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

Ladies and gentlemen, thank you for standing by. Welcome to the Charter Hall Social Infrastructure REIT 2023 Half Year Results Briefing. [Operator Instructions] Please note that this conference is being recorded today Tuesday, the 14th of February 2023. I would now like to hand the conference over to your host today, Mr. Travis Butcher, Fund Manager. Thank you. Sir, please go ahead.

Good morning, everyone, and welcome to CQE's results presentation for the half year ended 31 December 2022. Presenting with me today is Scott Martin, Head of Social Infrastructure REIT Finance. I'd like to commence today's presentation with an acknowledgment of country. Charter Hall is proud to work with our customers and communities to invest in, develop and manage properties on land across Australia. We pay our respects to the traditional owners, their elders past, present and emerging and recognize their continuing culture and contribution to this country. Turning now to Slide 5. Key highlights for the half year are as follows: Distributions paid to investors for the half were $0.086 per unit, an increase of 2.4% in the first half of financial year 2022. This is in accordance with the previously advised full year FY '23 distribution guidance of $0.172 per unit. Acquisitions of $186.7 million were made in social infrastructure assets across 6 properties on long leases with strong tenant covenants. Key transactions were the Geoscience Australia building in Canberra in October 2022 and Innovation Quarter acquisition in Westmead made in February 2023, both of which significantly enhanced the quality of CQE's portfolio. During the half, CQE achieved a revaluation uplift of $16.3 million representing a 0.8% increase since 30 June 2022, driven by portfolio rental growth during the period, offsetting mild cap rate expansion. As a result of the acquisition activity, CQE's gross assets have increased by 8.5% during the half to $2.3 billion. NTA per unit has increased by 0.2% to $4.09 as at 31 December 2022. In September, CQE was added to the S&P/ASX 200 Index. This was a pleasing milestone for CQE and should result in increased liquidity and institutional interest moving forward. The portfolio is very well positioned in this current environment, with a strong WALE of 13.6 years, 100% occupancy and a forecast weighted average rent review of 4% for the next 12 months. 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, through exposure to a diversified social infrastructure portfolio. We do this by focusing on enhancing income sustainability and resilience of the assets we own, targeting ongoing capital growth and undertaking continual portfolio curation. Turning now to Slide 7. During the half, CQE continued to enhance and diversify its income with acquisitions during the period and post balance date amounting to $186.7 million. In October 2022, CQE acquired a 25% interest in the Geoscience Australia life sciences complex in Canberra for $90.9 million. The property was acquired on a 7.4% yield, 9.6-year WALE and 3% annual increases. Geoscience Australia is a commonwealth agency that serves as the Australian government's technical adviser in all aspects of geoscience and custodian of Australia's geographic and geological data, occupying the premises since 1998. Given the scientific nature of the tenant, the purpose-built property incorporates specialized lab facilities and a national earthquake alerts seismic center. In February 2023, CQE acquired a 49.9% interest in Innovation Quarter for $66.9 million, a newly constructed healthcare, medical research, education and training hub in Westmead. The property is located adjacent to Westmead Hospital, Westmead Train Station, the future Metro West station and Parramatta Light Rail station, and sits within the Westmead strategic precinct, it's primary function is as a health, research and education hub. Western Sydney University occupies approximately 47% of the building on a 15-year initial term, with the CSIRO occupying approximately 16% of the property on a 10-year initial term. Other major tenants include Telstra Health, Psych Central and [ WentWest ]. The property was acquired on a 4.7% yield and has average rental increases of 3.6%. Childcare continues to be a critical social infrastructure asset class and integral to CQE's strategy. As such, CQE has continued to invest in high-quality childcare assets, with a further 4 assets acquired during the half, totaling $28.9 million on an average yield of 4.9%. These acquisitions are all on new 15-year leases to premium operators, who are existing CQE tenant customers. With respect to development activity, CQE completed 3 childcare developments during the half delivering brand-new assets with average lease terms of 15 years, valuation uplift of $5 million and yield on cost of 5.8%. As part of our active portfolio curation and capital recycling during the period, CQE disposed of 5 freehold childcare assets with an average WALE of 8.1 years for $15.3 million, at an average yield of 4.4%. In addition, in January 2023, CQE fully divested its 3.5% holding in listed Arena REIT, generating gross proceeds of $44 million. Based on Arena's current FY '23 distribution guidance, the divestment was undertaken on a 4.6% yield. Proceeds of both the childcare assets and Arena securities have been utilized to reinvest into direct social infrastructure properties, providing unitholders with stronger income and capital growth prospects. Moving now to Page 8. The broadened social infrastructure mandate has delivered higher-quality income from properties with stronger tenant covenants. Since the mandate was broadened with the purchase of the Brisbane Bus Terminal in June 2019, CQE has made acquisitions of $746 million, including $294 million in childcare and $452 million in other long-WALE social infrastructure properties. The long-WALE social infrastructure properties acquired include the Brisbane Bus Terminal, Geosciences Complex, the Emergency Command Center and the Robina TAFE, all assets providing essential services to the community. These acquisitions have allowed the fund to actively curate its childcare portfolio with divestments of $171 million over the same period. These assets were either centers with weaker tenant covenants, located in regional locations, poorly designed or aging centers facing obsolescence or competition effects. Social infrastructure is a growing asset class with long-term opportunities for future investment for CQE. Key thematics driving this are both the growing and aging population in Australia, with estimates of an additional 11 million people expected in Australia's major cities by 2054. The population is also aging, with 20% of the population expected to be over 65 in the next 10 years. This will require a significant investment in social infrastructure in the future. And as shown on Slide 25 of the presentation, government spending in childcare, education, health and transport are forecast to continue to grow. Governments will not be able to fund all the required infrastructure, creating significant opportunities for private capital. As the pie graphs shown on the right of this slide, CQE has diversified its income into broader social infrastructure subsectors, with childcare assets currently comprising 77% of the portfolio and other social infrastructure assets sitting at 23%. Over the medium term, we expect the childcare weighting to reduce to 50% to 70% of the portfolio as other social infrastructure assets added to CQE's portfolio. CQE unitholders have benefited from the Charter Hall transaction platform with significant acquisition activity, securing high-quality social infrastructure assets and predominantly off-market transactions. Turning now to Slide 9 and ESG. We remain focused on implementing sustainability initiatives across our portfolio and consider ESG as a driver of long-term value for the fund. Key points to focus on from a CQE perspective are: Continued partnership with our tenant customers to provide solar solutions across the CQE portfolio, of which now 0.5 megawatts have been installed across the portfolio. This will both support clean and affordable energy for tenants, but also enable CQE to better understand tenant operational performance through information sharing, which is currently not available under existing lease arrangements. Secondly, CQE has continued to work with the Green Building Council of Australia on the development of Australia's first social infrastructure rating tool for operational assets. And finally, we are entering the second year of our partnership with major tenant customer, Goodstart, to provide funding to enable 55 children from vulnerable families to access fee-free child care. I'd like now to hand over to Scott, who'll provide an overview of the financial performance of CQE.

Thanks, Travis, and good morning to everyone. A summary of CQE's earnings for the half year can be found on Slide 11. Net property income has increased by $7.6 million or 19% compared to the prior corresponding period and has been driven by like-for-like rental growth of 3.7% from the stabilized portfolio, and a further $6.8 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 $29.6 million, which equates to operating earnings per unit of $0.081. Distributions per unit were $0.86, in line with our full-year FY '23 distribution guidance released to the market. Turning to Slide 12, which provides a summary of CQE's balance sheet position at 31 December 2022. The $180.4 million increase in investment properties represents an increase of 9.1% since 30 June 2022 and has been principally driven by $154 million of property acquisitions transacted during the half and $16.3 million of property revaluations. Acquisitions and development expenditure have been debt funded, resulting in drawn debt increasing by $170 million to $723 million as at 31 December 2022. NTA has increased by 0.2% to $4.09 per unit at 31 December 2022, driven by the $16.3 million of property revaluations. Turning to Slide 13, which provides a summary of CQE's capital management initiatives. In September 2022, CQE increased its total facilities to $850 million, providing it with additional investment capacity to pursue new social infrastructure opportunities. CQE currently has a total of $75 million of available investment capacity. CQE has diversified funding sources with no debt maturity until January 2025 and a weighted average debt maturity of 3.5 years. CQE's weighted average cost of debt as at 31 December 2022 was 4.1%, which is calculated based upon drawn debt of $723 million and includes line fees on undrawn debt capacity. Balance sheet gearing was 33.7% and look-through gearing was 34.4% as at 31 December 2022, adjusted to include contracted acquisitions and disposals, the divestment of ARF units, together with the funding of the remainder of the childcare development pipeline. Gearing levels remain within CQE's target gearing range of 30% to 40%. During the current reporting period, CQE increased its level of hedging from $325 million to $475 million. In December 2022, CQE entered into a $150 million interest rate swap with a forward start date of June 2023 and a 2-year maturity. Hedge debt comprises $375 million of interest rate swaps and a $100 million interest rate cap, with an average hedge rate of 1.82%. The CQE has a weighted average hedge maturity of 2.9 years, with an average hedge percentage of 59% through to June 2025. I will now pass back to Travis to continue with the presentation.

Thanks, Scott. On Slide 15, we summarize CQE's portfolio. As detailed earlier in our strategy, we are focused on continued portfolio improvement and enhancement of income sustainability and resilience. As at 31 December 2022, CQE owns 373 operating properties with a total value of $2.2 billion across a diversified social infrastructure portfolio. During the half, CQE's portfolio increased by 5 properties, which included the settlement of the TAFE Queensland and [ various ] medical properties in Robina, Geosciences acquisition in Canberra and completion of 3 childcare developments, all improving the portfolio quality. The portfolio continues to be 100% leased, and WALE sits at a very healthy 13.6 years. Lease expiries within the next 5 years remain low at 4.2%, highlighting the importance of the property and lease term to the tenants business. It's also worth noting that of the 4.2%, only 1.4% is true expiries where there were no tenant options. Moving to Slide 16. CQE's current portfolio is well positioned to deliver both income and capital growth, with the portfolio heavily weighted to metropolitan locations, comprising 82% of income; and a strong Eastern seaboard weighting, also of 82%. As part of our strategy, we've worked to diversify our tenant mix, and our income composition has expanded now to include both federal and state governments. Concentration risk has reduced, with our largest tenant, Goodstart, providing 35% of CQE's income as at 31 December 2022. The fixed annual reviews comprised 78% of CQE's lease income at an average rate of 3%, with the balance of lease income based on CPI reviews. Rental growth for the next 12 months is forecast to be 4%, based on a CPI assumption of 7.5%. Over the next 5 years, 46% of CQE's rental income is subject to market reviews. These reviews are all childcare properties, with the majority occurring in the 3-year period from FY '25 through to FY '27 and are typically capped at 7.5%. This will allow CQE to capture rental growth from under-renting across the portfolio, which has been independently assessed by the value that was at approximately 5%. Rent revenue for the childcare operators, based on tenant data provided on the leases, sits at 12.1%, which is very sustainable for operators, which is very important, given the long lease terms. Turning to Slide 17. During the half, CQE revalued 100% of the portfolio, excluding acquisitions undertaken and developments completed during the half. The portfolio saw an uplift in valuations of $16.3 million, representing a 0.8% increase from 30 June 2022, with the average passing year of the portfolio now sitting at 4.8%. The valuation uplift has been driven by portfolio rental growth during the period, offsetting a mild yield expansion of 6 basis points. As can be seen from the graph on the right, the value of childcare market transactions for the last 6 months have slowed, with direct market transactions recorded of approximately $217 million. This is down from a record year in FY '22, where there were transactions of approximately $830 million. Transaction yields for the 6 months have increased to 5.3%, up from 4.7% in FY '22. However, there were limited transactions in the period, and the transactions were of lower quality and secondary stock with weaker tenant covenants. As has been proven in previous property cycles, due to the asset size of childcare assets, there is still liquidity in the market as purchases are often not reliant on borrowings to make property purchases. By way of example, in December, CQE exchange contracts for sale of 5 properties at an average yield of 4.4%. Turning to Slide 18, 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 a labor supply mechanism to the Australian economy and provision of quality, educational outcomes for children. Annual federal government spending is expected to increase by 44% to $14.1 billion in FY '26. A big proportion of this increase being 20% is expected to occur in FY '24 due to the implementation of the federal government's Cheaper Child Care plan, which is expected to be implemented in July 2023. The legislation to implement these changes successfully passed through Parliament in November 2022. This policy will increase the affordability of childcare through increased subsidy rates and higher family income eligibility. The outlook for the childcare industry continues to improve, with current operating performance strong. Occupancy levels have returned to above pre-COVID levels in most instances and daily fee growth has been achieved. Across our portfolio, operators have increased a daily fee by $4 per day or 3% over the last 6 months, with an average daily fee of $124. The additional government funding will also support occupancy growth. There are also early signs that the challenges faced by operators in attracting and retaining staff is starting to abate. Turning to supply. Net center supply levels for the year grew by 2.8%,or 238 centers, with 8,679 centers at 31 December 2022. This annual growth rate has pleasingly moderated from the prior year growth of 3.1%. Vacancy across the industry remains low and is estimated at circa 1%. Moving to Slide 20 and the outlook and guidance. CQE is focused on continuing with the execution of its diversified social infrastructure strategy. The key focus of this strategy is to actively curate the portfolio to larger-scale assets, underpinned by stronger tenant and property fundamentals. Today, we are reconfirming 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.

[Operator Instructions] The first question comes from the line of Solomon Zhang of JPMorgan.

Travis and Scott. A couple of questions from me. Just first one, just on the balance sheet. Gearing of 34% has picked up a little bit, and the interest coverage has dropped from 6.8x to 3.5x, [ debt ] covenants at 2.5x. Are you comfortable with debt levels at these levels in this point in the cycle? Are you sort of looking to reduce that over the next 6 months or so with further noncore asset sales?

Thanks, Solomon, it's Scott here. Just to clarify that the [ ICR ] covenant is 2x, not 2.5. But to answer your question in respect of gearing here, we're sitting right in the middle of our target gearing range of 30% to 40%. So like we're quite comfortable at that range. We've got significant headroom to our debt covenants with the banks. So we're very comfortable where we sit at the moment.

Great. Next one is just on the market rent reviews. It looks like it was 2.7% this half, a bit weaker than your 5% under assessment. Was there a little bit of a call to not push rents, given the more challenging operating conditions, or anything center-specific there?

So that's an interesting one. When you've got 4 properties over a portfolio, 350, each one has got individual circumstances. So I think we called out in the presentation that the values have assessed. We're sort of sitting 5% under market. We probably think that's a little bit conservative. We've always said we sort of think the 5% to 10%, but really comes down to how early in the lease terms that market review, a lot of different circumstances. So you can't really sort of take the results of fall, apply that across the whole portfolio.

Maybe just final one for me. Just on Slide 17, you sort of called out the robustness of the sub $5 million transactions? And what percentage of your portfolio is under that threshold will this [ be taking ]?