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

Welcome to the 5 o'clock session here at day 2 of Citi's 2022 Global Property CEO Conference. I'm Manny Korchman, Citi Research. We're pleased to have with us Douglas Emmett CEO, Jordan Kaplan. This session is for Citi clients only and if media or other individuals are on the line, please disconnect now. Disclosures are available here on the webcast and at the AV desk. For everyone joining us today, you may ask questions through live QA either on the portal or in the room. If anyone's brave enough, there are mics there, if you want to ask. With that, Jordan, I'll turn it over to you to introduce management, and then we'll go to Q&A.

Okay. Well, I'm here with our CFO today, which is Peter Seymour, sitting right here and our Vice President in Charge of Investor Relations, which is Stuart McElhinney, and he's sitting right here. All of us are ready to answer your toughest questions, Manny.

What are the top 3 reasons an investor should buy Douglas Emmett stock instead of any other listed property company?

Any other company in the universe, that's great. Okay. So I'll relate us to real estate companies just to make it a little easier. But First of all, I actually think we're in the best gateway market in the United States. And if you look at the trajectory of rents in our market as compared to New York, Boston, Washington, San Francisco, over the long haul, like 25-year haul, we've had north of a 4% CAGR on office rents, which you don't see anywhere else. For a little while, I think Washington was beating us, but I don't think it really is anymore. So it's a fantastic market. That's number one. Number two is, it's a unique market. It's small tenants, and we've built the platform that meets that demand. And as a result of that, we have a very high profit margin on our leasing and the tenancy in our buildings. We cater to small tenants. Our turnover costs are very low, and it allows us to drive cash flow. And we do have a lot of excess cash flow every year. And the last reason is because we have fantastic growth prospects. I mean -- and it admittedly is a tight market for acquisitions. So growth through acquisitions is very spotty, although we've historically done it. But we have tons of strong internal growth that we've been able to show by continuing to refine our platform to cater to small tenants. And as a result of that, even if you compare the period before the pandemic to the pandemic, which is a time when we were making -- during the pandemic, we had an opportunity to make a lot of refinements. We've, even during the pandemic, lowered further our turnover cost; that's TIs and commissions. We've done better, not where most companies said, we've had to step it up on TIs and commissions, we've gone down. So that's been a huge difference. And then externally, we have a ton of land that we can develop on, and we've been doing it. You've watched us deliver projects that have been extremely profitable. Ground-up residential, but it's -- because we own the land, the entitlements are very hard to get, but we get them kind of in sequence, and we've been very successful in developing both in Hawaii and in L.A. We've also used our construction platform to do building upgrades, which up to recently was primarily focused on ops building upgrades where we're getting very great returns. We saw that there was significant rent differentiation. As our market tightened up, there was rent differentiation between buildings and quality. And we saw that we were getting for redoing buildings, redoing lobbies, exterior, everything. We were getting returns that were extraordinary, like in the 20% range. So we're continuing to do those to the degree based on capacity. And now, we've even added a couple of our residential projects, which we're doing redoing on that. Lastly, we are so focused in these communities and have such a large percentage that it actually makes sense for us in many situations to do community enhancements. And as a result of community enhancements, our buildings do better. For people who have followed us the last couple of years or even pre-pandemic, you saw that we went in, we looked at converting an office building to a residential building, first, because we thought it would be a possible conversion, but we thought it would have a huge impact on the community and -- in that community. I spent, to you guys, I spent a decade apologizing for why not performing where it was supposed to be. After we did that, we saw Hawaii, first of all, perform as one of our best markets during COVID, into the '90s, we saw rents go up 18% and the residential deal ended up being successful. But that was a move that was meant to impact the community as well as the takeover sort of a park area that was around us. So because of our density, we have those opportunities in other markets, whether it be in Brentwood or other places, also in Los Angeles. So all of those growth -- all that growth stuff combined with what we have going on in our operations and the markets, the luck, I mean that's where we are, combined to make me think we really are the best investment. And I have been making further investments in Douglas Emmett myself. Too long?

Thank you for that. No, maybe it was more than 3 reasons, but...

No, they were 3 groups of reasons.

I guess, just on the second point, the unique small tenants. In the acquisitions you've done, were they similar in that sort of small tenant? And if not, have you successfully converted them to that smaller tenant use on an average basis?

That's been our history. So usually, I mean, first of all, it's sort of self-governing because we don't like to bid up against a fully leased or a single tenant lease building because you're paying partly for that lease and that never works for us. We're very comfortable with vacancy. We're very comfortable with issues because we have such a big platform. So we don't tend to win the bid on office deals that are 100% leased out for 10 years. We just don't tend to. That's not the way we look at things. With that said, we've done some very large deals and gone in and broken up space, but it takes years, and it takes years to get that building settled into a way where kind of our profit model is working at its best, but we have done that.

And then you mentioned that your acquisitions remain tough. Where is acquisition pricing today versus pre-pandemic?

So on the office front, it's very hard to tell. There haven't been enough deals to judge it. I mean, certainly, the fear of people that own office buildings is that pricing is not at pre-pandemic levels, and therefore they're not willing to bring their building out. And then people buying, maybe they're at pre-pandemic levels, but there's no way to tell. The only office deals that have traded that have been kind of meaningful, but not indicative, have been deals that had 10-year leases with a steady income stream. And those have traded at extraordinary prices like $1,800 a foot, very low cap rates because people are sort of trading against just where the treasury was during that time, maybe not really being look at it as a real estate deal. On residential, there are more of those deals coming out and people have confidence around residential because they've seen rent growth and they don't feel like they're going to get some kind of pandemic discount. Those deals are trading. There's not tons of them, but they are trading and that market is much tighter than the pre-pandemic market. We're looking at cap rates there that get down in the 3s, 3, I mean, very low cap rates.

Okay. The other question here in the live QA screen. When do you think you'll achieve the same EBITDA versus your pre-pandemic levels?

Like EBITDA, I don't focus that hardly, but I focus on FFO, AFFO, earnings before interest.

Pick your poison.

Yes. I mean, so look, yes, we -- so look, 2019, our FFO was $210 million. And 2020, the Street [ added it's ] $226 million. And if you would have asked me, I would go, that's good because I think we're going to beat that, right? We went into the pandemic and the government told people not to pay the rent, not to go into the office. So that was a problem. And we've dealt with that. But if you would ask me that trajectory, that trajectory would have been high 20s, somewhere in the 30s and moved up in that way. So there's 2 versions of like how can you catch up? One is, when will we catch up to just 2019? Well, we gave guidance that has a range, I mean, that could be within spinning distance, right, in the range we gave, we gave 204 as a midpoint. But that's not much of a win, right? Because we've done a lot during the pandemic that's increased our earning power, whether it be development projects coming online and other tactics that we've used around leasing. So you would hope that we could get past those numbers, certainly, if possible this year, certainly by next year without any kind of big twist in the system happening again with another type of Omicron or something like that. Still, I think that to get to where we would want to be, which would be back on track to where we were headed, thought we were headed in 2019, then you're going to take a couple of years only because where I think that parking will easily catch up, that will be fine. We have to regain the 600 basis points of occupancy that we lost. And so that is not something you can do instantly. It's going to take some quarters.

What would make that go faster versus slower? Or is it just a matter of time doing its thing, the occupancy bounce back?

Well, looking at our numbers, if you look at before the pandemic, we were 93.6% leased, and now we're 87.6% leased. So we got to that 93% basically by doing kind of a 800,000 feet, low 800,000 feet a quarter of leasing. When you get up into the higher 800,000 foot numbers a quarter, you're getting meaningful positive absorption. You know in order to push rents, we need to pick up about 200 basis points, right? That's like 360,000 feet. So that will be a lot to do in one quarter, 90,000 feet of pause. So that means we take any quarter, we renew about 70%, 30% is going to roll. Now out of that 30%, we're going to bring in new deals. Do we bring 90,000 feet more than those 30% that are rolling, do we bring 45,000 feet more. And so that pace, which we'll track and I think has continued to improve, that pace will dictate how quickly we recover.

All right. Somebody here is asking what the current utilization of your buildings is?

So on our third quarter call, we said we thought utilization was about 70%. And Michael probably re-asked that question of me 5 different ways and I gave him 5 different answers, but they were all the same. So then we went into the fourth quarter and then we got that kind of Omicron damped everything down, and we think our utilization dropped down maybe like 50 or 40. But it very quickly recovered. So when they asked the question in our fourth quarter call, which was in the beginning of February, we were back at 70%. And since that point, I think we are exceeding 70%. So I think it's higher than that number today, but I don't have any stats around that.

What we've learned, I think, across the office meetings we've had is that smaller and I think the cutoff has been kind of 50,000 square foot users, people below that have been more aggressive coming back and larger than that have been more conservative coming back. And I think that's been pretty consistent across markets. So I think that's consistent with what you're seeing as well.

It is. I think that one of the things going on is very large users seem to be managed from some central location in the United States, and that person is making decisions across many states in a very complicated pattern of restrictions. And so they're the most conservative. And smaller users are phoning their employees and saying, "Get back into the office." So it's a big difference. Even in the worst of the pandemic, when it was literally illegal to go into the office, we were seeing 30%, 35% utilization, when we were hearing numbers out of New York of 7%, 8%. In most cities, the utilization was being limited to what was called the central services, payroll, whatever, we all have rules that revolved around those kind of numbers. We were way beyond essential services, right, being up in the 30s. And then as things opened up, we spiked way up, and you saw that happen.

Are you still seeing your larger users more reticent to come in? Or are they in the 40% or 50% or 60% as well?

I don't have a great answer for that. I know that one of our larger users has all gone -- they've all come back in. We don't have a lot of large users, okay? But at this point -- we don't have a lot of large users, but at this point I'm not aware of anybody that is not got almost an immediate plan to go in or is in some sense netted in now and going in and refilling their space.

Have you seen, even since the earnings call, any acceleration in just incoming leasing calls or people interested in taking space?

Well, our pipeline of deals, and we said it on the earnings call, say it again now, has been very strong. And typically we have a tough first quarter. Think about a typical lease will be like it will end December 31 of the year, right? So they're in fourth quarter, they're out first quarter. So we a lot of times have a little more of a hurdle first quarter to get over in terms of move outs if you're doing your 70-30 and a 30% of a larger number. But I will also say our pipeline is very strong. We are seeing really positive flow in that new deal category that I was telling you about. And so that's causing me to be very optimistic and I hope I'm sounding optimistic.

But it wouldn't be surprising if at the end of the first quarter, your occupancy was lower than it was in 4Q, given all that you just said?

That's almost always been the case. But I'm not giving any guidance to what first quarter is going to be, but I will say there's a lot of versions of first quarters. We've had really rough first quarter, that we've still recovered in the next 3 quarters, and we've had more mild ones and, I mean, I don't want to guide to where I think this one is going to come out.

Just -- this is a good one. Are investors too negative on the overall story in California?

Of course, they are. Are you kidding?

So what are they...

So I think California has a couple of things going on. Number one, I remember very early on in pandemic, I saw a lot of notes, Douglas Emmett was going to get hit, and I'm calling this, California is going to get harder because we have smaller tenants and their credit is not as good. In fact, our credits turned out to be, and we said it would be, it has turned out to be extremely good. I suspect our default loss through the pandemic would be less than 1%, which I formally was saying 2%. So that's number one. Secondly, I think we came a little more unglued than other states and many states came unglued, but we came a little more unglued around the defund the police and kind of open up the gates and let the inmates run the place. So that has reversed itself in a pretty and extreme way. All of the lifestyle stuff, the homeless on the public rights of way, the -- being behind the police, funding the police, we have an election this year, governor doesn't matter. But we have a lot of -- we have a mayor of L.A. We have a lot of -- more than half of the city council shifting. And even the most progressive council members are talking about how much more they're going to fund the police and how many police they're going to add. So that's all shifted. Also the homeless and cabinets that were putting everybody insane are already being cleaned up and everybody that's running for -- many, many of the people running for election. Certainly frontrunners are talking about just rapidly finishing that cleanup. So that's a lifestyle thing that's going very positively in the right direction. But I understand why they were a little negative, pessimistic about California.

Okay. What's the biggest growth opportunity that you believe the market is not giving you credit for?

I will say rightfully so because I'm always hesitant to give a lot of disclosure around our development activities because then everybody ask me like, what's the next thing you're building? Where is it going to be? But I do think and I do think we've already demonstrated that we have the ability to continue developing and redeveloping properties and substantially changing our income as a result of that and getting high returns. You've seen me do it. And we have a pipeline of it ahead of us.

When do you think we can get the next announcement on that?

Well, we are already working on locations and -- well, we already said we've got a bunch of deals that we're working on where repositionings, which also includes a couple of apartment deals. In terms of a big ground-up development, we're working on deals both in L.A. and in Hawaii. Hawaii is going to move faster. But both of them should have been ready because we just finished The Landmark project and we're at the tail end of the 1132 conversion. So they should have been ready to go now. The problem is in both of those locations, I mean, if you think that the companies went home, I mean, the government went home with impunity, I mean, I don't even know if they're back now. And so the way the process works is you have to go in and you have to meet with homeowners and then you got to meet with council members, then you got to go in front, well, nobody has been coming in. I mean I was having phone calls with people that are phoning me from their closets in their apartment. So I mean there are many council members. I know I have a meeting in a week with a council member because I'm working on this project. And they said, that's the first in-person meeting they've had in 2 years. How do you run your -- your account member run your district, you had 0 in-person meetings in 2 years. Okay. I don't know what happen to Douglas Emmett if I had been like calling it in from my closet for the last 2 years, but it wouldn't have been good. So that's been going on in the government. So it set us off because we couldn't work on things like entitlements and making deals with people.

Do you think that set you back how long, a year, 2? How long did that set you back?

I don't know. I mean, we're working to get that stuff going again, make a new split, and I hope we're successful. We're super focused on it.

Okay. And what's your #1 ESG priority in 2022?

Politics. Changing the politics of L.A., changing the politics of the state.

Market, does that count?

I don't even know what you're asking me because John went ahead of me, so what do you need? Or you could have asked Victor or any other, so.

Well, company ESG priority.

Getting our occupancy back up to 90%. ESG?

ESG, yes, ESG.

Yes, my #1 priority. Number one ESG. So look, we are annually and have been for decades focused on the E. So it's not very exciting to talk about the E. We literally in my goals that I have, which we disclosed in our proxy, my pay, everything revolves around us continuing to lower our electrical usage on a per foot basis across our portfolio. We've done spectacularly well at that. I did just learn about this rule in New York, where you guys have 8 years in New York to lower your carbon footprint by 40%. That's beyond -- you're not going to be able to do it. I could give that answer, unless you're going to buy carbon offsets. But we have lowered ours 20% in a decade, and we still think we can continue at a pretty good pace of lowering it. Now with that said, on the electrical side, no one is going to win that without the governments taking responsibility and dealing with the generators of power, right? Because we're just on the grid. We can do a lot to lower, but unless the DWP, Edison, whatever, takes action to get off hydrocarbons or whatever the rest of it is, you can't sit there and beat up buildings for that. I mean that's where we get -- we're not going to set up our own energy farms. So that's on the energy side. I think it's worth noting because sometimes I forget that you guys don't know this, but going back literally 2 decades, Dan Emmett, the Emmett of Douglas Emmett, formed Emmett Institutes for the study of climate change at Yale, Harvard, Stanford and UCLA. So to say of a guy that's been focused on this issue way before any of us knew what ESG or any of this was, he's been focused on it, all of which are running and looking and focused on even with this carbon footprint. I just had an event in my house for all of those people. So he's super focused on that. He sits in the meetings, the monthly meetings, Dan does, as well as Ken, and are ensuring. Of late, the thing we've been most focused on is getting our Board lined up with the requirements of the State of California for public companies that are headquartered in California.

Right. We've all heard of -- going back to just the California stuff for a second. We've all heard about this outmigration and yet your multifamily business has done really well. Is that because the headlines have been making too much of that migration? Or is there something else going on with either people trading up or trading around that's keeping your multifamily doing as well as it has?

Okay. So those are 2 different things. So first of all, California and certainly the L.A. County in that area is a gargantuan economy and population, right, like the fifth largest economy in the world. So the -- I think there are -- obviously, you've seen the headlines, these buildings that are moving to lower tax or places with lower regulations, whether it be in Austin or Nevada or whatever the case may be or individuals that are investors that are high earners or some done paying California state taxes. That's a very different thing from kind of the concept of what's going on with apartments and housing. So we have been, as a state, because of rent control and because of city councils and local politics, where you can't get -- if you allow someone to build in your council district, you're probably not going to get reelected. So as a result of that, we have been going shorter and shorter on housing, just every year, we're more under-housed. As a result of that, regardless of whether there's some at the margin people leave in the state or we're not growing as fast as other states in population. Regardless of that, we're colossally under-housed. And as we've come out of the pandemic and people have looked for apartments or maybe stopped living with their parents, whatever is going on, it's just accelerated that issue. And so apartment rents are spiking up in a real meaningful way. Now I will say prior to the pandemic, on a longer look, apartment rents were moving at about 4.8% in our markets annual. That's a very strong number. They've -- they are now exceeding that number. I don't know that that's a number that you would think you would rely on to keep up, but it's a result of the shortage of housing that we have in our markets. We still have very strong industries. We have really strong generators of businesses. California is famous for sort of destructive incubation, right? When a company gets big, we sort of drive them out through regulation and taxation. But then we also like do huge funding and we support new industries and then they grow big again, right? So I don't -- I think that process, hopefully, we can moderate a little bit. We've gotten a little too extreme on that front, but it's a process that California has lived with for a long time.

Okay. The last topic I wanted to touch on was just inflation and how you're combating that in your operating costs?

So inflation is -- we have base year leases with expense pass-through. So it takes a little time for inflation to really flow through the system and be meaningful on our operating costs of our buildings. But inflation is meaningful. I'm not sure it's inflation as much as other -- like insurances run up considerably. That doesn't relate to inflation, okay? There are other items. Certainly, the labor pool has been disjointed, right? For a while, there was horrific unemployment. Now there's a bunch of people who don't even want to go back to work. So that probably doesn't relate to inflation, right? Maybe energy relates to inflation. I'm not sure that's been kind of played out right now. But there is generally -- there are some headline items. There's a comparison period. I think that when you talk about inflation and consumer goods and some of these other things, I think is a big part of that is being driven by supply chain stuff and an increased demand as a result, which is a typical inflation cause of dumping a lot of cash into the economy, especially disposable cash. So yes, it's impacting us, but our margins are very high. So I'm not sure it's an impact you guys are going to see in our numbers.

Next. I know you guys got to get out of here. So we'll close up with the rapid fire questions. What will same-store NOI growth be for the office sector overall in 2023?

Well, they have a pretty good comparison period. So I suspect they're going to do, okay, maybe in the 4% range, but that's nothing to do with what we're going to do. I mean that's -- and it's a total guess for me.

Stuart, you're supposed to prep them really hard, come on, man. What will the 10-year treasury yield be a year from today?

So it's now like 170.

Was 174 this morning, I checked.

Yes. I mean, I -- with everything that's going on and some of the fragility in the economy, I'm actually -- I think that we're a couple of years away from significant unemployment because I think this whole situation where people aren't working, then they're going to need to come back to work and companies are backfilling. So the amount of jobs are -- the jobs are changing. And I think when you say to someone, yes, you can come back to work, but you're working for your kids, they're going to freak out. So I think we're headed for some issues going forward around unemployment. Obviously, now you have to calculate in the global disruption around the war. So it may really moderate what the Fed has been talking about doing -- and by the way, that's at the short end anyway, with interest rates. So I'm not sure you're going to see a lot of increase in the 10-year treasury, but maybe it will be 1.5% to 2%, same, from where it is.

That was a long way to say flat.

I wanted to show you that I thought about it.

And will the office sector have more or fewer public companies a year from now?

Fewer.

Great. Thank you very much.

Thank you, guys.