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 2023 Full Year Results Briefing. [Operator Instructions] Please note that this conference is being recorded today, Friday, 11, August 2023. I would now like to hand the conference over to your host today, Mr. Travis Butcher, Fund Manager. Thank you, sir. Please go ahead.

Good morning, everyone, and welcome to CQE's results presentation for the full year ended 30 June 2023. 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 acknowledges the traditional custodians of the lands in which we work and gather. We pay our respects to elders past and present and recognize their continued care and contribution to country. Before starting the results presentation, I'd like to pause and acknowledge that in April this year we were greatly saddened by the sudden passing of CQE's Chair, Grant Hodgetts. Grant made a significant contribution to the Australian property industry over many decades and greatly contributed to the strategy and growth of CQE. We'll miss Grant's passion and leadership. Turning now to Slide 5. Key highlights for the year were as follows: Distributions paid to investors for the year were $0.172 per unit in accordance with the full year distribution guidance. Acquisitions of $184.2 million were made in social infrastructure assets across 6 properties on long leases with strong tenant covenants. Key transactions with the Geoscience Australia complex in Canberra in October 2022 and the Innovation Quarter acquisition in Westmead made in February 2023, both of which significantly enhance the quality of CQE's portfolio. During the year, we continued with our active portfolio curation resulting in $84.4 million of divestments being made, comprising 12 childcare property sales and the full sale of CQE's interest in Arena REIT. As a result of transactional activity, CQE's gross assets have increased by 8.9% during the year to $2.3 billion. NTA per unit has remained relatively stable, and as at 30 June 2023 was $4.04 per unit. During the year, CQE was active with hedging initiatives and has now hedged 80% of its variable interest rate exposure through the June 2025, providing protection against adverse interest rate movements and banking covenants. The portfolio is very well positioned in this current environment with a strong WALE of 13.2 years, 100% occupancy and achieving a weighted average rent review of 3.7% for the year. Moving to Slide 6 and CQE's strategy. CQE's strategy remains 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 continual portfolio curation. Turning to Slide 7. During the year, CQE continued to enhance and diversify its income with acquisitions during the year amounting to $184.2 million. In October 2022, CQE acquired a 25% interest in the Geoscience Australia life sciences complex in Canberra for $90.9 million. The property was acquired on a 7.4% yield, 9.6-year WALE and 3% annual rental increases. In February 2023, CQE acquired a 49.9% interest in Innovation Quarter for $66.9 million, a newly constructed health care, medical research, education and training hub in Westmead, approximately 25 kilometers from Sydney CBD. The property was acquired on a 4.7% yield as our average annual rental increase is 3.6%. 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 assets with a further 4 assets acquired during the year, totaling $26.3 million on an average yield of 4.9%. These acquisitions are all on new 15-year leases and located in metropolitan locations. With respect to development activity, CQE completed 4 childcare developments during the year, delivering brand-new assets with average lease terms of 15 years, valuation uplift of $5.5 million and yield on costs of 5.8%. As part of our active portfolio curation and capital recycling, during the year, CQE disposed of 12 freehold childcare assets of $40.4 million at an average yield of 4.5% and a premium of 4% to book value. Despite the increasing interest rate environment, liquidity and demand for childcare assets has continued, providing CQE with the ability to dispose of assets above their prevailing book values. In addition, in January 2023, CQE fully divested its 3.5% holding in the listed Arena REIT, generating gross proceeds of $44 million. Proceeds of both the childcare assets and Arena securities have been utilized to reinvest into direct social infrastructure properties, providing unitholders with stronger income and capital growth prospects. Turning now to Slide 8 and ESG. We remain focused on implementing sustainability initiatives across our portfolio and consider ESG as a driver of long-term value for the fund. Key points to focus on from a CQE perspective are, continued partnership with our tenant customers to provide solar solutions across the CQE portfolio, of which, 0.5 megawatts has been installed across the portfolio to date. This will support both clean and affordable energy for tenants in addition to enabling CQE to better understand tenant operational performance through information sharing, which is currently not available under existing lease arrangements. Secondly, we're continuing to work with one of our tenant customers and the Green Building Council of Australia on the development of Australia's first social infrastructure rating tool for operational assets. And finally, FY '23 was the second year of our partnership with major tenant customer Goodstart, where we supported the Early Learning fund, enabling at least 28 children from vulnerable families to access fee-free childcare. I'd like to now hand over to Scott, who will provide an overview of the financial performance of CQE.

Thanks, Travis, and good morning to everyone on the call. A summary of CQE's earnings for the full year FY '23 can be found on Slide 10. Net property income has increased by $16 million or 18.9% compared to the prior reporting period and has been driven by like-for-like growth of 3.4% and $13.6 million generated from net acquisition activity. The increase in operating expenses has been driven by portfolio growth and new acquisitions. Finance costs have also increased year-on-year as a result of higher levels of drawn debt, together with a 1.8% increase in CQE's weighted average cost of debt from 2.3% in FY '22 to 4.1% in FY '23. CQE delivered operating earnings of $59.2 million, representing a decrease of 5.9% on the prior year. Turning to Slide 11, which provides a summary of CQE's balance sheet position at 30 June 2023. The $184.5 million growth in total assets represents an increase of 8.9% since 30 June 2022, and has been principally driven by $235.9 million of property acquisitions, $36.7 million of childcare property divestments at/or above prevailing book values and the divestment of CQE's holding in Arena REIT in January 2023 for total gross proceeds of $44 million. There has been minimal movement in NTA per unit, which reflects the continued strong demand for quality social infrastructure assets. NTA per unit as at 30 June 2023 was $4.4 per unit, representing only a 1% decrease for the year. Turning to Slide 12, which provides a summary of CQE's capital management initiatives. In September 2022, CQE increased its total facilities to $850 million, which were drawn to $739 million as at 30 June 2023. Balance sheet gearing was 32.2% and look-through gearing was 32.8%, which remain within CQE's target gearing range of 30% to 40% and provides considerable headroom to gearing covenants. CQE has diversified funding sources with no debt maturity until January 2025 and a weighted average debt maturity of 2.9 years. CQE's weighted average cost of debt as at 30 June '23 was 4.3%, which is calculated based upon drawn debt of $739 million and includes line fees on undrawn debt capacity. During FY '23, CQE took out a further $275 million of additional hedging. CQE's proactive approach to hedging has seen the level of hedging increase to $600 million as at 30 June 2023, with a weighted average hedge maturity of 2.8 years. Importantly, CQE has 80% of its debt hedged for both FY '24 and FY '25 at an averaged hedged rate of 2.3%, which provides protection against rising interest rates and headroom to ICR covenants. I will now pass back to Travis to continue with the presentation.

Thanks, Scott. On Slide 14, we summarize CQE's portfolio. As detailed earlier in our strategy, we are focused on continued portfolio improvement and enhancement of income sustainability and resilience. As at 30 June 2023, CQE owns 366 operating properties with a total value of $2.2 billion across a diversified social infrastructure portfolio. The portfolio continues to be 100% leased with the portfolio WALE seeing at a very healthy 13.2 years. Lease expiries within the next 5 years remain low at 3.5%, highlighting the importance of the property and lease term to the tenant's business. It is also worth noting that the 3.5%, only 0.7% are true expiries where there are no tenant options. Moving to Slide 15. CQE's current portfolio is well positioned to deliver both income and capital growth with the portfolio heavily weighted to metropolitan locations, comprising 82% of income and a strong eastern seaboard weighting, also of 82%. As the pie graph shown on the right of this slide, CQE has diversified its income into broader social infrastructure subsectors with childcare assets currently comprising 77% of the portfolio and other social infrastructure assets sitting at 23%. The broadened strategy has also resulted in a diversification of CQE's tenant mix, with tenants now including both federal and state governments. Concentration risk has reduced with our largest tenant, Goodstart, providing 34% of CQE's income as of June 2023, down from 47% as at June 2020. Fixed annual reviews comprised 77% of CQE's leasing income at an average rate of 3%, with the balance of lease income based on CPI reviews. Weighted average rental growth for the year to June was 3.7%, including a mix of fixed market and CPI-based annual rent reviews. During the year, 8 market reviews were completed with an average 5.4% increase across these properties. The market reviews range between 22% and 10%, with the varying outcomes driven by the individual property and lease parameters. Over the next 5 years, 47% of CQE's rental income is subject to market reviews. These reviews are all childcare properties, are typically capped at 7.5%. In terms of timing, there was 2% of carry in FY '24, 15% in FY '25 with the balance of carrying over the following 3 years. This will allow CQE to capture rental growth from under-renting across the portfolio, which has been independently assessed where the value was at approximately 6%. Gross rent to revenue for the childcare operators based on tenant data provided under the leases sits at 12.2%, which is at the lower end of market parameters and is very important given the long lease terms. Turning to Slide 16. During the year, CQE revaluated 100% of the portfolio. The portfolio saw a like-for-like valuation increase of $9.9 million, representing a 0.5% increase from 30 June 2022, with the average passing yield of these properties at 4.9%. The valuation uplift has been driven by portfolio rental growth during the year offsetting a mild yield expansion. As can be seen from the graph on the right, the value of direct market childcare's transactions recorded in the last year were approximately $490 million. This is down from a record year in FY '22 where there were transactions of approximately $830 million. However, transactions remained relatively consistent with the level in FY '21. Transaction yields in the year have increased to 5.3%, up from 4.7% in FY '22. It's important to note that an analysis of FY '23 sales highlights that the transactions were of a lower quality and secondary stock with weaker tenant covenants. This analysis also shows there's approximately a 40 basis point spread between properties leased to Tier 1 tenant covenants, which we define as operators with over 50 centers compared to properties leased to small private operators. As has been proven in previous property cycles, due to the asset size of childcare properties, there is still liquidity in the market as purchases are often not reliant on borrowings to make property purchases. Investors are continuing to be attracted by properties in essential sectors and long leases with operators having favorable demographic and government funding tailwinds. During FY '23, CQE disposed of 12 assets at an average yield of 4.5%. The disposal rationale for each varied. It was a combination of smaller centers with average places of 71, shorter WALEs and smaller private operators. Recent sales completed the Burgess Rawson auctions in August saw Sydney childcare properties transact in Putney at 3.5% and Maroubra at 4.9%, demonstrating the continued resilience of the childcare property market. Turning to Slide 17 and an update on the childcare industry. The key positive change to the industry occurred in July 2023 with the introduction of the federal government's Cheaper Child Care Plan. This policy will increase the affordability of childcare through increased subsidy rates and higher family income eligibility. The improved childcare funding plan is a key driver of the increased government funding to the sector, with annual federal government spending forecast to increase by 41% to $15 billion in FY '27. During 2023, the childcare sector has been the focus of a number of government inquiries from both the ACCC and Productivity Commission. The ACCC interim report was released in July '23 and focused on the price and availability of childcare services, selection of services and the impact of government contributions. The consultation paper we published in September 2023, which will include a discussion of the cost of providing childcare and also identify a preliminary view on potential draft findings and recommendations. A final report is due to the Treasurer by 31 December 2023. Separately, the Productivity Commission is undertaking a review of the childcare sector in Australia with the terms of reference to make recommendations that will support affordable, accessible, equitable and high-quality early learning. It's currently too early to assess the outcomes of those reviews, however, it's important to note that both the reviews highlight that childcare is an essential and vital part of Australia's education system and is integral to increasing workforce participation. In terms of current operating performance, operators are seeing initial positive occupancy response to the improved government funding. Based on trading data provided by our tenants, daily fees have increased by 6% during the year to $127 per day. It's expected that the combination of improved funding, female labor force participation rates at record levels and population growth will all provide occupancy tailwinds in the coming years. Turning to supply. Net tenant supply levels for the year grew by 3.5% or 298 centers with 8,854 centers at 30 June 2023. The timing and supply of new centers has been disrupted during the COVID period and is now being impacted by increased construction and funding costs. However, it's important to note that with new supply, childcare is a very localized industry and that center catchments are typically 2 to 3 kilometers radius in size. Moving to Slide 19 and the outlook and guidance. We're focused on continuing to execute CQE strategy to actively manage the portfolio to maintain income security and capital growth. We see social infrastructure as a growing asset class with long-term opportunities for future investment for CQE. Key thematics driving this are both the growing and aging population in Australia with estimates of Australia's population increasing by 14% or 3.7 million people through to 2031, which will require significant social infrastructure investment. Today, we confirm that based on information currently available and barring any unforeseen events, the FY '24 forecast distribution guidance is $0.16 per unit. That concludes the formal component of our presentation. I'll now hand back to the operator and open up the line for your questions. Thank you.

[Operator Instructions] Our first question -- and it comes from the line of Lou Pirenc with Jarden.

Two questions for me. First of all, can you talk a little bit about the payout ratio? I mean it used to be 100% and last year, it was up quite significantly. What should we assume for your guidance in terms of payout versus earnings?

Yes. Thanks, Lou. So for FY '24, we've got forecast payout ratio of between 98% to 100%. In terms of forecast payout ratio for FY '24, it's between 98% to 100%.

I'm going to move on to the next question. All right, it comes from the line of Murray Connellan with MA Moelis Australia.

I was wondering whether you could just give us your -- a bit more color around your base rates, interest assumptions that go in the guidance, please?

Murray, it's Scott here. Look, we've rolled our first quarter debt, floating debt at 4.4%. We're not interest rate experts, which basing our guidance based upon the market curve. So just taking that 4.4% is the first rail and we'll see where we get to with the balance.

Sure. So probably 4.25% to 4.5% type range?

Yes, that's a reasonable basis based upon current curve, I'd expect.

And then just around how you're thinking about asset sales and capital deployment, please. Is there a gearing level that you'd like to be targeting near term?

Yes. Just on the gearing. Obviously, you can see it's at the lower end of our range, which we're very comfortable with. To give you some color, like for, say, $25 million of divestments that takes gearing down by circa 1%. But certainly, from my perspective, I'm comfortable where covenant headroom is. But I'll pass over to Travis now to finish that.

Yes, Murray. From an asset sale point of view. I think one of the strong points for the last 12 months has been the liquidity in the childcare space, in particular, the sub-$5 million space, where a lot of buyers are going to the bank to fund these purchases. They've identified child care is one of their key -- if they're seeking property exposure, they're seeking childcare given its essential nature. There's been a lot of people leaving the resi property market. So that's all playing -- what that sort of means is there's a really strong market for childcare. So we've sold -- divested 12 assets during the period at sort of average yield of 4.5%, sort of as part of an active portfolio curation. If we could all look to continue that -- obviously, it's dependent on market conditions, but if we could do something similar, I think that -- and now where cost of debt is, the marginal cost of debt, it's actually put you in a point where you're getting accretion from divesting your lower quality assets, which is a pretty good position to be in.

And then maybe just also how you're thinking about developments as well, please. The pipeline has obviously dropped off a bit around childcare developments in the last few years as construction costs have increased. But just given the new round government funding that's hit the market from the 1st of July. Are you seeing any fresh opportunities there?

Yes. So just, Murray, on that, in terms of what we'll do from a development point of view, we won't do the developments ourselves. We've got 4 developments on our books at the moment, which are sort of working through. But in terms of future, we'd look to partner with developers and be their sort of end takeout partner. I think you're seeing now we are starting to see more opportunities from developers seeking capital because it's getting harder for them to fund those transactions. So there will be more opportunities. Obviously, for developers, they've got the -- dealing with the construction costs increasing and holding costs increasing. So I think there will be more opportunities there. It all comes down to pricing and ultimately, are you getting the product you want with the tenant you want and the pricing makes sense. So we'll keep on looking at those opportunities and see down the track if opportunities present themselves.

I'm going to ask Lou to please move forward. We couldn't hear your second question for technical difficulties, Lou from Jarden. I'm going to the next question. It comes from the line of Solomon Zhang with JPMorgan.

First question is on capital management. I mean, CQE is trading at a pretty deep discount to NTA and in high implied yields. But as you noted earlier, childcare asset is still selling at or above book value. What would be your appetite to undertake a share buyback funded by asset sales, be accretive to earnings, NTA and also provide a bit of a good signal to the market?

I think Solomon, with that, any buyback needs to be a sort of material amount. So I think if we were to sell a significant amount of childcare assets is something that we may look at. But I think it needs to be -- just in order to do a buyback, you need to make it a meaningful amount. So I think any asset sales we do in the next 12 months will be sort of first put to retiring debt and reducing gearing.

Noted. So a question for Scott, just on the like-for-like NPI growth. Just noticed that that's slipped from 3.7% in first half to 3.4% for the full year. It sort of implies that second half is closer to 3%. Is there anything to call out there in terms of outgoings of the timing of rent reviews that would sort of explain that move?

Yes. Look, thanks, Solomon. Look, the 3.4% is the like-for-like movement in net property income. So yes, that -- you've hit the nail on the head. There's been some second half nonrecoverable outgoings, which are largely around the land tax in Queensland that's nonrecoverable. It's more a timing issue than a signal of anything longer term.

Final question, just on the swaps that you put on in FY '23. I think it was some forward starts in first half and then some additional ones in the second half. Could you just confirm the swap rates and as well as any capital if they were paid? I just noticed that there is -- in the cash flow statement, there's a $2.6 million derivatives payment. Is that accounting for the payment swaps?

Yes, that's correct. We put $150 million swap in place in December with a forward start of June this year. That was at a rate of 3%. So there was a small capital cost. Then all future swaps that have been put in place in the second half have all been at market rates.

[Operator Instructions] Our next question is from Ben Brayshaw with Barrenjoey.

A couple of quick ones from me. Scott, just if you could provide some more detail on what's the margin being paid on your debt facilities at the moment?

Average of $160 million.

$160 million. Okay. Great. And also just in regards to capital management. So interest cover declined at 3.1x for the full year, actually. What's your RCR on a rolling 6-month basis?

So the covenant is 2x. And I've rolled forward our calculation now with hedging in place. Like we got to -- we'd have to see double-digit floating rate interest rate to be anywhere near that 2x covenant. So we're very comfortable that we've got plenty of headroom, I reckon for the upcoming year. We'll probably be in the range of 2.8x to 2.9x coverage. So obviously coming back from that 3.1x, but still miles of headroom.

And I'm not showing any further questions in the queue. I will pass it back to Travis Butcher for final comments.

Now thank you, everyone, for your time today and your interest in CQE and look forward to catching up with all of you over the coming weeks. Thank you.

Thank you all for your participation. This does conclude the program, and you may now disconnect.