BPYPN - Two 10%+ Yields For 2023: Energy Transfer And Brookfield Property Preferred

Summary

• The market is currently offering up some deeply discounted high yielding opportunities.
• We discuss two of our favorites heading into 2023 in today's article.
• We look at the risks to show why we think - even if recession strikes in 2023 - these distributions will be safe.

At High Yield Investor, we spend tens of thousands of hours and dollars scouring the market for the very best high yield opportunities where the market is mispricing income-generating investments. In so doing, we are able to build a portfolio that generates high passive income yields while simultaneously outperforming the broader market. Thanks to a tough overall year for the stock market, rising interest rates, and growing fears of a recession hitting in 2023, the market is currently offering up some deeply discounted, high-yielding opportunities.

In this article, we discuss two of our favorites heading into 2023: Energy Transfer LP ( ET ) and Brookfield Property Partners ("BPY") Preferred shares ( BPYPO , BPYPP , BPYPN ). We will also look at the risks for each of these high yielders that offer double-digit forward yields to show why we think - even if recession strikes in 2023 - these distributions will be safe.

Why Energy Transfer Is Undervalued

The value case for ET is quite straightforward. First and foremost, it stands out as the clear cheapest among investment grade midstream businesses:

On top of that, it also trades at a clear discount relative to its own history with a five-year average EV/EBITDA of 8.85x.

Last, but not least, given that its distributable cash flow yield is over 21% at the moment and is expected to be returning nearly half of that to unitholders via distributions moving forward while reinvesting the other half into debt reduction and growth projects, it has a wide margin of safety for generating a market-beating return. This is especially true given that we are living in a time when the broader stock market is still overvalued and there are numerous bullish tailwinds for ET's business and sector (energy).

Why Energy Transfer's Distribution Is Safe

Though ET's current distribution is $0.2650 quarterly ($1.06 annualized), we expect ET to pay out $1.22 in distributions per unit in 2023. This is because ET's management has emphasized repeatedly throughout 2022 that achieving a quarterly distribution of $0.305 is a top capital allocation priority and current consensus analyst 2023 estimates put them in position to cover a $1.22 annual distribution by 2.2x with distributable cash flow $2.63 in distributable cash flow. As a result, this should be very manageable for them and leaves them with more than half of their distributable cash flow to continue paying down debt as it matures and investing in attractive growth projects.

This alone makes a compelling case for why ET's distribution is quite safe. However, there are other reasons, particularly the stability of its cash flows.

ET's business model is highly diversified across midstream subsectors, with no more than 28% and no less than 15% of its adjusted EBITDA coming from any single segment, giving it some insulation from individual commodity price risk. Furthermore, between 85% and 90% of its adjusted EBITDA is fee-based and is therefore commodity price resistant. This makes its earnings profile much less volatile than what is experienced in the broader energy sector and makes its cash flows much easier to model year-to-year. As a result of this cash flow visibility, ET should feel more comfortable with a higher payout ratio and makes its current payout ratio of well under 50% look quite conservative.

Last, but not least, ET's distribution is quite safe moving forward because its balance sheet is in solid shape. In addition to being investment grade already, ET is aggressively deleveraging and plans to continue doing so moving forward. As management stated on its latest earnings call:

we're clearly looking at paying down as much [debt] as we can...you nailed it when you said looking at trying to pay down as much as we can of [2023 debt maturities] if not moving some of it to the revolver only because when you look out over the remainder of the year and you see what the free cash flow continues throughout the year, we have a lot of financial flexibility right now is the way I'd like to leave that, and we're going to play the best options we can of reaching all the targets that we're going after.

With them being able to pay down just about all of their debt as it matures for the foreseeable future , ET should not have to worry about slashing its distribution due to financial distress any time soon.

Overall, we think that ET offers investors very attractive total return potential between a combination of growth, yield, and multiple expansion and its current distribution's sustainability also makes it arguably the most attractive all-around double-digit forward yield in the market today.

Why Brookfield Property Partners' Preferred Units Are Undervalued

BPY's preferred units are undervalued based on several metrics. One is simply historical: the units - down over 40% year-to-date - are trading at severely depressed levels not seen since the COVID-19 crash when office and retail real estate were being left vacant and the world economy was facing severe uncertainty. By comparison, the office and retail real estate sectors are in much better shape today, especially among Class A office and retail properties where BPY concentrates its real estate holdings.

In fact, their office portfolio is around 88% lease-occupied and retail has an occupancy rate of 97%. On top of that, there has been a massive flight to quality in the office space, especially towards trophy assets (which is BPY's emphasis):

Furthermore, trophy office assets have seen net effective rents increase by 6.8% since before the COVID-19 outbreak, whereas Class A office properties have seen net effective rents decline by 0.1% and Class B office properties have seen net effective rents decline by 11% over that span. The same is true in the retail space, where consumer spending is up 31% since 2019 and consumer spending is up 7% year-over-year. Meanwhile, tenant sales are up significantly while costs are down, leading to 2.4% year-over-year rent growth which is the highest rate since 2017. Overall, these numbers reveal a very healthy and vibrant real estate portfolio and a real disconnect in the preferred unit price.

Another reason why it is undervalued is simply due to the fact that the distribution yield has reached ~11%. That means - even without factoring in any potential recovery in the unit price back towards historical levels - the income alone should enable these units to generate alpha for investors given that the yield (which is cumulative) is greater than the long-term average total returns of the stock market. When you factor in the upside potential for the unit price once macroeconomic concerns abate, the total return potential becomes even more attractive.

Why Brookfield Property Partners' Preferred Distribution Is Safe

Of course, the yield and upside potential in the preferred units is wonderful, but that means little if the preferred distribution is not sustained. However, we believe it to be safe for the following reasons:

1. It is covered over five times by funds from operations, so there would have to be a calamitous decline in FFO for BPY to consider cutting it.
2. BPY's cash flows are quite stable given that they stem from trophy office and retail real estate assets which have lengthy lease terms and quality tenants. As was already mentioned, these assets are booming at the moment and - even if they experience a downturn in a recession in 2023-2024 - they should have a pretty stable baseline of cash flows given the lease structures, quality of the tenants, and the great locations of the properties.
3. BPY has an investment grade credit rating on its debt, the vast majority of its debt is non-recourse asset level, and BPY constitutes a very large percentage of the total equity of its parent Brookfield Asset Management ( BAM ). As a result, there is a low risk of bankruptcy for the company.
4. Furthermore, there is a strong incentive for BPY to continue paying its preferred distributions because they are cumulative, and the parent BAM will not be able to extract any cash flow from its equity stake in the business until all preferred distributions are paid. Furthermore, Brookfield and its subsidiaries make extensive use of preferred equity issuances as a means of raising permanent equity capital at a reasonable cost to finance its aggressive growth ambitions. If it were to defraud investors in one of its preferred entities by unreasonably suspending the distribution (and that would also require strong arming an independent third-party board of directors at BPY in a manner that would survive lawsuits), it would no longer be able to issue preferred equity in the future at any of its entities as the Brookfield name would be forever tarnished.

As a result, we believe BAM will make every effort - for its own sake - to ensure that BPY survives and ideally thrives over the long-term and its asset quality certainly positions it to do so. A worst-case scenario is that a prolonged and particularly steep downturn hits in conjunction with relatively elevated interest rates which in turn may force them to default on an outsized number of their property-level loans. This in turn may push BPY to temporarily suspend its preferred distribution for a few quarters or even a year. However, once the economy recovers and conditions normalize, they would resume and catch up on preferred distributions relatively easily given the preferred equity's small percentage of the capital stack.

As a result, we view BPY preferred units as a relatively low risk way to generate a double-digit passive income yield from world-class real estate along with long-term upside potential if/when the unit price recovers closer to par.

Investor Takeaway

As we head into 2023, there is a lot of uncertainty in the markets and investors - especially retirees - are increasingly challenged to find safe high yielding sources of passive income to offset inflation while also enabling them to sleep well at night with a recession on the doorstep.

After interviewing both ET and BPY recently (you can read those interviews here and here , respectively) and analyzing their balance sheets, business models, and valuations, we believe they are among the most attractive risk-adjusted high yields in the market today and both earn Strong Buy ratings while making up a substantial portion of our portfolio at High Yield Investor.

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