Kilroy Realty Corp (KRC) 2008 Q1 法說會逐字稿

Good day, ladies and gentlemen. Welcome to the First Quarter 2008 Kilroy Realty earnings conference call. My name is Katie and I'll be your coordinator for today. (OPERATOR INSTRUCTIONS)

I'd like to turn the call over to your host for today, Mr. Richard Moran. Sir, you may proceed.

Thank you very much. Good morning, everyone. Thank you for joining us. With me today are John Kilroy, CEO; Jeff Hawken, our Chief Operating Officer; 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 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 telecast live on our website and will be available for replay the next 10 days both by phone and over the internet. Our press release and supplemental package have been filed on a Form 8-K with the SEC and both are also available on our website. John will start the call with an overview of the quarter and our key markets and I'll add financial highlights and updated 2008 earnings guidance, and then we'll be happy to take your questions. John.

Thanks, Dick. Hello, everyone. Thanks for joining us. We had a good first quarter at KRC. Our leasing program produced solid results. In February we announced our 290,000 square foot lease with Bridgepoint Education that included the entirety of the 147,000 square foot third phase, Kilroy Saber Springs, which is currently under construction.

During the quarter we had new or renewing leases commence on just over 375,000 square feet of space at average rental rates 49% higher than expiring leases on a GAAP basis. Of the 1.4 million square feet of space scheduled to expire in our stabilized portfolio during 2008, (inaudible), approximately 750,000 square feet of that space. We ended the first quarter with 94.8% occupancy rate which was better than we projected, and our properties under construction remain on track with deliveries scheduled throughout the second half of the year. Our combined end process development and redevelopment program encompasses about 611,000 square feet in six projects for a total estimated investment of approximately 186 million. With the Bridgepoint transaction, these projects are now 65% leased. Not withstanding, our strong leasing results as we look at the broader economic environment, we do remain concerned about the direction of the economy.

As we have reported over the last several quarters, potential tenants continue to stretch out the real estate decisions. [Unemployment] rates have moved up slightly to 5.8% in Los Angeles, 4.6% in Orange County and 5.3% in San Diego County. So while we had good first quarter leasing results, we don't know that we'll be able to maintain these results throughout the remainder of the year. Having said that, we do continue to see reasonably good demand in most of our markets. Long Beach and El Segundo are performing particularly well, and we are pursuing several potential transactions in San Diego. With that introduction, let's take a closer look at our individual sub markets.

Starting in San Diego, CB Richard Ellis continues to report over 6 million square feet of demand. In central San Diego markets and competitive supply remains limited to a few projects in UTC and Rancho Bernardo. In Del Mar where KRC is the dominant office landlord with approximately two-thirds of the top tier class A product, current direct vacancy is approximately 7.5% and total vacancy is 10.9%. Our stabilized properties in Del Mar are 99.8% occupied. In the Sorrento Mesa sub market south of Del Mar, KRC competes in the two and three story office product where direct vacancy is currently 6.1% and total vacancy is 8.4%. Our stabilized properties here total approximately 1.9 million square feet and are currently 100% occupied. South of Sorrento Mesa in the UTC governor park sub market we also compete in the two story product type. Our properties here total 430,000 square feet of space. Current direct vacancy is 6.8% and total vacancy is 12%. Our only vacancy here is the 140,000 square foot building vacated in the third quarter of last year.

Along I-15 corridor we own approximately 750,000 square feet of stabilized office space, the two story product type here has a direct vacancy rate of 11.8% and total vacancy of 15.9 %. For class A, product direct vacancy is 21.8% and total vacancy is 23.7%. Our stabilized properties here are 81% occupied. In Orange County office is weak and industrial is strong. Our industrial portfolio of about 3.7 million square feet plus 95% occupied at the end of the quarter, our only significant vacancy in the county is the 157,000 square foot industrial project we are rezoning to residential. The Orange County industrial market has a vacancy rate of about 4.4%. Further North at Kilroy Airport Center Long Beach, our seven building office campus immediately adjacent to Long Beach Airport is currently 94% occupied, class A direct vacancy here is 8.1% and total vacancy is 9.6%. Moving up to El Segundo, our stabilized properties in this market are 97% occupied. Class A vacancy rates here are now in the single digits with direct vacancy at 8.6% and total vacancy at 9.6%. And in West L.A., direct vacancy is now 3.9%, total vacancy is 8.3%, our properties here are totaling 680,000 square feet are 99% occupied and, finally, along the 101 corridor market which runs through northern Los Angeles and southern Ventura counties, direct vacancy in the class A product is currently 10.6% and total vacancy is 11.4. Our properties here are 98% occupied.

To recap we had a good first quarter with strong leasing results, vacancy rates increased in sub markets and decreased in others, demand remains reasonably good across most of our markets but executing transactions continues to be challenging in an uncertain economy. Naturally, we're concerned about the economy's direction and the potential impact on our business but given the quality of our assets and markets we're confident that our team will continue to outperform the market. That's an update on our recent activities and markets. Now Dick will cover the financial results. Dick.

Thanks, John. FFO was $0.87 per share in the first quarter. That was higher than forecast primarily due to two factors, higher occupancy and lower G&A than reflected lower accrued incentive compensation expense than initially forecast. The lower accrued incentive compensation expense is mainly the result of a structure of our comp plan, the slowing economy has caused us to lower some of our operating projections a bit which in turn leads to lower projected incentive compensation. We ended the quarter with stabilized occupancy of 94.8% up from 94% at year end. By product type, both office and industrial occupancy ended the quarter at 94.8%. First quarter occupancy was a bit higher than we had expected as we reported last quarter we expected one of our industrial tenants that is experiencing financial problems to either vacate or downsize. That hasn't happened, at least not yet, and as of the end of the quarter they were current on their rent. If the tenant does vacate the 150,000 foot industrial project that it currently occupies it would impact our overall occupancy rate by 1.3%. We also had an unusual development in the first quarter when one of our tenants stopped paying rent and attempted to surrender its lease premises back to us. The negative effect of the missing rent on earnings in the first quarter was a penny a share. We won't be able to say anything beyond that regarding this issue since it's obviously now a legal matter.

Although vacancy rates have move up in some of our markets based in our latest detailed analysis of our portfolio, we haven't seen any material change in market rents since last quarter. We believe rent levels in our overall portfolio remain about 15% under market and that our 2008 expirations are about 10 to 15% under market. Rent growth on leases that commence during the first quarter was quite strong as GAAP rents increase 49% and cash rents increase 29%. The first quarter results are a bit anomalous and our rent increases will moderate back towards overall portfolio estimates over the remainder of the year. Same-store NOI was down 1% on a GAAP basis and up 1.6% on a cash basis for the first quarter excluding lease termination fees and bad debt expense, same-store NOI would have been up 2% on the GAAP basis and 4% on a cash basis. Capital expenditures in the first quarter totaled $5.4 million and our FAD pay out ratio was 79%. Our active development program which includes six projects under construction is on track. These projects represent a total investment of $186 million of which there $136 million has been spent today.

Turning to our balance sheet our strategy remains one of liquidity, conservative leverage and flexibility. We currently have there $383 million of debt capacity on our $550 million credit line with a single $73 million debt maturity coming due in August. We can either pay off the debt using our credit line or obtain a new term loan. We'll make that decision closer to the debt expiration based on market conditions in our capital needs. We repurchased 160,000 shares of our common stock in the first quarter for $7.6 million or an average price of $47.54 per share. We have 1,067,000 thousand shares remaining under our existing buyback authorization.

Now let me finish with updated 2008 FFO guidance. Although we ended the first quarter at an occupancy rate higher than we had forecast given the uncertain market conditions, we expect that our occupancy will moderate as the year progresses. On our last call we projected that our average occupancy for the year would be in the 92% to 93% range and we now expect we'll probably be at the low end of that range as the leasing environment continues to slow. As I mentioned earlier, our first quarter results were reduced by a penny because one of our tenants stopped paying its rent. To be conservative, for the moment we're excluding that rent from our tenant from our guidance for the remainder of the year. That would have an impact of about $0.12 a share on an annualized basis or $0.09 a share over the rest of the year. The lower projected occupancy in revenues are forecasted to be largely offset by lower interest rates and lower projected G&A costs.

Although LIBOR has obviously quite volatile of late, at current rates the fall in short-term rates would save us approximately $0.06 a share from lower interest expense over the rest of the year, and while last quarter we estimated the G&A would be between $40 million and $42 million for the year, our latest projections are that our incentive compensation costs this year will be lower than we previously estimated mainly as a result of the moderately lower leasing and operating results that we're now forecasting. So we now estimate that G&A will be in the $38 million range. That projected $2 to $4 million reduction in G&A costs is equivalent to a savings of there $0.06-$0.12 for the year. Taking all these assumptions together we're maintaining the same 2008 FFO guidance that we provided last quarter of $3.30-$3.50 a share with a mid point of $3.40 a share. That's the latest news from here. Now we'll be happy to take your questions. Operator?

(OPERATOR INSTRUCTIONS). Your first question comes from the line of Lou Taylor from Deutsche Bank. Please proceed.

Thanks, good morning, guys. Let's see, John, can you talk a little bit about what was the anomaly that drove the Q1 rents so much higher?

Well, Jeff, do you want to comment on that?

This is Jeff. We had one particular lease in San Diego that had very strong increases in both the cash and cap rent, that was the main driver.

Okay. And was there a corresponding big TI cost or leasing cost associated with that?

No, it was pretty much in line, it was about $25 a foot for that transaction.

Okay. Next question. Dick, with regards to the tenant that just stopped paying rent, was that flowing through lower revenue or did that flow through the bad debt expense?

Well, the rent loss is just shown as lower revenue.

Okay. And then what drove the bad debt expense higher in the quarter?

Well, we just in reflecting the general economic conditions, we're taking a somewhat more conservative position assuming that we will have an, what we would expect to be typical for the cycle of more bad debt expense in a softer economy. The individual tenant that stopped paying rent is obviously, that is an obvious anomaly because that's simply a contractual dispute.

Okay. So are you recognizing bad debt in terms of specific items or are you just creating a general reserve?

Specific items. We do specific identification, kind of a watch list concept, working closely with our Asset Management group to evaluate tenants credit.

Okay. So you've got some other tenants that you're maybe worried about collecting other than the one that you've referenced in your remarks?

Yes, and that is entirely natural. I'd characterize our overall view as entirely what we would expect for this point in the cycle, other than that one anomaly, I think we have we would characterize our watch list as entirely typical for this point in the cycle with no other significant surprises.

Okay. Then last question is you did have an increase in the same-store expenses but it looked like your reimbursements did not grow as much, which I was a little surprised at given your increase in occupancy. So what kind of drove the lower expense recoveries?

Well, actually, tenant reimbursements were up, not quite as much as expenses were up, but you don't typically recover all of your expense increases.

And then what was driving that? I mean you had higher occupancy so you should have a higher overall recovery rate, shouldn't you?

Lou, this is Dick. We had one particular utility agreement that expired that had given us benefit in utility costs and to some extent some of that impacts vacant space as well, so that was part of it. Other than that, it was just I don't think there was any one line item to which it was attributable.

Okay, thank you.

(OPERATOR INSTRUCTIONS). Your next question comes from the line of [Arwin Gusman] from Citi. Please proceed.

Hi, this is [Mark Montana] on behalf of [Erwin]. Quick question on the lower G&A expense assumption for the year. Just trying to get a little clarification. I think you might have mentioned, how much was core versus just your lower estimate for comp plan expense?

Well, I think, well it's lower projected incentive compensation expense, Mark, for the entire company including everyone.

So that's the major incremental difference between now and the previous guidance?

Yes. Other than that, G&A for the year is essentially as we had expected.

Okay, great. And then secondly, could you provide a little update on the level of interest in Sorrento Gateway or Saber Springs, they stabilized this year but are currently in lease?

Yes, this is John, Mark.

Hi.

On Sorrento Gateway we have two projects, one that the shell was recently completed, we call that Lot 3 and it's about 55,000 square feet. Frankly I'm surprised the building hasn't been leased by now. We've had a number of tours but we do have some strong interest right now from a couple of different folks. One instance is a full-building user and the other instances are partial building users. We may end up breaking the building up. Our first desire was to lease it to one user, but we are seeing some decent activity. I'd just make a comment that generally, and that's throughout the portfolio in all areas, that we're seeing a lengthening of the decision process and sort of a reluctance at times to pull the trigger which is again typical for this point in the cycle.

The other building that's under construction at Sorrento Gateway is Lot 1 which is about 52,000 feet. That is a three-story medical office building. It is one of the only sites in San Diego that's zoned for medical office. We have very strong demand from a couple different doctor groups as well as from a major health provider in that building, so it's a different product. It's not competing with the Lot 3. I think your other question was up about Saber Springs. There's two properties we have up there, Kilroy Saber Springs which is the class A office space which is now with the Bridgepoint lease essentially fully leased and the new building is entirely leased, and then we have Saber Springs Corporate Center which is in our redevelopment category and that project is about 100,000 feet. It's 19% leased and the balance of the space is available. We continue to tour people, but the I-15 market has been slow. Just a general comment about the I-15 market. There are three transactions in the marketplace right now, all of them household names in terms of the companies that total well over 500,000 square feet and all of them say they're going to sign deals within the next couple of months. So that's a significant change or improvement in that I-15 market over the last several quarters. I think that answered all of the projects you referenced.

Perfect, thanks very much.

You're welcome.

Your next question comes from the line of [George Araback] from Merill Lynch, please proceed.

Hi, good afternoon. Dick, just to follow-up on Lou's question, we should back out $.02 of revenue from the first quarter number to get a good run rate going forward?

George, could you amplify that in your question, just to make sure I got it right?

Well just in terms of the revenue rate going forward?

Go ahead.

Sorry, is it a bad connection?

Yes, go ahead, please I'm sorry. Did you say there $0.10?

I'm sorry, no, $.02 of the first quarter number.

Well the tenant that stopped paying rent was a penny and it would be there $.09 for the balance of the year.

So effectively they weren't paying for one month?

Essentially.

Okay. And John, could you give us an update on the Par-D site, I guess first how far along are you on the development site work and, second, what are your thoughts on when you might begin construction?

Well from a site work standpoint we haven't commenced anything there. What we've been doing is we bought and I think we talked about this in the last call, property zone for 500,000 square feet of office space and that's a matter of right. We've been working with the homeowner groups in the cities towards a mixed use project, and there seems to be a good deal of support. Both of those areas for an expanded project. Can't say for sure we'll get it approved. We've been interviewing architects. We're about ready to select the architect, as a master plan, mixed use expert for the site, and it could be that we end up with a project that is significantly larger and encompasses more uses than that which the properties entitled for today. So that effort is going to go on for several months. The city says they want it. Like I say, the homeowner groups say they want it. The traffic seems to support it. We've done an analysis on that. And now the question becomes what the mix will be, so I don't think we'll see any construction on that site this year.

Okay. Thank you.

You're welcome.

At this time I'm showing you have no further questions. I'd now like to turn the call back over to management for closing remarks.

Thank you all very much for joining us today. Have a good day.

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