Douglas Emmett, Inc. (NYSE:DEI) Q1 2023 Earnings Call Transcript May 7, 2023

Operator: Ladies and gentlemen, thank you for standing by. Welcome to Douglas Emmett’s Quarterly Earnings Call. Today’s call is being recorded. I will now turn the conference over to Stuart McElhinney, Vice President of Investor Relations for Douglas Emmett. Please go ahead.

Stuart McElhinney: Thank you. Joining us on the call today are Jordan Kaplan, our President and CEO; Kevin Crummy, our CIO; and Mona Gisler, our CFO. This call is being webcast live from our website and will be available for replay during the next 90 days. You can also find our earnings package at the Investor Relations section of our website. You can find reconciliations of non-GAAP financial measures discussed during today’s call in the earnings package. During the course of this call, we will make forward-looking statements. These forward-looking statements are based on the beliefs of, assumptions made by and information currently available to us. Our actual results will be affected by known and unknown risks, trends, uncertainties and factors that are beyond our control or ability to predict.

Although we believe that our assumptions are reasonable, they are not guarantees of future performance and some will prove to be incorrect. Therefore, our actual future results can be expected to differ from our expectations, and those differences may be material. For a more detailed description of some potential risks, please refer to our SEC filings, which can be found in the Investor Relations section of our website. When we reach the question-and-answer portion, in consideration of others, please limit yourself to one question and one follow-up. I will now turn the call over to Jordan.

Jordan Kaplan: Good morning, everyone. Thank you for joining us. Our revenue during the first quarter is up compared to the first quarter of 2022, but the increase was offset by higher operating costs and interest expense. The slowdown in the leasing pipeline that we mentioned on our last call, resulted in a decline in our lease rate, even though we actually signed more leases in the quarter than usual. We continue to have strong demand from tenants under 10,000 square feet who dominate our markets, but because larger tenants have become more conservative in response to recessionary concerns, we leased less total square footage. Accordingly, we have reduced our assumptions for average office occupancy and same-property cash NOI.

The national economy is challenging for all of us, but for some office CBDs, remote work, oversupply and overwhelming reliance on large tenants and concerns about reduced urban appeal seem to pose additional obstacles. As I have said before, our market supply constraints, smaller tenants, short commutes and low reliance on public transit supported relatively high leasing volume and utilization during the pandemic. As the pandemic eased, leasing in our markets was very strong until the fourth quarter of 2022 when larger tenants became more concerned about recession. While economic downturns are unpleasant, they are not new to us. We remain confident in the resilience of our portfolio and in our ability to navigate these challenges. We have guided our company through 4 recessions and always found the silver lining.

We repurchased 6 million shares of our common stock in late March and early April, and we are well positioned to take advantage of other opportunities created by the current economy. With that I will turn the call over to Kevin.

Kevin Crummy: Thanks, Jordan, and good morning, everyone. Our balance sheet and cash flow after dividends are strong. We have no outstanding debt maturing until December 2024 and almost half of our office portfolio remains unencumbered. We developed our debt strategy to protect our company during times like these. Our debt is all nonrecourse secured by first trustee mortgages at the property level. We have no corporate level debt and no corporate covenants. We have a perfect 30-year debt repayment record and are confident we will maintain it during this downturn. Our cash flow after dividends remains one of the best in our industry, and we use less than half of our AFFO for dividends, leaving us with substantial liquidity. Our multifamily projects continue to perform well and lease up at a good pace.

At Bishop Place in Honolulu, our office residential conversion project, we just delivered another floor of apartment units and expect to deliver 3 more floors by year-end. Only 2 unconverted floors will remain, which are currently leased by office users for several years. At The Landmark L.A. and Brentwood, we have now leased over 70% of the 376 new units that we began delivering in April last year. With that, I’ll turn the call over to Stuart.

Stuart McElhinney: Thanks, Kevin. Good morning, everyone. Smaller tenants continue to drive our leasing in Q1. We signed 235 office leases, covering 625,000 square feet, consisting of 168,000 square feet of new leases and 457,000 square feet of renewal leases. Our leasing spreads during the first quarter were positive 6% for straight line and negative 6.7% for cash. While this is somewhat better than recent quarters, we don’t expect to achieve meaningful gains in office rental rates until our lease rate begins to recover. Our leasing costs this quarter were $5.37 per square foot per year, which is a bit lower than recent quarters and well below average for other REITs in our benchmark group. Turning to multifamily. Our portfolio was 99.3% leased at quarter end, and rents continue to roll up across our portfolio. With that I’ll turn the call over to Peter to discuss our results.

Peter Seymour: Thanks, Stuart. Good morning, everyone. Turning to our results compared to the first quarter of 2022, revenue increased by 5.7%, reflecting the addition of new units to our multifamily portfolio, which has increased by 617 units and higher in-place office and multifamily rental rates. FFO decreased by 5% to $0.47 per share, primarily as a result of higher interest expense on our floating rate debt. AFFO decreased 13.5% to $81.4 million. Although our leasing costs per square foot remain low, we paid the tenant improvement costs this quarter to move in a large number of tenants with whom we executed leases last year. Same-property cash NOI decreased by 1.5% with higher rental revenue and parking revenue, offset by continued inflationary pressure on utilities and wages.

Our G&A remains very low relative to our benchmark group at only 4.3% of revenue. During late March and early April, we repurchased 6 million shares of our common stock at an average cost of $12.32 per share. Turning to guidance. As Jordan said, we are adjusting our assumption for average office occupancy, which we now expect to be between 81% and 83% for the year. We adjusted our expected range of same-property cash NOI growth to be between negative 1.5% and negative 0.5% and for straight-line revenue to be between $1 million and $3 million. These adjustments are offset by the benefit of our stock buyback. So our guidance range for full year FFO remains between $1.87 and $1.93 per share. For information on assumptions underlying our guidance, please refer to the schedule in the earnings package.

As usual, our guidance does not assume the impact of future acquisitions, dispositions or financings. I will now turn the call over to the operator so we can take your questions.

Q&A Session

Operator: And the first question will be from Alexander Goldfarb from Piper Sandler.

Alexander Goldfarb: So two questions. First, on the stock buyback, I believe you have a floating rate debt where the swaps burned off this year. So what are your thoughts on instead of the buybacks using that cash to pay down those floating rate loans to try and reduce the impact of rising rates?

Jordan Kaplan: Well, I mean, we have — I actually think the floating rate debt is at a good margin, and it’s pretty good debt. The question is just when do we want to re-swap it? I think there is going to become an opportunity to re-swap it. If you look a little longer out, not including this year, I think it swaps down back to a reasonable rate almost already. So I’m not anxious to use cash for that. I think there’s better uses for it, and that’s very good debt with a lot of time left on it. I’d like to mention something. In the lead-in to our call in Stuart section it said that Mona is our CFO, which actually, Peter is our CFO, so just behind the scenes is that Stuart doesn’t like to re-record his opening over and over again.

So he said, use my last one. He didn’t mean — use my last one from the dark ages. He actually just meant use my last one for like the last year. So they obviously pulled one from 4 years ago. But anyways, maybe nobody caught that except for us. Now what was your second question?

Alexander Goldfarb: And so the second question is, when we were out in Hawaii at the investor event, you were talking a lot about how Downtown L.A. tenants are moving to the West side, not enough space for all these tenants that are coming and yet you’re also talking about the large tenants being the weak spot in your portfolio. So small tenants, very active, large tenants, not active. And I’m just curious how we rationalize that if downtown L.A. tenants are moving to the West side, those — I would think, are larger tenants. So why wouldn’t we see some increase in large tenant activity in your portfolio as well?

Jordan Kaplan: So most of that increase has been reflected in Century City. They’re actually a bit larger than even we can accommodate. So now Century City, I think, almost all the 4 floors and the towers and some of those other buildings are gone, we don’t have a lot of blocks of space. To us, large tenant is 10,000 to 40,000 feet. And when you get over 20, that’s a full floor already, right? And so 10 to 20 is more — I mean, we don’t — we have full floor tenants, plenty of them, but nothing close to the way Century City operates. Now they moved in — a ton of them move to Century. I think Century City is very full right now. And we’re hoping that some will move in like Beverly Hills and West where are the other places where those people tend to head. And maybe there’s a little bit of activity there. But in those markets, we have not had the blocks of space that would have accommodated someone that’s looking for 50,000 feet when we just haven’t had it.

Alexander Goldfarb: Okay. But you would expect some spillover eventually?

Jordan Kaplan: Yes. Well, what I think is that more — there’s definitely tenants moving. I mean, you can look at the reports , some other reports of it. Tenants are moving from downtown to the west side. And I don’t know if it’s a — smaller ones there have a great reason to be there. They probably live over in Pasadena or in that area. And so it’s a big deal for them to make the hop all the way across. Now they might probably like these larger ones who are having trouble getting people to come into the office downtown. So they’re saying we’re moving. I mean, the anecdotal stories that I’ve heard is law firms that have called everyone back in and they’re saying, we’ll come back in, but we don’t want to be downtown. So they’re literally abandoning leases, are still paying on them and they are leasing space in Century City and they’re saying, okay, now everybody back in.

So that — I mean I don’t know that — I think there will be some spillover, I think, hope, whatever. But I mean, they’re definitely moving our way.

Operator: And the next question is from Camille from Bank of America.

Unidentified Analyst: Can we focus a bit more on what you’re seeing in the Olympic Corridor and Brentwood submarkets? What have the reasons — kind of it’s been saying to your leasing teams when they move out.

Stuart McElhinney: I mean, our tenants, as you — we’ve got almost 3,000 tenants and the list of reasons they move out is a long list. They’re growing, they’re shrinking, they’re partners retiring or they’re breaking off into 2 different firms. It’s a huge list of reasons. It’s kind of that same list of reasons that we’ve always seen. So no noticeable shift in — or trends to point to there. Some submarkets — you mentioned there some specific submarkets, I know we’ve had some movement around in some of the submarkets. But our submarkets are so small that they’re sensitive to small changes. So we really internally think it’s more useful to focus on in kind of our major regions, the West L.A., Valley and Hawaii because individual submarkets really can bounce around pretty easily with small changes.

Unidentified Analyst: Okay. And I guess as my follow-up question, the small tenants seem to be very active in your markets. Are you tracking enough demand to keep up this level of leasing momentum through 2023? And if you have any comments on your tenant watch list, if there’s been any changes following the recent events much appreciated.

Jordan Kaplan: Okay. So as we force shadowed last quarter, we saw the pipeline slowing down and it did slow down and you’re seeing it. So this is — if you’re asking me if it’s going to slow down more than this? No, we are not seeing that. We’re seeing this amount of activity, which is still a good amount of activity. I mean, over 600,000 feet, but not anything to what we’re used to which we want to be closer to 800,000. We want to be around 800,000 feet, and we did 4 quarter of 1 million feet. So it is substantially off, but I don’t consider — I don’t — we don’t view it as being able to go off a lot more. What was your second question?

Unidentified Analyst: If there’s been any changes to your credit tenant watch list?

Jordan Kaplan: There — so tenants are — I guess there’s 2 versions of that. So tenants are still chipping away and chipping away and paying that are kind of the hangover group from COVID, and that number stand down, down. I think the last time I saw that number, it was $17 million. And if you’re asking if more tenants are going on our watch list, yes, a little here and there, but not much, not noteworthy amount, no. And the credit of tenants is very good, and I don’t know if you would recall, but even in COVID, when almost 10% of our tenants weren’t paying because State said, you don’t have to pay. We kept saying that these people can all pay. That’s not going to be where we end up. I think where we are actually going to end up over the whatever, the 2 or 3 years of COVID is maybe like 20 basis points, forget about 10%.

I mean, it’s going to be almost nothing number. And the reason for that is, as we’ve said, it’s smaller tenants. They have very good credit. And by the way, they sign on the lease personally. So that — not a lot of default in our portfolio over the long haul, and I wouldn’t expect a lot right now.

Operator: And the next question is from Blaine Heck from Wells Fargo.

Blaine Heck: Jordan, several of your office REIT peers have expressed optimism this quarter around the return to office mandates that some of the tech companies that were really quick to go fully remote during the pandemic have now implemented. I know you guys don’t have much exposure to tech, but can you talk about whether you think this could be beneficial to the L.A. market in general and your portfolio in particular, maybe not from those tenants exactly, but others supporting kind of smaller tenants?

Jordan Kaplan: Yes. So I love seeing people come back to work, and I love seeing those tenants, bringing people back in. And I think it’s going to be — it’s very good for the economy and L.A. economy and all economies where large tenants don’t people stay at home and whether it be San Francisco or New York or anywhere. If you want to more specifically talk about our portfolio, I would love to say it’s going to be like a big deal and blah-blah, but we’ve been over 80% for a long time. Maybe we’re going to go to 100% or 95%. I don’t think it’s been getting in the way of leasing. I don’t think it’s been getting in the way of anything quite frankly. Even our parking, I know we — Ken sends me a little analysis of visitor blah, blah, blah.

And I mean we’re able to like more spot track it. It’s fast. And I noticed that on the last one, Ken sent me, our visitor is back to full, like back to the 100% level that it was pre-pandemic. So, I did — I’d like to say that would be a good benefit to us, but I actually think the entire issue that we’re facing is the — I don’t know if they want to call it a recession or whatever, the real estate recession that we’re having or the conservative way that people are approaching, expecting a real estate recession that’s caused a slowdown in leasing. I don’t think there’s anything else. I think it’s not dissimilar from the last 4 recessions that we’ve been in since we’ve been running this kind and — I’ve been running this company. And we have to work our way through the recession.

And as we come out of it, I’m sure we’ll come out extremely well.

Blaine Heck: Okay, that’s really helpful color. Switching gears real quickly to the investment front. Can you talk about any recent conversations you’ve had with your capital partners whether they’re willing and interested in acquiring office or multifamily assets and maybe what sort of return requirements or return targets that they have in this kind of environment?

Kevin Crummy: Blaine, it’s Kevin. We’ve been having those conversations and having meetings with our capital partners because as we’ve said on previous calls, we are super anxious to deploy some capital in this market. And there are not a lot of people that feel the same way, although there are some. So it’s going to be lower competition. And office and multifamily in West L.A. are both okay with our partners. And so we’ve all adjusted our return expectations in accordance with interest rates. And so it’s not going to be as it was. But we’re looking forward to some opportunities coming out and deploying capital.

Operator: And the next question is from Michael Griffin from Citi.

Michael Griffin: Maybe to piggyback on Blaine’s question there on capital allocation. You’ve talked about being kind of ready to look at opportunities. I think we’ve seen some stuff that’s mainly been in like Orange County, so not exactly your wheelhouse, sort of trade at discounted valuations. Anything you’re seeing from the transaction market or talking with your contacts out there? I know you’ve got Prop U and West L.A., so that kind of helps the supply front. And then Kevin, just on — you talked about office and multi being okay with your partners. Does one of these screen better as the other for a potential investment opportunity?

Kevin Crummy: Sure. So well, I think that there’s more certainty around the demand for multifamily in the near term and people are trying to figure out the demand for the office from a tenant perspective and an underwriting perspective. So I would expect that multifamily is going to trade at a tighter price range than office. And so far, we haven’t seen anything that really fits the profile of asset that we’re looking for. And what we look for specifically are assets with a smaller tenant base, maybe a problem in the rent roll or something that needs to be repositioned where we can deploy our operating platform into the asset to maximize its potential. And we just haven’t really seen that come out yet, although I’m optimistic that towards the latter half of this year, we’re going to see some opportunities.

Jordan Kaplan: I really feel like I will be surprised to see opportunities in residential, let me just say it that way. I think it still trading pretty tight. I think we have a better chance of making some good deals in the office, if you just — because we have a lot of conviction around it, and that’s where you see the weakest conviction from like the broader capital markets, which means that — I know it’s not fun to go against the tide, but that’s where we excel.

Unidentified Analyst: And this is Nick Joseph here with Michael. Just a question on occupancy. I think the guide is 82% average occupancy for the full year. Can you just talk through how you get there just given the 1Q ended?

Jordan Kaplan: Well, do you want to talk about it or do you want me? I mean, so we’re — so what happens is this quarter, we’d look at what happened this quarter in terms of leasing and we can start projecting out pretty good because occupancy is a function of leasing. And so we go well. We didn’t hit goals for leasing, and therefore, we’re going to be — our average occupancy is going to be lower. I mean, it’s actually just kind of calculating math out.

Operator: And the next question is from Steve Sakwa from Evercore ISI.

Steve Sakwa: Great. Jordan, thanks for clarifying about Peter. I thought I missed an announcement this morning about his resignation.

Jordan Kaplan: By the way, Mona still works here too. I mean — so maybe she was also surprised to hear that because she actually asked to do this but anyway yes, kind of weird.

Steve Sakwa: Yes. So coming back to leasing, Jordan, I know you did a lot of renewal leasing, but clearly, the lynchpin in getting occupancy and lease rate up is the new volume. And based on your comments, it sounds like it’s less of an RTO problem and more of an economic outlook problem. And then to the extent that, that doesn’t really clear up this year, does that sort of suggest that the leasing volume you did in this quarter on the new side is kind of the new run rate, if you will, until the economy is really on firmer footing?

Jordan Kaplan: So probably what you said, I hope not, but you certainly understand the situation. Let me say this that way. I hope that’s not true. I know we just keep accelerating our push on the new deal and the leasing, and we’re doing — we’re constantly adding and doing things. I actually think that it was oddly low this quarter and that there’ll be — that we probably, for the next 3 quarters, I’m hopeful that we’ll do a little better. Usually, when we have a very low quarter like this, we get some recovery. I think this number is lower than a run rate that I would expect, and it was lower. Obviously, I just said a second ago, it caused us to adjust our occupancy. So I’m not expecting — well, basically, what we’re expecting, we gave in our new — in our adjustment to the assumptions, which would probably not be this run rate of this quarter, all for the rest of it.

So I — but you certainly understand it, but I think we’ll get some recovery over the next 4 quarters, 3 quarters.

Steve Sakwa: Okay, great. And then on the capital deployment side, I’m sort of just wrestling with the share buyback. I sort of understand at the implied cap rate where you trade is probably high single digits, maybe on certain days, pushing low double digits and how that would stack up against the new deal. And I agree with you, apartments probably won’t come cheaply, so you’d have to be looking at office and I guess you already know what you own. So I mean, can you envision finding deals that are as good as what you already own to make them even more accretive than buying back stock?

Jordan Kaplan: Well, I can envision it. I can envision a lot of things. Now I know some deals where the people in the building are anxious to have us come in and take over, okay? So I think there might be some deals out there where people are saying, “You know, maybe I’m not getting top of this, but I’m not going to sell 100% of it. I’ll sell a big chunk to you, but we just don’t want to run this anymore.” And that — there might be opportunities there that are very good opportunities for us. Very, very good. And that’s frankly, a lot of what Kevin is focusing on, and he’s traveling and doing the whole deal around, so we — you’re right to say we own a lot, and we own — a lot of what we own is the best of whatever market happens to be in.

But there’s still deals out there, deals we’d like to do. And I think there’s still — there’s a few groups out there that are kind of having attitude that I just described. And that’s really the opportunity around office that I was talking about.

Operator: And the next question will be from Dylan Burzinski from Green Street.

Dylan Burzinski: Most of my questions have been asked already. But I guess just curious, given the news coming out of Hollywood and the sightseeing there, do you guys expect that to have any impact on your guys’ portfolio?

Peter Seymour: Dylan, it’s Peter. I probably shouldn’t have much impact. We’re — we don’t tend to have — a lot that’s — we get a little bit of temporary production space when it shows up and running and that might go away, but it’s pretty ancillary to our overall business.

Dylan Burzinski: And then do you guys have any update on sort of the discussions that you’re having with Warner Bros, given their expiration in the latter half of next year?

Jordan Kaplan: I don’t think we have much of an update. I mean, I said our expectation is that they move out, although they haven’t said they’re doing that, and I think they’re going through a lot right now. And so it’s — maybe they’re not — their plans are changing fast. Now on the other side of the coin, I also said we’re marketing the buildings. That’s kind of going to be in until they come to us and — they’re not under any pressure to say we’re moving out because they don’t have any options. So they’re going to play the end and see where they end up. I know they’re — at this moment, the reason we expect them to move out is because they’re — same announcements that you guys are able to read about how they’re working to cut costs. But if a company just continuously cuts cost, then they go away. So at some point, they’re going to change their view and say now we’re rebuilding this or that. And we don’t know where that’s going to end up.

Dylan Burzinski: Do you have a sense of the utilization of the space today?

Jordan Kaplan: I think the utilization is extremely low, like barely any. But I think that’s their utilization of like every office space that they have. I mean, if people start — studios have been very slow to bring people back into office space. I would just say it that way.

Operator: And the next question will come from Omotayo Okusanya from Credit Suisse.

Omotayo Okusanya: Yes. Just a quick question with regards to the swaps that are going to be dropping off. I think the mindset before was you were just going to let the underlying variable . Is that still kind of the idea given again some of the latest news from the Fed around rate policy?

Jordan Kaplan: Hey, did the Fed do their announcement yet — did they…

Omotayo Okusanya: Yes, they did .

Jordan Kaplan: Well, that’s new news to me. I heard it just now, so I have to think about it. I actually think there might be some opportunities considering we have some very good debt in terms of the margins to kind of let this year play out, it’s forward swap, maybe starting earlier next year. That number is down in the 3 range. We put our swaps more in the low 4s, which is fine, and we could swap out and start fixing some of this and start layering it back in. I mean, our intention is not to just put the whole company to floating, of course. But I also — as I’ve said in the past, I don’t like — nobody flies a kite during a storm, even though you need wind to fly kite. So I like to sell little time to see how things settle a bit before we do so.

Operator: The next question is a follow-up from Michael Griffin from Citi.

Michael Griffin: I think you touched on the Warner Bros lease, have a question — I’m curious, I know you have the conversion in Hawaii. I think you’re doing some stuff you said at Landmark. Is this a candidate for conversion? I mean, apartments might be pretty hard because of the floor place, but like could it be converted to a movie studio, like don’t they film — like they filmed around there or in that general area? Just a thought.

Jordan Kaplan: I mean the floor place is actually — that building could be converted to apartment building, but I can’t imagine a scenario which we do that. I mean that Burbank Media District, while during this recession and what’s going on, seems to be showing some weakness and maybe because of the new construction that happened there, it’s even showing more weakness. But I’m going to tell you that for like 25 years, it’s been the strongest office market in all L.A. County. I mean, it’s been a very strong off-market, maybe downtown Santa Monica and Beverly Hills. But it’s a really solid office market. So I can’t imagine unless you have a building down there that’s really like almost dysfunctional. I don’t see the spread between office rents and apartment rents being a wide enough gap to encourage anybody to do a conversion.

Frankly, I think out there, office rents are probably higher than apartment rents. So I mean, just because we have a tenant moving now, we’re going to have some vacancy, that’s miles from the idea of saying, it is a market where we do better long term with the conversion, especially in the media district.

Michael Griffin: But maybe to that point, like if it’s a big single tenant user of that building, they got like 430,000 square feet or whatever, how hard is it to cut up the building into like the smaller tenants, the unmet bread and butter, so to speak.

Jordan Kaplan: The floor plates are very good for being broken up. The building can be broken up quite easily. There’s larger tenants there, though. I mean, we can do a few floors of smaller tenants. My guess is you’re still dealing with tenants that are 50,000 to 200,000 feet. And that would be perfect. I mean, to do 3 or 4 tenants, there’s more what I’d like to go to, so we’re no long — I mean, the reality is they’re really our only large tenant. We have one other that’s large-ish, that’s WME. But they’re right in the middle of Beverly Hills, which is like the heartland of the small tenants, they just happen have grown big in one of our buildings. That’s it; that’s where the list ends.

Operator: Ladies and gentlemen, this concludes our question-and-answer session. I would like to turn the conference back over to Jordan Kaplan for any closing remarks.

Jordan Kaplan: Well, thank you all for joining us, and we look forward to speaking with you again in the quarter.

Operator: Thank you, sir. The conference has now concluded. Thank you for attending today’s presentation. You may now disconnect.