Real estate: Brookfield bets on bricks and mortar

Brookfield Asset Management’s real estate arm, Brookfield Property Group – which has around $150 billion under management – invests around a third of its portfolio in retail assets and has steadily increased that exposure over the last five years. So far this year, the firm has spent $150 million on the purchase of interests in three malls in the US that it plans to reposition. Through its stake in property firm GGP, it has acquired 13 anchor units that were previously occupied by Sears, with the intention to revamp them and lease to new tenants.

“We’re very actively investing in retail real estate today,” says Brian Kingston, chief executive officer of Brookfield Property Group, in New York. “Within GGP, we’ve been investing significant amounts of capital in repositioning and buying new assets. It’s a bit of a contrarian investment at the moment because everyone is so negative on it, but it is the one sector where there’s far less competition than in most real estate sectors; as a result we think the returns are quite compelling.”

The headlines have not been encouraging for retail property investors. Large department stores including Sears, Macy’s and JCPenneys – which typically serve as anchor units to shopping malls in the US – have together announced more than 400 store closures this year. Hedge funds have been cranking up bets against retail-related real estate stocks, a trend that some have been calling the next big short. But for Kingston, that is creating an opportunity. 

In a letter to unit holders in August, he outlined that through GGP (one of the largest mall owners and operators in the US) the firm has repositioned more than 100 anchor units and currently has no vacancies in any of its anchor sites. That repurposing also tends to yield higher returns because it means those units can be re-let at higher rents to more entertainment-focused businesses.

“Our strategy is to focus on very high-quality retail and then to curate those malls in a way that allows our retailers to be successful; and the way that you are successful is by creating an experience that can’t be replicated online,” says Kingston. 

“What we’ve been doing is increasing elements of entertainment in our shopping centres, whether that’s movie theatres or gyms or grocery stores or other uses like that, that pull customers in – you can’t go out for dinner on the internet, you have to go somewhere like one of our entertainment centres. There’s absolutely some truth to the concerns that the market broadly has around retail in the United States, but if you own high-quality real estate, we think it’s still a tremendous business to be in.”

Kingston acknowledges that the rise of online retailing has had an impact on some corners of the traditional retail market and, like other property buyers, Brookfield has been investing in the logistics sector to capture the growth in e-commerce. It owns around 45 million square feet of logistics space in the US and Europe and is developing a further 7 million square feet of space in the US this year.

“The key capability one needs to have to be successful in this sector right now is an ability to create new product, because that’s really where the tenant demand is: new modern logistics warehouses,” he says. “The specifications and the locations that tenants like an Amazon or some of these other users have are very different now than the specifications that warehouses were built to 15 or even 10 years ago. So we’ve been a very active developer in this space and our business runs at a very high occupancy. I don’t think this sector has ever been better than it is right now.”

Yet while e-commerce has been chipping away at traditional bricks-and-mortar retail, Kingston says part of the reason some stores are struggling at the moment is because of the amount of floor space dedicated to retail in the US. That led to a number of retailers over-expanding while at the same time failing to adjust their business models quickly enough to changing consumer demands. 

“Retailers that will be successful in the future are ones who can accurately predict consumer demand and be in the right place and effectively use the internet to complement a physical store location,” he says. “We do believe fully in the long term that retailers need a physical store front. Certain malls may suffer as there’s too much space and some of it has to be taken offline, but if you own very high-quality retail real estate that’s located close to large population centres and you curate those retail shopping centres in a way that continues to drive customer demand, you’re going to be just fine. The rumours of the demise of the mall are exaggerated.”

Given that the wider turbulence for retail assets in public markets has depressed retail values across the board, Brookfield has focused the bulk of its selling activities in the office sector, which makes up another third of its real estate portfolio. Brookfield is seeking to raise between $1 billion and $2 billion from asset sales this year, with much of that expected to come from office divestments.

“We’re looking to sell assets that have long leases in place where they provide a lot of certainty and, from our perspective, there’s not a lot of value-add left in it for us to do,” Kingston says. “If it’s an office building with a 15-year lease and it’s really just going to be collecting rent for the next 15 years, we are looking to either sell that or bring in partners with a lower cost of capital and then take that cash and redeploy it into something else where we can make higher returns.”

For example, in March it raised $689 million from the sale of its stake in 245 Park Avenue, which was bought by Chinese firm HNA Group for $2.2 billion, making it one of the most expensive skyscrapers on record in New York. Part of that sales strategy is also to shield against the potential impact of rising interest rates.

“If you believe that interest rates are going to go higher over the next several years, and we do think they will move modestly higher from here, then owning an office with a 15-year lease in place where the income is not going to change is a risky strategy because if cap rates move up on you or interest rates move up on you or both, you don’t really have anything that can offset that and you’re going to be faced with a potential capital loss,” he says. “What we’ve been doing increasingly is shifting our investment focus to assets with shorter-duration leases.”

That has meant buying self-storage units, where rents are monthly, and apartment blocks (or ‘multifamily’), where leases are typically for 12 months. In some cases, Brookfield has also invested in hotels where the leases are daily. With logistics, these assets make up the final third of the group’s real estate portfolio.

“Our business in multifamily is predominantly in the United States, mostly because that is the most developed institutional multifamily market,” Kingston says. “Over the last 10 years, you’ve seen a significant decline in the percentage of home ownership in the US, which has led to tremendous demand for multifamily rental apartments. Self-storage is another sector that we think is interesting because the demand drivers for self-storage are largely independent from overall economic growth, and so it gives you a bit of diversification away from that and is generally pretty undersupplied in the US.”

And even though Brookfield has been offloading some of its office properties, the sector remains central to the group’s real estate business, owning office buildings in 10 countries around the world, including Canary Wharf in London and Potsdamer Platz in Berlin.

“We’re very bullish on the outlook for office,” says Kingston. “What’s driving demand with office tenants around the world is a focus on efficiency, flexibility and amenities that will allow them to attract staff to their buildings. We spend a lot of time in our business ensuring that our assets are world-class in the sense where we’re developing or redeveloping to high environmental standards and finding ways to work with tenants to provide them additional amenities.”

One example is Brookfield Place in New York, which it recently renovated by improving the retail space in the office building complex, including a chef-driven quick-service food hall and other amenities such as a high-quality gym operator. Kingston says such revamps are being carried out in other office buildings it owns around the world in places such as Shanghai and Perth. 

An increase in companies merging two or more office locations under one roof is also fuelling demand for new office space. For instance, Brookfield recently completed an office development for Deloitte in downtown Toronto that merged five satellite offices from the surrounding suburbs as it sought to become a more attractive place to work.

“It’s happening at a different pace in different cities, but it’s all part of this urbanization trend where people are increasingly wanting to locate their premises in a more urban location. As a result you often see them consolidating several suburban locations into one, partly from an efficiency perspective and having all of their people in one place together, and partly as a way to attract talent,” Kingston says.

Toronto is just one location where Brookfield is developing office properties. It also has projects under way in New York, London and Sydney. “The way we think about development is that where prices on assets exceed replacement cost, those are the markets we will look to develop in, otherwise our preference is generally to acquire assets,” he says. “In Manhattan, office buildings do trade through replacement cost, so we are very active in office development in this market. If we can develop to an unlevered return on our cost that’s 200 to 300 basis points above where those assets would trade in that market, then we’ll generally look to development, so it’s really just a return equation.” 

In London, which remains one of the world’s most expensive commercial real estate markets, Brookfield has three office buildings under construction: London Wall Place and 100 Bishopsgate in the City and 1 Bank Street in Canary Wharf. All three of those buildings are due to be completed between now and 2019, coinciding with the negotiation period of Britain’s exit from the European Union – a background that has raised concerns among property owners that some global tenants could pull out of the UK.

“What we’re seeing currently is a slowdown in decision making, so that’s having a negative impact on activity but an uncertain impact on where rents are and where demand is, because a lot of people are just waiting to see what this all means,” says Kingston. “Notwithstanding what some tenants may be saying publicly about their potential plans, the reality is there is still a lot of uncertainty within those businesses.”

Brookfield has already pre-let around 75% of space in those developments, with tenants including Schroders, Royal Bank of Canada, Jefferies, Freshfields Bruckhaus Deringer and Société Générale. And despite the gloom around Brexit, Kingston is confident that London will retain its allure in the long term. “We’re big believers in the City of London, it has been a centre of commerce for thousands of years, it benefits from good rule of law, central time zone, a very favourable tax system, and generally it’s a very desirable place for people to live because of the infrastructure that’s in place there,” he says. “Large cities like London tend to adapt to changing circumstances.”

Kingston says New York is a prime example of a city that has adapted to a shifting market backdrop. Before the financial crisis, financial services companies were a big driver of office demand. Now financial services occupancy rates have fallen and been replaced by a new wave of technology and media tenants such as Google and Facebook. “London will ultimately adjust to whatever the impact of Brexit is, and for that reason we do think it will be resilient,” he says. “There will inevitably be some adjustment somewhere between that two- to three-year period and the very long term, and it could create some interesting investment opportunities for us, so we think in the fullness of time London is a great place to be.”

Brexit-related uncertainty has also constrained new construction activity; developments that had not broken ground before the referendum were put back on the shelf, keeping London’s supply and demand balance reasonably in check, Kingston says. Tighter lending restrictions around the world have also helped restrain speculative development elsewhere.“One of the differences this time round versus the last time when we saw real estate prices at these levels is that lenders are much more disciplined in terms of who they lend to and the types of project or real estate they’re lending against, so while debt capital markets are strong, it is only available to good sponsors who own high-quality real estate,” he says. “Financing is relatively difficult to come by if you’re a small sponsor and worse if you’re a small sponsor doing construction. In most of our markets, real estate fundamentals are really good; part of the reason is because lending on new development is fairly strict, so that’s really kept a lid on new supply.”

Those fundamentals are bolstering interest from investors looking to real estate funds as a way to boost returns in a low yield environment.“Most institutional investors have been pretty regularly increasing the percentage of their overall portfolios that are dedicated to real assets and obviously real estate is probably the easiest, most liquid component of a real asset portfolio to invest in,” says Kingston. “The benefits of that are they pick up a little bit of yield, but also by investing in real assets it provides them with good protection against inflation over a long period of time.”

And even if interest rates start moving higher, they are starting from such a low level that it is unlikely to disrupt the flow of capital seeking a home in real estate.“The likelihood of a massive interest rate spike back to levels we saw 15 or 20 years ago is highly unlikely, so we really don’t see that trend being interrupted,” he says. “Now that these investors have gone through that shift in their thinking where fixed income has become a smaller component of the overall portfolio and real assets have become an established investment class, we don’t see that allocation shift as a temporary phenomenon.”