2023-03-10 12:19:30 ET
Summary
- Investing in office REITs has not been a pleasant experience over the past few months and the year of 2022 - and there are good reasons for this.
- The market is seeing risk where risk does exist, but it's also overinterpreting some risks - as the market always does.
- I try to focus on the better-quality and fundamental picks in every sector. In Office REITs it's a must - and this is why I'm considering Kilroy be a "BUY"
Author's Note: This article was published on iREIT on Alpha back in mid-February of 2023
Dear subscribers,
It's no secret that Office REITs, including Kilroy Realty ( KRC ) and Brandywine Realty Trust ( BDN ), have been in a downward trend for over a year at this point when looking at many of them. There are very good reasons for this, obviously. We've been through them in other articles, but it never hurts to repeat sound facts and advice - and in this case, it's important to know what's going on.
The market is viewing the entire sector with uncertainty due to compressed cap rates and valuations, uncertain occupancy and remote work trends, especially in some areas, and a fundamental demand/supply concern, which I would argue is more of a regional question than an actually national one. There are areas where office space isn't easy to find, and there are places you can't walk a block without seeing ten "For lease" signs.
I haven't been shy about my priority picks in the sector - I even included one of them in a relatively recent article. The picks I make are Boston Properties ( BXP ), Highwood ( HIW ), and Kilroy. Oh, Brandywine does exist, and I own a stake in the company, but I would argue that the risk-reward ratio in that investment is outsized even considering the 10%+ yield.
Now, mind you, we have Brandywine listed as a "Strong BUY". And we do consider it quality - I consider it quality. Otherwise, I wouldn't be invested in the company.
But the fact is, that we're looking for safety above yield and even safety above upside - if we weren't, we would be invested heavily in speculative plays.
To that end, Kilroy's issues and challenges are fairly easy to describe. The reason for this is that Kilroy consistently outperforms peers. That's why I own it.
What do I mean by outperforming peers?
I mean that Kilroy has:
- Higher margins than competitors.
- Strong Dividend history
- A less-aged property/asset portfolio - Premium, in the RE vernacular
- A no-nonsense, BBB rating - not BBB- or below IG.
- Higher occupancy levels than peers.
What I mean by this is that they outperform most. Not all. In the investments I make and the aforementioned three companies, all of those are high quality. BXP is even BBB+, as I've written about before. Kilroy also has an attractive mix of properties.
As you can see, the company has not-inconsiderate conservative fundamentals with a relatively low (peer-average) leverage, and a pretty well-laddered maturity. Aside from this, it also has a very low payout ratio in terms of Funds available for Distribution, or FAD, and good liquidity.
In essence, the core worries about the sector and companies/REITs in the sector center around:
- The ability to raise rents.
- The ability to retain occupancy growth/stability
- The ability to pre-let or continue to lease new/upcoming square footage.
Those are the basics - because as with almost all REITs, it is essentially a play on occupancy and rent increases, which in turn rely on the appeal of the geography where its assets are found and the work/macro/micro there, which in turn relies on the economy, both macro and micro. It's no surprise to me, the amount of punishment office REITs took as these trends unwound - which is also why I stayed out of most of the sector until very late in 2022.
A big determining factor to check if you should invest in Office REITs in any geography, but in particular, on the west coast, where much of Kilroy's portfolio is found, is how you view the work-from-home trend.
If you believe that companies will continue to accept this to an outsized degree on a high level, then you might find different and more appealing plays that don't rely on this sort of space in other subsectors.
I haven't made a secret of the fact that I consider the work-from-home trend to be temporary. Oh, it might bring about more favorable changes in terms of home office work - but there are the simple facts that companies are mostly disinclined to pay people where they have no control over them (compared to at the workplace), combined with the fact that there are many, many areas, where work-from-home simply is not an option due to the complexity and requirement of the work.
What, you may ask?
Life sciences or science overall, for one. Most of those offices come with assets that require employees to be in the office full time - and KRC is among the leading REITs for exactly this sort of space.
And, let's be honest. I'm a business operator (in running my own business) with over 13 years of experience in hiring, staffing, managing, firing, and severing employees (and I'm only 38). While I expect many readers here to have experience in the same field, I've staffed and recruited for over 80 businesses in 5 nations and over 13 sectors - and my experience has been, without fail, that most people do need some sort of structural management only made possible in a more formalized office setting to perform at an optimal level. I am personally capable of working efficiently from a remote location, but even I prefer 2-3 days per week in a formal office setting.
To me, it's part of the working life, it's part of employment. It's a responsibility, and while this thinking may be outmoded in some demographics, I've found that it serves me very well in my peer groups.
I hold to it, and this is the reason why I'm positive, not negative, on the concept of appealing office REITs vis-a-vis the work-from-home question.
So Kilroy then.
Kilroy is primarily a play on California and Oregon. The Texas exposure is there, and it's growing, but it's small compared to the company's otherwise-clear profile here
Now, this might raise some concerns for you. While the company does not post as strong occupancy rates as some of the European office REITs do, which are above 94%, they are nonetheless still above 90.7%, or 92.6% if looking at what % of the portfolio is leased.
Also, Kilroy quite recently beat every single estimate in terms of FFO, in terms of revenue, and in terms of stability. What's more, the company can show extremely prudent capital allocation throughout market cycles. Take a look.
Couple this with the company's proven, high-level premium status in terms of portfolio - just take a look at the portfolio age, for instance...
.... and you'll see that KRC is about as far from an Office "slum lord" as you can come in the entire sector. While I have no favorite between my three picks as such, I will say that KRC beats out the entire sector in terms of its portfolio building age - and that is not a small thing by any means. This also directly translates into the highest amount of investment-grade rated tenants, at 31%. Another west-coast REIT is on par here, but other than that, Kilroy is once again leading the set.
How building age and tenant quality translates into operating efficiency can be seen in the math. The company has higher operating margins than all of its peers, standing at 72% OM. Portfolio occupancy isn't perfect - there are office REITs with 94-95%, as in Europe, but they are few. Most are between 88-90%, so Kilroy isn't by any metric "worse" than others.
The company also has one of the lowest annual average lease expirations up to 2025 of any Office REIT in existence - only 7% of its leases expire until then, and its rollover is one of the lowest among any close peer.
Unlike large parts of the market, Kilroy expects the technology and life science sectors to remain the driving force behind the market, and for the tech sector far from being down, to remain one of the primary forces in its portfolio.
In fact, even assuming zero additional leasings, and all-debt funding with a partially stabilized, 50%-leased model, the company's current Pro-forma for completion of its current $2.4B worth of development would result in leverage below 7.0x.
The one risk that I would actually focus on here would be its tenant concentration, particularly on the west coast, and particularly in the tech sector. Any warning sign from the company in the top 15 of ABR as a % needs to be looked at for Kilroy as well.
The company currently yields 5.43%, which isn't close to BDN but comes from a somewhat safer and more conservative, younger portfolio.
Brandywine and Kilroy Valuation
And I want to make it clear here - Brandywine Realty is a good Office REIT. We consider it a "Strong BUY", and not a speculative play here. However, while BDN is strong, its operating exposure to Philly and 90% of NOI from Penn, Austin, Texas, and the D.C. metro area, coupled with several near-term maturities and refinancing leads me to believe we might see even more attractive pricing.
Like KRC, BDN also reported the most recent results above expectations, and the trends in their actual numbers are clear. The earnings and FFO declines the market is expecting are just not materializing.
The market is essentially saying that "because the environment has changed, and we're expecting a 3% decline in FFO for 2023E, we're pushing you down from a 17-19.5x P/FFO premium to an 8.5x P/FFO. That's right - less than half"
Okay. But does something about that sound somewhat off to you? If so, you're certainly not the only one. Even if KRC doesn't manage to see much growth in terms of their FFO here, the level of valuation you're getting that yield and that value at is pretty amazing - it's COVID-19 level discount for residential and other quality REITs.
I don't believe that KRC or any office REIT should see any type of premium in its valuation. So that 18x P/FFO isn't relevant. But I do believe the company to be worth a range from 12.5x-15x P/FFO.
That comes to 19.7% annually from a low 12.5x P/FFO range to around 26.42%, or 96.81% in less than 3-4 years on a 15x P/FFO target.
This, to me, is a good enough opportunity to invest in. And BDN isn't bad either if your risk tolerance is higher. The reason is that BDN trades at less than 5x P/FFO, but the market is also including a double-digit 14-16% FFO decline in this coming fiscal, followed by some reversion, coming to somewhat negative growth over the next few years. Kilroy's estimates look different - that's part of the reason for the difference in these valuations here.
Still, even at the forecasted FFO level, BDN's dividend is more than covered. I don't expect it to rise, but I don't see any particular reason why the dividend would be cut. In fact, the company recently reaffirmed its commitment to it.
At the guidance midpoint our current dividend of $0.76 per share represents a 66% FFO payout ratio and 100% CAD payout ratio. Our business plan as we'll talk in a few moments does project between $100 million and $125 million of sales activity that could generate additional gains. And more importantly, with liquidity needs substantially addressed this targeted sale activity, we believe conservative underpinnings to our coverage ratios, we are keeping the dividend at current levels. Certainly as the business plan progresses, and we get more clarity on economic outlook, the board will as they always do continue to monitor both our coverages and the dividend payout levels.
(Source: BDN Earnings Call 4Q22, Jerry Sweeney)
So, for that reason, BDN is most definitely on my list as well. Quality here also, but with a bit more risk tolerance required for you to be comfortable sleeping at night.
However, the upside even to a sub-10x P/FFO, is nothing short of staggering.
Still, there is that BBB-, there is that somewhat higher drop, lower occupancy, and geographical diversification - or lack of it.
So, for those reasons I favor KRC over BDN at this time when it comes to my monthly allocations of REIT investing. And remember, the forecast accuracy for Kilroy is... well, superb.
We at iREIT on Alpha continue to consider Kilroy an attractive play. We would prefer a sunbelt-focus, but we'll live with the west-coast knowing the company's assets to be of very high quality.
Our target for Kilroy is currently $60/share - this comes to a conservative upside of almost 34%. When looking at other quality "STRONG BUY"s, this is only eclipsed by BDN, which has a target of $10.5, which comes to a 37% upside, more or less.
So either of these businesses are solid in terms of buying here, but my choice goes to Kilroy.
Questions?
Let me know!
For further details see:
Why I'm Buying Kilroy Over Brandywine At This Time