Looking for the REIT Bargain

With REITs getting hammered by the markets over the past couple of years, I have begun seeking out potential bargains in the sector. My basic hypothesis is that the market will overly punish a few quality REITs that may be had for huge discounts to their actual values. Thus far, I have examined Winthrop Realty Trust (FUR), Colonial Properties Trust (CLP), and Agree Realty Corporation (ADC). This is Part IV of my “Quest for Value REITs” series and I will focus on California-based Douglas Emmett, Inc. (DEI).

Business and Attractive Characteristics

Douglas Emmett is a real estate investment trust that owns and manages properties primarily concentrated in the Los Angeles metropolitan area, with a few holdings in the Honolulu area. While they own both office and multi-family properties, the former properties make up a much more substantial chunk of their overall holdings.

In their latest 10-K statement, the company says they focus on buying and managing “high quality assets … in premier submarkets” where supply is constrained. DEI also claims its properties offer key lifestyle amenities and are typically close to high-end executive housing.

In my previous articles, I have given several factors that I have been searching for when analyzing REITs:

• Relatively low leverage
• Insider buying and a substantial amount of inside ownership
• High levels of liquidity
• Properties in markets near a bottom
• Strong asset quality on Balance Sheet
• A focus on residential properties as opposed to commercial properties

I do not expect to find any REITs that are perfect on all of these fronts, but the more of these factors I see, the more intrigued I become about a particular company. Douglas Emmett jumped onto my radar screen for a few reasons: significant insider buying with a sizable chunk of inside ownership and relatively low leverage compared to their peers.

Douglas Emmett also continues to pay a cash dividend and recently announced a share repurchase plan; two additional signals that might suggest that the company could be a good buy. However, it is worth noting that the quarterly dividend was recently lowered from 18.75 cents per share to 10 cents per share; a significant decrease. Still, this makes Douglass Emmett preferable to alternatives that are unable to pay out a dividend at all.

The Macroeconomic Picture

Before I dip into Douglas Emmett’s financial picture more fully, I wanted to present my basic hypothesis on real estate prices. As I started writing about my theories, it morphed into an article all on its own. Take a read if you like.

The short version of that analysis is that real estate properties have an inherent value and there are reasons why prices are pushed above that value. The markets priced at the highest premiums over inherent values are also the ones most susceptible to changes in the overall economic environment. This does not mean that companies operating in those markets are good or bad investments, per se; it merely means they take on a greater level of risk in their operations as a change in the underlying economies where their operations are centered can have dramatic impacts on real estate prices.

As it applies to Douglass Emmett, I see the company as operating in “risky markets” based on my general hypothesis on real estate prices. Real estate prices sell at significant premiums over inherent value in both the LA and Honolulu markets. One question we must answer to value this company is whether the factors that have driven prices above inherent values in DEI’s markets will remain relatively intact over the coming years or if those factors will be partially undermined. Keeping this macro outlook in mind, let’s take a glance at the financials.

Balance Sheet, Debt, and Property Portfolio

As mentioned earlier, one of DEI’s most attractive attributes is its relatively low leverage compared to its peers. Their liability/value ratio is 66.3%, which compares favorably to other REITs. Long-term debt/equity ratio is healthy at 1.62.

Douglas Emmett is also in an enviable position of not having major long-term obligations due till mid-2012 and they have locked in a weighted average interest rate of 5.12%. While DEI does not have very much in the way of cash and liquid investments on their balance sheet, they do have a revolving credit facility with $49.3 million outstanding and its maturity date can be extended to October 2011.

One of my major initial concerns with DEI is the amount of their “net investment in real estate”, which is about $6.5 billion, compared to $4.5 billion in liabilities. This is potentially problematic because if those assets are significantly overpriced, this could dramatically alter the company’s valuation. However, DEI’s low level of liabilities at least gives them a bit of a cushion from falling prices in the real estate market.

Fortunately, Douglas Emmett did provide a comprehensive schedule of real estate assets in their most recent 10-K. Due to the accounting treatment of real property, properties acquired in the bubble period frighten me the most. It’s difficult to give a bright-line date to separate ‘problematic properties’ that might be significantly overvalued on the balance sheet from ‘safer properties’ that were purchased at a low enough cost basis, that it would be unlikely that they would fall below their book values. However, I decided to flag all properties acquired from 2002 – 2008 as potentially being vulnerable.

Using the above years as a guideline, I estimate that roughly 38.5% of the properties were acquired in the “bubble period”; however it should be noted that a significant number of those properties were purchased in 2008, after prices had already started to decline some. If we exclude 2008 properties, my “bubble period” properties drop to 26.2%. It will be important to have these figures in the back of our minds as we look to doing a valuation of DEI.

Cash Flows, Earnings, and FFOs

DEI’s Funds from Operations (FFOs) for the most recent quarter was 36 cents per share and $1.36 per share for the most recent fiscal year. Loss per share was 5 cents per share for the most recent quarter and 23 cents per share for the most recent fiscal year. Cash flows from Operations (CFOs) from the most recent fiscal year were $1.17 per share by my calculation.

Disturbingly, Douglas Emmett has not had positive earnings for the most recent three years. While long-term cash flows are always more important than accounting estimates of “earnings,” it does not instill confidence in me to see earnings in the red for such a long period of time. However, revenues have increased significantly year-over-year and depreciation expense seems to be the culprit driving the negative earnings.

Free cash flows (FCFs) have been decisively negative over the past three years due to heavy capital expenditures and property acquisitions. While I have lesser concerns about properties acquired the most recent fiscal year, I still see significant impairments in value as possible. Properties purchased from 2002 – 2007 worry me even more.

If dividends are, in a sense, an affirmation of real earnings, I do find myself disappointed that Douglas Emmett lowered their 75 cent per share annualized dividend down to a mere 40 cents per share. At the same time, if there are any concerns about their liquidity, its better that they shore up their position rather than squander valuable cash on dividend payments.

The Macro View and the Micro View

Shifting gears back to the macro view, Los Angeles and Honolulu are both “risky markets” based on my general real estate hypothesis. One of my concerns is that Douglas Emmett’s properties may be overvalued on their balance sheet due to the real estate bubble of this decade and potential impairments in value moving into the future.

The long-term economic outlook is not necessarily rosy for the Los Angeles area. It’s worthwhile to note that the state of California is fighting to stave off bankruptcy at the current moment, which might be a rather foreboding sign for the future. If the economic prosperity that was largely responsible for driving up real estate prices in supply-constrained markets like Los Angeles was undermined in the long-term, real estate prices and rental rates could fall downward for a significant period of time.

Due to the current recession, vacancy rates are already increasing, which should put more pressure on rental prices in the LA market. As of January 1, 2009, Douglas Emmett’s office property occupancy rate was 91.7%. This will, in all likelihood, be pushed further downward over the next year or two.

Given this, the two major questions become (a) how much value DEI’s property-heavy asset portfolio can maintain in the upcoming years and (b) will DEI’s cash flows be significantly impaired by falling rental rates? It’s difficult to accurately estimate how much an impairment in DEI’s property portfolio might be warranted, but based on my knowledge, I’d estimate a 10% - 15% would be in order, and a 20% - 25% cut would help us be a little bit on the safe side. We’ll have to look at a variety of scenarios on the FCF front, as we try to estimate the real long-term rate of FCFs, which is difficult to ascertain for Douglas Emmett. With that in mind, let’s do a few valuations.

Valuation and Scenarios

First things first --- I want to look at DEI’s asset values and how they might potentially be impaired. I’ve created the following chart to display “Adjusted Book Values” based on these impairments:

Impairment %	Impairment Charge	Adjusted Equity	Adjusted BV
0%	$0.00	$1,775.00	$14.55
10%	$505.33	$1,269.67	$10.41
15%	$758.00	$1,017.00	$8.34
20%	$1,010.66	$764.34	$6.27
25%	$1,263.33	$511.67	$4.19
30%	$1,515.99	$259.01	$2.12
35%	$1,768.66	$6.34	$0.05
40%	$2,021.32	-$246.32	-$2.02

Let’s create a few scenarios based on various predictions of impairment and future cash flows. For all scenarios, I have listed a “Year 1” free cash flow figure and have assumed a 3% growth rate. I have also used an arguably conservative 12% cost of capital based on the belief that interest rates will significantly rise over the next few years:

Scenario #1: 15% impairment, $1.50 in FCFs

Scenario #2: 15% impairment, $1.00 in FCFs

Scenario #3: 15% impairment, $0.50 in FCFs

Scenario #4: 20% impairment, $1.25 in FCFs

Scenario #5: 20% impairment, $1.00 in FCFs

Scenario #6: 20% impairment, $0.50 in FCFs

Scenario #7: 20% impairment, $0.25 in FCFs

Scenario #8: 25% impairment, $0.25 in FCFs

Here are the results:

	Valuation
Scenario #1	$24.90
Scenario #2	$19.38
Scenario #3	$13.86
Scenario #4	$22.83
Scenario #5	$17.31
Scenario #6	$11.79
Scenario #7	$9.10
Scenario #8	$6.95

There are significant flaws with all of these valuations. For one, if inflation increases and drives up the costs of capital to 12%, that would also mean that DEI’s property portfolio would take less of a hit. That’s one of the major benefits of holding real assets. I also have a really difficult time coming up with a reasonable FCF figure given divergent data in regards to past FCFs, CFOs, earnings, dividends, and FFOs for DEI. However, I normally run these scenarios more to get an idea as to how different dynamics will affect valuation rather than to come out with a definitive valuation.

Based on all the above scenarios and my own assessment of risk and my belief that inflation is on the way, I value DEI in the $9 - $12 range. In the next few years, downside risk would seem to be around $2 - $3. Upside potential is in the $25 - $30 range.

Concluding Analysis

Douglas Emmett appears to be one of the better managed REITs out there, but there are significant risks associated with their primary operating markets of Los Angeles and Honolulu. DEI is essentially a strong ship navigating its way through troubled seas. While I fully expect to see them make it through the storm, I still have significant concerns as to whether they can navigate the waters without absorbing significant damage to their ship.

I also have some doubts about their ability to continue to grow FFOs and more importantly, FCFs. Compared to the other three companies I have analyzed thus far in this series, I would see this as less of a bargain than Winthrop Realty Trust and Colonial Properties Trust. Despite having risky tenants, I also believe the upside for Agree Realty Corporation makes it a better value on a risk-reward basis than DEI.

All the same, Douglas Emmett does appear to be slightly undervalued to me and might end up being a worthwhile investment. However, my macro analysis and view of downside risks prevent me from going so far as to say this as a “buy” when I believe there are better deals in the market. If this stock were to drop back below the $6 mark, I think it would become significantly more attractive. At the $8 - $9 range, I find myself more neutral on Douglas Emmett.

Disclosures: Author holds no position in DEI.

Comments

[Complete Gr...:]

H.J., how does one contact you by email?

Tom Jacobs
[e-mail]

Mar 24 12:14 PM

[REITBull:]

H.J.,

I have become a fan of your articles due to the fact that you seem to do a very in-depth analysis and support your opinions with data. I'm going to take a look at the DEI 10K myself. If you are taking requests, I would love to see an analysis on commercial versus residential real estate from a macro standpoint and why you feel that residential will recover sooner. I'm not trying to challenge your opinions, I just like to question my own (I am more bullish on CRE then Residential).

Thanks

Mar 24 01:53 PM

[H.J. Huneycutt:]

User,

Why's that?

Mar 25 08:51 AM

[H.J. Huneycutt:]

REITBull,

In the abstract, residental RE got hammered earlier than commercial RE and has probably endured more of the carnage thus far. However, I think the US economy will struggle for years to come. You might call me an economic bear and an inflation bull, though, so I think certain hard asset investments will benefit.

People will always need places to live and as less people are buying homes, they have to go somewhere. As such, I think residential REITs can actually benefit moving forward. The value of commercial RE, on the other hand, is highly dependent on the cash flows that can be collected from tenants. Rising vacancy rates will push down leasing rates so that commercial RE will continue to flounder for a while in my view.

At the same time, valuation is key to me, so when looking at investments, there are a lot of factors that I would look at. As far as stocks go, there are some commercial RE stocks that have been hit so hard, that they probably will be more profitable to investors than residential RE counterparts. In fact, it seems like most of my articles (and most of the ones I'm planning) deal with REITs that focus on commercial RE. Mr. Market really hates commercial right now. And if Mr. Market is overly punishing a company, I like to take advantage, even if the outlook looks dim.

I've been fishing for bargains in other sectors with dim outlooks, as well, such as palladium and platinum miners like North American Palladium (PAL) and Stillwater Mining (SWC) and shipping companies like TBS International (TBSI) and Global Ship Lease (GSL). My belief is that people often overly discount companies based on the sector's current outlook while ignoring the value of their hard assets. Even in the worst-case, the market seems to go way overboard at times.

Mar 25 09:08 AM

[Trane250:]

First rate analysis, but I would not touch anything having to do with the LA market.

Mar 25 10:57 AM

[H.J. Huneycutt:]

Trane,

That was basically the same conclusion I came to, was it not?

DEI looks like a good company --- I just don't want to touch LA with a hundred-foot pole.

I regret that the SA editors managed to change my title to completely alter the meaning of it. Not sure why they do that occasionally. It was originally titled, "Douglas Emmett - Navigating In Trouble Seas"


On Mar 25 10:57 AM Trane250 wrote:

> First rate analysis, but I would not touch anything having to do
> with the LA market.

Mar 25 11:19 AM

[jksisco:]

I live in the Orange County, CA (30 miles south of LA) area and am in the process of leasing some office space, which is in abundant supply right now. Leasing rates are very favorable with significant discounting a renter's delight.
As far as Commercial REITS are concerned, I think the Author is overlooking a sub-category that always does well in any economy, and is the only sector in the market retaining their occupancy rates while realizing growth as well.

Mar 25 11:32 AM

[REITBull:]

Thanks for the feedback H.J.

My reason for being more bearish on Residential REITs is that as the price to own comes more in line with renting, these Rez REITs may loose many of their longer term renters as owning becomes more attractive. These renters can be replaced by those who are not in a position to buy, but at lower rents than the exiting tenants. These apartments will also have to compete with single family homes being rented out, adding additional pressure to rental income.

I believe much of the carnage in the residential markets was caused by the high number of residential loans that were securitized. Most commercial mortgages were kept as portfolio loans allowing greater flexibility for modifications and extensions.

I agree that rising vacancy rates will push down the value of CRE. The more important question to me is, which will recover sooner? Rez or Commercial? It is going to take some time to burn through the excess supply of residential real estate (option arms are still resetting and people are still walking away from underwater homes). On the other hand, I am not confident that the consumer will continue to maintain the current savings rate. Many consumers are not very disciplined when it comes to savings over the long term. As they begin to spend money at the malls, this will lift the industrial REIT's, Retail REIT's and eventually the office REIT's as more jobs are added back. Once this happens the jobs picture will look better and people will feel comfortable purchasing homes again (which will reduce supply and improve pricing power for Rez REITs). That's just my take and I don't assume that my opinion is any better than the next guy's.

I still agree with many of your analyses as you are taking a technical approach and you have demonstrated that in all likelihood many REITs may have been oversold. Thanks

Mar 25 12:31 PM

[Complete Gr...:]

Because we share a value orientation, I run an investment service, and I'd like to talk business. If I could find you any other way, I'd not be doing this in a public forum.

Tom Jacobs
[e-mail]
CompleteGrowth.com
Home of Complete Value Investor and Blueprint Investor


On Mar 25 08:51 AM H.J. Huneycutt wrote:

> User,
>
> Why's that?

Mar 25 04:39 PM

[H.J. Huneycutt:]

User,

It's in my profile, but it's [e-mail]

Mar 26 10:36 AM

[H.J. Huneycutt:]

REITBull,

Good reasoning. The reason I go in a different direction is that I expect inflation to rise significantly, which will force interest rates upwards. That might deter many potential homeowners from entering the market; driving up the number of renters, but not having significant long-term impacts on the underlying value of residential properties.

Mar 26 10:40 AM

[REITBull:]

Thanks H.J.

Mar 26 03:42 PM

[santamonican:]

If my memory serves me right, commercial properties experienced 20 % vacancies around 1985. Did you do a calculation of cash flow based on a 15% and 20% vacancy?

Apr 27 08:29 PM