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

I'm Michael Griffin with Citi Research, and we're pleased to have with us Douglas Emmett and CEO, Jordan Kaplan. This session is for Citi clients only. If media or other individuals are on the line, please disconnect now. Disclosures are available on the webcast and at the AV desk. [Operator Instructions] For those in the room or the webcast, you can sign on to liveqa.com and enter code Citi 2023 to submit any questions if you do not want to raise your hand. Jordan, I'll turn it over to you to introduce Douglas Emmett and members of management here with you today provide any opening remarks, and then we'll get into Q&A.

Okay. Thank you, Michael. So I'm Jordan Kaplan, I'm the CEO. To my right is Peter Seymour he's our CFO. And to my left is Stuart McElhinney, and he's our Vice President in charge of Investor Relations. I think most of you know this, but we're an office and residential company focused in Los Angeles and Honolulu. And I don't know, maybe that's all that everybody needs to hear and I'll let you go over to doing your questions.

Well, thank you, Jordan. We appreciate that. We're starting off each of these sessions with the same question. What are the top 3 reasons investors should buy Douglas Emmett's stock today?

Well, okay, I'd say, number one, just in general, if you think where is the most -- what is the most beaten up sector in our industry in the REIT industry, you got to say office, right? And therefore, where should you be looking? Office. So let's start out with that. I think everybody should be looking at all this. I don't see the crowded room here. So obviously, people are distracted by residential or industrial but offices the way they should be looking. Secondly, I think that when you think about the reasons why obviously people are looking elsewhere, it's because they're worried about whether it be oversupply or people not coming back to work and utilization or the amenities or safety or something revolving around these downtown markets that have a high density of loss buildings or maybe just I think commuting patterns are changing and people aren't going to be willing to commute any more. They don't like the long train ride. They don't feel like the train ride's safe, et cetera.

Thank you for that...

I'm not done, hold on. For starters, I don't even believe all those issues are going to stop people from coming into the office eventually. I think the office buildings are going to be filled again. So let's tell all my colleagues [indiscernible]. But I want to point out that the office markets we're in and also large tenants are struggling more bringing people back. The office markets we're in do not have any of those bills, okay? So first of all, we're smaller tenants. Our utilization has been high. It was high during the pandemic, it's very high right now, almost essentially back at 100%. The commuting, we don't have -- we just don't have transit. I mean we don't have it. So everybody drives it, parks in our space goes up there. Our amenity base is robust and full all around our office buildings, whether it be not just the housing, but I'm talking about the restaurants and they're walking around and all the rest of it. It's all there. It's all fine. I mean, everywhere has safety concerns. We have the most minor of safety concerns compared to all the other markets that are large gateway markets. And I'm not talking about downtown L.A. We're just in the West L.A. and San Fernando Valley. So why Douglas Emmett? Because I think we've performed in accordance with what I just said. If you look at our leasing, we came out of the pandemic in the fourth quarter of '21 did 1 million feet of leasing. We did basically 1 million feet of leasing for 4 quarters, a lot of leasing for a company our size. Fourth quarter of '22, we warned you that people were talking about the recession and things were slowing down. We at that time, did 770,000 feet, still a lot. I mean a lot of leasing 200 deals, right? So, I think that what I said has been proven out by the activity and the leasing in our markets. Now look, recessions are bad for real estate companies, and we're going to suffer from the impact of the recession, which is tenants becoming more conservative about doing deals. And of course, interest rates are up, so that's impacting us on our floating rate debt. But we don't think -- well, I don't think anybody is going to have long-term effects from what I discussed earlier. But I don't even think we're having short-term effects. We just need to get through the recession. That's the reason why I think Douglas Emmett is a good investment.

Appreciate it, Jordan. Maybe expanding on that, just with the headwinds facing the office sector currently, why is Douglas Emmett differentiated from the competition just in terms of portfolio composition, tenant makeup, you other growth opportunities. You talked about the specificity of your market. So maybe expand on that a little bit.

Well, in terms of portfolio composition, I mean, as I just talked about our markets, we also have the nicest buildings in those markets and more even important than that, unlike some of our competitors, so if you're -- these are great companies, SL Green, Boston properties, whatever. They're very sophisticated operating platforms, but they operate in markets where other owners have very sophisticated operating platforms. We do not. We have a very sophisticated operating platform in a market where we don't have a second place. right? There's nobody else that -- I mean we have a lot more brokers working directly for us going direct to tenants than most of the brokerage offices for CB and the other guys. So we're running a huge operation in-house ourselves and property management in leasing and all those other things. And that operating platform has historically, and this is mine and Ken's fourth recession I've been doing it for 36 years. That operating platform has historically carried us through all the other recessions and giving us the ability to do what you see happening now have a lot of excess cash flow and to grow during the recession. So what are our growth -- I mean, our growth opportunities are exactly the same set, as everybody else that everyone here is meeting with, right, you can pay down debt, you can do development, you can buy buildings or you can buy back your own stock. That's the entire list for capital in our business, right? We can talk about that. Maybe you have a debt question later. Debt's not an issue for us. We're in great shape on the debt front other than the floating rate that's costing us more at the moment. And then we have some development stuff that's going, but we just funded out of cash flow and we have plenty of cash flow. So that gets you down to our -- the same opportunity set everybody else has, which is buying buildings and buying back our stock. And we think both of those are developing as good opportunities, and we're certainly focused on them.

Just on the smaller tenant base, relatively lower CapEx or TI needs. Do you think this makes for a better strategy as we try to navigate the office landscape in a post-COVID world?

I think the smaller tenants are -- have a long -- I going to just keep repeating this. Long term, I think the post COVID world goes to the pre COVID world. I mean, just to be clear about that. But yes, all through this COVID and what's going on right now, small tenants have been fantastic. We went into the recession with people saying, short Douglas Emmett because their credit is going to be worse. In fact, I said to everybody, our defaults can be less than 2%. People guarantee the leases. Our default really is less than 1%. I mean it's basis points across all those years, right? We're collecting our money, that issue has gone away. Small tenants kept coming into the office, small tenants kept doing deals. Small tenants haven't had problems with the utilization issue. They told they want to come in, they're all in, right? So I actually think going through this period of time, they've been very good. The reason long term I'd like -- forget about the COVID thing, I like small tenants more is the cost of transitioning tenants in space, the cost of leasing is just substantially less. If you look at an office company and you're honest with yourself about the expenses of the company, the largest expense of the company is leasing costs, right? It's commissions and TIs and the downtime associated with moving people as opposed to if you were to compare it to an apartment deal, which they what, $300 a unit or something paying carpet, and it's a few days in a good market. The company is focused a lot on that number, that expense number and reducing it as much as we can. And we have, we're half of our peers. We're not half of our peers because we're smarter, we're not half of our peers because we're better. We're half of our peers because small tenants don't take a lot to turn them. 50% our deals are direct. I mean just going to the tenant and leasing to them, right? So that's a great -- that allows us to have substantially more cash flow and you guys see it in our numbers. You see how much cash flow we have even after our dividend all the time. So that's why I like small tenants more. And you're -- we're big and they're small, and therefore, you're able to sort of standardize the lease form and have a more fair set of economics that are not so tricky in the form.

Maybe just on leasing expectations. Are there anything tenants are looking for or asking for today that they might not have been 6 to 12 months ago? And have you seen a noted uptick in tenant interest from any particular industry. I think of your bread-and-butter tenant let's call it that, the 4 to 5 person wealth management kind of office that drives in from Beverly Hills. So any updated thoughts there?

I think the mix of our tenant base has stayed relatively the same throughout this whole thing. And so now I really - I can't say I've seen much of a difference. I did point out in the fourth quarter last year that the decline seemed to be mostly driven by larger tenants, which large for us is 20,000 to 40,000 feet. The small guys we're still going, and that's why we did 770,000 feet instead of 1 million.

Then just -- you touched on your commentary, particularly around the office occupancy, just more on the conservative side. You talked about your worries around a recession, you're not baking in much of anything for occupancy growth expectations in 2023. But do you think anything could happen where we could see occupancy surprised to the upside.

Of course. I hope for that I mean, look, we're making the same predictions that the predictions that are relevant and matter is using the same information that you guys have access to about whether we're going into a recession, whether tenants are going to slow down, how long is the U.S. economy going to be risk off, which is what causes tenants to slow down in their decisions. And then around interest, our predictions around interest is just we're using the same curve you guys can look up for our variable rate debt, and we're going to -- that curve is what we put into our guidance.

Yes, that's why we got rid of the 10-year treasury yield question for the rapid fire. So you don't -- we had an interesting question come in from live QA. So thank you for whoever put this in. The Water Garden asset in Santa Monica is now expected to sell at a lower per square footage valuation, I think, relative to where it was initially brought to market. I know this probably wouldn't particularly be in your wheelhouse, but any implications for your properties asset values and the transaction market in general?

Well, all transactions that close are implications for value for other buildings in the market. I mean we're not a large tenant company. That's a large tenant building. But yes, I'm sure there -- yes, it has implications. I don't know if the deal will happen or not, but has implications. Yes.

And then just expanding on this. Again, I know it's not in your wheelhouse, but the distress we've seen in office, particularly in downtown L.A., could your portfolio be a beneficiary of this kind of distress in terms of tenants maybe looking at opportunities more on the west side?

The primary beneficiary of tenants leaving the downtown market for quality of life reasons, I guess, basically, has been Century City, and they're extremely well leased. I mean they've gotten a lot of big tenants out of downtown that have kind of come to the conclusion even when there's a lot of time left on their lease, they've concluded, I can't bring my people back unless I move to the west side, so they just abandon their lease and we to the West side, and then they bring everyone back in the office. If you're kind of a natural kind of hunter downtown, you're going to have a comfort zone of Century City, if you want to be at the West side. We think some of those tenants could spill to Beverly Hills and to Westwood, Beverly Hills because there were people that are living there that were driving downtown say, I might just I forget I'm going to short my commute to 0. And then Westwood, because it does have those larger, more institutional buildings, and it's along the highway there. But we haven't seen anything close to what they're seeing in Century City.

And maybe just on Century City, I know there was that big lease with Creative Arts, I think, signed recently for the one building yet to be built there. I know that's, again, not your sort of general tenant that would look in your portfolio, but what does that say about the health of that submarket.

Century City is very healthy. But I think it's very healthy because of what's happening downtown. There's tenants I mean, like I just said, I mean they're leaving law firms are walking around away from 5 years left on their lease and saying, "If I want to bring my associates and everyone back in, I've got to move and so there -- and historically, people will be downtown. One of the reasons they were located, I mean, obviously, for government and for being by the courts, but one of the other reasons is that senior people live in Pasadena, San Marino, et cetera. Now that -- even that has shifted to the west side, and they're just moving the crew west.

And maybe just on external growth opportunities. We had a question come in. Just given where your cost of capital is already and you have significant submarket share in the submarkets we talked about, how would adding new assets make an appreciable difference? And why would external growth be it acquisitions or development opportunities make sense today?

Well, they make great sense because the strength of the company has come from the fact that we have such dominant market share and we're able to make all of our platform more efficient every time we gain share. And so we add buildings in these markets at substantially 25% less than the cost for someone else to buy a single building in that market. And as we do that, it's been very good for us to control the market, control it and we can spend more on marketing that market, and we have more options to show tenants. So if you believe in the market, if you believe in the long-term viability of the market, which obviously we do in the markets we're in, then owning a more dominant share, especially with the synergies we get out of doing that is super beneficial and it builds the long-term strength of the company.

And then just expanding on capital allocation priorities now. I mean, what might make the most sense at this juncture? You recently talked about right, you're outside your dividend, authorized the share buyback program. I mean, how should we think about that in the sense of what you're looking to target in 2023?

Well, we're -- I mean we could buy back shares and we could buy buildings, and we got to look at those various options as they're presented to us and where the best place is for us to put our capital, and that's what we're doing.

I guess to expand on that, does one maybe look more attractive relative to the other now? Or should we view it maybe in a greater context? You don't have to give me a specific number. You're going to buy that.

I can't be in. So -- they're -- depending on what's offered in the buildings and we watch the stock price, we watch all of that. And we will make decisions around all of that and all the other options we have for our capital. I mean that's -- I've never even been in love with telling people that we bought a building until after we bought it. So I don't have a lot more like announcements around that.

Just maybe getting back to the leasing and bigger expirations you might need to backfill. I think about one kind of notable one being Warner Bros discovery in 2023 and 2024. I guess any updated thoughts on how this might transact in terms of backfilling or any other commentary there would be great.

So that lease comes up at the end of '24 and the Discovery -- Warner Discovery, whatever it is. And I mean, we don't know what they're going to do. I suspect that if you sat in their boardroom and were listening to their conversations, they don't know what they're going to do. But right now, the building is not -- they're not occupying it to any meaningful degree. So then you should make the assumption that they could be moving out. But I don't know what's going to happen in the end. That's a -- that market -- while at the moment, that market is a large tenant market, and therefore, it's suffering from like the large tenant disease of bringing people back in and they're having trouble bringing people back in. It's been one of the best markets in the whole like L.A. County for decades. As a matter of fact, that building, we bought in 1993, it's never had 1 foot of vacancy, like 1 foot since 1993, right? So it's a very good market. So if they don't end up taking -- if they don't end up taking that space or take half of it or take 0 of it, then we'll just re-lease it. It's a great market. It's a great building.

Maybe just touching on the regulatory environment for the bid. I think about the mansion tax upcoming in L.A. How do you see this and the potential impact for demand for your business and product type? And how important is it to work with key public stakeholders in order to give tenants confidence in returning to the office.

Is key public stakeholders another name for politicians?

We could call it that.

Well, yes, we're spending a lot of time with politicians because I could tell you, I mean, I haven't been as vociferous John, but I haven't been happy with what's going on. So we've been spending a lot of time on it and been partnering with John and Victor and the people that have good positions in our markets. And there is actually shifting happening. I mean, it's Rick, he's not in the public market. I was going to say Rick Caruso. But he ran for Mayor and that would have been great, okay. But in fact, he made the conversation about cleaning up the street, making them safer, getting homeless people off the streets to wherever they need to properly end up. And that dead became the front-running discussion for Karen Bass. It wasn't even like kind of -- so that is the conversation in the city right now about dealing with those issues and cleaning things up and making them safe again, which is what we needed to have happen that has happened. So things have been going kind of in a much better direction, not in love with the tax that you brought up. It's obviously being challenged in multiple ways. And there's other legislation that's coming up that's going to even further challenge it and might decertify it. But we're -- there is politics, which for the first 30 years in my career, we're like literally 0 budget item has become a meaningful budget item. I mean because we have -- they're having such a significant influence on the quality of life in our markets.

Are there worries about continued out-migration trends in California and how that could impact the demand for your product? Or just the fact that you've talked about your tenant base being the smaller kind of tenants that go to the office more, is there any worry around that kind of longer-term trending to other markets away from California?

So I hate even saying this, but this isn't the first time for California. So California is very good at kind of creative destruction, right? So we built up -- we had the oil industry. We had the aerospace industry. I mean we had banking and we sort of destroy them. We seem not to be that in favor of big companies that provide great middle-class jobs. So we are great at incubating. We're an incubator state all new industries, we're great at it, and we'll give you tons of extra money and even let you waste it. But when you get big enough to really employ middle income people, get out. So we have been doing that for decades and decades and decades. And in my decades, I've seen it happen. And it's certainly -- we haven't been the easiest on large companies in the last 10 years. There's no doubt about it. But of course, we also are spending a lot of money in the healthcare -- healthcare and tech and there's like people coming here for that. So Yes. I mean, I will say I'm much less worried about out migration than I am about in migration. We need more migrants. And I'm not talking about like from Arizona. I'm talking about from out of the country. We need more migrants. We should be fully opening up and everybody that wants to come and work, bring them in, and California really needs it. I mean opening -- well you don't need to open a board of the north, but to the south, get more of those workers that are coming through and want to come in and work. That's creating a big problem for us. The other big problem that's being created for us is this ridiculousness over kids coming here, going to the universities, which we have great universities in California. And then after they lose their student visa and they're like telling them to go home after we just educated them, which they would be the most productive people. So -- it's an out migration , I'm not sure even if you really look at the stats, there's some high-profile people like Elon Musk that gave a finger and slammed the door. But really, what we need is more in migration. That's really where our issues are more surrounded. If you fix that, don't worry, the out migration is not as much of an issue.

To quote the great show Arrested Development, I'd rather be dead in California than alive in Arizona. So it seems like you're there month. Maybe touching on multifamily for a little bit. What is the growth opportunity set there? The portfolio is essentially fully leased. Are you seeing the ability to push rents? Or is the expectation for relatively softer rent growth in 2023?

'20 -- what do you mean, softer during '23 than '22? '22 was crazy. So of course, I'd be -- I mean I assume it to be softer. I don't know. It's still pretty strong. The opportunity for growth is we are still -- I still think there could be some rent growth there. But also we own -- I mean, that's a part of the state because when I say like oh, we're an incubator state. So when we go in like a certain direction, we really go all in. So there's many state laws that have been passed in Sacramento that override the city of zoning. And they really revolve around transit corridors and people who don't land on for transit corridors. We're -- when I say we're one the largest, we're overwhelming one of the largest, it was almost like a law passed for Douglas Emmett itself. So if this rezoning thing really works, a lot of sites that I would have formally said would take 3, 4, 5, 6 years for me to get it rezoned to be able to build an apartment building and by right, I can build one. So we're waiting and watching that come out because we have so many sites. And by the way, even without that, we have a lot of sites where you could potentially build. We just own a lot land as an adjunct to a lot of the office buildings and full blocks that we own. So we're following all that, and we're moving forward. And so the growth that you should expect out of that area of our company will come from development on land that we already own.

And so to that end, maybe on the acquisition front, are multifamily acquisitions may be more attractive to office or if you see an office acquisition potentially come up, maybe that would make more sense. Any color around that would be helpful.

Office is way more attractive that than multi-family. I think that they can't even touch it, are you kidding? And multifamily is still trading pretty tight. What forecast used to be [indiscernible]. Whereas offices like get that gargantuanly. So if you believe in the market, of course, you're going to focus more on office.

We have a question down here. [Operator Instructions].

Got it. Got it. So Jordan, you've differentiated yourself from the other office companies or at least in some ways, you're trying to make the case. If I ask other companies, the traditional office companies, if they could waive their one, what would they change? And I've gotten some interesting answers to them. How would you answer that question? If you could wave a wand change one thing right now about the business or about the outlook or about finance, whatever is the most important characteristic. What is it that you would change right now?

Well, you mean separate from just having the recession end. I would love to see the economy settle and interest rates. I think that's going to happen. I'd like to see it sooner than later on interest rates. I mean we're generally in a leveraged industry. So all of us are being impacted by that eventually. And then I think the other thing for me would be, I would like to move faster toward like the rule of law in all these coastal markets. I mean, wherever the country has gone on this craziness where you can steal $800 and all that, it's just us strong communities. I mean it's just destroying them. And I never knew that, that would be something I'd even have to think that could even happen and this thing you've been passing stuff now you get a ticket for Jay walking and now you -- I just think it's wrong. And if -- and I think we have every way -- hundreds of ways to win, all my peers do, too, but we do particularly in our markets and with what we're doing as long as they just don't just cut loose and like hand it over to barbarians. I mean, they just need to start enforcing the law. We need to hire more police. That's why we're all spending so much money and time on this. Like John is, and Victor is and I am it's like supporting the police, bringing more police in the area, even supporting hiring programs. We did a program where we went to the city of Santa Monica. We said, what do you need? We need more place and they said we want to restart our -- they had gotten their budget cut on the cadet program. I went -- it took me like one day, I called a bunch of owners around there. We all put in the money and we say, here's some money, restart your cadet program because they develop into the police officers. All of that stuff is getting a ton of focus out of us. I mean it's not like taxes are super bothersome but that stuff is way more important. So that's probably our biggest thing.

We're asking an ESG question in each of our roundtable discussions. Can you highlight important ESG initiatives that Douglas Emmett is undertaking?

So I don't -- I think I can't honestly say that we'd like SNG's never been a big bank, but energy has been a big thing for us. And in the energy side, we've been reducing our energy use for decades and still are, and we're very focused on it. I don't think on the social side, we're pretty well distributed in terms of our company and our employees almost perfectly match the communities that we work in, in terms of all type of ethnicities and all the rest of it. I don't know that we have any governance issues either. But energy is always something that you can focus on and especially focusing on it where it's profitable. And we've done that consistency consistently for years, and we continue to do it, not even with the focus or not focus on, and that's what we do. And so we expect to continue doing that and reducing our energy consumption.

Maybe we can talk about the Hawaii part of the portfolio for a bit. What opportunity sets are you seeing there? And could you expand that part of the portfolio? I know you've got the one office to resi conversion you've got there, other properties. So any color there would be helpful.

So Hawaii is a great development opportunity for us. We own 2 big 30-acre sites that are way underdeveloped. And we've already built 500 units on one of them, and we have the ability to build another 700 units on that same site and even another third phase beyond that. Then we also have 12 acres that only -- how many units are Hawaiian?

Thousands.

No. How many are there now?

Currently? Oh, 400.

Like 400 units, and we can have 2,000 units there or 475. So we have huge growth we could do there. Kevin, literally over COVID on Zoom. Our entitlements increased for a number of units in height right next to -- it's right next to downtown. I mean it's there. So we have a lot of development capacity on land that we already own, which has been very profitable for us in that market. So that's probably where you're going to see our growth, and we're going to continue doing development there.

And then just maybe one more on valuation and cost of capital. How do you consider your share valuation and implied cap rate when considering an acquisition or development? I mean even with higher cap rates, could you acquire or develop at an accretive level just given the current cost of capital?

Wow that's a long one. So implicit in your question is...

I didn't write it. It came from my...

It's Like another like a fifth way of getting at like when you look at the cap rate on the properties and your stock price and then you look at buildings, how -- why aren't you deciding to buy your stock or buy a building because it's not accreting more accretive. Look, I think it's good. The long-term health of the company it's good to buy the buildings, as I explained already, and I think it kind of increases our dominance in control. But you just can't ignore the stock price at this time. I mean, very rarely do you guys hear me even mention the word of like buying back stock. I don't think most of the time, long term, I don't think companies do very well, just tinkering with their stock, buying and sell like to think it's high. They issue some, they think it's low, they buy some. And historically, CEOs aren't that great at knowing when the stock is high and low, right? But it's very, very low right now. So it has to be on our list. It has to be on our menu, and that's the amount I'm an to say about it.

And then just probably one last one on the balance sheet. I know we're running up on time here. But just any appetite to execute on additional swaps or caps for the floating rate portion of the debt, given some of them are expiring here over the near term.

Well, I still feel like... If rates stay up or stay high longer, it's going to be very destructive to the economy. I think the economy is -- and I know the 517,000 new people entering the workforce and whatnot, but I still think we see it that everybody is shrinking back and I think the economy is going to do a surprising about face. And I think when they do, they'll drop rates. And so I'm not willing to swap right now and lock in the rates where they are today. I'm willing to -- I think for the money at cost, which is not horrendous for a company our size, I'm playing out this portion that's floating and seeing where things go by the end of the year. And that's just the decision we've made. And it's unfortunate because I hate having to make calls about interest rates. We want to make decisions about like the right real estate and developing on the rest of it. But we're being forced to make that call right now, and that's a call that we're making.

I have my 3 rapid fire questions to end the session. First, what is the best real estate decision for Douglas Emmett today, buy, sell, develop, redevelop or pause...

Buy and maybe a tiny bit of development, but mostly buy.

All right, we put them in the spreadsheet as buy. same-store growth expectations for 2024.

For like the whole industry?

The sector. Yes.

I don't know.

Lastly, more, fewer or the same number of office REITs a year from now.

I think there'll be fewer.

Great. Thank you.

Thanks, you guys. Thank you.