What Went Wrong With Brookfield Property Partners (Part 1): Core Retail

Summary

• This series of articles investigates why Brookfield Property Partners' value stayed far short of what was projected at the time of its spin-off.
• The managers acted as they described during meetings with investors, but failed to reach some of their goals.
• Operational performance in the Core Retail segment was solid but not outstanding.
• BPY comes with a risk notably lower than that of almost any other mall operator, and chances to profit from adverse conditions are also much higher.

When one considers the 5-year projections provided by the management in September 2013 (half a year after the inception), it is immediately apparent that the performance of Brookfield Property Partners (NASDAQ:BPY) fell far short of what was expected.

The aim of this series of articles is to analyze what went wrong during the last 5 years, why the results appear so poor and how the findings affect the valuation of BPY units. We will also check earlier management's projections against actual results (in contrast to many SA articles on BPY which mostly take those projections for granted).

Before we start, it is worthwhile to mention that the projections were not just hot air: Brookfield claims that since 1989, they invested more than $17B of equity into real estate, resulting in blended gross IRR of 16% p. a.; since 2004, the returns were 12% p. a. for core-plus and 25% p. a. for opportunistic investments --- thus the track record is quite formidable. (I have not cross-checked this, but since real estate constitutes a majority of Brookfield's business and the stock price of BAM has grown by ~19% p. a. over most of that period, it is quite believable. Their institutional investors also appear satisfied.)

In addition, with regard to distributions, the management actually kept their promise: the distributions were increased every year, by 6% on average, in line with management targets (that is, 3-5% at first, later increased to 5-8%). So anyone who bought just for the cash flow has little to complain about.

What did not go according to the plans was capital appreciation; neither IFRS NAV per unit nor BPY unit price have grown much, and definitely not at a rate that would correspond to the 12-15% total return targets. This also explains why Brookfield Asset Management achieved rather poor returns on invested capital: about half of their capital is invested in BPY whose share price hovered around $20 for the last 5 years. What is also clear is that the fees paid by BPY to Brookfield Asset Management (BAM) were not the main culprit (see my recent articles on the topic: the first one describes how the incentive fees are going to grow over the next decade from today's zero and the second one investigates how much they erode NAV and how they affect incentives of BAM).

One has to admit that the business is rather complex. The level of disclosure slightly improved over the years as one can see from gradual changes in supplemental information published every quarter. The amount of sheer data is vast, however, and extensive asset turnover ($47B sold over the last 5 years) and several large acquisitions (BPO, Canary Wharf, Rouse Properties, GGP) hamper the analysis.

Brookfield is famous for the complex structure of many of its deals and the GGP acquisition is a prime example. It started in 2010 when BAM made a $2.6B equity investment in GGP which was at that time in bankruptcy protection. As a part of this deal Brookfield received warrants to purchase more shares. In 2012, GGP spun off Rouse Properties, which were acquired by Brookfield in 2016. In 2017, Brookfield exercised all the warrants, increasing its stake in GGP; and in 2018, they offered to buy the whole company, partially for newly issued units, partially for cash. The offer was turned down, but the next one was successful and GGP was acquired by BPY. In the process a pre-closing distribution was to be paid to GGP unitholders and a new REIT security BPR was created; it was done in a way so convoluted that the tax consequences were to be determined only after the deal and subject to a post-hoc opinion of IRS. In particular, this was the state of the matter more than a month after the acquisition:

Ultimately, however, the taxable portion of each distribution, and the character of the dividends will depend upon the company’s earnings and profits and distributions for all of 2018, and thus cannot be determined at this time. In January, we will file a Form 8937 containing our final determination of the tax treatment of the distributions with the IRS and this information will also be available to the public.

With the price paid for GGP units offering barely any premium, it hardly made GGP unitholders happy. (And SA generated a nice chunk of revenue from many articles written and extensively commented upon by desperate investors endlessly discussing the acquisition over a couple of months preceding it.)

I included this lengthy introduction as a warning for any prospective unitholders, and also to forewarn the readers to take my analysis with a grain of salt: Brookfield is better at inventing complexity than I am at untangling it.

The data used in this article come from annual reports, unitholder letters, supplemental information documents, Investor Day presentations and transcripts available on the company website or via an e-mail request from their IR department. I will not link to those documents individually.

The results for 3Q18 have already been published, but it would be better to only use data up to 2Q18. The last quarter's data are significantly distorted by the recent acquisition of GGP, but since it only occurred in August, the 3Q data depict neither the situation before the acquisition nor the one after it, thus it will be much better to wait for 4Q18 data to analyze that acquisition. In the rest of this first article, we will focus on operational performance.

My overall opinion is that operationally, the business is sound. There are three segments (apart from corporate): core office, core retail, and opportunistic real estate. I will leave the opportunistic mishmash for another time. It is the smallest part of the mix, though perhaps the one most important for outsized returns --- management aims for 10-12% return on core assets and 15-20% on the opportunistic stuff. The Brookfield opportunistic real estate funds have projected gross IRR of 26% and multiple-of-capital above 2; those that are old enough have actually achieved something in that ballpark on average (the one initiated in 2006 did not, quite understandably; but it still produced a respectable 11% IRR). It is thus pointless to blame them for any underperformance of BPY.

Core retail

In the retail segment, occupancy consistently kept around 96% in the last 5 years and only declined to 94.6% after the recent GGP acquisition. Tenant sales per square foot have increased every year, from $511 in 2012 to $587 in 2017. Same-store NOI growth was also positive every year, usually above 4% (at constant currency). This growth has slowed down to 1.6% in 2017 and 2018, but it seems very distant from what we hear in various "death of retail" stories. Anyway, this slower growth did impact the overall performance, although only slightly. I have included the data for Simon Property Group (SPG) and Macerich (MAC) as comparables.

Since I do not expect Brookfield to be able to do some magic regarding rent increases and the starting position is rather similar, I would expect that same-store NOI growth rates are similar to those of the competitors and primarily determined by the malls owned. They are. For instance, Simon Property Group (SPG) reported comparable property NOI growth rates ranging between 3.2% and 5.2% over the last 5 years.

BPY believes that this slow-down in retail is only temporary and their redevelopment activities will lead to solid returns. Notably, there were no meaningful impairments charged against carrying values of BPY properties in 2016 or 2017 (three properties were sold under their IFRS value in 2016, leading to an impairment of $73M, but the segment they belong into was not disclosed).

The management is careful to point out that malls are not all created equal and that value of some of them consists chiefly in their location, not the actual buildings. Consequently, pure-play mall operators without sufficient access to large-scale capital (especially capital whose cost that does not depend on market prices) might be in trouble. Companies like Pennsylvania REIT (PEI), Macerich or Taubman Centers (TCO) might thus not be the best places to be in and, in general, even yields of 6-10% might not counterbalance the risks. During even a mild recession, stock prices of those companies will easily get below the level where it makes sense to issue equity, and then they will face unpleasant choices similar to those of Kinder Morgan (KMI) --- issue debt through the roof and lose investment grade credit rating, cut dividends, or stop redevelopment and let assets deteriorate. In either of those cases, shareholders will be stuck with a significant paper loss and without a good chance of timely price recovery (since there would be no high-ROE compounding machine strongly working in their favor no matter what the market prices will do in the short-term). I believe that such risks are much smaller with BPY. The chance of BPY actually profiting from such conditions is also much higher --- keep in mind that most of BPY's malls have been bought when other operators declared bankruptcy (e.g. GGP).

The supplemental information contains data on various leasing metrics, but thanks to high asset turnover --- in this case, several changes of BPY's stake in GGP and selling of some GGP Brazilian malls --- those come with fairly big jumps and thus can hardly be used as a basis for analysis, especially not by outsiders like me who are not really an expert on the topic and are not willing to do due diligence location by location.

Recently, BPY has acquired GGP, which seem to provide them with an almost endless runway for redeveloping, densifying, and adding mixed use to high-quality malls across the U. S. (See my recent article on the topic.) The acquisition closed in August 2018, so it is too soon to judge the results, but I am very keen to see what will be reported over the next several quarters. There is, however, one thing sure about the acquisition: GGP was bought cheaply, and that is a good start.

Conclusion

Albeit there are some clouds gathering over most of the retail shopping centers over the U. S., Brookfield Property Partners owns in large part those that appear insulated from major deterioration and they are actively working on getting rid of the rest of them. (And mind you, not in a fire sale; they are quite patient and actually plan to do minor redevelopments and stabilization before selling.) In addition, they have sound mixed-use redevelopment plans for those that do not perform very well, but are in attractive locations.

As for the question of poor performance of BPY, it was definitely not the operational performance in Core Retail: same-store NOI growth rate was positive every year, often above 4%.

Analyst’s Disclosure: I am/we are long BAM, BPY. 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.