Centuria Office REIT (COF) Earnings Call Transcript & Summary

Good day, and thank you for standing by. Welcome to Centuria Office REIT FY '22 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. Thank you. Please go ahead.

Good morning, and thank you for dialing in to the Centuria Office REIT Full Year 2022 Financial Results and Fund Update. My name is Grant Nichols, and I am COF's Fund Manager. Joining me today is COF's Assistant Fund Manager, Belinda Cheung. I would like to commence today's presentation with an acknowledgment of country. I'm joining you from the lands of the Gadigal people of the Eora Nation. Centuria manages properties throughout Australia and New Zealand, and pays its respect to the traditional owners of the land in each country, to their unique culture and to their elders, past, present and emerging. COF has delivered solid results for the 2022 financial year, including a 50% increase in net profit while delivering funds from operations and distributions consistent with guidance. These results were driven by COF's continued leasing momentum and its geographically diversified portfolio of young, quality assets, offer good workforce commutability, high levels of amenity and attractive affordable rents, which offer accommodation solutions that tenants are increasingly seeking. Looking to the year ahead, prevailing inflation and subsequent rising interest rates present market-wide challenges and consequently, our FY '23 forecast FFO has been impacted. Despite this, we believe COF continues to provide an attractive and compelling distribution yield with income underpinned by a quality portfolio of desirable assets. 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 on Slide 4. COF delivered a solid performance in FY '22, including generating funds from operations at $0.182 per unit, paying distributions of $0.166 per unit, maintaining gearing at around 33%, and increasing net tangible asset to $2.50 per unit. Looking at the results summary in more detail on Slide 5. The most pleasing aspect of the FY '22 results is the amount of leasing that COF continued to generate. In fact, since the outbreak of COVID-19, COF has leased over 120,000 square meters, equivalent to about 40% of net lettable area. In FY '22, specifically, leases were agreed over 41,283 square meters, representing 13.6% of the portfolios NLA. The leasing completed, saw occupancy as at 30 June increased to nearly 95%, while the weighted average lease expiry of 4.2 years was maintained. COF generated a like-for-like valuation gain of $37.9 million. And while our leasing activity contributed to the healthy valuation uplift, valuation gains were well supported by recent transactions across metropolitan and new city office markets. In fact, across the Australian office market, 71% of office buildings transacted during the second half of FY '22 were outside the core CBD office markets. Metrics from these sales strongly reinforce the property valuations, which make up COF's net tangible assets of $2.50 per unit, which I note is materially higher than COF's currently trading price. During the second half of FY '22, COF refinanced the year on $258 million of debt and added an additional $50 million of headroom, taking its total debt facilities to -- sorry, to $962.5 million across a diversified pool of 6 lenders. The debt refinancing increased the REIT's weighted average debt maturity from 3.3 years to 3.7 years, with no debt tranche expiring until FY '25. Despite the increased tenure, there has been no material change to the weighted average debt margin. This refinancing solidifies COF's capital position and insulates COF from potential increases in debt margins that may occur in the short to medium term. Looking forward to FY '23 and while we recognize that a rising interest rate environment creates some future uncertainty, we remain optimistic for Australian office markets. Tenant inquiry levels, backed by strong employment growth, continue to improve, and some of the strongest demand is within metropolitan office markets. This bodes well for medium-term rental growth. However, prevailing inflation and subsequent rising interest rates have impacted our FY 2023 FFO guidance, and we expect COF to have like-for-like net operating income growth through FY '23. For FY '23, COF provides FFO guidance of $0.15 per unit and distribution guidance of $0.141 per unit with distributions expected to be paid in equal quarterly installments. Based on the recent trading price, the distribution guidance equates to a distribution yield of 7.7%, which we believe provides an attractive, compelling yield within the current economic environments. In making FY '23 guidance, we have adopted an interest rate forecast with suitable buffers to manage potential further interest rate volatility. This interest rate forecast averages 3% over FY '23. We acknowledge that the velocity of current interest rates is unprecedented in recent times, and that there is both upside and downside potential to the adopted interest rate, and we will continually monitor our guidance in relation to it. For further context, for much of FY '22, COF was paying a floating interest rate of less than 20 basis points, contributing to an all-in FY '22 total debt cost of 2.2%. As of yesterday, the 3-month BBSW or floating rate was about 2.1%. And while it's materially below our forecast average FY '23 interest rate of 3%, it is significantly higher than interest rates paid throughout FY '22. And considering our debt position for FY '23 and while we have pursued debt refinancing to mitigate potential further increases in debt margins, COF has adopted a flexible hedging position, noting the difference between forecast cash rates and the yield curve. We'll continue to monitor the best position throughout FY '23. Moving to the vision, strategy and objectives for COF on Slide 6. Our focus for COF 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 seeks to further enhance the COF portfolio by taking advantage of the opportunities that have come from having a diversified portfolio of quality Australian office assets. Looking at this more practically on Slide 7. We believe tenants are increasingly seeking higher quality accommodation in new-generation buildings that provides healthy work environments, efficient floorplates, improved amenity and competitively priced accommodation. 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 age of 16 years; high-quality assets with 90% meeting A-grade specification; highly efficient buildings with a near 5-star average NABERS energy rating; buildings that provide large, efficient floorplates that are attractive to government and corporate tenants, which is important given that many metropolitan and near-city office markets are dominated by large corporate and government tenants; are in locations that are easily accessible by public and private transport, with generally genus car parking availability; and at a price point that is relatively affordable. For the tenants seeking new accommodation solutions after extended periods of working from home, we are noticing strong preference for improved standards of accommodation and building amenity. Despite the quality applied to experience it will likely lead to divergence between prime and secondary office stock, which will be advantageous for portfolios like COF. Within markets, we are also seeing robust tenant demand for metropolitan locations, with the Melbourne fringe having the strongest 6-month prime net absorption of any Australian office market. It may surprise some to note that 53% of the ASX 200 companies are headquartered in metropolitan or regional office markets. And many of the CBD headquartered companies such as CBA have significant metropolitan office market exposure. Before I hand over to Assistant Fund Manager Belinda Cheung to take you through the financials and portfolio metrics, I'll provide a brief overview of the manager and the benefits Centuria provides to COF on Slide 8. COF is an externally managed REIT that forms part of the largest Centuria Capital Group family, a leading Australasian real estate funds manager operating under the ASX ticker code CNI and included in the ASX 200 index. With more than $20 billion of assets under management, Centuria Capital Group specializes in real estate markets, including decentralized office, urban infill industrial facilities, cost-efficient health care property, daily needs retail, large-format retail and agriculture across Australia and New Zealand. It also provides nonbank financing to the Australian property market through Centuria Bass Credit. Additionally, Centuria provides investment bond options to through LifeGoals product range. COF accounts for around 12% of Centuria's total assets under management and is the platform's largest office real estate fund. There's strong alignment between the broader Centuria business and COF. Advantages are being managed by Centuria as the group has a long and successful track record in property funds management and has a substantial commercial property platform, particularly in relation to office real estate. With in-house property and facilities management, Centuria provides deep leasing capability and hands-on management of the COF portfolio. Centuria Capital Group remains COF's largest unit holder and 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 both the ASX 300 and FTSE EPRA Nareit Index. I'll now hand over to Belinda.

Thank you, Grant. Moving to the FY '22 financial results on Slide 10. COF produced funds from operations of $104.9 million or $0.182 per unit and paid distributions of $0.166 per unit in quarterly installments. The payout ratio for FY '22 was around 91%. Rising interest rates increased finance costs through the second half of FY '22 as applicable interest rates, particularly in May and June, were much higher than previously anticipated. FY '22 was again impacted by COVID-19 with an expected credit loss of $1.4 million, comprising rental waivers totaling approximately $800,000 and other provisions predominantly related to agreed rent deferrals. We do not expect rental waivers or deferrals relating to COVID-19 to impact FY '23. Pleasingly, FY '22 portfolio rent collections were 98.2% with the majority of arrears expected to be recovered. Turning to capital management on Slide 11. As already noted, during the second half of FY '22, COF refinanced $257.5 million of debt and added an additional $50 million of headroom, taking its total debt facilities to $962.5 million across a diversified pool of 6 lenders. The debt refinancing increased the REIT's weighted average debt maturity from 3.3 years to 3.7 years, with no debt tranche expiring until FY '25. Debt covenants of the 50% loan-to-value ratio and 2x interest cover ratio applied to the new and extended debt facilities in line with existing covenants. As at 30 June 2022, COF's loan-to-value ratio was 35.8%, and the interest cover ratio was 6.3x. In FY '23, we expect that COF's all-in cost of debt will be materially higher than the 2.2% incurred through FY '22. To reiterate, in making FY '23 guidance, we have adopted an interest rate forecast with buffers to manage potential further interest rate volatility. This interest rate forecast averages 3% over FY '23. As at 30 June 2022, cost debt was approximately 56% hedged. COF is adopting a flexible hedging position, noting the difference between forecast cash rates and the yield curve. We will continue to monitor this position through FY '23. Looking at portfolio metrics on Slide 13. COF has a truly geographically diversified portfolio of 23 assets without any single market concentration and exposure to most of Australia's major office markets. Metrics on this slide also represent the quality of assets COF has assembled in Australian metropolitan and near-city office markets. Beyond the asset metrics, such as 90% of the portfolio being A-grade with an excellent average NABERS energy rating of 4.8 stars, the portfolio is supported by excellent tenant covenants. Nearly 80% of the portfolio income is derived from government, listed and multinational tenants with only a small exposure to SMEs. The ability to attract quality tenants is reinforced by around 70% of cost tenants by area exceeding 2,000 square meters. This point is contrary to some market participants' understanding of metropolitan and near-city office markets who believes CBDs attracts larger tenants and better tenant covenants. As Grant mentioned earlier, 53% of ASX 200 companies are headquartered in metropolitan or regional office markets. Further to that, a number of metropolitan office markets are dominated by government tenants, which reinforce the availability of quality tenant covenants. Moving on to leasing on Slide 14. After a record leasing year in FY '21, COF continued to complete a significant number of leasing deals during FY '22 with over 41,000 square meters secured, representing 13.2% (sic) [ 13.6% ] of NLA across the portfolio. This includes 21 lease renewals across 23,678 square meters and 27 new leases across 17,605 square meters. The most significant leasing deals executed during this period occurred at 825 Ann Street in Fortitude Valley, where over 10,000 square meters of leases expiring in FY '23 have either been renewed or replaced; 46 Collins Street in West Perth, where IAG have renewed their circa 5,000 square meter tenancy for a further 7 years, noting that this was previously COF's largest FY '23 lease expiry at half year-end; and 576 Swan Street in Richmond, where approximately 3,000 square meters of vacant space has been leased. As a result of the portfolio leasing, COF has increased occupancy to 94.7%, and improved the resilience of the leasing profile with around 77% of the portfolio now expiring at or beyond FY '25. Maintaining high portfolio occupancy is a key management focus, and we are actively seeking outcomes to address our current vacancy and near-term expiry profile. Our primary focus for FY '23 is the pending lease expiries at 154 Melbourne Street and 203 Pacific Highway and the ongoing vacancy at 818 Bourke Street. Specific to 818 Bourke Street, we have leased around 3,500 square meters to [ CTV ] for short-term project space. The project, which relates to Melbourne infrastructure works, is set to be awarded in the coming months. If [ CTV ] is a successful contractor, it is obligated to take a longer-term lease over the space. Please note, the [ CTV ] lease has not been included in COF's current portfolio occupancy stats. Turning to Slide 15. And as noted earlier, 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 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. What is particularly pleasing is the amount of leasing completed since the COVID-19 outbreak. Since FY '20, COF has leased over 120,000 square meters of space during a period in which many had reservations about the depth of tenant demand. Clearly, COF is offering a product that is desirable to tenants supported by a nimble, creative and capable asset management team. Turning to portfolio valuations on Slide 16. As at 30 June 2022, 12 of the 23 assets were independently revalued, resulting in a like-for-like increase in portfolio value of approximately $9 million for the half year. As a result, COF's NTA per unit increased to $2.50 as at 30 June 2022. The valuation increase primarily resulted from the leasing success achieved across the portfolio with recent market-wide transactional evidence also strongly supporting COF's net tangible assets. The weighted average capitalization rate as at 30 June was 5.58%. Moving to sustainability initiatives on Slide 17. COF, by its nature as a REIT, has no [ staff ] and is solely a portfolio of assets. COF is externally managed by Centuria Capital Group and aligns itself to Centuria's sustainability framework, consisting of 3 core strategies: One, conscious of climate change relating to the environmental considerations; two, valued stakeholders relating to social initiatives; and three, responsible business principles referring to governance. Specific to the environment, over the course of FY '22, COF's enhanced energy efficiency with its portfolio average NABERS energy rating now at 4.8 stars. Social initiatives are measured through both Centuria's annual tenant satisfaction survey and annual employee engagement survey, both produced excellent results during the year. 96% of surveyed tenants were satisfied with Centuria as their landlord and 94% of Centuria's employees are proud to work at the company. Centuria is also committed to gender diversity and inclusion. At present, there is roughly a 40 to 60 split of female to male staff. On the governance front, we have adopted the Task Force on Climate Related Financial Disclosure recommendations. This means climate change is now a standard investment consideration with adaptation plans being developed across the Centuria portfolio. Slide 18 elaborates on specific case studies where COF's assets have benefited from ESG initiatives. Throughout FY '22, extensive works at 818 Bourke Street in Melbourne have lent themselves to improved worker health and well-being, while the improved environmental considerations have seen the assets NABERS rating improve to 5 stars for energy efficiency and 4 stars for water efficiency. The property also received a WiredScore Gold rating, which is an international recognition standard for digital connectivity. At 8 Central Avenue in Sydney, we are currently completing the installation of a solar panel system to deliver green electricity to the building, saving an estimated 355 tonnes of carbon each year. Green energy solar systems are being explored across other existing COF assets to further reduce carbon emissions. I will now hand back to Grant to cover the market outlook and guidance.

Thanks, Belinda. Looking ahead on Slide 20. As we enter FY '23, Australian office markets are navigating through the lingering impacts of COVID and the prospects of rising inflation. Despite these challenges, we believe there is a positive outlook for COF's office markets with the following key themes likely to dominate in the year ahead. Firstly, and as already mentioned, we expect tenants will gravitate toward high-quality office accommodation for a number of regions -- for a number of reasons, such as creating a new and enticing work environment after a prolonged period of working from home, seeking accommodation in buildings that offer higher levels of environmental and well-being credentials to align with the tenants' changing ESG requirements. And as technological and communication improvements necessitate change, tenants will be seeking a combination that meets these requirements. Tenants recognize the workplace can heighten company culture and will actively seek space that creates and cultivates rather than simply a place to work. This particular point is driving increased leasing activity with better quality buildings with strong amenity winning the lion's share. Commercial real estate agency, Colliers, have noted record demand for office leasing in the first half of calendar year 2022. And metropolitan off-market office leasing is on track to exceed its record year of 2021. What will further accelerate tenant activity is the robust Australian economic conditions and positive employment outlook. Australia is currently seeing a record number of job advertisements. And coupled with international borders reopening, there are very positive tailwinds for tenant demand across Australian office markets. Growth in employment numbers necessitates more office space, and we expect stronger positive net absorption through FY '22. In relation to the potential for rising inflation, it is important to note that commercial property is a natural inflation hedge. And many of the things that drive inflation such as low unemployment and strong economic growth are tailwinds for tenant demand. Regarding increased construction costs which are already evident in many markets across Australia, it is certainly an issue for developers that owners of established properties are somewhat insulated from these cost impacts and may, in fact, benefit as increased construction costs will likely temper office supply. Another aspect of increased construction costs is that it may lead to higher levels of tenant renewals as the cost of fit-outs become prohibited. Again, this will be beneficial to existing owners of established properties, particularly those that provide quality, affordable accommodation like COF. Strong investment demand for Australian metropolitan fringe and regional office assets continued throughout the second half of FY '22. And several of these transactions occurred in comparable office markets to COF have been detailed in the table on Slide 21. When this basket of comparable property transaction is collated, it demonstrates very strong demand as investors recognize the relative affordability and accessibility these markets provide the tenants. It is worth noting that over 70% of office transactions in the second half of FY '22 occurred outside of the core CBD office markets at Sydney, Melbourne, Brisbane and Perth. The average metrics from these sales illustrates strong investor demand for the types of assets COF owns with many selling on metrics that are significantly tighter than COF's current valuation metrics. This point is amplified when compared to COF's current trading price, which implies an average cap rate across COF's portfolio of around 6.8%. Concluding on Slide 22. We recognize that a rising interest rate environment creates some future uncertainty, but we remain optimistic for Australian office markets. Tenant inquiry levels, backed by strong employment growth continually improve with some of the strongest demand evident in metropolitan office markets, while rising construction costs are likely to tap the supply. This bodes well for medium-term rental growth. During FY '22, we witnessed a continuous shift in tenant preferences towards better quality accommodation that is close to key transport nodes, providing better commutability and subsequently improved work-life flexibility. COF's young portfolio lends itself to these leasing preferences with its modern and sustainable office buildings, providing better access to well-being amenity, retail, hospitality, while offering affordable rents. Australia's strong employment rate and rising return to office corporate policies, provide encouraging tailwinds for tenant demand in FY '23. 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 current vacancy and near-term expiry risk. For FY '23, COF provides FFO guidance of $0.158 per unit, distribution guidance of $0.141 per unit with distributions expected to be paid in equal quarterly installments. Based on the recent trading price, the distribution guidance equates to a distribution yield of 7.7%. Thank you for your interest in Centuria Office REIT. I will now hand back to the operator and invite any questions that you may have.

[Operator Instructions] First question comes from the line of Murray Connellan from Moelis Australia.

I was wondering whether you could give a little bit of color around the assumptions in your guidance. You've obviously mentioned that the big mover there being the interest rate assumptions of an average cash rate of 3%. But just around leasing and CapEx, the big movers there are obviously the Docklands South Brisbane and St Leonards. What are the assumptions for leasing in your guidance for FY '23?

Yes. Thanks, Murray. Looking at those 3 specifically, so the Docklands, we do have some of the space leasing through the back half of FY '23, but there is some of the space that we are not forecasting for lease for the balance of FY '23. As we move through that list, at 154 Melbourne Street, there's 4 to 5 levels that are coming available for lease in that building. Again, it's a staggered let-up assumption that we've made. And we're assuming that some of that space will be left from the early part of calendar year '23 and the back half of that space won't be leased in the balance of FY '23, but in the start of FY '24. For the expiry, the Healius expiry at 203 Pac Highway. So their in situ or their lease expires at the end of September. Again, that is a multiple floor expiry, and we have assumed a staggered let-up assumption with some of the space being left in the back half of FY '23 and the balance being left in the early part of FY '24.

Can you say what your average portfolio vacancy would be in the assumptions for FY '23?

Sure. So look, in terms of vacancies, we've taken a specific let-up assumption for each individual vacancy, but probably what is more pertinent to your and other's purposes for leases expiring through the year, our renewal assumptions is that there will be 4 months downtime within the cash flow. So obviously, if we can do our lion's share of renewal, there should be some potential upside for income through FY '22.

And then just around, I guess, some of the broader market conditions for prospective tenants and the inquiry that you're seeing in some of those key markets, can you maybe just give us a bit of a snippet on each?

Sure. Look, we've had very good leasing results. As Belinda went through during the course of the call, we've leased a lot of space since the event of COVID. And to be honest, we've seen pretty good leasing activity in all markets, probably outside of our one exposure in Docklands. So we've seen reasonable levels of inquiry in every other market that we're exposed to. We have addressed a lot of the vacancy that we've had within our portfolio outside of Docklands through to 30 June. So if I think about -- we did have nearly around 3,500 square meters of vacancy at Swan Street, Richmond in Melbourne, which we've mostly addressed. So over 3,000 square meters has been leased. And we did have some lingering vacancy at Canberra, which has subsequently been leased as well. So a lot of the vacant space that we've had within our portfolio has attractive tenants and has now been leased. So we're pretty comfortable with where leasing activity is in the vast majority of the markets we're exposed to. And just to reiterate, we have done a lot of leasing since COVID, over 120,000 square meters leased over the course of the last circa 3 years, which is nearly 40% of the portfolio NLA.

And then just the last one from me, obviously, within your guidance, there's quite a few moving parts, which probably make FY '23, but a tough one to forecast. In the event that FFO at the end of the year ends up differing from your guidance, are you expecting to keep that -- the 89% payout ratio that you're guiding to unchanged? Or does the dividend stay $0.141 regardless of the FFO backdrop?

Look, we've been saying for a little while now that we'd like to get our payout ratio between 85% to 90% of FFO. So if there was immaterial change to FFO, so if there was a slight dilution, I don't think you would see any impact on distributions. But at this stage, I think it's too early to tell what that impact would be. In making an FY '23 forecast or providing FY '23 FFO guidance, we did put a lot of thought into it. We have adopted an interest rate that we think is fairly -- reasonably conservative that will give us buffers to potential future or further volatility in the interest rate expectations. So we are pretty comfortable with what we put out there. I would be hopeful that there is more upside than downside risk to that. But at this stage, it's probably too early to tell to give you any further guidance on what I've just said, Murray.

[Operator Instructions] Your next question comes from the line of Tom Bodor from UBS.

Grant, I just wanted to check in around your flexible hedging policy. I think you mentioned that word a few times. I just wanted to know what you mean by flexible and where your hedging is at the end of FY '23. And if there's any sort of things to note around the hedging bit, sort of things like interest rate caps or any other things that are sort of unusual that you've looked to use to...

Sure, Tom. You were just fading there at the back end. Just to summarize, you just wanted to go through what we meant by our flexible hedging policy. So just overview of where our hedging will flow through FY '23 and whether we're considering any alternate hedging policies to vanilla interest rates, is that correct?

Yes, that's right. Yes.

Yes. So in terms of our hedging policy, what we mean by hedging or flexibility is that we haven't sought to put in a material amount of hedging in the immediate term, simply because there has been quite a wide divergence between interest rate expectations and where the yield curve has been. Now that is -- over the course of probably the last couple of weeks, that is staying too close. So there may be opportunities that we will look at further hedging in due course. In regards to looking at alternates, we have put an interest rate cap in for FY '23. So that is something that we will consider, and that's probably part of what we mean by flexibility. We will not simply look at just vanilla interest rate hedges, we will look at other ways of mitigating our interest rate risk. In terms of our interest rates and how they progress through FY '23, all our interest rate swaps are noted in the stat accounts. There will be hedges that roll off through the course of FY '23, and we will need to look at putting further hedging in place as we progress through the year.

So are the caps included in the 56%? Or are they outside it?

No, the caps are included.

And what's your policy minimum hedging?

50%.

And then just one final one for me. I just wanted to sort of understand, the direct market seems to be still very strong. Are you considering noncore asset sales to sort of produce your gearing? Or are you comfortable with where you sit?

Look, we'll always look at asset allocation. Over the course of the last 2 financial years, we have sold assets. And so if we deem that we've maximized value on any given asset, we will certainly consider selling assets. But at this stage, we have got no immediate plans to sell any of our portfolio.

Would you like to see it going lower? Or are you comfortable with the 34%?

Look, I think we are comfortable with where gearing sits at the moment. We have got ample debt covenant headroom. I think it's something that we'll continue to monitor as the year progresses. As mentioned during the call, there is quite a wide variety of expectations on where interest rates are headed. So I think you can probably -- it's probably worth waiting to see where interest rates moderate before taking a firmer view on gearing.

Our next question comes from the line of Lauren Berry of Morgan Stanley.

Just wanted to clarify your comments around the 3% cash rate. Are you referring to the RBA cash rate there or the BBSW?