Kilroy Realty Corp (KRC) 2007 Q1 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the first quarter 2007 Kilroy Realty Corporation earnings conference call. I will be your coordinator for today. At this time, all participants are in a listen-only mode. (OPERATOR INSTRUCTIONS) We will facilitate a question and answer session towards the end of this conference.

I would now like to turn the presentation over to your host for today's call, Mr. Richard Moran. Please proceed, sir.

Thank you very much and good morning, everyone. Thanks for joining us today. Our John Kilroy our CEO, Jeffrey Hawken our COO, Tyler Rose our Treasurer and Heidi Roth our Controller. At the outset, I need to say 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 the replay for the next 10 days both by phone and over the internet. On our press release and supplement package have been filed on a Form 8-K with the SEC and both are also available on our website. We released our first quarter results yesterday afternoon. FFO was $0.75 a share.

John will start the call with an overview of the quarter in our key markets, I will add financial highlights and updated earnings guidance and then we'll be happy to take your questions. John.

Thanks. Hello, everyone. Thanks for joining us. Commercial real estate in Southern California turned in a solid first quarter. Strong demand and limited supply continued to support favorable operating conditions. The state's current economic outlook also remains positive. Analyst suggest that barring an unforeseen global crisis, California will see the benefits of a six-year U.S. economic expansion. More specifically, the L.A. County Economic Development Corporation forecasts that the state will add nearly 160,000 net new jobs this year, the majority of them in Southern California. Their analysis predicts that softness in residential housing will be more than offset by continued growth in international trade, business, and professional services, biomedicine, and technology, commercial aerospace and tourism. Statewide unemployment continues to move within a very narrow band. In February California's unemployment rate was 4.8% for the third consecutive month and for the sixth time in eight months. With that steady economic back drop demand for commercial office space has grown steadily in Southern California and we've seen no change in the trend this quarter.

Here at KRC we made good leasing progress in the first quarter. Within our stabilized portfolio leases commenced on just under 300,000 square feet of space with average rent increases of 36% on a GAAP basis and 15% on a cash basis. Within our development and redevelopment pipeline our seven projects remain on track. We expect deliveries to begin as scheduled in the third quarter of this year and to continue through the end of 2008. The total estimated investment represented by these seven projects is approximately $383 million and there is 76% preleased. Included in these figures is our redevelopment project at Saber Springs corporate center located along the Interstate 15 in San Diego County. You'll recall that we purchase this two-building property in January for approximately $25 million. Since our last call we launched a redevelopment effort at the property that should take about six months or so and cost about $9.4 million.

We already are in negotiations with various prospects for this asset. In addition, as we previously reported, we closed in late January on a $28 million acquisition of 10.5 acres of land that will comprise third phase of our Santa Fe Summit project in the Del Mar market. At final buildout the entire three-phase Santa Fe Summit project will encompass more than 1 million square feet of state-of-the-art office and support retail space. In February we closed on Carlsbad Oaks acquisition adding the 32-acre parcel to our pipeline of entitled land for a purchase price of about $16 million. Given recent land sale transactions in Carlsbad, we believe this purchase price is well below market. Carlsbad Oaks is located near the Palo Mara airport in the San Diego County city of Carlsbad. With the completion of these transactions our future development pipeline now includes fully entitled land parcels located in the best submarkets of San Diego County including Sorrento Mesa, Del Mar, the I-15 Corridor and Carlsbad with total construction potential exceeding 2 million square feet of office space and representing total potential investment of between $700 million to over $1 billion depending on the density of future buildout.

Now let's review individual submarket conditions starting in San Diego where demand for commercial real estate remains strong and at levels similar to the last couple of years. Central San Diego, the location of all our properties in active development is currently registering active demand for office space of approximately 6.9 million square feet according to CB Richard Ellis. Given KRC's leadership role in both development and property ownership here, we monitor new supply trends very carefully. As of the first quarter there was about 2.2 million square feet under construction in our core markets, 1.2 million of which is our own 75% preleased development. In Del Mar one of the most attractive office markets in Southern California, KRC is the dominant office landlord with approximately a one-third market share and a two-thirds market share of top tier Class A product. Current direct vacancy here is approximately 5.2% in total vacancy at the end of the first quarter's recorded 15.3% not included in the first quarter 2007 total vacancy number is a recently completed sublease transaction that brings the total vacancy to 12%. Our stabilized properties in Del Mar are 100% occupied. South of Del Mar in the submarket of Sorrento Mesa, KRC competes many two and three-other office products. Direct vacancy for this product type is currently 6% and total vacancy is 9.5%. Our stabilized properties here total approximately 1.5 million square feet and are currently 100% occupied.

In the UTC Governor Parks submarket just south of Sorrento Mesa we also compete in the two-story product type current direct vacancy is about 1.4% and total vacancy about 5.7%. Our UTC properties totaled 430,000 square feet and are 100% occupied. On the I-15 corridor KRC now owns approximately 750,000 square feet of stabilized office space, the two-story product type here as a current direct vacancy rate of 8.4%, total vacancy of 11.4, and Class A product type direct vacancy is 11% and total vacancy is 14.5%. Our stabilized properties here are 91% occupied. Moving north to Orange County, KRC's 3.7 million square feet of industrial properties are 91% occupied. That vacancy rate reflects the 157,000 square feet industrial project we are currently rezoning to residential and two other industrial properties totaling 192,000 square feet that recently were vacated. We expect to have the rezoning process complete mid-year on the 157,000 square feet building and are in advance negotiations to lease the recently vacated 192,000 square feet. The Orange County industrial market continues to be quite strong with vacancy rate of only 3.8%. The County's unemployment rate is 3.4%, the lowest in the state. Further north at Kilroy Airport Center Long Beach our seven building office campus immediately adjacent to Long Beach airport is currently 92% occupied, demand here is instead by Class A direct vacancy of 6.1%, and total vacancy of 8%.

Now let's move to to El Segundo where our stabilized properties are currently 92% occupied. Direct vacancy in the El Segundo Class A market is now 17.3%, in total vacancy 17.5%. This market continues to improve both from internal growth and from the strength of the West Side Market.. In terms of West L.A., direct vacancy is 6.4% while total vacancy is at 7.5%. Rents for the better buildings in this market now have reached the mid-4 to mid-$5 range on a full service gross basis per month. As an example, we just recently approved a sublease transaction one of our buildings where the total consideration increase from about $3 per month to about $5 per month. Our properties in the market totaling 680,000 square feet are 97% occupied. Our final submarkets along the 101 corridor running through northern Los Angeles and southern Ventura Counties, this market has continued to perform well with low vacancies and rising rental rates, direct vacancy here is currently 6% and total vacancy 7.3%. Our properties here are 98% occupied. That's an update on our first quarter activities and markets.

Let me wrap up with a few general comments about our business. Job growth forecasts continue to be positive in the number of active tenant requirements remain strong. In our San Diego submarkets alone, there are over 20 active tenant requirements of 100,000 square feet or greater. As a company we feel we are well position to do capture a significant share of these leasing and development opportunities. We remain confident in our ability to continue our growth and build shareholder value. Now, Dick will cover the financial results. Dick.

Thanks, John. FFO in the first quarter was $0.75 per share, occupancy in our stabilized portfolio at March 31st was 94% compared to 95.8% at year-end. Our office portfolio was 95.5% occupied, and our industrial portfolio was 91% occupied. As John mentioned the decrease in industrial occupancy was mostly due to two vacancies in our Orange County portfolio, that total approximately 192,000 square feet. In addition our industrial occupancy is negatively impacted by our residential rezoning project in Irvine that accounts for 157,000 square feet or 4% over our industrial vacancy rate and that's equivalent to 1.4% of our overall vacancy rate. Same store NOI increased in the first quarter with GAAP NOI up 4.6% and cash NOI up 5.5%. While occupancy was down year-over-year rents were up during the quarter. GAAP rents were up 36% and cash rents were up 15%. While rents were up across the portfolio, most of the growth came from the west L.A. and San Diego office submarkets.

In addition, bad debt expense was lower compared to the first quarter of last year, the 700,000 reduction was a result of the collection of about 300,000 dollars in receivables that had previously been reserved and better overall collection experience. Based on our latest analysis, we believe that our overall portfolio rent levels are about 5 to 10% below market and that our remaining 2007 explorations are 10 to 15% below market. Capital expenditures in the first quarter totaled $4.3 million, our FAD payout ratio was 83%. As we discussed in our year-end call the first quarter was an active period for both acquisition and dispositions. We sold two El Segundo projects in January and over 62,000 square feet office building and a small 60,000 square feet industrial building. Net proceeds were 14.8 million and the book gain was 8.6 million. We also completed three acquisitions during the quarter including the $28 million Santa Fe Summit, Phase III land acquisition and the $24.7 million redevelopment project now under way at Saber Springs Corporate Center. In February we completed the purchase of the Carlsbad Oaks development site for a total price of $15.8 million. We have a large development program in progress this year with $383 million of development and redevelopment under way including seven projects totaling ten office buildings and just over 1.3 million square feet. We spent $216 million to date on these projects and they are 76% preleased. Delivery will begin later this year and we expect the program to make a significant contribution to earnings growth in 2008.

In terms of the balance sheet we announced in late March and closed early in the second quarter the sale of $460 million of convertible debt with a coupon of 3.25% in the five-year term. The conversion premium is 20% and we entered into transactions with underwriters to increase the premium to 40% to an effective conversion price of $102.72 a share. Of the $421 million of net proceeds $331 million was used to pay down our line of credit, $66 million went to pay off two secured mortgages, and $21 million will be used to pay off two additional secured mortgages later this quarter. We now have no outstandings our $550 million revolver. We have the entire amount to fund our growth program. The average cost of the debt repaid with the convertible debt proceeds approximately 6.2%. Our weighted average costs debt costs is now 4.7%, and 100% of our debt is currently fixed rate.

Before I move to guidance, let me make a few comments about our exposure to the subprime lending business. First, it is important to remember we have very little office space in Orange County where the subprime business in Southern California is (Inaudible) concentrated. We did have four small leases in San Diego, Seattle, and Long Beach with New Century that had annualized rent of approximately $680,000. In aggregate these leases are about 10% below market. Given its bankruptcy filing we're not including any further rent from New Century in our guidance. Beyond that our total annualized rent from the subprime lending sector is $5.4 million or 2.4% of our total annual GAAP rent that's comprised almost entirely of $5.1 million or 2.3% of our GAAP rent from a credit to home lenders which is a tenant of our in the Rancho Bernardo market of San Diego. Accredited lease is approximately 180,000 square feet in three buildings with leases that expire in 2016. A credited rent is equivalent to $0.15 a share on an annualized basis or $0.11 over the remaining three quarters of the year. It is worth mentioning that Rancho Bernardo is mainly an office location for tech, defense and other large corporate users. It doesn't have the subprime concentration that exist in Orange County and as John mentioned in the 2-story product type in the I-15 market that includes Rancho Bernardo, current direct vacancy is 8.4% and the total vacancy rate is 11.4%. We also have another $2.2 million or 0.9% of our GAAP rate-- GAAP rent, excuse me of exposure to non-subprime mortgage related tenants include Wells Fargo, Country Wide and American Home Mortgage.

Now let me finish with 2007 FFO guidance. Last quarter we provided 2000 FFO guidance of $2.87 to $3.03 a share. Our updated guidance includes the following key assumptions, first, that we receive no additional revenue from New Century, second, we continue to receive our scheduled rent from other remaining subprime tenants including the $0.11 a share due over the rest of the year from accredited, third, we expect as a result of the normal roll over on releasing cycle our occupancy rate will trend down another point or so through the middle of the year and then as we lease up the vacant space end the year in the 95% range.

Finally, our guidance includes a projected $0.11 a share increase in FFO related to our convertible debt offering. This assumes $0.24 in interest savings as a result of the approximately 3% savings in interest expense on the convertible debt, offset by $0.05 of related fee amortization, and $0.08 of lower capitalized interest from an approximately 1% lower weighted average debt costs as a result of the convertible offering all over the remainder of the year. Taking all of that into consideration, we're increasing our 2007 FFO guidance range from a prior range of $2.87 to $3.03 a share to a new range of $3 to $3.15 a share. That's the latest new from here and now we'll be happy to take your questions. Operator.

(OPERATOR INSTRUCTIONS) Your first question comes from the line of Michael Bilerman with Citigroup. Please proceed.

Erin Guzman here with Michael. My first question is about your Santa Fe Phases 2 and 3 which look like they will cost about $500 a square square foot all in. Can you talk about what rental rates are like there now and what rental rates are going to need to achieve the 9 to 10% yields you get on the rest of the pipeline?

Sure. This is John speaking. The rental rates that we're looking at there are going to be in the mid-$4 plus utilities, and if you back all of that out, it ends up being in the high $3 triple net equivalent. To give you an idea, there is where that is in the marketplace is there is a product under construction just south of Del Mar. It is in the Del Mar statistics although it is not yet reflected as being leased where they just signed a letter of intent with a 100,000 square foot plus tenant and I believe the going in rate is slightly north of 370 plus bumps and so forth. That would be a secondary location compared to the ones you're talking about.

Okay. What comprises most of the difference in cost versus Phase I? Looks like it is about $200 per square foot more. Is that mostly land?

Well, no. Some of that is land. Our land basis in Phase I was in the early 30's. Our land basis in Phase II is around I think around $70 a foot. Our land basis in Phase III, I am talking about buildable square foot, our land basis in Phase III is going to be in the 120 or thereabouts, but we've also encountered significant construction costs increases, 30, 40% since we did Phase II, and we're projecting increases for the future, so that's our best estimate based upon all of those factors.

Okay. Sticking with the development pipeline, how much do you guys expect to start out of the 1 billion in shadow, and where do you think that will be concentrated?

Well, it is going to be concentrated in San Diego. We have a number of negotiations going on at any one time, so I think you will see more in the Del Mar area and more in the Sorrento Mesa area this year if we continue to see what we think is going to happen.

Are you guys actively marketing any of those projects?

We're actively marketing all of our projects. We have discussions, tours, negotiations going on on most of our sites at any given time.

One other question on development. For the two projects that currently 0% preleased and they have been that since last quarter as well, is that intentional? Are you holding back on those projects?

We're not really holding back. If you take a look at the two projects you're referring to, one is at the Intersection of I-15 and 56, which is our Kilroy Saber Springs project in which is we have a new 140,000 square foot building under construction, that building will come on stream at the end of the year, at least the shell will. We think the market is getting better. Rates are certainly going up. It is a multi-tenant building. It is the third and final phase of what will be roughly a 450,000 square foot phase or project, and you don't normally have a lot of preleasing and multi-tenant. The other building you're referring to is the 57,000 square foot building that we started late last year on what we refer to as lot three at Sorrento Gateway. We have that building. We have a number of prospects interested in all or part of that building, and there is tremendous interest, so our hope and expectation is that we'll have that building leased before it is complete.

Okay. Just one more question and I will jump off. Can you guys break out what your expectation is for G&A for the year and what the comp piece of that is?

Based on our current forecast our expectation for G&A is about $9 million a quarter for the rest of the year.

How much of that are the two comp plans going to roll in this year?

The amortization related to the 2006 award program is about $0.28 a share, and the cost based on our current forecast for 2007 award program is about $0.28 a share.

Okay. Perfect. Thanks a lot.

You're welcome.

Your next question comes from the line of Jeff Miller with JMG Capital. Please proceed.

Hi. A few quick questions. Can you go over the subprime exposure again that you have in I think you had one building with new century.

We have essentially remaining exposure beyond the force model leases with New Century we're assuming we will not receive future rent on. Essentially our remaining exposure amounts to credited home lenders where the annualized rent is $0.15 a share, and the remaining three quarters exposure is $0.11 a share over the balance of the year. Obviously you guys can do your research on accredited and we just wanted to highlight that. Beyond that we have in round numbers we have under a $0.01 a share in all of our other subprime exposure. It essentially boil down to accredited, and as I mentioned and John touched on in his remarks the Rancho Bernardo market is essentially a corporate tech and defense market without much subprime exposure. That I think we feel very comfortable in the long-term dynamics of that market and doesn't have the concentration of subprime business.

Right. Can you just give me quickly the cash from operations generated for the first quarter? I didn't see any cash flow statement on your supplemental.

The net cash from operating activities activities if you flip to page 29 of the supplemental is about $35.3 million for the first quarter. Is that the number you're looking for?

Yes, 35.what? Sorry.

Page 29.

Page 29, $35.4 million for the quarter.

Great. Great. Thank you very much.

You're welcome.

Your next question is from the line of Lou Taylor with Deutsche Bank.

Thanks. Good morning, guys. John, just going back to the development start question this year, just ballpark in dollars, I mean what's your sense of what your starts will be this year?

Yes, Louis, we've said we think we're going to be somewhere in the 150 plus or minus, and right now we've got sort of 34 under way that we started this year with a new redevelopment project, the buildings that we acquired out essentially adjacent to our Kilroy Saber Springs building. Those are two low raise buildings. I think we're still very much in line with that earlier estimate. It obviously depends on how many deals we're going to land, but based upon our discussions with brokers, based upon our discussion with tenants, based upon where demand in the market is et cetera, our best guess right now although it is early in the year is we're going to reach that number. I know a lot of people have been talking about San Diego with regard to is the market cooling, and there hasn't been as much absorption this year and so forth, and I can't resist but to just deals that we are absolutely know about absorption brokers and I think we're right there with them is likely to be about where it was last year, maybe a little bit less. Last year was 2.5 million square feet, and that absorption in our markets it looks like it is going to be somewhere in the 2 to 2.2, 2.3 million square feet this year, and I think that bodes real well for development starts, Lou.

Thank you. Dick, you mentioned that your rents on your '07 rolls if I got it correctly about 10 to 15% below market. As you look at your '08 rolls, what's your estimate for those leases?

Just one second, Tyler says he has the exact number here.

On the office side they're up about the same rate, about 15% below market. On the industrial they're a little bit lower, so the total is about an 8% below market number.

Okay. What drove the anomaly in the first quarter with the number being so high?

Just a particular concentration of west L.A. and the most -- the busiest part of San Diego or the strongest part of San Diego.

Okay. And last question is just with regards to renewals you're working on right now, how far in advance are tenants looking? Are these people-- are these leases that are rolling late in '07 early '08 or do you have any late '08, '09 type of leases where people are saying rents are going to be higher, I want to do a blend and extend deal now. How far in advance are tenants looking with regard to renewals?

This is John again. I am going to ask Jeff to comment more specifically, but what we're seeing now is quite a few tenants are concerned about the long range facility costs, and want to engage us with regard to or landlords or whoever they may be with regard to trying to come to grips with that now because it is pretty clear that with where construction costs have gone and are going, and with the scarce at this of Greenfield, et cetera, et cetera, that rents are only going to go up and people are trying to figure out a way to moderate that.

This is Jeff. I would echo that. Obviously with the market rates increasing tenants are most anxious to try lock in rates now as the rates continue to go up it bodes better for landlords and owners.

Okay. Thank you.

Your next question comes from the line of Mr. Nagarajan with RBC Capital Market. Please proceed.

Most of my questions have been answered. Just a quick question on Carlsbad Oaks. The buildable square feet looks smaller given the 32 acres. Can you give us color on the future entitlement and what kind of use are you seeing? I notice it is office, but is there a possible for office and industrial mix here?

Sure. Our land base is very low there. There has been a recent sale of 10 plus acres that just sold it the over $30 a square foot for the land. Our price is quite low. The premise that we've always had with regard to that property is we have very unique views. We have very unique access, ability to those sites, and we have a very low bases, so we can go with more flex or we can go with office. We think it will end up being office. We can go with more density than we've talked about, but has has been historic with Kilroy is we try to under write these things, communicate to the market based upon a conservative approach to development rather than maximizing every square foot, and then we communicate if we feel that we can build more square footage and that makes sense we'll upgrade our or amend our supplemental with regard to square footage that we think is going to be built.

Okay. One quick bookkeeping question. In terms of the guidance itself obviously reflected on the factor the capitalized interest was going to go down given the interest rate, the weighted average interest rate. I am assuming that's the entire function is just the weighted average interest rate is going to go down by 2 to 4 percentage or so? Is that the --

Well, our weighted average cost to debt right now as I recall is 4.8.

4.7.

4.7, excuse me, went down roughly a point. You're correct. There is an offset there since we haven't a big development machine going on right now. It does reduce the what would otherwise be the earnings effect.

Okay. Great. Thanks.

(OPERATOR INSTRUCTIONS) Your next question comes from the line of Dave Aubuchon with AG Edwards. Please proceed.

Can you review one more time if you wouldn't mind the net proceeds from the exchangeable note offering and the different debt buckets you paid off?

Sure. One second. It was $331 million you see on our line as of March 31st was repaid, and then we had $66 million that paid off two secured mortgages already, and then as another $21 million that we'll use to repay two additional secured mortgages a little bit later this quarter. They're not quite open for repayment yet. It will be very short.

Okay. Then you have no cash then after that?

Essentially. We wound up with other than rounding essentially using the full proceeds in the near-term pay down debt obviously over time, but we expect to redeploy back into the development the immediate use was that.

Okay. With regards to Phase I of Intuit and the Cardinal Health development projects scheduled to be done or at least completed in the third quarter of '07, economically are you -- how much are you including in the guidance relative to 2007? Is it the full -- is it full bore in the fourth quarter of 2007?

With Intuit, I think it is about half a quarter. It come in the middle of the quarter.

In Q4?

No, in Q3.

Q3. Okay.

Half comes in Q3, and the balance comes in Q4.

Okay.

You'll get a full quarter of Intuit in the fourth quarter.

And then Cardinal Health?

That is later in the third quarter as well. You won't get much of that in the third quarter.

Right. Okay. And they then just so we know, you stripped out the New Century income from your guidance. How much was that?

That was roughly $0.02 a share.

Okay. For the balance, for the annualized.

That was annualized just short of a-- a little under $0.02 for the remainder of the year.

Thank you.

At this time we have no further questions. I would like to turn the call back over to Mr. Richard Moran for closing remarks.

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

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