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Kilroy Realty 10-Q 2005 Table of Contents
UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
FORM 10-Q
(Mark One)
For the quarterly period ended September 30, 2005
OR
For the transition period from to
Commission file number 1-12675
KILROY REALTY CORPORATION (Exact name of registrant as specified in its charter)
12200 W. Olympic Boulevard, Suite 200, Los Angeles, California 90064 (Address of principal executive offices)
(310) 481-8400 (Registrant’s telephone number, including area code)
N/A (Former name, former address and former fiscal year, if changed since last report)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes x No ¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
As of November 7, 2005, 28,923,325 shares of common stock, par value $.01 per share, were outstanding.
Table of ContentsEXPLANATORY NOTE
As previously reported by Kilroy Realty Corporation (the “Company”) on Forms 8-K filed with the Securities and Exchange Commission on October 25, 2005 and October 31, 2005, the Company determined that its hedge designation memos for six interest rate swap and two interest rate cap agreements entered into by the Company in 2000 and 2002 do not meet the technical requirements to qualify for hedge accounting treatment in accordance with Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”). Prior to entering into each of these agreements, the Company engaged an independent consulting firm specializing in derivatives to advise the Company with respect to derivatives and hedging matters. The Company consulted closely with the independent derivatives specialist during its preparation of the formal designation of the instruments to ensure that each instrument qualified for hedge accounting treatment under SFAS 133 and the related accounting guidance. Although both the Company and the independent derivatives specialist believed the designation documentation met the requirements under SFAS 133 at the time the derivative transactions were entered into, the Company subsequently determined that the designation documentation does not meet the technical requirements under SFAS 133 to qualify for hedge accounting treatment. As a result, the Company is restating its consolidated financial statements for the three and nine months ended September 30, 2004 in this Form 10-Q and will be filing amendments to its Annual Report on Form 10-K/A for the year ended December 31, 2004 and its Quarterly Reports on Form 10-Q/A for the quarters ended March 31, 2005 and June 30, 2005 to mark all of these instruments to market and to recognize the impact of this mark to market adjustment in the statement of operations for each affected period, rather than through other comprehensive income.
In addition, based on a recent related review of the Company’s accounting treatment for tenant improvements reimbursed by the tenant, the Company is also restating its financial statements to record a capital asset and related depreciation for leasehold improvements constructed by the Company that are reimbursed by tenants, with a corresponding liability for deferred revenue, which will be amortized into rental revenue over the lives of the related leases. In connection with the restatement, certain other immaterial adjustments have also been recorded.
For a more detailed description of the restatement, see Note 14 to the consolidated financial statements included in this Report.
Table of ContentsKILROY REALTY CORPORATION
QUARTERLY REPORT FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2005
TABLE OF CONTENTS
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CONSOLIDATED BALANCE SHEETS (unaudited, in thousands, except share data)
See accompanying notes to consolidated financial statements.
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CONSOLIDATED STATEMENTS OF OPERATIONS (unaudited, in thousands, except share and per share data)
See accompanying notes to consolidated financial statements.
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CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY (unaudited, in thousands, except share and per share data)
See accompanying notes to consolidated financial statements.
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CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited, in thousands)
See accompanying notes to consolidated financial statements.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Three and Nine months ended September 30, 2005 and 2004 (unaudited)
Organization
Kilroy Realty Corporation (the “Company”) owns, operates and develops office and industrial real estate, primarily in Southern California. The Company operates as a self-administered real estate investment trust (“REIT”). As of September 30, 2005, the Company’s stabilized portfolio of operating properties consisted of 84 office buildings (the “Office Properties”) and 48 industrial buildings (the “Industrial Properties”), which encompassed an aggregate of approximately 7.8 million and 4.7 million rentable square feet, respectively, and was 92.8% occupied. The Company’s stabilized portfolio of operating properties consists of all of the Office Properties and Industrial Properties and excludes properties currently under construction and “lease-up” properties.
The Company defines “lease-up” properties as properties recently developed or redeveloped by the Company that have not yet reached 95% occupancy and are within one year following substantial completion. Lease-up properties are reclassified to land and improvements and building and improvements from construction in progress on the consolidated balance sheets upon building shell completion. As of September 30, 2005, the Company did not have any properties in the lease-up phase. As of September 30, 2005, the Company had two development properties under construction, which when completed are expected to encompass approximately 103,300 rentable square feet. The Company had no redevelopment properties under construction as of September 30, 2005.
The Company owns its interests in all of its Office Properties and Industrial Properties through Kilroy Realty, L.P. (the “Operating Partnership”) and Kilroy Realty Finance Partnership, L.P. (the “Finance Partnership”) and conducts substantially all of its operations through the Operating Partnership. The Company owned an 88.6% general partnership interest in the Operating Partnership as of September 30, 2005. Kilroy Realty Finance, Inc., a wholly-owned subsidiary of the Company, is the sole general partner of the Finance Partnership and owns a 1.0% general partnership interest in the Finance Partnership. The Operating Partnership owns the remaining 99.0% limited partnership interest of the Finance Partnership. The Company conducts substantially all of its development services through Kilroy Services, LLC (“KSLLC”), which is a wholly-owned subsidiary of the Operating Partnership. Unless otherwise indicated, all references to the Company include the Operating Partnership, the Finance Partnership, KSLLC and all wholly-owned subsidiaries of the Company.
Basis of Presentation
The consolidated financial statements of the Company include the consolidated financial position and results of operations of the Company, the Operating Partnership, the Finance Partnership, KSLLC and all wholly-owned subsidiaries. All significant intercompany balances and transactions have been eliminated in the consolidated financial statements.
The Company consolidates all variable interest entities (“VIE”) in which it is deemed to be the primary beneficiary in accordance with the FASB Interpretation No. 46R (“FIN 46R”). As of September 30, 2005, the Company consolidated one VIE in connection with an agreement entered into in September 2005 to facilitate a 1031 tax-deferred property exchange. Under the terms of the agreement, the Company is obligated to purchase the operating property held by the VIE within 180 days of the acquisition of the property to complete the exchange. The Company retains all rights to appreciation and all exposure to depreciation in the value of the property during the period it is held by the VIE. The impact of consolidating the VIE is to increase the Company’s total real estate asset balance by approximately $24 million at September 30, 2005. The acquisition
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Table of ContentsKILROY REALTY CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
of the operating property was funded with borrowings under the Company’s Credit Facility (defined in Note 5). As of June 30, 2005, the Company had also consolidated a VIE as a result of an agreement entered into in May 2005 to facilitate a 1031 tax-deferred property exchange. This exchange was completed in July 2005, at which point the Company no longer had an interest in the entity.
Net income after preferred distributions and preferred dividends is allocated to the common limited partners of the Operating Partnership (“Minority Interest of the Operating Partnership”) based on their ownership percentage of the Operating Partnership. The common limited partner ownership percentage is determined by dividing the number of common units held by the Minority Interest of the Operating Partnership by the total common units outstanding. The issuance of additional shares of common stock or common units results in changes to the Minority Interest of the Operating Partnership percentage as well as the total net assets of the Company. As a result, all capital transactions result in an allocation between stockholders’ equity and the minority interest held by common unitholders of the Operating Partnership in the accompanying consolidated balance sheets to account for the change in the Minority Interest of the Operating Partnership ownership percentage as well as the change in total net assets of the Company.
The accompanying interim financial statements have been prepared by the Company’s management in accordance with accounting principles generally accepted in the United States of America (“GAAP”) and in conjunction with the rules and regulations of the Securities and Exchange Commission (“SEC”). Certain information and footnote disclosures required for annual financial statements have been condensed or excluded pursuant to SEC rules and regulations. Accordingly, the interim financial statements do not include all of the information and footnotes required by GAAP for complete financial statements. In the opinion of management, the accompanying interim financial statements reflect all adjustments of a normal and recurring nature which are considered necessary for a fair presentation of the results for the interim periods presented. However, the results of operations for the interim periods are not necessarily indicative of the results that may be expected for the year ending December 31, 2005.
Reclassifications
Certain prior period amounts have been reclassified to conform to the current period’s presentation.
Recent Accounting Pronouncements
In December 2004, the FASB issued Statement 123 (revised), “Share-Based Payment” (“FAS 123R”). FAS 123R requires that all share-based payments to employees, including grants of employee stock options, be recognized in the income statement based on their fair values. The new standard will be effective as of the beginning of the first fiscal year beginning after June 15, 2005. The adoption of this statement is not expected to have a material effect on the Company’s results of operations or financial condition.
In March 2005, the FASB issued Interpretation No. 47, “Accounting for Conditional Asset Retirement Obligations” (“FIN 47”). FIN 47 clarifies guidance provided in FASB Statement No. 143, “Accounting for Asset Retirement Obligations.” The term asset retirement obligation refers to a legal obligation to perform an asset retirement activity in which the timing and/or method of settlement are conditional on a future event that may or may not be within the control of the entity. Entities are required to recognize a liability for the fair value of a conditional asset retirement obligation when incurred if the liability’s fair value can be reasonably estimated. FIN 47 will be effective as of the end of the first fiscal year ending after December 15, 2005. The adoption of the interpretation is not expected to have a material effect on the Company’s results of operations or financial condition.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
Stock Option Accounting
Effective January 1, 2002, the Company voluntarily adopted the fair value recognition provisions of SFAS 123, “Accounting for Stock-Based Compensation” (“SFAS 123”) prospectively, for all employee stock option awards granted or settled after January 1, 2002. Under the fair value recognition provisions of SFAS 123, total compensation expense related to stock options is determined using the fair value of the stock options on the date of grant. Total compensation expense is then recognized on a straight-line basis over the option vesting period. All of the Company’s outstanding stock options were fully vested as of February 2005.
Prior to 2002, the Company accounted for stock options issued under the recognition and measurement provisions of APB Opinion 25 “Accounting for Stock Issued to Employees” and related interpretations. The following table illustrates the effect on net income and earnings per share if the fair value based method had been applied to all outstanding and unvested awards in each period.
In May 2005, the Company acquired an office property in Brea, California from an unaffiliated third party for a purchase price of $7.3 million. The building, which encompasses approximately 45,900 rentable square feet, was 100% leased as of September 30, 2005.
In June 2005, the Company acquired approximately 11.3 acres of undeveloped land located in San Diego County, California from an unaffiliated third party for approximately $24.0 million.
In September 2005, the Company acquired an industrial property in San Diego, California from an unaffiliated third party for a purchase price of approximately $24 million. The property includes a 20-acre land site and one building, which encompasses approximately 303,000 rentable square feet. Upon acquisition, the Company executed a one-year lease with the seller to continue to occupy the entire building through September 2006. The lease also includes a three-month extension option. The Company will recognize approximately $1.4 million in rental revenue during the next year in connection with this lease. At the termination of the lease, the Company plans to redevelop the site and currently anticipates developing approximately 600,000 to one million square feet of office space. The site includes entitlements to build approximately 1.8 million square feet of office and light industrial space. These acquisitions were each funded with borrowings under the Company’s Credit Facility (defined in Note 5).
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Table of ContentsKILROY REALTY CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
During the nine months ended September 30, 2005, the Company sold the following properties:
The Company sold four buildings in March 2005 through a portfolio transaction to an unrelated third party for an aggregate gross sales price of $38.7 million. The Company recorded a net gain of approximately $5.8 million in connection with the disposition. The Company sold the one industrial property in July 2005 to an unrelated third party for a gross sales price of $22.5 million, which consisted of an $11.25 million cash payment and an $11.25 million note receivable from the buyer. The note bears interest at an annual rate of 7.0%, requires monthly principal and interest payments based on a 30-year amortization period, and matures in July 2012. In addition, the principal and any accrued and unpaid interest may be prepaid in whole or in part at any time without penalty or premium. As partial consideration for the sale, the Company will also participate in certain future profits from the operation or sale of the property as set forth in a profit participation agreement, without risk of loss or further continuing involvement. The contingent future profits will be recognized in the period they are realized. The Company recorded a net gain of approximately $17.8 million in connection with the disposition. The Company used the net cash proceeds from the sale of these properties to fund its development program and to repay borrowings under the Credit Facility (defined in Note 5). The net income and the net gain on disposition for these properties have been included in discontinued operations for the three and nine months ended September 30, 2005 and 2004 (see Note 11).
Stabilized Redevelopment Projects
During the nine months ended September 30, 2005, the Company added the following redevelopment projects to the Company’s stabilized portfolio:
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Table of ContentsKILROY REALTY CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
Unsecured Line of Credit
As of September 30, 2005, the Company had borrowings of $199.0 million outstanding under its revolving unsecured line of credit (the “Credit Facility”) and availability of approximately $226.0 million. The Credit Facility bears interest at an annual rate between LIBOR plus 1.00% and LIBOR plus 1.70% depending upon the Company’s leverage ratio at the time of borrowing (4.97% at September 30, 2005), and matures in October 2007 with an option to extend the maturity for one year. The fee for unused funds ranges from an annual rate of 0.20% to 0.30% depending on the Company’s leverage ratio. The Company expects to use the Credit Facility to finance development and redevelopment expenditures, to fund potential acquisitions and for other general corporate uses.
Secured Debt
In June 2005, the Company borrowed $35.5 million under a mortgage loan that is secured by eleven properties, requires interest-only payments based on a variable annual interest rate of LIBOR plus 0.90% (4.67% at September 30, 2005) and matures in July 2008. The loan has two one-year extension options and allows for partial recourse, up to 25% of the principal balance of the loan. The Company used a portion of the proceeds to repay an outstanding mortgage loan with a principal balance of $29 million that was scheduled to mature in December 2005. The remainder of the proceeds was used primarily to repay borrowings under the Credit Facility.
Debt Covenants and Restrictions
The Credit Facility, the unsecured senior notes and certain other secured debt arrangements contain covenants and restrictions requiring the Company to meet certain financial ratios and reporting requirements, including a maximum total debt to total assets ratio, a maximum total secured debt to total assets ratio, a maximum dividend payout ratio, minimum debt service coverage and fixed charge coverage ratios, minimum consolidated tangible net worth and a limit of development activities as compared to total assets. The Company was in compliance with all of its debt covenants at September 30, 2005.
Capitalized Interest and Loan Fees
Total interest and loan fees capitalized for the three months ended September 30, 2005 and 2004 were $2.6 million and $2.1 million, respectively. Total interest and loan fees capitalized for the nine months ended September 30, 2005 and 2004 were $6.8 million and $5.7 million, respectively.
The following table sets forth the terms and fair market value of the Company’s derivative financial instruments at September 30, 2005:
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
In January 2005, the Company’s interest-rate swap agreement to fix LIBOR on $50 million of its variable-rate debt at 4.46% expired.
Minority interests represent the common and preferred limited partnership interests in the Operating Partnership. The Company owned an 88.6% and 87.7% general partnership interest in the Operating Partnership as of September 30, 2005 and 2004, respectively.
During the nine months ended September 30, 2005, 272,249 common limited partnership units of the Operating Partnership were redeemed for shares of the Company’s common stock on a one-for-one basis. Neither the Company nor the Operating Partnership received any proceeds from the issuance of the common stock in exchange for common limited partnership units.
In February 2005, the Company’s Executive Compensation Committee granted an aggregate of 101,112 restricted shares of common stock to certain executive officers and key employees. Compensation expense for the restricted shares is calculated based on the closing price per share of $41.35 on the February 23, 2005 grant date. Of the shares granted, 18,139 vest at the end of a one-year period, 61,812 vest in equal annual installments over a two-year period and 21,161 vest in equal annual installments over a five-year period. The Company recorded approximately $0.4 million and $0.3 million in compensation expense related to these restricted stock grants during the three months ended September 30, 2005 and 2004, respectively and $1.0 million during each of the nine months ended September 30, 2005 and 2004.
In May 2005, the Company’s Executive Compensation Committee granted an aggregate of 2,694 restricted shares of the Company’s common stock to non-employee board members as part of the board members’ annual compensation plan. Of the shares granted, 1,350 vest at the end of a one-year period and 1,344 vest at the end of a two-year period. Compensation expense for the restricted shares is calculated based on the closing per-share price of $44.56 on the May 17, 2005 grant date. The Company recorded approximately $15,000 and $22,000 related to these restricted stock grants during the three and nine months ended September 30, 2005, respectively.
In March 2003, the Company’s Executive Compensation Committee approved a special long-term compensation program for the Company’s executive officers. The program provides for cash compensation to be earned at December 31, 2005 if the Company attains certain performance measures based on annualized total stockholder returns on an absolute and relative basis. The amount payable for the absolute component is based upon the amount by which the annualized total return to stockholders over the period exceeds 10%. The targets for the relative component require the Company to obtain an annualized total return to stockholders that is at or above the 70th percentile of annualized total return to stockholders achieved by members of a pre-defined peer group during the same three-year period, and includes additional incentives for annualized total return to stockholders that is at or above the 80th percentile. Compensation expense under this program is accounted for using variable plan accounting. The Company estimates the amount to be paid based on the average closing share price of the Company’s common stock as reported on the New York Stock Exchange (“NYSE”) for the last ten days of the period, and records compensation expense equal to that portion of the total compensation applicable to the portion of the performance period that has elapsed through the end of the period. Under the absolute portion of the plan, for every $1 change in the Company’s ten-day average closing stock price, the total payable over the three-year term of the plan changes by approximately $1.7 million. During the three months ended September 30, 2005 and 2004, the Company accrued approximately $13.9 million and $5.8 million, respectively, and during the nine months ended September 30, 2005 and 2004, the Company accrued $28.1 million and $10.7
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
million, respectively, of compensation expense related to this plan, which is included in general and administrative expenses. The total amount accrued relating to the plan was $52.5 million as of September 30, 2005, which is included in accounts payable, accrued expenses and other liabilities.
During the nine months ended September 30, 2005, the Company accepted the return, at the current quoted market price, of 41,379 shares of its common stock from certain key employees in accordance with the provisions of its incentive stock plan to satisfy minimum statutory tax-withholding requirements related to restricted shares that vested during this period.
In January 2005, the Company paid $1.8 million pursuant to a court approved settlement agreement related to a lease termination that occurred in 2001. The amount was previously recorded as a charge to other property income during the third quarter of 2004.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
The Company’s reportable segments consist of the two types of commercial real estate properties for which management internally evaluates operating performance and financial results: Office Properties and Industrial Properties. The Company also has certain corporate level activities, including legal, accounting, finance and management information systems, which are not considered separate operating segments.
The Company evaluates the performance of its segments based upon Net Operating Income. Net Operating Income is defined as operating revenues (rental income, tenant reimbursements and other property income) less property and related expenses (property expenses, real estate taxes, ground leases and provision for bad debts) and does not include interest and other income, interest expense, depreciation and amortization and general and administrative expenses. There is no intersegment activity.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
In accordance with SFAS 144 “Accounting for the Impairment or Disposal of Long-Lived Assets,” the net income or loss and the net gain or loss on dispositions of operating properties sold and classified as held for sale are reflected in the consolidated statements of operations as discontinued operations for all periods presented. For the three and nine months ended September 30, 2005 and 2004, discontinued operations included the net income or loss and the net gain on sale of the five buildings sold during the nine months ended September 30, 2005. For the three and nine months ended September 30, 2004, discontinued operations also included the net income, the impairment loss and net gain or loss on sale of the two properties sold in 2004. The following table summarizes the income and expense components that comprise discontinued operations for the three and nine months ended September 30, 2005 and 2004:
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Table of ContentsKILROY REALTY CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
Basic earnings per share is computed by dividing net income or loss by the weighted-average number of common shares outstanding for the period. Diluted earnings per share is computed by dividing net income or loss by the sum of the weighted-average number of common shares outstanding for the period plus the number of common shares issuable assuming the exercise of all dilutive securities. The Company does not consider common units of the Operating Partnership to be dilutive since any issuance of shares of common stock upon the redemption of the common units would be on a one-for-one basis and would not have any effect on diluted earnings per share. The following table reconciles the numerator and denominator of the basic and diluted per-share computations for net income.
For the three months ended September 30, 2005, the effect of the assumed exercise of the 78,000 outstanding stock options and the effect of the 155,309 unvested shares of restricted stock were not included in the earnings per share calculation as their effect is antidilutive to the loss from continuing operations available for common stockholders.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
On October 18, 2005, aggregate dividends and distributions of approximately $16.6 million were paid to common stockholders and common unitholders of record on September 30, 2005.
On October 3, 2005, the Company borrowed from the Credit Facility to repay an outstanding mortgage loan with a principal balance of $9.8 million that was scheduled to mature in December 2005.
As of the date of this report, the Company is in escrow to sell an industrial property, which encompasses approximately 77,000 rentable square feet and is located at 2265 E. El Segundo. The sale is expected to close in the fourth quarter of 2005 or the first quarter of 2006. The Company expects to record a gain in connection with the disposition.
Derivative Instruments
Subsequent to the issuance of the Company’s interim consolidated financial statements for the three and nine months ended September 30, 2004, the Company determined that its hedge designation memos for six interest rate swap and two interest rate cap agreements entered into by the Company in 2000 and 2002 do not meet the technical requirements to qualify for hedge accounting treatment in accordance with Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”). Prior to entering into each of these agreements, the Company engaged an independent consulting firm specializing in derivatives to advise the Company with respect to derivatives and hedging matters. The Company consulted closely with the independent derivatives specialist during its preparation of the formal designation of the instruments to ensure that each instrument qualified for hedge accounting treatment under SFAS 133 and the related accounting guidance. Although both the Company and the independent derivatives specialist believed the designation documentation met the requirements under SFAS 133 at the time the derivative transactions were entered into, the Company has subsequently determined that the designation documentation does not meet the technical requirements under SFAS 133 to qualify for hedge accounting treatment. As a result, the Company has restated its consolidated financial statements for the three and nine months ended September 30, 2004 to mark all of these instruments to market and to recognize the impact of this mark to market adjustment in the statement of operations for each period, rather than through other comprehensive income.
Leasehold Improvements Paid by Tenants
The Company restated its consolidated financial statements to record a capital asset and related depreciation for leasehold improvements constructed by the Company that are reimbursed by tenants, with a corresponding liability for deferred revenue, which will be amortized into rental revenue over the life of the related leases.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
The Company also determined that certain immaterial costs that were previously capitalized and depreciated in subsequent periods should have been expensed. The restated financial statements include an adjustment for these amounts. The following tables summarize the effects of the above mentioned changes on the Company's consolidated financials statements:
Consolidated Balance Sheet
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
Consolidated Statements of Operations
Consolidated Statement of Cash Flows
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The following discussion relates to the consolidated financial statements of the Company and should be read in conjunction with the financial statements and notes thereto appearing elsewhere in this report. Statements contained in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” that are not historical facts may be forward-looking statements. Such statements are subject to certain risks and uncertainties, which could cause actual results to differ materially from those projected. Some of the information presented is forward-looking in nature, including information concerning projected future occupancy rates, rental rate increases, project development timing and investment amounts. Although the information is based on the Company’s current expectations, actual results could vary from expectations stated in this report. Numerous factors will affect the Company’s actual results, some of which are beyond its control. These include the timing and strength of regional economic growth, the strength of commercial and industrial real estate markets, competitive market conditions, fluctuations in availability and cost of construction materials and labor resulting from the effects of recent natural disasters and increased worldwide demand, future interest rate levels and capital market conditions. You are cautioned not to place undue reliance on this information, which speaks only as of the date of this report. The Company assumes no obligation to update publicly any forward-looking information, whether as a result of new information, future events or otherwise, except to the extent the Company is required to do so in connection with its ongoing requirements under federal securities laws to disclose material information. For a discussion of important risks related to the Company’s business and an investment in its securities, including risks that could cause actual results and events to differ materially from results and events referred to in the forward-looking information contained in this report, see the discussion under the caption “Business Risks” in the Company’s annual report on Form 10-K, as amended, for the year ended December 31, 2004 and under the caption “Factors That May Influence Future Results of Operations” below.
Impact of Restatements
Management’s Discussion and Analysis of Financial Condition and Results of Operations has been updated to reflect the restatements for the three and nine months ended September 30, 2004. For a more detailed description of the restatements, see Note 14 to the accompanying consolidated financial statements included in this Form 10-Q.
Overview and Background
Kilroy Realty Corporation (the “Company”) owns, operates, and develops office and industrial real estate, primarily in Southern California. The Company operates as a self-administered real estate investment trust (“REIT”). The Company owns its interests in all of its properties through Kilroy Realty, L.P. (the “Operating Partnership”) and Kilroy Realty Finance Partnership, L.P. (the “Finance Partnership”) and conducts substantially all of its operations through the Operating Partnership. The Company owned an 88.6% and 87.7% general partnership interest in the Operating Partnership as of September 30, 2005 and 2004, respectively. The Company conducts substantially all of its development services through Kilroy Services, LLC, which is a wholly owned subsidiary of the Operating Partnership.
Factors That May Influence Future Results of Operations
Rental income. The amount of net rental income generated by the Company’s properties depends principally on its ability to maintain the occupancy rates of currently leased space and to lease currently available space, newly developed or redeveloped properties and space available from unscheduled lease terminations. The amount of rental income generated by the Company also depends on its ability to maintain or increase rental rates in its submarkets. Negative trends in one or more of these factors could adversely affect the Company’s rental income in future periods.
Rental rates. For leases that commenced during the three months ended September 30, 2005, rental rates increased 12.6% on a GAAP basis, and 1.7% on a cash basis. Rental rates for leases that commenced during the
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Table of Contentsnine months ended September 30, 2005 increased 1.8% on a GAAP basis, and decreased 7.5% on a cash basis. The change in rental rate on a cash basis is calculated as the change between the initial stated rent for a new or renewed lease and the ending stated rent for the expiring lease for the same space, whereas the change in rental rate on a GAAP basis compares the average rents over the term of the lease for each lease. Both calculations exclude leases for which the space was vacant longer than one year. Rental rates for the nine months ended September 30, 2005 were significantly impacted by one lease the Company renewed, during the second quarter of 2005, with a tenant located in one office complex in Seattle, Washington which had a decrease in the rental rate of 62.0% and 63.6% on a GAAP and cash basis, respectively. The substantial decline in rental rates was mainly attributable to the prior lease having a term of approximately twenty-five years. Since this lease had periodic rent escalations and the lease term was longer than the Company’s average lease term, the ending rental rate was significantly above market. Excluding this lease, the change in rental rates for the nine months ended September 30, 2005 would have been an increase of 7.8% on a GAAP basis and a decrease of 2.5% on a cash basis. Management believes that the average rental rates for its properties are approximately at the current average quoted market rates, although individual properties within any particular submarket presently may be leased above or below the current quoted market rates within that submarket. The Company cannot give any assurance that leases will be renewed or that available space will be re-leased at rental rates equal to or above the current quoted market rates.
Scheduled lease expirations. In addition to the 906,000 square feet of currently available space in the Company’s stabilized portfolio, leases representing approximately 0.8% and 9.6% of the leased square footage of the Company’s stabilized portfolio are scheduled to expire during the remainder of 2005 and 2006, respectively. The leases scheduled to expire during the remainder of 2005 and the leases scheduled to expire in 2006 represent approximately 0.6 million square feet of office space, or 6.3% of the Company’s total annualized base rent, and 0.7 million square feet of industrial space, or 2.3% of the Company’s total annualized base rent, respectively. Management believes that the average rental rates for leases scheduled to expire during the remainder of 2005 and 2006 are slightly above the current average quoted market rates. The Company’s ability to re-lease available space depends upon the market conditions in the specific submarkets in which the properties are located.
Submarket Information
Los Angeles County. There continue to be signs of improvement in market conditions in the overall Los Angeles County region in 2005, based on third-party reports of positive net absorption and decreased levels of direct vacancy as well as an increased level of interest in leasing opportunities at the Company’s properties. Most notable have been the improvements seen in the West Los Angeles and Long Beach submarkets. The El Segundo submarket remains the Company’s most significant leasing challenge. However, management has begun to see signs of improvement in the region. At September 30, 2005, the Company’s Los Angeles stabilized office portfolio was 88% occupied with approximately 376,000 vacant rentable square feet as compared to 91% occupied with approximately 257,100 vacant rentable square feet at December 31, 2004. The decrease in occupancy was primarily attributable to one redevelopment project that was added to the stabilized portfolio during the third quarter of 2005 since one year had passed following substantial completion. As of the date of this report, the Company had executed leases or letters of intent for approximately 49% of the space, 19% of which was occupied as of that date. The building is located in a two-building office complex in the El Segundo submarket. As noted above, the El Segundo submarket is the Company’s most significant leasing challenge, as vacancy rates remain the highest in the region. However, the Company’s leasing efforts continue to show progress with several new office leases signed during the year in this office complex and at other properties in this submarket. The other building in this office complex, which encompasses approximately 127,900 rentable square feet, was approximately 88% leased as of September 30, 2005 compared to 37% as of December 31, 2004. Management expects conditions in the El Segundo submarket to continue to improve given the strength in the neighboring submarkets. As of September 30, 2005, leases representing an aggregate of approximately 26,300 and 223,000 rentable square feet are scheduled to expire during the remainder of 2005 and 2006, respectively, in the Los Angeles County submarket.
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Table of ContentsSan Diego County. San Diego County remains one of the strongest markets in Southern California real estate based on third-party reports of positive absorption, increased rental rates and growing tenant demand. The Company continues to expand its presence in this market by aggressively seeking and obtaining development and redevelopment opportunities in the region. See additional information regarding the Company’s development projects under the caption “—Development and redevelopment programs.” As of September 30, 2005, the Company’s San Diego stabilized office portfolio was 92% occupied with approximately 285,300 vacant rentable square feet compared to 97% occupied with approximately 102,300 vacant rentable square feet as of December 31, 2004. The decrease in occupancy is partially attributable to one redevelopment project, encompassing approximately 68,000 rentable square feet, that was previously in the lease-up phase and was added to the stabilized portfolio during the first quarter of 2005 since one year had passed following substantial completion. In August 2005, the Company executed a lease for 100% of this space, which is scheduled to commence per the lease agreement in December 2005. The decrease in occupancy is also attributable to lease expirations at two buildings in the Sorrento Mesa submarket, which were previously 100% occupied. One of the buildings, encompassing approximately 130,000 rentable square feet, was 11% occupied and the other building, encompassing approximately 63,400 rentable square feet was vacant as of September 30, 2005. There are no leases scheduled to expire during the remainder of 2005 and leases representing an aggregate of approximately 499,700 rentable square feet are scheduled to expire during 2006 in this region.
Given the geographic concentration of the Company’s development program in San Diego County, the Company’s operating results may be affected by the city of San Diego’s current financial difficulties and ongoing investigations with respect to the city’s finances, which affect San Diego’s ability to finance capital projects and may impact real estate development, costs of development and market conditions in this important submarket. As of the date of this report, the Company has not experienced any material effects arising from this situation.
Orange County. As of September 30, 2005, the Company’s Orange County properties were 98% occupied with approximately 106,400 vacant rentable square feet as compared to 99% occupied with approximately 35,200 vacant rentable square feet as of December 31, 2004. As of September 30, 2005, leases representing an aggregate of approximately 54,700 and 339,000 rentable square feet were scheduled to expire during the remainder of 2005 and 2006, respectively, in this region.
Sublease space. Of the Company’s leased space at September 30, 2005, approximately 742,300 rentable square feet, or 5.9%, of the square footage in the Company’s stabilized portfolio was available for sublease, as compared to 435,200 rentable square feet, or 3.5% at December 31, 2004. Of the 5.9% of available sublease space in the Company’s stabilized portfolio as of September 30, 2005, approximately 3.6% was vacant space and the remaining 2.3% was occupied. Approximately 55% and 42% of the available sublease space as of September 30, 2005 is located in the San Diego and Orange County submarkets, respectively. Of the approximately 742,300 rentable square feet available for sublease at September 30, 2005, none is scheduled to expire in 2005. Approximately 20,800 rentable square feet represents leases scheduled to expire during 2006.
Negative trends or other events that impair the Company’s ability to renew or re-lease space and its ability to maintain or increase rental rates in its submarkets could have an adverse effect on the Company’s future financial condition, results of operations and cash flows.
Recent Information Regarding Significant Tenants
The Boeing Company. As of September 30, 2005, the Company’s largest tenant, The Boeing Company, leased an aggregate of approximately 777,000 rentable square feet of office space under five separate leases, representing approximately 5.1% of the Company’s total annual base rental revenues. In April 2005, The Boeing Company extended, renewed or otherwise modified three of its existing leases. It extended one lease, which was scheduled to expire in January 2006, at a building located in El Segundo, encompassing approximately 101,000 rentable square feet. The extended lease expires in January 2007 and can be terminated by either party with 60-days advance notice anytime after April 30, 2006. The Boeing Company also renewed one lease at a building located in Anaheim, encompassing approximately 65,500 rentable square feet. The lease, which was originally scheduled to
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Table of Contentsexpire in October 2005, was extended through October 2010. In addition, an amendment was signed for a lease in Long Beach whereby The Boeing Company reduced its rentable square feet from 43,600 rentable square feet to 15,500 rentable square feet. This lease expired on September 30, 2005. Furthermore, one lease, encompassing approximately 211,100 rentable square feet, is scheduled to expire in December 2007; however, under the terms of the lease, The Boeing Company has the right to terminate this lease effective December 31, 2006 by giving the Company written notice one year in advance. The remaining two leases for approximately 286,000 and 113,000 rentable square feet are scheduled to expire on July 31, 2007 and March 31, 2009, respectively.
Intuit, Inc. As of September 30, 2005, Intuit, Inc. (“Intuit”), the Company’s sixth largest tenant, leased an aggregate of approximately 278,700 rentable square feet of office space under four separate leases, representing approximately 2.4% of the Company’s total annual base rental revenues. In March 2005, the Company executed a ten-year lease agreement with Intuit for approximately 365,000 rentable square feet of additional space. Under this agreement, Intuit will lease three of the four buildings in an office complex that the Company has committed to develop in the 56 Corridor submarket in San Diego County. See additional information regarding the Company’s development projects under the caption “—Development and redevelopment programs.” In November 2005, Intuit exercised its option to lease the fourth building. Of the currently occupied space, one of the leases, encompassing approximately 212,000 rentable square feet, is scheduled to expire in April 2007. In connection with the new lease agreement, Intuit has the option to remain in approximately 141,000 rentable square feet of this space until it can occupy the new buildings, which is expected to be in the third quarter of 2007. In addition, Intuit has extended its lease for the remaining 71,000 rentable square feet until August 2009. Intuit also has two leases in Calabasas which encompass an aggregate of approximately 63,000 rentable square feet and executed a third lease in October 2005 for approximately 28,000 rentable square feet, which will commence in December 2005. All three leases are scheduled to expire in July 2014. The last lease with Intuit is located in Long Beach and encompasses approximately 3,000 rentable square feet. This lease is scheduled to expire in December 2005. Upon commencement of the new San Diego lease, Intuit is projected to become the Company’s largest tenant based on its percentage of the Company’s total annual base rental revenues.
Development and redevelopment programs. Management believes that a significant portion of the Company’s potential growth over the next several years will continue to come from its development pipeline. The Company has continued to aggressively seek and obtain development opportunities in the San Diego County region, as it remains one of the strongest markets in Southern California. The Company has made significant progress in expanding its development program in 2005 through new lease transactions and targeted acquisitions as summarized below.
In March 2005, the Company committed to develop a four-building office complex in the 56 Corridor submarket of San Diego County. As of the date of this report, the Company has pre-leased all four buildings, or 100% of the rentable square feet, to a single tenant. See additional information under the caption “—Recent Information Regarding Significant Tenants—Intuit, Inc.” The Company began construction on the first phase of the project in the third quarter of 2005 and expects to complete the buildings, which will encompass an aggregate of approximately 466,000 rentable square feet, in the third quarter of 2007. The project has a total estimated investment of approximately $145 million. In June 2005, the Company acquired approximately 11.3 acres of undeveloped land located immediately adjacent to this project. The land site includes entitlements to build approximately 350,000 rentable square feet of office space.
In June 2005, the Company executed a lease agreement with a single tenant for a new three-building corporate headquarters in its Innovation Corporate Center, located in the San Diego County I-15 Corridor submarket. Two of the buildings, encompassing an aggregate of approximately 103,000 rentable square feet, are currently under construction and are scheduled to be completed in the fourth quarter of 2005. The Company plans to commence construction on the third building, which will encompass approximately 75,000 rentable square feet, in the first quarter of 2006. The total estimated investment for the three buildings is approximately $43 million.
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Table of ContentsIn September 2005, the Company purchased a fully-entitled 20-acre land site, which includes a 303,000 square foot building, located in the San Diego County I-15 Corridor submarket. The Company executed a one-year lease with the seller to continue to occupy 100% of the space through September 2006. The lease also includes a three-month extension option. At the termination of the lease, the Company plans to redevelop the site and currently anticipates developing approximately 600,000 to one million square feet of office space. The site includes entitlements to build approximately 1.8 million square feet of office and light industrial space.
The Company also owns approximately 49.5 acres of undeveloped land, including the 11.3 acres acquired in June 2005, upon which the Company currently expects to develop an aggregate of approximately 1.1 million rentable square feet of office space within the next three to five years. All of the Company’s undeveloped land is located in San Diego County. See additional information regarding the Company’s development portfolio under the caption “Development” in this report.
Management believes that another possible source of the Company’s potential growth over the next several years is redevelopment opportunities within its existing portfolio. Redevelopment efforts can achieve similar returns to new development with reduced entitlement risk and shorter construction periods. Depending on market conditions, the Company will continue to pursue future redevelopment opportunities in its strategic submarkets where no land available for development exists. The Company had no redevelopment properties under construction as of September 30, 2005.
The Company has a proactive planning process by which it continually evaluates the size, timing, costs and scope of its development and redevelopment programs and, as necessary, scales activity to reflect the economic conditions and the real estate fundamentals that exist in the Company’s strategic submarkets. However, the Company may be unable to lease committed development or redevelopment properties at expected rental rates or within projected timeframes or complete projects on schedule or within budgeted amounts, which could adversely affect the Company’s financial condition, results of operations and cash flows.
Other Factors. The Company’s operating results are and may continue to be affected by uncertainties and problems associated with the deregulation of the utility industry in California, since 95.7% of the total rentable square footage of the Company’s stabilized portfolio is located in California. Energy deregulation has resulted in higher utility costs in some areas of the state and intermittent service interruptions. In addition, primarily as a result of the events of September 11, 2001, the Company’s annual insurance costs increased across its portfolio by approximately 14%, 11% and 12% during 2002, 2003 and 2004, respectively. However, insurance costs have remained relatively constant for the nine months ended September 30, 2005 as compared to the same period in 2004. As of the date of this report, the Company has not experienced any material effects arising from either of these issues.
In addition, the California State legislature is currently evaluating split tax roll legislation, which if enacted, could have a material effect on the Company’s operating results. If this initiative is passed as currently proposed, the tax rate on commercial property in California would increase, which would result in significant increases in real estate taxes for the Company’s properties located in California, having an adverse impact on net income.
Incentive Compensation. The Company has long-term incentive compensation programs that provide for cash and stock compensation to be earned by the Company’s senior officers if the Company attains certain performance measures that are based on annualized stockholder returns on an absolute and a relative basis as well as certain other financial, operating and development targets. As a result, accrued incentive compensation in future periods is affected by the ten-day average closing price per share of the Company’s common stock at the end of each quarter. Future increases or decreases in the price per share of the Company’s common stock and the resultant cumulative annualized stockholder return calculations will cause an increase or decrease to the quarterly adjustment of the amount accrued relating to this program, resulting in an increase or decrease to general and administrative expenses and a corresponding decrease or increase to net income available to common
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Table of Contentsstockholders. Under the absolute component of a special long-term plan for the Company’s executive officers, every $1 change in the Company’s ten-day average closing stock price equates to an approximate $1.7 million change in the total amount payable at the end of the three-year term of the plan (see Note 8 to the Company’s consolidated financial statements for further discussion about the program). Management cannot predict the amounts that will ultimately be recorded in future periods related to these programs since they are significantly influenced by the Company’s stock price and market conditions.
Results of Operations
As of September 30, 2005, the Company’s stabilized portfolio was comprised of 84 office properties (the “Office Properties”) encompassing an aggregate of approximately 7.8 million rentable square feet, and 48 industrial properties (the “Industrial Properties,” and together with the Office Properties, the “Properties”), encompassing an aggregate of approximately 4.7 million rentable square feet. The Company’s stabilized portfolio of operating properties consists of all the Properties, and excludes properties recently developed or redeveloped by the Company that have not yet reached 95.0% occupancy and are within one year following substantial completion (“lease-up” properties) and projects currently under construction.
As of September 30, 2005, the Office and Industrial Properties represented 84.2% and 15.8%, respectively, of the Company’s annualized base rent. For the three months ended September 30, 2005, average occupancy in the Company’s stabilized portfolio was 93.9% compared to 93.2% for the three months ended September 30, 2004. As of September 30, 2005, the Company had approximately 906,000 rentable square feet of vacant space in its stabilized portfolio compared to 830,900 rentable square feet as of September 30, 2004.
The following table reconciles the changes in the rentable square feet in the Company’s stabilized portfolio of operating properties from September 30, 2004 to September 30, 2005. Rentable square footage in the Company’s portfolio of stabilized properties increased by approximately 0.5 million to 12.5 million at September 30, 2005, compared to 12.0 million at September 30, 2004.
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Table of ContentsComparison of the Three Months Ended September 30, 2005 to the Three Months Ended September 30, 2004
Management internally evaluates the operating performance and financial results of its portfolio based on Net Operating Income for the following segments of commercial real estate property: Office Properties and Industrial Properties. The Company defines Net Operating Income as operating revenues from continuing operations (rental income, tenant reimbursements and other property income) less property and related expenses from continuing operations (property expenses, real estate taxes, provision for bad debts and ground leases). The Net Operating Income segment information presented within this Management’s Discussion and Analysis consists of the same Net Operating Income segment information disclosed in Note 10 of the Company’s consolidated financial statements in accordance with Statement of Financial Accounting Standards No. 131 “Disclosures about Segments of an Enterprise and Related Information.” The following table reconciles the Company’s Net Operating Income by segment to the Company’s net income available to common stockholders for the three months ended September 30, 2005 and 2004.
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Table of ContentsRental Operations
Management evaluates the operations of its portfolio based on operating property type. The following tables compare the Net Operating Income for the Office Properties and for the Industrial Properties for the three months ended September 30, 2005 and 2004.
Office Properties
Total revenues from Office Properties increased $5.5 million, or 12.1%, to $51.3 million for the three months ended September 30, 2005 compared to $45.8 million for the three months ended September 30, 2004. Rental income from Office Properties increased $4.1 million, or 9.6%, to $46.3 million for the three months ended September 30, 2005 compared to $42.2 million for the three months ended September 30, 2004. Rental income generated by the Core Office Portfolio increased $0.8 million, or 2.1%, for the three months ended September 30, 2005 compared to the three months ended September 30, 2004. The increase in the Core Office Portfolio is primarily due to an increase in occupancy. Average occupancy in the Core Office Portfolio increased 0.6% to 93.1% for the three months ended September 30, 2005 compared to 92.5% for the same period in 2004. The remaining $3.3 million increase in rental income was attributable to a $2.6 million increase in rental income generated by the two office buildings acquired by the Company in the fourth quarter of 2004 and one office building acquired by the Company in the second quarter of 2005 (the “Office Acquisition Properties”), a $0.4 million increase in rental income generated by the office development property that was added to the stabilized portfolio in the third quarter of 2004 (the “Office Development Property”) and a $0.3 million increase in rental income generated by the office redevelopment properties that were completed during 2004 and added to the stabilized portfolio in 2005 (the “Office Redevelopment Properties”).
Tenant reimbursements from Office Properties increased $1.0 million, or 25.7%, to $4.8 million for the three months ended September 30, 2005 compared to $3.8 million for the three months ended September 30, 2004. Of this increase, $0.8 million was generated by the Core Office Portfolio due to an increase in occupancy in this portfolio, as mentioned above, and an increase in reimbursable expenses. Of the remaining increase of $0.2 million in tenant reimbursements, $0.1 million was attributable to the Office Development Property and $0.1 million was attributable to both the Office Redevelopment Properties and the Office Acquisition Properties. Other property income from Office Properties increased approximately $0.5 million, or 168.0%, for the three months ended September 30, 2005 compared to the same period in 2004. Other property income for the three months ended September 30, 2004 included a $1.8 million charge related to a proposed settlement for
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Table of Contentsoutstanding litigation offset by $1.3 million of other income related to a lease termination in 2001. This additional income had previously been reserved for financial reporting purposes until certain contingencies with the lease termination had been resolved. Other income for both periods consisted primarily of lease termination fees and other related income associated with early lease terminations within the Core Office Portfolio.
Total expenses from Office Properties increased $2.2 million, or 19.2%, to $13.4 million for the three months ended September 30, 2005 compared to $11.2 million for the three months ended September 30, 2004. Property expenses from Office Properties increased $2.3 million, or 29.5%, to $10.1 million for the three months ended September 30, 2005 compared to $7.8 million for the three months ended September 30, 2004. An increase of $1.6 million, or 21.5%, was generated by the Core Office Portfolio. This increase was primarily attributable to an increase in repairs and maintenance expenditures and an increase in variable operating expenses related to the increase in occupancy. Of the remaining increase of $0.7 million in property expenses, $0.4 million was attributable to the Office Acquisition Properties, $0.2 million was attributable to the Office Redevelopment Properties and $0.1 million was attributable to the Office Development Property. Real estate taxes from Office Properties decreased $0.2 million, or 5.9%, for the three months ended September 30, 2005 as compared to the same period in 2004. This decrease was primarily due to refunds received in 2005 for prior years’ real estate taxes, which were successfully appealed. The provision for bad debts from Office Properties remained consistent for the three months ended September 30, 2005 compared to the three months ended September 30, 2004. The Company evaluates its reserve levels on a quarterly basis. Ground lease expense for Office Properties increased $0.1 million, or 22.8%, to $0.4 million for the three months ended September 30, 2005 compared to $0.3 million for the three months ended September 30, 2004.
Net Operating Income, as defined, from Office Properties increased $3.4 million, or 9.7%, to $37.9 million for the three months ended September 30, 2005 compared to $34.5 million for the three months ended September 30, 2004. Of this increase, $0.9 million was generated by the Core Office Portfolio primarily due to an increase in occupancy in this portfolio as mentioned above. Of the remaining increase of $2.5 million, $1.9 million was generated by the Office Acquisition Properties, $0.3 million was generated by the Office Redevelopment Properties and $0.3 million was generated by the Office Development Property.
Industrial Properties
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Table of ContentsTotal revenues from Industrial Properties increased $0.4 million, or 4.0%, to $9.1 million for the three months ended September 30, 2005 as compared to $8.7 million for the three months ended September 30, 2004. Rental income from Industrial Properties increased $0.2 million, or 2.2%, to $8.0 million for the three months ended September 30, 2005 compared to $7.8 million for the three months ended September 30, 2004. This increase was primarily due to an increase in occupancy. Average occupancy in the Industrial Properties increased 1.1% to 97.4% for the three months ended September 30, 2005 as compared to 96.3% for the three months ended September 30, 2004.
Tenant reimbursements from Industrial Properties increased $0.2 million, or 20.6%, to $1.0 million for the three months ended September 30, 2005 compared to $0.8 million for the three months ended September 30, 2004. This increase is primarily associated with an increase in occupancy in this portfolio and a subsequent increase in reimbursable expenses. Other property income from Industrial Properties remained consistent during the three months ended September 30, 2005 as compared to the same period in 2004.
Total expenses from Industrial Properties increased $0.2 million, or 12.0%, to $1.4 million for the three months ended September 30, 2005 compared to $1.2 million for the three months ended September 30, 2004. Property expenses from Industrial Properties increased $0.2 million, or 34.7%, to $0.7 million for the three months ended September 30, 2005 compared to $0.5 million for the three months ended September 30, 2004. This increase is mainly attributable to an increase in repairs and maintenance expenditures. Real estate taxes from Industrial Properties remained consistent at approximately $0.7 million during the three months ended September 30, 2005 compared to the same period in 2004. The provision for bad debts from Industrial Properties decreased $0.1 million for the three months ended September 30, 2005 compared to the three months ended September 30, 2004. The Company evaluates its reserve levels on a quarterly basis.
Net Operating Income, as defined, from Industrial Properties increased $0.2 million, or 2.8%, to $7.7 million for the three months ended September 30, 2005 compared to $7.5 million for the three months ended September 30, 2004.
Non-Property Related Income and Expenses
General and administrative expenses increased $9.0 million, or 95.8%, to $18.4 million for the three months ended September 30, 2005 compared to $9.4 million for the three months ended September 30, 2004. The increase was primarily due to an $8.5 million increase in the charge for accrued incentive compensation and was driven by a special long-term incentive plan for the Company’s executive officers for which the amount payable under the plan is based on the Company’s absolute and relative stockholder returns (see Note 8 to the Company’s consolidated financial statements for further discussion about the program). Compensation expense under this program is accounted for using variable plan accounting. The Company estimates the amount to be paid based on the average closing share price of the Company’s common stock as reported on the NYSE for the last ten days of the period, and records compensation expense equal to that portion of the total compensation applicable to the portion of the performance period that has elapsed through the end of the period. The increase in the charge for accrued incentive compensation is due to the increase in the share price of the Company’s common stock at the end of the third quarter of 2005 as compared to the end of the second quarter of 2005 and the resultant cumulative adjustment recorded as of September 30, 2005 for the change in estimated compensation expense attributable to prior periods. The amounts accrued in future periods related to this plan will increase and decrease as the ten-day average price per share of the Company’s common stock at the end of each period increases or decreases. The remaining increase is primarily due to an increase in reporting, public company and payroll related expenses.
Net interest expense increased $1.0 million, or 11.2%, to $9.6 million for the three months ended September 30, 2005 as compared to $8.6 million for the three months ended September 30, 2004. Gross interest and loan fee expense, before the effect of capitalized interest and loan fees, increased $1.5 million, or 14.0%, to $12.2 million for the three months ended September 30, 2005 compared to $10.7 million for the three months
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Table of Contentsended September 30, 2004 due to a higher average outstanding debt balance and increasing interest rates during the three months ended September 30, 2005 as compared to the three months ended September 30, 2004. Total capitalized interest and loan fees increased $0.5 million, or 25.9%, to $2.6 million for the three months ended September 30, 2005 compared to $2.1 million for the three months ended September 30, 2004. This increase is primarily due to higher average construction in progress balances eligible for capitalization during the three months ended September 30, 2005 as compared to the three months ended September 30, 2004.
Depreciation and amortization increased $1.3 million, or 8.9%, to $16.2 million for the three months ended September 30, 2005 compared to $14.9 million for the three months ended September 30, 2004. This increase was mainly attributable to depreciation and amortization generated by the Office Acquisition Properties.
Other income and expense increased approximately $1.3 million, or 167.6%, to $0.5 million of income for the three months ended September 30, 2005 compared to $0.8 million of expense for the three months ended September 30, 2004. The increase in income was primarily due to a $0.9 million decrease in net cash settlement payments on the Company’s interest rate swap agreements as a result of a change in the composition of the Company’s derivative instruments and increasing interest rates. The Company had four outstanding interest rate swaps during 2004 with an aggregate notional amount of $150 million and a weighted average fixed swap rate of 3.34%. One of these interest rate swaps, which had a notional amount of $50 million and fixed swap rate of 4.46%, expired in January 2005. The remaining three instruments, which have an aggregate notional amount of $100 million and a weighted average interest fixed swap rate of 2.78%, expire in the fourth quarter of 2005 and in 2006.
Comparison of the Nine months ended September 30, 2005 to the Nine Months Ended September 30, 2004
The following table reconciles the Company’s Net Operating Income by segment to the Company’s net income for the nine months ended September 30, 2005 and 2004.
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Table of ContentsRental Operations
Management evaluates the operations of its portfolio based on operating property type. The following tables compare the Net Operating Income for the Office Properties and for the Industrial Properties for the nine months ended September 30, 2005 and 2004.
Office Properties
Total revenues from Office Properties increased $18.4 million, or 13.6%, to $153.5 million for the nine months ended September 30, 2005 compared to $135.1 million for the nine months ended September 30, 2004. Rental income from Office Properties increased $15.8 million, or 13.0%, to $138.0 million for the nine months ended September 30, 2005 compared to $122.2 million for the nine months ended September 30, 2004. Rental income generated by the Core Office Portfolio increased $5.1 million, or 4.5%, for the nine months ended September 30, 2005 as compared to the nine months ended September 30, 2004. The increase in the Core Office Portfolio is primarily due to an increase in occupancy. Average occupancy in the Core Office Portfolio increased 3.4% to 94.0% for the nine months ended September 30, 2005 compared to 90.6% for the same period in 2004. The remaining $10.7 million increase in rental income was attributable to a $7.1 million increase in rental income generated by the Office Acquisition Properties, a $2.3 million increase in rental income generated by the Office Redevelopment Properties and a $1.3 million increase in rental income generated by the Office Development Property.
Tenant reimbursements from Office Properties increased $2.2 million, or 17.8%, to $14.7 million for the nine months ended September 30, 2005 compared to $12.5 million for the nine months ended September 30, 2004. Tenant reimbursements generated by the Core Office Portfolio increased $1.2 million, or 9.5%, to $13.5 million for the nine months ended September 30, 2005 compared to $12.3 million for the nine months ended September 30, 2004. This increase is mainly attributable to the increase in occupancy in the Core Office Portfolio noted above. The remaining increase in tenant reimbursements is attributable to an increase of $0.7 million generated by the Office Redevelopment Properties, an increase of $0.2 million generated by the Office Development Property and an increase of $0.1 million generated by the Office Acquisition Properties. Other property income from Office Properties increased approximately $0.3 million, or 95.2%, to $0.7 million for the nine months ended September 30, 2005 compared to $0.4 million for the nine months ended September 30, 2004. Other property income for the nine months ended September 30, 2004 included a $1.8 million charge related to a proposed settlement for outstanding litigation offset by $1.3 million of other income related to a lease termination in 2001. This additional income had previously been reserved for financial reporting purposes until certain contingencies with the lease termination had been resolved. Other income for both periods consisted primarily of lease termination fees and other related income.
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Table of ContentsTotal expenses from Office Properties increased $6.4 million, or 18.4%, to $41.1 million for the nine months ended September 30, 2005 compared to $34.7 million for the nine months ended September 30, 2004. Property expenses from Office Properties increased $4.7 million, or 20.2%, to $28.2 million for the nine months ended September 30, 2005 compared to $23.5 million for the nine months ended September 30, 2004. An increase of $3.2 million, or 14.1%, was generated by the Core Office Portfolio. This increase was primarily attributable to an increase in repairs and maintenance expenditures and an increase in variable operating expenses related to the increase in occupancy. Of the remaining increase of $1.5 million in property expenses, $1.0 million was attributable to the Office Acquisition Properties, $0.3 million was attributable to the Office Redevelopment Properties and $0.2 million was attributable to the Office Development Property. Real estate taxes from Office Properties increased $0.7 million, or 6.4%, for the nine months ended September 30, 2005 as compared to the same period in 2004. Real estate taxes for the Core Office Portfolio decreased $0.2 million, or 2.0%, for the nine months ended September 30, 2005 compared to the nine months ended September 30, 2004. This decrease was primarily due to refunds received in 2005 for prior years’ real estate taxes, which were successfully appealed. An increase of $0.9 million in real estate taxes was attributable to an $0.8 million increase from the Office Acquisition Properties and a $0.1 million increase from the Office Development Property. The provision for bad debts from Office Properties increased $0.7 million for the nine months ended September 30, 2005 compared to the nine months ended September 30, 2004. During the nine months ended September 30, 2005, the Company increased its reserves for certain tenants on the Company’s watchlist that the Company closely monitors because the tenant may be experiencing financial difficulties or are consistently late in paying outstanding balances. The Company evaluates its reserve levels on a quarterly basis. Ground lease expense for Office Properties increased $0.3 million, or 26.3%, to $1.3 million for the nine months ended September 30, 2005 compared to $1.0 million for the nine months ended September 30, 2004.
Net Operating Income, as defined, from Office Properties increased $12.0 million, or 12.0%, to $112.4 million for the nine months ended September 30, 2005 compared to $100.4 million for the nine months ended September 30, 2004. Of this increase, $3.1 million was generated by the Core Office Portfolio primarily due to an increase in occupancy in this portfolio as mentioned above. Of the remaining increase of $8.9 million, $5.3 million was generated by the Office Acquisition Properties, $2.6 million was generated by the Office Redevelopment Properties and $1.0 million was generated by the Office Development Property.
Industrial Properties
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Table of ContentsTotal revenues from Industrial Properties increased $1.0 million, or 3.8%, to $27.2 million for the nine months ended September 30, 2005 as compared to $26.2 million for the nine months ended September 30, 2004. Rental income from Industrial Properties increased $0.5 million, or 1.9%, to $24.1 million for the nine months ended September 30, 2005 compared to $23.6 million for the nine months ended September 30, 2004. This increase was primarily due to an increase in occupancy. Average occupancy in the Industrial Properties increased 0.9% to 95.9% for the nine months ended September 30, 2005 as compared to 95.0% for the nine months ended September 30, 2004.
Tenant reimbursements from Industrial Properties increased $0.5 million, or 18.3%, to $3.1 million for the nine months ended September 30, 2005 compared to $2.6 million for the nine months ended September 30, 2004. This increase is primarily associated with an increase in occupancy in this portfolio and a subsequent increase in reimbursable expenses. Other property income from Industrial Properties increased $0.1 million during the nine months ended September 30, 2005 as compared to the same period in 2004. Other property income for both periods consisted primarily of lease termination fees.
Total expenses from Industrial Properties increased $0.5 million, or 12.5%, to $4.3 million for the nine months ended September 30, 2005 compared to $3.8 million for the nine months ended September 30, 2004. Property expenses from Industrial Properties increased $0.4 million, or 24.4%, to $2.1 million for the nine months ended September 30, 2005 compared to $1.7 million for the nine months ended September 30, 2004. This increase is mainly attributable to an increase in repairs and maintenance expenditures. Real estate taxes from Industrial Properties increased $0.1 million, or 3.9%, to $2.2 million for the nine months ended September 30, 2005 compared to $2.1 million for the nine months ended September 30, 2004. The provision for bad debts remained consistent for the nine months ended September 30, 2005 as compared to the nine months ended September 30, 2004. The Company evaluates its reserve levels on a quarterly basis.
Net Operating Income, as defined, from Industrial Properties increased $0.5 million, or 2.3%, to $23.0 million for the nine months ended September 30, 2005 compared to $22.5 million for the nine months ended September 30, 2004.
Non-Property Related Income and Expenses
General and administrative expenses increased $18.9 million, or 84.5%, to $41.2 million for the nine months ended September 30, 2005 compared to $22.3 million for the nine months ended September 30, 2004. The increase was primarily due to a $17.9 million increase in the charge for accrued incentive compensation and was driven by a special long-term incentive plan for the Company’s executive officers for which the amount payable under the plan is based on the Company’s absolute and relative stockholder returns (see Note 8 to the Company’s consolidated financial statements for further discussion about the program). Compensation expense under this program is accounted for using variable plan accounting. The Company estimates the amount to be paid based on the average closing share price of the Company’s common stock as reported on the NYSE for the last ten days of the period, and records compensation expense equal to that portion of the total compensation applicable to the portion of the performance period that has elapsed through the end of the period. The increase in the charge for accrued incentive compensation is due to the increase in the share price of the Company’s stock at the end of the third quarter of 2005 as compared to the share price at December 31, 2004 and the resultant cumulative adjustment recorded as of September 30, 2005 for the change in estimated compensation expense attributable to prior periods. The amounts accrued in future periods related to this plan will increase and decrease as the ten-day average price per share of the Company’s common stock at the end of each period increases or decreases. The remaining increase is primarily due to an increase in reporting, public company and payroll related expenses.
Net interest expense increased $3.7 million, or 14.7%, to $28.7 million for the nine months ended September 30, 2005 compared to $25.0 million for the nine months ended September 30, 2004. Gross interest and loan fee expense, before the effect of capitalized interest and loan fees, increased $4.8 million, or 15.6%, to $35.5 million for the nine months ended September 30, 2005 compared to $30.7 million for the nine months
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Table of Contentsended September 30, 2004 due to a higher average outstanding debt balance and increasing interest rates during the nine months ended September 30, 2005 as compared to the nine months ended September 30, 2004. Total capitalized interest and loan fees increased $1.1 million, or 19.3%, to $6.8 million for the nine months ended September 30, 2005 as compared to $5.7 million for the nine months ended September 30, 2004. This increase is primarily due to higher average construction in progress balances eligible for capitalization during the nine months ended September 30, 2005 as compared to the nine months ended September 30, 2004.
Depreciation and amortization increased $6.2 million, or 14.2%, to $49.7 million for the nine months ended September 30, 2005 compared to $43.5 million for the nine months ended September 30, 2004. An increase of $1.5 million was generated by the Core Office Portfolio. This increase is mainly attributable to expenditures incurred subsequent to September 30, 2004 for capital and tenant improvements. Of the remaining $4.7 million increase in depreciation and amortization, $3.6 million was generated by the Office Acquisition Properties, $0.9 million was generated by the Office Redevelopment Properties and $0.2 million was generated by the Office Development Property.
Total other income increased approximately $0.7 million, or 344.7%, to $0.9 million for the nine months ended September 30, 2005 compared to $0.2 million for the nine months ended September 30, 2004. The increase in income was primarily due to a $2.5 million decrease in net cash settlement payments on the Company’s interest rate swap agreements as a result of a change in the composition of the Company’s derivative instruments and increasing interest rates. The Company had four outstanding interest rate swaps during 2004 with an aggregate notional amount of $150 million and a weighted average fixed swap rate of 3.34%. One of these interest rate swaps, which had a notional amount of $50 million and fixed swap rate of 4.46%, expired in January 2005. The remaining three instruments, which have an aggregate notional amount of $100 million and a weighted average interest fixed swap rate of 2.78%, expire in the fourth quarter of 2005 and in 2006. This increase was offset by a decrease in the non-cash gain recorded as a result of the change in the fair value of the derivative instruments. The gain was $1.6 million higher during the nine months ended September 30, 2004 as compared to the same period in 2005.
Building and Lease Information
The following tables set forth certain information regarding the Company’s Office Properties and Industrial Properties at September 30, 2005:
Occupancy by Segment Type
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Table of ContentsLease Expirations by Segment Type
Leasing Activity by Segment Type
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Table of ContentsLeasing Activity by Segment Type
Development
The following table sets forth certain information regarding the Company’s in-process and committed office development projects as of September 30, 2005. See further discussion regarding the Company’s projected development and redevelopment trends under the caption “Factors That May Influence Future Results of Operations—Development and redevelopment programs.”
Development Projects
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Table of ContentsLiquidity and Capital Resources
Current Sources of Capital and Liquidity
The Company seeks to create and maintain a capital structure that allows for financial flexibility and diversification of capital resources. The Company’s primary source of liquidity to fund distributions, debt service, leasing costs and capital expenditures is net cash from operations. The Company’s primary sources of liquidity to fund development and redevelopment costs, potential undeveloped land and property acquisitions, temporary working capital and unanticipated cash needs are the Company’s $425 million revolving unsecured line of credit, proceeds received from the Company’s disposition program and construction loans. As of September 30, 2005, the Company’s total debt as a percentage of total market capitalization (presented under “—Factors That May Influence Future Sources of Capital and Liquidity”) was 29.1%. As of September 30, 2005, the Company’s total debt plus preferred equity as a percentage of total market capitalization was 36.1%.
As of September 30, 2005, the Company had borrowings of $199.0 million outstanding under its revolving unsecured line of credit (the “Credit Facility”) and availability of approximately $226.0 million. The Credit Facility bears interest at an annual rate between LIBOR plus 1.00% and LIBOR plus 1.70%, depending upon the Company’s leverage ratio at the time of borrowing (4.97% at September 30, 2005), and matures in October 2007 with an option to extend the maturity for one year. The fee for unused funds ranges from an annual rate of 0.20% to 0.30% depending on the Company’s leverage ratio. The Company expects to use the Credit Facility to finance development and redevelopment expenditures, to fund potential acquisitions and for other general corporate uses.
Factors That May Influence Future Sources of Capital and Liquidity
The Company has a special long-term incentive compensation program that provides for cash compensation to be earned by the Company’s executive officers if the Company attains certain performance measures based on annualized total shareholder returns on an absolute and a relative basis. Under the absolute portion of the program, for every $1 change in the Company’s ten-day average closing stock price, the total payable over the three-year-term of the program changes by approximately $1.7 million. If the Company’s ten-day average closing stock price at December 31, 2005 is the same as the Company’s ten-day average closing share price at the end of the third quarter of 2005, management estimates that the Company could make payments under this program in the first quarter of the 2006 fiscal year of approximately $58 million. As of September 30, 2005, the Company had accrued a total of $52.5 million relating to this program relating to the portion of the performance period that has elapsed through the end of the quarter, which is included in accounts payable, accrued expenses and other liabilities. (See Note 8 to the Company’s consolidated financial statements and “—Non-Property Related Income and Expenses” above for further discussion about the special long-term incentive compensation program).
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