federal government in response to COVID-19, over 85% is aligned to employment and infrastructure. This is particularly important because improvements in infrastructure will make many metropolitan office markets more accessible, but more importantly, the majority of employment within Australia is white collar jobs. So the continued improvement in Australian employment numbers will generate more white collar workers, requiring more office accommodation. To an extent, this has already started to become evident as a number of Australian office markets demonstrated improved tenant demand in the fourth quarter of calendar year 2020, as shown in the table on Slide 19. Despite this, the table indicates that 2020 was a very challenging period for some Australian office markets, particularly for Sydney and Melbourne CBDs. Unfortunately, much of the commentary around Australian office conditions have centered around these 2 markets, which incurred substantial negative net absorption and face a significant amount of upcoming supply. Given the overwhelming commentary, some may assume the conditions seen in Sydney and Melbourne CBD are representative of all Australian office markets. But this is clearly not the case, and there is a wide investable Australian office market outside of the Sydney and Melbourne CBD. Looking at some of the markets where COF has significant exposure such as the Sydney Fringe, St Leonards and Canberra, we saw positive net absorption, which is in stark contrast to the data generated by the Sydney and Melbourne CBDs through the same period. This contrast could be explained by the underlying uses, as the Sydney Fringe and Canberra are generally occupied by large corporates and government, but it could also indicate that businesses are more actively seeking accommodation solutions that enable staff to access workplaces closer to home. Another thing to consider when looking at this table is that many of the markets COF has exposure to have relatively low upcoming supply. When coupled with the already significant rental discount to the Sydney CBD, these market rents appear a lot more sustainable, particularly when compared to the Sydney CBD. The improving outlook for Australian office markets, coupled with the significant yield spread between office returns and the 10-year government bond rate shown on Slide 20, generated an increase in transactional activity in the second half of 2020 with several transactions demonstrating robust investment demand for quality office property. Looking at these in more detail on Slide 21. A number of these transactions occurred in comparable office markets to COF. When this basket of comparable property transactions are collated, it demonstrates very strong demand for metropolitan and regional office assets as investors recognize the relative affordability and accessibility these markets provide to tenants. The average metrics from these sales illustrate strong investment demand for the types of assets that COF owns, but also a disconnect between the direct market transactions and where listed markets are pricing office REITs, particularly those trusts whose assets are outside of CBDs. Concluding on Slide 22, our focus for COF throughout the remainder of FY '21 and beyond. We've continued generating predictable and quality income streams. We seek to build Australia's leading pure-play office REIT, positioning it to meet challenging tenant demand while providing high-quality and affordable office space. Across our portfolio, we are encouraged by the leasing activity that we have been able to generate and continue to see across our invested markets. This leasing activity gives us confidence as we proactively address any vacancy or near-term expiries across the COF portfolio. With quality assets, a robust and diversified capital structure and support from the wider Centuria business, we believe COF is well placed to continue delivering its strategic objectives. COF's resilient operating performance to date has enabled a reinstated FY '21 FFO guidance range of $0.194 to $0.199 per unit. COF also reaffirms its FY '21 distribution guidance of $0.165 per unit paid in equal quarterly installments, having a distribution guidance translate to a very attractive distribution yield of around 8.5%. In conclusion, I would like to thank COF unitholders for their continued support. I will now hand back to the operator and invite you to ask any questions that you may have.

[Operator Instructions] Your first question today comes from the line of Simon Chan from Morgan Stanley.

Grant. First question I've got, can you clarify the Foxtel surrender payment for us? How much exactly was it that came through the door during the last half?

Yes. Unfortunately, Simon, I'm unable to give you an exact number as it was -- it's under confidentiality clauses. But for argument's sake, and it's probably easy for you guys to ascertain what it was in terms of a ballpark figure, Foxtel had a lease through to September 23, and they paid out the bulk of that rent -- or effectively all of that rent discounted to June 2020. And the discount rate was [ likely to be about % ].

Okay. We can work that one out then. Hey, you -- like you said in your presentation, you did a fair bit of leasing during the half, I think 21,000 square meters or so. Just wondering if you could talk to some of the deal metrics, perhaps just the highlights -- the -- in terms of the bigger leases. What were the leasing spreads that you had, the average incentives, et cetera? It sounds like you managed to get a few tenants into Robina to backfill some of the space, et cetera. So yes, can you give us some color on those bigger deals that you did?

Yes. Thanks, Simon. It's a good question. And it was actually 28,000 -- over 28,000 square meters of leasing we completed, representing about 9.5% of the portfolio. And just to clarify, we completed leasing across pretty much all of our markets across Australia. So leases in Hamilton, Fortitude Valley, Robina, Chatswood, St Leonards. Lots of leases in Canberra. We completed some leasing in Adelaide. And we also did some leasing in Melbourne, albeit not at 818. So we are generating pretty good leasing inquiry across our entire portfolio, which is pleasing. Considering the amount of leasing we've done to date, we certainly have confidence in being able to address our leasing risk going forward. But in terms of metrics, the leasing spreads that we achieved were pretty good. So the rents were pretty much flat against passing or prior income. We did see an escalation in incentives, but the incentives probably, across our portfolio, averaged out to about 30% at the midrange.

Yes. But across the portfolio, [ face ] was pretty much flat? Did I hear you right?

Correct. Yes.

Cool. Just a last one, then. You do have a bit of vacancy to work through or tenants leaving, right? Docklands, Richmond. I mean the Brookes Street, Marcus Clarke as well. How should we think about -- I don't know if you classify it as maintenance CapEx or refurb CapEx. Will you be spending a bit of money on that over the next half or next 12 months? Or is that not really something you need to do due to the age or the state of the building?

Yes. So as I mentioned on the call, one of the benefits of the COF portfolio is that we have a very young building age, meaning that in terms of maintenance CapEx, there isn't a lot we need to do. In saying that, obviously we want to present our office space as best we can, considering that it is still challenging leasing conditions despite our ability to attract tenants today. So there will be some money that we will be spending on buildings to -- from an aesthetic purpose. So -- particularly at 818 Bourke Street, we are going through a process of trying to improve the building amenity within that building so that we can position ourselves better than our peers in those markets. But overall, there is not a lot of work that we need to do across our portfolio to reposition those assets [ forwards ].

Your next question today comes from the line of Tom Bodor from UBS.

Grant. I just wanted to sort of ask about your guidance range from an FFO perspective, and what's implied in terms of the second half is sort of $0.082 to $0.087. I just wanted to understand what you see as the key variables in that range. Is it simply a question of how quickly you can get those leases executed? Or are there other variables in there that you're accounting for in that range?

Yes. Tom, you're quite right. It's probably easiest to think about it in the 2 key variables. Firstly, that we do have ongoing COVID obligations, and there is the possibility for continued rent relief support that we'll have to provide. So that is one consideration that we have made in providing FFO guidance. But also, obviously, we do have some vacancy within that portfolio -- within the portfolio at the moment, and it depends on how we lease that up. So I think if you look at the lower end of the guidance, that probably projects that there is very limited leasing completed. And at the upper end of the guidance, there is potential for some leasing to be completed during the period.

Okay. And then within that, sort of the big one is obviously Docklands, and you were in a position where you couldn't really get inspections through late last year. Notwithstanding today's news, how have you come out of the blocks in Melbourne as things have reopened? And has there been good interest?

Yes. So we've got a few tenants looking at Docklands at the moment. Obviously, the continuing impacts of the pandemic on Melbourne has made it difficult to get strong traction, as there are still not a lot of workers who are back within Melbourne CBD. Saying that, we are talking to a number of large corporates and also government users for the space, and that will play out over the half. I think it is also worth remembering that this space only came back to us in terms of Infosys vacating in the very latter half of half year '21. So we've only just got the space back, and we are going through the process now of doing refurbishment works that are required to present that space in the best possible light. So over the course of this half, we'll not only complete those works but hopefully will start to generate even better lease inquiry than what we've received today.