Kilroy Realty (KRC) is a real estate investment trust (REIT) that develops, owns and operates class A office space and industrial buildings. The firm makes money by developing properties, leasing them to tenants and selling stabilized properties at a profit. KRC leases office space to tenants in the healthcare, legal and financial services industries, and its top ten tenants represent only 37% of the company's total rental revenue.
KRC operates 129 properties (86 office and 43 industrial buildings) all in Southern California, primarily in Los Angeles County, Orange County and San Diego County. These are high growth areas where high real estate costs form a barrier to entry for competitors. Demand for office buildings tends to follow the performance of the regional and U.S. economy. During boom times companies expand, hiring more workers and leasing a higher grade of office space. During economic downturns many companies try to save money by leasing less square footage. This is particularly troubling in the first quarter of 2008 when employment numbers are down and KRC has space up for re-lease.
As of December 31, 2007, KRC owned 86 office buildings and 43 industrial buildings totaling approximately twelve million square feet. It earns revenue by leasing these properties to tenants for rents charged on a square foot basis. Properties are leased to industrial tenants on a triple net basis and leased to office tenants on a full service basis. Full service means the landlord pays for tenants' share of real estate taxes, insurance, and operating expenses up to the amount inccurred in the first year of a tenants lease. Any increase in expenses is paid by the tenant.
KRC grows its portfolio through development. The company owns 116.7 acres of land on which it has the ability to develop over two million square feet of office space. In 2007 KRC had four properties in the process of development and another three that had completed the construction phase and were in the process of being leased. All these properties were expected to reach stabilized occupancy by the end of 2009. By using their development expertise to purchase prime land, keeping construction costs low and developing desirable buildings, KRC can earn higher returns through development than by purchasing stabilized properties, which have much more uniform capitalization rates. However, development also exposes the company to more risks than acquisition, including the risk that construction costs will be higher than anticipated, that the company will be unable to finance their short term, high rate construction loans, and that by the time the property is finished the market will have changed and there will be reduced demand.
In 2007 five of KRC's development properties, totaling 800,000 square feet, achieved stabilized occupancy. In order to fund its development pipeline, the company also divested of five under-performing properties totaling 600,000 square feet. The gain of square footage contributed to the company's revenue and net income increases. Though in 2007 industrial properties accounted for 32% of KRC's total operating properties by square footage, industrial properties accounted for only 13% of total operating income, with office properties accounting for the other 87%. The reason is the higher rental rates the company can achieve at its office buildings.
In 2007 revenue and net income increased in the company's office portfolio due to increased square footage and more operating properties. This increase was partially offset by decreasing occupancy; in 2007 occupancy at KRC's office portfolio was 93.7% compared to 94.7% in 2006. At the company's industrial properties net income declined from 2006 to 2007 due to a drop in occupancy from 97.6% in 2006 to 92.1% in 2007. The decrease in occupancy was due to three properties in the company's Orange County portfolio that the company was having trouble re-leasing. However, as of year end 2007 the company had leased approximately half the vacant space in those buildings, leading to a probable increase in revenues for 2007.
In addition to adding space to its portfolio, revenue and net income increases at KRC are driven by increases in rental rates. In 2007 new leases yielded rents 15% higher than the leases which had expired. Management at KRC believes that the company's portfolio is leased, on average, 15% below market rents leading to probable revenue increases when those properties renew leases.
The demand for office space is closely tied with the performance of the economy. During a boom economy employment rises and firms expand, leasing more square footage in higher quality buildings. Similarly, during economic contractions, employment falls, and companies no longer need as much office space and so cut back on the amount of space leased. The effect can take some time to have an effect on an office REIT's rents, however, as leases typically last for several years before they can be renegotiated. This poses a significant risk for KRC as the U.S. economy has been entering a recession in 2008. In April the U.S. labor department released a report estimating that the U.S. had cut jobs by 232,000 in the first three months of 2008, the first time the economy had lost jobs three months in a row since 2003. KRC is particularly exposed to this declining economy as leases on 31.5% of its total square footage are up for renewal in 2008 and 2009. It is likely that when those leases expire, fewer companies will choose to re-lease, increasing vacancy, and those that do re-lease will do so at lower rates, decreasing revenues. If firms do lease for lower rates the effect will last over the entire life of the lease, lowering KRC's revenues for the next several years.
According to the Census Bureau, U.S. imports increased 67% between 2002 and 2007. Chinese imports have increased particularly quickly, rising 257% in the same period. The demand for imports increases the demand for infrastructure surrounding the shipping industry, including receiving stations and distribution facilities. The ports of Los Angeles and Long Beach, markets in which KRC operates, are receiving stations for many cargo ships arriving from China and are quickly reaching capacity as shipments have increased. As ports reach capacity and require new infrastructure, property developers like KRC have a prime opportunity to benefit.
As a property developer KRC is exposed to interest rate risk. KRC, like many property developers, finances development using short term variable rate loans, and when a project reaches stabilization refinances to a low, fixed rate mortgage. Increasing interest rates lower KRC's income by increasing debt service payments on variable rate debt. They also increase the rate at which KRC must issue new debt, which in the case of fixed rate debt can cause large debt service payments over the life of the loan. During 2007 KRC reduced interest rate risk by refinancing and paying down a large portion of their variable rate debt - at the beginning of the year 39.0% of KRC's debt was variable rate debt, but by the end of 2007 only 13.2% of the company's 1.4B in debt outstanding was variable interest rate debt. Interest rate fluctuations also affect KRC's stock price. Because of government regulation that requires REITs to pay out 90% of their taxable income as dividends, KRC has historically issued a stable dividend, 1.94 since 2004. These consistent dividends mimic bond coupon payments. As interest rates rise, bonds provide a greater Return on investment (ROI) relative to KRC's stock. Since investors are able to earn a higher risk-adjusted return on fixed income instruments, they shift their investment out of KRC's stock and into bonds. When the number of people wishing to hold the stock decreases, the stock price falls.
Construction prices in the U.S. have grown dramatically in the past three and a half years, rising an average of 3-5% each year and far outstripping inflation. A depressed dollar and the rising cost of fuel both contribute to increase the price of imported construction materials while a declining pool of specialized construction workers has led to a sharp 4.7% increase in wages from July 2006 to July 2007. Rising construction costs decrease KRC's return on its development projects. They slow the company's growth and increase their expenses on existing projects. This decreases the company’s earnings, leading to a potential decrease in company stock price. However, there are some subtle benefits of rising construction costs. When construction costs rise developers cut back expansion as they are unable to earn a high return on their projects, helping KRC by keeping vacancy rates low and maintaining demand (and rental rates) for existing properties. Increasing construction costs can also increase the sale price of KRC's existing buildings as it becomes cheaper for property owners to acquire buildings rather than develop new ones.
As of December 31st, 2007 all of KRC's properties, projects under construction, and undeveloped land was located in Southern California. Because KRC is geographically concentrated, their ability to increase revenue and continue expansion depends upon the Southern California market. Because real estate is essentially a local business, by diversifying their geographic base a real estate operator can diversify its risks. For example, oversupply of properties in a market, reduction in market demand, changing market demographics and many government regulations, though sometimes influenced by national events, all occur primarily on the local level. Any adverse changes in any of these factors in Southern California affect KRC more than a company that is geographically diversified.
KRC competes with a wide range of office REITs to both lease space and acquire properties. KRC is differentiated from its competitors by its exclusive focus on Southern California; no other publicly listed office REIT operates exclusively in Southern California. The REITs KRC most closely competes with are described below. For a full list of office REITs, see REIT - Office.
Market share is listed by 2007 revenues. In 2007, KRC held just 2% of total U.S. office REIT market share, by revenues. There are 14 U.S. exchange traded REITs focusing on office properties. Of those, the top three Boston Properties (BXP), Brookfield Properties (BPO) and SL Green Realty (SLG) accounted for just over half of Market Share by 2007 revenues.