Welcome to the 11:00 A.M. session of Citi's 2024 Global Property CEO Conference. 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. For those in the room or the webcast, you can go to LiveQA.com and enter code GPC24 to submit any questions if you do not want to raise your hand. Jordan, we'll turn it over to you to introduce Douglas Emmett and the team, provide any opening remarks, and then we'll get into Q&A.
Thank you. Thank you for providing this opportunity. I'm here with our CFO, Peter Seymour, and our Vice President for Investor Relations, Stuart McElhinney. Douglas Emmett is 80% office, 20% residential. We have about 18 million sq ft, around 5,000 apartment units, a big apartment pipeline. Looking around the room, I think a lot of people know the company, so I'll let you just go right at it with questions.
Great. Thanks so much. We're starting off each of these roundtable sessions with the same opening question: What are the top reasons investors should buy Douglas Emmett's stock today?
Well, contrary to popular opinion, I don't believe office is dead. We're primarily an office company. We're priced extremely low, probably one of the greatest opportunities on the street. Why are we unique? We're unique because office is negatively viewed for three reasons. One is the kind of hangover of work from home is going to permanently degrade utilization, and therefore we're just oversupplied regardless of new construction. The second is there is an oversupply. And the third is tenants, for economic reasons, cost-cutting reasons, are cutting their footprint in terms of office. I think the first reason is wholly incorrect, and as a matter of fact, we're back to almost full utilization. So we haven't felt that as an impact for a long time in our markets. I know that's not the case for all markets. But we've seen people coming in.
We were at 35%+ even when it was illegal to come in. The second reason, which is overbuilding, I think you can look at, and many, many of the investors are informed by what's going on in their markets, which would be New York or Boston or San Francisco or Washington. I think they did have dramatic overbuilding running up over the last 6-8 years, even during the pandemic, still doing construction of office. I think they're heavily overbuilt markets. I think that's mostly what's clouding occupancy today because you're not seeing the rapid growth that we saw going that drove that building. Now, the third thing is impacting us, but that's not impacting us, by the way. We do not have any overbuilding. We've had almost no new supply come on the market since literally the Great Financial Crisis. The third thing, though, is impacting us.
We're seeing our larger tenants who are focused on cost-cutting. When the opportunity comes up, they're reducing their footprint, and they're doing layoffs. I don't think they're reducing their footprint because they expect their workers to work from home from here on. Matter of fact, we don't have a work-from-home issue in our markets. But I do think they're laying some people off, whether it be in tech or the entertainment industry or even insurance or banking. And as a result, they're trying to take a 40,000 sq ft footprint and turn it into 20,000 sq ft. And that is impacting us and acting as a drag on our recovery from the impact from the pandemic. So as a result of that, and because that's very temporary, I think that it's a fantastic investment.
By the way, we have been making that investment, and we bought back some of our stock and have done some other things. We are putting capital out.
Appreciate that. Maybe starting off with supply, I think, as you kind of alluded to, there are other markets where there are more pressures relative to yours. Is there any potential to see supply pick up kind of in those West LA submarkets, or does Douglas Emmett really put a governor on any new supply?
There's no potential to see new supply. I don't need to make a long answer. The answer is no.
Good to know. What are you going to have to see in order to see small tenant leasing pick back up?
Small tenant leasing has picked back up. Small tenant leasing is very strong. Matter of fact, we're doing so much small tenant leasing that we're doing more than some of our peers who are 2x, 3x, 4x our size. Large tenant leasing has not picked up, and that's been our problem.
What do you think it's going to take to see the larger tenant leasing pick back up? Is it business confidence? Is it new business formation? What are we going to have to see in order to make that move the needle?
We're going to have to see the mindset of these businesses, whether they be entertainment companies, insurance companies, banks, shift from being rewarded by the street for cost-cutting, setting out a cost-cutting plan and achieving it through a combination of layoffs and other cost cuts to being rewarded for growth and revenue growth strategies that require new capital investment. That's what we're going to need to see.
Do you think we'll see positive net absorption in your markets in 2024, or is the expectation still for negative net absorption?
In our markets? I don't know that answer. It depends on your view of what's going to happen with the economy.
What's your view of what's going to happen to the economy?
I think that we are going to limp along for a little while. I think that we're a little bit overshot in terms of trying to control inflation. I think capital spend has been shut down in a way that's going to have long-term impacts. I think the Fed recognizes it, which is why they went into the year saying they're going to make some rate cuts because it's not this year, but it's next year. And the next year, they're worried about impacting because you don't just lower rates and make capital cheap and immediately have new capital projects happen. So they have to play for two years, three years away, not this year. And if they don't get going, you're going to create a longer freeze in the system that's going to be hard to dig out of.
Why do you think that the smaller tenant base, relatively lower CapEx or TI needs, makes for a better strategy as we try to navigate the office landscape today versus trying to go after larger tenants?
Well, we're in the small tenant market, so our tenants are predominantly, regardless of what our desires are, they're going to be small tenants. Now, in fact, with regard to small tenants, the economics of the leases are typically much better than with large tenants. That's very easy to see, whether it be in tenant improvements, commissions, downtime, getting them in, all of those things. The reason small tenants are not what everybody focuses on is the other side of that coin is that you have to have a very robust platform because you're doing all the work for them, right? So we have all the lawyers. We have all the space planners. We have all the construction people. We have all the design people.
When a small tenant comes in and they want to do something, we embrace them with the entire process, including being able to just get them the furniture that they want. That has allowed us to kind of tune our platform, which has been very expensive historically. I mean, now it's providing returns to the tenant base that exists in our markets. Now our margins are extraordinarily high. If you look at the cash flow that the company produces, you'll see that it produces very high cash flow relative to our leasing. But that's a result of having spent huge amounts of money building a platform that's tuned perfectly to that tenant base.
We had a question come in from the Live QA feed. Why won't the impact of bigger tenant cyclicality hit smaller tenants? Why are smaller tenants immune to that?
Well, I'm not sure that they're immune or not immune to it in the sense that they're immune to the economy. But I do think they're private, and they run on margins, and they're in markets where the amenity base, their commutes, the quality of the building is a much higher factor for them. The cost of rent, the cost of their operations is a much smaller number for them than it is for some of these larger companies. They just run on very high margins. And so they were very quick to come back in. They were very quick to use their space. They were very quick even to expand their space as they were bringing people back in.
That's not something we saw at a larger tenant's—excuse me—that a lot of times are managed outside of our market, maybe out of New York with a sort of different mindset, are slower to bring people back, are trying to manage to accomplish goals that have to be consistent throughout sometimes the whole world, certainly throughout the rest of the country. So they're just having a tougher time from a management and other perspective getting their whole system running again. And they are more impacted by cost of capital shifting, where if you have a higher margin organization, they don't seem to be as impacted. But facts are that they are not only leasing at a very high velocity, and the rates are still strong, but they're leasing and even playing more than their part in terms of expanding.
They're just not able to eclipse the loss in the large tenants.
In terms of your submarkets, are there any that you're seeing greater demand and strength from? On the flip side of that, are there any that have been weaker than your expectations?
Well, our strongest markets, why? And our strongest markets, why? Because we pursued a strategy of taking office space out of the market and converting it. So we converted a building in Hawaii, and it was large enough that it reduced the supply, and rents moved, in fact, about 18% or 19%. And all through the pandemic, it was even a strong market in the '90s. We have other—I mean, we have other very strong markets. And I'm not—I mean, the whole Wests ide works to some degree in unison, including on Ventura. Warner Center runs a little different. It's still kind of peeling off large tenants, but Warner Center is getting the most capital spend of any of our markets because it's where the Rams are putting their headquarters. It's where Amazon's building studios.
You're seeing a lot of amenity growth there, and you're seeing no office growth. So it has actually kind of one of its best positions in a long time. And some of what's happening there is pulling; it's the one market where some dated office buildings are being pulled out of the market and reducing the supply. Mostly, that's being done by Kroenke, who's building a whole kind of Rams world out there.
In terms of leasing expectations, how have concessions, including free rent and tenant improvement dollars, been trending? And have you seen any signs of stabilization?
They didn't really go up much, so they stayed stable. We have not been a high concession market the whole time, even during the pandemic. I think we saw rents at least according to CoStar, we saw rents fall off to the bottom by about 6%, and they recovered back up about 4% of that. Maybe they're already fully recovered at this point. The fixed bumps in our leases have been retained and have actually increased a bit on a backdrop of inflation. Our TIs are still averaging even a little bit lower. Our TIs and commissions, our leasing costs, are still averaging a little bit below where they were in pre-pandemic, although that may be because our mix of large tenants isn't as great in our deals. And so when the mix is more small tenants, that number is just going to be lower.
In terms of.
We don't give much free rent. That's not a real factor for our market.
Gotcha. In terms of occupancy, it seems like occupancy is still expected to decline in 2024. When do you see this bottoming, and when do you think we could see occupancy inflect?
Well, our hope, look, I mean, we have one large tenant moving out. That's why you're saying decline in 2024. But for that large tenant, which is 460,000 sq ft, the goal for 2024 is to not have a decline in the rest of the portfolio, and we'll see how we do. But I think that's well within the range of something that could be possible.
Can you remind us what the mix of large versus small tenants is, and how do you define large tenants?
Well, for us, a tenant over 20,000 sq ft is large. But even using your definition of 100,000 sq ft, for us, they're vanishing fast. I mean, it's a horrible way to deal with your large tenants. But we had a large insurance company that was 150,000 sq ft. They cut to 75,000 sq ft. Larry Flynt was 60,000 sq ft, and he died. That's no secret. So there's 60,000 sq ft we got back. And then Time Warner, which is 460,000 sq ft, they're not renewing. And that building's been leased for 30 years straight. It's never had any vacancies. So we'll release it. It's fine, but not the market you would have chosen to have that happen in. And then our other large tenant was a big tenant in Beverly Hills, and they already renewed, and we announced that already.
All the other tenants that look like they're large are actually an unrelated combination of leases that are spread throughout the portfolio, whether it be B of A or UCLA or somebody like that. The leases don't operate in unison. While they represent as a large tenant from a credit perspective, they're not large. Individually, they're small tenancies.
Can you maybe talk a little bit about the Warner Bros. Discovery space and what your plans for backfilling that are? And have you seen much tenant interest on the space?
We have, and it has even been a bit of an uptick in terms of interest in it. I think that building will be leased in larger chunks of multi-floor, 50-100,000-foot chunks. Maybe we'll have one or two floors that's multi-tenant. But we have interest on a number of fronts. The tenant's not even out yet, but we are doing showings. We're getting good showings, and we're getting good interest, and we're working on it.
Would it ever make sense to sell the property just given it doesn't fit with your core small tenant strategy?
It could, except that that's a fantastic market and this is a fantastic building. So I've always felt like we own really, if not the best, one of the one or two best buildings in the market that's been one of the best markets in L.A. for 30 years. I mean, historically I know we're at a unique time right now, but historically, that market has had vacancy rates that have been like 4%-6%. It's really been a tight market, primarily because the studios are there. And as a result, not only do the studios take space in the buildings close to there, but all the kind of vendors that want to be close to the studios take space that are close to there. So it's been really an outstanding market. So I've been loath to let go of the asset we had there.
As I said, we bought that building in 1993. From 1993 to 2024, it's never had one vacant sq ft. I mean, and it's had a number of different roles and tenancies, from Columbia to Sony to Time Warner to it was multi-tenant, and then Time Warner just kept taking space. I mean, so it's been through a lot of iterations. It's just a super strong market. Our business is to lease space and make money by the revenue that we get off leasing space. We're not really traders. It's a high-quality building and a high-quality market. But you're right. It does cater to larger tenants, so that would be a reason. So that's a reason we haven't been rushing to sell it historically.
We've had a couple more questions come in through the live QA feed, specifically around media companies and their cost-cutting efforts right now. How important is it for this group to take space in order to recover occupancy?
In order to recover what?
Occupancy.
So our markets are kind of from a demand side. The foundation of demand for our markets comes, yes, from media, from entertainment. It comes from technology. It comes from education. It comes from medical and medical research. It comes from kind of foreign trade and all of the businesses that New York is known for, which is finance and accounting and banking. And so there isn't, while headlines always quote entertainment, or they might quote prior to the recession of tech expansion, each of them has played roughly that kind of 1/6 or maybe 1/5 rule. And so weakness in any of them is never great. Weakness in any of them does never dooms us. But you want strength in all of them.
While we only own one building in the Media District, so we really notice it when that tenant moves out, there's media spread throughout the whole West side. And we have media tenants all over, and there's law firms and all the rest that cater to media. But they also could cater to tech. They also could cater to trade. So they're that value. I mean, yeah, we want everybody to come back, but we aren't overweighted in any of them. We actually give you a pie chart to what our industry exposure is. And we try and look through a little bit and give that accurately. But you want them all to come back, and it's just as important as it is for them as for the rest of them.
Another one from Live QA. What is the vacancy in your markets currently, and how does that compare to vacancy in your own portfolio? And what is the impact of that vacancy on net effective rents?
So the vacancy, I mean, the different submarkets have different vacancies. The vacancy, as reported, I'm not sure I have a lot of confidence in. I think reporting, and we saw this after the financial crisis too. Reporting, which is sort of a self-report thing from building owners, becomes extremely inaccurate at times when vacancy is ticking up. We looked up those numbers at year-end, and we were three or we were above one number in certain markets, and we were below one number in certain markets. So I don't trust the number. But the impact it has had on rents has been kind of interesting because, as I explained, that a lot of the vacancy is driven by larger tenants, and what's left is a larger tenant footprint. So we have not seen, as I mentioned a bit earlier, we've not seen a huge move in rents.
That includes concessions and bumps and everything. The reason for that is, as I said, most of the rents, as reflected by what we're doing, are coming out of tenants that just need their space and want the space that they're in, and they're less sensitive to rate than they are to getting their space and getting what they want. That's number one. Number two is, in this inflationary environment, if you have 3%-4% bumps in a lease, and you get to the end of the lease, and you say to the tenant, "We'll keep your rent the same and keep the bumps going," that's the only deal they're getting where things aren't jumping up dramatically. So those have turned out to be relatively very makeable deals.
As a result, when we report these numbers quarterly, you're seeing that our kind of lease value-to-lease value comparison, total rent paid by the previous tenant, total rent paid by the new tenant, is still a healthy, positive number. It has continued that way. We haven't seen a big kind of move down in rents, and probably for the reasons I just described. I mean, if you're a small tenant, one of your options is to go to a full floor. Your option is to be in another space your size, and that market's still pretty robust and working.
Maybe touching on the regulatory environment for a bit, given it continues to be a key focus in your markets. How important is it to work with key public stakeholders in order to address quality of life issues in your markets?
Extremely important. It's gone from being a footnote to a primary set of goals within the company that gets a focus at the highest level, especially during election years like the one that we're in right now, 2024, in terms of city council members, district attorneys, and state propositions.
Do you think there's any confidence that we've turned a corner in L.A. in terms of some of those initiatives?
We turned a corner in 2022. There was a shift already at that time to more kind of quality of life, clean up the streets, get people off the streets, rule of law, support the police. That happened back in 2022. You can see that pretty easily reflected in the negotiations and the expansions, that new set of elected officials, the way they treated their police departments as opposed to the way they were being treated after the 2020 election. The whole conversation shifted in terms of additional budget, no more elected officials saying defund, actually additional money, better contracts to hire more people, and money to do more expansion and build out police forces.
Maybe just touching on external growth opportunities for a bit. You bought out your JV Partners interests in one of your funds recently. Can you talk a bit about this deal? Was your partner looking to diversify away from office, or is this the start of more distressed opportunities to come?
Well, I think there's some distressed opportunities coming. I don't know if in our portfolio there's any more partners that are going to come and say that because some of the partners, some of our largest partners, I think, are still buyers. And when we bought that, it wasn't just us, right? Every other partner in the deal decided they also wanted to buy it, so we only got our percentage of the deal.
The area which I'm hoping for, and I think we're starting to see a little bit of, and that's what we hope to do, is in this single asset or maybe 2 or 3 building or 4 building asset sales where we could go in and buy buildings in the same way we did in the '90s at cost per foot that are substantially below, where even the rents I mean, if you look at the rent trend versus the price per foot trend, they're completely out of whack now compared to the last 30 years. The last time you saw that was literally in the '90s, which I was buying in the '90s. So that relationship means if there's buildings that come available, we're going to want to make those trades because that's a fantastic relationship.
Are you expecting there to be more distressed opportunities on the office or the multifamily side?
Office. While I think there's apartment buildings that are being sold, most of what we've seen has been new construction that used kind of high-octane construction loans and got trapped by their own aggressive financing. They're not having a lease-up problem. They're not having an income problem. They just over-leveraged. We're not seeing them trade at crazily high cap rates. Maybe it's up a little bit, but maybe you would say that a brand new, fully stabilized apartment building in the hottest of times might have traded at a 4 cap rate or super top end of the 3s. Maybe today, it's a 4 going to a 5 or something like that. I think the movement and so I think the movement in office, especially on a cost per foot, has moved much more dramatically, and therefore, it's much more of an opportunity.
If you were to capitalize on some of these distressed opportunities in terms of acquisitions, how would you expect to fund them from an external growth perspective?
We have a number of ways to fund them. We actually have cash. We store equity in properties, and we have a pretty good investor solvent equity platform. Our first choice is always to work with our partners because if we don't continue to offer them product, we're going to lose them. So regardless of how good you think a deal is, you have to bring them into the deal because they don't want to feel like you negatively select against them. We try and have all our deals be available to them and do them with them. That's what we've been doing for the last few years.
We had a couple more questions come in just on leasing. Do you expect negative leasing spreads to continue in the future? And then secondly, are you seeing any AI-related office demand in your markets?
Well, when you say negative leasing spreads, we've had generally, on at least the lease comparison, we've had positive lease roll-up. The only thing we're having that's negative is the ending rent compared to the beginning rent in the new lease. That has gone down a bit, but that's because our leases have a very strong step function. So when you are at the end of a lease, you're at a dramatically higher rental rate than you were at the beginning of that lease. The new lease may not start at that rate, but it will average a higher rate than the previous lease. So we don't expect that to continue. And what was your second question?
That's on AI demand and anything you're seeing in your markets from an office perspective.
Well, as quantum computing is probably, in the end, going to power AI, you just saw a 70,000 sq ft brand new product of quantum computing go in in Victor's project, which he sold to UCLA. UCLA's uses for that is two things. They're about 500,000 sq ft of new immunology research funded by the state and managed by UCLA. It's all new, all new people, all new everything. And then also, 70,000 sq ft of a new quantum computing research center, also primarily all new use, new people, new research coming into that area, which I think will also draw a lot of other people into the area, not just the people working in that 570,000 sq ft facility. That's a huge research facility to plant right in the middle of the West side.
Beyond that, I don't know that we would know some of our office users are doing quantum computing research or some other type of computing research.
And then maybe just an update on the Barrington Plaza? How are you thinking about the downtime for this? And then after the renovations are complete, how much do you think you can increase rent when the property is updated?
The downtime's years. It's hard to determine. So it's real downtime. I mean, we're vacating the building, and it's a hugely expensive project of three towers and over 700 units. It's a big deal, and it's years. We haven't given any guidance on where we think we'll be when it comes back into the market.
You talked about Hawaii being one of your more favorable markets. What opportunities are you seeing there, and how can you expand your presence in that market?
Well, lately, we've been being outbid. So there actually was 2 trades in that market. We did one conversion that turned out to be enormously successful, which is an office-to-residential conversion. It's about 500,000 sq ft building. It's about 500 units. Then an entrepreneurial developer, a local developer, we were looking at another building to do that and outbid and bought it and has already started that conversion. So that's pulling another building out of the market. And then another building came on the market. That building was about 300,000 sq ft. And then one that's a little over 400,000 sq ft came on the market. And I thought, "Wow, that would also be a fantastic conversion, one of the best conversions." And I think we got outbid for it. So that's just a strong market. The pure office sales, I think everyone's still in a pretty good mood.
I don't see anyone selling just a pure office building. But some of the older, old office buildings that were good candidates for a conversion, which has now turned to be quite a profitable activity in that market, we have a flattering copycat. It's happening.
I know we're running up on time here. We have one more quick one from LiveQA. How much will Barrington add to FFO when it's fully stabilized?
Isn't that the same as asking me what the income's going to be at the end? And I said, "We haven't given guidance on.
Figured I'd ask it. Let's get to the rapid fire. What is the best real estate decision today? Buy, sell, develop, redevelop, or pause?
Well, I mean, my primary goal is to buy office. I think that's the best decision. I mean, there's times when I don't buy in general. I don't love the process of tinkering with our stock, where I hate issuing it, and I'm not in love with kind of going into your business and buying it. There's times when I can't ignore it. To make sure that I don't manage the company the same way I manage myself personally because I've been buying the stock all the way down, $1 million, $1 million, $1 million, we have a committee for the company, and everybody has to vote together to do it. It takes 100%, which has acted as a tremendous governor on buying back our stock, although you did see that I got to go one quarter, and we bought $110 million. But what will be my choice?
Next session, Next session. The next session, we'll be giving you a buyout.
What is your expectation for same-store growth for the office sector overall in 2025?
I don't know. Every market's going to act differently.
Lastly, will there be more, fewer, or the same number of publicly traded office REITs a year from now?
Fewer.
Great. Thank you so much.
Thank you.