Vital Healthcare Property Trust (VHP) Earnings Call Transcript & Summary

Thank you for standing by, and welcome to the Vital Healthcare Property Trust FY '24 Half Year Results. [Operator Instructions] I would now like to hand the conference over to Mr. Aaron Hockly, Fund Manager. Please go ahead.

My name is Aaron Hockly, Vital's Fund Manager, and I'm pleased to be able to present these results for the six months ended 31 December 2023, a period of ongoing delivery of our strategy. Despite rising interest rates in a volatile equity market, we have continued to improve Vital's property portfolio through noncore asset sales and developments. This, coupled with balance sheet improvements and ongoing sector leadership and sustainability have enhanced the future income security for our unit holders. Our overarching goal is to provide AFFO and DPU growth of 2% to 3% per unit per annum over the medium term. Whilst rising debt costs have hindered this over the last 18 months, ongoing portfolio and balance sheet enhancements and the expected repricing of future developments give us confidence of returning to this growth path in future periods. Presenting with me today, as usual, is Michael Groth, Vital's Chief Financial Officer; as well as Northwest's co-heads of this Australasian region, Richard Roos and Chris Adams. While Northwest's strategic review remains ongoing, this is outside the end of our discussion today, and we are at arms length from this process. We have previously advised the market that we are considering capital partnering, particularly in relation to future developments and potentially including existing assets. This process is ongoing. We don't have anything further to announce at this time. However, to support this process, we have released some proposed minor changes to Vital's statement of investment policy and objectives to our unitholders today. It cannot be overstated how important the choice of property is to the medium to longer-term returns for Vital's unitholders. Unlike many other asset classes, health care property remains a highly defensive sector with growing demand. Vital's existing $3.2 billion portfolio of best-in-class assets, market-leading WALE of 19.2 years and rents, which continue to grow each year, provide our unitholders with a high level of confidence around underlying income growth. The portfolio has continued to be enhanced by developments, which have lowered the average building age to a young 9.7 years, provide income and capital growth and ensure we continue to offer best-in-class facilities for our tenants. Developments are delivered by a specialist health care property team unmatched on either side of the Tasman. During the half, we were delighted to be named sector leader by GRESB for health care real estate globally. This is the highest possible achievement, reflecting our work across all aspects of sustainability and comes from the global ESG benchmark for financial markets, covering over 1,800 entities in 74 countries, valued at over US$7 trillion. Whilst there is still much to be done, we're confident that we are on the right track. Over the half, a further $164 million of noncore asset sales were completed, taking total sales during 2023 to over $220 million. These sales were undertaken at an 8% discount to market value, well below the discounts seen in most other property sectors. Among other things, these divestments have increased Vital's WALE by 2 years, reduced near-term lease expiries by 3.6%, reduced average building age by nearly 10 months and reduced balance sheet gearing by 450 basis points. Underlying property income rose by 4.1% during the half, reflecting rent reviews and developments. Vital's asset management team leased or renewed around 7% to Vital's portfolio with minimal or no tenant incentives. Rent reviews undertaken during the half had a weighted average of 3.3%. Our portfolio-enhancing development program continued with $134 million being spent on capital works, most of which was on the nine committed developments underway. As Michael will elaborate on, Vital has A$166 million of debt headroom, more than covering the amount expected to be spent on these developments over the next 12 months. In addition, at least a further $100 million is expected to be realized this calendar year from further noncore asset sales. In addition to being named sector leader by GRESB, Vital maintained its B- score from CDP in line or ahead of most of our peers. Vital and the wider Northwest group commitment to sustainability seeks to contribute to the communities in which we operate, attract and retain talent, offer best-in-class assets for our operators and deliver superior returns for our unitholders. As part of this commitment, all of Vital's new developments will be a minimum of 5-star Green Star and three developments are currently targeting 6-star Green Star. These are the assets that tenants, investors and debt providers will be most eager to support in the future, and we expect green-certified buildings to have higher valuations compared to those without such certifications. We are working through the final stages of data collection to produce our first TCFD report before October this year. Following its release, we intend to undertake a sustainability road show to help investors understand what we have achieved to date, what we plan to do and to receive further feedback on what investors would like us to focus on. We are conscious that GHG emissions reporting and management are critical for many of our larger institutional investors, in particular. Other group ESG commitments include release of a reconciliation action plan in Australia, which, given Vital's footprint in New Zealand, acknowledges Tikanga of Maori as Tangata Whenua and Treaty Partners and al Te Reo, as well as the release of Northwest's third modern savory statement. Our sustainability efforts cover the full spectrum of our operations. This slide draws out some key strategic initiatives and highlights our delivery over the last five years. As noted, our overarching target is growing AFFO and distributions by 2% to 3% per unit per annum over the medium term. Over the last five years, distributions have increased by 11.4% in total or 2.3% per annum. We acknowledge falling short of our AFFO target over the last 18 months, due to rapidly rising interest rates. However, we have several strategies in place to return to growth. Notably, the lift in interest rate hedging to 78% of drawn debt should reduce volatility going forward. Over the last five years, Vital's WALE has increased by 1.2 years despite five years passing. Single tenant concentration has reduced from 48% to 19%. Average building age has been lowered by 4.3 years, again, despite five years passing, and our metropolitan exposure has increased to over 89% of the portfolio. We have increased our exposure to our home market, New Zealand, which is up from $429 million to $1 billion and to Southeast Queensland, another key market, which has increased to 13% of the portfolio. We see ongoing opportunities to invest further in both places and have acquired land to support this future growth. We have divested $339 million over the last five years. And as noted, further divestments are underway. Despite significant growth in the portfolio by our acquisitions and developments, balance sheet gearing has been maintained below 40%, where we intend to keep it. We have also significantly extended our average debt maturity from 1.7 years to 3.3 years. Last December, Vital's Board and management spent three days in Auckland for strategy review meetings and asset tours, during which the Board reaffirmed Vital's strategy. Key elements include continuation of our focus on health care real estate, reflecting the board and management's conviction in this asset class, primarily due to underlying demand, low volatility and Vital's unique position to capitalize on the subsector. There is an increased focus on alternative sources of capital, and we hope to provide further announcements on capital partnering this calendar year. Finally, in order to remain relevant and attractive to the widest pool of investors, we will seek to remain at the forefront of ESG and health care real estate. I will now hand over to CFO, Michael Groth.

Thank you, Aaron, and good morning to all. Turning to Vital's financial results and capital management highlights for the period. Net property income increased to $72.4 million, up 0.5% over the prior comparative period. This result has been driven by a solid 4.1% increase in same property income on a constant currency basis, reflecting the benefit of over 86% of leases being linked to CPI. Unit holders will remember that while approximately 30% of the rent reviews are uncapped. Approximately 5% of the balance have carryforward provisions to capture CPI increases in excess of this cap. In other points to call out, corporate expenses have returned to baseline levels following a one-off Australian land tax refund received in HY '23. While management fees have reduced, reflecting the impact to the incentive fee due to unrealized investment property valuation declines. While we are beginning to see signs that New Zealand and Australian interest rates have or are approaching their peak, they are up significantly versus the prior comparative period. As a result, net interest expense has grown faster than the growth in net property income. It is up to $20.1 million for the half. This increase is despite capital recycling proceeds initially being applied to reducing debt and an active hedging program that has seen interest rate protection increased from approximately A$650 million to over A$800 million at 31 December. In saying this, we acknowledge more work is still to be done, and I will touch on this and other capital management considerations in a moment. Against this backdrop, AFFO stands at $0.0554 per unit, down 3.8% versus last year. Distributions are steady at $0.04875 for the half, representing a prudent payout ratio of 38%. Turning to the components driving the increase in net property income. As indicated earlier, a 4.1% increase in same property income on a constant currency basis as in underpins growth. Rents on rentalized and/or completed developments has contributed a further $2.7 million, partially offsetting the $3.6 million attributable to assets divested as part of Vital's $220 million asset recycling program over 2023. Taking into account the above and on a constant currency basis, net property income increased by 1.8%. As you all know, Vital's balance sheet remains well positioned in the current market, reflecting the quality of its property portfolio and cash flows. Gearing or debt to gross assets increased two percentage points to 38.3%, reflecting a 16 basis point softening in the weighted average cap rate of the investment portfolio to 5.21%. Reflecting the above, net tangible assets fell by $0.26 per unit for the half to $2.70. Our capital recycling initiatives have not only supported the delivery of high-quality and resilient developments, but also the quality of the portfolio has been enhanced in terms of the improved portfolio metrics Aaron spoke to earlier as noncore assets were divested. These initiatives are continuing with at least another $100 million of proceeds being targeted for sale, which, in conjunction with available debt, significantly exceeds the capacity required to deliver our development program and maintain gearing below 40% all other things being equal. In a moment, Chris will highlight the contribution and value-added development activities that has contributed to where vitals today and the continuing importance of this in creating long-term sustainable unitholder value for Vital's future. The next two slides focus on capital management of the group. As you all know, key banking ratios remained strong. No debt is expiring until March 2025, and we are already well progressed with term extension discussions to push this out further. I would now like to spend a few moments providing some further color in respect to our capital management approach. Our strategy and objectives remain unchanged. We are resoluting our focus in providing and maintaining a prudent level of leverage targeted to be below 40% at any point in time, appropriate for the quality and the certainty of Vital's long-dated contracted cash flows, ensuring that prudent funding certainty and optionality exists at all times, both in terms of Vital's development commitments and refinancing obligations and managing interest rate risk to support cash flow and earnings certainty and therefore, distributions to unitholders. In recent times, the importance of proactive capital recycling has been a key factor in ensuring Vital's balance sheet remains strong and flexible. However, this is only one of a number of levers available. Others include capital partnering that additionally diversifies risk and enhances the overall quality of the portfolio, raising equity in advance of it being deployed, like what occurred in late FY '22. And deferring or canceling development projects and CapEx with forecast returns don't create long-term value for unitholders. As I indicated earlier, we have more work we want to do on hedging. That said, we have been active in the half with over $250 million of Australian hedging activity completed, focusing on increasing overall hedging protection and prudently adding duration in the context of capital recycling activity and other potential balance sheet initiatives available. This has resulted in hedging protection, increasing to 78% of drawn debt, up from 30 June and 31 December last year. Looking ahead, the recent emergence of inverted interest rate yield curves in New Zealand and Australia is expected to provide opportunities to add further protection in the coming months, noting that markets are particularly volatile in the current moment. Now, I'll hand you across to Richard to take you through Vital's asset management outcomes for the year.

Thank you, Michael, and good morning, everyone. Turning to the portfolio section. With annual rent increases that are highly aligned to CPI, Vital's $3.2 billion portfolio generated income growth for the six months to 31 December of 4.1% on a like-for-like basis and 1.8% after the impact of asset sales, both on a constant currency basis. With over 86% of annual rent reviews aligned to CPI, this enables vital to partially offset higher interest rates and moderate the impact of higher capitalization rates on the value of our portfolio. In addition, the positive impact of CPI-linked reviews on AFFO will be magnified in the second half of FY '24, as annual reviews are based on the last 12 months of CPI data, and there are a higher percentage of rent reviews in the second half of the financial year. Vital has a portfolio and income stream, which is highly diversified by location, tenant and type of health care service provided. Over the past five years, we have grown our investment in New Zealand, both in absolute dollars from $449 million to $1 billion, and as a percentage of portfolio value from 45% to 31%. We continue to see significant opportunities for growth in New Zealand with New Zealand private hospital operators experiencing stronger financial returns currently than those in Australia. Since 2018, Vital has reduced its reliance on its largest tenant from 48% of income to 19% of income today. Our tenants include the 3 largest New Zealand hospital operators and 5 of the top 10 in Australia. These top-tier operator relationships are critical in that they provide Vital investors with diversity of income, strong covenants that provide security for that income and significant growth opportunities through the acquisition of additional existing assets, expansion of existing assets and new greenfield development. Over the last 10 years, Vital has increased its weighted average lease term from 14.9 years to over 19.1 years at the end of CY '23. Vital is not a passive provider of capital. Our strategy is to provide strong in-house analytical leasing, asset management and development capability that support the aspirations of our operator partners and strengthen our portfolio. We believe Vital has Australasia's highest quality investable health care portfolio. It is the envy of our competitors and one of our health care partners are committed to operating for decades to come. Turning the page. Our current divestment program of non-core assets implemented to reduce leverage and fund our development pipeline has strengthened our portfolio by increasing our weighted average lease term, reducing near-term lease expiries and lowering our overall CapEx obligations. It also allows us to ensure that the assets in our portfolio meet our ESG commitment to improve the sustainability of our assets and meet our carbon emission targets. The divestment strategy is also consistent with our focus on larger assets in core health care precincts leased on a long-term basis to leading health care operators. It has resulted in $222 million of asset sales in CY '23, of which $164 million occurred in the last six months to 31 December. In addition, we are targeting at least another $100 million of noncore sales by the end of CY '24, with several of those already being marketed. An improved, more resilient portfolio is expected to enhance returns for unitholders over the medium to long term. Health care real estate has become a mainstream asset class, one that is highly sought after by domestic and international institutional investors. This is evidenced by an increasing number of new institutionally backed funds looking to build health care real estate portfolios, particularly in Australia. This increased demand for a limited number of high-quality health care assets underpins the value of Vital's portfolio, a portfolio of irreplaceable health care assets in prime metropolitan locations that Vital has been acquiring and developing for over 20 years. The long-term partnerships we have built across the health care spectrum in New Zealand and Australia over the past 20 years, also drive real estate opportunities through sale leasebacks or expansion of existing facilities like the Ormiston Hospital in Auckland or Grace Hospital in Tauranga. And while like many businesses over the past few years, our hospital operators have experienced challenges with hiring staff, higher interest rates and increased costs. Overall industry metrics are strengthening with an aging growing population and constrained government budgets continuing to provide strong demand for the foreseeable future. I will now turn the presentation over to Chris Adams.

Thank you, Richard, and good morning all. As noted by my colleagues, development remains fundamental to the Vital portfolio as evidenced by $650 million of development undertaken over the last five years, building on a 20-year history of development, which have added value for our unitholders. The development and leasing skill set of the Northwest team enables us to deliver upgraded assets for our operator partners, as they renew, grow and enhance their health care operations, deliver resilient facilities for the future, including buildings that provide greater flexibility and design for future changes, contribute to higher quality patient outcomes and meet high standards to mitigate future risk against natural disasters, including flood, fire and earthquake. The focus on development for renewal and high grading of the quality of the portfolio is also supported by an additional strategic aim, to increase the percentage of portfolio within the medical precincts, which we strongly believe will drive higher returns over the long term. In light of market challenges, including cost of capital, construction costs and procurement risks, we continue to position our potential development pipeline to be shovel ready to respond to market needs for increased health services. Only a limited number of projects will meet our requirements for a strong business case, manageable construction costs and an appropriate return on capital. The Vital book stands at five development book stands at $512 million, with $170 million of spend expected over 2024. As Aaron noted, this is covered by existing debt headroom with asset sale proceeds also expected to cover a significant portion of the spending. The development yield remains 50 points over on completion valuations. This spread has been reduced by rising valuation yields since projects were initially approved. This reduces the development margin Vital receives, and so, we are in the process of repricing new developments. Unitholders benefit from a 5.7% average net yield on costs and projects that we believe will drive stronger returns over time, given the quality of the burden and precinct locations and a focus on leases that can deliver greater upside over time. Completed projects. The circa $500 million of work in progress has seen limited completions in the half year, but we entered 2024 with many key projects in their final stages, including imminent completion of the fund through project at Macarthur Stage 1 in Sydney, strand $57 million, which has currently been certified for a 6-star Green Star as built rating. Australia 43 million Playford Health Hub Stage 2 and Elizabeth South Australia early in Q2, also designed for a 6-star green star rating. Vital's component of the spend at Wakefield for Stage 2 of ANZ91 million being completed in the second half with the operating evolution to fund the balance of ANZ30 million, a six-year project to date, expansion of almost in hospital ANZ38 million in Auckland reaching PC around the middle of the year. The above $240 million of combined developments will see the proportion of the portfolio under development for materially to circa 9% by midyear. But as noted earlier, the shovel-ready strategy allows commencement of the new quality projects, including by our capital partnering model inappropriate. Ormiston Hospital. We have also included a short case study on Ormiston Hospital in Southeast Auckland to outline how Northwest seeks to establish precinct advantage by the curation of medical precinct over time. Ormiston was acquired in 2017 with a strong operating partnership in place, majority owned by Southern Cross. The initial acquisition reflected conviction in the local market being a significant growth corridor for Auckland, but with limited scope for expansion of the facility. Vital has subsequently acquired significant land to enable development and work with Ormiston 2. Firstly, design and develop a major expansion of the existing hospital and subsequently, to create a vision for the long term as a key health precinct to South Auckland. On completion of the current project due mid-'24, Vital's investment and expanded facility plus development land will be circa $100 million. Key project outcomes include expected 100% occupancy at practical completion. This was 70% of project commencement, a new 20-year lease across the hospital and the much needed addition of further consulting areas and the introduction of new health services, including cancer services. Whilst the border involvement in Ormiston has only been approximately 7 years to date, we see this precinct opportunity is one example of where unitholders will see strong value accrue over the long term, as the precinct vision is realized. I will now hand back to Aaron to conclude with the outlook and guidance.

Thanks, Chris. On to our final substantive slide, noting that there is significant additional information in the appendices to the investor presentation released today, as well as in our interim report. The report includes biographies of directors and key management, as well as full details of management and other fees on page 53. Vital's distribution guidance remains unchanged of at least $0.0975 per unit, retaining a payout ratio of under 90%. We are working on alternative sources of capital to help fund developments and enable us to continue to improve the resilience and returns from the portfolio. New developments in the existing portfolio are expected to benefit from ongoing growth in demand due to aging populations across Australia and New Zealand. Both the quality of Vital's existing portfolio and our development team remain unmatched in the market, putting Vital in a unique position to capitalize on sector tailwinds. Our noncore asset program remains underway, and we are targeting a minimum of $100 million this calendar year. Enhancements to our portfolio through sales and developments into our balance sheet through increased hedging and potential capital partnering, as well as embedded earnings growth under existing leases, are expected to help return AFFO and DPU growth to within our target range. We're now happy to take questions.

[Operator Instructions] Your first question on the phone comes from Arie Dekker with Jarden.

Good morning and thanks for the presentation. Just a couple of questions. Firstly, just on the capital partnering process. Just two questions. First one, just how far you are through the process and when you're targeting sort of conclusion? And then also, just whether you could sort of elaborate a little bit more about the proposed investment policy and objective changes and specifically what's sort of driving the desire to make it easier for Vital to earn management fees. I mean, is that something to simplify how partnering options might be structured? Or is it something else?

Yes. Thanks, Arie. Good morning. So, we are significantly down the path of capital partnering. We're about nine months into a process. As I indicated, we hope to be able to make announcements this calendar year. Obviously, as soon as we have anything agreed that we can announce, we'll do it as soon as we can. Specifically in relation to the amendment of the SIPO, because we're in active discussions with potential partners, what we want to make sure is that we have the widest possible options available to us through a transaction, we don't want to get to the end of the negotiation and then realize there's some technical limitation on Vital, which stops us agreeing to something which we take in the best interest about unitholders. So, there's no specific transaction. It's just to essentially to give management the widest possible options.

And on that ability to earn management fees, is that just to ensure that it goes down that track, and that's helpful for simplifying the structuring of the deal. Is that what's sort of behind that specific thing you called out?

That's right.

And then just on the development pipeline, can you just sort of give some visibility on how active you are in sort of conversations with operators across that pipeline at the moment and whether we might expect successful conclusion of partnering process to coincide with Vital entering into a number of new development commitments, if not at the same time then shortly after?

Yes, Arie, Chris here. I mean, I think it's multifacets to that question. I mean, working with our operator partners, there is always activity within their portfolios, particularly around brownfield development, as we said before, to continue to enhance and grow their businesses. So, those discussions are ongoing. We have a number of key precincts where we've planned them for the longer term. And again, we're getting the shovel ready. The attention right now is around the comments we made around how you manage risk in a procurement sense, how you get reasonable construction costs and how we get a return that's satisfactory and the cost of capital sense. So, I'm trying to pick those three boxes at the moment is a difficult proposition. But, in saying that, we've got to be ready to act. What we can't have these long lead times around town planning and other things that don't put us in a position to act on projects or act on projects where there's clearly a very high-quality project that can meet those criteria. But right now, there's lots going on, but they're limited in terms of things that are ready right now, but we certainly think in the future opportunities will come about that are strong.

And perhaps to give a bit more color on that $2 billion potential pipeline, project sizes range from the tens of millions of dollars up to the hundreds of millions of dollars, and it's in the hundreds of millions of dollars where we just need to consider whether it's the best investment for Vital to have such a big risk or such a big exposure to a single asset, single tenant, which has really been the achievements over the last 5 years. So, we wouldn't want to reverse a lot of what we've achieved. So, as much as anything as part of feeding into the development pipeline, it's about considering what's the appropriate funding for the particular development.

Which is not unusual. If you look across other probably subsectors, the larger projects are often in a capital partnering model or a co-ownership type structure. So, we think that's an appropriate thing to do.

But I guess I can sort of take it from you that with some of those other factors, the construction costs and getting adequate returns that while the capital partner is important to sort of enabling, committing to future developments, it's not kind of the last thing that needs to drop before you sort of enter into a bunch of new developments?

Yes, that's right. I mean we're going to continue to run a whole number of things in parallel to be in a position to execute when the time is right.

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

Could you just refresh my memory [indiscernible] swap restructure and then the tax impact of that outlook, I guess, its business from an effective tax rate perspective, excluding that for the half?

Yes. Sure, Nick, the swap restructure occurred in July, August of this half. It involved the transfer effectively of the interest rate swaps out of the New Zealand entity into the Australian entity where effectively the underlying debt is. As you know, that crystallized an income tax expense that has been excluded from AFFO. And has been represented in the numbers this half. Ultimately, it was necessary to provide ultimate flexibility as to how we manage our interest rate exposure, as opposed to being dealt with legacy issues that inhibited our ability to restructure or to extend duration on existing swaps that were in place.

And then just looking through the project, all the development book it's been a few minor changes, but one of them sort of inverse coffee project is sort of a little bit later. Can you just talk through what changed there now the wealth coming down quite a bit on that property to?

Sorry, Nick, it's a little bit hard to hear. Would you mind repeating the question?

No worries. Just on the development assets. Could you just talk through some of the, I guess, movements in time frames. So, in particular, the Grace has been pushed out quite a bit and then into Auckland, the cost has come up quite a bit?

Yes. Some of these projects -- Chris, again here, Nick. Some of these projects are very complicated because they're certainly the Grace is that the projects within a live operating environment. It was always intended to be -- well, it is based on an ultimate master plan of the hospital and based on staging. So, obviously, it was our best estimate at the time and certain things, including town planning durations, which was much, much longer than contemplated and also just the volatility in the construction market in that region has meant there's been some certain changes in terms of the time frame. And as part of that, you'll note there's on a change in terms of some incremental funding. Yes, there's some additional funding, but that's been done at a higher yield, circa 100 points higher than the previous component. That's an incremental component to it, but that's a reflection of escalation in construction markets. It's also a reflection of changes in scope as well. So, there's a reasonable amount to that.

On endoscopy, similar situation are going through procurement process would change. And also, I think important to note of an endoscopy, there were some changes to the nature quality of the building there. That supply green star building. There was a number of other changes, enhancements to the asset there that obviously came with some additional costs and also time frames to build, including some ground condition matters there. Those procurement projects are an example where a fair degree of the risk sits with the operator partner as the party that's leading the procurement piece on those projects, but we did play a very active role in that also.

And just lastly on investments. Can you put any color on the sort of additional sales sort of where they're tracking versus book, I guess at an aggregate level? And then the additional assets, you're looking at potential testing, any flavor of what they might be in the portfolio?

Yes. Thanks, Nick. Richard here. So, what we've flag is an additional $100 million of asset sales at least in CY '24. All of those assets are being actively marketed at the moment. And in one case, is fairly well advanced through the initial due diligence phase. So, it's something that we're very focused on and would look to exceed that amount in CY '24.

There are no further questions at this time. I'll hand the conference back to Mr. Hockly.

Thank you, everybody, for attending today. As usual, all of our details are available on the website, and please don't hesitate if you have follow-up questions to ask us after the call. Thank you very much. Have a good day.

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