Constrained Office Supply And Tenant Demand Will Support Long Term Earnings Resilience

Catalysts

About Centuria Office REIT

Centuria Office REIT owns and manages a diversified portfolio of metropolitan and near city Australian office assets focused on delivering sustainable income for investors.

What are the underlying business or industry changes driving this perspective?

• Persistent escalation in office replacement costs relative to COF's current asset values reduces the likelihood of competing new supply, which should support higher market rents and improve revenue and asset valuations over time.
• Increasing withdrawals and conversions of lower grade office buildings to alternative uses concentrate demand into existing A grade metropolitan stock, which is expected to bolster occupancy levels and strengthen net operating margins.
• Population growth and a rising pool of white collar employment are driving greater office space requirements in well connected metro locations, providing a backdrop for sustained leasing demand and FFO growth.
• Growing tenant preference for high amenity, energy efficient workplaces aligns with COF's young, A grade and highly rated portfolio, which should support positive leasing spreads and enhanced earnings resilience.
• Improving metro office market liquidity and renewed interest from global and domestic capital signal stabilising valuations, which can moderate gearing, lower perceived risk and underpin more stable earnings and distribution capacity.

Assumptions

How have these above catalysts been quantified?

• Analysts are assuming Centuria Office REIT's revenue will decrease by 6.1% annually over the next 3 years.
• Analysts assume that profit margins will increase from -12.8% today to 48.4% in 3 years time.
• Analysts expect earnings to reach A$61.8 million (and earnings per share of A$0.14) by about December 2028, up from A$-19.8 million today. However, there is a considerable amount of disagreement amongst the analysts with the most bullish expecting A$102.7 million in earnings, and the most bearish expecting A$22.8 million.
• In order for the above numbers to justify the price target of the analysts, the company would need to trade at a PE ratio of 14.8x on those 2028 earnings, up from -34.4x today. This future PE is lower than the current PE for the AU Office REITs industry at 54.8x.
• Analysts expect the number of shares outstanding to remain consistent over the next 3 years.
• To value all of this in today's terms, we will use a discount rate of 7.82%, as per the Simply Wall St company report.

Risks

What could happen that would invalidate this narrative?

• The long-running decline in funds from operations per unit from 19.9 cents in FY 2021 to 11.8 cents in FY 2025, alongside guidance for a further drop in FY 2026, suggests that even with improving market indicators, earnings may continue to be pressured if leasing recovery or cost reductions lag expectations. This would weigh on earnings and cash flow.
• High and rising gearing of 44.4 percent, combined with a distribution payout ratio approaching 90 percent of FFO and distributions not covered by free cash flow after capital expenditure, increases balance sheet risk in a higher rate environment. This could force future cuts to distributions or asset sales at weaker prices, impacting net margins and earnings.
• Management guidance assumes FY 2026 is the trough for FFO. However, conservative assumptions that treat whole floor vacancies and FY 2026 expiries as earning no income highlight that a slower than expected leasing recovery in challenging markets like Docklands and St Leonards could extend the earnings downturn and delay any stabilization in revenue and FFO.
• Structural trends such as constrained new supply and office stock withdrawals support long term rents and valuations. However, these trends are occurring against a backdrop of elevated incentives of up to 34 percent on new leases and ongoing market vacancy, which may continue to dilute effective rental income and constrain improvements in net property income and net margins.
• The strategy of maintaining distributions at current levels despite falling FFO is predicated on anticipated interest rate cuts and leasing improvements. If rates remain higher for longer or tenant demand weakens due to broader economic headwinds, the trust could face further valuation pressure, higher financing costs and a need to reset distributions. All of these factors would negatively affect earnings and potentially the unit price.

Valuation

How have all the factors above been brought together to estimate a fair value?

• The analysts have a consensus price target of A$1.22 for Centuria Office REIT based on their expectations of its future earnings growth, profit margins and other risk factors.
  
• However, there is a degree of disagreement amongst analysts, with the most bullish reporting a price target of A$1.61, and the most bearish reporting a price target of just A$0.94.
  
• In order for you to agree with the analysts, you'd need to believe that by 2028, revenues will be A$127.7 million, earnings will come to A$61.8 million, and it would be trading on a PE ratio of 14.8x, assuming you use a discount rate of 7.8%.
  
• Given the current share price of A$1.14, the analyst price target of A$1.22 is 6.8% higher. The relatively low difference between the current share price and the analyst consensus price target indicates that they believe on average, the company is fairly priced.
  
• We always encourage you to reach your own conclusions though. So sense check these analyst numbers against your own assumptions and expectations based on your understanding of the business and what you believe is probable.