Many income investors today bemoan the fact that stocks have rallied so strongly since their December 2018 bottom (the worst correction in a decade). Back then the forward PE on the S&P 500 bottomed at 13.7, 15% historically undervalued, and a level not usually seen except during bear markets.
It’s Been A Great Year For Stocks, REITs and Brookfield Property:
Since then almost all asset classes, including REITs have stormed higher and many now fear that there are no high-yield bargains to be found. Brookfield Property (BPR)(BPY) has slightly outperformed REITs over this time period, yet still remains attractively valued today.
In fact, at a 23% discount to 2020’s fair value, it’s a strong buy, and one of my top REIT picks for 2020.
There are three reasons for that, including its safe 7.1% yield, its strong long-term growth prospects (5% to 8% dividend growth guidance), and the potential to enjoy 9% to 21% CAGR long-term total returns from today’s $18.5 price.
Reason 1: World-Class Assets Managed By The Berkshire Of Global Real Estate
Brookfield Property is available in two forms, BPY and BPR. BPY is a limited partnership run by Brookfield Asset Management and BPR is technically a subsidiary that owns all its core retail real estate assets.
However, in reality, these two stocks are economically identical, and the only difference is in how they are taxed.
Dividends are identical, and grow at the same rate. Most REIT investors will want to own BPR, which uses a 1099 tax form and pays unqualified dividends just like any US REIT.
BPY uses a K1 tax form, which brings with it deferred tax benefits, but more complex tax preparation. BPY is structured to avoid UBTI and be safe for retirement accounts like IRAs and 401Ks.
In this article, I’ll be referring to BPR but all analysis pertains equally to BPY which is essentially the same stock (their prices move in lockstep and are nearly identical).
BPR And BPY Are Economically The Same Stock
BPR/BPY pay BAM a hedge fund-like fee structure:
a 0.5% (of market cap) management fee, with a $50 million minimum
BPY also pays 25% incentive distribution rights (it’s structured similar to an MLP), meaning 25% of marginal distributions also go to BAM
There is a 1.25% performance incentive fee, for market cap growth over a hurdle rate of $11.5 billion
Brookfield’s total management fees are currently running at $130.4 million per year or 1.4% of total return. Management is waiving the incentive distribution rights it’s entitled to. If it were to stop doing so annual management fees would rise to $185 million or 2% of revenue.
Is Brookfield Management worth those fees? They’re worth every penny. And here’s why.
Brookfield Asset Management (BAM) is the world’s premier hard asset manager, with $511 billion under management in real estate, infrastructure, utility and renewable power funds and LPs. Brookfield has 120 years of experience with hard assets, making it one of the most trusted names in a rapidly growing industry.
Brookfield’s real estate track record stretches back 90 years, and in 2018 it bought Forest City (another REIT) for $11.4 billion, which also has been in commercial real estate (specializing in retail properties) for 90 years. That same year it bought OliverMcMillan’s assets, a leading national mixed-use developer specializing in apartments that will be added to many of its trophy assets.
Brookfield operates globally out of 30 offices on five continents.
It’s able to put together deals that BPR participates in, including its highly lucrative LP investments.
Brookfield Property owns 88% of BAM’s real estate assets, 85% of which are in its core office/retail property portfolio. These are what generate stable rent (operating cash flow) over time.
Management is striving for 95% long-term occupancy and 2.5% SS NOI growth, driven by strong lease spreads sustained by its $7 billion total development backlog.
It also wants to opportunistically sell $2 billion worth of GGP assets at a profit to pay down 20% of the $10 billion in debt taken on to buy GGP for $15 billion in 2018. That acquisition is how BPR ended up owning 8% of America’s Class A malls.
Its core properties are expected to generate 10% to 12% CAGR total returns over time. LP investments (15% of assets) are where Brookfield can consistently generate up to 20% or more returns.
The 259 office buildings BPR owns that generate 95% of office NOI comes from some of the largest metro centers in the world, such as NYC, Washington DC, Toronto, Houston, LA, Syndey, and London.
Q3 SS NOI growth: 2.5%
YTD SS NOI growth: 3.2%
average remaining lease: 8.1 years
average rent/market price: 95% (built-in catalyst for future growth)
Core Retail Statistics
Brookfield considers its GGP class-A malls to be its core retail properties, and those continue to do well. Occupancy in Q3 was 95% and management expects to close the year at 96% courtesy of 10 million square feet of new leases in YTD 2019.
The quality of its mall can be seen by its high sales per square foot ($787) which is rising steadily over time, as well as the $62.14 average base rent which is on par with Taubman’s (TCO) industry-leading figures and higher than Macerich’s (MAC) and Simon Property’s (SPG).
lease spreads (same property basis): 5.4%
total lease spreads: 2.4%
sales per square foot: $787 (vs $325 US mall average) + 5.4% YOY
Lease spreads have come down significantly in 2019 due to a larger than normal amount of retailers closing stores in 2019. Management is confident that lease spreads will improve significantly in 2020, citing little trouble replacing failed tenants with omnichannel savvy ones.
Results this quarter continue to be impacted by bankruptcies that took place since the beginning of 2018. These bankruptcies which should aggregate three million square feet have put pressure on our same-property NOI results, which were flat on a period-over-period basis. But significant progress has been made in re-leasing 75% of that space at higher rental rates. We expect this impact to only be temporary.
– Bryan Davis, CFO Q3 conference call (emphasis added)
The elevated number of bankruptcies has resulted in about 2% of its square footage going dark. But the quality of its assets plus a skilled leasing team has been able to release 75% of those vacant stores already and at higher rental rates.
Here are some examples of how the failure of big-box department stores like Sears (OTCPK:SHLDQ) and Macy’s (NYSE:M) is actually helping BPR’s malls become more stable sources of recurring cash flow
• Paramus Park, Paramus, NJ: Sears box replaced with grocer Stew Leonard’s
• Tyson’s Galleria, McLean, VA: Macy’s box replaced with Bowlero and Lifetime Fitness
• The Maine Mall, South Portland, ME: Bon-Ton box replaced with Jordan’s Furniture
• Market Place Shopping Center, Champaign, IL: Bon-Ton box replaced with Costco
• Oxmoor Center, Louisville KY: Sears box replaced with TopGolf
In 2020, BPR’s lease spreads on its core retail properties should rebound back to their historical double-digit rates, based on the fact that management has already completed 50% of next year’s re-leasing plan but over a year ahead of schedule. Those new leases have yet to start contributing to cash flow.
We continue to see a backlog of digitally native retailers who wish to open stores within our malls. Our biggest issue today is to decide which retailers to lease space to in the limited vacancy that we have available for them. We believe this will increasingly be a focus for our business as online and store-based retail converge.
Looking forward to 2020, we’ve established a leasing goal of over 8 million square feet in our retail business of which almost half is already completed.
Brian Kingston CEO
When asked about long-term SS NOI growth in the retail business, CEO Brian Kingston provided the following”
Our expectations overall, we should be — the NOI should be growing in the neighborhood of 2% on an annual basis.
2% SS NOI growth in retail is basically what analysts expect from Class A malls over the long term, and what Simon expects as well, including in 2019.
The bottom line is that BPR is a hybrid REIT and not a pure-play mall REIT. The malls it does own are among the best in the country, as seen by its fundamentals, which are set to get stronger in 2020 and far beyond thanks to management’s $7 billion redevelopment plan.
Brookfield’s track record on achieving its return targets is legendary, with the world-class management team achieving almost 23% CAGR returns thus far with its six private equity funds.
Brookfield’s ability to deliver 19% CAGR returns (across its entire empire) over the past 20 years is on par with the best investors in history.
Over the past five years, BPY has invested $5 billion into LP investments with BAM. Over the next five years alone it expects to average $900 million in annual cash inflows from rent and realized capital gains (from $1 to $2 billion in annual asset sales). YTD BPR’s share of dispositions is $1.45 billion and management thinks it will finish the year at the upper end of its guidance.
For context today BPR’s operating cash flow is $1.4 billion, meaning realized gains would boost its distributable cash flow by 62% over the coming years.
Today BPR’s FFO payout ratio is 91%, though that falls to 70% when you include realized gains from its portfolio. Management guidance is for the FFO payout ratio to decline to about 80% by 2022. Asset sale profits are expected to provide an extra safety cushion with a combined payout ratio of about 65%, on par with Simon’s current FFO payout ratio.
BPR’s asset sales have averaged 4% above estimated book value showing the management is being conservative and trustworthy with its financial accounting.
BPR’s long-term goal is to deliver 5% to 8% dividend growth for investors, and it’s achieved that courtesy of 5% FFO/share growth over the past five years, driving 6% dividend growth.
In the future management’s $7 billion growth backlog is expected to drive 7% to 9% FFO/share growth, supporting its 5% to 8% long-term dividend growth plans.
And should long-term rates fall even lower causing cap rates on commercial real estate to decline as well then BPR estimates its NAV/share would rise significantly.
Over the last 12 months, we have seen interest rates decline dramatically in the U.S. and Europe but are yet to see this reflected in the valuation of our assets. To put this into perspective, a 100-basis-point reduction in cap rates adds almost $20 per share to our NAV.
-Brian Kingston, Q3 shareholder letter
For context, Brookfield, which is very conservative with its book value, estimates its intrinsic value at $28.61. A $20 increase in NAV/share would represent a 70% increase in book value which would give Brookfield Property an incredible ability to repurchase its stock at a 62% discount rather than the 35% discount that’s currently available.
Why does NAV matter to REIT investors? Because it’s one of the principal ways REIT investors value stocks and any REIT that buys back shares at a discount to NAV automatically boosts book value per share (intrinsic value).
BPR/BPY has repurchased $500 million in shares so far, funded with asset sale proceeds. $30 million more is authorized and management says it plans to continue repurchasing stock at highly accretive prices.
Despite a strong asset performance, BPY shares currently trade at a discount. We therefore continued on the path of repurchasing shares this quarter, since we believe it represents an attractive investment opportunity for us. As a result, total purchases for this year now total over $500 million…
We’ve been fairly active in the market over the past quarter and continue to be into the fourth quarter and I’d expect, we will be over the course of the year as we have been in the past.
The only other thing to think over and above that is whether we do another substantial issuer bid as we did in January and I think that really is a function of where the share price trades versus other investment opportunities that we’ve got. But we’ll certainly continue to be very active on the normal course issuer bid.
Brian Kingston Q3 conference call
Basically, Brookfield Property represents ownership in some of the world’s premier commercial real estate, managed by some of the most talented value-focused investors in the industry.
The core properties alone are worth owning this REIT, whose 7.1% yield is among the most generous available among high-yield blue chips today. The LP portfolio’s $800 million in annual capital gains proceeds represents a cherry on top that should allow Brookfield to self-fund its growth plans while steadily repurchasing its stock at highly favorable valuations.
While buybacks and opportunistic investments represent two ways BPR can grow in the future, the biggest growth catalyst, and second reason I am so bullish on this REIT, is the long-term growth runway.
Reason 2: Strong Growth Runway Means Generous And Steadily Rising Dividends For Years To Come
In the first three quarters of 2019, Brookfield developed over 5 million square feet of office/retail space, realized $2 billion in asset sale profits, and invested $1.3 billion into new developments and acquisitions.
Brookfield Property has $5.1 billion in growth projects under construction right now that it expects to increase its book value by $1.75 billion. For context, its book value is currently $28.86, meaning the $3.5 per share increase in NAV from projects under construction would increase the intrinsic value of the stock by about 13%.
What is Brookfield planning to spend that $5.1 billion on? 67 million square feet worth of upgrades to its 150 class-A malls, or 45% of its total retail square footage.
Brookfield plans to add thousands of apartment units, hotel rooms, and millions of feet worth of office space to improve its already world-class facilities.
This redevelopment plan is designed to take advantage of the major secular trend of increased urbanization, both in the US and abroad.
Growing cities around the globe should be conducive to steady rental growth in both office and retail properties in the years and decades to come.
In the three examples above, management expects these mixed-use improvements to potentially result in $870 million in potential realized profits should it sell those malls later. Remember, that’s three malls out of the 150 that Brookfield currently owns.
According to a study by George Washington University, mixed-use properties, on average boost the amount of rent generated by malls by 75%, relative to traditional properties.
Including the potential projects Brookfield is considering, the total growth backlog stands at $7 billion, matched only by industry juggernaut Simon Property Group (SPG), another of my top conviction REITs for 2020.
Brookfield expects to earn 6.9% average cash yields on investment with its current backlog which would represent $352 million per year in additional operating cash flow.
Over the long term, Brookfield is guiding for FFO/share growth of 7% to 9%, with the current $5.1 billion backlog representing 25% FFO growth (about 5% CAGR) all on its own. 2% to 3% SS NOI growth, plus buyback accretion, is how BPR can realistically get to that 7% to 9% growth target.
To finance this ambitious growth plan BPR has $7 billion in liquidity available, matching Simon Property for both the largest access to low-cost capital and the largest growth backlog.
Brookfield has been using non-recourse, asset-level debt for over 30 years, including during the Financial Crisis, when credit markets slammed shut for almost everyone (though not BAM).
$46 billion worth of total debt gives it a leverage ratio of 7.1 on a consolidated basis but investors are only responsible for $2.5 billion or 5% of that (effective leverage of 0.4).
Similarly, the interest coverage ratio of 1.1 is actually 22 at the corporate level, 11 times greater than the 2.0 or higher that are considered safe for REITs.
That’s why Brookfield has a BBB rated balance sheet according to S&P and is able to borrow at an average cost of 4.4%.
Over the next five years, Brookfield plans to use retained cash flow and asset sale proceeds to repay $3 billion worth of non-recourse debt and reduce its debt/equity ratio from 55% to 45%. 50% is considered very safe for REITs, and 60% is safe.
OK, so now you know why I like BPR, but there is one final reason why I consider this 7.1%-yielding REIT to be a very strong buy for 2020.
Reason 3: One Of The Best Values In REITdom Creates Double-Digit Long-Term Growth Potential
There are many ways to value a company, and one popular method is to look at NAV/share or book value.
Brookfield is conservative with its NAV estimates, as seen by the fact that it consistently sells assets at a premium (4% in Q3 same as the five-year average). BPR’s book value is currently $28.61 and management thinks that continued low-interest rates could significantly increase that in the future (as will opportunistic buybacks that automatically increase NAV/share).
However, due to its complex corporate structure (including external management fees), and high use of non-recourse debt, the market has never paid book value of BPY/BPR.
Thus, to estimate fair value for this REIT I apply the historical metrics investors have actually paid for its fundamentals, including dividends, EBITDA and EV/EBITDA.
2019 Fair Value
Approximate 2020 Fair Value
Discount To Fair Value
5-Year CAGR Total Return Potential
19% for 2019, 23% for 2020
9% to 21%
That’s how I estimate its fair value at $23 in 2019 and about $24 in 2020, based on 4% consensus EBITDA/share growth in 2020 per FactSet.
Margin Of Safety For 9/11 Blue Chip Stocks
5-Year CAGR Total Return Potential
4% to 16%
6% to 18%
9% to 21%
Very Strong Buy
11% to 23%
Based on 2020’s expected results BPR is currently a strong buy and offers the potential for strong double-digit long-term returns.
To model future returns I use the Gordon Dividend Growth model, which says total returns are a function of starting yield + long-term growth + valuation changes (mean reversion for individual companies).
This model has been relatively effective over 5+ year time periods since 1956 and is what numerous asset managers, including Vanguard founder Jack Bogle, have used for decades (the Dividend Kings as well).
BPR already sports one of the most generous safe yields on Wall Street so let’s look at its growth profile.
Management growth guidance: 7% to 9% CAGR
Historical growth rate (operating cash flow): 5% CAGR
Realistic growth range: 5% to 9% CAGR
Fair Value (for return modeling purposes): 2 to 3 times EBITDA/share (2.8 average since IPO)
For total return forecasting, I use a range that applies a company’s realistic growth range to its historical fair value range, based on the most appropriate metrics.
BPY has historically traded near 3 times EBITDA/unit but its historical EBITDA multiple range is two to three. For the conservative end of my total return potential range, I assume management will miss its guidance and deliver 5% growth, the same as its historical operating cash flow growth rate.
Then applying the very conservative 2 times EBITDA multiple we can see that BPR/BPY is still capable of 9% CAGR total returns, even if it grows significantly slower than management expects.
In case you think 9% return potential is weak, consider that most asset managers expect just 2% to 7% CAGR total returns from the S&P 500 over the next seven to 15 years.
The Gordon Dividend Growth model expects 4% to 6% CAGR returns from the broader market over the next five years.
BPR’s current yield, which is likely to grow at 5% to 8% over time per management guidance, is sufficient to likely outperform much weaker future returns from the S&P 500.
If management delivers the upper range of growth guidance, and the stock returns to the upper end of its fair value range, it could achieve 21% CAGR total returns.
My base case, for what I consider most likely, is 7% long-term growth (mid-range of management guidance), and a return to its historical 2.8 EBITDA multiple, generating 17% CAGR long-term returns.
But while Brookfield Property is one of the best REITs you can buy for 2020, that doesn’t mean it doesn’t have a unique risk profile to consider before entrusting it with your hard-earned money.
Risks To Consider
The biggest fundamental risks to Brookfield Property involve its heavy use of non-recourse debt. Right now, BBB-rated bonds are trading near their lowest levels in history, which means BPR should be able to lower its borrowing costs in the future.
However, as you can see BBB rated bond yields are highly volatile, rising and falling with economic and inflation expectations.
Currently, the bond market is forecasting low 1.75% long-term inflation, relatively in-line with the Fed’s 2.0% long-term target.
This means that low-interest rates are likely to persist for longer. How low? Well, since 1955, the average inflation-adjusted 10-year yield has been 2.33%.
If the bond market is correct and inflation runs at 1.75% over the next decade then a return to historical real treasury yields would mean 10-year yields max out at 4.1%.
However, there are also short-term rates to consider, because 30% of Brookfield’s debt is floating rate, and tied to LIBOR or the upcoming replacement for LIBOR. Floating rate loans are closely correlated to the fed funds rate.
Now, the good news is that Brookfield knows what it’s doing and has a good reason for using so much floating rate debt.
In part our decision around fixed or floating and this is true for malls or industrial or malls or office buildings, et cetera we try and match up the financings with our business plan.
So it just so happened, in this case, all of the malls that we refinanced this quarter either are transitional in nature where we’re spending some capital and we think there will be an opportunity to refinance again in a couple of years or assets where we’re looking to sell or bring in partners.
And so for that reason, we keep the debt terms a little more flexible.
In the fourth quarter, we were in the process of completing a couple of others. And they’re all going to be at fixed rates because they’re sort of longer-term hold. So, it’s more driven by the business plan of the assets than an interest rate call.
BPY CEO Brian Kingston
Brookfield uses short-term debt for assets it plans to sell quickly, but locks in low rates for assets it plans to retain and improve. However, the fact is that no management team is infallible and Brookfield is still taking a rather large bet about where short-term interest rates will be going.
The Fed is backing up Brookfield with the FOMC currently forecasting no rate hikes in 2020, and just one each in 2021 and 2022, respectively. The Fed’s long-term forecast calls for three rate hikes over the long-term meaning 2023 or beyond.
But there is always the risk that interest rate forecasts will change, such as if the economy continues to outperform long-term growth expectations. For example, the Fed’s forecast for three long-term rate hikes assumes 4.1% long-term unemployment.
According to the Atlanta Fed job calculator, just 105,000 net average new jobs need to be created to keep unemployment at 3.5%, the lowest level since 1969.
For context, we’ve averaged 180,000 average net jobs in 2018 and 205,000 over the past three months. And that was before the phase one trade deal was struck, which is expected to be signed in the first week of January.
What effect will the phase one trade deal have?
15% tariffs on $120 billion worth of apparel will fall to 7.5%
25% tariffs on $250 billion worth of intermediate goods stay the same
December 15% tariffs on $160 billion worth of apparel/consumer electronics are canceled
China agrees to buy more US imports (White House claims $50 billion per year, the actual amount to be determined by January 2020)
Phase two negotiations (surrounding IP protection and non-tariff trade barriers) to begin in early January 2020
Goldman Sachs estimates that phase one will boost US 2020 GDP growth by 0.2%, Jeff Miller 0.3%.
Goldman is forecasting 2.5% GDP growth next year (up from 2.3% pre-phase one), 3.3% unemployment and 3.5% wage growth (up from 3.1% today). Goldman’s unemployment and wage growth estimates might prove conservative now that corporate/small business/consumer confidence is likely to get a boost from phase one.
Unemployment Rate End Of 2022
Average Monthly Net Jobs Needed (Assuming Constant Labor Participation Rate)
1.2% (1944 record low)
205K (3-month average)
178K (2019 average)
2.5% (1952, non-WWII record low)
If the Fed is right that we won’t get a recession through 2022 (bond market puts 2021 recession risk at 25%) then very modest job growth could send unemployment much lower than expected. Those figures assume a constant labor participation rate (63.2% today) which has been trending higher since 2015.
In reality, unemployment isn’t likely to approach 1% or 2%, but it could very well challenge 1952’s 2.5% non-WWII record low over the Fed’s current forecast time frame. Non-supervisory wage growth (80% of workers) is running 3.7% YOY near the 50-year wage growth average of 4.0%.
If the economy does in fact grow around 2% over the next few years, then the Fed may end up having to raise rates a lot more than twice by 2022, possibly three or four times.
Would that threaten BPR’s dividend safety? Not likely, since a thriving economy would benefit its tenants and drive stronger SS NOI and cash flow growth. But depending on how rapidly inflation expectations rise, Brookfield’s short-term borrowing costs might increase faster than expected, generating a growth headwind that might cause its growth rate to come in at the lower end of its expected range.
In terms of valuation risk, BPR has little of that, given the significant margin of safety shares currently trade at. However, investors need to be aware that even though BPY/BPR has historically never been overvalued, it still experiences periods of intense volatility, far more than most REITs (a low beta sector).
Brookfield Property Peak Declines Since 2014:
Brookfield Property is actually still in a bear market right now that’s lasted 17 months, and it has experienced two corrections besides that over the last five years.
Over that time BPY has had a 25% higher beta than REITs and 31% higher standard deviation (i.e., annual volatility).
I don’t point out this historical volatility to scare you out of owning Brookfield Property. It is merely to highlight the fact that all stocks are volatile at times and thus prudent risk management is essential to sleeping well at night and avoiding costly portfolio mistakes (like selling during corrections or bear markets).
These are the risk management guidelines we use in managing all my portfolios.
Since 1945 we’ve experienced a 5+% pullback/correction/bear market, on average, every six months.
Pullbacks/corrections are a healthy and normal part of the market cycle and help keep bear markets rare (once per decade, usually during recessions) by keeping valuations from becoming dangerously inflated.
Today the S&P 500 is trading at a forward PE of 18.6, about 15% historically overvalued, according to JPMorgan Asset Management.
That level of overvaluation means that pullback/correction risk is now elevated, though we can’t know when the next one will start.
That’s because valuation explains just 10% of 12-month returns, rising to 46% over five years, and 90% over 10+, according to Bank of America and Princeton studies.
The point is that we’re very likely to get a pullback/correction sometime in 2020 and BPR/BPY can be expected to decline just like most stocks. Anyone considering this REIT needs to size their position according to their risk tolerance. MY recommendation is 5% to 10% of your portfolio, leaving sufficient room under that cap for opportunistic future buying.
Bottom Line: Brookfield Property Is One Of The Best REITs You Can Buy For 2020 And Far Beyond
Despite the strongest year for stocks and REITs since 2013, something great is always on sale. In this case, I consider Brookfield Property, in both its forms, to be one of the best high-yield blue chip REITs you can buy for next year, and far beyond. That’s due to:
A world-class management team, with 90 years of experience in opportunistically buying, improving and selling commercial real estate at impressive profits
a collection of premier trophy properties that will be improved via a $7 billion growth backlog
access to a mountain of low cost capital ($7 billion in liquidity, sufficient to finance 100% of its growth backlog)
a safe 7.1% yield that’s likely to grow 5% to 8% over time
23% discount to 2020’s fair value
9% to 21% CAGR long-term return potential (17% CAGR base case)
While no stock is without its risks, I consider Brookfield’s margin of safety high enough to make it a strong buy for 2020, and thus one of the best REITs you can buy for next year.
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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Author: Brad Thomas
Source: Seeking Alpha: 3 Reasons Brookfield Property Is One Of The Best REITs You Can Buy For 2020