Key Characteristics. Product Type. Payment Frequency Current Distribution** Issue Margin / Coupon Franking Credits Incl.

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1 Issuer Name Centuria Capital No.2 Fund Security Name Centuria Notes Key Characteristics Product Type Corporate Bonds Issue Size* $50,000, Par Value $ Dual Tranch Floating / Fixed Research Report Report Created on 31 March 2017 Last Price $ Accrued $0.00 Capital Price $ Running Yield** [6.295% / 7.00%] Security Recommendation Subscribe Security Risk High Payment Frequency Current Distribution** Issue Margin / Coupon Franking Credits Incl. ASX Listed Quarterly / Semi Annual [6.295% / 7.000%] [4.500% / 7.000%] No No (ISIN: To be advised) Yield to Maturity*** [6.295% / 7.00%] Trading Margin - Optional Call Date [April 2019] Legal Final Maturity [April 2021] Record Date - Issuer Outlook Convertible No First Payment Date [July 2017 / October 2017] Improving Stable Deteriorating GICS Sector Real Estate Next Cash Distribution*** [$1.57 / $3.50] *Issue size is subject to change but expected to be $50 million. **Based on issue margin of 4.50% plus 90-Day BBSW of 1.795%. ***Actual cash amount dependent on tranche and based on $100 face value. Summary On the 3rd of April 2017, Centuria Capital No.2 Fund (under terms and conditions set out in the information memorandum) announced a new issue, Centuria Notes. The offer will raise a minimum of $50 million with the ability to take oversubscriptions. The proceeds will be used for general corporate purposes including refinancing of the vendor note used to fund Centuria s acquisition of the majority of 360 Capital Group s (ASX: TGP) real estate management platform. The potential oversubscriptions will be used to purchase assets which will form part of the security pool. These securities are sold to wholesale investors only (no prospectus being issued) and are not listed on the Australian Securities Exchange. These securities are structured as direct, senior secured obligations of the issuer which holds the group s equity stakes in three listed property funds and four other unlisted property funds. Investors benefit from a guarantee by the parent company, Centuria Capital Limited (ASX: CNI), on a senior unsecured basis. Interest payments are non-discretionary, fixed (or floating) rate and paid semi-annual (or quarterly) in arrears. The interest margin is guided to be set at [4.50%] p.a. above the 90-Day BBSW for floating rate tranche and 7.00% for the fixed tranche. Investors are protected by event of default mechanisms (including cross default) and a negative pledge where secured debt cannot exceed 65% of total tangible assets. The guarantor (CNI) is subject to a minimum interest cover ratio of 2.00x when CNI wishes to incur new debt.the issuer has the right but not the obligation to redeem the notes prior to maturity on the nominated optional redemption dates (April 2019 ($102) and April 2020 ($101)) or if a Tax or Accounting Event occurs. The holder may request early redemption of the notes on the occurrence of a Change of Control Event. Legal final maturity date of the notes is April Figure 1: Capital Structure 1 Figure 2: Relative Value % Senior Secured 67.0% Common Equity 31 March 2017 Page 1

2 Security Recommendation - Subscribe as at 31 March 2017 We initiate our coverage on the Centuria Notes with a Subscribe recommendation. Following acquisition of the majority of 360 Capital Group's funds management platform Centuria Capital Group is well positioned for its next stage of growth. While acquisitive behaviour (debt funded) is typically viewed as credit negative, the recent transaction significantly grew the scope and scale of operations, increased the group s recurring revenue base and was primarily funded from new equity capital. As a result, Centuria s earnings profile is now underpinned by stable revenue streams and ultimately the final outcome improved the group s credit profile considerably. There are obvious downside risks inherent in this security such as moderating capitalisation rate compression and further acquisition activity, but in our opinion, there are sufficient risk mitigants in place. This includes a strong covenant package, designated security pool, cross-default mechanisms and most importantly, a guarantee from the group (on an unsecured basis) giving the issuer access to cashflow from the investment bond unit and property funds management unit if required. However, given the weighted average lease expiry of ASX Listed REITs is longer than the term of the notes (4 years) this is not a base-case scenario in our analysis. The biggest risk to our thesis is a sharp deterioration in the Australia commercial property market which would result in a rapid decline in fee revenue and cessation in co-investment distributions. While this event is always possible, we view it as unlikely over the investment horizon and take comfort in the group s dual earnings profile (i.e. investment bonds), track record spanning almost two decades and capital-light, high margin business model. Our valuation assumptions are based on the security being redeemed (in full) on the legal final maturity date (April 2021) and all interest payments being made in a timely manner. Due to the unique operating profile of the issuer, this security is difficult to inherently value but given recent primary issuance in the real estate sector and our issuer outlook we are confident the notes are offered to investors at a margin that is considered fair and commensurate with risk of the security. Positive / Negative Risk Factors What factors would change the Recommendation UP The weighted average lease expiry (WALE) of the ASX Listed REITs exceeds the terms of the security (4 years). As a result, current leasing arrangements within the security pool should sufficiently service the notes over the investment horizon. Following the 360 Capital Group acquisition, 77% of Centuria s revenue base is recurring (from property funds and investment bonds management fees and co-investment income) which will provide transparent and predictable cashflow moving forward. This is further supported by increased economies of scale where fee revenue growth will outpace expenses due to increased platform utilisation. Dual earnings profile comprising management fees derived from property funds and investment bond benefit funds. This increases the diversification and scope of group cashflow. Strong track record in Property Funds Management having delivered an annual return of 13.2% to investors since inception in Legislation regarding restrictions to superannuation investments (enforceable from 1 July 2017) should support the group s investment bond business as investors seek alternative tax-effective investments options. Centuria s property interests are primarily situated in Industrial and Office markets which are our preferred real estate exposures due to tight supply conditions. What factors would change the Recommendation DOWN The value of the security pool is determined by equity markets and is directly observable. While this offers transparency to bondholders, valuation may be volatile and is subject to non-expert opinion. The group fails to successfully integrate and manage the 360 Capital Group platform in a cost-efficient manner. As Centuria has developed a strong track record in property funds management, there is reputational risk. If historical returns cannot be replicated investors may become reluctant to do business with the group moving forward. Due to the nature of the group s operations, Centuria s balance sheet has limited tangible assets relative to other property groups (which typically directly own some real estate assets). Management have anticipated that further consolidation in the REIT space may occur and Centuria will participate in acquisitions if it makes sense to do so. Although the 360 Capital Group acquisition was mostly equity funded, increasing leverage to take part in corporate activity would be credit negative. This is partially mitigated by the note covenant package. At this point in the property cycle, capitalisation rates may plateau (or fall) putting downward pressure on fund performance. Over the half, property FUM growth of $97 million was due to asset revaluations. Traditionally the group s distribution network has mainly comprised of high net worth/advisor channels which can be highly competitive. This may result in downward pressure on fees. 31 March 2017 Page 2

3 Issuer Outlook - Stable as at 31 March 2017 Earnings While Centuria s earnings profile has transformed over recent years, it remains unique. Following the divestment of its insurance arm and the bulk of its reverse mortgage book in 2014, the group now derives its revenue from three primary segments, namely Funds Management, Investment Bonds and Co-Investment. The first two comprise total group Funds Under Management (FUM) where management, performance and other fees are generated while the latter (co-investment revenue) refers to distributions attributable to group equity interests in the property funds it manages. In the past dividends from co-investment have been fairly immaterial but in January 2017 Centuria acquired the majority of 360 Capital Group s (ASX: TGP) real estate platform for $217 million. This included co-investment in 360 Capital Office Fund (now Centuria Urban REIT, ASX: CUA) and 360 Capital Industrial Fund (now Centuria Industrial REIT, ASX: CIP) increasing the value of equity-accounted investments from $51 million to $129 million and as a result, is expected to contribute ~$9.9 million distributions in The transaction also included the management rights to these funds together with four unlisted property funds increasing the group s property FUM by 148% to $2.9 billion. As a result, 77% of the group s revenue base is now recurring (from 67%) providing predictable and stable earning streams. As the acquisition was settled post the reporting date it was not included in the group s latest earnings release (1H17). For the half year ended 31 December 2016, Centuria reported a 48% decline in underlying EBIT to $3.8 million. However, this change was primarily driven by significant performance fees earnt in the prior corresponding period. On a normalised basis, underlying EBIT actually increased from $1.3 million to $3.6 million highlighting the group s focus of recurring revenue (i.e. management fees, co-investment distributions). While the earnings shortfall from performance fees remains, the group expects this to be recovered from higher co-investment revenue and growth in the group s unlisted property portfolio (via transaction fees) for the full year. Over the longer term, recurring management fees will now underpin the earnings profile (~40% of revenue) and group s reliance on intermittent fees (as seen in FY16) has been reduced which is a credit positive. Cashflow On a statutory basis, the cashflow statement is heavily impacted by consolidated subsidiary cash payments primarily within the group s benefit funds (i.e. Centuria Life) and controlled property funds. As a result, Centuria provides a secondary cashflow statement which omits this and essentially tracks cashflow at a group level. On this basis, net operating cashflow is positive and increased by 94% over the period on the back of a $7.7 million increase in management fees. Given there is minimal capital expenditure requirements at a group level, dividends are comfortably paid from operating cashflows and residual free cashflow is consistently positive ($6.8 million over the half). This strong operational result was further bolstered by proceeds from the divestments which outpaced purchases (net result of $34 million). This allowed the group to comfortably repay its working capital facility ($26.5 million) which matured in February This facility was successfully renegotiated with the lender and extended until February At 31 December 2016, the group had $71.5 million of cash on balance sheet of which ~45% is arguably restricted as it resides within the life business or other controlled property funds. Additionally, the 360 Capital Group acquisition was settled post the reporting date which was funded ~11% by existing cash reserves. As a result, we estimate the pro-forma liquidity position (cash and undrawn debt facilities) of the group to be ~$45-50 million. Capital Management Due to Centuria s legal structure, the group consolidates various fund debt onto the group balance sheet. These facilities are generally secured by the underlying tangible assets (primarily investment properties) within the relevant fund. However, at a group level, the company has a $30.5 million corporate bank facility in which the bank guarantee has been utilised ($3.5 million) and a $50 million vendor financing facility with 360 Capital Group which will be refinanced by Centuria Notes. Unlike other property groups Centuria does not own property directly and as a result, the group s tangible asset base primarily consists of equity stakes in three listed and four unlisted funds it manages. We note that the balance sheet also holds financial assets within its investment bond benefit funds but given these are secured by investment bond contracts, we exclude them from our analysis. This is visible by the group s operating balance sheet which excludes the assets and liabilities of benefits funds and controlled property funds. Due to this relatively capital-light business structure, funding requirements are low at the group level and gearing is immaterial. However, on a look-through basis (which includes the proportional share of debt in group s fund investments) we estimate gearing to be around ~29% which is broadly in line with peers. Under the terms of the notes, the group is also subject to an Interest Cover Ratio minimum of 2.00x which is only tested when Centuria (the guarantor) wishes to incur new debt. Historically, interest coverage has been significantly above this threshold. As part of the transaction with 360 Capital Group, Centuria entered a 2-year put and call arrangement for equity interests in four unlisted property funds. Although this does not strictly constitute direct ownership, the group gained control over the funds from an accounting perspective and therefore consolidated the fund debt on balance sheet ($128 million). We have excluded this from our look-through debt calculation. Outlook For the 2017 financial year, Centuria is expecting to reach assets under management of $4 billion and generate ~$9.9 million in co-investment distributions. At a fund level, Centuria remains focused on conservative strategies such as asset recycling, tenant repositioning and deleveraging to maintain the quality of the underlying portfolio. Ultimately, this will flow through to steady, recurring group cashflow in the form of management fees and co-investment revenue. Although the group has experienced positive market conditions in recent years, our investment thesis for property groups remains unchanged in that we are in the latter stages of the commercial real estate cycle. While our outlook has given less attention to the group s investment bond business, it plays at integral part to the credit stability of the group. In comparison to the group s property FUM, investment bond FUM is relatively more stable and longer-term. We expect this unit to provide measured earnings growth for the group which represent a backstop to cashflow if property market conditions deteriorate (albeit not a base-case scenario). Overall, we believe management s track record stands as a reminder of their ability to efficiently manage their balance sheet at all stages of the property cycle. We expect the recent acquisition to unlock leverage in Centuria s extensive distribution network which has been developed over almost 2 decades and given the group's capital-light business model, this will largely flow through to increased cashflow and earnings. For this reason, we remain comfortable with the group from a credit perspective but hesitate to initiate our outlook at improving due to our concerns about the broader sector. 31 March 2017 Page 3

4 Figure 3: Credit Curve (Comparable Securities) 2 Figure 4: Historical Trading Margins of Comparable Securities 1 The balance sheet structure diagram represents a measure of liabilities and captial in order of seniority of the overall cash balance sheet. 2 Pricing as at close of business 30 March 2017 Source: BondAdviser 31 March 2017 Page 4

5 Relative Value Given the unusual operating profile of Centuria Capital Group it competes with a number of companies across different industries. In terms of the group s property funds management platform, key players include Charter Hall Group (ASX: CHC), Cromwell Group (ASX: CMW) and Folkestone Limited (ASX: FLK). On the other hand, the largest provider of investment bond solutions in Australia is Australian Unity (Unlisted) but the closest peer to Centuria of comparable size is Austock Group (ASX: ACK). Overall, this clear uniqueness of the group s business model spanning over two very distinct industries makes like-for-like analysis difficult. Given the structure of the transaction we focus our analysis on the real estate component of the business to conduct relative value analysis. There are a number of issuers in the Real Estate sector but these groups are typically involved in direct ownership of property assets and/or the underlying balance sheet can be subject to development risk. These are activities not associated with Centuria which primarily manages property interests on behalf of external investors. For this reason, securities from these issuers are only comparable at a sector level. Table 1. Comparable Securities based on Sector Risk as at 28 th of March Issuer Ticker Amount Coupon Term Yield to Yield to Maturity Worst 1 Peet Ltd PPCHA $100m 7.50% 4.2 yrs 6.76% 6.76% Villa World Ltd VLWHA $50m BBSW % 5 yrs 7.27% 7.27% US Masters Residential Property Fund URFHC $175m 7.75% 4.75yrs 7.27% 6.95% Sunland Capital Pty Ltd Unlisted $50m 7.55% 3.7 yrs 6.58% 5.57% Centuria Capital No.2 Fund Unlisted [TBC] 7.00% 4.0 yrs 7.00% 7.00% Centuria Capital No.2 Fund Unlisted [TBC] BBSW % 4.0 yrs 6.295% 6.295% 1The rule of thumb when evaluating a bond is always to use the lowest possible yield. This is known as the yield to worst and is the lower of the yield to maturity and yield to call. Note that PPCHA and VLWHA have no call date prior to maturity and hence, the yield to maturity is the yield to worst. Source: BondAdviser In our opinion, the most comparable security to Centuria Notes (Secured) was 360 Capital s $75 million senior unsecured bond issued in This security was redeemed early via a special resolution with bondholders as part of the acquisition between the two groups at a premium of 104%. The bond performed well over its life until redemption once the acquisition was settled (9 January 2017). While it does not constitute a direct comparison to Centuria Notes, it does give an indication of performance and ability of a similar business model to meet obligations. Figure 5. Historical Trading Margin for 360 Capital 6.90% % 4.50% 4.00% 3.50% 3.00% 2.50% 2.00% Trading Margin (LHS) Source: BondAdviser 31 March 2017 Page 5

6 Background Centuria Capital Group (ASX: CNI) is an ASX-listed investment manager specialising in listed and unlisted property funds management as well as investment bonds. The group derives earnings from property fund co-investment (dividends), property funds management (fees) and investment bond products (fees). Listed Property Funds Centuria s listed real estate platform comprises equity stakes in the Centuria Industrial REIT (ASX: CIP), the Centuria Urban REIT (ASX: CUA) and the Centuria Metropolitan REIT (ASX: CMA). CIP and CUA were acquired from 360 Capital Group (ASX: TGP) in January Combined, the ASX Listed REITs own 53 industrial and office property assets valued at $1.58 billion. Assets are geographically diversified across New South Wales, Western Australia, Queensland, ACT and South Australia. The notes will be secured against the issuers stakes in these REITs Table 2. Centuria Listed Fund Comparison as at 31 st December 2016 Name Industrial REIT (CIP) Urban REIT (CUA) Metro REIT (CMA) Market Cap $519.3m $165.6m $165.6m CNI Ownership % / $81m 19.99% / $33.1m 2.10% / $5.99m Earnings Revenue LTM 2 $111.6m $29.7m $42.1m Net Operating Income LTM 2 $33.5m $15.9m $30.0m Balance Sheet Total Assets $929.7m $213.3 $440.6 Total Liabilities $419.6m $46.9m $163.8 Property Assets $911.7m $210.4 $417.5m Gross Debt $396.6m $41.4m $138.6 Net Debt $391.5m $39.1m $129.9m Liquidity $27.5m $40.8m $34.1m Credit Metrics Calculated Gearing % 18.5% 30.1% Reported Gearing (LVR) % 19.7% 33.8% Gearing Covenant Headroom 12.1% (<55%) 30.3% (<50%) 16.2 (<50%) Interest Coverage (ICR) 4.3x 6.8x 5.3x ICR Covenant Headroom 1.3x (>2.0x) 4.8x (>2.0x) 3.3x (>2.0x) Property Metrics Capitalisation Rate 7.42% 6.86% 7.52% Occupancy 95.1% 99.2% 98.9% WALE 4.3 Yrs 4.6 Yrs 4.2 Yrs Net Lettable Area 639,620 sqm 27,779 sqm 112,664 sqm Fixed / CPI Rent Review 71% / 21% 78% / 18% 94% / 1% Avg Fixed Rent Increase 3.2% p.a. 3.8% p.a. 3.7% p.a. 1% Geographical Exposure (by value) 19% 9% 9% 2% 44% 72% 28% 27% 12% 18% 45% NSW VIC ACT WA QLD SA VIC QLD NSW ACT QLD SA 1 Based on market capitalisation as at 30 March LTM = Last 12 Months 3 Calculated Gearing = Net Debt / Net Tangible Assets 4 Reported Gearing = LVR (Loan to Value Ratio) Source: Company Reports On the 3 rd of March 2017, Centuria Property Funds Limited (CPFL) as responsible entity for Centuria Metropolitan REIT (CMA) and Centuria Property Funds No.2 Limited (CPF2L) as responsible entity Centuria Urban REIT (CUA) entered into a Scheme Implementation Agreement undertake a NTA-for-NTA merger. 31 March 2017 Page 6

7 If CUA unitholders approve the transaction on the 9 th of May 2017 the combined portfolio (which will trade under ASX: CMA) will be valued at $601.9 million post the implementation date (24 May 2017). Each unitholder will receive 0.88 CMA units and a $0.23 cash payment for each CUA unit held (~$16 million in total). On a pro-forma basis, the issuer will own approximately 8.64% of the merged entity and importantly, there will be no material change to the security pool as a result of the transaction. Table 3. Proposed Merged Entity Overview Portfolio Metrics Sector Diversification Geographic Diversification Market Cap 1 $417m CNI Ownership % / $36m 8% 7% Property Assets $601.9m 27% Capitalisation Rate 7.29% 43% 10% Gearing % Net Lettable Area 131,017 93% 12% Occupancy 98.8% NSW VIC ACT WALE 4,2 Yrs Office Industrial WA QLD SA No. of Properties 15 1 Based on market capitalisation as at 30 March 2017 Source: Company Presentation Unlisted Property Funds Centuria s unlisted property funds encompass 23 properties with a combined value of ~$1.5 billion. These assets are held in 18 funds entirely consisting of commercial office real estate. It is not unusual for these funds to contain only 1 asset which typically run for a ~5-year term. The 360 Capital platform acquisition added 4 new unlisted funds contributing a further $258 million of funds under management (FUM) to the unlisted platform. Overall, unlisted property funds contribute ~40% of group FUM which generate higher fees relative to the group s listed property funds (Table 4). As a result, these funds are an important source of earnings for Centuria. Table 4. Funds Management Fee Structure Name Source: Company Reports Listed Property Funds Property Funds Unlisted Property Funds Development Funds Management Fees % 1.00% 0.80% Performance Fees - ~20% over IRR of 10% p.a. ~25% over IRR of 15% p.a. Acquisition Fees % % - Sales Fees % -1.50% 2.50% of sale value per unit Development Management Fees % of project costs Figure 6. Unlisted Property Funds Under Management $1.6bn $1.4bn $1.2bn $1.0bn $0.8bn $0.6bn $0.4bn $0.2bn $0.0bn 1H17 2H16 1H16 2H15 1H15 2H14 1H14 2H13 1H13 2H12 1H12 2H11 1H11 2H10 1H10 2H9 1H9 2H8 1H8 2H7 1H7 Source: Company Reports 31 March 2017 Page 7

8 Investment Bonds Another significant source of earnings for Centuria is derived from its life subsidiary which predominantly deals in investment bonds (also known as insurance bonds). These products are long-term tax-effective vehicles and can be issued by life insurers or friendly societies. More specifically, any capital gain on an investment bond is tax-free if it is held for at least 10 years for holders. As a result, this earnings segment provides long-term, stable recurring revenue for the group. Centuria s investment bond division is operated out of Centuria Life Limited which is broken into two operating subsidiaries (Table 5). Referring to the table below, funds generated by investment bonds are held with Centuria Life Limited while funds generated from prepaid funeral plan products are held within Over Fifty Guardian Friendly Society (in which Centuria simply receives management fees on the investment mandate set by Guardian Care). Table 5. Centuria s Investment Bond Segment Centuria Life Limited Centuria Life Friendly Society Over Fifty Guardian Friendly Society Products Unit-Linked, Capital Guaranteed Bonds Prepaid Funeral Plans Delivery Managed and Sold by Centuria Managed by Centuria 1 Funds Under Management $350m $370m Management Fees % % 1Prepaid funerals plans are sold by Guardian Plan (subsidiary of Invocare Limited (ASX: IVC)) whereby Centuria acts as the investment manager. Source: Company Reports According to Plan for Life (an industry researcher), Centuria has a 10.2% share of the ~$7.3 billion investment bond market and is the 5 th largest provider behind Australian Unity (24%), IOOF (12%) and CBA/Colonial (11%) and One Path (11%). The market grew by 7.6% in FY16 which should continue in sync with the rapid growth of Australia s superannuation system. Furthermore, legislation surround restrictions to superannuation investments (enforceable from 1 July 2017) such as capped contributions should support the industry as investors seek alternative tax-effective investments options. Figure 7. Major Players Funds Under Management Centuria Capital 720 Colonial Group OnePath IOOF Aus Unity 1796 Source: Plan for Life (June 2016) $0m $200m $400m $600m $800m $1000m $1200m $1400m $1600m $1800m $2000m Figure 8. Projected Superannuation Assets $10000bn $8000bn $6000bn Forecast $4000bn $2000bn $0bn Source: APRA, ABS, Deloitte 31 March 2017 Page 8

9 Structural Considerations The notes are secured by the issuer s equity investments in its listed property funds and four other unlisted property funds outlined below. Figure 9. Simplified Business Structure Unsecured Guarantor Centuria Capital Limited Stapled Security (ASX: CNI) Centuria Capital Fund The Issuer Centuria Life Limited Property Funds Management Centuria Capital No. 2 Fund Investment Bond Business Centuria Life Friendly Society CMA (2.1%) CUA (19.9%) CIP (15.6%) Centuria Diversified Fund Over Fifty Guardian Friendly Society Woden GED Fund (20%) 19 Corporate Drive Fund (0.48%) ATP Fund (0.81%) Zenith Fund (6.40%) Security Pool Source: BondAdviser, Company Reports Debt serviceability is primarily a function of the group s co-investment revenue. This revenue is derived through distributions made by each of the funds within the security pool proportional to the issuer s relevant equity stake in the funds. As these distributions are residual, the smoothness of the note interest payments is dependent on each fund s net profitability and while the notes are secured at an issuer level by the equity interests in each fund, they are effectively subordinated to all fund creditors. Figure 10. Issuer Priority of Payments Security Pool Total Revenue - Operating Expenses - Finance Costs = Distributable Earnings x Payout Ratio = Distribution x Issuer Equity Interest = Issuer Distribution The Issuer Capital Structure Secured Creditors Secured Bank Debt Common Equity Payout Policy FY17 Industrial REIT (CIP) Urban REIT (CUA) Metro REIT (CMA) % of Distributable Earnings 100% 100% 92-94% Centuria Capital No. 2 Fund = Centuria Note Interest Source: BondAdviser, Company Reports as at 31 December March 2017 Page 9

10 In table 6 we outline note coverage from a capital and distribution perspective. Based on FY17 distribution forecasts, the indicative annual interest payment will be covered between 2.45x to 3.18x contingent on the final issue size of the notes. Similarly, the value security pool sufficiently covers the aggregate face value of the notes by 39.3% % also contingent on the final issue size of the notes. We have adjusted the upper bound of this range to reflect the additional $25 million of tangible asset purchases should the offer be upsized from $50 million to $75 million from oversubscriptions. Table 6. Security Pool CNI 1 FY17 Distribution Guidance Name Platform Ownership % / Distribution Per CNI Share Value Share Centuria Industrial REIT ASX: CIP 15.60% / $81m 20.5c $6.78m Centuria Urban REIT ASX: CUA 19.99% / $33.1m 16c $2.34m Centuria Metropolitan REIT ASX: CMA 2.10% / $5.99m 17.5c $0.44m Centuria Woden GED Fund Unlisted 20.0% / $1.23m Unlisted Centuria Zenith Fund Unlisted 6.40% / $5.06m Unlisted Centuria ATP Fund Unlisted 0.81% / $0.57m Unlisted Centuria 19 Corporate Drive Fund Unlisted 0.48% / $0.09m Unlisted ~$0.40m Total Security: $127.1m Total Distribution: $9.96m / $11.5m 2,3 Security Coverage ($50m / $75m): 39.3% / 49.3% Interest Coverage 3.18x / 2.45x 1 Based on market capitalisation as at 30 March Given the cash component of the proposed merger between CUA and CMA ($0.23 per unit), the total distribution will be $10.1 million if the transaction is approved and completed (i.e. pro-forma) assuming $50m transaction size. 3 Includes estimate distributions from the additional $25 million of assets purchases if the offer is fully oversubscribed. Source: Company Reports The issuer is subject to a negative pledge where secured gearing (Secured Debt/Tangible Assets) must be less than 65%. Additionally, proceeds from assets sales must be invested within 180 days or applied to repayment of secured debt. Guarantor The notes also benefit from a guarantee from the parent entity, Centuria Capital Limited. However, the primary difference here is that the guarantee is on an unsecured basis meaning it is subordinated to all secured debt present at a group level. Nonetheless, the guarantee grants the issuer access to other earnings streams such as investment bond fees and property management fees to service the notes if co-investment revenue is insufficient. At a group level, Centuria s primary credit line is its $30.5 million undrawn corporate working facility. As it is secured debt, it has first priority ranking for payment in an Event of Default but importantly, we note that the security pool is ringfenced on an unsecured basis. The guarantor is subject to a minimum interest cover ratio (Total Interest/EBITDA) of 2.00x which is tested when Centuria (the guarantor) wishes to incur new debt. Debt Structure Due to Centuria s complex structure, the group conducts the majority of its debt funding at a fund level. These facilities are generally secured by the underlying tangible assets (primarily investment properties) within the relevant fund and as a result, balance sheet gearing (which only includes group level debt) typically remains low (~3% on pro-forma basis). However, it is important to also consider this credit metric on a look-through basis which accounts for the proportionate share of interest-bearing liabilities of Centuria s co-investments. 31 March 2017 Page 10

11 Figure 11. Peer Analysis: FUM Size and Look-Through Gearing Funds Under Management $35bn $30bn $25bn $20bn $15bn $10bn $5bn $0bn 45.0% 34.4% 27.7% 28.7% 20.6% 15.3% Goodman Group Charter Hall Group Cromwell Group Centuria Limited Folkestone Limited Propertylink Group Listed FUM Unlisted Retail Unlisted Wholesale Look-Through Gearing 50.0% 45.0% 40.0% 35.0% 30.0% 25.0% 20.0% 15.0% 10.0% 5.0% 0.0% Gearing Source: Company Reports, BondAdviser Estimates Figure 12. Centuria Listed Funds Balance Sheet Gearing 70.0% 60.0% 50.0% 40.0% 30.0% 20.0% 10.0% 0.0% 60.7% 58.8% 45.5% 42.4% 42.1% 40.0% 42.6% 42.3% 31.9% 33.2% 28.7% 30.1% 24.0% 17.8% 18.5% H17 Centuria Industrial REIT Centuria Urban REIT Centuria Metro REIT Source: Company Reports, BondAdviser Estimates Property Outlook Real Estate is one of the largest sectors of the Australian economy comprising almost 20% of total gross value added. Over the past few years, the sector has benefitted from declining interest rates, strong investor demand and tight supply conditions. However, economic and industry data suggests Australia is nearing the peak of the commercial property cycle. In the second half of 2016, the market experienced less transaction activity than normal from the major participants and capitalisation rates approached pre-gfc lows. Although these indicators are typically a credit negative, capital management policies appear much more conservative relative to the pre-gfc era. This includes lower gearing levels, subdued acquisition activity and active asset recycling (i.e. divestments). As a result, we believe the sector is generally well positioned at this point in the cycle by using value-added strategies to maintain high quality portfolios. While higher bond yields driven by higher inflation expectations (following Trump s election) may have some impact on A-REIT portfolios, we are still in a very low interest rate environment and any increase in the cost of debt funding would not be high by historical standards. For this reason, we expect any yield steepening to have a negligible impact on sector credit quality. 31 March 2017 Page 11

12 Figure 13. ASX200 A-REIT Aggregate Revaluation Uplift and Weighted Average Capitalisation Rate $300 mn $250 mn $200 mn $150 mn $100 mn $50 mn $0 mn -$50 mn -$100 mn 8.00% 7.50% 7.00% 6.50% 6.00% ASX200 Rolling 12-Month Aggregate Revaluation Uplift ASX200 WACR Source: Company Data, BondAdviser Estimates Shopping centres are facing soft consumer spending and long-term headwinds from the rise of e-commerce but conditions for logistics and office real estate assets (the majority of Centuria s exposure), remain strong. As a result, we expect Centuria s direct and indirect property assets will continue to benefit from tight supply conditions resulting in low vacancy rates. Overall, there is no doubt that the compression of capitalisation rates is slowing which is consistent with our broader thesis on the sector and it is unlikely the group will see the same revaluation impact on earnings in coming years. However, it is difficult to identify a catalyst for a major correction in asset values given the current positive market conditions and conservative capital management policies in place. For this reason, we expect Centuria s listed funds (ASX: CIP, CMA, CUA) to add incremental value as the market moderates through alternative strategies (i.e. releasing policies, asset recycling) rather than outright asset acquisitions. This is further supported by the underlying quality of the funds assets which have vacancy rates below 5% and ~70% of rental contracts linked to fixed reviews. Figure 14. Historical Occupancy Rates consistently above 95% 100% 99% 98% 97% 96% 95% 94% Dec-2012 Jun-2013 Dec-2013 Jun-2014 Dec-2014 Jun-2015 Dec-2015 Jun-2016 Dec-2016 Source: Company Reports CMA CUA CIP Stress Test The obvious risk to any Commercial Real Estate business is a sharp and protracted period of negative asset price growth and/or a sudden increase in tenant bankruptcies (high vacancy). Given both these events are typically driven by similar underlying economic factors, they usually occur simultaneously rather than in isolation. Although this is not a base-case scenario in our investment thesis, for the sake of our analysis we have stressed the group s operating environment to simulate extreme economic conditions. According to the Property Council/IPD Australia All Property Index (a leading gauge of commercial real estate returns), capital returns on commercial property contracted by 10-15% during the Global Financial Crisis (GFC). This was slightly more prominent at 15-20% during Australia s last recession in Given the value of the underlying security pool would need to decline ~40% before capital coverage of the notes is breached, we remain comfortable from a tangible asset perspective. 31 March 2017 Page 12

13 Figure 15. Australia Commercial Property Returns (%Y/Y) 40% 30% 20% 10% 0% -10% -20% Source: MSCI, Property Council and IPD Capital Growth Income Return Total Return On the other hand, debt serviceability is primarily a function of co-investment revenue derived from rental income. Relative to the weighted average lease expiry (WALE) of the security pool, the tenor of Centuria Notes is short (4 years). This implies there is minimal re-leasing risk within the underlying funds and cashflow (via distributions from the security pool) will be sufficient to service the notes over the investment horizon. Nonetheless, we assume a scenario where the listed REITS experience an annual tenant default rate of 5% and only 50% of expired leases are released under the same terms. On this basis, there is still sufficient cashflow to pay interest obligations each year. Figure 16. Term: Centuria Notes, Recent Real Estate Security Issuance and Security Pool WALE Peet Bonds (ASX: PPCHA) GPT 3.591% 2023 GPT 3.657% 2026 Mirvac 3.50% 2023 GPT Office Fund 4.52% 2027 URF Notes III (ASX: URFHC) Centuria Notes Centuria Urban REIT Centuria Metro REIT Centuria Industrial REIT 5.0yrs 4.8yrs 4.0yrs 4.2yrs 4.6yrs 4.3yrs 7.0yrs 7.1yrs 10.0yrs 10.0yrs Security Pool Weighted Average Lease Expiry (WALE) Recent Real Estate Issuance Source: BondAdviser Years Additionally, we acknowledge cashflow can be sourced from the group s investment bond and property funds management business which is a major differentiator between Centuria and other property groups. Given the relatively short term to maturity of the notes and cashflow profile of the group, we are confident the notes can be serviced adequately over the investment horizon. 31 March 2017 Page 13

14 Covenant Analysis The primary maintenance covenant for the notes is the secured debt gearing ratio in which the issuer must ensure is that secured debt is less than 65% of total tangible assets (i.e. the security pool). On a pro-forma basis, the issuer s secured debt will completely comprise the Centuria notes and the covenant will be tested on a semi-annual basis. Figure 17. Centuria Capital No.2 Fund Pro-Forma Balance Sheet Assets Unaudited 31/03/2017 Adjustments ($50m Issuance) Pro-Forma Adjustments ($75m Issuance) Pro-Forma Cash at Bank Distribution/interest receivable Unlisted syndicate receivables (15.80) 0.00 (15.80) 0.00 Investments Total Assets (15.80) Liabilities Payables - Intercompany Put Option Liability Bank Debt (15.80) - (15.80) - Borrowings - Secured Notes Borrowings Capital (50.00) - (50.00) - Total Liabilities (15.80) Net Assets Equity Contributed Equity Retained Earnings (5.57) - (5.57) - (5.57) Total Equity Source: Information Memorandum On this basis, the pro-forma secured gearing ratio will be between 37.5% to 47.3% which is calculated similar to the capital coverage illustrated in Table 6. Contingent on the issue size of the notes, this implies secured debt headroom of $28-36 million and security pool headroom of $42-55 million. Figure 18. Secured Gearing Headroom $75m Offer 47.3% $50m Offer 37.5% $0m $10m $20m $30m $40m $50m $60m Headroom Security Pool Headroom Secured Debt Source: BondAdviser Under the terms of the security, the issuer will provide the Trustee a certificate of legal covenant compliance 90 days from each 31 December and 120 days after each 30 June. This gives the group sufficient time to take action if the covenant is breached and given the multiple levers at management s disposal (i.e. divestments, equity capital, cashflow from other business units), we believe this will be prudently managed. Additionally, excess cash from coinvestment distributions could also be retained at an issuer level which will increase covenant buffer over the life of the notes. 31 March 2017 Page 14

15 Centuria Capital No.2 Fund: Financial Summary Centuria Capital No.2 Fund: Financial Summary Recommendation Summary Subscribe 31 March 2017 Profit or Loss Note: Guarantor Funds Management ($m) Investment Bonds ($m) Reverse Mortgages ($m) Insurance ($m) 1.1 Corporate ($m) Underlying EBIT ($m) Finance Costs ($m) Underlying Pre-Tax Profit ($m) Taxation ($m) Underlying Net Profit ($m) Credit Metrics *Net Debt Immaterial Revenue Growth (%) EBIT Growth (%) EBIT Margin (%) Dividend Payout Ratio (%) Interest Cover (x) Cashflow Note: Guarantor Cash From Operations ($m) Net Benefit Fund Flows ($m) Taxation ($m) Other ($m) Net Operating Cashflow ($m) Payments for Benefit Fund Assets ($m) Payments for PPE ($m) Acquisition of Investments ($m) Other ($m) Net Investing Cashflow ($m) Net Equity Issuance ($m) Change in Borrowings ($m) Finance Costs ($m) Reverse Mortgages ($m) Dividends Paid ($m) Other ($m) Net Financing Cashflow ($m) Change in Cash ($m) Listed REIT Gearing CIP CUA CMA Balance Sheet Note: Guarantor Cash & Liquids ($m) Receivables ($m) Development Property ($m) Unit Trusts ($m) Reverse Mortgages ($m) Benefit Fund Financial Assets ($m) Intangibles ($m) Other ($m) Total Assets ($m) Payables ($m) Borrowings ($m) Interest Rate Swap ($m) Provisions ($m) Life Policy Liabilities ($m) Other ($m) Total Liabilities ($m) Net Assets ($m) Net Debt ($m) Source: Company data, BondAdviser estimates. 31 March 2017 Page 15

16 Research Methodology Every research report prepared by BondAdviser includes a clear recommendation - Buy, Hold or Sell - on the security. This recommendation framework is designed to help investors navigate different investment opportunities by identifying the market price, yield, term to maturity, liquidity, volatility and risk. The guide below may help you understand our research opinions. For further information on our research approach, you can refer to our RG79 statement by clicking here. Research Opinions key Buy - Over the next 12 months, the analyst expects the security to outperform the current yield due to credit spread tightening or favourable movements in the underlying yield curve. Hold - Over the next 12 months, the analyst expects the security to provide stable returns broadly inline with the current yield but with little credit spread tightening. Sell - Over the next 12 months, the analyst expects the security to underperform the current yield due to credit spread widening or adverse movements in the underlying yield curve. Suspended - The recommendation has been suspended temporarily due to the disclosure of new information or market events that may have a significant impact on our recommendation. This also includes situations where we have been given non-public information and we need to temporarily suspend our coverage in order to comply with applicable regulations and/or internal policies. Not Rated - A security that has not been assigned a formal recommendation. Analyst Nicholas Yaxley Credit Research nicholas.yaxley@bondadviser.com.au About BondAdviser BondAdviser is an independent research company that specialises in bonds and fixed income securities. We provide investors, advisers, brokers and institutions with research, data, education and tools to help them invest intelligently. 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