Earnings Call Transcript - DEI Q2 2023

Stuart McElhinney, Vice President of Investor Relations

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 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, and thank you for joining us. Since we last spoke, we took two very positive strategic steps toward enhancing the long-term health of the company and ensuring meaningful growth. First, we have formally begun the process of reconstructing our Barrington Plaza apartment community to install modern fire life safety systems and otherwise bring the asset up to date. Tenants have been notified that they are required to vacate the property, and approximately half have already done so. This is having a current impact on our earnings, but we have waited three years to begin this process, and I am very happy that it has started. Second, in July, we closed a new 10-year, $350 million nonrecourse interest-only loan secured by two recently completed residential projects. The loan is floating at 137 over SOFR, which we feel is a very good rate. Both properties were built using our free cash flow, so they were completely unencumbered. In a difficult loan environment, we are pleased to have this additional source of cash to take advantage of future opportunities. While new leasing from larger tenants has been slow, tenants over 10,000 square feet did account for nearly half our renewals in the second quarter. Overall, we signed 210 leases covering nearly 1 million square feet. We are seeing tenants renew further ahead of their expirations and for longer lease terms. This returns us to a more typical lease expiration pattern, reversing the short-term mentality we saw during the pandemic. I am also pleased that we have been successfully maintaining rental rates and controlling leasing costs. The overall value of leases we signed during the second quarter was higher than the prior lease value for the same space. At the same time, our focus on smaller tenants and simplifying the office leasing process has kept our leasing costs below our long-term pre-pandemic average and well below other office REITs. While Barrington Plaza reconstruction and the new loan are very positive for the long term, we are reducing our 2023 guidance to reflect their short-term impacts. We have significant cash on hand, strong cash flow after dividends, no corporate-level debt, and almost half our office properties remain unencumbered. I am very happy to report that over the past two quarters, we repurchased 9.1 million shares at an average price of just over $12 per share. I am confident that our buildings and markets will perform extremely well over the long term, which is supported by our substantial leasing activity during this downturn and the long-term supply-demand metrics of our markets. With that, I will turn the call over to Kevin.

Kevin Crummy, CIO

Thanks, Jordan, and good morning, everyone. Leasing remains strong in our two new multifamily development projects. At the Landmark LA in Brentwood, we have now leased almost 85% of our 376 new units. At Bishop Place in Honolulu, our office-to-residential conversion project, units continue to lease as quickly as we can deliver them. In July, we closed a new $350 million nonrecourse interest-only loan secured by these properties. Both properties are built using our free cash flow and are formally unencumbered. The new loan bears interest at SOFR plus 1.37% and matures in August 2033. The new loan proceeds add to our liquidity so that moving forward, we can take advantage of new investment opportunities. As Jordan mentioned, we have begun to vacate Barrington Plaza because of the requirement to install new fire life safety systems. Barrington Plaza is a 712-unit apartment complex spread across three high-rise towers in Brentwood. About half of the units have already been vacated. Most of the remaining units are scheduled to be vacated this fall, with some tenants having a right to remain until next May. With that, I will turn the call over to Stuart.

Stuart McElhinney, Vice President of Investor Relations

Thanks, Kevin. Good morning, everyone. During the second quarter, we signed 210 office leases, covering 957,000 square feet, consisting of 188,000 square feet of new leases and 769,000 square feet of renewal leases. While we were pleased to see an overall increase in the leasing activity, our leasing did not include many new tenants over 10,000 square feet and remains below levels needed to create positive absorption. As Jordan mentioned, our leasing activity was characterized by tenants renewing further ahead of their expirations and for longer lease terms. Nearly half of our renewals came from tenants over 10,000 square feet. Our office leasing spreads during the second quarter were positive 4.1% for straight line and negative 6.6% for cash, reflecting the strong annual rent growth built into our office leases. At only $5.23 per square foot per year, our leasing costs during the second quarter remained well below the average for other office REITs in our benchmark group. Turning to multifamily, our portfolio was 99.2% leased at quarter end and rent roll-up remained healthy 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. Reviewing our results, compared to the second quarter of 2022, revenue increased by 2.6%, primarily as a result of our multifamily portfolio, which now represents approximately 20% of our annual revenue. FFO decreased by 8.4% to $0.48 per share, primarily as a result of higher interest expense on our floating rate debt. AFFO decreased 16.5% to $74.9 million, with construction costs impacting AFFO this quarter related to our significant leasing last year. Same property cash NOI decreased by 0.9% with higher rental revenue and parking revenue, offset by higher insurance, janitorial, and parking expenses. Our G&A remains very low relative to our benchmark group at only 4.3% of revenue. Over the last two quarters, we have repurchased 9.1 million shares at an average price of $12.03 per share. These repurchases were accretive for both our FFO and our cash flow. Turning to guidance. We are adjusting our FFO guidance to reflect our Barrington Plaza move-outs and our new loan, offset by a number of positive developments, including the impact of the share buyback. Collectively, we expect those items to reduce FFO by about $0.07 per share. As a result, we now expect FFO per share to be between $1.81 and $1.85 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.

Steve Sakwa, Analyst

I just wanted to start on leasing. It's nice to see the renewal activity pick up, but as you mentioned, you really need more new activity in order to drive net absorption and ultimately occupancy. I'm just curious sort of if the pipeline is changing or what you think ultimately gets folks off the sidelines to sign new deals? And do you feel like the writer strike and actor strike is keeping any lid on that new activity?

Jordan Kaplan, President and CEO

I mean I can answer some of that, but I'm going to let Stuart generally answer it.

Stuart McElhinney, Vice President of Investor Relations

Yes, I'm very encouraged to see larger tenants very active on the renewal side, so I think that's a really good sign. Hopefully, that translates over to kind of new business soon, and we see more new tenants coming through of a larger size. I can't say yet that we've seen that in the pipeline. So no real trend there to speak of yet. But we're encouraged by the renewal activity that we saw. Regarding the writer strike and the actors strike, I think that maybe on the margin, it may have an impact, but I don’t think it’s going to be something that is materially impactful for our business. We do a little bit of that type of leasing, but it's not a huge part of the business.

Steve Sakwa, Analyst

And then go ahead.

Stuart McElhinney, Vice President of Investor Relations

I was just going to mention, when we're talking about leasing, I was just going to mention that if you look at expirations for next quarter, Q3 expirations, they're elevated. We've got one very large tenant that is expiring next quarter. We're expecting that tenant to renew but give back a large amount of space. So I just wanted to kind of give you guys the heads up that that's coming next quarter. Expirations look more normal in Q4.

Steve Sakwa, Analyst

And then, Jordan, as it relates to Barrington, I know that there's been a lot of discussion with the insurance proceeds and what might be covered and not covered. Do you have any kind of update on the timeline as to kind of when you might have an idea of what percentage of the costs are covered by insurance and what is out of pocket from Douglas Emmett?

Jordan Kaplan, President and CEO

I wish I could give you a clearer answer, but I don’t have one. Working with the insurance company has been quite challenging, and we are in the early stages of that process. We believe the situation is covered, but it has been complicated to navigate. As for Barrington's impact on our earnings, while I can’t provide future guidance, I’d like to share some estimates for context. In 2019, before the fire and the pandemic, Barrington added about $0.09 to our FFO. However, in 2022, after the fire and pandemic, this contribution decreased to around $0.07. This year, due to move-outs, we anticipate the property will only contribute about $0.04 to FFO. I wanted to share this information because it's been a topic of inquiry in the past.

Steve Sakwa, Analyst

I appreciate the color there. It sounds like we'll have to wait a few more quarters, perhaps, to get a finalization on that. But yes. I'm good for now.

Alexander Goldfarb, Analyst

Jordan, maybe sticking with the Barrington, the other item has been the news articles about the tenant litigation. I'm guessing they're not suing because they're upset that you're trying to make the building safer and less fire prone. I'm guessing this is more just trying to extract some financial settlement. But maybe you could just provide an update of what you can discuss, and if this is just a standard shakedown or if the city could decide to hold, pull your permits or your approvals to do this and if it could complicate your plans to make the building safer.

Jordan Kaplan, President and CEO

So this litigation really does not involve the city. This is a couple of tenants, and we're having trouble figuring out exactly who or how many have engaged in this litigation. I can't speculate on what their purpose is. I know that at least a few of them have already left the building, but we don’t have a lot of answers. Our position is very confident, and while litigation is always disruptive, we are assured of our stance and that's kind of where I have to leave it until this plays out.

Alexander Goldfarb, Analyst

So your view is, though, as far as the city goes and this litigation from the tenants, I understand it’s separate but related, you don’t think they would be able to win over any of the city people who would suspend your ability to undertake the work?

Jordan Kaplan, President and CEO

I don't want to speculate too much about what can and can’t happen in litigation. But as I mentioned, our position is particularly strong in terms of what we are doing and the processeswe're following. We are following the law to the letter.

Alexander Goldfarb, Analyst

The second question is on the mortgaging of Landmark and Bishop Place. You guys have had a strong capital position. You said you built both of those with free cash flow. I don't recall you using a corporate line of credit that often. So just sort of curious about the use of the proceeds and the decision to encumber the assets. I’m assuming this isn’t just to buy back stock, so I'm guessing that maybe this is either to help fund the rehab of Barrington until you get the insurance proceeds or maybe to start another apartment or residential conversion. So just sort of your thoughts on the mortgaging of those two assets and then the use of the proceeds.

Jordan Kaplan, President and CEO

To take the beginning of the question, we felt that the best and least expensive debt we could get were on those two assets, and we believe we secured it. 137 over is very favorable debt, right? It’s 10 years at 137 over. Now rates are high, and I understand that paying the interest on that loan is burdensome. But without making specific allocations, I can tell you that the reason we pursued it was to ensure we have ample liquidity. I think that this recession is not substantially different from the one in the early '90s. And like everyone back in 2000 during the dot-com bubble, they thought they were going to profit, but they didn’t. I believe that there will be genuine opportunities arising, and I wanted to ensure we had the capacity to seize them.

Blaine Heck, Analyst

Jordan, can you talk about the zoning changes that were made at the state level late last year that gave multifamily zoning to certain parcels on major thoroughfares? I think you were expecting guidance on that in July. So any update there? And do you think it could result in more development opportunities for you in the next year or two?

Jordan Kaplan, President and CEO

To answer the last part of your question first, I'm sure it will result in more development opportunities for us. We have sites that those state-level changes directly impact. I mean, it impacts in a way where I initially thought this would be a long process, but it has been expedited. However, this situation remains quite complicated. The city is not known for moving quickly, and we still have not received guidance. I'm anxious to ensure that the guidance complies with what the state requires. We have always seen opportunities but need everyone, including those who sign off on our approvals, to move in the same direction.

Blaine Heck, Analyst

Switching gears, can you talk about the increase you're seeing in property insurance that affected your same-store projection this year? Just give some color on that situation and maybe how long you expect that to be a headwind? Also, what you're seeing on the property tax side and whether you might be in for some breaks there in the future?

Jordan Kaplan, President and CEO

Regarding insurance, we've seen rates fluctuate over the decades. It’s one of those odd expenses that doesn’t just trend steadily up. When the market tightens, rates can spike dramatically, and then become competitive again. Currently, we are facing increased premiums due to high disaster claims across the country affecting reinsurers. This is impacting our overall costs. While I believe it will eventually correct itself, the recent increases are quite significant. As for property taxes, there are opportunities, especially with what's happening in the city right now, to appeal for property tax reductions if you feel that your property has seen a decline in its market value. There are opportunities to manage them, but it's a complicated process.

Michael Griffin, Analyst

Maybe going back to the leasing pipeline, I'm curious what the cause is for driving these longer lease terms that you mentioned in the release. Is it more certainty about space requirement needs, maybe a shifting view of the macro?

Stuart McElhinney, Vice President of Investor Relations

Michael, during the pandemic, we saw tenants adopt a shorter-term mentality, which was understandable due to uncertainty. As a result, average lease terms shortened. We're now pleased to see that the average lease terms are back to five years, which is our historical average pre-pandemic. This shows that tenants are gaining confidence and are more willing to commit to longer terms rather than postponing decisions.

Jordan Kaplan, President and CEO

As I mentioned, the million square feet that were leased last quarter, I’m beyond happy about that. I wish it were more new leases, but the strength of this market is evident through the significant activity we are seeing. While existing larger tenants are renewing for longer terms, which is a great sign, we still aim to attract more larger tenants to the available spaces.

Dylan Burzinski, Analyst

In terms of capital allocation, how do you weigh share buybacks versus being opportunistic on the acquisitions front? Is it simply some spread to your implied cap rate or just what does that internal process look like?

Jordan Kaplan, President and CEO

Typically, if you asked about our inclination, it's to pursue acquiring great buildings. They are vital for our long-term sustainability. We have enjoyed earnings growth for the last 35 years. In this mature market, owning high-quality buildings is key. However, sometimes it becomes difficult to overlook the opportunity presented in our stock. We always balance these two options.

Bill Crow, Analyst

Jordan, is it fair to assume that your decisions, including taking on more debt and maybe share repurchases and prospective new investments, are done against a backdrop that you assume that Warner Bros. Discovery does not renew in the next year?

Jordan Kaplan, President and CEO

Yes. We assume they're not renewing. That is correct. So obviously, the business interruption insurance covers a number of issues, including the physical cost of repairing the building.

Camille Bonnel, Analyst

As a recurring theme these past few months has been around preserving liquidity, which has been reflected in your actions to resize your dividend. When evaluating the best sources of capital, how do you balance deleveraging versus buybacks? Since everyone recognizes earnings will be under pressure given the current environment, instead of taking out that loan, could you have used the additional liquidity to address your needs?

Jordan Kaplan, President and CEO

I don’t feel we have any need to reduce our debt level. Our debt levels are relatively low right now. Beyond everything—including the dividend, debt service, and our operational costs, which we maintain very low—we have significant cash flow. We have an enormous amount of capacity to deleverage through adding real estate to cover or pay down debt. We have numerous tools at our disposal regarding debt. With minimal meaningful debt due until 2025, we entered this recession in a very strong shape, and this would be our fourth recession. We have learned many lessons over the years, and I don't want to miss opportunities to grow the company.

Operator, Operator

Our next question will come from Blaine Heck of Wells Fargo.

Blaine Heck, Analyst

Just wanted to circle back. Stuart, you mentioned a large tenant giving back space in the third quarter. Can you provide any more detail around where it is, how much is being given back, and why they might be moving?

Stuart McElhinney, Vice President of Investor Relations

We don't like to talk about individual tenants too specifically. We’re a flow business, but this is noteworthy because it's large, and you are likely to see the impact in the numbers next quarter. So it's a tenant in Woodland Hills, they are renewing but downsizing, which we are happy to have them stay in part of the space, but they wanted to give back some of the space that they had. Not much more to say beyond that; it's not an atypical situation. However, I wanted to mention it because it's likely to be noticeable.

Jordan Kaplan, President and CEO

Thank you all for joining us, and we will speak to you again next quarter.