Downtown Manhattan office rents are hitting new highs, and that is great news for Brookfield Properties ( BPO), one of the largest owners in the market. The spiking rents won't immediately boost earnings much, since Brookfield has few leases turning over next year. Nonetheless, the resurgence of downtown Manhattan from the gloom of the World Trade Center terrorist attacks significantly increases the value of Brookfield's properties in the market. About half of Brookfield's national office portfolio profits come from New York City, while good chunks also come from Washington, D.C., and major cities in Canada. The Trizec purchase provides the company with a significant Los Angeles presence. Asking rents are currently above $60 per square foot at Brookfield's downtown Manhattan properties, which include the four-tower World Financial Center, One Liberty Plaza and One New York Plaza (purchased from Trizec), says David Cheikin, the company's downtown office leasing broker. Downtown market rents were $30 per square foot in the third quarter of 2006, according to Brookfield's last earnings report. "The majority of the resurgence is midtown to downtown," says Frank Cento, a leasing broker with Cushman & Wakefield, who adds that a wide variety of financial services and law firms are returning downtown as space availability grows scarcer in midtown.
Brookfield owns some of the most top-notch office product downtown, where high-quality "Class A" space remains scarce. Brookfield, therefore, is "in a position where they can sit and wait" to grab healthy rents on new space, Cento says. The rub on Brookfield, however, is that its office portfolio has less lease turnover, or "rollover," each year than some other office real estate investment trusts, so the company can't immediately capture the increased market rents with new leases. "Their strategy is to have fairly long-term leases, which has fantastic results in down markets, but in up markets it means a company like Brookfield will trail its peers," says Cedrik Lachance, an analyst with Green Street Advisors. Brookfield's portfolio averages about 2% to 3% turnover each year, compared with the 12% to 15% average for office REITs, Lachance says. The company currently has about 1% of its downtown leases turning over in 2007. The Trizec portfolio, which Brookfield purchased for $8.9 billion with the Blackstone Group last year, offers higher national rollover for the company, with the exception of the downtown New York property at One New York Plaza. As the downtown market heats up, Brookfield could potentially change its strategy to that of SL Green ( SLG), another New York-focused REIT. SL Green also has low annual rent rollovers, but it allows more of its tenants to terminate leases, since it can re-rent the space at much higher prices.
In fact, Brookfield pursued the SL Green-like strategy recently with tenant Royal Bank of Canada. The bank signed a lease for 200,000 square feet at Brookfield's 3 World Financial Center, according to market sources. The bank is keeping three of its existing five floors of leased space at Brookfield's One Liberty property, but Brookfield is taking back two floors totaling about 120,000 square feet, sources say. The good news for investors is that the spiking office rents will eventually find their way into Brookfield's leases in some fashion. And from a valuation perspective, the perceived higher markets rents help justify valuing the company's properties on a higher per-square-foot basis. Cap rates, or initial rates of return, in midtown for high-quality office space are now below 4%, with downtown being about 50 basis points higher. (Lower cap rates translate into higher property prices.) Using the latest fourth-quarter market-cap rates from Cushman & Wakefield/Real Capital Analytics, TheStreet.com estimates that Brookfield deserves a 5% average cap rate for its national portfolio. At this cap rate, the stock has a net asset value of about $42 to $43, according to our estimates. Shares closed Tuesday at $41.42. On a comparable valuation level, Brookfield trades between owners of higher-quality space, such as SL Green, and names with lower-quality properties, such as Brandywine ( BDN).
So the valuation looks sensible, but not super-cheap. The Trizec portfolio offers significant opportunities to Brookfield. Since the Trizec deal was announced last spring, cap rates and real estate prices have risen in New York and in other parts of the country, says Dean Frankel, portfolio manager with Urdang Securities Management, which owns the stock. So it's not a stretch to say that Brookfield has already added value to that portfolio, he says. Rather than sell some of the Trizec assets, the company decided to issue equity at the end of 2006. Brookfield, with its $9.4 billion market cap, could also benefit from two fund flow issues: investors cashing out of $17.4 billion market-cap Equity Office ( EOP), which is going private, and investors looking for a stake in international real estate. Brookfield not only owns properties in major cities of Canada, it also is based there (although the stock also trades on the NYSE). So technically, Brookfield may fulfill "global real estate" mandates of pension funds and other institutions, Frankel says. And if a competing bid for Equity Office occurs above $50 (compared with the $48.50 current bid), this would give an extra boost to Brookfield as investors flock to the idea that office REITs may be underpriced relative to where the properties would trade on the private market.