Centuria Office REIT (COF) Earnings Call Transcript & Summary

Good day, and welcome to the Centuria Office REIT Half year '24 Results Presentation. [Operator Instructions] And finally, I would like to advise all participants that this call is being recorded. Thank you. I'd now like to welcome Mr. Ross Lees, Head of Funds Management, to begin the conference. Ross, over to you.

Good morning. Thank you for joining Centuria Office REIT's Half Year FY '24 Results Presentation. My name is Ross Lees, Head of Funds Management for Centuria Capital. Also presenting today is Grant Nichols, Head of Office and COF Fund Manager; and Belinda Cheung, COF's Assistant Fund Manager. Also present in the room is Jason Huljich, Joint CEO; and Tim Mitchell, Group Head of Investor Relations. Starting on Slide 3. I would like to commence today's presentation with an acknowledgment of country. We are joining you from the lands of the Gadigal people of the Eora Nation. Centuria manages property throughout Australia and into New Zealand and pays its respects to the traditional owners of the land in each country, to their unique culture and to their elders past and present. In today's presentation, Grant and Belinda will cover an overview of COF and current office market dynamics, COF's financial results, portfolio review and overview and concluding with an outlook and guidance statement. Moving to Slide 4. Centuria Office REIT is managed by Centuria Capital Group. Centuria has over $21 billion of assets under management and includes a significant team of professionals around the country dedicated to maximizing unitholder value. COF unitholders benefit from deep real estate experience across the Centuria platform, synergies from being part of the group's broadest $7 billion office real estate portfolio and strong alignment, as Centuria is COF's largest unitholder, ensuring the managers' interests are strongly aligned with yours as unitholders. Before passing over to Grant and Belinda, I'll make a few comments on the Australian office markets and COF's place within. Discussion on the future of workplace has dominated many conversations over the past 3 to 4 years and divergent views may continue for some time. It is our view that we're now into the new normal. Most organizations have more or less rightsized. We expect ongoing tenant demand from this point be generated from the typical drivers of growth in population and white collar employment, whilst the supply side will taper off due to increased construction costs and a significant divergence between prevailing market rentals and the economic rental required to create new supply. Belinda will speak about this in more detail later in the presentation. What's also clear from our data is that engaging workplaces are essential infrastructure to high-quality organizations to get the best out of their people. According to our most recent tenant survey, 75% of tenants have indicated they intend to either maintain or increase their tenancy footprint at their next lease expiry event. COF's strategy is leveraged to the future demands of office tenants. We have, over time, executed on our vision to become Australia's leading pure-play office REIT by building a portfolio of modern, high-quality assets within metropolitan markets that are differentiated by amenity, affordability and connectivity. These unique physical attributes capitalize on continued bifurcation between prime grade stock and secondary assets, underpinning COF's continued high occupancy rate. I'll now pass it over to Grant to discuss the first half results.

Thanks, Ross. Let's start with COF at a glance on Slide 7. For FY '24, we reaffirm both earnings and distribution guidance and believe COF offers a compelling investment opportunity based on current market pricing. Given that COF has relatively high occupancy, at 96.2% across its young, predominantly A-grade portfolio with a solid 4.4-year WALE. Based on the reaffirmed distribution guidance, COF is delivering an attractive yield of 9.6% based on Wednesday's closing price of $1.25. That $1.25 closing price represents a 37% discount to NTA, noting that the COF NTA is based off a comparatively high weighted average cap rate of 6.26%, and the discount to NTA implies an average valuation rate per square meter of around $5,700 for COF portfolio. This implied rate is significantly below replacement cost. Further into this presentation, we'll then go in detail a hypothetical development feasibility, which demonstrates the substantial gap between where COF is valued and replacement costs. Turning to COF's first half highlights on Slide 8. Entering FY '24, COF had 3 key priorities. First, to maintain high occupancy. COF has consistently achieved strong leasing results supported by the internal leasing team within Centuria Property Services. During the first half, leasing momentum continued with over 28,000 square meters leased, equating to nearly 10% of the portfolio NLA. This resulted in COF achieving 96.2% occupancy as at 31 December 2023, whilst WALE increased to 4.4 years. Among the leasing activity was the Commonwealth Government's renewal at 235 William Street in Northbridge, WA. This 13,000 square meter tenancy is the largest single lease within COF's portfolio and our renewal extends the Commonwealth Government's lease over its existing footprint for a further 10 years beyond its current 2025 expiry. Secondly, proactive capital management was a priority. In the first half, COF divested 2 assets for a total of $63 million, with the proceeds used to repay debt. Notably, the assets sold were either comparatively old or presenting short-term leasing risk and their disposal had improved COF's overall portfolio quality. COF will continue to assess further asset recycling throughout 2024, and we'll inform the market should any binding sales agreements be entered into. Further, COF maintained suitable liquidity, comfortable debt covenant headroom and has no debt tranches expiring until FY '26. The third priority is high portfolio quality. While bifurcation is now an overused term, the net absorption data is crystal clear. Tenant demand is absolutely gravitating to better quality accommodation and it is essential for landlords to provide contemporary, attractive and efficient accommodation solutions to maintain occupancy. COF's portfolio quality is further illustrated on Slide 9. 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 tenant and investors increasingly seek: high-quality accommodation and new-generation buildings that provide healthy, lifestyle orientated 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 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. In relation to the potential for future disposals, it is worth mentioning the average asset size by value is around $95 million. This makes COF comparatively liquid. As current market conditions dictate a very significantly deeper investment demand for assets valued less than $150 million. Before I hand over to Assistant Fund Manager Belinda, who will take you through the financial and portfolio metrics, I'll provide a brief overview of the market dynamics in pricing Australian office markets. Starting on Slide 10. This slide illustrates net absorption data for the major Australian office markets in the 4 years leading up to 31 December 2023. Net absorption is a great measure of tenant demand, with positive absorption indicating growing tenant occupation or demand. Two things are evident in this chart. First, the majority of markets have incurred positive net absorption through what many have considered to be a challenging leasing environment. In some markets, the net absorption during the period has been strong. Secondly, COF-exposed markets have materially outperformed, while the Sydney and Melbourne CBD substantially lagged. The comparison between the Melbourne fringe and Melbourne CBD is stark, with Melbourne fringe having almost a 500,000 square meter difference to the Melbourne CBD. For context, 500,000 square meters is about half the North Sydney office market. Interestingly, if we would instead look at the net absorption data for the last 12 months, the story is similar. The Brisbane fringe had the strongest absorption while the Sydney and Melbourne CBDs had the weakest. Finally, prime office stock has materially outperformed secondary stock in every market. This may be why COF has relatively high occupancy, given COF generally owns some of the best assets in the best markets. Continuing to Slide 11. Positive net absorption in most markets runs contrary to the perception that flexible working arrangements are calling tenants to reduce their footprint. The graph on this slide indicates the tenant relocations of greater than 1,000 square meters that have occurred in Australian metropolitan office markets in the 3 years to 31 December 2023, and it demonstrates the majority of tenants increased their footprint during this period. We believe that the proportion of tenants increasing their footprint is improving, as many tenants actively seek to reengage with their staff in an office environment. Tenants who have contracted their footprint have been mainly concentrated to the big 4 banks and some large corporates like Telstra. These tenants are mainly clustered in the Sydney and Melbourne CBDs, which may go some way to explaining the weak net absorption numbers in those markets. By contrast, many of the markets COF has invested into have little exposure to these types of industries and most tenants have already rightsized, positioning themselves for accommodation growth and the market deposit net absorption. As an example, over the last 12 months, around 3/4 of tenants who relocated in Perth extended their footprint. We believe this level of expansion will become more consistent across Australian office markets in the coming years. I will now hand over to Belinda.

Thank you, Grant. Moving to the half year '24 financial results on Slide 13. COF delivered funds from operations of $41.8 million or $0.07 per unit. Gross property income increased by $1.7 million to $93.7 million, reflecting improved occupancy during the period. Due to the sustained rises in interest rates, finance costs have increased by $7.3 million to $23 million over the first half. The average all-in cost of debt incurred was 4.9%. COF's expected all-in cost of debt for FY '24 is 5%, which is now relatively consistent with the marginal cost of debt. COF declared and paid distributions of $0.06 per unit across the period in quarterly installments, representing a payout ratio of 85.8%. Looking at capital management in more detail on Slide 14. COF has settled 2 property divestments since the start of the financial year: 35 Robina Town Centre Drive and 54 Marcus Clarke Street, with a combined price of $63 million. The net proceeds of the transactions were used to repay debt, reducing total borrowings. As Grant mentioned, COF will continue to assess further asset disposals throughout 2024. And given relative liquidity of the COF portfolio, we are confident that will occur. The REIT has a weighted average debt expiry of 2.7 years and no near-term expiries, with the first tranche maturing in FY '26. During the period, $180 million of interest rate swaps were executed, increasing the total hedge proportion to 76%. The weighted average hedge maturity was maintained at 1.5 years. The interest cover ratio, or ICR, for 31 December 2023 was 2.9x. And the loan-to-value ratio, or LVR, was 41.6%, providing comfortable headroom to our loan covenant requirements of 2x ICR and 50% LVR. Following the settlement of 54 Marcus Clarke Street, pro forma gearing reduced to 40.4%. We will continue to monitor COF's balance sheet and gearing levels. Moving to Slide 16. COF's portfolio comprises 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 average NABERS 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. Slide 17 examines COF's leasing expiry in detail. Since COF listed in 2014, Centuria's management has consistently leased a significant portion of the portfolio year in, year out, maintaining high levels of occupancy each year. This period is no exception. As a result of the portfolio leasing, COF has maintained high occupancy, at 96.2%, and improved the resilience of the leasing profile, with about 80% of the portfolio now expiring at or beyond FY '26. Achieving high portfolio occupancy is a key management focus, and we are actively seeking outcomes to further improve COF's lease expiry profile. A significant amount of leasing was completed during the period to push our FY '25 expiries and extend portfolio WALE to 4.4 years from 4.2 years as last reported in June. Our primary leasing focus for FY '24 and into FY '25 is the Ericsson lease expiry, at 818 Bourke Street; the Macquarie lease expiry, at 825 Ann Street; and the existing vacancy at 201 Pacific Highway. Moving on to valuations on Slide 18. COF externally valued 12 of its 22 assets as at 31 December 2023. The portfolio weighted average capitalization rate expanded 26 basis points to 6.26% over the first half, which is the highest cap rate of its comparative [ feature ] to date. Following the valuations, COF's net tangible assets, or NTA, is $1.98 per unit. COF's average valuation as at 31 December 2023 was $7,100 per square meter, which compares favorably to increasing replacement costs. As Grant mentioned earlier, future office supply is expected to materially reduce over the medium term as development feasibilities have been negatively impacted by rising costs. This table is a simple cost comparison for a hypothetical A-grade metropolitan office build in 2020 and 2024 in Sydney. Land value is the most variable cost between markets. So we adopted the same cost for both periods to highlight the impact other various costs have on the economic rent required to feasibly build. Key assumptions adopted for construction, leasing, financing and other costs are noted and are consistent with suggested market changes during the period. The total cost of build indicates replacement value to be over $15,000 a square meter. This has more than doubled COF's average property value per square meter and almost 3x its implied value based on the recent trading price. Further, the hypothetical feasibility indicates economic rents may have increased by approximately 60% since 2020. In many markets, this represents a substantial dislocation from prevailing market rents, particularly the market COF is typically exposed to, which are coming off a lower rent base. Now turning to sustainability on Slide 19. During the half, COF demonstrated its continuing commitment to environmental, social and governance initiatives and improved sustainability performance by participating in the 2023 real estate GRESB assessment. And we are pleased to disclose for the first time, a strong 4-star GRESB rating. We also recently announced new sustainability targets. COF is targeting Zero Scope 2 emissions, with 100% portfolio Scope 2 electricity sold from the equivalent of 100% renewable electricity by 2028. Additionally, the REIT aims to eliminate gas and diesel use from its operations by 2035, where practicable. COF is further committed to improving its energy efficiency with its NABERS sustainability portfolio index energy rating maintained at 4.9 stars, supported by ongoing solar installation projects across the office portfolio, reducing our carbon footprint. During the period, 350 kilowatts of new solar capacity was delivered in our buildings, with a further 499 kilowatts of planned -- planned for delivery this calendar year. Please refer to the Centuria 2023 Sustainability Report on our website for the 2023 Environmental Data. I will now hand back to Grant to cover the market outlook and guidance.

Thanks, Belinda. Turning to Slide 21. And to reiterate an earlier comment, Brisbane fringe had the strongest net absorption at any Australian office market in 2023. This is beneficial to COF, given we have a 20% weighting to this market. Positively, the Brisbane fringe has virtually no supply under construction. Notably, under construction supply is mainly concentrated in the CBD markets to see what [indiscernible] exposure, with the Sydney, Melbourne, Brisbane and Perth CBDs having between 5% and 8% of the total market currently under construction. Looking forward on Slide 21. We expect future offer supply beyond what is currently under construction to materially reduce over the medium term. Development feasibility has been impaired due to rising construction costs, increased financing costs and softening capital market transaction, and as Belinda demonstrated, this has pushed economic rents significantly above prevailing rates in the majority of Australian office markets. This could contribute to strong future tailwinds for the market COF is exposed to, especially in light of the forecast population in white collar employment growth. Federal budget estimates net migration of almost 1 million people between 2023 and 2025. And as each additional person to Australia's population translates to about 1 square meter of incremental office space demand, the net migration may add 1 million square meters of total office demand. Further, CBRE estimates there will be 2.6 million more Australians in the workforce by 2033. With CBRE suggesting 27% of those workers will be white collared workers, there could be up to 7 million square meters of additional office space demand. To context, 7 million square meters is almost 1/4 of Australia's existing office stock. Concluding on Slide 23. COF reaffirms 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 9.6%. 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] And your first question comes from the line of Tom Bodor from UBS.

Grant, I'd just be interested in the Keswick South Australia asset, which has transferred into IP classified for sale. Can you please update me on where you're up to with that and also other assets that may be considered for sale?

So Keswick has been moved to an asset held for sale within stat accounts. We are in discussions on that asset. But beyond that, I'd be reluctant to make any further comment. In regards to sales, probably 2 points I'll make. Firstly -- I probably refer the track record of having achieved sales recently and also just the average asset size of COF at $95 million makes our assets a lot more liquid. At this point, we would be reticent to put either a target or nominate specific assets that we are seeking to sell, simply because we think that would inhibit our negotiation position.

Okay. That's clear. But then the gearing, at over 40%, and that factors in the proceeds from, I think, the asset that's yet to settle, which is Marcus Clarke, where does that need to be for you to be comfortable?

So the pro forma gearing post settlement of 54 Marcus Clarke, which occurred in January, is now low 40s. Look, in terms of -- there's probably 2 things to consider in terms of where our gearing sits. Firstly, as mentioned, we think that our portfolio is relatively liquid. We think we'll be able to achieve asset sales into the future, which will moderate any gearing concern. But also COF has got a comparatively high cap rate compared to our peer sets. So from that perspective, we're relatively comfortable with where gearing sits now, but we are cognizant that the investment community would like to see gearing low.

Okay. Just be also interested in a lot of leasing in the period. Can you talk to kind of key metrics around incentives and where rents were struck relative to prior rents, sort of leasing spreads and incentives? And then a specific comment around the ATO extension at Northbridge.

So average incentives for the half, including the Commonwealth Government at Northbridge, were between 30% and 31%. That was for renewals and for new leases. In terms of leasing spreads, they averaged about [ 90% ] reduction through the half. When you strip the Commonwealth Government out, because the Commonwealth Government itself had about a 20% to 25% negative reversion upon expiry, that was pretty much flat. So our leasing spreads were close to flat elsewhere. Now specific on the ATO, as mentioned, that was probably our last material overrenting position across the portfolio, and there was negative reversion in terms of the rent that we achieved and was down about 20%, 25%. Following that, our over over- and underrenting position is now pretty much flat across the portfolio. So we are pretty much aligned with passing versus market. In terms of the ATO itself, we can be explicit on the incentive provided. There is quite a large lease. So there is potentially perception that the incentive that we provided may have a significant capital contribution. I can state that the capital contribution that we have provided or we will have to provide to the Commonwealth Government is capped as a proportion of their incentive and it doesn't have a material impact on our liquidity or gearing.

Okay. Sorry, I just didn't quite get the leasing spreads. When you put down 20% to 25% and the flat together, where was that? I just...

Sorry. So the ATO -- sorry, the Commonwealth Government in isolation was a circa 20%, 25% negative reversion. Outside of that, leasing spreads were relatively flat.

Yes. Okay. And just maybe a brief comment on what you see leasing and maintenance CapEx for the half.

So leasing and maintenance CapEx was noted on, I think, it is Slide 7. So maintenance CapEx was relatively similar to prior...

On Slide 13.

Slide 13, sorry. So maintenance CapEx is relatively similar to prior periods.

And then -- yes, that's great. And then the final one for me. Just was interested in where your rent paying occupancy was in the first half and where it's going to be in the second half, given all the leasing and moving parts?

Yes. So the rent paying occupancy at 31 December was pretty consistent with where our occupancy was. As we move into the second half, the biggest change will be Ericsson vacating at 818 Bourke Street, which is about 3% of the portfolio.

Your next question comes from the line of Murray Connellan from Moelis Australia.

Grant and team, I was just wondering whether you can make a few comments on some of the submarkets. It sort of feels like the vacancy and the pending expiries in the portfolio are starting to congregate around the Docklands and St Leonards assets. Maybe just an update on those 2 nodes, just what you're seeing in terms of the leasing market on the ground at the moment. And then are there any other submarkets that stand out as feeling particularly [indiscernible]?

Sure. So in terms of the pockets of vacancy, I probably wouldn't say that it's like -- using 818 Bourke Street as an example. We don't actually have a -- as at 31 December, we didn't have a lot of vacancy within that building. It's more that we will have to deal with the Ericsson expiry, which is now -- which will occur in the second half of FY '24. There's no doubt that Melbourne continues to be a challenging leasing market. But in saying that, we have demonstrated some pretty decent leasing success at Docklands and we have got some conversations going at the moment in relation to that Ericsson space, but also the remaining space that is vacant within that building. Looking along the Northshore. Look, the Northshore has again been a challenging market. It's been a challenging market for a little while now. I've been saying that within 203 and 201 Pac Highway over the last 12 months, we have leased a chunk of space. So if you think about that space, in St Leonards, we do offer excellent transport amenity in that space, a very contemporary accommodation. We think it is attractive, and we think that we'll be able to lease that in due course. But outside of those 2 markets, Murray, I think it's worth commenting particularly on Brisbane and in Perth, we are seeing much stronger leasing activity in those markets, which is certainly going to benefit the COF portfolio. COF is a very diversified portfolio, and we've got a 20% exposure to the Brisbane fringe, which, in our view, has been the standout market over the last 12 months, and we believe that will continue into the future given there is virtually no supply under construction in that market.

What are your initial expectations on outcomes at Fortitude Valley in '25?

So for FY -- we don't actually have a lot to lease between now and FY '25. In FY '25, we have got a Macquarie expiry that occurs in January 2025. It's likely that Macquarie will be vacating that space, but we're already in discussions with a number of tenants about re-leasing that space. So I'd be very confident that we will be able to have transaction activity on that space before Macquarie vacates and at rents that will be potentially much better than what we would have been forecasting 6 or 12 months ago.

[Operator Instructions] And your next question comes from the line of Sholto Maconochie from Jefferies.

Just a few since a couple of ones have been asked. Can you provide the actual percentage incentive on the ATO deal, like what the actual percentage was on the incentive?

Unfortunately, we can't. It's -- there is confidentiality requirements. As part of the lease, we can't be explicit.

Okay. And then that Ericsson, that's the 7,746 square meters in Slide 17 that comes up?

Correct.

At Bourke Street. Okay. And in the guidance -- you got 76% in hedging, with guidance towards 4.6% BBSW, sort of 4.3%. So that's probably a little slight tailwind to guidance. Just on the cap rate, it seems high relative, but it's still pretty light on given what we see in transaction markets and the implied cap. Where do you see valuations going based on your discussions with asset sales over the next sort of 6 to 12 months on the cap rate?

Look, it's quite difficult to provide an exact guidance on where we think valuations are headed, but the general sentiment across both listed investors and also the direct investors and the direct market participants that we speak with is that you'll probably see valuations continue to be under pressure come 30 June. But in the back half of the year, I think there's a general optimism. Thus you'll see improved transactional activity in the back half of this year and the valuations will have stabilized by that time. Obviously, that's going to be dependent on where interest rates head, but I think that's a general thematic. But beyond that, Sholto, I think it's worth mentioning that the assets that we've sold today have been very close to our book value. So whilst there may be some implied softness within our cap rate, I think the transactional activity that we've been able to achieve is very supportive of where our current NTA is.

And then Keswick, that's marked at $40.5 million. That's -- is that based on the independent valuation or indicative offers that you've sort of received yet?

That's the independent valuation at 31 December.

All right. And then just finally, what sort of buyer types are there? Is it syndicates? Is it offshore valuer? What sort of buyers are looking at this asset class given the disconnect on implied caps and where they're at?

Yes. Predominantly for the assets that we had discussions on, it's been either predominantly local; when I say local, Australian privates and Australian syndicates.

And that brings a close to our Q&A session for today. I would like to turn the call back over to Grant for closing remarks.

Well, I'd like to thank everyone for dialing in today. If you've got any further questions, please feel free to reach out to either myself, Belinda or Tim Mitchell. And with that, I would like to thank everyone again, and wish everyone a very nice day.

This concludes today's conference call. Enjoy the rest of your day. You may now disconnect.