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

Thank you for standing by, and welcome to the Precinct Properties 2022 Half Year Results Conference Call. [Operator Instructions] I would now like to hand the conference over to Mr. Scott Pritchard, CEO. Please go ahead.

Thank you, Kaley, and good morning, everyone, and welcome to the 2022 half year results briefing for Precinct Properties. I'm Scott Pritchard, and I'm joined by George Crawford, Precinct's Deputy Chief Executive; and Richard Hilder, Precinct's Chief Financial Officer. Somewhat similar to previous announcements, the first half of the 2022 financial period has been dominated by the impacts of COVID with prolonged lockdowns impacting on our portfolio, in particular, our retailers, our hospitality venues and event spaces. Despite those headwinds, the performance of the core office portfolio has been very strong, supported by our high-quality occupiers and a resilient office market. 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 results before reviewing our progress against our strategy. George will provide an overview of the transaction announced today with the Singaporean Sovereign Wealth Fund, GIC, before I provide some commentary on the key themes we are seeing at Precinct. I'll then hand over to Richard, who will take us through the interim results and our capital management position. George will summarize our markets and our portfolio performance, and I'll then provide an update on our development activities and finish with some concluding comments. Upon completion of the presentation, we will be very happy to answer any questions that you might have. Moving to the highlights page. Undoubtedly, the most pleasing outcome of today's announcement is the launch of our investment partnership with the Singaporean Sovereign Wealth Fund, GIC. As outlined at the annual results in August last year, we identified that utilizing third-party capital was a logical next step in Precinct's strategy. So it is really pleasing to be announcing our first step into this arena at today's result. George will provide more details on the partnership shortly. Also pleasing has been the resilience in our earnings, with net property income growing by 1.5% in the period, despite us providing $5.5 million in rental support to those occupiers in the portfolio who are entitled to it, but also those occupiers in our portfolio who we believe needed the support during the past 6 months. In light of the resilience that we've seen in our portfolio, we are delighted to reconfirm our dividend guidance for the year at $0.067 per share, acknowledging that the extent of support offered to some of our occupiers over the past 6 months and also likely in the next 6 months are expected to be one-off costs, which we don't foresee continuing beyond the 2022 financial year. Following the announcement today of our new investment partnership, our balance sheet has been considerably strengthened with our gearing reducing by 12 percentage points, providing Precinct with significant capacity to take advantage of market opportunities. And finally, on this slide, the performance of our investment portfolio and development activities have continued to demonstrate the benefits of owning premium grade real estate and how these types of assets continue to attract occupiers through different stages of the market. We remain really buoyed by the growth in rents that we are achieving on our leasing deals, and we do not see the market for premium grade real estate changing anytime soon. Turning to Page 4. Precinct has benefited from a well-established and clear strategy for some time. This slide outlines how our strategy will evolve, but we'll continue to focus on our 3 key pillars, including operational excellence, developing the future, but then focusing on our people and now adding our partners. Through our partners, we will access alternate forms of capital, which will allow us to participate in more market opportunities and allows us to leverage our market position and our capability. The result of this should be enhanced returns on our capital invested. Slide 5 provides an overview of how our strategy has evolved over the past decade and the key milestones along the way. Most importantly, since we internalized in March last year, we have been focused on reviewing our strategy and sourcing partners and capital, which will enable us to grow. We now have alternative forms of capital besides the equity capital market that we can access in order to participate in a wider range of market opportunities. This initiative announced today is the first step in this direction. Slide 6 provides more detail of our progress relative to our 3 key pillars. Operationally, we continue to see our main markets remaining very strong despite the challenges of COVID. In the past 12 months, we have completed significantly more leasing than our annual average, demonstrating the strength of our markets. Our commitment to sustainability continues as we maintain our group's score above the global average and are pleased with our disclosure scores, which Rich will discuss shortly. And we continue to progress our developments with the completion of our Generator building in Wellington, the significant pre-leasing of our developments and the ongoing investment in our people, who we continue to see as our key competitive advantage. I'll now hand over to George to take you through some more detail about the investment partnership.

Thanks, Scott. As we highlighted in our annual results in August, following internalization, we were considering how our strategy might evolve in a way that is consistent with our city center specialist focus and strength in developing high-quality and well-leased assets. We identified that we were considering partnering with third-party capital on both active and passive opportunities. We're pleased to announce today that we have achieved significant progress on this strategy with the formation of the investment partnership with GIC. The partnership has conditionally agreed to acquire 5 of Precinct's recently completed assets for $590 million, with the ability to further grow the partnership to around $1 billion potentially through Precinct's pipeline. The assets are being sold into the partnership at present valuations, and we will continue to own a 24.9% interest in the properties. Precinct will manage the partnership and the properties under market-based funds management and property management fee arrangements. This is a major step for the business and will position us with capital to invest in further opportunities as well as being earnings enhancing through the funds management income. In the short term, this fee income and the reduction in interest costs will offset the dilution from asset sales. In the medium term, as we use the capital from the assets we are selling at an average yield in the mid-4s to fund developments, which are yielding on average 6%, that will drive strongly enhanced returns on capital. As highlighted on Page 9, following this transaction, our gearing will reduce from 31.8% to around 20%, providing significant investment capacity. Our portfolio metrics will remain strong. And while our WALT reduces initially by around 1 year. With our development WALT sitting at 16 years, this will soon increase again. The transaction remains conditional on various consents. We expect the conditions to be satisfied around the middle of the year with settlement, therefore, not expected until next financial year. We're excited about this partnership with GIC and the potential that the continued execution of this strategy has for the growth of Precinct. In addition to exploring further opportunities, we are investigating the possibility of moving to a stable structure to support this business strategy. Thank you, and I'll hand back to Scott.

Thanks, George. Page 11 sets out the major themes we are facing, which remain broadly consistent with the themes identified in August last year at our annual results. Occupied trends are becoming very clear. While employers are offering increased levels of flexibility to their workforce, it is very evident that they also see the office as a key contributor to workplace culture and is a key tool for retention of talent and attracting new talent. We have seen elevated levels of leasing, which supports this view. The construction market has come under more pressure in the past 6 months with supply chain issues, labor shortages and significant demand, particularly from the public sector. More on this shortly. Inflation has continued to emerge as a major threat to asset values as central banks around the world look to increase rates to try and curb inflation. Our view is that it is critical to be adding value through this stage of the economic cycle by development activities and the use of third-party capital to capture upside in order to outperform inflation. And finally, for this slide, it is clear that New Zealand's main city centers have been severely impacted by COVID. We remain convinced that they will prevail, but it is worth acknowledging that they continue to be the most impacted sector from COVID. Following on with the occupied trends theme, Page 12 sets out some relevant data representing the impacts of COVID on the occupier market. We saw a material reduction in workers and offices in the back half of last year when we were placed into Level 4. Similarly, following the emergence of Omicron this year, we estimate that we have around 30% to 40% physical occupancy in our portfolio currently. Despite that, the chart on the bottom right demonstrates the extent of leasing achieved over the past 12 months. The 2021 calendar year has been our second highest on record with over 50,000 square meters of space leased and amidst a pandemic. As discussed previously, construction costs have increased significantly over the past 12 months, which has accelerated a trend, which had been occurring over the past 5 to 6 years. As evidenced by the charts on the right-hand side and highlighted best at our Wynyard Quarter developments, where we've seen our average cost of construction increase from around $3,500 per square meter in Stage 1, up to over $5,000 per square meter for the later stage that we have just begun. This is a material increase and reflects the challenges that the construction sector is facing. And finally, our city centers. We have seen foot traffic materially reduced in the city centers, and our retailers and hospitality venues have been impacted significantly. While both city centers are being impacted from a lack of people working in the city or visiting the city, the drivers for office space in each market are materially different. In Auckland, as mentioned, we are seeing corporates really prioritize this staff and are identifying premium grade office space as a lever to attract staff back into the office. Whereas in Wellington, we continue to see significant growth in government employees, which is underpinning this market and driving demand for more prime grade space that is seismically resilient. Given the lack of this type of space in Wellington, we continue to see value in this market for new office developments. I'd now like to ask Richard to take you through the financial results.

Thank you, and good morning, everyone. Total operating income after tax for the half was $40.7 million. This was down on the comparable period due to last year's significant revaluation gain. An internal review of the 2021 property valuation undertaking December indicated no material value movement in the period. It is important to note, however, that across our committed development, there remains around $145 million of unrecognized value, which will be released as projects progress. Operating income before income tax rose 5.9% to $45.5 million. A key contributor to this was the material reduction in management expenses following last year's internalization. Tax expense for the period was positive due to COVID abatements and the disposal of fixtures and fittings and the removal of contaminants at One Queen Street. Turning to the next slide. Before accounting for COVID abatements, investment property income increased 10% to $59.9 million, due largely to PwC Tower being fully income-producing. Recent development completions and acquisitions helped offset the impact from selling ANZ Centre and lifted total net property income to $66.7 million. Lockdowns and prolonged restrictions have uncatered several of Precinct's retailers and hospitality venues. COVID-related rental support provided to retailers during the period totaled $4.2 million. In addition to the support, there was a further $1.3 million of contractual abatements within the office portfolio. Support for impacted businesses, in particular retailers, remains ongoing. Precinct's operating businesses have also been impacted by continued disruptions. Generator's event business was heavily impacted, recorded an operating loss of $800,000, while Commercial Bay Hospitality recorded a loss in the period of $1.3 million due to the closure of Saxon & Parole and the prolonged restrictions. Turning to the next slide. Both funds from operations and adjusted funds from operations were lower than the comparable period. This was ultimately due to the level of COVID support provided. Total support, including the impacts on our operating businesses totaled around $7 million or 30 basis points per share, allowing for the level of abatement. Underlying AFFO and our dividend paying capacity remains very positive. The first half dividend of $0.0335 per share reflected an AFFO payout ratio of 104%. This level of payout is consistent with our policy of paying around 100% of AFFO and maintaining a sustainable long-term dividend. Turning to the next slide. The balance sheet continues to be repositioned. During the period, we elected to convert the convertible notes to equity and committed to a new $300 million bank debt facility. The new facility takes total committed funding to $1.6 billion, with the weighted average term to expiry of 3.9 years. Overall, Precinct has around $500 million of liquidity available, which is sufficient to fund all current committed projects. The announcement today to establish an investment partnership will further reposition our balance sheet and will improve our balance sheet utilization. As noted by George, the transaction will initially be used to repay bank debt and will reduce 31% both pro forma year-end to around 20%. This transaction provides the business with significant capital for future opportunities and growth. Our weighted average interest rate is currently 3.5% with hedging levels around 55%. Following the settlement of the investment partnership, hedging levels will increase to over 80%. Interest coverage remains good at 2.5x against a covenant of 2x. Turning to Slide 20. ESG remains a key focus for the business, demonstrated by the establishment of the Board ESG committee and another strong derivative score. Importantly, we have been recognized by GRESB as having a high level of ESG public disclosure, receiving a public disclosure score of A. The commitment to Wynyard Quarter Stage 3 has seen the value of our green assets increase to $2.3 billion. For Precinct, green assets are those eligible assets that have a minimum 5-star Green Star rating or has a NABERSNZ energy rating greater than 4. Given the good progress we intend on lifting our TCFD target during the year, with a focus on energy efficiency and meeting or exceeding New Zealand's excellence levels. Finally, we continue to have confidence in our earnings outlook and the potential for further dividend growth. Despite rising interest rates, we have a well-positioned portfolio that benefits from under-renting and structured reviews. In addition, our committed developments will provide additional earnings accretion with an attractive yield on cost of around 6%. The establishment of the investment partnership signals a shift in Precinct's strategy, providing us with new opportunities to grow earnings. Importantly, this transaction is initially earnings neutral for Precinct due to the portfolio's low initial yield and the offsetting interest expense savings in cornerstone and management fee income. Because of this, we anticipate that once the proceeds are reinvested, there will be material earnings growth for Precinct. Thank you. I will now hand over to George.

Thanks, Richard. Turning to Page 23. Over the last 6 months, we've seen a divergence between the city center office and retail markets. While office markets have continued to recover, underpinned by increased occupier investment in office workspace, city center retail has been bearing the brunt of lockdowns and restrictions. Unfortunately, in addition to the impact from last year's locked on, Omicron has been a further setback. However, despite this and perhaps reflecting that overseas markets are further along than NZ and emerging from the pandemic, there is interest from multinational retailers and high-profile city center sites. Turning to Page 24. Open city center office continues to experience good demand. However, the trend towards a 2-tier market for location and building quality that we identified at our full year result has continued and strengthened. The market has returned to a net absorption position with rental growth returning for prime buildings. Turning to Page 25. The Wellington market continues to perform well with low vacancy and continued strong demand, particularly from the government sector. This is clearly translating into market rental growth recorded at 5.1% year-on-year as of December, and it supports our strategy of having increased investment in Wellington development opportunities over the last 2 years. Moving to Section 3, operations on Page 26. As Scott noted in the introduction, we've had an exceptionally strong office leasing period with over 21,000 square meters leased at very good levels. Across both new leases and renewals, we have seen strong growth in rental levels, up 10.9% overall on new leases against prior contracted rents. Finally, as noted on Page 27, the portfolio continues to be underpinned by very strong metrics with high levels of occupancy, limited expiry in the short term and the high-quality client base. Thank you, and I'll hand back to Scott.

Thanks, George. And turning to Page 30. The current committed development pipeline consists of 6 developments comprising, Bowen Campus Stage 2, including 40 and 44 Bowen Street, Willis Lane, Bowen House, the Deloitte Centre in Auckland and the third stage of Wynyard quarter, 124 Halsey Street. Combined, these developments total around 64,000 square meters of space and provide the business with a blended development margin of 20% and a blended yield on cost of 6%. These developments are 79% pre-committed as at balance date with Wynyard Stage 3 only just commenced on a fully uncommitted basis. The total pipeline under construction is $1 billion in value on completion. Bowen Campus Stage 2, on Page 31, continues to progress very well. This project consists of around 20,000 square meters of office space with a combined entry lobby and large low-rise floor plates. Following further leasing to high-quality law firms in the period, we are now 96% leased and are on track to complete the project on time and on budget. This will provide Precinct with a completed development with returns equivalent to 30% development margin and a 6.5% yield on cost. On Page 32, we now turn to the Deloitte Centre. This project is progressing well and is now 91% committed, following leasing with Bell Gully in Deloitte and following the commitment by InterContinental Hotel Group to manage the hotel on our behalf. Construction is progressing well. And despite lockdowns in the back half of last year, the project remains on track to meet its program milestones with completion set for late 2023. The project offers a 22% development margin and a 6.2% yield on cost. Wynyard Stage 3 is now underway with the piling rig on site and construction starting in earnest. We have begun engagement with occupiers and expect to be well advanced with our leasing ahead of completion in late '24. The project will offer us a yield on cost of 5.75% once fully leased. And the remainder of our developments continue to progress with Bowen House well underway. Willis Lane about to get started in the Freyberg Building underway with design. Bowen House and Willis Lane are both committed developments and are underway while Freyberg remains as an uncommitted development until we advance design and feasibility. And lastly, some concluding comments. Today is a big day for Precinct as it marks another key milestone in the evolution of our business. As we have worked through our 2020 vision and delivered what we said we would deliver, it is refreshing to be able to launch a revised strategy, which will see Precinct participate in more opportunities and look to create value for our shareholders and also our partners. Precinct is in a strong position, and we believe we are well placed to outperform during these uncertain times. And due to that confidence and acknowledging that we are choosing to support many of our retailers, we remain committed to our dividend of $0.067 per share, and we feel very confident about continued growth in our AFFO profile. That brings us to the end of our presentation, and we're more than happy to take any questions that you might have.

[Operator Instructions] Your first question comes from Nick Mar with Macquarie.

Just on the partnership. Can you just talk about the valuation of that $590 0million versus book value?

George here. So the valuations that the assets are being sold is our book values, so based on the independent valuations at 30 June 2021.

With just a couple of differences, I think I added up about $578 million or something. So is there a little bit here and there that makes the difference?

There are a couple of differences, which relates just to -- on our Wellington assets, where there are arrangements that we have in place, which you may recall around the WAP2 leasing that we did in 2016. And so that results in it being slightly higher than those independent valuations, but it's basically to account for that difference.

No, that's great. And then kind of logically, would it make sense that some of the assets that are similar at Wynyard and Bowen, that are currently under development, would sort of look to go into that over time to make it up towards that $1 billion?

Yes, that's what we have in mind. So those types of assets, which are similar to the assets that are in the initial portfolio, that's where GIC is particularly interested in that sort of profile. So that would be the logical assets to move in, in the future.

And then, again, you might not want to disclose the fee structure, which is there. But in terms of that fund, where are you thinking of gearing it under the structure?

Yes. So in terms of the overall structure, we expect it to be in a range of 50% to 60% loan-to-value ratio. And looking at this portfolio, the long lease terms and the quality of the underlying covenants, we're comfortable with that level of gearing.

[Operator Instructions] Your next question comes from Jeremy Kincaid with UBS.

Just one question for me, a follow-on from Nick's questions. What's the end goal with the strategy? Do you think fast forward 10 years from now, you'll be 100% a fund manager? Or do you think you'll go down more of a dual strategy, where you do own some of the assets, but you also have the funds management business on the side?

Look, I think this is our first step, Jeremy. So at this stage, we're sort of not really ruling anything in or anything out. We really like the idea of GIC as a partner. They're very well aligned with us. And what we're seeing in the market is kind of more opportunities than we have the capital available to participate in. So finding alternate sources that allow us to participate in those opportunities is what we're really focused on. I wouldn't rule out us having other partners in the future. But I do probably see us always holding some real estate on balance sheet as well.

Your next question comes from Rohan Koreman-Smit with Forsyth Barr.

Just a question on the deferred tax selling assets that -- some of them, a couple of here that you've owned for a while. I was just wondering if there's any impost in terms of capital you have to repay, given we can now just depreciate structure, et cetera?

Yes, there will be the depreciation recovery on sale. We've got a provision for that. I think that the provision is around about [ $30 million ]. But there will be no cash payment for that. It will be obviously against the losses of the group that we have already.

And I'm just wondering, I know it's early in the year, but how is leasing at the moment? Is it a bit of a quiet patch while we get through the Omicron wave? Or are you still seeing people kind of wanting to move to quality buildings despite what's happening at the moment?

It's really strong, Rohan, if I'm honest. There's a handful of parties that we're already talking to about Wynyard Stage 3. So we've got 1 or 2 vacancies in the Auckland portfolio and Wellington basically full. So we're seeing real strength. And what we're seeing is kind of what we've been trying to sort of explain for a while is that businesses are really focused on getting into space that allows them to attract their workers back into the office. And I would say that kind of the thematic strengthened in the last 6 months rather than retreated. And our expectation is that it will continue along that way. Today's announcement that in the period, we've had 11% growth in our contract rents on new leasing, that's off a 2-year cycle. So that implies the annual growth that we're sort of seeing in our contract rents.

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

Thanks, Kaley. And look, thanks, everyone, for dialing in today. Obviously, a key announcement for us as well as announcing a half year result that we're really proud of. I think key to our results today has been continuing to support our occupiers and choosing to do that, and which I think is the right thing for us to do. Thanks for your support, and feel free to sort of send us any questions if you have any after the call. Thanks, everyone.

That does conclude our conference for today. Thank you for participating. You may now disconnect.