Douglas Emmett: Staying Away As Its Office Property Portfolio Is Underperforming (DEI) (2023)

Douglas Emmett (NYSE:DEI) is a real estate investment trust ['REIT'] that's self-administered and self-managed. The REIT owns office and multifamily properties in Los Angeles, California, and Honolulu, Hawaii, with an eye towards higher end real estate. After Douglas Emmett cut its dividend in December 2022 investors fled the name (seen through its tanking share price). The REIT is facing sizable medium-term headwinds at its office property portfolio due to changing employment trends though its multifamily property portfolio continues to put up strong results. I'm staying away from the name as Douglas Emmett is contending with rising interest rates and headwinds from the proliferation of remote/hybrid employment arrangements, factors that are beyond its control. Shares of DEI yield ~6.8% as of this writing after the payout cut.

Overview

At the end of March 2023, Douglas Emmett's multifamily portfolio consisted of economic interests in 14 properties with a little over 5,000 units that were 99.3% leased. The occupancy rate of its multifamily property portfolio has been incredibly high in recent years, coming in at 99.3% at the end of December 2021 and 99.4% at the end of December 2022, providing the REIT with a stable source of earnings and cash flow.

Douglas Emmett has historically done a solid job growing its multifamily property portfolio while maintaining high occupancy rates. Its real estate portfolio consisted of economic interests in 12 multifamily properties at the end of December 2021, and the REIT was able to add economic interests in two additional properties over the following five quarters while maintaining a leased-out rate north of 99.0%. Douglas Emmett noted in its first quarter of 2023 earnings report that rental rates have been strong at its multifamily property operations.

Pivoting to its office property portfolio, the situation here is far less promising. The rise of hybrid and remote work in recent years has meant that office properties are less relevant than they were previously, especially in more affluent areas that cater to the tech, financial services, and similar industries (the kind located in Los Angeles and Honolulu). Douglas Emmett had economic interests in 70 office properties at the end of March 2023 with ~18 million rentable square feet.

At the end of March 2023, its office property portfolio had a 85.5% leased rate and an occupancy rate of 83.5%. While that is not horrible performance, it clearly is not the same level of performance of its multifamily property portfolio. At the end of December 2021, its office property portfolio had a leased rate of 87.6% and an occupancy rate of 84.9%, indicating its performance on this front has been trending in the wrong direction in recent years, and management expects this situation will get worse in the near-term.

Guidance

The REIT adjusted its full-year guidance for its office property portfolio when reporting its first quarter of 2023 earnings. Here is what the company had to say in its latest earnings press release:

We are adjusting our assumption for average office occupancy, which we now expect to be between 81% and 83% for the year. As a result, we adjusted our expected range of same property cash NOI [net operating income] growth to be between -1.5% and -0.5%, and for straight-line revenue to be between $1 million and $3 million. These adjustments are offset by the benefit of our stock repurchase so our guidance range for full year FFO [funds from operations] per fully diluted share remains between $1.87 and $1.93.

We expect Net Income Per Common Share - Diluted to be between $0.35 and $0.41. Our guidance does not include the impact of future property acquisitions or dispositions, stock sales or repurchases, financings, property damage insurance recoveries, impairment charges or other possible capital markets activities.

Previously, Douglas Emmett was guiding for 82%-84% average occupancy at its office properties in 2023 (compared to 81%-83% currently). The staying power of hybrid and remote work arrangements in the US has made office properties less relevant than they were just a few years ago. Additionally, Douglas Emmet was previously guiding for $0.39-$0.45 in diluted EPS (compared to $0.35-$0.41 currently), which has since been revised lower. However, due to its share buybacks conducted in March and April of this year (the firm noted it repurchased ~6 million shares during this period in its latest earnings press release), the REIT maintained its funds from operations ['FFO'] guidance for 2023, which sits at $1.87-$1.93 per share currently.

While a non-GAAP metric, FFO per share is a useful measure of a REIT's ability to make good on its dividend obligations in the near-term. In 2022, Douglas Emmett generated $2.03 in FFO per share. At the midpoint of its full-year guidance, the REIT expects its FFO per share will decline by 6% year-over-year in 2023, highlighting the headwinds its financial performance is contending as it is having difficulties leasing out its office properties. In the first quarter of 2023, the firm generated $0.47 in FFO per share, down 5% year-over-year.

Net operating income from Douglas Emmett's same-store multifamily property portfolio on a gross basis (before factoring in the share its joint-venture partners are entitled to) rose robustly in the first quarter of this year (up 7% year-over-year) but declined at its same-store office properties (down 3% year-over-year, and again, this is on a gross basis and does not take the share of its joint-venture partners into account). As its office property portfolio generates the vast majority of its net operating income (over 85% of its same-store net operating income last quarter), the decline in its performance here dragged its company-wide same-store net operating income down by 2% year-over-year last quarter.

Payout Cut

In December 2022, Douglas Emmett cut its quarterly dividend down to $0.19 per share ($0.76 per share on an annualized basis) from $0.28 per share previously ($1.12 per share on an annualized basis). This move was made to improve the company's financial position and make room for the aforementioned share repurchases by freeing up $74 million per year that otherwise would have been paid out to investors. This move stung, though the company had to adjust to the changing landscape as its FFO per share contends with medium-term headwinds.

Douglas Emmett has a reasonable payout ratio, defined as dividends per share divided by its FFO per share. At the midpoint of guidance, its payout ratio should come in at 40% this year, which is well below the 80% level that's considered healthy (this is a rule of thumb). At the end of March 2023, Douglas Emmett had $0.3 billion in cash and cash equivalents on hand versus $5.2 billion in total debt (short- and long-term) on a consolidated basis however, some of that debt includes the share of debt owed by its joint-venture partners. Due to Douglass Emmett's large net debt load and hefty payout obligations, the REIT needs to retain access to capital markets to refinance that burden while being able to fund its growth ambitions and dividends to investors. The REIT has a $0.4 billion revolving credit facility to help manage its near-term funding needs, which had no borrowings against it at the end of March 2023.

The REIT generated $93 million in free cash flow during the first quarter of 2023, defining free cash flow as net operating cash flow less capital expenditures. It spent $44 million covering its total payout obligations ('distributions paid to noncontrolling interests' plus 'dividends paid to common stockholders') and $17 million buying back its common stock and operating partnership units (the bulk of this went towards its common stock repurchase program) last quarter. After cutting its payout, Douglas Emmett has the financial capacity to keep making good on its reduced payout obligations while investing in the business and repurchasing its common stock.

Concluding Thoughts

Douglas Emmett is in a tricky spot due to the rising interest rate environment driving up its cost of capital (tapping debt markets has become much more expensive in recent years) and net interest expenses, while its office property portfolio is contending with headwinds arising from changing employment trends. These factors are outside of the REIT's control, which prompted management to cut Douglas Emmett's payout last December so it could get a better handle on its financial situation. I'm staying away from the name as its office property portfolio continues to underperform.

Worked as an equity analyst for several years in the USA and have been writing financial articles and analyzing publicly traded companies for more than a decade.