Kilroy Realty Corporation (KRC) Q1 2008 Earnings Report, Transcript and Summary

Good day ladies and gentlemen and welcome to the First Quarter 2008 Kilroy Realty Earnings Conference Call. My name is Katy and I will be your coordinator for today. At this time all participants are on a listen-only mode. We will be facilitating a question and answer session towards the end of this conference. [Operator Instructions] I would like to now 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 our CEO; Jeff Hawken our Chief Operating Officer; and 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 in the next 10 days both by phone and over the internet. Our press release and supplemental package have been filed on 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, I will add financial highlights and updated 2008 earnings guidance and then we will be happy to take your questions, John.

Thanks Dave, hello everyone and 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 Sabre 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 schedule to expire in our stabilized portfolio during 2008 [indiscernible] approximately 750,000 square feet of that space, we ended the first quarter with 94.8 million 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 and six projects for total estimated investment of approximately $186 million. With the Bridgepoint transaction, these projects are now 65% leased. Now 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 their real estate decisions, unemployment's 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 will 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, lets take a closer look at our individual sub-markets. Starting in San Diego CB Richard Ellis continues to report over 6 million square feet demand in central San Diego markets and competitive supplier 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 products, 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 markets, south of Del Mar, KRC competes with two and three storey 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 storey product type. Our properties here total 430,000 square feet of space, current direct vacancy is 6.78% and total vacancy is 12%. Our only vacancy here is the 140,000 square feet building vacated in the third quarter of last year by Intuit, along I-15 corridor we owned approximately 750,000 square feet of stabilized office space. The two storey product type here has a current direct vacancy rate of 11.8% and total vacancy of 15.9%. For Class A products direct vacancy is 21.8% and total vacancy is 23.7%. Our stabilized properties here are 81% occupied. In Orange County, offices weak, industrial strong. Our industrial portfolio of about 3.7 million square feet was 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 of about 9.6%. Moving on to El Segundo, our stabilized properties in this market are 97% occupied. Class A vacancy rate 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 totaling 680,000 square feet are 99% occupied. And finally, the along the 101 Corridor market which runs through Northern Los Angeles and Southern Ventura Counties direct vacancy in a Class A product currently is 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 are concerned about the economies direction and the potential impact on our business. But given the quality of our assets and markets, we are confident that our team will continue to out perform 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 our comp plan, the slowing economy has caused us to lower some of our operating projects a bit which in turned 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 had expected one of our industrial tenants that is experiencing financial problem to either vacate of 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 stop paying rent and attempted to surrender its leased premises back to us. The negative affect 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 its obviously now a legal matter. Although, vacancy rates have moved up in some of our markets, based on our latest detailed analysis of our portfolio, we haven't seen any material change in market rents since last quarter. We believe that rent levels on our overall portfolio remain about 15% under markets and our 2008 expirations are about 10 to 15% under markets. Rent growth on leases that commence during the first quarter was quite strong as GAAP rents increase 49% and cash rents increase 29%. Thus first quarter results are a bit anomalous we expect that our rent increases will moderate back towards our overall portfolio estimates over the remainder of the year. Same-store NOI, was down 1% on the GAAP 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 payout ratio was 79%. Our active development program which includes six projects under constructions is on track, these projects represent our total investment of $186 million of which $136 million has been spent to-date. Turning to our balance sheet our strategy remains one of liquidity, conservative leverage and flexibility. We currently have $383 million of debt capacity on our $550 million credit line with the single $73 million debt maturity coming due in August. We can either payoff the debt using our credit line or obtain a new term loan. We will make that decision closer to the debt expiration based on market conditions and our capital lease. 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 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 progress. On our last call, we projected that our average occupancy for the year will be in the 92 to 93% range. We now expect that we will 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 stop paying its rent, be conservative for the moment, we are excluding rent from that tenant on 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 and revenues our forecast would be largely offset by lower interest rates and lower projected G&A cost. Although, LIBOR is obviously been 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 that G&A would be $40 million and $42 million for the year, our latest projected are that incentive compensation cost this year will be lower than we previously estimated mainly as a result of the moderately lower leasing and operating results that we are 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 cost is equivalent to a savings of $0.06 to $0.12 a share for the year. Taking all these assumptions together, we are maintaining the same 2008 FFO guidance that we provided last quarter of $3.30 and $3.50 a share with midpoint of $3.40 a share, that's the latest news from here and now we will be happy to take your questions, Operator? Question And Answer

Hello operator.

Yes I am sorry. Ladies and gentlemen [Operator Instructions] Your first question comes the line of Lou Taylor from Deutsche Bank. Please proceed.

Thanks. Good morning guys. Lets see John can you talk a little bit about what was the anomaly that drove the Q1 rents so much higher.

Well,Jeff you want to comment on that.

Louis, this is Jeff, we had one particular lease in San Diego that had very strong increases in both cash and cap rent, that was the big driver.

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

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

Okay. Next question, Dick with regards to the tenant that just stop 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 are taking somewhat more conservative positions assuming that we will have a...but we would expect to be typical for the cycle or more bad debt expense, softer economy. The individual tenant that stopped paying rent is obviously...that is obvious anomaly because that's simply a contractual dispute.

Okay. Are you recognizing bad debt in terms of your specific items or 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 tenant credit.

Okay. So you got some other tenancy, you may be worried about collecting other than the one that you can't reference in your remarks?

Yes, and that is entirely natural, I 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 is entirely typical for this point in the cycle with no other significant surprises.

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

Well actually I mean, tenant reimbursement were not quite as much as expenses were up. But you don't typically recover all of your expense increases.

Maybe what I was striving [ph] I mean you had higher occupancy, so you should have a higher overall recovery rate, shouldn't you?

Lou this is Dick, we have one particular utility agreement that expired, that had given us benefit in the utility cost and to some extent, there some of that impacts vacant spaces well. So that was part of it, other than that it was just, I don't think it was any line item to which it was attributable.

Okay. Thank you.

[Operator Instructions] The next question comes the line of Erwin Gorman [ph] from Citi. Please proceed.

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

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.

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

Okay, great and then. Secondly, could you provide a little update on the level of interest in Sorrento Gateway or Sabre Springs, both stabilized this year but are currently on lease.

Yeah, this is John Mark.

Hi.

On Sorrento Gateway, we have two projects, one that was shell was recently completed, we call that Lot 3, its about 55,000 square feet. We...frankly I am surprise the building hasn't been leased by now. We had a number of tours, but we do have some strong interest right now from a couple of different folks, one is full four user, I mean the full building user, 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 just make a comment that generally in that throughout the portfolio in all areas, that we are seeing a lengthening of the decision process. So we are reluctant at times to pull the trigger, which is again typical for this kind of...this point of cycle. The other building that under construction at Sorrento Gateway is Lot 1 which is about 52,000 feet, that is a three storey medical office building, it is one of the only sites in San Diego, that's zone four medical offices. We have very strong demand from a couple of 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 the other question was about Sabre Spring. Sabre Springs there is two properties, we have up there, Kilroy Sabre Springs, which is the Class A office space, which is now with the Bridgepoint lease is essentially fully leased and the new building is entirely leased and then we have Sabre Spring Corporate Center, which is in our redevelopment category, that project is about 100,000 feet, its 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 market place 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 are 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 the projects you referenced.

Perfect, thanks very much.

You welcome.

The next question comes the line of George Elback [ph] from Merrill Lynch. Please proceed

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

George could you amplify that on your question please. Just to make sure, I got it right.

Just, in terms of the revenue run-rate going forward?

Go ahead.

Back in action

Go ahead please, I am sorry you said $0.10.

I am sorry, $0.02 out of the first quarter number.

Well if our tenant stop paying around was a penny and there will be $0.09 for the balance of the year.

So that would be...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 or long are you in 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 have been doing is working with, we bought and I think we talked a little bit about this last call, property zone for 500,000 square feet of office space and that's a matter of right. We have been working with the homeowner groups in the cities towards a mixed use project and there seems to be a great deal of support both of those areas for and expanded project, can't say for sure, we will get it approved, we have been interviewing architects, we are 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 users than that which the properties entitled for today. So that effort is going to go on for several months, the cities say they want it, like I say the homeowner groups they want it, traffic seems to support it. We have done an analysis on that, and now the question becomes what the mix will be. So I don't think, we will any construction on that site, this year.

Okay. Thank you.

You welcome.

At this time, I am sure, you have no further questions. I would now like to turn the call back over to management for closing remark.

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.