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Morningstar | Tenant Credit Issue Damages Kilroy Realty's Bottom Line; Outlook Remains Unchanged

While Kilroy Realty reported a mixed bag of quarterly results, the short-term developments do not change our view of the firm’s long-term cash flow potential, and we will maintain our fair value estimate of $82 per share and our no-moat rating for the firm.

Kilroy reported funds from operations at $0.86 per share, which was down 1.1% from second-quarter 2017 and 2.2% below our quarterly estimate of $0.88 per share, though same-store cash net operating income was up 5.1% from the same period. The FFO miss was caused by a bad debt charge resulting from a credit issue with an unspecified tenant. The bad debt charge raises concerns regarding the credit of Kilroy’s largely tech-based portfolio, though we are relieved because many of their largest tenants are backed by larger companies like how Microsoft funds its largest tenant, LinkedIn, so we do not expect tenant credit to be an issue going forward.

Other fundamentals seem to be mostly in line with our forecasts as total revenue grew 2% ahead of our forecasts, though this was entirely offset by higher general and administrative expenses, the result of legal costs specific to one building in San Francisco, which we do not expect to continue far into the future. Kilroy updated its annual FFO guidance to be more in line with our estimates, as the midpoint of guidance was updated to match our 2018 annual estimate of $3.52.

Apart from the nonrecurring charges that affected the company's bottom line for the quarter, Kilroy is showing several reassuring signals. Two indicators of Kilroy’s portfolio strength are that cash rents grew 10.2% year to date, relatively in line with our leasing spread estimate, and that Kilroy retained strong occupancy. We also believe that Kilroy’s continued ability to land new leases with strong tenants, most recently shown by the company closing a large lease with GM Cruise, shows the quality of the company’s portfolio.

We were encouraged by the company’s purchase of a 19-acre life science development site in south San Francisco for $308.2 million, which dramatically increases the future development pipeline’s square footage. Due to diversification benefits, we generally like to see companies purchase a variety of smaller projects rather than invest in a single large project, but the life sciences sector is currently only 10% of the portfolio, so the project will add some diversity.

There were a few hiccups that prevented Kilroy from achieving a stronger quarter, but we do not believe that this quarter’s negative effects will last far into the future or that this quarter will materially affect shareholders' overall view of the company.