Kilroy Realty Corp (KRC) 2006 Q1 法說會逐字稿

Good day, ladies and gentlemen and welcome to the first quarter 2006 Kilroy Realty Corporation earnings conference call. [OPERATOR INSTRUCTIONS] Well conduct a question-and-answer session at the end of this conference. As a reminder, this call is being recorded for replay purposes. I would like to turn the call over to Mr. Richard Moran, Chief Financial Officer. Please proceed, sir.

Thank you very much. Good morning everyone, thank you 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 well be discussing this morning is forward-looking in nature.

Please refer to a supplemental package for a statement regarding the forward-looking information in this call and in the supplemental. This call is being web cast live on our website and will be available for replay for the next 10 days both by phone and over the internet. Our press release and the supplemental package have been filed on a form 8-K with the SEC and are also available on our website. We released our first quarter financial results yesterday afternoon. FFO was $0.82 a share.

John will begin the call with an overview of the quarter, followed by a review of our key markets. I'll add financial highlights and updated earnings guidance. Then we will be happy to take your questions. John?

Thanks, Dick. Hello, everyone, thanks for joining us. Our experience during the first quarter of 2006 suggests the year is going to be a good one for Southern California commercial real estate. The economy continued to improve.

Job growth remained healthy and demand for high quality office space in our submarkets remain strong. Unemployment rates across the five county Southern California region continued to fall on a year-over-year basis. Los Angeles county has now posted 23 consecutive months of year-over-year job gains and has an unemployment rate of 4.3%.

Orange county's unemployment rate is only 3.4%. And San Diego's is 3.9%. In a region where every market is improving, San Diego continues to be the strongest, the county nearly doubled its net absorption of office space in 2005 to over 2.5 million square feet. Pushing down vacancies to near single digit territory.

And sharply boosting rental rates in the strongest sub markets. The area now ranks number one on the urban land institute's annual index of markets to watch. [Inaudible], as most of you know, is the leading office landlord and developer in the strong coastal markets of San Diego.

So far in 2006, we've negotiated 2 more major transactions, earlier this month, we signed a lease with the medical technologies company for the last remaining significant piece of unleased square footage in our San Diego portfolio. And just yesterday we signed a lease with the fortune top 20 healthcare company for more than 400,000 square feet of space including new construction that we expect to begin later this year.

Our more than 4 million square feet of commercial office space in San Diego is now 99% occupied or committed, in addition our construction pipeline now over 860,000 square feet is 100% preleased. And market demand in the region appears ready to accelerate further in 2006. Given these dynamics, we're looking hard at additional opportunities to add to our land bank and we're evaluating additional office development starts for later in the year.

With that overview, let's take a closer look at KRC's individual sub market. As I mentioned, San Diego's market continues to improve and is now capturing national attention as the urban land institute's recent survey demonstrates. Commercial brokers, CB Richard Ellis, put current active demand for office space in central San Diego at 8.2 million square feet.

This is the location of all our current properties and the bulk of our future development sites. Let's begin our review of KRC San Diego sub markets starting with Sorrento Mesa, the location of 2 significant transactions we have recently completed. KRC competes here in the two-story product type, which currently has a direct vacancy of 7.3% and total vacancy of 9.9%. These rates are both down about 1 point from last quarter. Our stabilized properties here total approximately 1.5 million square feet and are currently 87% occupied and 100% leased.

As I mentioned earlier this month, we signed a new 8-year lease with Dex com Inc. a medical technologies company for all of its 66,000 square foot building at 6340 Sequence Drive. This was the last significant unleased square footage in the San Diego portfolio.

In addition, KRC just signed a development lease with Cardinal Health covering 411,000 square feet of space and two buildings. Cardinal Health is a major healthcare industry product and service provider that ranks 16 on the fortune 500, with a market cap of nearly 30 billion. Cardinal's lease with KRC encompass a 2-B developed building totaling approximately 318,000 square feet that will be built on property we currently own in Sorrento Mesa and one adjacent existing building totaling approximately 93,000 square feet.

Is expected that Cardinal will occupy its new San Diego campus in the third quarter of 2007. The Cardinal transaction is another example of how our control of the best development sites in San Diego has allowed us to capture a large lease with a strong credit tenant with the potential to create significant new value for shareholders. Moving south of Sorrento Mesa is the UTC sub market which includes La Jolla. KRC competes here in the two-story product type direct vacancy in that product type is currently about 6.4%. In total vacancy 7.2%.

Our UTC properties are 97% occupied. Just north of Sorrento Mesa is the sub market of Delmar where KRC is the dominate office landlord with approximately a 1/3 market share. Current direct vacancy here is approximately 4.1%. And total vacancy is 9.7%. Our properties in Delmar are 100% occupied.

Easterly extension of the Delmar market is the 56 corridor, which is where we are under construction with the first 4 office buildings totaling 465,000 square feet within our Santa Fe summit project. This first phase is 100% leased to Intuit Corporation. The 56 corridor connects at the eastern end to the I-15 freeway which runs parallel to the interstate 5 and where we have approximately 1 million square feet of stabilized office product and industrial space. Currently the two story product type along the I-15 corridor has a direct vacancy rate of 2.3% and total vacancy of 3.8%.

In the class A product type, direct vacancy is 14%. And total vacancy at 6.3%. Our stabilized properties in this sub market are 99.5% occupied. We are currently evaluating the potential to start construction on a one or more office buildings along the I-15 corridor later in the year, and are advancing our development plans for our 20 acre site now known as Kilroy Center Rancho Bernardo in previously referred to as the Unisys property.

Finally in Carlsbad where KRC is in escrow to acquire type land near the cities airport, we are on track for an early fourth quarter acquisition date. That absorption in Carlsbad totalled over 110,000 square feet in the first quarter and the office vacancy rate was down a point to 6.3%. Moving to Orange county, our 3.9 million square feet of industrial buildings remain 99% occupied. The overall market is benefiting from strong demand and historically low vacancy rates with direct vacancy in the first quarter of just 3.3%.

Traveling north along the 405 corridor to the long beach airport market, demand remains steady so far in 2006, class A direct vacancy is 5.3%. Traveling north along the 405 corridor to the Long Beach Airport market demand remains steady so far in 2006. [inaudible] direct vacancy is 5.3 %, total vacancy is 6.9%. Our 7 building office campus is [inaudible] currently 91% occupied and 93% leased.

Further north in El Segundo, market conditions here continue their steady improvement, demand is up. Direct vacancy in the class A market is 16.3% and total vacancy is 19.4%. Both improvements of about 1 point from year end. Our leasing efforts in the El Segundo market continue to yield progress are 999 Sepulveda property is now 94% committed up from 89.5 % at year end, and committment at 909 Sepulveda now total 66 % of the building up from 55% at year end.

As we had mentioned on prior calls, Boeing will vacate 100,000 square feet at 2240 East Imperial Highway at the end of this month. We are currently evaluating alternative plans for a complete renovation of this property given that Boeing and its predecessors occupied it for more than 20 years. Let's move on to west Los Angeles. The office market here continues to strengthen with direct vacancy now at 7.8% and total vacancy at 8.9%. Our properties in the market totaling 677,000 square feet are 99% occupied.

Our last market in the Los Angeles area is along the 101 corridor in northern Los Angeles and Ventura county, where the overall market has a direct vacancy of 6.1% and total vacancy of 6.6%. Our properties here are 100% occupied. I'd like to spend a moment to provide an update on a few of the value added opportunities within our core portfolio that we are making progress on. As we have reported on the last few conference calls, we have identified several potential value added opportunities in our portfolio including industrial to residential rezoning opportunities.

In Orange County, we are on track to have a city approval on a 9 acre plus site before year end. We expect to have further details on our progress later in the year. We have also entered into a letter of intent regarding lease termination with an existing tenant whereby the combination of the net lease termination fee that well receive up front and the value of the real estate unencumbered by the current lease creates the potential for significant added value as we pursue either redevelopment or a sale of the property. Dick will discuss the financial impact of this later in the call.

Our goal is to continue to identify and exploit value added opportunities in our core portfolio where we believe we can unlock additional shareholder value. In summary our stabilized portfolio of 12.4 million square feet is 95% occupied. Our committed development pipeline of 860,000 square feet is 100% preleased and our markets continue to improve. With our development pipeline totaling 1.5 million square feet of additional space, we believe we are extremely well positioned to continue to add state of the art development in the coastal high demand areas of San Diego county. As I said earlier, given these conditions we are evaluating both additional land purchases and additional construction starts in San Diego where we continue to see significant value creation opportunities with strong risk adjusted returns.

That's a recap of our markets. Dick will cover the financial results.

Thanks, John. FFO in the first quarter was $0.82 per share compared with $0.81 in first quarter of2005. Occupancy and stabilized portfolio at the end of the first quarter remained at 95% up from 94.1% a year ago.

Same store NOI during the quarter both on a GAAP and cash basis was up, GAAP NOAI was up 3.9% and cash NOI increased 7.3%. Those numbers reflect incremental improvement in both occupancy and rental rates. GAAP rates in the first quarter were up 5.1 % and cash rents were down 3.9 % as rental rates have increased in our markets, we now estimate that our overall portfolio rent levels are currently approximately 5% or so under current market rates.

Following our first quarter leasing activity we now have approximately 880,000 square feet of expiring leases through the remainder of 2006. Although, that includes the 300,000 square feet cover by the Unysis lease at the Rancho Bernardo property we purchased last year. Our plan since we acquired the site is to been to redevelop it when the Unysis lease expires in September. Capital expenditures in the first quarter were $ 2.7 million bringing our FAD payout ratio to 79%. Where no significant changes to our balance sheet during the first quarter are debt was [inaudible] 64% fixed.

To add additional funding capacity for our development program. We're currently in the process of modifying our unsecured bank line to increase the amount from 425 million to 550 million dollars plus 100 million dollar accordion feature lower the prices and extend the terms 2010. We expect to close the modification this week. We completed another disposition during the first quarter, selling a nonstrategic industrial building in Stockton, California for proceeds of just under $17 million. The book gain was approximately $ 5.7 million.

Turning to development with recently signed Cardinal Health transaction, our committed pipeline now comprises 6 buildings totaling 860,000 rentable square feet , which is all 100% preleased. We expect to spend about $ 245 million on these six buildings with about $ 74 million spent to date. Let me finish with 2006 earnings guidance. First I should mention that our annual 2006 executive LPI plan hasn't been determined yet, depending on how it is structured, it could be an effect on our future earnings guidance and reported results.

Last quarter we provided 2006 FFO guidance of $3.11 to $ 3.27 a share . Since that LIBOR has increased by just over 50 basis points which translates to an additional $ 0.06 of interest expense for the year based on our average projected floating rate borrowings, partially offsetting that, the new credit line extension we're about to enter into will cut our borrowing spread by 25 basis points which translates to a savings of approximately $0.02 a share over the balance of the year. Taken together, these two items would increase our financing cost by a net of $ 0.04 a share for the year. In addition, our latest forecast includes a variety of small pluses that add up to a potential $0.0 5 to $0.06 a share of other net earnings increases for the year. Going the other way, we expect $0.05 a share of higher G&A expense as a result of higher projected compensation costs.

And finally as we mentioned earlier, we're working on the possible lease termination -- possible termination of a lease on one of our projects with the objective of getting at and maximizing the value of the real estate. Assuming we convert the letter of intent we have with the existing tenant to a final agreement, the lease termination fee, net of all related costs would add roughly $0.10 or more, to its 2006 FFO. Taking all of that together, we're advising our existing 2006 FFO guidance range of $3.11 to $ 3.27 a share to a new range of $ 3.07 to $ 3.33 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 Mr. Louis Taylor, please proceed, Mr. Taylor.

Thanks, good morning, guys, congratulations on the quarter. John or Dick, can you tell me a little bit about the drop in leasing costs during the quarter. Do you expect that to be sustainable and if not. What do you think is a good range for the balance of the year.

You're referring to leasing costs, you mean -- I mean, that's bouncing around depending on where we're leasing our product. I think the average leasing costs over the last three quarters have declined slight limit overall, I don't think there's a trend down there.

Okay. The next question is, is John, in terms of -- as you look at your development pipeline, if everything went well, I mean, how much more do you think you could start the calendar '06.

That's always the 64,000 dollar question. If you look at last year, in the first quarter we announced intuit for 345,000 square feet, subsequently in the 4th quarter they took the 4th building to take that up to 465. We announced in the second quarter the American home lender deal for 270 some thousand square feet. So far this year, we're doing 318,000 square feet anew. I would be very surprised if we didn't see kind of a continuation of that trend.

It could be substantially greater if a decent percentage of the deals were currently negotiating or having detailed discussions on were to come to fruition. There's very little available product in the market that meets the needs of the types of tenants we're dealing with, so we think we're ideally positioned, but I don't know whether you want to give a run rate. I can't crystal ball it.

I'm not looking for a run rate. In terms of now and the end of the year, do you think you'll start 50 million, 100 million?

I think --

What's a fair?

I think that we stand a good chance to start another $ 100, 200 million of product based upon what I'm seeing right now. But I'm not going to rate that at 90%, I'm going to rate that some place, somewhere between 50 and 75.

Okay. Fair enough. Thank you.

You're welcome.

Sir, your next question comes from the line of Mr. Steve Sakwa of Merrill Lynch.

Thank you, good afternoon. John, I was wondering if you could talk a little bit about the San Diego development pipeline in general, not yours specifically, but the market. It seems like a lot of developers have come to San Diego and looks like the pipeline is continuing to ramp up, I'm wondering if that's your sense, whether you're even becoming moderately concerned about the amount of development and the new starts that you're talking. Would those be spec or build to suit?

Every time we've tried to do a spec building its ended up being -- not every time, but the lion's share have been leased prior to construction. I think we probably see a combination of both, if you go back to the vacancy rates I was mentioning, Steve, in the formal presentation they're pretty low. We're extremely well positioned, I think what we're really seeing is not only a combination of demand and scarcity of sites and so forth, and we control a lot of them. But we're also seeing a lot of our tenants and tenants we've been working with kind of gravitating toward our organization given the talents we've been able to demonstrate the kind of product we've been able to build down there and so forth. So it's -- you know, we think we're well positioned to kind of go over what's under construction in the markets in which we are active in San Diego in the UTC, La Jolla sub market you have 215,000 feet under construction. One is Alexandria's 65,000 square foot building plus or minus Life Sciences, which is 100 leased. You have EOP with their Bridgeport development under 50,000 square feet under construction. I don't know if they've announced any leases yet.

In Sorrento Mesa , you have 1.2 million square feet under construction. But when you take a look at that, two of those projects are for Qualcomm that are 100% leased and owned by Qualcomm. One is again [Genprobe], which is a big project also owned by them, and the remaining project that's not owner occupied or long term committed by owner is a 45,000 foot multi tenant building preleased, which is under construction, which is 50% preleased. If you move up to Delmar there's 705,000 square feet under construction which consists of two projects, one is the Crescent JMI joint venture of 240,000 feet. Which is 50% leased, my understanding according to the brokers is up to 75% committed with LOI's at rates of 375 plus utilities and the second project is KRC's first phase of Santa Fe summit which is 465,000 square feet and 100% leased to Intuit. And up at the I-15 corridor, have you three project under construction. One is in our NRICC development which has 75,000 feet which is a preleased 100%. You have a 5-story project that started of 115,000 square feet, I don't know if they have any tenants. And then you have Mental properties with 130,000 square feet under construction, and I don't know what their leasing status is.

If you move up to Carlsbad, have you 500,000 square feet under construction. What's interesting about that market is that while there are various owners and developments, what's under construction is essentially geared toward either small buildings for sale which is the vast majority of that 500,000 feet with quite a few pre sales and then there's two class A multi tenant buildings under construction. We don't compete with either of those with the property we're buying later on this summer at a very favorable cost basis. So I -- when you take a look at the available sites, you look at how Kilroy's positioned. You look at the status of that which is under construction. And by the way, I ignored a couple buildings in downtown San Diego because I don't view that as relevant to what we're doing. I think it's a healthy market for us.

Okay. And then could you talk a little bit about the development yields maybe on the incremental 100 to 200 that you mentioned earlier in terms of potential new starts, given where rents are in these sub markets. Could you talk about returns.

First of all. As I mentioned last quarter, this is bounced up a little bit, a few of the markets, over the next couple years, if you look at Kilroy's markets across our entire portfolio, we see rents increasing anywhere between 8 and 25% with an average being, I don't know, some place -- in the middle, I suppose, in San Diego we could see quite a bit better than that, in a few of the markets, again based upon the demand, supply characteristics, I can tell you on the deal we just did with Cardinal, which is about a $ 78 million build to suit, the component that's the build to suit, not the existing building. We got a return on cost cash 9.5% and just at 10% on straight line.

So you would see those types of returns, I guess consistent and achievable on kind of the land balance that's remaining, which is a little under a million feet.

Well, that's kind of the -- we shoot for sort of the 9 to 10, some cases it's higher, some cases it could be a shade lower, depending upon the characteristics of the transaction. Obviously we've seen a construction cost, which we're figuring into all of our numbers that it's gone up about 3/4 of a percent per month. We've seen a little bit higher, a little bit lower. But on average, that's what we're forecasting, and we're seeing rents grow at like I say, anywhere from in the better markets of San Diego, they're growing significantly above 8%, so I think those yields are probably pretty good. In the 9% to 10% range.

Thanks.

Sorry for the long answer.

Gentlemen, your next question comes from the line of Ross Nussbaum from Bank of America Securities. Please proceed.

Thank you. It's John Ken with Ross. Regarding 909 Sepulveda can you comment on the tenants looking at that space and if they're coming from other sub markets?

Yes, they are coming from a lot of different markets, we have a number of PR firms that have come from the Westside. We have a healthcare group that's come from outside the area. We have another public relations firm that's come from Santa Monica. We have a computer company that's coming from outside the area, so most of what we're seeing is not indigenous to El Segundo, it's outside.

When you're talking about commitments from 66% of that space, is that all going to be occupied sometime this year?

Yes.

Okay. Regarding the west L.A. Market and how --

Just one more thing, John.

Sure.

Just on El Segundo, kind of an interesting number, I'm looking at a piece of paper here, if you look at the 909999 as a percentage of the class A market it's roughly 8%, we capture -- we've had a capture rate of 42% in that market.

Is there anyway within your portfolio or even through new development that you could capitalize on the strength of the west L.A. market.

We're looking at a lot of different things, I don't feel comfortable getting into specifics with all the people that can listen to these calls and given the reporting, but just let's say that we're looking at every asset, we're looking at assets that we don't own with regard to how we can create better -- more value, and we have quite a few opportunities on the board, whether they'll all come to fruition is another thing. But we're working hard at both uncorking value in our core portfolio as well as evaluating new opportunities.

Okay. Final question just regarding the potential industrial redevelopment that you have in Orange county. Have you lined up a residential developer to partner with if you decide to do it on your own.

We wouldn't do it on our own. And there's the potential that we could partner, what we're thinking more of is the likely selling the property once it's rezoned, there's quite a premium on selling it once it's rezoned versus selling with the entitlement risk. We're told we're going to have the zoning here in the fourth quarter. At least on the first property we're rezoning. Were looking at a potential profit on that property from 40 to north of $ 50 million of a 9 acre site so depending upon--

Can't always say the market's going to hold up, everything we see right now suggests that's going to be a winner for us if we sell it. Could we create a better valuation by doing a joint venture, possibly? Will we look at it? Sure. Right now I'm probably inclined to sell it.

Okay. Thank you.

You're welcome.

Again, ladies and gentlemen, if you would like to ask a question, please press star one. Sir, your next question comes from the line of [Tre] [Nasarasa]

Thank you. My question has to do with your comments on the G&A expenses for the '06 guidance. You talked about the plan not being set. I was wondering if you would comment on where it is right now, and with respect to the 8K file that you guys filed last week.

Well, the 8K was, of course, just to note that the committee had approved structure for salaries and bonuses for the executives for this year and that they're still working on the LTI plan which we expect will be an evolution of the existing LTI plan but they haven't concluded on that yet. So that's what we said in the 8K and that's what I was mentioning here, we don't have a specifically determined program yet.

And in terms of your assumptions and what is going on the G&A, you don't assume any competent of that?

Well, we have an assumption in there, but but we don't know that we've been correct or incorrect. We've made our best estimate, but we want to be specific and say that we -- it's possible that we won't be right.

Thanks.

Gentlemen, your final question comes from the line of Mr. Dave Aubuchon of AG Edwards, please proceed, sir.

Thanks. John on the industrial to residential rezoning, would that be -- or maybe this is a question for Dick. Would that be a structure of the landfill, therefore included in FFO at some point in the future?

Dave, I don't -- we haven't obviously concluded on whether we would sell our venture or somehow otherwise retain ourselves, although we have different pro forma under different assumptions that I think in the past we've conformed to the definition and would continue to do so.

Thanks.

Gentlemen, I'm showing no further questions at this time.

Thank you all very much for participating in our quarterly call. We appreciate your interest in KRC. Have a good day. Thank you.

Ladies and gentlemen, thank you for your participation. This concludes the presentation, you may now disconnect.