Kilroy Realty (KRC -0.27%) has a hefty 7% dividend yield today. The reason is pretty simple: It operates a portfolio of office properties largely located in California. Investors are downbeat about the future for offices and tech-heavy California, but management is still very optimistic about the future. Here's how this real estate investment trust (REIT) can afford its generous dividend at a time when many of its office peers have slashed theirs.
Some unfavorable trends
SL Green (SLG -0.53%) cut its dividend. Vornado (VNO -0.53%) lowered its dividend. These two REITs are big names in the office niche in which Kilroy operates. Investors are clearly worried that other office REITs will end up following suit -- and in fact, some have. This is largely why Kilroy's dividend yield is so high at 7% (the average REIT has a yield of just 4.3%, using Vanguard Real Estate Index ETF as a proxy).
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But there are more negatives to consider here, too -- most significantly, the coronavirus' impact on working from home. Now that the practice is far more acceptable, some office markets are still seeing physical occupancy rates of 50% or less. While physical occupancy is slowly increasing in most areas as employers ask workers to come back to the office, the progress has been slow. And, in many cases, the office requirement is still not five days a week. That has resulted in some companies downsizing the office space they occupy.
As if that weren't enough, Kilroy's portfolio is heavily focused on major California markets. There's two problems here. Technology companies are key customers and many have embraced the work-from-home approach. Also, some businesses are moving to lower-tax regions, like Texas, in an effort to reduce costs. So not only is Kilroy facing the broader work-from-home issue, but there are also additional uncertainties specific to the markets it has chosen to focus on.
No wonder investors have pushed the stock price down and, thus, the yield up. There appear to be realistic concerns here about dividend safety.
Not as bad as it looks
First off, Kilroy's adjusted funds from operations (FFO) payout ratio is fairly strong, coming in at just 45% in the first quarter. So the REIT could withstand plenty of adversity before a dividend cut would be in order. That said, the company is guiding to lower adjusted FFO results through the rest of 2023, pegging the average over the remaining three quarters at around $1.06 per share compared to the $1.22 achieved in Q1. That would put the adjusted FFO payout ratio at around 50%, on average, through the rest of the year. That's not exactly a terrible figure, either, even though it isn't as strong as the first-quarter result. From this perspective, Kilroy doesn't look like it is in imminent trouble dividend-wise.
Second, Kilroy is seeing physical occupancy increase in its properties. Some are even nearing pre-pandemic levels, though others remain relatively low. But the direction is the key factor, as more people are coming (or being forced) back to the office. Office dynamics have changed, but the world doesn't appear to have moved to an all-work-from-home model, and that's good news for REITs like Kilroy. Also, given that some companies are moving from California to Texas, Kilroy has been expanding into that market. So even this trend is being addressed by the REIT. Neither of these issues is going to be solved in the short term, but it appears Kilroy is doing reasonably well with regard to both. Positive trends here suggest further potential increases for the dividend.
Third, the REIT's balance sheet is in solid shape. If you look at different leverage metrics, Kilroy has much lower leverage than the office REITs mentioned above that have cut their dividends. To put some numbers on that, Kilroy's debt-to-equity ratio is around 0.8, compared to 1.4 and 1.5 for SL Green and Vornado, respectively. Kilroy's financial debt-to-EBITDA (earnings before interest, taxes, depreciation, and amortization) ratio stands at 5.9 versus roughly 20 for the other two office REITs. A strong financial foundation makes supporting a dividend much easier.
KRC Financial Debt to EBITDA (TTM) data by YCharts
Fourth, the company's properties are generally newer and attractive. Having the most desirable assets in any given market is a key hallmark of Kilroy's business model. In good times, companies compete to be in the best office space. In lean times, strong businesses trade up to the best space. Basically, demand for top-tier office properties tends to be robust through the entire economic cycle. Occupancy may go up and down over time, but leasing out recently vacated office space is much easier if it is new and high quality. Again, this puts the REIT in a position of strength when it comes to supporting its dividend.
Different by design
Kilroy, with a heavy focus on tech-heavy markets in California, is an acquired taste. More conservative investors will probably want to avoid that kind of concentration risk. But it still looks like Wall Street may be throwing the baby out with the bathwater here. For more aggressive investors trying to find high-yield opportunities in an out-of-favor market niche, Kilroy's big yield looks relatively safe.
