Kilroy Realty Corp (KRC) 2005 Q3 法說會逐字稿

Good day, ladies and gentlemen. Welcome to the third quarter 2005 Kilroy Realty earnings conference call. My name is Minoshea and I will be your coordinator for today. At this time all participants are in listen only mode. We will be facilitating a question and answer session towards the end of today's conference. [OPERATOR INSTRUCTIONS] I would now like to turn the presentation over to your host for today's call, Mr. Richard Moran, Chief Financial Officer of Kilroy Realty Corporation. Please proceed, 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 Heidi Roth, our Controller. At the outset, I need to say that some of the information we will be discussing this morning is forward-looking and you should 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. It will be available for replay for the next ten days both by phone and over the internet. Our press release and supplemental package have been filed with Form 8K with the FCC and both available on our website. We released our third quarter financial results this morning. F.F.O. was $0.43 cents a share. That includes the positive impact from the restatement we reported last week and a negative impact on a higher accrual for the company's incentive compensation plan that terminates at the end of the year resulting from the increase in our stock price during the third quarter. Before we begin let me apologize for the short notice for our call here today. We know that a lot of you were about to leave [inaudible]. We wanted to get this information to you as soon as we could. Now let me give you a quick overview of what happened to our restatement. As we reported last week and detailed again in our earnings release, we restated our financial results back to 2002 for changes in accounting related to derivatives and tenant improvement costs. The net impact of these two items was to increase F.F.O. in the third quarter by $0.02 and for the nine months by $0.07 a share.. Both the derivatives and tenant improvement adjustments are noncash items, so on page 6 of our supplemental in our reconciliation from F.F.O. to F.A.D, we reversed both out of F.A.D. We've also included a couple of extra pages this quarter to help illustrate the effect of the restatement. Page seven of the supplemental is a reconciliation of net income as reported to what it would have been before the restatement and page eight is a similar post restatement reconciliation for F.F.O. Now John will begin with his usual overview of the quarter and the condition of our key markets. I'll follow with financial highlights and updated earnings guidance and then we will be happy to take your questions. John?

Thank you, Dick. And hello, everyone. Thanks for joining us. Southern California real estate markets continued to strengthen in the third quarter and KRC made substantial progress on a number of fronts. An active leasing program delivered significant results in both our stabilized and development portfolios and we made another strategic purchase to expand our development pipeline. I'll begin this morning with a few comments on regional economic conditions, then I'll provide an overview of the Southern California markets and I'll finish with my customary market by market review. California's economy produced steady, diversified growth during the third quarter. Employment hit another record high in September, according to the monthly survey of households while total nonfarm payroll jobs grew by 226,000 year-over-year. The unemployment rate as of September stood at 5.1%, down from a full percentage point from a year ago. Continued job growth has boosted other economic indicators including personal income which rose an estimated -- or rather an annualized 2.9% in the second quarter versus 2.2% a year ago. For the period California accounted for 13% of total national personal income.

Economic growth is visible across most industries and geographic regions. In recent months, job creation has been particularly robust in some of California's largest metro areas. That includes the San Francisco Bay area and greater Los Angeles which in August posted its strongest job creation performance since the spring of 2001. Looking more closely at September year-over-year employment gains, Los Angeles County added more than 34,800 net new jobs, San Diego County more than 17,000 new jobs, and Orange County nearly 28,000 new jobs. The unemployment rate in L.A. fell to 4.4%. In September while San Diego's rate was 4.1% and Orange County's was only 3.6%. KRC remained very productive during the quarter. Within our stabilized properties we have now signed new or renewing lease agreements on 1.4 million square feet of space year to date. And we continue to lead the pack in terms of deal capture and rental growth. Overall occupancy in our stabilized portfolio fell a couple of percentage points in the quarter to just under 93%. This occurred primarily because our recently renovated 909 Sepulveda property was moved to the stabilized portfolio and a tenant vacated a 130,000 square foot building in San Diego.

We also took another big step to expand our development pipeline last quarter purchasing a 20-acre fully entitled site in one of central San Diego's most attractive growth markets where we have had considerable success. I will discuss this further in a few moments. Looking forward we remain committed to a development strategy that we believe will deliver strong long-term value creation for our shareholders. We continue to evaluate high potential development and redevelopment acquisition opportunities as they arise in the Los Angeles, Orange County and San Diego submarkets where we operate. Now let me give you a big picture summary of what we are seeing in Southern California. As we have been saying for several quarters, the Southern California real estate markets have been strengthening. Throughout many of our markets we are seeing and the brokers are reporting a shift from a tenant's market to an landlord's market. This is more pronounced in some submarkets than others but there is more and more sentiment that tenants need to act now, particularly those with larger requirements. C.B. Richard Ellis is reporting tightening vacancies and rising lease rates in Los Angeles with minimal new construction.

The entire Los Angeles area only recorded 1.6 million square feet of construction in the third quarter out of a total inventory of over 175 million square feet. C.B. is predicting significant rent increases in Los Angeles as large blocks of space get absorbed and vacancy rates continue to decline. Our experience also supports an improving market in Los Angeles where our west side assets are effectively fully leased and we have begun to make significant progress in El Segundo. While it took a entire year following completion to get to 25% committed we have essentially doubled that in our 909 building in the last quarter, moving the committed percentage to 49% today. As for the Orange County office market, Cushman and Wakefield has also reported a move from an equilibrium market to a landlord's market as population growth and a growing economy are driving demand. Office vacancy rates are down to 10% from 14% a year ago and rents are up 6% year-over-year. This also signals a strong Orange County industrial market where we have 3.9 million square feet.

Finally in San Diego, we continue to see a significant increase in demand for new state-of-the-art facilities in the market in which we operate. Burnham is reporting over 600,000 square feet of absorption in the third quarter which is the best single quarter since the same period in 2003. Year to date net absorption in San Diego was 1.6 million square feet. C.B. Richard Ellis puts active demand for office space at more than 8.2 million square feet in central San Diego, the location of all our current properties as well as our future development sites. This is up from 7 million square feet of demand reported for the past several quarters. And during this period of increasing demand there was 1.6 million square feet of absorption and KRC signed leases on development projects were over 600,000 square feet. At KRC negotiations are underway with a number of well capitalized potential tenants seeking significant square footage in the region.

While there are no guarantees that any proposed transaction will go forward until it is documented we are very encouraged by the sheer number of prospective build to suit clients we are talking with. I would also like to point out a meaningful difference in this cycle versus prior cycles. And that is the modest level of construction activity we are seeing. One of the Southern California markets where new office construction does make sense is in the better San Diego submarkets where the combination of rental growth and robust demand provide attractive returns. In contrast, development does not make sense in most Los Angeles submarkets and won't until rents significantly increase. With this general overview let me update you on KRC's individual submarkets. Let's begin in Delmar where KRC is the dominant office landlord over an approximately one-third market share. The Delmar submarket has direct vacancy of approximately 4.9% and total vacancy of 12.1%. Our properties there are 99% occupied. This is also the market where we are developing our 830,000 square foot multiphased Santa Fe Summit project and are underway with 165,000 square feet. Sorento Mesa just sound of Delmar continues to improve with over 120,000 square feet of net absorption in the third quarter. KRC competes here in the two-story product type which currently has a direct vacancy rate of 7.9% and total vacancy of 9.9% .

Both down about a half a point since last quarter. Our properties in Sorento Mesa total approximately 1.5 million square feet. KRC's occupancy dipped in the third quarter to 84% in this market largely because we had a tenant vacate a 140,000 square feet building. We have several discussions ongoing to release this base and estimate that the expiring rent is approximately 30 to 40% under current market. In addition our occupancy in the submarket will improve further in the fourth quarter when Qualcomm takes possession of our recently redeveloped 68,000 square foot property at 5717 Pacific Center. We signed a 10 year lease with Qualcomm in August for 100% of the property. And the lease will commence in December. One of the key factors in making the deal was the mechanical upgrades we integrated into the building during our renovation. Further south in the UTC submarket, direct vacancy is 6.3% and total vacancy is 6.8%. Our UTC properties are 97% occupied. Now let's turn to the I-15 corridor, the location of much of our recent development activity. The two-story product type in this market currently has a direct vacancy rate of 3.9% and total vacancy of 7%, both down about a half point from last quarter. In the Class A product type, direct vacancy is 8.1%, down about a point from last quarter and total vacancy of 13.5% up about a point from last quarter.

Our properties in this market are 97% occupied. In addition to KRC's prominent position in the Delmar and Sorento Mesa submarkets, we have become one of the do dominant real estate companies along the I-15 corridor with new construction and a entitled development pipeline here that can more than double our portfolio presence over the next several years. We believe that this area along with the 56 corridor that connects the I-15 with the interstate 5 represents the most promising growth market in San Diego today. It offers all the characteristics we find desirable. High quality job growth, premiere residential communities, excellent school districts, superior infrastructure and a scarcity of comparative land sites for office development. Let's go over KRC's active development sites in these markets where we are uniquely positioned to deliver new, large, to-be-built projects. First Innovation Corporate Center located along the I- 15 at Rancho Bernardo where Accredited Home Lenders recently signed a lease for 178,000 square feet to occupy three new buildings. Office buildings where we have a site for one more building remaining. Second, Santa Fe Summit Phase 1 located along the 56 corridor and the future regional headquarters Campus for Intuit which has leased 78% of the 465,000 square feet of space committed for construction.

Third, Santa Fe Summit Phase 2, a fully entitled 11 acre land parcel immediately adjacent to the Intuit campus that includes entitlements for approximately 340,000 square feet of additional class A office space along with expanded amenities and more freeway identity that will enhance the long-term value of the overall combined Santa Fe Summit project. Fourth, Kilroy Saver Springs, located at the intersection of the I-15 and the 56 freeways, where rents have grown approximately 23% since we acquired the project last December and where we have entitlements to build a third building totaling approximately 143,000 square feet. And fifth, in late September we expanded our development potential in a strategic area even further purchasing a fully entitled 20-acre land site in Rancho Bernardo along the I-15 corridor for $24 million. The purchase included a highly improved 300,000 square foot industrial building that is currently occupied by Unisys. As part of the purchase agreement, Unisys signed a lease with KRC for a building that expires in September of next year with a three-month extension option. When it terminates we plan to redevelop the site adding 600,000 to 1 million square feet of office space in a phased development plan. The site is currently entitled for approximately 1.8 million square feet of office and light industrial space.

With this most recent acquisition KRC has now increased its development pipeline in San Diego to approximately 2.4 million square feet of potential new space with 640,000 square feet of space currently under construction or committed. This pipeline which excludes the future possible expansion phases of our Long Beach property now totals approximately 750 million to 950 million, depending on the ultimate product type, in ultimate square footage. Our position as the largest commercial landlord in San Diego with a development pipeline that is more than 25% of our total market capitalization has given us a unique foundation to create shareholder value. Just as we did with the acquisition of the Santa Fe Summits, two site following the commitment from Intuit for phase 1and the acquisition of the Unisys site following the leaseup of our Innovation Corporate Center project, it is our intent to continue to expand our pipeline when we see significant, diversified demand. To that end we see strong potential in some markets close by our existing properties and hope to have more to report on this shortly. Now moving to Orange County. Real estate markets here continue to be strong. We have 3.9 million square feet of industrial properties here that I mentioned are at 98% are occupied. And we are evaluating the development of additional product on sites where we have excess land.

Also in Orange County, given the current strength in residential economics we have the opportunity to rezone at least a couple of our industrial properties for residential and sell the sites to home builders at a significant profit. We expect to have more to come on this on future calls. Moving to the Long Beach airport market, demand remains solid. And rents are up about 6% year-over-year. Class A direct vacancy is 5.3% and total vacancy is 7.2%. Our seven building office complex there, totaling 1 million square feet, is currently 93% occupied and 95% leased. Given our favorable cost structure at this project, it will likely be among the first L.A. County based sites where new development will make sense. Further north in El Segundo, vacancy rates continued to show improvement and demand has increased. Direct vacancy in class A is 18.3% and total vacancy is 21.1% both down almost 2 points since last quarter. Total vacancy is down 10 points since the end of 2003. Our leasing efforts in this market are yielding steady progress. Our 999 Sepulveda property is now 88% leased. And as I mentioned we have made real progress at 909 Sepulveda where we are now 49% committed including leases and letters of intent up 25% in the last three months.

Much of our new leasing activity in this market is with P.R. firms that are relocating from the west side. Also in El Segundo just as we sold a nonstrategic asset in this market in the third quarter we are now in escrow to sell 2265 East Segundo Boulevard, a 77,000 square foot industrial building that is currently vacant to an owner/user for $124 a square foot. The sale is scheduled to close either in the fourth quarter of '05 or the first quarter of the new year. Continuing north, real estate markets in west Los Angeles have also been strengthening throughout the year. Direct vacancy is now 10.2% and total vacancy 11.1%. Both down about a point from last quarter. Our properties in this market total 677,000 square feet and are 98% occupied. Finally along the 101 corridor in northern Los Angeles and Ventura Counties, the overall market has a direct vacancy of 8.4% and total vacancy of 9.3%, both about the same as last quarter. Our properties here are 96% occupied. That's a recap of our markets. Now let me wrap up a few summary comments. The real estate markets are improving across the board in Southern California with a shifting taking place from a tenant's market to a landlord's market. The brokerage communities and others are increasingly indicating that there is a growing sense of urgency among tenants to find space.

San Diego is the market we like best and where demand for new development and development yields are strong. The strength in the markets is moving up the coast. While San Diego continues to be the strongest market in Southern California, Orange County has improved significantly over the last year. Most Los Angeles submarkets are also tightening and even El Segundo is now showing meaningful reductions in vacancy. Development is still a ways off in Los Angeles due to the scarcity of sites, high entitlement costs, and an increasing construction -- increasing construction costs coupled with rents that don't yet provide an adequate return on new development. For KRC we enjoy a unique cost competitive position with our Long Beach project which could be the next development project for us in the Los Angeles area. And finally, economic conditions in Southern California continue to get better with low unemployment, significant job growth, and positive net absorption in all of our markets. Now Dick will cover the financial results. Dick?

Thanks, John. F.F.O. in the third quarter was $0.43 a share compared to $0.64 in the third quarter of 2004. Excluding both the impact of the restatement I mentioned earlier and of the higher accrual in the company's special compensation plan that expires at the end of this year, third quarter F.F.O. would have been $0.64 per share, $0.05 higher than our internal forecast of $0.59. In terms of the company's special incentive compensation program our 10 day average stock price at the end of the quarter was $54.35, up from $47.96 at the end of the second quarter, so the quarterly expense for the plan in the third quarter was $0.43 a share, $0.23 higher than our forecast. That $0.23 effectively catches up the accruals from the prior quarters to the stock price at the end of the third quarter. So to summarize, we started with a forecast of $0.59, added $0.05 from better operating results, added $0.02 from the restatement and lost $0.23 from the higher than projected compensation expense to end up with actual F.F.O. per share of $0.43. Occupancy in our stabilized portfolio at the end of the third quarter was 92.8%, down from 95.2% at the end of the second quarter and 94.6% at the end of 2004. Occupancy declined for two primary reasons as John mentioned which we summarized in last quarter's call.

First we had a tenant vacate a 130,000 square foot office building at Sorento Mesa in the third quarter and second, we added our 242,000 square foot redeveloped office building at 909 Sepulveda Boulevard to the stabilized portfolio also during the third quarter. As John mentioned the good news is that we have made some real leasing progress in El Segundo. The 909 building was 19% occupied and 25% committed at the end of last quarter but it is now 49% committed. And with all the leasing we've done in El Segundo and elsewhere we can currently project that our overall occupancy rate will be up to 94% or so by the end of this quarter. ame story. NOI improved during the third quarter both on a GAAP and cash basis with GAAP NOI up 2.8% and cash NOI up 7.2%. The improvement in NOI reflects a year-over-year increase in occupancy. GAAP rents in the third quarter rose 12.6% and cash rents increased 1.7%. We believe that our overall portfolio in rent levels are currently approximately at market, with the office portfolio slightly below market and our industrial portfolio slightly above market. At the end of the third quarter we had less than 100,000 square feet of expiring leases through the remainder of this year. So far we've renewed 250,000 square feet of our 2006 expirations with a average rent increase of 5% on the cash basis and 15% on a GAAP basis. Beyond that, we have 1.1million square feet expiring in 2006, although 300,000 square feet of that is the Unisys lease at the property we just purchased. And we plan to redevelop that site when the lease expires.

Capital expenditures in the third quarter fell to $2.9 million down from $4.1 million in the second quarter. We expect CapEx for the year to be about $18 million. As we've mentioned in prior quarters the GAAP cost for the special compensation plan that expires at the end of this year runs through our income statement each quarter and therefore also affects reported FAD,although the payment will be made actually in the first quarter of 2006. Excluding the special compensation accrual the third quarter FAD payout ratio would have been 70%. There were no significant changes to our balance sheet during the third quarter. Our debt remains at 80% fixed or swapped. Moving to acquisitions and dispositions as John mentioned we acquired the 20-acre land parcel in Rancho Bernardo that Unisys will lease for one year. The Unisys lease translates to a 6% return, so the effect is that we're getting an essentially break-even return on the project while we do our redevelopment planning over the next year or so. As I mentioned during our last call, we completed the sale of a vacant El Segundo industrial project in July for a price of approximately $22.5 million. The book gain was approximately $18 million. As John mentioned, we're also in escrow to sell another El Segundo industrial building for $9.5 million. At that price the book gain would be approximately $7 million.

Turning to development, our committed pipeline now comprises 7 buildings two totaling 103,000 rentable square feet rental under construction and 5 buildings totaling 541,000 rentable square feet committed for development. We expect to spend about $189 million on these 7 buildings with about $43 million spent to date. The committed pipeline is 84% preleased under two large development leases we signed over the past 6 months with Intuit and Accredited Home Lenders. Combined, those two projects have projected going in cash return of approximately 9% and a projected GAAP return of just under 10%. Now let me finish with an update on our earnings guidance. Let me start with 2005. he last quarter we provided 2005 F.F.O. guidance in the range of $2.42 to $2.52 a share. As we have 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 $49.54 at the time. Since then our stock prices increased substantially. So to bring the numbers up to date based on our last ten days average stock price of $53.60, stock price increase since last quarter would reduce our 2005 earnings estimates by $0.21 a share. That change would reduce our prior guidance of $2.42 to $2.52 a share by $0.21 cents to an adjusted range of approximately $2.21 to $2.31 a share. As I mentioned our third quarter earnings excluding the impact of the restatement and the change in our special compensation plan were $0.05 higher than our original forecast. Finally the restatement had a $0.07 a share positive impact year to date.

So taking all these factors into consideration and tightening the range a bit we're providing new 2005 F.F.O. guidance of $2.35 to $2.40 a share. In terms of 2006, let me start with a few assumptions that bear mentioning. First, while the company's compensation programs for next year haven't been determined yet we've incorporated a range of possible costs for what we expect into our guidance. Second, while while we don't yet have definitive information to be conservative, we're assuming in our guidance that Boeing will move out of its 100,000 square feet at 2240 East Imperial Highway at El Segundo at the end of April and that the space isn't back filled at all next year. That would have a $0.06 a share impact on 2006 F.F.O. and third, we also assume higher interest rates and a likely debt deal to extend maturities that would also have a $0.06 impact on 2006 F.F.O.

Numerically the other assumptions we've used include average occupancy of 94 to 96%, a 65% retention rate. Same store NOI growth of 4% on a cash basis and 2% or so on a GAAP basis. G&A costs of 18 to $21 million. A development starts of $200 million or more including about $75 million for buildings three and four in Santa Fe Summit phase one and about $50 million of dispositions. Taking all of these assumptions together, including the $0.06 we assume we lose from the Boeing lease expiration in El Segundo, and $0.06 from higher short-term interest rates in a debt deal translates into our initial 2006 F.F.O guidance of $3.15 to $3.35 a share. That's the latest news from here. And now we'll be happy to take your questions. Operator?

[OPERATOR INSTRUCTIONS]. Your first question comes from the line of Steve Saqua [ph] with Merrill Lynch. You may proceed.

Good afternoon. I was wondering if you could maybe talk a little bit about the 909 Sepulveda. I mean obviously it had basically a doubling of the committed space there. Could you maybe just talk a little bit about the rental rates that you're seeing at that property?

Yeah. The rates we're seeing are around $2 per month. And the transactions are anywhere from 5 to 10,000 square feet. A couple larger.

And so I guess what is your expectation for that building over the next -- I mean do you anticipate that being stabilized in the next six months, 12 months?

Well, Steve, based upon the discussions we're having, as you know some of these things get prolonged. As I mentioned in my formal comments it took us a year to get to 25%. We got to 49% just in the last -- just since the last quarter. And based upon what we see going on we feel pretty good about being able to fill the building up over the course of the next six to 12 months. But whether it happens earlier as opposed to the entire 12 months, I just couldn't predict.

But it sounds like demand and interest has clearly built up. Over the last couple of months.

It has. And the nice thing about it is that we're starting to see what we've seen in our other cycles, which is as west L.A. fills up, as other markets in the South Bay fill up and we've seen very strong tightening here on the west side as well as down at the Long Beach airport, that generally bodes very well for El Segundo. We're very well positioned with having the highest quality office assets in that market with great views, great parking, great amenities. So we think that we're going to continue to capture more than our fair share. We're pretty excited about what we're seeing there. In the due course we hope to see the rents move forward. That's not likely to happen for the next quarter or so.

Okay. And a question for Dick, here, on the restatements. I mean is it fair to assume that from here forward these are nonissues or are these issues that may still fluctuate in down and into next year?

Fluctuate how, Steve?

Well, just in any other saying you've had the rerestate so I guess these are all behind us so there's no kind of issues going forward.

That's our understanding, yes.

Okay. I guess on the G&A side, it doesn't sound like you maybe have a definitive new plan in place but you obviously have some comfort about the level of expense that may be running through the P&L next year. Could you maybe break down the 18 to 21 between kind of base G&A and maybe how much you're allocating for some sort of L tip program?

Well, I think we don't have enough specificity on the details of the program yet or the combination of possible permeatations of the programs, let me put it that way. But we do have enough confidence to know that the outside we think we're in the range of 18 to 2 1. Put it this way, I think our baseline G&A this year was something on the order of $16 million.

17.

$17 million. Pardon me. And we anticipate that there would be some variability that we haven't fully defined yet about the size and the number of participants in the program and that sort of thing. So that's all in there along with some other sort of normal increases in G&A.

Okay. But it sounds like maybe the new L tip may be a couple million bucks a year at max.

I don't think we want to quote a specific number but I think you can infer from the difference between our 2005 expected G&A run rate and what we're talking about that it's at the outside just an little bit more than what we're talking about.

Okay. And then the last question is on construction costs. John, can you just talk about the level of construction costs? Obviously they've risen quite substantially here and how you're thinking about that given that you have perhaps the most aggressive development pipeline in the office space. Certainly relative to your size of your company but even just in the aggregate dollar amounts.

Sure. First of all, looking at it from total project costs or total development costs which is fully loaded, the way we refer to it is total project costs. Construction costs have increased significantly over the past four years with most of that occurring in the last 12 to 18 months. And we've regularly priced top Class A building, as a example, our Delmar buildings that we've built and we are regularly almost quarterly repricing them so that we know what changes have occurred. And if we look at our AMN building which is probably the highest quality building in San Diego which we came on stream in late 2002, the cost of that building core and shell is up about 40%. And that's plus or minus pretty much the same for other buildings. So the other thing that's increased is, depending -- it doesn't always effect Kilroy although it does when we buy new property is that land costs have increased in many markets, including San Diego. And I might add in that market we've been fortunate.

We have a long range of program of identifying sites and getting in early to acquire them so we continue to have a pretty good basis in our land. But if you sort of take a look at the combination of land price increases and construction price increases, it translates in a total development cost context to about a 25% increase in total project costs over the past four years. When we price our projects we price them based upon our expectation and the contractor's expectation for price increases over the next 6 months. So anything that we're doing now would include a projected increase of costs through mid second quarter.

So subject to one's land cost and entitlement costs to build a 4 to 6 story Class A office project with structured parking will now cost about 400 to $425 a square foot plus or minus in total project costs and to build a two story office project with mostly surface parking will have a total project cost in the range of 250 to $275 plus in that range. Not withstanding the increases that we've seen in total project costs and in what we're expecting to see between now and March, April of next year, yields on our development both underway and forecasted are in the near 9, high 8s, near 9 to 10% range and as the cycle progresses we expect to see some further increases, and particularly we expect to see some further increases in rents that will likely improve our yields, no guarantee. So that's the way we're looking at it. We're managing it very carefully and we spent a lot of time looking at these projects from a design standpoint so that we're not designing into them the areas. We're trying to mitigate in one way by not designing in the areas where we're expecting to see the greatest volatility from a commodity standpoint.

I guess just to kind of follow up, if you look at this new piece of land that you bought with this Unisys building, obviously you're not going to even start construction on that for maybe almost 15 months, maybe 18 months. So how do you think about underwriting that building from a cost standpoint? I mean are you taking today's costs and inflating that by X percent or do you just kind of take today's cost and -- how do you think about that?

Well, we're looking at today's costs and we're projecting it out. But Steve, one of the things that's particularly beneficial to Kilroy in connection with the acquisition of the site from Unisys is that we bought that site for $24 million. Now, we can build in excess of 1.8 million square feet. We forecasted that we're likely to build between 600,000 and a million square feet. There's an existing 300,000 square foot building that we're likely to save because it's in great shape and has a lot of infrastructure associated with it. So the cost basis we have, just looking at it in a land cost basis on that site, is amongst the lowest FAR costs of any site that we've bought because it has so much entitlement. Now, we forecasted we're only going to build about a million square feet max, not the entire 1.8 million we're entitled to build. So we feel we have a built in cushion. The other thing about that particular site is it has tremendous infrastructure on place. It has 12,000 K.V. of electrical and 10,000-tons of H.V.A.C. It has double gas services and electrical services and so forth. The point is, for what that building was built, a lot of that infrastructure will service the to-be-built buildings on that site. So we have we think a real hidden asset in that property. Forecasting our construction costs we're looking at it and saying, okay, when we underwrote this, how much could they go up? And they can go up an tremendous amount and we're still in great shape.

Okay. Thanks.

You're welcome.

Your next question comes from the line of Ross Nussbaum of Banc of America Securities. You may proceed.

It's John Kim with Ross. A couple questions on guidance. Does this include anything as far as termination fees in '06?

We have a small amount of other income in the numbers but it's not substantial.

Okay. So the Boeing lease that they could potentially leave at April 30th there is no termination fee for that.

That's correct.

And what does it assume as far as net acquisitions or disposition activity?

Fifty -- or 40 to 50 million in dispositions and no acquisitions.

What's your appetite for doing a large portfolio transaction in one of your markets?

Very, very remote.

Okay. And where do you see cap rates in your markets? Have you seen any dramatic move down or up in cap rates?

Yeah. Cap rates, we've seen them continually go lower. And obviously everyone's keeping abreast of what's been happening recently with some rebretheren and what's being talked about with some of our rebretheren. But looking more specifically at individual assets. What we're seeing is a number of second and third chair properties trading at 6% plus or minus cap rates, and I also mention maybe higher quality assets but not in very good markets in that same range and we're seeing high quality assets particularly particularly down in San Diego in a sub 6 range. We're not seeing any letup in the appetite for people to acquire. I've never seen more people wanting to acquire assets than today.

Okay. Real estate taxes were down on your entire portfolio and also on a same store basis. Why does this happen?

We got some property tax refunds this year that compared to last year that brought the number down.

And do you expect any dramatic increase in San Diego particularly with the economy there?

No. And with prop 13 they can only go up 2% a year. Sometimes the refunds vary quarter-to-quarter on timing. But going forward, property taxes can only go up under the California constitution now by 2% a year. At least under the current law that's the way it works.

Final question is on El Segundo. Can you comment on Thomas Properties Campus El Segundo and whether or not you believe Boeing will be moving into that space and how that effects your properties there?

Well, we have no understanding of anything to do with Boeing moving there. And I don't know how the owner of that property could end up with even a remotely, minimally satisfactory development yield based on the construction costs and land costs that could be -- it would produce a rate far in excess, in my opinion, of the existing rates that Boeing has at our property. To give you a example, new development we're forecasting in most markets, of course it depends on your land price again and your entitlement extractions and so forth. But if you go back to my number a few moments ago, sort of 250 to 300 for concrete tilt up office surface park and 400 to 425 for Class A office space, do the math and think about what you have to have in equivalent triple net rents in order to justify new construction. So I think they're going to be a long ways off if it's industrial or office on that site.

So is there a potential for Boeing to renew their space?

There's always a potential. As I've said before, it is our intention to reduce down our Boeing exposure. We never intended to have the exposure to Boeing that we have had because they went up on a buying campaign of buying up all the aerospace companies or big chunks of them and we've done a good job of moving that down. There are other folks that have needs in El Segundo that we're dealing with. And over time, they have options, John. So it's up to them to exercise them or not. If they exercise them then obviously we continue on. If they don't exercise them, then we'll do deals with other tenants.

Okay. Thank you.

You're welcome.

[OPERATOR INSTRUCTIONS] Your next question comes from Jim Sullivan of Green Street Advisors. You may proceed.

Thanks. Just following up on Steve's questions regarding 909 Sepulveda. Can you comment on how the economics of that transaction have been affected by the long leaseup? What's your stabilized yield going to be factoring all the additional costs of holding the empty building?

Jim, I don't think we typically comment on the individual returns on buildings in our stabilized portfolio. It's obviously considerably less than we would have liked just as the yield at our headquarters building here at West Side Media was less at the time we leased it during a recession. But it's no question that it's less than we liked. One reason we have done both our typical leases both here at West Side and El Segundo are not real long leases and contracts with the rest of our portfolio was to try and preserve the ability to when rents roll up we will be able to roll the rents later on, but there's no question that rents have been cyclically depressed and that the absorption period is taking considerably longer than we would have forecasted.

You talked about your desire to reduce Boeing exposure. Can you comment on Seattle and where that fits into the equation?

Boeing expires in December of '07, Jim. They have the ability to give notice to early terminate in December of '06 with one year's notice. We're actually in the course of talking to them about a extension right now beyond '07, though.

Does that cancellation right make that effectively unsalable in the meantime?

You mean unsalable in the context of the asset being for sale or being sold?

Yeah. Can you sell it knowing that Boeing still has some options and flexibilities to what they end up doing.

Sure, you could sell it. The question is whether you would have some discount associated with the right to earlier terminate. And in our calculations, if just on the top of my head it would be probably somewhere in the neighborhood of $3 million or so.

Okay. The incentive comp, what's the dollar amount on the end of the quarter balance sheet related to that liability?

52.5 million.

Okay. The property tax refunds, I'm surprised to hear you're getting refunds given the appreciation in values. Can you help me understand what would have generated tax refunds?

This relates back to when we bought out the Allen group in 2002. It's relating back to prior years where there was a decrease in value and it just took time for the Counties -- for us to reach negotiations with the Counties to come to an agreed upon value and the refunds were subsequently issued this year.

We have a continuous program of trying to manage our property tax assessments on every project because your assessments in California get locked in, in effect forever. It is a tremendous incentive as a owner to try and minimize them over time because the value is just not that year but it's in effect carries forward forever and ever. So we look at ever property every year and pursue very aggressively strategies to lower the basis. Sometimes it takes a considerable long-term effort to do that.

That was a catch up relating to diminished value during the down part of the cycle and not reflective of today's valuation, is that right?

Yes. Absolutely.

John, you talked about potential development at Long Beach. Can you remind me how the option works there? You don't own the land but have access to it. How does that work again?

Well, we have an option on a negotiated basis with the city. First let me state that we have 1.6 million square feet of entitlements that we can use in Long Beach without paying further traffic mitigation or development fees to the city. We have the right to spread that around our existing properties where we have surface parking and because we already have some surplus structured parking or we can exercise our option on what was formerly known as the California National Guard parcel. The economics on that are very favorable. I don't have them right at the top of my head, do you, Jeff?

No. At the time we would have given notice it's basically we have a agreement where we determine the actual fair market value of the ground rent at that time based upon all the limitations relative to the agreement.

So our view on that is when we run the math, given the fact that we have a couple hundred surplus parking spaces at least and given the fact we have already put in the infrastructure and back bone to service that site, and given the fact that we have a very favorable land arrangement, the reason we think that site could be the next for us in L.A. County is because we're in the mid 90's on occupancy, the market is in single-digit, there's strengthening demand at that location. And because of the cost structure we have, we can in essence deliver product at a much more favorable cost, Jim, than if it was a site we were buying. In round numbers I would estimate we would be somewhere in the neighborhood of $100 in FAR a buildable square foot less expensive developing there than if we were to go buy a site.

Got it. And then final question for you, John. Can you comment on Microsoft's decision to move from Santa Monica to downtown? We've see very little migration of tenants from west L A. to downtown. The ones that we have seen have been I think exclusively financial services firms and architectural firms rather than tech companies especially with the prominence of a Microsoft. Can you comment on your view of their decision and what it might mean for west L.A.?

Jim, I think it's an anomaly.

Why?

I just don't see it happening. Our experience is that kind of migration other than for the type of firms that you've mentioned generally doesn't happen. And I can't speak. I have no personal knowledge as to what was in the calculus for Microsoft. But I would view it as an anomaly unless people need to expand, on the west side and can't find space, then they can either direct themselves to downtown where there's a lot of space and an increasing amount of space given the Arbor Towers now being back in play. Or they'll go to some other market if they can't find space here. Space in the west L.A., I don't know of a site that you could deliver development under $500 an square feet. It's probably more likely $600 a square foot with all the extractions and so forth unless somebody has a unique basis that I'm not aware of.

Okay. Thanks for that perspective.

You're welcome.

Your next question comes from the line of Frank Graywe [ph] with of R.R. [inaudible] Associates. You may proceed.

Hi. I was just wondering first how the restatement factors into your 2006 guidance?

I'm sorry, Frank?

How does the restatement factor into our 2006 guidance?

We think that the accounting change going forward is probably plus or minus $0.05 on an annualized basis. The derivatives part of that is obviously inherently unpredictable. So that's why I have to hedge a little bit on that. No pun intended. But we're one of the things we're going to study is whether or not the one swap we'll have remaining after this year whether or not we'll continue with that or not.

Okay. As far as your land balance goes, can you talk about if you were currently capitalizing that amount and if you expect -- I'm sorry, are currently expensing amount and if you plan on capitalizing once construction begins.

As long as we're actively pursuing development on the land in our pipeline, we do capitalize interest and we are actively pursuing development on all of those sites as actively as we possibly can as we see tremendous demand for them.

Thank you.

Your next question comes from Rich Moore of Keybanc Capital Markets. You may proceed.

Hi. Good afternoon, guys. Is there anything in the G& this quarter that has to do with the restatement? Or is that big increase in G&A strictly from the compensation program?

Nothing to do with the restatement at all. Purely and simply the special comp plan.

Okay. Very good. And then as far as bad debt expense goes, that was actually negative in the quarter? And that happens to you guys once in awhile. What happened there exactly?

Once in awhile we get refunds or not refunds. We get payments where we've had prior reserves. It's just bounced around.

In the third quarter we get a payment from Peregrin over the last two years and in the next year or so of $750,000. That's a reversal in the bad debt account.

We had fully reserved for that because obviously they had previously been bankrupt. And so as we've done in the last couple of years we waited until we got it. And then when we got it in effect we recorded it when we received it.

Okay. So do you anticipate that bad debt sort of the accrual you take sort of goes back to a typical quarterly level next quarter?

Yes.

Okay. And then I noticed that T.I. -- and I realize that's only one quarter but T.I.'s in the office portfolio seem to be down pretty substantially. Is there any positive news there trend wise or is that sort of an anomaly?

I think in general, I think that's a bit anomalist. But I think in general we see two conflicting trends. We have generally somewhat more pricing power particularly in San Diego and west L.A. between us and tenants. On the other hand the same cost inflation that John mentioned of development is absolutely apparent in T.I. buildups. So the two of them net are tending to offset each other right now. Any improvement that we were hoping for overall tends to get more than offset or at least offset by cost inflation.

Okay. Great. Thanks, guys.

Sir, you have no further questions at this time. I would like to turn the call over to Mr. Moran for closing remarks.

Thank you all very much for joining us on a busy day. We hope to see you all at Nehring. Thank you again.

Ladies and gentlemen, thank you for your participation in today's conference. This concludes the presentation. You may now disconnect. Have a great day.