Brookfield Property Partners (BPY) (BPR) has built a stalwart reputation over the past several years as a potential core REIT holding. While concerns on the leverage aspect have been brought up with time, the focus has been on whether or not property level underperformance really would mean much risk to the REIT itself due to high levels of non-recourse debt. In my opinion, this discussion misses the real risk to the business model.
Peak to trough in the Great Recession, equity REIT prices fell 67%. However, net operating income ("NOI") for the entire sector only fell 15% over the same timeframe. While there are arguments that equity REIT prices outpaced the declines in the underlying real estate, the difference between that relatively benign NOI fall and equity price performance came down to a simple fact: REIT market valuations track net asset value ("NAV") and not cash flows. Leverage only amplifies that effect.
Bull Thesis At Brookfield
In general, I think the bullish thesis at Brookfield Property Partners is both well covered and succinct. Starting at a high level, management has a strong track record on value creation and now owns a great set of quality real estate with diversification in both office and retail. That asset quality is apparently strong enough for ratings agencies to overlook the massive gearing embedded in the model: nearly 13x EBITDA based on 2019 expectations (dependent on asset sale trends). Bulls point to the non-recourse nature of the debt which eliminates certain risks to the corporate structure - at least in the form of a lack of payment guarantee from the REIT itself. This is true.
On the NAV front, over the past five years, the firm has disposed of $47B in gross asset sales at a 4% premium to the carrying value on balance sheet (2018 Investor Day, Slide 14), a trend that has continued through 2018 past the Investor Day. Brookfield has made supportive statements of this view of NAV as well, putting its own capital behind it. Both the company and Brookfield Asset Management (BAM) have made open market purchases, the former implementing an issuer bid to take out up to $500mm of its own units; it received takers on nearly $300mm worth of units at an aggregate price of a little more than $21.00/share. See CEO Brian Kingston speaking on the economics during the Q4 2018 conference call:
Utilizing just $500 million of those $3.6 billion of proceeds to repurchase our units and shares at a 30% discount to IFRS will create almost $250 million of value for our remaining unitholders.
That IFRS NAV was at $28.73/share at the end of Q4, implying shares have a little less than 30% upside today. That certainly increases the attractiveness of investing cash flow back into the assets, particularly as what Brookfield owns is not what anyone would call distressed or in dire need of reinvestment. Why chase double-digit internal rates of return on development when risk free returns can be made buying back stock? This decision by management, somewhat also unusual given the incentive structure for Brookfield Asset Management does not encourage it, is a strong bullish call on the embedded current value. For those that follow strict capital allocation theory, the Brookfield strategy here just makes sense.
Asset Sensitivity Model
I don't think I've lost any bulls yet. However, I don't think we've seen much work that asks and answers a couple of core questions here:
- What type of cap rates does that imply? Are those cap rates feasible?
- How do those rates stack up historically for these assets?
- Given the leverage, how sensitive is Brookfield Property Partners to economic downturns that impact asset values?
Recall that cap rates imply the rate investors are willing to pay for a given level of NOI: a 7% cap rate implies $7 of property level income for every $100 of initial investment. In 2018, Brookfield Property Partners booked $3,302mm in proportionate net operating income ("NOI"). There was, however, only partial contribution from GGP; Q4 2018 run rate is $4,000mm, likely to be boosted next year from positive trends in leasing and new developments coming online. Let's call it $4,300mm in expected NOI, basically in line with Wall Street expectations. Proportionate enterprise value is basically $70,300mm due to the amount of outstanding debt, preferreds, and the fully diluted share count. This is a 6.1% cap rate.
Management bases its NAV valuation on a rough 5.5% cap rate, a factor that can be found on Slide 15 of the Q4 2018 Investor Presentation. They have some more assumptions that go into their model, but even pretty easy math backs into it: a 5.5% weighted average cap rate on $4,300mm in NOI gets you another $7,700mm in market cap value or another $7.25/share in upside today. All good so far. Are those cap rates realistic? Also true. NAREIT data for office and high-end mall data supports that thesis in full.
*Source: Author chart using NAREIT data.
However, investors might also note that, at least historically, cap rates at this level are unprecedented. If you go back even further than the above, that also holds true. Given Treasury yields have been much higher in the past, there just was never appetite for paying 5.5% cap rates for real estate when bonds had higher yields. Demanded risk premiums, a cornerstone of investing, in my opinion, just would not support that kind of investment thinking.
The high leverage at Brookfield Property has long been a discussion point. Investors have differing views on whether the non-recourse debt truly offers enough protection at a corporate level to run this kind of model. Personally, I have some hesitation here, not just due to the low interest coverage but the strong implications for NAV. Investors already saw signs of this in Q3 when IFRS NAV was adjusted down more than $2.50/share because one portion of the business model - the mall values - caused overall asset values to be reduced 2%:
The main changes to mall values from Q2 relate to adjustments to future cash flow assumptions related to leasing commissions, reserves for bad debts and certain property tax adjustments, which reduced overall asset values by around 2%. As anticipated, the transaction resulted in a dilution to our IFRS value per share from $31.23 at the end of Q2 to $28.60 at the end of this current quarter.
*Source: Author calculations.
A reversion to 7% cap rates would imply 40% downside. This is only a 90bps shift from where we trade today. 7% blended cap rates on these assets seem outlandish? Investors last saw those levels in Q1 2010 when 10yr Treasury rates spiked to 3.75% and "double-dip recession" fears dominated the narrative. Today, after years of slow and steady economic improvement, it is easy to forget that such market gyrations and fears are normal and often commonplace. With economic trends slowing today, it would not be odd to see some short-term fears impact real estate.
While not making a directional call on either demanded risk premiums or the 10yr to head back that way - in fact, I've been a Treasury bull for the past year - there is no doubt that the market has felt differently for some time and, even with recessionary fears, overall CFTC speculatory positioning remains short Treasuries. That's a call on higher interest rates going forward and, in general, higher rates mean higher cap rates on commercial real estate.
Like it or not, REIT market valuations tend to follow NAV - even if the cash flows are not fundamentally impacted. By being long on one of the most levered REITs in the market today, investors in Brookfield are accepting greater sensitivity to trends in asset prices. For those that are more risk averse, I would personally view owning REITs with similar real estate quality and lower leverage profiles, even if that meant foregoing some of that juicy current NAV discount.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.