While the stock market has held its ground over the past six months, specific sectors have seen immense difficulty. Specifically, stock market sectors with greater leverage levels and interest rate sensitivity, such as financials and REITs, were the worst sectors over the past six months, excluding energy. Throughout many articles (1, 2 – more notable ones), I warned investors of these sectors last year, with the overarching idea that higher interest rates would cause their asset valuations to decline disproportionately to their liabilities – causing a significant decline in net equity value. Combined with a broader economic activity slowdown, I believe most companies in these segments face significant headwinds; however, in some instances, their low valuations offset that risk.
My long-term view regarding inflation, interest rates, and the associated impact on equity valuations began in late 2020 as immense QE seemed likely to have a negative long-term consequence on monetary stability. One interesting stock-specific example was my short thesis for Kilroy Realty Corporation (NYSE:KRC), detailed in November 2020. At that time, I was extremely bearish on KRC because KRC seemed to face the most significant number of negative macroeconomic and microeconomic catalysts of almost all REITs. As detailed in that article, this included a valuation decline associated with a predicted rise in capitalization rates (fueled by higher mortgage rates), the secular decline in office lease demand due to work-from-home, and specific risks associated with weakness in California’s technology/startup industry (and the departure of some companies from that area).
Around two and a half years later, most of those catalysts have begun to play out, causing KRC to decline by around 55% since then. However, as is often the case, my view was undoubtedly early, as the stock remained around the $60 to $70 level throughout 2021. Despite that, most other analysts have held a consistently bullish view on the stock, giving it the sixth-highest average analyst rating among office REITs. Of course, KRC is now well-below my older price target of $44, which was based on an estimated 1% increase in the capitalization rate of its portfolio. Accordingly, I believe it is an opportune time to take a closer look at the stock to judge its recovery and risk potential better.
A Realistic View of Office Properties
In my experience, many investors and analysts have very extreme views regarding office REITs. For years, many have believed that the work-from-home trend would inevitably reverse as the world returns to ‘normal.’ While I can understand the sentiment behind that view, it is not supported in the data – as seen in the recent collapse of most office REITs. For most companies, the savings associated with ending office leases far outweigh the potential productivity costs from hybrid or remote work. For most employees, working from home is preferable, providing further cost savings and competitive benefits for companies that adopt the trend.
One issue I see amongst office REIT investors is the failure to realize this trend’s lagged impact on revenue and cash flows. Most companies use long-term office leases of 5-10 years, so companies that transition often pay for empty space for several years – thereby keeping office REIT sales from falling too quickly. When I discussed my outlook in 2020, many thought this view was incorrect by 2021 because office REITs had only seen a 5-10% sales decline. However, now that it is 2023, we’re seeing a massive increase in office vacancies as leases expire (a 50%+ increase since 2020).
Unsurprisingly, the sharpest increase in vacancy rates is seen in technology and startup-centric areas, such as San Francisco at 19.4% and Austin at 22%. In general, more expensive areas are seeing the most significant increase in vacancy rates as companies in those areas experience much more significant work-from-home savings. Further, the layoff and business closure trends have been the most important for technology and startup companies dependent on external financing – a problematic dependence now that money is much more expensive. Since most of Kilroy’s properties are in these areas and leased to these companies (58% directly technology), it faces more significant headwinds than most other office REITs.
This shift is having a negative impact on Kilroy. The occupancy rate for its stabilized portfolio has declined by 2% over the past year to 89.6%, with the most significant decline seen in Los Angeles (17.1% of its NOI), from 85.2% in Q1 2022 to 80.8% in Q1 2023. Indeed, Kilroy’s occupancy performance is generally better than is seen in office properties in the areas in which the company operates. However, that largely stems from the fact that most of Kilroy’s properties are much newer, meaning its lease expiry timeline is shifted more into the future. Around half of the REITs leases as a percent of base rent will expire in or past 2029 (10-K – pg. 49). Further, 20% of its leases are set to expire 2023-2025.
The longer weighted-average lease term of Kilroy’s portfolio can obfuscate its situation. From a short-term standpoint, it will not suffer as significant cash-flow losses as its peers. Further, should the work-from-home trend reverse over the coming years, then it will not be impacted. Of course, I believe that is extremely unlikely, with most data suggesting the trend will grow as companies and employees adopt the change. The end of COVID-related issues created a sharp reversal last year, but more recent data suggests the more important long-term trend remains in that direction. While some believe a recessionary increase in white-collar layoffs (which we’re seeing today) could slow the trend, the opposite may also be true as companies search for more ways to save money or go bankrupt.
Current estimates suggest that 25% of office inventories will be obsolete by 2030, while 60% will need upgrades. While it is true that Kilroy’s younger portfolio lowers its obsolescence risk, rental rates on all office space will likely decline due to the massive increase in competition – likely be enough to dramatically negatively impact the valuations of most properties built or purchased during the low-rate era (pre-2021).
What is KRC Worth Today?
My base case view is that KRC will experience a 5% reduction in inflation-adjusted sales per share over the next three years and a 10-15% decline over the next six years – with both measures depending mainly on the state of the economy through these periods. I expect this decline to be triggered by a continued decrease in occupancy, exacerbated by lowering revenues per square foot due to increased competition associated with higher market vacancy rates today. Potential inflation could offset sales per share losses, however, with the caveat of pushing mortgage even rates higher and thereby negatively impacting capitalization rates. As an example, Kilroy has seen material increases in sales since 2020, which is driven mainly by previous equity raises to purchase new properties and inflation – with CPI-adjusted sales per share being essentially flat since then.
Thus, to value Kilroy, I will assume “2023 dollars” and no changes to its outstanding shares since growth with equity dilutions is inconsequential for investors. Currently, annualizing its Q1 data, the company is generating around $1.17B in sales per year, with an operating margin of 30.6%, an operating income of $357M per year, and $375M in depreciation – giving it a $732M NOI. Since a reduction in sales would disproportionately impact its NOI (since OpEx does not always decline with sales), I expect a 10% sales decline to come with an operating margin decline to ~24%, or the low end of its range over the past decade. Accordingly, I expect its sales to decline to $1.05B (10% lower) while its operating income falls to ~$253M. That target gives KRC an NOI forecast of $628M (since depreciation should not change), ~14% below current levels. Again, this assumes no change in inflation and shares outstanding but a slight occupancy decline and rental price rate.
The problematic aspect of valuing KRC is assessing capitalization rates since they are moving quickly today. After falling from ~7% in 2013 to ~5.2% in 2021, they rose back to 6.15% last year, roughly tracking changes in interest and mortgage rates. In 2022, office property cap rates varied significantly from 5-12%, with KRC’s properties likely toward the lower end of the spectrum due to their younger nature. In 2020, the company traded at a meager implied cap rate of ~5%. If we’re looking at backward-looking metrics, we could assume KRC’s “fair value” cap rates should be around 6-7% based on the general 1% increase in capitalization rates in all properties since the bottom.
Of course, this data is lagged because property valuations slowly change to variations in demand and interest rates. With commercial property mortgage rates around 7% (from ~3% in 2020-2021), there is very little reason why capitalization rates should be below 7%, mainly on properties with a negative demand outlook. In Q1, total US commercial real estate transaction volume was down by ~62% YoY, and Q1 2022 was well-below 2021 levels. The office sector has taken the most significant hit, with a ~25% price decline on sale values, indicating the cap-rate increase for office properties will be significantly higher than most other properties. The banking industry’s troubles may exacerbate the strain as most banks tighten lending standards, mainly commercial property loans.
With these factors in mind, I believe Kilroy’s portfolio’s “fair value” capitalization rate is likely in the 8-9% range today. At the same time, that may seem like a significant increase from 2020’s 5% level, which accounts for the ~4% increase in financing rates (or a 2% increase in financing rates after expected inflation) and the relatively large decrease in office property stability. Based on this outlook, using Kilroy’s current NOI level of $732M and an 8% capitalization rate, its properties may be fairly valued at up to $9.15B. Using my estimated outlook for its NOI of $628M and a 9% capitalization rate, its properties could be worth as low as $6.97B. In my view, such an extensive range reflects the significant potential variance regarding the west-coast office market and interest rates.
Aside from properties, Kilroy owns ~$1.2B in other tangible assets, giving it an estimated total asset value range of $8.12B to $10.6B. Offsetting this, the company currently has ~$5.3B in total liabilities and $240M in other equity ownership, bringing its estimated NAV for its common equity to $5.54B below its estimated asset value range. Accordingly, this gives KRC a NAV estimate of $2.56B to $5.06B. The average of that range is $3.81B, which is 22% above its current market capitalization.
The Bottom Line
Overall, I believe KRC is fairly valued today but could be undervalued or overvalued based on variations in assumptions. Based on my “base case” assessments, KRC could be undervalued by around 22%, considering a relatively large increase in capitalization rates to ~8% and a material decline in its sales of about 4-8%. In my view, the reality could be a bit worse than that if a large recession occurs, as that would likely accelerate sales decline and capitalization rate increases. Toward the low end of my valuation range ($2.56B), KRC would be around 22% overvalued today.
Investors who do not have a recessionary outlook doubt the extent of the work-from-home trend (or its knock-on impact on higher-quality properties), and believe interest rates will reverse may find an attractive value opportunity in KRC. Under assumptions that still account for an ample rise in capitalization rates, KRC could rise by around 60% to return to a $5B market capitalization. My outlook is, however, slightly bearish due to my view regarding the economy, work-from-home trends, and interest rates. That said, KRC’s price today is low enough that there is no short opportunity on the stock since its value should not decline significantly under relatively significant adverse changes in its fundamentals. However, if a huge and prolonged recession occurs, I would need to re-value KRC as a more extreme negative shift in market fundamentals could eventually push its asset value below its liabilities.
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