Kilroy Realty Corp (KRC) 2003 Q3 法說會逐字稿

Good afternoon, welcome ladies and gentlemen, to the Kilroy Realty third quarter conference call. I would like to inform you that all participants are on a listen only mode. I will now turn the conference call over to Mr. Richard Moran Jr., please go ahead, sir.

Thank you, good morning, everyone. Thanks for joining us, I'm Dick Moran. With me are John Kilroy, Jeff Hawken, our COO, Tyler Rose our treasurer and Ann Marie Whitney our controller. Some of the information we will discuss is forward looking in nature. Please refer to our package regarding the forward looking information in this call and the supplemental. This call is being web cast live on our web site and will be available for replay both by phone and over the Internet.

Our press release and supplemental package have been filed on the form 8K with the SEC and are also both available on the web site. We released our roots yesterday afternoon. It was $1.17 a share including 48 cents from the per grin settlement, 9 cents ahead of consensus. I'll talk about the results more. John will start with an overview of the quarter and key conditions in our markets. Then we'll cover the financial highlights and we'll take your conference.

Thanks for joining us. A lot has happened in California since our last call. Most notably the election of Arnold Schwarzenegger as the state's new Governor. It's hard to predict what this will mean for the state, but in general, it is a move in the right direction. The most recent employment numbers for the state are mixed. Payroll jobs in California fell by 16,000 in September while the unemployment rate improved to 6.4% from a revived 6.7% the month before. Other state data is more in line with the improving national picture.

Retail sales are growing. Tax revenue is run ago head of expectations. New business incorporations recently hit record highs. Exports are he are covering and home building remains strong. Perhaps now that wife bit more political clarity in California, we'll begin to see more economic clarity as well. Meanwhile Southern California's commercial real estate markets are performing better than they were just three months ago. San Diego continues to be the strongest office market in the region, and we see increased although still somewhat sluggish activity in the weaker Los Angeles markets. In San Diego, 2003 job growth projections have increased 50% from earlier forecasts and the unemployment rate has fallen from 4.6% in the first quarter to 4.1% in the third quarter. In the life science sector, there are improved fundamentals and an increased availability of funding. All of this has led to demand for real estate being up in every submarket and every product type. Based on CV report, there is currently 6.1 million square feet of demand in central and coastal San Diego, up from 5.5 million square feet at the end of the second quarter and up from 4.2 million square feet one year ago. This includes demand for office, R&D, and life science space.

This is clearly demonstrated in our success at repositioning the former peregrine and Prowbeck campuses. Total approximately 700,000 square feet and given where we were at the beginning of the year, we have made tremendous progress. As of last quarter, we have repositioned 77% of the space to a diverse growth of tenants. Since that time, we've been able to lease or sign LOI’s on additional space to raise that number to 89% at rents superior to those we were receiving from peregrine and Prowbeck. Our success in the second quarter has come as a result of several transactions, the largest of which is a 112,000 square foot letter of intent we signed way health care company for a 17-year lease term for all of the five story building at Kilroy center Delmar. Subject to lease execution, this will occupy the first two floors in July of 2004, the third floor in January 2005. after existing -- and the remaining two floors with the existing tenants lease expires in November 2005, subject to their two one-year extension options. With this letter of intent, the building, 540,000 square foot center Del mar previously known as the peregrine campus is now 93% committed.

During the quarter we also completed construction in Del mar of our 200 thousand building for AMF healthcare. These transactions reflect increased near term demand and in the long-term planning bite healthcare, medical and life science sectors in northern San Diego county. It also demonstrates that we continue to outperform the market in terms of both absorption and rental rates. In addition to our progress in Del mar, we have also seen a pickup in activity in other parts of San Diego and with demand increasing for to be developed pre-leased office, life science and medical buildings. We are in negotiate with numerous prospective tenants for the development of several hundred thousand square feet on land we own.

While we have nothing to report yet, activity is at a level we haven't seen since the peak at 2000. We hope it will translate into executed deals in the near future. In other development news, we move four properties totaling 404,000 square feet to our stabilized important foal yore your during the third quarter. These four properties are currently 69% committed. Our remaining committed pipeline consists of one development project and two redevelopment projects to three totaling about $525,000 square feet. They include one project in Delmar, one life science conversion in San Diego, and an office redevelopment at 909 Sepul Veda in El Segundo the new properties are currently 33% committed.

Now, let's take a more detailed look at our markets. As I've mentioned, KRC's four submarkets in coastal San Diego are all experiencing an increase in tenant demand. In both the ranch at Bernardo and La Jolla UTC submarkets we compete in the two story product type -- our properties are currently 100% occupied, market wide Rancho Bernardo has an 11% direct vacancy rate. And a 13% total vacancy rate. UDC has a 9% vacancy rate and a 19% total vacancy rate. While rental rates are flat in both of these markets, demand is up in a variety of industries, including software, financial services, defense, medical, life science and electronics.

The Reno Mesa has the highest vacancy rate in San Diego, although all of our properties there remain fully occupied.. The two story product type that we compete in has a direct vacancy rate of 14% and a total vacancy of 23%. Demand is coming from the medical device, wireless, life science and defense industries. Our fourth San Diego submarket is Del mar which we have already touched on. Direct vacancy is currently 7% and total vacancy is totally 13%, and these levels will be decreasing as our new leases take effect. Rents in our buildings are up more than 29% versus the rents we were receiving from ProBeck and peregrine based on our last transactions. Moving north from San Diego, Orange County industrial properties remain 96% occupied. We had a small redeveloped office property in the region to our stabilized portfolio last quarter. It is currently 41% committed. And Long Beach our 7 building Kilroy airport center is 84% occupied although we have recently executed LOI’s that will bring our occupancy further to 87% as a result of several tenants expansions. There is a direct vacancy of 9% and total vacancy of about 13%.

Continuing north the city of El Segundo remains our biggest leasing challenge although we are beginning to see signs of improvement. Activity has increased over the last few months and we are aware of new fairly immediate space requirements for amounts of space. Last week we executed an LOI for about 25% of our 999 SEPULVEDA building for a credit term of 7 years. Our statistics reflect weakness in the class A market of 20% and total vacancy of 25%. In west LA, leasing activity remains somewhat sluggish although we see a stream of interest in our west side project.

The 380,000 square foot center is now 63% leased and 68% committed with LOI’s. Overall the west LA market has a vacancy rate of 15% and a total vacancy rate of approximately 18%. To summarize, in most of our markets, we're beginning to see decision-makers starting to move forward and make new space commitments. This is particularly apparent in San Diego and seems to be more and more the case in the Los Angeles markets. That's an update on our key market. Now Dick will cover the financial results.

Thanks, John. Let me start by calling your attention to a presentation change we've made in our income statement. We've broken out our provision bad debts on its own line item. Previously we had offset the bad debt provision against revenue. The change is merely in presentation and has no effect on the bottom line. The effect on our results is to increase revenues and the new bad debt expense line items by the same amount which in the third quarter was $2.8 million. FFO per share was $1.17 in the third quarter up from 72 cent in the third of last year. We have received $18.3 million of the $21.3 million peregrine settlement that we announced in July. $15.4 million or 48 cents per share of the peregrine settlement was included in -- so excluding the payment it was 69 cents.

To recap the impact of the peregrine settlement we received $18.3 million or 66 -- net of legal costs in the second quarter. Of that $2.5 million or 8 cents a share was recognized in the second quarter in the form of a reverse Sal of receivable and other reserves that by we took in 2002 when peregrine first informed us on its intent to default on its leases. And the remaining $15.4 million or 48 cents a share was recognized in the third quarter as a lease termination fee.

Beyond this year, as far as the peregrine settlement we're scheduled to receive $3 million and four annual payments of approximately $750,000 each over the next four years. From an accounting perspective on our income statement we reported the net present value of the $3 million in future payments or $2.6 million as a lease termination fee in the third quarter and then fully reserved the same amount in the provision for bad debts. We expect to reverse the reserves as we receive those payments.

The effect will be to recognize the future payments in earnings when they are actually received. That's another way of saying that even though we reported those future payments from peregrine as a lease termination fee in the third quarter, that didn't have any net effect on earnings, since we also reported an offsetting reserve. The actual peregrine payment we received in the third quarter was $18.3 million, which was a penny a share of what we originally expected. Beyond the peregrine situation, third quarter earnings were positively affected by a couple other items that they are mentioning.

First, we received 2 cents a share more than expected from peregrine at holdover rent on states that's been vacated. In addition we had a penny a share from a lease termination fair unrelated to the peregrine situation. And beyond the peregrine situation that I just mentioned we had lower bad debt expense. In the third quarter we didn't have any bad debt expense in our current tenant receivables and had a lower provision for deferred rent receivables given an overall improvement in our collection experience.

This increased earnings of 3 cents a share compared with the first two quarters of the year. We hope that's an indicator of an improvement in the economy. Those four items added up to 7 cents a share in the third quarter. Occupancy in our stabilized portfolio declined to 89.8% at the end of the third quarter. The drop in occupancy from 91% last quarter was largely a result of stabilizing four development and redevelopment projects that collectively were 47% occupied on September 30. We also had one tenant bankruptcy in 109,000 foot Orange County industrial building. This was offset partially by the commencement of the fair Isaac occupancy in Del Mar. Our same store economic occupancy excluding the peregrine was actually up from 92% in the third quarter of last year to 92.5% in the third quarter this year. That resulted in same store rental revenues increasing by 1.6%.

We see this as a positive trend going forward. Our current overall occupancy breaks down to 94.4% in industrial, 86.8% in office, that's a reasonably accurate reflection of the comparative strength of the two markets today. Third quarter story NOI was up 56% on a cash basis and 51% on the GAAP basis, largely as a result of the peregrine settlement. Excluding that, story NOI on a gap basis was up 4.5% primarily from slightly higher rental revenues and lower bad debt expense offset partially by higher repair and maintenance cost. Turning to lease expirations we have 181,000 square per feet of space for less than 2% of our portfolio that will rollover in the remainder of 2003. We've renewed or released a third of that space and are working on the remainder. In terms of 2004 expirations we have 1.1 million square feet rolling and we've completed 19% that have to date. The Boeing lease in el SEGUNDO and 15 leases totaling over more than 440,000 square feet in our Orange County portfolio make up about two-thirds of our total expirations next year.

Given all of the leasing we've done this year, particularly in San Diego, our tenant improvement and leasing coughs were up substantially in the third quarter to a total of $8.8 million. We expect that this to moderate some in the fourth quarter and to be in the $3 to $4 million range. Our committed ext development pipeline now includes one office project and two redevelopment projects. The office project is a 209,000 square foot six-story building in Del mar that is 84% leased to healthcare that represents a total investment of $62 million of which $15.8 million has been spent to date. The only available space left in this building is the top floor which makes up 16% of the building.

Our two remaining projects are a life science conversion and the rehab of 909 Sepul Veda in el Segundo. We expect to spend about $36 million in redeveloping the two projects with about $6 million spent to date. Turning to the balance sheet we sold $40 million of perpetual preferred stock in October at a coupon of 7.08%. The offering will close on November 21st and the proceeds will be used to redeem at $35 million 9 and 3/8 issuance of perpetual -- will be callable in November. As a result of the redemption we will have a non-cash charge of 3 cents a share in the fourth quarter from the write-off of the issue Wednesday cost of the preferred being redeemed. Let me finish with an update on earnings guidance. Our 2003 FFO guidance last quarter was 3.25 to 3.35 a share, including our third quarter results our year to date FFO per share is $2.79. Our fourth quarter results will be lower than the third quarter excluding peregrine payment the full impact of -- from the stabilized portfolio and the three-cent charge from the reduction of the preferred units that I mentioned. This adds up to a range of 60 to 62 cents in the fourth quarter which translates to a range of 3.39 to 3.41 for the year or 4 to 6 cents above the high end of last quarter's guidance.

In terms of 2004 guidance, we're in the midst of our annual detail bottoms up budgeting process, balancing the more positive readings we're getting from the markets with the uncertainties still out there, we feel covering comfortable providing 2004 FFO guidance in the 260 to 280 range today. Let me close with a comment on fire conditions here. As has been well reported there are a number of serious fires across Southern California. They are concentrated in the rural and less developed residential areas. We haven't suffered any damage from the fires, nor are any of our buildings currently imperiled. All of our buildings and projects have been open without interruption.

Fortunately, weather conditions seem to be improving as they are forecasted through the balance of the week with winds scheduled to die down some and the temperatures scheduled to moderate so we're all very hopeful in our thoughts and prayers are with those affected adversely by the fire. That's the latest news from here, operator. With that, we would like to open up the call for questions.

The question-and-answer session will begin at this time. If you are using a speaker phone pick up the hand set before pressing numbers. Should you have a question press star 1 on your push button telephone. If you wish to withdraw that question, please press star 2. Your questions will be taken in the order they are received. Please stand by for your first question. Our first question comes from Dan Oppenheim from of Banc of America Securities. Please state your question.

This is Dan and Lee Schalop here as well. Just wanted to ask you a question, big picture question on development. You've talked about how the environment is improving in terms of demand for the occupancy levels still aren't that high. How is it that you are looking at potential starts going forward and when do you think you would potentially get more aggressive on that?

Hi, Dan, John Kilroy. First, let me put this in perspective. The -- while we're seeing a significant increase in activity in that area, there have not been a lot of deals signed in the marketplace yet. We happen to be well positioned because of our land holdings. It's coming from a rather broad base group of people, people in the finance area, people in life science, medical offices, et cetera. We don't intend to start anything on a bill for inventory or speculative basis. We would only do it with substantial pre-leasing. As I mentioned in my remarks, we haven't signed a transaction yet. We have a number in negotiation. So what's going trigger that is substantial pre-leasing with the appropriate kind of credit quality.

It takes anywhere from 12 to 24 months to bring a building on stream depending on its complexity and size. So that sort of gigs you a feel. If we start landing some of this stuff in the next quarter, the next couple of quarters in '05.

Okay. Thanks. And I have another question.

Could you bring us up to date what's happening with Boeing? That's obviously a big space that comes up next July and what you expect will happen there?

Well, Lee, we've got a very active negotiation going on with that firm regarding that 290,000 square feet in El SEGUNDO. We have nothing to report. We will make the appropriate announcement as appropriate. But that's where we stand. It has the attention of the senior management here and the attention of their folks there.

Just understanding that you are in the middle of negotiations, can you give us some perspective on what the range of possibilities are? And could we see rent up? Down? Likely to be in the same range and how you handicap it?

I'm really reluctant to get into comments there and it might influence our negotiations.

Okay, I hear you. Thanks.

Thank you, our next question comes from Jay Luc of RBC Capital Markets.

David Copp here with Jay. A question with regard to your guidance for '04. Can you tell us what you are assuming in terms of occupancy when you take into account that developments will be added to your portfolio?

Okay pansies see assumption for 2004, when you take into account your developments that you'll we adding or over the course of the year.

In the middle of the range we're expecting occupancy to be in the 93%, 94% average for the year.

Okay. Could you talk a bit about the Orange County industrial market? You mentioned that was a pretty suck substantial portion of your rollover in '04.

The market is -- this is John Kilroy again. The industrial market in orange county generally speaking, particularly the markets that we're in, I would consider the demand to be characterized as fairly strong. Jeff, do you want to --

Yeah, of the 15 leases scheduled to expire next year, we're basically about 40% through that, and about another 40% in active discussions.

Okay. Fair enough. And then could you refresh my memory on when your series D preferred issuance is callable?

D is callable next November.

Next November, okay, great. Thank you.

Our next question comes from Lou Taylor of Deutsch bank. Please state your question.

As a follow-up to Lee's question on Boeing, John, can you maybe give us a sense for your discussions with regards to lease duration? If Boeing were to stay, does it appear that it would stay for a long time or go with the previous lease and something shorter?

Well, last lease we had on that building was 20 years, Lou, and we're not expecting anything in that range for sure. Their policy as a company appears to be relatively short leases that have significant number of options and I think it's a policy from what we've been told that they have with their various operating groups. So I think that's the kind of lease we'll see if we get there.

Dick, can you just comment on the G&A ramp for the quarter? What were some of the drivers there?

Sure, I think if you look at the quarter, and you take -- GNA in fourth quarter of the same -- at the same level roughly, I think that it would bring our GNA to a little over $17 million for the year which would be $4.3 or so million a quarter. Last year our GNA was 1$2.5 million or roughly $3.1 million a quarter. So the increase over the year is likely to be in the $1.2 million or $1.3 million a quarter range. About -- if I recall correctly, roughly three quarters of that is attribute tobacco and higher compensation costs and roughly a quarter of it is attributable to higher public company reporting and compliance costs. The reporting and compliance costs is the story that everybody has. The balance of the higher incentive costs are if you look at our reported results this year, the metrics that are incentive compensation is measured on are primarily reported earnings, leasing velocity, and a new provision in this year's plan was an absolute shareholder returns.

It just happens that all of those metrics we have been sort of at the extreme top end of any range, and so that's what's driven the costs up this year.

Okay. Can you talk a little bit about the CAPEX for the quarter and what some of the drivers were in terms of bringing that number up?

Well, the CAPEX was mainly related to a lot of leasing that's been done in San Diego. So it's the leasing commissions associated with the leases that we've done down in peregrine project.

Okay. Is that number on dollars spent or on, you know, dollars committed to a lease?

The number that you are looking at is dollars committed.

Dollars committed, okay. Okay. In one of the schedules you converted an office building to a life science building at the request of a tenant around $7 million. I guess how did you structure the return on that? Was that an increase in base rent? Was it just kind of an amortization of the TI costs over the lease? Is that really in your revenue number? You know, how was that kind of reimbursement flown through your numbers?

Well, I think that was a new tenant to the building, so it wasn't a change in the lease. But we structured that typically with, you know, the rent that you need to receive to make those transactions economic is higher, you don't necessarily have separate TI amortization build into the lease. I don't remember on that transaction.

It's all comfort in the rent.

I believe so.

All right. Fine, thank you.

Our next question comes from Frank Greywitt of McDonald Investments.

I was wondering what the chances are that you would receive in any negotiations you have with ProBeck and the changes you might receive a settlement with them?

Well, we're pursuing that. We have legal action against ProBeck, and we had under one of the -- under both of the leases we had some guarantees and so forth. One of the buildings we immediately re-leased and we did not have damages. The other building, while we've been able to lease it very substantially, we will incur some damages. It remains to be seen whether we're going to collect from either ProBeck or the partners, but we do have a cause of action against them. And the magnitude of that, Jeff is $3.8 million.

Great, thanks.

Plus legal fees.

Our next question comes from David Loeb of Friedman, Billings & Ramsey. Please state your question.

A couple of people have asked mine already but I would like to to elaborate on the CAPEX, the dollars per foot were up dramatically. What was it about those leases that led to that sequential jump from 18.43 a foot per office for -- that was the year to date number.

It's the type of space that we're leasing. We're in the upper end of the quality level in the bro back and peregrine building. The TI’s are 2345R8 naturally higher there. The portfolio is diverse in terms of TI’s and so these are on the upper end of that.

And for John, maybe a little background about EL Segundo. It's 25% vacant or available. Why does Thomas want to build campus el Segundo why do they want to add office?

My understanding of Thomas is that he structured a transaction buying the property from Fed Ex, but he has a free time through the entitlement process litigation related there too. He filed his response to the appeal on the last possible date, and I could have my information wrong, but the information that I've heard is that that's the way he structured his deal, so all of this delay may very well positively impact him in the context that he doesn't have to take the property down earlier. I could be wrong, as I say on that, so, I have no clue in my mind why anybody would want to buy that property today to build new product for which it's zoned, because I don't believe the current rental rates will justify building new construction.

Do you think he's got a tenant or tenants in hand that are looking for new space? Clearly on everybody's mind is Boeing playing with them as they are talking to you?

I can't speak to that. I don't believe that's the case with regard to Boeing, but I don't know. With regard to others, he may have, but the markets talk. It's very difficult to keep a sizable transaction in your back pocket and not have the market know about it for very long. So, I would be surprised but then again, who knows.

I guess final question on that point, given that the market is speaking in another way in terms of the vacancy, in terms of the rent, at what point do you guys stop working to stop them and just let it fizzle out?

Well, you know, we're not spending a lot of money on that at this point. We have spent our money. We do have an appeal, because we believe that the process violated the various state statutes with what we call see qua here and that is to be decided by the appellate court and so we'll see what happens related to that decision when it comes up here presumably either the latter part of this year or early next year.

Final question for Dick, in your guidance, how did you treat the Boeing renewal?

At the bottom end of the range, David, we have assumed no rent beyond the expiration of the existing lease. We just wanted to make sure that the bottom end of the range incorporated the most conservative assumes, which is to say that we would not renew that lease on any terms at all. I'd that's not a forecast of the outcome, we just wanted to have the most conservative assumption built into the bottom end of our range. At the middle and top end of the range we have waited average with different expectations of rental rates.

Okay, thanks.

Our next question comes from Jamey Feldman of Prudential Equity Group. Please state your question.

I was wondering if you could break out the '04 guidance in terms of same store growth or internal growth or external growth?

Those are the kind of things we're still working on. We're still in our bottoms' up budgeting process. More to come on that.

Okay. Does that number assume any acquisitions or dispositions?

It assumes no acquisitions and it assumes $50 million in dispositions in the middle of the year.

Okay. And then one more question on the Boeing space, is it -- is that space in pretty good shape or would there -- if they did in the lease would there be substantial CAPEX?

Well, the space is in good shape. Boeing as an obligation with what we call restoration to bring the space back to a true office building configuration. They have a number of labs and other things they put into the building. I don't anticipate significant CAPEX associated with a renewal with Boeing, and we believe that if they were to move out, that their restoration obligation would be rather substantial and would certainly help offset if not entirely offset, the repositioning of that asset with regard to tenant improvements.

Okay. Thank you.

Ladies and gentlemen, as a reminder, should you have a question, please press star 1 on your push button telephones at this time. Our next question comes from Jim Sullivan of Green Street Advisors. Please state your question.

Thanks. Question on acquisitions. You've been quiet on the acquisition front. You don't have any acquisitions dialed into your '04 guidance. Can you comment on what's happening in terms of the acquisition environment? You talked quite a bit about tenant demand and that becoming stronger and more attractive in a lot of your submarkets. What about on the acquisition front?

Well, Jim, we take a look at most everything that comes up, not only in the markets where we're active as owners or developers, but also in other markets that we have our eyes on. We can't make sense out of a lot of the numbers that folks are paying from the perspective of our investors. A lot of this is very low cap rates, not always high quality buildings, not always in the best markets. We're not going to deviate when from what we consider to be the best markets and the appropriate quality of buildings within those markets. There are certainly those that are looking at positive spreads between debt costs and what they are able to buy the buildings at.

I have not seen anything that tickles our fancy. There is nothing out there that we've looked at that we would consider paying the price for versus the alternatives that we have. In terms of demand, certainly there is an increase in demand, but what we're seeing is in almost every market is folks stepping up. They want the higher quality building. They want to be in the better market. I think that doesn't bode well for some of the properties that may be well leased today but some of those will have roll-down exposure. If they are not in the best market or the best quality buildings, there is a bit of reshuffling of the deck here that I think is going on and will continue to go on for sometime.

Okay. That's helpful. And John, on the peregrine space and the Burbank space, I think you said that the rents that you are getting now are 29% higher than what you got previously. Was that correct?

That's on a transaction that we've done since the last quarter.

Is that gross rent?

On an effective NOI basis.

Effective factoring in the TI’s?

Actually, it's a little bit higher when you factor in the TI’s. The 29% is on a GAAP and cash turned out to be the same number approximately. It was on a GAAP base rate basis.

Old rent to new rent for GAAP rent to gap rent. The number on the effective rent basis is actually higher.

Including the TI’s?

Yes.

Thank you.

Ladies and gentlemen, if there are any further questions at this time, please press star 1 on your push button telephones. Please stand by for any further questions. If there are no further questions, I will now turn the question back to Mr. Moran to conclude.

Thank you all very much for your -- we look forward to talking to you again next quarter.

Thank you, sir. Ladies and gentlemen, this concludes our conference for today. Thank you all photographer participating and have a great day. All participants may now disconnect.