Douglas Emmett Inc
NYSE:DEI
Earnings Call Analysis
Q4-2023 Analysis
Douglas Emmett Inc
In the context of 2023, the landscape is influenced by higher interest rates, which have ignited recession fears and nurtured a sense of caution in tenants. This has led to a slowdown in office leasing and a regression from post-pandemic leasing gains. Office occupancy has seen a downtrend, yet this has been partly cushioned by factors such as fixed rent increases, steady rental rates, and limited concessions in the company's operative markets. Interestingly, despite the surge in remote work, it hasn't significantly dampened demand among existing tenants. Added resilience is provided by the fact that over two-thirds of current leases were signed post-pandemic onset, suggesting that a base level of activity has been maintained despite broader economic headwinds.
The company has extended its residential portfolio, materially contributing to rental revenues—nearly a fifth now comes from this segment. Despite market-wide readjustments in the post-pandemic period, the residential arm remains strong, capitalizing on the completed lease-up of the 376-unit Landmark L.A. and advancements in office to residential conversions in Honolulu. With the ongoing conversion projects and full lease-up of current units, there is a consistent and growing stream of revenue from this sector.
Across 2023, the company was active in securing leases, resulting in the signing of 872 office leases that cover a substantial 3.2 million square feet, translating to an average of 800,000 square feet per quarter. In the fourth quarter alone, 202 leases were signed, indicating robust activity despite economic challenges. The value of new leases increased modestly, and cash spreads saw a decline, reflecting the substantial annual rent increments inherent in the firm's leases. Moreover, the leasing costs have remained competitive compared to industry benchmarks. The residential properties also closed the year with strong leasing figures.
Revenue growth was moderate at 2%, boosted mainly by multifamily revenues and ground rent. FFO per share fell by 12% primarily due to increasing interest expenses, while AFFO declined by 8.1%. Same-property cash NOI also saw a marginal drop. However, G&A expenses stayed low, evidencing strong management of operating expenses. Looking ahead into 2024, FFO per share is expected to range between $1.64 and $1.70. This outlook considers the move-out of a major tenant in Burbank, the temporary suspension of Barrington Plaza from the rental market, and rising interest expenses.
With the expectation of enduring higher market interest rates, the company's refinancing approach includes timing its swap and debt maturities. The strategy aims to maintain a window of opportunity to refinance with favorable spreads, ensuring financial prudence in a fluctuating rate environment.
The company's agile handling of its joint ventures reflects a nuanced approach to investment, selling, and liquidity provision based on market dynamics and partner needs. A recent minor sales event within their JV portfolio showcased their ability to navigate these partnerships effectively.
There's an expressed confidence in procuring potential acquisitions, likening the current market situation to the worthwhile opportunities encountered decades prior. Despite vacancy concerns, this optimism underscores an active pursuit of investments, buoyed by favorable supply-demand dynamics and diverse demand drivers such as tech, entertainment, academia, and research in their markets.
In terms of tenant renewals, the company has historically seen a high retention rate within the 65% to 70% range. Although there's expectation of market distress affecting both office and multifamily sectors, the company’s long-term occupancy track record indicates resilience and an ability to navigate through periods of instability.
A notable lease extension with one of their largest tenants until 2037 exemplifies the firm's focus on sustaining long-term tenant relationships. The extension assures significant cash flow and rent increases in the future, even though immediate cash revenues will not be affected, reflecting a strategic perspective on tenant engagement and portfolio stability.
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Ladies and gentlemen, thank you for standing by. Welcome to Douglas Emmett's Quarterly Earnings Call. Today's call is being recorded. [Operator Instructions].
I will now turn the conference over to Stuart McElhinney, Vice President of Investor Relations for Douglas Emmett.
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 to be incorrect. Therefore, our actual future results can be expected to differ from our expectations, and those differences may be material. For a more detailed description of some potential risks, please refer to our SEC filings, which can be found in the Investor Relations section of our website. When we reach the question-and-answer portion, in consideration of others, please limit yourself to one question and one follow-up.
I will now turn the call over to Jordan.
Good morning, and thank you for joining us. In 2023, higher interest rates fueled recession fears. As a result, tenants became more cautious, office leasing slowed and our leasing gains immediately following the pandemic were reversed. Our office occupancy declined, but large fixed rent increases, stable rental rates and low concessions in our markets mitigated the impact on revenue.
Interestingly, remote work does not seem to have meaningfully reduced demand from our tenants. In addition, due to our typical 5-year lease terms, more than 2/3 of our current leases were actually signed after the pandemic began. As Peter will tell you, our 2024 guidance anticipates lower FFO as a result of vacating the Barrington Plaza apartments, the expiration of 1 large lease and higher interest costs.
Our guidance does not take into account any significant recovery in leasing demand, even though we see the potential for that as tenant confidence increases. I am pleased that shortly after quarter end, one of our largest tenants signed an early renewal for 250,000 square feet. We continue to grow our residential portfolio. We have added almost 1,300 apartments over the last 5 years in our strongest markets. Despite removing Barrington Plaza from the market, our residential portfolio now provides almost 20% of our rental revenue. In addition, we have not experienced the residential building boom seen in other major markets. So our apartments remain fully leased. That said, the rapid rent growth during the pandemic seems to be normalizing. There are challenges and opportunities ahead. We are prepared for both, as I am confident in the long-term prospects of our markets. Our supply/demand dynamic is among the best in the U.S. Our submarkets are vibrant, and our office tenants have overwhelmingly returned to work.
We have significant cash on hand, meaningful free cash flow, no corporate level debt and almost half of our office properties remain unencumbered.
With that, I will turn the call over to Kevin.
Thanks, Jordan, and good morning, everyone. I would just like to take a moment to mention that we have completed the lease-up of our 376-unit Landmark L.A. property in Brentwood. At our office to residential conversion in Honolulu, we finished the conversion of another office floor, and as expected, the 22 new apartments are leasing quickly. As the remaining 2 office floors vacate over the next few years, we will add the final 47 units to complete that project.
Otherwise, our cash and strong JV relationships position us to take advantage of new opportunities in our markets and we're focused on finding those opportunities in both residential and office. Stuart?
Thanks, Kevin. Good morning, everyone. For all of 2023, we signed 872 office leases totaling 3.2 million square feet for an average of 800,000 square feet per quarter. During the fourth quarter, we signed 202 office leases covering 710,000 square feet, including 243,000 square feet of new leases and 467,000 square feet of renewal leases. These results do not include the 250,000 square foot renewal in Beverly Hills, signed after quarter end, extending the term for 10 years through 2037. The overall value of new leases we signed in the quarter increased by 4.3%. Cash spreads were down 6.1%, reflecting the strong annual rent increases built into our leases. At an average of only $5.86 per square foot per year, our leasing costs during the fourth quarter remained well below the average for other office REITs in our benchmark group.
Our residential properties continued to perform well during the fourth quarter, ending the year at 98.5% leased. With that, I'll turn the call over to Peter to discuss our results.
Thanks, Stuart. Good morning, everyone. Reviewing our results compared to the fourth quarter of 2022, revenue increased by 2%, partly from higher multifamily revenues and ground rent. During the fourth quarter, we prevailed in a ground rent reset arbitration on land that we own. The result was a onetime payment of accumulated back rent of approximately $5.5 million. And going forward, there will be approximately $1 million of additional annual rent.
FFO decreased by 12%, $0.46 per share, primarily as a result of higher interest expense. AFFO decreased 8.1% to $74.6 million, and same-property cash NOI decreased by 1.1%, driven by a comparison to a strong prior period that benefited from onetime tax refunds on a residential portfolio. Adjusting for those items, residential cash same-property NOI would have been positive 3.3% and overall cash NOI growth would have been negative 0.6%. Our G&A remains very low relative to our benchmark group at only 5.6% of revenue. Turning to guidance. For 2024, we expect FFO per share to be between $1.64 and $1.70, reflecting the expected move out of 1 large tenant in Burbank, the removal of Barrington Plaza from the rental market, higher interest costs and modest leasing assumptions.
For information on assumptions underlying our guidance, please refer to the schedule in the earnings package. As usual, our guidance does not assume the impact of future acquisitions, dispositions or financings.
I will now turn the call over to the operator so we can take your questions.
[Operator Instructions] The first question comes from Blaine Heck with Wells Fargo.
So Jordan, it seems like some of the rhetoric in the market has shifted back towards interest rates that could be higher for longer. I guess how are you thinking about where rates go in the next year or 2? And has anything changed around your thoughts on how to handle the upcoming swap and debt maturities in '24 and beyond?
The reason there are swaps coming up is that we typically do a 7-year loan, and we swap 5 years of it. That gives us a 2-year window to then refinance the loan. So most of the time when swaps are coming up, it means that we need to start to have a point of view towards refinancing. But more importantly, it means that it's probably not worthwhile to try and swap 2 years or 1 year or whatever is left, which is, to some degree, what you see coming up. But as we refinance those loans, we will focus on then swapping them, and they'll be fixed at whatever rate we're in the market at that time. And hopefully, we have a good spread.
All right. Great. That's helpful. Then just a second question. With respect to Barrington Plaza, I guess, can you guys give any update on your expectation with respect to insurance proceeds. Any update on litigation from prior tenants and then talk about kind of the mechanics of that project, especially how capitalized interest might impact numbers and just at a high level, how we should be thinking about kind of the impact to earnings this year and beyond?
Okay. So I'll answer the first part, and I'll let Peter answer the second part. But in terms of the -- well, go ahead, you can answer your section, then you can come back and ask me whatever you don't answer.
Yes. Okay. It's Peter. Yes. I mean, with respect to the impact of Barrington this year, we had about [ $0.45 ] of Barrington in 2023. And that will be reduced to about [ $0.005 ] in our numbers for 2024, mostly due to the remaining retail commercial tenants who are in the property. And then our interest guidance assumes a certain level of capitalized interest. But obviously, that's going to depend on how quickly we move and how much we spend.
Okay. So then your question then revolved around the litigation and the insurance, right? Your beginning questions. And well, we feel it's insured. I mean we still have to get the insurers on board with that. So we're dealing with that. And then in terms of litigation coming from tenants, I mean, obviously, that is also insured, but it's ongoing and all litigation is disruptive. So I mean, that's -- it's a drag that is going on, but we're dealing with that.
All right. We'll stay tuned for an update.
The next question comes from Michael Griffin with Citi.
Jordan, I want to go back to your comment you made on the leasing front. You said that 2/3 of your leases have already been signed during or after the pandemic. Is it fair to assume that leasing is going to materially pick up in the next couple of years? Or is this just kind of the new normal that we should expect?
I fully believe that leasing will pick up over the next couple of years. As a matter of fact, as I tried to really make this point a huge amount of time, which is that -- you saw our leasing pick up right after the COVID kind of got lifted. But what's happened now is the country and particularly a lot of people holding office space, have gotten some sort of recessionary fears shrinking cost cutting. I mean you don't hear about many companies saying, here's the units that we're expanding, right? Everybody is focused on cutting expenses and we're just -- one of the results from that going on across the country. And certainly, here. So people aren't making big commitments to doing new things. Our smaller tenants are going forward, great, and you see it. You see we're doing a lot of leasing. But large ones are very hesitant around commitments, and frankly, what I keep seeing and having nothing to do with COVID or return to work or any of it. I just see that they're showing -- telling the analysts, you guys what you want to hear, which is we're cutting cost by cutting staffing and there's just one article or another like that. So as soon as that lightens up, I fully expect the market to return to where we were before. And by the way, most of our history when we weren't in a process of buying or acquiring a lot of vacancy, we have been at very high levels of occupancy with the portfolio, ranging from [ 93 to 95, 96 ] and you go. What's the reason for that? And why do we feel it's such a great market is what I said, we have the best supply-demand dynamic of any market in the United States. We effectively have no new supply coming in and we have a lot of industries that drive demand. And I know nobody wants to keep hearing about tech and entertainment, but we have medicine, we have universities, we have research. All of those are our space takers. And you're seeing articles about it even today. So I'm very optimistic about where our buildings will be headed as soon as what -- I think what you'll actually see is you'll see interest rates like lighten up and tenants kind of come back strong into the market all around the same time. So -- but we all need to make predictions about that. And I don't think they are market-specific for us.
Got you. I appreciate the insights there. And then I was wondering if you could give some additional color on the 20% acquisition in your JV fund. Was this more opportunistic given the existing relationship you have there? Or should we read into this as you're looking more proactively at acquisition opportunities?
So, in general, when we're in these JVs, our recommendation is always -- we think this is a good hold or we think we should all be selling at the same time. But then in the specific -- when 1 of our JV partners want to sell, we work hard to make sure there's a market for that and they can get liquidity. And this was a relatively small deal. I mean it's not very material, but we were certainly happy to provide that liquidity for that partner that want to get out, and that's all that really happened there.
The next question comes from Nick Yulico with Scotiabank.
Maybe first question is on acquisition opportunities and how you're thinking about those. And particularly in relation to if you have a portfolio right now where you're already dealing with some unstabilized occupancy levels. I mean are you still willing to go out and find investments if they pencil and make sense and put capital to work with JV partners?
Absolutely. Absolutely. I mean, I think, I mean, we're spending -- definitely spending time trying to find deals. And I think it's an amazing opportunity right now. And when I think back to the last time I thought it was such an obvious and amazing opportunity, which may be the [ rest of the world didn't think ], but it did turn out to be the case. You've got to go all the way back to 1990, '91, '92, '93 when Ken and I -- we're just getting going with this company with Dan and Chris, and we looked at what was going on out there, and we said, wow, I mean the price you can buy these buildings for assuming some of this stuff comes up and we have a chance to get it, they're epic -- apparently, they're 130 years, and I don't want to miss that opportunity at all.
All right. And then second is just on the William Morris extension. Are you able to give us any feel for how the rent spread worked on that? I mean, I guess we'll learn next quarter when you put the new rent in this up. But any preview you can give us on that along with how to think about the capital you had to extend to get the lease done?
Yes. So the current expires in 2027, this a 10-year extension. So now it's 2037. They kept all their current space. There's not going to be any current impact on cash revenues because it doesn't start for a while. But we're doing some building work, but I don't think that TIs, I don't think you're going to look at the TIs and say that was a big difference. I doubt that will impact anything in terms of averages or any of that. And there will be very significant cash and straight-line rent roll up.
The next question comes from Jay Poskitt with Evercore.
I was wondering if you could just provide a little bit of color on where you typically see renewal percentages at the start of the year, just thinking through kind of how occupancy will trend throughout '24?
Jay, yes, our long-term average renewal rate for our office tenants is in the high 60s, between 65% and 70% kind of over the long term. If you're looking at the supplemental on the role over the next 4 quarters, obviously, that renewal percentage goes down the closer you get because most of our tenants have renewed 6 months or a year before their term end. So if you want to try to like map something more specifically near term, you're not -- should talk about that offline, but the long-term average is in the high 60s range.
Okay. That's helpful. And then just going back to the distress front as well. I'm curious if you could provide anything on just where you expect to see that, whether it's on the office front, multifamily, maybe a combination of both?
I'll take that. We're going to see it on the combination of both. I mean when you look at the headlines, lenders are taking back both office and multifamily. And I mean, candidly, I was just at something yesterday where they were showing upcoming maturities and the pending defaults on some of these very, very low cap rate multifamily assets that were bought with floating rate debt. It's a pretty deep bench. So I'm expecting that we're going to see more of both of those as the year progresses.
The next question comes from Dylan Burzinski with Green Street.
I appreciate your comments sort of on longer-term leasing expectations. But as we think about what's embedded in the current occupancy guidance, is it your sense that, call it, the 700,000 square foot leasing volume per quarter is going to be more the norm here as the economy works its way through a lot of the uncertainty? Or do you think that the level seen earlier last year is more representative of what's embedded in guidance today?
Well, I mean, actually, we averaged last year, I think 800 or a little over 800,000 square feet. I'm hopeful, but I'm not gutsy enough to say that we're willing to put in guidance some kind of big recovery. And that's why, as we said, we probably, hopefully, in terms of the leasing and what we thought would happen. I mean that's in our guidance, and you have it now. But I'm hopeful, but just like everybody is kind of watching the overall economy, which won't be any different for us than it will be for the rest of the country.
And then as you think about acquisition opportunities, understanding that we may be in the early innings of things. But just curious, internally, as you guys think about deploying capital, is there some sort of yield on cost or IRR that would really get you guys excited? And if so, can you kind of walk through sort of how you guys are thinking about that?
Look, each opportunity is unique based on the rent roll, what the property is. The metric that gets us really excited right now is cost per square foot is going to be very attractive. And then it's a function of taking what we believe in the leasing and the debt market and figuring out what that IRR is going to be. But the opportunities are certainly going to be richer than they were pre-interest rate environment hike.
[Operator Instructions] The next question comes from Upal Rana with KeyBanc Capital Markets.
Just going back to the retention rate here. Based on your occupancy guidance, retention seems to imply about 62%, which is marginally below your historical range that you mentioned. If most of your new leases doesn't come online in '24 or if new leases slows, the required retention rate would need to be increased. So I was just wondering how curious -- how confident you are on that and if you can achieve that?
Yes. So of course, this year includes the Warner Discovery move out, which is 2.5% of our square footage. So that -- and that's built into the range we gave you. So that's going to skew the retention average for this year down lower than it normally would be. The high 60s retention rate, that's our historical average is over a long period of time. But something that large will skew this year So that's certainly taken into account. Beyond that, one [indiscernible] move out, as Jordan mentioned, we're keeping our leasing assumptions pretty in line with what we've seen the last couple of quarters, and we're not assuming kind of any ramp up from here.
Okay. Got it. That was helpful. And then just I want to get your thoughts on the future of UCLA in your portfolio. They've made that pretty big purchase at Westside Pavilion mall and they do have a number of expirations coming up over the next couple of years. So I want to get your thoughts on what their future looks like with you guys?
Well, it's a lot of different leases. So I cannot -- I know the mall deal is not -- it's all new. So it's a whole new program. The whole -- the state is funding a new center for research and immunology, and then also there's a completely separate set of backers that are funding a brand-new research on 500,000 feet, and there's 70,000 feet with brand-new whole research center for quantum computing. And so that's not in any sense of drain of anything, even from campus, I mean from anywhere. In terms of just in general, UCLA's plans and what they're doing, it's very hard to tell. All those leases are -- the decisions about those leases are independently made by the people in those departments. And so it's hard to say one thing or another about them.
The next question comes from Peter Abramowitz with Jefferies.
Just wondering if you could provide an update. Have you had any initial tenant conversations about potentially backfilling that space in Burbank? Is it more likely to be -- do you think you can do it as 1 large lease? Or is it something you anticipate having to break up in to the small or midsized leases?
Well, when we're doing showings and there are certainly tenants there. I think there's reticence to committing. But I mean, I think that will happen. So I'm not nervous about leasing up the building. And all I can say is I hope it's not 1 large lease again because we've spent 30 years talking about that lease every 10 years when it came up rather there'd be multiple leases and be done, be done talking about, but I'm not sure how it will end up. There's obviously large tenants in that market.
And then one other. Besides the move out of Discovery there, any other kind of big components in the same-store NOI growth guidance to consider sort of what are sort of the other swing factors there aside from that move out.
I don't know. Same store is a tricky calculation, I couldn't make a good analysis of that for you. You could give, Peter call, I guess, later and try and figure if there's something else.
I don't think there's anything unique driving that guidance. And also, Studio Plaza is not included in the same-store.
Okay. So it's mainly the occupancy drag that's kind of leading to the negative growth there, but other than Discovery.
That's correct.
The next question comes from Camille Bonnel with Bank of America.
Hi, everyone. Can we get your thoughts on the media sector and how its recovery is trending since the strikes have been resolved just based on the conversations you're having in the pipeline?
I don't know that I have the great -- I mean, I don't have a lot of thoughts. I mean they're -- do you have anything to...
Camille, I'd say this, we -- giving the strikes result has to be a good thing on the margin. We do certainly have entertainment clients and tenants. And so some of that stuff did slow down a little bit on the margin during the strike. So I think it's got to be a good thing for us going forward. But I don't know that it's a huge needle mover in the near term. There's still caution in the market, as Jordan's been describing. But I think happy that those are resolved. We need those tenants to grow. And hopefully, that will happen here when the economy gets a little better.
I think we have 1 large entertainment tenant, and we know they're leaving. So I don't think we have any other big entertainment tenants.
But we do small. We do see all tenants, small leases with writers groups and other small entertainment groups.
Yes. Just trying to get a sense of like the smaller guys are coming back to the table to have conversations, looking to start new projects? Just trying to get a sense if anything has changed since?
Well, I mean you saw -- I mean, you just saw a renewal of the tenant in Beverly Hills that we renewed is an entertainment tenant.
Got it. And -- for my second question, I was just wondering if you're able to provide any additional color on the same-store NOI outlook for office versus multifamily?
Yes. We don't break that out between the two. I think that the recent trends that you've seen are -- would be helpful for you to think about going forward. Residential has remained pretty strong, and we're dealing with the occupancy drag that's hurt office a little bit. So that will be the case for 2024 as well, I'd assume.
The next question comes from Bill Crow with Raymond James.
Two quick questions. First of all, is there any real organic or nonorganic, I guess, demand in your markets? In other words, is it just a market share gain still? Are you seeing actual new space demands?
I think we -- I don't think from large tenants, we're seeing new space demands, but I think we're seeing kind of from the smaller ones, I think we're seeing a lot of business as usual. But larger ones for us are really like over 10,000 or 20,000 feet. So it's impactful when they don't grow or don't renew.
Okay. And second on downtown, and I know it's not your market, but the flow out of downtown can be helpful. Have we reached bottom on this downward cycle? Or is it still -- is the market still declining?
Well, downtown -- most of the downtown went to Century City, right? I mean a couple of other deals. And it was probably pretty positive. It was pretty positive for Century City. I'm not sure how the cycle downtown will play out. I mean if you're there, you maybe have a better feel than me. I mean, there's a lot of people that are focused on getting that area recovered, but there's a lot of tenants that have said, for better or worse, my next 10 years is going to be on the West side. It's not going to be in downtown. So that's certainly going to have an impact. I don't know how that's going to play out.
So you're still seeing out migration from downtown?
I don't think we've been -- I mean, our markets have been a beneficiary. I'm not sure that we've been a primary beneficiary. So what we are in particular seeing, I cannot say that we're seeing anything meaningful from that.
This concludes our question-and-answer session. I would like to turn the conference back over to Jordan Kaplan for any closing remarks.
Well, thank you for joining us, and we look forward to speaking with you again in a quarter.
The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.