Alert: Market Panic Triggers Our Stop Losses On Kilroy (KRC) And Highwoods Properties (HIW)

In our monthly issue earlier this week, we featured Kilroy Realty (KRC) as a discounted buying opportunity.

Our analysis of the office space real estate investment trust (REIT)’s quality, safety, assets, and balance gave us a fair value buy-up-to price of $81.75.

However, Kilroy and another one of our positions, Highwoods Properties (HIW), have come under pressure as the market thrashes around among the current banking crisis.

We initially recommended Kilroy and Highwoods back when we launched on January 12 for the same reasons Howard Marks, Ray Dalio, Paul Tudor Jones, Jim Simmons, and Jeremy Grantham, and other billionaires were buying them.

They represent some of the best office properties in America, with skilled and adaptable management and strong investment-grade balance sheets.

They have good access to growth capital, which is essential in recessions and banking crises.

But sometimes, getting stopped out of a high-conviction position happens. We have a strong conviction about all our stocks, including their fundamentals and dividend safety, but the market doesn’t care about that.

As of market close yesterday, both hit our 30% hard stop losses from the point of our entry. So we will be removing them from our portfolio.

It’s unfortunate to remove an opportunity right after highlighting it. However, we must stick with our risk management policy.

Let me break down some details on what happened with these positions…

Recently, a banking crisis has swept U.S. regional banks and its effects reverberated all around the world.

Over in Europe, it forced UBS to buy Credit Suisse for pennies on the dollar.

Financial stocks as strong as Charles Schwab, which has an A- credit rating and $152 billion in liquidity – enough to cover all its depositors pulling money and then some – have been crashing as much as 20% in a single day. That’s the extent of the market panic right now.

I’ve been covering this crisis in our most recent issue and weekly video updates for this exact reason.

And among all this turmoil, the office REIT space has been selling off ferociously. Why have Kilroy and Highwoods fallen over 20% since the SVB crisis began?

It’s because investors still remember – and fear – what happened with REITs back during the Great Financial Crisis.

At that time, REITs like Kilroy and Highwoods had high debt. They were not prepared for credit markets to slam shut. As a result, 87% of REITs had to cut their dividends during the Great Recession.

REITs suffered almost as badly as financials because this is a naturally high-leverage sector, where 6X debt-to-cash flow is considered safe by rating agencies.

And here’s where the rubber hits the road… Regional and small banks do 80% of commercial real estate lending.

Having lived through the chaos of 2008, when REITs were forced to deal with a severe credit crunch, Wall Street is acting as if Kilroy and Highwoods are facing a liquidity freeze with more and more regional banks coming under fire.

In a panic, the market doesn’t care about strong fundamentals; it remembers the last big crisis, and investors get spooked easily.

The truth is: Today is nothing like 2008. Today, the REIT sector’s balance sheet is the strongest in history.

Elevated debt levels are safe for this sector. REITs have long-term leases with strong companies, creating predictable cash flow to service the debt they use to buy their properties.

Highwoods has a $364 million credit facility provided by a syndicate of several banks. These aren’t anything like high-risk SVB, First Republic, or PacWest.

We’re talking about JPMorgan, Wells Fargo, US Bank, and Goldman Sachs. The megabanks are the ones providing almost all REITs with their credit revolvers.

Those banks are getting stronger since $550 billion in regional bank deposits have flowed into megabanks in the last two weeks, according to JPMorgan.

That is also true for Kilroy, and its $1.3 billion credit revolver is enough to fund its entire growth plans… three times over.

And their high dividends, 8% for Kilroy and 10% for Highwoods, are still well covered by cash flow, even when the recession is factored in.

On top of that, these two high-quality office property REITs are expected to see their cash flows fall 6% to 9%, even facing a recession. The average earnings decline for the S&P during recessions is 13%.

That’s the power of long-term leases with strong tenants like Amazon, Microsoft, and Salesforce, who can and will pay their bills on time and in full.

In other words, REITs got hammered in the Great Recession because their creditors slammed shut their credit facilities. And the fear is it’ll happen again.

Today, the banks lending to REITs – including Kilroy and Highwoods – are healthy and getting stronger.

But we’re selling Kilroy and Highwoods because the most important rule of successful investing is to use disciplined risk management.

For us, that includes 30% hard stops. And unfortunately, we bought Kilroy at $39.48, which was a 51% discount.

We bought Highwoods at $29.34, a 39% discount to its fair value of $48.09.

If you purchased shares since our issue went out or in the last few days, we’re confident a hard stop of 30% from that entry should insulate you from much further losses.

Our hard stop is from the point of entry in our model portfolio, so you should monitor your own portfolios and sensible position sizing accordingly.

In other words, we’re not selling Kilroy and Highwoods because their investment thesis has collapsed. It’s because the only thing we’re more committed to than wonderful deep-value investments is following strong risk management principles.

And since this is a speculative REIT sector, we recommended a 2.5% to 5% risk cap. In our model portfolio, we use uniform 4.4% position sizing across all our positions.

The combination of 30% hard stops and modest position sizes means even if the fundamentals break (such as this becoming a full-blown financial crisis 2.0), our losses are small and easy to recover from.

Even with HIW and KRC turning against us, that’s a 2.4% loss to Fortress, which four months of the portfolio’s dividends will recoup.

There are no sacred cows at Wide Moat. Our only loyalty is to our valued subscribers and, thus, to the truth.

When the facts change, we change our minds and let you know in weekly updates, monthly issues, and special alerts like this one.

I hope you join us for next week’s video update, where we’ll let you know how the U.S. financial system is faring and what, if any, impact that has on Fortress Portfolio companies. If you have any questions you’d like me to address, please write in here.

In the meantime, I’ll be doing a deep dive into new recommendations to replace the two we closed out of today. And we’ll keep the dividend income rolling in…

Safe investing,

Adam GalasChief Analyst, Fortress Portfolio