Real estate investment trusts (REITs) have a number of ways they can grow their businesses, each of which has to compete for precious capital. Open-air shopping center landlord Brixmor (BRX 0.66%) has around $1 billion worth of high-return spending in its pipeline -- and it blows the doors off new construction. Here's what you need to know.
There's a big problem for REITs when it comes to growth. In exchange for avoiding the double taxation of dividends, the REIT corporate structure requires passing at least 90% of taxable earnings on to shareholders as dividends. (Those dividends get taxed as if they were regular income at the shareholder level.) That means there's not a whole lot of cash left over for growth spending. So REITs have to tap the capital markets for capital, either by selling stock or issuing debt.
Cost of capital winds up being a very important metric. But that plays against the returns that can be achieved by the various forms that growth spending can take. The lower the cost of capital, the lower the expected returns a REIT can accept when investing. Right now, strip mall REITs like Brixmor are in a bit of a quandary on the return front because pricing for grocery-anchored properties is pretty aggressive. The REIT is finding assets to buy, but they are one offs, often with a bit of a value tilt (more on this in a second).
Construction is another option, but building from the ground up can be a long and costly process. Which is why it's so important that Brixmor has a large pipeline of redevelopment projects, a third growth option, ready to be built within its own portfolio. The size of the pipeline? Roughly $1 billion, but it expects there to be more beyond that in the future. That's partly because when it does buy a new asset, it is paying top dollar but finding properties where there are opportunities to improve the expected returns. That can be as simple as increasing occupancy or by redeveloping or upgrading the property to augment its rental footprint.
How good is this opportunity?
So the big question here is how much value can Brixmor add as it redevelops the properties in its portfolio? CEO James Taylor laid it out pretty well during Brixmor's third-quarter 2021 earnings conference call:
We also delivered another $52 million of reinvestment in the quarter at an average incremental return of 10%, creating over $34 million of incremental value. As we've observed before, to create the same amount of value [from] ground-up development, we would have had to deliver over $200 million or four times the investment at much higher risk.
That makes the company's billion-dollar backlog of work a huge money maker and very hard for other forms of investment to compete with. But why is the REIT bothering with acquisitions if it has so much redevelopment opportunity? The answer is simple: Buying new assets that need a little love, even if they come at a dear price, allows Brixmor to keep putting redevelopment capital to work at high rates of return. That improves the returns on the specific asset and allows Brixmor to keep investing for the future at the same time. Notably, it can sell updated properties that have appreciated in value if it wants to raise some capital for other purposes, like doing more high-return redevelopments.
It's kind of a virtuous cycle, all driven by the backlog, which Brixmor is looking to keep fresh with new capital investment opportunities. The goal is to spend around $150 million to $200 million a year on redevelopment, so the current pipeline could last around a decade. Longer if it can find the right acquisitions. That's a material amount of long-term growth built right into its portfolio.
The best part
For investors, meanwhile, the best piece of the story is that redeveloping a property that Brixmor already owns is a pretty low-risk endeavor. Between 2016 and 2020, the REIT completed 166 projects at a cost of $542 million with a return of around 11% and an average project size of just $3 million. Three million is a rounding error for a company like Brixmor with a market cap of $7 billion. Considering the 4% yield and a 10-year $1 billion pipeline of redevelopment projects, investors looking for a grocery anchored strip mall REIT would do well to take a close look at Brixmor today.