As a real estate investment trust (REIT) specializing in class A office and industrial real estate in California, Kilroy Realty (NYSE:KRC) has had one of the best seats in the house for the recent real estate boom. However, the laws of physics still apply, and Kilroy's recently reported results, although strong, proved mildly disappointing to investors who may have expected a bit too much.

In the fourth quarter, Kilroy's sales increased 7% to $64 million, and its funds from operations (FFO) -- a measure of cash flow -- more than tripled to $27.3 million. Much of this improvement came from the reduction of a special compensation plan for the company's executives. For the year, sales improved 6%, and FFO jumped to $118 million from $63 million. The company also signed some leases in the El Segundo market with prime tenants such as Mattel (NYSE:MAT), DirecTV (NYSE:DTV), and Boeing (NYSE:BA), totaling roughly 750,000 square feet.

In the earnings call, management noted that "Our 2007 G&A (general and administrative) costs will include most of our first-year costs of both the 2006 and 2007 executive compensation plans." In other words, because the laws of accounting say so, some compensation expenses in 2006 will be pulled into 2007. Management estimates $0.31 per share in additional compensation costs in 2007. Thus, the company provided 2007 FFO guidance of $2.87-$3.03 per share, down from 2006 FFO of $3.48.

About 60% of the company's net operating income comes from Southern California markets in San Diego, Los Angeles, and Orange County. As a result, the company's properties are in some of the most attractive markets that have been prime beneficiaries of the real estate boom -- in the past four years the shares have more than quadrupled. The California economy and population continues to expand; according to management, California added 170,000 net new jobs in 2006 and has seen some rents escalate in the near-double digits.

Occupancy for stabilized properties ended the year at 95.8%, down slightly from the third quarter. Management noted that 95% is about as good as it gets, so much of the company's same-store improvement will have to come from rent escalation. However, management did estimate that their overall portfolio rent levels are 5%-10% below market level. This should provide a built-in gain when leases come up for renewal; in the fourth quarter, cash rents increased 5.9%.

Despite all the positive things about Kilroy -- great geography, great exposure to office property, prime tenants -- one has to wonder about the company's valuation. At roughly $86 per share, the company trades at nearly 30 times 2007's estimated FFO. Bidding wars for companies such as Equity Office Properties (NYSE:EOP) have hiked the price of real estate, and in many cases, the bidders have been some of the best real estate investors in the land, such as Vornado (NYSE:VNO). The reasoning for the high prices may stem partly from the lofty replacement costs and scarcity value of certain real estate properties (i.e., Manhattan office buildings), which may justify their seemingly nosebleed prices. However, I am unable to speculate on the valuation this methodology would place on Kilroy; unlike San Francisco or Manhattan, Southern California doesn't exactly lack for land to develop. For now, I'm putting this one in the "too hard" bin, and moving on to a stock I can more easily figure out.

For some more REIT reading:

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Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the companies mentioned above. Emil appreciates comments, concerns, and complaints. The Motley Fool has a disclosure policy.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.