Description

Overview

If you can issue a mezzanine security to Brookfield for their office portfolio in Downtown Los Angeles with IRR that range from 15-67% tied to a 2018 through 2023 payback of the preferred and accrued dividends, would you? 

This is the essential question surrounding the Brookfield DTLA 7.625% Series A Preferred.  Back in 2013, Brookfield acquired MPG Office Trust.  While the common were paid $3.15 per share, the preferred stock remains outstanding till this day.  The preferred stock accrues unpaid dividends, but the interest does not compound.  As of end of day today, the preferred trades at $25.45.  As of March 31, 2018, the preferred has $15.70 of accrued and unpaid dividend for a total liquidation value of $40.70 or 60% upside versus the trading price today.  The accrued dividend grows by $1.91, $0.48, and $0.16 per year, quarter, and month, respectively. 

Liquidation Waterfall

https://www.dtlaofficefund.com/~/media/Files/B/BrookField-DTLA/reports-and-filings/dtla-pref-investor-day-may-2018.pdf

Per the most recent presentation issued by the company for the DTLA preferred shareholder market update presentation, the waterfall for the company looks like this:

$3.623 bn gross RE value (Implies $143mm NOI @ 4.0% cap rate and a $483/sqft valuation)

-$1.991 bn mortgage (Adjusted for Mar 31, 2018 figures)

-$191 mm Senior B Interest

$396 mm Series A Interest (Adjusted for Mar 31, 2018 figures)

$387.8 Series A-1 Interest  (Adjusted for Mar 31, 2018 figures)

$657mm of Common Equity

This portfolio will generates about $143mm of NOI in 2018. See the investor presentation here for additional details.

IRR Analysis

The implied following table illustrated the IRR associated with various Payoff period for the preferred

We can see that investors can earn an IRR that range from 14% to 135% depending on the holding period.  Why did we pick 2023 as the likely end date?

1)    Brookfield took on additional outside investors to acquire the office portfolio.  On October 15, 2023, the lockup period ends.  The outside investors are free to redeem their funds.  We believe this redemption clause will create a liquidity event for Brookfield to exit DTLA

DTLA elects to be treated as a REIT, hence any distribution to common holders will triggered payments to preferred

2)   

Additional Qualitative Factors To Consider For DTLA preferred

3)      Bulldog’s Investors’ two board members – After six quarters of non-payment, preferred shareholder can received two board seats as typical with preferred securities.  Andrew Dakos and Phil Goldstein have been elected as two directors to the board.  We have followed Bulldog for years for their activist campaign involving close end fund discounts.  We believe that we have the right activist watching our interest.  It is generally known that big companies like Morgan Stanley, Brookfield, etc do not want the reputational damage versus a small closed end fund manager whose livelihood depends on them remaining the CEO of a close end fund. 

4)      What is Downtown LA like?  Does it deserve the low cap rate?  The market has 20% vacancy.  We have become somewhat familiar with DTLA through our ownership of LAACO.  We have personally visited the area in the last two years during the Daily Journal meeting.  Our takeaway is that DTLA is clearly gentrifying.  They recently added a Nomad hotel and will add an Apple store.  They bought in a Wholefood and a high end mixed use apartment above it.  Walking and driving around DTLA, it is obvious that the area is fast changing.  Real Estate development in Los Angeles and California is difficult in general.  There are no new supplies of office towers in the work.  If anything, office towers are being converted into residential buildings.  We believe there is high likelihood of rent growth and occupancy increases in the future.  In real estate investment, long term demographic trends can sometime overwhelm the prices you pay.  If an area is gentrifying, it tends to solve issues of paying low cap rates.  At the preferred prices of $25.45 today, we are creating this portfolio at 5.3% cap rate.  The existing leases has 2-3% escalators built in.   We believe that NOI will increase from $143mm to over $160mm in the next 5 years without any increases in occupancy.  At $160mm of NOI, the cap rate would have to be over 6.0% for the preferred to be impaired. 

5)      Replacement Cost – At the $2.66bn valuation implied at the preferred trading price today, we are buying the portfolio at $358 per sqft.  From my personal experience, this is likely way below the replacement cost of the building structure alone without any assignment to the land value.  This is important as it deters new supply coming into the market that would be of similar quality.  New supplies would have to be built assuming rent in the $40-50/sqft range to justify the kind of replacement cost for the DTLA portfolio.   

6)      Tenants Finding Lowest Cost – Over time, tenants tend to find the most affordable office product.  We believe that DTLA’s portfolio exhibits these qualities.  We have personally noticed how tenants arbitraged the delta between Midtown and Midtown South following the Great Recession.  The delta in rent was too high that Google, FB, and other tech companies set up shop and now Midtown South rivals the rent of Midtown.  We believe that overtime, the $25/sqft of rent for office products in Los Angeles will be arbitraged away as well. 

7)      Brookfield has improve the quality of the buildings since the acquisition including an extensive lobby and common corridor renovation for Wells Fargo Center and a $61.3mm renovation of the retail atrium and plaza underway with completion in 2019.  The Gas Company Tower’s lobby was also extensively renovated in Q2 2017 including the creation of an outdoor amenity space.  The retail center of FIGat7th was renovated in 2012 and a Nordstrom Rack opened in October 2017 to much fanfare.  If you want to understand how Brookfield adds value, go visit Brookfield place in New York City.  Most New Yorkers would remark about how Brookfield totally transformed the old awkward World Financial Center into a thriving Live Work Play destination worthy of a special trip.   

Risk

The portfolio currently does not generate much excess cashflow

1)      Cap Rate expansion

2)      Trends reverse in DTLA 

3)      Occupancy declines

4)      Interest rate rises sharply

Catalyst

1)      Excess cashflow that must be paid out due to REIT status triggered payment of the preferred accrued dividends

2)      Outside investors redeeming capital leading to payment to preferred

3)      Bulldog pushes Brookfield to pay distribution