Centuria Office REIT (COF) Earnings Call Transcript & Summary

Good day, and thank you for standing by. Welcome to Centuria Office REIT Half Year 2023 Results. [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, COF Fund Manager. Thank you. Please go ahead.

Good morning, and thank you for dialing into the Centuria Office REIT Half Year 2023 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; Group CEO, Jason Huljich; Centuria Head of Funds Management, Ross Lees; and Group Head of IR, Tim Mitchell. I would like to commence today's presentation with an acknowledgment of the country. I am joining you from the lands of the Gadigal people of the Eora Nation. Centuria manages property 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 generated solid results for HY '23, delivering funds from operations and distributions consistent with guidance. Further, COF has achieved significant leasing outcomes during the first half of FY '23, continuing to reach considerable leasing momentum since the start of the pandemic, which has resulted in new and renewed terms across more than 50% of the portfolio. During the first half of FY '23, COF has leased over 24,000 square meters of vacant space, which increased portfolio occupancy to 96.4%. These leasing outcomes were enabled by COF's geographically diversified portfolio of young quality assets that offer good workforce commutability, high levels of amenity and attractive affordable rents, providing the accommodation solutions that tenants are increasingly seeking. COF's geographic diversification has been particularly important as many office markets outside the Sydney, Melbourne CBD demonstrated positive net absorption through 2022. 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 HY '23, including generating funds from operations in line with guidance with FY '23 FFO guidance reiterated, paying distributions in line with reaffirmed FY '23 distribution guidance, representing a current distribution yield of over 8.5%, delivering an NTA of $2.40 per unit after like-for-like portfolio revaluations as at 31 December, '22, declined by less than 2% from COF's prior value and maintaining ample debt covenant headroom and undrawn debt with 35.6% gearing as at 31 December and hedging at 58.1%. Further, portfolio occupancy increased to 96.4%. This increase in occupancy was particularly pleasing considering COF incurred material vacancies at 154 Melbourne Street, South Brisbane and 203 Pacific Highway, St Leonards post 30 June. These vacancies have already been largely addressed. Looking at the results summary in more detail on Slide 5. During HY '23, leases were executed over 15,000 square meters, representing 5% of the portfolio's NLA. Further to the executed leases, COF has received Signed Heads of Agreement for an additional 15,336 square meters, including 2 Heads of Agreement, which combined to over 7,000 square meters at 818 Bourke Street in Docklands, which will largely address the vacancy at this property, a Heads of Agreement for around 2,500 square meters at 203 Pacific Highway at St Leonards, which will also largely address the property's vacancy and an increase in pre-commitment at the Wyatt Street Adelaide development to 76%. Construction is on track to complete in the second half of FY '23. Rent commencements from these lease commitments mostly occur in the first half of FY '24. Of the over 30,000 square meters of total leasing, pleasingly, around 24,000 square meters related to previously vacant space, pushing occupancy to 96.4% with a WALE of 4.2 years. As a result of the leasing only around 14% of COF's portfolio leases expire before FY '25. Like-for-like portfolio revaluation declined by less than 2% from COF's prior portfolio value, with the weighted average capitalization rate expanding 17 bps during the half to 5.75%, resulting in net tangible assets of $2.40 per unit. In regards to valuations, while there has been a noticeable reduction in transaction volumes across the market, of those assets that have transacted, there is evidence of bifurcation based on quality and leasing risk. Well-tenanted high-quality buildings have continued to trade on competitive sales metrics. For the remainder of FY '23, COF reiterates FFO guidance of $0.158 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 in excess of 8.5%, which we believe provides an attractive compelling yield. In reaffirming guidance, COF is taking into account current and forecast changes in interest rates and continues to monitor economic conditions. Moving to the vision, strategy and objectives for COF on Slide 6. Our focus at 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 seek 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 high-quality accommodation in new-generation buildings to provide healthy lifestyle-orientated work environments, efficient floorplate, improved amenity and competitively priced accommodation. Furthermore, there is increased demand to be located in areas that provide efficient commute to improve employee satisfaction and attract the best talent. When looking specifically at the CF portfolio, it has been positioned to deliver on many of these qualities by offering a young portfolio with an average age of 17 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 attracted 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, locations that are easily accessible by both public and private transport, with generally generous car parking availability and a price point that is relatively affordable. Moving to Slide 8. Another aspect of the COF portfolio, which we think has materially contributed to COF's recent leasing success is COF's geographic diversification. COF's portfolio of 23 assets is truly diversified with no single state exposure greater than 25%. Contrary to speculation that demand for office space would be soft and universally reduced across all office markets, particularly in non-CBD markets, many Australian office markets demonstrated positive net absorption or an increasingly space over the past 12 months. Much of this positive net absorption occurred in metropolitan or near city office markets, with the Melbourne fringe demonstrating the strongest 12-month net absorption of any Australian office market. Notably, negative net absorption was concentrated in the Sydney and Melbourne CBD, markets COF has limited or no exposure to. Further, [ also ] Sydney CBD is the largest Australian office market. It is only around 18% of the national office market and not indicative of all office market conditions. Since the first impact of COVID in 2020, COF has leased over 150,000 square meters of office space, representing more than 50% of the portfolio. So, rather than being a one-off, we believe that COF's exposed markets consistently provide a sustained level of tenant demand. Cost encouraging leasing activity since COVID also runs contrary to the anecdotal speculation concerning the impact of flexible work may have on demand for office space. Positive industry data reveals an increasing number of workers returning to the office across all markets and tenants are generally seeking to accommodate peak occupancy rather than average occupancy as tenants increasingly recognize the benefits offices provide to collaboration and culture. Consequently, we are confident tenant demand will continue. 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 that Centuria provides to COF on Slide 9. 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 $21 billion of assets under management, Centuria Capital Group specializes in the 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. COF accounts for around 11% of Centuria's total assets under management and is the platform's largest office real estate fund. There is strong alignment between the broader Centuria business and COF. Advantages of being managed by Centuria is that 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 innovative deep leasing capability and hands-on management of the COF portfolio. Centuria Capital Group remains COF's largest unitholder 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. The latest demonstration of CNI support for COF and office more generally is Cirque by Centuria, which has been detailed on Slide 10. Cirque by Centuria recently opened in 2 of COF's assets and is a new Centuria operated flexible workspace business that provides quality workspace solutions within the underserviced metropolitan and new city office markets. Offering excellent technology and best-in-class facilities, Cirque delivers existing and potential COF tenants enhanced building amenity with the opportunity to easily add additional office space for project-based work or to potentially branch into new markets with a satellite office presence. We think the creation of the Cirque business will definitely assist COF in attracting and retaining tenants. I will now hand over to Belinda.

Thanks, Grant. Moving to the HY '23 financial results on Slide 12. COF produced funds from operations of $48.6 million or 8.1% per unit and paid distributions was $0.0705 per unit in quarterly installment. The payout ratio for the first half was around 87%. Due to the rapid rise in interest rates, finance costs have increased by $6.3 million to $15.7 million for the first 6 months to December 2022. During HY '23, COF incurred an average floating interest rate of 2.6%. The impacts from COVID-19 have continued to dissipate with the expected credit loss and rent waivers reducing by $1.2 million from HY '22 and the rent collection for the period remaining strong, averaging over 97%. Turning to capital management on Slide 13. $257.5 million of debt refinancing was finalized during HY '23, bringing total debt facilities to $962.5 million across a diversified pool of 6 lenders. The REIT's weighted average debt maturity is 3.4 years with no debt tranche expiring until FY '25. During the period, COF executed $210 million of new swaps resulting in approximately 58% of the total debt hedged. We will continue to monitor COF's balance sheet and hedging profile closely. COF's loan-to-value ratio was 37.1% and the interest cover ratio was 4.9x. Both provide ample headroom to our debt covenants of 50% and 2x, respectively. With ample headroom and over $100 million of available liquidity, COF's balance sheet remains robust and well supported by its financiers. Turning to the portfolio overview on Slide 15. Metrics on this slide 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. Around 80% of the portfolio income is derived from government, listed and multinational tenants with only a small exposure to [ S&H ]. The ability to attract quality tenants is reinforced by nearly 70% of cost tenants by area exceeding 2,000 square meters, indicating robust large tenant demand for quality metropolitan and near city office market assets. These statistics just [indiscernible] misunderstanding of metropolitan and near city office markets regarding the belief that only CBDs attract larger tenants and better tenant covenants. In what may surprise some, over 50% of ASX 200 companies are headquartered in metropolitan or regional office markets. Additionally, 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 16. COF continued to complete a significant number of leasing during the first half with over 30,000 square meters secured, representing 10% of portfolio NLA. As a result of the portfolio leasing, COF has increased occupancy to 96.4% and improved the resilience of the leasing profile with more than 84% of the portfolio now expiring at or beyond FY '25. Most notably, occupancy has increased to 100% at 584 Swan Street, Richmond and to 90% at 818 Bourke Street, Docklands. Maintaining high portfolio occupancy is a key management focus and we are actively seeking outcomes to further improve COF's lease expiry profile. Turning to portfolio valuation on Slide 17. COF externally valued 13 of the 23 assets as at 31 December 2022. The portfolio weighted average capitalization rate slightly expanded 17 basis points to 5.75%, which resulted in a circa 2% decrease or $45 million decline on a like-for-like basis. Note that recent significant executed Heads of Agreement received at 818 Bourke Street, Docklands and 203 Pacific Highway have not been included in this valuation cycle. COF's average valuation per square meter as at 31 December, 2022 was $8, 346 per square meter, which compares favorably to increasing replacement costs. While there has been a noticeable reduction in transaction volume of the assets that are transacted, there is evidence of bifurcation based on quality and leasing risk. Well-tenanted high-quality buildings have continued to trade on competitive sales metrics. Recent examples include 88 Langridge Street in Collingwood, which sold on a yield for 4.8%, 220 London Circuit in Canberra, which sold on a yield for 4.25% and 2 Eden Park Drive in North Ryde which sold on a yield of 5%. Moving to sustainability initiatives on Slide 17. COF's by its nature of the 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. Specific to the environment, COF has maintained its energy efficiency with its portfolio average NABERS energy rating of 4.8 Stars. All current and future COF developments are targeting a minimum 5 Star Green Star rating. Solar installation projects are ongoing across the office portfolio. Social initiatives include Centuria's Annual Employee Engagement Survey, where 94% of Centuria's employees reveal that they are proud to work for the company. A new tenant -- a new digital tenant portal, T.E.N or Tenant Engagement Network was also launched to enhance relations and communication with office tenants. Centuria is also committed to gender diversity and inclusion. At present, there is roughly a 45% to 55% split of female to male staff. On the governance front, Centuria delivered its second sustainability report in October, adopting the Task Force On Climate Change-related Financial Disclosure recommendation. This name, climate change is now a standard investment consideration with adaptation plans being developed across the Centuria portfolio. Centuria also published its Third Modern Slavery Statement in late 2022 and issued its Code of Conduct to suppliers and contractors, setting out Centuria's minimum standards to be adhered. I will now hand back to Grant to cover the market outlook and guidance.

Thanks, Belinda. Looking ahead on Slide 20, we believe the following key themes are likely to dominate 2023. Firstly, we expect tenants will continue to gravitate toward workspace that 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. Regarding increased construction costs, though it appears that further rises may be moderating, increased costs are already evident in many markets across Australia. Whilst this is certainly an issue for developers, owners of established properties are somewhat insulated from these [Technical difficulty] may in fact benefit as increased construction costs will likely temper office supply. Another aspect of increased construction cost is that it may lead to higher levels of tenant renewals because the fit-outs become prohibitive. Again, this will be beneficial for existing owners of established properties, particularly those that provide quality of [Technical difficulty] work. Turning to tent demand on Slide 21. And as already mentioned, many Australian office markets have demonstrated robust tenant demand throughout 2022, and COF is exposed to a number of them. While Melbourne fringe has had the strongest net absorption, positive absorption was also clearly evident in Brisbane, Perth and Canberra. Though some commentators expect the flight to CBDs, the weakest tenant demand was evident in the Sydney and Melbourne CBDs. Reasons for this could be lifestyle amenity is driving demand. And key to that is the commute. The shorter [Technical difficulty] is second most important factor in job selection after remuneration. 80% of tenant moves occur with [Technical difficulty] markets and a substantial amount of key tenants allocated outside the main CBDs with 53% of ASX 200 companies headquartered in metropolitan or regional office markets. [Technical difficulty] for tenant demand, we have seen evidence of rental growth for highly desirable buildings in Brisbane and to a lesser extent, Perth and Canberra. Concluding on Slide 22. 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 gives us confidence as we proactively address current vacancy in near-term lease expiry. Rising interest rates throughout [ HY '23 ] impacted asset and debt pricing. In reaffirming guidance COF is taking into account current and forecast changes in interest rates and continues to monitor economic conditions. COF will also continue to monitor and manage its balance sheet and debt exposure. For the remainder of FY '23, COF reiterates FFO guidance of $0.158 per unit and distribution guidance of $0.141 per unit with distributions expected to be paid in quarterly installments. Based on the recent trading price, the distribution guidance equates to a distribution yield in excess of 8.5%. We 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 Sholto Maconochie from Jefferies.

Lot of leasing, well done on the leasing front. I just have a couple of questions from the call that, was it saying the [ stuff ] at Bourke Street and Pacific Highway will more contribute to earnings in -- from 1 half '24?

Correct.

And then I just noticed, obviously, because you have quite a lot of leasing volume was up materially sort of 59% is a lot year-on-year and sequentially on the volumes. Is that what's driving the big increase in the amortization add-back because it seemed to go up quite a lot on that because the base effective rental growth was sort of even backing out the lower [ ECO ] was muted, but it was about $13 million of add-back versus $8.2 million last year. Was that because of the higher incentives and leasing volumes in the period?

No. If you actually go in your stat accounts, which breaks out that number, it's mainly been impacted by straight lining. If you recall, in the first half of particularly last year, we had a number of leases that surrendered so that new tenants would come in. When you modify or surrender a lease, a straight lining has to be reset. So, that is what is really impacting that number.

And what were the incentives? I know you put in on the leasing, what do they do sort of year-on-year on a percentage number?

Yes. So, leasing incentives are pretty consistent with what we were doing through the prior financial year. So on average, for new tenants we're giving [Technical difficulty] 31% and for renewals, it was about 22%.

Not bad for renewals, okay. And then just on the cost of debt, what are you assuming in the second half to get to your guidance on the WACC for the period?

So, we're looking at a management curve that's thinking about where the current yield curve is and obviously building a buffer into that. So at the moment, our forecast is pretty consistent with the broader market.

And then just on the gearing. I think the target was 25% to 35%, you're sitting above that. Is there any plans to sell some assets to sort of get that lower than the sort of top end of your range?

In terms of gearing, we're pretty comfortable at the moment in that we have got a lot of debt covenant headroom. We've got a nice ICR of 5x and we can withstand quite some potential changes in valuation before we get close to breaching the LVR covenant. Notwithstanding that, obviously, balance sheet management is a key priority and we will look at our asset allocation through the course of this calendar year in relation to our gearing.

Because if you look forward to '24 sort of ICR is around about 3-ish and you've got some transaction [ evidence ] for some good quality suburban markets that below your cap rate, you'd look to capitalize on that because you're trading below and care to be accretive to potentially sell them to your NTA if there was demand to trim the portfolio? Would you look at that potentially or something in...

Yes. I think when you think about asset allocation, obviously, balance sheet is one aspect, but also whether or not we've maximized value on each individual asset also -- and I've said this previously, we are -- we have created a portfolio of relatively young assets. So, there are some older assets within the COF portfolio that we will probably transition out over time. But it's a matter of getting those assets in the most available for us to maximize the value before we will look at doing that or affecting that transaction.

Just finally, you look around the CBDs, I think Melbourne last week, and there's a lot more traffic people around Sydney. Have you seen an increase in your physical occupancy in sort of December-January, now it's early days, but it seems a bit busier the CBDs and even suburban markets?

So, it's probably been the last 2 weeks that we started to notice a more material return to work. And I think this is a universal that we're seeing across Australia. But in saying that a lot of the markets we're exposed to have had better return to work rates than what we've seen in Sydney and Melbourne. So, if you think about Brisbane and Perth, particularly, they have almost normal or it's come to pre-COVID levels. So, I think it's more that Sydney and Melbourne are catching up to where other markets are already at.

And then, well done today on the result.

The next question we have Simon Chan from Morgan Stanley.

Belinda, I just got a follow-up question. The 24,000 square meters of new leases that you signed in HY in the first half, will they contribute to second half earnings? Or are they more a delayed start? I'm more referring to Melbourne Street rather than Bourke Street, which you covered off on in the previous question.

Yes. So, [Technical difficulty] of agreement that we discussed, they pretty much all impact the start of FY '24 or through the first half [ FY '24 ]. At 154 Melbourne Street, we have done slightly better leasing than what we anticipated, but it's still not going to have a material impact on FY '23 earnings. We are most likely to incur slightly higher debt costs than what we initially posted and that will be offset by a slightly better leasing that we've done through that period.

So what contributes to rent in the first half will be pretty much be the same as the bucket that will be contributing to rent in the second half? And it's not until first half of '24 when we should we should see a kick up in genuine rent-generating occupancy. Is that correct?

Correct.

Can you walk us through the economics of this Cirque by Centuria? I appreciate you've put Slide 10 there in the pack, but like can you give us some numbers in terms of the sort of returns you're expecting or the rent you're charging relative to, say, the rest of the building in Help Street or Melbourne Street?

Because COF is a trust, we can't operate a business. So, the way the scenario works is that CNI has effectively taken a lease over that space and will operate that business. So, in terms of the reason why Centuria has looked at these assets and looked at the co-working business, I think we have a firm view that co-working is pretty ubiquitous in particularly Sydney, Melbourne CBD, but in a lot of the markets that we're invested into, there is an undersupply of co-working opportunities. So, having this flexible workspace business, we think will not only add amenity to obviously, the COF portfolio but provide a business opportunity for the wider group.