Rating Action Overview

• Australian Prime Property Fund Commercial's (APPF Commercial) sizable debt-funded acquisitions completed in the fourth quarter of fiscal 2022 (ended June 30, 2022), coupled with high interest rates, have reduced the company's credit metric headroom.
• The property fund's office development projects could further weaken its credit metrics. We project APPF Commercial's adjusted ratio of funds from operations (FFO) to debt to decrease below our downgrade trigger of 12% for fiscal 2023.
• We have revised our rating outlook on APPF Commercial to negative from stable. At the same time, we affirmed our 'A-' rating on the property fund and its senior unsecured debt.
• The negative outlook reflects our view that APPF Commercial's financial leverage and cash flow adequacy are likely to remain weak over the next six to 12 months.

Rating Action Rationale

APPF Commercial's weakened leverage metrics could deteriorate over the next six to 12 months.

The fund's new office development at Victoria Cross in north Sydney will likely worsen its credit metrics. The project will have minimal income generation until its scheduled completion by the first half of calendar 2025. We expect APPF Commercial to spend about A$330 million over the next two fiscal years for its projects and acquisitions. The current high interest rate environment will also weigh on the fund's cash flows.

We forecast the S&P Global Ratings adjusted FFO-to-debt ratio for APPF Commercial will be below 12% for fiscal 2023. The fund will likely improve its adjusted FFO-to-debt ratio to above 12% beyond fiscal 2024.

The fund's leverage weakened primarily due to the approximately A$520 million spent to acquire a 20% interest in Sydney Place Precinct and to acquire 19 O'Connell Street, a commercial property in Sydney, during the fourth quarter of fiscal 2022. As a result, the adjusted FFO-to-debt ratio fell to 13.6% in fiscal 2022 from 17.6% in fiscal 2021. We have revised our assessment of the fund's financial risk profile down to intermediate from modest based on the above factors.

We believe APPF Commercial is committed to reducing debt and maintaining a financial profile consistent with a 'A-' rating.

Given the ongoing capital expenditure (capex), we expect the fund's look-through gearing (ratio of debt to assets) to breach the 25% upper bound of its targeted gearing ratio in the first half of fiscal 2024. The ratio was 23.2% as of March 31, 2023.

The fund manager has articulated a strategy to return gearing to 10%-20% and provide enough headroom to accommodate the future debt-funded capital commitments. This is despite the office market likely to remain challenging. We believe the fund manager is committed to reducing debt usage and will seek to take capital management initiatives to repair its credit metrics. This could include equity raisings or asset sales.

APPF Commercial's growing portfolio will bolster its business risk profile.

The fund's high-quality, well-located properties underpin its competitive position. The acquisition of Sydney Place Precinct and the completion of the Victoria Cross project will further improve the asset portfolio.

Given APPF Commercial's predominant focus on prime grade (premium and A-grade) assets, we believe the fund is well placed to maintain strong occupancy and attract new tenants. As of March 31, 2023, the fund had an occupancy level of 96.1% and a weighted-average lease expiry of 5.3 years.

Outlook

The negative outlook reflects our view that APPF Commercial's financial leverage and cash flow adequacy are likely to remain weak over the next six to 12 months. This is due to the fund's increased debt usage and sizeable capex projects.

During this period, assets being developed will generate minimal income, further eroding the credit metrics. We project APPF Commercial's adjusted FFO-to-debt ratio will drop below 12% for fiscal 2023. The fund is likely to pursue capital management initiatives to sustainably improve the ratio to above 12%. This could include equity raising or asset sales.

Downside scenario

We could lower the rating if APPF Commercial consistently reports adjusted FFO-to-debt ratio of less than 12% beyond the next six to 12 months. This could happen if the financial deleveraging strategies are not successfully implemented.

Rating pressure could also eventuate from more aggressive debt-funded growth initiatives or weaker tenant occupancy and rental income.

Upside scenario

We could revise the outlook to stable if APPF Commercial can sustain its adjusted FFO-to-debt ratio above 12% and complete the ongoing asset developments consistent with its operating strategy.

Company Description

APPF Commercial was established in 1994 as a wholesale unlisted property trust. It was launched and managed by Lendlease Real Estate Investments Ltd., a subsidiary of property developer and manager, the Lendlease group. The fund's property portfolio was valued at A$6.96 billion (look-through gross assets) as of March. 31, 2023. It comprises interest in 21 office properties on the east coast of Australia.

Our Base-Case Scenario

Assumptions

• Australia's real GDP growth of 1.6% in 2023 and 1.7% in 2024; population growth of 1.7% in 2023 and 1.6% in 2024; and unemployment rate of 4.0% in 2023 and 4.3% in 2024;
• APPF Commercial's occupancy rate of about 96% despite weaker leasing market conditions across key markets;
• APPF Commercial's weighted average lease expiry stays above 5.3 years;
• Total capex of about A$450 million across fiscal years 2023-2025;
• Unitholder distributions of A$450 million-A$500 million in fiscal years 2023-2025;
• Distribution reinvestment of A$10 million-A$20 million in fiscal years 2023-2025;
• Our base-case forecasts do not include any external equity raises or material equity redemptions, given the next redemption window is not until 2026.

Key metrics

Based on these assumptions, we expected the S&P Global Ratings' adjusted FFO-to-debt ratio to be 9.5%-10.0% for fiscal 2023 and 8.5%-9.0% for fiscal 2024.

Liquidity

In our view, APPF Commercial has strong liquidity, with sources of funds exceeding uses by more than 1.5x over the 12 months ending March 31, 2024. We expect sources less uses to remain positive even if EBITDA decreases by 15%. APPF Commercial's sound relationships with banks support its liquidity. These strengths should enable timely refinancing of debt maturities and establishment of new facilities when required.

We expect APPF Commercial to have the following sources and uses of liquidity over the 12 months ending March 31, 2024:

Principal liquidity sources

• Cash FFO of A$140 million-A$160 million;
• Undrawn bank lines maturing beyond 12 months of about A$390 million as of March 31, 2023;
• Cash balance of approximately A$17 million; and
• Active distribution reinvestment uptake of A$10 million-A$20 million.

Principal liquidity uses

• No upcoming drawn debt maturities;
• Capex of A$140 million-A$170 million;
• Acquisition costs of A$20 million-A$30 million; and
• Unitholder distributions of A$150 million-A$170 million.

Covenants

APPF Commercial maintains significant headroom against its financial covenants. The fund's bank facility borrowings are subject to various financial covenants, including a look-through gearing ratio of less than 50% (26.6% as of Dec. 31, 2022). We expect APPF Commercial to continue to maintain sufficient cushion under its covenants.

Environmental, Social, And Governance

ESG credit indicators: E-2, S-2, G-2

Environmental, social, and governance (ESG) factors have had no material influence on our credit rating analysis of APPF Commercial.

In our view, APPF Commercial has integrated ESG management practices within its core operations, development activities, and investment decisions. This is demonstrated by its early completion of its 2025 net zero target (scope 1 and 2) by 2019. In the 2022 Global Real Estate Sustainability Benchmark (GRESB) assessment, the fund was ranked second out of 145 global funds for the "high rise office" category. In addition, APPF Commercial is undertaking initiatives such as electrification-feasibility studies on new building designs and inclusion of green lease clauses for tenants. These initiatives are essential to the fund's long-term performance and to make its asset base attractive to tenants.

Issue Ratings - Subordination Risk Analysis

Capital structure

As of March 31, 2023, APPF Commercial's capital structure consisted of about A$1.2 billion of look-through drawn debt with a weighted-average debt maturity of about 4.4 years (based on drawn amount). The funding is well diversified through a mix of bank facilities, rated medium-term notes, and U.S. private placement bonds (unrated) on a look-through basis.

During the third quarter of fiscal 2023, APPF Commercial refinanced A$300 million of existing bank facilities and raised additional facilities of A$275 million. In the absence of external equity raises, we expect the additional debt capacity to be utilized to fund the Victoria Cross and other capital projects over the next 18 months.

Ratings Score Snapshot

Related Criteria

• General Criteria: Environmental, Social, And Governance Principles In Credit Ratings , Oct. 10, 2021
• General Criteria: Group Rating Methodology , July 1, 2019
• Criteria | Corporates | General: Corporate Methodology: Ratios And Adjustments , April 1, 2019
• Criteria | Corporates | Industrials: Key Credit Factors For The Real Estate Industry , Feb. 26, 2018
• Criteria | Corporates | General: Methodology And Assumptions: Liquidity Descriptors For Global Corporate Issuers , Dec. 16, 2014
• General Criteria: Methodology: Industry Risk , Nov. 19, 2013
• General Criteria: Country Risk Assessment Methodology And Assumptions , Nov. 19, 2013
• Criteria | Corporates | General: Corporate Methodology , Nov. 19, 2013
• General Criteria: Methodology: Management And Governance Credit Factors For Corporate Entities , Nov. 13, 2012
• General Criteria: Principles Of Credit Ratings , Feb. 16, 2011

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