Centuria Office REIT (COF) Earnings Call Transcript & Summary

Good day, and welcome to the Centuria Office REIT FY '23 Results Presentation. Please note that this call is being recorded. [Operator Instructions] I would now like to turn today's call over to Mr. Grant Nichols, Centuria Head of Office and Centuria Office REIT Fund Manager. Please go ahead.

Good morning, and thank you for dialing into the Centuria Office REIT Financial Year '23 Results and Fund Update. My name is Grant Nichols, and I'm COF's Fund Manager. Joining me today, COF's Assistant Fund Manager, Belinda Cheung; Centuria Head of Funds Management, Ross Lees; and Group Head of Investor Relations, Tim Mitchell. I would like to commence today's presentation with the acknowledgment of country. I'm joining you from the lands of the Gadigal people of the Eora Nation. Centuria manages property throughout Australia and New Zealand and pays respect to the traditional owners of the land in each country to their unique culture and to their elders past and present. FY '23 was an operationally successful year for COF with portfolio occupancy increasing. Our capital management initiatives have resulted in an improved debt position with no debt tranche expiring until FY '26. 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 '23, including paying distributions of $0.141 per unit, in line with FY '23 distribution guidance. Generating funds from operations at $0.156 per unit, which was slightly below FY '23 guidance due to the impact of rising interest rates. Recent noncore disposals delivered a pro forma gearing of 36.7%, and NTA of $2.20 per unit based on a weighted average cap rate of 6% and increased portfolio occupancy to 97.1% while maintaining a healthy WALE of 4.2 years. Looking at the results summary in more detail on Slide 5. During FY '23, COF completed over 42,000 square meters of leasing, representing around 14% of the portfolios NLA. Of the 42,000 square meters of leasing, over 31,000 square meters related to previously vacant space, which has resulted in portfolio occupancy increasing to 97.1%. Pleasingly, this leasing largely addressed some of the more material vacancies within the portfolio. Notably, almost 8,000 square meters at 154 Melbourne Street, South Brisbane; 7,000 square meters of 818 Bourke Street, in Docklands; and 3,000 square meters in 203 Pacific Highway, in St Leonards. During the second half of FY '23, COF refinanced $225 million of debt while maintaining a diversified pool of 6 lenders. The debt refinancing improved the REIT's weighted average debt maturity to 3.2 years with no debt tranche expiring until FY '26. The refinancing saw no material change to the weighted average debt margin and the improved debt maturity profile solidifies COF's capital position and insulates COF from potential increases in debt margins that may occur in the short to medium term. The sale prices achieved for the noncore disposals of 54 Marcus Clarke Street, in Canberra and Robina Town Center Drive were consistent with COF's year-end portfolio valuations, which declined by around 4% from COF's December 2022 portfolio value. As of 30 June 2023, the REIT's weighted average capitalization rate was 6% with a cap rate expanding 42 bps across FY '23. In regards to valuations. There has been a noticeable reduction in transaction volumes across the market. It is evident that there is greater investment demand for assets valued less than circa $150 million. This is particularly relevant to COF, which has the highest weighted average cap rate in the comparable listed office sector, while at the same time having one of the lowest average asset values of less than $100 million. Belinda will provide further detail on both these points on Slide 19 shortly. Looking towards FY '24. COF's all-in cost of debt is now elevated compared to recent past periods and is expected to be higher in FY '24 than FY '23. Higher expected debt costs have impacted FY '24 guidance. Further, while COF has a relatively benign expiry profile in FY '24, the largest 2 expiries will result in vacancies and downtime through the coming period with IQVIA vacating around 3,000 square meters in 201 Pacific Highway, St Leonard in July, and Ericsson Center vacated around 7,000 square meters in 818 Bourke Street, Docklands in January. Both these tenants were underutilizing their premises since pre-COVID and the departers were not unexpected. For FY '24, COF provides FFO guidance of $0.138 per unit and distribution guidance of $0.12 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 8.4%, which we believe provides an attractive compelling distribution yield. While we recognize that this rising interest rate environment causes some future uncertainty, we remain optimistic for Australian office markets, and it is worth spending some time looking at the impacts from the evolving workspace on Slide 6. Firstly, while acknowledging hybrid working arrangements and increased workplace flexibility are likely to become more prevalent, it is becoming increasingly apparent that the office will remain an important and focal point in many operations. And changes in office utilization may not materially alter footprints. In our view, the impact from work from home on tenant demand have been overstated. In the 12 months to 30 June 2023, we saw above average tenant demand in a number of markets, particularly those with limited exposure to tech and financial tenants, most notably Brisbane and Perth, which achieved strong net absorption during the year. Further, Adelaide, Brisbane, Canberra and Perth, all have less than 10,000 square meters of sublease availability as of 30 June 2023, a material contrast to Melbourne and Sydney. These stats are reinforced by the results of the Centuria 2023 tenant survey with 75% of tenants anticipate retaining or increasing their office space requirements over the medium term. Notably, Centuria's office portfolio is mainly located in Australian office markets, excluding the Sydney and Melbourne CBDs. We have also seen return to office gaining momentum with public transport utilization increasing and more organizations enacting return-to-work policies globally. Many of these return to office policies are a reaction to diluting corporate culture and falling productivity. Australian labor productivity recorded its largest ever annual decline in the March 2023 national accounts without put per hour work back to December 2019 levels. Further, a study conducted by the ANU, Wollongong and Macquarie Universities, found that working from home made the average worker less productive, more anxious, depressed, and lonely while limiting their professional development. It should be noted that return to office has been materially stronger in Asia Pacific, including Australia, than it has been in Europe and America. This is important because many commentators are suggesting that the current issues confronting U.S. office markets may be a precursor to future office trends worldwide. These return to office stats, coupled with a strong net absorption in markets like Brisbane and Perth, suggest otherwise. Current U.S. office vacancy rates could also be explained by the comparative supply as the U.S. has 40% more office space per capita than we have here in Australia. Returning to COF specifically on Slide 7. Our strategies and priorities for FY '24 and beyond are 2. Firstly, maintain high occupancy. COF consistently achieved strong leasing results supported by the internal leasing team within Centuria Property Services with nearly 170 square meters of leasing completed across the COF portfolio since and through COVID. Continuing this momentum is our primary objective. The next priority is high portfolio quality. Since listing in 2014, COF has materially improved the quality of the portfolio in terms of building age, building grade, environmental performance and the quality of tenant covenant. Improvement in portfolio quality is important, particularly in the current environment, where there is clear bifurcation in tenant demand gravitating to prime over secondary office space. And thirdly, for active capital management. The steps COF took in FY '23 to preserve a diverse lender pool and expiry profile while maintaining liquidity and debt covenant headroom will continue in FY '24 and management remains open to considering further asset disposals if they similarly contribute to enhanced portfolio quality. The evolution of COF from listing in terms of portfolio quality is further illustrated on Slide 8. We believe the COF portfolio has been cultivated to provide quality, highly connected and affordable office space that is consistent with the style of workspace that both tenants and investors increasingly seek, higher quality accommodation and new-generation buildings that provide healthy lifestyle-orientated work environments, efficient floor plates, improved amenity and competitively priced accommodation. Furthermore, there is increased demand to be located in areas that provide efficient commutes to improve employee and workplace 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 17 years, high-quality assets with 90% meeting A-grade specification, highly efficient buildings with a near 5-star average NABERS energy rating, significant geographic diversification, providing exposure to Australia's better-performing office markets, 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. Before I hand over to Assistant Fund Manager, Belinda Cheung, to take you through the financials and portfolio metrics, I will provide a brief overview of the manager and the benefits 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 ticket code CNI and included in the ASX 200 Index. With more than $21 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, agriculture and real estate finance across Australasia. 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. I will now hand over to COF's Assistant Fund Manager, Belinda Cheung.

Thanks, Grant. Moving on to the FY '23 financial results on Slide 11. COF delivered funds from operations of $93 million or $0.156 per unit. Gross property income increased by $6.6 million to $183.1 million, reflecting strong leasing outcomes achieved during the year. Due to the sustained rises in interest rates, finance costs have increased by $17.1 million to $36.8 million over FY '23. The average all-in cost of debt incurred for the year was 4.3%. COF also paid distributions of $0.141 per unit in quarterly installments, representing a payout ratio of 90.5%. Looking at capital management in more detail on Slide 12. COF refinanced $225 million of debt during the year, which included $50 million of additional facilities and $175 million of current facilities extended across existing lenders. This extended the REIT's weighted average debt maturity to 3.4 years with no debt tranche expiring until FY '26. During the year, COF executed $510 million of swaps, increasing the hedging profile to 69.1% and a weighted average maturity of 1.5 years. COF now has 3x the amount of noncurrent hedges in place compared to the same time last year. The interest coverage ratio, ICR, for 30 June was 3.5x and the loan-to-value ratio, LVR, was 39.9%, providing headroom to our covenant requirements of 2x ICR or 50% LVR. Following the settlements of the Canberra and Robina assets, the pro forma gearing reduces to 36.7%. We will continue to monitor COF's balance sheet and gearing levels. On to the portfolio on Slide 14. COF is a portfolio comprised of young quality assets 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 native SPI Energy rating of 4.9 stars. The portfolio is supported by strong tenant covenants. Almost 80% of the portfolio income is derived from government-listed and multinational tenants with only a small exposure to SMEs. As seen on Slide 15, the portfolio is also geographically diversified with a significant portion of the portfolio exposed to well-performing leasing markets, showing strong net absorption over the last year. This is evidenced by COF completing leasing of over 168,000 square meters or 56% of portfolio NLA since COVID started. Now turning to Slide 16. And as noted earlier, one of the key benefits of Centuria's management is the strong capabilities of the in-house asset management team. With a dedicated leasing team, Centuria has consistently maintained high occupancy across all 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. COF continued to complete a significant amount of leasing during the year with over 42,000 square meters secured, representing 14% of portfolio NLA. This included 20 lease renewals over 11,000 square meters and 42 new leasing deals over 31,000 square meters. The most significant volume of leasing was completed for 818 Bourke Street in Docklands, where over 8,000 square meters was leased to the Costa Group and the [indiscernible] government and at 154 Melbourne Street, South Brisbane where 7,800 square meters of leasing was done to new and existing tenants. Slide 17 is a case study featuring the strategic repositioning of 154 Melbourne Street, South Brisbane, following the departure of a larger tenant within the building during the year. The strategy took into consideration the competition in the surrounding leasing market. Initiatives undertaken to improve building amenity through the refurbishment of the foyer and upgrades to the end of trip facilities as well as improving the work amenity through the introduction of Cirque by Centuria, a flexible work solution. [ These all ] contributed to driving tenant demand and resulted in 7,800 square meters of leasing across 12 deals, which improved well from 1.2 years to 4 years and drove occupancy up by 26% to 94.1% at 30 June. Our focused approach on improving the quality of our asset drives tenant demand for our product. Moving on to COF's staggered lease expiry on Slide 18. As a result of the portfolio leasing, COF has increased occupancy to 97.1% and improve the resilience of the leasing profile with about 90% 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 further improve COF's leasing period profile. Our primary focus for FY '24 are the vacancies and upcoming expiries at 818 Bourke Street, Docklands and 201 Pacific Highway, St Leonards. Moving on to valuations on Slide 19. COF externally valued 13 of the 23 assets as at 30 June 2023. The portfolio weighted average capitalization rate expanded 42 basis points to 6% over FY '23, which is the highest cap rate of its comparative peer set. Following revaluations, COF net tangible assets are $2.20 per unit. COF's average valuation as at 30 June 2023 was $7,377 per square meter, which compares favorably to the increasing replacement costs. As Grant mentioned earlier, while transaction volumes are still relatively low, there is evidence of bifurcation based on quality, leasing risk and asset size. Well-tenanted high-quality buildings under the $150 million threshold have continued to trade on competitive sales metrics. Now turning to sustainability on Slide 20. 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. A number of COF-specific ESG initiatives implemented during year, including the launching of 2 new sustainability targets, targeting 0 Scope 2 emissions by 2028 and targeting to eliminate gas and diesel equipment where practical by 2035. COF has also continued to improve its energy efficiency with its NABERS Sustainable Portfolio Index energy rating again -- increasing again to 4.9 stars, supported by ongoing solar installation projects across the portfolio, reducing our carbon footprint. Centuria is committed to gender diversity and inclusion. At present, there is roughly a 45% to 55% split of female to male staff. The environmental data for 2023 will be included in the Centuria 2023 Sustainability Report, which will be made available in Q4 this calendar year. Slide 21 provides a case study for the development completed at 57 Wyatt Street, Adelaide earlier this year. Development was executed by Centuria Capital Group's in-house development team and was completed with a 5-star Green Star design and as built ratings and targets of 5.5 NABERS energy grading. During construction, 90% of building waste was diverted from landfill. The building, both high sustainability credentials and being fully electric [ surveys and current ] operations aligns with COF's commitment to eliminate gas and diesel where practical as part of its new sustainability targets and adds to the quality of COF's portfolio. I will now hand back to Grant to cover the market outlook and guidance.

Thanks, Belinda. Turning to tenant demand on Slide 23. And as I already mentioned, many, in fact, the majority of Australian office markets, demonstrated positive net absorption through FY '23. With softness in tenant demand quarantine to the Melbourne CBD and Sydney generally. The strongest market was once again Fringe office market with Fringe demonstrating the strongest net absorption of any Australian office market. Within the Brisbane Fringe, Fortitude Valley saw its vacancy rate reduced 6% year-on-year, which will benefit COF's assets 825 Ann Street and 100 Brookes Street. There has also been a clear bifurcation trend in the data with a significant gap between national net absorption rates for prime and secondary space. This bifurcation might explain why there has been evidence of reasonable face rental growth in a number of markets, suggesting there may be a potential change in the vacancy equilibrium that some secondary office space becomes redundant. Looking forward, we expect there will be a material reduction in supply over the medium term due to rising construction costs, finance costs and cap rates. Combined, these factors have substantially increased the required economic rents that are mostly currently unfeasible. We understand that a number of development sites are consequently looking at alternate uses such as build to rent. This will be beneficial for existing quality office portfolios like COF. Concluding on Slide 24. As I mentioned earlier, we recognized an increased interest rate environment creates some future uncertainty but we remain optimistic for Australian office markets. Tenant demand has been better than many has predicted, and the majority of expanding industries and office using sectors with strong projected deployment growth for professionals. Looking ahead, we will continue to focus on maintaining high portfolio occupancy, improved portfolio quality and preserve a solid balance sheet, maintaining sufficient liquidity in debt covenant headroom. For FY '24, COF provides FFO guidance of $0.138 per unit and distribution guidance of $0.12 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 8.4%. I thank you for your interest in the Centuria Office REIT. I will now hand back to the operator and invite any questions that you may have.

[Operator Instructions] Our first question comes from Tom Bodor with UBS.

I just had a couple of quick questions. Thank you very much for providing maintenance CapEx and CapEx on incentives. That was really helpful. If I look at your distribution, still above AFFO, if we were to deduct that number from FFO, only a couple of percent in '23. I'd just be interested in understanding if you would like over time to be paying out less than AFFO or what your thinking is around that?

Yes. Sure, Tom. So I think we've started this for a little while now. We're aiming to get our distribution payout ratio between 85% and 90% of FFO. For a smaller portfolio, will be -- we're a medium-sized portfolio. You do get lumpiness in terms of CapEx payments and incentive payments. So that does create a bit of volatility in distributions. So for FY '24, we are smack bang in between 85% to 90% in terms of what our FFO ratio is forecast to be.

Yes. I'm just interested because as you say, I noticed that number is a bit volatile from year-to-year. So your maintenance CapEx was 9 basis points and 18 basis points. Your incentive CapEx was 25 and 50. If I look at peers, they're quite a bit higher. I appreciate the differences in the portfolio, but is there not an argument to just say payout 95% of AFFO or a lower number of FFO to ensure that you're sort of never paying out more than AFFO given the gearing?

Yes. Look, I think when it comes to maintenance CapEx, one of the benefits of having a younger portfolio is that we should have less maintenance CapEx than some of our peers. So from that perspective, I think that is going to be an ongoing benefit for COF for a little while now. And then in regards to incentives. Look, they will bounce around, and it probably refers back to the prior comment I made for smaller or medium-sized portfolios, that number can vary year-to-year, which makes it hard to peg to an AFFO number if you're looking to get some sustainability into your distribution number.

Just a quick one around asset sales. Are you still looking to sell further assets if the opportunity is there? I mean, I think it's good progress on a couple of years old, but what's your thinking around that?

Yes. So as mentioned on the call, we remain open to considering asset disposals throughout FY '24. Look, in the pool of assets that we own in the markets we operate, most of the transactions that have occurred have been off market. So we will consider those opportunities as they arise throughout the course of the year, particularly if they go to benefit the portfolio overall. As mentioned on the call, one of our key objectives is to continue to improve portfolio quality. And I think the sales that we transacted this year, when you think about 54 Marcus Clarke, it was one of our oldest assets, it would have been over 40 years, probably approaching 50 years in age. And Robina had about a 1-year while. So both those assets certainly did go to not only improving our balance sheet, but improving the overall portfolio quality.

And then finally, just be interested on just thoughts around that Docklands market, that's sort of been still difficult. Where do you think that will land?

Yes. There's no doubt Docklands has been tough. I think when you're looking at leasing markets, generally, Australia, a lot of Australian office market has been performing quite well. But Sydney generally and Melbourne CBD have been struggling. Within Melbourne CBD, docklands has probably been one of the tougher segments of that market. We've had a really good run in terms of the leasing we completed through FY '23. We completed in excess of 7,000 square meters of leasing or new tenants coming into that building. But I completely acknowledge that it's still a grind, and it will probably continue to be over the short to medium term.

Your next question comes from Murray Connellan with Moelis Australia.

Just on your upcoming expiries in '24, that 6% of income -- or 6.4% of income rather. What have you seen in your guidance number in terms of retention and leasing up there? Or to ask the question differently, how much of that 6.4% is missing relatively from '24's guidance?

Yes. So in terms of looking at the FY '24 expiry, the 2 big ones that expire through FY '24 is Ericsson at 818 Bourke Street in Docklands. So that's circa 7,000 square meters that expire in January, and they will vacate. And we haven't assumed that there will be any income coming into FY '24 post the expiry. The other major expiry is IQVIA at 201 Pacific Highway. They vacated 3,000 square meters in July. We've assumed that there will be no income generated from that space for the remainder of FY '24 as well. When you go past those 2 expiries, it's mostly bits and pieces from there on. So it will be a combination of assumptions made on those. Generally, what we've assumed for tenants that are expiring where we don't have a line of sight is that there will be at least 4 months downtime following their expiry.

And then maybe just to touch on FY '25, the major expiry being the ATO in Perth. Have you had any engagement with them in terms of what their intentions are?

So we're in discussions with the ATO at the moment, but nothing is concluded as yet.

[Operator Instructions] Your next question comes from Ronny Cheung with Jefferies.

I was just wondering, in relation to the gearing situation, we've noticed that the gearing sort of increased past the top end of your target range. How many asset sales do you -- are you potentially looking at to bring us back in line in terms of dollar value?

Yes. Look, I don't think -- we haven't made an explicit target in terms of what we're looking at. It really is dependent on what assets we deem would be beneficial for the overall portfolio quality. You'd also give consideration to the assets where you think you have maximized value. So as mentioned on the call, we are open to continuing to look at asset disposals since COF listed in 2014, we have done a number of asset disposals to improve portfolio quality but we are not issuing a specific target of asset sales that we need to complete. Given where gearing sits at the moment, we are pretty comfortable with where gearing sits. It is slightly above where our target gearing is. But at the same time, we do have quite a potential amount of debt covenant headroom that we are not concerned about at this point in time.

And my second question, just on the leasing. I think there was a bit of a leasing slowdown in the second half where we had in FY '23, there was only around 12,000 square meters. So I think of my calculations with leasing executed. Are you expecting a bit of a reversion in terms of leasing momentum into FY '24 and onwards?

I think it's probably more a function of what we had to lease. If you think about when we started FY '23, so if we go back 12 months, we had 6% vacancy and 14%. I think it was 6% and almost 10% of the portfolio expiring through FY '23. We are in a much more benign situation now as a result of the leasing that we've done. So vacancies circa 3%. We've got about 6% expire through the course of FY '24. So a bit of that is a function of what we have to lease. As mentioned on the call, we are seeing differences in markets in terms of the amount of leasing momentum that we're seeing. Sydney has been tough going and Melbourne CBD has been tough going. But outside of that, we have generated a lot of momentum in markets, particularly in Brisbane. So I wouldn't say that it's a consistent theme nationally or that you can really read too much into our first half or second half performance.

There are no further questions at this time. With that, I will turn the call back to Mr. Grant Nichols for closing remarks.

Once again, thanks for your interest in Centuria Office REIT. If you have any following questions, please don't hesitate to contact myself or Tim Mitchell. Otherwise, thank you, and have a nice day.

This concludes today's conference call. You may now disconnect.