Kilroy Was Here

One of the most interesting conference calls I’ve listened to in the past few weeks’ worth of earnings calls was a REIT called Kilroy Realty.

I don’t know the company well, but I thought the call would be worth a listen.

It was.

For the record, “Kilroy Realty Corporation, a real estate investment trust (REIT), engages in the ownership, operation, development, and acquisition of Class A suburban office and industrial real estate in suburban submarkets, primarily in Southern California.”

The following are excerpts from the conference call transcript, with no elaboration. California’s economy produced steady, diversified growth during the third quarter. Employment hit another record high in September, according to the monthly survey of households while total nonfarm payroll jobs grew by 226,000 year-over-year. The unemployment rate as of September stood at 5.1%, down from a full percentage point from a year ago. Continued job growth has boosted other economic indicators including personal income which rose an estimated — or rather an annualized 2.9% in the second quarter versus 2.2% a year ago. For the period California accounted for 13% of total national personal income.

KRC remained very productive during the quarter. Within our stabilized properties we have now signed new or renewing lease agreements on 1.4 million square feet of space year to date. And we continue to lead the pack in terms of deal capture and rental growth. Overall occupancy in our stabilized portfolio fell a couple of percentage points in the quarter to just under 93%. This occurred primarily because our recently renovated 909 Sepulveda property was moved to the stabilized portfolio and a tenant vacated a 130,000 square foot building in San Diego.

Now let me give you a big picture summary of what we are seeing in Southern California. As we have been saying for several quarters, the Southern California real estate markets have been strengthening. Throughout many of our markets we are seeing and the brokers are reporting a shift from a tenant’s market to a landlord’s market. This is more pronounced in some submarkets than others but there is more and more sentiment that tenants need to act now, particularly those with larger requirements. C.B. Richard Ellis is reporting tightening vacancies and rising lease rates in Los Angeles with minimal new construction.

C.B. is predicting significant rent increases in Los Angeles as large blocks of space get absorbed and vacancy rates continue to decline. Our experience also supports an improving market in Los Angeles where our west side assets are effectively fully leased and we have begun to make significant progress in El Segundo. While it took a entire year following completion to get to 25% committed we have essentially doubled that in our 909 building in the last quarter, moving the committed percentage to 49% today. As for the Orange County office market, Cushman and Wakefield has also reported a move from an equilibrium market to a landlord’s market as population growth and a growing economy are driving demand. Office vacancy rates are down to 10% from 14% a year ago and rents are up 6% year-over-year.

Finally in San Diego, we continue to see a significant increase in demand for new state-of-the-art facilities in the market in which we operate.

One of the Southern California markets where new office construction does make sense is in the better San Diego submarkets where the combination of rental growth and robust demand provide attractive returns. In contrast, development does not make sense in most Los Angeles submarkets and won’t until rents significantly increase.

Also in Orange County, given the current strength in residential economics we have the opportunity to rezone at least a couple of our industrial properties for residential and sell the sites to home builders at a significant profit. We expect to have more to come on this on future calls.

The real estate markets are improving across the board in Southern California with a shifting taking place from a tenant’s market to a landlord’s market. The brokerage communities and others are increasingly indicating that there is a growing sense of urgency among tenants to find space.

The strength in the markets is moving up the coast. While San Diego continues to be the strongest market in Southern California, Orange County has improved significantly over the last year. Most Los Angeles submarkets are also tightening and even El Segundo is now showing meaningful reductions in vacancy.

Construction costs have increased significantly over the past four years with most of that occurring in the last 12 to 18 months.

And if we look at our AMN building which is probably the highest quality building in San Diego which we came on stream in late 2002, the cost of that building core and shell is up about 40%. And that’s plus or minus pretty much the same for other buildings. So the other thing that’s increased is, depending — it doesn’t always effect Kilroy although it does when we buy new property is that land costs have increased in many markets, including San Diego..

Cap rates, we’ve seen them continually go lower.

What we’re seeing is a number of second and third chair properties trading at 6% plus or minus cap rates, and I also mention maybe higher quality assets but not in very good markets in that same range and we’re seeing high quality assets particularly particularly down in San Diego in a sub 6 range.

We’re not seeing any letup in the appetite for people to acquire. I’ve never seen more people wanting to acquire assets than today. If the Fed is seeing what Kilroy is seeing, I wouldn’t expect the Fed to let up any time soon.

Jeff Matthews I Am Not Making This Up

© 2005 Jeff Matthews

The content contained in this blog represents the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews’ recommendations.