Douglas Emmett: One Of The Smartest Risk-Adjusted REIT Opportunities Since 2009 (NYSE:DEI)

Douglas Emmett (NYSE:DEI) is a high-rise Class A office and high-end apartment building real estate investment trust [REIT], with operations focused on the Pacific beaches in Los Angeles, California and Honolulu, Hawaii. At the time Douglas Emmett went public in 2006, the company was valued as one of the largest IPO's in industry history.

Technical momentum indicators are starting to act better, especially my favorite volatility measurements, following an extended slide in price during 2022. $15 a share seems to have reached at least a temporary resting place, with a balance of buyers and sellers since early winter.

The upside argument is based on the REIT's lowest raw valuation in well over a decade. Honestly, the bearish valuation sentiment on Wall Street for office building investments (as employers have allowed workers to stay home to do their jobs during the pandemic) has been the big negative overhang hurting the sector. Futurists and analysts are wondering if the U.S. now has too much office space for occupancy needs. More specifically for Douglas Emmett, a dividend cut to better fit the current cash flow outlook, and worries about its larger than REIT-typical debt position ($5.2 billion in debt vs. $3.1 billion in common equity market capitalization at $15 per share) have caused an exit of investor interest.

Hence, the opportunity to buy DEI on the cheap has arrived, with the possibility slightly lower quotes soon will open an even greater long-term proposition for new capital. Insiders also seem interested in the company's ownership units under $20, with a number of buys around this area in late summer. Lacking any insider/management sell orders since then, we may be closer to the bottom than the top in price.

Business Summary

Douglas Emmett is effectively the blue-chip choice if you want to own Los Angeles real estate near the beach. Below is a summary of occupancy/leases, plus a revenue breakdown for 2022 from the just released 10-K.

The good news is the company's office properties are leased at a high 87% rate, which compares favorably to a national average around 85% for Class A space (88% pre-pandemic).

And, you would guess cash flow and income numbers are moving in reverse from the 50% share price haircut in 2022. Nevertheless, this is not the case. Strong interest expense hedging activity and rising real estate values from the Federal Reserve's money printing in overdrive helped rents and Funds from Operations [FFO] to rise nearly 10% last year at Douglass Emmett.

Net operating income [NOI] at its various properties rose almost 4% on the year, and the reconciliation to GAAP accounting jumped final earnings by approximately 50%!

Debt/interest rate hedges and swaps have been purchased to keep interest expense very low this year and next, with most loans in the 2% to 4% yearly net expense range, not maturing for years into the future. (Less than $1 million in debt is maturing during 2023, with $401 million due for repayment or refinancing in 2024 likely at much higher rates vs. 2021.) However, total interest expense will gradually rise after 2022 vs. 2021's flat showing, as swap rate hedges expire on $837 million in debt during calendar 2023, with additional expirations in 2024 and beyond.

Above-average debt to assets of 54% is and has been one of the company's calling cards for investors. When interest rates are rising, I would rather not own a debt-laden enterprise. I completely understand Wall Street worries, and this is the main explanation for the rotten stock performance since 2021.

Below is a decade-long graph of debt/assets vs. major peers in the office and apartment REIT spaces, including Corporate Office Properties (OFC), Highwoods Properties (HIW), Cousins Properties (CUZ), JBG SMITH Properties (JBGS), Boston Properties (BXP), Alexandria Real Estate (ARE), AvalonBay Communities (AVB), and Camden Property Trust (CPT).

For optimists, my thinking is a recession in 2023 may encourage lower interest rates by the end of the year, keeping total interest costs in a gradual rising trend over the next 3-5 years, without a rapid escalation. A mild recession that doesn't demolish office/apartment rental demand, alongside lower interest rates in America would be the best-case scenario for Douglas Emmett's shareholder worth from today.

Ultra-Cheap Valuation

The debt overhang and fears of rising interest costs into the future have sunk the valuation on trailing fundamental operating statistics. Is this an overreaction by Wall Street? Possibly, if real estate inflation picks up again in 2024, as climbing rents should offset much of the increase in interest expense.

And, if the Federal Reserve is forced into another round of record money printing to reverse the economy out of recession, far lower interest rates and much stronger real estate inflation will be leveraged in a positive way for shareholders over a period of years. In a nutshell, my bullish argument is to purchase Douglas Emmett on the cheap today in preparation for this scenario unfolding.

On price to trailing sales, cash flow, tangible book value, earnings and free cash flow, DEI is the least expensive in over a decade, with a setup approaching the blowout lows of the Great Recession achieved during 2009. Today's valuation is a good 60% discount to 10-year averages.

Last Decade

Great Recession 2008-09 Period

Looking at price to sales, cash flow, and tangible book value vs. the peer REIT group, Douglas Emmett is now the bargain buy of the group. The company is selling for discounts of 20% to 50% to the industry, depending on which stat is reviewed.

Dividend Story

Another piece of the investment puzzle is the dividend yield. Funds from operations are expected to dip slightly in coming years, to a level just under $2.00 per share. Slow back-to-office forecasts after the pandemic ends, a possible recession in 2023, and the effect of rising interest rates cutting into cash flows all play a role in this weak outlook.

The headwinds convinced management to reduce the dividend payout in December from $0.28 to $0.19 quarterly, while installing a new incremental return of capital idea. A $300 million share buyback plan should allow greater flexibility to reduce the float of shares when (1) price falls and (2) cash exists to pay for it.

On a trailing basis, the nearly 7% cash distribution has been reduced to 5.1% on a forward basis. Assuming the dividend payout is made AND share buybacks take place, the net payout yield to shareholders should remain in the upper-tier of peer REITs.

While the dividend coverage from earnings has been on the lower end of the range vs. the peer group, funds from operations have been able to consistently outpace the cash payout ($420 million FFO vs. $197 million in common dividends). The new return of capital plan is a conservative proactive decision by management, which better positions the organization for a recession and the negative effect of higher interest rates down the line.

Technical Chart - Signs of Life

The catalyst for me writing a story on Douglas Emmett is the improving technical trading picture. My momentum indicators were not very optimistic on a turnaround in the share price in November, but this setup has been changing rapidly.

On the 18-month chart of daily price and volume below, I have drawn several of the bullish indicator changes I am watching. First, boxed in green, the 21-day Average Directional Index has been trending at a very low number since December. I like to use the ADX as a signal of balance between buyers and sellers, before a real uptrend in price appears. Scores around 10 the last three months are telegraphing a bottom is getting close, although another month or two of downside cannot be ruled out.

Second, the Accumulation/Distribution Line has quietly reversed course in 2023, marked with the red arrow. The minor uptick could be signaling buyers are beginning to outnumber sellers during each trading session.

Third, On Balance Volume has transitioned from a steady decline to a rising trend since December. Despite the flat to lower price zigzag, rising OBV is a healthy development and may indicate dollar investment size is becoming larger. You have to go back to early 2021 to find both OBV and ADL rising in tandem.

How does this chart pattern compare to the 2009 bottom during the Great Recession? Believe it or not, some similarities are popping up. On the chart below (price has been adjusted for dividends), I have boxed in green the period where a low monthly ADX reading (under 15) aligned with rising ADL and OBV. This circumstance appeared in the summer, a few months after the final price bottom. In terms of history rhyming, it will be interesting to see if a big Douglas Emmett upturn in price appears later in 2023.

Final Thoughts

Unlike many integrated businesses, the company can easily sell buildings to pay down debt or meet shorter-term obligations in the future in a pinch. And, rising interest costs are manageable with a theoretical $50 million in yearly expense added for every 1% increase in rates (which would happen over a period of years of refinancings). In addition, Douglas Emmett has a $400 million credit revolver untapped, no significant debt maturing anytime soon, and cash flow coming in the door to easily cover the current stated dividend payout. In terms of a liquidity crunch for the business, I do not see such happening this year or next.

The upside investment logic is DEI represents a "leveraged" inflation play, with low interest expense on debt for a few more years moving into the next economic cycle upswing. Back-to-office management orders after COVID are appearing daily from America's biggest corporations. For sure, if office workers return in greater numbers this year, Douglas Emmett would be a major beneficiary. A safer and more sustainable dividend payout going forward is in place, producing an upfront 5.1% dividend yield, which is TRIPLE the S&P 500 yield, and the same or higher rate than the entire Treasury yield curve for maturity dates.

I have drawn the buy-and-hold performance from the Great Recession REIT bottom in March 2009 to just before the COVID-19 pandemic hit in February 2020. Notice that Douglas Emmett outperformed both the diversified Vanguard Real Estate ETF (VNQ) and the SPDR S&P 500 ETF (SPY) by a decent margin over these 11 years. Will the early 2023 buy proposition represent another great opportunity to accumulate a stake?

I rate DEI a Buy around $15 per share, but will likely get more excited on further price declines, especially if my momentum indicators continue to improve. I have a plan to buy a small stake this week and add to it over coming months on any price weakness. This cost-average approach gives me immediate upside, in case price turns higher unexpectedly or another large REIT makes a buyout offer. Plus, I can reduce my per share cost (increasing my future cash yield and real estate leverage) if a recession in 2023 knocks price closer to $10 a share.

I am modeling prices from $10-$20 for a target range in 2023, rising to $20-$25 by the end of 2024, as lower interest rates and hopefully an upturn in the economy take hold. In a deep recession where interest rates stay elevated, I can foresee additional skittishness and selling in DEI. My worst-case downside over the next 12 months is $10 per share. At that quote, price to trailing sales would be less than 2x, price to cash flow under 4x, and price to tangible book value around 0.7x. Really, only February-July 2009 traded any lower since its IPO.

To reach a sub-$10 share quote, a major recession in office space demand on the U.S. west coast and even higher interest rates on real estate may be necessary. A U.S. stock market crash might also produce the same result.

My best-case scenario, including a drop in interest rates and a mild recession, is price returns to $20 or somewhat higher by January 2024. I do think optimism for 2024 makes clear practical sense. The odds favor a rerating of the valuation back toward long-term norms at some point. A "reversion to the mean" move in the valuation stats of 6x sales, 11x cash flow, and 2x tangible book value would roughly double the DEI quote to $30.

The further out we go, the stronger the economy should be. Interest and inflation rates should stabilize at lower levels, and hopefully traditional work-in-the-office trends will reappear (although at a lower level than existed pre-pandemic). If you buy at $15, collect two years of dividends, and can sell at $25 in 24 months, your total return would be +76% (or +33% compounded annually). Again, a lower entry price could provide even better long-term upside and logic for ownership.

Thanks for reading. Please consider this article a first step in your due diligence process. Consulting with a registered and experienced investment advisor is recommended before making any trade.