Description

Executive Summary

I am positive on Brookfield Property Partners (BPY), a recent Brookfield Asset Management (BAM) spin-off containing most of BAM’s real estate assets. Since the spinoff, BPY performed poorly due to:

1. BAM’s incentive to intentionally have BPY trade as weakly as possible right after the spin-off

2. Related to point 1, BAM shareholders received an insignificant $ amount of BPY units, leading most BAM shareholders to liquidate BPY united received without much thought

3. Limited float

4. Governance issues

5. Portfolio of publicly traded securities easily replicable by investors

6. Limited disclosure

7. Not initially in any relevant indices

8. No research coverage despite a ~$14 bln market capitalization

9. BAM management fees imposed on BPY

Currently, BPY is working to (and is heavily incentivized to) address many of these concerns and I believe a near-term target of $25 is reasonable, with a longer-term target of $35+. In the near-term, there are many near-term catalysts that should help narrow its NAV discount, as well, fundamentals are expected to improve meaningfully in the near to medium term.

1. Taking Brookfield Office Properties (BPO) private could reduce holdco discount

2. BPO take-out also improves float via BPY share issuances

3. Recent inclusion in the S&P/TSX Composite Index and the Global Property Research GPR 250 index. BPY is working to be included in the FTSE NAREIT index.

4. Expected leasing success at BPO’s New York and LA office properties

5. GGP continues to improve its lease terms and rents

6. Potential unit buyback post BPO privatization

7. Potential sale of assets not captured by public security holdings

Background

BAM has a 100 year history (formerly Brascan) and reputation for being a solid capital allocator in the areas of real estate, renewable power, infrastructure and private equity – generating a 19% compounded annual return on its shares in the past 20 years.

Within a decade ago, BAM came to the realization that it could generate superior return on capital by 1) managing more third party assets (for base management and incentive fees) and 2) spinning off/converting its own assets into fee generating limited partnership vehicles, while maintaining a significant equity ownership and de facto control (usually as general partner). As a result, BAM began its process of spinning off its core assets into limited partnership vehicles where BAM would receive a base fee and an incentive payout, generally based on distribution per unit hurdles. Starting with its infrastructure assets, BAM spun-off Brookfield Infrastructure Partners (BIP) in January 2008. Given the challenges and opportunities presented by the financial crisis, BAM took until November 2011 before merging its renewable energy assets with Brookfield Renewable Power Fund into Brookfield Renewable Energy Partners (BEP). While both vehicles had some difficulty in attracting initial investor interest, both performed quite nicely as: 1) BAM made good capital allocation decisions, 2) improved the spin-off entity’s float by reducing its position over time, and 3) increased its per unit distributions (and hitting the performance hurdles in the case of BIP).

I suspect the spin-off of BAM’s real estate assets took the longest to coordinate largely because of two reasons: 1) BAM’s involvement in General Growth Properties (GGP) during the financial crisis and 2) the nuance of BAM’s 50.1% voting interest in Brookfield Office Properties (BPO), an already publicly traded company without the management fees and potential incentive payouts BAM would have preferred.

The BPY Spin-Off

In April 2013, BAM completed the spin-off of its commercial real estate assets into a limited partnership, BPY. These assets primarily included holdings in publicly traded entities including BPO, GGP, Rouse (a GGP spinoff), and Canary Wharf (Songbird Estates PLC (SBD) serves as a publicly traded proxy for BAM’s 22% interest).

At the onset, the spinoff was unlikely to be received well for a number of factors including:

1. BAM shareholders were to receive only 5.74 BPY units per 100 shares of BAM (relatively insignificant, considering the spinoff represented ~ less than 4% of BAM’s share price)

2. The spin-off was a taxable dividend, making shareholders receiving BPY units more likely to sell it (as the distribution was already taxed)

3. Through a complicated LP structure (and with BAM directly owning Redeemable Exchangeable Units on BPY), BAM would still retain ~ 92.5% of BPY units, making its float quite small despite a significant implied market capitalization

4. BPY was not included in relevant indices

5. BPY being a limited partnership with governance issues

6. The majority of its underlying assets are publicly traded entities that can be easily replicated

7. The incentive/performance related fees to BAM appear quite generous

8. The overhang associated with the expected issuance of units to take BPO private

While spin-offs generally tend to create selling pressure, I would speculate it was in BAM’s interest to see a depressed BPY unit price post spin-off. Specifically, BAM receives an “equity enhancement distribution” which is basically a performance payment equal to 1.25% growth in BPY’s total capitalization. Going through the company’s filings, it becomes apparent that the initial total capitalization calculation is set based on the first 30 day VWAP and never gets reset (see exhibit below).

Interestingly, BPY units continued to languish even after the initial 30 day period post-spinoff for many reasons I identified previously. Further, I speculate 3 additional events made it worse for BPY: 1) a prominent hedge fund manager spoke poorly of BPY (of which many points are valid, although some have since been alleviated), although their concerns were ultimately more tied to GGP, 2) hearsay that some mutual fund(s) were precluded from owning limited partnership units in their funds. Realizing that they did not want to “puke” out their units at the same time everyone else is, they supposedly tried to amend their “rules” to delay their disposition creating an overhang, and 3) BPY was sufficiently complicated that the sell-side has not initiated coverage yet. However, some analysts provided “shadow coverage” and talked about the holdco discount that should be placed on BPY (I believe this point is partially incorrect)

BPY Overview

The following is a brief overview of BPY, for details please read the BPY annual report (20-F filing since it is a foreign company) and its tender offer filing (for BPO). Please note it is also brief because I do not have the level of real estate expertise to discuss BPY’s 330 million square foot portfolio property by property – in fact, BPY has not publicly disclosed all its property holdings by individual location. Associated with this shortcoming, I am reluctantly forced to adopt the “standard” real estate profitability measures including Net Operating Income (NOI, which seems to be property level profitability before depreciation) and Funds From Operations (FFO, which seems to be NOI less admin, finance expenses and non-controlling interest, plus share of equity income). I am, however, confident that BPY is undervalued.

BPY is an owner and operator of real estate assets spread across North America, Europe, Australia and Latin America (Brazil). Since the spinoff, BPY has issued units to acquire industrial real estate, increased its GGP stake and commenced a 2 step tender offer for BPO (privatization).

Currently, their portfolio can be placed into 3 buckets:

Office: BPY owns or has an indirect interest in 168 office properties (97 mln sq.ft.) primarily located in the central business district (CBD) of major cities (New York, London, LA, Washington DC, Syndey, Toronto, etc.). Most of BPY’s office assets are represented in BPO. It appears BPY’s thesis is that CBD vacancies remain stubbornly high (for instance their Manhattan and LA properties) due to tenant turnover and the general lag in corporations’ desire to hire and finalize square footage requirements since the great financial crisis. In other words, current vacancy rates are transient and quality CBD properties should ensure full(er) occupancy rates longer-term.

Outside of BPO, BPY holds a number of properties outside BPO, including 22% of Canary Wharf in the UK, 100% of 20 Canada Place building in the Canary Wharf estate and Australian office assets.

Retail: BPY has interests in 163 retail properties in the US, Brazil and Australia (totalling 152 mln sq.ft.). BPY’s U.S. assets are primarily shopping malls, represented by their stake in GGP and Rouse. BPY’s thesis appears to suggest GGP’s retail mall properties have suboptimal tenants and below market rents. These unfavourable mix of tenant and rents were largely a function of sacrificing quality for liquidity during the financial crisis given GGP’s debt load. Looking ahead, the lack of new mall supply (fears of e-commerce) and BPY’s desire to upgrade its tenant/rent mix should drive sustainably higher profitability.

Outside of GGP and Rouse, BPY’s direct holdings of retail assets are in Brazil.

Industrial, Multi-family and other: This catch-all category captures BPY’s direct interest in 58 mln sq.ft. on industrial real estate, 22,000 multi-family units and 8 hotels.

BPY’s interest here is primarily industrial. Their thesis is that the U.S. industrial market is highly fragmented with little institutional interest. As a result, real estate yields are generally higher than other asset classes. Further, the potential cost synergies from a roll-up strategy and the relatively lower capital expenditure requirements of industrial properties give BPY the potential for superior risk adjusted returns.

Qualitatively, longer-term, it is conceivable that BPY could trade at a premium to NAV given some of its advantages relative to peers:

• Ability to benefit from BAM’s real estate performance track record

• Information advantage on real estate markets given BAM’s geographic reach and diverse holdings

• Lack of “institutional imperative”. Unlike most REITs, BPY is free to allocate capital across different asset classes and geographies in search of superior risk-adjusted returns. On the other hand, the average REIT tends to focus on a narrow asset class and geography because investors want to “seek exposure” to a particular type of real estate. The argument goes that if investors wanted to diversify or have different property exposures, they could do it better themselves. As BPY stated in a recent conference call, it is difficult to generate excess returns over a cycle if you’re only limited to trading one specific asset class.

BPY Valuation

Given the sheer number of properties and underlying publicly traded companies, valuing BPY is a little complicated. However, I will demonstrate in the following sections a number of valuation yardsticks/benchmarks that should give comfort that BPY is attractive. Also, I think it is important to recognize the hidden value in BPY assets not reflected its publicly traded securities. Finally, I attempt to demonstrate the BPO tender offer has essentially tipped BPY’s hand in revealing what they may truly think BPY is worth longer term.

BPY IFRS NAV as a Starting Point

With IFRS accounting theoretically meant to reflect the fair value of assets and liabilities on the balance sheet, BPY’s IFRS NAV is a good starting point. Relative to its current trading price, BPY looks to be trading at a ~20% to NAV.

While the $25 NAV figure is open to debate, keep in mind that according to Bank of America Merrill Lynch, REITs in the U.S. trade at an average 98% of NAV, with office REITs trading at a premium 103% of NAV. One would have to go back ~15 years to see REITs trading at a trough 78% of NAV (1999).

BPY NAV Using Only Underlying Publicly Traded Securities Held

This is also a fairly straight forward exercise of taking BPO, GGP, Rouse and Canary Wharf (using Songbird Estates as a proxy) shares BPY held at 1Q14, multiplying it by the current market price. The implication here is simple: at current prices, you are essentially getting BPY’s direct office and retail assets, and the entire industrial/multi-family operation for free.

Clearly, this is an oversimplification of situation and one can quibble with this NAV as unitholders can’t easily liquidate BPY given the Master Services Agreement with BAM. Further, BAM’s management fee will erode this NAV over time if they do nothing and detract value.

My feeling is that the sell-side (without formal coverage) believes a large holdco discount is appropriate for BPY (hence this analysis is flawed), and discount would narrow when BPO is completely privatized, making it impossible for investors to buy BPO shares directly. While I think the BPO privatization will serve as a catalyst, I actually disagree it has much to do with the implied holdco discount – instead I think it has to do with BPY taking BPO at a big NAV discount. From my understanding, a holdco discount stems from several factors which I will address:

• Marketability – true it would be difficult to dump its large block of shares immediately

• Tax implication discount – BPY is a Bermuda entity that should pay no taxes on selling its shares

• Lack of control discount – BPY actually has de facto control in BPO and GGP (even before the BPO tender offer, which is why BPO itself was trading at a discount to NAV as BAM held 50.1% of the votes). Not only should there be no discount, one can argue for a control premium

While one might point out the market price for BPO shares reflect a take-out premium given BPY’s bid, I would argue the bid represents a “take-under” and minority shareholders realize they are unlikely to ever command a significant take out premium given BPY/BAM’s 50.1% voting interest. Before BPY’s bid for BPO, it is very interesting to see consensus NAV estimates were $25.61 in 2014 and $26.00 in 2015 – likely reflecting the value attained once BPO leases out its Manhattan office space.

Putting in a $24 value for BPO moves BPY’s NAV to $23.25 per unit.

Although it is beyond the scope of this report to fully analyze BPO, GGP and Rouse, I have included the salient consensus estimate metrics for these public companies. By taking the BPY’s proportionate interest in the FFO of these companies, we can see what the “read through FFO” looks like. This is particularly important for 2 reasons: 1) one is free to run various P/FFO multiples and come to the same conclusion that BPY is inexpensive and/or BPY’s non-public security holdings are ignored, and 2) Morgan Stanley’s BPY valuation work (see next section) seems particularly conservative. It is debatable whether one includes the GGP warrants in the read-through FFO (since you have to exercise and pay for them to get the FFO). Regardless, the read-through FFO for just BPO/GGP/Rouse is > $900 mln.

Morgan Stanley’s BPY Forecast in Tender Offer Document

In making its bid for BPO, BPY’s tender offer document provides investors with previously non-public information on BPY’s internal assumptions and budget for the next few year (until 2017). For those willing to spend the time to comb through the 600 page document, there are also many clues as to what management thinks BPY should be worth longer-term. In particular, Morgan Stanley (MS) was retained to provide BPY financial projections until 2017 based on a “base case” and an “adjusted financial projections” scenario. I will go through the “adjusted financial projections” scenario primarily because the BPO bid was eventually bumped so this scenario makes more sense. However, it is very interesting to note the implied management assumption that all BPO FCF will be sent back to BPY starting in 2015 – I interpret to mean BPY is gearing up for a distribution hike in the near to medium term.

Before we take MS’s (BPY management assumptions driven) forecast as gospel, I would highlight that their forecast is likely to err on the side of being overly conservative. After all, a forecast that is seen to be positive and optimistic is likely to help justify a higher bid price for BPO – clearly something BPY does not want to advocate and something that may influence how conservative BPY’s set of assumptions are when they pass on their assumptions/budget to MS. This hypothesis is somewhat consistent with our “read through FFO” exhibit earlier in this write-up, in the range of $900 mln+ for 2015E using consensus estimates. In contrast, MS’s FFO 2015 estimate is only $835 mln, even though our “read through FFO” only captures BPO, GGP and Rouse’s FFO (no FFO from Canary Wharf, 20 Canada Place, other office, other retail and the industrial/multi-family segment)!

Having established that MS’s forecast is likely very/overly conservative, it is interesting to see the 2017E BPY NAV is still expected to be $34.60 per share. As well, distributions are estimated at $1.17 per unit (clearly the first $1.15 hurdle) and FCF is estimated at $1.39 per unit (cash FFO less maintenance capex).

Even more interesting, during the 4Q13 call, BPY very reluctantly addressed a caller’s question on the MS forecast by stating they had to do it, they don’t really want to elaborate and the forecast did not aggressively assume cap rate compression (only improvement in fundamentals). My personal guess is they did not want to bring attention to the forecast because, clearly, they don’t want to pay any more to take BPO private.

The bottom line for me is this: although the MS numbers look rosy on the surface, I’ve come to realize it is probably unduly conservative when we compare to our “read through FFO”. So I would guess we have a good chance of hitting the 2017 $35 per unit NAV, having a sustainably higher distribution per unit, and have BPY buy back units over this time period (notice the negative share issuances forecast in 2015 and 2016?).

My Own Best Guess NAV

As I stated in the beginning of my write-up, I did not procure a team of real estate experts to visit every single BPY property to come up with a bottom up NAV. However, by using a combination of scuttlebutt and extrapolating the NOI not reflected in the public securities, I tried to isolate the value of the real estate not accounted for under BPO/GGP/Rouse/Canary Wharf – which is ~ $4.50 per unit. Using BPO’s share price as is, I get a BPY NAV of $23.60. Plugging in BPO’s pre-bid consensus NAV, I get a BPV NAV of $26.90.

Improvement in Spin-off Dynamics

While it is nice to talk about BPY’s theoretical NAV and upside, it is important to recognize a number of recent and near-term developments/catalysts that should narrow the NAV discount gap.

First, BPY is now included in the S&P/TSX Composite Index, the S&P/TSX Composite Dividend Index, the S&P/TSX Capped Real Estate Index and the Global Property Research GPR 250 Index. I understand that BPY is working to get on the FTSE NAREIT index, although it currently prohibits the inclusion of LPs (the S&P/TSX Composite also prohibited LPs but BPY was somehow able to convince them otherwise).

Second, related to index inclusion, BPY’s float is set to increase from ~58 mln at the end of December 2013 to ~275 mln units after the BPO privatization. I suspect the 4x increase in public float and the associated more meaningful index weighting would drive demand for BPY units (and help narrow its NAV discount gap).

Third, it is understandable that the sell-side has not initiated coverage of BPY given its complexities and the BPO privatization bid. Upon taking in BPO, I expect research coverage to significantly ramp-up for BPY. As reference, there are currently 15 analysts covering BPO, which will soon cease to exist. It should be a good bet many of these analysts will be covering BPY soon.

Fourth, the natural improvement in fundamentals should also help narrow the NAV discount gap. Specifically, the recent May 22 announcement that Time Inc. has signed a long-term 700K square feet lease at Brookfield Place New York should alleviate concerns of BPY’s relatively high New York vacancy. With a total of 2 million square feet to fill, I expect more signings to serve as a near-term catalyst

Fifth, BPY is also keenly aware of its trading discount to NAV. Most recently, it stated in its 1Q14 release that it intends to pursue a buyback program in the near-term. BPY’s buyback should serve two purposes: 1) to help narrow the NAV discount by buying units back, and 2) illustrate to investors that BAM will not recklessly increase total capitalization by pursuing acquisitions to generate fees – instead, it will remain BPY unitholder friendly, especially in light of its significant equity stake.

Sixth, BPY has publicly stated its plans to reduce its NAV discount, including the possibility of pursuing asset sales with values not readily recognizable (i.e. assets not covered by public securities).

Seventh, BPY appears to be increasing its marketing efforts with its recent California investor tour. I believe it is important BPY gets the message out that the management fee and incentive structure is not overly egregious. Unitholders should recognize BAM’s ability to pursue accretive acquisitions. At the same time, BAM will let its ownership interest get diluted over time despite creating value. Therefore, the incentive fees are meant to offset some of the dilution BAM would face over time.

Risks

On a macro level, there are many risks relevant for BPY, including interest rate and cap rate risks. All I can offer is for you to look at the higher end of NAV discounts and lower end of FFO multiples to account for this risk.

Specific to BPY, there are property level risks associated with the current higher office vacancies and the ability to drive through rent increases for its GGP assets. Also, in theory, BAM owns a bunch of Redeemable Exchange Units that BAM can redeem for cash (forcing BPY to issue shares) starting in ~ April 2015.

Disclaimer: The write-up is only intended for VIC members and not for dissemination.

Not investment advice, no warranties expressed or implied, subject to material and potentially egregious errors. Basically, do your own homework.

Catalyst