Kilroy Realty Corp (KRC) 2004 Q2 法說會逐字稿

Good afternoon, and welcome, ladies and gentlemen to Kilroy Realty's second quarter conference call. At this time I would like to inform you that this conference is being recorded and all participants are in a listen-only mode. At the request of the company we will open up the conference for questions and answers after the presentation. I will turn the conference over to Richard Moran, Jr., Executive Vice President and Chief Financial Officer. Please go ahead, sir.

Thank you very much. Good morning, everyone and thank you for joining us. With me 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 will be discussing this morning is forward-looking in nature. Please refer to our supplemental package. This call is being webcast live on our website and available for replay for the next 7 days both by phone and over the internet. Our press release and the supplemental package have been filed on a form 8-K and both available on our website. We released our second quarter financial results yesterday afternoon. FFO was 72 cents a share in the second quarter, in line with consensus estimates.

As usual, John will begin with an overdue with an overview of the quarter and conditions in our key markets. I'll finish with financial highlights and updated earnings guidance, then we'll be happy to take your questions. John?

Thank you Dick. Hello everyone and thanks for joining us. I would like to cover three topics this morning. The first is to briefly comment on the southern California economy, which continues to produce jobs. The second is to review some of our recent highlights, including the commencement of two San Diego office buildings and the third is my customary review of KRC's submarkets. In terms of the economy, the news continues to be encouraging here in southern California. Our job markets are showing study growth. Our state's economic outlook is improving and our commercial real estate markets continue to strengthen.

Our economy remains the story of two states. While we are hearing that northern California is beginning to turn the corner, southern California continues to generate the bulk of the state's new job growth and economic momentum. State wide unemployment was down .10% in June to 6.2% and 12-month job growth in the state was up nearly a full percentage point. According to a state employment survey, California's total of employed, number of employed, hit a record last month. Much of that growth was in southern California, over the past 12 months, the five county region has produced 62,000 new jobs. San Diego experienced one of the best growth rates adding nearly 20,000 positions over the past year. A 1.5% improvement. Los Angeles and Orange county have also experienced positive growth. Mid-year force from the Los Angeles economic development corporation suggests we'll see more of the same in 2005, with job growth ranging from 1.5-2.5% in the three counties where is we have our properties.

Against that back drop, let me update you on some of the highlights since our last conference call. Our focus on leasing generated several new completed transactions during the quarter in each of our major markets. In San Diego we converted a 33,000 square foot LOI for the sixth and final floor of our 209,000 Del Mar corporate center 3building, into a ten-year lease with Relational Advisors, a private investment banking firm. The property is now 100% leased. In El Segundo we converted an LOI for 45,000 square feet, or 19% of our 909 Sepulveda building, into a five-year lease for the corporate headquarters of Cars Direct. In west Los Angeles, we converted a 39,000 square foot LOI for the entire third floor of West Side Media Center 2, into a five-year rate with Biz rate.com. And in Calabasas, we signed two leases totaling 80,000 square feet with Intuit and Broadspire. Overall through the first half of the year we signed leases and LOIs for just under 1 million square feet of space, and as a result our stabilized occupancy has risen another percentage point to 92%.

In terms of our development pipeline, our confidence in the San Diego market has led us to begin the development at the third phase of Innovation Corporate Center in Rancho Bernardo along the I-15 corridor. The first two phases of the center, which are 100% leased, total approximately 290,000 square feet in 5 buildings. Phase 3 will include 2 buildings totaling approximately 103,000 square feet. We began construction earlier this month and expect completion in about a year. Total investment the two buildings will be 23 million of which we have spent 7 million today. Although neither property has any lease commitments yet, both the volume and quality of the discussions we are having with prospective tenants in the region has convinced us that initiating development was a prudent step to take. Tenants looking for space in Rancho Bernardo come from a wide variety of industries including technology, healthcare, defense, and financial services.

In addition to these two new office buildings, our committed pipeline includes one project in lease up and two projects in redevelopment. Our future uncommitted pipeline includes the potential to build over 1.1 million square feet in our San Diego submarkets. Looking ahead we continue to have very encouraging conversations with numerous prospective tenants for several development sites. We will update you as soon as we have more definitive news. Now let's briefly walk through KRC's individual markets. San Diego county remains one of the strongest commercial real estate markets today. Brokers are reporting more than 6.9 million square feet of active demand in central San Diego, where we own our properties, and where our San Diego development sites are located. During the second quarter the San Diego markets in which we own properties experienced positive net absorption of approximately 450,000 square feet as compared to 260,000 square feet in the first quarter. In Del Mar, the most popular of several strong coastal submarkets, we continue to see upward pressure on rental rates and a robust demand from a variety of tents. Direct vacancy is 7.6% and total vacancy is currently 14.7%. Both improved slightly from last quarter.

As I mentioned, since last quarter we executed the ten-year lease with Relational Advisors for 33,000 square feet covering the entire sixth floor of our recently completed High Bluff Drive building. AMN Healthcare is the major tenant in the building and occupies all remaining floors. Our Del Mar properties totaling over 1.1 million square feet are now 96% leased. Just south of Del Mar, the 15 million square feet Sorrento Mesa submarket has the highest absorption of any of our San Diego markets with over 500,000 square feet of net absorption so far this year, compared to negative absorption in 2003 of 1.1 million square feet. This has been the San Diego submarket hardest hit over the last few years but now it's turning around nicely with a significant pickup in demand. Properties there remain 98% occupied. Overall the two story product type in Sorrento Mesa, in which we compete, has a direct vacancy rate of 12.5% and total vacancy of 15.2%. These rates have also improved slightly from last quarter.

In both the Rancho Bernardo and La Jolla UTC submarkets, where we compete in a similar 2-story product type, our properties are currently 100% occupied. In both of these markets, total vacancy rates have declined since last quarter. Rancho Bernardo has a 7.5% direct vacancy rate and an 11.7% total vacancy rate. UTC has a 10.4% direct vacancy and a 15.3% total vacancy rate. Moving north to Orange county, currently industrial properties are currently 97% occupied and demand in general for industrial properties here remains strong. In the Long Beach airport market, KRCs 1 million square foot, 7 building campus is the currently 89% occupied. Overall, the Long Beach airport market has direct vacancy of 6.8% and total vacancy of 10.7%, which is down 1 percentage point from last quarter. This market continues to be the strongest in the South Bay with good activity. Further north in El Segundo, leasing activity in the class A market continues to be sluggish, but is showing signs of improvement with direct vacancy of 22%, and total vacancy of 24%. both down more than 2% from last quarter. As I mentioned we successfully converted an LOI to a lease for 45,000 square feet of corporate headquarter space in our 909 Sepulveda building.

Based on the current level of demand, we anticipate a continued improvement in this submarket over the next year. In west Los Angeles, the market absorbed another 200,000 square feet of space in the second quarter. Vacancy rates remain stable compared to last quarter with direct vacancy of 15% and total vacancy at 17%. Momentum at our Westside Media Center project continues to build as we have converted our previously announced LOIs to leases and are in different stages of negotiations with multiple prospective tenants for all the remaining space in phases 2 and 3. With BizRate now in occupancy for 39,000 in the second phase, the entire 380,000 square foot complex is 82% leased. Phase I remains 100% leased, Phase 2 is now 87% leased, and Phase 3 is 69% leased.

In summary, we are seeing strengthening demand and we continue to make leasing progress throughout our portfolio and throughout all of our markets. Finally, let me make a point about acquisitions versus development. As we discussed last quarter, we have recently looked at several acquisition opportunities but are not convinced that the combination of very low initial returns and likely single digit IRRs make sense for us over the long-term. Given the improving market fundamentals that we are experiencing, we would rather use our capital for development, where we can achieve higher returns, build brand new state-of-the-art product and choose the submarkets that have the highest demand. Now Dick will cover the financial results.

Thanks, John. FFO per share was 72 cents in the second quarter compared with 78 cents in second quarter of 2003. Occupancy in our stabilized portfolio increased to 92% at the end of the second quarter up from 90% at year end and 91% at the end of the first quarter. The improvement was spread across all of our major markets, including Los Angeles, San Diego and Orange counties. Broken down by product type our office occupancy at the end of the quarter was 90%, up from 89% last quarter, and 88% at the end of 2003. Our industrial occupancy continues to be very stable at 95%. [Last year's] Second quarter FFO including 7.5 cents a share related to the reversal of bad debt and leasing cost reserves from the Peregrine settlement, that reduced last year's operating expenses and resulted in a quarter over quarter increase in this year's same store operating expenses of 18.5%. Excluding the Peregrine reversal, same store property expenses would have been up 7.6%, primarily related to variable cost increases from higher occupancy in our office portfolio. Same store NOI was up 2.3% on a GAAP basis and 2.4% on a cash basis in the second quarter.

Excluding the effects of the Peregrine settlement on last year's results, same store NOI would have been up 5.4% on a GAAP basis and 5.6% on a cash basis. The reason for the increase in NOI during the quarter was almost all due to higher office occupancy. For the first six months same store NOI was up 5.7% on a GAAP basis and 6.6% on a cash basis. Excluding the Peregrine reversal, same store NOI in the first 6 months would have been up 7.3% on a GAAP and 8.3% on a cash basis. As in prior quarters, G&A expense was affected by the market nature of our long-term incentive program which is based on stock price performance. As we talked about in prior calls, a $1 change in our stock price translated to approximately 3 cents a share change in FFO. Given to all the leasing we've accomplished, our exposure to lease expirations over the second half of the year if fairly modest at approximately 250,000 square feet or 2% of our portfolio.

Cap Ex for the second quarter increased to $5.6 million, up from $3.7 million in the first quarter. That figure includes $752,000 related to building upgrades and 4.8 million of normal TIs and leasing commissions. We expect Cap Ex to remain relatively high for the rest of the year, as we incurred TIs on all the leasing we've done. As John discussed earlier, our committed development platform expanded during the quarter with the addition of the third phase of our Innovation Corporate Center project in San Diego county. We expect to spend about $123 million on our 5 committed development and redevelopment projects, with about $79 million spent to date.

Let me talk for a moment about the balance sheet. We continued our recycling efforts as we mentioned we contracted to sell an office building in Riverside for $19.5 million earlier this year. That sale closed during the second quarter.

We continued to pursue a strategy of extending debt maturities and locking in current interest rates. To that end, we've raised $115 million in long-term debt so far this year and are currently working on a $144 million private placement of 6 and 10-year notes. We expect to close that deal shortly with an average coupon of 6.14%. Proceeds will be used to repay floating rate debt and a $74 million 8.35% CMBS loan that is open to prepayment next month. Historically we've targeted 85-90% of our debt fixed or hedged and the balance floating. Since we're planning to do the $144 million fixed rate financing, I just mentioned, we terminated 2 out of the money interest rate caps at the end of the second quarter. When the new financing closes, about 90% of our debt will be fixed or swapped.

Finally, let me finish with an update on earnings guidance, last quarter we provided 2004 FFO guidance in the range of $2.65-2.85 per share. The $144 million private placement we're about to close, will cut earnings by 12 cents per share on an annualized basis and 6 cents over the third and fourth quarters this year. More than offsetting that note, we've continued to make good leasing progress that's translated to sequential improvements in occupancy. So despite the 6 cents a share cost of the private placement, we are comfortable tightening our range from $2.65-2.85 to new 2004 FFO guidance of $2.72 to $2.78 a share. That's the latest news from here and now we can take your questions. Operator?

Thank you, sir. The question and answer session will begin at this time. If you are using a speaker phone, please pick up the hand set before pressing the numbers. If you have a question, press star 1 on your push button telephone. If you wish to withdraw you question, please press star 2. Your question will be taken in the order it is received. Please stand by for your first question. Our first question comes from Jay Leupp of RBC Capital Markets. Please state your question.

Actually it's Dave Copp here with Jay. Couple of questions. Last quarter you mentioned you had interest interest from some potential build to suit users, I believe they were specially in San Diego, now a couple of spec developments here. Can you give us an idea of what happened to those deals or should we be seeing some leasing announcements are forthcoming here?

Let's just say that we're continuing to have very detailed discussions.

Okay. And then could you give us an update on the litigation surrounding the El Segundo campus?

It's over.

And don't have any up deal plans, it's all done and gone?

I'm sorry?

You don't have any intent of appealing, it's just a dead deal now?

I think our attorneys are looking at it but our view is to let it go.

Fair enough. Thank you.

Thank you. Our next question comes from Keith Mills of UBS. Please state your question.

Good day, gentleman. How are you?

Fine.

Dick, can you just provide some background on the G&A. You had stated, I think you referenced this in your prepared remarks, you thought G&A would be around 3.1 million second quarter, it turned out to be 5, and that's a function of the stock price. Can you walk through specifically, is it an average stock price in the quarter? The average stock price over the quarter? Is it the stock price as of the last day of the quarter? I thought SG&A was closer to the $5 million rather than the 3.1 with the stock performance.

It is based on the period ending stock price. The way the program works is that it is the whole program is based on the stock price at the end of the three-year period. The way it is accounted for is that it is measured or benchmarked at the end of each reporting period. In this case, the stock price on June 30th.

Okay. So your stock price on March 31 was 35.50 and your stock price on June 30 was 34.10.

Yes.

So based on that, would have thought your expecting your stock, your G&A should still have been around $5 million.

3.1 was a number that we offered, if you recall, when we did our second quarter call when the stock price was under 32.

Okay.

At the time it was based on the stock price at that time.

At that time. Okay. Appreciate that. Your property operating expenses second quarter were up significantly relative to the year over year increase in first quarter. Most of it seemed to be on the non same store portfolio? Can you talk to us about what happened there as it specifically relates to the second half in that area?

I think there are two major, major factors there. One is that last year we had a big credit running through the numbers because of the Peregrine settlement. We anticipating getting a lot of money back and reversed some previous reserves so it had the effect of depressing our expenses last year. And the second thing is we have done lots of leasing so we have higher variable costs associated with the higher occupancy. I think fundamentally what we are seeing at a larger scale, a broader comment would be, we see at least right now overall, a degree of if not equilibrium, at least stability in both operating costs and overall rental rates and concessions. We have seen rental rates up move very smartly in Del Mar, of course, but more broadly across the whole portfolio, we are not seeing too much movement in pricing power either in revenues or expenses right now.

Okay. A couple more questions for you. John, on the build to suit activity, you talked about on the last call about 2 million square feet this year, or somewhere between $25-50 million. Is that still a number you'll achieve this year?

Wait a second. I'm confused by the way you said that, Keith. You talked about 2 million square feet and 50 million. We indicated last quarter that we had about 2 million square feet in various stages of negotiation, and we continue to have about that number. With regard to the second part of your question, can you restate it?

Sure, I thought the 2 million was also related to the 25-50 million. Something about by the fourth quarter, for full year 2004, somewhere between $25-50 million in build to suit.

I think what we were talking about is we anticipated starting $25-50 million of buildings this year, in the second quarter here as we've announced, we've started $23 million in buildings so far. I think there were two separate things although they are obviously quite related. One is what's the volume of discussions that we have going on, recognizing that some of those discussions relate to major corporate moves and take a year or two to come to fruition. And the second question is, second issue is what are we planning for development starts this year and that's as much a modeling question as anything else for anybody and we said at the time we could start from 25-50 million, somewhere in that bandwidth later this year. We were anticipating starting that toward the end of the year. We actually moved that up a bit to the second quarter at least as to the first 23 million.

25 and 50 million reasonable next year as well, Dick?

Yeah, in terms of starts for next year you can model in $25-50 million.

Just two more questions. One for John, the status of the land acquisition you spoke about on the first quarter call? In San Diego you referenced due diligence in that area, can you expand upon that and give us an update?

We're in due diligence on a couple of parcels.

Okay. And finally just want to ask you based on your outlook and what's happening here in southern California in terms of fundamentals, can you talk to us about the policy going forward? You haven't increased dividend and your thoughts when you might see an opportunity to increase the dividend going forward and specifically, was that a quarterly event or annual event?

Our board likes to look at that at the beginning of each year. We talked about it and we left open the possibility that we might revisit it during this year.

From a management point of view, we take a lot of comfort and want to know whether the dividend is sustainable. I think what we are likely to do is consider our recommendation to our board at the first quarter meeting next year as to what the dividend should be and obviously first I'd say I don't want to telegraph anything because we aren't there yet but hopeful we'd like to get back on a stair step increase in dividends but we aren't there yet and we'll look at that at the beginning of the year but hopeful there's justification for doing so.

I appreciate your comment.

The outlook for southern California, we are feeling increasingly that and we single this the last couple quarters and I would just say that our comfort level with the demand and with the market fundamentals is continuing to go up and we think that this next year could be a pretty doggone good year with regard to not only leasing but development. Rental rates have generally been going up in San Diego in all markets, been more stable in our Orange county and L.A. markets but the concession packages are generally starting to go or to improve from a landlord's perspective so all of that is good.

Appreciate your comments. Thank you.

Thank you. Our next question is coming from Dave Aubuchon of AG Edwards. Please state your question.

Thanks. John, you mentioned the Cars direct lease in El Segundo. Curious about the tenant profile in El Segundo, the people that you're talking to about leasing space. Has that changed at all versus the last couple years and the bigger deal of 45,000 square feet or little spaces that get leased up and a slower ramp up over time there.

First deal with the profile of the type of tenant and then I'll get in to the size. We are seeing and let's go back, as you know, six months ago or a year ago we had almost no activity in the market. Now we're seeing fairly broadbased activity at least from the types of industries, financial services, airlines again, defense, foreign trade, folks related to travel that use the airport regularly, et cetera.

The other thing that's happening is with the continued development of the Playa Vista property and expansion of the airport and other things going on, a variety of people that would have driven further before are now saying, gosh, if you live in Manhattan Beach or Hermosa Beach, including the South Bay, you're probably going to take a good, hard look at El Segundo. Those are positive things. We have buildings that accommodate in their floor plate, multi tenants, small tenants as well as larger tenants and it's going to be a mixed bag. It always has been in that market. Only a few tenants talking about 100,000 square feet of the market but there are dozens and dozens of tenants talking about 3,000 feet to up to 20,000-25,000 feet and a few in between. It's going to be a mixed bag. What we try to look at is what is kind of the ideal profile in each and every building that we have. We can't always get there, but try to break it down so we can accommodate expansion for folks and obviously, we're not interested generally in making long-term leases if we have our preference in a market like El Segundo because the rents still are in the 1.85 plus or minus range and historically the rates there got up into the $3 range. So we think over time as that market improves, we'll see a return to higher rents.

Is it your opinion that El Segundo is kind of the last submarket to respond to the recent real estate recovery?

Yeah, in terms of the markets that we're in. The El Segundo which has historically been strong these last years has been tough. We're seeing finally an improvement. I don't want to forecast or say that, gee, everything is wonderful in El Segundo and it's only going to get better because until it happens, we're not going to forecast that but the trends we are seeing are positive.

Okay. The life science redevelopment in Serrento Mesa, is that property more single tenant or multiple tenant?

Likely to be either one or two tenants. We actually are in negotiations right now with somebody that, you know, I can't really speak about, just say that it was geared to where it could accommodate 4 tenants and it could very well end up being four or less.

Then your interest level in further life science after this building gets leased up?

We'll be opportunistic where we think there is the opportunity to add value, that market from what we're seeing is a fair amount of product that is available over in Torrey Pines for sublease, which is uncharacteristic over the last years of that particular sector, but we don't have a business plan that's dependent upon life science.

Right. At this point in the cycle, do you believe the return from the life science product is higher that traditional commercial?

Well, obviously it depends what your basis is. What we're seeing is certainly compression there. When you're dealing with companies that have burn rates rather than true net worth which is frequently the case. Although typically, we've dealt with companies that have a real product but when you're dealing with a circumstance, you would expect to get a higher return.

Right. One last question, Dick, on the refinancing, you were going to pay down $7 millionish in fixed rate debt and the rest would go towards floating?

Yes.

Okay. Thank you.

Our next question comes from Sarah Woodward of Green Street Advisors. Please state your question.

I was curious why your development product in Del Mar, California is in lease up but it is 100% leased?

We don't categorize it that way until the final floor has taken occupancy. The building is 100% leased but not 100% occupied, and that lease will take occupancy, I believe, in the fourth quarter.

Okay. Great. We were also wondering, do you know what the approximately mark to market is on your leases that are maturing in the second half of '04 and then also in '05?

In general our portfolio is at market or potentially slightly above market. Less than 5% and I'd say that would be true for the remaining leases this year and next. I don't have the numbers in front of me. It would approximate that.

Okay. Great. And one final question is do you have any plans for refinancing your line of credit? You have $140 million outstanding currently?

Our line of credit matures in March of 2005 and we're actively working on a new line.

Great. Thank you.

Should you have a question, please press star 1 on your push button telephone at this time. Thank you. Our next question comes from Jamie Feldman from Prudential Equity Group. Please state your question.

Thank you. What is the new guidance assumed for acquisitions and dispositions for the rest of the year?

It assumes no acquisitions.

And $30 million of dispositions in the fourth quarter.

Okay. And what kind of yield are you expecting on the innovation 3 development?

Somewhere in the neighborhood of 10% ROC on leverage. Straight line's about 150 basis points or something like that higher on leverage.

What's realistic for, like, a fourth quarter occupancy number?

I think there's we're, we've built in some wiggle room, and obviously, in a range, individually, we'd rather just rest on earnings guidance, but we're hoping and planning to continue to expect sequential improvement in occupancy.

And a revised same store outlook for '04, excluding the Perergrine settlement?

Excluding the Peregrine settlement, we should be in the 5% range for the year.

As a reminder, should you have a question, please press star 1 on your telephone at this time. I'm showing no further questions at this time. I will now turn the conference back to Mr. Moran.

Thank you all very much for your time today and thank you for your interest in KRC. Thank you.

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