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Edited Transcript of VHP.NZ earnings conference call or presentation 19-Feb-20 10:30pm GMT

Half Year 2020 Vital Healthcare Property Trust Earnings Call

Auckland Mar 5, 2020 (Thomson StreetEvents) -- Edited Transcript of Vital Healthcare Property Trust earnings conference call or presentation Wednesday, February 19, 2020 at 10:30:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Aaron Hockly

Vital Healthcare Property Trust - Fund Manager

* Chris Adams

Vital Healthcare Property Trust - Executive Director of NorthWest, Developments & Acquisitions

* Michael Groth

Vital Healthcare Property Trust - CFO of Vital Healthcare Management Limited

* Richard Roos

Vital Healthcare Property Trust - MD of Australia

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Conference Call Participants

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* Adam Lilley

Craigs Investment Partners Limited, Research Division - Research Analyst

* Nick Mar

Macquarie Research - Analyst

* Owen Batchelor

Jarden Limited, Research Division - VP of Equity Research

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Presentation

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Operator [1]

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Thank you for standing by, and welcome to the Vital Healthcare Property Trust FY 2020 Interim Results Conference Call. (Operator Instructions) I would now like to hand the conference over to Mr. Aaron Hockly, Fund Manager. Please go ahead.

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Aaron Hockly, Vital Healthcare Property Trust - Fund Manager [2]

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(foreign language) Welcome to the interim results presentation for Vital Healthcare Property Trust. My name is Aaron Hockly, Vital's Fund Manager. With me today is CFO, Michael Groth; as well as Richard Roos and Chris Adams, Executive Directors of the Property Portfolio and Projects.

We will take you through the highlights of the half year and provide commentary on where we see the sector and Vital in particular going next. There will be an opportunity for questions at the end of the call, but we also welcome questions and comments at any time via phone or e-mail and contact details are on our website.

Slide 4 provides a snapshot of Vital, the owner of just under $2 billion of real property in New Zealand and Australia with the longest weighted average lease expiry in the sector at just under 18 years, close to 100% occupancy, debt to assets of 35%, and importantly, same currency rental growth of 2.5% per annum.

Slide 5 highlights the geographic subsector and tenant diversification of Vital's income. Asset acquisitions, disposals and portfolio composition is assessed on the basis of stability, growth and diversification of earnings as well as the expected performance of properties and tenants.

The current split between New Zealand and Australia is seen as appropriate. A weighting of around 60% to acute surgical, i.e. private hospitals, is also seen as appropriate. The other 40% of the portfolio is split between mental health, medical offices, rehabilitation and aged care. The split between these areas may move over time.

Given the size and nature of the asset class, Vital is currently underweight in aged care as announced to the market at least as far back as 2015. I will return to aged care at the end of this presentation. We also have 4% of the portfolio in strategic assets, providing opportunities for future growth. Richard Roos will provide an example of how we put these assets to use shortly.

Slide 6. Vital's unitholders own units in the trust, which owns Vital's properties. The trust is externally managed by a subsidiary of a global health care real estate owner and manager, Northwest Healthcare Properties REIT, which is listed in Canada. Unitholders investment exposure is, therefore, limited to the performance of Vital's properties with management risk with the manager, Northwest.

Slides 7 and 8 provide an overview of the health care sector, focused on where Vital has a role to play. Aging and growing populations with higher health care expectations and costs support increased demand for private health care facilities and services. This, in turn, supports the income of our tenants and the demand for health care infrastructure.

Turning to the highlights. Key highlights from the half are shown on Slide 10. Net distributable income, being the income available for distribution to unitholders, normalized to exclude nonrecurring or unusual items, increased by nearly 15% to $22.1 million from the prior corresponding period. Adjusted funds from operations or AFFO increased by nearly 12% from the prior corresponding period. This is the income from Vital's properties excluding items such as revaluation changes and maintenance CapEx.

Vital's gearing reduced to 35.1% over the half. For the bulk of Vital's unitholders, distributions matter most, and the Board has committed to paying not less $0.0875 per unit over this financial year. We are seeking to grow this distribution stream over time. The proposed restructuring, if approved by unitholders, in preparation for a foreign exempt listing on the ASX, is expected to positively impact distributions.

Of course, to continue to grow distributions, we need to grow underlying earnings. As a result, the 2.5% annual income growth at a property level is important. Approximately 60% of Vital's leases renewed during the half were CPI-linked, were 27% fixed and the balance to market. Vital's earnings stability is underpinned by an average of only 1.6% of leases by income expiring annually over the next 10 years.

Acquisitions, developments and expansions are expected to enhance earnings either immediately or over time. During the half, $11.2 million was spent acquiring small sites which adjoined Vital's existing properties. These acquisitions are expected to support Vital's future growth. Just over $36 million was spent during the half on developments and expansions, providing an average return on cost of 6.1%.

Slide 11 shows net property income over the half versus the prior corresponding period. Notably, 2 one-off items, being the roll-off of fit-out rent in New Zealand and foreign exchange losses, were offset by growth in earnings from rent reviews and development income. As these negatives are nonrecurring whereas rent reviews and development income is expected to continue, this bodes well for our future growth.

Slide 12 shows Vital's significant outperformance versus the sector, particularly in more recent periods. I will now hand over to the CFO, Michael Groth.

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Michael Groth, Vital Healthcare Property Trust - CFO of Vital Healthcare Management Limited [3]

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Thank you, Aaron, and good morning. If I can now turn your attention to Vital's financial results and capital management for the period. Starting on Slide 14, Vital reported a statutory profit before tax, including property revaluations and other unrealized income, of $68.5 million, up 21.4% versus the prior comparative period, while operating profit before tax and other income was up 27.9% to $23.6 million.

The key factors influencing the operating results for the period included solid growth of 2.2% in net property income. Noting that on a like-for-like property and constant currency basis, net property income actually grew by 2.5%. This reflects the strength and certainty of the structured CPI and fixed rent review terms present in Vital's long-term leases across its property portfolio.

Corporate costs were up $0.6 million for the period, predominantly reflecting one-off costs associated with completing the fee and governance review and new and increased foreign investor land tax surcharges in Australia.

Management fees decreased by $2.5 million as the fee and governance review changes were applied in the current period, delivering a lower base management fee and incentive fee when compared to the same period last year.

Net finance expenses also declined, reflecting a lower interest rate environment, with Australian interest rates down approximately 100 basis points compared to the same period last year, increased interest capitalized from a higher work in progress balance on Vital's brownfield projects and the repayment of the Healthscope loan during the period.

Both normalized net distributable income per unit at $0.0492 and adjusted funds from operations at $0.049 per unit were up on the prior comparative period. Distributions remained steady at $0.04375 per security for the half. A full reconciliation of net distributable income and adjusted funds from operations, including normalization adjustments, can be found in the appendices, Slides 37 and 39.

Turning to Slide 15 and Vital's balance sheet. Net tangible assets per unit increased 2.2% to $2.36. Investment properties increased $90.3 million or 4.9% during the period, reflecting ongoing development projects capital expenditure of $39.1 million, committed property acquisitions of $11.2 million, and revaluation gains of $42.6 million.

Debt to gross assets declined marginally over the period to 35.1%, reflecting the August repayment of the Healthscope loan, offset partially by ongoing project capital expenditure. The recognition of property acquisition commitments and increased deferred tax following property revaluations are the primary factors leading to increased other liabilities of $21.6 million. Both unitholder funds and units on issue have increased, reflecting the issuance of units under the distribution reinvestment plan and the settlement of the manager's 2019 incentive fee in units.

Delving a little deeper into the key factors driving the increase in NTA per unit, we turn to Slide 16. Property revaluations, net of deferred tax for the half, made a positive contribution of $0.09 per unit. This has been partially offset by a strong New Zealand dollar versus the Australian dollar on the conversion of the group's Australian property portfolio and units issued to the manager in satisfaction of the incentive fee.

On Slide 17 we summarize the group's debt position. As I touched on earlier, Vital's debt-to-total-assets ratio was 35.1%, comfortably within the group's financial covenant requirements. At this level and headroom and taking into account Vital's pipeline and opportunity set, the Board is very comfortable. This position reflects the unique and defensive characteristics of health care property as an asset class, in particular the quality and features of Vital's property portfolio and potential portfolio optimization initiatives available.

On Slide 18, we provide additional information on the group's debt facilities. I would firstly like to draw your attention to the credit approved terms, including market-based pricing, that have been received from existing financiers to extend short-term expiries and increase available facility limits by $40 million. Documentation has commenced and following execution, the group's weighted average debt duration will increase to 2.3 years.

Incorporating the above, debt facility headroom at $265 million remains healthy, providing sufficient capacity to support both the group's committed opportunity pipeline and further opportunities as they arise. Debt diversification and further increases to the group's weighted average debt duration will be a priority for the remainder of this year.

On that note, I will now pass across to Richard, who will provide an update on the performance of the property portfolio.

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Richard Roos, Vital Healthcare Property Trust - MD of Australia [4]

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Thank you, Michael. Please now turn to the portfolio overview and updated details, starting on Slide 20. As you can see from the data on Slide 20, all of the key portfolio metrics are in great shape. We continue to experience near 100% occupancy with limited near- to medium-term expiries and a weighted average lease term of just under 18 years.

Slide 21 provides details on a rent reviews scheduled for FY '20 with 47 rents reviewed during the half with an average annualized increase of 2.6%. For the balance of FY '20, we will complete rent reviews on an additional 76 leases, representing $64 million of rental income. We expect a similar percentage increase for the balance of FY '20 rent reviews as what was achieved in the first half.

Turning to Slide 22. Looking at like-for-like property performance, we see that the half year net property income has increased by 2.5% or $1.2 million when compared to the same period last year, while gross property income increased by 2%. The outperformance and income growth relative to revenue is a result of a 6.7% reduction in property expenses.

On Slide 23, as Michael mentioned in his remarks, we experienced a portfolio revaluation gain in the half of $42.6 million. In percentage terms, this translates to a half year gain of 2.3% compared with a full year gain for FY '20 of 6%. The gain roughly aligns with the split of the portfolio by country, with 70% of the increase coming from the Australian properties and 30% from New Zealand.

The primary driver of the gain was cap rate compression, with growth in rents providing 14% of the gain and development margin, the balance. Overall, the portfolio weighted average cap rate firmed 9 basis points to 5.52%.

As the numbers suggest, there is continued strong demand for health care assets. New industry entrants are looking to acquire assets and additional capital has been allocated to the sector. This demand, along with the impact of lower interest rates, noting 10-year government bonds have dropped 80 basis points in New Zealand and 100 basis points in Australia over the past year, have been the primary drivers of continued cap rate compression in the half year result.

Looking forward, we see continued modest tightening of cap rates in the near term with strong demand for health care assets expected to continue, the impact of lower interest cost and evidence based on recent market transactions.

Slide 24 provides information on Vital's forward lease expiry profile over the next 10 years. The expiry profile with a small percentage of annual lease expiries on an income basis is reflective of Vital's long WALE and we expect -- and we continue to expect proportion of renewed leases to be very high.

Prior to concluding the portfolio management section, I thought it would be helpful to provide an example of the strength of our tenant relationships and the manner in which we work together with our hospital operator partners to drive mutually beneficial outcomes.

As part of the $126 million Epworth Eastern Hospital expansion, which Chris Adams and his development team are managing, it was identified that we could save several months of schedule and simplify the construction management process by moving the tenants of the Epworth Eastern Medical Centre, which is being repurposed to core hospital space, first, to an off-site location before moving them into the new consulting suites in the 14-story tower once completed.

As a result, we commenced searching for appropriate alternate accommodation for 18 doctors within the Box Hill medical precinct. Limited options presented a challenge until, through off-market discussions, we secured 120 Thames Street for an acquisition price of $10.5 million.

In order to make the economics work for Vital, it was negotiated with Epworth that the acquisition would be contingent on Epworth sharing the risk by leasing more than 50% of the space being acquired for terms of up to 10 years as well as covering the cost of incentivizing the doctors to move off-site.

This example of proactive asset management carried out with a high level of coordination and cooperation with the hospital partner and their doctors could not have done -- could not be done without the strong partnership we have with our tenants. And this, in my view, is what makes health care assets unique. I will now turn the presentation over to Chris.

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Chris Adams, Vital Healthcare Property Trust - Executive Director of NorthWest, Developments & Acquisitions [5]

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Thank you, Richard. Turning now to overview of the projects. The fund has continued its long-standing strategy of brownfield development with construction of a number of major projects well underway. These projects each look to enhance already strongly performing hospital businesses, expand and upgrade the quality of the properties at each site, reflect Vital's return on cost methodology for development, are being managed in partnership with hospital operators by our in-house development team and are underpinned by hospital operator pre-commitments.

Page 27 details each of these projects, with construction well advanced at each of Lingard Day Surgery in Newcastle and The Hills in Sydney. In addition, key milestones have been reached at the 2 largest projects: Stage 1 at Wakefield Hospital in Wellington; and $126 million Epworth Eastern and Box Hill, Melbourne, where a significant portion of in-ground works are complete, signifying the end phase of higher risk works from a construction perspective.

In particular, at Wakefield, foundation works have commenced, including base isolation, which will make this one of New Zealand's safest buildings from a seismic perspective. The structure has also commenced and Stage 1 remains on target for Q1 completion in 2021.

At Epworth Eastern, piling is complete, with this being a very sensitive component of the works given proximity to existing radiotherapy bunkers. Bulk excavation is now underway with the project remaining on time for completion, forecast for late 2021. The return on cost metrics across the fund's book of committed projects averaged 6.1%.

With these projects being debt funded by VHP's headroom under existing facilities, this level of return provides attractive upside to unitholders. We look forward to continuing to advance these value-adding projects for our key tenants and unitholders. Now passing back to Aaron regarding outlook for the fund.

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Aaron Hockly, Vital Healthcare Property Trust - Fund Manager [6]

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Thanks, Chris. So the outlook. Slide 31 provides an update on Vital's proposed foreign exempt listing on the ASX. Although this will not impact Vital's strategy, asset base or primary NZX listing, it is expected to enhance our equity base for earnings accretive acquisitions. The proposal would bring Vital in line with over 50% of our NZX top 50 peers and has been developed to ensure all New Zealand unitholders receive higher distributions than our current guidance of at least $0.0875 per unit. We hope to release a notice of meeting with full details of the proposal shortly.

Commercial terms have been agreed for 3 aged care acquisitions, as shown on Slide 32. The 3 aged care facilities totaled $60.1 million and are leased to one of Australasia's largest not-for-profit aged care operators, Bolton Clarke, with a WALE of 16.6 years. Being acquired on a market capitalization rate of 6.5%, they are year 1 earnings accretive.

The acquisitions are subject to finalizing due diligence to the satisfaction of Vital (technical difficulty). We are considering several other acquisitions and also considering some disposals. Over the next 2 years, I expect Vital to be a net acquirer of assets.

A number of investors have asked me about aged care. And so we've included a slide about the sector on Slide 33. The alternative real estate asset class in Australia is equivalent to office and industrial combined at around AUD 280 billion. The largest subset of alternatives is health care and the fourth largest is aged care at around $30 billion, making aged care a significant investment class in its own right.

Aged care, unlike retirement, can offer the investment characteristics Vital seeks, primarily clean ownership structures, rental returns from leases to operators and strong health care property fundamentals. Aged care assets are supported by growing demand and from Vital's perspective, offer higher yields than most hospitals. Key to our investment in the sector as well as normal property fundamentals is the strength of an operator.

Key elements of Vital's short- to medium-term outlook are summarized on Slide 34. As soon as the foreign exempt listing has been dealt with, we will turn to extending and diversifying Vital's debt. Our sector-leading WALE needs to be matched by a significantly longer debt expiry. The commitment to appoint an independent Chair before 2020 AGM remains.

So bringing it all together, why invest in Vital? Vital is the only specialist listed owner of health care real estate in New Zealand or Australia. Vital gives investors access to a high-quality portfolio of assets in a defensive asset class with significant embedded earnings growth, which we will continue to enhance by acquisitions, developments and expansions in order to continue to deliver attractive risk-adjusted returns to our unitholders. We will now take questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Your first question comes from Nick Mar with Macquarie.

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Nick Mar, Macquarie Research - Analyst [2]

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Just one on Royston. Can you just talk through what the potential increase in scope is there? I think there was an article out saying that there's a private hospital going in nearby. Can you just talk to how that may affect the operators, your EBITDA and the outlook for that exit as well?

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Chris Adams, Vital Healthcare Property Trust - Executive Director of NorthWest, Developments & Acquisitions [3]

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Sure. Chris Adams here. The business case is subject to a positive revision currently. And we're working through those changes with Acurity. Competition, whether it's current or proposed, is always a key part of that -- any business case we look at. So this is obviously part of the broader mix in that revision.

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Nick Mar, Macquarie Research - Analyst [4]

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So have you got any initial view on how that competition may affect the performance of the hospital and its future room potential?

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Chris Adams, Vital Healthcare Property Trust - Executive Director of NorthWest, Developments & Acquisitions [5]

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I mean the project was recently announced, but the structure -- a bit reluctant to go into too much details regarding an operator's business and their business case, but the revisions that are being put forward are positive and relate to a strong commitment from clinicians to the Royston site.

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Aaron Hockly, Vital Healthcare Property Trust - Fund Manager [6]

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Just to be clear, though, Nick, the revisions are tenant requested and are separate from the recent announcements in relation to the competition. So the tenant's just seeking to enhance the outcome there, and we're just working through our internal approval process to make sure that it works from a Vital perspective.

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Nick Mar, Macquarie Research - Analyst [7]

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So do you think the tenant was aware of the potential of the hospital and that project going on in the background when they made that decision?

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Chris Adams, Vital Healthcare Property Trust - Executive Director of NorthWest, Developments & Acquisitions [8]

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It is part of the consideration, yes.

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Nick Mar, Macquarie Research - Analyst [9]

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Okay. No, that's cool. And then in terms of the aged care stuff, one of the comments you made on there was the high rental yields, particularly when compared to hospitals. How do you look at that on a risk-adjusted basis? Obviously, there's a lot more operating leverage in aged care, especially when they sell the real estate off than there is in hospitals. Could you just talk through that?

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Aaron Hockly, Vital Healthcare Property Trust - Fund Manager [10]

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Yes. I mean you're right that there is a different risk element. There's much higher barriers to entry for a private hospital than aged care. So that does need to be compensated for in the yield.

I think we look at the strength of the operator, that's really key. I think there's potential for sector -- sorry, operator consolidation, particularly in Australia. And we're particularly cognizant of that. We look at the strength of the underlying property, so how long is the lease, the dynamics of the catchment that it's in and make an assessment on that basis. I don't know if you want to add anything.

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Richard Roos, Vital Healthcare Property Trust - MD of Australia [11]

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No, I think it was well said, Aaron. Thanks.

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Nick Mar, Macquarie Research - Analyst [12]

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Cool. And just on those properties that you've acquired, can you just talk through what the rental growth in those is and whether or not you guys are liable for the maintenance CapEx as well?

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Aaron Hockly, Vital Healthcare Property Trust - Fund Manager [13]

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So rental growth is 2% per annum. And in terms of maintenance CapEx, there's a bit of a mixture that the tenant being responsible for some and us being responsible of more elements like structural, water tightness, that sort of thing.

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Operator [14]

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Your next question comes from Owen Batchelor with Jarden Securities.

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Owen Batchelor, Jarden Limited, Research Division - VP of Equity Research [15]

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Just on the aged care acquisitions, so Northwest has recently signaled its intentions to divest around $350 million of assets into Vital and/or its Australian JV. Just wondering whether the $60 million of aged care assets was part of that $350 million.

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Aaron Hockly, Vital Healthcare Property Trust - Fund Manager [16]

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It does, yes.

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Owen Batchelor, Jarden Limited, Research Division - VP of Equity Research [17]

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Okay. Great. And I guess do you expect there to be more -- is that all of the portion that's going to come forward to you guys? Or is there more within that $350 million?

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Aaron Hockly, Vital Healthcare Property Trust - Fund Manager [18]

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That's all the -- that's the only portion that's expected to come to Vital.

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Owen Batchelor, Jarden Limited, Research Division - VP of Equity Research [19]

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Okay. Great. And then just on divestments, you've sort of previously flagged a number of around $100 million. Is this still the number that you're roughly thinking of?

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Aaron Hockly, Vital Healthcare Property Trust - Fund Manager [20]

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I think in broad terms, it probably is. I think what we're thinking from an internal management perspective is how do we make sure we're maximizing the value for unitholders. And some of the assets were scheduled for sale last year. There's been some dynamics underlying, and it probably means that we don't quite achieve the sale price that we would have liked to achieve.

So we're just working through in terms of some lease extensions, potentially some minor works and just bringing them up to a level that's appropriate for sale, but in very broad terms, that's sort of about the level at the moment.

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Owen Batchelor, Jarden Limited, Research Division - VP of Equity Research [21]

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Okay. Great. And then just can you provide an update on how rent-to-EBITDA metrics are looking across the portfolio and how they've moved over the past 6 months?

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Richard Roos, Vital Healthcare Property Trust - MD of Australia [22]

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Yes. It's Richard here. Generally speaking, rent-to-EBITDAR metrics are -- they're broadly stable. On a portfolio basis, they're in the neighborhood of 40% rent-to-EBITDAR. Some of the individual tenants from time to time would be above that depending on where they are in development ramp-up, but we're very broadly comfortable with where all of our operators sit on affordable rent metrics.

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Operator [23]

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Your next question comes from Adam Lilley with Craigs Investment Partners.

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Adam Lilley, Craigs Investment Partners Limited, Research Division - Research Analyst [24]

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Just a quick one for me. On the restructure proposal, I notice you included the wording of resetting interest rate swaps as part of that wider transaction. Just help us -- give a bit of color as to the thinking behind that.

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Aaron Hockly, Vital Healthcare Property Trust - Fund Manager [25]

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Yes, sure. So there is likelihood that there's going to be a significant one-off upside as a result of the transaction. And so we've got a deferred tax liability. And it's just the opportunity to match those, essentially. I don't know if you have anything to add, Michael.

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Michael Groth, Vital Healthcare Property Trust - CFO of Vital Healthcare Management Limited [26]

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No, that's right. So part of, I suppose, the complex mechanisms that are required to be able to facilitate the restructure, we're trying to match a liability on one side with this -- in this asset. It's crystallized.

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Adam Lilley, Craigs Investment Partners Limited, Research Division - Research Analyst [27]

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So sorry, I'm -- so the liability being the swaps, the --.

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Michael Groth, Vital Healthcare Property Trust - CFO of Vital Healthcare Management Limited [28]

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Being the tax -- being a tax outcome of one of the necessary steps as part of the restructure. So you crystallized a tax liability on one side and it gets fully offset by a corresponding tax asset on the other side that evolves in the end as a result of the restructure.

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Adam Lilley, Craigs Investment Partners Limited, Research Division - Research Analyst [29]

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Okay. And so I imagine we'll be getting a bit more detail on all that when the notice comes through.

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Michael Groth, Vital Healthcare Property Trust - CFO of Vital Healthcare Management Limited [30]

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Yes. So the notice of meeting goes through and explains that in detail.

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Operator [31]

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There are no further questions at this time. I'll now hand back to Mr. Hockly for closing remarks.

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Aaron Hockly, Vital Healthcare Property Trust - Fund Manager [32]

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I'd like to thank everybody for their time this morning. And as I said, happy to take any questions or comments following the call. Have a good day.