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|
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:
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.
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.