Charter Hall Social Infrastructure REIT (CQE.AX) Earnings Call Transcript

Ladies and gentlemen, thank you for standing by and welcome to the Charter Hall Social Infrastructure REIT 2021 Half Year Results Briefing. [Operator Instructions] Please note that this conference is being recorded today, Thursday, 11th February. I would now like to hand the conference over to your host today, Mr. Travis Butcher, Fund Manager, CQE. Thank you, sir. Please go ahead.

Good morning, and welcome. I'm Travis Butcher, and I'm joined today by Scott Martin and Nathan Chew to present CQE's FY '21 half year results presentation. I'll commence the presentation with CQE's key metrics, strategy and operational highlights. Scott will provide an update on the financial metrics. And then I'll return to cover portfolio activity, an update on the childcare industry, followed by a summary of CQE's outlook. Commencing on Slide 4. CQE has delivered a strong financial and operating result for the half, and with recently announced acquisitions is pleased to announce an upgraded FY '21 distribution of $0.157 per unit, up from $0.15. Key metrics for the period were as follows: operating earnings for the half were $0.08 per unit with the distribution paid of $0.075 per unit. From a capital point of view, CQE is well positioned from a balance sheet perspective, with gearing at 24.8% and available investment capacity of $130 million. CQE has been active with its portfolio management, which has resulted in the weighted average lease expiry of the fund increasing by 10% to 14 years, up from 12.7 years as at 30 June, 2020. This has been driven by lease extensions during the period across 58 leases with Goodstart, CQE's largest customer. Valuations undertaken during the period have resulted in a valuation uplift of $25.3 million or 2.2% across the portfolio, highlighting the portfolio resilience and strong ongoing demand for childcare assets. The valuation increase was a key contributor to NTA growth of 3.8% during the period, resulting in NTA per unit of $3.03 and gross assets of $1.4 billion. In relation to the operating environment, which CQE operates in, 2020 was a story of 2 halves, with the first half dominated by the initial wave of the COVID-19 pandemic, which saw attendances at centers drop to 25% to 35%, causing significant challenges to both CQE's operators and CQE. Moving into the second half of 2020, pleasingly, we have seen a strong recovery in the childcare market across Australia, with attendances generally returning to pre-COVID levels and operators cautiously optimistic about 2021. The federal government, which provides approximately $9 billion per annum to the sector, provided tailored support mechanisms to assist operators to remain viable during this challenging period, demonstrating again the essential nature and resilience of the industry. Moving to Slide 5 and CQE's strategy. CQE's strategy is unchanged. Our aim is to provide investors with secure income and capital growth through exposure to social infrastructure property. We do this by focusing on enhancing income sustainability and resilience of the assets we own, targeting ongoing capital growth and undertaking ongoing portfolio curation. Turning to Slide 6. CQE has had an active 6-month period delivering on its strategy. During the half, CQE secured 2 high-quality social infrastructure assets with an on-completion value of $202.5 million, being the Mater headquarters and training facilities and the South Australian Emergency Services Command Center. Following the settlement of these 2 acquisitions, income derived from nonchildcare assets will increase to 15% of the portfolio. I'll talk to these acquisitions in more detail later. The extension of the 58 Goodstart leases in the period by an average of 12 years to 20 years was a key contributor to the increase in the portfolio WALE and has also increased CQE's weighting to fixed rental increases to 63.3% of the portfolio. As part of active portfolio curation, CQE completed 5 childcare developments with a further 5 forecast to be completed by June 2021. Key divestment activity during the half included the divestment of 30 childcare assets for $55.6 million, including the remaining 20 New Zealand assets, and the divestment of the 15% interest in the unlisted Charter Hall CIB Fund for $18.4 million. The portfolio is in very strong shape with the occupancy of the portfolio sitting at 99.7% and a WALE of 14 years with minimal lease expiries in the next 5 years of 4.7% of portfolio income. Moving forward, CQE is well positioned to continue with its strategic objectives and capitalize on attractive long WALE social infrastructure opportunities that may arise as a result of COVID-19, in particular, in the government and tertiary education areas. Moving to Slide 7 and some more detail on the recent acquisitions, starting with the acquisition of the Mater headquarters and training facilities. In October 2020, CQE agreed to acquire an A-grade, 11-story building in a sale and leaseback transaction with the Mater, Queensland’s largest Catholic, not-for-profit health provider. The site is centrally located in Newstead, approximately 2.6 kilometers from the Brisbane CBD and also within 5 minutes drive of Mater's existing hospital campus in South Brisbane. The purchase price of $122.5 million on completion reflects a passing yield of 4.84% and is underpinned by a new 10-year lease to the Mater with two 5-year options and fixed annual increases of 3%. The building is currently under construction with practical completion expected to occur in the June 2021 quarter. This transaction introduces a new and well-capitalized health care tenant into the CQE portfolio, with CQE gaining exposure to the highly resilient health sector and opening up potential future partnership opportunities with the Mater. Moving to Slide 8 and the acquisition of the South Australian Emergency Services Command Center. In November 2020, CQE contracted to purchase the new purpose-built command center and adjacent multi-deck car park currently under construction. On completion, it will be leased to the South Australian government on a 15-year lease with fixed 2.5% annual rent increases and two 5-year options. The property is located in Keswick, approximately 2 kilometers from the Adelaide CBD and was selected by the South Australian government based on its location and transport options. The settlement of the land and works completed to date occurred in December 2020, and CQE will fund the remainder of the development on a progressive basis for a total consideration of $80 million. Completion is expected in October 2021. The adjacent hardstand also has future development potential and the opportunity for other government-related services to co-locate. Upon completion, this adds an additional government tenant to CQE's portfolio, enhancing the quality of CQE's income. I'll now pass on to Scott to discuss the financial results for CQE.

Thank you, Travis, and good morning, everyone. A summary of CQE's half year FY '21 financial performance can be found on Slide 10. CQE delivered operating earnings of $29.1 million, representing an increase of 14.1% on the prior corresponding period. Operating earnings per unit were $0.08 and distributions per unit were $0.075. Key drivers of the increase in operating earnings include a $2.6 million increase in net property income, comprising $1.3 million of organic rental growth and $1.3 million of net property income from property acquisitions, development and disposal activity. In addition to this, finance costs have reduced by $0.8 million due to the lower levels of borrowing and a lower cost of debt in half year FY '21. There has been minimal impact on CQE's half year FY '21 earnings as a result of the COVID-19 pandemic, with 99.6% of rent collected during the period. A summary of CQE's balance sheet position at December 31, 2020, is presented on Slide 11. Investment properties have increased by 6.3% or $75 million since June 2020, primarily driven by $25.3 million of net property revaluations and the acquisition of the South Australian Emergency Services Command Center. The net decrease in the securities is attributable to the divestment of CQE's 15% interest in the Charter Hall CIB Fund, which was disposed of in November 2020 for $18.4 million. This has been partially offset by the $8.7 million valuation gain on CQE's unit holding in Arena REIT. The receivables balance at 31 December, 2020, includes $2.1 million of deferred rent relating to the period of April to June 2020, provided to tenants impacted by the COVID-19 pandemic. The deferred rent will be progressively repaid over the next 2 years. NTA per unit increased 3.8% from $2.92 at June 2020 to $3.03 at 31 December, 2020, driven by net property revaluations and the valuation uplift on Arena REIT units. A summary of CQE's debt and hedging position is presented on Slide 12. CQE has $500 million of debt facilities, which were drawn to $250 million at 31 December, 2020. CQE has diversified funding sources with no debt maturity until March 2023, and its weighted average cost of debt is 3.3%, which is calculated based upon drawn debt of $250 million at the reporting date. Balance sheet gearing was 24.8%, and look-through gearing was 26%, which have both been calculated based upon drawn debt at 31 December, 2020, adjusted for the committed acquisitions and the divestment of the New Zealand childcare portfolio. Following these committed acquisitions and disposals, CQE has an investment capacity of approximately $130 million, providing it with the ability to further pursue new social infrastructure opportunities, together with funding committed childcare acquisitions and development expenditure. There has been no change to the amount of hedging in place in the current reporting period with the current hedge book totaling $160 million. CQE has a staggered hedging profile through to December 2025 with an average amount hedged of 57% at a rate of 0.55%. I will now pass back to Travis to continue with the presentation.

Thanks, Scott. On Slide 14, we have CQE's portfolio summary. As detailed earlier in our strategy, we are focused on continuing portfolio improvement and enhancement of income sustainability and resilience. Portfolio WALE as at 31 December, 2020, has increased by 10.2% to 14 years as a result of a number of activities. This has included the following: agreement on 59 new leases with average expiry of 20 years, with 58 of these with our major tenant, Goodstart. This is in addition to the 40 new 20-year leases agreed earlier in 2020, 2 acquisitions and 5 completed developments with average lease terms of 18 years. And finally, 4 out of 5 year options of 5 years renewed, which extends their expiries from 2025 to 2030. Lease expiries within the next 5 years remain low at 4.7%, highlighting the importance of the property and lease term to the operators' business. The remaining lease expiries within the next 5 years include only 1.6%, where the tenant does not have options to extend the lease. Moving to Slide 15. CQE's current portfolio is well positioned to deliver both income and capital growth, with 83% of the portfolio weighted to Australia eastern seaboard states and 73% of CQE's income underpinned by the top 5 tenants who are all larger operators. Fixed annual reviews continue to increase from 53.3% to 63.3% as at 31 December, 2020, predominantly due to the completed Goodstart transaction. There was 4 market rent reviews completed during the period, with an average increase of 4% achieved. Three of these properties achieved a full 5% cap demand allowable under the lease with the final center located in Western Australia, achieving a 3% increase, noting that this lease only commenced 5 years ago and has fixed increases of 3% since inception. As we've previously highlighted and as can be seen by the market review outcomes, CQE's portfolio rental levels are lower than the industry benchmark, leaving CQE well positioned to capture future rental growth. Rental growth moving forward is forecast to be 2.3%, comprising 63.3% fixed increases, which average 3% and the balance of CPI increases, which are forecast to be 1.2%. Turning to Slide 16, an acquisition and disposal activity for the childcare portfolio. Our portfolio curation strategy is focused on increasing our weighting to larger assets with high-quality tenant covenants, demonstrated by the activity in the half. During the period, we settled 2 existing acquisitions totaling $8.4 million, with a further acquisition totaling $4.2 million contracted and expected to settle in April 2021. These acquisitions have an average WALE upon acquisition of 20 years with annual rent reviews of 3% or higher. Consistent with improving the portfolio's tenant covenant, all the acquisitions are leased to listed ASX operators. The average yield of center acquisitions was 6.4%. It is our preference to acquire in higher socioeconomic areas as these attributes support childcare businesses as well as land value growth in the long term. This is measured by a SEIFA rating with 10 being the most advantaged. The average SEIFA rating was 8 across the new locations. In relation to divestments, during the period, we divested or contracted to divest 30 properties for a total value of $55.6 million at an average selling yield of 6%. As at 31 December, 2020, 2 of these properties had settled with the remaining 28 to settle prior to 30 June, 2021. The major transaction during the period was the agreement to divest the remaining 20 properties in New Zealand for NZD 40.1 million. These properties have a WALE of 6.6 years, are small with an average size of 62 places and are on average over 30 years old. In addition, the property return on these assets was diminished due to tax leakage in New Zealand. Turning to Slide 17. CQE undertook 340 childcare valuations during the half. That saw an increase of 2.9% from their 30 June, 2020, valuations. This comprised the 129 independent valuations and 211 direct valuations. The Brisbane Bus Terminal was also independently valued, resulting in a 5.3% increase, with CQE's 50% interest having now increased by $3.75 million or 7.3% since the acquisition in June 2019. As can be seen from the bottom right graph, the value of market transactions picked up in the first half of FY '21 with sales of $132 million compared with the previous half, which was impacted by COVID-19. Yields have continued to compress with average transaction yields of 5.8%, reflecting the resilience in the childcare property market. Activity has particularly increased since October 2020 with investors showing strong demand for long WALE assets in essential nature industries such as childcare. A recent sale in January for a center in Ringwood East, 25 kilometers from Melbourne, transacted at a 5.4% yield. Our secondary value driver for CQE is the underlying land value or alternate use of CQE's portfolio, which is being supported by the price growth in the residential market, noting that CQE's land holdings of approximately 100 hectares, of which 75% is residentially zoned. Turning to Slide 18. During the half, CQE completed 5 developments with a total valuation on completion of $31.6 million and a yield on cost of 6.2%. A further 2 developments have been completed since 31 December, and we are forecasting a further 7 completions, resulting in forecast completions for 2021 of 9 centers. The total development pipeline currently sits at $123 million across the remaining 19 sites, with a forecast cost of completion of $49.4 million and a yield on cost of 6.1%. The completion of development is a key focus for CQE as upon completion, these projects commence generating return to CQE as well as delivering modern properties in strong locations. Turning to Slide 19. We have an ongoing focus on environmental, social and corporate governance performance. We've undertaken climate risk exposure assessments for all of our childcare centers across Australia as part of development of a climate change mitigation approach for the portfolio. As part of our new developments across the portfolio, we continue to undertake a range of sustainability initiatives, with this slide providing some examples of design elements at our recently completed Box Hill North and Bexley developments. We're also looking at opportunities that we can partner with our tenant customers on energy management and renewable energy initiatives across our properties. Another important initiative is our focus on modern slavery. We have completed our Modern Slavery Statement, and we are reviewing the suppliers in our supply chain to identify where potential risks lie and how we address these risks. Moving to Slide 21 and an update on the childcare industry. Following the COVID-19 pandemic, it's important to highlight that the 2 key drivers of growth in childcare demand continue. Firstly, childcare remains an essential labor supply mechanism to the Australian economy, which has been demonstrated during 2020 with continued government assistance provided to operators to remain open. Secondly, the significant learning benefits that children obtain from attending childcare. The quality of childcare is measured against the national quality framework, with the overall rating of the services provided continuing to improve. The impact of COVID on attendances was significant, with attendances reducing to circa 25% to 35% during the height of the pandemic. Pleasingly, there has been a strong recovery in attendances with operator occupancy levels returning to pre-COVID-19 levels. It's also important to note, there's not been any structural changes in demand as a result of COVID-19 with working from home not having any negative impact on demand, and operators still requiring specialized premises in which to operate their services. Government funding provides critical support for the sector, which is forecast to be $9 billion in FY '21. Funding the childcare has bipartisan support, and the Labor Party made childcare a key part of their budget reply in October, with plans to increase the CCS cap and increase the CCS rate to make childcare both more affordable and increase workforce productivity. Recent industry reports prepared by both the Grattan Institute and KPMG have detailed the economic benefits of increased government expenditure on childcare. The utilization rate for children aged 4 and under has also trended upwards, has now increased to circa 50% with approximately 785,000 children utilizing long day care services. This has increased from 38.1% 10 years ago. Turning to supply. Net center supply levels for the year grew by 3.7% or 294 centers with 8,188 centers at 31 December, 2020. The annual growth rate of 3.7% is down compared to the prior year, where annual growth was at 4.2%. Supply of childcare is linked to operator demand for new centers with minimal speculative development. It is estimated that across Australia, the vacancy rate at a property level is circa 1%. However, it's important to understand with supply and demand dynamics that childcare catchments are very localized, and there will always be outliers of both under and oversupply in locations. Moving to Slide 23 and the outlook. CQE is well positioned in the current environment with predictable and growing income, a portfolio WALE of 14 years, low gearing and investment capacity of $130 million. There is optimism in the childcare sector following the challenges of 2020 with occupancy returning to pre-COVID levels and no structural changes to the industry. Government support, a vital component of the sector, remains strong, with continuing lobbying to increase funding and participation in the sector. Recently announced acquisitions with the Mater and the South Australian Emergency Command Center and completed childcare developments will contribute to FY '21 income. However, the full benefit of this activity will not incur until FY '22 and beyond. We're pleased to advise that based on information currently available, continued tenant performance and barring any unforeseen events, the FY '21 forecast distribution guidance has been increased by 5% from $0.15 per unit to $0.157 per unit. That concludes the formal component of our presentation. I'll now hand back to the operator and open the line for your questions. Thank you.

[Operator Instructions] Your first question comes from Krzysztof Kaczmarek of JPMorgan.

Just in terms of your guidance, can you just talk to whether you're assuming any of that $130 million is deployed over and above what's going to be deployed on the development pipeline?

Krzysztof, it's Scott here. Yes, thanks for your question. The guidance is based upon, obviously, the announced acquisitions of Safecom, which we're receiving a coupon on the way through and Mater settling in the June '21 quarter. Yes, we're not baking into that guidance any additional acquisitions with that $130 million of investment capacity.

Okay. Great. And just in terms of the $130 million of capacity, what does that sort of imply in terms of the level of gearing that you're comfortable with going forward?

So with the gearing, our stated target range is 30% to 40%. It obviously pulled back to the mid-teens when we raised the equity back in May and now is sort of ticking back up there. If we deploy that $130 million into new acquisitions, once that's deployed, the gearing range then sits at the -- in the low 30s. So we're back within the target range. And that's where -- we're comfortable at that range, and we're comfortable with the 30% to 40% stated gearing range as where we're happy for it to sit.

Excellent. And just one more question from me. In terms of the development pipeline, a quick scan of it just seems to indicate you haven't added anything to that development pipeline. I know you sort of previously talked about that being in decline or you're not really looking at further development on the balance sheet. How should we be thinking about the development pipeline going forward? Is it essentially in runoff mode at the moment?

Krzysztof, yes. That's correct. We're looking to reduce our development exposure. So I think the focus for childcare investment will now move towards purchase upon completion or existing site acquisition.

[Operator Instructions] Your next question comes from Nira Sonah of EAP.

Just a couple of questions from me. Firstly, can you provide color around occupancy cost in portfolio for the childcare centers?

Nira, was that occupancy across our centers or occupancy cost?

Just occupancy, general occupancy.

Yes. So where we have -- it's been a really pleasing recovery in attendances and occupancy to our operators. So what we've seen was you got down to as low as 25% to 35% at sort of the peak of that pandemic in March and April. And now pleasingly, we're -- generally, across the board, we're back to most operators at or around pre-COVID levels. So that sort of sits in that 75% to 80% occupancy. Obviously, with all things childcare, this does vary. There's 8,000 -- approximately 8,200 centers across Australia. So each one does have its own supply and demand characteristics, but we're really pleased with the strong rebound in childcare occupancies.

Yes. And just in terms of your growth pipeline, when you talk about social assets, how should we be thinking that -- would you be -- is that more tilted toward childcare centers or more like government assets?

I think -- that's a good question. And we're still heavily focused on childcare, but I think where we're looking to -- in line with our strategy of broadening and increasing our income resilience and quality, we're looking to increase that nonchildcare exposure to approximately 30% to 50% of CQE's income over a 3- to 5-year period. So childcare is still going to be a very important part of the portfolio, but we're looking to -- where we can, similar to what we've done with the South Australian asset and the Mater asset, where there's good quality social infrastructure assets that we can add that improve the overall portfolio and the quality of the income, we'll add those. But I think that's sort of an indicative range of where we're looking to head to.

And is there a threshold cap rate that you would look at when you're looking at acquisition, the max that you're willing to pay on an asset?