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Douglas Emmett, Inc. (NYSE:DEI)

Q1 2010 Earnings Call

May 4, 2010 2:00 pm ET

Executives

Mary Jensen – VP IR

Jordan Kaplan – President & CEO

William Kamer – CFO

Analysts

Alexander Goldfarb – Sandler O’Neill

Brendan Maiorana – Wells Fargo

John Guinee – Stifel, Nicolaus

George Auerbach – ISI

Michael Bilerman – Citigroup

Richard Anderson – BMO Capital Markets

Michael Knott – Green Street Advisors

Mitch Germain – JMP

[Chris Tatham ] – Morgan Stanley

David Harris – Gleacher Securities

Operator

Welcome to Douglas Emmett’s 2010 first quarter earnings conference call. (Operator Instructions)

At this time, 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. William 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 8-K with the SEC and both are available on our website at www.douglasemmett.com.

During the course of 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, 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 prove to be incorrect. As a result, our actual future results can be expected to differ 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 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, BRE for the Los Angles office markets, MPF Research for the Los Angeles multifamily market and Property & Portfolio Research for Honolulu multifamily market.

Before I turn the call over to Jordan, we would like to remind those of you that will be participating in the question-and-answer portion of the call to limit your questions to two per person. Thank you, and go ahead Jordan.

Jordan Kaplan

Thanks Mary, good morning everybody. I’m very happy with how things are shaping up and expect that this will be a good year for Douglas Emmett. Our operating platform, lender relationships, market knowledge and presence and capacity to take advantage of new opportunities have never been better.

In fact, I think the company is in the best shape it has been in during my 25-year career. Over the past three months we have a substantial improvement in both the equity and debt markets. Lenders have clearly returned to the market and spreads have compressed considerably.

We anticipate that there will be further improvement over the coming months. As we discussed last quarter we are currently targeting the fourth quarter of this year to complete the refinancing of our 2012 loan maturities.

We are on track with our fund strategy. Last quarter we stated that we have raised more than $450 million in equity commitments and that we believe we will meet our goal of $500 million by the end of June. I will refrain from an in depth update until the subscription period is over, but I can say that it looks promising that we will meet and likely exceed our goal.

On the acquisition front, the environment remains very competitive however we are seeing opportunities within our core markets to buy office properties at market prices that we believe represent tremendous long-term value.

It is not appropriate for me to comment on pending deals, but I can say that we are optimistic about the prospect of completing purchases over the next few quarters. The capital from our fund strategy, our own available cash, our $350 million credit facility that has zero drawn, and our access to joint venture capital should provide us with sufficient sources of capital to bring these opportunities to fruition.

Unlike many other REITs, we did not need to issue stock at depressed pricing levels in 2009 so we have future capacity in the public markets to match a capital raise with an attractive use for the proceeds. Turning now to leasing fundamentals, the overall trends have remained on par with our expectations.

Our leasing volume continued at a strong pace. We leased approximately 511,000 square feet of office space and 155 transactions. That tenant demand from smaller entrepreneurial tenants, our core customers, has continued to grow. During the first quarter we signed 73 leases with new tenants totaling 176,000 square feet.

The number of new leases signed during last quarter was higher than in any quarter since we became a public company in 2006. As anticipated occupancy continues to be effected by lease defaults and space reductions, primarily from our larger tenants who reduced their work force during the recession and are now downsizing their offices.

Although we are fortunate that we focus on smaller sized tenants, the negative impact from our larger tenants has offset our strong leasing volume. This trend is seen most notably in our Warner Center/Woodland Hills submarket, where our lease percentage during the first quarter declined by 1.7% to 82% and where we also have the greatest concentration of large tenants.

Overall the lease percentage of our REIT owned office portfolio declined 40 basis points in the first quarter to 91.3% in line with our expectations. Our view on 2010 occupancy is unchanged from last quarter.

We anticipate the headwind from downsizing larger tenants will likely cause occupancy levels to continue a modest but uneven decline over the next several quarters. However we are encouraged that the strengthening of tenant demand across a wide variety of industry groups appears to be continuing.

We are therefore increasingly optimistic that a strong recovery in leasing fundamentals will be at hand fairly soon. With that I would like to turn the call over to William Kamer, who will provide details on our first quarter operating results.

William Kamer

Thanks Jordan, in the first quarter the company reported FFO of $48.1 million, or $0.31 per diluted share. AFFO for the quarter ended March 31, 2010 was $40 million or $0.26 per diluted share. Same property net operating income in the first quarter of 2010 decreased 3.1% on a GAAP basis and decreased 2.2% on a cash basis when compared to the first quarter of 2009.

Same property total revenues in the first quarter of 2010 decreased 2.9% on a GAAP basis and decreased 2.3% on a cash basis, when compared to the first quarter of 2009. As previously stated the fund was deconsolidated in February, 2009, therefore the company’s financial results include fund properties on a consolidated basis for the months of January and February, 2009 and exclude fund properties thereafter.

The following revenue and expense results are adjusted to exclude fund properties throughout all applicable periods so as to provide more meaningful comparison. Total revenues for the entire portfolio owned by the company totaled $137.8 million in the first quarter of 2010 compared to $141.8 million in the first quarter of 2009.

Total office revenues in the first quarter of 2010 totaled $120.8 million compared to $124.6 million in the first quarter of 2009. Included in last quarter’s office revenue was $313,000 of lease termination income which was somewhat higher than normal. Total multifamily revenues in the first quarter totaled $17 million compared to $17.3 million in the first quarter of 2009.

Office operating expenses totaled $36.1 million in the first quarter of 2010, down from $37.1 million reported in the first quarter of 2009. Multifamily operating expenses totaled $4.6 million for the quarter ended March 31, 2010 compared to $4.5 million for the quarter ended March 31, 2009.

Our total office and multifamily FAS 141 income for the first quarter of 2010 was approximately $7.3 million. Included in the quarterly FAS 141 income was one-time income of approximately $700,000 attributable to defaults and early terminations.

G&A in the first quarter of 2010 totaled $5.9 million which is down approximately 8% from the first quarter of 2009 and interest expense in the first quarter of 2010 totaled $45.1 million. With respect to liquidity our cash position continues to improve.

At March 31, 2010 the company had $94.3 million in cash and cash equivalents on hand which is an increase of $21.6 million from December 31, 2009. In the first quarter recurring office capital expenditures totaled $0.03 per square foot and recurring multifamily capital expenditures totaled $31.00 per unit.

Turning to operations, the office percent leased for our 10 submarkets declined 90 basis point sequentially to 86.7%. Market rents for our 10 submarkets declined 1.5% sequentially. As Jordan mentioned we continued to see healthy leasing activity during the first quarter. We signed 73 new leases aggregating almost 176,000 square feet compared to 58 new leases totaling 192,000 square feet in the fourth quarter.

Overall we entered into 155 new and renewal office lease transactions totaled 511,000 square feet compared to 715,000 square feet of office leasing done in the fourth quarter of 2009. At the end of the first quarter our office portfolio excluding fund properties was 91.3% leased and 90.4% occupied.

Including fund properties our office portfolio was 89.7% leased and 88.6% occupied. Our multifamily portfolio was 99.5% leased on March 31, 2010, up 50 basis points from the fourth quarter of 2009. Tenant improvements, leasing commissions and other capitalized leasing costs during the first quarter totaled $20.67 per square foot compared to $17.84 per square foot for the fourth quarter of 2009.

During the first quarter our mark-to-market and rent roll metrics are as follows, on a mark-to-market basis our in place cash rents were 6.8% higher than our asking starting rent. On a straight-line basis the average rent from expiring leases was 0.4% higher than the average rent from new and renewal leases signed for the same space.

On a cash basis the ending cash ramp from expiring leases was 8.8% higher than the beginning cash rent from new and renewal leases signed for the same space. Now turning to guidance, we are maintaining our full year 2010 FFO guidance range of $1.19 to $1.25 per diluted share.

As previously stated this guidance excludes any impact from future acquisitions, dispositions, equity purchases, debt financings, recapitalizations, or similar matters. Further our guidance is based on the following estimates and assumptions for 2010.

Total FAS 141 income is estimated to range between $25 and $206 million. Straight-line income is estimated to range between $6.5 and $7.5 million. G&A is anticipated to range between $25 and $26 million. Total interest expense is estimated to range between $164 and $165 million. Consistent with previous guidance this excludes the impact of any new or refinanced debt, and assumes that the non-cash interest expense related to the company’s pre-IPO interest rate swap contracts will approximate straight-line amortization.

Further this guidance assumes that one month LIBOR which is currently 29 basis points, will average 100 basis points during the period from August through December of 2010, the period following the expiration of the $1.11 billion of interest rate swap contracts.

Based on the foregoing estimates and assumptions our 2010 FFO guidance range is consistent with 2010 same property cash NOI decreasing between 1.4% and 3.7% when compared to 2009. 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 comes from the line of Alexander Goldfarb – Sandler O’Neill

Alexander Goldfarb – Sandler O’Neill

Your comments were pretty up beat and on the market, on acquisitions, on fund raising, sort of on everything, but I wanted to delve into the business confidence, just looking at some of the leasing stats it looked like the LA market overall had a significant amount of negative absorption including on the west side and there were some blocks in Century City and Santa Monica, so just want to get a little more color on what gives you the optimism and how we should contrast that with some of the leasing stats that we’re seeing from the brokers.

Jordan Kaplan

Well in terms of the leasing stats, when you look at what we’ve come through and where we’ve been I feel like we’re now much more confident in our predictions and we do seem to be scrapping along the bottom or bouncing along the bottom. And what gives me the most good feeling on the leasing stats is the incredible amount of leasing this organization is doing, positive leasing its doing in terms of new deals and renewals.

Yes, we’re also losing space but as things improve and that space lost especially from the large tenants, the 20,000 foot, or the 10,000 feet or whatever, we feel like that’s tapering off. Defaults have already tapered off considerably and that the machine we’ve built that’s actively leasing so much, 700,000 feet two quarters ago, 500,000 feet this quarter is, that’s not going to go away.

So that’s why I’m optimistic about the underlying economics. In terms of the capital markets I’m more on the capital market side and things have been relatively quiet for quite a while and it feels great now to see deals happening and to be working on deals and deals I think are very good deals in terms of the acquisition front and also to be, have debt, kind of going to where we thought it would go in terms of spreads and things.

I think we feel great that we did do stuff last year. We called the cycle right. We targeted where spreads were going to go. They seem to going there at a pretty good clip. Rates hopefully with fingers crossed haven’t backed up too much on us so I do feel very, very good about this year in terms of what we’re going to do with our debt, what we’re going to do with acquisitions, our fund raising on the fund front.

Because we’ve been through a couple of very tough years on those fronts. So that’s why maybe I’ve just been held down for so long that now a little bit of release of the pressure is making, I’m giddy about it, but I do feel very good about this year.

William Kamer

I just wanted to say the stats in terms of where the leasing fundamentals are this quarter are really right down the center line of what our expectations were when we commented a quarter ago, so we’ve been saying that we thought there’d be some continued erosion and it really is, it is really consistent with that.

The reason for some greater optimism this quarter than before when we first started seeing an increase in leasing volume in 2009, we did have a little bit of concern that maybe there was some pent up demand from the really bad quarters of the end of 2008 and beginning of 2009 and we were concerned about whether that increase in activity was going to be a short run phenomenon or whether it was going to build from there.

We’re getting more and more confident each quarter that we’re seeing a continued build of leasing demand and activity and it seems like its sticking and that we’re building on it. Notwithstanding the fact that as we’ve said and we’re continuing to say we think we’ve got some headwinds with existing tenants that are going to damp down the occupancy numbers for a while.

But the underlying pulse, we’re feeling better and better about.

Alexander Goldfarb – Sandler O’Neill

And then the second question, just continues the refinancing theme, in fourth quarter it sounds like you’re going to target all the $2.6 billion of the 12 rolls, or should we expect that there’ll maybe some prepay penalties or what are the lenders thinking about that and then as we think about that roll, should we think about all debt or the potential for some equity to be included to manage that $2.6 billion.

Jordan Kaplan

There’s no prepayment penalties. There aren’t any now. So you’re probably talking about the $2.3 billion on the office or are you, on the residential stuff that comes up in 2012.

Alexander Goldfarb – Sandler O’Neill

No sorry my mistake, more on the office side not the—

Jordan Kaplan

So on the office side, there are no prepayment penalties, there is no yield maintenance in it because just the way we normally do debt its LIBOR floaters that we’ve swapped. So you have to deal with breaking the swap if you want to reswap for a longer period of time, but that’s the only charge, swap can have positive or negative value but with where rates are they have negative value.

Now our swaps are burning off and that’s why we’ve said for a while if these swaps burn off we’re in a very good position in the latter half of this year to do refinancings. Now the other thing you needed to have happen was you needed for rates to stay low which they seem to have stayed reasonably low, and you need, and we wanted to see, we believed spreads would come in.

And spreads have come in from 350, 400 over to the point where now we’re optimistic they will be 200 over or less than 200 over. So that’s a big move there with the rates being low. We will move aggressively to take advantage of that situation with respect to the $2.3 billion at the end of this year.

Operator

Your next question comes from the line of Brendan Maiorana – Wells Fargo

Brendan Maiorana – Wells Fargo

Just had a question regarding your comments, it sounds like everything is firming up and you’re outlook is looking good, and you have a lot of scale in your local markets with a lot of operating leverage so to say, so what’s your strategy going forward in terms of dealing with your tenants, just kind of looking at because you have so much scale and so much local presence, you might have the negotiating leverage risk to your tenants and tenants might not have the space that’s available to them, so I was just thinking about what you are thinking going forward.

Jordan Kaplan

Well the market right now still has I don’t know 12% vacancy or something like that. To really get negotiating leverage we need to pick up 200 or 250 basis points of occupancy before we can start, before things shift back into what you might call landlord’s market. The good news is and why we feel good about what’s going on and what we’re doing strategically about it, is that since the market has not, didn’t really just crash, so in the early 90’s we were dealing with markets that got down to 80 and sub 80.

To be where we are today and to feel the bottom and feel the energy that we can pull back out of it I think what’s its done is its caused a lot of tenant, I don’t know if you call this our strategy or not, is they’re trying to lengthen their lease, they’re in willing to make deals. They want to make deals and I think that the feeling is when they sense the market is that the rates that they’re making deals at today are good deals for them.

And they want to lock them up. And that feeling comes from the fact that they expect probably rightfully so that as things tighten up it doesn’t take a lot to pick up a couple hundred basis points in occupancy in the market and then guess what, rates really start moving again because there’s no new supply here.

But right at this moment I’d say the strategy that we’re pursuing is we want to keep our portfolio as well leased as possible so when things turn we are in a position with not too much space that we have to fill to put pressure on rents in the space that we’re leasing.

Brendan Maiorana – Wells Fargo

And just to go back to your comments regarding small tenants versus large tenants, it sounds like you’re having better luck with small tenants, but when we hear from your competitors not necessarily on the west coast, but some other markets, it sounds like larger tenants are doing better. Could you just perhaps explain what could be possibly different from your markets.

Jordan Kaplan

Yes, because in our market a large tenant is a small tenant in New York. We say large tenant for a tenant that’s 20,000 feet, 30,000 feet, and when our average tenant sizes, I think its 5800 feet and our medium is like 2500 feet, so when you lose a 20,000 or 30,000-foot tenant, think about it, we have to do what like 10 deals right to backfill that space.

That’s a lot of work. And when you think about the guys in New York and they’re talking about tenants that are 300, 500, maybe a million square feet and these huge investment banks, they’re not really defaulting on their leases so they’re carrying them through even though that space may not be very well occupied. Maybe they’re subleasing or who knows what they’re doing.

Our guys, we don’t have a lot of sublease, we tend out a lot of shadow type space. Our guys are in or out and our larger tenants when they have a chance to shrink down they could end up as I said and we have some examples of guys that have gone from 40 to 20 and so it’s a lot of work for us to backfill that space.

Now the good news is is that as you, the more we go multi tenant and refill those spaces with a number of smaller tenants just the more protected and diversified the portfolio of tenants becomes. But its always work to make those shifts.

Operator

Your next question comes from the line of John Guinee – Stifel, Nicolaus

John Guinee – Stifel, Nicolaus

Can you just sort of discuss the dynamics of how you basically downsize these buildings which I think is essentially what you’re doing. We noticed that your new leasing activity was 176,000 square feet, 73 tenants, that averages about 2400 square feet per tenant. My guess is you have apartments that are larger than that. But if you can just walk through the cost to take a 15, 20,000 square foot floor plate and subdivide it down to six or 10 smaller spaces and are you running that all through your leasing costs or are you not running through some of the costs of putting in a common area corridor etc.

Jordan Kaplan

William is going to do a better job of answering that question.

William Kamer

Yes, we do run all of those costs through. We have a very active program in building what we call spec suites and I know in other parts of the country it tends to be called as built suites and we have actually, we go through a very proactive program with that where we have different levels of finish for TI’s to anticipate the demand.

And that, frankly our operational people are straining to keep up with that demand and we try to stay just, keep the carrot just a little bit ahead of the horse on that so that you’re CapEx, you’re not putting in a huge amount of CapEx on a spec basis but that you’ve got the product to be able to deliver.

So we’re able to modulate that pretty well. Our operations people do a fantastic job of getting that mix exactly right and meeting that demand without basically wasting CapEx by front ending it too much.

Operator

Your next question comes from the line of George Auerbach – ISI

George Auerbach – ISI

Just to go back to the rate question given that spreads have contracted to 200 basis points or so over and that base rates haven’t moved much since you’re last call where do you think the [inaudible] in interest cost is to refinance the 2012 office maturities if you ignore the in place swaps.

Jordan Kaplan

Well I think William has been saying between 5% and 6% and while I hope to beat that I think that’s a very good range to use.

George Auerbach – ISI

And are you concerned at all with the recent back up in the forward swap curve.

Jordan Kaplan

I want rates to stay low and anything that predicts that they’re not going to stay low, is like a bad piece, is a bad piece of news but I will also say that my general attitude or my whole executive groups’ general attitude because we talk about interest rates and this dead issue constantly is that there is enough window left that we should be able to successfully take advantage of where rates are basically where rates are today and lock in some pretty good new swaps that ought to protect us from rate risk for many years into the future.

William Kamer

I’m going to add to that we’re, our anticipation in terms of our timing for addressing the loan maturities takes into account and assumption that the underlying index rates will be increasing during that time period. So we have that in mind and the analysis is that the advantage of both declining spreads but frankly even more importantly the burning off of our over market swap interest rates, that combination more than offsets our anticipated increase, but to be clear we are assuming in our planning that the underlying index rate will increase between now and the end of the year.

Operator

Your next question comes from the line of Michael Bilerman – Citigroup

Michael Bilerman – Citigroup

Just a follow-up on the refinancing can you just repeat whether you think you’ll be able to roll over the entire amount and also how much you think you might be able to lock up from your existing bank syndicate.

Jordan Kaplan

I don’t have a good answer about how much of the existing bank syndicate will want to stay with the deal and how and whether we’ll replace any of them, although the feedback we’ve gotten so far is that the very, very high majority want to stay with the debt. Maybe one or two that aren’t in a position to but only that.

And we have a real good, aside from them we have a real good group that is anxious to get into the deal so I think I have probably the right mix of pressure in terms of demand for our debt to, we’re well positioned to make a deal that makes a lot of sense for us. In terms of, there’s a lot of grades of can we replace it, we for sure can replace the debt.

Now what will we choose to do in the end of the day, will we choose to replace the entire 2.3, or a lesser amount, that has to do with kind of our feel for what additional pricing benefits we can get and where we’re comfortable in terms of the leverage in the company and the leverage on those properties.

So I don’t know where that’s going to fall out, but we haven’t taken off the table the option of doing a pay down but if you ask me the simple question could you if you had no money replace that debt today, the answer is yes. That doesn’t mean that’s what we’re going to do.

Michael Bilerman – Citigroup

And the 5% to 6% total costs, you think that assumes rolling the whole thing.

Jordan Kaplan

Yes I think we could probably roll the whole thing and stay within that range and not do a pay down. We may not choose to do that but I believe we could.

Michael Bilerman – Citigroup

And where are your thoughts on the duration of the new debt.

Jordan Kaplan

We’re going to try and, if we do this floating we’re going to try and push it as long as we can because a lot of times there’s not a lot of extra cost if someone wants to be five year to push it seven year or later. Seven years seems to be the sweet spot for a lot of these guys coming into the debt and in the debt, so we would effectively have five years to the current maturity.

Michael Bilerman – Citigroup

Are you considering laddering the maturities at all or will be a prepayable along the way with the final bullet at the end.

Jordan Kaplan

I think probably, I don’t know the answer to that question. We are considering laddering it. We were considering some spot where maybe we can use some 10 year but I think probably it will take two rounds to actually have something that’s laddered so like first round get everybody all settled and re extend it seven years and then maybe take another chunk of it after we’ve done that in a year or two and take that out maybe another seven or 10 years and break it up that way in a less stressed environment because we might be because there’s all the lenders are in this all the same bed even though its across these various pools, we might be asking for too complicated a transaction to try and not only extend everybody we can and have the proper sort of demand pressure on it and people staying in and have them recognize the benefit of the fact that maybe they’re going to get higher spread in the earlier part of the loan.

To mix that in and also say and by the way this piece is going to be five, this is going to be seven, this is going to be 10, it just might be too much for this round.

Operator

Your next question comes from the line of Richard Anderson – BMO Capital Markets

Richard Anderson – BMO Capital Markets

When you think about the acquisition environment what do you think the forces are that are in place that are will stop their, and I know this is kind of a rhetorical question but there won’t be any kind of fire sale type of situation if banks start to unload some loans and all that kind of stuff, what are the forces that will keep you within a very reasonable cap rate range in your mind.

Jordan Kaplan

I will start by saying I don’t think there’s fire sales right now.

Richard Anderson – BMO Capital Markets

I know there’s not but how do you not see an uptick in cap rates if suddenly the banks start to move on some of their portfolios.

Jordan Kaplan

Well its harder on that question for me to speak to other markets around the country but in terms of the kind of markets we’re focused on here and primarily Honolulu and LA markets, there is just not that much quality product in the hands of banks quite frankly for them to dump.

When I look at what’s going to trade and people love to bring up Blackstone as a potential for us because its an incredible match for us and we do a lot for the company well, they’re real sophisticated bunch over there. They are, its going, its already going to trade expensively. I think stuff is trading in a relative and historical sense, stuff is way down, but in a current sense I think cap rates are low.

And if they were to bring that down I don’t think they’d bring it on in a way that would you’d say oh good, now they’re dumping their property and cap rates are going to rise again. I don’t really see a scenario like that. As a matter of fact I don’t really see any seller that could meaningfully sell property in any of our markets being the type of seller that would bring it on in a way that would do anything that would depress values because “to supply a product out, had outdone the demand for it.”

Richard Anderson – BMO Capital Markets

Just a quick follow-up, who do you think all these buyers are then, are they and where is the money coming from for them to finance it.

Jordan Kaplan

Well the good news for us is we’re not seeing a lot of REITs in our markets trying to be buyers but we’re seeing plenty of private funds and private capital and wealthy individuals and wealthy foreign individuals and separate accounts managed by guys. We’re seeing all that.

Operator

Your next question comes from the line of Michael Knott – Green Street Advisors

Michael Knott – Green Street Advisors

If I can ask a similar question just maybe a little bit differently, you mentioned that you feel Douglas Emmett is as well positioned as its been in your 25 years, and I’m assuming part of that includes a view on acquisitions that you’ve had before, I’m just curious what gives you the confidence that you think you’ll be able to fund deals that will fit your return characteristics that you look for etc.

Jordan Kaplan

Well the main thing is is that I’m looking at our pipeline right now, deals we’re working on and I feel good about them. Now if you go beyond the pipeline of what we’re working on now, I feel like and it might sound self-serving but I feel like we just went through this whole bit about smaller tenants or larger tenants making trouble for us, and the smaller tenants you look at the number of transactions we’re doing, we’re just in a very abusive market in terms of being on operator and its hard for people to come in and be competitive with us in terms of buying properties that are filled with smaller tenants.

If you’re backing, if you’re someone back east and you’re thinking about making an investment in a building and you say, what do you do, you say well what gives me comfort. Okay, really the income is coming from three big good credit tenants that I know, so I’m comfortable with that deal and I’m comfortable riding that out.

There’s nothing that trades here that does that for them. Its all little tenants they never heard of. And so its like, wow I get in the game and I ride away a happy dude, 30 leases the first year, 50, just to keep things rolling and it just makes it harder for them to get comfortable with what’s going on. Whereas that’s dead center of our comfort zone. But its because we’ve set up this huge sort of assembly line operation and we’re very comfortable with the flow that we have going through the company and being able to direct that flow.

So I feel like that edge which we’re better now than we’ve ever been on that operations front and when you combine that with I see the deals that have taken people, I see, people are going to sell buildings not distressed or anything but they’re fatigued. They’ve owned them for a long time. They wrote them up, they wrote them down, now they’re back up a little bit and they’re like, we want to get off the rollercoaster and we’re not going to be criticized because values have come back a bit.

And now we can get out of these nice, see those deals coming right now. And so I think we’ll make those trades and be the winning bids in our markets on those buildings and I think debts at a great position and I think we’re operating extremely well and I’m optimistic in terms of, another one of the same old story, but there’s no new supplies so as the market picks up we have a couple hundred basis points to recover and its going to be one day the market will go down again but I do feel we’ll have some real good sailing for a couple of years.

William Kamer

Let me just pick up on that last point that Jordan raised, a part of our feeling about the optimism on a relative basis with prior periods is if you look at earlier periods when we were buying the outlook in terms of the underlying leasing fundamentals was not nearly as strong as it is today. It was way more of a leap of faith years ago in terms of the demand but more importantly the supply that was still available to come on stream.

We really have only had one up cycle in our experience where we could enjoy the constraints on supply that have existed and when we look forward now, we say okay that remains in place and as we continue to build going forward it’s a lot easier for us to feel comfortable with the long-term strength of the underlying west LA market as we look forward than it was years ago.

Michael Knott – Green Street Advisors

What’s sort of your outlook for Warner Center and how long do you think it will take to get back to a stabilized level and maybe what do you think is a stabilized occupancy level for your portfolio there compared to your west side portfolio.

Jordan Kaplan

We gave you such a big answer to your first question, I don’t even know if you should get a second question.

Michael Knott – Green Street Advisors

Come on Jordan, come on.

Jordan Kaplan

Warner Center is another I don’t everything to be a story but we still believe very much in that market and its going through, we discussed it one or two calls ago that the lifecycle of that market and what its going through. I think it will stabilize in the 90’s which most of these markets stabilized 92 to 95 and we had very rare moment when we got up to 96.

But that was very rare. Its going through, its not a bad market, its actually a great market if you look at the demographics, or the people living there and the energy, the businesses that are there and are forming there. Its just that its going through restructuring. A large guy moves out a couple hundred thousand foot guy moves out and you’re backfilling it with 5000 foot guys, that’s very painful process.

But it doesn’t mean that when you look at that market in general it doesn’t have a great future in terms of the amenities and the schools, and now the supply constraint that’s moving in there because the residents have created homeowners association. Those things didn’t exist there 10 years ago when they were building Warner Center and when Voyt was doing their work there and building it out.

So we saw that and we’re long-term and we’re not quarter to quarter and we thought that’s a good market to get into because it’s the next if you will Century City or west side for LA but its still a couple of years out. So everything we’re going through is painful to go through in a down market to have, to be losing more of the larger tenants and to be backfilling them.

We are doing backfilling but its not that we don’t have any more negative view on that market.

Operator

Your next question comes from the line of Mitch Germain – JMP

Mitch Germain – JMP

Could you give us a sense of what the deal pipeline looks like today, maybe the size, location, asset type.

Jordan Kaplan

Its office in LA and Hawaii and we’re trying to get, I’d love to get some residential in and you know what we’ve bid on some residential but that was in the valley and we missed, pretty big miss on our part because maybe we didn’t have the confidence out there that hasn’t seen on the west side, we haven’t seen as much come up.

One deal that we worked on but it ended up, there was a structural reason why it didn’t sell at all. So we’re having more trouble getting residential in and I would say what you’d expect to see from us is office, Honolulu office and west LA office.

Mitch Germain – JMP

Do you still have about 60 days left in the fund raising or is that been extended.

Jordan Kaplan

No it ends June 30.

Operator

Your next question comes from the line of [Chris Tatham ] – Morgan Stanley

[Chris Tatham ] – Morgan Stanley

First question is what type of capital costs do you anticipate to lease some of the office vacancy, what state is the vacancy in in terms of finishes and then two, the annual lease transaction costs for this quarter jumped up to about $5.00 a foot and I wonder if that’s a good number to think of going forward or if there was something unusual in the quarter that led to a higher number.

William Kamer

Let me just say by and large that the space that we’re [turning] is in good shape, its conventional build out and we’ve been saying for a number of quarters that we have not seen a notable change up or down in our CapEx costs. The stats from quarter to quarter have bounced around, they were down significantly a few quarters and we said, don’t view that as a decrease, longer-term trend, its been relatively flat maybe edging up slightly.

It tends to get skewed again I know this sounds like a broken record on this theme but it really is as is true with some of these other metrics we’ve been talking about its largely a function of large versus small tenants, way more that than it is new versus renewal space.

So when we have a quarter like we did in Q1 where we had a number of stats skewed by several for us relatively larger tenants the capital costs go up and some other metrics change a little bit as well in that context. So I think probably the numbers you see this quarter are a little on the high side in terms of a good run rate and a more normalized run rate because we’re really not seeing any significant change. Whether there may be the occasional larger block of space where there’s a greater CapEx cost that might skew a quarter in the future as well.

But the blend normally is that we’re at a pretty flat level. And we really are not looking at, there’s really nothing in the way of significant blocks of first generation space or big blocks of space that have to be basically demoed back to that level, pretty, by and large its good space, that could use for second generation.

[Chris Tatham ] – Morgan Stanley

On the multifamily portfolio looks like same store cash ticked up 2.3% I’m wondering qualitatively what you’re seeing in that portfolio as far as say rent escalations on renewal and whether or not there are any kind of move outs related to the housing cycle.

William Kamer

For people who have followed us for the, each quarter since we’ve been releasing data since October of 2006 you can see each and every quarter we’ve had or at least a percentage in our multifamily portfolio at 99% and that’s either been a little under that or this quarter its on the high end of it at 99.5 but its really within that tight range.

That’s a dynamic that large part comes from the fact that we have rent control in the units that we have so that tends to both keep a good stabilized base for us and also adjusts bumps in each year. They tend to be more regular kind of increases that don’t spike up but at certain times and now don’t decline very fast.

We have been continuing to see a very modest decline in rent levels in terms of roll that’s offset by pickup that we have in some older units that are at very low rents under rent control that tick up. So its been fairly flat, likely to continue so for the foreseeable future.

[Chris Tatham ] – Morgan Stanley

So the rent control is that on a level basis or on annual escalation basis.

William Kamer

There are annual escalations that in the LA jurisdiction tend to approximate CPI and in Santa Monica they vary it year to year. Sometimes you can get as close to CPI, sometimes its pretty nominal. But in both cases the rents go to market on vacancy and we tend to roll the entire portfolio of market renewals every sort of 18 months or so, so we get up to market pretty quickly so in that way it doesn’t constrain us.

It just becomes sort of I would call it stabilizing for us.

Operator

Your final question comes from the line of David Harris – Gleacher Securities

David Harris – Gleacher Securities

I’ve got a question for you on the west side and downtown, is there any new dynamic to that story, with rents coming down on the west side are you stealing tenants from downtown.

Jordan Kaplan

I don’t think so because I think any tenant that was downtown that wanted to come to the west side already came and I think if someone is downtown today, they’re there for a reason. We get, when you see a little more and I wouldn’t call it stealing but you could have a law firm that needs to have a presence downtown to be near the courts but they also have sort of let’s say a high end business practice presence that’s in Century City.

And you could definitely watch the flow where the Century City office grows and the downtown office shrinks because more lawyers want to be here on the west side and work near where they live unless they live in Pasadena I guess, so we see more shifting there where they’re growing the offices here and the same goes for with the investment banks.

But in terms of a wholesale kind of we’re leaving downtown and heading for the west side, to make a move because its affordable, I don’t know, has anyone around this table heard any of those. I haven’t heard of any of those.

William Kamer

They’re two very distinct markets and frankly in either direction you don’t see big moves going back and forth.

David Harris – Gleacher Securities

No I guess downtown is more characterized by your big space, so you really couldn’t accommodate them even if they wanted to come in many instances.

Jordan Kaplan

There’s a lot of government, union, they’re not coming to the west side. They’ve got to be down there near the kind of, the offices of the City and the state and the courts and—

David Harris – Gleacher Securities

My second question is on the fund and you’re exclusivity there if you were to find a property vendor that wanted to take OP units for example, do you still have to offer the property in the first instance to the fund.

Jordan Kaplan

Well what we have to do, if someone wants to sell a building and they’d only do it with OP and we’re able to do it, but we have to first try and get them to take an interest in the fund as opposed to OP units and our obligation is to try and make it a deal that works well for the fund. But if there is no possibility the fund doing it it would come under the classification of being kind of an equity deal.

It has a name in the agreement and then we do have the ability to do it directly in the REIT using OP units.

David Harris – Gleacher Securities

It’s a leading question, but is there any more interest from your side or from the potential seller side to use OP’s in the current environment.

Jordan Kaplan

You know we have one deal we’re working on that’s a possibility and we, not a lot, one’s a possibility that we’re talking to them about it and if I think about, let’s say four or five that hopefully more imminent then I would say one’s a chance. But no, generally I don’t see that as a huge carrot today.

David Harris – Gleacher Securities

Is that more a reservation on your side or the other side.

Jordan Kaplan

I think its probably the other side because when someone kind of crosses the moat and commits and says I’m selling I think they just decide they’re selling and some people are selling because they’re worried about taxes going up and they want to have their gain this year.

Thank you everybody for joining us on this call and we look forward to speaking with you again next quarter. Bye, bye.

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Source: Douglas Emmett, Inc. Q1 2010 Earnings Call Transcript
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