Work-from-home has changed the way most of us interact with our jobs. The COVID-19 lockdowns ushered in a massive experiment in remote working, and it is hard to deny its success. Businesses that don't require in-person interaction were able to adapt to the new environment with relative ease. Remote working is now a feature for most knowledge workers, and the era of commuting five days a week to the office may be over.
This raises questions for office real estate investment trusts (REIT) like Kilroy (KRC -2.10%). Will companies adapt to the new paradigm by reducing their office footprint or going 100% remote? Kilroy Realty recently gave an update on the office market during its third-quarter earnings conference call that should give office REIT investors some comfort.
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Kilroy has exposure to the most attractive markets
Kilroy Realty is an office REIT that focuses on the West Coast markets. Its portfolio totals 15.2 million square feet of office space in Los Angeles, Seattle, San Diego, and the San Francisco Bay Area. The company recently announced that it is expanding into Austin, Texas as many tech companies are being priced out of many of these West Coast markets.
Kilroy focuses heavily on technology and life sciences tenants. Its biggest tenants include Dropbox, General Motors' Cruise division, Microsoft, Adobe, and salesforce.com. Tech companies account for 58% of Kilroy's rental revenue, and life sciences are next at 13%. Life sciences companies got a big boost from government grants related to COVID, and both sectors are competing for scarce modern office space with all the amenities.
During the call, the company noted that it is "really starting to see the revitalization of cities across the West Coast" as city dwellers are "returning to their urban apartments and once again embracing city life." It mentioned that net absorption (which means people moving into apartments) is approaching 100,000 units in its big markets. The flight to the suburbs during the pandemic might be reversing.
Demand for office space is not declining
On the earnings call, the company addressed concerns that demand for office space might be declining:
But the office will remain the center of the work ecosystem. It may change in its configuration, but it's going to remain the place where people come to conduct meetings and collaborate. And we're seeing companies, both our clients and others spending a lot of money on their office space. So I think that's one important point. Hybrid work is going to be [a] given. We know that. The third point I'd make is that the net impact of hybrid work, we think, is going to be minimal in terms of space demand reduction or footprint shrinkage. CBRE conducted a survey nationally of 185 companies and only 9% of those surveyed expect to experience a decrease in square footage.
The other important indication for Kilroy is rent increases. During the third quarter, Kilroy leased 600,000 square feet, which was more than the first two quarters combined. In addition the company was able to increase rents 26% in its existing portfolio. Rising rents are a key indicator of demand. With rents rising at a healthy clip, and a cost of borrowing of only 3.8%, Kilroy should see increasing earnings.
Kilroy recently upped its dividend
Kilroy maintained guidance for 2021 funds from operations (FFO) per share of $3.77, so it is still being somewhat cautious. Still, at current levels, the stock is trading at 18.9 times 2021 FFO per share, which is reasonable for an office REIT. The company also recently increased its dividend 4% to $0.52 per share. This means it is distributing about 55% of funds from operations, which is pretty conservative for a REIT. Kilroy is growing, so it will want to plow as much cash as it can back into the business.
Overall, it looks like the fears of a mass exodus from office spaces is not playing out. In fact, it looks like we are seeing people return to urban areas. Kilroy has exposure to the hottest markets on the West Coast, which gives it an advantage over companies like SL Green that are focused on the East Coast. Earnings this year were impacted by COVID-19-related issues; however, as these fade into the background the company should return to faster growth.
