Description

This is a highly contrarian idea right now especially w/interest rates rising and the market presuming the death of office. I don’t have a strong view either way where interest rates will ultimately peak but I believe for this investment to work, we need to be in the 7^th inning of increases. The high level thesis is as follows:

1)      West Los Angeles (core DEI market) has extremely restrictive zoning laws = very low supply

2)      Occupancy rates won’t decline as much as the market expects

3)      Borrowing costs don’t move up meaningfully until 2025

4)      15%+ of the business is in multi-family and is more resilient than office

5)      Levers to create value within the portfolio – convert office to apartments (Hawaii example)

6)      Replacement cost is much higher than current NAV

7)      Dividend payout is “safe” for the next 4 years

8)      Overall valuation is extremely compelling

1)      West Los Angeles (core DEI market) has extremely restrictive zoning laws = very low supply

In general, I do not feel DEI is the typical commodity office REIT. They are absolutely dominant in their sub markets. For example in Brentwood they control 60% of the office stock by sq ft  & Westwood 40%+ or said another way 35% of office on the westside and 45% of office in the valley. There are serious network effects w/this broad level exposure. There is also significantly restrictive zoning laws where new office supply since 2009 only grew by 2.5% vs SF at 13% or Boston @ 20%. LA office is not overbuilt like other markets and combined w/DEI network effects, it is more than likely that pricing will stabilize faster in LA than other markets. This also explains why West LA rent growth historically has been much higher than other sub markets. Over the last 25 years LA grew rents over 110% vs SF @ 65% or midtown NYC at 57%. 

2)      Office occupancy rates won’t decline as much as the market expects

Office occupancy has declined by about 600bps since the start of COVID and there is a large unknown where occupancy will bottom. This is particularly concerning given DEI has 16% of leases expiring over the next 12 months.  Given where the stock is trading today, I think the market is imputing occupancy bottoming in the mid/low 70% range. I find that very hard to imagine as there is enough evidence to say that we are closer to the bottom of occupancy than the market realizes.

DEI recently put out a presentation that shows the utilization of their office portfolio growing every quarter since the covid bottom and now we are about 80% back to “normal.” They use parking data as the metric to base utilization. If I spot check parking revenue pre-covid vs 2Q22 we are off about 20% which puts us at about 75% occupancy based on parking demand. I expect parking to continue to grow as that has been the trend almost every quarter since 2Q20. So I do not view 75% as realistic occupancy which is where the market is at today. Occupancy will likely bottom somewhere south of where we are today but much further north of 75%. 

Further evidence is in DEI’s leasing volume, which has been very strong and inflected positively since 1Q21 while rent declines seem to have stabilized. Shown in the chart below (total sq ft on left axis, rent % growth on right axis):

In terms of recovery trajectory to get back to 90% occupancy which is where DEI can get pricing again, we are one year off if we assume 300bps of absorption, two years off if 200bps of positive absorption and three years off if assume only 100bps of positive absorption from where we are today.

3)      Borrowing costs don’t move up meaningfully until 2025

The current 1 month SOFR rate is 2.75%. However, for my analysis I assume 4.5% SOFR as I am using the forward curve to imply what interest rate moves are expected to be next year. As you can see in the chart below, interest borrowing costs do not move up materially for DEI given the current swaps in place. Looking out, the market assumes today that interest rates will start to decline before 2025, meaning the ultimate impact to DEI FFO is probably <15% hit.

Also it is worth noting that about $1.1 billion of the $5.4 billion debt balance is held within JV structures and should not materially impact DEI cash flow so the effect from the above would actually be less. When I ran the numbers for just DEI’s share of debt, the impact is more likely <10% to current FFO through beginning of 2025.

4)      15%+ of the business is in Multi-fam and is much more resilient than office

DEI currently has 4,577 units spread across West LA, Santa Monica & Honolulu. The occupancy is very high in the portfolio, basically fully leased, and there is scarcity value to these assets. For example, the apartment building they built in Brentwood was the first new high rise built west of the 405 in 40 years. If you were to put a 4 cap on their apartment portfolio, that would value it at almost $3B which implies the office portfolio trades at $5.7B or $315/sq ft. There are also further opportunities for DEI to strategically add to the multi-fam portfolio and diversify away from office as I will explain in the next section.

5)      Levers to create value within the portfolio – convert office to apartments (Hawaii example)

Before covid the Honolulu office market was oversupplied. However, there was a strong need for more apartments in downtown. DEI’s solution was converting 1132 Bishop which was a 25 story/490k sq ft office building into 500 apartments. The cost was between $80-$100million and helped tighten the office market. DEI office occupancy in the market went from the mid 80s to 93% and they are not even complete w/the transformation. They are also having no issue leasing up the apartments as they come available. If office occupancy in LA begins to rise, DEI could convert some of their office portfolio into apartments in select situations which could accrete value to shareholders as it will lower the overall portfolio cap rate and tighten occupancy in their core office markets. There might be some select opportunities to do this at the Warner center or even in West LA given the current supply/demand imbalance for apartments. 

6)      Replacement cost is much higher than current NAV

NAV is clearly a moving target because you can choose any cap rate to get NAV which is too subjective. The current EV is $8.4 billion, so I will use that as NAV. DEI recently built an 376 unit apartment building in Brentwood for about $220 million excluding land costs. If I assume the average unit is about 800 sq ft = 301K sq ft building at about $731/sq ft. If I assume land costs an extra $20 million we can gross that up to almost $800/sq ft fully built. Applying this number to their office (18.1 million sq ft) & apartment (4,577 units x 800sq ft/unit = 3.7 million sq ft) portfolio we get a $17.5 Billion replacement value. This is 2x current EV and after debt = $12.6b market cap or about $60/share. I am not saying this is worth $60/share, but this provides a huge margin of error if you are buying this at $16-17 today.

7)      Dividend payout is “safe” for the next 4 years

Current AFFO estimates are $1.76 this year vs dividend payout of $1.12 = ~65% payout ratio. For the payout ratio to go above 100% it would have to be due to a dramatic decline in occupancy and not on interest rates alone because as I described earlier, interest rates don’t materially impact FFO until at least 2025. I estimate that the office portfolio occupancy would have to get into the low 70s for DEI to be forced to cut the dividend.  Even if you assume no leases renew over the next 12 months we are in the mid 70s for occupancy, still not enough to cut. The amount of square footage DEI has been able to lease up should provide comfort that this is overly draconian. As an example, in 2020 DEI was able to sign leases for 2.7 million sq ft which compares to 2.5 million expiring over the next twelve months.

8)      Overall valuation is extremely compelling

I mentioned the discount to replacement cost earlier which gives me comfort underwriting this today. Currently DEI trades at a 6.75% yield which is extremely compelling given the quality of the asset and safety of the payout. I believe the multi-family business should trade at a 4 cap or $3 billion in value and the office at a 6 cap or $9 billion in value. This totals to $12 billion NAV or about $35/share. To get this target I assume SOFR peaks at 4.5%, occupancy bottoms in the low/mid 80s and I have a 3 year investment horizon. If I convert the equity to a yield-to-maturity equivalent, I get close to 35% annualized return (3 year price CAGR of 28% + 6.75% dividend yield).

If you want to choose different cap rate assumptions as you think I am being too aggressive, I laid out a sensitivity analysis on NAV below to get a sense of downside risk:

Risks

1)      SOFR rises much more than 4.5%. I mentioned <15% hit to FFO before 2025 but if SOFR went to 6% it would be about a 20% hit in 2024 and much more as we move through 2025. A key catalyst is for the Fed to be nearing the end of rate hikes after this year.

2)      Occupancy continues to decline and doesn’t find a bottom – the catalyst for this to work is that occupancy finds a bottom in the next 12 months

3)      DEI is acquisitive but has been using the JV recently given cost of capital. They are likely buyers of office in this market which although good, will decrease exposure to multi-fam over time.

4)      Although rent moratoriums have largely expired or will soon, it is very hard to operate in California as there is always something that comes up that could impact commercial real estate. Ie: prop 15 a few years ago.

5)      California population exodus is real but small as a % of the population today

6)      Not a lot of office has traded hands so really hard to understand what the cap rates are today in DEI markets. Likely some assets will trade for higher than expected cap rates creating some headline risk.

Catalyst

1) Interest rate increases are in the 7th inning

2) Occupancy bottoms within the next 12 months in the low/mid 80s

3) Opportunities to convert office to multi-family

4) Company retains dividend payout

5) Sentiment begins to shift more favorably toward office given current valuations