Tuesday, October 03, 2006

Douglas Emmett DEI and the 1.1 Billion Dollars

All systems go at Douglas Emmett (DEI), as the REIT plans an IPO of 55 million shares at between $19.00 and $21.00 per share. This pricing implies an IPO takedown of $1.1 Billion dollars for a portfolio of trophy office/residential properties located in Los Angeles and Honolulu. See more background about DEI here.

DEI plans to pay a dividend of $0.70/share, equivalent to 3.5% yield on a $20 offering price. Assuming a post IPO book value of $16.91/share, Douglas Emmett will trade at an 18.2% premium to book value.

That dividend would high by the standards of the few "trophy" REITs such as SL Green (SLG) and Boston Properties (BXP) which have sub 3.0% dividends. The trophy REITs specialize in owning Class-A/Trophy real estate in supply-constrained markets. These companies own skyscrapers in downtown central business districts. Only a few REITs have such properties and they trade at premium valuations.

At this point it is clear that principals of DEI will do very well in the IPO, but for current and future investors it is not so clear. DEI does have some built in growth, from rent rollups and fully leasing a few properties that are slightly vacant. All in, I would expect yearly FFO growth of around 4%. For various reasons the major equity REITs are trading at incredibly high valuations.

As Benjamin Graham observed: "the Margin of safety is always dependent on the price paid. It will be large at one price, small at some higher price, non-existent at some still higher price." I think these valuations, including the out of the gate valuation of DEI, give investors a negative margin of safety.

While Douglas Emmet is a very nice REIT; real estate and even very nice real estate, has risks and should trade a yield premium to risk free assets. If online savings accounts are paying 5.0% or more, is 3.0% with no safety of principal compelling?

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