Earnings Call Transcript - DEI Q2 2021

Operator, Operator

Good day, everyone. And welcome to the Douglas Emmett Second Quarter 2021 Earnings Conference Call. All participants will be in a listen-only mode. After today’s presentation, there will be an opportunity to ask questions. Please note that this event is being recorded. I would now like to turn the conference over to Stuart McElhinney. Please go ahead, sir.

Stuart McElhinney, Chairman

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 one question and one follow-up. I will now turn the call over to Jordan.

Jordan Kaplan, CEO

Good morning, everyone. Thank you for joining us. During the second quarter, we signed a record 253 office leases, covering an all-time high of 1.3 million square feet. That included our second highest quarter of new leasing since becoming a public company and a substantial increase in the average tenant size. As expected, even record leasing was not enough to completely offset our abnormally high lease expirations during the quarter, so we still had a slight decline in our leased rate. In addition, as it takes time for new tenants to move in, our lease to occupied spread is at its highest point in many years. Happily, we are once again recording straight-line rent roll-off and are continuing to see substantial savings in our re-tenanting costs. While our leasing pipeline remains healthy, we still face headwinds from our local government’s response to the pandemic. Los Angeles has extended its lease enforcement moratorium until September 30th and has returned to a mask mandate, despite our submarkets' vaccination rate of approximately 80% for people over 16 and over 65% for teens. Even with the moratorium extension, we have made additional progress collecting past due balances, still without giving any meaningful rent forgiveness. Our aggregate rent collections for the five quarters affected by the pandemic is now 95%, including 96% of our residential rent, 96% of our office rent, and 63% of our retail rent. The next few quarters may be choppy depending on the course of the pandemic and the timing of the expiration of moratoriums. As I have said, we expect to collect much of our remaining unpaid rent once the moratoriums expire, although those collections will be spread over a number of quarters. In addition, some tenants who have not been paying rent during the moratoriums will move out once we can enforce their leases, though we do not expect the impact on our occupancy to be meaningful. Once the turbulence moves out, I am excited about our future. We are emerging from this downturn as a stronger and more efficient company. For example, I am confident that our new seamless leasing platform, as well as the diversity and strength of our markets resulted in this quarter’s record leasing volume. I will now turn the call over to Kevin, who will give you an update on our development efforts and recent balance sheet activity.

Kevin Crummy, CIO

Thanks, Jordan, and good morning, everyone. Our two multifamily development projects continue to progress nicely. We have leased all of 174 apartments we completed at 1132 Bishop, our 493-unit Downtown Honolulu office to residential conversion. Our Brentwood apartment tower is ahead of schedule as we now expect to deliver our first units in the fourth quarter of 2021. We plan to begin pre-leasing units in the coming months. During the quarter, we closed a new secured non-recourse $300 million interest-only term loan that matures in May 2028. The loan bears an interest at LIBOR + 1.40%, which we have effectively fixed at 2.21% until June 2026. The loan is secured by three previously unencumbered office properties. We used $175 million of proceeds to pay off our revolving credit facility balance. This new loan lowered our weighted average fixed interest rate to only 2.94%. We still have no debt maturities before 2023, and 46% of our office portfolio remains unencumbered. Given the current attractive interest rates, we continue to pursue opportunities to lower our average rate and further ladder out our debt maturities. As I have discussed in prior quarters, although property sales in our markets remain slow, we have ample liquidity for acquisitions as they become available. I will now turn the call over to Stuart.

Stuart McElhinney, Chairman

Thanks, Kevin. Good morning, everyone. In Q2, we signed 253 office leases covering a record 1.3 million square feet. We signed 451,000 square feet of new leases and 846,000 square feet of renewal leases. Our leasing recovery was initially led by smaller tenants, but in the second quarter, we saw progress with medium and large tenants. Indeed, the average lease signed in Q2 increased to 5,100 square feet, which is not only about the last few quarters but also exceeds our long-term average. As we wait for tenants to move in, our record leasing activity has increased the spread between our leased and occupied rate to 250 basis points. Our leasing spreads during the second quarter improved to 0.95% for straight-line and negative 6.6% for cash. Our net effective rents continue to benefit from lower leasing costs, which declined again in Q2 to their lowest level in almost a decade. At 99.4% leased, our multifamily portfolio is essentially full, with rents now increasing across all of our residential submarkets. With that, I will turn the call over to Peter to discuss our results.

Peter Seymour, CFO

Thanks, Stuart. Good morning, everyone. Turning to our results, compared to the second quarter of 2020, FFO increased 14.3% to $0.47 per share, AFFO declined 3.3% to $77.9 million, and same-property cash NOI increased by 0.7%. Compared to the first quarter of 2021, FFO per share increased by $0.03, primarily due to better rent collections and about $0.01 per share of higher business interruption insurance recoveries. It’s worth noting that only 1.2% of our revenue came from non-cash straight-line rent and above and below market lease adjustments. The decline in AFFO this quarter was due to higher TIs and leasing commissions driven by the strong leasing volume in the last couple of quarters. And that only 4.2% of revenues, our G&A for the second quarter remains well below that of our benchmark group. Turning to guidance, we expect third quarter FFO per share to be between $0.44 and $0.46. This reflects the usual higher seasonal utility expenses, as well as additional interest expense from our new loan, lower office occupancy and lower business interruption insurance recoveries. We are not comfortable giving guidance for the fourth quarter, as our results will depend on the course of the pandemic and the timing and immediate impact of the expiration of the moratoriums. As usual, this guidance does not assume the impact of future acquisitions, dispositions, financings or property damage recoveries. I will now turn the call over to the Operator, so we can take your questions.

Operator, Operator

Thank you. Our first question today will come from Craig Mailman with KeyBanc Capital Markets. Please go ahead.

Ardie Kamran, Analyst

Hey there. This is Ardie Kamran on for Craig. I appreciate the color on the rent collections. But can you guys give an update on the cash rents outstanding on kind of a nominal dollar basis? I know the last quarter you mentioned it was closer to the $60 million to $70 million range, but where does that kind of stand today and as you guys continue to make deals with tenants, can you talk about what these deals look like in terms of timing and term of repayment?

Jordan Kaplan, CEO

Yeah. So, depending on where you are in the month, because that number rises a little bit, but if you go to the middle of the month, you are in the 50s. The number moves 50 to 60, like you ask me how much cash, like we snapped our fingers, we would collect, if the moratoriums were off and everyone paid what they owed. In terms of the deals that are being made, basically, people are making early deals to be able to extend their payments over more than three months or six months. But four quarters, five quarters, six quarters, whatever the case may be, and they are also maybe extending leases or doing something else or putting interest on it, doing something to give us some benefit for being willing to do that.

Ardie Kamran, Analyst

Great. Thanks. And just on the leasing front, you guys did a nice job in the second quarter. Can you comment on kind of how that momentum has continued into the third quarter given some of the recent COVID-related rollbacks? And on the occupancy front, how should we think about occupancy? You guys mentioned the spread, so it seems like you are going to get a little bit of a pickup in occupancy? But how should we kind of think about that through the remaining of the year and how are you guys kind of underwriting the bottom in occupancy?

Jordan Kaplan, CEO

Well, I obviously started out my remarks talking about the leasing, because I felt like over the last, I don’t know whatever it’s been, five quarters of the pandemic, people have been questioning the strength of the market, market coming back or tenants coming back or only small guys coming back or big guys coming back. If there was ever a question about the pulse of the market, I mean the market is performing like an Olympic athlete, I mean, I was really impressed. And that’s aside from our platform and how well the platform is able to take advantage of that now. So, I am really happy about that. In terms of moving forward, obviously, we got some better quarters coming, because we don’t have as much move out in the next few quarters, and we are hopeful that we can turn things. Well, what was your second question?

Ardie Kamran, Analyst

Just kind of thinking about, so you kind of mentioned that less move-outs, but like thinking about how leasing has picked up in the last quarter-to-date, given how things have kind of rolled back. I mean, have you noticed any sort of impact?

Jordan Kaplan, CEO

Well, yeah. If COVID heats up again, I am sure there’s going to be an impact. But it’s kind of interesting and back to your question on collections, but that people are just sort of adjusting even to the moratorium being extended and whether the mask mandate’s back on, people want to get back so badly that as you have already heard, I mean, they are making deals. I think we have now made deals on something in the range of 25% plus of what was owed to us in the past, which is all in the face of moratoriums being extended though, I think people are realizing that the end is coming, and they want to get back.

Ardie Kamran, Analyst

Got it. And just last one for me, can you guys talk about kind of the biggest pain points for tenants who have been leaving the portfolio? And as you guys are kind of thinking about the leverage you can pull between rents or occupancy and retention and lease term kind of how you guys are thinking about that in your leasing process moving forward?

Jordan Kaplan, CEO

The difference between leased and occupied largely depends on the volume of new deals we engage in. This quarter was significant for new deals. When we have many new agreements, the gap between leased and occupied spaces increases compared to renewals because tenants need to move in. I’d prefer to leave some questions for others. Let's keep the discussion going. You’ve had a great run here. Thank you for all your questions.

Operator, Operator

And our next question will come from Elvis Rodriguez with Bank of America. Please go ahead.

Elvis Rodriguez, Analyst

Hey, everyone. Great work on the leasing and thank you for answering the questions. Jordan, could you provide an update on your portfolio's cash mark-to-market status today in comparison to recent months?

Jordan Kaplan, CEO

Yeah.

Peter Seymour, CFO

Today, the overall portfolio is slightly positive, around 1%. This performance is stronger in our Honolulu and Westside markets, but softer in the Valley, as you might expect, so it remains slightly positive.

Elvis Rodriguez, Analyst

Great. And then, on your Brentwood apartment project, are you able to share where market rents are today versus your underwriting and your expectation for the lease-up of that project?

Jordan Kaplan, CEO

Well, I wouldn’t say. I mean, we don’t go into individual buildings, so I wouldn’t say that. I would say, in general, the apartment portfolio is seeing real increases in rents and you see that in the numbers that we present you with, the same-store numbers and you can see it in all kinds of studies about what’s happening in the residential market rents in all of our markets, both in LA and in Honolulu.

Elvis Rodriguez, Analyst

Great. I will leave some more questions for the others. Thanks.

Jordan Kaplan, CEO

Thanks.

Operator, Operator

And our next question will come from Manny Korchman with Citi. Please go ahead.

Parker Decraene, Analyst

Hey, everyone. This is a Parker Decraene on for Manny. Thanks for taking the question. My first one is just about the Macerich lease that appeared on your guidance as the largest tenant schedule. I think that there’s some space in the building that is currently out on sub-lease that’s a little bit lower than what Macerich is currently paying. I was just wondering if you guys can talk about a potential rent roll down, as well as just your thoughts on whether that space is comparable to Macerich just overall?

Jordan Kaplan, CEO

I don’t even know the sub-lease space you are talking about and we don’t talk about individual leases. Although, of course, just the sort of the tide going out has caused the Macerich lease to show up on that schedule. If you go back a ways it was on the schedule and then as we leased up and fell off schedule, now it’s come back on. But I don’t have a lot of comments about the Macerich lease in particular.

Parker Decraene, Analyst

Okay. Yeah. That’s fine. I guess and then my second question is just about any differences that you guys saw from an industry perspective that came through in leasing activity this quarter just with it increasing so much?

Jordan Kaplan, CEO

No. I think we still had great demand across our broad set of industries, which is what we love so much about these markets since we do have such a diverse group here and we did see that show up in Q2, no real trends to read through. Although, the one trend that was notable was the one I mentioned in my prepared remarks, which is we did see the average size increase significantly, so the larger tenants and the median tenant for us were in fact transacting in Q2, which was great to see.

Parker Decraene, Analyst

Okay. Thanks that’s all for me.

Jordan Kaplan, CEO

Thanks.

Operator, Operator

And our next question will come from Steve Sakwa with Evercore ISI. Please go ahead.

Steve Sakwa, Analyst

Hi. I guess still good morning out there. Jordan, I was just wondering if you could talk a little bit about the new leasing activity. I am just curious were these tenants that were working from home and decided to take space now or these tenants that just had outgrown their old space and needed to move? Just trying to get a better sense for kind of the big surge in new activity and maybe how the footprints of the 450,000 compare to what they were in prior?

Jordan Kaplan, CEO

Big tenants are returning and securing space, and the size variations are significant. I was amazed by the amount of new leasing we accomplished, which exceeded 450,000 square feet. It was impressive to see that we were able to achieve such a volume. I attribute this success to our platform, which allowed us to handle 250 deals in a single quarter and close them while engaging with numerous tenants, including some larger transactions. I also believe the market is aggressively shifting back towards wanting to re-enter this space. While there are concerns about ongoing pandemic trends, the market is showing strong pent-up demand, which brings me great optimism. The range of tenants spanned various industries, and we observed notable strength in areas we have consistently highlighted, such as Hawaii, which has remained robust since our change, as well as significant activity in West LA and along Ventura Boulevard in the Valley. Overall, we saw positive engagement across tenant sizes and industries.

Steve Sakwa, Analyst

Great. Thanks. And then maybe second, I just wanted to follow up a little bit on the apartment question. We are seeing a pretty big rebound in many of the coastal markets, obviously, at full occupancy at 99.4%, so I am not going to fill that up much more. But can you maybe just expound a little bit on the types of rent increases that you are kind of putting through to existing tenants in the current portfolio today or how are the renewal discussions going with folks?

Kevin Crummy, CIO

Yeah. I think we were super pleased to see great activity in the resi portfolio this quarter. Like you said, occupancy has remained strong. We are getting good roll ups. You saw 4% increase in revenues, our average in-place rents are up. So, good news across the board and activity remained strong.

Steve Sakwa, Analyst

Thanks. That’s it for me.

Kevin Crummy, CIO

Thanks, Steve.

Operator, Operator

And our next question will come from Daniel Santos with Piper Sandler. Please go ahead.

Daniel Santos, Analyst

Hey. Thanks for taking my question. My first one is on the eviction moratorium extension and whether or not you think that might impact deal flow going into the second half of the year. I’d say prior to this all signs pointed to a pretty busy second half. So I am wondering if your view on that might have changed?

Jordan Kaplan, CEO

My initial perspective was that the eviction moratorium was set to conclude on June 30th, so its extension shifted my viewpoint significantly. I believe the eviction moratorium continues to have an impact on us, particularly in terms of rent collection. Some tenants are not making their payments, and they will likely leave. However, I don’t expect this to affect occupancy statistics in a meaningful way, but it will free up space for us to lease, which we've been eager to regain. I don’t think the eviction moratorium is the main factor holding back the market; instead, the overall situation with COVID, including the return to wearing masks and the requirement for everyone to wear a mask indoors regardless of vaccination status, is presenting more significant challenges for us. The eviction moratorium primarily affects our rent collection. Importantly, any new leases signed during the pandemic, even under the moratorium, are enforceable. Therefore, the leases that fall under the eviction moratorium are only those established prior to the pandemic.

Daniel Santos, Analyst

Got it. That’s helpful. And then I was wondering if you could comment on activity up in the Valley. From our conversations with other management teams, it seems like the market is particularly strong?

Kevin Crummy, CIO

Yeah. We had really good activity, as Jordan mentioned, on Ventura Boulevard and through the Valley. So that’s always been a strong market for us. Sherman Oaks/Encino, we have kind of grouped that in with the core Westside markets and so great to see tenants coming back there and some larger deals in that market.

Daniel Santos, Analyst

Perfect. Thanks.

Kevin Crummy, CIO

Thanks.

Operator, Operator

And our next question will come from Rich Anderson with SMBC. Please go ahead.

Rich Anderson, Analyst

Thanks. Good morning. So, do you guys, I guess, I will ask one question two ways. First of all, do you have a retention rate that you are working towards in the office space, and more abstractly, when you are having conversations, are people changing their plans in any meaningful way about how much space they want to keep if their lease comes due? I am just curious if you can speak kind of quantitatively and qualitatively about the leasing experience when you are renewing a lease.

Jordan Kaplan, CEO

In terms of the retention rate, we have observed over the last 30 years that despite our efforts to achieve higher retention, it has remained consistently around 69%, typically fluctuating between 69% and 70%. I've seen attempts to increase that number even by just 2%, but it's quite challenging. While it doesn't decrease, it consistently lands around that figure over multiple quarters. This seems to be our target moving forward, so that’s what you should expect. What was your second question?

Rich Anderson, Analyst

When you negotiate a deal, do you consider a tenant retained if they decrease their space from 5,000 square feet to 3,000 square feet, or is your retention rate based solely on whether the tenant stays or leaves?

Jordan Kaplan, CEO

So it would be a 3,000-foot retention instead of 5,000.

Rich Anderson, Analyst

Okay. So, it’s on a square foot basis. So are you saying then that people are not readjusting downward much, they are either making a decision to...

Jordan Kaplan, CEO

Yeah, we've put a lot of effort into understanding the mindset of our tenants, whether they choose to lease or not, and the reasons behind those decisions. I don't think we can provide a clear summary of this. I've heard various anecdotes, but I’m hesitant to share just one or two stories, as they might lead people to wrongly conclude that's why tenants are starting to take space again. There are many factors at play, but overall, I believe the economy is recovering, and people want to return to work.

Peter Seymour, CFO

I discussed this briefly on the last call. Regarding our space planning in our program, it has been very effective for us and will continue to attract new business through leasing. Our focus is on spaces around 2,000 to 2,500 square feet, where we are seeing significant leasing activity, and we have maintained our layout. It offers approximately 225 square feet per person, which has consistently been successful for us and continues to perform well.

Rich Anderson, Analyst

Okay. And then real quickly, of the $50 million to $60 million rents that are still kind of outstanding, how much of that is in retail utilization or is that just office?

Jordan Kaplan, CEO

Compared to our company, it is heavily focused on retail.

Rich Anderson, Analyst

Okay.

Jordan Kaplan, CEO

Well, you have it. We are telling you, 96% collection office, 96% collection residential, and 65% retail. So retail is representing too much of that number, more than its fair share.

Rich Anderson, Analyst

Yeah. I know I have the dumb question, because you said that, but I guess my thought was, when you said people might leave once the moratorium ends, are you kind of most worried about that in the retail part of the portfolio?

Jordan Kaplan, CEO

I am not most worried about that in any of the sections. I would say I don’t expect a lot of that. Actually, the areas where, and I will say this again, anecdotally, I am hearing that is in residential, not necessarily in retail or office. When I read the list of everyone, well, more often, in residential, I will see something that says, when the moratorium is over this tenant tends to kind of just move out and this is unlikely to be collectible, I see that on the list.

Rich Anderson, Analyst

Okay. Got it. Thanks very much. Appreciate it.

Jordan Kaplan, CEO

Thanks.

Operator, Operator

And our next question will come from Frank Lee with BMO. Please go ahead.

Frank Lee, Analyst

Hi. Good morning, everyone.

Jordan Kaplan, CEO

Hi, Lee.

Frank Lee, Analyst

If we look at the average lease term on the leases signed in the quarter, looks like the term’s over five years now versus three and a half or so in the past couple of quarters. Do you get the sense that tenants are willing to commit to moratorium now that reopening plans are in motion or was there anything unusual in the quarter?

Kevin Crummy, CIO

Frank, I think, mostly what that had to deal with was the larger leases that we signed. So larger tenants tend to sign longer-term deals and you saw that I mentioned the average lease size was way up this quarter and that was really the driving factor to increase the average term of the leases that you saw.

Frank Lee, Analyst

Okay. Thanks. And then you provided the remaining spend for the multifamily developments in the south this quarter. Just wondering if there are any changes to the total cost or are the construction costs still tracking within the initial budget range?

Jordan Kaplan, CEO

I believe that everything is still on track. We have received numerous inquiries about our remaining expenditures. Regarding the Landmark project, we have increased our spending, and I am confident it is within 10% because we are trying to accelerate our progress. Interestingly, no one has raised this point or noticed it. We initially planned to begin leasing next year, but we have expedited the process, which has not been inexpensive, particularly given the current supply chain challenges. Therefore, we have been prepared to invest to start leasing this year. Overall, I feel optimistic about our position, especially concerning both projects.

Frank Lee, Analyst

Okay, guys. Thank you.

Jordan Kaplan, CEO

Thanks.

Operator, Operator

And our next question will come from Bill Crow with Raymond James. Please go ahead.

Bill Crow, Analyst

Thanks. Good morning. On the commercial leases signed during the quarter, have you seen any increase in the tenants relocating from downtown, maybe any sense of how many of those new move-ins are coming from larger spaces?

Kevin Crummy, CIO

Well, again, we certainly saw a lot of large tenant activity this quarter, which we hadn’t seen kind of throughout the pandemic. We had been relying on very small tenants. I think our average tenant size a couple of quarters ago was only 3,100 feet and it was up to 5,100 feet in Q2. So, certainly larger tenant showed up. Your first comment about relocations from downtown, I don’t know that we ever draw tenants from downtown. It’s not something I ever hear from our leasing guys.

Jordan Kaplan, CEO

I agree, I haven't noticed us trading with downtown much.

Kevin Crummy, CIO

That's not a usual occurrence. If you're living on the Westside near our submarkets, commuting downtown can be lengthy. Most people prefer a shorter commute, so they tend to stay within our submarkets or move between different submarkets on the Westside or between buildings we don't own and those we do own. However, it's somewhat unusual to hear about this happening.

Jordan Kaplan, CEO

Yeah.

Bill Crow, Analyst

Yeah. Okay. And we are seeing in other markets where as workers are working part-time from home a little bit of a shift in the location of office space. But, Jordan, how politically...

Kevin Crummy, CIO

I think we might see that headed toward a center. We have people commuting in from those areas to the Westside, and in the past, we've observed that individuals open satellite offices toward Warner Center and the Valley to shorten their commute. So that's something we are monitoring.

Jordan Kaplan, CEO

And I think that, by the way, I know I have been reading those same articles that you are talking about. And frankly, I think the Westside went through that sometime in the 1980s or something, when the traffic was so bad to get downtown that people just insisted on having their office space closer to their homes and that’s what really created the Westside.

Bill Crow, Analyst

Yeah. Interesting. Jordan, how politically difficult is it going to be to actually evict residential tenants? I mean, even though you have all the right to, once the moratorium ends, how tough is that going to be from a PR perspective?

Jordan Kaplan, CEO

I don’t think we are going to have very many tenants we are going to need to evict. I mean, first of all, only 4% is not paying, I think most of them are going to pay. I mean, so you are talking about numbers that could be as small as single digits or 10, 20. I mean it’s not a lot.

Bill Crow, Analyst

Yeah. Most of that’s in rent-controlled spots. Is that fair?

Kevin Crummy, CIO

Not necessary.

Jordan Kaplan, CEO

No, I don’t think so. The instances I observed were not from businesses run by rent-controlled individuals; they were instead from those in nice places who faced unexpected challenges with their business or engaged in risky strategies, and now we're left uncertain about the situation and unable to reclaim the space.

Bill Crow, Analyst

Yeah. All right. Appreciate the insights.

Jordan Kaplan, CEO

All right.

Operator, Operator

And this will conclude our question-and-answer session. I’d like to turn the conference back over to Jordan Kaplan for any closing remarks.

Jordan Kaplan, CEO

Well, thank you all for joining us and we will speak with you again next quarter.

Operator, Operator

The conference is now concluded. Thank you for attending today’s presentation. You may now disconnect your lines at this time.