Brief Market Background
Over the last one year, there has been a precipitous drop in the share price of retail REITs due to negative news about the retailers (department stores and some smaller retailers in particular):
MSCI US Retail REIT Index
However, retail REIT fundamentals still remain strong when looking at the occupancy levels (generally all are above 90% leased and have maintained occupancy) and re-leasing spreads:
Source: Bloomberg; BRX Company Presentation
There has been a lot of talk about Macy’s (NYSE:M), Sears (NASDAQ:SHLD), J.C. Penney (NYSE:JCP) and so on closing stores, but not much comes out in the press in terms of the positive space absorption the sector has seen and demand still outpacing supply as seen from the charts below:
Source: JLL Q4-2016 Retail Outlook
Source: JLL Q4-2016 Retail Outlook
For every store closing, there have been numerous other retailers that are looking to expand as seen below:
Source: BRX Company Presentation
Finally, regardless of the chatter about how online shopping will kill all retailers and retail landlords, 91.5% of shopping representing $1.14 trillion still happens in brick and mortar stores, and that segment has seen a 4.3% growth rate from Q1-2016 to Q1-2017.
With the above in mind, I believes that the retail REIT sector is trading more on a headline basis and the market ignoring the underlying fundamentals. I believe that while online shopping will take more market share in the future, but with overall sales increasing, brick and mortar and online shopping will coexist and complement each other.
Comparing Some REIT Stocks In The GAVOR REIT Segment
There are various sub-sectors within the retail REIT segment, including malls, outlet centers, net lease retails, and GAVOR (grocery anchored and value oriented retailer). In general, stocks in all these segments have fallen down sharply. But in this article, I compared a very small subset of three REITs in the GAVOR sector on various quantitative attributes. The three REITs compared are Kimco (KIM), DDR (DDR) and Brixmor (BRX).
I picked the GAVOR sector as it is considered one of the most internet-resistant and wanted to balance the (headline) risk and reward available in the sector. I picked KIM, DDR and BRX as these are some of the largest REITs in the GAVOR sector and offer a lot of diversity in terms of number of properties and geographic dispersion.
Below is a chart comparing the three REITS:Source: Company filings
In the above chart, I tried to come up with a capitalization using the right side of the balance sheet as it would imply what the public markets are implying. The basic premise is that in a balance sheet: Asset (A) = Debt (D) + Equity (E). Generally speaking, for a well-diversified REIT with long term leases, one can say that the Asset side of the balance sheet is fairly stable and should not move on a day to day basis, but the same cannot be said about the Liability side as the Equity prices move constantly based on factors that may or may not be relevant to the underlying real estate. This dynamic creates an opportunity from time to time, and sometimes the Asset side becomes cheaper compared to the Liability side and vice versa. My goal was to understand this discrepancy and take advantage of the same.
In the chart above, the top section of the table shows the Capitalization (D+E; including preferred equity if any), adjusted for each company’s portion of JV debt and cash. The next section shows some basic Property Portfolio statistics including # of properties, square footage owned, rents and occupancy. The next section shows portfolio NOI followed by a section of Miscellaneous Stats. The idea behind collecting this information is to compare the three REITs on the following criteria (highlighted in green above):
- Debt / Capitalization,
- Basis ($/sf) based on the current stock price (Basis = D + E, where E is the public market capitalization),
- Base Rent ($/sf) and releasing spreads,
- NOI and Recent NOI growth rate,
- Implied Cap Rate calculated using NOI and Basis,
- Ratio of Basis to Rent and
- Secured Debt as a % of Total Debt; Fixed Rate Debt as a % of Total Debt.
Based on the criteria described above, I believe BRX is best from a quantitative point of view for a few reasons. First, BRX is trading at an attractive cap rate of approximately 8% (at 92.5% occupancy), Basis is $134/sf and has a modest 52% Debt to Capital ratio. Second, Basis/Rent ratio is 10.2x, which is cheap compared to the other two REITs (12.9x for KIM and 12.3x for DDR). Third, the Base Rent (13.12/sf) is the lowest among the three REITs and releasing spreads have been generally good, implying good upside available to investors. Note that this does not mean that KIM or DDR are not attractive; the idea was to pick the best on the above mentioned criteria only; there may be qualitative factors that might make KIM or DDR more attractive than BRX.
Before I go into too much detail about BRX, let me give you a brief background about the company.
BRX Company Background
BRX is a retail REIT that owns and operates one of the nation’s largest portfolios of open-air shopping centers, with more than 500 properties located across 38 states. Tenants include grocers, value retailers and consumer oriented service providers, well suited for today’s consumer environment. Below is a snapshot of BRX:
Source: Brixmor Company Presentation
BRX has a very stable rent roll for various reasons. First, the rent roll is very granular with no tenant representing more than 3.3% of revenues. Second, 70% of the shopping centers are occupied by grocers, which are considered internet-resistant. The average grocer sale is $550/sf (36% above national average), and 90% of the grocers have an occupancy cost (rent/tenant sales) of less than 3%. Third, most of the top tenants are investment grade rated and generally in expansion mode. Fourth, BRX has minimal exposure to department stores like Macy’s, Sears and J.C. Penney, which have been closing stores. Sears occupies 2.1% of the space and generates 0.8% of the revenues, and only pays $4.33/sf in rent vs. $8.86/sf for the top 20 tenants. So even if Sears goes under, BRX can recapture the space, lease it up and generate higher revenues from the recaptured space.
Source: BRX Company Presentation
BRX Management has been smart about working on only projects that yield higher IRRs and not looking to do ground up new development due to lower yields in that segment. Seven projects have been delivered as of Q1-2017 totaling $15M at an NOI yield of 14%; $217M of projects in process with average expected NOI yields of ~10%. Management has identified a pipeline of approximately $1 billion of projects ($150-200 million annually) that will drive future NOI growth. It should be noted that BRX has a 50% FFO ratio (5.5% dividend yield) and expects to fund the capital projects with cash flow only, without having to raise debt or equity capital.
Source: BRX Company Presentation ; BRX Company Presentation
Financial Model Summary
Based on the information provided in the public filings of BRX, I tried to come up with a financial model using the methodology used by private equity investors to calculate returns (IRR/Multiples) for a real estate investment. The goal was to understand the impact of following attributes on returns:
- Share price
- NOI growth rate
- Lease up: occupancy and rental rate
- Rollover schedule and associate TI/LC costs
- Impact of interest rates and deleveraging of the balance sheet
- Redevelopment potential
- Partial sales
- Exit cap rates
Before diving into the assumptions and cash flows, I would like to talk about the use of a cash flow model versus the traditional valuation metrics like P/FFO, NAV comparison etc. While easy to use and calculate, the traditional valuation metrics are simplistic valuation measures and do not account for any of the factors mentioned above. For e.g., REIT A can be at a 10x P/FFO and REIT B might be at a 9x P/FFO and one would pick Reit B on this measure. But what if RREITeit A is only 90% occupied vs 99% for REIT B, or what if REIT A has only 10% of the space expiring in the next 5 years vs. 50% for Reit B, or what if REIT A is only 50% levered vs. 75% for REIT B. In general, one would pick Reit B on a P/FFO basis, but REIT A provides better risk-adjusted return. A true cash flow model takes into account these nuances and gives better results.
I organized the assumptions into various assumption categories and looked at the Worst, Base and Upside case. Please note the following:
Existing NOI Assumptions: Starting NOI is calculated by annualizing the Q1-2017 NOI. Note that the model implicitly assumes that all maturing leases will be renewed at the then prevailing lease rates at expiration. In reality, BRX has been able to get significant positive spreads and hence is a source of upside.
Note that management has been guiding the following for NOI growth. In this model, I have not incorporated any growth due to acquisitions/capital recycling.
Lease Up Assumptions: BRX’s portfolio is about 92.5% leased currently. I assumed that over the next 3 years, occupancy will increase by 1.75% (1.5 million sf of additional leasing) such that stabilized occupancy is 94.3%. Note that Kimco is at 95.3% occupancy and DDR is at 94.3%. The rental rate, tenant improvements and leasing commissions are in line with what the company has been getting over the past 12 months.
Refinancing Assumptions: Existing debt is assumed to be refinanced at the current cost of debt (3.89%) plus the yield curve steepening assumption. For e.g., in the Base case, in one year interest rates are expected to go up by 0.25%/year, so any debt maturing in one year will have a rate of 4.14% (3.89% + 0.25%). Also note that in the Base case I am assuming only 75% of the maturing debt will be refinanced, with the remaining 25% being paid down by BRX. For e.g., if $100 million of loans/notes mature in a particular year, only $75 million will be refinanced with the company coming out of pocket with the difference. This assumption allows me to delever the balance sheet and in the Base case leverage goes from 52% today to about 42% over the next 5 years, with an average leverage of 47% during the hold period.
Operational Assumptions: Management has announced that they have identified about $150-$200 million of redevelopment projects annually to drive NOI growth. The redevelopment projects are being done at about a 10% yield. In the Base case, I assumed about $90 million of projects over the next 5 years at a 10% yield.
Capex Assumptions: The company provides the lease rollover schedule and tenant improvement, leasing costs in the Q1-2017 Quarterly Supplement. I used those figures and estimated the annual capex cost.
Exit Assumptions: Assumed a 60 month hold period and 7% exit cap rate. Note that it is assumed that in the Worst case, an investor will hold the investment for 10 years.
The financial projections were based on the assumptions shown above. Again, projections are shown for Base, Worst and Upside cases. Please note the following with respect to the Base case projections:
- The company pays $1.04/share in dividends or about $317 million/year. To approximately model this, I assumed that excess cash flow will be used to pay down the debt, such that the Levered NCF – After G&A is approximately equal to the dividend payment (4 year avg. = $307 million versus annual dividend of $317 million).
- In the Base case, NOI is expected to go up from $910 million currently to $1,071 million in 5 years or an annual growth rate of 3.3%. Note that sources of this growth are: ((i)) leases have contractual rent bumps, (ii) NOI added from redevelopments and ((iii)) modest increase in occupancy (of 1.75% in 3 years); company is expected to spend $987 million over a 5 year period in capex to maintain and generate the incremental NOI.
- A sales price of $174/sf is assumed (7% cap rate), which implies a Price/Rent ratio of 11.9x, which is still below where KIM (12.9x) and DDR (12.3x) are currently trading. Note that BRX traded at about $29/share not too long ago, which implied a Basis of $172/sf, Price/Rent ratio of 12.9x and an implied cap rate of 6.2%. So exit assumptions are reasonable and have been achieved in the past.
As explained above, I looked at three scenarios: Worst, Base, Upside case and the returns under the three scenario are shown below. Please note the following:
The returns are very attractive in the Base case and the Upside case at very modest leverage levels. The 18.6% IRR / 2.17x MOIC (multiple on invested capital) shown under the Base case are the type of returns (before fees) that private equity investors in the opportunistic commercial real estate space are trying to solve for, but at much higher leverage levels. In this case, the average leverage level is only 47%. Private equity investors typically use 60-65% leverage, and if that kind of leverage is used for BRX, returns will get amplified to about 24-27% IRR (shown in the green sections below).
The Base case returns assume a 7.0% exit cap rate versus about 6.5% cap rate prevailing currently in the private markets. If interest rates stay steady and the portfolio can be exited at a 6.5% cap rate, then returns go up from 18.6% / 2.17x to 20.9% / 2.38x.
I believe this to be an attractive investment, but I am a human being and what if I am completely wrong? The Downside case assumes a very draconian scenario and shows the “margin of safety” available in this investment.
The Downside scenario tries to quantify what kind of returns an investor can expect to generate in a draconian scenario. For e.g., the Downside case assumes existing NOI down 8.7% over a 10 year period (after BRX has spent $1.13 billion in capex over 10 years), occupancy drops by 2% over the next 3 years, 1% annual increase in interest rates for the next 4 years (10 Yr Tsy approx. 6.4%), 8% exit cap rate, etc. Under this scenario, the sales price at the end of 10 years will be about $118/sf (versus $134/sf implied by the stock price now) and an investor is expected to generate 4.8% IRR / 1.46x MOIC.
Base Case Returns Sensitivity To Stock Price
I believe that different investors have different risk tolerances and different cost of capital. Therefore an investment in BRX at about $19/share might be a good use of capital for one investor and may not be good enough use of capital for someone else. So below I provide a sensitivity to Base case returns at different stock prices.
What are the biggest risks to the above cash flow analysis?
I have prepared this report using readily available public information, without the benefit of talking to company management or doing extensive site visits to assess quality of the portfolio. Some of the major risk factors to the above and their impact on returns:
- Starting NOI
- Exit Cap Rate
- Tenant Defaults
1. Starting NOI
As explained above, I modeled starting NOI to be $910 million by annualizing the data provided by the company in Q1-2017 supplement. I did not adjust the NOI up or down based on dispositions and acquisitions that might have happened recently.
2. Exit Cap Rate
I assume a 7% exit cap rate for this analysis. But what if BRX’s portfolio is of weaker retail properties and should command a 7.5% cap rate?
To quantify the adverse impact of the above, I ran a scenario with a starting NOI of $880 million and a 7.5% exit cap rate, and in this scenario, Base case IRR fell from 18.6% to 15.0%, still yielding an attractive return.
3. Tenant Defaults
While there is always a risk that tenant defaults can/will occur in the future, but by taking a look at the top tenants it does not appear that BRX is that much exposed to the troubled department stores (like JCP or Sears) or to smaller tenants (like Ascena (NASDAQ:ASNA)). Also as shown above, the only troubled tenant in the top 20 tenant list appears to be Sears, which occupies 2.1% of the space and generates 0.8% of the revenues, therefore not a significant exposure. In addition, Sears only pays $4.33/sf in rent vs. $8.86/sf for the top 20 tenants. So even if Sears goes under, BRX can recapture the space, lease it up and generate higher NOI from the recaptured space.
Nevertheless, tenant default is a big risk when buying retail properties, and I do not purport to be a retail expert and cannot say when will a particular retailer will go under. The best I can do is assess what happens to returns if BRX loses tenants due to defaults or otherwise and accordingly ran a scenario which assumed that BRX loses occupancy by 3% (92.5% to 89.5%) over the next three years and does not increase occupancy after that.
Combining all of the three negative scenarios above, Base case IRR fell from 18.6% to 12.9%, still a respectable return in this environment.
How Can BRX Management Create Value?
Management has a herculean task in front of them and have been doing the right things. But a few simple actions (which again might be easier said than done) can create immense value for shareholders if the management can pursue them:
- At the current stock price, the implied cap rate is about 8% with good growth prospects available to the company. Therefore, management should not look to buy new properties at the market rates of 6.5% cap rates, unless they think they can add value and increase cap rate above 8%.
- Management should absolutely buy some shares at these levels as the implied cap rate is 8% at the equity level and it is more attractive to buy its own equity than properties for now.
- Management could look to do joint ventures with private equity investors or outright sell a few properties at lower cap rates (around 6.0-6.5%) and use proceeds to pay down debt and/or buy the common equity. Author estimates that if BRX sells 10% of the NOI in a year at 6.5% cap rate, Base case IRR goes up from 18.6% to 20.5%. Note that the company may or may not be allowed to do such a thing due to REIT rules, but nevertheless show some embedded upside that can be achieved.
- G&A is about $90 million annually; the company has a large portfolio, so maybe this is fine, but management should look to reduce this if possible.
- Recent decline in retail REIT stock prices has created an opportunity for investors in public markets to acquire high-quality REITs and earn attractive returns.
- I analyzed BRX in more detail and prepared a cash flow model and concluded that under very defensible assumptions under the Base case, investors can expect to make a high-teens IRR.
- I am cognizant of the risks facing the retail sector, but even under some draconian scenarios, investors are expected to make a positive return in the long run due to strong NOI generated by BRX through a very diverse portfolio.
- I believe that at these prices, management should absolutely buy more shares with excess cash flows OR by modestly levering up the balance sheet OR sell some properties at lower cap rates and using proceeds to pay down debt and/or buy equity.
- Finally, there is no right or wrong answer in this analysis. I believe the framework provided above is a good way of looking at REITs and helps answer some of the questions related to the impact of certain variables on returns.
Disclosure: I am/we are long BRX, DDR.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Author is long BRX, DDR and KIM, the three stocks mentioned in the article