Douglas Emmett, Inc. (NYSE:DEI) Q3 2023 Earnings Call Transcript

Douglas Emmett, Inc. (NYSE:DEI) Q3 2023 Earnings Call Transcript November 1, 2023

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

Stuart McElhinney : Thank you. Joining us today on the call are Jordan Kaplan, our President and CEO; Kevin Crummy, our CIO; and Peter Seymour, 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 1 question and 1 follow-up. I will now turn the call over to Jordan.

Jordan Kaplan : Good morning, and thank you for joining us. Our office leasing activity during the third quarter continued at a strong pace. We executed 225 office leases covering close to 1 million square feet. Third quarter activity had a much higher percentage of new leases as compared to second quarter. It also included quite a few new tenants over 10,000 square feet, all very good news. As we indicated last quarter, 1 large tenant in Woodland Hills renewed but downsized, which was the primary cause of our negative absorption. Nationally, office faces 3 challenges. Many commentators have simply focused on the narrative that work from home has permanently weakened office demand, that is wholly inconsistent with our experience and long-term expectations.

Once vaccinations became ubiquitous and offices reopened, we saw meaningful jumps in leasing volume, absorption and building utilization. It was not until the Fed raised rates to control inflation, that we saw the slowdown in large tenant leasing that impacted our absorption. Even with that slowdown, our office utilization has returned to very high levels which was likely aided by our markets short average commute times and low reliance on public transportation. We feel that the remaining 2 challenges have had a more meaningful national impact. One of those challenges is that many gateway markets are suffering from new construction overhang as a result of recent overbuilding. Fortunately, that has not been a problem in our markets, where strong supply constraints have limited new construction.

In fact, over the past 15 years, our markets have only added 3% to total office inventory. The third challenge, which has been most impactful for us is that tenants, in particular, large tenants have become cautious about new investment. This is understandable and likely an intended reaction to the Fed raising the cost of capital to slow the economy. Our results in recent quarters have been significantly impacted by this last factor, though the Fed’s intervention is clearly cyclical. This is our fourth experience managing Douglas Emmett through a recession, which typically comes with a mix of pain and opportunity. We feel well prepared for both and are confident in the long-term health and resilience of our markets. With that, I will turn the call over to Kevin.

Kevin Crummy : Thanks, Jordan, and good morning, everyone. Our 2 recent multifamily development projects continue to progress nicely. Our 376-unit Landmark L.A. property in Brentwood is now almost 90% leased. At our office-to-residential conversion in Honolulu, we have completed 424 of the 493 units and are on track to convert another floor into 22 apartments before year-end. We’ve been leasing these units as fast as we can convert them. As the remaining few office tenants move out, we will convert the last 2 floors. This quarter, we closed the new $350 million loan that was mentioned in our last call. The loan is secured by the 2 development properties, which were built using our free cash flow. The new loan bears interest at SOFR plus 137 and matures in August 2033.

At Barrington Plaza, our 712-unit apartment complex in Brentwood A significant majority of the tenants have already vacated in preparation for the installation of upgraded fire life safety systems. Tenants occupying 170 units have the right to remain until next May, and we expect them to move out at an uneven pace in the intervening period. The transaction market has remained slow, but as acquisition opportunities come to market, we are ready with ample liquidity. With that, I will turn the call over to Stuart.

Stuart McElhinney : Thanks, Kevin. Good morning, everyone. During the third quarter, we signed 225 office leases, covering 934,000 square feet, consisting of 267,000 square feet of new leases and 667,000 square feet of renewal leases. As Jordan noted, we are pleased to see more demand from new tenants over 10,000 square feet. Reflecting the fixed annual rent growth built into our office leases, average rent on our in-place office leases continues to rise, reaching a record high in the third quarter. However, as leases expire, these higher ending rents put pressure on cash leasing spreads. Still, the overall value of our new leases increased by 3.6%, even though cash spreads were down 9.7%. At an average of only $5.59 per square foot per year, our leasing costs during the third quarter remained well below the average of other office REITs in our benchmark group.

Our residential properties continue to perform well during the third quarter, providing 18% of our overall revenues, even with increasing vacancy at Barrington Plaza, which is being emptied in preparation for a major fire life safety upgrade. Our portfolio was 99% leased at quarter end with healthy rent roll-ups across all markets. With that, I’ll turn the call over to Peter to discuss our results.

Peter Seymour : Thanks, Stuart. Good morning, everyone. Reviewing our results compared to the third quarter of 2022, revenue increased by 0.7%, primarily due to higher tenant recoveries and parking revenue from our office portfolio, and new units delivered in our multifamily portfolio, partly offset by tenants vacating Barington Plaza. FFO decreased by 15% to $0.45 per share, primarily as a result of higher interest expense on our floating rate debt. AFFO decreased 24% to $68.7 million as we built out more square footage this quarter as a result of higher leasing volume, and same-property cash NOI increased by 0.4%, driven primarily by our higher revenues. Our G&A remains very low relative to our benchmark group at only 5% of revenue.

Turning to guidance. We increased our assumptions for occupancy and same-property NOI growth, but the positive impact from these changes was not enough to increase the FFO guidance outside of the range we gave you last quarter. 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.

Operator: [Operator Instructions] And our first question will come from Michael Griffin with Citi.

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Q&A Session

Michael Griffin : Maybe just on the leasing front. I’m curious if you need to see larger tenant demand pick up more kind of in order to see that net absorption rate turn positive via later in the year into 2024. And anything you could comment there would be helpful.

Stuart McElhinney: Yes, Michael, thanks. So happy to see the increase in — particularly in new leasing in Q3. That was good to see. We need that ratio of new to renewal to be in that 30% range because we know on average, we’re going to renew in that high 60s is kind of where our historical renewal rate is. So we do need to see that new leasing kind of in that range to see positive absorption, of course, this quarter. We warrant you do we had that large move-out in Woodland Hills, which drove most of the negative there. So — and then looking at ’24 expirations. We’ve talked a lot about Warner Bros. We know that’s going to be a headwind for absorption next year when they move out at the end of Q3.

Michael Griffin : Great. And then with the new term loan, you’ve got ample dry powder with cash on the balance sheet. Can you maybe talk a little bit about opportunities you’re seeing out there in the market, be it office or multifamily? How or when we can see you capitalize on potential distress in the market?

Jordan Kaplan: Yes, I may — I don’t want to hold for distress for anybody, but I can’t tell you we’ve seen anyone coming to us with significant distress, although we are working on stuff. I’ve said before, our preference is to try and buy some of the — there are some really great buildings that we don’t own in these markets, and we still have a real positive view of the market. But people aren’t — I don’t think people’s private — it’s mostly in private hands, and I don’t think their internal values are anywhere around clearly where maybe — some people are certainly valuing REITs or anything else similar to that.

Operator: Our next question will come from Alexander Goldfarb with Piper Sandler.

Alexander Goldfarb : I guess, Jordan, to that point, obviously, the Blackstone Howard Hughes project has gotten a lot of interest — or sorry, made a lot of headlines, I should say, headlines that is. But clearly, is outside of your core markets, are there — when you say you guys are working on distress, would you say or underwriting deals, is it deals like that, like private equity type deals from the last cycle that are the ones that you guys are looking at? Or are there other deals, be it like a family that has loans coming up that they don’t have the capital to put in? Just trying to get a framework for what kind of distress if it’s like the typical sort of over-levered PE type thing and not to say the Blackstone deal is that way? Or is it like perhaps long-held family or partnership where the partners just don’t want to put any more money in, and therefore, it’s “distressed” even though to those of us that wouldn’t look like distress.

Jordan Kaplan: Okay. So — the Howard Hughes project hasn’t been offered for sale, just by the way, but I know I’ve been reading the same articles you guys have been reading. The stuff that I’d say we’re working on the hardest or the most hopeful are — a lot of assets have been owned for a very long time by families that might have debt coming up or the debt coming up is going to be at a much higher rate, or do they want to put a lot of capital into remargin those loans at this time. It’s — some of it is that kind of thing. And some of it is what you described — you were kind of loosely having Howard Hughes represented, which is institutionally owned real estate that the institution certainly could put the money into remargin, but they’re just not and they’re going — we don’t want — we’re not happy with this and with donning this, we’ve gone too long.