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

Thank you all for standing by, and welcome to the Charter Hall Social Infrastructure REIT 2022 Full Year Results Briefing. [Operator Instructions] And I'd now like to hand the conference over to your first speaker, Mr. Travis Butcher, Fund Manager of CQE. Thank you. Please go ahead.

Good morning, everyone, and welcome to CQE's results presentation for the full year ended 30 June, 2022. Presenting with me today is Scott Martin, Head of Social Infrastructure REIT Finance. I'd like to commence today's presentation with the acknowledgment of country. Charter Hall is proud to work with our customers and communities to invest in and create places on lands across Australia. We pay our respects to the traditional owners that Elders past and present, and value their care and custodianship of these lands. Turning now to Slide 5; CQE has had a strong year, continuing to deliver on its strategy and achieving robust financial and operating results. Key highlights for the year were as follows: Operating earnings were $0.173 per unit with distributions paid of $0.172 per unit, an increase of 8.1% and 9.6%, respectively, on FY '21. During the year, CQE achieved a revaluation uplift of $269.4 million, representing a 19.4% increase since 30 June, 2021, reflecting the strong demand and yield compression for long WALE social infrastructure assets. Acquisitions of $232.7 million were made during the year in social infrastructure assets across 26 properties, on long leases with strong tenant covenants. As a result of the revaluation growth and acquisition activity, CQE's gross assets have increased by 35% during the year to $2.1 billion. CQE has available investment capacity of $160 million, allowing CQE to pursue opportunities consistent with the fund strategy. The valuation uplift was a key contributor to the growth in NTA per unit of 25.5%, resulting in NTA per unit of $4.08 as at 30 June, 2022. The portfolio is well positioned with a WALE of 14.3 years, 100% occupancy and a weighting of 80% of income to metropolitan locations. Moving to Slide 6 and CQE's strategy. CQE's strategy remains unchanged. Our strategy is to provide investors with secure income and capital growth for exposure to a diversified social infrastructure portfolio. We do this by focusing on enhancing income sustainability and resilience to the assets we own, targeting ongoing capital growth and undertaking ongoing portfolio curation. Turning to Slide 7; during the year, CQA continued to enhance and diversify its income. Child care continues to be a critical social infrastructure asset class and integral to CQE strategy. As such, CQA has continued to invest in high-quality child care portfolios leased to well-capitalized operators, with a total of $157.3 million of acquisitions during the year. All of the acquisitions are well located, with an average lease term of 14 years with the operators, including the 2 largest operators in Australia's childcare sector, Goodstart and G8 Education. With respect to development activity, CQE completed 6 childcare developments during the year, delivering brand-new assets with average leases of 16.7 years and valuation uplift of $8.6 million or 25%. In October 2021, CQE acquired a health care asset in Heidelberg, Victoria, leased to Healius, a leading ASX listed healthcare operator. The asset is strategically located within one of Victoria's largest medical precincts, adjacent to a Healius operated pathology lab. In December 2021, the development of the South Australian Emergency Services Command Center was completed and is now occupied by the 4 government agencies. The building is leased on a 15-year term with fixed annual rent increases of 2.5% and 2 5-year options. In April 2022, CQE acquired a 50% interest in a newly constructed TAFE campus and specialist emergency medical care facility in Robina, Queensland. Robina is located within the Gold Coast growth corridor. The properties are underpinned by long-term leases to TAFE Queensland, a state government-owned education provider and Wise Medical. Both properties have 10-year lease terms with average fixed annual rental increases of 3.2%. Settlement of these properties is expected to occur in September 2022. Turning now to Slide 8, in environmental, social and corporate governance. We remain focused on implementing sustainability initiatives across our portfolio and consider ESG as a driver of long-term value for the fund in addition to investor and tenant customers. At a group level, Charter Hall has taken accelerated climate action, with a renewable power purchase agreement, which secures 7-year renewables in partnership with Global Energy Giant ENGIE, a critical step in the group achieving its target to be 100% powered by renewable electricity by 2025. CQE has participated in this renewable PPA, with 100% grid supply of renewables, powering 2 assets in our operational control. Additionally, CQE is partnering with tenant customers to provide solar solutions across the CQE portfolio. This will support clean and affordable energy for tenants in partnership with the fund. This will also enable CQE to better understand tenant operational performance for information sharing, which is currently not available under existing lease arrangements. Once implemented, CQE will be able to measure the impact of the solar initiatives and reduce the fund's Scope 3 operational emissions. CQE has also announced a partnership with the Green Building Council of Australia to develop Australia's first social infrastructure rating tool for operational assets. This will support operational performance, promote active tenant partnerships and create awareness of social and environmental initiatives at an asset level. Moving to Slide 9. In December, we launched a 2-year partnership with tenant customer Goodstart to provide funding to enable children from vulnerable families to access fee-free child care. We expect that the funding provided, will enable 55 children to be able to attend childcare as a result of this partnership, which in turn supports employment opportunity for parents and carers. I encourage you to view the case study we've included on Page 24 in the results presentation to understand the impact of the early learning fund. This initiative with Goodstart is a part of Charter Hall's approach to creating strong communities. I'd now like to hand over to Scott, who will provide an overview of the financial performance of the REIT.

Thanks Travis, and good morning to everyone. A summary of CQE's earnings for the full year FY '22 can be found on Slide 11. Net property income has increased by $12.5 million or 17.4% compared to the prior reporting period and has been driven by like-for-like rental growth, which contributed 1.8 and $10.7 million generated from net acquisition activity. The increase in operating expenses has been driven by portfolio growth and new acquisitions and finance costs have also increased period-on-period, as a result of higher levels of drawn debt and an increase in floating interest rates. CQE delivered operating earnings of $62.9 million, representing an increase of 8.4% on the prior corresponding period. Operating earnings per unit were $0.173 and distributions per unit was $0.172 in line with our full year guidance released to the market. Turning to Slide 12, which provides a summary of CQE's balance sheet position at 30 June, 2022. The $507.9 million increase in investment properties, represents an increase of 34.2% since 30 June 2021 and has been principally driven by $269.4 million of property revaluations, $168.8 million of property acquisitions transacted during the year and $53.1 million of expenditure on childcare developments and the completion of the South Australian Emergency Command Center. Acquisitions and development expenditure have been debt funded, resulting in drawn debt increasing by $253 million to $553 million as at 30 June, 2022. NTA per unit has increased 25.5% from $3.25 per unit at 30 June, 2021 to $4.08 per unit at 30 June, 2022, driven by the $269.4 million increase in property revaluations. Turning to Slide 13, which provides a summary of CQE's capital management initiatives. As outlined in CQE's half year results, the REIT has worked closely with the Charter Hall treasury team on a range of debt initiatives that have continued to strengthen CQE's balance sheet position through extension of facility terms and debt maturities, together with a reduction in margins. In February 2022, CQE increased its total facilities to $800 million, providing it with additional investment capacity to pursue new social infrastructure opportunities. CQE currently has a total of $160 million of available investment capacity. CQE has diversified funding sources, with no debt maturity until January 2025 and a weighted average debt maturity of 3.9 years. CQE's weighted average cost of debt as at 30 June, 2022 was 3.2%, which was calculated based upon drawn debt of $553 million and includes line fees on undrawn debt capacity. Balance sheet gearing was 29.8% and look-through gearing was 30.7% as at 30 June, 2022, adjusted to include contracted acquisitions and disposals, together with the funding of the remainder of the childcare development pipeline. Gearing levels remain at the lower end of CQE's target gearing range of 30% to 40%. During the current reporting period, CQE increased its level of hedging from $225 million to $325 million. Hedge debt comprises $225 million of interest rate swaps, with an average hedge rate of 0.54% and a $100 million interest rate cap, which entitles CQE to pay the floating rate of interest up to 3% and a fixed rate of 3% above this rate. As at 30 June, 2022, CQE has 59% of its balance sheet debt hedged, with a weighted average hedge maturity of 3.6 years. I will now pass back to Travis to continue with the presentation.

Thanks, Scott. On Slide 15, we have CQE's portfolio summary. As detailed earlier in our strategy, we're focused on continual portfolio improvement and enhancement of income sustainability and resilience. The portfolio continues to be 100% leased and the portfolio WALE sits at a very healthy 14.3 years. During the year, acquisition activity across 22 properties that settled and completion of 6 childcare developments and the South Australian Emergency Command Center, delivered average WALE of 14 years to the portfolio. Lease expiries within the next 5 years remains low at 4.6%, highlighting the importance of the property and lease terms to the operator's business. It's also worth noting that in FY '27 in FY '28, with our lease expiries amounting to 5.5% of income, that over 90% of these expiries have options, which we expect to be exercised during FY '23. Moving to Slide 16; CQE's current portfolio is well positioned to deliver both income and capital growth with 69% of CQE's income, underpinned by the top 5 tenants were all well-capitalized entities. The portfolio is heavily weighted to metropolitan locations, with 80% of income derived from these locations and a strong Eastern Seaboard weighting with 79% of income derived from these states. Childcare assets currently comprise 85% of the portfolio, with health assets sitting at 9% and government assets at 6%. Over the medium term, we expect the childcare weighting to reduce to between 50% to 70% of the portfolio, as other social infrastructure assets, including the Robina acquisitions are added to CQE's portfolio. Fixed annual reviews comprised 75% of CQE's leases, at an average rate of 3%, with the balance of leases based on CPI reviews. FY '23 rental growth is forecast to be 3.5%. Over the next 5 years, 44% of rental income is subject to market reviews. The majority of these reviews occur in the 3-year period from FY '25 to FY '27 and are typically capped at 7.5%. This will allow CQE to capture rental growth, both from under-renting across the portfolio and also periods where inflation exceeds the fixed rental reviews. Turning to Slide 17; during the year, CQE revalued 100% of the portfolio, excluding acquisitions undertaken and the developments completed during the year. The portfolio saw an uplift in valuations of $269.4 million, representing a 19.4% increase from 30 June, 2021, with the average passing yield of the portfolio now sitting at 4.7%. The valuation uplift and compression we have seen, is a function of strong demand for long WALE social infrastructure assets in essential sectors, with growing and resilient income. As can be seen from the graph, the value of childcare market transactions are at record levels with sales of approximately $832 million compared to the full FY '21 year with sales of approximately $550 million. Direct market transactions post 30 June, 2022 have slowed. However, transactions have included the sale of 100 Place Center in Toowoomba at 4.75%, 112 place center in Brisbane and 4.8% and the sale of a smaller center in Woodcroft in Sydney, at a yield of 4.5%. Turning to Slide 18, which provides an update on CQE's childcare developments. During the year, CQE completed 6 developments with a total valuation and completion of $42.3 million and an average yield on cost of 5.8%. All these developments are in high-quality locations and provided a valuation increase upon completion of $8.6 million, 25% non-cost. There are further 8 remaining properties in the development pipeline, and we're forecasting 5 of these to be completed prior to 31 December 2022, with the balance in calendar year 2023. The remaining properties have a forecast cost to completion of $18.5 million, and an average yield on cost of 5.6%. Turning to Slide 19 and an update on the current childcare market. The last 6 months have been very positive for the childcare sector from a government policy perspective, and once again, highlight the importance of the sector, as both the labor supply mechanism to the Australian economy and provision of quality educational outcomes to children. Annual federal government funding is expected to increase by 25% over the next 4 years to $12.4 billion in FY '26. This is expected to further increase, as a result of the introduction of the federal labor government new childcare funding policy. This policy will increase the affordability of childcare through increased subsidy rates and higher family income eligibility. The government has targeted an implementation date of July 2023. This additional funding follows the improved funding package by the previous government, which was implemented in March 2022, which has assisted in improving the affordability of childcare. In June, both the Victorian and New South Wales governments announced a significant funding investment in the provision of 3 and 4-year-old kindergarten programs in their respective states, which is expected to provide significantly improved education outcomes and drive an increase in participation levels for long day care centers that provide kindergarten services. Current operator performance is strong, despite the operating challenges faced by operators in attracting and retaining staff, which is consistent with the broader labor shortage across the Australian economy. Net center supply levels for the year grew by 2.7% or 224 centers with 8,556 centers at 30 June, 2022. This annual growth rate has pleasingly moderated from the prior year growth of 3.7%. Vacancy across the industry remains low, is estimated at circa 1%. Moving to Slide 21 and the outlook and guidance. CQE is focused on continuing with the execution of its strategy to pursue opportunities in social infrastructure areas, underpinned by strong tenant and property fundamentals. We're pleased to advise that based on information currently available and barring any unforeseen events, the FY '23 forecast distribution guidance is $0.172 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] Our first question comes from Solomon Zhang at JPMorgan.

Just a question on Slide 16, just on your comment around the 44% market revenues over the next 5 years. Two parts to my question; firstly, could you just provide an update on where you are rented versus market? And secondly, just the breakdown of the mechanisms, you mentioned the majority are at 7.5% cuts. Could you just provide a rough split there, please?

So in terms of your first question, based on our tenant data, our rent revenue sits at 11.8%. And typically, market sits between 12% to 15%. So we're sitting under-rented, which is obviously a good position to be in. In terms of then onto the market reviews, the majority of those fall in that FY '25 through FY '27 period, and there's approximately 180 over that period, sort of 60 in each of those periods. So when we come to that period, you sit down with the tenant and look at the current passing rent. But sort of using that current sort of under-renting across the portfolio, we're confident we'll get some increase in rents through that period.

Great. Maybe one more from me, just on the labor shortage issues you called out on Slide 19. What sort of wage growth are you seeing across the operators, and is that impacting the EBITDA margins as much? And do you think they will have much of a slowing impact on market rent growth for Charter?

It's definitely challenging for them. And it's actually been prior to COVID. It's always been an issue for operators attracting and retaining staff, just given the low levels of wages they're paid. So I think there's definitely some wage pressure. I think on the flipside, you're seeing good funding increases from the government. The prior Morrison government with their funding increases that came through in March, and the new labor government, which is coming through in July next year, will really provide some funding increases, which will ultimately help operators maintain their EBITDA margins.

Yes. So it is still sort of tracking at a 15% to 20% mark across new incentives?

Yes, correct. It does vary between operators and in different models. But yes, on average, you're probably sitting 15% EBITDA margin at a center level.