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Kilroy Realty 10-Q 2011
e10vq
Table of Contents

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
 
     
(Mark One)
 
þ
  QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2011
OR
o
  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from          to          
 
Commission File Number: 1-12675 (Kilroy Realty Corporation)
 
Commission File Number: 000-54005 (Kilroy Realty, L.P.)
 
KILROY REALTY CORPORATION
(Exact name of registrant as specified in its charter)
 
         
Kilroy Realty
Corporation
  Maryland
(State or other jurisdiction of
incorporation or organization)
  95-4598246
(I.R.S. Employer
Identification No.)
 
         
Kilroy Realty,
L.P.
 
  Delaware
(State or other jurisdiction of
incorporation or organization)
  95-4612685
(I.R.S. Employer
Identification No.)
 
12200 W. Olympic Boulevard, Suite 200, Los Angeles, California 90064
(Address of principal executive offices) (Zip Code)
 
(310) 481-8400
(Registrant’s telephone number, including area code)
 
N/A
 
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.
 
Kilroy Realty Corporation  Yes þ     No o
 
Kilroy Realty, L. P.   Yes þ     No o
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
 
Kilroy Realty Corporation  Yes þ     No o
 
Kilroy Realty, L.P.  Yes o     No o
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
 
Kilroy Realty Corporation
     Large accelerated filer þ Accelerated filer o Non-accelerated filer o Smaller reporting company o
(Do not check if a smaller reporting company)
 
Kilroy Realty, L.P.
     Large accelerated filer o Accelerated filer o Non-accelerated filer þ Smaller reporting company o
(Do not check if a smaller reporting company)
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
 
Kilroy Realty Corporation  Yes o     No þ
 
Kilroy Realty, L.P.  Yes o     No þ
 
As of May 2, 2011, 58,456,893 shares of Kilroy Realty Corporation common stock, par value $.01 per share, were outstanding.
 


Table of Contents

 
 
This report combines the quarterly reports on Form 10-Q for the period ended March 31, 2011 of Kilroy Realty Corporation and Kilroy Realty, L.P. Unless stated otherwise or the context otherwise requires, references to “Kilroy Realty Corporation” or the “Company” mean Kilroy Realty Corporation, a Maryland corporation, and its controlled and consolidated subsidiaries, and references to “Kilroy Realty, L.P.” or the “Operating Partnership” mean Kilroy Realty, L.P., a Delaware limited partnership, and its controlled and consolidated subsidiaries. The terms “the Company,” “we,” “our,” and “us” refer to the Company or the Company and the Operating Partnership together, as the text requires.
 
The Company is a real estate investment trust, or REIT, and the general partner of the Operating Partnership. As of March 31, 2011, the Company owned an approximate 96.8% common general partnership interest in the Operating Partnership. The remaining approximate 3.2% common limited partnership interests are owned by non-affiliated investors and certain directors and officers of the Company. As the sole general partner of the Operating Partnership, the Company exercises exclusive and complete discretion over the Operating Partnership’s day-to-day management and control and can cause it to enter into certain major transactions including acquisitions, dispositions, and refinancings and cause changes in its line of business, capital structure, and distribution policies.
 
There are a few differences between the Company and the Operating Partnership which are reflected in the disclosures in this Form 10-Q. We believe it is important to understand the differences between the Company and the Operating Partnership in the context of how the Company and the Operating Partnership operate as an interrelated, consolidated company. The Company is a REIT, whose only material asset is its ownership of partnership interests of the Operating Partnership. As a result, the Company does not conduct business itself, other than acting as the sole general partner of the Operating Partnership, issuing equity from time to time and guaranteeing certain debt of the Operating Partnership. The Company itself is not directly obligated under any indebtedness, but guarantees some of the debt of the Operating Partnership. The Operating Partnership owns substantially all the assets of the Company either directly or through its subsidiaries, conducts the operations of the Company’s business and is structured as a limited partnership with no publicly traded equity. Except for net proceeds from equity issuances by the Company, which the Company is required to contribute to the Operating Partnership in exchange for partnership units, the Operating Partnership generates the capital required by the Company’s business through the Operating Partnership’s operations, by the Operating Partnership’s incurrence of indebtedness or through the issuance of partnership units.
 
Noncontrolling interests and stockholders’ equity and partners’ capital are the main areas of difference between the consolidated financial statements of the Company and those of the Operating Partnership. The common limited partnership interests in the Operating Partnership are accounted for as partners’ capital in the Operating Partnership’s financial statements and as noncontrolling interests in the Company’s financial statements. The Operating Partnership’s financial statements reflect the noncontrolling interest in Kilroy Realty Finance Partnership, L.P. This noncontrolling interest represents the Company’s 1% indirect general partnership interest in Kilroy Realty Finance Partnership, L.P., which is directly held by Kilroy Realty Finance, Inc., a wholly-owned subsidiary of the Company. The differences between stockholders’ equity, partners’ capital and noncontrolling interests result from the differences in the equity issued at the Company and the Operating Partnership levels and in the Company’s noncontrolling interest in Kilroy Realty Finance Partnership, L.P.
 
We believe combining the quarterly reports on Form 10-Q of the Company and the Operating Partnership into this single report results in the following benefits:
 
  •   Combined reports better reflect how management and the analyst community view the business as a single operating unit;
 
  •   Combined reports enhance investors’ understanding of the Company and the Operating Partnership by enabling them to view the business as a whole and in the same manner as management;
 
  •   Combined reports are more efficient for the Company and the Operating Partnership and result in savings in time, effort and expense; and


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Table of Contents

 
  •   Combined reports are more efficient for investors by reducing duplicative disclosure and providing a single document for their review.
 
To help investors understand the significant differences between the Company and the Operating Partnership, this report presents the following separate sections for each of the Company and the Operating Partnership:
 
  •   consolidated financial statements;
 
  •   the following notes to the consolidated financial statements:
 
  •   Secured and Unsecured Debt of the Operating Partnership;
 
  •   Noncontrolling Interests on the Company’s Consolidated Financial Statements;
 
  •   Partners’ Capital of the Operating Partnership;
 
  •   Net Income Available to Common Stockholders per Share of the Company; and
 
  •   Net Income Available to Common Unitholders per Unit of the Operating Partnership.
 
This report also includes separate sections under Item 4. Controls and Procedures and separate Exhibit 31 and Exhibit 32 certifications for each of the Company and the Operating Partnership to establish that the Chief Executive Officer and the Chief Financial Officer of each entity have made the requisite certifications and that the Company and Operating Partnership are compliant with Rule 13a-15 or Rule 15d-15 of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), and 18 U.S.C. § 1350.


3


 

 
KILROY REALTY CORPORATION AND KILROY REALTY, L.P.
 
QUARTERLY REPORT FOR THE THREE MONTHS ENDED MARCH 31, 2011
 
 
                 
        Page
 
       
PART I—FINANCIAL INFORMATION        
             
  Item 1.         5  
             
            5  
             
            6  
             
            7  
             
            8  
             
            9  
             
            9  
             
            10  
             
            11  
             
            12  
             
            13  
             
  Item 2.         27  
             
  Item 3.         45  
             
  Item 4.         45  
       
PART II—OTHER INFORMATION        
             
  Item 1.         46  
             
  Item 1A.         46  
             
  Item 2.         46  
             
  Item 3.         46  
             
  Item 4.         46  
             
  Item 5.         46  
             
  Item 6.         47  
       
SIGNATURES     48  
 EX-31.1
 EX-31.2
 EX-31.3
 EX-31.4
 EX-32.1
 EX-32.2
 EX-32.3
 EX-32.4
 EX-101 INSTANCE DOCUMENT
 EX-101 SCHEMA DOCUMENT
 EX-101 CALCULATION LINKBASE DOCUMENT
 EX-101 LABELS LINKBASE DOCUMENT
 EX-101 PRESENTATION LINKBASE DOCUMENT
 EX-101 DEFINITION LINKBASE DOCUMENT


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Table of Contents

 
 
ITEM 1. FINANCIAL STATEMENTS OF KILROY REALTY CORPORATION
 
KILROY REALTY CORPORATION
 
(in thousands, except share data)
 
                 
    March 31,
    December 31,
 
    2011     2010  
    (unaudited)        
 
ASSETS
               
REAL ESTATE ASSETS:
               
Land and improvements (Note 2)
  $ 498,963     $ 491,333  
Buildings and improvements (Note 2)
    2,470,989       2,435,173  
Undeveloped land and construction in progress
    296,245       290,365  
                 
Total real estate held for investment
    3,266,197       3,216,871  
Accumulated depreciation and amortization
    (695,548 )     (672,429 )
                 
Total real estate assets, net
    2,570,649       2,544,442  
CASH AND CASH EQUIVALENTS
    6,708       14,840  
RESTRICTED CASH
    1,899       1,461  
MARKETABLE SECURITIES (Note 9)
    5,425       4,902  
CURRENT RECEIVABLES, NET (Note 4)
    4,816       6,258  
DEFERRED RENT RECEIVABLES, NET (Note 4)
    93,392       89,052  
DEFERRED LEASING COSTS AND ACQUISITION-RELATED INTANGIBLE ASSETS, NET (Notes 2 and 3)
    129,578       131,066  
DEFERRED FINANCING COSTS, NET
    15,742       16,447  
PREPAID EXPENSES AND OTHER ASSETS, NET
    13,724       8,097  
                 
TOTAL ASSETS
  $ 2,841,933     $ 2,816,565  
                 
                 
LIABILITIES, NONCONTROLLING INTEREST AND EQUITY
               
LIABILITIES:
               
Secured debt, net (Notes 5 and 9)
  $ 446,539     $ 313,009  
Exchangeable senior notes, net (Notes 5 and 9)
    301,652       299,964  
Unsecured senior notes, net (Notes 5 and 9)
    655,866       655,803  
Unsecured line of credit (Notes 5 and 9)
    57,000       159,000  
Accounts payable, accrued expenses and other liabilities
    78,847       68,525  
Accrued distributions (Note 13)
    20,443       20,385  
Deferred revenue and acquisition-related intangible liabilities, net (Note 3)
    78,992       79,322  
Rents received in advance and tenant security deposits
    26,433       29,189  
                 
Total liabilities
    1,665,772       1,625,197  
                 
COMMITMENTS AND CONTINGENCIES
               
                 
NONCONTROLLING INTEREST (Note 6):
               
7.45% Series A Cumulative Redeemable Preferred units of the Operating Partnership
    73,638       73,638  
                 
EQUITY:
               
Stockholders’ Equity (Note 13):
               
Preferred stock, $.01 par value, 30,000,000 shares authorized:
               
7.45% Series A Cumulative Redeemable Preferred stock, $.01 par value, 1,500,000 shares authorized, none issued and outstanding
           
7.80% Series E Cumulative Redeemable Preferred stock, $.01 par value, 1,610,000 shares authorized, issued and outstanding ($40,250 liquidation preference)
    38,425       38,425  
7.50% Series F Cumulative Redeemable Preferred stock, $.01 par value, 3,450,000 shares authorized, issued and outstanding ($86,250 liquidation preference)
    83,157       83,157  
Common stock, $.01 par value, 150,000,000 shares authorized,
52,419,393 and 52,349,670 shares issued and outstanding, respectively
    524       523  
Additional paid-in capital
    1,214,463       1,211,498  
Distributions in excess of earnings
    (264,848 )     (247,252 )
                 
Total stockholders’ equity
    1,071,721       1,086,351  
Noncontrolling interest:
               
Common units of the Operating Partnership (Note 6)
    30,802       31,379  
                 
Total equity
    1,102,523       1,117,730  
                 
TOTAL LIABILITIES, NONCONTROLLING INTEREST AND EQUITY
  $ 2,841,933     $ 2,816,565  
                 
 
See accompanying notes to consolidated financial statements.


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Table of Contents

KILROY REALTY CORPORATION
 
 
                 
    Three Months Ended March 31,  
    2011     2010  
 
REVENUES:
               
Rental income
  $ 80,290     $ 60,656  
Tenant reimbursements
    6,422       5,718  
Other property income
    1,413       445  
                 
Total revenues
    88,125       66,819  
                 
EXPENSES:
               
Property expenses
    17,689       12,020  
Real estate taxes
    8,169       6,036  
Provision for bad debts
    26       26  
Ground leases
    339       (58 )
General and administrative expenses
    6,560       7,095  
Acquisition-related expenses
    472       313  
Depreciation and amortization
    29,311       20,938  
                 
Total expenses
    62,566       46,370  
                 
OTHER (EXPENSES) INCOME:
               
Interest income and other net investment gains (Note 9)
    184       384  
Interest expense (Note 5)
    (20,876 )     (11,956 )
                 
Total other (expenses) income
    (20,692 )     (11,572 )
NET INCOME
    4,867       8,877  
Net income attributable to noncontrolling common units of the Operating Partnership
    (34 )     (192 )
                 
NET INCOME ATTRIBUTABLE TO KILROY REALTY CORPORATION
    4,833       8,685  
PREFERRED DISTRIBUTIONS AND DIVIDENDS:
               
Distributions to noncontrolling cumulative redeemable preferred units of the Operating Partnership
    (1,397 )     (1,397 )
Preferred dividends
    (2,402 )     (2,402 )
                 
Total preferred distributions and dividends
    (3,799 )     (3,799 )
                 
NET INCOME AVAILABLE TO COMMON STOCKHOLDERS
  $ 1,034     $ 4,886  
                 
Net income available to common stockholders per share-basic (Note 11)
  $ 0.01     $ 0.11  
                 
Net income available to common stockholders per share-diluted (Note 11)
  $ 0.01     $ 0.11  
                 
Weighted average common shares outstanding-basic (Note 11)
    52,302,075       43,012,100  
                 
Weighted average common shares outstanding-diluted (Note 11)
    52,572,956       43,014,532  
                 
Dividends declared per common share
  $ 0.35     $ 0.35  
                 
 
See accompanying notes to consolidated financial statements.


6


Table of Contents

KILROY REALTY CORPORATION
 
 
                                                                 
                                        Noncontrol-
       
                                        ling Interests
       
          Common Stock     Total
    – Common
       
                      Additional
    Distributions
    Stock-
    Units of the
       
    Preferred
    Number of
    Common
    Paid-in
    in Excess of
    holders’
    Operating
    Total
 
    Stock     Shares     Stock     Capital     Earnings     Equity     Partnership     Equity  
 
BALANCE AS OF DECEMBER 31, 2009
  $ 121,582       43,148,762     $ 431     $ 913,657     $ (180,722 )   $ 854,948     $ 28,890     $ 883,838  
Net income
                                    8,685       8,685       192       8,877  
Issuance of share-based compensation awards
                            1,391               1,391               1,391  
Noncash amortization of share-based compensation
                            1,720               1,720               1,720  
Exercise of stock options
            4,000               83               83               83  
Repurchase of common stock and restricted stock units
            (59,782 )             (2,121 )             (2,121 )             (2,121 )
Adjustment for noncontrolling interest
                            36               36       (36 )      
Preferred distributions and dividends
                                    (3,799 )     (3,799 )             (3,799 )
Dividends declared per common share and common unit ($0.35 per share/unit)
                                    (15,354 )     (15,354 )     (603 )     (15,957 )
                                                                 
BALANCE AS OF MARCH 31, 2010
  $ 121,582       43,092,980     $ 431     $ 914,766     $ (191,190 )   $ 845,589     $ 28,443     $ 874,032  
                                                                 
                                        Noncontrol-
       
                                        ling Interests
       
          Common Stock     Total
    – Common
       
                      Additional
    Distributions
    Stock-
    Units of the
       
    Preferred
    Number of
    Common
    Paid-in
    in Excess of
    holders’
    Operating
    Total
 
    Stock     Shares     Stock     Capital     Earnings     Equity     Partnership     Equity  
 
BALANCE AS OF DECEMBER 31, 2010
  $ 121,582       52,349,670     $ 523     $ 1,211,498     $ (247,252 )   $ 1,086,351     $ 31,379     $ 1,117,730  
Net income
                                    4,833       4,833       34       4,867  
Issuance of share-based compensation awards (Note 8)
            66,208       1       1,874               1,875               1,875  
Noncash amortization of share-based compensation
                            1,420               1,420               1,420  
Exercise of stock options
            15,000               395               395               395  
Repurchase of common stock and restricted stock units (Note 8)
            (11,485 )             (732 )             (732 )             (732 )
Adjustment for noncontrolling interest
                            8               8       (8 )      
Preferred distributions and dividends
                                    (3,799 )     (3,799 )             (3,799 )
Dividends declared per common share and common unit ($0.35 per share/unit)
                                    (18,630 )     (18,630 )     (603 )     (19,233 )
                                                                 
BALANCE AS OF MARCH 31, 2011
  $ 121,582       52,419,393     $ 524     $ 1,214,463     $ (264,848 )   $ 1,071,721     $ 30,802     $ 1,102,523  
                                                                 
 
See accompanying notes to consolidated financial statements.


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Table of Contents

KILROY REALTY CORPORATION
 
(unaudited, in thousands)
 
                 
    Three Months Ended March 31,  
    2011     2010  
 
CASH FLOWS FROM OPERATING ACTIVITIES:
               
Net income
  $ 4,867     $ 8,877  
Adjustments to reconcile net income to net cash provided by operating activities:
               
Depreciation and amortization of building and improvements and leasing costs
    29,059       20,728  
Increase in provision for bad debts
    26       26  
Depreciation of furniture, fixtures and equipment
    252       210  
Noncash amortization of share-based compensation awards
    1,106       1,706  
Noncash amortization of deferred financing costs and debt discounts
    3,450       2,924  
Noncash amortization of above/(below) market rents (Note 3)
    653       (28 )
Noncash amortization of deferred revenue related to tenant-funded tenant improvements
    (2,326 )     (2,352 )
Changes in operating assets and liabilities:
               
Marketable securities
    (523 )     (774 )
Current receivables
    1,416       297  
Deferred rent receivables
    (4,340 )     (2,014 )
Other deferred leasing costs
    197       (1,776 )
Prepaid expenses and other assets
    (2,906 )     (3,068 )
Accounts payable, accrued expenses and other liabilities
    15,923       3,375  
Deferred revenue
    (301 )     13  
Rents received in advance and tenant security deposits
    (2,756 )     5,424  
                 
Net cash provided by operating activities
    43,797       33,568  
                 
CASH FLOWS FROM INVESTING ACTIVITIES:
               
Expenditures for acquisition of operating properties (Note 2)
    (33,000 )     (17,950 )
Expenditures for operating properties
    (15,985 )     (14,217 )
Expenditures for development and redevelopment properties and undeveloped land
    (6,714 )     (4,362 )
Increase in escrow deposits
    (5,000 )     (3,000 )
(Increase) decrease in restricted cash
    (438 )     2,027  
Receipt of principal payments on note receivable
          38  
                 
Net cash used in investing activities
    (61,137 )     (37,464 )
                 
CASH FLOWS FROM FINANCING ACTIVITIES:
               
Borrowings on unsecured line of credit
    42,000       63,000  
Repayments on unsecured line of credit
    (144,000 )     (10,000 )
Principal payments on secured debt
    (1,598 )     (98,560 )
Proceeds from issuance of secured debt (Note 5)
    135,000       71,000  
Financing costs
    (1,160 )     (569 )
Decrease in loan deposits
    2,027       1,420  
Repurchase of common stock and restricted stock units
    (732 )     (2,121 )
Proceeds from exercise of stock options
    395       83  
Dividends and distributions paid to common stockholders and common unitholders
    (18,925 )     (15,705 )
Dividends and distributions paid to preferred stockholders and preferred unitholders
    (3,799 )     (3,799 )
                 
Net cash provided by financing activities
    9,208       4,749  
                 
Net (decrease) increase in cash and cash equivalents
    (8,132 )     853  
Cash and cash equivalents, beginning of period
    14,840       9,883  
                 
Cash and cash equivalents, end of period
  $ 6,708     $ 10,736  
                 
SUPPLEMENTAL CASH FLOWS INFORMATION:
               
Cash paid for interest, net of capitalized interest of $1,620 and $1,902 as of March 31, 2011 and 2010, respectively
  $ 6,965     $ 6,980  
                 
NONCASH INVESTING TRANSACTIONS:
               
Accrual for expenditures for operating properties and development and redevelopment properties
  $ 4,753     $ 8,714  
                 
Tenant improvements funded directly by tenants to third parties
  $ 2,800     $ 657  
                 
NONCASH FINANCING TRANSACTIONS:
               
Accrual of dividends and distributions payable to common stockholders and common unitholders
  $ 18,950     $ 15,686  
                 
Accrual of dividends and distributions payable to preferred stockholders and preferred unitholders
  $ 1,909     $ 1,909  
                 
Issuance of share-based compensation awards (Note 8)
  $ 6,432     $ 4,647  
                 
 
See accompanying notes to consolidated financial statements.


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ITEM 1: FINANCIAL STATEMENTS OF KILROY REALTY, L.P.
 
KILROY REALTY, L.P.
 
 
                 
    March 31,
    December 31,
 
    2011     2010  
    (unaudited)        
 
ASSETS
               
REAL ESTATE ASSETS:
               
Land and improvements (Note 2)
  $ 498,963     $ 491,333  
Buildings and improvements (Note 2)
    2,470,989       2,435,173  
Undeveloped land and construction in progress
    296,245       290,365  
                 
Total real estate held for investment
    3,266,197       3,216,871  
Accumulated depreciation and amortization
    (695,548 )     (672,429 )
                 
Total real estate assets, net
    2,570,649       2,544,442  
CASH AND CASH EQUIVALENTS
    6,708       14,840  
RESTRICTED CASH
    1,899       1,461  
MARKETABLE SECURITIES (Note 9)
    5,425       4,902  
CURRENT RECEIVABLES, NET (Note 4)
    4,816       6,258  
DEFERRED RENT RECEIVABLES, NET (Note 4)
    93,392       89,052  
DEFERRED LEASING COSTS AND ACQUISITION-RELATED INTANGIBLE ASSETS, NET (Notes 2 and 3)
    129,578       131,066  
DEFERRED FINANCING COSTS, NET
    15,742       16,447  
PREPAID EXPENSES AND OTHER ASSETS, NET
    13,724       8,097  
                 
TOTAL ASSETS
  $ 2,841,933     $ 2,816,565  
                 
                 
LIABILITIES AND CAPITAL                
LIABILITIES:
               
Secured debt, net (Notes 5 and 9)
  $ 446,539     $ 313,009  
Exchangeable senior notes, net (Notes 5 and 9)
    301,652       299,964  
Unsecured senior notes, net (Notes 5 and 9)
    655,866       655,803  
Unsecured line of credit (Notes 5 and 9)
    57,000       159,000  
Accounts payable, accrued expenses and other liabilities
    78,847       68,525  
Accrued distributions (Note 13)
    20,443       20,385  
Deferred revenue and acquisition-related intangible liabilities, net (Note 3)
    78,992       79,322  
Rents received in advance and tenant security deposits
    26,433       29,189  
                 
Total liabilities
    1,665,772       1,625,197  
                 
COMMITMENTS AND CONTINGENCIES
               
7.45% SERIES A CUMULATIVE REDEEMABLE PREFERRED UNITS
    73,638       73,638  
CAPITAL:
               
Partners’ Capital (Note 7):
               
7.80% Series E Cumulative Redeemable Preferred units, 1,610,000 units issued and outstanding ($40,250 liquidation preference)
    38,425       38,425  
7.50% Series F Cumulative Redeemable Preferred units, 3,450,000 units issued and outstanding ($86,250 liquidation preference)
    83,157       83,157  
Common units, 52,419,393 and 52,349,670 held by the general partner and 1,723,131 and 1,723,131 held by common limited partners issued and outstanding, respectively
    979,271       994,511  
                 
Total Partners’ Capital
    1,100,853       1,116,093  
Noncontrolling interests in consolidated subsidiaries
    1,670       1,637  
                 
Total capital
    1,102,523       1,117,730  
                 
TOTAL LIABILITIES, NONCONTROLLING INTEREST AND CAPITAL
  $ 2,841,933     $ 2,816,565  
                 
 
See accompanying notes to consolidated financial statements.


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KILROY REALTY, L.P.
 
(unaudited, in thousands, except unit and per unit data)
 
                                 
    Three Months Ended March 31,              
    2011     2010              
 
REVENUES:
                               
Rental income
  $ 80,290       60,656                  
Tenant reimbursements
    6,422       5,718                  
Other property income
    1,413       445                  
                                 
Total revenues
    88,125       66,819                  
                                 
EXPENSES:
                               
Property expenses
    17,689       12,020                  
Real estate taxes
    8,169       6,036                  
Provision for bad debts
    26       26                  
Ground leases
    339       (58 )                
General and administrative expenses
    6,560       7,095                  
Acquisition-related expenses
    472       313                  
Depreciation and amortization
    29,311       20,938                  
                                 
Total expenses
    62,566       46,370                  
                                 
OTHER (EXPENSES) INCOME:
                               
Interest income and other net investment gains (Note 9)
    184       384                  
Interest expense (Note 5)
    (20,876 )     (11,956 )                
                                 
Total other (expenses) income
    (20,692 )     (11,572 )                
                                 
NET INCOME
    4,867       8,877                  
Net income attributable to noncontrolling interests in consolidated subsidiaries
    (34 )     (45 )                
                                 
NET INCOME ATTRIBUTABLE TO KILROY REALTY, L.P. 
    4,833       8,832                  
PREFERRED DISTRIBUTIONS
    (3,799 )     (3,799 )                
                                 
NET INCOME AVAILABLE TO COMMON UNITHOLDERS
  $ 1,034     $ 5,033                  
                                 
Net income available to common unitholders per unit-basic (Note 12)
  $ 0.01     $ 0.11                  
                                 
Net income available to common unitholders per unit-diluted (Note 12)
  $ 0.01     $ 0.11                  
                                 
Weighted average common units outstanding-basic (Note 12)
    54,025,206       44,735,231                  
                                 
Weighted average common units outstanding-diluted (Note 12)
    54,296,087       44,737,663                  
                                 
Distributions declared per common unit
  $ 0.35     $ 0.35                  
                                 
 
See accompanying notes to consolidated financial statements.


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KILROY REALTY, L.P.
 
(unaudited, in thousands, except unit and per unit data)
 
                                                 
    Partners’
          Noncontrolling
       
    Capital           Interests
       
          Number of
          Total
    in
       
    Preferred
    Common
    Common
    Partners’
    Consolidated
    Total
 
    Units     Units     Units     Capital     Subsidiaries     Capital  
 
BALANCE AS OF DECEMBER 31, 2009
  $ 121,582       44,871,893     $ 760,756     $ 882,338     $ 1,500     $ 883,838  
Net income
                    8,832       8,832       45       8,877  
Issuance of share-based compensation awards
                    1,391       1,391               1,391  
Noncash amortization of share-based compensation
                    1,720       1,720               1,720  
Exercise of stock options
            4,000       83       83               83  
Repurchase of common units and restricted stock units
            (59,782 )     (2,121 )     (2,121 )             (2,121 )
Other
                    20       20       (20 )      
Preferred distributions
                    (3,799 )     (3,799 )             (3,799 )
Distributions declared per common unit ($0.35 per unit)
                    (15,957 )     (15,957 )             (15,957 )
                                                 
BALANCE AS OF MARCH 31, 2010
  $ 121,582       44,816,111     $ 750,925     $ 872,507     $ 1,525     $ 874,032  
                                                 
 
                                                 
    Partners’
          Noncontrolling
       
    Capital           Interests
       
          Number of
          Total
    in
       
    Preferred
    Common
    Common
    Partners’
    Consolidated
    Total
 
    Units     Units     Units     Capital     Subsidiaries     Capital  
 
BALANCE AS OF DECEMBER 31, 2010
  $ 121,582       54,072,801     $ 994,511     $ 1,116,093     $ 1,637     $ 1,117,730  
Net income
                    4,833       4,833       34       4,867  
Issuance of share-based compensation awards (Note 8)
            66,208       1,875       1,875               1,875  
Noncash amortization of share-based compensation
                    1,420       1,420               1,420  
Exercise of stock options
            15,000       395       395               395  
Repurchase of common units and restricted stock units (Note 8)
            (11,485 )     (732 )     (732 )             (732 )
Other
                    1       1       (1 )      
Preferred distributions
                    (3,799 )     (3,799 )             (3,799 )
Distributions declared per common unit ($0.35 per unit)
                    (19,233 )   $ (19,233 )             (19,233 )
                                                 
BALANCE AS OF MARCH 31, 2011
  $ 121,582       54,142,524     $ 979,271     $ 1,100,853     $ 1,670     $ 1,102,523  
                                                 
 
See accompanying notes to consolidated financial statements.


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KILROY REALTY, L.P.
 
(unaudited, in thousands)
 
                 
    Three Months Ended March 31,  
    2011     2010  
 
CASH FLOWS FROM OPERATING ACTIVITIES:
               
Net income
  $ 4,867     $ 8,877  
Adjustments to reconcile net income to net cash provided by operating activities:
               
Depreciation and amortization of building and improvements and leasing costs
    29,059       20,728  
Increase in provision for bad debts
    26       26  
Depreciation of furniture, fixtures and equipment
    252       210  
Noncash amortization of share-based compensation awards
    1,106       1,706  
Noncash amortization of deferred financing costs and debt discounts
    3,450       2,924  
Noncash amortization of above/(below) market rents (Note 3)
    653       (28 )
Noncash amortization of deferred revenue related to tenant-funded tenant improvements
    (2,326 )     (2,352 )
Changes in operating assets and liabilities:
               
Marketable securities
    (523 )     (774 )
Current receivables
    1,416       297  
Deferred rent receivables
    (4,340 )     (2,014 )
Other deferred leasing costs
    197       (1,776 )
Prepaid expenses and other assets
    (2,906 )     (3,068 )
Accounts payable, accrued expenses and other liabilities
    15,923       3,375  
Deferred revenue
    (301 )     13  
Rents received in advance and tenant security deposits
    (2,756 )     5,424  
                 
Net cash provided by operating activities
    43,797       33,568  
                 
CASH FLOWS FROM INVESTING ACTIVITIES:
               
Expenditures for acquisition of operating properties (Note 2)
    (33,000 )     (17,950 )
Expenditures for operating properties
    (15,985 )     (14,217 )
Expenditures for development and redevelopment properties and undeveloped land
    (6,714 )     (4,362 )
Increase in escrow deposits
    (5,000 )     (3,000 )
(Increase) decrease in restricted cash
    (438 )     2,027  
Receipt of principal payments on note receivable
          38  
                 
Net cash used in investing activities
    (61,137 )     (37,464 )
                 
CASH FLOWS FROM FINANCING ACTIVITIES:
               
Borrowings on unsecured line of credit
    42,000       63,000  
Repayments on unsecured line of credit
    (144,000 )     (10,000 )
Principal payments on secured debt
    (1,598 )     (98,560 )
Proceeds from issuance of secured debt (Note 5)
    135,000       71,000  
Financing costs
    (1,160 )     (569 )
Decrease in loan deposits
    2,027       1,420  
Repurchase of common units and restricted stock units
    (732 )     (2,121 )
Proceeds from exercise of stock options
    395       83  
Distributions paid to common unitholders
    (18,925 )     (15,705 )
Distributions paid to preferred unitholders
    (3,799 )     (3,799 )
                 
Net cash provided by financing activities
    9,208       4,749  
                 
Net (decrease) increase in cash and cash equivalents
    (8,132 )     853  
Cash and cash equivalents, beginning of period
    14,840       9,883  
                 
Cash and cash equivalents, end of period
  $ 6,708     $ 10,736  
                 
SUPPLEMENTAL CASH FLOWS INFORMATION:
               
Cash paid for interest, net of capitalized interest of $1,620 and $1,902 as of March 31, 2011 and 2010, respectively
  $ 6,965     $ 6,980  
                 
NONCASH INVESTING TRANSACTIONS:
               
Accrual for expenditures for operating properties and development and redevelopment properties
  $ 4,753     $ 8,714  
                 
Tenant improvements funded directly by tenants to third parties
  $ 2,800     $ 657  
                 
NONCASH FINANCING TRANSACTIONS:
               
Accrual of distributions payable to common unitholders
  $ 18,950       15,686  
                 
Accrual of distributions payable to preferred unitholders
  $ 1,909     $ 1,909  
                 
Issuance of share-based compensation awards (Note 8)
  $ 6,432     $ 4,647  
                 
 
See accompanying notes to consolidated financial statements.


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KILROY REALTY CORPORATION AND KILROY REALTY, L.P.
 
 
Three Months Ended March 31, 2011 and 2010
(unaudited)
 
1.   Organization and Basis of Presentation
 
 
Kilroy Realty Corporation (the “Company”) is a self-administered real estate investment trust (“REIT”) active in premier office and industrial submarkets along the West Coast. We own, develop, acquire and manage primarily Class A real estate assets in the coastal regions of Los Angeles, Orange County, San Diego, greater Seattle and the San Francisco Bay Area, which we believe have strategic advantages and strong barriers to entry. We qualify as a REIT under the Internal Revenue Code of 1986, as amended (the “Code”). The Company’s common stock is publicly traded on the New York Stock Exchange (“NYSE”) under the ticker symbol “KRC.”
 
We own our interests in all of our real estate assets through Kilroy Realty, L.P. (the “Operating Partnership”) and Kilroy Realty Finance Partnership, L.P. (the “Finance Partnership”). We conduct substantially all of our operations through the Operating Partnership. Unless the context indicates otherwise, the term “Company” refers to Kilroy Realty Corporation and its consolidated subsidiaries and the term “Operating Partnership” refers to Kilroy Realty, L.P. and its consolidated subsidiaries. The terms “we,” “our,” and “us” refer to the Company or the Company and the Operating Partnership together, as the text requires. The descriptions of our business, employees, and properties apply to both the Company and the Operating Partnership.
 
The following table of office buildings (the “Office Properties”) and industrial buildings (the “Industrial Properties”) summarizes our stabilized portfolio of operating properties as of March 31, 2011. As of March 31, 2011, all of our properties and all of our business is currently conducted in the state of California with the exception of the operation of one office property located in the state of Washington.
 
                                 
    Number of
    Rentable
    Number of
       
    Buildings     Square Feet     Tenants     Percentage Occupied  
 
Office Properties
    101       10,485,950       374       89.0 %
Industrial Properties
    40       3,605,407       59       95.9 %
                                 
Total Stabilized Portfolio
    141       14,091,357       433       90.8 %
                                 
 
Our stabilized portfolio excludes undeveloped land, development and redevelopment properties currently under construction, “lease-up” properties, and one industrial property that we are in the process of repositioning for residential use. We define “lease-up” properties as properties we recently developed or redeveloped that have not yet reached 95% occupancy and are within one year following cessation of major construction activities. As of March 31, 2011, we had no properties that were in the lease-up phase. We are currently redeveloping one of our office properties that was previously occupied by a single tenant for over 25 years and expect to complete the redevelopment in the third quarter of 2011. This redevelopment property encompasses approximately 300,000 rentable square feet of office space and is located in the El Segundo submarket of Los Angeles county. As of March 31, 2011, we also had one industrial property that we are currently in the process of repositioning for residential use and we are currently evaluating strategic opportunities for this property.
 
As of March 31, 2011, the Company owned a 96.8% general partnership interest in the Operating Partnership. The remaining 3.2% common limited partnership interest in the Operating Partnership as of March 31, 2011 was owned by non-affiliated investors and certain of our directors and officers (see Note 6). Both the general and limited common partnership interests in the Operating Partnership are denominated in common units. The number of common units held by the Company is at all times equivalent to the number of outstanding shares of the Company’s common stock, and the entitlements of all the common units to quarterly distributions and payments in liquidation mirror those of the the Company’s common stockholders. The common limited partners have certain redemption rights as provided in the Operating Partnership’s Fifth Amended and Restated Agreement of Limited Partnership (as amended, the “Partnership Agreement”) (see Note 6).


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KILROY REALTY CORPORATION AND KILROY REALTY, L.P.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 
Kilroy Realty Finance, Inc., our wholly-owned subsidiary, is the sole general partner of the Finance Partnership and owns a 1.0% general partnership interest. The Operating Partnership owns the remaining 99.0% limited partnership interest. Kilroy Services, LLC (“KSLLC”), which is a wholly-owned subsidiary of the Operating Partnership, is the entity through which we conduct substantially all of our development activities. With the exception of the Operating Partnership, all of our subsidiaries, which include Kilroy Realty TRS, Inc., Kilroy Realty Management, L.P., Kilroy RB, LLC, Kilroy RB II, LLC, Kilroy Northside Drive, LLC, and Kilroy Realty 303, LLC, are wholly-owned.
 
 
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 of our wholly-owned subsidiaries. The consolidated financial statements of the Operating Partnership include the consolidated financial position and results of operations of the Operating Partnership, the Finance Partnership, KSLLC, and all wholly-owned subsidiaries of the Operating Partnership. All intercompany balances and transactions have been eliminated in the consolidated financial statements.
 
The consolidated financial statements of the Company and the Operating Partnership also include variable interest entities (“VIE”) in which we are deemed to be the primary beneficiary. As of March 31, 2011 we had one bankruptcy-remote VIE, Kilroy Realty Northside Drive, LLC, which was formed in 2010 to hold three properties that secure the debt we assumed when we acquired the properties in 2010. The assets held by this entity are not available to satisfy the debts and other obligations of the Company or the Operating Partnership.
 
The accompanying interim financial statements have been prepared by 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 that 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, 2011. The interim financial statements for the Company and the Operating Partnership should be read in conjunction with the audited consolidated financial statements and notes thereto included in our annual report on Form 10-K for the year ended December 31, 2010.
 
Change in Reportable Segments
 
Our chief operating decision-makers internally evaluate the operating performance and financial results of our portfolio based on Net Operating Income for the following two segments of commercial real estate property: Office Properties and Industrial Properties. We define “Net Operating Income” as operating revenues (rental income, tenant reimbursements, and other property income) less operating expenses (property expenses, real estate taxes, provision for bad debts, and ground leases).
 
During the three months ended March 31, 2011, the amount of revenues and Net Operating Income generated by our Industrial Properties, in relation to our total consolidated operating portfolio revenues and Net Operating Income, had fallen below the required 10% quantitative reporting thresholds for the Industrial Properties to be considered a reportable segment under GAAP. Therefore, for the three months ended March 31, 2011, our only reportable segment is our Office Properties segment. See Note 10 for a reconciliation of our Office Properties segment to our consolidated revenues, Net Operating Income, and net income.


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KILROY REALTY CORPORATION AND KILROY REALTY, L.P.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 
2.   Acquisitions
 
During the three months ended March 31, 2011, we acquired the office property listed below from an unrelated third party. The acquisition was funded with borrowings under our unsecured line of credit.
 
                                         
                        Percentage
       
                  Rentable
    Occupied
    Purchase
 
    Property
  Date of
  Number of
    Square
    as of
    Price
 
Property   Type   Acquisition   Buildings     Feet     March 31, 2011     (in millions)(1)  
 
250 Brannan Street, San Francisco, CA
  Office   January 28, 2011     1       90,742       76.7 %   $ 33.0  
                                         
Total
            1       90,742             $ 33.0  
                                         
 
 
(1) Excludes acquisition-related costs.
 
The related assets and results of operations of the acquired property is included in the consolidated financial statements as of the date of acquisition. The following table summarizes the estimated fair values of the assets acquired at the acquisition date:
 
         
    250 Brannan Street,
 
    San Francisco, CA  
    (in thousands)  
 
Assets
       
Land
  $ 7,630  
Buildings and improvements
    22,770  
Deferred leasing costs and acquisition-related intangible assets(1)
    2,600  
         
Total assets acquired(2)
  $ 33,000  
         
 
 
(1) Represents in-place leases (approximately $1.5 million with a weighted average amortization period of 2.5 years), above-market leases (approximately $0.7 million with a weighted average amortization period of 2.6 years), and unamortized leasing commissions (approximately $0.4 million with a weighted average amortization period of 1.7 years).
 
(2) There were no lease related obligations, debt or other liabilities assumed in connection with this acquisition.
 
The following table summarizes the results of operations for the property at 250 Brannan Street, San Francisco, California, from January 28, 2011, the date of acquisition, through March 31, 2011:
 
         
    (in thousands)
 
Revenues
  $ 569  
Net income(1)
    185  
 
 
(1) Reflects the net operating income less depreciation for this property and amortization of lease related intangibles.
 
Refer to Note 13 to our consolidated financial statements included in this report for further discussion of acquisitions completed subsequent to March 31, 2011.


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KILROY REALTY CORPORATION AND KILROY REALTY, L.P.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 
3.   Deferred Leasing Costs and Acquisition-related Intangible Assets and Liabilities, Net
 
The following table summarizes our identified deferred leasing costs and acquisition-related intangible assets (acquired value of leasing costs, above-market and in-place leases) and intangible liabilities (acquired value of below-market leases) as of March 31, 2011 and December 31, 2010:
 
                 
    March 31,
    December 31,
 
    2011     2010  
    (in thousands)  
 
Deferred Leasing Costs and Acquisition-related Intangible Assets(1)(3):
               
Deferred leasing costs
  $ 122,007     $ 128,980  
Accumulated amortization
    (39,255 )     (45,869 )
                 
Deferred leasing costs, net
    82,752       83,111  
Above-market leases
    21,982       21,321  
Accumulated amortization
    (3,354 )     (2,163 )
                 
Above-market leases, net
    18,628       19,158  
In-place leases
    33,505       36,964  
Accumulated amortization
    (5,307 )     (8,167 )
                 
In-place leases, net
    28,198       28,797  
                 
Total deferred leasing costs and acquisition-related intangible assets, net
  $ 129,578     $ 131,066  
                 
Acquisition-related Intangible Liabilities(2)(3):
               
Below-market leases
  $ 18,112     $ 21,938  
Accumulated amortization
    (1,771 )     (5,094 )
                 
Below-market leases, net
  $ 16,341     $ 16,844  
                 
 
 
(1) Included in deferred leasing costs and acquisition-related intangible assets, net in the consolidated balance sheets.
 
(2) Included in deferred revenue and acquisition-related intangible liabilities, net in the consolidated balance sheets.
 
(3) Balances and accumulated amortization amounts at March 31, 2011 reflect the write-off of the following fully amortized amounts at January 1, 2011: deferred leasing costs (approximately $10.4 million), in-place leases (approximately $5.0 million), and below-market leases (approximately $3.8 million). Our accounting policy is to write-off the asset and corresponding accumulated amortization for fully amortized balances on January 1st of each fiscal year.
 
The following table sets forth amortization for the period related to deferred leasing costs and acquisition-related intangibles for the three months ended March 31, 2011 and 2010:
 
                 
    Three Months
 
    Ended
 
    March 31,  
    2011     2010  
    (in thousands)  
 
Deferred leasing costs(1)
  $ 3,768     $ 2,705  
Net above (below)-market leases(2)
    653       (28 )
In-place leases(1)
    2,173       18  
                 
Total
  $ 6,594     $ 2,695  
                 
 
 
(1) The amortization of deferred leasing costs and in-place leases is recorded to depreciation and amortization expense in the consolidated statements of operations for the periods presented.
 
(2) The amortization of above-market leases is recorded as a decrease to rental income for the three months ended March 31, 2011 and the amortization of below-market leases is recorded as an increase to rental income for the three months ended March 31, 2010 in the consolidated statements of operations.


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KILROY REALTY CORPORATION AND KILROY REALTY, L.P.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 
 
The following table sets forth the estimated annual amortization expense related to deferred leasing costs and acquisition-related intangibles as of March 31, 2011 for future periods:
 
                         
    Deferred
    Net Above-/(Below)
       
Year Ending   Leasing Costs     -Market Leases(1)     In-Place Leases  
          (in thousands)        
 
Remaining 2011
  $ 12,083     $ 1,811     $ 5,452  
2012
    14,649       2,051       6,059  
2013
    13,008       1,719       5,077  
2014
    11,573       1,398       4,290  
2015
    8,710       396       2,280  
Thereafter
    22,729       (5,088 )     5,040  
                         
Total
  $ 82,752     $ 2,287     $ 28,198  
                         
 
 
(1) Represents estimated annual net amortization related to above-/(below)-market leases. Amounts shown for 2011-2015 represent net above-market leases which will be recorded as a decrease to rental income in the consolidated statement of operations, and amounts shown for the periods thereafter represent net below-market leases which will be recorded as increases to rental income in the consolidated statement of operations.
 
4.   Receivables
 
Current Receivables, net
 
Current receivables, net is primarily comprised of contractual rents and other lease-related obligations due from tenants. The balance consisted of the following as of March 31, 2011 and December 31, 2010 :
 
                 
    March 31,
    December 31,
 
    2011     2010  
    (in thousands)  
 
Current receivables
  $ 7,657     $ 9,077  
Allowance for uncollectible tenant receivables
    (2,841 )     (2,819 )
                 
Current receivables, net
  $ 4,816     $ 6,258  
                 
 
Deferred Rent Receivables, net
 
Deferred rent receivables, net consisted of the following as of March 31, 2011 and December 31, 2010:
 
                 
    March 31,
    December 31,
 
    2011     2010  
    (in thousands)  
 
Deferred rent receivables
  $ 97,218     $ 92,883  
Allowance for deferred rent receivables
    (3,826 )     (3,831 )
                 
Deferred rent receivables, net
  $ 93,392     $ 89,052  
                 
 
5.   Secured and Unsecured Debt of the Operating Partnership
 
 
In January 2011, the Company borrowed $135.0 million under a mortgage loan that is scheduled to mature on February 1, 2018. The mortgage loan is secured by our 303 Second Street property in San Francisco, bears interest at an annual rate of 4.27%, and requires interest-only payments for the first two years with a 30-year amortization schedule thereafter. Although the new mortgage loan is secured and non-recourse to the Company, the Company provides limited customary secured debt guarantees for items such as voluntary bankruptcy, fraud, misapplication of payments, and environmental liabilities. The Company used a portion of the proceeds to repay borrowings under the Operating Partnership’s unsecured line of credit (the “Credit Facility”).


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KILROY REALTY CORPORATION AND KILROY REALTY, L.P.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 
 
The following table summarizes the balance and significant terms of the Company’s 3.25% Exchangeable Notes due 2012 (the “3.25% Exchangeable Notes”) and 4.25% Exchangeable Notes due 2014 (the “4.25% Exchangeable Notes” and together with the 3.25% Exchangeable Notes, the “Exchangeable Notes”) outstanding as of March 31, 2011 and December 31, 2010:
 
                                 
    3.25% Exchangeable Notes     4.25% Exchangeable Notes  
    March 31,
    December 31,
    March 31,
    December 31,
 
    2011     2010     2011     2010  
    (in thousands)  
 
Principal amount
  $ 148,000     $ 148,000     $ 172,500     $ 172,500  
Unamortized discount
    (3,253 )     (4,004 )     (15,595 )     (16,532 )
                                 
Net carrying amount of liability component
  $ 144,747     $ 143,996     $ 156,905     $ 155,968  
                                 
Carrying amount of equity component
  $33,675   $19,835
Maturity date
  April 2012   November 2014
Stated coupon rate
    3.25%(1)     4.25%(2)
Effective interest rate(3)
  5.45%   7.13%
Exchange rate per $1,000 principal value of the Exchangeable Notes, as adjusted(4)
  11.3636   27.8307
Exchange price, as adjusted(4)
  $88.00   $35.93
Number of shares on which the aggregate consideration to be delivered on conversion is determined(4)
  1,681,813   4,800,796
 
 
(1) Interest on the 3.25% Exchangeable Notes is payable semi-annually in arrears on April 15th and October 15th of each year.
 
(2) Interest on the 4.25% Exchangeable Notes is payable semi-annually in arrears on May 15th and November 15th of each year.
 
(3) The rate at which we record interest expense for financial reporting purposes, which reflects the amortization of the discounts on the Exchangeable Notes. This rate represents our conventional debt borrowing rate at the date of issuance.
 
(4) The exchange rate, exchange price, and the number of shares to be delivered upon conversion are subject to adjustment under certain circumstances including increases in our common dividends.
 
Capped Call Transactions
 
In connection with the offerings of the Exchangeable Notes, we entered into capped call option transactions (“capped calls”) to mitigate the dilutive impact of the potential exchange of the Exchangeable Notes. The following table summarizes our capped call option positions as of both March 31, 2011 and December 31, 2010:
 
                 
    3.25% Exchangeable Notes(1)   4.25% Exchangeable Notes(2)
 
Referenced shares of common stock
    1,121,201       4,800,796  
Exchange price including effect of capped calls
  $ 102.72     $ 42.81  
 
 
(1) The capped calls mitigate the dilutive impact to us of the potential exchange of two-thirds of the 3.25% Exchangeable Notes into shares of common stock.
 
(2) The capped calls mitigate the dilutive impact to us of the potential exchange of all of the 4.25% Exchangeable Notes into shares of common stock.
 
For the three months ended March 31, 2011, the per share average trading price of the Company’s common stock on the New York Stock Exchange (“NYSE”) of $37.96 was higher than the $35.93 exchange price for the 4.25% Exchangeable Notes. As a result, even though there would be no dilutive economic impact to our earnings until our share price exceeded $42.81, which is the exchange price after the impact of the capped calls, and even though the 4.25% Exchangeable Notes were not convertible as of March 31, 2011, we are required to include the dilutive impact of the 4.25% Exchangeable Notes based on the $37.96 average share price in our diluted earnings per share calculation for the three months ended March 31, 2011 (see Notes 11 and 12). If the 4.25% Exchangeable Notes were able to be converted as of March 31, 2011, the approximate fair value of the shares upon conversion at that date would have been equal to approximately $182.5 million, which would exceed the $172.5 million principal amount of the 4.25% Exchangeable


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KILROY REALTY CORPORATION AND KILROY REALTY, L.P.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 
Notes by approximately $10.0 million. The 4.25% Exchangeable Notes were not included in our diluted weighted average share calculation for the three months ended March 31, 2010 and the 3.25% Exchangeable Notes were not included in our diluted weighted average share calculation for the three months ended March 31, 2011 and 2010, since the per share average trading price of the Company’s common stock on the NYSE was below the respective exchange prices for these periods.
 
Interest Expense for the Exchangeable Notes
 
The unamortized discount on the Exchangeable Notes is accreted as additional interest expense from the date of issuance through the maturity date of the applicable Exchangeable Notes. The following table summarizes the total interest expense attributable to the Exchangeable Notes based on the effective interest rates set forth above, before the effect of capitalized interest, for the three months ended March 31, 2011 and 2010:
 
                 
    Three Months Ended
 
    March 31,  
    2011     2010  
    (in thousands)  
 
Contractual interest payments
  $ 3,035     $ 4,254  
Amortization of discount
    1,688       2,307  
                 
Interest expense attributable to the Exchangeable Notes
  $ 4,723     $ 6,561  
                 
 
 
The following table summarizes the balance and certain significant terms of the Credit Facility as of March 31, 2011 and December 31, 2010, respectively:
 
                 
    March 31,
    December 31,
 
    2011     2010  
    (in thousands)  
 
Outstanding borrowings
  $ 57,000     $ 159,000  
Remaining borrowing capacity
    443,000       341,000  
                 
Total borrowing capacity(1)
  $ 500,000     $ 500,000  
Interest rate(2)
    2.93%       2.99%  
Facility fee(3)
  0.575%
Maturity date(4)
  August 2013
 
 
(1) We may elect to borrow, subject to bank approval, up to an additional $200 million under an accordion feature under the terms of the Credit Facility.
 
(2) As of March 31, 2011 and December 31, 2010, the Credit Facility interest rate included interest at an annual rate of LIBOR plus 2.675%.
 
(3) The facility fee is equal to 0.575% of the total borrowing capacity and is paid on a quarterly basis. In addition to the facility fee, we also incurred debt origination and legal costs of approximately $5 million, which will be amortized as additional interest expense from the August 2010 origination date through the August 2013 contractual maturity date.
 
(4) Under the terms of the Credit Facility, we may exercise an option to extend the maturity date by one year.
 
The Company intends to borrow amounts under the Credit Facility from time to time for general corporate purposes, to fund potential acquisitions, to finance development and redevelopment expenditures, and to potentially repay long-term debt.
 
 
The Credit Facility, the unsecured senior notes, and certain other secured debt arrangements contain covenants and restrictions requiring us to meet certain financial ratios and reporting requirements. Some of the more restrictive financial covenants include a maximum ratio of total debt to total asset value, a minimum fixed-charge coverage ratio, a minimum unsecured debt ratio, a minimum unencumbered asset pool debt service coverage ratio, and a minimum unencumbered


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KILROY REALTY CORPORATION AND KILROY REALTY, L.P.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 
debt yield. Noncompliance with one or more of the covenants and restrictions could result in the full or partial principal balance of the associated debt becoming immediately due and payable. We believe we were in compliance with all of our debt covenants as of March 31, 2011.
 
 
The following table summarizes the stated debt maturities and scheduled amortization payments, excluding debt discounts, as of March 31, 2011:
 
         
Year Ending   (in thousands)  
 
Remaining 2011
  $ 73,418  
2012
    304,292  
2013
    62,311  
2014
    261,327  
2015
    331,177  
Thereafter
    450,028  
         
Total
  $ 1,482,553 (1)
         
 
 
(1) Includes full principal balance of outstanding debt before impact of all debt discounts.
 
 
The following table sets forth our gross interest expense, including debt discount and loan cost amortization, net of capitalized interest, for the three months ended March 31, 2011 and 2010. The capitalized amounts are a cost of development and redevelopment, and increase the carrying value of undeveloped land and construction in progress.
 
                 
    Three Months Ended March 31,  
    2011     2010  
    (in thousands)  
 
Gross interest expense
  $ 22,855     $ 14,540  
Capitalized interest
    (1,979 )     (2,584 )
                 
Interest expense
  $ 20,876     $ 11,956  
                 
 
6.   Noncontrolling Interests on the Company’s Consolidated Financial Statements
 
Series A Preferred Units of the Operating Partnership
 
As of both March 31, 2011 and December 31, 2010, the Operating Partnership had 1,500,000 Series A Preferred Units representing preferred limited partnership interests in the Operating Partnership with a redemption value of $50.00 per unit. There were no changes to this noncontrolling interest during the three months ended March 31, 2011 and 2010.
 
 
The Company owned a 96.8% common general partnership interest in the Operating Partnership as of both March 31, 2011 and December 31, 2010, and a 96.2% interest as of March 31, 2010. The remaining 3.2% and 3.8% common limited partnership interest as of both March 31, 2011 and December 31, 2010, and March 31, 2010, respectively, was owned in the form of common units by non-affiliate investors and certain of our executive officers and directors. There were 1,723,131 common units outstanding held by these investors, executive officers and directors as of both March 31, 2011 and December 31, 2010.
 
The noncontrolling common units may be redeemed by unitholders for cash. We, at our option, may satisfy the cash redemption obligation with shares of the Company’s common stock on a one-for-one basis. Whether satisfied in cash or shares of the Company’s common stock, the value for each noncontrolling common unit upon redemption is the amount


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KILROY REALTY CORPORATION AND KILROY REALTY, L.P.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 
equal to the average of the closing quoted price per share of the Company’s common stock, par value $.01 per share, as reported on the NYSE for the ten trading days immediately preceding the applicable balance sheet date. The aggregate value upon redemption of the then-outstanding noncontrolling common units was $65.2 million and $61.4 million as of March 31, 2011 and December 31, 2010, respectively. This redemption value does not necessarily represent the amount that would be distributed with respect to each common unit in the event of our termination or liquidation. In the event of our termination or liquidation, it is expected in most cases that each common unit would be entitled to a liquidating distribution equal to the amount payable with respect to each share of the Company’s common stock.
 
7.   Partners’ Capital of the Operating Partnership
 
Common Units Outstanding
 
The Company owned 52,419,393, 52,349,670, and 43,092,980 common units representing a 96.8%, 96.8%, and 96.2% common general partnership interest in the Operating Partnership as of March 31, 2011, December 31, 2010, and March 31, 2010, respectively. The remaining 3.2%, 3.2%, and 3.8% common limited partnership interest as of March 31, 2011, December 31, 2010, and March 31, 2010, respectively, was owned by non-affiliate investors and certain of our executive officers and directors in the form of noncontrolling common units. There were 1,723,131 common units outstanding held by these investors, executive officers and directors as of March 31, 2011, December 31, 2010, and March 31, 2010. For a further discussion of the noncontrolling common units during the three months ended March 31, 2011 and year ended December 31, 2010, please refer to Note 6.
 
8.   Share-Based Compensation
 
 
At March 31, 2011, we had one share-based incentive compensation plan, the Kilroy Realty 2006 Incentive Award Plan as amended (the “2006 Plan”). As of March 31, 2011, 3,878,182 shares were available for grant under the 2006 Plan. The number of shares that remains available for grant is calculated using the weighted share counting provisions set forth in the 2006 Plan, which are based on the type of awards that are granted. The maximum number of shares available for grant subject to full value awards (which generally include equity awards other than options and stock appreciation rights) was 1,328,144 shares as of March 31, 2011.
 
 
A summary of our nonvested shares activity from January 1, 2011 through March 31, 2011 is presented below:
 
                         
          Weighted-
 
          Average
 
          Grant Date
 
          Fair Value
 
Nonvested Shares   Shares     Per Share  
 
Outstanding at January 1, 2011
    50,032             $ 58.40  
Granted
    66,208               37.76  
Vested(1)
    (5,985 )             70.16  
                         
Outstanding as of March 31, 2011
    110,255             $ 45.37  
                         
 
 
(1) The total shares vested include 2,198 of shares that were then tendered to satisfy minimum statutory tax withholding requirements related to the restricted shares that have vested in accordance with the terms of the 2006 Plan. We accept the return of shares at the current quoted market price of the Company’s common stock to satisfy tax obligations.


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KILROY REALTY CORPORATION AND KILROY REALTY, L.P.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 
 
A summary of our nonvested and vested shares activity for the three months ended March 31, 2011 and 2010 is presented below:
 
                                 
    Shares Granted     Shares Vested  
          Weighted-Average
             
          Grant Date
          Total Vest Date
 
    Non-Vested Shares
    Fair Value
          Fair Value(1)
 
Three Months Ended March 31,   Issued     Per Share     Vested Shares     (in thousands)  
 
2011
    66,208     $ 37.76       (5,985 )   $ 232  
2010
                (10,217 )     281  
 
 
(1) Total fair value of shares vested was calculated based on the quoted closing share price of the Company’s common stock on the NYSE on the day of vesting.
 
Summary of Restricted Stock Units
 
A summary of our restricted stock unit (“RSU”) activity from January 1, 2011 through March 31, 2011 is presented below:
 
                                 
    Nonvested RSUs              
          Weighted-Average
             
          Grant Date
             
          Fair Value
             
    Amount     Per Share     Vested RSUs     Total RSUs  
 
Outstanding at January 1, 2011
    125,754     $ 29.88       588,068       713,822  
Granted
    97,597       37.76             97,597  
Vested
    (10,079 )     30.18       10,079        
Issuance of dividend equivalents(1)
                6,521       6,521  
Canceled(2)
                (8,399 )     (8,399 )
                                 
Outstanding as of March 31, 2011
    213,272     $ 33.47       596,269       809,541  
                                 
 
 
(1) RSUs issued as dividend equivalents are vested upon issuance.
 
(2) We accept the return of RSUs, at the current quoted market price of the Company’s common stock, to satisfy minimum statutory tax-withholding requirements related to either RSUs that have vested or RSU dividend equivalents in accordance with the terms of the 2006 Plan.
 
A summary of our RSU activity for the three months ended March 31, 2011 and 2010 is presented below:
 
                                 
    RSUs Granted   RSUs Vested
        Weighted-Average
       
        Grant Date
      Total Vest-Date
    Non-Vested RSUs
  Fair Value
      Fair Value(1)
Three Months Ended March 31,   Issued   Per Share   Vested RSUs   (in thousands)
 
2011
    97,597     $ 37.76       10,079     $ 382  
2010
    146,650       30.18              
 
 
(1) Total fair value of RSUs vested was calculated based on the quoted closing share price of the Company’s common stock on the NYSE on the day of vesting.
 
 
The total compensation cost for all share-based compensation programs was $1.4 million and $2.1 million for the three months ended March 31, 2011 and 2010, respectively. Of the total share-based compensation cost, $0.3 million and $0.4 million were capitalized as part of real estate assets for the three months ended March 31, 2011 and 2010, respectively. As of March 31, 2011, there was approximately $8.0 million of total unrecognized compensation cost related to nonvested incentive awards granted under share-based compensation arrangements


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KILROY REALTY CORPORATION AND KILROY REALTY, L.P.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 
that is expected to be recognized over a weighted-average period of 1.7 years. The remaining compensation cost related to these nonvested incentive awards had been recognized in periods prior to March 31, 2011.
 
9.   Fair Value Measurements and Disclosures
 
Assets and Liabilities Reported at Fair Value
 
The only assets and liabilities we record at fair value in our consolidated financial statements are the marketable securities and related deferred compensation plan liability, both of which are related to our Deferred Compensation Plan. The following table sets forth the fair value of our marketable securities and related deferred compensation plan liability as of March 31, 2011 and December 31, 2010:
 
                 
    Fair Value (Level 1)(1)
Description   March 31, 2011   December 31, 2010
    (in thousands)
 
Marketable securities(2)
  $ 5,425     $ 4,902  
Deferred compensation plan liability(3)
  $ 5,331     $ 4,809  
 
 
(1) Based on quoted prices in active markets for identical securities.
 
(2) The marketable securities are held in a limited rabbi trust.
 
(3) The deferred compensation liability is reported on our consolidated balance sheets in accounts payable, accrued expenses, and other liabilities.
 
We report the change in the fair value of the marketable securities at the end of each accounting period in interest income and other net investment gains (losses) in the consolidated statements of operations. We adjust the deferred compensation plan liability to fair value at the end of each accounting period based on the performance of the benchmark funds selected by each participant, which results in a corresponding increase or decrease to compensation cost for the period. The following table sets forth the related amounts recorded during the three months ended March 31, 2011 and 2010:
 
                 
    Three Months Ended
Description   March 31, 2011   March 31, 2010
    (in thousands)
 
Other net investments gains
  $ 187     $ 201  
Compensation cost
  $ (187 )   $ (201 )
 
 
The following table sets forth the carrying value and the fair value of our other financial liabilities as of March 31, 2011 and December 31, 2010:
 
                                 
    March 31, 2011   December 31, 2010
    Carrying
  Fair
  Carrying
  Fair
Description   Value   Value   Value   Value
        (in thousands)    
 
Liabilities
                               
Secured debt
  $ 446,539     $ 459,723     $ 313,009     $ 329,456  
Exchangeable notes
    301,652       318,076       299,964       312,598  
Unsecured senior notes
    655,866       683,523       655,803       661,644  
Credit Facility
    57,000       57,523       159,000       159,659  


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KILROY REALTY CORPORATION AND KILROY REALTY, L.P.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 
10.   Segment Disclosure
 
We have one reportable segment which is our Office Properties segment and we have one non-reportable segment which is our Industrial Properties segment. We also have certain corporate level activities including legal administration, accounting, finance, and management information systems, which are not considered separate operating segments.
 
We evaluate the performance of our 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 provisions for bad debts) and excludes other non-property related income and expenses such as interest income and interest expense, depreciation and amortization, acquisition-related expenses and corporate general and administrative expenses. There is no intersegment activity.
 
The following tables reconciles our reportable segment activity to our consolidated net income for the three months ended March 31, 2011 and 2010:
 
                 
    Three Months Ended March 31,  
    2011     2010  
    (in thousands)  
 
Reportable Segment—Office Properties
               
Operating revenues(1)
  $ 80,819     $ 59,601  
Property and related expenses
    22,913       16,256  
                 
Net Operating Income
    57,906       43,345  
                 
Other Non-Reportable Segment—Industrial Properties
               
Operating revenues(1)
    7,306       7,218  
Property and related expenses
    3,310       1,768  
                 
Net Operating Income
    3,996       5,450  
                 
Total Segments:
               
Operating revenues(1)
    88,125       66,819  
Property and related expenses
    26,223       18,024  
                 
Net Operating Income
    61,902       48,795  
                 
Reconciliation to Consolidated Net Income:
               
Total Net Operating Income for segments
    61,902       48,795  
Unallocated (expenses) income:
               
General and administrative expenses
    (6,560 )     (7,095 )
Acquisition-related expenses
    (472 )     (313 )
Depreciation and amortization
    (29,311 )     (20,938 )
Interest income and other net investment gains
    184       384  
Interest expense
    (20,876 )     (11,956 )
                 
Net income
  $ 4,867     $ 8,877  
                 
 
 
(1) All operating revenues are comprised of amounts received from third-party tenants.


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KILROY REALTY CORPORATION AND KILROY REALTY, L.P.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 
11.   Net Income Available to Common Stockholders Per Share of the Company
 
The following table reconciles the numerator and denominator in computing the Company’s basic and diluted per-share computations for net income available to common stockholders for the three months ended March 31, 2011 and 2010:
 
                 
    Three Months Ended
 
    March 31,  
    2011     2010  
    (in thousands, except share and per share amounts)  
 
Numerator:
               
Net income attributable to Kilroy Realty Corporation
  $ 4,833     $ 8,685  
Preferred distributions and dividends
    (3,799 )     (3,799 )
                 
Net income available to common stockholders
    1,034       4,886  
Allocation to participating securities (nonvested shares and RSUs)
    (322 )     (299 )
                 
Numerator for basic and diluted net income available to common stockholders
  $ 712     $ 4,587  
Denominator:
               
Basic weighted average vested shares outstanding
    52,302,075       43,012,100  
Effect of dilutive securities- Exchangeable Notes and stock options
    270,881       2,432  
                 
Diluted weighted average vested shares and common share equivalents outstanding
    52,572,956       43,014,532  
                 
Basic earnings per share:
               
Net income available to common stockholders per share
  $ 0.01     $ 0.11  
Diluted earnings per share:
               
Net income available to common stockholders per share
  $ 0.01     $ 0.11  
 
The effect of the 4.25% Exchangeable Notes was not included in our diluted earnings per share calculation for the three months ended March 31, 2010 and the effect of the 3.25% Exchangeable Notes was not included in our diluted earnings per share calculation for the three months ended March 31, 2011 and 2010 since the average trading price of the Company’s common stock on the NYSE was below the Exchangeable Notes exchange price for these periods. Therefore these instruments were not considered to be in the money for the purposes of our diluted earnings per share calculation for these periods (See Note 5).


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KILROY REALTY CORPORATION AND KILROY REALTY, L.P.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
 
12.   Net Income Available to Common Unitholders per Unit of the Operating Partnership
 
The following table reconciles the numerator and denominator in computing the Operating Partnership’s basic and diluted per-unit computations for net income available to common unitholders for the three months ended March 31, 2011 and 2010:
 
                 
    Three Months Ended
 
    March 31,  
    2011     2010  
    (in thousands, except unit and per unit amounts)  
 
Numerator:
               
Net income attributable to Kilroy Realty, L.P. 
  $ 4,833     $ 8,832  
Preferred distributions
    (3,799 )     (3,799 )
                 
Net income available to common unitholders
    1,034       5,033  
Allocation to participating securities (nonvested units and RSUs)
    (322 )     (299 )
                 
Numerator for basic and diluted net income available to common unitholders
  $ 712     $ 4,734  
Denominator:
               
Basic weighted average vested common units outstanding
    54,025,206       44,735,231  
Effect of dilutive securities-Exchangeable Notes and stock options
    270,881       2,432  
                 
Diluted weighted average vested units and common unit equivalents outstanding
    54,296,087       44,737,663  
                 
Basic earnings per unit:
               
Net income available to common unitholders per unit
  $ 0.01     $ 0.11  
Diluted earnings per unit:
               
Net income available to common unitholders per unit
  $ 0.01     $ 0.11  
 
The effect of the 4.25% Exchangeable Notes was not included in our diluted earnings per unit calculation for the three months ended March 31, 2010 and the effect of the 3.25% Exchangeable Notes was not included in our diluted earnings per unit calculation for the three months ended March 31, 2011 and 2010 since the average trading price of the Company’s common stock on the NYSE was below the Exchangeable Notes exchange price for these periods. Therefore these instruments were not considered to be in the money for the purposes of our diluted earnings per unit calculation for these periods (See Note 5).
 
13.   Subsequent Events
 
On April 15, 2011, aggregate dividends, distributions, and dividend equivalents of $19.2 million were paid to common stockholders and common unitholders of record on March 31, 2011 and RSU holders of record on April 15, 2011.
 
In April 2011, we completed the acquisition of four office buildings aggregating approximately 280,000 rentable square feet in Kirkland, Washington for a purchase price of approximately $100.1 million. The purchase price consisted of approximately $70.1 million in cash and the assumption of approximately $30.0 million in mortgage debt with an interest rate of 4.94% per year and a maturity date of April 15, 2015. We are currently in the process of completing the purchase price allocation for this acquisition.
 
In April 2011, the Company completed an underwritten public offering of 6,037,500 shares of its common stock. The net offering proceeds, after deducting underwriting discounts and commissions and offering expenses, were approximately $221.2 million. The Company used a portion of the net proceeds from the offering to finance the property acquisition discussed above and used the remaining net proceeds for general corporate purposes.


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ITEM 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 
The following discussion relates to our consolidated financial statements and should be read in conjunction with the financial statements and notes thereto appearing elsewhere in this report. The results of operations discussion is combined for the Company and the Operating Partnership because there are no material differences in the results of operations between the two reporting entities.
 
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, property development and redevelopment timing and costs, and investment amounts. Numerous factors could affect our actual results, some of which are beyond our control. These include the breadth and duration of the current slowness of economic growth and its impact on our tenants, the strength of commercial and industrial real estate markets, market conditions affecting tenants, our ability to complete and successfully integrate pending and recent acquisitions, competitive market conditions, interest rate levels, volatility in the trading prices of the Company’s securities, 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. We assume no obligation to update publicly any forward-looking information, whether as a result of new information, future events, or otherwise, except to the extent we are required to do so in connection with our ongoing requirements under federal securities laws to disclose material information. For a discussion of important risks related to our business, and related to investing in our securities, including risks that could cause actual results and events to differ materially from results and events referred to in the forward-looking information, see “Item 1A: Risk Factors” in the Company’s and the Operating Partnership’s annual report on Form 10-K for the year ended December 31, 2010, and the discussion under the captions “—Factors That May Influence Future Results of Operations,” “—Liquidity and Capital Resources of the Company,” and “—Liquidity and Capital Resources of the Operating Partnership” below. In light of these risks, uncertainties, and assumptions, the forward-looking events discussed in this report might not occur.
 
 
We are a self-administered REIT active in premier office and industrial submarkets along the West Coast. We own, develop, acquire and manage primarily Class A real estate assets in the coastal regions of Los Angeles, Orange County, San Diego, greater Seattle and the San Francisco Bay Area, which we believe have strategic advantages and strong barriers to entry. We own our interests in all of our properties through the Operating Partnership and the Finance Partnership, and conduct substantially all of our operations through the Operating Partnership. We owned a 96.8% general partnership interest in the Operating Partnership as of both March 31, 2011 and December 31, 2010, and a 96.2% interest as of March 31, 2010. All our properties are held in fee except for the seven office buildings located at Kilroy Airport Center in Long Beach, California, which are held subject to leases for the land that expire in 2084.
 
 
Acquisitions.  As a key component of our growth strategy, we continually evaluate selected property acquisition opportunities. During 2010 we acquired ten office buildings in eight transactions for approximately $697.8 million and in January 2011, we completed our third acquisition in San Francisco with the purchase of an office building located at 250 Brannan Street for approximately $33.0 million. In April 2011, we also completed the acquisition of four office buildings located at 10210, 10220, and 10230 NE Points Drive and 3933 Lake Washington Boulevard NE in Kirkland, Washington, which encompass an aggregate of approximately 280,000 rentable square feet, for approximately $100.1 million. We generally finance our acquisitions through debt and equity offerings and borrowings on our unsecured line of credit.
 
We consider potential acquisitions on an ongoing basis and may have one or more potential acquisitions under consideration at any point in time, which may be at varying stages of the negotiation and due diligence review process. Costs associated with acquisitions are expensed as incurred and as a result, such costs may be incurred in


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periods prior to closing. During the three months ended March 31, 2011, we incurred approximately $0.5 million of third-party acquisition costs and we anticipate that we will incur additional third-party acquisition costs throughout 2011 as we pursue other potential acquisitions. We also expense, as applicable, non-refundable deposits in connection with uncompleted acquisitions.
 
Leasing Activity and Changes in Rental Rates.  The amount of net rental income generated by our properties depends principally on our ability to maintain the occupancy rates of currently leased space and to lease currently available space, newly developed or redeveloped properties, newly acquired properties with vacant space, and space available from unscheduled lease terminations. The amount of rental income we generate also depends on our ability to maintain or increase rental rates in our submarkets. Negative trends in one or more of these factors could adversely affect our rental income in future periods. The following table sets forth certain information regarding leases that commenced during the three months ended March 31, 2011.
 
Lease Commencement Information
For Leases That Commenced During the Three Months Ended March 31, 2011
 
                                                                 
                            2nd Generation(1)  
    1st & 2nd Generation(1)                       Weighted
 
    Number of
    Rentable
          Changes
          Average
 
    Leases(2)     Square Feet(2)     Changes in
    in Cash
    Retention
    Lease Term
 
    New     Renewal     New     Renewal     Rents(3)     Rents(4)     Rates(5)     (in months)  
 
Office Properties
    15       10       167,909       73,956       (19.6 )%     (23.2 )%     65.3 %     61  
Industrial Properties
    2       1       84,789       36,971       0.0 %     0.0 %     86.0 %     87  
                                                                 
Total portfolio
    17       11       252,698       110,927       (18.6 )%     (22.1 )%     71.0 %     72  
                                                                 
 
 
(1) First generation leasing includes space where we have made capital expenditures that result in additional revenue generated when the space is re-leased. Second generation leasing includes space where we have made capital expenditures to maintain the current market revenue stream.
 
(2) Represents leasing activity for leases that commenced during the period, including first and second generation space, net of month-to-month leases.
 
(3) Calculated as the change between GAAP rents for new/renewed leases and the expiring GAAP rents for the same space. Excludes leases for which the space was vacant longer than one year, or vacant when the property was acquired.
 
(4) Calculated as the change between stated rents for new/renewed leases and the expiring stated rents for the same space. Excludes leases for which the space was vacant longer than one year, or vacant when the property was acquired.
 
(5) Calculated as the percentage of space either renewed or expanded into by existing tenants or subtenants at lease expiration.
 
The changes in rents and changes in cash rents reported above exclude leases of approximately 230,100 rentable square feet for the three months ended March 31, 2011, for which the space was vacant longer than one year or we are leasing the space for the first time. We exclude space vacant for more than one year in our change in rents calculations to provide a meaningful market comparison.
 
During the first quarter of 2011, we executed 28 leases for an aggregate of approximately 356,000 rentable square feet. The weighted average change in rents as compared to the expiring rents for the same space for these new leases was a 12.1% decrease in GAAP rents and a 17.4% decrease in cash rents, excluding leases for which the space was vacant longer than one year. As of March 31, 2011, we believe that the weighted average cash rental rates for our overall portfolio, including recently acquired properties, are approximately 10% above the current average market rental rates, although individual properties within any particular submarket presently may be leased either above, below, or at the current market rates within that submarket, and the average rental rates for individual submarkets may be above, below, or at the average cash rental rate of our portfolio.
 
In general, rental rates have stabilized in many of our submarkets over the last two quarters. Our rental rates and occupancy are impacted by general economic conditions, including the pace of regional economic growth and access to capital. Therefore, we 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 market rates. Additionally, decreased demand and other negative trends or unforeseeable events that impair our ability to timely renew or re-lease space could have further negative effects on our future financial condition, results of operations, and cash flows.


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Scheduled Lease Expirations.  The following table sets forth certain information regarding our lease expirations for the remainder of 2011 and the next five years.
 
 
                                                 
                            Percentage of
       
          Net Rentable
    Percentage of
          Annualized
    Average Annualized
 
          Area
    Leased
    Annualized Base
    Base Rental
    Base Rental
 
          Subject
    Square Feet
    Rental Revenue
    Revenue
    Revenue Per
 
    Number of
    to Expiring
    Represented by
    Under
    Represented
    Square Foot Under
 
    Expiring
    Leases
    Expiring
    Expiring Leases
    by Expiring
    Expiring Leases
 
Year of Lease Expiration   Leases     (Sq. Ft.)     Leases     (000’s)(2)     Leases(2)     (000’s)(2)  
 
Office Properties:
                                               
Remainder of 2011
    54       511,795       4.1 %   $ 10,287       3.4 %   $ 20.10  
2012
    73       790,139       6.3 %     22,240       7.3 %     28.15  
2013
    73       934,485       7.4 %     26,324       8.6 %     28.17  
2014
    62       1,181,423       9.4 %     31,225       10.2 %     26.43  
2015
    88       1,516,705       12.1 %     50,023       16.4 %     32.98  
2016
    35       468,656       3.7 %     11,418       3.7 %     24.36  
                                                 
Total Office
    385       5,403,203       43.0 %     151,517       49.6 %   $ 28.04  
                                                 
Industrial Properties:
                                               
Remainder of 2011
    1       78,605       0.6 %     733       0.2 %   $ 9.33  
2012
    11       452,557       3.6 %     2,647       0.9 %     5.85  
2013
    9       628,386       5.0 %     4,671       1.5 %     7.43  
2014
    16       557,386       4.4 %     4,482       1.5 %     8.04  
2015
    10       544,864       4.3 %     3,839       1.3 %     7.05  
2016
    5       317,198       2.5 %     3,687       1.2 %     11.62  
                                                 
Total Industrial
    52       2,578,996       20.4 %     20,059       6.6 %   $ 7.78  
                                                 
Total
    437       7,982,199       63.4 %   $ 171,576       56.2 %   $ 21.49  
                                                 
 
 
(1) The information presented reflects leasing activity through March 31, 2011. For leases that have been renewed early or space that has been re-leased to a new tenant, the expiration date and annualized base rent information presented takes into consideration the renewed or re-leased lease terms. Excludes space leased under month-to-month leases and vacant space as of March 31, 2011.
 
(2) Reflects annualized contractual base rent calculated on a straight-line basis in accordance with GAAP excluding the amortization of deferred revenue related to tenant-funded tenant improvements and expense reimbursement revenue. Additionally, the underlying leases contain various expense structures including full service gross, modified gross and triple net. Amounts represent percentage of total portfolio annualized contractual base rental revenue.
 
In addition to the 1.3 million rentable square feet, or 9.2%, of currently available space in our stabilized portfolio, leases representing approximately 4.7% and 9.9% of the occupied square footage of our stabilized portfolio are scheduled to expire during the remainder of 2011 and in 2012, respectively. The leases scheduled to expire during the remainder of 2011 and in 2012 represent approximately 1.3 million rentable square feet of office space, or 10.7% of our total annualized base rental revenue, and 0.5 million rentable square feet of industrial space, or 1.1% of our total annualized base rental revenue, respectively. We believe that the weighted average cash rental rates are approximately 10% to 15% above the current average quoted market rates for leases scheduled to expire during the remainder of 2011 and 2012, although individual properties within any particular submarket presently may be leased either above, below, or at the current quoted market rates within that submarket, and the average rental rates for individual submarkets may be above, below, or at the average cash rental rate of our overall portfolio. Our ability to re-lease available space depends upon both general market conditions and the market conditions in the specific regions in which individual properties are located.
 
Development and Redevelopment Programs.  We believe that a portion of our long-term future potential growth will continue to come from our development pipeline and redevelopment opportunities within our existing portfolio. Redevelopment opportunities are those projects in which we spend significant development and construction costs on existing buildings pursuant to a formal plan, the result of which is a higher economic return on the property. In recent periods we have delayed the timing and reduced the scope of our development program, which impacts the average development and redevelopment asset balances qualifying for interest and


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other carry cost capitalization. During the first quarter of 2011, we did not capitalize interest on six of our seven development pipeline properties with an aggregate cost basis of approximately $155.1 million, as it was determined these projects did not qualify for interest and other carry cost capitalization under GAAP. As of March 31, 2011, our development pipeline included 116.7 gross acres of land with an aggregate cost basis of approximately $269.2 million. While in recent periods we have delayed the timing and reduced the scope of our development program activity as a result of economic conditions in our submarkets, we continue to proactively evaluate development and redevelopment opportunities throughout the West Coast.
 
In the third quarter of 2010 we commenced the redevelopment of one of our buildings in the El Segundo submarket of Los Angeles County which encompasses approximately 300,000 rentable square feet. We are currently upgrading and modernizing the building and adjacent common areas since it was previously occupied by the Boeing Company and its predecessors for more than 25 years. The redevelopment project has a total estimated investment of approximately $50 million and is currently expected to be completed in the third quarter of 2011.
 
Over the next two years, we also plan to continue to evaluate redevelopment opportunities for certain other of our properties, which have been occupied by long-term tenants and require significant capital expenditures to upgrade and modernize the buildings. In addition, we plan to continue to focus on enhancing the entitlements for our existing development land pipeline, and performing additional activities to prepare for the time when development will again be economically attractive.
 
Incentive Compensation.  Our Executive Compensation Committee determines compensation, including equity and cash incentive programs, for our executive officers. The programs approved by the Executive Compensation Committee have historically provided for equity and cash compensation to be earned by our executive officers based on certain performance measures, including financial, operating, and development targets. Incentive compensation for our executive officers for 2011 has been structured to allow the Executive Compensation Committee to evaluate a variety of key factors and metrics at the end of the year and make a determination of incentive compensation for executive officers based on the Company and management’s overall performance. As a result, accrued incentive compensation and compensation expense for future incentive compensation awards will be affected by our operating and development performance, financial results, the performance of the trading price of the Company’s common stock, and market conditions. Consequently, we cannot predict the amounts that will be recorded in future periods related to such incentive compensation.
 
Share-Based Compensation.  As of March 31, 2011, there was $8.0 million of total unrecognized compensation cost related to outstanding nonvested shares of restricted common stock and nonvested RSUs issued under share-based compensation arrangements. That cost is expected to be recognized over a weighted-average period of 1.7 years. The $8.0 million of unrecognized compensation cost does not reflect the future compensation cost for any potential share-based awards that may be issued based on the Company’s and management’s performance in 2011. Share-based compensation expense for future incentive compensation awards will be affected by our operating and development performance, financial results, the performance of the trading price of the Company’s common stock, and market conditions. Consequently, we cannot predict the amounts that will be recorded in future periods for such share-based awards. See Note 8 to our consolidated financial statements included in this report for additional information regarding our share-based incentive compensation plan.


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The following table reconciles the changes in the rentable square feet in our stabilized portfolio of operating properties from March 31, 2010 to March 31, 2011:
 
                                                 
    Office Properties     Industrial Properties     Total  
    Number of
    Rentable
    Number of
    Rentable
    Number of
    Rentable
 
    Buildings     Square Feet     Buildings     Square Feet     Buildings     Square Feet  
 
Total as of March 31, 2010
    94       8,797,261       41       3,654,463       135       12,451,724  
Acquisitions
    10       2,078,011                       10       2,078,011  
Property moved to the redevelopment portfolio
    (1 )     (286,151 )                     (1 )     (286,151 )
Dispositions
    (2 )     (106,791 )     (1 )     (51,567 )     (3 )     (158,358 )
Remeasurement
            3,620               2,511             6,131  
                                                 
Total as of March 31, 2011
    101       10,485,950       40       3,605,407       141       14,091,357  
                                                 
 
 
The following table sets forth certain information regarding our stabilized portfolio:
 
Stabilized Portfolio Occupancy
 
                                         
    Number of
    Square Feet
    Occupancy at(1)  
Region   Buildings     Total     3/31/2011     12/31/2010     9/30/2010  
 
Office Properties:
                                       
Los Angeles and Ventura Counties
    29       3,065,626       90.7 %     89.3 %     89.6 %
San Diego
    63       5,466,298       87.8       86.4       82.2  
Orange County
    5       540,656       93.9       93.1       78.7  
San Francisco
    3       1,291,267       87.0       84.3       89.4  
Greater Seattle
    1       122,103       100.0       100.0        
                                         
      101       10,485,950       89.0       87.5       84.8  
                                         
Industrial Properties:
                                       
Los Angeles County
    1       192,053       100.0       100.0       100.0  
Orange County
    39       3,413,354       95.6       93.5       90.0  
                                         
      40       3,605,407       95.9       93.9       90.6  
                                         
Total Stabilized Portfolio
    141       14,091,357       90.8 %     89.1 %     86.4 %
                                         
 
                                 
    Average Occupancy for
    Three Months Ended
    March 31,
    Stabilized
  Core
    Portfolio(1)   Portfolio(2)
    2011   2010   2011   2010
 
Office Properties
    88.8 %     80.9 %     88.9 %     81.3 %
Industrial Properties
    94.5 %     85.2 %     94.5 %     85.0 %
Total Portfolio
    90.2 %     82.2 %     90.6 %     82.4 %
 
 
(1) Occupancy percentages reported are based on our stabilized portfolio as of the end of the period presented.
 
(2) Occupancy percentages reported are based on Office Properties and Industrial Properties owned and stabilized as of January 1, 2010 and still owned and stabilized as of March 31, 2011.
 
As of March 31, 2011, the Office Properties and Industrial Properties represented approximately 91.6% and 8.4%, respectively, of our total annualized base rental revenue and approximately 93.5% and 6.5%, respectively, of our total net operating income, as defined.


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Although real estate fundamentals continue to be challenging in many of our regional submarkets, we have started to see a general increase in occupancy across our portfolio, and we have generally seen a modest decrease in vacancy rates across many of our regional submarkets as well as a stabilization in rental rates and lease concession packages.
 
Los Angeles and Ventura Counties.  Our Los Angeles and Ventura Counties stabilized office portfolio of 3.1 million rentable square feet was 90.7% occupied with approximately 283,800 available rentable square feet as of March 31, 2011 compared to 89.3% occupied with approximately 328,800 available rentable square feet as of December 31, 2010.
 
As of March 31, 2011, an aggregate of approximately 424,800 and 188,500 rentable square feet are scheduled to expire in this region during the remainder of 2011 and 2012, respectively. The aggregate rentable square feet scheduled to expire in this region during the remainder of 2011 and 2012 represents approximately 4.9% of our occupied rentable square feet and 4.5% of our annualized base rental revenues in our total stabilized portfolio. Approximately 205,000 rentable square feet of the 424,800 rentable square feet that are scheduled to expire during the remainder of 2011 is related to a lease with one tenant in buildings along the 101-Corridor in Ventura County. The tenant is scheduled to vacate the properties upon expiration of the lease. Furthermore, as of the date of this report, we have leased approximately 70,000 rentable square feet in this region that was vacant at March 31, 2011. The new leases are scheduled to commence during the remainder of 2011.
 
San Diego County.  Our San Diego County stabilized office portfolio of 5.5 million rentable square feet was 87.8% occupied with approximately 666,100 available rentable square feet as of March 31, 2011 compared to 86.4% occupied with approximately 744,300 available rentable square feet as of December 31, 2010. As of the date of this report, we have leased approximately 155,800 rentable square feet in this region that was available at March 31, 2011. The new leases are scheduled to commence during the remainder of 2011.
 
As of March 31, 2011, leases representing an aggregate of approximately 42,300 and 463,200 rentable square feet are scheduled to expire during the remainder of 2011 and 2012, respectively, in this region. The aggregate rentable square feet scheduled to expire in this region during the remainder of 2011 and 2012 represents approximately 4.0% of our occupied rentable square feet and 4.4% of our annualized base rental revenues in our total stabilized portfolio.
 
Orange County.  As of March 31, 2011, our Orange County stabilized industrial portfolio was 95.6% occupied with approximately 148,800 available rentable square feet compared to 93.5% occupied with approximately 220,100 available rentable square feet as of December 31, 2010.
 
Our Orange County stabilized office portfolio of approximately 540,700 rentable square feet was 93.9% occupied with approximately 33,100 available rentable square feet as of March 31, 2011 compared to 93.1% occupied with approximately 37,300 available rentable square feet as of December 31, 2010.
 
As of March 31, 2011, leases representing an aggregate of approximately 99,100 and 510,700 rentable square feet are scheduled to expire during the remainder of 2011 and 2012, respectively, in this region. The aggregate rentable square feet scheduled to expire during the remainder of 2011 and 2012 represents approximately 4.9% of our occupied rentable square feet and 1.7% of our annualized base rental revenues in our total stabilized portfolio. Of the 609,800 rentable square feet scheduled to expire during the remainder of 2011 and 2012, approximately 531,200 rentable square feet is industrial space. As of the date of this report, we have leased approximately 133,100 rentable square feet of the 181,900 rentable square feet that was available in this region as of March 31, 2011. The new leases are expected to commence during the remainder of 2011.
 
San Francisco.  As of March 31, 2011, our San Francisco stabilized office portfolio was 87.0% occupied with approximately 167,900 available rentable square feet as of March 31, 2011 compared to 84.3% occupied with approximately 188,900 available rentable square feet as of December 31, 2010. The increase in the San Francisco stabilized office portfolio occupancy is primarily attributable to the commencement of a lease with approximately 36,600 rentable square feet during the first quarter of 2011. Furthermore, we acquired an office building encompassing approximately 90,700 rentable square feet in this region in the first quarter of 2011, which was 76.7% occupied as of March 31, 2011.


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As of March 31, 2011, leases representing an aggregate of approximately 24,200 and 80,300 rentable square feet are scheduled to expire during the remainder of 2011 and 2012. As of the date of this report, we have leased approximately 101,200 rentable square feet in this region that was available at March 31, 2011. The new leases are scheduled to commence during the second and third quarters of 2011. The aggregate rentable square feet scheduled to expire in this region during the remainder of 2011 and 2012 represents approximately 0.8% of our occupied rentable square feet and less than 1.1% of our annualized base rental revenues in our total stabilized portfolio.
 
Greater Seattle.  As of March 31, 2011, our Greater Seattle stabilized office portfolio consists of one office building in Redmond, Washington, encompassing approximately 122,100 rentable square feet. The building was 100.0% occupied as of March 31, 2011 to a single tenant and the lease expires in 2015.
 
 
Management internally evaluates the operating performance and financial results of our portfolio based on Net Operating Income for the consolidated portfolio. We define “Net Operating Income” as operating revenues (rental income, tenant reimbursements, and other property income) less operating expenses (property expenses, real estate taxes, provision for bad debts, and ground leases). The Net Operating Income information presented within this Management’s Discussion and Analysis of Financial Condition and Results of Operations is the same Net Operating Income information disclosed in our segment information in Note 10 to our consolidated financial statements.
 
Comparison of the Three Months Ended March 31, 2011 to the Three Months Ended March 31, 2010
 
The following table reconciles our Net Operating Income, as defined to our net income for the three months ended March 31, 2011 and 2010.
 
                                 
    Three Months Ended March 31,     Dollar
    Percentage
 
    2011     2010     Change     Change  
    ($ in thousands)  
 
Net Operating Income, as defined
  $ 61,902     $ 48,795     $ 13,107       26.9 %
Unallocated (expense) income:
                               
General and administrative expenses
    (6,560 )     (7,095 )     535       (7.5 )
Acquisition-related expenses
    (472 )     (313 )     (159 )     50.8  
Depreciation and amortization
    (29,311 )     (20,938 )     (8,373 )     40.0  
Interest income and other net investment gains
    184       384       (200 )     (52.1 )
Interest expense
    (20,876 )     (11,956 )     (8,920 )     74.6  
                                 
Net income
  $ 4,867     $ 8,877     $ (4,010 )     (45.2 )%
                                 


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The following table compares the Net Operating Income, as defined, for our total portfolio for the three months ended March 31, 2011 and 2010.
 
                                                                 
    Total Portfolio     Core Portfolio(1)  
                Dollar
    Percentage
                Dollar
    Percentage
 
    2011     2010     Change     Change     2011     2010     Change     Change  
    ($ in thousands)     ($ in thousands)  
 
Operating revenues:
                                                               
Rental income
  $ 80,290     $ 60,656     $ 19,634       32.4 %   $ 62,414     $ 59,056     $ 3,358       5.7 %
Tenant reimbursements
    6,422       5,718       704       12.3       5,419       5,315       104       2.0  
Other property income
    1,413       445       968       217.5       1,359       445       914       205.4  
                                                                 
Total
    88,125       66,819       21,306       31.9       69,192       64,816       4,376       6.8  
                                                                 
Property and related expenses:
                                                               
Property expenses
    17,689       12,020       5,669       47.2       13,057       11,404       1,653       14.5  
Real estate taxes
    8,169       6,036       2,133       35.3       5,856       5,640       216       3.8  
Provision for bad debts
    26       26                   26       26              
Ground leases
    339       (58 )     397       684.5       335       (61 )     396       649.2  
                                                                 
Total
    26,223       18,024       8,199       45.5       19,274       17,009       2,265       13.3  
                                                                 
Net Operating Income, as defined
  $ 61,902     $ 48,795     $ 13,107       26.9 %   $ 49,918     $ 47,807     $ 2,111       4.4 %
                                                                 
 
 
(1) Properties owned and stabilized as of January 1, 2010 and still owned and stabilized as of March 31, 2011.
 
 
Rental income increased $19.6 million, or 32.4%, for the three months ended March 31, 2011 compared to the three months ended March 31, 2010 primarily resulting from:
 
  •   An increase of $17.7 million generated by ten office buildings we acquired during 2010 and one office building we acquired in the first quarter of 2011 (the “Acquisition Properties”);
 
  •   An increase of $3.4 million primarily as a result of an increase in average occupancy for the properties owned and stabilized as of January 1, 2010 and still owned and stabilized as of March 31, 2011 (the “Core Portfolio”). Average occupancy increased 8.2%, from 82.4% for the three months ended March 31, 2010, to 90.6% for the three months ended March 31, 2011; and
 
  •   An offsetting decrease of $1.4 million generated by one office building that was moved from the stabilized portfolio to the redevelopment portfolio during the third quarter of 2010 upon the expiration of the lease for that building (the “Redevelopment Property”).
 
 
Tenant reimbursements increased $0.7 million, or 12.3%, for the three months ended March 31, 2011 compared to the three months ended March 31, 2010 resulting from:
 
  •   An increase of $1.0 million generated by the Acquisition Properties;
 
  •   An increase of $0.1 million as a result of an increase in the Core Portfolio’s average occupancy, as discussed above under the caption “—Rental Income”; and
 
  •   An offsetting decrease of $0.4 million generated by the Redevelopment Property.


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Other property income increased $1.0 million, or 217.5%, for the three months ended March 31, 2011 compared to the three months ended March 31, 2010. Other property income for both periods consisted primarily of lease termination fees and other miscellaneous income within the Core Portfolio.
 
 
Property expenses increased $5.7 million, or 47.2%, for the three months ended March 31, 2011 compared to the three months ended March 31, 2010 primarily resulting from:
 
  •   An increase of $4.3 million generated by the Acquisition Properties; and
 
  •   An increase of $1.7 million generated by the Core Portfolio primarily resulting from:
 
  •   An increase of $1.5 million attributable to an increase in legal fees and consulting costs primarily related to a dispute with a former tenant at one of our industrial buildings; and
 
  •   An increase of $0.3 million attributable to an increase in certain recurring operating costs such as utilities, property management expenses, janitorial and other service-related costs partially as a result of an increase in average occupancy, as discussed above under the caption “—Rental Income.”
 
 
Real estate taxes increased $2.1 million, or 35.3%, for the three months ended March 31, 2011 compared to the three months ended March 31, 2010 primarily attributable to the Acquisition Properties.
 
 
Ground leases increased $0.4 million, or 684.5%, for the three months ended March 31, 2011 compared to the three months ended March 31, 2010 primarily as a result of a ground rent expense adjustment in 2010 for our Kilroy Airport Center, Long Beach project. We were successful in negotiating a lower rental rate under the terms of the ground lease retroactive to January 1, 2006 which resulted in a lower ground rent expense for the three months ended March 31, 2010. The current period expense represents the expected ground rent expense for future periods.
 
 
Net Operating Income increased $13.1 million, or 26.9%, for the three months ended March 31, 2011 compared to the three months ended March 31, 2010 for the reasons stated above.
 
Other Expenses and Income
 
Depreciation and Amortization
 
Depreciation and amortization increased by $8.4 million, or 40.0%, for the three months ended March 31, 2011 compared to the three months ended March 31, 2010, primarily related to the Acquisition Properties.
 
 
The following table sets forth our gross interest expense, including debt discounts and loan cost amortization, net of capit