Kilroy Earnings: Occupancy Declines Weigh on Profitability, but Shares Remain Compellingly Cheap

No-moat-rated Kilroy Realty’s KRC second-quarter results were largely in line with our expectations as the demand for west-coast office real estate remains muted due to macroeconomic factors and a slower recovery in physical office utilization rates. The firm reported funds from operations of $1.19 per share in the second quarter, which was around 1.7% higher than the $1.17 per share FFO reported in the second quarter of the previous year. The short-term outlook for office real estate remains challenging, but shares are compellingly cheap from a long-term perspective.

The shares of the company have rallied around 35% in the past couple of months from its mid-May lows. However, we still think that the current share price of the company reflects excessive pessimism. Kilroy Realty is trading at around $35 per share after releasing its second-quarter results, which implies a 7.8 times 2023 FFO multiple. We think that a 7.8 times FFO multiple for high-quality office properties with low leverage offers an attractive entry point for patient investors who can stomach short-term volatility. We agree that it will take several years for the office sector to recover, but the patience of prospective investors will be duly rewarded.

We are maintaining our fair value estimate of $63 per share for Kilroy Realty after incorporating the second-quarter results.

The portfolio occupancy rates declined 300 basis points on a sequential basis and 480 basis points on a year-over-year basis as it was reported at 86.6% for the second quarter. We note that the decline in occupancy rates was largely anticipated by the market and was in line with management’s previous guidance. The same-store GAAP rental income declined by 2.0% and the same-store GAAP net operating income declined by 2.3% on a year-over-year basis in the second quarter mainly due to lower occupancy rates.