Brookfield Property’s 12% Yield Is Screaming ‘Buy Me’ (NASDAQ:BPY)


This article was co-produced with Williams Equity Research.

Due to the myriad of Brookfield Asset Management (BAM) listed partnerships, coupled with their income and growth focus that aligns well with our goals, we’ve written extensively about this top alternative asset manager’s empire.

This article covers Brookfield Property Partners (BPY) and Brookfield Property REIT (BPYU). As discussed in previous articles, shares of BPYU, the U.S. REIT security, can be exchanged at any time for shares in BPY, a traditional limited partnership (“LP”).

Generally speaking, investors using qualified funds will want to stick with the REIT vehicle. The U.S. REIT security owns the retail portfolio rather than a portion of the entire BPY empire consisting of office, retail, and LP investments.

But given a share of BPYU can be exchanged for BPY at any time, the “difference” doesn’t really exist. Cash flows and capital gains will be identical. After-tax figures, however, will vary.

In addition, BPY owns 90% of BPYU via Class A, B, and C shares. While no doubt a complex structure, the result is the creation of a 1099 instead of a K-1. Lastly, BPY is based in Bermuda and has no withholding tax.

That’s likely the best choice for international investors. Pay close attention to the preferred tickers as well to ensure they are attached to the right entity for tax purposes (e.g. (BPYUP) is a 6.375% preferred issuance tied to the REIT).

With that introduction, let’s analyze Brookfield’s commercial real estate entities BPY and BPYU.

(Source)

Two Quick Side Notes

First, there are many charts and graphs in this piece. These entities own an incredible amount of real estate, and it takes considerable due diligence to evaluate the asset base, balance sheet, and other characteristics necessary to come to an educated decision. That means digging through SEC filings of multiple entities and aggregating key data.

Second, BPY and BPYU contain different information in their quarterly filings, so we’ll be referencing both. This is a necessary evil given what Brookfield decides to include and exclude in various filings and reports. The most valuable property level and tenant information, for instance, is contained in BPY’s filings. It is also not domiciled in the U.S., and is therefore subject to 20-F reporting and other measures that are different than those for BPYU.

September 24, 2020 Release

Source: Brookfield Property Partners Investor Day

Let’s start with the most recent data on the portfolio’s assets and scale. We timed this article to coincide with the release of Brookfield’s Investor Day presentation.

Source: Brookfield Property Partners Investor Day

Brookfield’s two entities encompass $86 billion in total assets and $25 billion in equity. Brookfield focuses in “core” commercial real estate assets. As a reminder, core real estate is considered more conservative in nature due to their leverage profile, occupancy, geography, and asset type.

On the other side of the spectrum are distressed and opportunistic real estate; these tend to have significant cash flow problems, reside in unorthodox markets, and or encompass unusual property types.

As more experienced investors know all too well, no type of real estate is immune to all market conditions. That applies to the safest core property in the supposedly most durable market.

Source: Brookfield Property Partners Investor Day

The portfolio’s construction is critical to understand. 43% and 42% of invested capital consists of office and retail real estate, respectively.

Office (43%)

While office properties have held up moderately well, as demonstrated by SEC filings from the likes of W.P. Carey (WPC), Boston Properties (BXP), and even New York-based SL Green Realty (SLG). We wrote about SLG in June for those interested.

As of the end of Q2, Brookfield’s office properties were 94% occupied with an average remaining lease term of 10 years. These are in line with better-quality office operators and owners. We’ll be providing granular detail on each segment’s performance later in the article.

Retail (42%)

Retail, on the other hand, has been the epicenter of the “Amazon Effect” and coronavirus lockdowns – not a fun place to be. A common saying around our office is two disparate things can be true simultaneously.

Source: Brookfield Property Partners Investor Day

While this data is from Brookfield, we’ve seen the same numbers from dozens of sources. Despite the headlines, physical retail sales grew from 2016 through 2019. At the same time, the percentage of brick-and-mortar sales has declined. Online sales is the place to be for rapid growth, but that doesn’t result in the immediate obsolescence of physical retail.

Let’s look more closely at year-to-date sales using data from the U.S. Census Bureau.

Source: Brookfield Property Partners Investor Day

Interestingly, total retail sales – online and physical – fell modestly in March and sharply in early April. Contrary to what most people believe, total retail sales have recovered far above Q1’s levels. Digital sales were 25% of July, compared to 22% in all of Q1.

That’s a material gain at a macroeconomic level, but physical stores still represent the vast majority of retail sales. It’s foolish to ignore the oscillation between digital and brick-and-mortar sales, but it’s equally counterproductive to dismiss the latter on bad assumptions.

These are important considerations for BPY and BPYU because they own 19% of all high-quality retail property in the U.S. To put that into perspective, 64% of the entire U.S. population lives within 60 minutes of a BPY/BPYU property.

Source: Brookfield Property Partners Investor Day

Over the past decade, the retail segment’s occupancy has ranged from 92% to 95%. Rent has grown at rates well above inflation over the same period with no year-over-year declines.

Development Pipeline

A key aspect of Brookfield’s strategy is capital and asset recycling. We’ve covered this in-depth previously, but in a nutshell, this describes the company’s process of actively buying assets at favorable valuations and exiting them at attractive internal rates of return (generally 15%) over time. This is unique within the industry, as it takes considerably more skill and expertise to execute.

Source: Brookfield Property Partners Investor Day

It also means that Brookfield’s ability to purchase, develop, and sell properties in a profitable manner is potentially more important than other REITs. It is targeting the completion of large-scale New York City office properties in 2020 and 2023. An office building in London and mixed-use building in Toronto are schedule to come on-line in 2021 and 2022, respectively.

Source: Brookfield Property REIT Inc. 10-Q

This is a summary of redevelopment and development projects included in Brookfield’s latest quarterly filing. For those interested in more detail, the below chart provides just that.

Source: Brookfield Property REIT Inc. 10-Q

#1 Challenge

Retail real estate faces numerous challenges, but the fundamentals were mostly solid prior to the nationwide lockdowns and other implications due to the coronavirus.

Source: Simon Property Group 2019 Annual Report

Using the largest mall owner as the proxy, Simon Property Group (SPG) managed record revenue, Net Operating Income (“NOI”), comparable FFO per share, and dividends per share in 2019.

The closure of Macy’s and J.C. Penney locations begin to accelerate in late Q1 2020. Year to date, these department stores have closed or announced the closure of the up to a third of their stores nationwide.

Brookfield and Simon need to solve the big-box department store exposure. The good news is both firms are keenly aware of this problem and clearly working toward a solution. We anticipate that both parties will leverage their investments in the likes of Authentic Brands to repurpose these spaces. Coupled with increased interest from industrial property tenants, such as Amazon (AMZN), Brookfield and Simon’s deep balance sheets and liquidity may be enough to turn these vacant spaces around.

Source: Brookfield Property Partners Q2 2020 10-Q

Tenant analysis is either very cumbersome or simple, depending on how one looks at it. On one hand, the top 10 tenants shown above represent only 21.0% of gross exposure. Underwriting each tenant, therefore, takes a large amount of time.

We’ve already analyzed every one of these companies, since they overlap with the likes of Simon and Tanger Factory Outlet Centers (SKT).

  • L Brands (LB) is hanging in there and still sports an $8.43 billion market capitalization. It’s up 63.7% in the past 12 months.
  • LVMH (OTCPK:LVMHF) is also positive in the last year and up 18.5%. It’s a true heavyweight with a nearly quarter-trillion-dollar market cap as of Friday’s close.
  • The Gap, Inc. (GPS) and Foot Locker, Inc. (FL) haven’t withstood the crisis as well but are still stable financially.
  • Forever 21 is now owned by AGB, Simon and Brookfield.
  • Ascena (ASNA) recently emerged from Chapter 11 bankruptcy and continues to operate many Ann Taylor, LOFT, Lane Bryant, Justice, and Lou & Gray stores, although with a reduced footprint.

Despite that background, we haven’t covered 79% of Brookfield’s tenants. It’s positive that large big-box department stores, such as Macy’s (M), Sears (OTCPK:SHLDQ), and J.C. Penney (OTCPK:JCPNQ), don’t appear on the above list.

Since the combined entities own nearly a fourth of all core retail real estate in the nation, it makes more sense to evaluate the portfolio as a proxy for the industry rather than dissect each tenant’s financial standing. On the plus side, Brookfield’s incredible diversification means no single tenant – or even group of tenants – can really rock the boat.

Recent News

It was very recently reported that Brookfield is among several property owners considering returning J.C. Penney-anchored malls to lenders. Specifically, Brookfield is reportedly over 90 days past due on its $90 million CMBS loan for the Florence Mall in northern Kentucky. This property was value at $158.6 million in 2012 and encompasses 384,111 square feet anchored by both J.C. Penny and Macy’s.

This is different from a traditional foreclosure; Brookfield appears to be seeking a deed-in-lieu transaction. This is the act of exchanging the title or deed of a property for relief from the mortgage. This is an orderly way to get out from under a property you know longer want to own but requires negotiation with the lender.

For those that have read our series of Brookfield, you already know that the firm often takes property-level rather than corporate-level debt. While corporate debt comes with greater financial backing, and subsequently lower interest rates, the firm can’t easily escape its liabilities. Using Brookfield’s strategy, however, it can relatively easily dispose of a property without impacting the broader company’s financial standing.

In other news, Brookfield and Simon Property Group entered an agreement to purchase struggling J.C. Penny for $1.75 billion. This is particularly interesting given Brookfield and Simon own the real estate a huge portion of J.C. Penney’s reside in. Approximately 30% of J.C. Penney stores are anticipated to close as a result of the May bankruptcy filing.

Brookfield provided data on its tender offering via an August 18, 2020 press release. The offer was to purchase up to 9,166,667 shares for $12.0, of which 7,321,155 were tendered for an aggregate cost of $87.9 million. This reduced BPYU’s share count to 47.9 million (Class A). This was a sharp change versus the initial expectations that the tender offer would be oversubscribed. The apparent change in sentiment suggests shareholders became more optimistic about the stock’s future.

Cash Flow and Property Valuation

Source: Brookfield Property Partners Q2 2020 10-Q

Brookfield’s recent SEC filings state:

The global economic shutdown had a modest negative impact to our commercial property revenue earned in the quarter, mostly due to a reduction in parking and fee income. While our commercial property revenues were not materially impacted by the shutdown, near term cash flows have been impacted and future revenues and cash flows produced by these operating properties are more uncertain than normal as a result of the rapid impact to the global economy in response to measures put in place to control the pandemic.

The real impact was the company’s revised estimates for the near and mid-term of reduced cash flows, higher vacancy, longer leasing downtime, and greater bad debt. Total property revenue declined $85 million in Q2 compared to the prior year due to lower parking revenue, property dispositions, and foreign currency translations. Property expenses declined $34 million, which augmented cash flow. Overall, the trends in revenues and expenses for this division were consistent across the first half of the year.

Source: Brookfield Property Partners Q2 2020 10-Q

The firm’s estimates of fair value were volatile, and mostly offset each other over the past year and a half.

Source: Brookfield Property Partners Q2 2020 10-Q

Hospitality is a different story. Revenues fell dramatically (58.1%), although lower expenses lessened the blow. Brookfield stated that decrease is “almost entirely attributable to the global economic shutdown.”

Source: Brookfield Property Partners Q2 2020 10-Q

This segment experienced large downward revisions in fair value since the start of 2019. The remaining segment, LP Investments, demonstrated net losses in fair value approximately in between the two larger segments.

Source: Brookfield Property Partners Q2 2020 10-Q

The math behind the reduction in property values and cash flow assumptions begins with this table. Core office terminal capitalization rates are in the 5-6% range for North America and Australia, with Europe at 4.0%. Brookfield is assuming a 5.4% terminal cap rate on its core retail properties; this looks optimistic in today’s environment.

Source: Brookfield Property Partners Q2 2020 10-Q

Total NOI declined from $1.104 billion to $800 million from Q2 2019 to Q2 2020. Interest expense declined proportionately, but not enough to relieve the drop in FFO from $335 million to $178 million year over year (this includes adjustments for BSREP III earnings, transaction costs, and depreciation/amortization of non-real estate assets to arrive at a more accurate cash flow figure).

BPYU has paid $0.3325 per share quarterly for the past four quarters. The Board of Directors doesn’t view the distribution policy through the traditional lens of stable cash flow, because Brookfield develops and recycles properties as part of its strategy. Executed properly, capital gains will be a steady source of cash flow available for distributions. 2019’s cash available for distribution totaled approximately $1.2 billion with realized gains of $350 million.

Source: BPY

We need to review distribution coverage in a couple of ways:

Q2’s FFO and realized gains totaled $0.18 per share compared to distributions of $0.33, or a payout ratio of 183%. In Q2 2019, the distribution payout ratio was a reasonable 86.8%.

If we look back over the past 12 months, which includes Q2’s poor coverage, the payout ratio is an even 100%. That compares to 84% in 2019 and 64% in 2018. It’s not possible to determine if the current cash flow deficit warrants a dividend reduction. Brookfield has the capacity to continue to pay the $0.33, and most analysts agree that Q3 will be significantly better than Q2.

Depending on the Board’s time frame, it could maintain the distribution, but we need to acknowledge the risk that it could be reduced by 30-50% for the remainder of 2020.

Frankly, it seems late to announce this given we are on an upward trajectory with lockdowns easing and overall economic activity accelerating from the lows in March and April. That said, it would likely be reduced toward current levels within 24 months.

Balance Sheet

Source: Brookfield Property REIT Inc. 10-Q

The entities carry ~$27.4 billion in total debt, of which ~$10.8 billion is associated with affiliates. The remainder is the $16.6 billion shown above in the first column. Approximately three-fourths of all outstanding debt is non-recourse. That means the individual property is simply returned to the lender if Brookfield no longer wishes to own it.

Source: Brookfield Property REIT Inc. 10-Q

The interest rates on the individual property and corporate level are reasonably competitive with lower investment grade REITs.

Source: Brookfield Property Partners Q2 2020 10-Q

Equity per unit is $27.01, down from $29.72 at the end of 2019. That’s far and away from the current share price, so let’s move to the final section. The firm’s debt to capitalization of 59% at the end of Q2 is relatively high but that risk is offset by the fact that about 75% of loans are non-recourse. As long as Brookfield can acquire leverage at cost effective rates, this system should continue working.

Valuation and Conclusion

Source: Brookfield Property Partners Q2 2020 10-Q

As a reminder, FFO was down sharply in Q2, and projections for 2020’s full-year results vary widely. Given the capital gains component is going to be on the backburner for at least another quarter or two, aggregate cash flow is likely to be weak in 2020.

Net asset value (“NAV”) per share and book value per share (“BVPS”) are $27.0 and $27.25, respectfully. With debt-to-capitalization of 59%, the firm won’t be in the “low-risk” category any time soon.

(Source: Yahoo Finance)

If we model out funds from operations for 2020, 2021, and 2022, we land at approximately $1.05, $1.20, and $1.35 as the retail properties stabilize and some realized gains occur.

(Source: Yahoo Finance)

That puts the cash flow multiples at 10.3x, 9.1x, and 8.2x for those three years. That’s sufficiently attractive to warrant going long the stock, while recognizing a real risk of a distribution cut. (we are upgrading to spec buy and maintaining underweight malls).

This results in a 1-year price target of $17.50 on the conservative side and $22.50 for the optimistic case. That represents gains of approximately 70% and 120% for the base and bullish case, respectively. We believe this level of upside potential makes Brookfield attractive despite its high complexity and other flaws.

We recently launched the iREIT IQ scoring tool (on iREIT on Alpha), and BPYU has a score of “66” (0-100), the third highest score in the mall REIT sector:

(Source: iREIT)

Author’s note: Brad Thomas is a Wall Street writer, which means he’s not always right with his predictions or recommendations. Since that also applies to his grammar, please excuse any typos you may find. Also, this article is free: Written and distributed only to assist in research while providing a forum for second-level thinking.

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Disclosure: I am/we are long BPYU, SPG, SKT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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