Kilroy Realty Corp (KRC) 2009 Q2 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the second quarter 2009 Kilroy Realty Corporation earnings conference call. My name is Francine, and I will be your coordinator for today. At this time, all participants are in listen-only mode. We will be facilitating a question and answer session towards the end of this conference. (Operator Instructions).

I would now like to turn the presentation over to your host for today's call, Mr. Richard Moran, Executive Vice President and 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 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 for the next ten days, both by phone and over the internet. Our press release and supplemental package has been filed on the 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 earnings guidance for 2009. Then we'll be happy to take your questions. John?

Thanks, Dick, and hello, everyone. Thanks for joining us today. Let me start by saying that while commercial real estate conditions in Southern California remain difficult, the overall economic environment here seems to more or less to have bottomed. Reflecting that, we saw market activity pick up in the second quarter compared to the first three months of the year.

The increase in activity generated the successful execution of approximately 300,000 square feet of new and renewing leases during the quarter. The leasing occurred in all of our markets and included both office and industrial properties. In addition, we have about 300,000 square feet of LOIs in place. Although as we have previously reported, lease negotiations are painfully slow, competition is tough and rental rates are under pressure. As always, there is no assurance that these LOIs will turn into executed leases. Clearly we are not in a position to forecast if the increased tenant activity will continue, or when we will see a sustainable recovery in real estate demand, but we definitely have more interest from prospective tenants in our available properties last quarter.

A good example of our leasing progress is at our Kilroy Silver Springs campus at the intersection of the I-15 and 56 corridors in San Diego. We have three six-story buildings there, totaling approximately 432,000 square feet. We delivered the third building about a year ago. With some recent leases just executed, the campus is now 98% committed compared to 84% at the beginning of the year. Another example of our progress is the execution of approximately 100,000 square feet of leases in Orange County during the quarter, about half in our industrial portfolio, and half in our office portfolio. These were all relatively small deals, totaling 12 separate transactions.

Despite our improved leasing performance for the quarter, our occupancy dropped roughly 2 percentage points during the quarter to 85.5%. Accredited Home Lenders vacated the three buildings it leased in San Diego, totaling 182,000 square feet and Boeing moved out of 113,000 square feet of industrial space in Orange County. Dick will cover the financial impact of the Accredited vacancy in his remarks, but the good news is that included in the LOIs I mentioned earlier are two transactions that relate to the former Accredited space for a total of about 90,000 square feet, or roughly half of the former Accredited campus.

One silver lining in today's market is that there is a clear differentiation in the marketplace between companies with sound balance sheets and access to capital and those operating under significant financial constraints. We are now seeing some tenants demanding letters of credit from potential landlords, as part of lease negotiations to ensure their ability to perform. We certainly did not predict today's extreme credit dislocation or its impact on real estate, but it has reinforced our belief of the fundamental importance of a strong conservative financial structure and a well protected balance sheet.

That was an important factor in our decision to move ahead with a common stock offering last quarter. The proceeds from the 10 million shares we issued, just under $200 million, have reduced our leverage and broadened our flexibility to respond to whatever we encounter down the road, whether potential challenges or opportunities. Dick will review the details with you. I mention it here because I believe it is an important example of our conservative long-term approach to our business. When our markets do turn around, and they will, KRC will be better prepared to capitalize than most of our competitors here. Meanwhile, in the short-term, our priorities are clear. Our focus remains on strong leasing execution, and a sound balance sheet.

Now let's take a quick review of our individual submarket conditions. I'll start in Del Mar, San Diego County, where KRC is the dominant office landlord with approximately two-thirds of the top tier Class A product. Current direct vacancy here is approximately 17.5% and total vacancy is 21.4%. Our stabilized properties in Del Mar are 92% occupied.

South of Del Mar in the Sorrento Mesa, KRC competes in the two and three-story office market. Direct vacancy for this product type is currently 8.5% and total vacancy is 10%. Our stabilized properties here total approximately 1.9 million square feet and they are 88% occupied. Further south in the UTC Governor Park submarket, we compete in the same two-story product type. Our properties here total 431,000 square feet of total space. Current direct vacancy is about 10.6% and total vacancy is 68.8%. We currently have two vacancies in this market for an aggregate occupancy of 57%.

Along the I-15 corridor east of Del Mar, KRC owns approximately 1.2 million square feet of stabilized office space. The two-story product type here has current direct vacancy rate of 12% and total vacancy of 13%. For class A product, direct vacancy is 24.9%, and total vacancy is 25.8%. As a result of the accredited vacancy, our stabilized properties here are now 64% occupied.

Further north in Orange County, the industrial property market has a current vacancy rate of just 5.6%, with the sale of a small property here during the second quarter, our industrial portfolio in Orange County now totals about 3.5 million square feet. It was 90% occupied at the end of the quarter.

Moving north to Los Angeles County, the submarkets of El Segundo and Long Beach remain reasonably strong, our Airport Center Long Beach, our seven-building office campus immediately adjacent to Long Beach Airport is 95% occupied. Class A direct vacancy here is 7.4%, and total vacancy is 10.1%. In El Segundo, our stabilized properties now total 1.3 million square feet and are 98% occupied. Class A direct vacancy in El Segundo was currently 13.4% and total vacancy is 14.1%.

Further north in West LA, direct vacancy is 12.5%. Total vacancy is 17.4%. Our properties here total 680,000 square feet and are 81% 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 22.7% and total vacancy is 27.2%. Our properties in the market are currently 77% occupied. That's an update on our market conditions.

Dick will cover the financial results. Dick?

Thanks, John. FFO was $0.79 a share in the first quarter. That includes about $0.02 related to the settlement of prior period lease termination and about $0.04 of letter of credit proceeds received as a result of the Accredited Home Lenders bankruptcy. The letter of credit proceeds offset the reserve we took on the Accredited straight line rent receivable last quarter.

Occupancy in our stabilized portfolio was 85.5% at the end of the second quarter. That's down from 87.6% at the end of the first quarter. and 89.2% at the beginning of the year. As John mentioned, the decline in occupancy from the first quarter is the result of Accredited's default and Boeing's move-out in Orange County. By product type, office occupancy was 83.5%, and industrial occupancy was 90.2%.

Same-store NOI was up 2.1% in the second quarter on a GAAP basis, reflecting the reversal of bad debt expense related to the collection of the Accredited letter of credit. Same-store NOI on a cash basis was down 5.6%. For the first six months of the year, NOI was down 3.1% on a GAAP basis and 7.4% on a cash basis. The decline in same-store results this year is largely a result of lower occupancy.

Rents increased 13% on a GAAP basis and 7% on a cash basis on leases that commenced during the second quarter. With the new leases signed in the second quarter, we now have about 445,000 square feet of space expiring through the remainder of the year. Most of it office. From a regional perspective, we have 121,000 square feet expiring in Los Angeles, 121,000 square feet expiring in Orange County, of which 55% is industrial and 199,000 square feet expiring in San Diego. The largest remaining 2009 expiration is the 173,000 square-foot Epicore office lease in Sorrento Mesa that expires at the end of August. Epicore will be moving out of that space.

We sold one asset during the second quarter, a 64,000 square foot industrial building in Orange County for $5 million. The building was empty at the time of sale. Based on estimated market rents, we think that the cap rate on the sale was roughly 6%. We reported a $2.5 million gain on the transaction.

As John mentioned in early June, we completed the sale of just over 10 million shares of common stock for total net proceeds of $192 million. We used the proceeds to pay down a substantial portion of the borrowings under our unsecured revolving credit line. As a result, we ended the second quarter with $94 million outstanding on our $550 million credit line, giving us $456 million of committed available debt capacity. Our credit line runs through April 2010, with a one-year extension off the April 2011.

As we reported in an 8-K last week, we also amended our credit line to suspend the 85% unencumbered pool occupancy covenant, as long as we maintain unsecured debt service coverage above 3.5 times, calculated on a trailing four-quarter basis. We ended the second quarter with unsecured debt service coverage of 5.1 times. We estimate that our debt coverage will increase going forward as a result of a lower leverage from our recent equity offering. As a footnote, our total cost of the amendment was approximately $175,000.

Second quarter G&A costs were down 21% from the second quarter of 2008, $27.3 million from $9.2 million last year. For the first half, G&A was $14.4 million, down 22% from 18.4 million last year. The decrease is largely a result of lower incentive compensation costs.

Now let me finish with 2009 earnings guidance. As John mentioned earlier in the call, despite an uptick in tenant interest and marketing activity in the second quarter, we're not assuming any meaningful rebound in our markets this year, and as I said in prior calls, our internal forecasting and guidance reflect information and marketing intelligence, as we know it today, there are significant uncertainties in today's economy and our markets going forward that could affect our results in ways not currently reflective in our analysis. At the time of our equity offering in early June, we confirmed our prior FFO guidance range pro forma for the impact of the offering at $2.57 to $2.77 per share. We are now tightening and slightly increasing that range and provide updated 2009 FFO guidance of $2.62 to $2.77 per share.

That's the latest news from here. And now we'll be happy to take your questions. Operator?

(Operator Instructions) Our first question comes from the line of Michael Bilerman of CitiGroup.

Hi, this is Mark Montana on behalf Michael. First question, just with respect to your lease expirations in 2010, looks like 17% rolled, about 47% from LA office, 22% from San Diego office, about 26% from Orange County industrial. Wanted to get a little bit more granularity on this if possible, wondering if these are weighted towards the beginning or back half of the year or if it's spread pretty evenly throughout. And then also how these negotiations are proceeding, sort of how long they have been in the works and what your outlook is there.

This is Jeff. The 2010 expirations, a majority of a larger transactions are actually back weighted to the third and fourth quarter of 2010, so it's a little early to predict exactly how those are going to turn out. We have been talking to a lot of tenants, but I think in prior calls, we've mentioned a lot of tenants are taking a wait and see and aren't making decisions until they absolutely have to.

Okay. That's helpful. Thanks. And then with regards to retention rates, as you mentioned, they clearly picked up over 1Q levels. Wondering if this could, do you believe this is mostly attributable to just pent-up demand as you mentioned just before from people taking that wait and see attitude in the first quarter and then coming to the table in the second quarter? Or, f you believe that something is structurally shifting.

This is John John Kilroy speaking. The volume of transactions in all of our markets at least that we're seeing, have increased or in almost all of our markets, but it's a little too early to develop some thesis as to, as to why. Certainly there's some pent-up demand. We've seen a lot of folks that had been close to signing an LOI and then backtracked and decided to stay and do a one-year lease in their existing space. So we do think there's some pent-up demand with regard to improving people's facility structures, but there clearly has been a wait and see attitude, as Jeff mentioned, amongst the broad number of tenants throughout Southern California, given the economic conditions.

What's important is that we are seeing a substantial increase in activity. As I say, in most of our markets, and that's measured by tours, RFPs, proposals and counter proposals, LOIs and leases, and as an example, demand in our San Diego markets as reported by the brokerage community be up about 500,000 square feet quarter over quarter. I wish that we could say we've got this figured out. This is exactly what's happening. It's not that way at all.

We're very dedicated to moving forward with our leasing. We think we're very well positioned with the product that we have and with the balance sheet that we have and with the team that we have. Just a little too early at this point to make heads or tails out of what's driving folks.

Got you. And then I guess on the same topic, if you could just give a little detail possibly about the leasing activity trends during the quarter with the signings, whether, you noted that LOI interests and proposals that you're beginning to pick up, wondering if a lease activity and signing trended up through the quarter or if there was no noticeable trend there.

Well, as we said, we did 300,000 square feet, which was about a 30% increase over the first quarter and quick back of the envelope math and we've got 300,000 square feet of LOIs, but as we've cautioned, can't bank on those until they are converted to leases. We obviously, that's an improvement over the previous few quarters, but again, it's way too early to say that's a trend. As time goes by, people need to make decisions, but at the same time, you've got every executive in the country, every CEO and CFO saying, hey, if you don't need to do something, don't do it, and wait. We think this is sort of the yin and yang that's occurring in the marketplace right now. We do know, and we've mentioned this back at NAREIT that many of the tenant rep brokers are telling their tenants now is the time to sign up and do longer leases because you're going to get much better deals than you would have gotten in the past and that's generally a sign that they believe things are starting to bottom out as well. But again who knows what will come out of Washington next that will unset the apple cart or not.

All right, great. Thanks very much.

The next question comes from the line of Dave AuBuchon of RW Baird.

Thank you. First off, John, congrats on winning the Trans Pack race. Well done.

Oh, thank you.

Wanted to ask you about Epicore, the 173,000 square feet that expires next month, correct, is there any subleasing in that space right now?

There is some subleasing, but those folks are going into a building that I believe Irvine company owns over in UTC. But I am happy to say that we've got several folks that are going through that campus right now. So we have our fingers crossed that we're going to be able to see some good activity there. But again, no deal is a deal until it's signed.

Right. So assumption is 173,000 square feet goes vacant next month.

That's correct.

Okay. Relative to 2010's expiration, the question was asked about exposure there. Boeing has about 290,000 square feet, is that correct, in El Segundo?

That's correct.

That expires July 8. I remember the last negotiation, this lease got extended three years to end in July 2010 and the prior lease had at Boeing had a requirement to let you guys know what they were going to do a year ahead of time. Is that requirement still in place for the current lease?

Actually, Dave, when we did the extension that we're in right now, we specifically did not give Boeing so there is not an option under the lease that's going to expire next year.

There's no extension option?

That's correct.

Okay, but do they have to give you a year's notice that they do?

No.

Okay.

No, they wouldn't have to give us any notice.

And what's your current -- I know obviously it's July of next year and you have a lot of work to do from now until then, but any particular conversations with the tenant and where they could go, even if they wanted to move?

Yes, Dave, this is always a tricky subject when you're talking about folks that, let's just say that folks listen to conference calls, okay? So it's very difficult, particularly even more so in this market when talking about some of these expirations that are going to occur, or scheduled to occur to talk about what's going on. So I, I don't mean to be cute. I just would say that obviously we're talking with quite a few people, both existing tenants and new tenants about all the space that we have rolling next year and I feel very uncomfortable getting into the details of that until we have something to report.

Fair enough. Moving to Sorrento Mesa, I know it's a fairly small building, but the one you just completed, and I believe you want to try to target that to be medical office, any particular movement there? Obviously it shows up as zero percent lease in the supplemental. But do you have a little background on that building?

Yeah, on that particular building, we're actually seeing good interest right now, both from a multiple number of smaller tenants and then with a couple of groups that are interested in anywhere from 2 to -- it's a three-story building, anywhere from two to three floors. We thought a couple months ago we would start breaking it up. Then we started talking with folks that were interested and strategically it's important to them. So we've got great activity on the building. Disappointing that we haven't been able to sign any, any leases yet. I think we probably could have signed some smaller ones, but we didn't want to give up the opportunity to do a bigger transaction. So our -- you know, we're very focused on that and the good news is we're seeing more activity. The bad news is we haven't seen a lease yet.

Okay. Last question about capital allocation. At this point, how hard do you think it will be building the portfolio through acquisitions? I'm assuming development's going to be much harder to accomplish over the next couple of years. Do you see your company being active in trying to potentially scoop up some assets at big discounts to replacement costs?

Absolutely. As we said at our IPO 12 years ago, that we were both an acquirer and developer of both office and industrial and that we would play all four of those things as it was appropriate, given the point of the cycle that we're in, and we think we have a -- we're in good shape to become a substantial acquirer. We think it's a little too early in the market right now. We have some initiatives here in the company that I think are going to pay off for us as the market comes around, but, yeah, I would say that we will -- we'll be a seller when it's appropriate to be a seller, and we'll be a buyer when it's appropriate to be a buyer.

Perfect, thank you.

Our next question comes from the line of Michael Knott with Green street advisors.

I want to expand a little bit on the acquisition since you guys do have such a good balance sheet. Can you explain a little bit more, like what kind of assets you would target, whether they would be fully leased or whether you would be willing to consider kind of lease-up assets. And in what markets? Because I know you have plenty of assets to lease already in San Diego, so would you look for similar type assets there or more on the LA market?

This is Dick speaking. I think it's early yet to give specific color on that, as John mentioned. We think the cycle is early. It's obviously still, as you guys have pointed out, well -- quite a bit of uncluttering of assets and related debt to come. But I think right now, we're looking -- we're looking fairly broadly at markets where we might be about to add value over time.

Okay, and then regarding the San Diego portfolio, it looks like besides the known moveout that occupancy held up fairly well, do you foresee besides the Epicore moveout, is that going to be the low point for the occupancy next quarter or what is built into your guidance?

That's really the only major expiration we have for the remainder of the year in San Diego. So assuming no other changes, that would be the only negative. As John mentioned, we're working on new leases there, so we hope to improve that number. But we don't anticipate that going any lower.

Okay, and then do you have any assumptions for the LA portfolio, as like a bottom-out. Because if you run just retention ratio on the square footage expiring next year that would you would get a change of 10% portfolio vacancy. Do you have kind of any number built into your guidance, or any assumptions there?

We haven't given any guidance for next year yet at all.

Okay. All right. Well, thanks for that.

Thank you.

The next question comes from the line of [George Arberdas of ISI].

Good afternoon. Just a few questions on the land bank. First, given the recent pullback in construction costs, I was wondering if you could update us on the hard costs that you would expect on new development if you were to put a shovel into the ground today.

I'm sorry, George. This is Dick speaking. Do you have a sense for what our hard building costs above land today?

That's correct.

I don't have that number at the top of my head. Hang on one second here. So we're looking at two-story office. We've priced that recently for a tenant in San Diego excluding land. Now, our soft costs are going to include carry-on land, so this will come down. Somewhere in the neighborhood of $225 a foot with a -- I'm not sure what the -- I don't have the breakdown of what the TI cost is on that. But that's fully loaded. I just -- I think we would have to respond, have to try to respond to you with a follow-up to that question. I don't have the information before me.

And this is Dick speaking. I'll just follow on to what John said, that as you might expect, what we are seeing across the board is that building costs, both the commodity and the labor, are way down. We see that in TI work and obviously we're -- if anybody was to build a building today, it would be way lower, because essentially all building contractors have now become TI contractors and there's been a great squeeze-out effect. So actual incremental building costs, if somebody was to build a new building in Southern California today, would be I think quite a bit lower than even we even now expect because with a formal bid going, I think at least in our prior experience, you start with the clean slate and the first few buildings built are done at completely different prices, even below what you expect.

Right.

And there is no new net construction taking place today at all, as you might expect. The only construction is TI's.

Right. Could you maybe quantify where you think construction costs have moved over the last 12 or 18 months relative to net effective rents?

Well, rents, I mean rents have jumped around for sure and the dilemma with that topic is, as you know, if there was some pretty aggressive ask rents and to go through market by market and look at where rents were, actual rents and where they have come down, that's a pretty broad -- the way you have asked it, it's a very broad question. It gets specific on, because it's going to be different in every market. But we've clearly seen major reductions in the, in the commodity and labor side of the cost equation and in some cases, that's been anywhere from 30 to 40%. In some cases, it's been less. But the -- and that contrasts where we were say a year and a half ago when we were forecasting substantial, 30, 40% increases in cost over what was then the high point of the cost structure. So I, I'm happy for us to supply some kind of numbers to you, but I -- but to discuss them here and make it a general comment specific to, kind of all inclusive to all markets, I think we would be just, just too generalized.

Okay. I'll follow up offline then. Thank you.

You're welcome.

Our next question comes from the line of Dave Rodgers, Capital Markets.

Hi. This is Mike Carroll here with Dave. Could you guys give us an estimate of what your current mark-to-market is on your in-place leases?

Obviously it's a difficult question in this market, but we estimate we're about at market for our portfolio.

All right, thank you.

And our next question comes from the line of [John Ugicek of RIEES].

Hi, guys, can you talk at all about activity at the Sony building, if there's any in West LA. Obviously the market is soft, but you have a big space there.

Yeah, we have LOI for about half of it right now.

Great, thanks.

You're welcome.

(Operator Instructions) Our next question comes from the line of Michael Knott of Green Street Advisors.

Hi, just one follow-up. I'm not sure if I missed this earlier, but if you guys could comment on what the cash rent roll-up was on the leases signed during the second quarter as opposed to the commencement in the supplemental.

Yeah, rents on a GAAP basis were down about 3%. On a cash basis, down about 4%.

Okay, great. Thank you.

And our next question comes from the line of Michael Bilerman of Citi.

Just had a quick follow-up. With regard to the exchangeable notes, I know they rallied fairly significantly off of lows still off peak prices. Just wanted to get your thoughts on buying those back through the remainder of the year and as you look forward.

This is Dick speaking. We were obviously preoccupied in a way with completing our equity offering and then we wanted to get that amendment that we announced done. I think we have been actively watching the pricing on the convertibles. We found that post equity offering had bounced more than we felt comfortable with paying at the time and so that's something we're looking at and watching very carefully and will continue to do so.

Okay, great. Thanks.

We have no further questions in the queue.

Thank you, all, very much for joining us today. We know it's a busy day. Thank you, and have a good summer.

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