Real estate investment trusts (REITs) focused on owning office buildings have been under a lot of pressure since the pandemic started. Investors sold off shares on the concern that office tenants won't need as much space in the future as more of their employees work from home permanently or as part of a hybrid model. Those concerns have weighed on the shares of office REITs, which produced a negative 18.4% total return last year. While the sector has started to recover in 2021 as companies announce their return-to-work plans, there's still a lot of uncertainty weighing on the office REITs.
Douglas Emmett (NYSE: DEI) isn't immune to these headwinds, as its stock has lost more than 18% of its value since the start of last year. Here's a look at whether that sell-off is a buying opportunity or if investors should steer clear of this office REIT.
The case for buying Douglas Emmett
Douglas Emmett has a focused strategy of owning office properties in tight markets. It currently concentrates on the Los Angeles and Honolulu markets, where it's the largest office landlord. In addition to office properties, the REIT has a small portfolio of multifamily properties in each city that contribute about 15% of its total annual rent.
The company also has a unique tenant focus. It concentrates on leasing office space to smaller, affluent tenants in the legal, financial services, entertainment, real estate, and accounting/consulting sectors. The main decision makers of those businesses tend to live near their office suite and are willing to pay a premium for proximity. While they can work remotely, they highly value having an office presence. On its first-quarter conference call, the company noted that these small tenants are leading the return to the office following the full reopening of California's economy.
The return to the office is a big catalyst for Douglas Emmett. First, it should boost its parking revenue. Second, it's driving office tenants to make leasing decisions, which will take away some of the uncertainty on occupancy levels and rental rates. That will also clarify asset values for sellers, enabling the company to use its strong balance sheet on new acquisitions. Add in the company's multifamily development projects, and it has several catalysts that could help drive its stock prices higher over the next several quarters.
The case against buying Douglas Emmett
While the reopening of California's economy -- Douglas Emmett's largest market at 90% of its total annual rent -- should provide some clarity on future occupancy and lease rates, the company is facing a notable near-term lease expiration headwind. CEO Jordan Kaplan stated on the first-quarter conference call:
In the first quarter, we signed leases totaling 750,000 square feet. Given our seasonally larger expirations, this leasing was not enough to create positive absorption. As we have said, we expect to lose occupancy during the first half of the year.
As a result, its occupancy declined to 87.7%. Meanwhile, new rental rates also fell because it offered lower rates to incentivize tenants to sign leases. While the company is optimistic that these trends will reverse as more tenants return to the office -- especially medium and larger-sized ones -- an increase in working from home and hybrid work models could weigh on demand for office space for the foreseeable future.
Another knock against Douglas Emmett is its lack of development upside compared to its peers. Several rivals have large-scale office developments underway, giving them visible growth because most have secured tenants for the bulk of that space. While Douglas Emmett has two multifamily projects under construction, it has no office projects in the pipeline. That's unlikely to change given the constraints in the LA and Honolulu markets. On the one hand, those supply limitations should eventually translate into higher occupancy levels and rental rates at its existing office buildings. However, it also limits the company's investment opportunities to acquisitions and multifamily developments.
Not enough compelling catalysts to buy
Douglas Emmett should benefit from the reopening of the California economy, enabling more people to return to their offices. However, there's still a lot of uncertainty about occupancy across its portfolio and what will drive future growth. Because of that, it doesn't stand out as an attractive buy compared to other office REITs.