This REIT Is Not Worth Its Skyscraper Price

Although there are reasonable ways to justify  Douglas Emmett's (DEI) current share price, we think the downside risk outweighs the upside potential. We have a positive view on Douglas Emmett's near- and medium-term operating prospects, but the market appears to be anticipating an even rosier outlook. The stock is trading 65% higher than our $13 fair value estimate.

We share the sentiment reflected in recent commercial real estate research that the Los Angeles office leasing market is near or just past a bottom; however, we do not expect Douglas Emmett to immediately enjoy the full benefit of its main market's improving fundamentals, due to in-place, above-market rents. Roughly 30% of its office portfolio is subject to expiring leases through 2013. Most of these leases were written during peak cycle years, and we expect the portfolio to experience negative re-leasing spreads through 2013, as in-place rents roll down to the level of lower market rents.

Douglas Emmett's stock price appears to be well ahead of operating fundamentals. Our base forecast anticipates same-store net operating income growth to turn positive in 2012 and increase each year through 2015, averaging 4.2% annually over the next five years. Over the same time frame, we anticipate 600 basis points of occupancy improvement and 460 basis points of net operating income margin improvement. Market signals analysis suggests that Mr. Market may be anticipating an even rosier outlook than ours, with same-store NOI growth potentially averaging roughly 8% over the next five years.

While we are bearish on the stock, we do not think our forecasts are unduly bearish. After years of declines in portfolio operating fundamentals, we expect 2012 to begin a multiyear recovery, albeit off cyclically depressed levels. We believe the office leasing market in Los Angeles is near or just past a cyclical bottom, and our near- and medium-term forecasts reflect a strong recovery in Douglas Emmett's office portfolio. Furthermore, our assumptions for Douglas Emmett's long-term office occupancy and portfolio net operating margin exceed the company's average historical performance and are closer to its portfolio's historical peak levels.

Although our long-term forecasts for these variables are significantly above recent historical averages, recent history includes roughly three years of cyclically depressed levels of operations during which Douglas Emmett experienced stress in its portfolio. For that reason, we wouldn't expect long-term normalized averages for these variables to be that low. On the other hand, these long-term assumptions are near Douglas Emmett's historical peak levels, so they may skew toward the bullish end of reasonable expectations. However, we expect its portfolio to perform better than its markets' averages, which supports a relatively high occupancy rate assumption, and we expect its higher-margin multifamily properties to account for relatively more portfolio revenue over the long term, which supports a relatively high portfolio NOI margin assumption.

Our expectation that Douglas Emmett will transition in 2012 from a multiyear period of same-store NOI declines to a multiyear period of same-store NOI growth is driven initially by our expectations for occupancy gains, related margin expansion, and rent escalators on in-place leases as opposed to higher rents on new leases. In fact, based on the current level of in-place rents across Douglas Emmett's office portfolio (roughly $36 per square foot) relative to the market rents it has achieved on leases signed recently (roughly $31) and recently reported asking rents (roughly $32), we expect rents on new and renewed leases to roll down through 2013, with positive re-leasing spreads returning in 2014. So although we expect its markets to begin recovering in 2012, we expect stronger growth for Douglas Emmett beginning in 2014, when it should start to see the benefit from increased rental rates on its expiring leases in addition to the benefit from occupancy gains, related margin expansion, and rent escalators on in-place leases.

Although we're optimistic about a Los Angeles office market recovery, risk remains that the recovery will be uneven or slower than we anticipate. The market in general suffers from total vacancy around 18%, and although Douglas Emmett's portfolio is in much better shape with its 89.3% leased rate, we do think its portfolio can be negatively affected by the weaker broader market. With 18% total vacancy in the area and nearly 11% availability in Douglas Emmett's portfolio, tenants still command a strong position in lease negotiations, in our view. Furthermore, our forecasts may prove too optimistic if the next few years see any shocks to the global financial system or the Southern California economy.

Our discounted cash flow-based fair value estimate implies a 0.76 fair value/book ratio for Douglas Emmett's properties. We're neither surprised by nor concerned about this implied discount, as Douglas Emmett's assets were generally put into the real estate investment trust at near peak levels, and we think there is mark-to-market risk to both its income statement (in terms of rent roll-downs) and its balance sheet (in terms of property market values below carrying values).

Why Does the Market Love Douglas Emmett?
We've contemplated why the market is valuing this stock at levels we deem high, and while it is impossible to be certain, we've identified four possible reasons.

Douglas Emmett has made real progress on debt maturities. At the beginning of 2011, it faced $2.3 billion of maturities through 2012 on interest-only loans consummated near the commercial real estate market's peak. Without any shareholder dilution, Douglas Emmett has refinanced those loans at rock-bottom interest rates near 4%, so its balance sheet is in much better shape today than 12 months ago.

Douglas Emmett has exposure to the multifamily property sector, which has been on a tear recently. (Although we think it is generally the most overvalued property sector we cover.) We believe Douglas Emmett's multifamily assets are attractive. They're generally located in areas where home ownership can be prohibitively expensive and where shorter commute times can be highly valued, so they are likely to experience relatively strong performance over time, although they did suffer along with the rest of the portfolio during the recent downturn. However, Douglas Emmett's multifamily assets contribute a relatively minor 13% of our forecast 2012 net operating income.

The dividend payout ratio is low. Douglas Emmett's 2012 projected annual payout of $0.52 per common share is just 55% of our forecast for $0.94 of adjusted funds from operations. We think there is negligible risk of a dividend cut and very good prospects for continued growth, even if the Los Angeles recovery does not happen as quickly as we forecast.

Douglas Emmett has capacity to take advantage of strategic acquisitions, should they become available. The firm has an additional $170 million committed to its investment fund, which can be leveraged up to provide a reasonable war chest with which it can be opportunistic about asset purchases.

We're Not Convinced, However
Douglas Emmett's stock appears priced to perfection at a time when market uncertainty--both at the micro and macro levels--remains relatively high, in our opinion. Furthermore, the stock appears to incorporate internal growth assumptions that we doubt are achievable over the medium term. At the current quote, though, that appears to be what Mr. Market is offering, and we think investors would be wise to consider selling shares owned at this level.

As a check on our $13 discounted cash flow-derived fair value estimate, we ran net asset value and implied cap rate analyses for Douglas Emmett, and we think the stock looks expensive based on these measures as well. While we recognize that any valuation analysis, and particularly our forward-looking discounted cash flow approach, requires the use of estimates of future performance that are inherently uncertain, we believe Douglas Emmett's share price looks stretched by multiple measures. Of the stocks in our real estate sector coverage, Douglas Emmett trades at the largest premium to our fair value estimate; nearly all of the other stocks represent more attractive relative investment options, although only a handful of those we cover currently trade at discounts to our fair value estimates, and none trade at a wide enough margin of safety at which we'd be aggressive buyers.