Kilroy/mar17/bb/ 34inches1stjc/mark2nd

BRAD BERTON

Staff Reporter

Just how hot are Southern California REITs?

Too hot for comfort, say some experts, who believe that investors are paying way too much to get on the REIT bandwagon.

"West Coast office REITs are a hot product now, but it's not a big enough market, so there's too much money chasing too little product," said industry veteran Mark Cassidy, who recently joined the Summit Commercial Properties affiliate of El Segundo's Highridge Partners real estate firm.

Cassidy and others point out that Wall Street is paying local office building owners too much of a premium for stakes in portfolios and might get stung when the markets for real estate investment trusts cools down.

Others are less concerned, noting that the pricing of publicly traded office building portfolios are cooking at just the right temperature albeit a feverish one.

That's because REIT stock prices reflect expectations about a real estate market's future, they say, and that L.A.-area suburban markets where the major local REITs are focused are poised for a strong recovery.

Richard Ziman, chairman and chief executive of Arden Realty Inc. one of L.A.'s hottest new REIT stocks stressed that the "multiples" institutional investors are paying for REIT issues remain well below those of other sectors, such as high tech.

While some of the tech stocks are trading at 30 or 40 times earnings, hot REITs are trading at multiples closer to 12 or 15.

Also, Ziman said, Southern California office markets are just starting to recover from the bottom of the market cycle. He added that REITs' "underlying assets" the office buildings themselves "won't go away or become obsolete in a year" as can happen with some high-tech products and services.

Whatever scenario ultimately proves closest to reality, there's no question that shares of L.A.'s two newest office REITs, Arden and Kilroy Realty Corp., are on fire.

Kilroy's share price is already up more than 18 percent since its late-January initial public offering. And Arden shares are now trading at nearly 50 percent above the company's initial $20 offering price just last October.

Both hit new highs last week, Kilroy at $28.12 on March 13 and Arden at $29.50 the previous day.

Hence, predictably, more major Southern California office portfolio offerings are in the offing.

"I can tell you our office is very active ... and you'll see several (REIT offering) transactions by the end of 1997," said REIT expert Richard Klein, partner with real estate consultancy E & Y;/Kenneth Leventhal in Century City.

He said much of the current frenzy stems from local commercial real estate market conditions, as well as nationwide capital-market trends.

While "expected yield growth" is the general driver of demand for specific REIT stocks, the rapid growth in Los Angeles appears to be driven by other factors including the presence of proven management teams and the belief that L.A.'s commercial market is poised for a rebound, Klein said.

REITs were originally started in the 1960s as a means for investors with limited funds to invest in real estate. They operate much like closed-end mutual funds, except that the investments are not in stocks but in real estate.

Many institutions are now reallocating investments from "direct" ownership of individual properties into REITs, said Cassidy.

In part, that's because REITs which aren't taxed at the corporate level as long as earnings are regularly distributed to shareholders offer more liquidity, diversity and security than direct investments, he added.

And that helps explain why Wall Street has embraced the L.A. area's two major new office REITs and perhaps too much so, according to Cassidy and others.

The potential downside for investors is that share prices can cool substantially if REITs fall out of favor with notoriously fickle capital markets, Cassidy and Klein agreed.

So while the real estate operations of a REIT might continue distributing dividends, falling share prices would reduce a shareholder's overall yield (i.e., the combination of dividend earnings and share appreciation).

"That's the typical investor cycle like it today, hate it tomorrow, like it again next week," said Klein. "Perhaps that partly explains why (office REIT stocks) seem to be doing so well today in the face of what in reality are mixed and confusing signals with respect to (prevailing) real estate values," he added.

But Richard Schoninger, head of lead Kilroy underwriter Prudential Securities Inc.'s real estate investment banking group, disagrees with that assessment.

Schoninger stressed that it's Kilroy's future yield prospects, rather than simply a temporarily hot REIT IPO market, that are attracting Wall Street's attention.

"The REIT market in general likes the focus of management teams that are very established and (retain) a significant amount of equity in the company," he said.

"Kilroy has been around for 50 years and is one of the companies that have survived the (real estate) downturn intact with a very strong and committed management team," he added.

Kilroy's experience in particular illustrates how the hot REIT stock market places more value on future earnings expectations than on prevailing fundamental real estate market conditions.

In January, just a few weeks after the 50-year-old Kilroy Industries real estate development/management company registered to sell about an 80 percent stake to the public, an ominous announcement came out of Lexington, Mass. Raytheon Co. had agreed to acquire Hughes Electronics Corp.'s defense units.

While those specific units aren't the biggest tenants within Kilroy's portfolio, experts in L.A.'s long-depressed South Bay region wondered aloud whether the announcement would significantly nullify interest in the pending Kilroy stock offering.

The merger could induce Raytheon to vacate some of the facilities housing the Hughes units it is acquiring potentially decreasing rental rates within the South Bay, where the bulk of Kilroy's 3.3 million-square-foot portolio is located.

Despite such apparent exposure, the developer's Jan. 29 initial public offering exceeded even the rosier predictions.

Kilroy initially projected it would raise perhaps $195 million, at $19 to $21 per share, if Wall Street liked the offering and the underwriters exercised over-allotment options.

As it turned out, investors poured $287.5 million into the Kilroy Realty Corp. issue at $23 per share and the share price jumped 10 percent during the first NYSE trading day.

In their pursuit of future yield growth, investors have paid more and more for Kilroy shares, even though the Green Street Advisors REIT analyst group in Newport Beach says Kilroy has yet to prove that it can grow profitably through acquisitions.

Kilroy's "ability to successfully implement an acquisition-oriented growth strategy holds forth some uncertainty," according to Green Street's pre-IPO report on Kilroy.

Nevertheless, Joe Harvey, director of research at Cohen & Steers Capital Management Inc. in New York which purchased nearly 1.3 million Kilroy shares on behalf of its investor clients is bullish on the new REIT.

"Kilroy has a powerful balance sheet that gives it much acquisitions capacity. And when you add up the growth potential from acquisitions and the recovery of the (L.A. area) office market in general which helps the existing portfolio it creates an attractive growth profile for the company."

For reprint and licensing requests for this article, CLICK HERE.