Brookfield Property Partners’ Preferreds Promise Higher Returns

Brookfield Property Partners Celebrates The Opening Of Brookfield Place

Eugene Gologursky

The preferred units (NASDAQ:BPYPP), (NASDAQ:BPYPO), (NASDAQ:BPYPN), and (NASDAQ:BPYPM) issued by Brookfield Property Partners (BPY), currently Brookfield Property Group or BPG, remain public even after the company was privatized in July 2021. The information about them is available in 6-K reports (Reports of Foreign Issuer since BPY is domiciled in Bermuda), Prospectuses, and one of Brookfield’s sites. As usual, it is summed up on the Quantumonline site.

These securities are difficult to analyze due to BPY’s complicated structure and that makes them relatively unpopular. Perhaps, this is the reason why they are currently cheap and promise extraordinary returns.

Securities descriptions

Until recently, investors thought of Brookfield Asset Management (BAM) as primarily a real estate company. BAM conducted most of its real estate operations through Brookfield Property Partners, externally managed its operations, and owned about two-thirds of it. BPY was not particularly popular with outside investors and in the summer of 2021, BAM agreed to buy out public investors and made the company private, except for four issues of preferred units that are listed in the table below (there are many other public hybrid securities issued by BPY’s subsidiaries):

BPY preferred units

BPY preferred units (author, company)

BPYPP, BPYPO, and BPYPN are traditional perpetual cumulative preferred units issued by BPY and are directly comparable. BPYPM is not perpetual (though maturity in 2081 does not make it that different), was issued not by BPY but by its special subsidiary (“New LP”) created solely for this purpose, and is trading in both US and Canada (BPYP.PR.A).

BPYPM was issued as compensation to BPY limited unitholders in the process of privatization and is guaranteed by BPY and several entities within BPY. Let me quote from 6-K:

The payment obligations of New LP to the holders of the New LP Preferred Units, including accrued and unpaid distributions, are fully and unconditionally guaranteed by the partnership, the Operating Partnership and several Holding Entities (Brookfield BPY Holdings Inc. (“CanHoldco”), Brookfield BPY Retail Holdings II Inc., BPY Bermuda Holdings Limited, BPY Bermuda Holdings II Limited, BPY Bermuda Holdings IV Limited, BPY Bermuda Holdings V Limited and BPY Bermuda Holdings VI Limited).

On the BPY balance sheet, BPYPM is listed among “capital securities” as opposed to “preferred units” for the other three. Practically speaking, I do not see a substantial difference between them.

Why BPY preferreds are attractive

The yields in the table above (dated Oct 14) draw attention immediately (stripped yields are slightly higher and closer to ~10%). But this is just the beginning. Quite a few SA readers/authors may disagree with me, but it is not a good idea to buy preferreds on yield. To support this statement, I will quote from Benjamin Graham who described in “The Intelligent Investor” second-grade (junk) bonds and preferred stocks together:

Second-grade bonds and preferred stocks possess two contradictory attributes which the intelligent investor must bear clearly in mind. Nearly all suffer severe sinking spells in bad markets. On the other hand, a large proportion recover their position when favorable conditions return, and these ultimately “work out all right.” This is true even of (cumulative) preferred stocks that fail to pay dividends for many years…It may well be true that, in an overall accounting, the higher yields obtainable on second-grade senior issues will prove to have offset those principal losses that were irrecoverable. In other words, an investor who bought all such issues at their offering prices might conceivably fare as well, in the long run, as one who limited himself to first-quality securities; or even somewhat better. But for practical purposes the question is largely irrelevant. Regardless of the outcome, the buyer of second-grade issues at full prices will be worried and discommoded when their price declines precipitately. Furthermore, he cannot buy enough issues to assure an “average” result, nor is he in a position to set aside a portion of his larger income to offset or “amortize” those principal losses which prove to be permanent. Finally, it is mere common sense to abstain from buying securities at around 100 if long experience indicates that they can probably be bought at 70 or less in the next weak market.

Graham advocates buying preferred stocks only when they are trading at least at a 30% discount to their liquidation value during “a bad market” because at a certain future point during “a good market” they are expected to approach their liquidation value as long as no negative credit events occur. Only under this scenario, preferred issues are truly attractive combining yield and capital appreciation. BPY preferred units meet this test but it does not mean that they cannot drop further.

For example, during the pandemic panic of 2020, BPYPP was trading lower than today (as low as $12!) but it lasted for only one week from March 17 to March 25. Since preferred issues are less liquid than common, they often drop precipitously during panics. Once panic selling is over, they recover rather quickly.

A repeat of panic selling is certainly possible but most likely it will not last long unless this panic is caused by some universal disaster like a full-scale nuclear war. Nuclear escalation remains a threat for all equities and many bonds but apart from it, we should not be concerned about short-term drops caused by trading as opposed to fundamental issues. However, systemic risks have to be carefully regarded.

Interest rate risk

The good news is that this risk has already materialized. But rates can go still higher. Long-term rates were considerably higher than today during 1965-2003 and the repeat of this scenario represents a considerable risk for all long-term fixed-income investments.

To better gauge this risk, I will present a chart of 30-year Treasury yield over the last 25 years:

30-year Treasury yield

30-year Treasury yield over the last 25 years (Trading Economics site)

I will not try to guess the future of long-term yields – it is a futile effort. If these rates go up back to 6% or so, all preferreds will drop.

The fact that the Fed is quite aggressive now makes us cautiously optimistic regarding the interest rate risk. We are not concerned if the rates will go up to 6% and then revert. But we should be concerned that the rates may REMAIN far above the current 4% for longer than, say, 5 years (in my opinion, the investment horizon shorter than 5 years is insufficient for any equities including preferreds). The aggressive Fed actions are directed firmly against this negative long-term scenario. It is also hard to believe that the US Government can allow interest rates that high for a long period judging by the current level of indebtedness and costs of serving it.

BPY credit risks

BPY is highly leveraged. I will present its latest balance sheet for your judgment:

BPY Balance Sheet

BPY Balance Sheet (6-K filing)

To make the picture even clearer, I will also present the list of the company’s debt obligations:

BPY debt obligation

BPY debt obligations (6-K filing)

Despite this staggering amount of debt, BPY has an investment-grade rating which implies certain level of safety for its preferred units. Those who are familiar with Brookfield operations will not be surprised. For others, I will explain how Brookfield companies leverage their balance sheets:

  • Most of the debt ($42B out of $50B total) is on the asset level (“secured debt”) with no recourse to BPY. If an asset stops performing it will affect only this asset and not the company as a whole. This has happened many times including quite recently. The company would just relinquish the troubled asset in return for satisfying the particular secured debt obligation in full.
  • While high, debt obligations are much lower than $100B+ in assets. IFRS estimates of asset values use a lot of assumptions and are not conservative. Still, BPY sells these assets almost regularly at a premium to their IFRS values. Currently, the company is trying to reduce its real estate footprint over the next 5 years or so. Together with asset sales, leverage is expected to go down as well. During the first half of 2022, the leverage got reduced by 10%.
  • BPY operates in 3 segments. Their office properties are mostly trophy assets with strong cash flows from long-term creditworthy tenants. If needed, interest in these properties can be rather easily sold to provide additional liquidity. Their opportunistic properties are purchased and/or developed by Brookfield real estate private funds (BPY is a contributor to these funds). These properties are typically sold after several years at huge profits. Their US retail segment is by far the weakest. But the worst (inflicted by the pandemic) seems over and cash flows are recovering rather quickly. One can observe a similar recovery in a more transparent Simon Property Group (SPG) to understand what is going on. During the first half of 2022, BPY produced FFO of $206M. This figure includes interest expenses but does not include proceeds from the sale of assets. For comparison, only ~37M is needed for preferred distributions for 6 months.
  • All this should not be sufficient to consider BPY preferreds relatively safe if it were not for the implicit support of the parent. Per BAM’s filings, its investment in BPY is ~$15B of $42B of BAM’s total equity. Almost all of BAM’s businesses (with BPY being the weakest of them) are performing very well and I find it improbable that BAM will fail to support BPY if the latter’s resources prove insufficient.

Brookfield risk

It is no secret that all entities within the Brookfield universe are managed only in the interests of BAM and BPY is no exception. Is it possible that through some kind of legal maneuvering BPY will stop paying preferred distributions (getting preferred “stranded”) to save some money for BAM?

The documents on BPY preferred’s website have this warning in bold: “Your ability to enforce civil liabilities under the United States federal securities laws may be affected adversely because we are formed under the laws of Bermuda…”. Having read this, one may become even more suspicious.

In our opinion, almost all preferreds may get stranded as long as the issuer targets this outcome. Preferreds are definitely more vulnerable than debt but unexpectedly, under many scenarios, they are more vulnerable than common shares despite the former’s seniority. For those who do not believe it, I suggest reading this document written by a lawyer. In several legal cases dealing with conflicts between common and preferred shareholders, Delaware courts sided with the former.

What is possible in Delaware is, perhaps, even more possible in Bermuda. Lawyers should know it better, but in principle, Brookfield may exploit preferred’s vulnerabilities. However, this risk seems rather low.

In the past, Brookfield got preferreds stranded two times on my memory. The latest case involved Teekay Offshore (TOO) (currently Alterra) acquired by Brookfield Business Partners (BBU). But I am not aware of any case when issues of either BAM or its direct subsidiaries with the Brookfield name (i.e. BPY, (BIP), (BEP), BBU, (BAMR)) were affected.

Brookfield’s subsidiaries issue preferreds for strategic purposes. It is very clear in BIP’s example. While BIP generates ROIC of 11-13%, it pays 4-5% distributions on preferreds. Preferreds are a very important source of cheap capital for BAM’s subsidiaries. BAM also receives significant distributions on its BPY’s limited units which are possible only when preferred distributions are intact. Even putting aside ethical and legal concerns completely, playing with preferred distributions will damage BAM’s business.

Conclusion

Of the four issues, I prefer relatively low-yielding BPYPN. It is cheaper than others and consequently has lower risks and higher capital appreciation potential. If interest rates get low again it may add ~50% of capital appreciation in several years to ~9.5% of yield.

BPY is a partnership and investors will receive K-1s. Before privatization, BPY was structured to avoid UBTI (unrelated business taxable income) and investors could purchase it for their IRA accounts without any consequences. Most likely it has not changed but I have not checked it specifically.

Trading issues are quite important for these securities. They are rather attractive right now but, ideally, one should wait for some kind of “small” panic and buy them even cheaper.

I am running a fairly concentrated portfolio with big holding of BAM and BIP and reluctant to increase my exposure to Brookfield. At this point, I do not own these securities but may buy them under favorable circumstances or if I change my allocations.

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