The last time we had the chance to cover Brandywine Realty Trust (NYSE: BDN) was all the way back in December last year in an article titled: “The Future Remains Uncertain”. In this room we expressed our appreciation for the various qualities that Office REIT possesses, but at the same time pointed out that the overall macroeconomic environment was not favorable to BDN and that secular social and economic changes posed a significant risk to the business model underlying.
Since then, the Philadelphia-based REIT has been hammered in the markets, with the stock price falling more than 53.8%. In our view, this creates an attractive value proposition, with our previously noted negatives already being slowly discounted into the stock price. BDN is selling near all-time lows, last time being similarly priced during the financial crisis. As of this writing, shares of the REIT can be purchased for just $6.57. In fact, the current valuation looks extremely compelling and the downside potential appears to have become significantly limited.
The real estate portfolio
Brandywine Realty Trust is one of the largest publicly traded office real estate companies in the United States, primarily focused on markets such as Philadelphia, Pennsylvania and Texas. It develops, rents and manages a real estate portfolio with an urban vocation.
The Office REIT was more diverse at the time, including owning a lot of real estate in the DC metro area, but has divested in recent years and focused on markets such as Philadelphia, developing projects such as Schuylkill Shipyards. In 2013, Brandywine Realty Trust operated 204 properties across the United States. This included real estate in the Washington DC metro area, New Jersey, Delaware, Virginia and California. The now excluded portion of the portfolio occupied 44% of total square footage and generated nearly 42% of BDN’s ROI.
According to the latest quarterly filing, the Philadelphia-based REIT owns and operates 74 properties totaling 12.99 million square feet. The portfolio is currently 92.1% let, while the actual occupancy rate is slightly lower at 89.6%.
The effect of the redeployment of the strategic portfolio can be seen in the current regional diversification. Brandywine’s 12 properties in Philadelphia represent nearly 35.5% of the portfolio and are currently leased at a very high rate of 97.5%. Its 34 properties in Pennsylvania occupy 29.7% of the portfolio and are 95.0% rented, as are the 20 properties in Austin, which occupy 20.3% of the real estate portfolio and are rented at a slightly lower percentage of 87, 4%. BDN is struggling to find new tenants for its 4 properties in Washington DC, but they occupy only 5.7% of the portfolio.
While the real estate portfolio remains heavily preoccupied with what they see as key markets, BDN remains well diversified, trying to avoid risk as much as possible in other regards. In terms of diversifying its roster of tenants, Brandywine has done a terrific job.
Their top five customers only get 16.9% of total annualized rent and 15.6% of total occupied square feet. Their main tenant is International Business Machines (IBM) which contributes only 4.8% of their ABR, followed closely by Spark Therapeutics (OTCQX: RHHBY) with 4.1% and Comcast Corporation (CMCSA) with 2.8 % of their ABR. Together, the twenty largest tenants occupy only 35.0% of occupied square feet and generate only 38.1% of annualized rents. Overall a very satisfactory composition.
Another bright spot on our books is the lease expiration schedule, at least in the short to medium term. In the third and fourth quarters of the year, only 4.1% of leases come to an end. This is followed by 23.9% of leases expiring at the end of 2025. Thus, around a third or a quarter of the portfolio “will be under pressure” over the next 14 quarters. It is some 3.55 million square feet that BDN will attempt to renew at a time when it has reached a retention rate of 70.3%.
Historically it has been much worse and hovered around 50% for a long time. Given the secular changes with the introduction of hybrid working and working from home, combined with the macroeconomic environment we find ourselves in, even if leases are renewed, it would likely be from a weaker bargaining position . Essentially, the combination will most likely result in heavy pressure on FFOs in the medium term.
We have already seen a downgrade in forecasts earlier this year due to the effect of rising interest rates. Management’s expectation for the full-year FFO range was revised down from $1.37-$1.45 per share to $1.36-$1.40.
And looking at our 2022 forecast. Tom will explain in more detail, but the bottom line is that our initial 2022 business plan calls for interest charges between $70 million and $72 million. We respected this assumption for the first half of the year. However, looking to the second half, due to rapidly rising short-term rates, our interest expense, including our share of joint ventures, will increase by approximately $0.03 per share. So while our operating plan remains fully on track based on rising interest rates, we are narrowing and adjusting our FFO range from $1.37 to $1.45 per share to 1.36 $ to $1.40 per share. And as I mentioned, Tom will elaborate on that in a moment. Based on our leasing activity and development spending in 2022, we continue to expect our debt to EBITDA range to be between 6.6x and 6.9x.
Jerry Sweeney, President and Chief Executive Officer – Second Quarter 2022 Results
However, this brings us directly to the question of valuation, which remains the most attractive aspect of BDN. The REIT generated $60.53 million in FFO in the second quarter, in line with the previous one. It comes in at $0.35 in FFO per share, which is also largely in line with results from previous quarters.
The REIT distributes just $0.19 in dividends per quarter, with an FFO payout set at 54.28%. Brandywine is currently trading at $6.57 per share and offers a very attractive dividend yield of 12%.
Brandywine Realty Trust is currently selling for an NTM P/FFO of 4.72x and an NTM P/AFFO of 7.01x. As we can see, this type of attractive value proposition is not unique within the Office REIT subspace. With the exception of a few of the biggest players in the industry like Alexandria Real Estate (ARE) and Boston Properties (BXP), most O-REITs have had a tough few years in the market and are trading at relatively low valuations offering high yields. .
For example, Piedmont Office Realty (PDM) has returned 46.17% YTD and is currently selling for an NTM P/FFO of 4.91x and an NTM P/AFFO of 7.98x. The New York-oriented SL Green Realty (SLG) has returned 48.43% YTD and is currently selling for an NTM P/FFO of 5.90x and an NTM P/AFFO of 8, 63x. All of these look quite attractive at their current valuations, especially compared to some of the more common options in other sub-sectors such as Realty Income Corporation (O), Rexford Industrial Realty (REXR), Digital Realty Trust (DLR) and others. Overall, while we think the market is correct in pricing the multiple headwinds facing office REITs, we suggest it might be somewhat overdone at this point.
Risks still present
The secular changes in the nature of the work that we anticipate over the next two decades will put significant pressure on the REIT and its ability to find new tenants after leases expire. Even if he succeeds in renting the properties, he will likely do so thanks to a relatively weaker negotiating position, which will lead to pressure on the top and bottom results. Brandywine does not operate on a triple net lease model and does not focus on single tenants, which makes them even more vulnerable to ongoing changes. The REIT’s over-focus on the Philadelphia, Texas and Pennsylvania markets could also prove to be a double-edged sword, depending on how resilient the two markets are to secular changes. Nonetheless, we feel comfortable with the level of risk associated with Brandywine Realty Trust at these price points.
Final Thoughts and Conclusions
Brandywine Realty Trust appears to be immensely valued, offering the potential investor a fascinating dividend yield of 12% sold at a multiple x4.72 P/FFO. In a previous article on REITs, I pointed out that it is doubtful that the discount is high enough given the problems the potential investor faces. At the time, the REIT was “only” offering a dividend yield of 5.62% accompanied by a P/FFO multiple of x9.92, and we didn’t like that risk/reward profile of the investment. . However, the risk/reward profile has undoubtedly changed since the last time we covered Brandywine. BDN’s current valuation almost appears to indicate that economic activity is going to come to a halt, losing pricing power on releases and forcing the REIT to cut or cut its dividend distributions entirely.
Even if something quite drastic happens with the dividend halving, it would still mean a return of around 6% for investors willing to consider BDN at $6.57 per share, more than three times the current dividend yield of the S&P 500 (SPY). This would in theory lead to further price declines, limiting total return and leading to capital losses, but for strictly income-oriented investors, who happen to be the majority of those considering REITs, we see potential for somewhat limited decline. In fact, we’re starting to look at desktop REITs at these discounts, and Brandywine Realty Trust in particular is starting to look very compelling.