Kilroy Realty Corp (KRC) 2009 Q3 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the third quarter 2009 Kilroy Realty Corp. earnings conference call. My name is Katy and I'll be your coordinator for today. (Operator instructions). I would like to turn the call over to your host for today, Mr. Richard Moran, Executive Vice President and Chief Financial Officer. Please begin.

Good morning, everyone. Thank you for joining us. With me today are John Kilroy our CEO, Jeff Hawken, our COO, Tyler Rose, our Treasurer, and Heidi Roth, our Controller. At the outset, I need to say that some of the information 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 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 a Form 8K (inaudible) and both available on our website. John will start call with an overview of the quarter in our key markets, I'll add financial highlights and updated earnings guidance for 2009, and then we'll be happy to take your questions, John?

Thanks, [Jack]. Hello, everyone. Thanks for joining us today. Conditions for commercial real estate in southern California remain soft. Vacancy rates have increased, market rental rates have decreased and lease negotiations continue to be slow and challenging. Having said that, over the past several months, we started to gain some traction. We have had two quarters in a row of solid leasing and we continue to see a pickup in activity. In the second quarter, we reported that we signed about 300,000 square feet of leases, and 300,000 area feet of letters of intent. In the third quarter we have matched those results with another 300,000 square feet of LOI's and signed leases and importantly, it looks like our capture rate on the second quarter LOI's will be over 95%. That conversion rate is a sharp improvement from earlier in the year. Included in our converted LOI's is a new lease with Universal Music for 56,000 area feet within our Santa Monica media center buildings previously occupied by Sony Music. Universal is expected to move in during the first quarter.

While the real estate markets clearly haven't returned to normal, we sense that the improvement in the capital markets may be helping to increasing tenant demand and allow decision-makers to make new commitments. We are seeing more companies take advantage of the opportunity to lock in the real estate requirements at attractive rents as tenant rent brokers have been telling their clients that it is the tenant's time in the cycle and now may be the best time to move forward. In addition landlord stability and financial strength continue to be a theme amongst tenants and brokers. We are seeing tenants shying ago way from buildings where there are ownership uncertainties. Given our long-term presence in the markets, high quality assets and availability of capital to fund TIs, and leasing commissions, we believe KRC has a real advantage here and can further improve our capture rate versus our competitors.

Despite a somewhat improved market there are still various users who are experiencing the difficulties that you see, particularly in the latter stages of the bottom of the cycle. For an example, an industrial tenant in Orange County defaulted on 144,000 square feet during the quarter. While the economic impact is modest, it had a more meaningful impact on our occupancy.

Now let's review our markets and what we are seeing beginning in San Diego. This is a region where our occupancy has fallen from 91% two years ago to 78% today. San Diego in general has been hit hard by the economic crisis, and KRC in particular has had several tenant bankruptcies and other related defaults. While we may have another tenant issue down the road or two, the good news is that during the third quarter, and into the fourth quarter, we have seen a significant increase in activity, tours, lease negotiations, across almost all of our vacant space in San Diego. We have several hundred thousand square feet made up of numerous tenants in active negotiations throughout our San Diego portfolio and it is our task to convert those negotiations into signed leases and we are committed to doing so.

The individual San Diego sub market vacancy rates and our occupancy rates in those markets are as follows; starting with Del Mar - current direct vacancy is approximately 20.2% and total vacancy is 21.4%. Our stabilized properties in Del Mar are 93% occupied. 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 9.9% and total vacancy is 11.6%. Our stabilized properties in the sub market total approximately 1.9 million square feet, following Epicore's lease expiration in August, our occupancy here declined to 79%. Further south in the UTC governor parks market we compete in the same two-story product type with properties totaling about 431,000 square feet. Current direct vacancy is about 8.8% and total vacancy is 15.6%. Our occupancy rate is 55%.

Along the I-15 corridor east of Del Mar, KRC owns approximately 1.2 million square feet of stabilized office space. Two-story product type here as a current direct vacancy rate of 16% and total vacancy of 17%. For Class A product direct vacancy has increased to 34.9% and total vacancy is 36.3%. Our stabilized properties here are currently 66% occupied.

Further north in Orange County, the industrial property market has a current vacancy rate of 5.9% and while this hasn't changed significantly from last quarter, demand is fairly light as the smaller entrepreneurial industrial tenants have generally has been hit harder by the credit crunch. Our industrial portfolio there totals about 3.5 million square feet and taking into account the recent default, our industrial occupancy in Orange County fell from 90% to 84%.

Moving to Los Angeles, our overall occupancy rate has remained stable at 89%, and while demand here is not strong, we are slowly making progress, leasing space as with the universal transaction and renewing expiring leases. The sub markets of El Segundo and Long Beach continue to perform well. Kilroy Airport Center Long Beach, our seven building office campus immediately adjacent to the Long Beach Airport, is currently 94% occupied overall Class A direct vacancy is 8.1% and total vacancy is 10.8%.

In El Segundo our stabilized properties total 1.38 million square feet and are 98% occupied. Class A direct vacancy in El Segundo is currently 12.6% and total vacancy is 14%. As you know, Boeing leases 286,000 square feet in our Kilroy Airport Center El Segundo project which also includes DirecTV as the other major tenant. Boeing's lease expires at the end of July of next year. Boeing and its predecessors have been in that building for more than 25 years and our plan is to take the space back and completely modernize and upgrade the building so that it is positioned for the growing diversity of the El Segundo tenant base. Further north in west LA, our properties total 680,000 square feet and are 81% occupied. When Universal Music moves its new space in the former Sony building in the first quarter of 2010, our occupancy in the market will rise to 89%. Overall direct vacancy in LA is currently 13.2%, total vacancy is 18.6%.

Finally along the 101 corridor market which runs through northern Los Angeles and southern Ventura counties, direct vacancy in a Class A product is currently 23% and total vacancy is 29.5%. Our properties in the market are currently 77% occupied.

In summary, we have got our work cut out for us until we get to the steeper part of the recovery but we sense as we mentioned last quarter, that we have seen the bottom of the cycle. We have made leasing progress two straight quarters and have seen an increase in activity in both Los Angeles and San Diego. And we are off to a good start in the fourth quarter as we have signed another 200,000 square feet of leases so far, and are working on several meaningful letters of intent for spaces throughout our portfolio.

Looking forward, I'm absolutely certain that the emerging distinction of top quality well capitalized real estate companies like KRC will give us a competitive advantage both with regard to those seeking space in our sub markets, and in our capacity to take advantage of future growth opportunities. That's an update on market conditions. Now Dick will cover the financial results. Dick.

Thanks, John. FFO was $0.66 per share in the third quarter and $2.25 a share for the first three quarters of the year. Included in third quarter FFO is a GAAP gain of $0.07 a share related to the repurchase of $40 million of our convertible debt. We paid $35.3 million for a $40 million face amount of the debt or average of about $0.88 on the dollar. Occupancy in our stabilized portfolio was 82.5% at the end of the third quarter, down from 85.5% at the end of the second quarter. Decline in occupancy from the second quarter was largely due to the 173,000 square foot Epicore lease termination in Sorrento Mesa that we discussed last quarter and the 144,000 square feet industrial tenant default in Orange County that John just mentioned.

From an economic perspective, the industrial tenant that defaulted was contributing about $0.03 per year in FFO per share. Same story NOI in the third quarter was down 20.3% on a GAAP basis and 21.3% in a cash basis. That decline affects our lower occupancy as well as the $5.2 million in lease termination fees that we collected in the same quarter in 2008.

Excluding lease termination fees, our third quarter same store NOI would have been down 12.7% on a GAAP basis and 4.9% on a cash basis. For the first nine months of 2009 NOI was down 9.3% in a GAAP basis and 12.4% on a cash basis with the declines driven essentially by occupancy losses. The leases commencing during the third quarter rents increased 17% on a GAAP basis and 5% on a cash basis. For leases signed during the third quarter, rents increased 3.6% on a GAAP basis and decreased 0.6% on a cash basis. G&A costs were down 20% to $7.7 million in the third quarter. That compares to $9.6 million in the earlier period. In the first nine months of 2009, G&A was down 22% to $22 million, from $28.1 million in the first months of 2008.

Now let me finish with updated 2009 earnings guidance. Given today's uncertain economic circumstances, we remain cautious in our near term outlook. Also it bears repeating once again our internal forecasting and guidance reflect the information and market intelligence as we know it today. There are significant uncertainties in the economy in our markets going forward that could affect our results in ways not currently reflected on our analysis. On our last conference call we provided 2009 FFO guidance of $2.62 to $2.77 per share, other than the $0.07 third quarter gain related to the debt buy back we expect to remain right in the middle of our range, so after adding in the gain our updated 2009 FFO guidance -- $2.71 a share to $2.81 a share. That is the latest news from here and now operator, we'll be happy to take your questions. Thank you.

(Operator instructions). Your first questions comes from the line of Michael Bilerman from Citi.

This is [Mark Montana] on behalf of Michael. Had a couple of questions on LA and San Diego markets in particular. Just looking at some of the recent market data, it appeared there is some disconnect coming to fruition between the LA and San Diego markets and that San Diego is showing more significant signs of stabilization in terms of both vacancy and rental rate trends. Just wondering if you are seeing the similar trend that I'm seeing in the data on the ground floor?

Well, this is John, Mark. There is a lot of data out there, depends on how current it is, of course. In San Diego, I think it's safe to say that we are seeing a lot more tenant interest and activity than we are seeing in Los Angeles. It is a smaller market, of course, we are not in every sub market in LA, we are in the better sub markets as you know in San Diego, but we are seeing a lot more tenants out in the market, major tenants, a diverse group of tenants looking for space than we are elsewhere.

Great and then in terms of rents and more particularly I guess rents, are you seeing more stabilization there as well due to the overall activity? Or is it too early to tell.

You know, it's hard to get anything you say about rents, all you can say is they have come down on all markets and face rates are not exactly the average rates throughout the period of leases today. There is more free rent involved in transactions. So I can't speak what others are doing. In San Diego, I feel like we have seen the bottom. We are definitely seeing an uptick. I don't know that we have seen the bottom in LA. I think there is more pain to come on the 101 corridor, although we are seeing good interest in the space we have vacant there. We have been able to do this deal with Universal here, and on the west side of Los Angeles, where we think we are doing well with regard to upcoming roll over, but we are not seeing huge amounts of demand. Like I said, down rental rates in San Diego, I think we are going to see those, whether those have totally bottomed or not in every market I can't tell you but we are beginning to see a little lift off what we thought with his the bottom awhile back.

Okay and then along the same lines and the letters of intent that you mentioned on the call and in the release that levels are sort of holding steady over what you were able to achieve last quarter, I was wondering both in the tenant activity that you are seeing as well as the actual letters of intent that you have achieved, is this coming from a specific sector? Or is it pretty broad-based wondering if you know a lot of the financial services and law firms are sort of out of the picture now, and you are seeing incremental demand from sectors you weren't really seeing before?

In San Diego, we are seeing Defense, we are seeing medical office, we have made some progress there, we are seeing the health services, we are seeing some increase in demand in the biotech, although we are not very big players in that as you know, general office in the service category, which includes the lawyers, has increased -- we're in the letters of intent of a couple law firms now. We are seeing it as I mentioned with the Defense industry, in the telecom industry so it is pretty broad base and we think that is a healthy sign.

Great. Thank you.

You are welcome.

Operate next question comes from the line of George Auerbach, please proceed.

Good afternoon John, wondering if you could clarify for us on the 600,000 square feet of leases signed in the third quarter, how much that have activity relates to tenants within the portfolio with 2009 and 2010 expirations?

George, just to make it clear, the 600,000 square feet, about 300,000 of that is leases signed and 300,000 square feet of that is new letters of intent. And within, to answer your question, I think, on the 300,000 square feet of leases signed, the locations for those are about 150,000 square feet in LA , 50,000 square feet in Orange County and 150,000 square feet in San

Right but how much of that activity is sort of net demand in your portfolio as opposed to you going out -- ?

About 40% is related to vacant space and 60% is related to expiring space.

Right. Okay. And I guess also 2010 is a large expiration year for you in Los Angeles. Could you just give us some color on discussions you are having with those tenants, what you are asking in terms of occupancy loss in the LA portfolio next year? And also where you think taking rents are today? First the $24 per square foot expiring GAAP rate?

Well, I'll take the first part that have in terms of 2010 expirations, we are not going to get into the details as you know the big lease next year is with Boeing for 286,000 square feet which John mentioned. The only other lease that's over 100,000 square feet is with Fair Isaac in San Diego and we are in discussions with them. Besides that everything else is under 100,000 so it sort of singles and doubles and we're working on that. We are not going to really comment much more on that. On the rent question, can you be a little more specific? What is your question there?

Well the average expiring rents in LA are $24 a square foot on a GAAP basis. I was wondering where you thought your sort of roll up or roll down would be relative to that rate?

Yes our view overall for the portfolio for next year that includes not just LA but the overall portfolio is we are about at market for 2010 expiration. So that includes Los Angeles.

Great. Thank you.

Next question comes from the line of Dave Rodgers. Please proceed.

This is Mike Carol here with Dave. My first question is how sustainable is the traffic that you have seen across your portfolio? Do you think it's a single wave? Or more of a broad based move?

Well, it's hard to tell in a period like this, Mike. From what we are seeing, and the fact that it is a combination of tenants that have been in the marketplace, looking for space and agonizing over space commitments and now seeing some light at the end of the tunnel themselves, where you need to pull the trigger there is that pent up. We are seeing quite a bit of new demand that wasn't there a quarter or two ago so it is pretty hard to predict. But the feeling that I get and I think our people have generally is that decision makers are not as reluctant, not as reticent to make a decision and pull the trigger. Having said that, all negotiations take an agonizingly long period of time. I have seen this in multiple cycles in my life and sometimes I wonder if no offense to the attorneys who might be listening, but if the attorneys, if they had 10 deals before, and now they have four deals, they have still got to sell those hours, and somehow I think that contributes to the length of time it takes to complete things. But we are seeing more volume in San Diego right now. We have over 900,000 square feet of negotiations going on and most of that is for product that is currently vacant. As I said, somebody else's earlier question, it's across a broad spectrum of tenants, and we are starting to hear people talk about that they are going to hire more. So, those are all good signs, I don't mean to be cute, but your crystal ball's probably as good as mine.

Do these leases you acquire, are you guys giving more rent abatements out? And can you quantify how much free rent are you giving tenants?

This is Jeff. It really is deal specific. You know on a 5 year deal I think the market is typically one month per year. And on a 10 year deal it is somewhere between six and eight months so I think we tend to be on the lower end of those market scales in terms of rent relief, but it is deal specific and renewal versus a new tenant and what sub market we are dealing in.

Okay, great. Can you give us some color on your HP lease or HP and their attempt to sub lease their lease in LA ?

San Diego?

LA, I believe. Or is it San Diego?

San Diego. Yes they are actively trying to find another subtenant and more to come on that. They have obviously got a listing team and looking at prospects, but nothing lined up at this point.

I might point out that they have one of five buildings in Kilroy Center Del Mar. The first building is the smallest. It's roughly 52,000 feet. That is the one that Paul Hastings was in. We are close to signing a lease for two-thirds of that building and have demand on the balance, Fair Isaac, we think things are moving in the right direction there, and the building that you are mentioning, or inquiring about, HP, we and some others occupy the fifth floor, HP has got the bottom four floors, and that lease comes up in 2012, Jeff? I believe if I'm not mistaken late 2012. We think we are going to be in good shape if that space gets turned back to us at the expiration of the lease and obviously we'll work with HP for the right kind of tenant. Yes 2012.

Great. And then have you had any discussions about extending your line of credit? Or renegotiating that?

This is Dick speaking. That is something that we are at the preliminary stages of and anticipate a good result. We anticipate being in the market for reach in general we expect the size of credit lines to decline, we are prepared for that. We have 19 banks, which is a great number of banks for a relatively small company, we have strong leadership in our bank group, strong support in our bank group and we have an annual bank meeting coming up to kickoff the process. We don't anticipate any difficulties there outside of the norm we expect on the new market terms.

Okay. Then do you have the ability to repurchase your exchangeable notes? Or is that appetite done?

That's something we continued to look at. Continue to have an interest in. In effect, you could think of it as a sinking fund, which I know others have said is an apt way of looking all the it.

Then my last question is can you quantify the headcount reductions within Kilroy? The amount of G&A savings provided you guys on the current G&A level right now is good run rate going forward?

I think the average in the first three quarters is probably absent some change in activity that is unanticipated, a good average run rate, plus or minus for the fourth quarter. We, earlier this year and late last year, had about a 5% perhaps little bit more headcount reduction. We have had a couple of selective reductions since then, we're basically, I think done with that, and confident that we have the staff we need to manage the current activity level and obviously as John reports, and as does Jeff, our leasing activity level is showing some kinds of encouraging growth. Beyond that, the only thing that would vary that is if there's dramatic levels and compensation levels and that sort of thing and I don't think we have any information to report on that. But we certainly are aware of the current environment.

Good. Thank you, guys.

(Operator instructions) Next question comes from the line of Dave AuBuchon, please proceed.

Thank you. Can you give any guidance relative to leasing costs going forward? Looked like they jumped significantly in third quarter. Is that an anomaly or obviously the market's weaker or so we should be underwriting maybe something much more significant in line with third quarter numbers?

That line sort of bounces up and down I think in the third quarter we had six leases that were over $50 a area foot and four of those leases were in one project in San Diego where we were relocating the tenant. So it is a little bit higher than normal. I don't think there is a trend there, necessarily. I think it is just a small subset as Jeff I think talked about the TI amounts aren't going up dramatically.

Most of your vacant space is in San Diego, you don't think the improvement costs are specifically related to those leases obviously we can extract going forward?

We can't promise anything. But we don't see that's the trend that we are going to be in a $50 kind of number going forward on a renewal.

It's more a function, Dave, of both a small sample size. And the particular building they were in. I think the softness was seen in pricing as John and Jeff were touching on earlier has been in free rent and that is, as Jeff outlined, relatively contained and that is not softening more at the current moment, at least.

Okay. Just one more question from me. Obviously you have plenty of growth in your portfolio through lease up, but are there any interest in acquisitions now John? Any closer to pulling a trigger on a deal if you felt that was the right thing to do?

If I felt it was the right thing to do, we are talking with quite a few folks, we are taking a hard look at different areas, we haven't focused on any specific asset or transaction, Dave. But we have sort of, if I could use this expression, we have one eye on making sure that we lease up a vacant space that we have now or as it becomes available and we have another eye on being opportunistic as the circumstances warrant and we intend, as the circumstances warrant, to be able to be acquires in this part of the cycle. As you know, we were very disciplined over the last five years or so and only bought when it was something that was very strategic to us and where we could add value. We think the markets come our way now and we see quite a few of what would have been our competitors had we been buying over these last four or five year. Now crippled and with legacy issues and other financial problems and we think this could be very much a beginning of a good cycle for Kilroy.

Do you feel the redevelopment in el Segundo next year will take away capital from any acquisition plans you have?

No.

Thank you.

I mean, on the margin it takes a few bucks away no, I don't think it has any significant impact.

Okay, thanks.

You are welcome.

Next question from the line of Michael Matt from Green Street Advisors.

Hey, this is Enrique Torres on behalf of Michael. Question regarding once again on the 2010 lease expirations, I know you broke out the two big ones and there is a lot of singles and doubles to hit. Any indication of whether you expect retention rates to be part of what we have seen this year in the 55% range? Or would you expect it to be higher or lower than that?

Enrique, this is Dick speaking. Other than the Boeing, the single large expiration that Tyler mentioned earlier, it is still early yet, but our preliminary work suggests right now we are shooting at an improvement over the current year retention rates. Probably not one that's cosmic in size, but certainly directionally encouraging.

Okay. That's helpful. Then one more thing was we are seeing from some market sources there may be vacancy at the asset you have in Del Mar where Next Wave is your tenant. Can you just clarify what the situation is there?

Yes. That was a sub tenant of HP. And they moved on. HP continues to be our tenant. We never had a relationship with NextWave other than the fact they were the sub tenant of HP.

Okay. So in the lease there expires, that was 2012 expiration?

End of April 2012.

Okay. All right. Thank you.

Welcome.

(Operator instructions). Next question comes from the line of Chris Cadeen from Morgan Stanley.

Good morning, just wanted to pickup again on the transaction market is for a second. Wondering where you are seeing buyer interest where is it the strongest and where is it the weakest? And to the extent you have it, where is pricing for good quality product versus more challenging product there in southern California?

You know, it's so all over the lot. What we have seen is a lot of doggie product, if I could use that term, trade. Real bottom fishers. There is some stuff in south Orange County that has been largely empty that's traded it below replacement costs. So it is hard to put a cap rate on that, of course. But you know, there just haven't been huge volumes of transactions, particularly a property that we would view as a competitive set to ours. So a lot of stuff we just ignore, because it is not in areas and/or it's not the kind of product that is directly competitive with Kilroy's.

This is Dick speaking, as John pensioned we have been extremely disciplined and there is a relentless continuity and a remorseless certainty to the coming debt maturity. So we expect the, that we will remain very disciplined, as the knife keeps falling on pricing. We will be very, very disciplined on the way we deploy capital. But we do expect significant opportunities to be out there.

And as you look at those debt maturities, what is the time horizon that you anticipate with some of these challenge situations? Well, I don't mean to be flippant, but you can read the macro debt maturity schedules probably better than we can. You probably have better access to the data. But there is a transient wave about us that is still building. So we certainly expect this to be a cycle of some depth and some breadth and some length. Thank you.

At this time I'm showing you have no further questions. I would hand the call back over to Dick for closing remarks.

Thank you very much for being with us on this busy day. We appreciate your interest in KRC. Thank you.