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

Thank you for standing by, and welcome to the Precinct Properties 2023 Full Year Results Call. [Operator Instructions] I would now like to hand the conference over to Mr. Scott Pritchard, CEO. Please go ahead.

Thank you, Harmony, and good morning, everyone, and welcome to the 2023 annual results briefing for Precinct. I'm joined today by George Crawford, Precinct's Deputy CEO; and Richard Hilder, Precinct's CFO. 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 touching on some major themes in reviewing Precinct's strategic progress. I'll then hand over to Richard, who will cover the financial result before George provides an overview of our capital partnerships and our investment performance. Following that, I'll cover off our development progress and offer some concluding comments. As usual, we'll be delighted to answer any questions that you might have at the conclusion of the call. Moving to the strategic highlights slide. Precinct has made significant progress over the past 12 months with now $1.8 billion of capital partnerships established. During the year, new partnerships totaling $1.4 billion have been secured. To enable our new strategy and retain the benefits of the prior regime, Precinct to moved to a stapled structure effective in July this year. In the period, total transactions of $180 million have occurred, including the sale of our development project at Wynyard Quarter Stage 3 to GIC and the sale of 40 and 44 Bowen Street to our partnership with private asset manager, PAG. George will provide more details of our capital partnerships shortly. We've also established our position in the multiunit residential market with the entry into a 50-50 JV with Tim and Andrew Lamont forming Precinct Properties Residential Limited. We are excited about this opportunity and the potential benefits for Precinct into the future. Supporting our continued approach to growing our capital partnerships as the capital management initiative announced today regarding consideration for the issuance of a subordinated convertible note. Turning to highlights operationally. We're very pleased with the performance over the past 12 months. Portfolio occupancy remains at elevated levels with 99% occupancy and a weighted average lease term of 6 years. Significant leasing progress has been made in the last 12 months with over 53,000 square meters of space leased, including leasing to Beca into the Ministry for Foreign Affairs and Trades. Most pleasing has been the strength of demand for our investment portfolio, resulting in almost 14% re-leasing spreads. This has underpinned our operating results with our AFFO improved to $0.0669 per share, an increase of 2.8%. With the continued growth of AFFO, we have delivered a payout ratio of 100% and further demonstrated the trajectory of Precinct's dividend. In the period, we have commenced works at 61 Molesworth Street, a new office development in Wellington as well as commenced works on 117 Pakenham Street to enable occupation by Beca at Wynyard Quarter. And of course, we remain very excited about the prospect of developing the Downtown Carpark building in Auckland. We remain in exclusive negotiations with Eke Panuku and expect to have these negotiations concluded in the near term. Turning to Page 5. Our 3 key pillars of focus remains on our people and our partners, operational excellence and developing the future. Through these pillars, we believe that we have 3 key areas to deliver outperformance for shareholders. Firstly, our investment portfolio and a continued focus on owning premium grade office space. Our portfolio of assets continues to perform well, attracting significant demand from the market and generating strong growth in portfolio rentals. Secondly, our development track record and the opportunity to utilize our development activity for our benefit and for the benefit of our capital partners. We believe our ability to continue to create premium grade real estate through our development as a key feature in growing our capital partnerships into the future. And finally, those partnerships. We're thrilled at the pace of growth and the progress made in the past 18 months. With interest rates rising and return requirements changing, we continue to believe that having the right partners and retaining a disciplined approach to investment returns are key to maintaining momentum. Page 6 sets out a summary of the key themes which we are observing in our markets. The occupier market for premium grade space continues to perform incredibly well with continued demand from office occupiers. Most interesting has been the performance of Auckland and Wellington office market compared to other markets in Australasia. Both Auckland and Wellington had cyclically low vacancy levels with only limited supply forecast. Supporting occupier demand has been the continued return to the office for office space workers. This theme is more pronounced than prime markets, but clearly evident based on our own portfolio performance. The investment market has been impacted by higher interest rates as a consequence of higher inflation. Our own result announced today recording a near 70 basis point softening in cap rates as evidence of the valuation declines across the market. With cap rates having previously compressed to record lows it is now the ability to generate rental growth which will set apart prime grade assets and secondary assets in the near future. We expect further cap rate softening and are encouraged by the rental growth that we are achieving to partially mitigate the impacts of this. The construction market remains under some pressure given elevated levels of activity. However, with project feasibilities becoming challenging due to softening cap rates and higher funding costs the market is beginning to show more eagerness regarding future work. The extensive competition in the vertical construction market will depend on how many government-sponsored projects commence in the next few years. And finally, third-party capital continues to be a key theme for our business and for the market we're now operating in. Importantly, like all participants in the market, direct investors are regularly reviewing their return requirements and reassessing the types of opportunities that they're seeking from the market. Our view is that long WALT assets are less preferred currently and there's a preference for value-add and development opportunities for specific types of real estate. We will continue to work with our partners to meet their requirements and support the growth of Precinct's capital partnership base. I'd now like to hand over to Richard to take you through the financial results.

Thank you, and good morning, everyone. Precinct reported a loss for the period of $147.5 million. This was down on the comparable period due to the nonoperating revaluation loss on the investment properties. Consistent to the half year operating performance remains robust and continues to improve with operating income before indirect expenses increasing $11.6 million. Despite an increase in interest expense, positive contributions from our investment portfolio generator and management income led to operating income before income tax increasing by $6.8 million. And finally, the devaluation movement of around $250 million saw net tangible assets reduced $0.16 to $1.38. Turning to [indiscernible] Net property income increased $5.6 million to $130.2 million. After adjusting for COVID support and recent transactions, normalized property income grew 3.1%. With around 60% of Precinct's investment portfolio income coming from its Auckland office buildings, it was pleasing to see income growth of 5% for these assets. Commercial Bay trading performance improved substantially in the period with foot traffic and turnover increasing 54% and 62%, respectively. This improvement generated a 67% lift in income relative to the comparable period. However, after allowing for FY '22 support, income growth was largely flat. With the completion of 1 Queen Street in FY '24, and tourism steadily recovering we anticipate trading performance will continue to improve over the next 12 to 18 months. As noted earlier, Precinct's operating businesses have made a material contribution to this year's operating income growth. Compared to the comparable period, the combined EBITDA was around $4.5 million higher with generators on site recently opening overall membership occupancy at year-end was 74%, providing the potential for future earnings growth. Turning to the next slide. Funds from operations for the period were $0.719 per share, while adjusted funds from operations, which measures our dividend paying capacity was $0.0669 per share. This was a strong result and demonstrates the benefit of our partnership strategy with management fee income, combined with Cornerstone income, helping deliver this performance. The FY '23 dividend of $0.067 per share was unchanged from the previous period. This is a good outcome. Despite the impacts from COVID and rising interest rates, Precinct has managed to grow its dividend since 2019 by around 12%. This dividend stability and growth has stood Precinct apart and demonstrates the quality of our revenue and assets combined with the benefits generated from our strategy. Slide 11 provides a valuation overview. The revaluation movement reflected a 7% decrease on book values, excluding developments, the investment portfolio shown 8% decrease. Overall, cap rates across the office portfolio have softened 70 basis points to 5.5%. And with Wellington cap rates softening 60 basis points. As mentioned in February, the Wellington occupier market remains robust due to demand for quality space and seismically resilient buildings. This demand resulted in Wellington market rental growth of 10%, which helped offset the 4% of cap rate movement. In Auckland, the revaluation movement reflected a 9% decrease on book value with office cap rates softening around 75 basis points. Consistent to Wellington, a strong occupier market and demand for prime office space led to a 5% uplift in Auckland market rents. The value of Commercial Bay retail was impaired by around 12% due to cap rate expansion, but also lower assumed market rents. As at 30 June, the portfolio value totals $3.3 billion. Moving to capital management. It has been a very busy 12 months for the business with the activity over the period, repositioning the balance sheet at year-end. Including the sale of 40 and 44 Bowen Street that settled in August we have sold around $680 million of assets. Importantly, we have retained a minority interest in these high-quality assets, providing future management fee income. After allowing for the sale of 40 and 44 Bowen Street, gearing at 30 June was around 35%, well below our banking covenant of 50%. On the same basis, hedging increased from 70% to around 85%. Consistent with the interest rate environment, our weighted average interest rate increased to 5.6% as at 30 June. Again, after factoring in the repayment of floating debt from the proceeds of 40 and 44 Bowen, our average debt cost reduces to around 5.3%. Reflecting our proactive approach to capital management and the level of development activity that was occurring during FY '23, we have agreed with our borrowing group to permanently reduce the interest coverage ratio covenant to 1.75x. Looking forward, we forecast interest coverage to improve due to recent sales, development completions and management fee income. We continue to be well funded with a [indiscernible] debt maturity profile and a diverse source of funding. However, as we progress our third-party capital strategy, it is anticipated that we will rely more on banks within those off-balance sheet platforms. Given this, we have an objective to increase Precinct's weighting to nonbank funding. Consistent with this and turning to the next slide, Precinct has today announced that it is considering an offer of between $150 million and $200 million of fixed-rate subordinated convertible notes. These notes provide Precinct both strategic and capital management benefits. The main benefit relates to the semi permanent nature of the notes, which will allow us to advance our partnership strategy. For instance, it enables us to warehouse property for future partners or participate in opportunities with our existing partners as they arise or to progress our residential development strategy. Importantly, should further opportunities not eventuate or as developments complete and are sold on market or into partnerships Precinct maintains the flexibility to repay the notes in cash. We previously issued this form of capital in 2017. At that time, they allowed the business to grow and execute strategy. This remains true today. However, with the additional benefit of being able to invest the capital into opportunities that provide higher investment returns. In addition to the strategic benefits, the notes will reduce our gearing as measured under our borrowing covenants, which disregards subordinated debt to around 29%. The notes will also reduce our exposure to bank debt increased FY '24 hedging levels to around 100% and support a added debt maturity profile. Turning to dividend guidance. We have announced today an FY '24 dividend of $0.675 per share. Despite rising interest rates, we have a well-positioned portfolio with underrenting of 11% and an average annual rental growth for FY '24 of 3.3%. These portfolio features combined with an improving operating environment, growth and third-party capital strategy and attractive development returns give us confidence in our earnings outlook. We are forecasting that PP NZ will contribute around $0.059 per share to the Precinct Group AFFO with a flat tax expense forecast for the period. Precinct investments should contribute the balance with an effective tax expense ranging between 15% and 20%. Lastly, ESG. We continue to make good progress. During the year, we became a signatory to the World Green Building Council Net Zero Carbon Commitment. This commitment is to achieve net zero carbon emissions for all buildings under our direct operational control by 2030. Looking forward, we are focused on social initiatives, particularly in relation to developments and on climate change scenarios. We are underway with technical work to better understand the impact of these scenarios on our business, and we look forward to sharing this with you in the future. Thank you. I will now hand over to George.

Thank you, Richard. Good morning, everyone. On Page 17, we lay out a summary of our capital partnering strategy. Fundamentally, this strategy is about leveraging the market position, capabilities and quality portfolio that Precinct has established through our track record of city center investment and development. By investing alongside capital partners, we create alignment. And by being a local partner with deep market knowledge, we aim to provide our partners with superior investment performance. The key benefit for Precinct is an improved return on equity. We can use our balance sheet more effectively and participate in a greater range of value-add activities alongside partners capital. The chart on the right-hand side indicates the range of returns we are seeking across our activities which exceeds our cost of equity. As shown in this chart, it also provides a premium over the cost of the convertible note issue that we are considering. These target returns across a range of investment activities show the disciplined approach we're adopting to capital allocation and the level of returns we need to achieve to continue to attract partner capital. On Page 18, we acknowledge that the interest rate environment means investment markets are difficult and global concerns around future demand for office mean it is a less preferred sector. However, the quality of our real estate and disciplined approach to generating returns has meant we've been able to maintain momentum in our capital partnering strategy. Key highlights of the past year have been agreeing the sales of Precinct developed Wynyard Quarter Stage 3 and 40 and 44 Bowen into partnerships. These transactions are a testament to ongoing demand for the quality assets that our development business creates. The returns required for investment capital have continued to increase materially which means capital is looking for clear value creation. The joint venture we established with Ngati Whatua Orakei and partnership with PAG as a strong example of the more complex opportunities we are pursuing to create value. Page 19 summarizes the growth and the scale of our operations with Precinct direct and indirect assets now totaling $5.2 billion. On Page 20, in addition to discipline on required returns, we have a focused and achievable growth goal for our capital partnering strategy. This growth path moves us from our current partnerships of $1.8 billion, through to around $4 billion to $5 billion. As I've just outlined, we're focused on building strong relationships with our existing capital partners, and this is key to our growth opportunity. Our residential development platform provides additional growth, recognizing that this is a semipermanent project capital, which will cycle [ and the night ] as projects are committed, complete and then settled. Finally, we intend that the Downtown Carpark development will be undertaken alongside partner capital. Scott will update more on this opportunity shortly. Moving through to investment update. Office leasing demand over the last year has been very strong in Auckland and Wellington with these markets being standards across the region. Strong demand for quality office space to attract employees back into the office, combined with limited new supply has translated to high levels of leasing activity and substantial rental growth. Across the portfolio, we've seen a 13.8% re-leasing spread, equating to a CAGR of 4.6%. With the portfolio 10.6% under rented, and as Richard mentioned, valuation rentals over the last year, growing by over 8%, further rental growth looks likely. For Auckland, as set out on Page 23, the prime market continues to strengthen with absorption driving vacancy rates lower. This contrasts with the secondary market, primarily in the Midtown area, where locational preferences and poor quality buildings are seeing vacancy levels continue to increase. In Wellington, the market remains very tight. While vacancy has increased slightly, this reflects an increase in stock from recent completions, including the return of [ Astron ] host of the market. Our understanding is that available space in these buildings as meaning strong demand and supporting market rental levels. While news headlines are filled the stories of demise of the office market, we believe the fundamentals of our office markets are quite different and indicate undergoing demand and rental growth. These key themes are further explored on Pages 25 and Page 26. Firstly, in the top chart on Page 25, the levels of new supply in our markets over the last 10 years have been well balanced by stock withdrawals. This is particularly the case for Wellington following the 2016 Kaikoura earthquake. Secondly, the return to office post-pandemic has seen physical occupancy across most buildings returned to close to pre-pandemic levels. This is shown through access card data as well as through the volume of leasing transactions. Third, under shown in the bottom right-hand chart, compared to inflation, rents remain affordable, indicating potential for continued growth to be sustained as vacancy levels are lower. Fourth and on the next slide, and this is probably most significant. We have limited levels of new supply in the pipeline and the economic rents required to create new supply have significantly increased. The key drivers of the left and economic rents are construction costs and higher funding costs. Combining this with investor preference for sectors other than office means that the suppressed supply outlook is likely to persist. The top right-hand chart provides an economic rent analysis for 188 Quay Street showing a spread of 30% between the economic rent and current market, a fame which should continue to underpin Precinct's performance. Thank you, and I'll hand back to Scott.

Thanks, George, and turning to the development section. Page 28 sets out an overview of the development portfolio with over 74,000 square meters of development under construction valued at over $1 billion. Across these developments, pre-leasing has been advanced to now sit at 90%. Over the past 6 years, Precinct has successfully completed $1.8 billion in development projects. The most recent completions being Bowen Campus Stage 2 and Willis Lane, both in Wellington. The commencement of 61 Molesworth Street in Wellington and 117 Pakenham Street at Wynyard Quarter in Auckland, have replenished the pipeline with further smaller residential projects anticipated starting later this year. Over the page, specific details are provided for each of 1 Queen Street, Molesworth Street, Wynyard Quarter Stage 3 and Bowen House in Wellington. The next development completion that we anticipate will be 1 Queen Street, where we're expecting practical completion now in early 2024. Page 30 provides a quick update on the Downtown Carpark redevelopment opportunity. While we were hoping that this development agreement would have been concluded by now, we are confident that this opportunity will be secured in the near term providing Precinct with a material development opportunity over the next 6 to 8 years. We are advancing design for this opportunity and expect that the composition of the development will likely include office, large-scale residential, hotel and retail, with adjacent civic spaces being contemplated. The final slide within the development section provides an update on the residential pipeline with 4 development projects included. Onehunga Mall Club is due for completion in December this year, and the business is focused on commencing works for future projects over the next 6 to 12 months. To date, Precinct has not invested in any of the direct projects. However, may consider some participation depending on the opportunity and the return metrics. Summary, there remains little doubt that the economy is facing some headwinds with rising interest rates and global uncertainty. As we know, New Zealand is exposed to these risks and managing our market position and our balance sheet remains a priority. We are supported by the strength of our office markets here in Auckland and Wellington with workers now back in the office and the demand for premium grade space continuing to grow. Pleasingly, our development pipeline remains robust, and we look forward to advancing this aspect of our business in the future. Our progress with our capital partners has been most pleasing and has delivered a diverse source of capital for us and allows us to align ourselves with global best practice investors who believe in our market position, believe in our portfolio and in our developments. There remains some challenges in our market, and we look forward to leveraging our market position. That brings us to the end of our presentation, and we'd be delighted to answer any questions that anyone has.

[Operator Instructions] Your first question comes from Bianca Fledderus from UBS.

So yes, great result in terms of strong demand and re-leasing during the year, of course. Just in terms of your portfolio, are there any areas or certain type of assets that you are struggling to re-lease or lift rents? Any examples of 1 of your tenants moving to a lower grade building, for example.

Bianca, I think the 1 area in the portfolio where like you said an NPI line where we've had some challenges has been some of our gross leases in Wellington. We're having to absorb higher interest costs and increases in rates. And so that's resulted in less relative growth at the kind of net property income line. Beyond that, there may have been 1 or 2 instances where we've had occupiers that have kind of stepped down the quality grade, but that's quite a rare thing at the moment. What we're seeing quite materially is occupiers both within our portfolio and within the market, really wanting to increase the quality of their premises to try and get workers back into the office.

Yes. Okay. And then just a couple of questions around the joint venture with the logo you announced, it was last week. So that sounds like a great partnership, including some high-quality buildings and good waterfront locations in Auckland, of course. The 30 Mahuhu Crescent property where more than half of the building is vacated mid-2024. Could you just comment on how the re-leasing of that sort of progress? I know you mentioned it's a key priority, but do you have tenants in mind there that are sort of where the lease is coming up next year, I guess?

Bianca, George here. Yes, so 30 Mahuhu, the whole building actually becomes vacant on expiry of BNZ's lease middle of next year, just under 8,000 square meter building, large floor plates and with quite significant parking under that building. We think there'll be really strong demand for that in the market. The price point that we'd be expecting to lease that as attractive relative to sort of closer into the core city center. And so we think it will appeal to a range of occupiers across sort of public sector, private sector, parties who are perhaps in like more suburban locations, but we'd prefer to be near public transport links and still with our parking being close to the motorways. So we anticipate that, that will go well.

Okay. And then just quickly, last question. So your DPS guidance for FY '24. Could you provide some color around what FO payout ratio that would reflect.

100%.

Your next question comes from Nick Mar from Macquarie.

Just in terms of the amount of assets under the platform, the $400 million under resi, is that the existing projects that the JV is managing?

Yes, Yes, that's right.

And does that include the sort of small office portfolio as well?

Yes, it does. Yes.

That's good. And then in terms of the sort of market conditions, the economic rents are super high. And I imagine if there's something like Downtown, it would be even more than that. Do you think particularly feasible project, I appreciate it's a few years away, but it doesn't feel like the economic rents will get much cheaper. It's just whether the other stuff catches up a little bit. Can you talk to your sort of thinking on that at this stage.

Yes. Nick, I guess, still early days, and we're still yet -- as we mentioned, we're still yet to sort of sign the dotted line, although we've got a good deal of confidence that we'll get there reasonably shortly. Advancing concept design sort of turns your mind to the composition or structure of a development like that. It's really large scale. It's significantly bigger than Commercial Bay. What we're sort of focused on is the highest and best use and where you might derive that value. And as we mentioned in the presentation, we see a fair amount of residential in that site as much as we do office. And so -- and also other kind of uses such as hotel and retail. But -- in terms of highest and best use, the opportunity for a site like that for it to accommodate some really high-quality residential will allow us to also be able to deliver [indiscernible] office accommodation, which is able to make the market.

And then just on Bowen House, the sort of completion timing seems a bit later now, but I appreciate the rents have started. Can you just talk about what happened there?

Yes. So our responsibility was to deliver the base build works and our works have been completed and that triggers the rent start date. The Crown is the occupier is still working through its sort of set our design and works and so on. So -- that will probably take them a little longer before they ultimately occupy and before that lease actually commences. But for intents and purposes, our -- we're happy with how that's going.

Great. And then, Rich, on the ICR, sort of the reasons for lowering that, obviously, you're sort of at a point of time where it's challenging given moving of various products into funds. Is there just a structural issue around how fee income and consistent income sort of accounted for in that structure?

Sorry, on the ICR?

Yes.

Yes. The main factor for the reason for shifting out was the amount of capitalized interest, which is included in that calculation just coming through FY '23. We had -- it was a pretty smooth process, given the pre-leasing that we had across the development book.

And the reason to permanently move it rather than just sort of temporarily.

To give us more headroom effectively. But we still anticipate that ICR will be in the mid-2s to high 3s -- sorry, high 2s.

And then just lastly, in terms of leasing, the post-balance you've done, how does that compare to what market rents the values have on those properties?

Yes. Look, we're still seeing an upward trend in market rents. And obviously, 30 June was kind of independent valuations completed and sort of sets the benchmarks for each of the assets in terms of market rents and we're still seeing good growth, good example in HSBC Tower here in Auckland. And I think what we're continuing to see is that the space that when it comes out, it's well sought after and so that's driving good attention and rent. So we're very pleased with how that's been -- or the demand that that's sort of attracting from the market.

Your next question comes from Rohan Koreman-Smit from Fortis Bar.

Well done on another year under the belt. Just first question for me. Generator did 4.4% NOI in the first half and 2% the full year. Can you just talk through what was the headwind for the second half and if that's, I guess, new sites that aren't at capacity or if there is a kind of seasonal pattern because I noticed there's some prior periods as well.

The main change there, Rohan is the Bowen, Wellington site opening up. So it's a very large site relative to Generator. So it's just filling up through the period. So that's the main kind of half-on-half impact there.

Perfect. And you talked about capital partnerships in terms of demand for value-add type assets development more than a long way. If you look at 61 Molesworth, that's got a very long WALT. Is that 1 that you are probably going to have to warehouse a little bit longer now than when you purchased the asset in terms of initial expectations?

Rohan, Scott here. Look, yes, I mean, there's a couple of things there. We're still working through the kind of final aspects of procurement and getting ourselves into a sort of a fixed price position. And so there is a preference to understand that kind of cost situation before we sort of go and engage with capital partners. But at the same time, we're definitely seeing from the market preference for value-add type opportunities. So if we have to, we'll very happily continue to complete that project. I'm still very confident that that's the type of asset or the type of project that will be sought after by our capital partners at some stage.

Perfect. And as a good segue into construction costs. Others have talked to a view that vertical construction costs will come down. Just wondering what your kind of internal experience is with tendering.

Yes. We're hopeful -- we're hopeful, but we've also got some pretty good visibility into some other potential stimulus for the vertical construction market, and we mentioned it in the preso, I mean I think government-based -- government-sponsored projects, local government-sponsored projects I think that could provide a floor to activity levels. And so it's going to be interesting to see how that plays out. And obviously, kind of later on this year is going to have an influence over that. And of itself right now, there's definitely more eagerness from main contractors and subcontractors, particularly at that Tier 2 level for more work. We're seeing particularly trades starting trades on jobs start to get really hungry. Finishing trades are still busy at the moment, but that could change. And I think it might change. So we'd like to see costs come down a little bit, but I think it's going to be influenced by kind of what happens over the next 6 to 12 months.

And final 1 for me for Richard. The cost to permanently lower the ICR is there a slightly higher line fees and margins, do we need to think about here.

No change, Rohan.

There are no further questions at this time. I'll now hand back to Mr. Pritchard for closing remarks.

Great. Thanks, Harmony. Look, it's been a really big year for the business. And $680 million of transaction and advancing our kind of strategy that's evolved quite rapidly over the last couple of years. We're really delighted with the progress we're making. It's not lost on us that we're in a challenging environment, but we feel like the position that we're in will allow us to take advantage of the market that we're in as well. And so we're looking forward to the next 12 months. We're well supported by our investor base and also our capital partnership. So thanks very much for dialing in today. We really appreciate the support. Thanks.

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