It's an old saying, usually attributed to Warren Buffet, that when the tide goes down you can see who has been swimming naked. Well, things have clearly been at low tide for commercial real estate companies, especially those associated with brick-and-mortar retail. These sectors were already under pressure from the trend towards e-commerce, but with the coming of a global crisis and a rolling series of on again/off again shutdowns, the tide has gotten very low indeed.
The tide is of course an analogy for market conditions. But what about the naked part? That's an analogy for debt. When companies owe a high proportion of money relative to their underlying assets, they are in a sense uncovered. As real estate prices drop, certain provisions in their agreements with their lenders kick in, forcing them to a very weak bargaining position.
Let’s take a look at a recent example. PPTY formerly owned a significant holding (1%) in GGP (acquired by Brookfield Property REIT). This was substantial given that PPTY is a highly diversified fund. So, in order to continue to own a portion of the assets formerly in GGP, we would have had to invest in Brookfield.
But there were some problems. Brookfield's model violated our governance principles because it separated management from ownership of the property, leaving incentives misaligned. Operators don't have the same incentive to manage property at high efficiency and high long-term value creation as companies that both own and operate.
But more to the current point, Brookfield also violated our principles regarding excess debt leverage. It was not sufficiently covered in the event of a low tide, and then along came a low tide in the world of shopping centers. For example, in April, Brookfield was only able to collect 1/5th of its rents from those properties. (Source: Financial Times)
Therefore, as of the next rebalance after that acquisition (in July 2020), we constituted the portfolio with a zero weighting to Brookfield.
The Financial Times recently reported that due to mass defaults on rents, the company was forced to renegotiate $6.4 bn in debt by severely restricting its ability to pay dividends to investors in order to gain forbearance for its high debt service.
"Brookfield has renegotiated a $6.4bn credit facility, offering sweeping concessions to banks that have lent money to its property arm after the coronavirus prompted many retailers to stop paying rent. The revised terms impose restrictions on the dividends that can be paid by Brookfield Property Reit, which is one of America’s biggest operators of shopping centres and has suffered heavy economic damage from the pandemic."
In addition to the reduced prospect for future dividends, investors took heavy losses in the form of reduced prices in shares of the company. According to a Financial Times report as of June 30, 2020:
"…mass defaults on property leases and other commitments are radiating through markets, transmitting losses to lenders, bondholders and holders of other financial assets. Shares in Brookfield Property Reit, which trades under the ticker BPYU, have fallen one-third since the beginning of the year, reflecting investors’ uncertainty about whether — and how quickly — landlords can recover from a pandemic-induced crisis in the retail industry. Brookfield collected just one-fifth of rents owed by retail tenants in April, its executives said earlier this year."
Analysis of management structure and leverage, Vident Financial