AUSTRALIAN PROPERTY INVESTMENT RESEARCH. Centuria Zenith Fund. An opportunity to invest in an A-grade office asset in Chatswood, Sydney

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1 AUSTRALIAN A PROPERTY INVESTMENT RESEARCH Centuria Zenith Fund An opportunity to invest in an A-grade office asset in Chatswood, Sydney

2 Contents 1. Overview 3 2. Fund Overview 5 3. The Property Investment Analytics Management & Corporate Governance Past performance 20 Appendix Ratings Process 21 IMPORTANT NOTICE PIR has not been commissioned to produce this report. This means that PIR has not received a direct fee for reviewing and assessing this product. In compiling this report, PIR s views remain fully independent of influence or conflicts of interest. Our team of analysts undertake an objective analysis of the offer and conclusions are presented to senior officers for review. Disclaimer & Disclosure of Interests This publication has been prepared by PIR and is authorised under Australian Financial Services Licence (AFSL) No PIR has not been commissioned to prepare this independent research report (the Report ) and will not receive fees for its preparation. The company specified in the Report (the Participant ) has provided PIR with information about its activities. Whilst the information contained in this publication has been prepared with all reasonable care from sources that PIR believes are reliable, no responsibility or liability is accepted by PIR for any errors, omissions or misstatements however caused. Any opinions, forecasts or recommendations reflects the judgement and assumptions of PIR as at the date of publication and may change without notice. PIR and the Participant, their officers, agents and employees exclude all liability whatsoever, in negligence or otherwise, for any loss or damage relating to this document to the full extent permitted by law. This publication is not and should not be construed as, an offer to sell or the solicitation of an offer to purchase or subscribe for any investment. Any opinion contained in the Report is unsolicited general information only. Neither PIR nor the Participant is aware that any recipient intends to rely on this Report or of the manner in which a recipient intends to use it. In preparing our information, it is not possible to take into consideration the investment objectives, financial situation or particular needs of any individual recipient. Investors should obtain individual financial advice from their investment advisor to determine whether opinions or recommendations (if any) contained in this publication are appropriate to their investment objectives, financial situation or particular needs before acting on such opinions or recommendations. This publication is not for public circulation or reproduction whether in whole or in part and is not to be disclosed to any person other than the intended recipient, without obtaining the prior written consent of PIR. This report is intended for the residents of Australia. It is not intended for any person(s) who is resident of any other country. PIR and/or the Participant, their officers, employees or its related bodies corporate may, from time to time hold positions in any securities included in this Report and may buy or sell such securities or engage in other transactions involving such securities. PIR and the Participant, their directors and associates declare that from time to time they may hold interests in and/or earn brokerage, fees or other benefits from the securities mentioned in this publication. PIR, its officers, employees and its related bodies corporate have not and will not receive, whether directly or indirectly, any commission, fee, benefit or advantage, whether pecuniary or otherwise in connection with making any statements and/or recommendation (if any), contained in this Report. PIR discloses that from time to time it or its officers, employees and related bodies corporate may have an interest in the securities, directly or indirectly, which are the subject of these statements and/or recommendations (if any) and may buy or sell securities in the companies mentioned in this publication; may effect transactions which may not be consistent with the statements and/or recommendations (if any) in this publication; may have directorships in the companies mentioned in this publication; and/or may perform paid services for the companies that are the subject of such statements and/or recommendations (if any). However, under no circumstances has PIR been influenced, either directly or indirectly, in making any statements and/or recommendations (if any) contained in this Report. The information contained in this publication must be read in conjunction with the Legal Notice that can be located at For more information regarding our services please refer to our website P a g e 2

3 Centuria Zenith Fund The Centuria Zenith Fund (the Fund) is a closed-ended, single-asset fund with an initial term of five years to July The Fund s Responsible Entity, Centuria Property Funds Limited (RE or the Manager), will manage the asset together with its associated entities. The Fund is seeking to raise $78.7M through the issue of 78.7M units at $1.00 per unit to acquire a 50% stake in the Zenith office complex (Zenith or the Property). Zenith consists of two A grade office towers at 821 Pacific Highway, Chatswood NSW. The Fund is co-investing alongside a fund managed by BlackRock (a leading global financial institution), with each party holding a 50% stake in the Property through a special purpose Holding Trust. A unitholder agreement, sets out the rights and obligations in respect of the Holding Trust and governs decision making. Please refer to the PDS for more details. The purchase price of $279.1M (100% share) is at a 2.8% discount to the valuation of $287.0M. The asset metrics are: (1) 94.8% occupancy; (2) Weighted Average Lease Expiry (WALE) of 2.7 years; and (3) a diverse mix of 41 tenants. A $27.8M capex program is planned, which will assist in attracting new tenants and as well as provide opportunities to increase rental income. The Property is well placed to benefit from the potential growth in the Chatswood office market over the next two years as a result of; (1) a lack of new developments in the Chatswood Office market; (2) significant upgrades to transport facilities positioning Chatswood as a major hub; and (3) a spill over of tenants into Chatswood as a result of office withdrawals in the Sydney CBD and North Shore. The RE forecasts strong average annual distribution yields ranging between 7.6% and 9.8% pa over the initial term of the Fund, based on a ~65% weighted average probability of lease renewals. Based on the RE s forecasts and conservative assumption of no terminal yield compression, the pre-tax equity IRR is estimated at 9.8% pa, with no performance fee expected to be paid to the RE. The Holding Trust will enter into a 3-year $180M debt facility, initially drawn to $147.5M. The Loan-to-Value (LVR) covenant will step down over the facility term, starting at 62.5% and reducing to 58.5% by The initial LVR is 51.4%, and assuming no cap rate compression over the Fund term, the LVR is expected to peak at 54.0% in 2018 (vs 60.5% covenant). The debt facility will need to refinanced in 2019, when the LVR is expected to be 51.5% (vs 58.5% covenant). The step down in the LVR covenant presents a key risk to expected outcomes should market conditions deteriorate. The RE intends to split the title of the two office towers, creating smaller investment parcels that should be attractive to a deeper pool of buyers. In the opinion of the independent valuer, this has the potential to result in up to 50bps of cap rate compression, equating to a 5-7% increase in the current value of the property. This potential valuation uplift would reduce the forecast LVR peak to 50.3% (vs 60.5% covenant), and to 48.0% at the time of refinancing in 2019 (vs 58.5% covenant). This provides further comfort around the risk of an LVR covenant breach. Investors need to consider the trade-off between the modest headroom against the LVR covenant versus the potential growth in market rents, the repositioning of Chatswood as a major commercial hub, and valuation upside by creating two separate titles. Investor suitability In PIR s opinion, the Fund provides an attractive yield with potential valuation upside. However, investors should see this Fund having a higher risk/ return profile than other property funds with lower gearing levels. Potential investors should see this as an illiquid fund. Investment Rating See the Appendix for a description of our ratings. The above rating must be viewed in the context of comparable syndicates and not across all products. Offer Details Offer Opens 15 Offer Closes 20 July 2016 Min. Investment 5 years Period Min. Investment $50,000 Liquidity Distributions Illiquid Monthly Initial NTA $0.91 Distribution (cents) (annualised) 1 Forecast annual distribution for year ended 30 June FY18 distribution guidance is for 7.7cps. Manager Contact Details Brad Watson Michael Blake Risk/Return Profile Capital Return Capital Return Volatility Risk to Capital brad.watson@centuria.com.au (03) michael.blake@centuria.com.au (02) Income Return Income Volatility Tax Effectiveness Note: This report is based on the Centuria Zenith Fund PDS, dated 30 May 2016, together with other information provided by Centuria. P a g e 3

4 Key considerations Well-regarded fund manager with a solid track record of managing property funds. Good track record on corporate governance and improving occupancy rates. The Property consists of two A-grade office towers located at Chatswood. The suburb is well positioned to benefit from increased transport facilities from the Sydney Metro project, and increased office demand as a result of Sydney CBD and North Shore withdrawals due to residential conversions and compulsory acquisitions for the Sydney Metro project. Investment rationale. Refurbishments and a strengthening lease market provide an opportunity to renew leases expiring in FY18 at higher market rents, providing potential increases in yields. Splitting of the towers into separate titles provides a potential upside to the property valuation through smaller marketable parcels which attract a deeper pool of buyers. WALE of 2.7 years with major lease expiries in FY18. The financial forecasts assume incentives at 20% to 30% of gross face rent. Capex assumptions of $27.8m (at the 100% level) to be spent over the 5 years of the Fund. Works to be done include lift upgrades, refurbishments to office space and facilities, the addition of end of trip facilities and allowances to split the titles of the two towers. LVR and ICR metrics. The initial LVR is 51.4% (vs 62.5% covenant), and assuming no cap rate compression, is expected to peak at 54.0% in 2018 (vs 60.5% covenant). The LVR is expected to be 51.5% when debt is refinanced in 2019 (vs 58.5% covenant). An expected valuation uplift from splitting the title would provide further buffer against LVR covenants (see figures 2 and 3 for further analysis). The step down in the LVR covenant presents a key risk to expected outcomes should market conditions deteriorate. The initial Interest Cover Ratio (ICR) is 3.7x (vs 2.0x covenant). Distribution profile. An initial distribution yield of 7.6% in FY17 is forecast (70% tax deferral) and 7.7% in FY18 (100% tax deferral). Total return profile. The pre-tax equity IRR is expected to be 9.8% pa. based on the RE s ~65% average weighted probability of lease renewals, no terminal capitalisation rate compression and assuming an average interest cost of 4.1% pa throughout the full term of the Fund. NTA starting at $0.91: The purchase price of the portfolio is at a 2.8% discount to the independent valuation which assists in bringing the Net Tangible Assets (NTA) to $0.91 per unit. Market risk. Returns to investors may be lower than PIR s estimate if: (a) economic or market conditions deteriorate, (b) the Fund fails to achieve a satisfactory sale price for its assets, or (c) the Fund releases space on worse-than-expected terms. Illiquid investment. Investors must accept that by their very nature, unlisted property funds are illiquid. Investment term: The Fund will have an initial term of five years (initial term), which may be extended by a further two years if authorised by an ordinary resolution of investors. Subsequent extensions will require 100% approval or give investors the chance to exit. Please refer to the PDS for details on exit conditions. Fixed interest rate of 4.1% for the debt facility in the first three years (100% hedge) with a need to refinance thereafter. Fee structure: Fees on the initial portfolio are comparable to peers see Figure 6. Key Qualitative Criteria Management Track record Investment process and philosophy Corporate Governance Product Structure Fees Liquidity Leverage/Capital structure Portfolio Property Grade/Asset quality Property diversification Tenancy profile Tenant lease term Investment Profile Number of properties 1 Property location Property sector The Zenith Centre, 821 Pacific Highway Chatswood, NSW Office Initial Gearing/ Bank 51.4%/62.5% covenant ICR/ Bank covenant Source and Application of Funds 3.7x/2.0x A$M Equity sought (includes Fund Set up fees) 78.7 Co Investor Equity 74.7 (BlackRock) Debt Total sources of funds Financial Forecasts Levered IRR 1 (pretax,post fees, %) Valuer s 10-year unleveraged IRR 2 (%) Performance fee hurdle (%) Min. investment period Tax advantage (per PDS) Distribution frequency 9.8% 8.6% 10.0% (Levered IRR) 5 years 70% tax deferral on FY17 distributions, 100% for FY18 1 IRR base case estimate is post-disposal and performance fees, and assumes no terminal capitalisation rate compression. 2 Based on the independent valuation report. Monthly P a g e 4

5 2. Fund Overview The Fund is a closed-ended unlisted property fund that is seeking to raise $78.7M through the issuance of 78.7M units at $1.00 per unit. The funds will be used to co-invest with a fund managed by BlackRock to acquire the Zenith office complex located at 821 Pacific Highway, Chatswood NSW (Zenith or the Property) for $279.1M. Chatswood is located 12km from the Sydney CBD and is part of the extended North Shore office market. The property consists of two A grade 21 level office towers with a net lettable area (NLA) of 44,271sqm. Occupancy is currently 95% (including areas that are subject to a heads of agreement to lease) with vacant space covered by a 12-month rental guarantee (vendor funded). Centuria has forecast distributions in FY17 of 7.6% and in FY18 of 7.7%, which are 70% and 100% tax deferred respectively. The tax deferral decreases investors capital base for the purposes of Capital Gains Tax purposes. The Fund will have an initial investment term of five years, and may be extended by an additional two years by an ordinary resolution of investors (50% of votes cast must be in favour of the extension). The Fund may only be extended beyond seven years, for up to two years at a time where a unanimous resolution is passed (100% of votes cast are in favour of the extension) or where a unanimous resolution is not passed but all investors who vote against the resolution are given an opportunity to have their units sold or redeemed at NTA less costs. Exit decisions are also subject to the terms of the unitholder agreement between the co-investors at the Holding Trust level (please refer to the PDS for the details). The Fund will pay unitholders on a monthly basis, usually within 10 business days of the end of the month. An investment in this Fund will be illiquid and investors must stay invested for the Fund s initial term to benefit from forecast returns. The Fund has a WALE of 2.7 years (by Net Lettable Area as at 1 August 2016) with ~35% of gross rental expiring in FY18. Centuria Property Services has an extensive $27.8M capital expenditure program in place. Centuria has a good track record on increasing occupancy rates in office buildings and this combined with the expected increase in the demand for A-grade office supports PIR s thesis of the Fund maintaining high occupancy levels. Nonetheless, investors should also be willing to accept the impact of lower occupancies should market conditions deteriorate. Lower occupancy, and therefore lower rent income under such a scenario would impact the valuation of the Property and place undue pressure on the initial LVR of 51.4% against bank covenants that reduce from an initial 62.5% to 58.5% in FY19. Figure 1: Fund structure Source: Centuria/ PIR P a g e 5

6 Investment rationale As has been the case with several recent syndicates, investors need to consider the trade-off between a core property syndicate with long lease durations (passive high yield funds) against investing in a fund requiring active asset management. Active asset management strategies may involve significant capex spend to reposition the building, the need to renew maturing leases, or taking on a counter-cyclical approach to investing in particular markets. PIR notes that active asset management strategies deployed by fund managers are generally considered to have a higher risk/ return profile and a higher gearing profile when compared with passive high yield funds. As such, they are an important consideration for investors. Furthermore, PIR believes the following points specific to the Centuria Zenith Fund need to be taken into consideration: Expected initial forecast distributions yields in the first two years of 7.6% and 7.7%, with tax deferrals to provide tax effective returns; An experienced and proven property management team who have a reputation for improving occupancy levels through appropriate capital expenditures and proactive leasing strategies; The Fund is co-investing with a fund managed by the world s largest investment manager, BlackRock; Based on market research, there is an expectation of good rent growth potential and is also well supported by improving tenant demand; Potential to achieve a significant capital uplift by splitting the title into two separate office towers; and From a capital structure perspective, the significant capex spend will result in a peak LVR of 54% against a covenant of 60.5%. As such, a key risk is that the Fund could breach its LVR covenant should market conditions deteriorate. The Offer The Centuria Zenith Fund seeks to raise $78.7M through the offer of 78.7M units at $1.00 per unit. The funds will be used to acquire a 50% interest in the Holding Trust which will own the Property, as well as to fund the establishment fees and expenses for the Centuria Zenith Fund (estimated at around $4M). BlackRock will own the other 50% interest via a $74.7M investment. Together with a $147.5M debt facility, a total of $300.9M funds will be raised. Investor s initial equity or net tangible assets (NTA) will be diluted to $0.91 per unit after factoring in the fees/costs to set up the Fund. To launch the Fund, Centuria and/or its associates may acquire Acquisition units at the prevailing unit price. These units will rank equally with ordinary units but may be redeemed via the issue of ordinary units at the prevailing issue price of units. If Centuria determines not to proceed with the offer, any units issued will be compulsorily redeemed with the original amounts returned to investors. PIR notes that this is typical for an unlisted property fund. Debt facility and metrics The Holding Trust will enter into a debt facility as part of the acquisition of the Property. The debt facility will have a $180.0M limit and will be initially drawn to $147.5M at an assumed interest rate of 4.1% for three years. PIR considers the debt facility to present a risk to investors due to: The three-year maturity on the loan presents uncertainty for unitholders in a five-year fund. A renegotiation with less favourable loan terms in July 2019 may impact the returns available to investors in the remaining two years of the Fund; LVR covenants on the loan are on a stepped down basis, placing increased pressure on the Property to maintain its valuation. The LVR covenant is 62.5% in 2017, in calendar year 2018, the LVR covenant reduces to 60.5%, and in 2019 it reduces to 58.5%. Figure 2 summarises the key debt metrics of the Fund. P a g e 6

7 Figure 2: Key debt metrics Details Metric Loan facility limit ($M) Initial draw down ($M) Loan maturity date July 2019 (3 years) Interest Rate 4.1% LVR Covenant Up to Dec-17 = 62.5% Jan-18 to Dec-18 = 60.5% Jan-19 to Jul-19 = 58.5% Peak LVR / Year 54.0% / 2018 Initial interest covered ratio / bank covenant 3.7x / 2.0x Low ICR / Year 3.0x / 2020 Source: Centuria/PIR Leverage Based on the PDS and the RE s forecasts, including the assumption of no cap rate compression, the Fund s LVR is expected to remain within the debt provider s covenants. However, when the LVR peaks at 54.0% in 2018, the valuation headroom is forecast to narrow to $34.0m or 10.7%. The RE may need to manage debt risk, especially if market conditions deteriorate, by: Refinancing of the 3-year facility in 2019 on more favourable terms, such as a higher LVR covenant; Reducing debt levels via a lower cap ex spend, or other capital measures; and Creating a greater LVR covenant buffer by splitting the title and achieving a valuation uplift. The independent valuer expects a title split to deliver up to 50bps of cap rate compression, equating to a 5-7% uplift in the current property value. The following table shows the LVR over the 3-year debt facility, as well as an assumed 2-year debt extension based on 2019 loan conditions. The analysis assumes no cap rate compression. The bottom of the table applies a 50bps cap rate compression based on a title split and shows the resulting additional LVR buffer. Figure 3: Key debt metrics Holding Trust Start Aug-16 Year1 Aug-17 Year 2 Aug-18 Year 3 Aug-19 Year 4 Aug-20 Year 5 Aug-21 Debt ($M) Valuation ($M) LVR 51.4% 52.4% 54.0% 51.5% 51.1% 52.4% LVR Covenant 62.5% 62.5% 60.5% 58.5% 58.5%* 58.5%* Valuation at Covenant Limit ($M) Headroom from Valuation price ($M) Headroom from Valuation % 16.2% 10.7% 12.0% 12.6% 10.4% Headroom 50bps compression ($M) Headroom 50bps compression (%) % 22.2% 16.8% 18.0% 18.6% 16.7% * assumes expiring LVR covenant of 58.5% continues Source: Centuria/PIR P a g e 7

8 Liquidity The initial term of the Fund is five years from the close date of the Offer. Investors may extend the Fund for a further two years, but only if 50% of votes are in favour of the extension. After that, the Fund may only be extended for up to two years at a time if (a) 100% of votes approve a second extension; or (b) if fewer than 100% of votes approve an extension, the Fund may be extended if unitholders who did not approve the extension are given the opportunity to sell/redeem units at NTA. There is no other means of providing liquidity in the Fund, although units may be transferred (subject to transfer provisions under the Fund s constitution). The RE may facilitate this on a best endeavours basis, but it is not obliged to repurchase these units at any point over the term of the Fund. Exit decisions are also subject to the terms of the unitholder agreement between the co-investors at the Holding Trust level (refer to the PDS for full details). Sources and Application of Funds The majority of the capital raised will be used to fund the purchase of the property and associated costs. It should be noted that the Fund has an additional $4.0M in costs associated with the setup of the structure (see the section below on Costs over the Term of the Fund). Thus the Fund needs to raise $78.7M in order to purchase $74.7M in units of the Holding Trust. The table below shows the sources and application of funds. Figure 4: Sources and Applications of Funds Sources of funds: ($'000) % of equity raised % of total funds Equity subscriptions The Fund 78, % 26.2% Equity subscriptions Co-Investor 74, % 24.8% (BlackRock) Bank loan 147, % 49.0% Total sources of funds 300,896 Applications of funds: Holding Trust Purchase price 279, % 92.7% Stamp duty 15, % 5.1% Debt Establishment/Arrangement (Bank Fee) % 0.3% Other Costs Holding Trust 1, % 0.5% Centuria Zenith Fund Acquisition fee (paid to RE) 2, % 0.1% Hedge Fee (Bank Fee) % 0.2% Interest on Centuria Capital Funding % 0.0% Fund set-up costs (legal, technical reports, % 0.2% DD, marketing, other fees, etc.) Total applications of funds 300, Unsecured loan provide by Centuria Capital to finance the acquisition deposit, expected to be repaid at settlement. Source: Centuria/PIR Costs over the Term of the Fund The components of fees and cost recovery charged by the RE are as follows: Ongoing Management Costs Ongoing management fee: 0.8% pa of gross asset value (GAV) of the Fund; and Ongoing Fund costs (reimbursed to the RE) equating to 0.22% per annum of GAV. The ongoing management fees are consistent with industry practice. The Management Expense Ratio (MER) is within the typical range seen by PIR (0.7%-1.1%). P a g e 8

9 Figure 5: Summary of fees charged by Centuria Acquisition fee 2.0% of purchase price Industry average is 1.5%-2.0% Ongoing fee (MER) 1.02% of gross asset value At the top end of industry peers. Disposal fee 1% of sale price of property Third-party agency fees will be paid out of this fee. Performance fee Source: Centuria/PIR 20% of the portion of outperformance over a pretax levered IRR of 10%pa after all fees and costs. In-line with industry peers. A performance fee, if owing, will also become payable should investors sell more than 80% of the units on issue. All-in fee analysis As a percentage of total Fund cash flow In Figure 6, below, PIR analyses how much of the Fund s cash goes to the RE in fees, and how much is left over for investors. Our key assumptions include: Capex of $27.8M as per the PDS, which includes $4.2M to split the titles; Calculations exclude the disposal fee (1% of the sale price) and ongoing administration costs, which we treat as costs to the Fund; A performance fee has not been included; The capital gain forecast is based on applying a terminal cap rate of 7.75% at the time of sale in FY21, which effectively assumes no cap rate compression. A lower terminal cap rate would lead to a higher sale price and hence, higher performance fees may be payable. Analysis of fees paid to the RE in relation to the fund s cash flows is provided in Figure 5. Overall, PIR estimates that the RE takes 7.8% of the total cash generated by the Fund, which leaves investors with $1.51 per unit, or approximately 92% of the total. PIR believes this is in line with similar products that we have recently rated. PIR stresses that these are estimates of how much investors will receive and not guaranteed amounts. For further details, please refer to the Performance Analytics section. Figure 6: Fees in Perspective (based on initial portfolio only) PIR estimates that for every $1.00 of equity invested, the Fund can return: Principal repayment to investors (a): $1.00 Income and capital gains to investors (b): $0.51 Total cash to investors (c): $1.51 Fees for the RE (incl perf fee, ex disposal/admin costs) (d): $0.12 Total cash generated by Trust (e) $1.63 Fees = % of total cash generated (before fees) Calculated as d / e 7.8% Source: PIR/ Centuria P a g e 9

10 Fund Structure Responsible Entity (RE) Investment Term: Centuria Property Funds Limited (Centuria) Minimum of 5 years from the first closing date (refer to Liquidity/exit strategy section, page 7), which investors may extend up to two years by passing an ordinary resolution. The Fund may be extended for a further two years at a time, either by a unanimous resolution or where a unanimous resolution is not passed but all investors who vote against the resolution are given an opportunity to sell or redeem their units at NTA less costs. Exit decisions are also subject to the terms of the unitholder agreement between the co-investors at the Holding Trust level (refer to the PDS for full details). Issue Size/LVR: Equity issuance of A$78.7M, resulting in an initial LVR of 51.4%. Cost of Borrowings: Security: Fund Profile Geographic Exposure: Sector Exposure: Tax Disclaimer: Capital gains: Distributions: Legal Structure Wrapper: Forecast all-in cost of borrowing is 4.1%p.a. (100% hedged) for the first three years of the Fund. After this, the terms of the debt will need to be negotiated. The bank loan is to be secured by a first ranking mortgage over the Property and a general security deed over the assets of the Head Trust. 100% Sydney metropolitan, NSW. 100% to the Sydney metropolitan office market. Tax consequences depend on individual circumstances. The following comments cannot be considered tax advice and investors should seek their own taxation advice. Capital gains tax (CGT) is likely to apply upon the winding up of the Fund as capital is returned to investors. As the investment term is in excess of 12 months, Australian resident investors will most likely be eligible for the CGT discount upon sale of the asset and eventual returns to investors as per the current CGT ruling. Distributions will be treated as income in the year they are earned. Distributions may contain a tax deferred amount, which decrease the cost base and will give rise to a capital gain should the investment be sold at a price higher than the adjusted cost base. Centuria has forecast distributions for the financial year ended 30 June 2017 to be 7.60% with 70% tax deferral; and year ended 30 June 2018 to be 7.70% with 100% tax deferral. Distributions may not be reinvested. Unlisted Unit Trust Custodian Perpetual Corporate Trust Limited ACN Offer Document: The Product Disclosure Statement, dated 30 May Returns Capital vs. Income: Distribution Frequency: Risks Property/Market Risk: Interest Rate Movements: Property specific risks Fees/Expenses Base Management Fee: Acquisition Fee: Based on the RE s forecasts, applying a terminal yield of 7.75%, approximately 75% of the estimated total return would be made up of income. Monthly, within 10 business days of the end of each month. For a more detailed list of the key risks, refer to the Risks section (Section 11) of the PDS. Capital at risk depends on a single property located in Chatswood NSW. Coupled with an initial LVR of 51.4%, this exacerbates the risks associated in adverse market conditions. Any change in the all-in cost of borrowings beyond the initial term, when interest rates need to be reset, will affect the Fund s distributable income. An increase in vacancy rates, a decrease in prevailing market rents, or functional obsolescence could reduce the market value of the asset and therefore may negatively impact on estimated unitholder returns. 0.80% p.a. of the gross asset value (GAV) of the Fund. GAV should generally resemble the carrying value of the portfolio. In addition to the management fee, the PDS estimates that other Fund costs will account for another 0.22% of GAV (custodian, unit registry and admin expenses). An acquisition/ placement fee of 2.0% of the purchase price will be payable to the RE when the Fund is operational. Performance Fee: The RE is entitled to 20% of the portion of outperformance over an IRR of 10%. Disposal Fee: A performance fee, if owing, will also become payable should investors sell more than 80% of the units on issue. The RE is entitled to an asset disposal fee of up to 1% of the Gross Sale Price, out of which it will pay external agents fees. P a g e 10

11 3. The Property Property location & overview The Zenith consists of two A grade 21-level towers located at 821 Pacific Highway Chatswood NSW. The Zenith is a high profile building in the Chatswood Office precinct providing excellent views, landscaped gardens, and a high ratio of parking. Chatswood is located approximately 12km north of the Sydney CBD and is also considered to be the largest retail shopping precinct outside of Sydney s CBD. The suburb has two shopping centres Westfield Chatswood and Chatswood Chase with an excess of 20 million shopper visits annually. The railway station services around 35,000 commuters daily and is a major interchange for both rail and bus services. The Sydney Metro project currently under construction will extend rail services from Chatswood connecting Sydney through Macquarie Park, Epping, Cherrybrook, Norwest and Bella Vista in the north. As such, Chatswood is considered to have good long-term potential to become one of Sydney s major office and retail hubs. Figure 7: Location view Property features The Zenith was constructed in The building has an expansive forecourt and atrium. Zenith has one of the largest car parking facilities in the North Shore with 799 car spaces. Wilson Parking leases 699 space with the remaining 100 spaces leased to Abigroup/Lend Lease. The building is located within close proximity to Chatswood train station and is zoned B3 Commercial Core allowing the Property to be used for office space, serviced apartments or as a hotel. Centuria does not have any current plans to redevelop the property during the term of the Fund. However, it is exploring options to split the title of the two towers into two separate titles. This will create smaller investment parcels, potentially maximising the potential for sale of the Property due to a deeper buyer pool. Estimated costs to do so are $4.2M, which has been included in the Fund s budgeted capex program. P a g e 11

12 Valuation of the property We highlight the key acquisition metrics in Figure 8. The purchase price of $279.1M is at a ~2.8% discount to the independent valuation of $287m undertaken by Cushman & Wakefield, a well-regarded global real estate agency. The independent valuation makes several assumptions regarding market rents, tenant incentives, re-letting, and other factors based on available market evidence. We discuss the main assumptions below that have been adopted in the valuation model. Figure 8: Property portfolio summary (based on 100% ownership) Title The Zenith, Chatswood Freehold Construction Date 1987 Ownership 50% Centuria Zenith Fund 50% a fund managed by BlackRock Net Lettable Area (sqm) 44,271 Major Tenants Weighted Average Lease Expiry (WALE) Occupancy Initial net passing income Net market income (fully leased) Rent growth Purchase price Valuation Passing initial yield NSW Transport (22%), Abigroup (11%), Wilson Parking (9%), Austrac (9%) 2.7 years by NLA 94.8% by NLA, including areas subject to a signed Heads of Agreement to lease. Vacant space is subject to a 12 month rental guarantee (vendor funded) $24.0M $25.1M NSW Transport (3.75% pa), Abigroup (4.0% pa) Wilson Parking (4.0% pa) $279.1M $287.0M Cap rate 7.75% Valuer Discount rate 8.50% Purchase price / sqm $6,304 Terminal Yield 8.13% Valuer s unleveraged IRR (%) 8.59% Source: Cushman & Wakefield, Centuria, PIR 8.36% (based on independent valuer report) Cushman & Wakefield Leases, tenants, and income Key points on the tenancy profile are: 94.8% occupancy by NLA (including areas subject to a signed Heads of Agreement). Vacant space is subject to a 12 month rental guarantee (vendor funded). Weighted Average Lease Expiry (WALE) of 2.7 years (by area) or 2.5 years (by income). The buildings have a diversified mix of 41 tenants from both the public and the private sector. AAA rated state and federal government tenants contribute around 40% of the Property s net income. Major expiries in FY17 include Wilson Parking and Lend Lease who have indicated an intention to renew. FY18 lease expiries remain uncertain (Abigroup and NSW Transport with a combined 32.5% of rental income). PIR expects Centuria to actively negotiate renewals to maintain occupancy levels over the Fund s initial term. The Chatswood office market is experiencing good demand conditions, a reduction in incentives offered to tenants compared to 12-months ago, and significant increase in transport infrastructure (from the Sydney Metro project) to support growth in office and retail markets. P a g e 12

13 Figure 9: Lease expiry (as a % of passing yield) Source: Cushman & Wakefield Valuation Report / Centuria / PIR Capex The RE will undertake an extensive capital works program in order to reinforce the building s premium reputation. An estimated $27.8M in total capex (based on 100% ownership) is expected to be spent over the next five years. The Fund s share of 50% equates to $13.9M. The estimated split is as follows: Essential & Desirable Works (incl Lifts $7.4M) $9.3M Refurbishment Works (Bathrooms, Lobbies, Vacancies) $12.8M Allowances for title and services split $4.2M End of trip facilities $1.5M The RE forecasts that capex will be fully funded by debt resulting in peak debt of $197.4M at the end of the five-year term. A peak LVR of 54.0% is expected in 2018 against a 60.5% covenant. Refer to Leverage section of this report for more details. We have adopted the Manager s capex assumptions on the basis that they were based on independent technical reports. The inherent assumption here is that the capex spend is likely to improve the value of the building. While this has been the case in recent years, PIR reminds investors that this may not be the case in adverse market conditions. Notwithstanding this, PIR believes the Chatswood Office market, and more broadly the North Shore office market, are likely to be beneficiaries of the significant improvements in transport infrastructure and the withdrawal of office space in the Sydney CBD and North Shore. Market Commentary The Chatswood office market is expected to be impacted by changes in the Sydney CBD and greater North Shore office markets over the next few years. The Sydney Metro project, an $8.3B Northwest Link (estimated to be completed in 2019) and an $11B City and Southwest Link (estimated to be completed in 2024) is expected to increase Chatswood s profile and connectivity with the rest of Sydney. As a result of the planned transport works, a number of compulsory government acquisitions are likely to significantly increase office withdrawals: 19 buildings are expected to be acquired in the Sydney CBD 17 buildings are expected to be acquired in North Sydney and St Leonards. P a g e 13

14 It is widely anticipated that vacancy levels will fall as businesses seek to relocate. A- grade tenants which cannot secure leases in the Sydney CBD are likely to consider the North Shore and Chatswood markets. Office vacancy rates at the end of January 2016 were 6.3% in the Sydney CBD, 7.8% in the North Shore, and 7.7% in Chatswood as per the Property Council of Australia. According to BIS Shrapnel, by 2018, the Sydney office vacancy rate is forecast to fall to 4%, with Chatswood forecast to fall to 5%. Chatswood has no office space currently under construction or in a planning stage and is likely to benefit from the expected withdrawals. Market Rental Evidence Below, we present excerpts from the independent valuer s list of comparable office lease deals completed over the last 12-months. Passing rents at The Zenith are marginally below market levels. This is based on the current passing net rent of $465/sqm and average net market rent of $485/sqm. This provides comfort there is a small amount of conservatism in the rental forecasts. Market rents sourced from other property research houses also forecast growth of 5%pa over the next five years providing a level of comfort around achievable rents on future lease expiries and renewals. Figure 10: Office rental evidence Address 80 Pacific Highway, North Sydney 76 Berry Street, North Sydney 100 Arthur St, North Sydney 1 Pacific Highway, North Sydney 601 Pacific Hwy, St Leonards 601 Pacific Hwy, St Leonards Lease Area Term Rent Reviews Incentives start (sqm) (yrs) ($/sqm) (% pa) Feb-16 1,781 5 $670 net 3.75% 25% Feb $570 net 4.0% 28% Feb-15 1, $725 net CPI+ 1% NA Apr $580 net 4.0% 29% Oct-15 1,800 5 $475 net 4.0% 30% Jul $485 net 4.0% 30% The Zenith, Passing Rent (Average) $465 net 3.75% % Source: Cushman & Wakefield / PIR 20% - 30% Figure 11: Market Prime Gross Face Rents Figure 12: Sydney office market - incentives Source: JLL Research Q P a g e 14

15 Market Sales Evidence The Zenith was purchased for an average price of $6,304/sqm. This is around 10% lower than the recent weighted average sales price of $7,020/sqm for comparable office blocks. The lower purchase price for the Zenith provides the Fund with the option to achieve a capital return through the sale of two smaller marketable parcels once the property has split titles. The last sale price for The Zenith was in January 2007 when the Property was purchased for $252.5M. The current sale price of $279.1M represents a modest 10.5% premium over the last nine years. The following table shows recent comparable sales for office blocks. Figure 13: Market sales evidence Property Address Sale date Sale price Price ($/sqm) Cap Rate WALE 22 Giffnock Ave, Jul-15 $74.0m 5, % 6.6 Macquarie Park Talavera Rd, Jul-15 $80.0m 6, % 8.4 Macquarie Park 78 Waterloo Rd, Macquarie Nov-15 $106.0m 7, % 5.1 Park 20 Berry Street, North Jul-15 $59.0m 6, % 5.4 Sydney 33 Berry St, North Sydney Sep-15 $91.7m 6, Arthur St, North Sydney 201 Pacific Highway, St Leonards 203 Pacific Highway, St Leonards 207 Pacific Highway, St Leonards Jun-15 $58.2m 7, % 2.4 Jun-15 $115.0m 6, % 2.5 Dec-15 $86.0m 7,315* 8.1% 5.0 Aug-15 $168.6m 8, % 4.1 The Zenith Jul-16 $279.1m 6, % 2.5 * Leasehold asset Source: Knight Frank Sales Analysis, JLL Research, CBRE 203 Pacific Highway Fund valuation report, PIR P a g e 15

16 4. Investment Analytics Below is a summary of the forecasts provided in the PDS, reflecting the Holding Trust which owns the 100% freehold interest in the Property and the Centuria Zenith Fund s 50% interest. It should be noted: The forecast is for the part-year term 1 August 2016 to 30 June Working capital in FY17 of $1.1m is retained, the majority of which is released in FY18 as distributions. Forecast distribution of $0.076 is estimated to be 70% tax deferred. This equates to $ which can be considered as a capital reduction for tax purposes. Effectively this means that for tax purposes, the units are deemed to be acquired for $ per unit. An additional $0.077 distribution in FY18 is 100% tax deferred, thereby further reducing the deemed acquisition price of units to $ This reduction in the entry price has potential tax benefits for investors upon their exit. Figure 14: Forecast Income and Distribution Statement Holding Trust (100% share) - $ Year ended 30 June 2017 Year ended 30 June 2018 Gross Property income 28,390,229 27,014,772 Interest Income 30,782 32,382 Total Income 28,421,011 27,047,154 Total Expenses (5,993,068) (7,070,513) Net Operating Income 22,427,943 19,976,641 Net Finance Costs & Straight Lining of Rent (6,508,344) (7,056,795) Distributable income 15,919,599 12,919,846 Add: Amortised Leasing Fees paid from Debt Facility ,452 Net distributions 15,920,090 13,253,298 Centuria Zenith Fund (50% share) - $ Trust Income 7,960,045 6,626,649 Total Expenses (1,353,473) (1,686,219) Distributable Funds 6,606,572 4,940,430 Movement in Working Capital (1,134,122) 1,118,632 Net Distributions 5,472,450 6,059,062 Return on Cash contributions 7.60% 7.70% Estimated Tax Deferral 70.0% 100.0% Source: Centuria NTA Analysis The starting NTA is an important consideration. It should be assessed in the context of statutory costs and fees paid to the fund manager, which dilute investors return over the term of a fund. In this case, NTA is $0.91, with most of the dilution coming from stamp duty. This is largely offset by the RE purchasing the property at a 2.8% discount to the current valuation. Cents per unit % of initial equity Issue price $ % Less: Stamp duty ($0.10) -10% Acquisition fee (paid to RE) ($0.02) -2% Fund setup costs ($0.02) -2% Add: Acquisition (premium)/discount to valuation $0.05 5% NTA per unit $0.91 Source: Centuria / PIR P a g e 16

17 Figure 15: Pro-forma balance sheet at start of Fund Holding Trust $ Investment property 287,000,000 Accumulated cash, receivables and prepayments 250,000 Total assets 287,250,000 Borrowings 147,500,000 Less: capitalised borrowing costs (1,764,936) Total liabilities 145,735,064 Net assets 141,514,936 Centuria Zenith Fund $ Units in Holding Trust 70,757,468 Accumulated cash, receivables and prepayments 540,000 Total assets 71,297,468 Borrowings - Total liabilities - Net assets 71,297,468 Units on issue 76,689,111 NTA per unit $0.91 Source: Centuria/ PIR Expected Future Performance (IRR Sensitivity) The three main performance drivers in a property syndicate are: 1. The property income profile (lease structure); 2. The terminal value upon the sale of the property (asset quality + market conditions); and 3. The cost of debt (depending on leverage). Figure 17 summarises our expected IRRs. Based on the RE s forecasts PIR expects a 5-year pre-tax equity IRR of approximately 9.8% based on a 4.1% cost of debt. A 50bps cap rate compression is estimated to improve the IRR to around 12.0%. Figure 17: Pre-tax, 5-year IRR (after fees) sensitivity analysis terminal yield Terminal cap rate Cost of debt 3.1% 4.1% 5.1% 7.25% 12.7% 12.0% 11.1% 7.50% 11.6% 10.9% 10.0% 7.75% (base case) 10.6% 9.8% 8.7% Source: Centuria/ PIR 8.00% 9.4% 8.5% 7.4% 8.25% 8.2% 7.2% 6.0% P a g e 17

18 5. Management & Corporate Governance Background of the Responsible Entity Centuria Property Funds Pty Ltd (CPF) is a wholly owned subsidiary of the ASX listed- Centuria Capital Limited (ASX: CNI). CPF, formerly Century Funds Management, was formed in 1998 with the specific focus on the purchase of high quality, growth oriented commercial property investments. At present, CPF has approximately $1.2 billion of property under management spread across 13 unlisted property funds and one A-REIT what was listed on the ASX in December 2014 (ASX: CMA). Board of the Responsible Entity PIR has reviewed the composition of the RE Board and senior executive team. We believe they have the relevant skills and experience to operate the Fund successfully: Figure 18: Board of the Responsible Entity and Key Management Name Role Experience John McBain Jason Huljich Nicholas Collishaw Victor Georos Peter Done Matthew Hardy Darren Collins CEO Centuria Capital Ltd CEO Unlisted Property Funds Centuria Capital Ltd Exec. Director Centuria Capital,Centuria Property Services CEO Listed Property Funds Head of Portfolio & Asset Management Centuria Property Funds Ltd Independent Chairman Centuria Property Funds Ltd Non-executive Director Centuria Property Funds Ltd Non-executive Director Centuria Property Funds Ltd CEO since On the Centuria Capital Board since Over 30 years industry experience. Founding member of Century Funds Mgmt, Waltus Investments Australia Ltd and Hanover Group Pty Ltd. Head of Unlisted Property Funds since On the CPF Board since Founding member of Century Funds Management. Over 18 years of industry experience and is currently President of the Property Funds Association of Australia. Appointed CEO Listed Property Funds in May Prior to this was CEO and Managing Director at Mirvac Group. Over 30 years experience with senior positions at James Fielding Group, Paladin Australia, Schroders Australia and Deutsche Asset Management. Head of Portfolio and Asset Management since July Experience in asset and investment management, development and funds management, across the office, retail and industrial sectors including at GPT and Lend Lease. Appointed to the Board of Centuria Property funds in 2007, with 27 years experience as a partner at KPMG until retirement in Has been lead audit partner in property development sector. Former non-executive director of Mirvac Funds Management Ltd. Former general manager of Capital Property Trust. Over 30 years experience in direct real estate, equities and funds management. Former executive of Computer Sciences Corporation (CSC). Former non-executive director of three IT services companies, listed in Singapore, Hong Kong, and Kuala Lumpur, respectively. Source: Centuria/ PIR P a g e 18

19 Compliance and Governance The Fund s compliance committee comprises the three independent members of the board of Centuria Property Funds (Peter Done, Matthew Hardy and Darren Collins). Compliance with ASIC Regulatory Guide 46 ASIC Regulatory Guide 46 Unlisted property schemes: Improving disclosure for retail investors and Regulatory Guide 198 Unlisted disclosing entities: continuous disclosure obligations describe ASIC's preferred benchmarks and principles. PIR has reviewed the PDS in reference to the six benchmarks and eight disclosure principles recommended by RG46. The PDS adheres to the ASIC guidelines. Governance around Related Party Transactions Centuria Property Funds maintains, and complies with ASIC requirements for, a written policy on related party transactions, including assessment and approval processes for such transactions. All related party transactions will be conducted on an arm s-length basis and will require appropriate sign-offs at the Board level. Removal of the RE The RE can be removed and replaced with another appropriately licensed responsible entity if investors pass an extraordinary resolution to that effect at a properly convened meeting of investors. If such a resolution is successful (requiring 35% of all units on issue and 50% of all units actually voted to approve), the RE will be entitled to recover any deferred fees. The RE will not be eligible to receive exit fees if removed prior to the completion of the Fund. PIR notes that this is a strong feature of the Fund, better than industry norms. P a g e 19

20 6. Past Performance Centuria Syndicate Performance Since 1999, Centuria has managed 32 funds to completion representing $1.2 billion of asset sales, with an average total return to equity investors of 12.7% per annum. Fund returns have generally been correlated with their vintage the strongest returns can generally be found in the early (late 1990s/early 2000s) funds. Readers should note that that past performance is not a reliable indicator of future performance as each fund, and its respective underlying property, has its own specific risks and attributes. P a g e 20

21 Appendix Ratings Process PIR has developed a framework for rating investment product offerings in Australia. Our review process gives consideration to a broad number of qualitative and quantitative factors. Essentially, the evaluation process includes the following key factors: product management and underlying portfolio construction; investment management, product structure, risk management, experience and performance; fees, risks and likely outcomes. The Ratings Financial Advisers and investors should note that for all ratings categories, the product may not suit the risk/return profiles of all investors. AAA: This is the highest rating provided by PIR, indicating this is a best of breed product that has exceeded the requirements of our review process across a number of key evaluation parameters and scored exceptionally in a number of categories. The product provides a highly attractive risk/return trade-off. The Fund is likely to effectively manage endogenous and, to the extent that it can, exogenous risk factors with industry best practice. AA+: Indicates that PIR believes this is a superior grade product that has exceeded the requirements of our review process across a number of key evaluation parameters and scored exceptionally in a number of categories. AA: Indicates that PIR believes this is an above-average grade product that has exceeded the minimum requirements of our review process across a number of key evaluation parameters. In addition, the product rates highly on one or two attributes in our key criteria. It has an above-average risk/return trade-off and should be able to consistently generate above-average risk adjusted returns in line with stated investment objectives. The Fund should be in a position to effectively manage endogenous and, to the extent that it can, exogenous risk factors. This should result in returns being reflective of the expected level of up-side and down-side risk. AA-: Indicates that PIR believes this is an above-average grade product that has exceeded the minimum requirements of our review process across a number of key evaluation parameters. It has an above-average risk/return trade-off and should be able to consistently generate above-average risk adjusted returns in line with stated investment objectives. A+: PIR believes this is a suitable product that has met the aggregate requirements of our review process across a number of key evaluation criteria. The product provides some unique diversification opportunities, but may not stand apart from its peers. It has an acceptable risk/return trade-off and should generate risk adjusted returns in line with stated investment objectives. A: PIR believes this is a suitable product that has met the aggregate requirements of our review process across a number of key evaluation criteria but may not stand apart from its peers. There are certain assumptions, the outcome of which is sometime in the future and, therefore, less predictable. The product has an acceptable risk/return trade-off and is potentially able to generate risk-adjusted returns in line with stated investment objectives. A-: PIR believes this is a suitable product that has met the aggregate requirements of our review process across a number of key evaluation criteria. There are certain assumptions, the outcome of which is sometime in the future and, therefore, uncertain. However, it has an acceptable risk/return trade-off. The product has an acceptable risk/return trade-off and is potentially able to generate risk-adjusted returns in-line with stated investment objectives. B+: PIR believes this is a product that has a number of positive attributes; however, there are a number of risks that make investing in this product a speculative proposal. While PIR does not rule out investing in this product, investors should be very aware of, and be comfortable with, the specific risks. The product may provide unique diversification opportunities. However, concerns over one or more features mean that it may not be suitable for most investors. B: PIR believes that despite the product s merits and attributes, it has failed to meet the minimum aggregate requirements of our review process across a number of key evaluation parameters. While this is a product below the minimum rating to be considered Investment Grade, this does not mean the product is without merit. Funds in this category are considered to contain high risks which are not reflected by the projected return. Performance volatility, particularly on the down-side, is likely. This report has not been commissioned, and, as such, PIR has not directly received a fee for its publication. Under no circumstances has PIR been influenced, either directly or indirectly, in making statements and/or recommendations contained in this report. P a g e 21