While the equity markets have created game-changing wealth for long-term shareholders over several decades, just a handful of stocks have driven the majority of these gains. This means finding winning bets consistently is pretty difficult, given that most companies fail to outperform the broader markets.
So, while it is essential to identify quality companies and add them to your equity portfolio, it is equally important to avoid fundamentally weak companies. One such stock I wouldn’t touch with a 10-foot pole is Kilroy Realty (NYSE:KRC). Let’s see why.
An overview of Kilroy Realty
Valued at US$4.1 billion by market cap, Kilroy Realty is a U.S.-based landlord and real estate developer with operations in San Diego, Los Angeles, Austin, Seattle, and San Francisco. The company ended 2023 with a real estate portfolio totalling 17 million square feet of office space. It also owns around 1,000 residential units in Hollywood and San Diego, with an average occupancy rate of 92.5%.
Unlike several other real estate investment trusts (REITs), Kilroy Realty has struggled to provide shareholders with inflation-beating returns. In fact, shares of the REIT have risen marginally over the last two decades. If we account for dividend reinvestments, Kilroy Realty stock has returned 118% since March 2004. In this period, the S&P 500 index has returned 577%.
Let’s see what makes Kilroy Realty a high-risk investment today.
The commercial real estate market is under pressure
The commercial real estate market south of the border is wrestling with headwinds such as rising interest rates. Generally, REITs, including Kilroy, leverage debt to acquire properties. While bond rates were quite low in the decade prior to 2022, interest rates touched multi-year highs, making it difficult for property developers to refinance their debts.
According to a report from the National Bureau of Economic Research (NBER), commercial real estate loans held by U.S. banks are around US$2.7 trillion. Further, the NBER emphasized that 14% of commercial real estate loans and 44% of office building loans have outstanding debt that is greater than property values. This means property valuations for commercial real estate have fallen significantly in recent years.
Another report from Green Street, an analytics firm, stated commercial property values are down 22% while office prices have plunged 35% since 2022 due to lower demand and the shift towards work-from-home.
How did Kilroy Realty perform in Q4 of 2023?
Similar to other commercial real estate companies, Kilroy will be impacted by the work-from-home trend in the upcoming decade, increasing its vacancy rates in the process. Currently, Kilroy has a vacancy rate of 14%, which is lower than its peers as it aims to diversify away from commercial real estate.
In the fourth quarter of 2023, Kilroy reported revenue of $269 million and a net income of $0.40 per share. Its funds from operations stood at $129.3 million, or $1.08 per share.
Kilroy pays shareholders an annual dividend of $2.16 per share and expects funds from operations per share to range between $4.10 per share and $4.25 per share in 2024, indicating a payout ratio of less than 60%, which is sustainable.
While Kilroy’s fundamentals are quite strong, it is part of a market that might be on the brink of collapse, driving share prices significantly lower in the upcoming decade.
