Douglas Emmett, Inc. (DEI) Earnings Call Transcript & Summary

Hi, this is Jamie Feldman, the senior office and industrial analyst on Bank of America's U.S. REIT team. I'm joined today by Nicole Fang on our team. And we want to thank you for joining this Bank of America Global Real Estate Conference virtual roundtable discussion with the senior management team from Douglas Emmett. Douglas Emmett is a West Coast office REIT focused in Los Angeles and Honolulu. Joining us today from Douglas Emmett are Jordan Kaplan, President and CEO; Pete Seymour, Chief Financial Officer; Kevin Crummy, Chief Investment Officer; and Stuart McElhinney, Vice President of Investor Relations. Management will spend the first 5 to 10 minutes of our discussion, providing an introduction to the company and update on operating conditions. We'll then move on to Q&A. We hope to make this an interactive session. So please add your questions on the Vericast platform so we can weave them into the discussion. I'll now turn the call over to Jordan to get us started.

Well, thank you, everyone, for joining us. And as Jamie said, Kevin, Peter and Stuart are here with me. I'll really rip through the summary because I think you all know it. We have 18.3 million square feet of Class A office. It's almost 91% leased. We're in markets with no new supply coming on. We have 4,200 apartment units. They're essentially full. We have 2 development projects currently under construction, that will add over 800 units. And we have a pretty significant development pipeline for continuing to build multifamily projects on our sites. In fact, just recently, and when I say recently, I'm saying in the last couple of weeks, we were approved at our Waena project for significant zoning upsizing that will allow us to build another 50...

2,800.

2,800 apartment units on a 12-acre site, that's right next to downtown. In terms of the fundamentals, we have had very tenant-friendly local ordinances in place for quite a while that restrict lease enforcement and have created real headwinds towards collections. Most of those seem to be ending September 30, with respect to commercial, although there's always a chance of the extended at the state level, the governor's ordinance that empowers the cities to have those ordinances in place as opposed to expire September 30. So if he lets that expire, then maybe we would see some changing -- some change. In terms of new leasing volume, it's been slower than usual, but still, we signed 650,000 square feet, which is 125 deals. We did out of that, 150,000 square feet of new in Q2. You might have expected the new deals to be double that, still those numbers are relatively strong compared to what I expected for a quarter when everybody was locked down. We have no debt maturities until 2023, but we do have debt that we would be interested in refinancing once the banks become more aggressive on their spreads and start lending. Our acquisition pipeline is relatively low, but we maybe surprisingly have a few deals that we're working on that we hope will happen this year. In terms of looking forward, we believe that our long-term strategy is still the right strategy. We're in markets with very diverse top industries, entertainment, technology, health care, health care research, robust university systems, foreign trade, tourism, greentech, and that's all juxtaposed against small tenants and very little new supply coming on in terms of office. We have very restricted zoning laws and well-organized community groups. So it's not easy for sites to be rezoned to add additional office. We feel like we have a competitive advantage operationally due to our market share, which is almost roughly 40%. We've got a very integrated operating platform. And in the last -- during this pandemic, we spent a lot of time and energy and money, strengthening our leasing backbone to make it more fluid and virtual. And we think we're getting some very positive results out of that, and we think that, that will continue even after the pandemic in terms of making it easy for tenants to lease office space from us and have it feel more like you're leasing an apartment unit, which speeds up and makes a big difference. The entire process that reduces our turnover costs and it reduces the amount of time that we spend between tenants without collecting rent. We have very low G&A and CapEx relative to our peers, which means that we convert more FFO into AFFO in a very small spread there. Last year, the spread between FFO and AFFO was only 15% versus an average of 55% for our peers. In terms of growth going forward, of course, we're highly focused on acquisition opportunities in our markets. We think as we continue to strengthen our concentration in markets that we love for the very long term, 30-year term, I think they're going to be strong markets. That's always good. We have the development I talked about earlier. We have a number of sites where we can build ground up, residential on land that we already own. We have a residence -- we have a one that we're building right now in Brentwood, we have a conversion that we're doing right now in Honolulu that's having a bigger impact on that market. And then, of course, as we see in terms of office buildings and other residential buildings that are old that we already own as we see an opportunity to redo those buildings and change the rent, increase the rent and get good returns out of that. We've been doing a lot of that. Prior to pandemic, we did roughly 7 projects. We had slated 4 going into this year that we put on hold just out of caution to make sure that the economics that we were relying on to get those returns would still be in place after the pandemic. That's a big mishmash for you of what's going on. But I think at this point, I've talked too long. So we'll be happy to take questions.

All right. Great. Thank you. That's very helpful. Less to dig into. I guess just going back to your comment on September 30 and Governor's plan, and maybe just talk about how the tone has changed among tenants? I think you've been saying since the start, there's a lot of tenants that really should be paying that haven't been. Has there been any change in tone from those type of companies? And then what are your most recent rent stats or I'm sorry, rent collection stats?

I don't have a reason to believe our rent -- go ahead, do you want to answer that?

Yes. Jamie, we haven't provided an update on specific collections since the Q2 call. So we're not giving an update today on those numbers, but we'll give you our collection numbers on the next earnings call.

Yes. I think I will tell you, though, to answer your question. I would say that as the moratoriums roll off, collections improve, right? So that's a big positive. And I'll get back to the more tyrant in a second. But as -- especially in our retail group, which represents a big portion of our non collections, as we go longer and the likelihood of PPE or whatever the government funding that was supporting those companies, is that goes farther in the rearview mirror and they become more anxious about their situation, that goes to the downward direction. So those 2 are just opposing each other, right? I suspect that office will improve and retail will deteriorate if we stay in the position that we're in right now, I don't know how that all net plays out. We might get some improvement out of residential. Now when you say -- let me explain what's happened. So the governor back in March issued an emergency ordinance that empowered local cities to put in lease enforcement moratoriums. And they took many different forms. They could have simply said, you cannot evict your tenants. But many cities went way beyond that and said, you cannot evict your tenants. They don't have to pay you back for super long and you're not allowed to charge interest or fees or penalties or anything else. Kind of designed a kind of landlord hostile super aggressive structure that encouraged, and regardless of your financial situation or your ability, encouraging almost not to pay your rent because it was absolutely free loan and they told you weren't going to have to pay it back for a year. So first, we had to spend months trying to educate city councils and trying to get them off of that. And we made progress in a variety of places and less in other places. At this point through that sort of battling, a couple of things have happened. First, the governor's emergency ordinance vis-à-vis apartments rolled off, I think, September 5. And that was at the end of this legislative session for California. And he said, I'm not renewing it. I'm done getting involved in leases. So he said to the state legislature, if you want some type of ordinance in place that allows -- that protects tenants and stops evictions, you better come up with one that you can agree on and then I'll sign it. And they did. And the one they came up with required people at least to pay 25% of the rent and didn't cover people that made over $100,000, then covered people that -- whose income was over 130% of the median. And just had a whole list of things and said all the money that you had deferred had to be paid back by February. Okay. So that became kind of the law of the land for California with respect to residential. So that's the rule now, okay? That ordinance, when it was brought up, it could have included commercial. It specifically said we're not including commercial. Okay. So that was interesting and probably good. Legislation is not even in session now. Now the commercial ordinance expires -- the commercial emergency ordinance from the governor expires September 30. Now this is going to get super tricky and interesting because in normal times, the cities would not be able to dictate any terms of a validly executed lease or any type of contractual agreement between businesses. So this one moment under our emergency condition, they were allowed -- they went hog wild, start -- all kinds of terms. Most of them didn't even understand how a lease worked. I mean stuff that you almost couldn't even do. They were coming up with during their city council sessions because it's all new territory for them. Needless to say, they came up with plans, where the person could pay back over 12 months, first -- if you waited. If you didn't notify them, they had to pay a back in 18 months, if you did notify them, you had some smaller amount of months and you could charge them half of either interest or -- I mean all kinds of crazy stuff. So the question is two part. One, now most of them have ended their ordinance September 30, but ending it means now that tenants have to pay their rent, but in their minds and have such and such an amount of time to pay back rent that they haven't paid beginning in March and ending in September. But the question is whether they even have a right to have any impact on anybody once the emergency ordinance ends. So number one, will the governor extend the commercial emergency ordinance? He seems to be indicating he's not planning to do that. If he does not extend the commercial emergency ordinance, all the shenanigans of the city payback for this amount of time for this, that amount of time for that, does it have any impact on anybody? Because at that point, they have no say over anything. They came into this without any right to impose restrictions on that process, and they will be leaving without any right. Or will you get to September 30, and the governor has not extended his ordinance, but somehow, cities take the position. But what we said that goes beyond the ordinate should still apply. I -- some of the law firms I've talked to have said, they don't think that's actually right. They don't think you can be empowered to do something for a short time and then say -- and by the way, when I lose the power to do this, I'm setting rules for the next 12 months on something. And some people, I'm sure some other people are going to take off such position. And of course, we're still at risk that the governor says, "Oh, no, I'm going to extend that for another month or whatever the case might be, although that would be complicated for him because he would then have to put in some type of similar rules the way the legislature did for residential. And I don't think he would like to do that. So we will see what happens at the end of September. And then in terms of -- that's a very long answer to your question. But in October, I'll tell you whether not having those ordinances in place have played a big role. But I will say my sense of the world and what's going on is the ordinances are coming off, are -- would be very good, but not having any PPP or PPE or whatever it's called, particularly for our retail tenants, will make a similar difference in terms of negative difference if they don't have any support towards them paying rent. So we'll see in the end what happens.

Okay. Have you reserved against those retail leases, though?

Yes.

So from an earnings impact, you're probably not going to do much in the downside?

Well, every quarter -- I mean every reserve -- certainly, we reserve against with AOS. We reserve against a straight line and all that. Now if you ask me a question, I mean I did future reserves. So if they don't pay me in October, I didn't get that money, right? I mean I will reserve against it, but I didn't get it.

I guess you sound like 2Q was a big quarter for impairments and right...

Yes. We took all -- we tried -- in Q2, we tried to take all of the people that didn't pay and reserve. So retail, as I told you in the last one, while they're not a big part of our economy, they're like 5% of the company, they played a very large role in the money that we didn't collect, right? Because I tell you, retail is like 35% and office was 93% and resi was 96%. So that's why I'm saying you, if the moratoriums roll off, yes, I think we'll collect a lot more on the office. And I think we'll collect from some of the cheaters down to Santa Monica shores that are making $500,000 a year and have a place at the beach. But I'm not sure the retail guys are going to say, "Oh, okay, here's your money because they've been closed."

Yes. No, that definitely makes sense. So based on the leasing you've done and just conversations you're having, I mean, can you read through any changes here, maybe more demand for suburban or kind of closer to homes, less demand for downtown or any change in space layouts? Are people thinking about changing space per employee? Or just any trends you think starting to emerge as things do get better?

So that's like that's 2 groups of questions. One is leasing that we've done, so what's the trends on leasing we've done. The other is like TIs and stuff like that. So I'll do the second one first. So I'll come back -- look, I'll do the first. In terms of leasing, I have to tell you, when I look at the renewals and what we've done, and then I think we've run about 60% of our typical new deal, right? So we came into this year knowing we had a tough second quarter just because non move-outs. But with our pipeline, the strength of our pipeline, we also thought we'd recover back all the way up to that 93%, maybe doing them a little better by the end of the year because we had so much demand. I mean there was coming in as a lot of tension in the market. Second quarter, we had those move-outs. We did a spectacular job on renewals. And now going in the next 2 quarters, our new deals were, as I said, we did 60% of new deals as we would have expected. So I'll assume that the next 2 quarters, we will not have that recovery that I would have otherwise expected since new deals would have gotten us back up to the 93%. We're not going to have that, right? But when then you look at the statistics and you say yourself, well, still -- I mean it's not like we're holding up a couple of deals. We did what's normal, 200 deals. We did 125 deals during that quarter, April, May, June. Probably the most vicious quarter in terms of people doing the stay-at-home, right? That's a lot of deals. And that was boosted by the fact that we were using that quarter to restructure the backbone of our leasing operations, which, if you want to think of it as, we went the last mile in terms of transportation. And so now you could do a ton online. You could do space. You could do a lot of things. Now you can literally video tour the space, look at buildings, use our filters, choose space you like, start talking to a broker, you can get plans for the space, all this online and on the phone and they could send you back modifications to space plans. They could send you finishes, cool finishes, warm finish, whatever. And online, you can sign through DocuSign, the whole process. You can sign a letter of intent. And by the way, on top of that, that letter of intent now is instantly converted into a lease and the lease is back in your hands in less than 24 hours. And by the way, you can sign that lease, too. Now that is super helpful in terms of new deals, but you can't even express how helpful it is in terms of renewals. Because now on the renewal front, if a tenant is sitting there and they say, "Oh, I got my renewal coming up." And they could just log in and renew and be done and they wanted some paint and carpet, and it's done. And we'll get it done when they're open again, and we'll just do it. And now their new lease has started, I mean, that is, I mean, nirvana in terms of moving the system faster and picking up time. And we think while it's working now during COVID, I think it's going to work even better as time goes on. So that's made a big difference on that front. Now to go to your second question, which maybe is around more demand supply and rental rates and all the rest, well, first, also to add the question -- answer the question. Our space, our markets have been built because of average 9-story buildings, because of floor plates that are 15,000 to 24,000 feet, we don't have buildings that are giant cube farms. So most of our office space, and when I say most, I really mean like high in the 90% zone, is built out with -- obviously, we have our core bathroom et cetera. We have our offices around the perimeter. And then you have a couple of cubes and some interior conference rooms and kitchen and file room, okay? So we don't have the density that you come across, whether it'd be in San Francisco, New York, Boston, on those very large 1 million-foot buildings. So as a result, our space is built out to about 225-feet per person. We're in 50,000 feet. I think that we went through and for a 6-feet of distancing, we had 10 cubicles we had to axe off. And we have over 200 people. We have 220 people in here. So -- and I think that's probably more typical of all the space it's built out throughout our markets, whether it'd be in Hawaii or L.A. So people have not been prevented structurally from coming back in, and they have not been in a situation where they've had to say, "wow, to get my people back in, I need to lease more space right away." Maybe that's a negative, right? I think it's probably going to help the people whether it'd be the big JPMorgan facilities or the big facilities in New York and in San Francisco, look, regardless of what they're saying about work-from-home, we know all those people are out looking for space. And by the way, we don't have any mass transit. But I know this is a normal time. This is a slap on us. But we're a car culture with enough parking spaces in every single one of our buildings for everyone to drive in. And so when I was asked about how many people take mass transit to get to work last quarter, I said, I won't be able to tell you when we get mass transit. So we don't have a number of the barriers. So as a result of that, I mean, we're probably seeing 40%, maybe a little better companies coming in on an extremely regular basis. But I would say all our buildings, one way or another, people are showing up at their offices, whether it'd be at regular hours, whether it'd be on the weekend. We aren't seeing the completely deserted and you're not allowed to come in and stay, we aren't seeing that here. We're seeing the lights on and pretty much anywhere at some point in time. So in one sense, I don't think COVID is going to play a big role in the office space of stopping us from reopening. But in a negative sense, COVID probably, in our market, is not going to encourage tenants here to take a lot of additional space in order to support social distancing. What was this last question?

You answered both.

Well, I answered. Did I answer all your questions?

Yes, you did. Another question, a follow-up question came in from the audience. So just 2 parts to it. Number one is, you look at the weakness we've seen in L.A. residential. Does that cause you any concern on what that could mean for office? We'll take that one first, and then I'll go into the second.

Well, I think over about the last 5 years or 6 years, maybe even longer, we've seen extraordinary rent growth in residential. The numbers were like 6% -- 5%, 6%, which was never sustainable, like a bad year would have been 4%. Over the last year or so, we saw those numbers drop down to numbers of like 2% -- 1%, 2%, I mean, bragging 2.5%. I'm not sure that -- I don't know if that's a trend, I don't know if that's COVID -- it's not COVID-related because they happened before COVID. I will also tell you, though, that when you make slight adjustments in rent, like instead of the very fast rental growth, you're still dealing with -- we're still essentially full, 98%, 99% full. If you look at our particular portfolio and not the market-wide stats, our portfolio is probably not a great indicator of what's going on because a lot of -- we're completely full, but a lot of our rental income that you're used to seeing, if you do a decline in income comes from the fact that we had the fire at Barrington. So those fire proceeds that paying the rent now show up in other income. And then in this most recent quarter, we had a lot of move out from universe -- from military deployment in Hawaii. And universities not opening up and maybe 20 to 30 something is moving home. But what was interesting is we went in -- in terms of percent leased, we went in, I think, 98% leased. And we actually ended the quarter 98% leased. But we've got all the way down during the quarter to 92% or 93%, but there's such tremendous pressure for housing here in one -- all within that quarter, we leased it all the way back up. And we're able to absorb the shock of the military, the COVID people coming home and the universities not opening up. So speaking about residential, individually without its impact on office, I would say, I think there's -- in terms of population growth and a lot of tension around a shortage of residential, I think that's still here. But yes, recently, rents haven't moved up as fast as it has in the past. If you say apartment residential impact on office, I think that -- I'm not sure residents are having the biggest impact, at least in our portfolio on office rentals. The people renting our office space or the people making those decisions are mostly in homes. And I've actually been surprised to how home values have held up and even gone up, especially in all the areas along the mountains here. People have been -- maybe they've been home too long and decided to spend some money to they have a larger house or they don't -- they realize they need to pull for the kids or whatever it may be. But home values have held up pretty well. And I actually think apartment rents, well, they aren't performing the way they were. I think they are holding up well and occupancy in apartments is holding up well. I don't think anything I've seen in the apartment sector is making me think that the core supply demand metrics that have been driving office rents and occupancy are going to change. I mean I named all those industries that are growing industries that are in our markets. And I sincerely tell you, we see really meaningless new supply on the horizon. So I still feel very good long term about all those things in our markets.

Okay. We're running low on time. I want to get to some of the more questions -- some of the other questions that are in the queue here. Can you talk more about the Honolulu entitlement and timing to get that going and cost?

So wait, you're talking about the entitlement of Waena or getting a permission to do 1132?

The one you mentioned.

The one you just announced at the beginning of the call, you said 2,800 apartment units...

Yes, that was a new enhancement. And that was done by Kevin and Michelle not by me. I did announce that, which the world didn't know that, but so that was -- but I made an announcement on this, right?

Yes.

Okay. So that was a big deal because we've been saying to you guys, look, we have all this excess land in these different locations. And by the way, MHA was already entitled for like a couple of thousand more units, which you saw us build 500 units, right? And so that's done. That zoning is done. That's by right. But we had bought this other site, which is 12 acres called lying there. And when we looked at it, we said, "Wow, it's in a weird way, it's our best position site because it's really close to downtown." and in another way, in the side facing downtown, all good. Bank has built a new building, et cetera. Behind it, it's senior, but the city is focused on cleaning up that city area and making it nicer. Larry has been in the process of working on that. So we looked at that and we said, "Wow, we don't like -- we would like to be able to build a lot more here. I mean if this place keeps getting cleaned up the way we think it will, this would be -- this is actually some fantastic location for development. I mean it's on the -- right on the rapid transit line and almost a point of -- even from there, you could literally walk and be in downtown, okay? So -- and it's 12 acres, right, which really like scattered with low rises, like you take a couple of lame little 12-, 15-unit low rises down and put much bigger. So Kevin and Michelle, mostly Kevin went in and he started a process growing for quite a while at the city and said, we want to upzone this. We know you guys want more housing. Why won't you let us up selling this site. It's a perfect site for this. We'll still have the amount of low-income housing that we have, but allow us to build additional housing. And I just want to say we just got approved by the city council 2 weeks ago. It was 2 weeks, yes. We got our final -- we had to go through a lot of approvals. It's been not a short amount of time that we've been going through this, put it on your calendar or not on our clock. But I think 2 weeks ago, city, we got our final approval from city council. So we're really happy about that. Now we could build 1,500 units there, sorry?

2,800.

2,800 units there. So that makes a colossal difference. Change the value of that site.