CA - Brookfield's Real Estate Not In Great Shape

2023-11-22 10:10:00 ET

Summary

• Brookfield Property Partners has struggled compared to other Brookfield subsidiaries and failed to become a source of fee-paying capital for Brookfield Asset Management.
• BPY was acquired by Brookfield Corporation, but the real estate continues to struggle and FFO turned negative thanks to higher interest rates.
• BN's reported real estate asset values seem significantly overstated.
• BN's distributable earnings are of lower quality than suggested in the presentations.

As part of valuing Brookfield Corporation ( BN ), I took a look at Brookfield's real estate. Most of Brookfield's real estate operations were held within Brookfield Property Partners ( BPY ), a vehicle similar to Brookfield Infrastructure Partners ( BIP ) and Brookfield Renewable Partners ( BEP ) - a paper entity paying high distributions to public unitholders and high fees to Brookfield Asset Management ( BAM ). Unlike BIP and BEP, BPY was way less successful and the 5-year projections never materialized; unit price was slowly trending downwards.

Apart from some minority stakes in BAM's funds, BPY was almost exclusively office and retail real estate and thus hit quite hard by COVID-19. Many of the malls were in dire need of redevelopment, and BPY could not raise enough cash for that - it was indebted to the hilt and the low unit price forbid issuance of new units. At the bottom, the distribution yield was 14-17%, and units traded below 0.4x NAV. In 2021, BPY was taken under by BN for a price significantly below NAV, though with a ~30% premium to the market price. Thankfully, unitholders could elect to be paid in BN shares, which were also notably undervalued at the time, so one cannot say Brookfield robbed the unitholders by offering a price way below their own estimates of NAV.

From then on, the properties are held directly at BN under the label Brookfield Property Group ((BPG)). BN also holds stakes in various BAM funds, and about 65% of the balance sheet item "Direct investment" is real estate (p. 15 of 3Q supplemental - in the following text, if only a page is mentioned, it refers to this document). It is no secret that a large part of the real estate owned within BN is to be sold and they are diligently working on that, though buyers (at decent prices) are likely few and far between in the current environment. (I'd warrant a guess that many are waiting for the higher interest rates to work their magic, and we are starting to see office buildings coming to the market at prices well below construction costs.) Some properties have been transferred to Brookfield Reinsurance ( BNRE ), Brookfield's own insurance operation, where they comprise about 8% of the investment portfolio (p. 16).

Recently, BIP's FFO was investigated by several people and was found somewhat lacking. For instance, in 2020, BIP's FFO seems higher than operating cash flow, and it is always much higher than net income (I wrote an article on this - I'd suggest reading the discussion which includes some answers to direct questions from BIP's IR and varying opinions on the issue). Why talk about 2020? Well, newer annual reports don't contain certain cash flow disclosures anymore. My opinion is that FFO is "the best there is/could be made under assumptions not too unreasonable" - Brookfield is very promotional in their presentations, barely ever mentioning any downside or failure or mistake, and even if they do, they do it just to provide some (often anecdotal) counterpoint. They have total control over FFO which is non-standard and hardly reconcilable to any standard accounting measure, so I guess if it was possible to make it higher, they would. Similarly, their IFRS carrying values represent "the best price one could expect to be able to get over the next few years" - they often repeat that they are selling assets above IFRS values (typically 4-10%), but they sell only what currently commands a good price and it does not imply that all the assets could be sold for the IFRS values.

For real estate, they disclose assumptions used in valuing the properties. I have to admit I am not good at valuing real estate. Cap rates commonly used (not only in accounting but also in actual market transactions) always seem too low to me - why assign a 25-30x multiple (i.e., 3-4% cap rate) to cash flows from an office building when we tend to assign just 15x for earnings of businesses that also tend to rise with inflation? (Stocks trading at 25x P/E tend to grow by 10-20%, a different league compared to timid growth in real estate rents.) Also, discounting cash flows at 6.5% seems inconsistent with other types of equity/stocks where rates around 10% are used. As COVID-19 and the subsequent period demonstrated, office and retail properties are way more risky than previously thought, so in my estimates, I'll adjust the IFRS values reported by Brookfield downwards at least by a third (which corresponds to increased discount rate and higher terminal cap rates). Another argument supporting such a reduction is that privately owned real estate tends to be adjusted downward much less than similar publicly traded assets (have you heard about " volatility laundering " or the story of increased BREIT redemptions? ).

Back to BN. I'll use B and M to denote billions and millions of USD, respectively. After applying the adjustment to real estate on BN's balance sheet, we get something like 9B instead of 12B for direct investments, and just 8B instead of 22B for BPG. Wait, what? Well, leverage. BPG uses around 50% loan-to-value, so 22B in equity means about 44B of real estate assets and 22B of debt. After assets are adjusted to ~30B, only 8B of equity remains. We see that even a modest change in valuation assumptions curtails the equity significantly, so one has to be careful.

Another relevant data point comes from yields of BPY and BPO preferreds. These two entities are somehow entangled in the web of BN's subsidiaries, but each has its own capital stack, including publicly traded preferred stocks. Those have recently been discussed in an article (together with a pessimistic S&P opinion ) and the key observation is that they trade at yields of 12-19%. Such exceptionally high yields (vs. 7-9% currently typical for similar preferreds) indicate a fairly high probability that the common equity of BPY and BPO will be completely wiped out and even the preferred equity will be affected.

An important feature of Brookfield's real estate debt is that it is mostly non-recourse, i.e., tied to a particular property and not to BN itself. That allows them to have failed properties (they are already in discussion with several lenders about restructuring the debt or giving up the keys entirely) while the rest are unaffected. The effect of this non-recourse policy is that the equity value is not supposed to go below zero. But if the only choice you have is to give up most properties, because they are bleeding cash, it not only damages the balance sheet but also would massively tarnish Brookfield's reputation as an asset manager, hurting BAM's fundraising and fee growth.

A key question is thus whether the properties are cash flow positive or not. There is a clue: operating FFO from real estate was minus 4M for 3Q (p. 20) and just 21M for 2Q (compared to something like 200M a quarter previously). Net operating income is similar (812M vs. 804M), so the obvious culprit is interest expense. This is omitted from the BN supplemental (ditto for real estate debt maturities, etc.), so I looked into the BPY 3Q report (they have some preferreds outstanding, so probably have to publish it). I did not dig deep enough to fully reconcile BPY with BPG (it is likely futile anyway, based on my and others' experience with Brookfield filings), but for indicative purposes, it should be sufficient.

Net operating income for 3Q was 1171M, FFO was minus 165M (it was 72M in 3Q2022, much lower than in previous quarters), and interest expense was 1222M. On 66B of debt, that would imply a 7.4% interest rate, roughly in line with current retail mortgages. Thus I'd not expect much further increases unless all rates moved up, despite a lot of refinancing coming up: 25B of mortgages (more than a half) before the end of 2024 (but refinancing is a risk on its own). Overall, there is lots of floating rate debt and many interest rate hedges expiring up to 2030, so it is unclear if interest expense will rise after refinancing.

On 3% of mortgages, BPY has suspended payments. I've not tried to investigate how individual properties are doing. BN claims that more than 95% of core properties are leased, but not everything is going well . The interest rate increase alone made FFO slightly negative, and if problems with re-leasing arise, some properties are certain to get in big trouble. And recall that FFO tends to be an optimistic projection with Brookfield (assuming depreciation is not real), not a conservative estimate, and surely not a lower bound on operating results. I did not put effort into estimating the required future maintenance on Brookfield's properties, but if you want a trophy property, you have to keep it in top shape. I can hardly imagine a successful shopping mall not being significantly refurbished every 10 or so years. That would turn the slightly negative FFO into a lot more negative cash flow.

It is way beyond me to come up with some reliable projections about how Brookfield's real estate business will do in the future. But it is entirely clear that it is currently not doing as well as management says in their presentations. From the 3Q BN shareholder letter :

We continue to achieve strong performance in our core real estate portfolio, with growth in same-store net operating income of 9% compared to the prior year. Foot traffic increased by 7% versus the comparable period at our core retail portfolio, while leasing activity remains robust, with 0.8 million square feet completed in the quarter across our office assets.

I have doubts that negative FFO is considered "strong performance" by shareholders (in my opinion, it is definitely worth mentioning how many of the properties are producing negative cash flow, but no). And that's surely reflected in BN's unit price: while BN estimates the value of their "capital" to be $73.68 per share (p. 7), the market price is just around $34. Notice also that the quality of BN's distributable earnings is likely lower than suggested in the reports. There is 179M from BPG included in "distributable earnings before realizations", while FFO was negative. There is nothing to suggest that the cash distribution is recurring or safe in the future.

At this moment, I don't have a conclusive opinion on BN. I keep a reduced stake and have to think about it further. It appeared very cheap to me a while ago, but the cash flows from operating subsidiaries are questionable and what is reported cannot be taken at face value. It might be that BN trades with some conglomerate discount and that is all there is - a large part of what they report as "capital" and "distributable earnings" might prove illusory in an economic environment less favorable than we had over the last 10-15 years.

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