In the most recent example of taking from one pocket to pay another, Merrill and JPM underwrote 8.75 million shares at $20/share for Kilroy Realty Corp (KRC), a REIT that owns, operates, develops, and acquires Class-A suburban office and industrial real estate in bankrupt southern California. But don't bother Cohen and Steers with the fundamentals - after all not only are REITs the primary recipient of taxpayer subsidies via the PPIP pumpage of CMBS, now Arnie is making sure taxpayers double dip, and bail out his state as well. As such, for taxpayers going long a REIT debacle such as KRC makes all the sense: at the end of the day the choice is either paying yourself in advance on April 15 by buying the worst garbage Wall Street has to offer, or not paying taxes at all.
And, in a much maligned but extremely profitable tradition, all the offering proceeds of $166.7 million, will go to pay back Merrill's revolver with KRC. Everyone is eagerly awaiting the upgrades to buy yet another stock which will soon have negative FFO after all California tenants which are not too big to fail stop paying their rents.
But before we get the inevitable Strong Buy boost from the revolver repayment beneficiaries, here is an objective summary analysis of KRC compliments of Dan Amoss of Strategic Short Report:
Kilroy’s 92 office buildings and 42 industrial buildings are located in Los Angeles, Orange, and San Diego counties. The occupancy rate of Kilroy’s 12.4 million square feet of total rentable space was just 89.2% at December 2008, down from 94% in 2007. This is an important metric because not only are many of Kilroy’s tenants in businesses like mortgage sales going away permanently, but healthy tenants are gaining the upper hand in lease renewal negotiations.
Demand for office space tends to lag employment trends. The dramatic recent jump to 10.5% in California’s unemployment rate will make Kilroy’s 2009 and 2010 lease renegotiations very unpleasant. The fact that California’s state government is insolvent doesn’t help Kilroy’s lease renewal efforts. The state will likely impose higher taxes and fees on businesses to balance its budget, driving many more out of the state to havens like Nevada.
Kilroy’s tenant profile is diversified across industries, but is 85% concentrated in the following industries: professional services (34%), manufacturing (19%), education and health services (17%), and financial and real estate services (15%). Its top 15 tenants by size contributed 39% of 2008 revenue. Lease expirations are a significant risk for Kilroy shareholders, because the tenants that do renew in 2009 and 2010 will do so at steadily lower rents. Kilroy’s 10-K discloses lease information that paints an ugly picture for shareholders. In addition to the 10.8% of Kilroy’s square footage that lies vacant, leases representing another 8% and 15% of Kilroy’s 2008 revenue will expire in 2009 and 2010, respectively (see blue line in nearby chart). Yet another obscure metric shows how much Kilroy’s space is underutilized: 3.9% of Kilroy’s currently leased space is available for sublease.
Let’s take a quick look at one of Kilroy’s tenants. Bridgepoint Education is a for-profit education company that accounts for 3.5% of Kilroy’s 2008 rental revenue. It is expected to become Kilroy’s second-largest tenant by this fall if it follows through on commitments to take more office space. Bridgepoint just completed its initial public offering and trades on the NYSE under the symbol BPI. Bridgepoint is “me too” stock — one of a long list of for-profit online colleges that look to serve the interests of insiders more than students. Famed short seller Jim Chanos has gone public with the disclosure that he is short most of the for-profit education companies. Chanos considers the business model to be unsustainable, and I agree with his assessment.
Bridgepoint’s IPO looks rushed. Insiders and private equity backer Warburg Pincus probably wanted to cash out before the Dept. of Education cracks down on abuses of Title IV education funding — likely to come later in 2009. The risk factors in Bridgepoint’s SEC filings make for entertaining reading. I’ll keep an eye on Bridgepoint, because the potential loss of this tenant is a hidden risk in Kilroy’s fundamentals.
Kilroy's Debt Load Is the Biggest Risk
The biggest risk for KRC stock is the leverage on its balance sheet. Kilroy has $1.4 billion in total debt, preferred stock, and minority interest — a good portion of it built up during the office construction and renovation boom. The green line in the nearby chart was drawn from data in Kilroy’s cash flow statements going back 10 years (courtesy of CreditRiskMonitor). It is a proxy for Kilroy’s annual investment in its real estate portfolio: capital investment plus acquisitions minus divestitures — all as a percentage of total property book value. As you can see, Kilroy invested pretty heavily in 2006 and 2007, and the return on those investments is going to be disappointing.
Covenant Risk Growing Larger
Kilroy’s capital structure is roughly 72% debt, if you measure it as total debt and preferred stock (the red columns in the chart) as a percentage of the book value of real estate (the black columns in the chart). But the market value of Kilroy’s real estate will likely be lower than book value in coming years. Kilroy may have to impair the value of its underperforming properties fairly soon. According to its 10-K, the following indicators determine whether a write-down of property value may be necessary: “Significant increases in market capitalization rates, continuous increases in market capitalization rates over several quarters, or recent property sales at a loss within a given submarket, each of which could signal a decrease in the market value of properties” [emphasis added].
Write-downs would not be good for Kilroy’s coverage of its debt covenants — one of which hinges on total debt to total asset value. But the most immediate covenant in danger of violation is a minimum occupancy requirement for Kilroy’s unencumbered assets: This must be least 85%. As of year-end 2008, this figure was 92% and will head lower in 2009.
Kilroy Must Meet Daunting Obligations Over Next 2 Years
Kilroy’s $1.4 billion in secured debt, unsecured debt, preferred stock, and minority interest is roughly twice the $700 million market value of its common stock. Kilroy must fund roughly $625 million in contractual payments by the end of 2011, which includes principal and interest payments on its debt (see chart above). It will have to fund this through some combination of funds from operation, refinancing, asset sales, or secondary equity offerings.
Let’s consider how much free cash flow Kilroy can generate in 2009, 2010, and 2011. My generous estimate of total funds from operation for these three years, adjusted for the capital expenditures necessary to merely maintain its properties, is roughly $230 million. But this doesn’t include the dividend payments Kilroy must pay to its shareholders to maintain its REIT status. If Kilroy maintains its current dividend, the cash outflow over these three years will be $240 million.
This lack of free cash flow to pay down debt will force Kilroy into a scenario that destroys shareholder value. All forms of debt financing for REITs is getting much more expensive, simply because demand for credit is overwhelming and supply of credit from banks is scarce and expensive. The weighted average interest rate on Kilroy’s debt was just 4.8% in 2008. This ultra-low interest rate is a symptom of the poor underwriting standards during the commercial real estate lending bubble.
Interest rates will soar for any REIT looking to refinance unsecured debt. For example, Simon Property Group — the biggest mall REIT in the U.S. — recently issued $650 million in 10-year senior notes at 10.35%. If Simon had to pay that much for long-term financing, then the rest of the industry is in serious trouble.
Kilroy’s weighted average interest rate could easily double by the end of 2011, which would transfer much of its future rental cash flow from shareholders to creditors.
Property Sales Would Be Self-Defeating for Kilroy Shareholders
If Kilroy considers asset sales, this option would be selfdefeating. It may have to sell properties at lower values than it is carrying them on its books. Maguire Properties will be a distressed seller in Kilroy’s neighborhood, depressing property prices. Maguire has earned the distinction of having made some of the dumbest commercial real estate purchases at the peak of the bubble. Bloomberg describes one of Maguire’s recent sales:
“Maguire Properties paid $2.88 billion in 2007 for 24 office properties and 11 development sites. The purchase, from Blackstone Group LP, encompassed all of the real estate in downtown Los Angeles and Orange County that Blackstone acquired in its acquisition of Equity Office Properties Trust. The purchase came just as Orange County vacancies were rising with the collapse of the subprime mortgage industry. The subsequent credit market freeze blocked Maguire’s efforts to refinance...
“Maguire last month sold its 18581 Teller office building in Irvine for $22 million, including the buyer’s assumption of a $20 million mortgage on the property. The property was one of those purchased from Blackstone.”
What does Maguire’s office building sale mean for Kilroy? It’s just two miles away from an empty industrial building on Von Karman Avenue that Kilroy is in the process of re-entitling for residential use. This is just one example of the risk facing Kilroy’s property values.
Kilroy will likely follow in the footsteps of its strapped REIT peers and pay most of its dividends through 2011 in the form of shares, rather than cash. Kilroy management mentioned the possibility of paying the dividend in stock on its last conference call. Recent IRS guidance allows Kilroy to maintain its REIT status if it satisfies up to 90% of its dividend requirement through the distribution of new shares, rather than cash.
But this is all data, that Cohen and Steers, and all who bought into KRC's offering are well aware of. Plus who cares, as ML is expediently running up the stock and completely groundless upcoming upgrades are merely days if not hours away. It is now becoming crystal clear why Sakwa decided to call it a day.
Disclosure: no position in KRC securities.