Undervalued by 46% and Yielding Almost 7%, This Stock Is a Buy

Focusing on office space in technology and life sciences market clusters, Kilroy Realty probably isn’t on the buy lists of many dividend investors, but at its current price, we think it should be. Demand for office space on the West Coast—where many of Kilroy’s properties are—does remain under tremendous pressure. Yet we think the shares of this well-managed REIT are notably cheap and attractive for long-term investors. Kilroy appears on Morningstar analysts’ list of 33 Undervalued Stocks for the third quarter. It’s also one of Morningstar chief US market strategist Dave Sekera’s 4 New Stocks to Buy With Catalysts for Future Gains.

Kilroy owns, develops, acquires, and manages premier office, life sciences, and mixed-use real estate in Los Angeles, San Diego, the San Francisco Bay Area, Seattle, and Austin. The REIT has positioned itself to benefit from the burgeoning life sciences sector with material exposure in its portfolio and development pipeline. The company’s strategy is to achieve long-term growth by developing and owning the highest-quality real estate in technology and life sciences market clusters. The average age of its high-quality portfolio is just 11 years compared with 30 years for peers. We believe that although remote and hybrid work solutions will gain increasing acceptance, offices will continue to be the centerpiece of workplace strategy and will play an essential role in facilitating collaboration, harnessing innovation, and maintaining a company’s culture.

Key Morningstar Metrics for Kilroy Realty

• Fair Value Estimate: $59
• Star Rating: 5 Stars
• Economic Moat Rating: None
• Uncertainty Rating: High

Economic Moat Rating

Given the availability of substitutes in Class A office space, limited supply restrictions in Kilroy’s key geographic markets, the uncertainty in demand associated with remote work, and the ease with which competitors can lure tenants away with concessions, we view a large proportion of the portfolio as replicable and therefore do not believe that the company has a durable competitive advantage. We calculate that over the past few years, Kilroy’s adjusted return on invested capital has been substantially below its weighted average cost of capital, and we expect this to remain the case over the next decade. Therefore, we believe there is currently not enough quantitative or qualitative evidence of an economic moat for Kilroy.

Read more about Kilroy Realty’s moat rating.

Fair Value Estimate for Kilroy Stock

Our fair value estimate is $59 per share. We expect companywide portfolio occupancy to decline to 82.9% by 2025 as the West Coast office market remains under stress. We project an 88.7% occupancy rate by the end of 2033 as we expect office utilization rates to increase over time, resulting in demand recovery for office real estate. Over the next decade, we expect a 0.9% compound annual growth rate in average rent per square foot for the portfolio and a 1.3% CAGR for same-store net operating income. We forecast a 3.1% CAGR for funds from operations per share over the next decade, mostly due to contributions from acquisitions and developments. We think Kilroy’s significant development pipeline will provide yields around 6.50% through 2033, adding incremental net operating income and contributing significantly to the company’s valuation.

Read more about Kilroy Realty’s fair value estimate.

Risk and Uncertainty

The remote work dynamic is probably the biggest source of uncertainty for the office real estate industry. The pandemic showed us that technology can help employees collaborate and maintain productivity as they work remotely. Hybrid workplace policies are now increasingly becoming the norm and present a significant challenge to future office demand. Workplace management solutions like hot-desking can materially reduce square footage per employee, leading to further stress on office demand. Macro trends surrounding employment and demographics can have a significant impact on demand for office space. Kilroy’s geographic concentration in California and high exposure to the tech and life sciences sectors are also a significant risk.

Read more about Kilroy Realty’s risk and uncertainty.

Kilroy Bulls Say

• A focus on technology and life sciences market clusters should benefit Kilroy in the long run as we expect buoyant growth in these areas. The company’s high-quality office buildings with good amenities should benefit from the flight-to-quality trend.
• The management team demonstrated that it is able to successfully recycle capital and pursue growth over the past business cycle.
• Regulatory barriers to construction in cities like Los Angeles and San Francisco mean that Kilroy will continue to benefit from relatively muted supply.

Kilroy Bears Say

• Employees are still hesitant to return to the office, and physical building occupancy rates remain well below prepandemic levels.
• Technology-enabled hybrid and remote work solutions have the potential to materially reduce per capita office space utilization, leading to lower demand for office space.
• With a tenant base that is concentrated in technology, media, and life sciences, Kilroy is susceptible to changes in these high-risk industries.

This article was compiled by Susan Dziubinski and Sylvia Hauser.