Kilroy Realty Corp (KRC) 2004 Q1 法說會逐字稿

Good afternoon and welcome ladies and gentlemen to the Kilroy Realty first quarter conference call. At this time, I would like to inform you that this conference is being recorded and that all participants are in a listen-only mode. At the request of the Company, we will open the conference up for questions and answers after the presentation.

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

Thank you. Good morning everybody. Thanks for joining us. With me today are John Kilroy, our CEO, Jeff Hawken our COO, Tyler Rose, our Treasurer, and Anne 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 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 8-K with the SEC and are also both available on our web site.

We released our first quarter financial results yesterday afternoon. FFO was 65 cents per share; that included a 2-cent a share impairment charge for an unrealized loss on a property held for sale. I'll cover that in more detail later in the call. John will begin the call with an overview of the quarter and conditions in our key markets. I'll finish with the financial highlights and updated earnings guidance. Then we'll be happy to take your questions. John?

Thanks, Dick. Hello everyone. Thanks for joining us. I would like to cover four topics today on the call. The first is to quickly mention the improvement in California's economic and political climate. The second is to highlight my personal view that Southern California is turning the corner in terms of seeing meaningful job growth. The third is my customary review of KRC's sub-markets, and the fourth is a brief comment on acquisitions.

My first point is that since we last spoke in February, the state made several steps forward in addressing some of its broader economic issues. Our new governor has succeeded in passing reform legislation for California's controversial workers compensation program, and a variety of analysts have suggested it represents significant improvement for the state's business environment. And as most of you know, the governor also gained a clear mandate from the voters in March to pursue his strategies for financing the state's current budget deficit. While there is still a lot to do, real progress is being made and we think this is good for business.

Secondly, we are beginning to see anecdotal evidence, which is also supported by several economic forecasts that many industries in Southern California are starting to meaningfully expand. Year-over-year job creation has been positive but sluggish. However, discussions we've had with several large corporations have indicated that some sectors of the economy will significantly increase their hiring over the next year or so.

Economists are predicting Southern California job growth in the area of 1% or so this year, and over 2% next year. And this is from a base that has outperformed the rest of the state and much the country. San Diego and Orange County already have the lowest unemployment rates in our region, 4.1% and 3.6%, respectively. And this is all translating into an increase in tenant demand for office space.

With leasing being the key focus for us at KRC, we signed over 650,000 square feet of leases and letters of intent so far this year. Perhaps most important, we signed an amendment with Boeing to extend until July 2007 Boeing Satellite System's Headquarters lease of our 286,000 square foot office building within Kilroy Airport Center, El Segundo. This 700,000 square foot complex remains 99% leased. The remainder of our leasing progress was made throughout our portfolio, including West L. A., El Segundo, Long Beach, Orange County and San Diego.

Much of this was related to companies expanding. Taken together, while we ended the quarter 91% occupied, if we add leases that haven't yet commenced we are about 93% leased. Of course, that number could change if there is occupancy erosion from yet-to-be renewed tenants that decide to move out. And we've made progress on our three development and redevelopment properties, moving the committed percentage to 48% from 33% last quarter.

Now, let's briefly walk through KRCs individual markets. San Diego county continues to outperform most other commercial real estate markets in California today, with brokers reporting more than 6.2 million square feet of active demand in the central San Diego sub-markets, where we own our properties and the bulk of our development sites.

In the first quarter, there was positive absorption in our San Diego sub-markets of approximately 260,000 square feet, compared to the fourth quarter of 2003 when 150,000 square feet was absorbed. And vacancy rates have either remained flat, or have declined, in each of our markets compared to last quarter. This is particularly evident in Del Mar where we are seeing positive pressure on rental rates and continued demand from a variety of tenants.

Direct vacancy is currently 8%, and total vacancy is currently 15%. We signed a 33,000 square feet LOI with a new tenant for the sixth floor of our recently completed High Bluff Drive building that is 84% leased to AMN HealthCorp Care. This 209,000 square foot building is now 100% committed. In addition, Fish and Richardson, the law firm, an existing tenant in our three building, 370,000 square foot Del Mar Corporate Center, agreed to take an additional floor in the project to bring its total occupancy to 120,000 square feet. Del Mar Corporate Center is now 94% committed.

While not as robust as Del Mar, [Sereno Mesa] has also seen an increase in demand from last quarter, and our properties there remain 98% occupied. Overall, the two-story product type in Sereno Mesa in which we compete as has a direct vacancy rate of 13%, and a total vacancy of 17%. Total vacancy in Sereno Mesa is down more than 7% from last quarter.

Moving on to the Rancho Bernardo and La Jolla UTC sub-markets where we compete in a similar two-story product type, our properties are currently 100% occupied. Market wide, Rancho Bernardo has an 8% direct vacancy rate, and a 12% total vacancy rate. UTC has a 10% direct vacancy rate and a 20% total vacancy rate.

In summary demand in San Diego's coastal sub-markets continues to grow in both depth and breath, and an area of particular growth is the re-emergence of companies interested in build-to-suit facilities to satisfy the expansion requirements I mentioned earlier.

We are receiving more and more request to submit proposals to build buildings for a variety of tenants, including those in the defense, financial services, healthcare and technology industries; most of these are for development on land we already own. We've also begun to see these types of requests in both Orange County and Los Angeles. Although there's a long lead time to put these transactions together, we expect to capture more than our fair share of these opportunities.

In terms of Orange County, our industrial properties remain 96% occupied and the industrial markets on which we are focused continue to remain strong. During the quarter we signed a lease with Netflix for 39,000 square feet, one our Santa Ana properties that is now 100% leased. This is a property we had renovated last year.

In the Long Beach Airport market, we've seen continued strength and demand. KRC's 1 million square foot, seven building campus is 87% occupied and with signed deals is 91% leased. We were 80% occupied at this time last year. Overall, the Long Beach Airport market has a direct vacancy of 7% and total vacancy of 12%. We are also seeing improvement in El Segundo, where direct vacancy in the Class A market is currently 23% and total vacancy is 27%. These vacancy rates continue to inch down, and leasing interest is picking up. We recently signed an LOI for 45,000 square feet of corporate headquarters space at our 909 [inaudible] Building.

This, coupled with our previously announced leases with [Aeon] and and other smaller tenants at the adjacent 9999 Building, plus significant tenant interest by others, has given us optimism that this market is finally but slowly turning the quarter. In West Los Angeles we saw significant positive absorption in the first quarter of about 1.1 million square feet, which was the highest since the second quarter of 1999 and reversed a negative trend. And vacant sublease space declined from 1.3 million square feet to 800,000 square feet since last quarter.

Overall, the West LA market has a direct vacancy rate of 15% and total vacancy rate of 17%, which is down from 17% and 22%, respectively, one year ago. In this market we recently signed a five-year 39,000 square foot lease to accommodate new tenant's corporate headquarters in the Second Phase of our three building West Side Media Center. As a whole, the 380,000 square feet complex is now 82% committed. This is up from 69% last quarter. Phase I remains 100% leased, Phase II is now 87% leased, and Phase III is 56% leased and 69% committed with LOIs. That's a review of our markets.

Finally, let me make a quick comment regarding acquisitions. In summary, we are remaining patient. We recently pursued a few large acquisition opportunities in Los Angeles and Orange County, but pricing was at a level that we couldn't get comfortable with. For superior office assets and superior locations, we are seeing cap rates below 7% and unleveraged IORs around 9% or so.

While we were very interested in specific real estate on two separate transactions, we passed when pricing reached unattractive levels. Until market conditions appreciably change, we will continue to focus on leasing efforts, operating result,s and positioning ourselves to capitalize on development opportunities as they arise.

Now Dick will cover the financial results. Dick?

Thanks, John. FFO per share was 65 cents in the first quarter, compared with 83 cents in the first quarter of 2003, which included the 13 cent per share lease termination fee from Ericsson. Occupancy in our stabilized portfolio increased to 91% at the end of the first quarter, up from 90% at year end. The good news is that we saw modest occupancy improvements in each of Los Angeles, San Diego and Orange Counties. Our overall occupancy breaks down to 94% in industrial and 89% in office.

First quarter same store NOI was up 7.6% on a GAAP basis, and 9.6% on a cash basis. This was primarily due to an increase in office occupancy and other income, partially offset by a small decrease in industrial occupancy. Other income was about $1 million in the quarter, partially due to the receipt of about $500,000 in settlement proceeds related to a 2001 tenant default.

Property expenses were up 6.6%, mainly from an increase in wages and other variable costs associated with higher occupancy. G&A expense was up in the first quarter, mainly as a result of the long-term incentive program that was previously reported about, where the expenses was, essentially, a function of stock price performance. G&A increased 7.2 million in the first quarter when our stock price was at an all-time high. At our current stock price, G&A for the second quarter would be down to $3.1 million.

The quarterly run rate, thereafter, would be about $5.2 million, and projected G&A for the year would be in the 20 to $21 million range, which would be up from $19.1 million in 2003. And although we do expense stock options as a matter of policy, that isn't a factor in our numbers because the company's last stock option grants to management were in 1998.

In terms of lease renewals, at the beginning of the year we had about 1.1 million square feet of leases expiring in 2004, with the execution of the growing amendment and the other leasing that John mentioned would now whittle that down to about 450,000 square feet of expirations during the remainder of 2004.

We added a new page to our supplemental package this quarter that breaks out lease expirations by quarter. We spent $3.7 million in capex during the quarter, which was down from $4.5 million last quarter. $1.9 million this quarter was related to building upgrades at four office projects, and 1.2 million of the remainder was for normal [inaudible] and leasing commissions at our Long Beach complex.

We expect capex to remain relatively high through the rest of the year as we incur the [T I's] in all the leasing we've done. Our committed development pipeline remains the same as last quarter, with one development project and two redevelopment projects.

The development project is a 209,000 square foot, six-story office building in Del Mar that is 84% leased and 100% committed, with a total investment of $62 million, of which 59 million has been spent to date. Our two redevelopment projects include a life science conversion in Sereno Mesa, and the renovation of 909 [inaudible] in El Segundo. We expect to spend about $36 million for redeveloping the two projects, with about 11 million spent to date.

I'm sure that most of you are aware of the complexity and asymmetry that's developed regarding the accounting for gains and losses on property sales. Without getting bogged down in the details, while gains on sale are always excluded from FFO, losses now sometime flow through FFO as an impairment charges on assets held for sale.

We had that situation in the first quarter when we took a $726,000, or two cent a share, impairment charge for an unrealized loss on a building we own in Riverside that's under contract to be sold in the second quarter. This is a matter of perspective.

It's worth noting that over the past five years, we sold $291 million of non-core assets resulting in net gains of $27 million, all of which have been excluded from FFO. In terms of funding, in March we amended our 8.075% Series A Perpetual Preferred Operating Units to lower the rate to 7.45%. The units are now redeemable on September 30, 2009.

In addition, we closed an $81million, 8.5-year mortgage loan in February. The rate floats at 175 over LIBOR until August, and is then fixed at 5.57% for the remaining eight years. We also closed a similar $34 million, 8.5-year mortgage loan in March. The rate also floats at 1.75 over LIBOR until October, and then it's fixed thereafter at 4.95%.

Finally, let me finish with an update on earnings guidance. Last quarter, we provided 2004 FFO guidance in the range of $2.60 -- $2.80 cents per share, based on current conditions in the real estate and Capital Markets, and the leasing progress we've made. We are pleased that we were able to increase that range a bit now, to a new range of $2.65 to $2.85 a share. That's the latest news from here. We'll be happy to take your questions now. Operator?

Thank you. The question and answer session will begin at this time. [Caller Instructions]. Our first question comes from David Copp from RBC Capital. Please state your question.

Hi, good morning, guys. Here with [Jay Leupp] as well. I apologize if I missed this in your comments, but last quarter you mentioned that you had been approached by several potential tenants looking for some build-to-suits. Wanted to see if any of those were indeed coming to fruition?

Yeah. Hi, Dave. It's John Kilroy. We have about 2 million square feet in various stages of negotiation. That's from early to barely-extended proposals going back and forth. Don't have anything inked yet. We think we will before the end of the year. Can't tell you exactly when, but there's quite a bit in play.

And can you give us a taste of where that demand is coming from? Are these just pure office users or is it more life science or a mixed bag?

Well, it's a mixed bag. It's everything from high tech companies to financial services companies, medical, life sciences, it's kind of over the broad spectrum. About, say, 60-70% of that is in San Diego, and the balance is in Orange and LA counties.

Okay. Great. One final question. Could you refresh my memory on the term of the [Selestica] industrial lease you got?

I believe that has about five or six years left.

So it's pretty far out.

Yes.

Great. Thanks.

Our next question comes from Lee Schalop from Banc of America Securities. Please state your question.

Hey guys. Couple questions. On the first one, John, you laid out a pretty optimistic case for California. Talk to us about when you could see accelerating pipeline; you guys get some shovels in the ground and start to build back up a big pipeline that you've had in past points on the cycle.

You know Lee, we're sort of forecasting on the lower end; that we are going to start 25 to $50 million worth of new product this year weighted towards the end. This stuff generally takes anywhere from 14 to 18 months to bring on stream, depending upon what type of construction it is. But we are beginning to feel that that could increase, perhaps substantially, based upon negotiations we have underway right now.

Obviously, the justification process that company's go through before pulling the trigger is just like leasing today. It's more rigorous. It's more time-consuming but it is very clear to us and it's particularly on the land that we control that there is building demand for new product. These are companies that are expanding as well as consolidating into new products and older products.

And in terms of if is there a preleasing number you'll be looking for? Or is that -- it'll be less preleasing, it'll be more based on your confidence of demand that's going to appear down the road?

Well, generally we like to see significant preleasing or at least significant interest from multiple users before starting a building. It's not to say that we wouldn't under the right circumstances start a building as inventory. But in that instance, that would be a fairly modest commitment, at least at this point.

What we are seeing now is vacancy rates, particularly in San Diego, declining very nicely and rental rates beginning to accelerate in some of the markets in which we are entertaining buildings. And we think that's a good trend.

Okay. Dick, you mentioned that the options aren't an issue, but I'm just looking at the G&A line, which appears to have gone up pretty notably 1Q '03 to 1Q. '04. Take us through what factors are in there?

The main change --excuse me-- is a couple of complex, long-term incentive programs that dated back to 2003. They were implemented, I think, right around a year ago. They're three-year programs. And in lieu of stock options -- there aren't any stock options, as I mentioned -- and so that's the main change.

And as we've mentioned in several prior quarters, the minus -- the thing we don't as a management care for in the program -- is the volatility that it imparts to our income statement based on stock price performance there. Academically, the programs make sense because it drives us, it motivates us to care about stock price performances. Just as a matter of course, marking to market, your G&A quarter-to-quarter is not something that I would have preferred, but it is what it is.

And then going forward, is there a run rate that we should use for G&A, I guess, assuming a stable stock price?

At the current stock price, as I touched on earlier, the number would be roughly 20 to 21 million for the year, which compares to 19 last year. That is very lumpy because of the volatility implicit in the way these things work. So it would be 7 million in the first quarter, then 3 in the second quarter, and then five each in the last two quarters. And there's sort of a catch up marked-to-market, when the stock price changes, that's why the second quarter would be lower than the first quarter at today's price.

But if we just took a steady state at today's price, the run rate is just over 5 million, roughly 20 million to 21 million a year.

Okay. One last question. John, you mentioned on the acquisition front you are going to be patient. I'm curious if you've seen any movement at all in terms of cap rates, or we're not even at the stage where you can start to get excited about acquisition prospects?

I was pretty excited on two projects, that were real terrific property in markets that we know well and have properties in, and then this is just in the last 30 or so days and prices just took off. It's a combination of there's [REITS] out there, there's private [REITS] out there, there's offshore investors out there. There seems to be no limit of money and I have not seen cap rates increase.

Great. Thanks.

Thank you. Our next question comes from Lou Taylor from Deutsche Bank. Please state your question.

Yeah, hi. Thanks. So Dick, just kind of maybe concluding on the G&A comment, to just work around the average of 20 to 21 for the year, and recognizing this thing is going to bounce around quarter to quarter as the stock price changes.

Yeah. Lou, that's all predicated, of course, that the stock price winds up the year at the same place we are now. And as a rule of thumb, the delta would be that a dollar change in the stock price is roughly three cents a share.

Okay. John, can you talk a little bit more about the build-to-suit activity that you have in the pipeline? As you talk to those companies about their requirements, what percentage of them are expanding their space as opposed to just going to a different location and getting, say, newer space or really keeping the same square footage?

I would say over 80%, maybe higher than 90%, are expansions.

Now, in terms of your life sciences experiences so far, is this a segment do you see yourselves expanding in or keeping your exposure somewhat low, as it is now?

Well, obviously, things tend to grow at different industries at different times. We don't see a significant amount of demand from the life sciences industry right now. It's not as high as it's been, and it hasn't been that way for the last couple quarters. Although as we've also seen increased funding to companies, so that may change.

But I don't see it becoming a significantly -- more significant ,if I can say it that way -- portion of the company than it is now. Anything can change depending upon demand. But the lions share, the vast, vast, vast majority of what we are in discussions on now is unrelated to life science.

Okay. And then lastly, now that you've got the Boeing lease behind you, can you maybe just summarize just what appears to be Boeing's space strategy, in say, the LA market. In terms of you know, they've got relatively short leases. And I mean, do you anticipate kind of maybe another consolidation in shrinkage in their requirements, say three to four years down the road? What seems to be driving their decision-making process right now?

I'm not sure I'm qualified to say that. And I don't mean to be glib; they have had a policy for many years of short term leases to stay flexible. We viewed the lease that they just recently renewed with us -- or extended -- as being strategically important to them. After all, it is the headquarters of that group.

It's right across from the manufacturing facility, as you know, where they make their satellites and so forth. Boeing, of course, has had a lot of press over the last couple years, and I would imagine that they are staying flexible just to make sure that they have that flexibility whether they -- depending upon what happens on a lot of the government programs they have.

They've recently announced that they've gotten more orders down in Long Beach that affects the B 17 and so forth. I think they are doing what they've been doing for several years, and that's staying flexible.

Okay. Thank you.

Our next question comes from John Kim from UBS. Please state your question.

Hi. Good morning. It's John with Keith Mills. Congratulations on the Boeing lease, but can you discuss, in general, about the reduced restoration provisions and how big of an issue this was for Boeing?

Well, yeah. It's a big issue with them for sure, and we still have a restoration provision. We gave gave up a significant portion of it, as it related to various things that we felt that we could live with. They still have an obligation if they're doing thing in there that are beyond a base line to restore. We feel like the negotiation went very well for us.

Looking at the near future lease rollovers in 2004, you have a high, average base rent on your office leases. It looks like it's coming in LA in the fourth quarter of this year. Can you comment on the renewal or leasing prospects of these leases and the expected rent roll down?

Keith, this is Jeff. Basically, we've got roughly 450,000 square feet to go, and of that, we're in pretty advanced discussion with about 60% of that number. I think you will see the rent basically be sort of flat, maybe slightly down.

Okay. This may be a housekeeping issue, but your Thousands Oaks office property was reclassified from the LA portfolio to other. Should we read into this as a noncore property or potential disposition?

No, that was just a move. It's technically in Ventura County, and we wanted to make it clear that it's not in Los Angeles County.

You shouldn't read anything into it other than punctilious housekeeping.

Final question. Your TI's per square foot per year of lease term have held relatively stable for the last four quarters. Where do you think this plays out for the rest of the year and when do you think we'll get back to 2002 levels?

We aren't really thinking -- seeing any marked changes in the markets right now, John. So I think that we see comparative stability. Obviously, as a fairly small company, we can have quarter-to-quarter variations just based on changes in mix, where if we renew leases in one higher or lower cost market, it can have an influence on the reported quarterly numbers. But when you step back from reported numbers, because [inaudible-audio interference] our current experience in the market right now, is relative stability.

The market has reached a relative equilibrium, at least in our experience and we can't really extend beyond our experience and observation, but there are not any marked changes one way or the other right now in our experiences in what [inaudible--audio interference] .

Okay. Thanks a lot.

Our next question comes from David Loeb from FBR. Please state your question.

A couple of mine have been answered already, but just to go back to the restoration issue. John, prior to this renewal, it seems like there was a pretty hard restoration number that Boeing would have to pay if they moved out. Is there a similar hard number today for the extension?

Well, the number -- the hard number if you will -- that you're speaking of was a number that we had arranged of what we thought it would cost Boeing if they had moved out. Now what we have is a much more complicated formula. They've been forgiven most of that, but there is a base line -- and I don't know what that would translate to, that would be a guess.

If had you chosen not to renew the lease -- basically, if you had said, "No, thanks. We don't want that deal," would they have be required to pay that restoration fee?

Yes. It would have been subject -- it wasn't a defined amount in the lease. The amount came as a result of looking at a different base line and the changes they've made to the building and the requirement to take it back. We would, of course, had had our argument with them, but we think we would have prevailed.

I see. So in this modification, I guess you were weighing what you were giving up on that and the change in the rent versus the vacancy?

Well, yeah. I mean, remember that El Segundo is the company's softest market. The dynamics that went through our mind is this: Boeing's a company that's gone through a lot of transitions and so forth, and it seems -- this is my terminology, they may or may not agree with it -- is they seem to be trying to regain its footing in regards to various contracts it has with the government.

They've been we well publicized for some things that have been unfortunate. They obviously want to maintain their flexibility. At the same time, we weren't interested in a transaction that was long-term with them. They fortunately weren't wanting to do a long-term transaction, because it would have been at rates tha,t as we know, roll down from the prior rates.

We, of course, have indicated over the past year and a half or so that El Segundo has been our company's weakest market. And while we've announced -- as we did earlier today -- that we are beginning to see improvement. We didn't feel that it was appropriate to be on stream with 300,000 square feet, plus down at 909 and 999, and at the same time, potentially have another 286,000 square feet coming back from Boeing.

We think the market has a good chance of making major corrections on the upside over the next three years. We think by then we'll be through with 909 and 999, and the market will be more stabilized. So we think we consider this a significant victory in our strategy for El Segundo.

Any thoughts on competitive supply in a very weak sub-market? It sounds like there's still some noise for about the potential for development in El Segundo. What's your latest thought on that?

I think you'd be crazy to start development in El Segundo today.

Any thought on whether there might be a build-to-suit opportunity for Boeing for three years from now?

I've not heard of anything. I don't think that -- my read is this. And I think that I can speak with some degree of authority on what it costs to build buildings and even with minimal returns, what somebody would need based upon cost structure. And in my view, it would be hard for Boeing to move into a build-to-suit building, even if the land were free, and end up with a lower rate than they got from us.

Yep. Okay. That makes perfect sense.

Thank you. Our next question comes from[ Frank Graywood from Kay McDonald]. Please state your question.

Hi guys. Going back to the acquisitions and the prices people are paying. On a price per-square-foot basis, how significantly higher is it than replacement cost, if at all?

Excuse me. I didn't quite get your question -- this is John Kilroy.

Okay. As far as the acquisitions and the prices that people are paying, how does that compare to replacement cost? As far as what is the price per square foot on some of these acquisitions that are being sold or --

I mean, obviously, they move around a lot. In the markets in which we are interested in the type of product that we like, in many cases, the acquisition prices are greater than replacement costs; in some cases they are less.

But when they are, they -- in our view -- tend to be priced, as I mentioned in my remarks, at such as to produces a return that's far inferior to that which we'd receive from development. We don't think a 9% IRR is a great real estate transaction.

Okay. And then as far as your balance sheet on the swaps and caps that expire in January of '05, do you have any strategy as to what do you with those?

This is Dick speaking. I suspect that we will probably replace those with something. We are contemplating the possibility of extending maturities on some more debt just as we have done earlier this year, and just with what we just a talked about today. So I think we'll probably extend maturities at some point during the rest of this year.

Okay. So extending maturities on the floating rate?

Yes.

And then you would also extend the hedges, I assume?

Well, frankly that's -- we haven't concluded on what exactly which way we would execute. I think that the concept is that we would, as we have been, continue to extend maturities even though it does, obviously, impact earning in the near-term, because you are going from a low floating rate to a higher intermediate or long-term fixed rate. But my guess is we would, probably, extend out moderately far on the yield curve.

Okay. Thanks.

[Caller Instructions]. A our next question comes from Jim Sullivan from Green Street Advisors.

Thanks. John, you talked about accelerating build-to-suit proposals. Your last addition in San Diego would seem to position you exceptionally favorably in that market. But you also talked about opportunities in Orange County and LA where you don't own any land currently.

How can you be competitive in the build-to-suit business without a land position? And what is your plan with respect to acquiring more land, or trying to control more land, in Orange County and LA?

Okay. Well, we are not on a land-buying spree right now. In Orange County, we have a very significant early-stage negotiation on a project that's gone through a couple of phases of architectural -- I mean, not architectural but layout. And we've had proposals going back and forth, and this would be a very significant build-to-suit.

That is a situation where the company controls the land and where they sought Kilroy out because of experience they've had and their brokers had with us, and they would like us to build and own their facility. In LA County, we do have another pieces of property in [Calabasis] and we've been approached by both the city and a major financial institution that is interested in us building a more modest building of roughly -- a little over 100,000 square feet on a long-term basis for them.

So those are the two that get us out of San Diego, Jim. With regard to replenishing the pipeline, there -- ultimately, if you look at San Diego, there is as there is anywhere -- there's a finite amount of land, particularly in these coastal markets. And we are and we have continued, to be vigilant with regard to what's going to become available.

We have a couple of discussions going on with various land owners that would allow us to position ourselves for further downstream. Again, not with any financial commitment up front now. But we are very mindful of the franchise that we have there, and we intend to maintain it.

Okay. Thanks, John.

Thank you. Our next question comes from James Feldman from Prudential Equity Group. Please state your question.

Thank you. What's your current outlook for same store NOI in 2004?

For the year, it would be somewhere in the 3.5 to 4% range.

3.5. How about 2005?

I don't know if we are prepared to talk about that at this point. I think our objective is to increase occupancy, and hopefully, we will continue to get positive absorption next year.

Thanks.

[Caller Instructions]. Our next question comes from[ Ralph Block from Bay Isle Financial]. Please state your question.

High guys. It looks like there is still a fair amount of sublease space available in your markets. Could you give us an update on what's going on with that, how fast it's abating?

Well, Ralph, this is John Kilroy. We are seeing a fairly significant decline in -- it's different in different markets, of course -- in vacancy. And generally, a disproportionate amount of that is in the higher quality sublease space, because that's the space that people tend -- if it's high quality and if it's relatively new and so forth -- company's tend to discount that more heavily.

We mentioned in my remarks earlier that west LA, we've seen in the last quarter, not only did we have 1.1 million square feet of positive absorption, but we also saw the sublease space go down from 1.1 million a quarter ago to under 800,000 square feet today. [Siren] I hear a siren someplace.

Sorry about that.

I hope it's not related to you. Similarly in San Diego, we've seen sublease space decline pretty dramatically in the various markets. There are always incidents where you have somebody that's in 25,000 feet, they want to sublease 3,000 feet on the same floor. They don't have it demised to sublease, so it's in the database and you add those little ones up and they account for a lot of square footage. But practically speaking, they are difficult to, in fact, sublease.

So we feel pretty positive what we are seeing in our markets, both with regard to reduction in sublease and with regard to declining vacancy rates. And you put that back with what we see as a stronger demand, and we think it's a pretty good trend and we just hope it holds.

Okay. So is it fair to say that a lot of the sublease spaces is smaller blocks, and that's sort of what's driving the interest in some build-to-suits?

Well, I don't know that I'd necessarily make that connection. If you're thinking is, why wouldn't people go into sublease space versus go into a build-to-suit, the same thing could be said, why wouldn't they go into just vacant space that's direct with the landlord? And the answer is they would if it was a better economic transaction, and it accommodated their needs.

Frequently it doesn't accommodate their needs, because they have -- what we are seeing more and more, particularly in the type of product we do --is people want to have a campus. That it's part of their retaining their most valuable asset, which is their people and attracting people, and they may not want to be in somebody else's building.

So the demand side on the to-be- built buildings are generally for people that have been unable to find somebody something that exists. It might be because there's not enough square footage, it might be because it doesn't accommodate their location, it might be because it doesn't properly represent what they are trying to accomplish for their people.

Okay. Thanks.

You're welcome.

Thank you. If there are no further questions, I will turn the conference back to Richard Moran Jr., to conclude.

Thank you all very much for your interest in KRC. Have a nice day. Bye.

Thank you. Ladies and gentlemen, this concludes the conference for today. Thank you for participating and have a nice day. All parties may now disconnect.