Saturday, November 04, 2006

Douglas Emmett and the 1.4 Billion Dollars.

Douglas Emmett (DEI) is attracting the attention that biggest REIT IPO of 2006 does deserve. DEI's portfolio of trophy office property in Los Angeles and Honolulu is unmatched. The company is profitable from the get-go with prospects for internal growth. DEI is going to become a core holding for investors in BIGREITs: the large actively traded real estate investment trusts that make up the Cohen & Steers Realty Majors Portfolio (ICF).

The underwriters increased the size of Douglas Emmett's IPO from 55 million shares to 66 Million shares, and priced them at $21 per share. The top end of the proposed IPO range. Substantial money was left on the table as DEI shares opened trading at $23.50. This IPO set a record for the largest REIT IPO ever, raising $1.4 billion dollars.

Assuming a starter dividend of $0.175 per quarter, DEI is yielding 3.0% at the current price of $24 a share on book value of $17.81. I think this is bit pricey for investment purposes, but not unreasonable when compared to the rest of the (ICF) universe. Instead of repeating myself, I will quote myself pointing out that:

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 Emmett 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?

Most of DEI's future growth comes from fully leasing up the few buildings in its portfolio that are partially vacant, and rolling leases. Most of DEI's growth is internal. That is good because such growth is low risk, but internal growth tends to converge (revert to the mean) of CPI+1% or so. Going forwards Douglas Emmett will have a hard time buying new properties for reasonable prices in its target markets.

This is where professional real estate investors and the common public part ways. If you were to hand Douglas Emmett's management a term sheet for a deal that had %3 yield with 4% annualized growth, they would reject it. But if you give the public that same term sheet, it gets bought out for a premium.


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