April 19, 2008

Broofkfield Properties: Value Idea


Brookfield Properties Corporation (BPO) is a commercial real estate company. The Company operates in two principal business segments: the ownership, development and management of commercial office properties in select cities in North America, and the development of residential land. As of December 31, 2007, the Company’s commercial property portfolio consisted of interests in 109 properties totaling 73 million square feet, including 10 million square feet of parking. As of December 31, 2007, its development/redevelopment portfolio comprised interests in 16 sites totaling 18 million square feet. The Company’s primary markets are the financial, energy and government center cities of New York, Boston, Washington, D.C., Houston, Los Angeles, Toronto, Calgary and Ottawa.

Office Real Estate Macro Factors Affecting Supply and Demand:

  • Foreign buyers and sovereign wealth funds are looking to focus on buying trophy office properties in major cities like Boston, new York, Chicago...etc. This will put a floor on potential steep price decline.
  • Although demand for downtown office space is expected to decline slightly over the next one-year horizon, Moody's said that supply has also slowed to barely a trickle-down to 0.6%, its lowest level since 2005. As a result, the relatively small supply-demand imbalance should not undermine market stability too profoundly.
  • Fundamentals are deteriorating as vacancy rates are increasing and due to low absorption rates there is downward pressure on asking rents in the short term.
  • Immigration towards "mega cities", see my post earlier here. The trend of immigration towards mega cities will create demand for office space and real estate in general. The table to the side displays the percentage rent growth year over year in major cities. The demand for limited down town office space will grow as long as the trend is intact.
  • Supply will be limited in the future. The lending issues will slow development down dramatically, and it already has nationally. Nationally it has greatly slowed down the pace of new development. Capital will not be as readily available for new projects unless there are just very compelling reasons to do so — unique locations, tremendous pre-leasing to creditworthy tenants. Good projects will get done. Marginal projects won't be offered capital to develop them.
  • The boom in material and base metal prices will undermine new projects as costs are becoming more prohibitive and decreasing potential returns. This will lead to decrease in new supply in the future increasing the value of current properties.

BPO Micro Factors Affecting Revenue Growth:

  • BPO owns premier class A office buildings in major metropolitan cities like New York, Los Angles, among others highly dense populated cities. Below is a listing of their cities and owned space.
  • Most of these properties are downtown properties. Any downtown property in a major city has a very sustainable competitive advantage: high barrier to entry. with down town properties there exist a high barrier to entry as New building supply in some of these markets is not easy to come by.
  • Rent charged to BPO's tenants is below market asking rent. BPO have a chance to grow its rent by raising new leases with tenants to market asking rent. The growth potential from new leases can contribute to BPO's FFO growth.

Total Area (000,000's Sq. Ft.)% of total
New York Downtown13.218%
New York Midtown6.38.6%
Washington, D.C.6.58.8%
Los Angeles10.714.6%

Risks and Uncertainties:

A broad recovery in property share prices is likely to hinge on how quickly and completely the global economy works through the liquidity and credit crises that escalated in 2007. U.S. real estate securities were trading at an 18% discount to their underlying net asset value as of December 31, 2007, compared with a premium of 13% at the end of 2006, and compared with a historical average premium of 5%. The size of this discount suggests that the market is expecting at least a mild U.S. recession and a meaningful decline in property values. However, the strength in commercial real estate fundamentals and cash flows, I do not think a meaningful decline in property values will occur.

  • Economic Risks: There is a high probability that slower economy would impact the intrinsic value of BPO. As the economy slows down and money centre banks layoffs accelerate due to the credit crunch, office space demand will slow. In general there is a small probability that commercial real estate will decline by 15-20%. However the office market in major city centres will face a smaller decline due to high barriers to entry. I estimate 0-5% chance of such decline for cities like New York, Toronto, Houston and LA. If we have a severe recession in the U.S., it will put stress on the system. Right now I am not seeing a multitude of tenant bankruptcies, but there are profits decline. If you have a rash of tenant bankruptcies, it will slow down demand for office space.
  • Income Risk: With a high probability of slowing demand to one of BPO's biggest markets, New York, due to lay offs in the financial industry, BPO can't realize the rent growth or sustain high level occupancy. BPO will be very hard pressed to raise rates in such an environment. It won't see rent declines but growth in rental revenues will be limited. The Canadian office market may offset some of this risk as the Canadian office vacancy rates at record low levels.
  • Financing Uncertainty: with the credit issues still hangs over the banking sector, financing or refinancing any property is difficult. However, BPO is a premier property company, it will get any financing done through insurance companies, commercial banks or pension fund companies as they are still large player in commercial financing. Having said that I think the financing will be at a higher rate absent the competition from the CMBS market. However, in this uncertain credit market it will present financing risks particular to BPO in several ways:

    1. Higher financing costs. Most fixed financing, which what most real estate operators use, has higher rates due the tightness of lending.
    2. Miss match of funding. With higher fixed rates BPO have opted to use the variable and short term debt packages, which leads to miss match between its asset and liability. Miss match funding is very risky for a real estate owner, which can lead to fire sale if BPO could not refinance in the future. The episode of Macklowe unravelling properties due to short term financing is a perfect example of funding miss match risks. Macklowe had to liquidate the premier and the crown jewel of his properties in a hurry to raise funds as he failed to refinance a one year loan to buyout seven building from Blackstone deal with Sam Zell.
    3. High leverage of BPO. BPO has a higher leverage ratio compared to other US and Canadian reits, management says it is not a problem, but I beg to differ. BPO employs 61% Long term debt to Enterprise value, while other US reits uses just under 50% with the quality names using under 45%. Since values are falling in the short term, the last thing you want is too much debt. With the lack of financing in the market, this means we are left with a select few of longer-term investors—those with significant equity to invest as part of long-term programs. This shift will definitely start to dictate lower pricing if BPO needs to sell something and in general will reduce the intrinsic value of the company.
    4. Refinancing risk. BPO has 11% of its commercial debt due with 12 months. That is a large chunk to be refinanced in this environment. Commercial banks in Q1 of 2008 have reduced their lending activities by 26% year over year ( figure from Reuters Loan Pricing Corp). If the loans are refinanced, it is going to be at a higher rates that will eat into their FFO figures. Moreover they have 8.8% of their long term debt from Commercial Mortgage Backed Securities debt that they have to refinance at various times which poses a significant refinancing risk. The CMBS market has all but shut down for any new securitzation. BPO has to find an alternate funding source from a commercial bank or an insurance company.

Given these risk and the potential for a company like BPO and Commercial real estate in general, there are two possible extreme scenarios in the intermediate future, and many combination in between, as follows:

Expected Return
Worst case:

1. deflating asset prices due to continuation and deepening of the credit issues, which can put a downward pressure on commercial real estate prices in the short term as well as increase financing costs.

2. economic activity takes a steep turn for the worse

3. BPO refinancing risk is realized.

decline of 15-20% of NAV
Best case:

1. a recovery in financial industry and

2. a resolution of the credit crises, which means a substantial reduction in the risk profile explained above.

This scenario will likely play out in the span of 18-24 months.

increase in 5-10% of NAV


The stock is not cheap. I figure it is fairly valued at $20 a share; its Net Asset Value (NAV) ranges between $21-29 per share. I have determined its NAV in two ways:

  1. Using Cap rates for recent quarter and applying it to BPO's recent Net Operating Income (NOI).
  2. computing average recent sales per sqr ft for comparable properties in BPO's markets and applying it to its owned space.

Please note that sales prices in Q1 2008 are scarce as not many transaction have been done due to tight credit and financing. That's will affect most of the valuation points that I gathered whether it is CAP rates or market sale price per sqr ft. Therefore I will apply a discount of 3% to all valuation computed using the decline in the S&P/GRA Commercial Real Estate Index from its peak in 2007 as a measure of decline in BPO properties.

Cap Rate Approach:

The current prevailing national blended cap rate for office real estate is 6.5%, according to CBRE. Using this cap rate the market value of BPO properties is $21 Billion, 33% higher than its book value of $15.8 Billion. I am confident that BPO's specific properties will yield much tighter CAP rate than a blended average. Their properties are all class A buildings in the heart of mega cities where CAP rate can reach 4-5% even in slow economic times as the one we are in. Here is a range of probable real estate values:

CAP RateProperties ValuePremium to BV
7%$ 18 Billion14%
6.5%$ 21 Billion33%
5.5%$ 22.9 Billion45%

Using recent Sale prices, I got the following prices (using LoopNet DB):

NET OWNEDHigh MKTLow MktHigh end ValueLow end Value
MarketINTEREST (000)Price per Sq FTPrice per Sq FTin 000sin 000s
Boston2,150 520 700 1,505,000 1,118,000
Calgary2,899 200 250 724,750 579,800
Denver1,795 300 400 718,000 538,500
Edmonton157 200 250 39,250 31,400
Houston3,744 200 300 1,123,200 748,800
Los Angeles4,721 200 300 1,416,300 944,200
Minneapolis3,008 100 200 601,600 300,800
New York13,210 1,000 1,100 14,531,000 13,210,000
Niagara Falls47 100 100 4,700 4,700
Other73 100 100 7,300 7,300
Ottawa618 382 400 247,200 236,076
Toronto5,770 364 400 2,308,000 2,100,280
Vancouver759 200 250 189,750 151,800
Washington, D.C.4,093 300 500 2,046,500 1,227,900
Total25,462,550 21,199,556
Discounted Value24,698,67320,563,569

BPO's properties seem to range from a low end of $20.5 to a high of $24.5 Billion. Both figures represent a NAV premium to the market price of BPO between 2%-39% (adjusting for some balance sheet accounts).


With several risks that outweigh potential rewards or upside in BPO, I will stay out of this one for the time being. I will start buying at or below $17.5, which the stock have touched in recent weeks, but I was in the midst of my analysis then. I think at that level I have enough of a discount to justify taking on mainly financing risks associated with BPO. I will also be a buyer at $20 per share, if the credit issues are resolved and the lending environment returned to normal, or showed signs of returning to normal as it is showing now.


Ali Majid said...

It's nice to see a financial blog that is transparent as well as well-researched. Shows some inspiration to CFA candidates like myself.

Keep up the good work.

Sami said...

Thanks Ali for the kind words.

Good luck with your upcoming CFA exam!