The Southern California office and industrial markets have been on a tear this year, and real estate investment trusts focused on the region have seen their share prices surge. Arden Realty ( ARI), a major office owner in Los Angeles and Orange County, is seen as a likely buyout target due to its portfolio. In coming months, Douglas Emmett -- a well-respected Los Angeles office and apartment owner -- is expected to file for an initial public offering. What's got everyone abuzz about Southern California is that the area's office and industrial markets have been solid performers in a generally lackluster national environment. Job growth in the area has been strong, leading to low vacancy rates and growing rents across the region. In turn, investors who placed bets on REITs focused on the area have been rewarded this year. Kilroy Realty ( KRC), one of the largest owners of office and industrial properties from San Diego to Los Angeles, is up 44% year to date. Arden Realty is up more than 20%, mostly due to the buyout rumors. Maguire Properties ( MPG), which mainly owns trophy Los Angeles office buildings, is up about 14%. "Basically the Southern California office and industrial markets are light years ahead of the national market right now," says David AuBuchon, an A.G. Edwards & Sons analyst. Office vacancies across the region range from 9% to 12%, lower than the 14.5% national average for metropolitan areas. In the third quarter, Orange County had the nation's second-best office vacancy rate, at 8.9%, followed by a rate of 9.2% in the neighboring San Bernardino-Riverside Counties, according to Reis, a research firm. Only Washington, D.C., with a vacancy rate of 8.3%, performed better. Kilroy, Arden and Maguire are the only pure Southern California office real estate plays, because nearly all of their buildings are in the region. Other major office and industrial REITs have exposure there, but not enough to really get investors excited on the stocks.
That is why an expected REIT IPO by Santa Monica-based Douglas Emmett next year will likely see a lot of interest. Douglas Emmett owns one of the largest portfolios of Class A office and apartment buildings in Los Angeles, focused on the Westside and San Fernando Valley areas. The company, which also recently expanded to Hawaii, is expected to file within the next few months for an IPO of about $500 million to $1 billion, according to Barry Vinocur, editor of Realty Stock Review. Another market source confirmed the expected filing. Douglas Emmett's receptionist said the company doesn't respond to press inquiries. The recent Casden Real Estate Economics Forecasts from the University of Southern California's Lusk Center for Real Estate say the Southern California office and industrial markets are poised to continue their solid growth in 2006. "Stable job growth has helped reduce office vacancy rates and raise rents throughout the region," said Delores Conway, director of the Casden Forecast, at a real estate meeting in Los Angeles held earlier this month. "Southern California office and industrial markets will continue to hold their value through 2006 thanks to a flood of capital from mutual funds, REITs and pension funds needing to diversify real estate holding and lock in long-term revenue streams." With Southern California's operating fundamentals so solid, a flood of capital has been chasing properties in the region. Cap rates, or yields on acquisitions, of quality office properties are now down to between 5% and 6%. Because of these low yields, Arden -- which owns 18.5 million square feet of office space in Los Angeles, Orange County, and San Diego -- is considered a great portfolio buy. AuBuchon, the A.G. Edwards analyst, says a deal to take the company private is likely to be finalized soon -- with suitors having been narrowed to GE Asset Management, Morgan Stanley Real Estate Fund and Starwood Capital. AuBuchon expects the deal could fetch $50 a share, which would represent a premium of about 11% from where Arden's shares are currently trading. After hovering around $38 in September, Arden's shares have since run up more than 18% as the merger talk heated up.
The fact that buying properties in Southern California is so difficult also has propelled Kilroy's stock. The company owns over 12 million square feet of office and industrial space in Southern California. Rather than try to buy in this low-yield environment, Kilroy is focusing on developing its huge land holdings in the region. Its development pipeline under construction now totals 644,000 square feet, and will cost $189 million. The company also plans an additional 1.1 million square feet of office development in San Diego, for a total investment of $409.1 million. Kilroy will see cash yields of 9% to 9.5% on its current developments, substantially higher than the 5% to 6% acquisition cap rates in Southern California right now. Kilroy is a "great story over the next three years because they don't have any pressure to buy (properties)," says AuBuchon, who rates the company buy. "They have this built-in internal growth pipeline." A.G. Edwards expects to receive or seek compensation from Kilroy within the next three months. But it might be difficult to still take advantage of the upside on Kilroy. The company is trading at 18.6 times the consensus estimate for its 2006 funds from operations, a common metric for measuring REIT performance. Industrial REITs, on average, are trading at 14.5 times next year's FFO, and office REITs are at an average 14 times FFO, according to SNL Financial. Kilroy's dividend yield is down to 3.3%. The average dividend yield for all REITs, except mortgage REITs, is currently 5.17%, according to SNL. But with its strong development pipeline, analysts, on average, expect Kilroy to grow FFO 11% annually over the next five years. AuBuchon thinks 8% to 10% growth annually is more realistic. But even that growth rate is better than what can be expected for many REITs, which helps explain Kilroy's higher valuation.