One of the most out-of-favor sectors over the past couple of years has been the office real estate investment trust (REIT) space. Vacancy rates have climbed ever since the pandemic started, and in some cities, the vacancy rates are unofficially close to 50%.
Kilroy Realty (KRC -0.27%) is one of the top office REITs, with a 5.9% dividend yield. In these conditions, the dividend sustainable?
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Kilroy is an office REIT serving tech and life sciences companies
Kilroy Realty is a REIT that focuses on office and residential spaces. Its office tenants are concentrated in the technology and life sciences sectors. As of June 30, 2023, Kilroy operated 119 office buildings with 16.2 million square feet. The company also operated three residential properties with 1,001 units. Occupancy on the office properties was 86.6%, while occupancy on the residential properties was 93%.
Work-from-home has been a headwind for the office REIT sector
Office REITs have struggled since the COVID-19 pandemic proved the efficacy of the work-from-home model. This has caused the overall U.S. national office vacancy rate to increase 17.8%, which was the highest rate in 30 years. Fears about a possible upcoming recession have also made tenants more reluctant to take on new office leases.
Kilroy's life sciences exposure has helped
Kilroy is a bit better off than the typical office REIT, due to its exposure to the life sciences industry. Competitor Alexandria Real Estate Equities (ARE -0.90%) is in a similar position. The life sciences sector has seen additional government funding ever since the COVID-19 pandemic began, and resources should continue to flow to that sector as the population ages. Life sciences companies also require sophisticated lab spaces, which can't be replicated in the work-from-home model. The technical and regulatory expertise required to maintain these spaces means that Kilroy and Alexandria have less competition.
The big question about work-from-home is whether it is a permanent change or simply a symptom of a tight labor market. In the immediate aftermath of COVID's worst, demand for workers outstripped supply. As the Fed has raised interest rates, job openings are falling, and the labor market is coming into more balance.
Since work-from-home is more popular with employees than employers, the trend will probably be toward moving back to the office. Indeed, on the second-quarter earnings conference call, Kilroy CEO John Kilroy cited a statistic that the number of remote job listings has fallen 900 basis points since 2022. Companies like Alphabet's Google are now requiring employees to spend a certain number of days a week in the office.
Kilroy just raised guidance
Kilroy raised its 2023 guidance for funds from operations (FFO) during the Q2 earnings call. REITs like Kilroy report FFO as a supplemental earnings measure, because net income as reported under generally accepted accounting principles (GAAP) understates the cash flows of the company. This is because REITs have a lot of depreciation and amortization (D&A), which is a non-cash charge. This means that the proper metric to value a REIT is price to FFO, as opposed to the generic price-to-earnings (P/E) ratio.
The dividend is well-covered and the stock is cheap
Kilroy's 2023 guidance for FFO per share is a range between $4.43 and $4.53. Kilroy pays a quarterly dividend of $0.54, so the annual dividend is under 50% of FFO per share. This is very low for a REIT, since they are required to pay out most of their earnings as dividends. Based on current guidance, Kilroy is trading at 8.2 times FFO guidance, which is an attractive multiple.
Kilroy is a good, solid company in a hated sector. Investors who think the weakening labor market will push more workers to the office might find Kilroy attractive. However, negative sentiment on the entire sector will remain a headwind.
