Brookfield Property Partners L.P. (BPY) is a major owner, operator, and investor in commercial real estate. In 2019, the firm generated approximately 46% of its net operating income (NOI) from retail assets, 35% from offices, and 19% from equity investments in Brookfield-sponsored real estate opportunity funds.
We expect the coronavirus pandemic to impact each of these income sources, pressuring Brookfield Property's credit metrics and causing its distribution to no longer be covered by cash flow in at least the short to medium term.
As a result, we are downgrading Brookfield Property's Dividend Safety Score from a low Borderline Safe score to Unsafe.
Brookfield Property's office portfolio (35% of NOI) will likely be the most resilient. These properties are primarily located in gateway markets such as Los Angeles and Berlin, and its major tenants include government agencies and large corporations (Morgan Stanley, Deloitte, Amazon, etc.).
However, New York and London account for 25% and 20% of this segment's NOI, respectively. These are two of the hardest-hit markets from COVID-19 and will likely remain closed for longer than other cities, perhaps making tenants less willing to pay rent even if they have the means to.
But the primary concern is Brookfield Property's retail portfolio (46% of NOI), which consists of 122 malls and urban retail properties.
In recent weeks, it's become increasingly clear that rent collection will be a major ongoing issue for mall landlords.
Nareit, a producer of REIT research, recently conducted a survey of 54 publicly-listed REITs and found data suggesting that malls have collected less than 25% of their rent this month as of mid-April.
Looking across Brookfield Property's top 10 retail tenants, most of them have already stopped paying rent. Some, like Gap, have even warned they could run out of money in the next 12 months.
And the firm's largest retail tenant, L Brands, recently saw a buyer for its Victoria's Secret chain back out of the deal due to the coronavirus, creating further uncertainty about its ability to survive.
Source: Brookfield Property Annual Report
Besides rent payment issues, 10.5% of Brookfield Property's retail leases expire in 2020, and another 10.7% are up for renewal in 2021. The firm's 96% retail occupancy rate seems likely to fall since finding replacement tenants will be extremely difficult in this environment.
If more of Brookfield Property's storefronts become vacant, shoppers have less incentive to visit its malls. And that could create a downward spiral if it reduces the perceived value of the firm's properties in the eyes of prospective tenants.
Even once malls are allowed to reopen, perhaps by this summer, we believe crowds will be slow to return.
Lingering contagion concerns could persist, and shelter-at-home orders have likely sped up the trend towards online shopping, which accounted for only 11% of total U.S. retail sales in 2019.
The bottom line is that the coronavirus has a good chance of accelerating the retail revolution, which could still be in the early innings.
As a result, we are doubtful that Brookfield Property will ever be able to collect full rent from many of its distressed retail tenants, and a return to its past occupancy rates could be a struggle.
Finally, Brookfield Property's investments in real estate funds, which accounted for 19% of its NOI last year and target "opportunistic" total returns, could be challenged in this environment.
Retail properties account for 20% of the funds' investments, and hotels represent another 16% of invested capital. Most of these properties will be stressed by the coronavirus for the foreseeable future.
Brookfield Property achieves most of its return when these funds realize gains on exits of successful investments. The pandemic seems likely to put a damper on these transactions for now.
From a financial perspective, in 2019 Brookfield Property generated funds from operations of $1.39 per unit and paid $1.32 in distributions, representing a payout ratio of about 96%.
Realized gains from its real estate fund investments added another $0.18 to earnings, bringing the payout ratio down to 84%. However, these contributions are volatile and may not be significant this year due to the virus outbreak.
Source: Brookfield Property Earnings Supplement
We estimate that even if investment gains equal their 2019 performance this year, Brookfield Property's rental income from malls would only need to fall around 15% to 20% for its distribution to no longer be covered by FFO.
And if no investment fund gains are realized, mall rent would only have to fall around 5% for the payout ratio to exceed 100%.
Brookfield Property states in its 10-K that a payout ratio of 80% of FFO will allow it to retain sufficient cash flow to cover sustaining capital expenditures, tenant improvements, and leasing costs.
Assuming the payout ratio rises higher this year compared to 2019, management will presumably have to borrow money or sell more "non-core" assets if they want to maintain the distribution and cover these basic ongoing needs.
This places further strain on the company since Brookfield Property already planned to recycle capital or raise external capital to continue financing its substantial development and redevelopment projects across its offices and malls.
Given the potentially prolonged dip in retail cash flow and the importance of liquidity in this uncertain operating environment, Brookfield Property may not be inclined to take on additional debt to support its dividend in the short term.
The company has the means to do it with $6 billion of undrawn credit lines and cash on hand (the distribution costs around $1.3 billion annually), but that's probably not the most responsible choice.
After all, Standard & Poor's already has the firm's BBB credit rating on a negative outlook. Not only are retail challenges a concern, but the ratings agency said that "a potential delay in asset sales and development completions could result in some deterioration to credit metrics in 2020."
Brookfield Property Partners reports earnings on May 8 and will provide a first look into its ability to collect rents. Management will likely provide clarity on how they are thinking about the distribution going forward as well.
A lot of bad news is already reflected in Brookfield Property's stock price, but current unitholders should weigh whether they are comfortable holding a stock that has questionable distribution prospects and could struggle to return to growth anytime soon.
As conservative investors with fairly concentrated portfolios (20-30 holdings), we prefer to invest in businesses with safer payouts and clearer paths to growing in value in the years ahead. The fast-changing nature of the retail sector has never helped with those objectives.
