Precinct Properties NZ Ltd & Precinct Properties Investments Ltd (PCT) Earnings Call Transcript & Summary

Thank you for standing by, and welcome to the Precinct Properties 2021 Half Year Results Conference Call. [Operator Instructions] I would now like to hand the conference over to Mr. Scott Pritchard, CEO. Please go ahead.

Thanks, Amanda, and good morning, everybody, and welcome to the 2021 interim result briefing for Precinct Properties. I am Scott Pritchard, I'm the Chief Executive for Precinct; and I'm also joined today by George Crawford, Precinct's Chief Operating Officer; and Richard Hilder, Precinct's Chief Financial Officer. The first half of the 2021 financial year has certainly been unique, with the completion and opening of Commercial Bay at the start of the period in the middle of a global pandemic. It's fair to say that when we started this $1 billion project, we never imagined we would be completing and opening the project with our borders shut and with us having spent several weeks locked down in our homes. Despite this, the business has demonstrated remarkable resilience as the strategy that we have followed for the past 8 years has stood us in good stead. We've completed high-quality new assets attracting high-quality clients with long leases, which provide very defensive investment characteristics. It is the quality of our portfolio that has driven Precinct's operating and financial performance, and we're pleased to be here today to provide an overview of the company's position. The program for today's call is outlined on Page 2 of the presentation. I'll shortly provide an overview of the highlights of the result before reviewing our progress against our strategy. I'll then hand over to Richard, who will take us through the interim results and capital management for Precinct. George will summarize our markets and our portfolio performance. I'll then provide an update on our development activities and finish with some concluding comments. Upon completion of the presentation, we'll be very happy to answer any questions that you might have. Moving to the highlights page. Undoubtedly, the most pleasing outcome has been the revaluation gain recorded at the half. With growth in excess of 8% in Wellington and over 4% in Auckland, our portfolio is benefiting from having a low-risk, high-quality set of occupiers who are on long-term leases with structured growth. These characteristics have been recognized by the independent valuers, given the quality of the real estate and the performance of the portfolio during the period. This revaluation has led to a total comprehensive income of $167 million, underpinned by a growing earnings profile and growing AFFO. Our balance sheet has been strengthened in the period with the sale of the remaining 50% of the ANZ Centre for $177 million, with settlement due to occur in April. And finally, the performance of our investment portfolio and development activities have been outstanding and are reflected in the interim revaluation gain. While there has been significant discussion around the strength of office markets, it is pleasing to record over 11,000 square meters of leasing transactions with new leasing securing growth in rents of close to 8% over passing rents. These outcomes give us further confidence in our business and our strategy and in our markets despite some commentary to the contrary. Turning to Page 4. Precinct has benefited from a well-established and clear strategy for some time. This slide outlines the strategy that has been established, including our focus on our people, our operations and our developments. And also identifies the opportunities for Precinct to outperform, which is centered around stock selection, development activity and operating activities. Over the page, our progress in the past 6 months with regards to our strategy is highlighted here. Most pleasing, we have once again increased our GRESB score, now achieving 83 out of 100, which is significantly ahead of the global average of 70. Consistent with our approach to sustainability, we have also launched a sustainable debt program and launched our climate-related financial disclosure document. Our investment portfolio and developments had further advanced in the period, which is consistent with our strategy. Our continued investment in our people has continued in the period with an ongoing commitment to training and development for our staff. Page 6 sets out the major themes that we are facing, which remain consistent with the themes identified in August last year at our annual results. While the same themes exist, there has been subtle shifts which are worth identifying. Workplace trends are continuing to evolve. It is clear that employers are offering increased levels of flexibility. However, it is also evident certainly within our portfolio that our client base is utilizing their offices with between 85% and 90% of physical occupancy now evident. I'll touch on workplace strategies again shortly. The occupier market remains resilient with the emergence of some sublease space. However, much of it exists within secondary inference locations. To date, Precinct has had just 1 occupier out of its entire portfolio who had proceeded with subleasing their space since COVID emerged 12 months ago. The construction market has evolved rapidly in the last 6 months. Our expectation 6 months ago was for a softening in this market with a corresponding reduction in construction costs expected. However, the market has responded rapidly in the last 2 to 3 months with elevated levels of construction activity occurring, leading to a resurgence in construction costs and a further tightening for resource. And finally, for this slide, it is clear that city centers around the world have been impacted by COVID. However, the Auckland city center has been heavily disrupted, particularly by the flow-on impacts of COVID and the heavy concentration of MIQ facilities in the city centers. Despite this impact and the ongoing impacts of city center construction works, we remain firmly of the view that the long-term drivers for city centers will prevail. We're encouraged by the early signs in the 2021 calendar year, which showed increasing pedestrian counts and an increased number of occupants on floor in our portfolio. Following on from the workplace trends theme. Page 7 sets out our perspective of the proposition for working from the office. Our view remains that the city center office is as important as ever, with occupiers benefiting from higher productivity, enhanced collaboration and teamwork and the benefits of being immersed in an environment that has energy, activations and encourages motivation. With that in mind, Precinct's long-term strategy of creating spaces for clients to thrive has never been more important. The idea of having concentrated ownership of real estate, supported by high levels of amenity enhances our ability to attract occupied back to the office. Consistent with this strategy, we have launched Precinct's first loyalty program, the Commercial Bay Club, an app-based program which is exclusively for occupiers of Precinct buildings and Auckland's Commercial Bay. Our approach is simple. We plan to offer our occupies a range of benefits that are highly valued, attractive to every worker in our Precinct and ensure our community is thriving. This will, in turn, ensure that our clients remain in our buildings. And for them, help them with their productivity and help them drive value for their own shareholders. Launched in the last 6 months, we already have over 2,000 members who are benefiting from benefits such as week -- free weekly fitness classes, yoga classes, discounts through our Commercial Bay, VIP access to bars and restaurants as well as the monthly speaker series. Notwithstanding the obvious benefits of this loyalty program, we also see significant opportunity to capture data that this program will also offer us. In summary, our view is that this approach ensures that Precinct will have a relationship with every occupier of our buildings, not just the CEO or COO. We think this strategy will have huge benefit for Precinct, and we expect to broaden this offering for the balance of our portfolio over time. I'd now like to ask Richard to take you through the financial results.

Thank you, and good morning, everyone. As mentioned by Scott, total comprehensive income after tax for the half was $167.9 million. This compares to $53.6 million last year, with the difference relating to the strong revaluation gain of around $149 million. Operating income before indirect expenses was up 16% due to the recent completion of Commercial Bay. The completion of this project has also seen indirect expenses increase due to the lower level of capitalized interest and a high level of base management fees. The reintroduction of depreciation and structure and a favorable ruling in relation to contaminant expenditure has led to a positive tax outcome. Expenditure relating to the removal and encapsulation of contaminants as part of the demolition of building structure have been rolled as being deductible expenditure. Over the past 4 years, Precinct has spent $13 million on this type of expenditure, including site remediation at Wynyard, the demolition of the old Downtown Shopping Centre and significant works within the Wellington RFP assets. Turning to the next slide. Net property income increased 22% to $60.2 million, which was largely due to development completions. Pleasingly, despite multiple fitout and extended void periods throughout the Auckland portfolio, investment income remains stable. COVID continues to impact the business, with operating income for the period adversely impacted by $6 million. This impact can be broken down to both temporary timing differences relating to the occupation of Commercial Bay and other impacts. The delay in occupation of Commercial Bay resulted in income for both the tower and retail center being around $5 million lower than anticipated. It is important to note that this is a timing difference only. The lower income was partly offset by higher occupancy and income at HSBC Tower, ANZ Centre and the now decanted One Queen Street building. Precinct continues to help retail businesses impacted by COVID through a range of measures with $1 million of support provided. In addition to this, we are investing in marketing and promotion to support our retail clients. Precinct's operating businesses were also impacted by COVID lockdowns and delays. Generator operating income fell $1.7 million, while Commercial Bay Hospitality recorded a loss for the period of $800,000. Lastly, regarded 70% of our revenue coming from office occupiers, it is important to note that no further support was provided across our core office portfolio. Turning to the next slide. Funds from operations and adjusted funds from operations were both higher. FFO grew by 13%, while AFFO grew slightly less by around 7% due to higher leasing costs associated with elevated portfolio activity. The first half dividend of $0.0325 this share was 3% higher than the previous year, and reflected an AFFO payout ratio of 98%. Slide 13 provides a revaluation overview. The revaluation movement reflects a 5% increase on book values. Excluding development, the investment portfolio saw a 5.4% increase with Wellington assets recording an almost 8% uplift. Overall, cap rates across the office portfolio have firmed by 40 basis points to 4.9% with Wellington cap rate firming 60 basis points, driven by a strong investment market. This shift in sentiment has benefited the Wellington corporate assets with NTT Tower recording a 17% increase in value. The occupier market in Wellington remains strong with continued demand for quality, seismically resilient buildings and a growing government workforce. This demand has resulted in some market rental growth for the Wellington assets. In the Auckland, the revaluation reflected a 4.5% increase on both values, with cap rates firming 20 basis points and market rents remaining flat. Excluding Commercial Bay retail, which broadly remained unchanged, the Auckland office portfolio drove 6.6% revaluation gain. As at 31 December, the portfolio value totals around $3.3 billion, with Precinct's NAV per share at balance date increasing to $1.55. Turning to the next slide. We continue to take a proactive approach to capital management. Following the sale of ANZ Centre, gearing will reduce from 30% to 26%, putting this business in a strong position to deliver future developments. Total committed funding remains around $1.2 billion with a weighted average term to expiry, excluding the convertible note, of 3.8 years. We continue to look at capital sources, including further capital recycling opportunities. With the expectation that the convertible notes will be converted to equity, the mix liquidity equivalent we are focused on remains the maturity of the $75 million bond in December. Our weighted average interest rate has reduced to 3.7% of hedging levels remaining around 60%. Effective hedging levels will increase over the next 6 months due to forward starts and the sale of ANZ Centre. Interest coverage remains good at 2.1x against a covenant of 1.75x. Turning to Slide 15. It has been a busy period in relation to sustainability. We again improved our GRESB rating to above the global average, aligning with our Oceania peers who are global leaders in the space. Supporting this, we have achieved a CDP score of B-, meaning we are achieving to a management level. And have disclosed our TCFD risks, a commitment we made to shareholders last year. One of the key successes has been the establishment of a sustainable debt program. This program requires eligible assets to have a minimum 5 star Green Star rating or to have NABERSNZ energy rating greater than 4. Both these ratings are defined as meeting New Zealand's excellence levels. Finally, we continue to have confidence in our earnings outlook and the potential for further dividend growth. Our portfolio is well positioned, benefiting from quality occupiers underrenting a long WALT, high occupancy levels and less review structures that will generate earnings growth. These portfolio characteristics should also see our maintenance and leasing costs remain low for some time. The developments to be completed over the next couple of years will provide additional earnings accretion with an attractive average yield on cost of 6.4%. And lastly, we continue to target an EBITDA margin for Generator of between 10% to 15%, with COVID-related earnings reversion to come. And the business expanding in Wellington, it is expected that Generator will make a meaningful contribution to future AFFO. Thank you. I'll now hand over to George.

Thanks, Richard, and good morning. Turning to Section 2 and our markets on Page 18. As Scott noted, the city centers and Auckland, in particular, have borne the brunt of the impacts of COVID-19 in New Zealand. Not only have we had the loss of international visitors with the border closed, but local visitation to the city center is also down. The chart on the right-hand side overlays the last 12 months public transport use on the prior 12 months. And you can see the impact not only of the lockdown periods, but also the lag in recoveries post lockdown. Encouragingly, the data has shown a faster recovery from the second lockdown. However, for Auckland, we are still 30% to 40% down on the prior year, while Wellington was around 20% down. While these impacts are real, they are strong by comparison with Australian cities. We firmly believe these impacts are temporary and that the importance and economic value of city centers will be sustained and will recover. On a positive note, the Wellington market continues to be underpinned by strong demand from an increase in the public sector workforce. Since 2017, there has been an increase of 27%, which at the typical government full year ratio would equate to demand growth of over 80,000 square meters and will continue to underpin that market. Turning to Page 19. Both Auckland and Wellington are seeing robust levels of leasing activity, reflecting underlying business confidence, which has surprised on the upside. While the Auckland market has had increased vacancy, this is largely focused in secondary locations, which I will talk to further shortly. Wellington leasing demand remains solid with very low levels of prime vacancy. The shared workspace market is to be a beneficiary of the acceleration of current occupier trends towards greater flexibility and the need for a workspace to provide more than a desk. With a short tenure typical in this part of the market, it has also been much quicker to adapt to current workspace trends. This is reflected in the line half of our Generator occupiers overutilizing their private office space. For example, for having a 10 person office for a workforce of 15, with either split office days or supplementing their core office with the use of hop desks. While retail sales have outperformed expectations, prime city center retail is challenging. However, those retailers that have continued to perform strongly are focused on securing high-quality locations for their brands and retain a desire to have a city center presence. Turning to Page 20. Overall, Auckland city center office vacancy has increased by around 4 percentage points to sit close to 9%. But this is not reflective of the Commercial Bay submarket where we are mainly invested. The Commercial Bay Precinct vacancy remains tight at 2.9%. The depth of demand for this location is shown by the extent of leasing activity, which we have completed and the growth in rentals on new leasing, which I'll talk to you more shortly. We attribute this largely to the changing workplace trends where businesses are willing to pay a premium for the location of their choice with good benefits and amenities for their staff. Turning to Page 21. Strong occupier demand in Wellington continues to see solid rental growth and very low levels of prime vacancy. As Richard noted earlier, we have seen a strong uplift in Wellington valuations, which has been underpinned by some strong sales evidence. As outlined on Page 22, there has been extensive market commentary around the potential for a large amount of sublease space coming to market and the expectation that this could depress market rents. In Auckland, sublease activity has been concentrated in higher quality buildings around the CBD fringe, and the volume of space coming to market has been less than initially indicated. Our understanding is that several of the larger spaces available, have now been subleased, with the excess space being absorbed by businesses, which were struggling to secure suitable premises when we entered this current market price. Similarly in Wellington, we understand that the sublease space available in good buildings is being highly sought after and is not impacting our market rents. Within our own portfolio excluding ANZ Centre, we are not aware of any significant spaces which are being offered for sublease. At our last results, we mentioned 1 larger financial services occupier who is in the market to sublease their space. And I'm pleased to say that we have a greater surrender there to enable us to complete a new long-term lease with an existing client. Moving to Section 3. Our core office portfolio remains in very good shape. And despite the environment, we have had a busy leasing period with 11,300 square meters of leasing completed in our stabilized portfolio. Good quality businesses remain attractive to our assets and are showing the confidence to commit to new long-term leases. Pleasingly, we have continued to secure solid rental growth, with an average uplift on previous contract of around 8%. As set out on Page 25, our portfolio metrics remain very strong, with just 4% of the portfolio expiring this year and a weighted average lease term at 7.7 years. The strength of our core office portfolio continues to underpin our cash flows. And the quality of our occupiers is shown in the fact that we have no rental abatements whatsoever at our office portfolio for the 6-month period. Turning to Pages 26 and 27. We acknowledge that there's been a number of headwinds during the first 6 months of trading for Commercial Bay retail. But with this context, we are pleased with the sales performance. The impact of the city center lockdown and foot traffic, lack of international visitor spend as well as the major streetscape works, have made a read-through to the underlying performance challenging. We remain highly confident in the quality of Commercial Bay. And the current performance indicates that it will perform strongly as these markets recover. We were encouraged by a strong November/December trading period, and are seeing a continued strong sales performance from the Harbour Eats foothold as well as from international fashion retailers, in particular. Overall, we estimate that our sales are sitting around 15% to 20% lower than our pre COVID estimates after taking account of lockdown periods. Given that we expected international tourists to comprise around 30% of our sales and we've got less domestic city center visitors, we think this is a strong sales outcome and bodes well for how Commercial Bay retail will perform when markets improve. Turning now to our operating businesses on Pages 28 and 29, comprising our Commercial Bay Hospitality venues and Generator. The Commercial Bay Hospitality venues achieved successful openings in the circumstances, however, recorded a net loss of $700,000 after covering rent expenses. Before rent expense, business has made a positive contribution. And while we acknowledge the environment will remain challenging, we expect that these businesses will be stable over the next 12 months, and importantly, will continue to underpin the high-quality food and beverage offer at Commercial Bay. Generator has outperformed expectations over the last 6 months despite the impact of the second lockdown. The event business had a particularly strong period, considering it had to close during lockdowns, and had a November and December performance ahead of the prior year. Membership has contracted as anticipated, but is now back in growth mode with good levels of inquiry and sales. We retained a higher-than-expected number of members through delivering on the promise of flexibility and supporting as many as possible to downsize rather than leave. We are now seeing their growth return. We controlled expenses tightly, and we remain on track to breakeven over the full financial year. The business now has an improved quality of customer, who see Generator as their core business accommodation and value the flexibility and amenity that Generator provides. We're confident that Generator is on track for a profitable second half, and will continue to support Precinct's broader strategy of providing high levels of amenity as well as further earnings growth. Thank you, and I'll hand back to Scott.

Thanks, George. And turning to Page 31. The current committed development pipeline consists of 3 developments comprising Wynyard Quarter Stage Two and Bowen Campus Stage Two, which includes 40 and 44 Bowen Street. Combined, these developments total around 30,000 square meters of office space and provide the business with a blended development margin of over 23% and a blended yield on cost of around 6.4%. These developments are 60% precommitted as at balance date with Wynyard Stage Two now effectively completed with its office space fully leased. The next stage of our development pipeline consists of One Queen Street and Wynyard Quarter Stages 3 and 4, with anticipated returns of 15% margins and a minimum of a 6% yield. Most notably, as we advance our developments and successfully complete each project, we are enhancing the business and reducing the risk that the business carries. Moving to Wynyard Quarter Stage Two. 10 Madden Street, base build works are now complete, with clients fitout works currently underway. Media Design School will commence its operations from the site on March 1. And the U.S.-based tech firm, whose leased levels 5 and 6, is currently fitting out. Pleasingly the development will record a margin in excess of 15% with a yield on cost of around 7%. Bowen Campus Stage Two on Page 33 outlines a real success story for our business. The second stage is the final 4,000 square meters of land to be developed on this site following its initial acquisition in 2012. Bowen Stage Two consists of around 20,000 square meters of office space with a combined entry lobby and large low-rise floor plates. Initially designed and intended for Crown occupation, the corporate market has been attracted to this development due to its proximity to government, the seismic resilience of the design and the benefits the broader campus can provide. Most pleasingly, we are attracting high levels of interest from occupiers for the remaining vacant space, and the return metrics for this development look very promising. On Page 34, we now turn to One Queen Street. This development was initially designed and committed during 2018. However, following the emergence of COVID 12 months ago and taking advantage of the fact that we hadn't started construction, we worked with our main contractor to revisit the design and composition of the building. We remain incredibly excited about this project and the prospect of continuing to build a hotel here. However, our expectation is that once we commit, which is anticipated to be in the next 6 months, the hotel component will be much smaller with additional office and some dedicated flex space being introduced into the scheme. The revised composition of uses for One Queen Street is set out on Page 35 and highlights the reduction in hotel space for the project. We are now advancing with the scheme with revised design underway and a separate procurement process set to begin. And lastly, some concluding comments. There is no doubt that we remain in uncertain times. And the most recent lockdown last week is evidence of this. Despite this uncertainty, we remain convinced that the position of our portfolio with an 8-year weighted average lease term combined with the very highest quality occupier base will ensure that the business maintains and grows its AFFO and dividends. The clear strategy that we have had in place for a long time and the completion of over $1.5 billion in developments has ensured that our business presents low-risk defensive characteristics. The decision to target structured growth and own a very young portfolio of assets will ensure good growth as we progress into future periods. That brings us to the end of our presentation. We're more than happy to take any questions.

[Operator Instructions] Your first question comes from Arie Dekker from Jarden.

Just a couple of questions focused on the development slide that you just finished on. Firstly, with regards to One Queen Street. I mean, you mentioned you're going back out to tender on that. But in terms of the redesign, do you expect the cost to be broadly in line with what you previously indicated?

Yes, we do, Arie. I don't think that's going to change too much.

Sure. And then in terms of commitment by the end of calendar year, what sort of minimum level of precommits have you sort of set yourself in terms of -- to go ahead?

Yes, we've still got -- as we've announced previously, we still have an agreement with a large law firm, who remain really focused on moving into the building. And we're working through our commercial arrangements with InterContinental Group at the moment. So on the basis of admittedly a slightly smaller hotel but with the addition of that office commitment, we would actually be comfortable to go ahead based on the current level of commitment that we have. What we're really focused on at the moment is completing the redesign, which is underway, which is not extensive, but it is worth concluding that so that when we go out and get really firm tender bids, we can be certain that our design is advanced enough that there's not a lot of sort of risk around sort of cost increases throughout the project. So we're engaging with the subcontractor market through our main contractor quite extensively at the moment. We're trying to take advantage of the construction market. We do acknowledge that actually costs are starting to rise again. But we do think that if we go with a really clear package that we can get good property.

Yes. So it is really a process and confirmation of cost that is the remaining gating item to pressing the go button rather than leasing?

Yes. We're certainly focused on trying to get a cost plan that we're comfortable with, and that offers us really good prospects for returns that meet our hurdles.

Great. And then just with regards to 44 Bowen Street and I guess 40 as well. What's your sort of expectation? What is -- in terms of timing for an announcement of additional deals? And do you have something in mind in terms of where you'd like to be on commitments by the end of this calendar year?

Well, certainly, our expectation for 40 and 44 is that would be fully leased by completion. And if not fully leased, very close to it. And the engagement that we're having with the moment with occupiers suggest that we'll be able to achieve that. As it stands at the moment, we've got both Crown and corporate occupiers looking at that space, and we're really encouraged by that. We've got quite a lot more inquiries than we have space available. And so it's clear that, that market has a real thirst for high-quality space that's seismically resilient. And so we're benefiting from that at the moment. So look, I think by the end of this calendar year, we will have advanced quite a bit of leasing in this project.

Yes. I mean, you have a well-positioned site, obviously, and a good offering there. I mean, in terms of competitive tension for occupiers on the supply side, are you sort of noticing anything there that sort of increases the risk of sort of completing the leasing up or not?

Yes. I mean, the main -- the other main supplier that's coming. The most significant one is the old Caltex site, and that's fully leased. And then in addition to that, it's site 9 on the waterfront, which is a very small building, that's less than 5,000 square meters, and a large chunk of that has already gone. So there's not a lot of other uncommitted space that's coming to a market that could compete. So that, I think, puts us in a pretty strong position.

We would also just comment on that. The price point that we can offer to the market at Bowen as well within the price point of the waterfront locations, which is in our favor.

Your next question comes from Jeremy Kincaid from UBS.

Just firstly on COVID costs. You mentioned there's likely to be no further rent relief for the core office portfolio. But should we interpret that as there's still some more relief to be had in the retail portfolio going forward?

Jeremy, it's George here. So look, across -- that's correct. Across the office portfolio, we don't anticipate anything further. Across both office and retail, obviously, we're in an environment of uncertainty as regarding lockdowns, and we have to respond to that. As it currently stands we have only a very small number of retailers who we would be providing further relief to. But obviously, we'll have to respond to what happens over the next 12 months or so.