Charter Hall Social Infrastructure REIT

ASX:CQE

Earnings Call Analysis

Earnings Call Transcript 2020-Q2

[Operator]

Ladies and gentlemen, thank you for standing by, and welcome to the Charter Hall Social Infrastructure REIT 2020 Half Year Results Briefing. [Operator Instructions] Please note that this conference is being recorded today, Wednesday, the 12th of February 2020.I'd now like to hand the conference over to your host today, Mr. Travis Butcher, Fund Manager of CQE. Thank you, sir. Please go ahead.

[Travis Scott Butcher, Fund Manager]

Good morning, and welcome. I'm Travis Butcher. I'm joined today by Scott Martin to present CQE's half year result presentation.I'll commence the presentation with the key highlights and discussion on CQE strategy, and Scott will provide an update on the financial metrics. I'll then return to cover portfolio activity and update on the childcare industry, followed by a summary of CQE's outlook.Commencing on Slide 4. Key highlights for the half year as follows. The first half of 2020 saw strong asset growth of 7.3%, driven by a combination of acquisition activity and valuation uplift. This combination resulted in a 3% uplift in NTA from $2.96 to $3.05 over the period. The portfolio yield also continues to be healthy at 6.1% as at December 31, 2019.One of the key highlights during the half was a strong leasing activity. This included 40 new 20-year leases agreed with Goodstart and the renewal of 37 5-year options. This has resulted in CQE's WALE increasing to 11.7 years, up from 9.9 years at June 30, 2019. The Goodstart transaction is a very positive outcome for both parties. Goodstart are a key customer of CQE, contributing 46.5% of CQE's rental income. It's been a great outcome to partner with them to secure their ongoing occupation and involvement in the CQE portfolio.For investors, we've delivered earnings per unit growth of 2.4% for the half, to $0.085, with the full year EPU forecast maintained at a range of $0.17 to $0.172 per unit, representing a growth of 3% to 4% on FY '19.Importantly, we've received credit approval to increase CQE's debt facility by $103 million to $500 million, which will result in undrawn capacity of $179.5 million, allowing CQE to fully fund its contracted acquisitions and remaining development pipeline spend. The development pipeline continues to be a source of growth for investors. The pipeline has a completion value of $184.8 million across 30 properties. We expect to deliver 14 sites within the next 12 months.Moving to Slide 5 and CQE's strategy. CQE's strategy is to provide investors with stable and secure income and capital growth. We've successfully delivered this over the last 5 years, with distribution growth of 5.5% per annum and capital or NTA growth of 12.5% per annum.One of our key focuses, which can be seen throughout the activities in this half, is the enhancement of income sustainability and resilience through economic cycles. We aim to achieve this through a mix of investment in childcare and social infrastructure assets. We continue to look to grow income and capital values through active asset management via leasing, development and portfolio curation. Where we see opportunities for acquisitions or developments, our goal is to fund these through the sale of noncore assets within the childcare portfolio. If we're issuing new equity, we are focused on acquisitions or developments that enhance earnings, NTA and portfolio and covenant quality.Ultimately, our investment approach would be to remain disciplined and focus on assets with the following attributes: specialist use with limited competition and low substitution risk; strategic locations with high underlying land values; predominantly triple net lease structures with minimal CapEx leakage; and assets and improved tenant covenant quality.Moving to Slide 6 and to reconfirm CQE's asset preferences. Childcare remains our primary focus, followed by educational assets, government services and facilities, transport and health in that order of preference. We believe that the existing income stream derived from childcare can be enhanced with greater sustainability and resilience from assets and other social infrastructure subsectors with stronger tenant covenants. Previously, CQE was unable to access these opportunities and is now in a position to leverage the Charter Hall transactional platform.Areas of focus will be on real estate as opposed to operational assets that provide the attributes previously noted. It's our expectation that as the population continues to grow and with increased community demand and expectations as to the range and standard of government or mandatory services, Australia may experience a shortfall in the provision of assets and services in CQE's 4 key subsectors of interest. This should provide benefits of scale to CQE by participating in what is expected to be a significantly deeper social infrastructure sector in years to come.I'll now pass on to Scott to discuss the financial results for CQE.

[Scott Nicholas Martin, Head of Diversified Finance]

Thank you, Travis, and good morning to everyone. A summary of CQE's half year '20 results are summarized on Slide 8. CQE delivered operating earnings of $25.5 million, an increase of $4.3 million or 20.3% on the prior corresponding period. Earnings per security for this half were $0.085, representing 2.4% growth on half year '19. And distributions declared for the half were $0.0835 per security, representing 4.4% growth on half year '19 and is consistent with our full year distribution guidance.Key drivers of the increase in operating earnings from half year '19 to half year '20 included a $3.2 million increase in lease income, comprising $0.7 million of organic rental growth, $2.1 million increase from net property acquisitions and a $0.4 million increase in development site rents. In addition to this, we generated $0.9 million share of operating earnings from the Brisbane Bus Terminal joint venture and also a $1.4 million reduction in finance cost due to lower levels of borrowing and a lower cost of debt.These items were partially offset by operating expenses, comprising funds management fees and fund administration costs increasing by $0.7 million due to portfolio growth in new acquisitions, a $0.4 million increase in nonrecoverable outgoings primarily relating to land tax and a $0.2 million increase in valuation fees due to the increase in third-party valuations completed in the current reporting period.A summary of CQE's balance sheet position at December 31 is presented on Slide 9. NTA per security has increased by 3% from $2.96 at June 30, 2019, to $3.05 at December 31, 2019, primarily due to investment, property and security revaluations. Total assets have increased by 7.3% to $1.3 billion since June 30, 2019, which has been driven by the acquisition of 7 operating properties for total consideration of $41.6 million, $26.5 million of expenditure incurred on CQE's development pipeline and property revaluations of $21.3 million. The property valuation movement was a result of a reduction of 10 basis points in the property portfolio yield from 6.2% at June 30 to 6.1% at December 31, 2019.Balance sheet drawn debt increased by $47 million during the current period to assist with funding new acquisitions and development expenditure.A summary of CQE's debt and hedging position is presented on Slide 10. As Travis has already touched on earlier in the presentation, CQE secured an increase to its facility limits with ANZ and HSBC of $103 million from $397 million to $500 million, providing it with undrawn capacity of $179.5 million to fully fund contracted existing property acquisitions and future committed development expenditure. CQE has also extended the maturity dates of these facilities from September 2021 to February 2023 and September 2023 to February 2025.CQE has diversified funding sources with no debt maturity until February 2023, a weighted average cost of debt of 3.8%, including amortization of deferred borrowing costs and a weighted average debt maturity of 4.3 years.At December 31, 2019, CQE had $320.5 million of drawn debt. Balance sheet gearing was 24.9% and look-through gearing was 26.3%. The difference between balance sheet and look-through gearing ratios relates to CQE's share of the joint venture debt facility for the Brisbane Bus Terminal. CQE's gearing remains below the target gearing range of 30% to 40%. CQE has a staggered hedging profile through to December 2025 with an average 58% hedged and a hedge rate of 1.75%.I will now pass back to Trevor to provide an operational update and childcare industry overview.

[Travis Scott Butcher, Fund Manager]

Thanks, Scott. On Slide 12, we have CQE's portfolio summary. As detailed earlier in our strategy, we are focused on continued portfolio improvement, enhancement of tenant covenants. This is achieved for a portfolio curation, including acquisitions, developments, disposals and leasing activities.WALE as at December 31, 2019, has increased to 11.7 years, following the agreement on 14 new 20-year leases with Goodstart and 5 new 15-year leases with other tenants. Importantly, this has resulted in a reduction of lease expiries within the next 5 years from 18.9% to 9%. The remaining lease expiries within the next 5 years include only 3%, where the tenant does not have options to extend the lease.In relation to tenants, we're focused on improving the overall portfolio tenant covenant and our focus is on tenants that are well capitalized, ASX-listed or have strong parent entity backing. We've reduced the number of tenants in the portfolio down to 30, as we've been divesting centers tenanted by smaller operators.Moving to Slide 13. Our reliance on CPI-based reviews continues to decrease. We forecast CPI reviews in FY '21 reducing to 41% of rental income. This is a reduction from 70% during 2015. We continue to look for opportunities to reduce the percentage of CPI reviews through new lease negotiations and completion of new developments and acquisitions.There was one market rent review completed during the half with an increase of 3% achieved, noting that this market review occurred 5 years after lease commencement. The weighted average rent review across the portfolio currently sits at 2.4%. CQE's portfolio rent to revenue analysis highlights the under-rented nature of the childcare portfolio. Based on existing operator metrics, the portfolio remains below the industry benchmark of rent to revenue of 12% to 14% on a good average management basis, with CQE averaging 11.2% on a passing revenue basis.Moving to CQE's geographical location. Australia, eastern seaboard states comprise 81% of the portfolio. This is expected to increase with the completion of the development pipeline, which has 26 developments on the eastern seaboard. Despite our focus on these markets, it's also worth noting that we're seeing good acquisition opportunities in both South Australia and Western Australia.Turning to Slide 14, an acquisition and disposal activity. During the half, we have settled 7 existing acquisitions totaling $41.6 million, with a further 8 acquisitions totaling $45.9 million contracted and expected to all settle in the second half of FY '20. New acquisitions have an average WALE upon acquisition of 16.5 years and with annual rent reviews of 3% or more. Consistent with improving the portfolio's tenant covenant, 9 out of the 15 acquisitions have leases to listed ASX operators. The average yield of center acquisitions was 6.4%.As part of assessing acquisitions, we're strongly focused on the location, in particular higher socioeconomic areas. These attributes support childcare businesses as well as land value growth in the long term. This is measured by SEIFA rating, with 10 being the most advantaged. Our average SEIFA rating was 8 across the new locations. In terms of viabilities at childcare center, the demand ratio, which measures number of children in a location to the existing number of places, was 4.3. In other words, 4.3 children for every childcare place, demonstrating locations with an undersupply of childcare places. The occupancy of centers opened during calendar year 2019, which have been trading for greater than 4 months, is 82%, which demonstrates our ability to target acquisitions in the right locations with the right operators.In relation to disposals, during the period, we have sold 9 properties for a total value of $13.8 million, an average selling yield of 7% and a premium to book value of 9.9%. Our disposal strategy is based on a number of criteria, which includes properties with low underlying land value and low SEIFA ratings, as evidenced by the sales completed during the half, with the average SEIFA rating as 3.Turning to Slide 15. CQE undertook 361 valuations during the half year that saw an increase of 2.8% or an average 10 basis point reduction in passing yield. We've now adopted a 2-year independent revaluation cycle compared to the previous 3-year cycle. In terms of the 2.8% valuation increase, 1.6% was attributed to rental growth, with 1.2% due to cap rate compression. The states with the highest valuation growth was South Australia with a 5.1% increase and Western Australia with a growth of 4.8%, although these states have historically lagged the eastern seaboard states.As can be seen from the bottom right graph, the value of market transactions was slightly down during the last 12 months to $327 million due to reduced availability of stock. A large proportion of assets offered for sale in the open market did not meet CQE's investment criteria based on a combination of factors, which included location, tenant covenant and pricing. We continue to seek out quality opportunities, which meet these criteria. We still see the potential for yield compression inside the CQE portfolio, and this is driven by the quality of the new stock being developed and acquired replacing less efficient and typically smaller assets.Turning to Slide 16. The development pipeline continues to be a good source of quality assets that are accretive to CQE's earnings as well as providing superior long-term growth. CQE has moved to balance the development portfolio for greater utilization of third-party developers on 13 properties. In addition, moving forward, it's our strategic preference to enter into agreements with third-party developers to provide CQE with assets paid for upon completion. This derisks the development of new centers for CQE by shifting planning, completion and licensing risk to the developer. There are 15 developments under construction with a further 11 to commence prior to June 2020.We expect 14 developments to be delivered within the calendar year 2020, which will provide earnings growth in FY '21 and beyond. We have encountered planning delays in some locations, which has resulted in additional costs. And as a result, the current forecast yield on cost is 6.5%.Moving to Slide 18, an update on the childcare industry. The Child Care Subsidy scheme, or CCS, introduced in July 2018 has increased demand for childcare since its introduction. The number of children utilizing long day care has grown by 4% or approximately 30,000 children in the 12-month period to September 30, 2019, and has increased by 12.5% since the CCS was introduced. Western Australia sees the highest rate of annual change at 7.1%, with Victoria at 7%. This aligns with CQE activity with 5 existing center acquisitions in Western Australia and 20 developments currently being completed in Victoria.The participation rate has increased to 49.9%, with over 780,000 children utilizing long day care services. This has increased from 38.1% 10 years ago. Children are attending for longer periods, with average hours increasing from 28.6 hours at June 2018 to 30 hours at September 2019. Average affordability is 4.2% lower since the introduction of the CCS, with price increases of 8.6% eroding a significant proportion of the initial CCS impact. Female labor participation rate is at a record level of 61.2%, and the overall workforce participation rate remains at 66%.Turning to Slide 19 and supply. Net center supply levels for the year grew by 4.2%, with 7,894 centers at December 31, 2019, with the strongest growth occurring in Victoria at 5.7% growth and South Australia at 4.9%. An important trend in the sector is a downwards trend of family day cares centers, which has reduced by 16.7% during the last 12 months and by over 50% over the last 5 years. This is due to low levels of profitability and parents' preference for the long day care center format.The graph on the bottom right shows the annualized growth in both supply and demand over the last 5 years. In terms of demand, the impact of the CCS can be seen in the blue shaded area, which showed a strong increase in demand during the first 12-month period, with growth now returning to the average rate. Over the last 5 years, the growth in supply has averaged 3.7% per annum, which is consistent with the growth in the number of children at 3.7% per annum over the same period, demonstrating an equilibrium level of demand and supply. However, childcare catchments are very localized, and there will be outliers of both under and oversupply. Quality operators have invested in their care offering. Staff and premises are best positioned to take advantages of the increases in demand.Moving to Slide 21 on the outlook. The outlook for CQE remains sound with a focus on delivering to unitholders stable and secure income and capital growth. We expect the settlement of 8 existing centers and completion of 9 development sites in the second half of FY '20. We continue to see attractive opportunities in the childcare market, where the focus is on strategic locations leased to well-capitalized quality operators. We're continuing to pursue opportunities in the social infrastructure market that can provide greater sustainability and resilience to CQE's income stream with stronger tenant covenants whilst matched to CQE's existing property attributes.With respect to earnings guidance for FY '20, subject to continued tenant performance, CQE reaffirms earning guidance of 3% to 4% for FY '20 over FY '19, which equates to $0.17 to $0.172 CPU, and distribution guidance of $0.167 per unit, representing 4.4% growth over FY '19.That concludes the formal component of our presentation. We look forward to your questions. Thank you.

[Operator]

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

[Krzysztof Kaczmarek, Analyst]

Just a question on the 45 new leases that were agreed in the half. Can you just talk through how that sort of came about? Was there any change in passing rents? And was there any CapEx or incentive sort of provided to the tenants there?

[Travis Scott Butcher, Fund Manager]

Thanks, Krzysztof. At this stage, we're not able to provide commercial details, as documentation is still to be completed. However, the great transaction, it's a positive transaction for both parties. And it's fair to say that rents are on better terms than the existing leases, with fixed rental increases that are greater than the current CPI. And at this stage, that's all we can really provide, Krzysztof.

[Krzysztof Kaczmarek, Analyst]

Right, okay. And then just -- can you just talk about the sort of the broader mandate? Have you been looking at any sort of social infrastructure assets in the half? Have you passed on any opportunities? And I guess, what sort of held you back from acquiring? And also, do you see any opportunities going forward in that social infrastructure space, that are sort of imminent?

[Travis Scott Butcher, Fund Manager]

Yes, we've looked at a number of assets. However, we haven't been able to secure any yet and that's been -- just not been able to meet investment criteria: location, tenant covenant and pricing. One example we had was in Mill Park in Victoria. There was a government-tenanted medical facility, sort of the Royal Melbourne Hospital, 15-year lease, 3% fixed increases, which sort of fitted our mandate perfectly. However, that asset exceeded our price range and sold for sort of a sub-5% yield. So we're sort of actively looking, but the key thing is we just want to really match up any new social infrastructure asset with those sort of key property attributes, which have been sort of the hallmark of CQE's success in the past.

[Krzysztof Kaczmarek, Analyst]

And just on sort of medical, would you be open to acquiring something that's not tenanted by government? Or you're pretty much in that medical space only focused on government tenants?

[Travis Scott Butcher, Fund Manager]

Really comes down -- I think you probably noticed the message throughout. Just really, we're focusing on tenant covenant. So preference would be government. However, depending on the quality of that tenant covenant, we would consider it as well.

[Operator]

[Operator Instructions] Our next question comes from Jeff Pehl from Goldman Sachs.

[Jeffrey Robert Pehl, Associate]

Just want to go back to the supply levels for CY '19 sitting at 4.2%. What is your forecast for CY '20? Is it going to go down to more of that long-term level or remain elevated? And if you can give the -- maybe the forecasted amount of centers you expect as well?

[Travis Scott Butcher, Fund Manager]

Thanks, Jeff. That's a hard one to actually predict what it's going to be in terms of new centers for calendar year '20, just because you can look at DIs, and it's probably hard to get a true picture of the number of DIs in Australia, because no one reports an accurate number. What's important is to look at what's happened in January 2020. Currently, we're sitting at 63 new openings versus 60 in the prior January. So you're sort of on similar levels. And I think the -- over the last 4 years, demand for childcare from children's averaged 3.7%. Supply has been 3.7%. So it's sort of been in that equilibrium. What you will find with childcare, and it's important to note, is that childcare catchments are very localized. So you will see outliers are both undersupply and oversupply. So to answer your question, it's probably a hard one to -- we can't sort of predict. I think it will be a similar level, that high 3% to around that low 4% growth. The exact number, it's hard to predict.

[Jeffrey Robert Pehl, Associate]

Is there any of the catchments that maybe give you some concern on oversupply, anyone you can point to?

[Travis Scott Butcher, Fund Manager]

What we do, Jeff, when we look at -- I think one of the true tests of our -- when we buy assets and which I noted in the presentation, of some of -- 6 assets, which we opened during calendar year '19, they've all got occupancy of 82%. So I think one of the key -- we use all the data we've got available, plus other analytics and mapping tools and really predict those or find those areas with an undersupply of childcare places. And obviously, the flip side is the ones we look to sell are ones where you look at and go, we might have an older style center, that the performance is starting -- you can see downward trends in terms of performance. And there might be a new center opening in that location. So we look to divest and move those assets on.

[Operator]

Our next question comes from Gavin Peacock from CBRE.

[Gavin Peacock;CBRE Clarion Securities;Analyst]

Just wondering if you could give us any color on whether or not the new leases with Goodstart have come through into valuations yet? And also, any color you could give us around where you see valuations moving to in the childcare space?

[Travis Scott Butcher, Fund Manager]

Thanks, Gavin. In terms of the Goodstart transaction, that will be a second half of FY '20 when that comes through. So we'll be able to provide further updates to that. Obviously, when those leases get concluded, we'll announce that to the market, and as part of that, provide the valuation impact. In terms of the broader portfolio, we've seen 10 bps of compression across the portfolio in this half. A significant proportion of that -- of the 2.8% growth, 1.6% of that was rental growth. So obviously, we'll see that moving forward. And we expect, over time, what we're doing with the portfolio is improving the quality of it. So we expect to see the yield -- overall yield of the portfolio come in as we sort of curate the portfolio over time.

[Gavin Peacock;CBRE Clarion Securities;Analyst]

So with the latest round of revaluations, you just revalued roughly 1/4 of the portfolio. Is that right? Is it rolling quarterly basis over the 2-year period, that works?

[Travis Scott Butcher, Fund Manager]

Yes, correct. So we did 129 independents, and then we supplemented that with directors' valuations, which largely picked up rental growth since June '19.

[Operator]

Our next question comes from Krzysztof from JPMorgan.

[Krzysztof Kaczmarek, Analyst]

Just 1 more from me. I'm just looking at your key statistics on Slide 26 at the back of the presentation. There's -- you've got 2% like-for-like rent growth, which is down quite a bit on '18 and then a little bit on '19. Is that really just due to the lower contribution of market rent reviews. What's sort of driving that number lower?

[Travis Scott Butcher, Fund Manager]

Yes. You've got one of the elements to it, Krzysztof, and the other one is just the low CPI across the portfolio. I think our average CPI increase across the year was 1.6%, combined with that lack of market rent reviews, pulled back that like-for-like rental growth.

[Operator]

[Operator Instructions] There appears to be no further questions at this time. I might pass back to Travis for any follow-up or closing comments.

[Travis Scott Butcher, Fund Manager]

Thank you all for your attendance and look forward to catching up with some of you over in the coming weeks, and we're always happy to answer questions. If any investors got questions, feel free to give us a call. Thank you.