Douglas Emmett, Inc. (DEI) Q3 2013 Earnings Report, Transcript and Summary

Ladies and gentlemen, thank you for standing by. Welcome to Douglas Emmett's Third Quarter 2013 Earnings Call. Today's call is being recorded. [Operator Instructions] I will now turn the call over to your host, Mr. Stuart McElhinney, Vice President of Investor Relations of Douglas Emmett. Sir, you may begin your conference.

Thank you. Joining us today on the call are Jordan Kaplan, our President and CEO; and Ted Guth, 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. 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. [Operator Instructions] I will now turn the call over to Jordan Kaplan, President and CEO of Douglas Emmett. Jordan?

Good morning, everyone, and thank you for joining us. Fundamentals in our markets remain strong. We continue to achieve higher net effective rents in our office portfolio, with the exception of Warner Center, which has seen good growth in occupancy over the last year and continues to experience strong new deal flow. This is also the second consecutive quarter where we signed new leases with better economics than the expiring leases for the same space. Performance of our multifamily portfolio remains excellent, with average asking rents at the end of the third quarter 7.4% higher than a year ago. All of this reflects the continued recovery of Los Angeles, which is still led by strong tenant demand in West L.A. and the Encino/Sherman Oaks markets. During the quarter, we purchased 16501 Ventura, a 191,000 square-foot office building in Encino, for a contract price of $61 million. It is one of the best-looking buildings in one of our best submarkets with great freeway access, small tenants and about 20% vacancy when acquired. We purchased it in an off-market deal and closed all cash. I'm happy to report that by quarter end, less than 45 days after closing, we had already cut the building vacancy in half, reaching approximately 90% leased. As most of you know, there was a fire last month at our Barrington Plaza apartment property in one unit. With the exception of 2 floors damaged by the fire, mostly from water and smoke, we reopened all of that building within a few days. We currently expect that the remaining 20 units will be fully restored within a few months, and that our insurance should cover the damage and loss of rent. Finally, in January, we will increase our dividend to an annualized $0.80 per share. Over the last 2.5 years, we have doubled our dividend payout. At the same time, we continue to have one of the lowest AFFO payout ratios among our peers, leaving us with good cash flow as well as room to grow our dividend in future periods. I will now turn the call over to Ted.

Thanks, Jordan. Good morning, everybody. I'm going to begin with our results, and then I'll address our office and multifamily fundamentals, and finish up with an update on our 2013 guidance. Compared to the same period in 2012, in the third quarter, our FFO increased 11.7% to $64 million or $0.37 per diluted share, treating debt interest rate swaps as fully terminated in the quarter of termination. Our AFFO increased 10.1% to $49.2 million or $0.28 per diluted share. And our G&A totaled $6.5 million or 4.4% of total revenues. Our operating platform remains highly efficient converting NOI to cash flow, with both our G&A and our CapEx among the lowest of our peers as a percentage of revenue. Comparing the results of our combined office and multifamily same properties in the third quarter of 2013 to the third quarter of 2012, our revenues increased 1% on a GAAP basis and 1.3% on a cash basis. Our expenses increased by 2.4%, both on a GAAP basis and on a cash basis. And our net operating income increased 0.4% on a GAAP basis and 0.6% on a cash basis. As we mentioned in our last quarterly call, operating expenses in the second half of the year included expected increases in utility rates and in other third-party costs. Overall, we still expect same-store operating expense growth of between 1% and 2% for the entire year. Now turning to office fundamentals. During the third quarter, we increased the leased percentage for our total office portfolio, excluding the acquisition we made during the quarter, by 20 basis points to 91.7%, and our occupied percentage by 10 basis points to 89.8%. During the third quarter, we signed 179 office leases, covering 693,000 square feet, including 350,000 square feet of new office leases. Given our higher net effective rents on a mark-to-market basis, our average office asking rents were about 30 basis points higher than our in-place cash rents on September 30. For the second straight quarter, the leases we signed had better overall economics than the expiring leases for the same space. Thus, the average starting rent on office leases we executed in the third quarter was 4.7% higher than the average starting cash rent for the comparable prior lease. In addition, the overall straight-line economics of the new leases were 1.5% higher than for the comparable expiring leases. Because of higher rent growth from annual rent escalations, the ending cash rent on expiring leases was 11.8% higher than the beginning cash rent on the new leases. During the third quarter, growth in our cash rent from annual rent escalations in our continuing leases more than offset lower cash rent on our new leases. On the multifamily side, our 2,900 units were 99.5% leased at September 30, 2013, with both our in-place and our asking rents again at all-time highs. During the last 12 months, we raised our residential asking rents by an average of 7.4%. The current asking rents for our multifamily portfolio now exceed our in-place rents by an average of 23.2%. This embedded rent growth represents potential annual NOI of approximately $16.2 million, and mostly reflects the deferral caused by rent control in a rapidly rising market. About half of this embedded rent growth relates to our 248 remaining pre-1999 units. Recurring capital expenditures for our apartment communities during the third quarter of 2013 averaged $86 per unit. Now turning to our balance sheet. Even after the purchase of 16501 Ventura, we still had over $148 million in cash on our balance sheet at the end of the third quarter. Our net leverage was 44% of enterprise value, well within our target range. We continue to have ample liquidity for potential acquisitions and other working capital uses. During the fourth quarter, we expect to close on a $300 million secured credit line and to pay off the remaining $150 million of our 2015 loan. Although this will provide us with additional liquidity and reduce our interest expense going forward, we expect that our FFO in the fourth quarter will be negatively impacted by the early write-off of approximately $325,000 in unamortized loan costs for our 2015 loans. Finally, we have increased our guidance for 2013 to be between $1.48 per share and $1.50 per share. The increase in the midpoint primarily reflects improvements in our fundamentals and our recent acquisitions, partly offset by the negative impact of the write-off of unamortized loan costs I mentioned earlier. For more information on the factors underlying this guidance, please refer to the schedule in our earnings package. With that, I will now turn the call over to the operator, so we can take your questions.

[Operator Instructions] And your first question comes from the line of Josh Attie.

Can you talk about the occupancy decline in Santa Monica and what the backfill pipeline looks like? I know it's a very strong market and the absolute occupancy levels are still very high, but it looks like it came off a bit from last quarter.

Well, we've told you guys that we think that full is 96%, and we told you that keeping it at levels above that is just very hard with turning properties. And so truthfully, I'm still stunned that it's as high as it is.

It's just a few guys kind of moving around gives you a little bit of vacancy. I wouldn't take it as a sign of anything, but that Santa Monica is superstrong.

Okay. And Jordan, I think in the prepared remarks, you mentioned strong new deal flow in Warner Center, and your occupancy in that market was flat sequentially. Could you just elaborate on that and what the outlook is?

Yes, I guess. Without talking about specific deals, we're just getting a lot of showings, a lot of good-sized tenants looking at our properties out there. It's -- in every sense, the deal flow's good. Showings, guys kind of negotiating, the whole 9 yards. So as I said, we feel pretty good about that market.

And you'll remember that the occupancy in that market was up something just under 300 basis points over the last year. So the reality is, we keep telling you guys, there are going to be quarters where there are slight pauses like this, and I think that's what we're expected to be.

And your next question comes from the line of Alexander Goldfarb. Alexander David Goldfarb - Sandler O'Neill + Partners, L.P., Research Division: Two questions here. First, on everyone's favorite, I'm trying to understand mark-to-market. When we look out over the next 4 quarters in Beverly Hills, Santa Monica and Westwood, there seems to be some healthy rents that are expiring. What should we expect from these 3 markets, as far as mark-to-market as those rents expire? Are those spots where maybe it's top of the building, where the rents are going to renew at similar levels, or are these really material rolldowns?

Well, the first thing to remember is that what expires in a quarter is not what we renew or what we execute in a quarter. So you got to be very careful in trying to figure out anything on any given quarter. And secondly, the answer is that, in general, those changes reflect differences in buildings and spaces more than they reflect fundamental differences in the underlying leases. Alexander David Goldfarb - Sandler O'Neill + Partners, L.P., Research Division: Okay. So should we expect -- so as far when those -- over the next 4 quarters in those 3 submarkets, when those rents roll, should we expect much of a material hit to the bottom line or it sort of gets washed out in the leasing noise?

I don't -- there's not likely to be any real hit to the bottom line. Because as we said today, the increases in cash rents on the rest of the portfolio more than outweigh it. But in terms of whether it affects the statistics of a cash rent rolldown, as I said, the problem with that is you don't know which quarter those are going to hit in. So it's very hard to project that out.

He's just saying the quarter they hit in is when we do the new lease deal. Most of that stuff will probably be renewals. So you're right to the extent of saying a lot of it will be in those quarters. I don't think we have any reason to believe that those deals are going to act any different than, on average, what's been going on. They're very strong markets. They have strong rents. We expect to continue to get strong rents. Alexander David Goldfarb - Sandler O'Neill + Partners, L.P., Research Division: Okay. Second question is just in the L.A. Times, I think it was in today's, they had a big article on a bunch of new developments that are slated to come on board. How much of this is stuff that actually will happen, maybe, in conjunction with the expo expansion versus this is just normal market talk of this tower or that redevelopment going on, but at the end of the day, most of this stuff won't happen?

Well, a lot of it -- actually, you're talking about Santa Monica? Alexander David Goldfarb - Sandler O'Neill + Partners, L.P., Research Division: Yes, they were talking about like the Fairmont Hotel. I think they circled your deal on the map. I mean, so...

Yes. A lot of it is obviously residential hotels, retail related to it. There's not a lot of development in our markets, obviously. And what's happened is, if there's such a thing as a community being clenched up, Santa Monica has the worst case of that. And so in order to try and deal with it, they came up with a plan to -- like, a more long-range planning for the various portions of Santa Monica, East Santa Monica, Downtown Santa Monica, along Wilshire. And what it did was it almost made things worse, where they stopped approving anything until the plan was done. So, for instance, the Fairmont, which is a good point. And frankly, I wrote a letter in favor of that, saying, that we're in favor of that project, because we feel like the hotel, the redo of the hotels and the retail is -- obviously, we're not looking for more office, but the redo of the hotels and the retail is super positive for us. But -- and I think probably Santa Monica even feels like that's positive, but they can't get themselves around to agreeing on anything. So you have sort of this build up going on. In terms of Douglas Emmett, I don't think there's any kind of meaningful office competition, and not even really residential competition. Most of what's going on there is people trying to get their hotels and retail projects through. I mean, Santa Monica has something. They're trying to do a resi deal that has a lot of parking in it, in the middle of town there. So I guess it adds up to what looks like quite a bit. And frankly, most of that I would be cheering for, but I don't know that much of it will happen. Alexander David Goldfarb - Sandler O'Neill + Partners, L.P., Research Division: Okay, but at the end of the day, it sounds like most of this is either condo or retail. It's not going to be competitive for...

Well, hotel -- it's redoing the hotels. I mean, those hotels are packed. We have people come to see us all the time. It's hard to get in. And I'd love to see the Fairmont expand and get these condos done and do the big -- the whole corner, they're doing a big park. And I mean, it would be great for 100 Wilshire, right across the street, looking down on that. But they just -- there's a fight going on. The hotel behind it is trying to block it. There's builders from -- it's 3 -- the biggest part of what they're working on is 3 major hotel projects.

And your next question comes from the line of Michael Knott.

Curious. Any comments you have on the investment market? And obviously, there are some big fish out there, as we understand it, in Century City. So just curious whether you think 2014 might be a more acquisitive year for you, potentially.

You know that every year, I hope that the -- that year or end of next year are more acquisitive years for us. Instead of inquisitive, acquisition-oriented years. I'm not going to talk about it, deals that are out there in the world at this exact moment, but we're -- I'm happy with -- that we've been able to make a few deals and buy a few buildings and people are trading again. And certainly, there's probably a good balance right now of people being a little more comfortable selling and us still being well within our comfort zone in terms of values and buying buildings, because we have -- as you know, I have a strong bend towards feeling like the fundamentals are improving here.

But just a clarifying comment. You guys haven't done any kind of really gigantic transaction since you went public. What's your broad thoughts around a $2 billion-type acquisition? You feel like you could finance that, and you feel like you could go down that path, if there was a deal out there of that size that made sense for you?

Well, are you trying to get all the information about the Century City deal without me actually mentioning it? I mean, look, I don't want to get -- and I'm not trying to say it one way or another. I don't want to get in a situation where, by answering or not answering on acquisitions, people go, "Oh, they're doing it. They're not doing it." So I'd rather just let, whether it be that one or Howard Hughes or any of the other big deals that are out there, just let them play out. I will be happy to talk about it after they happen, and either as owned assets or not owned assets or to take shots at the guy that bought it and tell you he made a mistake or made a good deal, all that good stuff, but not when they're right in the heat of battle.

Fair enough. I had to swing the bat, as you understand. Ted, one question for you. It sounded like you guys feel more optimistic about your fundamentals, and you did take up your guidance a little bit. But when I look at all the detailed components of your guidance, it didn't look like any of the real drivers of the business changed in terms of your forecast. I'm just curious id your comment at the end there, that -- the part of the FFO increase that was related to fundamentals, was that maybe just sort of the ranges for some of these metrics moving to the higher end from the middle? Or just curious how you thought about that.

Yes. I think, generally, that we started off being bullish on fundamentals, and the year has come in as we were sort of expecting it. So I don't think you're correct. We didn't make a huge change in the guidance, and a lot of that related to the acquisitions. I think it does underline that, within the range, as you said, there is better fundamentals.

And your next question comes from the line of Brendan Maiorana.

Jordan or Ted, so kind of related to Michael's question. But if I look at your occupancy thus far this year, as you state in the sup, you've taken on a little bit of vacancy with some of the acquisitions. But if I just compare where you are at September 30 with December 31, it's flat for the overall portfolio. And you kept that range unchanged at plus 100 to 150 basis points. So is that -- I mean, effectively, are you saying that you expect a very big ramp in the fourth quarter in terms of where your occupancy will be?

I think that would be a fair inference, which is not dissimilar to what happened last year.

That's the math. You got that.

Okay, just asking the obvious question. Fair enough. And then, Ted, a point of clarification. The -- so in the third quarter, was the space reduction from AIG included or is that something that hits later? And can you refresh my memory on when that free rent portion for them burns off and won't be a burden to your same-store numbers?

Well, let's see. Let's start with the first one. The answer is that AIG is still using transition space, so it has not been a significant hit at this point. The second...

Our first quarter...

So that's going to hit first quarter. And we told you, we haven't given you the details on the AIG lease. We did tell you that the lease expiration date was in August. And we did tell you guys that it was that -- we gave you some guidance that, in general, in those markets, we were giving a little less than half a month of free rent per year. And that, that was a little more in areas where there was, like at warner Center, where the market was not as strong and also for a larger tenants. And that it's typically -- so that gave you the guidance, but we did not give comments on the exact free rent in the AIG lease.

Okay, just point of clarification here, the transition space. So is that -- so that's not impacting occupancy, but the free rent portion in August, or the market free rent, that we should assume that, that is in -- at least was in a portion of your results in Q3?

That is correct. We're...

It's happening now. It's going.

And your next question comes from the line of John Guinee. John W. Guinee - Stifel, Nicolaus & Co., Inc., Research Division: A couple quick questions about the things we never talk about. What's happened to market rents in Brentwood and Santa Monica on the apartment side in the last 4 or 5 years? And how are you underwriting continual rental -- market rent increases in apartments? And then second, just kind of refresh our memory as to what's going on in Honolulu.

Okay. Go ahead. Do you want?

Okay. I think, actually, I gave it in my section. Didn't I have the growth that we've seen most recently? Our 7.4% high growth, and that's across our entire multifamily portfolio. And I think it's actually, in the market you just asked about, a little stronger than it is in the Hawaii market. So you'd weight that a little bit in this direction, although both are improving well, I mean, extremely well.

Right. And we've given you those numbers every quarter over that period of time, and it's -- I don't have those in my head, but they've basically all been in that 6% to 8% range per quarter. So if you went over the 2 years, I would guess that, that's probably a fair assessment on that. John W. Guinee - Stifel, Nicolaus & Co., Inc., Research Division: So last 4 or 5 years has been mid-to-high single digits?

No, no. Not last 4 or 5 years, last 2 or 3 years.

Yes, I think during the recession, we -- I don't think we went down. I think we just slowed down on growth, because there was this weird thing where people were giving up houses and moving into apartments. I'm trying to think back to 3, 4 years ago...

There was, I think, in the 2008, 2009, there was a slight decline, but not very much in asking rents. And then it started to recover, as I said, probably 2 or 3 years ago, pretty quickly. John W. Guinee - Stifel, Nicolaus & Co., Inc., Research Division: And then Honolulu, the CBD appears to me to be sort of a government and quasi back-office market. Is there any demand growth in that office market?

Well, first of all, it certainly is more government there than we have in our West L.A. portfolio, just because it's a governmental center. But on the other hand, remember that the average size of the tenant there is about the same size as our tenants here. So it's about 2,400, 2,500 square feet of these -- the median size, rather. So you have somewhat more government, but it's not overwhelming though.

It's not dominating it. The government office use is sort of right next door to the downtown office area. So you probably see a lot of that, although I think they own a lot of their buildings that they're in. I know there's a big redo of one government project there. It's not -- so I would -- but I wouldn't call it government-dominated. I actually wouldn't call it back-office either, because it smaller tenants and it's their whole operation. But there is sort of a back-office thing going on. You see some of the, let's say, larger players have gone out to the west area, Campbell area, to put the larger back-office uses, because we just don't have that kind of big amounts of space for them, and it's cheaper out there, but it screws up their commuting. John W. Guinee - Stifel, Nicolaus & Co., Inc., Research Division: Then the last question is, it looks to me like the last 7 or 8 quarters, you're running about $4 per square foot per year of lease term for concessions. Usually, what happens is those numbers tighten before rental rates go up. Is that what you would expect to see happening in your markets, or is the re-leasing cost sort of a fixed number that's embedded into the business?

Yes. Well, there are 2 aspects to it. But first of all, we start off with such a low level of things for a lot of our tenants, it's just paint and carpet. And so there's not really, unfortunately, for us, a long way to go down from an already-very-low floor. Then secondly, as rental rates are moving up and lease values are moving up, the leasing commission side of it actually tends to go up there. So you're getting a little bit of upward mobility there, and not a lot of ability to make it a lot smaller on the tenant side.

And there are no further questions in queue at this time.

Thank you, everybody. It was a pleasure speaking with you.

And you do have a follow-up question from Josh Attie.

Can you give us an update on the residential development projects that you've spoken about, and if any of that spend is going to start next year?

Josh, I'm sorry to tell you that I already had my hand on the door to leave. I think that was our last question, so I don't know if I can answer any more. But I'll do yours, and actually Rich also is in there. Yes, we're -- I mean, we're in Hawaii, for sure, spending money. We're spending entitlement-style money already in Brentwood. But we'll be spending construction money in Hawaii next year.

Can you tell us how -- what magnitude?

What do we think for Hawaii next year? Looks like, 50 -- something in the $50 million range, it could be, if we're fast and maybe a little -- the payments lag the construction. So I'm trying to figure out, out of our whole thing, what would fall into 2014. But it's a pretty good chunk of money. I mean, I suspect we will have paid half the bills by the end of 2014 and be substantially more than half into the game of building.

And that would be for the first phase of Hawaii. And for L.A., would you be spending any money on construction?

No, L.A. is...

No, no. here's the incredible thing. I'm spending like construction-style money, can't get any entitlements. But -- so we are spending money but not on, unfortunately, construction, other than consultants to do immense amounts of environmental impact and all the other enjoyable tasks that L.A. sets for you in order to get in front of them and get a deal through.

Just to remind you, Josh, we are planning to break ground, or we hope to break ground in Hawaii, probably sometime end of the first quarter, second quarter of next year. And it's probably a year later before we break ground in L.A.

And it sounds like, from a financing perspective, it's a small enough number that you could put on the new line that you talked about getting in the fourth quarter, is that the right way to think about it?

That is correct. It's very -- yes.

And your next question comes from the line of Rich Anderson.

So I was going to ask about the longer-term same-store firepower of the company. You have obviously come through the recession, and now you have an issue with utility costs the second half. But then I also think back to '07, when you're really hitting the ball off -- the cover off the ball. What do you think the -- kind of the normalized internal growth prospects is of Douglas Emmett once you kind of get to a more normalized environment? Do you think it's mid-single digits or do you think we'll always be kind of in this low-single-digit territory?

I actually think that -- well, first of all, when you do kind of same-store NOI, that's expenses and the revenue side. So just to break it down, expenses, as you come out of a recession, you should expect -- we did a herculean job of holding capital and expenses. I expect expenses to start moving in a way. And we -- as you see this here, we're saying 1% to 2%. And we've had years of 0%, right? So they're going to start moving. At the same time, if you look at the revenue side, it gets driven by 2 things, which is occupancy and rental growth. And we're making some pretty good occupancy gains already. We're getting up into some good territory. We could still pick up a lot of good revenue from occupancy gains in Warner Center. But beyond that, that's going to get tighter and tighter. And then you start getting same-store impacts from growth in rental rate, which are just slower to, like, work their way into the system. Although I will say that, if you want to go just on the subject of rental rate, I expect it to -- there isn't like a stable, like, "Oh, rents normally go up 4% a year or some." I mean, they like to do 0, negative or some big huge number, and we definitely seem to be moving into the larger rental growth -- rental rate numbers much larger than the 4s, 5s, 6s, 7s. It feels like we're moving up into the -- closer to the double-digit territory.

One of the things to remember when you're looking at the rental rate increases, is that compared to our office peers, we have a significantly shorter lease -- average lease term. And so as those rental rates come through, if you're in double-digit rental rates, they actually flow through to our NOI much quicker than they might otherwise.

Bill's giving us a note saying, he thinks we're going to have pretty good same-store NOI growth.

That's nice and precise. So are you needing more occupancy gains though to have significant pricing power? Is that the thinking for heading into next year?

Well, what we've said to you guys is, actually, the issue for us is not more occupancy in our portfolio. Obviously, it's always nice to have more of that. The real issue has been that because of our operating platform, our occupancy is above the rest of the submarkets, and that makes it hard for us to raise rents. So what we need to do is see the -- that either that gap shrink, or both of us continue to move up nicely. And it's not that far away from it, but it does have to happen.

And are you still getting 4% escalators in new leases?

Well, it's now become pretty standard for us to ask for that, and I think that we'll see it in new proposals. And as we move through the process, we're expecting that, that will -- may become standard in the executed leases as well.

Okay. And then my last question is, Ted, at the beginning, you said the CapEx is the lowest of the percentage of revenues versus your peers. What would be your argument again if somebody were to say, "Well, maybe they're leaving some CapEx on the table and there's a deferred maintenance issue in places in the portfolio." Do you -- obviously, you disagree, but why do you disagree?

Well, I think first of all, that issue has been an issue that people use that argument for us for the last 7 years since we've been public. And I think that if you look at the buildings, that's not a true statement. And I think when you look at our buildings, they look very good. It is absolutely our philosophy, which is that you spend what's necessary to do -- to make the buildings be right, and then you try and keep that low. But the first and most important thing is keeping it, I think[ph] . It really is about why we like smaller tenants. Because the issue is, if you're just doing paint and carpet, your TIs are just that much lower, whereas if you've got somebody who -- in most tenants that are 100,000 square feet, they want a complete redo of the space every time you turn the lease.

Thank you, everyone. It was a pleasure speaking with you. We'll see -- we'll speak with you next quarter.

This does conclude today's conference call. You may now disconnect.