There is a perverse pleasure in the prospect of proving a contrarian wrong.
Take, for example, the schadenfreude that swept skeptics when Brookfield Asset Management, the giant Canadian alternative-asset manager, bucked conventional wisdom with huge bets on shopping malls and office buildings — just as e-commerce and Covid-19 were wreaking havoc with commercial real estate.
The naysayers predicted a jolting end to Brookfield’s two-decades-long streak of 20 percent compounded annual returns. The chorus grew even louder after BAM shut down its publicly listed real estate subsidiary and bought back its shares from investors at a steep discount.
But a glance at BAM’s earnings reports over the past year and a half shows no slowdown. And Brookfield continues to raise record funds for its ongoing brick-and-mortar projects.
BAM executives can pat themselves on the back for some adroit management and financial measures that kept the firm on an upward course. Chief among them are a low debt load and a pile of cash to weather the economic storms ahead.
More surprising, though, BAM was also able to count on help for its priciest real estate projects from its strongest competitors: shopping mall giant Simon Property Group and alternative-asset leader Blackstone.
BAM executives brag that their best investments are those that just about everybody else considers terrible. In fact, Brookfield’s corporate culture encourages staff to avoid the seduction of growth companies in favor of longer-term investments.
“Often you can buy assets for less than their intrinsic value,” says BAM chief executive officer Bruce Flatt, sounding more like Warren Buffett than an alternative-asset tycoon. “So we try to hire and train people to become value investors.”
BAM is far more than a real estate enterprise. Thoroughly diversified across renewable energy, insurance, private equity, and credit, it is also the leading asset manager in infrastructure, with projects circling the globe.
But real estate remains its largest business, accounting for more than a third of BAM’s $725 billion in assets under management. And nationwide, the real estate sector faces strong headwinds in the months ahead. Rising interest rates and fears of recession are already undermining commercial property sales.
Brookfield has had to grapple with problems of its own making, too. The public listing of its real estate subsidiary Brookfield Property Partners, or BPY, in 2013 surely rates as its worst misstep.
BAM has had more success with the public listing of its other subsidiaries, covering infrastructure, renewables, and a host of businesses. The fee-earning capital raised by these subsidiaries is supposed to last forever, without any pressure to liquidate or have investors pull out.
“Their holy grail is permanent capital,” says Samuel Smith, vice president of Leonberg Capital, a Dallas-based investment boutique specializing in alternative-asset classes. “It’s a very stable income stream for Brookfield.”
But in the case of BPY, forever lasted only about eight years. “Its structure flew in the face of the dictum that the market likes simple stories,” says Joseph Pagliari, a real estate professor at the University of Chicago Booth School of Business. BPY was a Bermuda-based partnership, 60 percent owned by BAM, rather than being a C-Corp or a real estate investment trust. And its holdings were an unholy mix of malls and office buildings — the property types that suffered most during the pandemic.
BPY failed to perform well throughout its publicly listed existence. In some years, parent company BAM’s share price rose six times as much as BPY’s.
“The whole purpose of being publicly listed is to grow the share price, raise capital, and make acquisitions,” notes Brian Kingston, chief executive of Brookfield’s real estate group and former head of the now-defunct BPY. “But the stock persistently traded at a discount to what we thought was the underlying value of the real estate.”
So last year, BAM privatized BPY in a $6.5 billion cash and stock deal. By Kingston’s reckoning, that amounted to a 30 percent discount on real estate holdings worth more than $80 billion. As a bonus, Brookfield no longer had to worry about quarterly earnings or investor impatience over projects that might take years to generate returns.
“It was smart of Brookfield to unplug the public spotlight on its office and mall businesses in order to address challenges in a more private setting,” says Michael Knott, a REIT analyst at commercial real estate analytics firm Green Street.
But CEO Flatt concedes that the privatization of BPY has left the firm overexposed in real estate. “We are liquidating that excess real estate to return capital and do other things,” he says, citing Brookfield’s insurance business and planned acquisitions of technology firms as examples.
In the meantime, shopping malls are the biggest challenge inherited from BPY. The rise of Amazon and other online retailers led Brookfield’s main alternative-asset competitor, Blackstone, to invest heavily in e-commerce-related warehouses. In a massive contrarian wager made between 2016 and 2018, BPY acquired a portfolio of commercial properties — mainly shopping malls — known as GGP, with a market value of more than $15 billion.
Brookfield became the owner of 125 malls — out of a total of about 1,100 in the U.S. — sprawling over the equivalent of 16 square miles. The acquisition placed Brookfield in direct competition with the mall market leader, Simon Properties Group, just as increasing numbers of shoppers were staying home and making their purchases online. This trend accelerated with the advent of the pandemic.
Malls are most vulnerable when their anchor tenants are endangered. The big stores drive foot traffic to other, smaller retailers in the malls. “For a landlord, an empty anchor tenant is a catastrophe,” says Mark Cohen, director of retail studies at Columbia University Business School and former chairman and chief executive of Sears Canada.
Not only does a failed anchor deprive the landlord of income, it can also enable the other retail tenants to leave — because they have kick-out clauses in their leases — or force the landlord to renegotiate their tenancy contracts.
JCPenney is the largest anchor store in the malls owned by both Simon and Brookfield. At its peak, a half-century ago, JCPenney owned more than 1,600 department stores. Today it operates 640 stores, including 100 in Brookfield malls and 69 in Simon malls.
So when JCPenney declared bankruptcy in 2020, Simon and Brookfield rushed to acquire it for $1.75 billion, including debt — each taking a 42 percent share. For the two largest rivals in the mall space to share ownership of their biggest anchor tenant is “unprecedented and based on expediency,” says Cohen.
Under the rescue plan agreed on by Simon and Brookfield, the JCPenney stores will be restocked with more-attractive brands like Brooks Brothers, Aéropostale, and Forever 21, supplied by a third partner — Authentic Brands Group, which has the remaining 16 percent share. Though e-commerce won’t disappear, the partners are gambling that most shopping will continue to take place in stores.
Brookfield isn’t counting just on a revitalized JCPenney. It is aiming to transform so-called A-rated malls — those in high-density, upscale neighborhoods — into a combination of shopping centers, entertainment destinations, and multifamily residential buildings.
The top-50 A-malls make up about 85 percent of the value of Brookfield’s retailing portfolio. “And that’s where we spend most of our time,” says Kingston.
As an example of a successful A-mall conversion to multiple uses, he cites the Cumberland Mall in affluent northwest Atlanta. It’s located at the intersection of two major highways and directly across from the Atlanta Braves’ stadium. When the mall’s JCPenney store closed, Brookfield replaced it with a new Costco. Last year, that anchor tenant recorded $225 million in sales — making it one of the most profitable big-box retailers in the entire country.
Cumberland Mall’s Sears outlet also shut its doors, and that space was redeveloped into Round 1, a bowling and amusement facility. Brookfield has started a multifamily residential project in the remaining mall space.
Although A-rated malls account for most of Brookfield’s retail activity, the firm is also stuck with dozens of B and C malls. These malls didn’t start off that way. Typically, they lost their anchor tenants to newer, nearby malls owned by rival landlords. A reduction in foot traffic and plunging sales soon followed.
Brookfield placed several of these flailing malls in voluntary foreclosure, and the firm is trying to find other uses for at least part of their retail space. Most of these B and C malls are located in low-density neighborhoods unsuitable for multifamily high-rises. Brookfield is exploring the possible conversion of some of these malls into medical centers by taking advantage of their access to nearby highways and ample parking spaces.
But one such project — the replacement of a Sears store with a medical facility at a Brookfield-owned mall in Bensalem, Pennsylvania — was abandoned because of its doubtful profitability.
As another possible way to restore profitability to B and C malls, Brookfield is seeking to integrate e-commerce with brick-and-mortar. The same strategy has proved successful at Walmart and Target.
Shoppers buy online and use the store as a fulfillment center to pick up their purchases — or to cancel an order at the last moment should they change their minds after viewing the goods. For Brookfield, this hybrid approach cuts down on logistics costs by removing the need to deliver purchases to individual homes or to pick them up if they are rejected.
Brookfield is also hoping that the e-commerce tide has peaked. According to Jones Lang LaSalle, a global commercial real estate services company, internet purchases accounted for 14.3 percent of all retail sales in the first quarter of this year. That was down from 16.4 percent in the second quarter of 2020, when anxieties over Covid were running highest.
Throughout the pandemic, Brookfield has been on a firmer foundation with its office buildings than with its malls.
Deploying its trademark contrarian strategy, the alternative-asset manager pushed ahead with investments in pricey, upscale office towers even as increasing numbers of corporate employees worked from home.
And to ensure the success of its costliest recent real estate venture, on Manhattan’s far-west side, Brookfield invited archrival Blackstone to invest as a virtual joint venture partner in the project’s initial office tower.
The competition between the two alt leaders is fierce. Only three years ago, the firms ran neck and neck in total assets under management. More recently, Blackstone has galloped ahead and seems likely to reach a trillion dollars in AUM by the end of 2022 — several years before BAM.
But both sides see advantages in cooperating to ensure the success of Brookfield’s massive Manhattan West project.
Sprawling across eight acres next to Hudson Yards, it will eventually comprise six towers, including 7.5 million square feet of offices, 850 luxury apartments, and 300,000 square feet of retail and hotel space. Qatar’s sovereign wealth fund, the Qatar Investment Authority, holds a 44 percent stake in the $4.5 billion project, which is scheduled for completion in 2023.
“Whenever we have investors in town, this is what we take them to see,” notes Kingston.
The first of the properties to be completed, in 2019, was One Manhattan West. The 67-story office tower was fully leased by the end of 2021, with prominent tenants like the National Hockey League and Ernst & Young. At that point, Brookfield decided to lighten up on its capital and held an auction for a 49 percent share in the building.
In March of this year, Blackstone claimed the stake with a $1.4 billion winning bid that valued the building at $2.85 billion, or almost a billion dollars more than its development cost.
It wasn’t the usual real estate deal for Blackstone, which makes most of its property investments in e-commerce fulfillment centers, rental housing, hotels, and life science office space. “When you look at the scale of our overall global real estate business, U.S. traditional office is a very small percentage of that portfolio,” explains Nadeem Meghji, head of Blackstone’s Real Estate Americas.
“But One Manhattan West is the quintessential office building of the future,” he adds, citing its upscale amenities for tenants, energy efficiency, and proximity to public transportation. “We also like the fact that it’s fully leased and produces predictable, steadily growing income.”
In this post-pandemic era, when stay-at-home employees must be lured back to offices, One Manhattan West offers terraces, coffee lounges with views of the Hudson River, and latest-fad gym facilities. Just outside the building, there are lush green spaces, acclaimed restaurants, and luxury shops. Penn Station — the Manhattan train terminal for Long Island and New Jersey commuters — is only two blocks away.
For these attractions, plus higher energy efficiency, corporate tenants in Manhattan’s far-west neighborhood pay rents that are an average of more than 40 percent higher than in the traditional Midtown area, according to Colliers, a global commercial real estate services firm.
So why is Brookfield buying up older office towers in Midtown Manhattan if rents and occupancy there are falling? BAM insists that conventional wisdom is mistaken about the decline of Midtown’s appeal. “What is on the wane are 1950s-era buildings that don’t meet today’s standards,” says Kingston.
Testing this assertion is Brookfield’s investment in 666 Fifth Avenue. The financially troubled 41-story building, erected in 1957 and now owned by Jared Kushner’s family, struggled to attract tenants. In 2018, BAM purchased a 99-year lease on the building for $1.3 billion, leaving the Kushners with ownership.
The deal was tinged with political controversy. Some media coverage hinted that by paying what seemed to be an exorbitant total rent up front, Brookfield was seeking to ingratiate itself with the Trump administration. After all, Blackstone chairman and CEO Stephen Schwarzman, a longtime friend of the president, had emerged as the business community’s chief envoy abroad.
But the successful transformation of the building has quieted critics. When the $400 million renovation is completed, by the end of this year, the building will have a new glass façade, triple the window space, terraces on several floors, and a new address — 660 Fifth Avenue — to suggest a complete break with its past. It’s still an easy walk from Grand Central Terminal for Westchester County and Connecticut commuters.
In May, Brookfield inked a lease with the first tenant, Macquarie Group, the big Australian financial services firm. BAM expects other large corporations to fully occupy the building by next year.
Another Midtown building, Lever House, at 390 Park Avenue, drew its share of skepticism when Brookfield acquired its lease in 2020 for $250 million, in partnership with Waterman Interests. The iconic, 21-story building, completed in 1952, was considered more of a trophy property than an income generator. Some tenants complained that though the building offered architectural status and a fine street-level view, it failed to meet 21st-century corporate needs.
Brookfield is spending $100 million on a redevelopment that is scheduled for completion in 2023. A main feature is a tenant-exclusive “Lever Club” with a third-floor lounge for dining, socializing, and entertainment that extends onto a landscaped outdoor terrace overlooking Park Avenue.
Says Kingston, “It’s a jewel box of a building that will be perfect for family offices.”
Last year, BAM generated a record $12.4 billion in net income, rebounding from a $700 million loss in 2020. That included $1.2 billion in funds from operations in its real estate segment in 2021, up from $880 million the year before. (Brookfield uses FFO to report real estate earnings instead of the usual metric of distributable earnings adopted by other asset managers.)
In 2021, Brookfield raised $12 billion in new real estate funding. It has already matched that figure in the first half of this year and is hoping to end 2022 with a record $17 billion in real estate fundraising.
BAM also took advantage of the long period of low interest rates to refinance liabilities with fixed-rate debt at lengthy maturities. Inflation isn’t much of a concern, since its real estate and infrastructure assets have inflation adjustments in their contracts.
Flatt contends that neither the rapid rise in interest rates nor the increasing certainty of a recession is altering BAM’s business model.
“Any interest rates now being discussed by the Federal Reserve or the European Central Bank don’t bother us,” he says. “And we always expected a recession at some point and underwrite with that in mind.”
That optimistic assessment might not hold up if interest rates rise to 7 or 8 percent over an extended period. A growing number of BAM’s tenants and investors may not have the asset manager’s financial wherewithal. And the likelihood of a recession will put a crimp on investments across the economy.
But Flatt has experienced tougher times. His most renowned contrarian bet followed the 9/11 terrorist attacks. Although few investors believed the lower Manhattan neighborhood could quickly recover, Brookfield transformed much of the devastated acreage into a swank shopping and business complex, including its own New York headquarters.
Though Brookfield has taken some office space in its Manhattan West project, there are no plans to move most staff there. For one thing, there is too much money to be made from tenants.
Says Flatt, “The leasing market in those buildings is extremely strong.”