Brookfield’s ‘core’ weakness

Deep inside the nested layers of funds, companies, insurers and partnerships of Canada’s Brookfield Corporation lies a real estate business that no longer covers the cost of its debt: Brookfield Property Partners, known as BPY.

BPY’s income from real estate in the first half of the year was less than it paid out in interest costs, prompting S&P Ratings to warn this month that it may cut the entity’s credit rating to junk.

The situation highlights a contrast between the deteriorating hard numbers disclosed in obscure filings for Brookfield’s property portfolio, and the Corporation’s focus in commentary on successful “trophy” assets.

For instance, chief executive Bruce Flatt channelled Dickens in his first-quarter letter to shareholders, calling real estate fundamentals “a tale of two cities”.

Responding to popular concerns about commercial real estate — rising interest rates and work-from home-trends — he said:

We have always focused on owning premier real estate in the best locations, which is why 95% of our office portfolio is either trophy or Class A office space that continues to vastly outperform the broader market.

Flatt’s second-quarter letter to shareholders said (with our emphasis):

Our real estate business continues to benefit from strong tenant demand for space in high-quality, well-located buildings and shopping malls, with our core portfolio 96% leased.

The thing is, occupancy of Brookfield’s core office property portfolio as defined in BPY filings to the Securities and Exchange Commission is not 96 per cent. At the end of June, it was 86 per cent.

We calculated that figure from BPY’s Q2 results. While the entity was taken private two years ago for $5.9bn, outstanding preference shares require it to continue filing quarterly reports with the SEC.

BPY’s core property portfolio contains almost 200mn gross square feet of office and retail space, in about 200 locations. From the filing:

Our diversified Core Office portfolio consists of 88 million square feet across 131 premier office assets in some of the world’s leading commercial markets such as New York, London, Dubai, Toronto, and Berlin . . . 

Our Core Retail portfolio consists of 110 million square feet across 109 best-in-class malls and urban retail properties across the United States.

BPY owns some of those assets outright, some via Brookfield investment funds it controls and consolidates, and some in funds where it holds only small minority stakes that are accounted for as equity investments.

These were the core office occupancy figures at the end of June:

BPY didn’t disclose second-quarter occupancy for its core retail portfolio. At the end of last year it said occupancy was 95 per cent for the 19 properties, out of 109, it intends to own long term; that group includes trophies such as Ala Moana in Honolulu and Fashion Show in Las Vegas.

Based on the full-year figures BPY published for 101 malls and urban retail properties, overall core retail occupancy at the start of 2023 was 94.3 per cent.

When we asked Flatt about the apparent discrepancy this week, he said: “We have a transitional portfolio which are new developments and non-core assets, we have stuff like that, but if you take our premium core portfolio, which is two-thirds of real estate, occupancy is 96 per cent.”

That two-thirds is by value. What’s more, Brookfield Corporation has a different definition of “core” to BPY, its wholly owned subsidiary described as “Brookfield Corporation’s primary vehicle to make investments across all strategies in real estate”.

At the parent, core is “an irreplaceable portfolio of trophy mixed-use precincts in global gateway cities”, while the rest is labelled “transitional and development”, according to materials published alongside the Corporation’s second-quarter results:

Flatt said the core is “luxury premium properties you hold for ever, and valuations on a daily basis aren’t too relevant . . . Whereas for the transaction business we have very little retail. Almost none, and very little office, almost none, in the transaction business in the funds with our clients.”

On a square-footage basis, Brookfield Corporation’s “core” represents around two-fifths of the office space and one-fifth of the retail space in which BPY is invested.

The comparative low value of Brookfield’s large non-core footprint might add to the fears of some bankers that the worst of times lie ahead, as the buildings are financed primarily with non-recourse debt. BPY disclosed that at the end of June it had suspended payments on “approximately 3 per cent” of its $48bn of secured debt obligations. High profile defaults have included office complexes in Washington DC and Los Angeles.

BPY reported interest costs in the quarter of $1.2bn, almost double those in the same period in 2022 and a sum not covered by operating income generated from property. BPY has $18bn of secured debt maturing next year:

“We’re having no problems doing refinancings”, Flatt said.

The situation comes as analysts at Loomis Sayles have sounded the alarm about a potential “doom loop” in US commercial real estate, where defaults cause banks to restrict lending and as a result prompt more defaults:

Systemic stresses emanating from the intersection of challenged bank capital positions and acute weakness in commercial real estate could intensify in 2024 and beyond. Policymakers may eventually need to weigh direct capital injections to stabilise institutions versus the risk of cascading damage.

S&P rates BPY’s debt BBB-, the lowest investment grade credit rating. Announcing that the entity was on “CreditWatch”, the firm said:

. . . interest rates have risen materially over the past year, and BPY’s substantial exposure to floating-rate debt (45% net of interest rate hedges as of June 30, 2023) has rapidly deteriorated coverage metrics.

S&P also said that “BPY has one of the weakest financial risk profiles within our North America real estate coverage given elevated leverage and thin interest coverage.”

However, the rating agency did say that it saw the suspension of debt payments as “a portfolio management exercise by BPY, not a default”, and that parent Brookfield Corporation, with $850bn of assets under management, was in a good position to negotiate with banks reluctant to take back assets in the current climate:

In many cases, we expect the banks to provide extensions on maturing debt, albeit at higher rates. In some cases, particularly when weaker operating fundamentals (low occupancy or high lease rollover risk) are reducing asset values, we would expect BPY to hand back the asset to the servicer.

Brookfield, whose reputation is built in part on commercial real estate, has long experience of its sometimes dramatic business cycle: the group emerged from the near-collapse of the Edper conglomerate three decades ago when a crash left it overleveraged and exposed.

Still, Flatt said he is unconcerned: “We have very little debt in BPY so it’s not really relevant. We just had a rating on it and they’re negative on what’s going on in the industry.”

Further reading:

-Brookfield: inside the $500bn secretive investment firm
-Will Canary Wharf become a financial ghost town?
-After Brookfield’s asset shuffle what cards are left to be played?