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Morningstar | Precinct Pushes Harder into Development. FVE Raised to NZD 1.55

Precinct Properties’ reported first-half fiscal 2019 operating earnings before performance fees of NZD 39.8 million or NZD 3.29 cents per security, or cps, increased slightly on NZD 38.2 million, or NZD 3.15 cps in the previous corresponding period, or pcp. The small increase is due to organic rental growth being offset by income loss on asset sales and rental downtime at assets undergoing redevelopment works. Fiscal 2019 pretax guidance was retained at "around NZD 6.6 cps" before performance fees, implying a similar result in the second half. Dividend guidance remains at NZD 6.0 cps.

Precinct is in the rare position of having its portfolio 100% occupied. This is consistent with its key markets, where vacancy is only 3% for Prime Auckland CBD assets and 1.2% for Prime Wellington CBD. Leasing outcomes across the Auckland portfolio have continued to surprise to the upside, with rents for new leases 11.3% above prior contracted rents and renewed leases were struck at rates 5.7% above valuers' assessment of market rates. Following upgrades to our rental growth rate expectations for the Auckland assets, our fair value estimate increases to NZD 1.55 from NZD 1.45. At current levels, narrow-moat-rated Precinct screens as fairly valued.

Coinciding with the half-year result, Precinct is undertaking a fully underwritten NZD 150 million equity raise, composed of a NZD 130 million institutional placement and a NZD 20 million retail offer, that Precinct has discretion to increase up to a further NZD 10 million. Under the retail offer, eligible shareholders can apply for up to NZD 50,000 of new shares. The equity raise is subject to underwritten floor price of NZD 1.45 per security, a discount of 5.5% to last close.

We see Precinct as very differentiated from most conventional REITs, and there are numerous positives from this strategy. First, the firm is undertaking far more development than most REITs would normally undertake, with committed development having an estimated value on completion of NZD 1.7 billion, or 68% of property assets at December 2018. This is transformational and will result in the weighted average age of Precinct’s portfolio falling to seven years from 20 years. This should result in annual maintenance costs of the portfolio being roughly half the industry average for a number of years. The high level of development would ordinarily carry significant risk, but with ultralow vacancy in Precinct’s markets of Wellington and Auckland, we see leasing risk as low.

Second, the portfolio will be heavily weighted toward the highest-quality Premium office buildings, which we see as attracting higher-quality tenants. This supports lower vacancy risk as the tenants tend to have stronger cash flows. However, rents at this end of the office spectrum are still sensitive to a contraction in tenant demand.

Third, having invested NZD 7.4 million to acquire the 50% remaining stake in "Generator," Precinct is now a significant player in the Auckland flexible workspace market. Flexible desks offered by Generator currently stand at 1,245 which is a more than sixfold increase on the 190 in 2017. Flexible workspace taken up by Generator and competitors currently represents around 1.2% of Auckland office space, but could increase to as high as 5% if the penetration rate follows that of major global cities. Generator is already the dominant provider of flexible workspace, with a 60% market share in Auckland. It seems likely that Precinct will be able to leverage its position as the dominant office landlord in Auckland, by incorporating sublease deals with Generator into forthcoming leases to accommodate flex in tenants' space requirements. While only a small part of the business at present, we see Generator as long-term strategic positive. Precinct also plans to extend the footprint of Generator into the Wellington city centre.