Kilroy Realty Corp (KRC) 2002 Q3 法說會逐字稿

Ladies and gentlemen, thank you for standing by, and welcome to the Kilroy Realty third quarter 2002 earnings conference call.

During the presentation, all participants will be in a listen-only mode. Afterwards we will conduct a question and answer session. At that time, if you have a question you will need to press the one, followed by the four on your telephone.

As a reminder, this conference is being recorded Tuesday, October 29th, 2002.

I will now turn the conference over to Mr. Richard Moran, Executive Vice President and Chief Financial Officer. Please go ahead, sir.

Thank you. Good morning, everyone. Thank you for joining us.

I'm Dick Moran. With me today are John Kilroy, our CEO, Jeff Hawken, our COO, Tyler Rose, our Treasure, and Ann Marie Whitney, our Controller.

At the outset, I need to remind you that some of the information we'll be discussing this morning is forward-looking in nature. Please refer to our supplemental package for a statement regarding the forward-looking information in this call and in the supplemental. This call is being Webcast live on our Web site and will be available for replay for the next seven days, both by phone and over the Internet. Our press release and supplemental package have been filed on a Form-8K with the SEC and are also both available on our Web site.

We released our third quarter financial results yesterday afternoon. FFO was 72 cents a share, a penny above consensus estimates. EPS was 28 cents a share. John will begin with first view of the quarter and conditions in our key markets, I'll cover the financial highlights and then we'll be happy to take your questions. John?

Thanks, Dick, and good day, everyone. Thanks for joining us. Here in California, economic activity looks and feels pretty much like it did three months ago. Employment is stalled with total non-farm jobs in the state down about 50 thousand from a year ago. Regional and statewide unemployment figures have improved slightly in recent months, but they remain above the historic low points achieved two years ago. Private employers continued to pursue a wait and see attitude about new hiring and state government spending is limited by a large budget deficit. Overall, we have yet to see the spark that will re-ignite our economy. Southern California continues to lead the state in economic health we measure by job creation. San Diego and Orange Counties continue to report among the lowest unemployment rates in California and, more broadly, the five county region is currently the only substantial source of new jobs in the state.

Although Southern California remains one of the world's largest and most vibrant economies, generally speaking, we are simply treading water right now. Our commercial real estate markets reflect this. While individual industries such as biotech, entertainment and defense are producing some modest leasing success stories, the overall mood of the markets is passive and non-committal.

There's increased tenant consolidation and cost cutting, as well as declining tenant credit quality that is still being affected by the recession. San Diego remains our strongest market, but stabilized occupancy there has dropped six points in the quarter, almost entirely due to Peregrin's bankruptcy reorganization. Occupancy in our Los Angeles office properties improved two percentage points in the quarter, largely due to recent leasing activity on the West Side. But the overall market remains a challenge. Our Orange County properties, mostly industrial, continue to perform well. The overall performance of our state-wise portfolio last quarter reflected these trends. Occupancy decreased to 93.1 percent at the end of the quarter, rental revenues were off slightly in the quarter and are flat year-to-date.

In development, we completed in state-wise an 89,000 square foot office property in Del Mar last quarter that is one hundred percent leased for 10 years to a regional law firm. Going forward, our committed development pipeline now encompasses just over 600,000 square feet in properties which is currently 53 percent leased.

Now let me give you an update on the situation with our two largest tenants, Boeing and Peregrine. First, let me review the status of our discussions with Boeing on leases at our properties in Seattle, El Segundo and Long Beach. As we've noted in past calls, the Boeing Company has been reviewing its entire lease position in the Western United States over the past several months. Various divisions of Boeing currently occupy just under 1.1 million square feet of space in KRC properties located in Seattle, El Segundo, Long Beach and Anaheim. These properties and their associated leases are detailed in our supplemental package. Beginning with Seattle, we are still in negotiations with Boeing for the 211,000 square feet that expires at the end of the year. We expect to have news on that space shortly. In El Segundo, Boeing has decided to vacate our office property at 909 North Sepulveda Boulevard when the existing lease expires in February 2003. Boeing currently occupies the entire 248,000 square foot building. As we have always planned upon Boeing's vacancy, we will be taking this property out of service and fully renovating the building.

Boeing has also told us that it will vacate 51,000 square feet its Military Transport Aircraft Group occupies in our Long Beach project when the lease expires in January. We understand that Boeing will be consolidating some of its people from these El Segundo and Long Beach projects into existing Boeing space in the area and laying off others.

Now let's move to the situation in San Diego. Earlier this year, held leases on five KRC buildings totaling 540,000 square feet in what was then known as . Since then, has rejected the leases on three of those buildings totaling 297,000 square feet.

As we announced in September, one of those buildings has now been leased to the , a global distributor of specialty semiconductors and it plans the 115,000 square foot as its corporate headquarters, consolidating staff from several San Diego and United Kingdom locations. The lease term is for 10 years and calls for to occupy four floors of the building by March 2003, taking occupancy of the remaining floor on or before March 2005. The rental rate of the lease is about four percent less than the rate on the lease.

The remaining two unleased buildings in the Center together total about 182,000 square feet and are actively being marketed. Both buildings were designed as multi-tenant properties, and we are seeing a significant number of inquires from a variety of potential replacement tenants. The two buildings still leased by total about 242,000 square feet or about 45 percent of the total space. One of those buildings is currently 58 percent subleased to a variety of prominent law firms, amongst others.

Now let's take a more detailed look at our markets. San Diego real estate markets continue to benefit from strict development constraints, an attractive concentration of highly educated scientists and engineers, and a relatively healthy regional economy. in biotech life science industries are the greatest source of demand here today.

For example, we executed another lease with TRW in Rancho Bernardo related to its defense business, and we are actively working on several biotech transactions for both new product and redevelopment opportunities where we have the opportunity to significantly increase rental rates and returns.

Looking at specific sub-markets, Sorrento Mesa currently has a direct vacancy rate of seven percent and a total vacancy of about 16 percent in the two-story product type which continues to attract life science tenants. Our properties there are all fully leased. We have virtually no rollover in this market next year.

Del Mar, which remains one of the most popular markets in coastal San Diego, has seen its direct vacancy rate increase to 13 percent and total vacancy rise to about 25 percent. This is largely due to consolidation, but a fair amount of subleased space has come onto the market in Del Mar over the last few quarters, as well.

Moving eastward to Rancho Bernardo area, the two-story market there has a seven percent direct vacancy and an eight percent total vacancy. Last quarter we signed a five-year lease with TRW to take the remainder of available space in our most recently completed property there, Innovation Corporate Center. We are now 100 percent leased in this sub-market.

In Orange County, our industrial properties remain almost fully occupied with an overall occupancy rate of 98 percent.

Moving further north, market conditions in the Kilroy Airport Center Long Beach remain soft, although we have recently seen some pickup in interest from a few medium-sized tenants in the area. Our project there encompasses seven buildings with approximately one million square feet. They are currently 85 percent leased, down from 95 percent at year-end 2001. The direct vacancy of 12% at a total vacancy of about 14%. Our El Segundo has probably been the most challenging market we have faced over the last few quarters. We are seeing a few transactions in the market currently. Tenant demand has been significantly near the events following 9/11, in the uncertainties in the economy in general. The direct vacancy rate is 17%, and total vacancy is approximately 25%. Moving to West LA, we continue to see interests in our website media center project, but the market remains challenging. The good news is the entertainment industry is showing more life than we've seen in recent quarters. Overall the West LA market has a direct vacancy rate of 17%, and a total vacancy of 21%. Year-to-date, we have now leased and signed in the West LA market for about 140,000 square feet, the majority of which is in our 380,000 square foot West Side Video Center. In terms of West Side Video Center's leasing space, the space is 80,000 square feet, and 100% leased to AT&T. Phase two is 150,000 square feet, and now 43% leased, and a just completed phase three is also 150,000 square feet, and is 23% leased. Closing out our market review, all of KRC's recently developed buildings in Calabasas, located along the north - excuse me, Interstate 101 corridor, are now completed, stabilized and substantially occupied. That is an update on our key markets. Now all in all, it has been a tough year so far for commercial real estate in Southern California, and frankly, we don't expect the environment to prove - improve much in the near term. But we have had some important successes in our leasing program, and we continue to market our properties aggressively. As we have stated in prior quarters, we are extremely cautious when pursuing new development. More proudly we remain confident in the overall strength of our stabilized portfolio at KRC, our properties are among the highest quality in their respective locations. We have diversified across many of southern California's strongest submarkets, and we have stayed away from second and third share markets and lower quality that are currently feeling the most pain. In KRC's experience and track record remains a magnet for regions and less attractive tenants. Short-term, we had a financial strength in management expertise to navigate through the challenges ahead. Long-term, we remain as committed as ever to executing our business plan, but the central goal of creating lasting value for our shareholders. Now Dick will cover the financial results, then we will take questions.

Thanks John. per share was $0.72 in the third quarter, up from $0.67 in the third quarter of 2001. Although they were both up - they were up last year, our third quarter results were adversely affected by both the softer economy and the bankruptcy. Reflecting the economy, our occupancy rates have fallen as the market has softened during the year. We began the year with 95.8% occupancy in our stabilized portfolio. At the end of the third quarter, our stabilized occupancy rate was 93.1%, which breaks down to 96.2% in industrial, and 91% in our office portfolio. On a cash basis, same store NOY was down 1% for the quarter, and up 2.8% for the year. On a GAAP basis, same store NOY was down 3% in the third quarter, and flat year-to-date. For the year, we expect same store NOY on a GAAP basis to be down 1%, reflecting the bankruptcy and reorganization. If had paid its rent as originally contracted, our same store NOY for the year would have been up by about 1% on a GAAP basis. We are nearly complete on leasing activity for leases that roll over this year. Looking forward, we have a million and a half square feet that will turn over next year. The Boeing leases in Seattle, El Segundo, and Long Beach that John discusses earlier, make up about 1 - about a third of our expirations next year, and another third is in our Orange county industrial portfolio, and the remainder is spread throughout our overall portfolio.

We have about a quarter of our 2003 rollovers under active negotiation, about half of that is the Boeing space in Seattle and the other half is spread throughout the portfolio.

The sublease space in our portfolio has remained essentially unchanged over the last quarter. About seven percent of our portfolio is available for sublease, of that about five percent is vacant space and the other two percent is occupied. Almost none of the sublease space is in Los Angeles, about half is in three Orange County industrial buildings, with the remainder in smaller spaces in Orange County and San Diego. The average remaining term on the three subleased Orange County buildings is 10 years, and the remaining term for all the sublease space is seven years.

In other portfolio news, we sold a small office building in San Diego last quarter, reporting a gain of $470,000. And we acquired 107,000 square foot industrial park, it's in Orange County - that is adjacent to an existing renovation project that we have underway.

We completed one new development project with an investment of 24 million in the third quarter. That building is located in Del Mar and is fully leased. Our committed development pipeline includes four projects for a total investment of $199 million, of which $133 million has been spent to date. The pipeline is currently 53 percent leased.

Turning to our balance sheet, we completed the $23 million mortgage loan last quarter. That reflects our strategy to extend maturities periodically when rates are advantageous. We also have $150 million swap expiration coming due next month. We're evaluating our hedging and timing options on that and we expect to continue to adhere to our policy that roughly 80 percent or so of our debt will generally fixed, capped or swapped.

Now let me finish with an update on earnings guidance. Our year-to-date FFO was 89 cents in the first quarter, 73 cents in the second, and 72 cents in the third quarter. That adds up to 2.34 a share or 2.33 after rounding. For the fourth quarter our guidance is a range of 71 to 73 cents a share, for the year that translates to annual guidance of 3.04 to 3.06 per share. That's essentially right in the middle of last quarter's guidance of $3.00 to $3.09 a share for 2002.

Given the - given the tight economy, it's obviously somewhat difficult to project perspective financial results. Having said that, our guidance for next year is a range of 2.75 to $3.00 a share. That compares with current consensus estimates of 2.93 a share for 2003.

Our assumptions for the higher end of the range for 2003 of $3.00 a share include average expense - average occupancy of 93 percent, flat interest rates, slightly lower rents, and essentially flat expenses. The lower end of the range of 2.75 a share assumes that average occupancy would fall three percent from our current rate to 90 percent, a one-percent increase in interest rates, and slightly lower property and other expenses that would result from lower occupancy.

Since we have two property sites, let me amplify a little bit on the occupancy assumptions implicit in our guidance. At the top of our 2003 range of $3.00 a share our overall occupancy assumption of 93 percent - consistent with our current occupancy rates - is 96 percent in industrial and 91 percent in office.

At the bottom of our 2003 range of 2.75 a share our overall occupancy assumption of 90 percent is consistent with occupancy rates three percent lower across the board or roughly 93 percent in industrial and 88 percent in office. This is obviously a difficult market and our guidance doesn't assume any improvement in the economic environment next year. So we're completely focused on our marketing, leasing and operating efforts as we've managed through the cycle.

That's the latest news from here and with that, Operator, we'd like to open up the call for questions.

Thank you.

Ladies and gentlemen, if you'd like to register a question for today's question-and-answer session, you will need to press the one, followed by the four, on your telephone. You will hear a three-tone prompt to acknowledge your request. If your question has been answered and you would like to withdraw your registration, you may do so by pressing the one, followed by the three.

If you are using a speakerphone, please lift up your handset before entering your request.

One moment, please, for the first question.

The first question comes from Lou Taylor from Deutsche Bank. Please go ahead with your question.

Thanks.

John, can you talk a little bit about the Boeing lease that expires in '04, and where those discussions stand, and when you think Boeing will make a decision on that space?

Well, we're in negotiations with Boeing all the time. As we've been saying, we're in negotiations with them in Seattle, and we think we're getting close. But until -- and particularly in this market -- until we have a definite deal, we're obviously are not going to announce one. In El Segundo, they are moving out, as we said, of the 248,000 foot building at 909 Sepulveda. We'll get that building back in February. And in the leases that expire in at Kilroy Airport Center -- we're in negotiation with them currently with regards to some extensions. But again, it's too early to say whether those are going to be completed or not at this time.

But, how about in terms of the process within Boeing? What is your sense of when they will make a decision on the '04 expirations?

I can't -- as I say, we're in negotiation on some of that right now. But, Lou, I hope you can appreciate -- I'm not gonna speculate on when somebody's gonna make a decision. We're working in earnest with them, but I'm not gonna make a prediction.

OK. Thank you.

The next question comes from the line of Lee Schalop of Banc of America Securities. Please go ahead with your question.

Thanks very much. Hey, everyone.

Can you talk about how the projects and have been accounted for in terms of projecting guidance for '03? I mean, specifically when you start expensing things, and what you've assumed as far as expensing those projects relative to the existing .

Well, there's the two projects that you are referring to that are not leased in our at 909 Sepulveda and . And those projects will either in the middle of next year, but we stopped capitalizing, I think, in June or July for those properties.

And so, in giving us '03 guidance, have you assumed that they get leased, or that they don't get leased and that you get fully hit with the expenses related to those?

In the top end of our guidance, we assume it's leased up throughout the year, and in the lower end of our guidance we assume that the buildings are not fully leased by the end of the year. But, we don't just say it's at one point. It's a process throughout the year on the top end, and a slower phased process on the bottom end.

At the bottom end of the guidance we assume very little, very little rent received next year -- almost none.

So, I guess -- I'm putting it differently -- if it turns out that these projects don't get leased at all, you can still meet the bottom end of your guidance for '03?

Yes.

OK. Thanks.

The next question comes from the line of Rahul Bhattacharjee from Merrill Lynch. Please go ahead with your question.

On the Boeing lease in Seattle -- does Boeing have a renewal option, and what are the terms of the renewal option? You know, we reported earlier that as a matter of what we understand to be Boeing policy that they terminated those leases where they had a termination option. And I believe it was at the end of -- correct me, guys -- was it the end of 2001?

No, it was at the end of 2001, they had a one-time right at that specific moment in time to earlier terminate the lease effective the end of this year, and they exercised that right. Over the course of the last few months, , they've been negotiating a new lease for that space.

So any sense as to where market rents are to be for that kind of space seems to be the ?

I think it's going to be pretty flat.

And then second, John, can you just walk through what market rents has done in L.A. and--in your major sub-markets in L.A. and San Diego?

OK. Well, the--I would say it this way, . There's clearly pressure on rents and that's a function of the demand. It's different in different markets, of course. We're just not seeing enough data, in my mind, to project a definite trend. We are seeing, in some cases in San Diego, rents going up, in some cases--a case in point would be the new transaction with where that is with one of the Peregrine buildings where it was just slightly below par and, in some cases, we're seeing rentals go down a little bit. I don't feel comfortable predicting a trend because I don't believe there's enough data right now to really get a good prediction. It is clear, though, that those buildings that are not in the top-tier locations and those buildings that are not top-tier buildings are definitely, as Dick pointed out, suffering more pain than the high-quality assets. I hate to be trite, but the old location, location, location, and add to that high-quality, in my mind, has always served this industry well. We are seeing some B tenants move up to A space and the activity we're seeing here on the West Side is an example, I think is because we have the best building in the market. But the rentals aren't where we forecasted them to be when we first proceeded with the development, but they're fairly close to what we predicted them to be in our 2002 business plan.

Alright. And then just finally, as a point of clarification, in terms of all the occupancy numbers you provided, those account for the West Side Media Center Phase II as being an operating asset, right?

Yes.

Yes.

OK. Thank you.

The next question comes from the line of David from FBR. Please go ahead with your question.

Just a follow-up on question. I don't want to beat a dead horse, but as you talked to Boeing about El Segundo, have you gotten any indication of where they're going to take the people from 909? Are they moving them into other buildings in Airport Center, are they looking at some kind of long-term solution for all of those people in the Satellite Systems Division? Could you give us anymore color on what you think their thoughts are longer term?

Well, you know, we read the same articles, I think, everybody reads with regard to Boeing and they clearly have not, as I understand it, seen the demand they had originally forecasted in their Satellite business and, as a result, they have down-sized within that market. They are, from what we can tell, likely to densify further some of the buildings that they lease from us at Airport Center and I say that based upon what I understand to be their need for additional parking that we can provide. I know that--I've been told that some of the people that were in the 909 building as well as some of the other buildings in the area have let go. They've been pink slipped. So they, of course, are going through their adjustments related to their commercial aircraft as well as some of their other activities.

The good news down in Long Beach is some of the space that they're getting out of, we've got some tenants that want that space. Too early to tell whether we'll consummate transactions there, but we are seeing, you know, some different types of tenants come into some of these markets.

I guess what I'm trying to get a feel for is just any way to handicap what you think they're thinking about for '04. I guess of particular concern is 2260 East Imperial, where the rents are obviously very high. And I guess that's one-half of your ...

Well, that is ...

Are you finished, ? Sorry. I didn't mean to interrupt you.

That's OK.

That is their headquarters for their Satellite Group, and it is - that project is very near to their satellite manufacturing facility. So we've always viewed that as a very strategic asset for them. And typically over the years when there were other downturns, when Hughes owned the satellite group that they sold to Boeing, that was always considered to be one of their very strategic assets because of all of the locational features and some of the other features that that asset has.

But I can't help you with handicapping it beyond that because I'm not inside Boeing's head other than as a landlord, and we're in constant negotiation and contact with them, you know, always.

OK, thanks.

You're welcome.

Ladies and gentlemen, if there are any additional questions, you will need to press the one, followed by the four at this time.

The next question comes from from Insurance Company of the West. Please go ahead with your question.

Hi. I was wondering if you could comment on any credit issues. You know, I'm just wondering in the context of letters of credits or concerns about companies that, you know, may file. You know, have you - have you done a thorough financial analysis of, you know, your bigger tenants that might run into trouble in the coming months?

Yes, , this is Dick Moran. We have a credit watch list that we look at every month or more regularly in difficult times. And we go through our reserves in a very - in very complete detail of all of our people every month. And I think we would like to say that there's no credit deterioration and there's none projected further. I don't - I just don't think we can say either. The - obviously the quality of the credits is just a function of the economy, and the economy has shown weakness.

Having said all of that, we're very fully reserved and feel very confident in our position there, and we don't see - on our watch list right now, we actually don't see anybody in - of any significance at all in imminent danger. We watching and waiting carefully obviously. But the big event for us in the credit story this year obviously in tenant credit story was the bankruptcy and that was an issue of irregularities and it was unfortunately entirely unforeseen.

But beyond that, I don't think we - we don't have anything significant on our radar screen at all. We have the normal sort of recession credit issues at this point in the cycle that we would expect. And we're, I think, quite conservatively reserved on that and as we should be at this point in the cycle.

OK, thank you.

Ladies and gentlemen, if there are any additional questions, you will need to press the '1' followed by the '4' at this time.

I am showing no further questions at this time. Please continue with your presentation and any closing remarks that you may have.

Well, thank you all very much for your interest in KRC. I know it is a busy day for every one, and with that, thank you again. Good day.

Ladies and gentlemen, that does conclude your conference call for today. You may all disconnect, and thank you for participating.