Kilroy Realty Is Optimistic About Continued Demand for Its Office Space

The constant question these days for office real estate investment trusts (REITs) is whether COVID-19 has been a real game-changer for the investing sector. Will companies embrace the work-from-home model, let their leases lapse, downsize space requirements, and move to where rents are cheaper?

We have already heard from Manhattan office REIT S.L. Green, whose management doesn't see that happening. But what about the West Coast? Are we seeing the same sentiment in the ultra-expensive big West Coast cities?

Office REIT Kilroy Realty (NYSE: KRC), based in Los Angeles, provided some insight when it reported second-quarter earnings late last week.  Modern office building

Image source: Getty Images.

Tenants want to return to the office

On the earnings conference call, John Kilroy, CEO of Kilroy Realty, addressed the question and gave some color on what clients are saying: 

"We are in constant contact with our tenant base up and down the coast, and they are focused on reestablishing their work environment and getting back to the office, while at the same time, protecting the safety of their employees. The next 12 months is likely to be a transition period. There's likely to be trial and error, experimentation and stops and starts as the pandemic runs its course. 

He went on to explain that the consensus seems to be that work from home will be an additional option for employees, but there seems to be little interest in a wholesale exit of urban office space, especially given the company's typical tenant. 

One of the youngest portfolios on the West Coast

Kilroy is an office, residential, and retail REIT that is concentrated in the big West Coast cities of San Diego, Los Angeles, San Francisco, and Seattle. The company prides itself on sustainability and has one of the youngest portfolios on the West Coast, with an average age of 10 years for its properties. Kilroy's tenants are concentrated in technology and life sciences, often with investment-grade credit ratings. These tenants also have large spaces with many of their employees living within walking distance of the office. These employees will prefer that the offices remain where they are. This means these offices will not be easy to replace.

Kilroy believes the COVID-19 crisis will make office buildings with tighter access, fewer stories, and larger spaces more attractive. More flexible spaces allow greater control over how interior office space is laid out and how traffic flow is directed, including better HVAC systems. Kilroy's focus on sustainability and amenities is likely to resonate with younger, better-educated knowledge workers. This gives Kilroy a strategic advantage in its markets. 

Tenants are paying rent

During the second quarter (which coincided with some of the worst months of the stay-at-home orders related to the pandemic), Kilroy collected 95% of all contractual billings. Collection rates were 98% from office, 87% from residential, and 46% from retail. About 4% of its leases will expire through 2022. While retail closures have a negative effect on collections, they are relatively minor. The company gave two months' rent deferral to about 90% of its retail tenants, which costs about $1.5 million per month. During the quarter, Kilroy generated $93 million in funds from operations during the second quarter, so the retail environment is navigable. 

Total liquidity for the REIT is $1.3 billion, and there are no material debt maturities until 2023. Kilroy's remaining development spend for the next two years is about $625 million, and it has a cushion of about $250 million in income before bank covenants become an issue. The company is certainly in a good place with respect to its obligations. 

The eulogy for the office REIT is premature. While there may be some effect from COVID-19 on office demand, it will probably be felt with the smaller Class B and Class C properties. The best Class A spaces will always have demand.

As far as Kilroy is concerned, the life sciences companies are probably not suited for mass remote working to begin with. While everything ultimately depends on how the pandemic plays out in the future, at least for the moment, fears of a mass exodus from urban office spaces appear overblown. 

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