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Douglas Emmett, Inc. (NYSE:DEI)

Q4 2008 Earnings Call

February 11, 2009 2:00 pm ET

Executives

Mary Jensen – Vice President Investor Relations

Jordan L. Kaplan – President, Chief Executive Officer & Director

William Kamer – Chief Financial Officer

Analysts

Analyst for Michael Bilerman – Citigroup

Anthony Paolone – JP Morgan

Ian Wiseman – Bank of America Merrill Lynch

Richard Anderson – BMO Capital Markets US

James Feldman – UBS

Chris Haley – Wachovia Securities.

John Guinee, III – Stifel, Nicolaus & Company, Inc.

Michael Knott – Green Street Advisors

David L. Aubuchon – R. W. Baird

David Harris – Arroyo Capital

Operator

Welcome to Douglas Emmett’s 2008 fourth quarter earnings conference call. Today’s call is being recorded. At this time all participants are in listen only mode. A question and answer session will follow managements’ prepared remarks. At this time instructions will be provided to queue up for questions. I would now like to turn the conference over to Mary Jensen, Vice President of Investor Relations for Douglas Emmett.

Mary Jensen

With us today are Mr. Jordan Kaplan, President and Chief Executive Officer and Mr. Bill Kamer, Chief Financial Officer. Please note that this call is being webcast live on our website and will be available for replay for the next 90 days and by phone for the next seven days. Our press release and supplemental package have been filed on Form 8K with the SEC and both are available on our website at www.DouglasEmmett.com.

During this call management will be making forward-looking statements. We caution investors that any forward-looking statements are based on the beliefs of, assumptions made by and information currently available to us. The actual outcome will be affected by known and unknown risks, trends and 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 inevitably improved to be incorrect. As a result, our actual future results can be different from our expectations and those differences may be material. For a more detailed description of these risks, please refer to the company’s press release and the current SEC filings which can be accessed in the investor relations section of the Douglas Emmett website.

Please note that the market data resources that are referenced in managements’ prepared remarks are CB Richard Ellis for Honolulu and Los Angeles office markets, [Bree] for those Los Angles office markets, MPF Research for the Los Angeles multifamily market and Property & Portfolio Research for Honolulu multifamily market. With that I would like to turn the call over to Jordan Kaplan, President and CEO of Douglas Emmett.

Jordan L. Kaplan

My remarks today will center on our overall view of the company’s current position and future prospects during this period of extraordinary economic turmoil. I will then turn the call over to Bill Kamer who will provide a detailed account of our financial and operating results for the fourth quarter of 2008 and FFO guidance for 2009.

First, in an effort to put the current economic climate in to perspective it is important to note that Douglas Emmett entered this down cycle in a stronger position than it did at the beginning of every prior downturn over the past 40 years. Each prior downturn was heralded by the completion of excessive new supply and an active pipeline of additional supply under construction and nearing completion.

This time very little new office supply was delivered in our 10 submarkets during the last several years and almost no new space will be coming on line for the foreseeable future. As a result and unlike during prior soft markets we are not facing competition from building owners armed with construction loans containing large tenant improvement allowances in an effort to lease up new projects.

We have a highly diversified tenant base of 2,100 office leases presenting a broad variety of businesses. Therefore, we have a limited vulnerability to the collapse of any one tenant or industry. That being said, this recession is notable for its breadth and depth across virtually all businesses and industries.

As we have suggested in the past, we are seeing an increase in tenant defaults. We lost 15 leases representing 63,000 square feet of occupied office space due to tenant defaults during the fourth quarter of 2008. This compares with 27,000 square feet of tenant defaults in the third quarter but is slightly less than the 64,000 square feet of defaults that we incurred in the second quarter of 2007 which was the highest quarter of defaults since our IPO in October of 2006.

While future occupancy losses from tenant defaults are very difficult to predict we are assuming that throughout 2009 the default rate will remain at or above our fourth quarter level. We are also experiencing a decline in new leasing volume. Businesses are deferring long term commitments for new space and existing tenants are holding off renewals until closer to their expiration dates. Renewing tenants are also showing a preference for shorter lease durations.

In addition to having a fully integrated operating platform, we have an extremely well seasoned and experienced operations and leasing team who have worked together effective in prior downturns. We have implemented pro active programs to minimize the adverse effects from tenant business reversals. With these measures in place we are confident that we will continue to outperform others in our markets.

We also remain optimistic about the inherent strength of our portfolio. We own some of the highest quality properties concentrated in the strongest most desirable submarkets of Los Angeles. We believe that our submarkets will provide superior performance in coming years to those markets where the transformation of major industries is fundamentally altering the landscape for tenant demand.

Our submarkets are characterized by relatively short term leases, typically about five years. The higher lease rollover schedules that result from shorter lease terms will likely cause published vacancy rates to rise more quickly in the near term then in other gateway markets across the country. We expect that our diverse economy, the absence of new supply, our small tenant profile and the small number of large blocks of vacant space will permit our submarkets to improve rapidly as soon as the national economy stabilizes and begins to recover.

Before I move to the balance sheet discussion, I would like to mention that at the end of December we purchased the remaining land interest under our One Westwood office project that we did not already own. You may recall that we previously owned a one sixth interest in the land at an option to require the remainder.

In terms of our balance sheet, we have maintained ample liquidity with our revolving credit facility. Our credit line has approximately $49.3 million outstanding as of the end of 2008 and its maturity date can be extended to October, 2011. Of course, we also have our fund where we remain hopeful that we will have in excess of $500 million in equity commitments. We have no term loans maturing until June, 2012 and the interest on all of our term loans is effectively fixed by swaps to an average rate of approximately 5.12%.

In addition to the absence of any near term debt maturities, we are in the enviable position of not having major development or other capital funding requirements. As a result, we should be able to meet all of our capital spending needs in the foreseeable future from cash generated by operations and without the need to obtain any additional financing.

I would like to conclude with a comment concerning our dividend policy. Much has been said and written recently about the pros and cons of REITs significantly cutting their dividend at a time when as is true for Douglas Emmett, they are strongly capitalized and have ample liquidity to meet their near and midterm needs. We will continue to study this subject in advance of our quarterly dividend announcement next month and we’ll make that decision based on what we feel is in the best long term interest of the company and our shareholders.

On that theme, I should mention our recent announcement that none of our 2008 dividends are taxable for United States federal income tax purposes. So, if we should decide in the future to cut our dividend we will have considerable flexibility to do so without the need to incur the expense and dilutive effect of issuing stock. Now, I’d like to turn the call over to Bill Kamer who will provide specific details on our fourth quarter operating results.

William Kamer

For the fourth quarter the company reported FFO of $55.6 million or $0.36 per diluted share, an increase of 15.2% over the fourth quarter of 2007. As we have discussed in prior quarters, our pre IPO interest rate swap contracts are net assets on our balance sheet that are amortized as non-cash interest expense until the swaps expire. Over the remaining life of the interest rate contracts, the amount of non-cash interest expense that will be incurred is a fixed amount of $42.9 million.

However, in order to conform to applicable accounting standards we are unable to report this amortization on a straight line basis. As a result, and as we have previously advised, we have seen and expect to continue to see significant quarter-to-quarter fluctuations until our pre IPO interest rate swap contracts expire.

In the fourth quarter of 2008 our non-cash interest expense from pre IPO swap amortization totaled approximately $1.3 million. If the amortization had been calculated on a straight line basis, the amount would have been approximately $4.6 million and FFO for the fourth quarter would have rounded to $0.33 per diluted share.

For the year the company reported FFO of $211.7 million or $1.36 per diluted share, an increase of 15.7% compared to the FFO per diluted share for 2007. AFFO for the quarter ended December 31, 2008 was $34.6 million, an increase of 25.7% compared to the fourth quarter of 2007. For 2008, the company’s AFFO was $145.4 million, an increase of 25.9% compared to 2007.

Turning to our same property results, same property net operating income increased 5.7% on a cash basis and decreased 1.7% on a GAAP basis in the fourth quarter of 2008 compared to the fourth quarter of 2007. During the fourth quarter 2008 we increased our straight line rent reserves by approximately $2.4 million which we believe was prudent in view of the potential for future tenant defaults in this economy.

Excluding the addition to reserves, same property NOI increased .8% on a GAAP basis for the quarter. Same property total revenues in the fourth quarter of 2008 increased 3.9% on a cash basis and decreased .8% on a GAAP basis compared to the fourth quarter of 2007. Breaking out the office and multifamily portfolios, same property office revenues in the fourth quarter of 2008 increased 3.9% on a cash basis, decreased .5% on a GAAP basis but increased 1.5% if the additional straight line reserve is excluded from the GAAP calculation.

Same property multifamily revenues in the fourth quarter of 2008 increased 3.5% on a cash basis and decreased 2.6% on a GAAP basis. As we’ve discussed over the last several quarters the GAAP decrease is due to a decline beginning second quarter of approximately $1 million of FAS 141 income generated as a result of our IPO. FAS 141 multifamily income should total approximately $3.5 million in 2009.

Moving away from same property statistics, total revenues for our entire portfolio increased 11.9% to $155.6 million in the fourth quarter of 2008 compared to the fourth quarter of 2007. Office rental revenues increased 12.9% year-over-year to $110.5 million in the fourth quarter. Office revenue rentals included only $110,000 of lease termination income. Office parking and other operating income rose 9.9% year-over-year to $17.7 million in the fourth quarter.

Our total office and multifamily FAS 141 income for the fourth quarter was approximately $10.6 million and was $42.9 million for the year ended December 31, 2008. We anticipate the total FAS 141 income will decline to approximately $33 million for all of 2009. On the expense side for the fourth quarter office operating expenses increased 17.7% compared to the fourth quarter of 2007 primarily due to the new office acquisitions. Multifamily operating expenses decreased 5.3% fourth quarter when compared to the same period in 2007.

G&A in the fourth quarter of 2008 totaled $6.4 million and was $22.6 million for the year ended December 31, 2008. We expect the G&A in 2009 will range between $24 and $25 million. Interest and other income totaled approximately $3 million in the fourth quarter 2008. This primarily relates to the transition in to the fund of the six properties that the fund now owns. As additional capital is drawn from the fund investors and as the company’s ownership percentage in the fund changes, we anticipate that the company will recognize additional income during the first and second quarters of 2009.

Interest expense in the fourth quarter of 2008 increased to $48.1 million from $42.5 million in the fourth quarter of 2007. This increase is primarily explained by the new loans we obtained in 2008. As I mentioned earlier, non-cash interest from the amortization of our pre IPO swaps totaled $1.3 million in the fourth quarter which is $2.4 million less than the fourth quarter of 2007. Interest expense for all of 2008 totaled approximately $193.7 million.

Recurring office capital expenditures totaled $0.14 per square foot for the quarter and $0.46 per square foot for all of 2008. Recurring multifamily capital expenditures totaled $254 per unit for the fourth quarter and $547 per unit for 2008. We expect that both of these amounts will be lower in 2009.

Turning to the operational side, the office percent leased for the 10 submarkets where Douglas Emmett’s office properties are located declined 60 basis points sequentially to 90.7%. Market rents for the 10 submarkets where office properties are located declined 3.1% sequentially. During the fourth quarter we entered in to 96 new and renewal office lease transactions totaling 323,000 square feet compared to 515,000 square feet of office space leasing done in the third quarter of 2008.

Our office portfolio was 93.1% leased and 92.4% occupied at December 31, 2008 in each case down 90 basis points sequentially. I should note that taking in to account leases that fell out of occupancy on January 1, 2009, we began 2009 with office occupancy at 91.7%. Our multifamily portfolio was 99.1% leased at December 31, 2008 which was down 50 basis points sequentially.

Office tenant improvement leasing commissions and other capitalized leasing costs during the fourth quarter totaled $18.28 per square foot compared to $14.30 per square foot for the third quarter of 2008. Our mark-to-market and rent roll up metrics during the fourth quarter are as follows: on a mark-to-market basis the spread between our in place cash rents and our asking starting rents was 14.6% down from 20.8% at the end of the third quarter 2008.

On a straight line basis the average rent from expired leases compared to the average rent from new leases signed from the same space in the fourth quarter 2008 was 32.9% down from 37.5% in the third quarter 2008. On a cash basis, the ending cash rent from expiring leases compared to the beginning cash rent from new leases signed for the same space was 16.8% down from 20.1% in the third quarter of 2008.

Now, turning to guidance, we are providing a guidance range for full year 2009 FFO of between $1.24 and $1.30 per diluted share. This guidance excludes nay impact from future acquisitions, dispositions, equity purchases, debit financing, recapitalization or similar matters. This guidance also assumes that our 2009 non-cash interest expense relating to the amortization of our pre IPO interest rate swap contracts will conform more closely with straight line amortization and will be approximately $18.5 million.

With that I will now turn the call over to the operator so we may take your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question is Analyst for Michael Bilerman – Citigroup.

Analyst for Michael Bilerman – Citigroup

Jordan you talked a little bit about how the supply picture is different this time from how it was in the last cycle. Can you give us a little more color on what you’re seeing in terms of the difference in demand structure relative to last time around?

Jordan L. Kaplan

On the supply side I guess. You understand on the demand side I would say that what I said in the script which is this economy is sort of hitting everybody equally so all industries, all tenant sizes, everybody is getting hit so we’re not seeing anyone sector and we obviously don’t have any one tenant that is really failing for us.

But, I guess last time I don’t know how – we compared them both by just saying that this time people are shrinking a little bit but still seem to kind of be staying in business whereas last time we saw just the combination of the vacancy and the ability of guys to move with all the extra dollars because it was a much more of a tenants market I guess I would say. It’s a tenants’ market this time but it was much more of a tenants market last time.

William Kamer

Let me just add to that Irwin, in terms of as Jordan mentioned in his remarks, some of the other markets are going through a fundamental remaking of their economies in tenant demand. We in Las Angeles went through a similar phase in the early 90s when the aerospace defense industry at the end of the cold war scaled down dramatically and our whole economy had to be reinvented. That’s the noticeable difference this time is that we’re not seeing any one industry in LA that is suffering greatly. On the other hand, as Jordan said this recession is so broad and deep that its affecting just about everybody so there’s impacts across the board.

Analyst for Michael Bilerman – Citigroup

Bill, just one other questions, can you tell us what kind of rental spreads and what kind of occupancy loss get you to the high and the low end of your range or what we should sort of be expecting?

William Kamer

It’s hard to do that. If you notice we have a little bit wider band this year than we had last year. We’re still trying to get our hands around it so we put in a fairly wide band. Obviously, we’re seeing that the direction in occupancy if trends continue is down throughout the year at least modestly but I don’t want to get in to speculating beyond that.

Operator

Your next question comes from the line of Anthony Paolone – JP Morgan.

Anthony Paolone – JP Morgan

Have you all tried to proactively look at your 2012ish maturities and try to push those out or work with lenders to maybe flatten that maturity schedule a little bit?

Jordan L. Kaplan

We almost got laughed out of the room. We obviously talk to our lenders all of the time staying in touch with them not only for our existing debt but because we want to always have a feel for what kind of debt is available for new acquisitions we may make and because we would need debt for that. When we started bringing up with them the idea of hey maybe we’d be willing to do something with them to extend out some of our 2012 they would say to us things like, “You’ve got to be kidding. You have great loans, you have a huge amount of time. We’re dealing with people’s loans who are coming up in the next three to six months. You’re not even on our radar.” Frankly, they didn’t even want to deal with us.

So, it’s just too far out and the loans are in very good shape, current, great coverage, there’s no loan to value issues, they’re just in great shape so you can’t get their attention for something that is three and a half to four years away so we sort of stopped pressing on that front and have focused more on what people are willing to do for new acquisitions that we may make in the fund which we’ve gotten some pretty positive feedback on.

Anthony Paolone – JP Morgan

In terms of just going back, you gave some colors to the portfolio and you being in a better position versus prior downturns, can you give us some color as to maybe where your markets or even some of your assets may have trended from peak to trough in the late 80s, early 90s during that downturn?

Jordan L. Kaplan

Well, it was a very different portfolio then. I would say in the worst of it we lost about between 400 and 500 basis points of occupancy from peak to trough going in to that. We had one building that we were in the process of leasing up that we had built so that was quite a struggle but we did get that dealt with in the middle of that market, not dissimilar from the way we got our fund closed in the middle of one of the toughest capital raising markets.

We’ve got great kind of operating platform. Our operations in markets like this always come through and I don’t want to say save us but it’s really where you see when you put money in to your operation side, this is where it really pays off. As I just told you, the hit in the last down turn was not that severe. In the same as this one we sort of skidded through it with some scrapes and stuff but we were able to focus as we are this time on raising funds, buying properties, taking advantage of some of the distress that other people in our market were having.

We’re seeing something similar now but we also aren’t in the middle of having to lease up say new construction and some of the other stuff we were going through then when we were a much smaller company.

Anthony Paolone – JP Morgan

The last question on the dividend, it seems like you wouldn’t necessarily have to pay one giving your taxable and you might be able to retain upwards of $150 million of capital here. What would be the case to continue to pay a dividend if you don’t have to?

Jordan L. Kaplan

We’ve been sort of listening to the REIT debate on dividend cutting both what people have been saying and the debate in the press. There are certainly I feel, strong arguments to both sides of that question and it is very tough. I’ve got to tell you I’m thinking about it every day, I mean we’re reading about it and I’m thinking about it every day.

As I said in the prepared remarks, if you look at our sort of capital structure and our near and midterm needs we’re in very good shape but then an argument similar to the one that you just made might argue in the other direction of cutting and saving cash. We’re reviewing it and we’ll make a decision as I said, that we think is best for the company and our investors but we’re still just going through it.

Operator

Your next question comes from Ian Wiseman – Bank of America Merrill Lynch.

Ian Wiseman – Bank of America Merrill Lynch

Just a follow up on the questions about the fundamentals. Your markets have witnessed vacancy pickup several hundred basis points and one thing you didn’t talk about was rents. In peak to trough where would you see rents coming through 2010? Are we talking high teens in terms of coming down, or 20%, 25%?

Jordan L. Kaplan

Well, peak to trough on rents is a much tougher number than occupancy when we’re looking at our portfolio because there’s I think a lot of weak information about where rental rates are in the various markets that we’re in [inaudible] market rents which are people’s asking rents. If you look at and especially in this market that we’re in right now I think we saw a wider spread from asking to what was really happening in the submarkets than we’ve ever seen in the past in a strong market.

As a result of that, you’re probably looking at a bigger fall but from a number that I don’t think that we were ever really at. If you take a look at where we kind of felt the real economics of kind of the regular leasing that we were doing was at and obviously this varies in submarkets and you compare it to where we kind of think we’re ending up in this whole thing, you’re off anywhere from 15% to 25% and it just varies in submarkets.

Ian Wiseman – Bank of America Merrill Lynch

Give the reserves that you’ve taken so far and what you I guess commented on for 2009, is it safe to assume that a) your occupancy ticks below 90% and that your low end of the guidance assumes negative same store NOI growth?

Jordan L. Kaplan

I think it’s safe to say that we’re conservative guys as you’ve seen over the last couple of years and we’ve made some conservative assumptions with regards to all of the items that you just mentioned.

Ian Wiseman – Bank of America Merrill Lynch

Finally, while many people are not in the acquisition mode, there are a number of assets which have hit the market. I guess Broadway is being forced to auction off property and I understand that [Landtana] is on the market or coming to the market. What does pricing look like today and how much capital is actually out there to buy real estate in your markets?

Jordan L. Kaplan

Good knowledge of our market about what’s coming up. There are a couple of deals that we are really I don’t want to say involved in, watching, closely watching, whatever and so far its’ been a little surprising first of all in terms of the number of bids that you’re getting. There are still quite a few people out there that are bidding on good assets, that’s number one, or looking or taking hard looks at them at least.

The second is that – and maybe this is still happening but the pricing hasn’t moved as dramatically as we had expected. There are some deals right now going on where I’m very surprised by the pricing, I mean much higher than I thought it would have otherwise been. Obviously, they’re not done and they need to play out and we’ll watch what happens with [Landtana] and see how it plays out.

But, there’s still a pretty good level of interest in those sorts assets. I mean I’m talking about better than 10 strong players. Maybe as the year goes on the bid and the ask will get closer together but let’s see what happens.

Ian Wiseman – Bank of America Merrill Lynch

What type of capital is out there now looking at these properties?

Jordan L. Kaplan

Well, I’ve seen funds, I’ve seen individual foreign investors. I’ve seen even some domestic JV partnerships going after individual assets. I mean, I’m not saying any of the big hedge funds or anything, or Blackstone Fortress type companies.

Ian Wiseman – Bank of America Merrill Lynch

Can you kind of give us just a range of cap rates that you’re seeing or price per square foot for assets like [Landtana] or the Broadway property?

Jordan L. Kaplan

You want me to jinx [Nelson]?

Ian Wiseman – Bank of America Merrill Lynch

Not a jinx, I just want color.

Jordan L. Kaplan

I’m sure [Nelson] is going to get a great number for that project, it’s a great project. I don’t have that detail of information on those deals. I don’t want to cap or handicap those deals.

Operator

Your next question comes from Richard Anderson – BMO Capital Markets US.

Richard Anderson – BMO Capital Markets US

I guess just going back quickly to the dividend I wonder why despite the attraction of saving $150 million annually, I wonder why you would even consider it considering you guys are not in no way, shape, or form in my mind at least in a distressed situation and that a dividend cut would maybe send a single do distress. I guess if you could expand more on the thought process on the dividend in light of that?

Jordan L. Kaplan

The first way I was asked that question about two minutes ago was how could you not be cutting that dividend, what would be the arguments not to and you’re asking the question how could you consider cutting your dividend? Well, that combination is why we’re just still studying it very carefully. By the way, it’s closer to $120 million than $150.

Richard Anderson – BMO Capital Markets US

Bill, I think you gave some guidance about interest in other income that to me suggested your expectation for some near term fund activity in the first half of 2009. Did I connect those dots correct?

William Kamer

What was referring to Rich is that in the transition in to the fund there’s cost recoveries that we have that are shown in that $3 million other income item. Those incomes the way we recognize those amounts is based on drawn capital in the fund and as ownership changes. We’re in a transition period in the fund until our ownership settles down and the money is drawn which happens – the date for that is June this year. So we have this interim period where we’ll be recognizing those amounts sequentially until that settles down and the number gets finalized in June. That’s why I refer to those amounts coming in first and second quarter.

Richard Anderson – BMO Capital Markets US

In terms of the guidance, you had a low level of lease termination income in the fourth quarter, maybe surprisingly low, do you expect that to ramp up in 2009?

William Kamer

There’s no real way of predicting it, it sort of comes when it does. We’ve always had very low lease termination income and the number this past quarter was right in the zone. Maybe actually, to tell you the truth a little on the higher end then we’re we’ve been over the last several quarters but, it’s always been very low. Given the nature of our tenancies it’s unlikely that you’ll see any real large amounts of lease termination income in any quarter. We could always have the outlier situation which occurs from time-to-time where we get that but unlikely.

Richard Anderson – BMO Capital Markets US

You mentioned some occupancy loss during January. Can you provide a little more color on what that was?

William Kamer

We mentioned I think last quarter that as you know we have a very small tenant profile and for us our relatively larger leases in the scheme of things nationwide still pretty small but we had a Health Net lease as we discussed before, 51,000 feet that we’ve known is non-renewing or consolidated in another space. That hit in terms of falling out of occupancy happens to hit right on New Year’s day, January 1 so it’s in our year-end numbers as occupied and then at the beginning its out. We wanted to give everyone some clear visibility of a starting point of where our occupancy was going in to ’09.

Richard Anderson – BMO Capital Markets US

The last question I guess maybe conceptual more for Jordan possibly, your tenants are asking for shorter term leases which isn’t a surprise but is that potentially a blessing in disguise? I guess if you have shorter term leases and the market recovers in a year and a half or the economy recovers in a year and a half or so that maybe gives you an opportunity to tap in to some more of that untapped growth say 2010/2011? Are you look at it that way at all?

Jordan L. Kaplan

It’s not in disguise, it could be a blessing. In a sincere view on the economy, if you think in the next two years things are going to recover in any reasonable way then I would tell you that we have a very strong springing board that we’re launching off of here. When I look at the last couple of times whether it be ’89, ’90, ’91, that recession or the one that hit us in the 2000 range, we had all this space that had to be like reabsorbed and digested and maybe in the Dot com one we had these large guys that had to go out and had to be turned back in to space for little guys, in the early 90s we had all that new construction, I mean we had whole buildings with nobody in them, totally vacant buildings, new office buildings.

So, we don’t have any of that now so what we expect to happen over the next year or so is just like this creepy crawl down just kind of chipping away. So, if the economy turns, we don’t have that redigesting absorption thing to go through that we’ve had the last few times and it should turn very sharply. Remember, on a relative basis the rents, whether you want to take these lower rents or the slightly higher rents we were at last year, they’re all low rents relative to the cost structure of the tenants that we have.

So, the next time things turn if we can get a good run out of it, a good healthy turn out of it, we ought to have years of a real good ride where we adjust up pretty dramatically since we’re very cheap relative to everything and every other major gateway market not only in the US but around the world.

Operator

Your next question comes from James Feldman – UBS.

James Feldman – UBS

On the last call you guys did a good job of telegraphing the Health Net lease and kind of what was to come at the Warner Center. Can you give an update on the ’09 roll, maybe some of the big box that you feel may not be occupied?

William Kamer

Let me try to do that. We’ve got I think at this point as you said we did try to telegraph that one, coming up in first and second quarter I don’t think we have a similar situation of a relatively large tenant that we know is going out that hasn’t already been discussed and I think we’re at this point expecting our larger tenants and I doing think there are very many of them but the larger tenants that are rolling at that time period to renew.

James Feldman – UBS

Then in the back half of ’09?

William Kamer

It’s out far enough and as Jordan said earlier one thing that I guess we can’t emphasize too much is in the current economy, one phenomena that we’ve really seen is that tenants, even relatively larger tenants, they’re going right up to the wire on expirations before they’re showing their cards and are willing to make a commitment. From the feedback we get, a lot of these companies they have their own lack of visibility in the future of their own business so they’re just not willing to even give a good picture on what they’re going to be doing other than that they’re not willing to make a definite commitment early on.

James Feldman – UBS

And in the other submarkets where you seem to have the biggest occupancy hit was Honolulu and Beverly Hills. Can you give a little color on vacancy there?

William Kamer

The issue there is the numbers in quarters are pretty sensitive to the defaults that we incur and where they fall out. It just happens that in the fourth quarter that a large percentage of the 64,000 square feet of defaults happened to fall both in Honolulu and Beverly Hills.

James Feldman – UBS

Which actually leads to my final question, the reserves that you’ve taken, it sounds like it’s a straight line reserve but is it also an assumption that that space will go vacant? I guess the question is what’s your policy on reserving?

William Kamer

Well, the main portion of the $2.4 million increase in reserves was a general increase in reserves which is just based on as Jordan is saying culturally we tend to be pretty conservative but on the other hand with the economic uncertainties we think conservatism is warranted right now so we have increased our general reserve just because we think that the levels that we saw in the fourth quarter we think that and maybe a little bit higher levels are probably where we’re going to be this year but it’s just uncertain so we’ve taken a little bit higher reserve. This is again it’s straight line so it’s amounts that have been booked in to income on a non-cash basis and straight line and that’s where we want to show the conservatism.

James Feldman – UBS

Then that reserve flows through what, top line revenue or is it an expense?

William Kamer

Yes.

James Feldman – UBS

Top line revenue?

William Kamer

Yes, it goes through rental revenue.

James Feldman – UBS

Then do you have an assumption for the ’09 guidance on additional reserves or no?

William Kamer

No. I mean we’ll revisit it from time-to-time but we’re not anticipating changing the policy.

Operator

Your next question comes from Chris Haley – Wachovia Securities.

Chris Haley – Wachovia Securities.

A question on the dividend, just to make sure to clarify, you said from a taxation perspective you would not have to pay it out, correct? Then you would not be inclined to issue, use equity to pay it?

Jordan L. Kaplan

Well, okay that’s a good question and I’m happy to clarify. First of all, I’m not trying to give tax guidance on next year but last year we had our entire dividend was a return of capital so there were no taxes associated with it. So, you would expect this to be somewhere in that range this year, right. [Inaudible] public a few years ago and we got a big book up in the assets in there creating a lot of depreciations so we have a very low taxability to our dividend, in fact a zero taxability to our dividend.

So, this year if we’re similarly situation which I assume we will be, there’s no requirement for us to issue stock in order to maintain our REIT status and to cover the REIT roll that requires us to distribute 90% or 95% of our earnings which is the basis under which I suspect all these other organizations are issuing stock. So, the point we were just making is one thing you won’t see us do is we won’t say, “Well, we’re not cutting the dividend we’re changing its nature we’re giving half of it in cash and half of it in stock.” We won’t be doing that.

So, if we cut the dividend it just means we’re giving out less cash but we’re not going to do anything dilutive with stock and we certainly wouldn’t issue any additional stock. That was a long answer but just to get it all in there why it’s so clear that we’re not issuing stock.

Chris Haley – Wachovia Securities.

But all this debate with companies paying out the dividend in stock, it is treated, you’re getting the stock at fair market value so at the end of the year the taxation of the dividend is still largely a function of what you the REIT, what your tax structure looks like. So, one of the things we’re interested in is how far down the road have you gone in terms of looking at that? If that’s the case then it doesn’t really matter whether you pay it out in stock or cash, if it’s all going to be return of capital, generally speaking really the only issue becomes whether or not you’re comfortable issuing it below current whatever the perceived value of the business is.

Jordan L. Kaplan

I’m saying more than that. I’m saying our feeling of our company is, that if you don’t have a tax reason to issue a stock dividend then there’s no reason to do it. So, if we’re going to cut the dividend then the amount of cash we give out will be less but we won’t be issuing a stock dividend because we know for ourselves that we probably won’t have a tax reason for issuing.

Chris Haley – Wachovia Securities.

Could you help me with where do you think your current mark-to-market on the portfolio is in the office?

Jordan L. Kaplan

You mean mark-to-market in value?

Chris Haley – Wachovia Securities.

No, I’m sorry. In where you think your cash effective rents are?

William Kamer

We had indicated that our mark-to-market spread at the end of December was 14.6% and the comparison between our asking and in place cash rents.

Chris Haley – Wachovia Securities.

So that’s the leases that were signed in the fourth quarter or where you think they are today?

William Kamer

I’ll just go through all three again. The mark-to-markets, the spread between our asking and in place rents on a cash basis 14.6% which is down from 20.8% at the end of the third quarter. [Inaudible] for leases actually signed in the fourth quarter, the mark-to-market there is 32.9% and the ending cash rent to starting cash rent is 16.8% down from 20.1%.

Jordan L. Kaplan

The last two are for leases signed in our portfolio.

Chris Haley – Wachovia Securities.

Lastly, on the capital expenditure side, the concessions offered in the fourth quarter, the ratios were higher than the year-to-date figures through September 30th. I know you haven’t commented specifically regarding 2009 but if you could that would be helpful in terms of your expected leasing costs or concession levels for 2009 as it compares to 2008.

Jordan L. Kaplan

Chris, in terms of the capitalized leasing costs, in the fourth quarter as we indicated we were up a little bit in the fourth quarter to $18 in change from $14 in change in the third quarter. There’s noise in that number. We’ve indicated quarter-to-quarter in the past where we’ve had the numbers be unusually low because we might have had a large as in renewal that skewed the number down.

This particular quarter we had for us a larger, it was a 10 year lease which is unusual for us and a larger space in our portfolio that hit in the quarter so that noise pushed the number up. Our overall view is that the TI side of things in our market is very flat and it’s been flat for a while and we’re not really seeing that trending up even in the softening market.

Operator

Your next question comes from John Guinee, III – Stifel, Nicolaus & Company, Inc.

John Guinee, III – Stifel, Nicolaus & Company, Inc.

I guess Bill could you walk through the accounting on your fund which closed I think October 7th? Particularly where the $57 million other liability and your partners income offset and where the fees are coming through?

William Kamer

Let me answer it this way John and I’m happy to get back to you and go through the – unfortunately with the way all this accounting stuff works it’s probably a long technical kind of discussion. But, on this call let me just say it this way which is as we indicated last quarter we’re showing the fund on the consolidated basis at this point.

As I mentioned a little earlier on the call we’re going through this transitional phase as we’re raising funds and drawing funds from investors and until the structure of the fund as it were settles down and is finalized which we’re anticipating in June of this year. So, between now and then we’re showing on the consolidated basis, I know it’s a little confusing in terms of past presentations and there’s a bunch of different ways that impacts the numbers a little bit but I think what I’ve tried to do is in the call give you some color on the amount of income that was generated as part of that transition and that we’re expecting to see some numbers in the first and second quarter. But, the main point is that we’re reporting it at this point on the consolidated basis.

John Guinee, III – Stifel, Nicolaus & Company, Inc.

So what’s the other liability of $57.3?

William Kamer

It’s drawn capital from the non REIT investors.

Jordan L. Kaplan

Because it’s consolidated we have to reverse back out the other guys investments.

William Kamer

Adjusted by a few things but basically it’s drawn capital.

John Guinee, III – Stifel, Nicolaus & Company, Inc.

When we’re trying to work out an NOI for Douglas Emmett what should we look at on a cash basis or a GAAP basis the income offset for your fund partners? How should we look at that?

Jordan L. Kaplan

For ’09 and going forward compare to ’08, there’s a dilutive effect of those funds moving from full ownership of the REIT in to the fund in terms of the REIT books as we own a lower percentage. So, those numbers again I think it’s hard to give something very precise until again, the structure and ownership percentages settle down over the next several months. Suffice it to say in terms of directionally I think you’d be in the right ballpark if you viewed it as somewhat fairly mildly dilutive in the early stages.

William Kamer

As we own less of the fund properties, the fund properties are a positive, they’re very profitable so as people come in to the fund and we own less of them it’s dilutive towards the earnings on a go forward basis. But, we have to see how many people we get in and as we settle up where that number ends up.

Operator

Your next question comes from Michael Knott – Green Street Advisors.

Michael Knott – Green Street Advisors

Can I ask about your outlook for raising additional capital for the fund before June?

Jordan L. Kaplan

Well, as I said in the script we’re still hopeful, I think is the word we used that we will reach our $500 million threshold where we had originally given you a number. $500 million to a $1 billion is where we had hoped the fund would end up and we still are hopeful that we will get there with some positive feeling that we will get there.

Michael Knott – Green Street Advisors

It looks like there could be a chance maybe at the low end of that range where may this is not an exclusive acquisition vehicle for very long, I would wager. Should we think about it that way?

Jordan L. Kaplan

For so long as the fund has money, it has to be the exclusive acquisition vehicle. Now, if deals come up and the fund deploys all its capital then it’s not the exclusive vehicle anymore because there’s no money to spend. But then we would most likely start another fund for so long as we think there are opportunities out there. That’s a structure we’re pretty committed to and for so long as we’re committed to the fund structure, I think it’s reasonable to assume that whichever fund has funds at any particular time will be our exclusive acquisition vehicle.

Michael Knott – Green Street Advisors

On the lease rollover side, about half of your’09 roll is in the valley. What’s that number for 2010? Is it a similar roughly half?

William Kamer

Mike, I don’t think we have that handy for 010 broken out by submarkets. I’ll have to get back to you on that.

Michael Knott – Green Street Advisors

On the tenant side, are you seeing any tenants ask for rent concession to help them get through or pay their bills?

William Kamer

That’s definitely a product now because of the breadth of the economy, everybody in all sectors is trying to cut their operational costs and before Jordan indicated in his remarks about our management group and our proactive programs. One of the principal programs that we have in place is with all of our property managers and we’ve set up a lot of procedures that in order to respond to those kinds of requests and the fact is when you ask for tax returns and get in to the details of it, you wind up through that approach, 90% or more wind up falling by the way side as people just trying in every direction to try to reduce costs.

There will be some situations, hopefully relatively small where we have some reason to modify leases for existing leases but the vast bulk of them by setting up the kind of procedures that we do and separating it out we think we can keep that down to a pretty rock bottom minimum.

Jordan L. Kaplan

We actually, which is something we haven’t had to do for many years, but we took our portfolio managers, put them through additional days of training on how to deal with these kinds of questions when they come in, what you ask back, what kind of information you ask for, how you deal with it. We included also role playing for our portfolio managers so when people come in and start asking for concessions so they could get comfortable with how to talk to them and how to deal with it.

I think we’re getting hit with a lot of that but I think we’re dealing with it extremely well. So, I think we’ve taken every step to mitigate that impact and I think it is going to be substantially mitigated throughout all of this year.

William Kamer

In terms of your other question, we got the information while we were discussing this, for 2010 Warner Center, the expiration is down significantly from ’09. It’s well under 300,000 feet so it’s quite a bit lower in 2010 than 2009.

Michael Knott – Green Street Advisors

Then my last question, can you just give us a little commentary on sort of your comfort level with sort of your two valley submarkets as it would compare to your six West LA submarkets?

Jordan L. Kaplan

Sort of the middle of the valley along Ventura seem to be doing extremely well. The one out, the Warner Center Woodland Hills area, that’s where there are larger tenants so that’s where you’re seeing the vacancy and when we lose one large tenant it creates real problems for us out there. So, we’ve got a lot of focus, an incredible amount of focus out there even to the extent that Kent has been going out there every Friday really focusing on holding occupancy up and dealing with actual lease deals and calls that are coming in.

That’s probably the market in the valley that we’re worried about weakness the most. The one along Ventura, the [inaudible] strip there, Encino, Sherman Oaks, I think is holding up extremely well, very strong. Honestly, out in the Burbank media district, we only have one building and its leased for another 14 years or something.

Operator

Your next question comes from David L. Aubuchon – R. W. Baird.

David L. Aubuchon – R. W. Baird

Just one question left, relative to your smaller tenants, do you have much sublease base in your portfolio?

Jordan L. Kaplan

I don’t think we have been facing that very much. I know I’ve been reading about what’s going on in New York and the huge concerns about the amount of sublease space that’s coming on but we’re certainly not seeing it in our portfolio and we’re not generally seeing it. There’s some spots that I could kind of look at and say hey there’s sublease or that kind of space available but not in any of the areas where we’re competing or where our buildings are. We aren’t seeing a lot of it yet.

William Kamer

Just to follow up on Jordan’s point, the one thing that’s important for you to keep in mind is sublease space in our markets, with our tenant profile is very different than what you’re use to in other parts of the country because with the shorter lease terms and smaller spaces almost without exception, any time we have a tenant that is subleasing it does not compete with our leasing activities.

Jordan L. Kaplan

Right, they can’t afford to give PI dollars, they can’t afford to make any changes so it’s not very cost effective for some to sublease typically.

David L. Aubuchon – R. W. Baird

I guess what I’m trying to figure out is whether or not, if you had a smaller tenant in your portfolio is it a – and typically a company would have a choice to sublease the space if they weren’t going to use it but if some of your smaller tenants don’t exist anymore, does that translate in to quicker vacancy in your portfolio versus other or the market?

Jordan L. Kaplan

To the extent they don’t exist that’s a direct vacancy and you’re seeing that in our numbers and that’s why we’re saying we’re expecting a crawling increase in vacancy. But, whereas in other markets a lot of times vacancy is just half the picture and you need to find out what sublease is, I don’t think that’s the case here. Vacancy has become pretty much the story.

David L. Aubuchon – R. W. Baird

And I understand the 63,000 square feet of defaults in Q4, those businesses just went away?

Jordan L. Kaplan

Those caused vacancy. Yes, they had some kind of extraordinary problem and contracted or I mean default. They had deadly financial problems and now we’re dealing with them in some type of collection mode to took back the space.

David L. Aubuchon – R. W. Baird

And you mentioned Jordan I think the level of defaults in this quarter was the highest since Q2 ’07? Was there a bigger lease within that second quarter of ’07 that drove most of that 64,000 square feet?

Jordan L. Kaplan

The Q2 ’07 number was we had the hurricane force winds hit a lot of other markets when the mortgage tenants got their blows at the beginning. It seems like a thousand years ago now, at the very beginning of the credit situation. Our very mild version of that was a few mortgage tenants in the second quarter of ’07 and that accounted for that amount. That’s why that’s still the high water market of default at this point.

Operator

Your next question comes from David Harris – Arroyo Capital.

David Harris – Arroyo Capital

I’ve got a question on the fund, you’ve probably thrown this out in previous calls but just remind me what return are you targeting?

Jordan L. Kaplan

12 to 14 to the investor.

David Harris – Arroyo Capital

And that’s a levered return obviously isn’t it?

Jordan L. Kaplan

Yes, the leverage return is 50% to 60%.

David Harris – Arroyo Capital

Now, you’re obviously talking to a lot of these guys today looking for top ups or some new sources of funds. Can you give us a sense to how those return expectations are changing from the fund investor perspective if at all?

Jordan L. Kaplan

I think fund investors are more interested in how realistic your assumptions are nowadays than they are whether you’re throwing out their huge IRRs. So, I don’t think that’s been sort of a gating issue for us and by the way, this is our 10th fund and those are the same returns we were proffering for all previous nine funds. I mean, we haven’t changed those numbers.

David Harris – Arroyo Capital

Is that assuming the same leverage throughout?

Jordan L. Kaplan

Yes.

David Harris – Arroyo Capital

Which is what 65%?

Jordan L. Kaplan

We can run 50% to 60%. Usually a particular fund will average around 50% although we have a right to leverage up in to the 60s, we don’t tend to do that.

David Harris – Arroyo Capital

Now forgive me asking this question, as an Englishman in New York, is there any reason, particular reason that we should be concerned from a landlord’s perspective about the current state of the state’s finances?

Jordan L. Kaplan

We’re one of a few states where we wanted to make it a little more interesting around budget time so it take two third votes of our legislature to pass a budget. So, California really likes to shine when it comes to screwing that kind of thing up. We were talking about this, it’s funny you ask that because we were talking about it a day or two ago trying to figure out is there anything there that could get us. I don’t think we have the type of tenant base, we’re not in markets that are very highly dependent on let’s say government leases or tenants that are getting a lot of their funding from government contracts.

So, we couldn’t put our finger on anything that in particular would be directly impactful to us. Although, you like to live in a state that is a little more fiscally sound than the way California seems to be operating lately. But, I don’t know of anything special no.

David Harris – Arroyo Capital

One final question, if I go back a couple of years ago there was an outstanding unresolved real estate taxation question. Is that largely settled now and we kind of look at the quarterly numbers as being a reasonable go forward number?

Jordan L. Kaplan

Yes.

Operator

Your next question comes from Analyst for Michael Bilerman – Citigroup.

Analyst for Michael Bilerman – Citigroup

Just on the apartment side, are you seeing anything else on the market today and sort of how are you looking at sizing up apartment versus office prospects and whether you try to be more aggressive there or not?

Jordan L. Kaplan

I would say that we are equally aggressive or interested in both apartments and office deals in our market. I mean obviously we’re really watching to see how [Art Stone] plays out and what happens with those assets because those are a lot of apartments that could come for sale that are in our markets. But, I don’t see a lot of apartment deals. When we look at the radar of what’s coming up there are not a ton coming up for sale. Apartments are even less than office have not come down as dramatically because the financing of apartments is still supported by Fannie and Freddie.

Analyst for Michael Bilerman – Citigroup

What can you do in the fund? As it stands with the capital that you’ve raised today, how much more can you put in to the fund assuming no additional closings?

Jordan L. Kaplan

Well, we still have the ability to buy property. Are you asking me how much can we still buy?

Analyst for Michael Bilerman – Citigroup

Right.

Jordan L. Kaplan

We still can buy. The fact that we haven’t bought anything is we haven’t found a deal as good as that last one that we did. As a matter of fact, when you look at sort of the comps post our acquisition it’s a huge outlier because it’s so far below where deals happened even after we closed our deal.

Analyst for Michael Bilerman – Citigroup

On what a price per pound or per yield?

Jordan L. Kaplan

Price per foot basis. It’s hard to do a deal that’s worse than that deal so we’re watching these deals come up and that’s why I said earlier that I’m surprised by the strength of the number of bidders and the type of pricing that these projects seem to still be commanding. But, with that said, there’s very little activity that you can put your finger on to really peg where the market is.

Analyst for Michael Bilerman – Citigroup

So on the fund basis there hasn’t been any subsequent closings from the initial round.

Jordan L. Kaplan

As we said earlier we’re not going to do a sort of board on the front of the building that says, “We’ve closed this money today,” with a thermometer. If our expectations change for the amount that the fund will be for in total at the end we’ll let you know that but short of that we’re going to just let the fund play itself out and then after June when it closes we’ll let people know where we ended up.

Analyst for Michael Bilerman – Citigroup

Then just a suggestion, Bill, a lot of companies that have whether it be consolidated or unconsolidated joint ventures, do show that income statement. So, while I know there are a lot of messy accounting things and a lot of different lines maybe just showing a pro rate will help us understand what’s going on line by line.

William Kamer

As I said, we’re going through a transitional period and we will settle things out on presentation when we complete it.

Analyst for Michael Bilerman – Citigroup

Was there anything in parking and other in the quarter that lifted that number pretty significantly? Year-over-year it went up $5 million.

William Kamer

Well, year-over-year its largely as a result – you’re starting on a consolidated basis so [inaudible] acquisition of the fund properties in March so it’s additional properties that are in that number. That’s the primary reason.

Analyst for Michael Bilerman – Citigroup

So that $17.7 is a more stable number, it’s not just that you had more parking revenue?

William Kamer

The increase is not a same property increase.

Operator

Your next question comes from Michael Knott – Green Street Advisors.

Michael Knott – Green Street Advisors

Can you give a little bit of commentary on the pricing and your thought process on the land acquisition you mentioned in your prepared remarks?

Jordan L. Kaplan

It was very small. We were talking about it so I put it in. I think it was between $7 million and $8 million was all it was to finish buying the remainder. It was a kind of two appraisal, third tie breaker process where we had an absolute right to buy the property at market and the way market was defined. So, it was obviously a very good deal for us to be able to buy the land in that manner and it does dramatically reduce the ground rent expense that we’ll have going forward which is already figured in to our guidance for you guys. But, it wasn’t a very big number in comparison to all the numbers in the company.

William Kamer

Mike, in terms of the thought process we’ve always intended, matter of fact, going back to our IPO we always indicated back then that we intended that the right to exercise the option was going to come up in ’08 and that we intended to exercise it. So, we just completed that process.

Jordan L. Kaplan

Before going public we sold our other ground lease deals. We kept the ones where we knew we had a right to buy the ground.

Michael Knott – Green Street Advisors

Is there a relevant value per foot to share?

Jordan L. Kaplan

No, I don’t think it would be comparable to anything. It was its own structure for figuring out that value. It’s not like I would call it a real market comp for anything.

Operator

There are no further questions. Management I’ll turn it back over to you for closing comments.

Jordan L. Kaplan

Thank you everybody. It was a pleasure speaking with you again this quarter and I’m sure we’ll all be speaking again in another quarter.

Operator

Ladies and gentlemen that will conclude today’s teleconference. If you would like to listen to a replay of today’s conference please dial 303-590-3000 or 800-405-2236 and enter the access code of 11124572 followed by the pound sign. We thank you again for your participation and at this time you may disconnect. Have a nice day.

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Source: Douglas Emmett, Inc. Q4 2008 Earnings Call Transcript
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