Kilroy Realty Corp (KRC) 2005 Q2 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the second quarter 2005 Kilroy Realty Corporation earnings conference call. My name is Coby, and I will your coordinator for today. (OPERATOR INSTRUCTIONS) I would now like to turn the presentation over to your host for today's call, Mr. Richard Moran, Chief Financial Officer. Please proceed, sir.

Thank you and good morning, everyone. Thank you for joining us. With me today are John Kilroy, our CEO, Jeff Hawken, our COO, and Tyler Rose, our treasurer. I'd also like to welcome Heidi Roth, who's been with us since 1977 in a series of progressively more responsible positions and was recently appointed controller of KRC. Heidi replaced Ann Marie Whitney, who just left the company to spend more time with her 3 young children.

At the outset I need to say that some of the information we will 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 website and will be available for replay over the next 10 days by both -- by phone and over the Internet. Our press release and supplemental package have been filed on a Form 8K with the SEC and are also both available on our website.

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

Thanks, Dick. Hello, everyone, and thanks for joining us. The second quarter was a busy and productive time for KRC as economic conditions in our key Southern California markets continued to gather strength. We executed leases in both our stabilized and development portfolios and moved decisively to continue to expand our development pipeline. I'll begin this morning with a few comments on regional economic conditions, then I'll review some of the most significant actions we've taken during the quarter, and I'll finish with more details in my customary market-by-market review.

California passed a notable economic milestone in May. Total non-farm employment in the state set a new record of more than 14.7 million jobs, surpassing the previous peak reach just before the 2001 recession. California's unemployment rate as of June was 5.4%, down almost a full percentage point from a year ago. Over the past 12 months the state has added more than a quarter of a million net new jobs with visible growth in nearly every major sector of our economy. Other indicators also suggest an improving economy, including rising state revenue from personal and corporate income taxes and sales tax receipts.

Meanwhile, here in Southern California, most industries continue to expand and specifically the aerospace, electronics and defense industries received a powerful boost this spring when the Pentagon revealed it has no interest in closing or redeploying any of its substantial research and development programs and facilities in Los Angeles and San Diego as part of its current base closing process. This is particularly good news for El Segundo, which is home to many companies in these industries.

Looking more closely at recent year-over-year employment gains, Los Angeles added more than 37,000 net new jobs, San Diego County added 16,000 new jobs, and Orange County just over 18,000. As you know, job growth is the key to absorption in the office business. The unemployment rate in Los Angeles fell to 5.6%, while San Diego's rate was 4.4% and Orange County's unemployment rate was only 3.9%. Improvement is also visible in our commercial real estate markets where we saw positive net absorption in all of our markets during the second quarter. With this economic picture as a backdrop, KRC continues to move forward in several important areas.

Within the leasing program for our stabilized properties, we have now signed new or renewing lease agreements on more than 1.1 million square feet of space year to date and ended the quarter with an occupancy rate of 95.2%. We are also continuing to see strong interest in both our available and to-be-developed space and expect to be able to report more progress as the year moves forward.

In terms of our development pipeline, we signed a 10 year lease in June with Accredited Home Lenders for a 3 building corporate headquarters totaling 178,000 square feet at our Innovation Corporate Center development in Rancho Bernardo, located along the Interstate 15 corridor in San Diego. This is a lease in which we anticipated an improving market and started 2 buildings last year without any pre-leasing. The Accredited lease absorbs both of these buildings and calls for a third building that will begin early next year. The size and scope of this transaction once again underscores the growing attractiveness of the I-15 corridor market and our expanding dominant position in coastal San Diego.

We also took action during the quarter to expand our development pipeline. In early June we announced the acquisition of a fully entitled (ph) 11 acre land site immediately adjacent to our current Santa Fe Summit project that we are building for Intuit along the new 56 freeway. This transaction expands the development potential for the combined sites to more than 80,000 square feet of office space. In our view, it significantly enhances the long-term value of the overall development.

Finally, earlier this month we capitalized on a strong market for California real estate by selling an El Segundo industrial property for 22.5 million. Prior to selling this building, which has been vacant for a couple of years, we had opportunities to lease it at a discounted rent, but we were patient and resisted that temptation. We saw a bigger payoff in the end by hunting for a specialized buyer and waiting to sell it at an attractive price to an organization that could take advantage of the unique improvements in the property.

Looking to the future, we continue to evaluate high potential redevelopment related acquisition opportunities in our core markets that would further our efforts to expand our development pipeline. We also expect to report progress on this front by the end of the year, most likely in San Diego.

Now let's briefly walk through KRC's individual markets, beginning in San Diego where commercial real estate activity continues to lead the state. The brokerage community currently reports active demand for about 7.1 million square feet of space in central San Diego, the area that encompasses all of our current properties and future development sites. In Del Mar, where KRC is the dominant landlord with approximately one-third market share, a significant amount of sublease space was absorbed in the second quarter. Direct vacancy in the sub-market remained flat at 6%. The total vacancy declined to 9.8% from 13.2% in the first quarter. Our properties there remain 99% occupied.

Sorento Mesa, which is just south of Del Mar, also showed improvement in the second quarter with over 400,000 square feet of absorption. KRC competes here in the 2 story product type, which currently has a direct vacancy rate of 8.8% and total vacancy of about 10.5%, both down slightly from last quarter. Our properties in Sorento Mesa, totaling approximately 1.5 million square feet, are currently 91% occupied. In the UTC sub market, direct vacancy is 5.8% and total vacancy is down to 8.3%, both down about 3% from last quarter. Our UTC properties are 94% occupied.

Turning to the I-15 corridor where we recently signed the Accredited lease in the 2 story product type, the direct vacancy rate was 4.4% and total vacancy 7.9. In the Class A product type, direct vacancy was 8.9 and the total vacancy 12.4%. Our properties in this market are 96% occupied. The I-15 and 56 corridors have been the focus of much of our development activity during the last several quarters. We have targeted these areas based on the direction of job growth, the location of premier residential communities, and the scarcity of land sites for office development.

I will summarize our 3 recent transactions here one by one. First, as you will recall, the 56 corridor is the location of our new 4 building master plan office development known as Santa Fe Summit. Last quarter we announced that software developer Intuit had agreed to lease 78% of this development for a new regional headquarters campus. We are on schedule to commence construction on all 4 buildings this quarter.

Second, as I mentioned in my earlier comments, we purchased in June a fully entitled 11-acre land site immediately adjacent to Santa Fe Summit for a price of $24 million. This new site, on which we plan to build a second phase of Santa Fe Summit, includes entitlements for approximately 340,000 rentable square feet of additional office space. This acquisition not only increases our current development potential in San Diego to almost 1.8 million square feet of office space, but we believe it also enhances the long- term value of the overall master plan Santa Fe Summit project with greater size, expanded amenities and more freeway frontage.

Finally, as I mentioned earlier, in mid June KRC signed a 3 building 178,000 square foot lease with Accredited Home Lenders at Innovation Corporate Center. The lease term for the first 2 buildings is 10.5 years and begins in December 2005. The lease term for the third building is 9.5 years and begins in 2006. With the completion of the third building, Innovation Corporate Center will encompass 8 buildings totaling approximately 468,000 square feet, all of which are fully leased, and one remaining development site which can accommodate up to approximately 80,000 square feet of additional space. Based upon the strong demand and interest we're seeing in that market, we will likely start the last building later this year or early next.

Now let me move north to Orange County. This market continues to perform well with our 4.2 million square feet of industrial properties, over 99% occupied, up from 98% last quarter. In the Long Beach Airport market our 7 building office campus is 94% occupied. Demand in the market remains steady with overall Class A direct vacancy at 4.8% and total vacancy at 8.4%. As we have mentioned in prior calls, Boeing will vacate the balance of their space in this property, about 26,000 square feet, in the third quarter and we are making good progress in re-leasing that space.

Further north in El Segundo we have seen some improvement in vacancy rates, although they still remain among the highest in the region. Direct vacancy in the Class A market is 20% and total vacancy is 22.9%, down 3% and 6% respectively since last quarter. Our leasing efforts continue to show progress, with several new office leases signed in the second quarter. These include a 30,000 square foot lease with American Express to take the remaining space at our 185 South Douglas property and several leases at our 999 Sepulveda property that will bring our leasing in that building from 56% last quarter to approximately 89% currently.

Recapping El Segundo, we've made a lot of progress over the last year. We signed our previously announced renewals with Boeing, DIRECT TV and Mattel that total almost 800,000 square feet. We sold a vacant 114,000 square-foot industrial building I mentioned earlier. We executed new leases with American Express and CarsDirect and made significant progress at 999 Sepulveda. And we expect conditions in El Segundo to continue to improve given the strength in the other South Bay markets.

Continuing north, real estate markets in west Los Angeles continued to improve with an additional 878,000 square feet of space absorbed during the second quarter, amid more signs that rental rates are on the rise. Direct vacancy is 11% and total vacancy is 12.3%, both down about 2 points since last quarter. Our properties in this market, totaling 677,000 square feet, are 97% occupied.

Finally, along the 101 corridor in northern Los Angeles and Ventura Counties, the overall market has a direct vacancy of 8.2% and total vacancy of 9.3%. Our properties are 94% occupied in this market.

Let me conclude by reiterating our growing optimism about our business. We are seeing an improving economy here in Southern California and improving market conditions in our sub-markets. Job growth is positive, demand is strengthening and tenants are expanding. Obviously, economic and market conditions here aren't any secret, so we continue to see a very strong acquisition...

Pardon the interruption Ms. O? Hi, is anyone on the line? Pardon the interruption; is anyone on the line?

...position development pipeline. Our long held strategy remains the same. It is far more profitable to our shareholders to develop at near double digit returns than to acquire existing assets with low to middle single digit returns. And we continue to do just that.

We're making progress in our development program, both in new lease transactions and in expanding our development pipeline to capitalize on the expanding job growth we are seeing in our sub-markets.

Now Dick will cover the financial results.

Thanks, John.

FFO in the second quarter was $0.44 a share compared to $0.72 in the second quarter of 2004. Excluding the impact of the company's special compensation plan, our second quarter results were $0.03 higher than our internal forecasts of $0.64. The majority of impact on second quarter FFO was from the company's special incentive program, which expires at the end of this year.

We ended the second quarter with a 10-day average stock price of $47.96, up from $41.22 at the end of the first quarter, so the quarterly expense for the plan in the second quarter was $0.38 a share, $0.23 of which was not in our forecast. That $0.23 effectively catches up the accruals from our prior quarters to the current stock price. So to summarize, we started with a forecast of $0.64, added $0.03 from better operating results, and lost $0.23 from higher than projected compensation expense to end up with actual FFO per share of $0.44.

Occupancy in the portfolio at the end of the second quarter was 95.2%, up from 94.1% at the end of the first quarter and 94.6% at the end of 2004. Broken down by product type our current office occupancy at the end of the second quarter was 93.8%, industrial occupancy was 97.7%.

With the year-over-year improvement in occupancy, same store NOI also showed improvement with GAAP NOI up 4% and cash NOI up 5.5%. GAAP rents in the second quarter decreased 11.3% and cash rents were down 16.7%. The reduction was primarily due to, one, above market lease in Seattle that was renewed at a 62% lower GAAP rent. Excluding that lease, GAAP rents would have been up 3.3% and cash rents would have been down 3.1%. Those numbers are more representative of what we're seeing in our core Southern California portfolio. At the end of the second quarter we had just 350,000 square feet of expiring leases over the remainder of the year.

Our capital expenditures declined slightly in the second quarter to $4.1 million. Our FAD payout ratio was 189%, which includes the effect of the special compensation plan that expires at the end of this year. The GAAP cost of the special compensation plan runs through our income statement each quarter and, therefore, also affects reported FAD, although the payment will actually be made in the first quarter of 2006. Adjusted for the special compensation plan accrual, the second quarter FAD payout ratio would have been 78%.

In terms of our balance sheet, we extended the maturity and slightly increased the outstanding amount of a term loan this quarter. The new $35.5 million loan has an interest rate of LIBOR plus 90 and matures in 2008. Our debt is now 82% fixed as well.

Moving to acquisitions and dispositions, we purchased a $7 million office building in the Brea sub-market of Orange County that is adjacent to and shares parking with one of our existing buildings. We also completed a disposition of a vacant El Segundo project earlier this month for a price of approximately 22.5 million. The book gain was approximately 18 million. We received half the proceeds in cash and the other half in the form of a 7 year note. We also retained a carried interest in the project that could pay off 5 to 7 years down the road if the project performs particularly well.

In terms of our development pipeline, our committed projects now include 7 buildings totaling 644,000 rentable square feet, either under construction or committed for new development, and one building totaling 242,00 rentable square feet in redevelopment. We expect to spend about $257 million on these 8 buildings with about $98 million spent to date.

The $257 million committed portion of our pipeline includes the 2 large development leases we have signed during the last 2 quarters for to-be-built projects that total $188 million in investment, $144 million for the first phase of Santa Fe Summit, of which Intuit is taking 3 out of 4 buildings, and $44 million for the Accredited headquarters project. Combined, these 2 projects are 84% leased and have an estimated going-in cash return of approximately 9% and an estimated GAAP return of approximately 10%. And those returns are on brand new state of the market products that we're building in one of a handful of the best growth markets in the entire country. These projects are examples of what we continue to see as the tremendous opportunity to create shareholder value through our development business.

Now let me finish with an update on our earnings guidance. Last quarter we projected 2005 FFO guidance in a range of 2.72 to 2.87 a share. As we've said before, our guidance for the balance of this year is in part a function of the stock-based special compensation plan that expires at the end of this year. Our guidance last quarter was based on our stock price of $42.50 at the time.

Since then, our stock price has increased substantially. So to bring the numbers up to date, based on our last 10 day average stock price of $49.54, the stock price increase since last quarter would reduce our 2005 earnings estimate by $0.36 a share. That change would reduce our prior guidance of 2.72 to 2.87 a share by $0.36 to an adjusted range of approximately 2.36 to 2.51 a share.

As I mentioned, our second quarter earnings, excluding the impact of the change in our special compensation plan, were $0.03 higher than our original forecast. So taking that into consideration and narrowing our range a bit, we're providing new 2005 FFO guidance of $2.42 to $2.52 a share.

That's the latest news from here and now we'll be happy to take your questions. Operator?

Yes, sir. (OPERATOR INSTRUCTIONS) Your first question comes from the line of Brian Legg (ph). Please proceed.

Brian Legg for Merrill Lynch. The industrial building that you sold for just under $200 a foot, was that the data center in El Segundo and was that sold to a public company?

It was the data center and it wasn't sold to a public company.

Okay. And just curious, how long have you had that thing on the market and why such a rich price for the building?

The building has been on the market for a couple of years and the building has quite a bit of power in it and so forth. So they're able to use it with the use that they're going to put it to.

Okay. And just turning to the comp plan, what would be -- at the current price of $51 a share, what would be the cash payment at the -- in 1Q06?

Well, at -- Brian, at a stock price of $50, I think -- well, put it this way. At the quarter end stock price, I think, as you'll see in our 10-Q, I think the accrual would be -- by December 31st would be 47 million. I believe at the current stock price that would be increased to roughly $50 million.

And obviously you've signed some large lease campus type deals. Are there a lot of other large blocks of space out there trolling the market, looking for campus type projects that you could start more developments in San Diego?

Brian, this is John Kilroy. We've got a number of different users, and if I can just sort of deal with those that are, call it about 80,000 square feet or above, we've got over 2 million square feet of discussions going on on properties that we own.

Oh, okay. So they're all large blocks of space. And are they looking for-- are they looking for -- are they coming out of existing buildings or are they looking for newly built buildings?

Well, let me see if I can answer that, if I understand your question right. In many cases there's expansion, and in some cases it's consolidation and want more efficient facility and moving out of multiple locations. The demand is coming out of life sciences, technology, defense services, software, et cetera. It's pretty broad-based.

And last, combined question. Can you talk about market rent growth in your markets, in your sub-markets, and also cap rates in your markets for both office and industrial properties?

Let me deal with the rental rates first. If you just kind of move to San Diego and Del Mar market, the market rent range is sort of 2.95 to 3.35 for Class A plus utilities. KRC has been doing quite a bit better than that market. Our range has been the mid to the high $3 plus utilities and we expect somewhere in the neighborhood of a 10% increase over the next couple of quarters in Del Mar.

In Sorento Mesa, 2 story product, which we own and build there, the market range over the last few quarters was in sort of the $1.25 to $1.50 triple net range. This quarter the market is up 8% above that. KRC has been sort of in the 100 -- or rather the $1.80 plus range and we expect that market in Sorento Mesa, the 2 story, to move up around 10% over the next 3 or 4 quarters.

In the UTC market, that market's basically been basically flat. And I-15 corridor in the 2 story product, the market range over the first half of this year has been $1.75 to $2 triple net. It's moved up to $2.10 triple net today and we expect it to increase further over the coming quarters. In the Class A along the I-15, the market has ranged from $2.25 to $2.50 plus utilities.

KRC has moved our Saber Springs (ph) project that we acquired in December of last year rents from roughly $2.80 in the fourth quarter of '04 to $3.25, $3.30 plus utilities in our most recent deals. And we moved the occupancy, by the way, in that building up from 90 to 95%. We expect somewhere in the neighborhood of a 5% to 10% increase over the next year in the Class A on I-15.

Carlsbad, where we're not currently in the market, the rents are pretty much flat, in the 2.25 to 2.75 plus utility range for Class A and around $1.35 to $1.65 triple net. In Orange County office is flat to slightly up. Industrial, we're seeing sort of a 2 to 5% over the next couple of quarters based upon what we hear from the brokers. In L.A. County, West L.A., we're expecting about a 5% increase over the next quarter or so. In Long Beach Airport we're seeing flat to 2 to 3% increases in rent. In El Segundo rents are flat. And in the 101 corridor we're expecting somewhere between a 5% and 10% rental growth over the next couple quarters.

Now, you had another question, which was cap rates. Cap rates continue to move lower. There are a number of buildings that are in escrow today in the mid 5% range fully leased; not a lot of growth. I think the bogey there is anywhere -- for stabilized properties in sort of that 5 to 6.5, depending upon the type of building where it's located, et cetera.

Your next question comes from the line of Ross Nussbaum. Please go ahead.

It's John Kim (ph) with Ross. Can you share some details of your new long-term comp plan, particularly if it'll be capped and how it'll be tied to peer performance?

Well, John, as we've talked about before, that's something that we won't be ready, we don't think, to talk about at least until next quarter. We're not sure exactly when all the details will be concluded. We have, as we've said before, requested and received a commitment from our comp committee that whatever new plan or plans are implemented, they won't have the inherent deficiencies that are obvious in our current plan. We're not in position simply because we don't know yet. But we do expect to have more news to come later. But we can tell you definitively that it won't -- whatever happens, the new plan won't include the deficiencies that are in the current plan.

The timing of announcement of your new plan will be in the fourth quarter, then?

Well, we're not exactly sure. We plan to offer guidance one quarter from now at the end of the third quarter and we've had discussions with our board that that guidance obviously needs to have in it our expectations for what any and all cost would be for next year, including compensation. So the only reason I'm hedging is I don't think we can presume when the committee might definitively act. But we can say that we will offer guidance and we will have enough information about the structure of the plan so that we will be able to say specifically what assumptions we're using.

If I look at your G&A as a percentage of total revenue during the last 3 years of the current plan, it's been running at around 13%. Is this an accurate run rate assumption going forward?

I think that you have to -- I don't think what we've done in the last 3 years is necessarily accurate only because it includes the effect of the special compensation plan and, as I've said just now and as we've said in many other quarters, we will not have that same kind of a plan going forward.

I apologize if I missed this, but can you talk about leasing prospects at 5717 Pacific Center and if you believe this should be converted back into an office building?

We're under a letter of intent with a well-known technology company.

Okay. And, John, you discussed the strength of the California economy, but what do you think the tax implications are in San Diego with the city's large budget deficits and pension shortfall?

Well, we're not seeing any impact, although I think where you'll see it is for those projects, development projects that don't have their entitlements. You may very well begin to see increased exactions for traffic mitigation off sites, et cetera. Fortunately, in our development portfolio everything we own or that we're looking at is entitled, off sites are in place, the mitigation fees have been predetermined. So I can't speak other than just guessing.

Your next question comes from the line of David AuBuchon. Sir, please state your company name before proceeding.

A.G. Edward. Pac Center, question was just asked. In terms of the expirations that you see in the rest of this year, there's a 130,000 square foot lease in San Diego that appears that way. The one tenant that is expiring or is scheduled to expire in the third quarter of this year, can you comment on the potential for renewal there or if not, what the prospects are for that space?

The tenant is not going to renew and we have a number of folks that are looking at it. Unfortunately, that's a lease that's well below market.

And can you disclose what sub-market that's in?

I beg your pardon?

Can you disclose what sub-market it is in?

Sure. It's at a key intersection in the Sorento Mesa sub-market.

Okay. The industrial building you sold was vacant. There's another industrial building that is, at least on your supplemental, also 100% vacant and it looks to be very close to going to sold. Is there potential there for another asset sale or is there some type of leasing prospect that you think you can capture at that building?

Well, I think the answer to both directions is yes. We feel that the market for that type of asset that is an industrial building, it's one of the few buildings that is zoned for freight forwarding in El Segundo. Whether it will go to that use or whether it will go to a higher use, can't say. But we do have people interested in the building, so our hope is that we're going to move that some time before the balance of the year.

I'm sorry, on the leasing side or the sales side?

It could go either way, Dave. We're not -- we're indifferent in that asset. We don't consider it to be a strategic asset.

Okay. And then it looks like a number of leases, maybe it was just timing in the El Segundo market kind of hitting the quarter, is there movement there, momentum that may be finally starting to kick in?

Well, I'm not going to say that El Segundo is going to take off and be like some of the sub-markets in San Diego, but the way we -- we expect to see continued progress. We have out-performed the market in every way over the past several quarters. We continue to think that that will happen. Our product is excellent product. The market has cleaned up, as I mentioned a little bit. It's down 3% to 6% in its vacancy rates. There is more demand in the market.

I don't think we're going to see a pattern where we just have ever-increasing amounts of space leased in every quarter for the next few quarters at least, but we do think directionally the market is improving. It is at the north end of the South Bay market, Long Beach Airport would be the south end. We're seeing quite a bit of improvement elsewhere in the South Bay. We think that bodes well for El Segundo.

We also frankly have seen quite an improvement in the west side, and there's not great blocks of space available on the west side, so we think that bodes well for El Segundo. We think we're well positioned given the quality of our assets and we think we'll continue to make deals. But I can't give you some kind of guidance of we're going to lease 100,000 square feet a quarter or 200,000 square feet a quarter at this point.

Your next question comes from the line of Kristen Brown (ph). Please state your company name and proceed.

Deutsche bank. I just wanted to ask you a little bit more about rent roll-downs. It sounds like you had kind of a hiccup this quarter, but where do you see them moving going forward over the remainder of the year and next year?

Well, in terms of our overall portfolio, we still think we're about at market. In terms of the remainder of this year, we think we'll be -- we're at 0 to 5% above market. And next year, we'll provide more details on that next quarter.

Okay. And your same store NOI, I noticed that property expenses were a little bit higher, about 9 or 10%. What was the primary driver there?

It's mainly related to higher occupancy variable costs, going up from higher occupancy.

There was also, Kristen, some catch-up from the rainy season in the first quarter, where we had some expenses we deferred into the second quarter just because we couldn't effectively do the work during the rain.

Okay. And then my last question is in regards to Boeing. You said they were vacating their space in Long Beach in the next month or 2, the 26,000 square feet?

26,000 square feet.

Okay. Can you comment as to how you perceive their real estate strategy in Southern California going forward?

No, I don't -- at this juncture I can't speak specifically to their strategy. Sometimes it's difficult to follow. But as we have said, our intent as a company is to continue to reduce our Boeing exposure. We've done that pretty significantly over the past few years. So the market in Long Beach, I think they have 50,000 feet they were getting out of. We remarketed half of that. They're getting out of this 26,000 square feet. We've already leased roughly a third or a half of that. We view it as a strong asset to -- that they're moving out and we're back-filling it with other tenants.

Your next question comes from the line of Jay Leupp. Please state your company name and proceed.

Jay Leupp here at RBC Capital Markets with Dave Ronco (ph). Asset sales, you had the one sale this quarter. In the lower cap rate environment, can you comment on your outlook for asset sales through the back half of the year? And also your attitude perhaps to taking additional pieces of land down or a little bit more risk taking on the land development side given that you're taking double digit yields on your developments.

Well, as I mentioned in my formal remarks I think you're going to see us -- we've expanded our development pipeline. I think you'll continue to see us expand our development line. And, as I mentioned in the formal remarks, I think that you'll see that happen first in San Diego. So stay tuned for later this year.

With regard to-- what was the first part of the question?

Asset sales.

Asset sales, pardon. We've historically evaluated all of our assets regularly and determined which are non-strategic or which have reached the point where we think it's appropriate to sell and redeploy into other opportunities and we'll continue to do that. So we're going to be very opportunistic. Not going to tell you that we're going to sell an asset between now and the end of this year, but we may very well. We obviously have a lot of discussions going on with people from time to time on different assets.

Our core -- this is Dick speaking. Our core strategy, Jay, remains the same. We're a capital recycling developer and we're trying to maintain the discipline to sell at attractive current cap rates and reinvest the proceeds into development at high-risk adjusted returns.

Okay. And, Dick, just a couple of follow-up balance sheet related and coverage questions. Fixed charge coverage ratio in the quarter fell off in the previous quarter from 2.9 to 2.1 times. Can you talk about what you expect that to look like over the next couple of quarters and if there could be some capital raising to counter that? And also the FAD ratio shooting up to 188% of the dividend, if you see that changing going forward and also what you expect it to be given your current comp plan?

I think that -- well, the answer to both those questions, both ratios you're talking about, Jay, lies in the regrettable paradox that's inherent in the current special compensation plan. The paradox is just this, that the higher our stock price and the more we achieve our core objective of higher shareholder return, the more it also adversely affects current period reported FFO and FAD and, therefore, other ratios, like fixed charge coverage ratios.

And that's why obviously if only -- we have one more conference call this year, so there's one more call we'll be talking about this, but after this year we will not have a similar plan. And so I think that whatever affect, the adverse effect, it will last the rest of this year and then we will be on something that doesn't include those deficiencies. So I think if you look at our FAD payout ratio, as an example, excluding the special compensation plan, the affect in the current quarter, the FAD payout ratio in the second quarter was 78%. And obviously what our core objective over time is, as I say, to remain a capital recycling developer.

We want to have the balance sheet that permits us to undertake new development projects and also, at the same time, presuming that our core earnings increase over time, we'd like to have a sustainable dividend increase that we can continue to increase at a measured pace in any year of economic expansion. So I think what you'll see is I think our ratios will return to something that's much more conventional at the beginning of next year.

If you exclude the special comp plan, our fixed charge compensation would have been over 3 times.

The next question comes from the line of Frank Graywit (ph). Please state your company name and proceed.

Reese (ph). Just a couple of questions -- or just one question regarding your comments on Boeing. In 2007 it looks like there's a number of significant expirations. Do you think that by '07, '08 that you will have reduced that exposure that you look to achieve?

Okay, I'm guessing a little bit, Frank, with regard to that question, so maybe you could restate it.

There's significant exposures in 2007, a significant roll with leases that are leased to Boeing and I'm just curious if by the end of '07 and into '08 that you will have achieved the reduction of Boeing as far as being one of your larger tenants?

Well, those leases rolled down, what was it, last year and we think the market's going to be above that. Whether Boeing stays or not, we anticipate the rents are going to go up. They do have options to continue, so that's going to be in their court. But if they move out, then I'd consider that over time to be a good thing for Kilroy.

And have you had any discussions with them in regard to those leases or is it still too early to tell?

We're having discussions with some others with regard to that space.

The next question comes from the line of Rich Moore. Please state your company name and proceed.

KeyBanc Capital Markets. Following up on Frank's question just real quick, when are you notified on this 2007 expirations? When do you hear from Boeing specifically about those?

I believe the lease requires a 12 months notice to exercise an option.

Okay, but you're already, as you were saying, looking at other potential tenants as possibilities?

That's correct.

Okay, great. And then on the development pipeline, in the supplemental you have 365 million of total spending, 88 million of which you've done. How does the remaining 270 million break out over the next couple of years?

Well, I think, Rich, that just depends on the velocity of leasing and the overall pipeline with respect to that. I don't think we -- I think much of it would come next year and it's basically next year and the year after would be the 2 years, I think roughly ratably (ph) over the 2 years. But I think our objective is obviously we had substantial unused debt capacity and beyond that you can continue to expect us to be very disciplined in recycling capital.

Okay. And, Dick, just out of curiosity I was getting to that as well. Are you comfortable with the floating rate debt? I'm assuming you will do some construction loans with regard to the developments.

Well, we have lots of capacity under our line. And we've always said that our basic strategy, our strategic objective is to maintain our fixed or functionally fixed through-swap (ph) portion of our debt at roughly 85% plus or minus, in that range, and somewhere in the 80 to 90% range. We're 82%today, so I think you'll expect -- you can expect us to continue to remain somewhere in that bandwidth.

And over time I think you can expect to see us continue to extend maturities periodically with fixed rate debt, as we've done the last couple of years. My guess is we'll probably tend not to do construction loans just for reasons of simplicity and economic efficiency and rely on our line. But I think the economic substance is essentially the same.

Okay, very good. Thanks. And then when would you expect in the industrial and office portfolios the year-end occupancy to be roughly?

I'm not sure. I'm not sure it would differ materially from where we are now other than we've -- I think it's relatively easy to talk about it in overall terms and our current occupancy rate will be affected I think by several things. First, we've done a fair amount of leasing that John touched on and talked about that will, by itself, increase our current occupancy rate.

In addition, we have that one building in San Diego that John also touched on where the tenant has notified us they're moving out of their building in Sorento Mesa and we are actively remarketing that program. But there will likely be a period where it goes vacant for a time.

And then in addition we also have the 909 Sepulveda building which will, in the next quarter, transfer into our stabilized portfolio. That's obviously just reclassification; it doesn't change the substance of what's going on. And that building is currently leasing but will take some time to finish.

I think all of that said, when you net all those 3 things out I think that probably takes our overall occupancy down a point or so over the next quarter or 2, but that's within the realm of a normal quarter to quarter fluctuation. So I think we expect, other than obviously -- most that net difference is attributable to reclassification of the 909 Sepulveda building. The positive leasing will be roughly offset in the near term by that one building in San Diego that will temporarily be vacant.

Okay, very good. Thank you, Dick. And then one thing I forgot to ask you guys on developments, John, I think you mentioned that stay tuned for later in the year when you would have more development announcements. I'm assuming those are for 2007 or maybe '08 and beyond?

Not necessarily.

So it could have something a little bit earlier?

Could be.

Okay, very good. And then the last thing, on the G&A expense, am I looking at this right? If the stock stays at $49, then basically we have what we have for the year and if it goes up a point, we take another $0.06 out of our estimate. If it ends the year a point higher, we take roughly $0.06 out per quarter?

Between $0.05 and $0.06.

The next question comes from the line of Sarah Bellis (ph). Please state your company name and proceed.

With Green Street Advisors. I was curious what the amount of NOI was that you received from your redevelopment pipeline in the quarter?

NOI from our development pipeline or redevelopment?

Redevelopment pipeline, the 909 Sepulveda.

Oh, sorry.

We received $157,000 of NOI from 909 Sepulveda.

There are no further questions in the queue. Mr. Moran, you may proceed with final remarks.

Well, thank you all very much for joining us on a busy day. We appreciate your interest in KRC. Have a good day. Thank you.

Thank you for your participation in today's conference. This concludes the presentation. You may now disconnect. Good day.