Brookfield caught in U.S. meltdown

http://www.theglobeandmail.com/servlet/story/RTGAM.20080915.wbpo0915/BNStory/Business/

Analysts are downgrading their recommendations on Brookfield Properties following the announcement its largest tenant, Merrill Lynch & Co., is being acquired by Bank of America Corp. for $50-billion (U.S.).

The purchase has caused speculation Merrill’s offices will end up being scaled back or relocated.

Compounding the issue was Monday’s filing for bankruptcy protection by investment bank Lehman Brothers Holdings Inc., with both situations expected to exacerbate the slowdown of the Manhattan office market.

The deteriorating state of the U.S. financial services sector is being felt by Manhattan’s largest office landlords, including Brookfield Properties Corp., which is half-owned by Toronto-based Brookfield Asset Management Inc.

“While we continue to believe in the quality and long-term potential of the company, we expect it may be difficult to generate above-average returns when faced with what is likely to be an accelerated deterioration of fundamentals in [Brookfield Property’s] core Manhattan market,” Karine MacIndoe, analyst at BMO Nesbitt Burns Inc., said in a research note.

Ms. MacIndoe downgraded her recommendation on the stock to “market perform” from “outperform.”

Brookfield Properties owns more than 20 million square feet of office space in downtown and midtown Manhattan, and dozens of other top-tier skyscrapers in cities across the United States and Canada.

The company’s shares plunged on Monday alongside those of other major New York City office landlords, including SL Green Realty Corp. and Vornado Realty Trust.

It has already been a tough year for Manhattan real estate, with big blocks of office space coming available due to corporate cutbacks and planned relocations to less expensive buildings.

These circumstances led to “rocky” conditions in the New York City office market in the second quarter of 2008, according to a report by commercial real estate services firm Colliers ABR, Inc.

The over-all vacancy rate for office space in New York City rose to 8.7 per cent in the second quarter of 2008 from 7.8 per cent in the first three months of the year. It is expected to climb to almost 11 per cent by the end of 2008, Colliers said.

An issue specific to Brookfield Properties is the fact that Merrill is its largest tenant, accounting for 9 per cent of its total commercial property revenues, Sam Damiani, analyst at TD Newcrest, said in a research note.

“We view the takeover of Merrill as increasing the chances of Brookfield having to deal with a large vacancy in 2013, which combined with recent office market weakness will likely result in higher costs to re-lease the space, and potentially at reduced rents,” said Mr. Damiani, who cut his stock recommendation to “hold” from “buy,” and his 12-month target price to $22 from $24.

Most of the 4.9 million square feet of office space Merrill rents from Brookfield are at its World Financial Centre office complex, a lease that expires in September, 2013.

Excluding space sublet to other tenants, the rents on space Merrill occupies itself account for 6 per cent of Brookfield’s commercial property revenues, Mr. Damiani added.

For 2007, Brookfield reported commercial property net operating income of $1.3-billion, up from $836-million in 2006.

Brookfield Properties had no comment regarding its lease with Merrill or the state of the New York City office market, said Melissa Coley, vice-president of investor relations and communications.

Both Lehman and Merrill also own large commercial property portfolios which could end up being sold, putting further pressure on Manhattan property values, Ms. MacIndoe said.

A silver lining for Brookfield Properties is the fact that Merrill is co-owner of Tower 4 of the World Financial Centre. This could give Merrill some “incentive” to optimize the building’s value, providing Brookfield Properties with leverage when renegotiating its lease, Mr. Damiani said.

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