Earnings Call Transcript - DEI Q1 2023

Operator, 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, Vice President of Investor Relations

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, President and CEO

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 expenses. 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 four recessions and always found the silver lining. We repurchased six 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, CIO

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 three more floors by year-end. Only two 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.

Stuart McElhinney, Vice President of Investor Relations

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, CFO

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 six 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.

Operator, Operator

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

Alexander Goldfarb, Analyst

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, President and CEO

I believe the floating rate debt is in a good position, and it’s solid debt overall. The main consideration is when we should re-swap it. I anticipate that there will be an opportunity to do so. Looking further ahead, excluding this year, we could see it revert to a reasonable rate soon. Therefore, I’m not inclined to use cash for that and believe there are more beneficial uses for it. This debt has a long duration remaining. I would like to clarify a point: in the introduction to our call during Stuart’s segment, it incorrectly stated that Mona is our CFO; in fact, Peter is our CFO. This happened because Stuart prefers not to re-record his opening repeatedly and opted to use an older recording. He intended to refer to the most recent one from the past year, not one from four years ago, though it seems they pulled from the older version. Perhaps only we noticed that. Now, what was your second question?

Alexander Goldfarb, Analyst

In your remarks during the investor event in Hawaii, you mentioned that tenants from Downtown L.A. are relocating to the West side due to a lack of space, and you noted that large tenants are currently a weak point in your portfolio while small tenants remain active. I'm curious about how we reconcile this information. If tenants from Downtown L.A. are moving to the West side, which I assume includes larger tenants, why aren't we seeing increased activity from large tenants in your portfolio as well?

Jordan Kaplan, President and CEO

Most of the increase has been observed in Century City, which is actually larger than what we can accommodate. Almost all of the floors in the towers and some of the other buildings are fully leased. We don't have many blocks of space available. For us, a large tenant occupies between 10,000 to 40,000 square feet, and anything above 20,000 is essentially a full floor. While we do have plenty of full-floor tenants, nothing compares to how Century City operates. Many tenants have moved to Century City, and it seems very full at this point. We're hopeful that some of them will also consider locations like Beverly Hills and West, where we might see some activity. However, in those markets, we haven't had the necessary blocks of space to accommodate anyone looking for around 50,000 square feet, which we simply haven't had available.

Alexander Goldfarb, Analyst

Okay. But you would expect some spillover eventually?

Jordan Kaplan, President and CEO

Yes, I think there is definitely movement among tenants. Reports indicate that tenants are relocating from downtown to the west side. Smaller companies likely have less reason to stay downtown, especially if they're based near Pasadena, making the commute across the city inconvenient. Larger companies are facing challenges attracting employees back to downtown offices, which has prompted them to announce relocations. I've heard anecdotal accounts of law firms requiring their employees to return but choosing not to stay downtown, leading them to abandon their leases while continuing to pay for them, as they lease new spaces in Century City and call everyone back. I believe there will be some spillover, and I am hopeful about it, but it's clear that they are moving in our direction.

Operator, Operator

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

Unidentified Analyst, Analyst

Can we discuss what you're observing in the Olympic Corridor and Brentwood submarkets? What feedback have your leasing teams received from tenants who have moved out?

Stuart McElhinney, Vice President of Investor Relations

Our tenants number nearly 3,000, and there are many reasons why they move out. They may be expanding, contracting, experiencing partner retirements, or splitting into separate firms. This list is extensive and remains consistent with what we've observed in the past. There hasn't been a significant change in trends to highlight. As for specific submarkets, while there has been some movement, these areas are small and can be easily affected by minor variations. Therefore, we believe it makes more sense to focus on our major regions such as West L.A., the Valley, and Hawaii, as the smaller submarkets tend to fluctuate with slight changes.

Unidentified Analyst, 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, President and CEO

Okay. As we predicted last quarter, the pipeline has slowed down, and you can see that. If you're asking me whether it will slow down more than this, no, we're not observing that. The level of activity is still decent, over 600,000 feet, but it's not at the level we're accustomed to; we aim to be closer to 800,000. We achieved 4 quarter of 1 million feet, so we are significantly below that, but I don't believe it will decrease much further. What was your second question?

Unidentified Analyst, Analyst

If there's been any changes to your credit tenant watch list?

Jordan Kaplan, President and CEO

Tenants are still gradually paying, and the current total for outstanding payments is around $17 million. While a few tenants are going onto our watch list, the numbers aren't significant. The credit quality of our tenants remains strong, and even during COVID, when nearly 10% of our tenants were not required to pay, we maintained confidence that they could meet their obligations. I believe that in the long run, the impact of COVID will result in only a minor increase in delinquency, perhaps around 20 basis points, rather than the 10% some feared. The tenants we have are smaller and possess good credit, and they sign leases personally, which reduces the risk of defaults in our portfolio, both now and in the future.

Operator, Operator

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

Blaine Heck, Analyst

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, President and CEO

Yes. I really enjoy seeing people return to work, and it's great to witness tenants bringing employees back in. This is beneficial for the economy, particularly in L.A. and other areas where large tenants are encouraging employees not to stay at home, whether in San Francisco, New York, or elsewhere. Regarding our portfolio, while I might want to say it's going to be a significant deal, the fact is we've maintained over 80% occupancy for quite some time. We might reach 100% or 95%, but I don't believe this trend has hindered our leasing efforts or anything else, to be honest. Even our parking metrics show an increase; Ken has provided me with visitor traffic analyses, and we've efficiently tracked it. According to Ken's latest report, our visitor count has returned to pre-pandemic levels. While I would like to think that's advantageous for us, I believe the primary challenge we're facing is related to the ongoing real estate recession or the cautious approach that people are taking due to expectations of a slowdown in leasing. This situation mirrors the last four recessions we've navigated since starting this company. We will work through this recession, and as we emerge from it, I am confident we will do very well.

Blaine Heck, Analyst

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, CIO

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, Operator

And the next question is from Michael Griffin from Citi.

Michael Griffin, Analyst

In response to Blaine's question about capital allocation, you've mentioned being open to exploring opportunities. It seems that there have been some developments mainly in Orange County, which isn't typically your area, but these are being offered at discounted valuations. Are you noticing anything in the transaction market or from your contacts? Considering you have Prop U and West L.A., that seems to support the supply aspect. Additionally, Kevin, you mentioned that both office and multifamily sectors are performing reasonably well with your partners. Is one of these sectors more promising than the other for potential investment opportunities?

Kevin Crummy, CIO

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, President and CEO

I think it will be surprising to find opportunities in residential. The market is still quite tight. However, I believe we have a better chance of making strong deals in the office sector, as we have a lot of confidence in it. This sector shows the weakest confidence from the broader capital markets, which means that while going against the trend may not be popular, it is where we thrive.

Unidentified Analyst, 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, President and CEO

Do you want to discuss it or should I? This quarter, we've analyzed leasing activity and can begin making projections because occupancy depends on leasing. We didn't meet our leasing goals, which means our average occupancy will likely be lower. It's really just straightforward math.

Operator, Operator

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

Steve Sakwa, Analyst

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

Jordan Kaplan, President and CEO

By the way, Mona still works here too. She might have been surprised to hear that because she actually requested to do this. But anyway, yes, kind of weird.

Steve Sakwa, Analyst

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, President and CEO

I hope what you mentioned isn't the case, but I understand the situation. Let me put it this way: I'm optimistic that's not true. We are continuing to push forward with new deals and leasing, consistently making additions and improvements. I found our performance this quarter surprisingly low, and I believe that in the next three quarters, we can do somewhat better. Typically, after a quarter like this with low numbers, we see some recovery. This figure is below what I would typically expect, and it has led us to adjust our occupancy projections. So, I don't anticipate that this quarter's run rate will continue at this level for the remainder of the year. I think there will be a recovery over the next few quarters.

Steve Sakwa, Analyst

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, President and CEO

I can see it happening. There are definitely situations where people in certain properties are eager for us to come in and take over. I believe there are opportunities out there where owners might think, 'I'm not going to get the highest value, but I don’t want to manage this any longer. I can sell a significant portion to you.' This could create very valuable opportunities for us. Much of what Kevin is currently focusing on and exploring involves this concept. You’re correct that we own a lot, and a significant portion of our holdings are among the best in their respective markets. However, there are still deals out there that we’re interested in pursuing. I believe there are a few groups with the mindset I just mentioned, and that represents the opportunity in the office sector that I was referring to.

Operator, Operator

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

Dylan Burzinski, Analyst

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, CFO

Dylan, it's Peter. It probably shouldn't have much impact. We don't tend to have a lot that's significant; we get a little temporary production space when it shows up, but that might go away. Overall, it's pretty ancillary to our business.

Dylan Burzinski, Analyst

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, President and CEO

I don't think we have much of an update. Our expectation is that they will move out, although they haven't confirmed that, and they are currently dealing with a lot of challenges. Their plans might be changing quickly. On the flip side, we are marketing the buildings, and they are not under any pressure to announce their move since they don't have any alternatives. They are likely waiting to see how things unfold. The reason we anticipate their departure is due to their announcements about cost-cutting measures. However, if a company keeps reducing costs without a plan for the future, they risk going away entirely. Eventually, they will need to shift their approach and think about rebuilding or making changes, but we don't know what direction that will take.

Dylan Burzinski, Analyst

Do you have a sense of the utilization of the space today?

Jordan Kaplan, President and CEO

I think the utilization is very low, almost nonexistent. This seems to apply to their overall use of every office space they have. Studios have been quite slow to bring people back to the office, and that's one way to look at it.

Operator, Operator

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

Michael Griffin, Analyst

I think you mentioned the Warner Bros lease, and I have a question. I'm curious about the conversion in Hawaii. I believe there are some projects at Landmark. Is this site a candidate for conversion? Converting it to apartments might be challenging due to the floor plans, but could it be turned into a movie studio? They have filmed in that area, so it's just a thought.

Jordan Kaplan, President and CEO

The building could potentially be changed into an apartment complex, but I find it hard to envision that happening. The Burbank Media District is currently facing some challenges during this recession, and the recent construction may have contributed to this difficulty. However, for around 25 years, it has been the leading office market in Los Angeles County. While downtown Santa Monica and Beverly Hills are also strong, the office market in Burbank remains solid. Unless we have a property in that area that is nearly dysfunctional, I don't see a significant enough difference between office and apartment rents to make a conversion appealing. In fact, office rents might be higher than apartment rents. Just because we have a tenant moving out and some vacancies does not mean we are leaning towards a conversion in this market, particularly in the media district.

Michael Griffin, Analyst

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, President and CEO

The floor plates are very suitable for division. The building can be segmented easily. There are larger tenants present, but we can accommodate a few floors of smaller tenants. I estimate that we will still be dealing with tenants ranging from 50,000 to 200,000 square feet, which would be ideal. I would prefer to have three or four tenants in that size range. Currently, we primarily have one large tenant, with WME being another relatively large one. They are located in Beverly Hills, which is a core area for smaller tenants; they just happened to expand within one of our buildings. That sums up our large tenant list.

Operator, 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, President and CEO

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

Operator, Operator

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