Charter Hall Social Infrastructure REIT (CQE.AX) Earnings Call Transcript & Summary

Ladies and gentlemen, thank you for standing by, and welcome to the Charter Hall Social Infrastructure REIT 2022 half year results briefing. [Operator Instructions] Please note that this conference is being recorded today, Thursday, the 17th of February 2022. I would now like to hand the conference over to your host today, Mr. Travis Butcher, fund manager for CQE. Thank you. Sir, please go ahead.

Good morning, everyone, and welcome to Charter Hall Social Infrastructure REIT's results presentation for the half year ended 31 December 2021. Presenting with me today is Scott Martin, Head of Social Infrastructure REIT Finance. I'd like to commence today's presentation with an acknowledgment of country. Charter Hall is proud to work with our customers and communities to invest in and create places on lands across Australia. We pay our respects to the traditional owners, the elders past and present; and value their care and custodianship of these lands. Turning now to Slide 5. CQE has had a strong first half to FY '22, continuing to deliver on its strategy and achieving robust financial and operating results. Activities during the half resulted in the fund being well positioned to continue to deliver unitholders secure income and capital growth. Key highlights for the half year were as follows. Operating earnings were $0.085 per unit, with distributions paid of $0.084 per unit, which were an increase of 6.3% and 12%, respectively, on the first half in FY '21. CQE has available investment capacity of $200 million following the expansion and extension of CQE debt facilities, allowing CQE to pursue opportunities consistent with the fund strategy. We've made significant progress in respect of CQE's ESG framework during the current period, including the commencement of the rollout of a solar installation program across the portfolio, with a commitment made of up to $8.6 million. In addition, we have recently announced a 2-year partnership with our major tenant customer Goodstart to provide funding to enable vulnerable children to access childcare. CQE's balance sheet is in a very strong position with gross assets increasing by 28.2% in the current reporting period to $1.9 billion. This growth has been driven by a combination of acquisition activity and revaluation gains. The revaluation uplift of $175.4 million or 11.9% increase since 30 June 2021 reflects the strong demand and yield compression for long-WALE social infrastructure assets. The valuation uplift is a key contributor to the growth in NTA per unit of 16.3%, which has resulted in an NTA per unit of $3.78 as at 31 December 2021. The portfolio is in a very strong position with a portfolio WALE of 14.6 years, 100% occupancy and a weighting of 79% of income to metropolitan locations. CQE is pleased to reconfirm the upgraded FY '22 distribution guidance provided in December of $0.172 per unit, reflecting growth of 9.6% over FY '21 DPU. Moving to Slide 6 and CQE's strategy. CQE's strategy is unchanged. Our strategy is to provide investors with secure income and capital growth through exposure to a diversified social infrastructure portfolio. We do this by focusing on enhancing income sustainability and resilience of the assets we own, targeting ongoing capital growth and undertaking ongoing portfolio curation. Turning to Slide 7. During the half, CQE continued to enhance and diversify its income. The development of the South Australian Emergency Services Command Centre was completed in December 2021, and it's now occupied by the 4 government agencies. The building is leased on a 15-year term with fixed annual rent increases of 2.5% and 2 5-year options. The property was valued at completion, which has resulted in an uplift of $6.5 million or 8.1% on purchase price. Secondly, during the half, the Mater hospital completed their fit-out works and occupied their new headquarters and training facilities in Newstead. This asset is underpinned by a new 10-year lease with 2 5-year options and fixed annual increases of 3%. A valuation uplift of $4.5 million or 3.7% was achieved as part of the December revaluation process. Finally, during the half, CQE has acquired a health care asset in Heidelberg, Victoria, leased to Healius, a leading ASX-listed health care operator. The asset is strategically located within one of Victoria's largest medical precincts, adjacent to a Healius-operated pathology lab. These 3 assets, combined with the Brisbane Bus Terminal, now contribute 15% of CQE's income and provide 4 well-capitalized tenant covenants to the CQE portfolio. Turning to Slide 8. Childcare continues to be a critical social infrastructure asset class and integral to CQE's strategy. As such, CQE has continued to invest in high-quality childcare portfolios leased to well-capitalized operators, with a total of $189.1 million invested during the half. A portfolio of 18 childcare centers in Western Australia was acquired in December 2021 for $100 million, with average lease expiries at 12.5 years. These properties are leased to the 2 largest operators in Australia's childcare sector, Goodstart and G8 Education. In addition to the WA portfolio, a further 5 childcare center assets were acquired, including 3 assets in the greater Melbourne metropolitan area, 1 in metropolitan Brisbane and 1 in the Sunshine Coast. They're leased to premium operators Niño early learning and Only About Children on new 20- and 15-year leases, respectively. Settlement of 3 of these assets occurred in January and February 2022, with the remaining 2 settlements to occur by April 2022. All of the acquisitions are well located for childcare and positioned with 88% metropolitan weighting; and combined with the fixed 3% to 4% reviews, will deliver long-term income and capital growth. CQE unitholders have benefited from the Charter Hall transaction platform with significant acquisition activity in the period securing high-quality, accretive social infrastructure assets in predominantly off-market transactions. Turning now to Slide 9 and environmental, social and corporate governance. Continuous ESG performance is a key focus area for the fund. Year-to-date, we've made significant progress towards the integration of ESG into our stabilized portfolio; and believe active tenant partnerships will unlock environmental and social value alongside financial outcomes. Some of the REIT's key highlights include approval of up to $8.6 million to provide solar solutions across the CQE portfolio. This will support clean and affordable energy for tenants in partnership with the fund. We have agreed to terms on 31 properties during the half. This will also enable CQE to better understand tenant operational performance for information sharing, which is currently not available under existing lease arrangements, and therefore be able to measure the impact of the solar initiatives and reduce the fund's scope 3 operation emissions. The initiative will assist CQE's focus on improved performance in industry-recognized ESG assessments such as the fund's GRESB performance. In December, we launched a 2-year partnership with tenant customer Goodstart to provide funding to enable children from vulnerable families to access fee-free childcare. We expect that the funding provided will enable 55 children to be able to attend childcare in CQE centers 2 days per week as a result of this partnership which in turn supports employment opportunity for parents and carers. Finally, we're excited to announce the partnership with the Green Building Council of Australia to develop Australia's first social infrastructure rating tool for operational assets. This will support operational performance, promote active tenant partnerships and create awareness of social and environmental initiatives at an asset level. I would now like to hand over to Scott, who'll provide an overview of the financial performance of the REIT.

Thanks, Travis. And good morning to everyone. A summary of CQE's earnings for FY '22 half year can be found on Slide 11. Net property income has increased by 12.6% compared to the prior corresponding period. And it's been driven by a combination of like-for-like rental growth of 3.1% and $3.3 million generated from net acquisition activity. There was no impact on CQE's earnings as a result of the COVID-19 pandemic during the half, with all rents collected in full. Finance costs and operating expenses increased period-on-period by 27% and 36.6%, respectively, due to portfolio growth and new acquisitions. CQE delivered operating earnings of $30.8 million, representing an increase of 5.8% on the prior corresponding period. Operating earnings per unit were $0.085. And distributions per unit were $0.084, in line with our full year guidance. Turning to Slide 12, which provides a summary of CQE's balance sheet position at 31 December 2021. The $362 million increase in investment properties represents an increase of 24% since 30 June 2021. And it's been principally driven by $175.4 million of property revaluations, $135.4 million of property acquisitions settled during the period and $44 million of expenditure on childcare developments and the completion of the South Australian emergency command center. Acquisitions and development expenditure have been debt funded, resulting in drawn debt increasing by $265 million to $565 million as at 31 December 2021. Cash reserves at reporting date were $55.1 million in order to fund committed acquisitions in the March 2022 quarter and payment of the December quarter distribution. NTA has increased by 16.3% from $3.25 per unit at 30 June 2021 to $3.78 per unit at 31 December 2021, driven by the net property revaluations and the uplift on CQE's unitholding in Arena REIT. Turning to Slide 13, which provides a summary of CQE's capital management initiatives. During the current reporting period, the REIT has continued to work closely with the Charter Hall treasury team on a range of debt initiatives that have continued to strengthen CQE's balance sheet position through extension of facility limits and debt maturities, together with a reduction in margins. Post reporting date, CQE increased its total facilities to $800 million, providing it with $200 million of available investment capacity to pursue new social infrastructure opportunities. CQE has diversified funding sources with no debt maturity until June (sic) [ January ] 2025 and a weighted average debt maturity of 4.2 years. CQE's weighted all-in cost of debt is 2.5%, which is calculated based upon drawn debt of $565 million and includes [ loan fees ] on undrawn debt capacity and amortization of borrowing costs. Balance sheet gearing was 30% and look-through gearing was 30.8% as at 31 December 2021, adjusted to include contracted childcare acquisitions and disposals, together with the funding of the remainder of the childcare development pipeline. Gearing levels remain at the lower end of CQE's target gearing range of 30% to 40%. During the current reporting period, CQE increased its level of hedging to $325 million, comprising a mix of fixed-rate swaps and interest rate cap. CQE has a staggered hedging profile through to December 2025 with an average amount hedged of 54% at an average hedge rate of 0.54%. I will now pass back to Travis to continue with the presentation.

Thanks, Scott. On Slide 15, we have CQE's portfolio summary. As detailed earlier, in our strategy, we are focused on continued portfolio improvement and enhancement of income sustainability and resilience. The portfolio continues to be 100% leased, and the portfolio WALE sits at a very healthy 14.6 years. During the half, 18 childcare acquisitions settled. And 4 childcare developments completed, with average lease terms of 13 years. Disposal activity has reduced due to significant portfolio curation completed in previous years, with only one asset divested in the half at a premium of 39% to book value; with a second asset contracted for divestment, with settlement to occur in February at a premium of 36% to the 30 June 2021 book value. Lease expiries in the next 5 years remained low at 3.9%, highlighting the importance of the property and lease term to the operators' business. It's also worth noting then, in calendar year '27, where there is lease expiries amounting to 5.8% of income, that 97% of this income have options with typically 5-year notice periods. And therefore, we expect that a significant proportion of these options will be exercised during 2022. Moving to Slide 16. CQE's current portfolio is well positioned to deliver both income and capital growth, where 71% of CQE's income underpinned by the top 5 tenants are all well capitalized. The portfolio is heavily weighted to the eastern seaboard states, with 79% of income derived from these states and 79% of income derived from metropolitan locations. Childcare assets comprise 85% of the portfolio, and over the medium term, we expect this to reduce to 50% to 70% of the portfolio as other social and infrastructure assets are added to the portfolio. Fixed annual reviews comprise 75% of the portfolio income at an average rate of 3%. It is important to note that, in the 3-year period from FY '25 to FY '27, there are approximately 180 market reviews in the portfolio, allowing CQE to capture rental growth both from under-renting across the portfolio and also if inflation exceeds fixed rental growth up until the market review period. Rental growth, moving forward, is forecast to be 3%, comprising both fixed increases and the balance of CPI increases. Turning to Slide 17. CQE undertook 337 childcare valuations during the period, which represents 100% of the portfolio, excluding acquisitions undertaken during the half. The childcare portfolio saw an uplift in valuations of $159.8 million or 13.2% from 30 June 2021, with the average passing yield of the childcare portfolio now sitting at 5%. As can be seen from the bottom right graph, the value of the childcare market transactions are at record levels with sales of approximately $619 million compared to the full FY '21 year with sales of approximately [ $550 million ]. Yields have continued to compress, with average transaction yield of 4.6%, which is 40 basis points tighter than the value of CQE's childcare portfolio. The 4 non-childcare assets were also independently valued as at 31 December, resulting in a $15.6 million or 5.2% increase, noting that the health care asset acquired in October is being [ held at the valuation ] undertaken at the time of acquisition. The non-childcare portfolio has an average passing yield of 4.4%. The compression we are seeing in the long-WALE social infrastructure sector is a combination of strong demand for long-WALE assets in "essential" sectors with stable income and a low interest rate environment. Turning to Slide 18, which provides an update on CQE's childcare developments. During the half, CQE completed 4 developments with a total valuation on completion of $28.3 million and an average yield on costs of 5.6%. All these developments are in high-quality locations and provided a valuation increase upon completion of $5 million or 21.5% on cost. There are further 10 remaining properties in the development pipeline, and we are forecasting 7 of these to be completed during calendar year 2022. The remaining properties have a forecast cost to completion of $26 million and average yield on costs of 5.6%. The completion of developments is a key priority for CQE, as upon completion, these projects increase CQE's net property income and add to CQE's portfolio of high-quality childcare centers. Moving to Slide 20 and an update on the social infrastructure sector. It's estimated that expenditure for additional social infrastructure assets in Australia could reach [ $700 billion ] over the next decade, providing opportunities for CQE to further expand its social infrastructure portfolio. As shown in the graph, annual government spending on essential social services like health, education, childcare and transport is forecast to reach $180 billion per annum in FY '25. There are several key drivers of demand supporting this level of expenditure and providing a fundamental basis for ongoing social infrastructure investment. These are demographic and societal changes. Notably there's a growing and aging population, with Australia's population aged over 65 projected to grow 21% by 2066, increasing the demand for health-related services and assets. There's greater focus on more equitable opportunity and participation, which is a key factor in increased demand for childcare services, with the female participation rate increasing from 55.1% 20 years ago to 61.5% as at December 2021. Fiscal constraints with the provider of social and community services and the ability of these providers to utilize capital more efficiently is expected to provide increased investment opportunities in the medium to long term. In many cases, the rate of demographic change and social evolution outpaces the ability of government and other providers to fund required expansion and upgrading of social infrastructure assets. Turning to Slide 21, more specifically childcare. The essential nature of childcare continues to be demonstrated throughout the COVID-19 pandemic, with continued federal government assistance provided to operators to navigate through both the impact of reduced attendances and staff absences. The operators have faced a very challenging and fluid period in the last 2 to 3 months. However, school holiday is amended and COVID cases and isolation rules have eased. Conditions are improving for operators on a week-by-week basis. Despite this environment, CQE received 100% of its contracted revenue for the first half of FY '22 and has collected 99% of its contracted revenue for January and February, highlighting the resilience of the portfolio. Federal government funding, which amounts to $9 billion in FY '21, provides critical support for the sector. Additional government funding aimed at improving childcare affordability and workforce productivity has been brought forward to March 2022. This was targeted at lower- to middle-income families and is expected to benefit approximately 250,000 families, which will provide good support for the sector as attendances recover post COVID. It is expected that -- as part of the approaching federal election that both major parties will focus on childcare affordability as part of their election campaigns, which could result in further increased funding to the childcare sector. Turning to supply. Net center supply levels for the year grew by 3.1% or 249 centers, with 8,441 centers at 31 December 2021. The annual growth rate of 3.1% has pleasingly moderated from the prior year growth of 3.7%. There are 130 new center openings in the current period compared with 183 in the prior corresponding period. Moving to Slide 23 and the outlook and guidance. CQE is focused on continuing with the execution of its strategy to pursue opportunities in both the childcare and broader social infrastructure areas underpinned by strong tenant and property fundamentals. CQE's future earnings and distribution growth will benefit from the full year impact of acquisitions and completed developments during the half. We are pleased to reconfirm that, based on information currently available and barring any unforeseen events or a further deterioration in the COVID-19 environment, the FY '22 forecast distribution guidance is $0.172 per unit, resulting in an increase of 9.6% on the FY '21 annual [ distribution ] paid. That concludes the formal component of our presentation. I'll now hand back to the operator and open the line for your questions. Thank you.

[Operator Instructions] Your first question comes from Solomon Zhang with JPMorgan.

First question, just on development yield on costs. So 5.6% this period, it's down a little bit from [ prior periods, completion and construction ] cost pressures coming through. Just interested in your thoughts on yield on costs going forward and, I guess, the level of development activity you want to undertake in the short to medium term.

Yes, thanks, Solomon. So in terms of that 5.6%, that's a reflection of increased construction costs, also just delays in terms of some of the projects, with a majority of those projects based in Melbourne. And just with construction delays due to COVID, that sort of increased the holding costs on that. From a development pipeline moving forward, it's our preference to really move more towards upon completion or acquisition of existing sites. What's driving that is really around we've got to make sure that we get accretion in earnings from day 1 in terms of acquisitions. And also I just want to really avoid the development risks from a fund point of view. Obviously, with developments, there's planning approvals, construction delays, cost escalations. That's really taking that risk out of the funds moving forward.

That's great. Just next question, just on sort of market rents versus portfolio [ owned ]. Could you quantify what the [ gap ] is at the moment on an aggregated basis?

I think, on a conservative basis, we're probably sitting 5% under market; called out the -- in the presentation that, FY '25 through FY '27, we've got approximately 180 market reviews. So that gives the fund a good opportunity to pick up that under-renting. And also, if inflation does run north of our fixed 3% increases which -- across 75% of the portfolio, that gives us an opportunity to pick that up as well in that sort of 3-year period.

Got it. Maybe just final, quick one for me, just around operator attendance levels at the moment. Are you seeing a strong bounce back, or is it still pretty challenged?

It does vary center by center. I think what you've seen is that January is typically a slow month, anyway, just with you have the older-year level go up to start prep. You've seen the Queensland school start delayed by 2 weeks but all the operators we speak to have said attendance is improving week by week. I think what you're seeing is that people are getting more comfortable and learning to live with COVID. You've seen the isolation rules ease, so operators now -- I think government support has been fantastic through that period, but operators are seeing that, week by week, attendance has increased, which is really positive.

And sort of ballpark percentage of pre COVID...

It's really hard to answer that one at the moment, but we're sitting -- like, pre COVID, we were sitting around -- the portfolio was sitting around 79%, but it really does depend tenant by tenant, location by location, so it's hard to give that sort of exact answer, Solomon.

Your next question comes from Mollie Urquhart with Barrenjoey.

So you've got $200 million of investment capacity. You're continuing to divest at the margins. Given where assets are trading and your earlier remarks about intending to step away from development risks in the portfolio, where are potential returns most attractive to deploy this capital?

Well, I think we've got that 2-pronged strategy. Obviously childcare continues to play a big part in the strategy. We bought 24 assets in the half, so -- and then also the broader social infrastructure assets we're looking at. So it really comes down to can we secure opportunities in either of those 2 areas. And it comes down to which one of these, really depending on the ultimate -- the property fundamentals of the deal, [ who the covenant is ]. Then ultimately can you secure it at a price that makes sense for the fund? I think what's been one of the strong things we've done during the half is the off-market transactions in terms of the childcare. [ 2020, 2023, we're off market ]. And that's sort of leveraging that Charter Hall transaction platform, also leveraging our relationship with our tenant customers. For example, the Only About Children deal was done off market. Only About Children bought the business and we bought the freehold and [indiscernible] new leases. So it's you need to get creative. It is quite a competitive market out there, so it's all about making sure that it's the right price. Is the price right for the property deal you're getting and the covenant you're buying?

Yes, for sure. And then on childcare, at the operator level, can you give us some color on how tenants are tracking. Where are occupancy costs? And when you look across your book, do you see any risks within the current labor and inflation environment?

Yes. So in terms of just picking up on the comments I made before, it really is improving. And I think we've had a lot of discussions with operators in the last week; and there's a lot of operators talking about growth, talking about expansion. We've seen some M&A activity happening already, so we're getting [ assignment ] requests. So there is still that, which gives you confidence that the operators are coming out of this period positively. So in terms of our rent and where occupancy costs sit, across our portfolio, we're 10.6%. So I think, as I talked about before, that's sort of under market, so I think operators have obviously had a challenging time working through this with staff absences. And obviously they've still got that problem, the challenge around long-term labor and having labor suppliers, which both federal and state governments are looking at solutions to assist there, but I think one thing to always bear in mind with childcare. The operating margins are typically -- good operators achieving 15% to 20% EBITDA margins. So there is room for increasing labor to -- and obviously they've got the flexibility of increasing the fees to parents as well, so there is some flex in terms of enabling more to be paid to the workers while still keeping that -- profitability levels.

And just on that increasing of fees. Do you have a number for what the average daily fee is at the moment?

Across our portfolio, it's $116.

Okay. And then just lastly, on the inflation point you were talking to before. 25% are linked to CPI. What's the majority of the mechanism there? Is it [ the greater at ] fixed-store CPI? And perhaps what you're expecting to get out of those leases in terms of above-average growth. And what's assumed in your guidance?

No -- so we're just -- actually [ it's quite simple. So yes ], 75% are fixed average 3%, and the balance are just CPI. So we've assumed -- and it depends on which quarter that rental increase falls, but we're assuming a 3% CPI increase for the next 6 months. And that's what's been factored in the guidance as well. And it's interesting with -- if inflation -- say for example we're talking about the market reviews we touched on earlier. If inflation [ ran at 4% ] for the next 3 years -- so that's sort of 1% above our fixed 3%. That sort of 3% -- obviously a bit higher than that, compounding it. We'd -- we've picked that up sort of in the market reviews that happened throughout FY '25 to FY '27 period.

[Operator Instructions] There are no further questions at this time. I'll now hand back to Mr. Butcher for closing remarks.

Thank you, everyone, for your participation today. And we look forward to meeting with many of you over the coming weeks. Thank you.