The Long and Short
Add REIT allocation with Kilroy Realty intermediate notes
Dan Bruzzo, CFA | February 3, 2023
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
Kilroy Realty (KRC) intermediate notes offer an attractive discount to the larger, higher-rated office REIT peers Boston Properties (BXP: Baa1/BBB+) and Alexandria Real Estate (ARE: Baa1/BBB+). The company also has a much more compelling operating niche with its young portfolio of West Coast properties, servicing an attractive technology and life sciences tenant base, that make it a more favorable option over smaller, similarly valued names, such as Highwoods Properties (HIW: Baa3/BBB) and Corporate Office Properties (OFC: Baa3/BBB-/BBB-). A recent piece highlighted the relative value of the REITs sector within the investment grade corporate index; adding KRC builds REIT exposure with a solid credit profile issuer. While office REITs are confronted with both cyclical and secular challenges, KRC appears well equipped to weather both short-term and long-term periods of uncertainty.
Exhibit 1. KRC vs intermediate Office REIT peers (investment grade)
KRC 3.05% 05/15/30 @ +266/10-year; G+262; 6.02%; $83.19
KRC 2.65% 11/15/33 @ +268/10-year; G+265; 6.04%; $73.44
Issuer: Kilroy Realty LP (KRC)
CUSIP: 49427RAP7, 49427RAR3
Amt Outstanding: $500 million, $450 million (both index-eligible)
Senior Debt Rating: Baa2/BBB
Global Deals (2033s are Green Bond)
KRC is a well-positioned office REIT, known for its mostly West coast footprint of young properties and niche tenant base of extremely well capitalized technology and life science companies. The company’s core markets include greater Los Angeles, San Francisco and the larger San Francisco Bay Area, San Diego, greater Seattle, and more recent expansion into Austin TX. KRC’s office portfolio consists of 119 properties occupying over 16 million square feet valued at just under $13 billion. The company also has a modest development portfolio with a well-established track record. KRC’s niche position among tech/life sciences tenants and attractive, young property base help insulate the company from both the cyclical (i.e. risk of recession) and secular (i.e. work-from-home trends) pressures that confront the broader office REIT subgroup. By comparison, similarly sized REITs, HIW and OFC, are positioned with predominantly suburban properties, which could be more susceptible to secular deterioration in the office space.
KRC’s top 15 tenants represent a sizable portion of its property base (46.5% of rental revenue), which lends stability to rental income, but no single tenant represents more than 5% of the company’s total rent base. Among KRC’s top 15 tenants are well capitalized and well-known tech companies that include Amazon, Netflix, Adobe and Salesforce.com. Life science has been expanding and now represents about 20% of the KRC’s total net operating income, with 75% coming from office and about 5% coming from its smaller portfolio of residential and retail properties. The breakdown of NOI per region is as follows: 27% San Francisco, 21% San Francisco Bay Area, 19% greater Los Angeles, 18% greater Seattle and 15% San Diego.
KRC’s average building age is currently around 11 years. That compares with a peer office REIT average closer to 34 years. Younger properties are in higher demand from its tech savvy client base and the majority are classified as sustainable (LEED certified), giving the issuer more flexibility to bring green bonds to the market.
KRC reported fourth-quarter earnings this week with funds from operations (FFO) per share of $1.17 edging out the $1.15 consensus estimate. Revenue rose 9% year-over-year to $284 million also ahead of analysts’ expectations. Occupancy for the quarter was 91.6% with 92.9% leased. For comparison, BXP occupancy was at 88.6% for year-end 2022, ARE reported full-year 2022 occupancy at 94.8%, and OFC and HIW were at 92.8% and 90.5%, respectively, as of last quarter. Management provided full-year guidance for FFO of $4.40 to $4.60, the higher end of which fell just shy of the $4.61 consensus estimate. Their estimates for average occupancy in 2023 are in the 86.5% to 88.0% range, which also appeared to fall short of expectations. While management’s expectations for the coming year appear to paint a conservative operating picture we believe KRC is well positioned to weather the modest downturn and will be poised for improvement in the following year.
KRC’s adjusted leverage has been running consistently in the mid-6x range over the past several years, which is commensurate with its mid-BBB ratings profile. The debt level is in-line with larger, higher-rated peer ARE and currently running about two turns lower than that of BXP. The rating agencies would likely only consider a downgrade of KRC if that level rises a full turn of leverage and remains sustainably in the mid-7x range. The company has a standard debt covenant package in its bond indentures and is currently running well below the necessary debt thresholds. Total debt to total asset value (required below 60%) is currently in the low 30% area, while secured debt to total asset value (required below 40%) is only about 2%. That enables KRC a lot of financial flexibility to securitize its attractive property portfolio in the event of an emergency need for capital.
KRC boasts a solid liquidity profile with just under $350 million in cash and equivalents on the balance sheet as of year-end and the entirety of its $1.1 billion revolving credit facility available to it through 2025. There are no public scheduled debt maturities in 2023, after which KRC has $425 million due in 2024 and another $400 million due in the following year. As mentioned, flexibility under its debt covenants provides capacity to meet debt obligations through securitization in the event of a prolonged cyclical downturn and cash flow deficiency.
Dan Bruzzo, CFA
1 (646) 776-7749