Kilroy Realty Corp (KRC) 2008 Q4 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the quarter four 2008 Kilroy Realty Corp earnings conference call. At this tim,e all participants are in listen-only mode. We will conduct a question-and-answer session towards the end of this conference. (Operator Instructions). As a reminder, this conference is being recorded for replay purposes. I would now like to turn the call over to Mr. Richard Moran, Chief Financial Officer. Please proceed, sir.

Thank you, very much, and good morning, everyone. Thanks for joining us. With me today are Jeff Hawken, our Chief Operating Officer, and Tyler Rose, our Treasurer, and Heidi Roth, our Controller. Unfortunately John Kilroy woke up ill this morning and won't be able to be with us today. 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 for the next 10 days by phone and over the internet. Our press release and supplemental package have been filed on form 8k with the SEC and both are also available on our website. Jeff will start the call with an overview of the quarter and the year and then review our key market. I'll add financial highlights and our 2009 initial earnings guidance and then we'll be happy to take your questions. Jeff.

Thanks, Dick. Hello, everyone. Thanks for joining us. Considering the turmoil in the economy and the credit markets during 2008, KRC had a good year in many respects. We capitalized on our portfolio strengths, including location and asset quality to deliver strong pleasing results. For the year we executed new or renewing leases on more than 2.1 million square feet of space. That's more than a 25% increase over 2007. As part of that leasing effort, we made solid progress on our 2009 expirations, reducing by almost half the roughly 2 million square feet of space that was set to expire in 2009. In total, on the 2.1 million square feet of leasing, rents were up 25% on a GAAP basis and 9% on a cash basis. In a world of deteriorating credit capacity, we maintain our longstanding strategy of financial strength and conservative leverage. Throughout the year our balance sheet emphasized simplicity, transparency, and liquidity.

Where necessary we also acted decisively to address changing economic conditions and their impact on our operations. In the fourth quarter we took the painful but prudent step of decreasing our headcount by about 5%. With all that said, however, it is clear that continued severe credit market constraints and weakening national and regional economics are now translating into a more difficult period for commercial real estate in southern California. It is evident in our operating results and our recent market experience. Year-end occupancy in our stabilized portfolio was 89%, down nearly five percentage points from beginning of the year. More anecdotally, our lease negotiations continue to be slow and protracted. Businesses are demonstrating extreme caution in taking on new real estate obligations. And while none of our major tenants have exhibited credit problems or announced major layoffs, we received a few calls from smaller tenants asking for some rent relief.

It is also evident in the employment picture here in California, county unemployment rates continue to move up through December, with Los Angeles 9.5%, Orange County at 6.5%, and San Diego at 7.4%. But as we said last quarter, this is the point in the real estate cycle when patience, quality assets, solid execution and financial strength are rewarded. At KRC we are approaching 2009 with our typical relentless determination. Our top priority this year will be to outperform the market once again in leasing. We have high quality properties in some of southern California's strongest submarkets and we will use those advantages to capture demand as it materializes, as well as to strengthen and possibly expand our relationship with existing tenants. In development, having completed construction last quarter on our one committed development project, we will focus our efforts on enhancing the titlement rights within our land pipeline, reaching for the broadest and most flexible range of potential uses to capture opportunities as they emerge.

Finally, we will continue to emphasize liquidity, discipline cost control and concertive leverage in all of our financial decisions. We want plenty of dry powder as the business cycle evolves, especially given heightened uncertainty associated with current economic conditions. With that overview, let's move through a quick recap of individual submarket conditions starting in San Diego. Our central County submarkets here are currently registering active demand of approximately 4.6 million square feet, according to CB Richard Ellis. This is down from prior quarters as a few large leases were executed in San Diego in the fourth quarter. 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 17.1% and total vacancy is 19.3%. Our stabilized properties in Del Mar are 92% occupied.

Just south of Del Mar in Sorrento Mesa, KRC competes in the two and three-story office market. Direct vacancy for this product type is currently 7.8% and total vacancy is 9.3%. We added Sorrento Gateway lot three, a 56,000 square foot office building, to our stabilized portfolio during the fourth quarter, increasing our stabilized properties in the submarket to approximately 1.9 million square feet. These properties are currently 85% occupied. Further south, in the UTC Governor Park submarket, we also compete in the two-story product type. Our properties total 431,000 square feet of space. Current direct vacancy is about 5% and total vacancy is 8.8%. We currently have two vacancies in this market for an aggregate occupancy of 57%. Along the I-15 corridor east of Del Mar, KRC now owns approximately 1.2 million square feet of stabilized office space, including two projects newly stabilized in the fourth quarter.

They include a newly developed third office building at Kilroy Saber Springs that is 100% leased to Bridge Point Education, and our two building redevelopment project at Saber Springs Corporate Center, currently 19% leased. The two-story product type in the I-15 corridor submarket has a current direct vacancy of 11% and a total vacancy of 11.6%. Our class-A product direct vacancy is 28.4% and total vacancy is 29.6%, but the recent additions, our stabilized properties here, are 78% occupied. Further north in Orange County industrial demand remains solid with a current vacancy rate of just 4.5%. Our industrial portfolio totals about 3.5 million square feet here. It was 96% occupied at the end of the quarter, excluding the 157,000 square foot project we are currently rezoning to residential in Irvine. Moving north to Los Angeles County, the submarkets of El Segundo and Long Beach are both exhibiting resilient demand strength. At Carrier Port Center, Long Beach, our seven-building office campus immediately adjacent to Long Beach Airport is 94% occupied.

Class-A direct vacancy here is 5.9% and total vacancy is 7%. In El Segundo our stabilized properties now total 1.3 million square feet and are 98% occupied. Last saved direct vacancy in El Segundo is now at 11.7% and total vacancy is 13.2%. Further north in west Los Angeles, direct vacancy is 10.6% and total vacancy is 15%. Our properties here total 680,000 square feet and are 95% occupied. 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 22% and total vacancy is 24.6%. Our properties in the market are currently 78% occupied. That's an update on conditions in our markets. In summary, we are concerned about the economic uncertainty and impact it will have on the real-estate industry, but remain very confident in the quality of our assets, the strength of our financial position, and the talent and experience of our Management Team. Now Dick will cover the financial results. Dick.

Thanks, Jeff. FFO was $0.78 a share in the fourth quarter and $3.42 for the year. Occupancy in our stabilized portfolio was 89.2% at the end of the year. That compares to 90.7% at the end of the third quarter and 94% at year-end 2007. By product type, office occupancy was 86.2% at year-end and industrial occupancy was 96.3%. These numbers exclude the 150,000 square foot project in Irvine that we're attempting to rezone to residential, given that we're not trying to release the existing industrial space while we are pursuing the rezoning. We have removed the project from our stabilized portfolio, as you can see on page eight of the supplemental. On a GAAP basis same-store NOI was down 5.1% in the fourth quarter and was flat for the year. On a cash basis it was down 3.4% in the quarter and up 3.1% for the year. The lower same-store results are primarily a function of lower occupancy. Office rents increased 19% on a GAAP basis and 10% on a cash basis for leases that commenced during the fourth quarter.

Industry rents were down 2% on both a GAAP and a cash basis. For the year office rents were up 36% on a GAAP basis and 18% on a cash basis. Industrial rents were up 24% on a GAAP basis and 1% on a cash basis. While it is difficult to make estimates about market rents with any real confidence in these times, our most recent analysis of market conditions suggests that rent levels in our overall portfolio are approximately 5% to 10% under market and our remaining 2009 expirations are about 5% under market. Given current economic conditions, we expect that our pricing power will weaken before it improves. After a strong leasing effort last year, we now have approximately a million square feet of space remain -- remaining space expiring in 2009. About 36% of that is industrial and 64% is office. From a regional perspective, we have 293,000 square feet expiring in Los Angeles, 470,000 square feet expiring in Orange County, of which 76% or 355,000 square feet is industrial, and 218,000 square feet expiring in San Diego.

Capital expenditures were $7.2 million in the fourth quarter and $26.6 million for the year. In the fourth quarter we transferred three development and redevelopment projects that are currently 55% leased from lease-up to our stabilized portfolio. We also completed the construction of our one remaining committed development project during the quarter, Sorrento Gateway lot one. A 51,000 square foot medical office building is now in our lease-up category. We ended the year with $252 million outstanding on our $550 million credit line, giving us just short of $300 million of committed available debt capacity. Our credit line runs through to April, 2010 and we have a one year extension option to April, 2011. This year we have one loan maturing, a $75 million 10-year mortgage that comes due in April. Our current expectation is that we'll pay off the maturing debt using our credit line.

Now let me finish with our current thinking for 2009 earnings guidance. As an overarching comment, we're not assuming in any rebound in our markets this year. And as we said last quarter, it's important to preface any discussion of projected earnings with the caveat that our internal forecasting of guidance reflect information and market intellegence as we know it today. There remains significant uncertainties in the economy and our markets going forward that could affect our results in ways not currently reflected in our analysis. With that caveat, let me outline some of the key assumptions that we've made in our guidance at this point. Given the uncertainties in the economy and the corollary uncertainty in our own market outlook, at this point we've simply assumed essential flat average occupancy at 89.6% for the year. We've also assumed G&A costs of $34 million this year, down from $38 million last year.

That $34 million projection for this year includes amortization of prior year stock awards at the higher prices that were then prevalent. On a pro forma basis our estimated G&A run rate would be $27 million based on the expected maximum potential incentive compensation amounts for 2009. Beyond that we've assumed no acquisitions or development starts, average LIBOR on our floating rate debt of 1.25%, interim refinancing under our credit line of the maturing $75 million mortgage I mentioned a moment ago, the continuation of our dividend at the current level of $2.32 a share, and finally, adoption of the new convertible accounting and EPS rules, which will have roughly a $0.24 a share noncash impact on 2009 FFO based on the interpretations of the rules as we understand them so far. Taking all those assumptions together, our initial 2009 FFO guidance is $3.05 to $3.25 a share for 2009. That's the latest news from here and now we will be happy to take your questions. Operator.

(Operator Instructions). Your first question comes from the line Irwin Guzman with Citi. Please proceed.

Hi, this is actually Mark Muntain in on behalf of Irwin. Quick question, two questions. What was the timing of your fourth quarter lease expirations? In particular were they weighted towards the end of the quarter? Even more specifically, do you know what percentage occurred in December?

Well, we only had 219,000 square feet expiring in the fourth quarter. And I just don't know off the top of my head what the percentage was in December. I can get back to you on that.

Okay, thanks. And then secondly, regarding the tenant retention rate, are you finding that tenants are having the tendency to trade down to lower priced space or -- primarily due to other reasons. I know you noted in your prepared remarks some tenants coming back to you asking for some leniency on their rents?

This is Jeff. In terms of the tenant retention, you saw we entered the year around 65%. And I think, looking at 2009, we anticipate seeing that to be probably closer to 60%. We haven't seen a lot of examples of where tenants are moving from one building to another. Obviously they're very mindful about economics, but I think what we're finding right now is that tenants tend to be doing a lot more underwriting of landlords as they seek space. A lot of tenants want to stay in space if they can. It's disruptive to move. It's expensive to move. But they are also spending a fair amount of time underwriting who their landlords are.

Okay. Great, thank you.

Your next question comes from Lou Taylor with Deutsche Bank, please proceed.

Thanks. Good morning, guys. Dick, can you just clarify a little bit on guidance the impact of the convert?

Sure. It's -- obviously you know, Lou, that guidance is fairly complicated. As we know it, as I mentioned, there's a $0.24 estimated impact of the convertible accounting and the EPS impact of this new treasury method to a two-class method. That breaks down to $0.20 for the convert and $0.04 for the treasury method. As I understand it, there's the potential, and I'll defer to Heidi here if she wants to amplify, that there may be another interpretation of a related rule that might change that and -- but we don't -- I don't think we have any further ability to estimate that effect right now. It's ultra technical, as I understand it.

Okay, but your $3.05, $3.25 is net of that.

Yes, we've already included that $0.24 in total. Everything we know and can estimate so far, yes. And I think that's essentially the substance of it.

Okay. And then with regards to the leasing decline in San Diego, how much was just due to market weakness versus just the recent development deliveries going into the stabilized pool?

Well, it's a combination. We had the Paul Hastings expiration in the fourth quarter on the stabilized side, but on the development side we had the two, the Saber Springs Corporate Center coming on-line that added 80,000 square feet of vacancy and Sorrento Gateway lot 3 that added 50,000 square feet of vacancy. So it is a combination of both.

And then for Jeff, just in terms of trying to lease new space versus existing space, how reluctant are tenants to move to new space either because of just image issues or just cost issues, and what kind of incentives do you have to give on new space versus existing space these days.

Well, Lou, again I think it really depends on a case-by-case basis. We're seeing a lot of our tenants like the product, we obviously have very great product location, et cetera, so tenants tend to want to stay. There are tenants that from time to time do have to move and move for economic reasons. I think they go to different submarkets that are seeking lower cost points. Obviously, disruption to move. The TI packages, I think we're starting to see are increase in some cases where landlords are doing more turnkey, the TI packages to make sure they can capture new tenants. So I think a lot of tenants are -- they like to stay if they can. If business reasons take them to smaller space or different market, then obviously they will move and I think landlords are being more agressive in trying to capture those tenants.

Okay. And then last question, back to Dick. In terms of the dividend, what is the general thinking among the Management Team with regards to that being paid in cash versus stock this year?

That's obviously a key issue that we are carefully evaluating and that is something that we'll obviously be discussing with our board later this quarter. Our objective is, as always been, to have a sustainable dividend that could be continued to be paid through recessions and through the course of cycles. This cycle is obviously unprecedented in any of our lifetimes. So I think that's something that we'll look real carefully at. Our preference is to continue to pay it in cash. More to come, though, we haven't made that decision as to what we would recommend to the board. A strong preference is to pay it in cash.

Thank you.

Your next question comes from Dave Rogers with RBC Capital Markets. Please proceed.

Hi, guys, this is Mike Carroll here with Dave. My first question is what is the progress with the Sony space in LA and did they vacate on January 1?

This is Jeff. Yes, Sony did vacate at the end of the year, as of January 1st. We've just gotten the building back. We're making improvements to the lobbies, et cetera, and clearing out space that makes it show better. So we've had a little bit of interest, but now that we have the building back and under our control, we expect to see more tours as we go forward.

Okay. And then what drove the higher T.I. level on this past quarter and should we expect that going forward?

That was a little bit of a mix. We had a couple leases, one in Long Beach and one in Calabasas that were sort of in the mid-$50 TI and leasing commission level and we didn't have that many transactions, so that drove it up. So it really depends on the mix quarter by quarter. And I don't think, and Jeff can comment, whether we were seeing that trend or not.

Yes, I'd just amplify Tyler, I think those were, in many cases, full floor tenants' requirements what tend to be higher TI packages, but we haven't seen yet increase on our TI packages. The renewals are obviously pretty low and even new tenants we've got high residual value in our space. So we haven't really seen a trend increasing too much.

So you don't have any more full floor tenants coming due or going to be signed for 2009 or SO, it is going to be minimal?

Again, it's going to be a function of how the leasing goes for the balance of the year. We've obviously done a lot of renewals already and those TIs were fairly minimal. But we will just sort of case-by-case basis on, if we get a building back or a full floor we may have higher TIs, but it will just be a function of those buildings as we release them.

Okay. And then were there any onetime or nonrecurring items in the quarter embedded in the property income or G&A expense?

On the G&A side we had about $1 million of severance cost. On the expense side, it was a little bit higher than normal related to repair on a couple buildings and some legal costs. But there wasn't any unusual lease termination fees or anything like that this quarter.

Was there a charge for a headcount reduction in the quarter or was that not taken?

That was the severance costs that Tyler just mentioned of $1 million.

Okay. And then what gives you confidence there or what would give you confidence in this market for you guys to repurchase your discount and exchangeable notes back?

That's a good question, Mike. It's something we're continuing to think about and evaluate. It obviously relates fundamentally to our confidence in our liquidity level and the outlook for the economy and particularly the dividend decision that Lou asked about a moment ago. So we just are obviously being quite risk averse right now and careful about our liquidity, but that is a -- we view that as an enormously attractive potential investment opportunity, so we're carefully considering that. Obviously, once we're through the blackout period here we'll be thinking more of it, but I would emphasize that the dividend is a decision that we're thinking through carefully and it will take a little time before we conclude on what we recommend to the board. And then obviously we'll just be discussing it with them as the quarter progresses.

Okay. And then my last question is can you tell me what's the market thinking about smaller loans, single mortgages, and your access to that kind of capital.

Well, it's challenging right now. There are banks and insurance companies that are in the market, but the terms are different than they were a couple years ago. Loan to values are a lot lower, and -- but there is money out there, but it just depends on the term and the type of quality of the assets.

Okay. Thank you, guys.

You are welcome.

Your next question comes from George Auerbach with Merrill Lynch, please proceed.

Hi, good afternoon. Jeff, regarding the loss of occupancy in your office portfolio, in general have the tenants you have lost moved to other assets in your submarkets, exited the core markets for better rents in secondary markets, or have the tenants simply pulled back on their space requirements?

It's a little of all of that. We've seen some cases like where Sony they moved out of the building in west L.A. and downsized and moved into a different submarket that we're not in and for lower economics. Other tenants are consolidating, other tenants are moving out of the area, and some other tenants are seeking much lower price points in moving to lower priced submarkets.

So in general, is the driving sort of factor better rents elsewhere? And if so, how far down do sort of core San Diego rents have to go to compete with those secondary markets?

Again, I think in some cases what's driving it is the tenants are realizing they don't need as much space. They're looking to downsize, they are trying to move to other buildings, sometimes it's image, sometimes it's price. In San Diego I think some of the bigger transactions we've seen have been in the Kearny Mesa submarkets, which are not in our core markets. I think they can get a fairly attractive lower economics going to the Kearny Mesa markets than the UTC, Sorrento, Del Mar or the I-15 corridors.

Okay. Through 2010 you have over 25% of your office leases scheduled to expire. How active are those negotiations with the tenants in 2010 and, I guess, second, how interested are those tenants in discussing extensions or renewals today versus taking more of a wait-and-see approach?

The first part of your question, we're already talking -- we were talking to people last year, in 2008, about 2009 and 2010. So we're, I think, way out in front trying to make sure we understand what our tenants need and want and are they expanding or contracting. So we tend to be out in from of our tenants very early. What we tend to find right now is that most tenants are unwilling to make long-term decisions or renewals. They're waiting for the lease expiration. Their boards are more conservative, more disciplined about what the requirements are going to be. So we found somewhat a reluctancy of tenants, even if they want to renew, they are going to kind of wait and see what happens. Okay, great. Thank you.

(Operator Instructions). Your next question comes from Dave Aubuchon with Baird, please proceed.

Thanks. The 89.6% occupancy that was in your guidance assumption, right, Dick?

Yes.

Just given the comments that you've all made at the start of this call, doesn't that seem aggressive certainly relative to, you have already lost 75 bps from the Sony lease and just the difficulties in the market in how long the lease negotiations seem like they're going to protract this year?

I think that's certainly a possibility that it is. Brian set stretch targets and given the outlook I suppose it would be fair to say there's probably somewhat more risk to the downside there than there is possible upside to it. Nevertheless, we thought long and hard about that and for the moment, at least, that's where we wanted to start.

Should we assume that that is the midpoint of the guidance, or they're just, like you said, calculating guidance is more difficult than just kind of simplifying it to that?

Sure. I think my own gut instinct is the midpoint is the midpoint right now. I think you have identified the core risk to our guidance for this year, though. That is it. The rest is noise.

The Nugent/ Teletech leaves, I believe in the third quarter supplemental, I know, that you showed it at 100% occupancy. In this supplemental it is down to 0%. Has there been a conclusion, a resolution to that situation or how should we think about that?

No, we just concluded that from an occupancy perspective we should represent it as 0% occupied since we're now working with the tenant to lease the space.

And you are not receiving rent, correct?

Correct.

Where do you think you have best, the best pricing power on your 2009 expirations? You've identified what exposures in L.A., what's in Orange County and San Diego, and that your embedded mark-to-market is 5% to 10%, but likely lower in 2009, where do you feel like you have the best pricing power in 2009?

I think the Los Angeles region has performed the strongest and continues to. As Jeff said, in El Segundo and Long Beach, those markets are continuing to perform better than the other markets and then west LA's not as strong as it has been, but it continues to do well. So that area would be the stronger area.

And then relative to the development pipeline, obviously you're not starting any projects. Should we assume that the capitalized interest number that you booked in Q4, $2.7 million, that that is a suitable run rate going forward or should that trail down because you are not starting any projects and it's basically land?

That should trail down. In 2009 we're -- at the beginning of the year we're capitalizing on only two of our seven projects. And so the run rate on that basis for 2009, it's fairly complicated, but for 2009 it is about $6.5 million of capitalized interest for the year.

Based on what? I'm sorry, Tyler. That's on the Q1 2009 run rate?

No, the full year 2009.

You're anticipating to be $6.5 million.

Right.

Okay. Dick, when you consider what the development pipeline, do you think that there is a possibility at all that you put a shovel into the ground this year trying to forecast when the economy may be improving and trying to get the first development project out, or is your cost of capital just too uncertain at this point?

I think -- obviously I mentioned in our guidance that we're not assuming any acquisitions or development starts this year at this point. So I think, knowing what we know right now, we would assume that we -- the odds of us starting a new project this year are exceptionally slim, given the likely economic outlook. But having said that, I think, if anything, the world has taught us over the last year that our power as human beings to forecast the future out for extended periods of time is fairly limited. Our objective remains to be ready to have land and key barrier to entry markets, the very best sites and to be ready to build, at the same time to be very cautious and conservative in so doing. And so I think having said that, bottom-line is I doubt that -- I think it's highly doubtful that we would start anything this year.

Okay. I have one more question, sorry. I just want to clarify. On the Teletech issue, I believe you said in the past that that's $0.12 of FFO. Just want to make sure that that is not in your guidance in 2009.

It is not.

It is not in the guidance. And I'm assuming, since you are trying to sublease the space, that you no longer will have -- did you just rip up the lease? I'm trying to figure out what's happening there.

This is Jeff. We're actually in the midst of a lawsuit with Teletech and Nugent, so we really don't want to get into a lot of detail, but the tenant is trying to sublease the space and obviously we're monitoring the situation.

Right, thanks.

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

Thank you very much for joining us today. We appreciate your interest in KRC and thanks and have a great day.

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