Centuria Office REIT (COF) Earnings Call Transcript & Summary

Good day and thank you for standing by. Welcome to the Centuria Office REIT FY '21 Results. [Operator Instructions] Please be advised that today's conference is being recorded. [Operator Instructions] I would now like to hand the conference over to your speaker today, to Mr. Grant Nichols. Thank you. Please go ahead.

Good morning and thank you for dialing in to the Centuria Office REIT 2021 Financial Results and Fund Update. I am Grant Nichols, COF's Fund Manager. FY '21 has been a strong year during which COF delivered a record amount of leasing, FFO at the top end of the guidance range and a significant amount of debt refinancing, which secured COF's future debt requirements. We believe this performance was made possible due to COF's geographically-diversified portfolio of young quality assets, which offer good workforce commutability and attractive affordable rents and exposure to Australia's better-performing office markets. 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 an average building age of around 17 years and ample undrawn debt and debt covenant headroom, COF remains well placed to continue delivering attractive income returns to unitholders. Earlier today, we published various documents on the ASX relating to the full year results, including a results presentation, which we will go through this morning. Starting with the vision, strategy and objectives for COF on Slide 3. Our focus for COF throughout FY '21 has been and will continue to be generating predictable and quality income streams by building Australia's leading office REIT. Through active and engaged management, Centuria seek to further enhance the COF portfolio by taking advantage of the opportunities that come from having exposure to Australia's better performing office markets. Looking at this more practically on Slide 4, we believe COF has been well positioned to first meet changing tenant demands and secondly, deliver COF's primary objective of sustainable quality income returns to our investors. Owning a geographically diversified portfolio without single market concentration enhances the sustainability of COF's income returns as COF's largest single market exposure is Canberra at around 17%. Geographic diversification reduces risk to a specific market slowdown, or in the case of the current environment, specific market lockdown, while also allowing greater exposure to various industries contributing to the Australian economy's employment growth. Over the longer term, we believe there will be a strong employee preference towards working closer to home. For some time, we've said a key contributor to employee satisfaction is the length and quality of their commutes. This thinking has 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 component of working from home is reduced time commuting to the workplace. Consequently, we believe businesses will actively seek accommodation solutions that provide staff with workplaces close to their home, providing better commutability. This workplace change will directly benefit metropolitan and fringe office markets that COF is exposed to. We also believe, particularly in times when some markets had elevated vacancy, that there will be flight to quality of its accommodation. Some [indiscernible] industry buyers may assume that flight to quality would see metropolitan and fringe tenants seek alternate CBD accommodation. While this may have happened in the past, current market data indicates the reverse. Over the past 6 months, we have seen positive net absorption in the Sydney Fringe, Melbourne Fringe and Brisbane Fringe office markets, while each one of their CBD counterparts continue to incur negative net absorption. What this illustrates is applied to quality accommodation in modern buildings outside of core CBD locations. In the medium term, we believe tenants will seek to improve standard of accommodation and building amenity. As such, we believe there will be a preference towards newer generation offered stock, which should benefit the COF portfolio as the average building age is around 17 years. Affordability is always a key consideration for office tenants. Again, we believe COF is well placed, as the portfolio provides consistently high-quality office accommodation at attractive affordable rents, with COF's average portfolio rent below $500 a meter. This rental base generally produces lower income volatility than high-end rents while still providing greater opportunity for future growth. Moving on to Slide 6 with a short overview of COF's manager. Centuria Capital Group is an established real estate investment manager that operates on the ASX code, CNI. With over $17 billion of assets under management, Centuria Capital Group provides its investors with exposure to quality office, industrial, convenience retail and healthcare real estate investments across Australia and New Zealand and investment bonds through the Centuria Life business. COF accounts for around 12% of Centuria Capital Group's total assets under management. Slide 7 further highlights the alignment between the broader Centuria business and COF. Advantages are being managed by Centuria, is that the group has a 20-year plus successful track record for 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. The recent merger with Primewest further enhances Centuria's real estate capability and with now a much larger commercial office portfolio under its management, Centuria offers even greater synergies and opportunity to COF investors. Centuria Capital Group remains COF's largest unitholder with 19.9% of the register. It has been a strong supporter in COF's evolution to now be Australia's largest ASX-listed pure-play office REIT that is included in the ASX 300 Index. With recent changes in threshold measures, COF is also now positioned for potential inclusion in the FTSE EPRA Nareit Index. Turning to COF specifically on Slide 8. COF delivered a strong performance through FY '21, completing a record amount of leasing, while maintaining high rent collections of over 98%. COF's resilient operating performance generated in FY '21 FFO of $0.199 per unit, which was at the top end of the guidance range. FY '21 distributions of $0.165 per unit provide an attractive yield of around 7% at the end of June and an FFO payout ratio of around 83%. Looking at the results summary in more detail on Slide 9. The COF portfolio performed well throughout FY '21, generating a see record level of leasing activity with leases agreed for around 52,000 square meters or over 18% of portfolio NLA. This has improved occupancy to 93.1%, while maintaining a weighted average lease expiry of 4.3 years. COF enhanced debt profile through the period with $405 million of debt refinanced in the second half of FY '21, increasing the weighted debt maturity to 4.2 years while providing $107 million of undrawn debt. The REIT now has no debt tranche expiring before June 2024 and maintained a competitive all-in debt cost of approximately 2.4%. The COF portfolio is underpinned by high-quality tenants with around 27% of income coming from Australian state and federal government tenants. Additionally, COF benefits from a relatively young portfolio with an average building age for around 17 years. Younger buildings generally have lower capital expense requirements, lower operating costs and tend to be more attractive to tenants, offering greater building efficiencies and generally better building amenity. Moving back to the FY '21 financial results on Slide 11. COF produced subs from operations of $102.2 million or $0.199 per unit and paid distributions of $0.165 per unit and quarterly installments over FY '21. Funds from operations during FY '21 benefited from the receipt of a surrender payment from Foxtel, which surrendered its lease across the entire building at 35 Robina Town Center Drive. Under the agreement, COF received a surrender payment equivalent to the rent payable under the remaining Foxtel lease term discounted to June 2020. Pleasingly, since the surrender occurred in July 2020, the building has been largely re-leased with occupancy increasing to 88% which again demonstrates COF's success and focus on active leasing management. COF demonstrated resilience to the continued impact of COVID-19. COF's portfolio rent collection averaged more than 98% for the full year to 30 June 2021. Provided rent relief, both waivers and deferrals totaled around $1.9 billion to FY '21 with limited rent relief provided during the second half of the year. Turning to capital management on Slide 12. As already noted, COF secured a significant $405 million debt refinance which increases its weighted average debt maturity to 4.2 years with no debt tranche expiring until June 2024. Our recent debt refinancing maintained COF compared to 2.4% all-in cost of debt across a diversified pool of 5 lenders. This provides the REIT with sufficient undrawn debt and substantial debt covenant headroom, providing a robust capital structure. Refinancing also signifies strong support from our lenders, who have confidence in the quality of the COF's office portfolio. Shifting to Slide 14. One of the key benefits of Centuria's management is the strong capabilities of Centuria's in-house asset management team. With a dedicated leasing team, Centuria has consistently maintained high occupancy across all of its listed and unlisted platforms. Since COF listed in 2014, Centuria management has consistently leased a significant portion of the portfolio year in, year out, maintaining high levels of occupancy each and every year. In FY '21, the Centuria team has delivered a record level of leasing in what has been a challenging but improving leasing market. Achieving high portfolio occupancy is a key management focus, and we are actively seeking outcomes to address our current vacancy, particularly at 818 Bourke Street, where leasing efforts are progressing and have been impeded by ongoing market lockdowns. Looking forward to the FY '22 upcoming expiries, and we confront a much more benign expiry profile than we did 12 months ago, when the forward-looking 12-month expiries were more than double that of the current FY '22 upcoming expiries. Moving on to the portfolio on Slide 15. 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. Breaking down a record 52,077 square meters of leasing and COF secured separate lease transactions, representing 18.1% of portfolio NLA. Of the agreed deals, more than 26,000 related to new tenants across 33 separate deals, the balance right into tenant renewals. As a result of this leasing, COF now has a more resilient leasing profile with more than 63% of the portfolio expiring at or beyond FY '25. Detailing some of the leasing success in more detail on Slide 16. During the year, COF completed leasing in virtually every market COF has exposure to however, in this slide, we will provide some greater detail on the leasing that has been completed across COF's Queensland portfolio. At 100 Brookes Street in Fortitude Valley, we'll lease more than half the building during FY '21, which increased occupancy to 100% while extending the WALE to almost 5 years. At the neighboring 825 Ann Street in Fortitude Valley, we leased about 3,000 square meters, which again increased occupancy to 100%. And on the Gold Coast, the 35 Robina Town Centre Drive released almost 8,000 square meters following the full building surrounded by Foxtel in July 2020. All in all, we leased nearly 16,700 square meters across the COF Queensland portfolio, of which about 4,600 were new tenants attracted to COF's quality assets. What makes this leasing particularly pleasing is that if the new tenants who were open to the portfolio, 4 were greater than 1,000 square meters. The rhetoric we are hearing across Australian leasing markets is that tenant demand is improving that has been largely concentrated to the SME and small tenant market. By contrast, COF has been able to attract both small and large tenants, corporate and government alike. Looking at the tenant mix on Slide 17. The COF portfolio income is underpinned by diverse quality tenants with more than 80% of the portfolio income being derived from government-listed or multinational tenants with 27% derived from Australian state and federal government tenants. In addition to the high quality, the COF tenant mix is very diversified with only the Australian federal government, making up more than 5% of portfolio income, and that Australian federal government exposure comprises a number of different departments across multiple buildings. Another aspect of the COF portfolio worth highlighting is the average COF tenant size, as around 72% of portfolio income is derived from tenants of greater than 2,000 square meters. One of the misconceptions about metropolitan and fringe office markets is that they suffer in relation to tenant quality compared to CBD office markets, with the assumption being that they are more aligned on small tenants and small to medium-sized enterprises. This is clearly not the case. Turning to portfolio valuations on Slide 15 (sic) [ Slide 18 ]. As of 30 June 2021, 14 of the 22 assets were independently revalued, resulting in an increase in portfolio value of approximately $16.3 million. As a result, COF's NTA as of 30 June '21 increased from $2.45 to $2.48. The increase in value was primarily a result of leasing success achieved across the portfolio. The weighted average capitalization rate compressed slightly to 5.81%. Looking into sustainability on Slide 19. As Centuria Office REIT is externally managed by Centuria Capital Group, it aligns itself to Centuria's sustainability approach. Throughout FY '21, Centuria and COF implemented various ESG initiatives, including drafting Centuria Capital's first sustainability report, which will be released later this year and will include responses to the task force of climate-related financial disclosure recommendations. There has been diversification of COF's responsible entity Board with the appointment of Matthew Hardy as Independent Chair and Nicole Green as Independent Non-Executive Director. Other initiatives and sustainability highlights during FY '21 are the establishment of Centuria's culture and ESG Board Committee. The release of Centuria's first modern slavery statement, completing employee and tenant engagement surveys where 94% of employees expressed enjoyment working at Centuria and 91% of tenants recommend Centuria, and returning Centuria membership to the Diversity Council Australia. Specific to the environment on Slide 20. During the course of FY '21, COF have sought to enhance energy and water efficiency under the NABERS rating scheme. Furthermore, COF has disclosed its 2019 and 2020 energy consumption, water consumption and greenhouse gas emissions' intensity in the appendices of this results presentation. During FY '21, we actively sought to enhance COF's energy and water efficiency, delivering improved 2020 NABERS energy 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. Testament to the Centuria facility management team, we have seen a reduction in consumption and emissions intensities throughout the portfolio. We are particularly proud of the average NABERS energy rating across the COF portfolio, which is an excellent 4.7 stars. Looking ahead on Slide 22. The leading indicators for office demand are positive and has been solid momentum in job creation across a number of office-based industries. Looking at the labor force statistics June from the ABS and there has been continued job creation across those industries, which traditionally consume office space, and we expect this will lead to continued improvement in tenant demand across Australian office markets. Underpinned by significant fiscal and monetary support, there's been strong growth in employment in office demand industries, particularly in New South Wales and Victoria. To an extent, the employment growth is already starting to become evident as a number of Australian office markets demonstrated improved tenant demand in the second half of FY '21, as shown in the table on Slide 23. What is also telling in this table is the strength of Australia's metropolitan and fringe office markets. While Sydney CBD experienced negative net absorption of 150,000 square meters, and Melbourne CBD, a negative 187,000 square meters throughout FY '21, fringe and metropolitan markets have demonstrated recovering tenant demand and resilient gains. Over the last 6 months, we have been -- we have seen positive net absorption in many markets COF has exposure to such as Sydney Fringe, Melbourne Fringe, Brisbane Fringe, West Perth and Canberra, which is in stark contrast to the data generated by the Sydney, Melbourne CBD through the same period. These contrasts could be explained by the underlying tenant occupiers, but it could also indicate that businesses are more actively seeking accommodation solutions that enable staff to access workplaces closer to home. Something else 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 of the Sydney CBD, COF's average portfolio rent of less than $500 a meter appears very sustainable, which should generate lower income volatility while still providing great opportunity for future growth. Turning to the investment market on Slide 24. There has been strong investment demand for Australian metropolitan, fringe and regional office assets throughout FY '21 and several of these transactions occurred in comparable office markets to COF and have been detailed in the table on Slide 24. When this basket of comparable property transactions are collated, it demonstrates very strong demand as investors recognize a relative affordability and accessibility these markets provide to tenants. The average metrics from these sales illustrate strong investor demand for the types of assets COF owns, with many selling on metrics that are stronger than pre-COVID sales and that are significantly tighter than COF's current valuation metrics. These transactions not only underpin COF's NTA but suggest there could be positive future valuation implications. Concluding on Slide 25. Our focus for COF throughout FY '22 and beyond will be to continue generating predictable and quality income streams. We seek to build Australia's leading pure-play office REIT, positioning it to meet changing tenant demands by providing high quality and affordable office space. Across COF's portfolio, we are encouraged by the leasing activity that Centuria has been able to generate and continue to see across our invested markets. This leasing activity gives us confidence as we proactively address the current vacancy and near-term expiry risk across the COF portfolio. At the beginning of FY '21, COF was one of the few REITs to provide distribution guidance despite the effect of COVID-19 prevailing at that time. Notwithstanding the recurring impacts of COVID-19 operating conditions, it is my pleasure to again provide FY '22 distribution guidance of $0.166 per unit, equating to a current distribution yield of 6.7% with an FFO guidance of -- $0.18 per unit. In making this guidance, we have made a number of allowances for the impact of COVID lockdowns that have been impacted across our portfolio and the possibility of current lockdowns being extended. As always, this guidance remains subject to unforeseen material changes in operating conditions. 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] Our first question is from Tom Bodor from UBS.

Thanks for the update. I just wanted to ask a couple of questions around sort of the leasing and just what your expectations are around the CapEx that you are requiring to spend at 818 Bourke and just whether you sort of expect incentives to come in on that one.

Sure. So at 818 Bourke Street, we already completed a fair amount of the CapEx works that are required to reposition that asset. So through FY '22, we're probably only tidying up the works to be completing. So in total, on-floor works, we're spending, I think it's about $2 million to $3 million on the on-floor works and we're spending about another $2 million on enhancing building amenity. So I think -- and we've discussed previously, we've talked about what we're looking at doing in that building. So we're putting in third space on the ground floor, reconfiguring building foyer and on the rooftop of this building, which is a very large open space that faces onto the Melbourne Harbor and has a noteworthy aspect. So it is quite different from a lot of Melbourne assets, and we are putting exercise equipment, outdoor meeting space and a lot of other building amenity. In regards to incentives, obviously, Melbourne, as mentioned on the call, Melbourne CBD has been one of the core performing markets across Australian office markets, and we have seen incentives rise in that market. So at this stage, we are forecasting that we'll be paying incentives probably in the mid-30s percent. But given the amount of work we're doing to the -- to that building, we think we'll be able to do better than a prevailing market in regards to being able to attract tenants and get an incentive right.

Okay. And then for the Robina asset, where the leasing was good sort of to see that progress come through. But I do know there's a pretty material expiry in '22. And from memory, you kind of got a short-term deal away there that could be extended for a few years. I was wondering if you can -- could update the progress on that potential extension, if that is that 56% to the expiry chart for that asset?

Yes. Sure. So just to provide a bit of detail on that. So the 3 floors of that building have been leased to Concentrix, and that totals in excess of about 4,500 square meters. Concentrix is a call center operator, and they have a number of contracts backed by Australian corporates and government agencies. Now the way that those call center contracts go, there is an initial -- I suppose a testing period or trial period. And following that, they get a longer-term commitment. So we resort to mirror the lease commitment to that. So Concentrix have taken an initial 6-month term that expires 31 December of this year. And then following that, there is a 3-year option. So that 3-year option will have to be exercised during the course of that initial term. At this stage, Concentrix are on the floor, they're operating at almost full capacity and they're indicating to us that everything is going to plan. So we are making the assumption where I think it's a fair assumption that, that will stay. But in making a guidance for FY '22, we have assumed there is 6 months downtime following that expiry at 31 December. So if they do renew, which is what we think will occur at this stage, there will be upside to the FY '21 FFO -- FY '22 FFO.

Can you quantify that upside in given that there's a good chance they stay, can you just sort of quantify that in sort of FFO per share, just the expense on that?

Yes. Look, it's probably going to be in the realms of $1 million to $1.5 million, which is between $0.002 and $0.003 per unit.

Our next telephone question is from Lauren Berry from Morgan Stanley.

Just if we can go back to the guidance, are you able to give a little bit more color around what you are assuming in terms of your occupancy throughout the year and also any rent release that you might have to provide the tenants?

Yes. So we're certainly making assumptions at the moment for ongoing COVID relief. Those assumptions are probably consistent with what we've had to provide through FY '21 and the back half of FY '20. So we are certainly making assumptions on that. In regards to leasing assumptions, given current circumstances, we haven't been overly optimistic in terms of our earnings guidance in terms of being up to lease that space. So most prominently 818 Bourke Street, we have impacted very little income into the FY '22 guidance. At this stage, I have full confidence that we'll be able to address the 818 Bourke Street vacancy during the course of FY '22, but I still don't think that we'll be able to get too much income into FY '22 from that vacancy. So we have taken a reasonably conservative view on forecasting simply because of the circumstances we find ourselves in at the moment.

Okay. Okay. Cool. And just on the DPS that you've set, can you just give us a sense of how you set that amount? Like is it covering AFFO or any of the CapEx that you're doing on your various assets this year? And I guess, how should we think about the payout ratio going forward?

Yes. So the payout ratio that we're looking to get -- probably over the longer-term payout ratio between 85% and 90% of FFO. So when we're thinking about that, we are thinking that the payout ratio or what is withheld will cover maintenance CapEx and the incentive component for contributions over the longer term. While COF is becoming a much larger portfolio, we do have some larger tenants within that so there is going to be some bumps in regards to incentives that are paid over the period. So we are looking for an average incentive amount. So that's probably what we're looking to cover. And as a maintenance CapEx guidance, given we have got a relatively young portfolio, we sort of assume that payments CapEx over the longer term will be around that sort of 30 to 40 bps of portfolio value.

Does the extra work that you're doing on energy and water efficiency at the moment contribute more to CapEx at the moment?

So the way we look at that type of work -- so a lot of that work actually has a positive payback period. So they are actually beneficial to FFO in some respects. So particularly if you've got a gross billing and you're getting a payback of less than 5 years, that is almost immediately earnings accretive plan to taking those works. In addition to that, a lot of the work we are doing within energy improvement is management. So we do a lot of monitoring and trying to get as much out of the assets as we possibly can without having to incur further capital expenditure.

Okay. Great. And then just final one for me. Are you able to talk a bit more about the leasing you've done in the period? You've obviously done -- you've had a big half of activity. Can you just talk about where the tenants are upsizing or downsizing, the average tenure of the leases that are being signed again?