UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
For the quarterly period ended September 30, 2003
OR
For the transition period from to
Commission file number 1-12675
KILROY REALTY CORPORATION
(Exact name of registrant as specified in its charter)
12200 W. Olympic Boulevard, Suite 200, Los Angeles, California 90064
(Address of principal executive offices)
(310) 481-8400
(Registrant’s telephone number, including area code)
N/A
(Former name, former address and former fiscal year, if changed since last report)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes x No ¨
As of November 3, 2003, 28,048,827 shares of common stock, par value $.01 per share, were outstanding.
QUARTERLY REPORT FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2003
TABLE OF CONTENTS
Item 1.
Consolidated Statements of Operations for the Three and Nine Months Ended September 30, 2003 and 2002
Consolidated Statement of Stockholders’ Equity for the Nine Months Ended September 30, 2003
Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2003 and 2002
Item 2.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Item 3.
Item 4.
Item 5.
Item 6.
SIGNATURES
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PART I—FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
CONSOLIDATED BALANCE SHEETS
(unaudited, in thousands, except share data)
ASSETS
INVESTMENT IN REAL ESTATE (Notes 2 and 3):
Land and improvements
Buildings and improvements, net
Undeveloped land and construction in progress, net
Total investment in real estate
Accumulated depreciation and amortization
Investment in real estate, net
CASH AND CASH EQUIVALENTS
RESTRICTED CASH
CURRENT RECEIVABLES, NET
DEFERRED RENT RECEIVABLES, NET
DEFERRED LEASING COSTS, NET
DEFERRED FINANCING COSTS, NET (Note 5)
PREPAID EXPENSES AND OTHER ASSETS
TOTAL ASSETS
LIABILITIES AND STOCKHOLDERS’ EQUITY
LIABILITIES:
Secured debt (Note 4)
Unsecured line of credit (Note 4)
Accounts payable, accrued expenses and other liabilities (Note 5)
Accrued distributions (Note 13)
Rents received in advance, tenant security deposits and deferred revenue
Total liabilities
COMMITMENTS AND CONTINGENCIES (Note 8)
MINORITY INTERESTS (Note 6):
8.075% Series A Cumulative Redeemable Preferred unitholders
9.375% Series C Cumulative Redeemable Preferred unitholders
9.250% Series D Cumulative Redeemable Preferred unitholders
Common unitholders of the Operating Partnership
Total minority interests
STOCKHOLDERS’ EQUITY (Note 7):
Preferred stock, $.01 par value, 26,200,000 shares authorized, none issued and outstanding
8.075% Series A Cumulative Redeemable Preferred stock, $.01 par value, 1,700,000 shares authorized, none issued and outstanding
Series B Junior Participating Preferred stock, $.01 par value, 400,000 shares authorized, none issued and outstanding
9.375% Series C Cumulative Redeemable Preferred stock, $.01 par value, 700,000 shares authorized, none issued and outstanding
9.250% Series D Cumulative Redeemable Preferred stock, $.01 par value, 1,000,000 shares authorized, none issued and outstanding
Common stock, $.01 par value, 150,000,000 shares authorized, 28,028,827 and 27,419,880 shares issued and outstanding, respectively
Additional paid-in capital
Distributions in excess of earnings
Accumulated net other comprehensive loss (Note 5)
Total stockholders’ equity
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY
See accompanying notes to consolidated financial statements.
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CONSOLIDATED STATEMENTS OF OPERATIONS
(unaudited, in thousands, except share and per share data)
REVENUES (Note 10):
Rental income
Tenant reimbursements
Other property income (Note 9)
Total revenues
EXPENSES (Note 10):
Property expenses
Real estate taxes
Provision for bad debts (Notes 1 and 9)
Ground leases
General and administrative expenses (Note 9)
Interest expense
Depreciation and amortization
Total expenses
OTHER INCOME
Interest income
Total other income
INCOME FROM CONTINUING OPERATIONS BEFORE NET GAIN ON DISPOSITIONS AND MINORITY INTERESTS
Net gain on dispositions of operating properties
INCOME FROM CONTINUING OPERATIONS BEFORE MINORITY INTERESTS
MINORITY INTERESTS:
Distributions on Cumulative Redeemable Preferred units
Minority interest in earnings of Operating Partnership attributable to continuing operations
Recognition of previously reserved Development LLC preferred return
Minority interest in earnings of Development LLCs
INCOME FROM CONTINUING OPERATIONS
DISCONTINUED OPERATIONS (Note 11)
Revenues from discontinued operations
Expenses from discontinued operations
Net (loss) gain on disposition of discontinued operations
Minority interest in loss (earnings) of Operating Partnership attributable to discontinued operations
Total (loss) income from discontinued operations
NET INCOME
Income from continuing operations per common share—basic (Note 12)
Income from continuing operations per common share—diluted (Note 12)
Net income per common share—basic (Note 12)
Net income per common share—diluted (Note 12)
Weighted average shares outstanding—basic (Note 12)
Weighted average shares outstanding—diluted (Note 12)
Dividends declared per common share
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CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY
(unaudited in thousands, except share and per share data)
BALANCE AT DECEMBER 31, 2002
Net income
Net other comprehensive loss
Comprehensive income
Issuance of restricted stock (Note 7)
Exercise of stock options
Non-cash amortization of restricted stock grants
Repurchase of common stock (Note 7)
Conversion of common limited partnership units of the Operating Partnership (Note 6)
Stock option expense (Note 1)
Adjustment for minority interest (Note 1)
Dividends declared ($1.485 per share)
BALANCE AT SEPTEMBER 30, 2003
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CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited, in thousands)
CASH FLOWS FROM OPERATING ACTIVITIES:
Adjustments to reconcile net income to net cash provided by operating activities (including discontinued operations):
Depreciation and amortization of buildings and improvements and leasing costs
Minority interest in earnings of Operating Partnership
Non-cash amortization of deferred financing costs
Increase in provision for uncollectible tenant receivables
(Decrease) increase in provision for uncollectible unbilled deferred rent (Note 9)
Minority interests in earnings of Development LLCs
Depreciation of furniture, fixtures and equipment
Net gain on disposition of operating properties
Other
Changes in assets and liabilities:
Current receivables
Deferred rent receivables
Deferred leasing costs
Prepaid expenses and other assets
Accounts payable, accrued expenses and other liabilities
Net cash provided by operating activities
CASH FLOWS FROM INVESTING ACTIVITIES:
Expenditures for operating properties
Expenditures for undeveloped land and construction in progress
Net proceeds received from dispositions of operating properties
Acquisition of operating property
Acquisition of minority interest in Development LLCs
Net cash used in investing activities
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from borrowings or issuance of secured debt
Net (repayments) borrowings on secured line of credit
Principal payments on secured debt and unsecured term facility
Distributions paid to common stockholders and common unitholders
Increase in restricted cash
Financing costs
Proceeds from exercise of stock options
Net distributions to minority interests in Development LLCs
Net cash (used in) provided by financing activities
Net increase (decrease) in cash and cash equivalents
Cash and cash equivalents, beginning of period
Cash and cash equivalents, end of period
SUPPLEMENTAL CASH FLOW INFORMATION:
Cash paid for interest, net of capitalized interest
Distributions paid to Cumulative Redeemable Preferred unitholders
NON-CASH TRANSACTIONS:
Accrual of distributions payable (Note 13)
Issuance of common limited partnership units of the Operating Partnership to acquire minority interest in Development LLCs
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Nine Months Ended September 30, 2003 and 2002
(unaudited)
1. Organization and Basis of Presentation
Organization
Kilroy Realty Corporation (the “Company”) owns, operates and develops office and industrial real estate, primarily in Southern California. The Company operates as a self-administered real estate investment trust (“REIT”). As of September 30, 2003, the Company’s stabilized portfolio of operating properties consisted of 82 office buildings (the “Office Properties”) and 50 industrial buildings (the “Industrial Properties”), which encompassed an aggregate of approximately 7.3 million and 4.9 million rentable square feet, respectively, and was 89.8% occupied. The Company’s stabilized portfolio of operating properties consists of all of the Company’s Office Properties and Industrial Properties and excludes properties currently under construction or “lease-up” properties.
The Company defines “lease-up” properties as properties recently developed or redeveloped by the Company that have not yet reached 95% occupancy and are within one year following substantial completion. Lease-up properties are reclassified to land and improvements and building and improvements from construction in progress on the consolidated balance sheets upon building shell completion. As of September 30, 2003, the Company had one development office property encompassing approximately 209,000 rentable square feet which was in the lease-up phase. In addition, as of September 30, 2003, the Company had two redevelopment office properties under construction, which when completed are expected to encompass an aggregate of approximately 316,000 rentable square feet.
The Company owns its interests in all of its properties through Kilroy Realty, L.P. (the “Operating Partnership”) and Kilroy Realty Finance Partnership, L.P. (the “Finance Partnership”) and conducts substantially all of its operations through the Operating Partnership. The Company owned an 86.9% general partnership interest in the Operating Partnership as of September 30, 2003. Unless otherwise indicated, all references to the Company include the Operating Partnership, the Finance Partnership and all wholly-owned subsidiaries and controlled entities of the Company.
In 1999, the Company, through the Operating Partnership, became a 50% managing member in two limited liability companies (the “Development LLCs”), which were formed to develop two multi-phased office projects in San Diego, California. The Allen Group, a group of affiliated real estate development and investment companies based in San Diego, California, was the other 50% member of the Development LLCs. On March 25, 2002, the Company acquired The Allen Group’s interest in the assets and assumed The Allen Group’s proportionate share of the liabilities of the Development LLCs. Subsequent to this transaction, the Development LLCs were liquidated and dissolved. The Development LLCs were consolidated for financial reporting purposes prior to their dissolution on March 25, 2002, since the Company controlled all significant development and operating decisions.
Basis of Presentation
The consolidated financial statements of the Company include all entities for which the Company has a controlling financial interest as measured by a majority of the voting interest. All significant intercompany balances and transactions have been eliminated in the consolidated financial statements.
Net income is allocated to the common limited partners of the Operating Partnership (“Minority Interest of the Operating Partnership”) based on their ownership percentage of the Operating Partnership. The ownership percentage is determined by dividing the number of common limited partnership units held by the Minority
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
Interest of the Operating Partnership by the total common limited partnership units outstanding. The issuance of additional shares of common stock or common limited partnership units results in changes to the Minority Interest of the Operating Partnership percentage as well as the total net assets of the Company. As a result, all capital transactions result in an allocation between the stockholders’ equity and Minority Interest of the Operating Partnership in the accompanying consolidated balance sheets to account for the change in the Minority Interest of the Operating Partnership ownership percentage as well as the change in total net assets of the Company.
The accompanying interim financial statements have been prepared by the Company’s management in accordance with accounting principles generally accepted in the United States of America (“GAAP”) and in conjunction with the rules and regulations of the Securities and Exchange Commission (“SEC”). Certain information and footnote disclosures required for annual financial statements have been condensed or excluded pursuant to SEC rules and regulations. Accordingly, the interim financial statements do not include all of the information and footnotes required by GAAP for complete financial statements. In the opinion of management, the accompanying interim financial statements reflect all adjustments of a normal and recurring nature which are considered necessary for a fair presentation of the results for the interim periods presented. The results of operations for the interim periods are not necessarily indicative of the results that may be expected for the year ended December 31, 2003. These financial statements should be read in conjunction with the audited consolidated financial statements and the notes thereto included in the Company’s annual report on Form 10-K for the year ended December 31, 2002.
Reclassifications
In reporting periods prior to June 30, 2003, the provision for bad debts was netted against rental income in the Company’s consolidated statements of operations. For the periods subsequent to June 30, 2003, the provision is separately classified under expenses in the consolidated statements of operations. Prior year amounts have been reclassified to conform to current periods’ presentation.
Recent Accounting Pronouncements
On January 1, 2003, the Company adopted the provisions of SFAS 145, Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections (“SFAS 145”). The most significant provisions of this statement relate to the rescission of Statement No. 4 “Reporting Gains and Losses from Extinguishment of Debt.” SFAS 145 also amends other existing authoritative pronouncements to make various technical corrections, clarify meanings or describe their applicability under changed conditions. Under SFAS 145, any gain or loss on extinguishment of debt that was classified as an extraordinary item in prior periods presented that does not meet certain defined criteria must be reclassified. The adoption of this statement did not have a material effect on the Company’s results of operations or financial condition.
On January 1, 2003, the Company adopted the provisions of SFAS 146, “Accounting for Costs Associated with Exit or Disposal Activities” (“SFAS 146”). SFAS 146 addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies Emerging Issues Task Force Issue No. 94-3 “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity”. SFAS 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred. The adoption of this statement did not have a material effect on the Company’s results of operations or financial condition.
On January 1, 2003, the Company adopted the initial recognition and measurement provisions of Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others” (“FIN 45”). FIN 45 significantly changes the current practice in the
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accounting for, and disclosure of, guarantees. Guarantees and indemnification agreements meeting the characteristics described in FIN 45 are required to be initially recorded as a liability at fair value. FIN 45 also requires a guarantor to make significant new disclosures for virtually all guarantees even if the likelihood of the guarantor having to make payment under the guarantee is remote. The Company adopted the disclosure provisions of FIN 45 as of December 31, 2002. The adoption of the provisions of this interpretation did not have a material effect on the Company’s results of operations or financial condition.
In January 2003, the FASB issued FASB Interpretation No. 46, “Consolidation of Variable Interest Entities” (“FIN 46”). FIN 46 clarifies the application of Accounting Research Bulletin No. 51, “Consolidated Financial Statements” and provides guidance on the identification of entities for which control is achieved through means other than voting rights (“variable interest entities” or “VIEs”) and how to determine when and which business enterprise should consolidate the VIE. This new model for consolidation applies to an entity in which either: (1) the equity investors (if any) lack one or more characteristics deemed essential to a controlling financial interest or (2) the equity investment at risk is insufficient to finance that entity’s activities without receiving additional subordinated financial support from other parties. The provisions of this interpretation are applicable to VIEs formed after January 31, 2003. For VIEs formed prior to January 31, 2003, the provisions of this interpretation apply to the first fiscal year or interim period beginning after December 15, 2003. On February 1, 2003, the Company adopted the provisions of this interpretation, which did not have a material effect on the Company’s results of operations or financial condition.
In April 2003, the FASB issued SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities” (“SFAS 149”). SFAS 149 amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments imbedded in other contracts and for hedging activities under SFAS No. 133 “Accounting for Derivative Instruments and Hedging Activities.” The provisions of SFAS 149 are generally effective for contracts entered into or modified after June 30, 2003 and for hedging relationships designated after June 30, 2003. The adoption of this statement did not have a material effect on the Company’s results of operations or financial condition.
In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity” (“SFAS 150”). SFAS 150 establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. The statement is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. The adoption of this statement did not have a material effect on the Company’s results of operations or financial condition.
On July 31, 2003, the SEC issued a clarification of Emerging Issues Task Force Topic D-42, “The Effect on the Calculation of Earnings per Share for the Redemption or Induced Conversion of Preferred Stock” (“Topic D-42”). Topic D-42 provides, among other things, that any excess of the fair value of the consideration transferred to the holders of preferred stock redeemed over the carrying amount of the preferred stock should be subtracted from net earnings to determine net earnings available to common stockholders in the calculation of earnings per share. The SEC’s clarification of the guidance in Topic D-42 provides that the carrying amount of the preferred stock should be reduced by the related issuance costs.
The July 2003 clarification of Topic D-42 is effective for the Company beginning with the quarter ending September 30, 2003. The Company intends to redeem all of the outstanding 9.375% Series C Cumulative Redeemable Preferred Units (“Series C Preferred Units”) in November 2003 with the net proceeds from its 7.80% Series E Cumulative Redeemable Preferred Stock offering, expected to close in November 2003 (see Notes 6 and 7). Management expects that this redemption will result in a $0.9 million charge in the fourth quarter of 2003 relating to the initial issuance costs of the Series C Preferred units.
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Stock Option Accounting
Effective January 1, 2002, the Company voluntarily adopted the fair value recognition provisions of SFAS 123, prospectively, for all employee stock option awards granted or settled after January 1, 2002. Under the fair value recognition provisions of SFAS 123, total compensation expense related to stock options is determined using the fair value of the stock options on the date of grant. Total compensation expense is then recognized on a straight-line basis over the option vesting period.
Prior to 2002, the Company accounted for stock options issued under the recognition and measurement provisions of APB Opinion 25 “Accounting for Stock Issued to Employees and Related Interpretations.” The following table illustrates the effect on net income and earnings per share if the fair value based method had been applied to all outstanding and unvested awards in each period.
Net income, as reported
Add: Stock option expense included in reported net income
Deduct: Total stock option expense determined under fair value recognition method for all awards
Pro forma net income
Net income per share:
Basic—as reported
Basic—pro forma
Diluted—as reported
Diluted—pro forma
2. Acquisitions and Dispositions
Acquisition of Land
In April 2003, the Company acquired the fee interest in a parcel of land at 12100 W. Olympic Boulevard, Los Angeles, California from an unaffiliated third party for approximately $1.5 million. The Company had previously leased this land from the seller. This land comprises part of the site of one of the Company’s properties.
Dispositions
During the nine months ended September 30, 2003, the Company sold the following properties:
Location
4351 Latham Avenue
Riverside, CA
5770 Armada Drive
Carlsbad, CA
Anaheim Corporate Center
Anaheim, CA
4361 Latham Avenue
Total
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During the nine months ended September 30, 2003, the Company recorded a net gain of approximately $3.6 million in connection with the sale of these properties. The Company used the net cash proceeds to fund its development and redevelopment programs, pay down principal on mortgage loans and repay borrowings under the Credit Facility (defined in Note 4). The net income and the net gain on disposition for these properties have been included in discontinued operations for the three and nine months ended September 30, 2003 and 2002 (see Note 11).
3. Development and Redevelopment Projects
Development
During the nine months ended September 30, 2003, the Company added the following development projects to the Company’s stabilized portfolio:
Property
Type
12100 West Olympic Blvd.
West Los Angeles, CA
999 Sepulveda Blvd.
El Segundo, CA
3721 Valley Centre Drive
Del Mar, CA
Redevelopment
During the nine months ended September 30, 2003, the Company reclassified the following two properties out of the Company’s stabilized portfolio and into the Company’s redevelopment portfolio. The Company is converting one of these properties from office space to life science space and is performing extensive interior refurbishments at the other property since it had been occupied by a single tenant for approximately 30 years.
Pre and PostRedevelopment
5717 Pacific Center Blvd.
Sorrento Mesa, CA
909 Sepulveda Blvd.
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During the nine months ended September 30, 2003, the Company added the following redevelopment projects to the Company’s stabilized portfolio:
Pre and PostPropertyRedevelopment Type
1700 Carnegie
Santa Ana, CA
10421 Pacific Center (2)
4. Unsecured Line of Credit and Secured Debt
As of September 30, 2003, the Company had borrowings of $222.0 million outstanding under its revolving unsecured line of credit (the “Credit Facility”) and availability of approximately $112.3 million. The Credit Facility bears interest at an annual rate between LIBOR plus 1.13% and LIBOR plus 1.75% (2.87% at September 30, 2003), depending upon the Company’s leverage ratio at the time of borrowing, and matures in March 2005. The fee for unused funds ranges from an annual rate of 0.20% to 0.35% depending on the Company’s leverage ratio. The Company expects to use the Credit Facility to finance development and redevelopment expenditures, to fund potential acquisitions and for other general corporate uses.
In August 2003, the Company borrowed $80.0 million under a mortgage loan that is secured by 12 office properties, requires monthly principal and interest payments based on a fixed annual interest rate of 3.80% and matures in August 2008. The Company used the proceeds from the loan primarily to repay an outstanding mortgage loan with a principal balance of $67.7 million that was scheduled to mature in October 2003. The remainder of the proceeds was used to repay borrowings under the Credit Facility.
The Credit Facility and certain other secured debt arrangements contain covenants requiring the Company to meet certain financial ratios and reporting requirements. Some of the more restrictive financial covenants include a minimum debt service coverage ratio, a maximum total liabilities to total assets ratio, a maximum total secured debt to total assets ratio, a minimum cash flow to debt service and fixed charges ratio, a minimum consolidated tangible net worth and a limit of development activities as compared to total assets. The Company was in compliance with all of its debt covenants at September 30, 2003.
Total interest and loan fees capitalized for the three months ended September 30, 2003 and 2002 were $2.5 million and $3.5 million, respectively. Total interest and loan fees capitalized for the nine months ended September 30, 2003 and 2002 were $9.8 million and $10.6 million, respectively.
5. Derivative Financial Instruments
As of September 30, 2003, the Company reported liabilities of approximately $4.0 million, reflecting the fair value of its interest rate swap agreements, which are included in other liabilities in the consolidated balance sheets. As of September 30, 2003, the Company reported an asset of approximately $12,000 reflecting the fair value of its interest rate cap agreements, which is included in deferred financing costs in the consolidated balance sheet.
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The following table sets forth the terms and fair market value of the Company’s derivative financial instruments at September 30, 2003:
Type of Instrument
Maturity Date
Interest rate swap
Total included in other liabilities
Interest rate cap
Total included in deferred financing costs
The instruments described above have been designated as cash flow hedges. As of September 30, 2003, the balance in accumulated net other comprehensive loss relating to derivatives was approximately $5.9 million relating to the net decrease in the fair market value of the instruments since their inception. The $1.9 million difference between the total fair value of $4.0 million and the $5.9 million balance in accumulated net other comprehensive loss primarily represents the unamortized balance of the premium the Company paid for the two interest-rate cap agreements at their inception during 2002. The $2.4 million premium is being amortized into earnings over the term of the cap agreements using the caplet value approach. For the nine months ended September 30, 2003, the Company did not record any gains or losses attributable to cash flow hedge ineffectiveness since the terms of the Company’s derivative contracts and debt obligations were and are expected to continue to be effectively matched. Amounts reported in accumulated other comprehensive loss will be reclassified to interest expense as interest payments are made on the Company’s variable-rate debt. During the twelve months ending September 30, 2004, the Company estimates that it will reclassify approximately $4.2 million to interest expense.
6. Minority Interests
Minority interests represent the common and preferred limited partnership interests in the Operating Partnership and interests held by The Allen Group in the Development LLCs prior to their dissolution on March 25, 2002. The Company owned an 86.9% general partnership interest in the Operating Partnership as of September 30, 2003.
During the nine months ended September 30, 2003, 23,000 common limited partnership units of the Operating Partnership were redeemed for shares of the Company’s common stock on a one-for-one basis. Neither the Company nor the Operating Partnership received any proceeds from the issuance of the common stock to the common limited partners.
On October 22, 2003, the Operating Partnership notified the holders of its Series C Preferred Units that it intends to redeem all 700,000 outstanding Series C Preferred Units on November 24, 2003 (see Note 7).
7. Stockholders’ Equity and Employee Incentive Plans
In February 2003, the Company’s Executive Compensation Committee granted an aggregate of 118,733 restricted shares of the Company’s common stock to certain executive officers and key employees for the 2002
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annual performance period under the Company’s 1997 Stock Option and Incentive Plan. Compensation expense related to the restricted shares is calculated based on the closing per share price of $21.63 on the February 10, 2003 grant date and is amortized over the performance and vesting periods. Of the shares granted, 25,903 vest over a one-year period and 92,830 vest over a two-year period. The Company recorded approximately $0.7 million related to this restricted stock grant during the nine months ended September 30, 2003. Restricted shares of common stock have the same dividend and voting rights as unrestricted shares of common stock and are included in the Company’s calculation of weighted average diluted outstanding shares.
In May 2003, the Company’s Executive Compensation Committee granted an aggregate of 3,945 restricted shares of the Company’s common stock to non-employee board members as part of the board members’ annual compensation. In July 2003, the Company’s Executive Compensation Committee granted 1,000 shares to the Company’s newly elected board member representing his initial equity award. The restricted stock was granted under the Company’s 1997 Stock Option and Incentive Plan in accordance with the Company’s new Board of Directors compensation plan. The new Board of Directors compensation plan was approved by the Board of Directors in May 2003. Compensation expense for the 3,945 and 1,000 restricted shares is calculated based on the closing per share price of $25.38 and $28.48 on the respective May 8, 2003 and July 24, 2003 grant dates and is being amortized over the respective two-year and four-year vesting periods. The Company recorded compensation expense of approximately $21,000 related to these restricted stock grants during the nine months ended September 30, 2003.
In March 2003, the Company’s Executive Compensation Committee implemented a special long-term compensation program for the Company’s executive officers that provides for cash compensation to be earned at the end of a three-year period if the Company attains certain performance measures based on annualized total shareholder returns on an absolute and relative basis. The targets for the relative component require the Company to obtain an annualized total return to stockholders that is at or above the 70th percentile of annualized total return to stockholders achieved by members of a pre-defined peer group during the same three-year period. The amount payable for the absolute component is based upon the amount by which the annualized total return to stockholders over the three-year period exceeds 10%. Amounts paid under the special long-term compensation program are payable at the discretion of the Executive Compensation Committee. During the nine months ended September 30, 2003, the Company accrued approximately $2.5 million of compensation expense related to this plan.
During the nine months ended September 30, 2003, the Company accepted the return, at the current quoted market price, of 78,630 shares of its common stock from certain key employees in accordance with the provisions of its incentive stock plan to satisfy minimum statutory tax-withholding requirements related to restricted shares that vested during this period.
In April 2003, the Company filed a registration statement on Form S-3, to register the potential issuance and resale of up to a total of 1,398,068 shares of the Company’s common stock that may be issued in redemption of 1,398,068 common limited partnership units of the Operating Partnership previously issued in connection with the acquisition of the minority interest in the Development LLC properties. The common limited partnership units may be redeemed, at the Company’s option, for shares of the Company’s common stock on a one-for-one basis in lieu of cash. Neither the Company nor the Operating Partnership would receive any proceeds from the issuance or resale of the common stock resulting from any such redemption.
In October 2003, the Company priced a public offering for 1,610,000 shares of its 7.80% Series E Cumulative Redeemable Preferred Stock (“Series E Preferred Stock”). The Series E Preferred Stock has a liquidation preference of $25.00 per share and may be redeemed at the option of the Company on or after November 21, 2008, or earlier under certain circumstances. Dividends on the Series E Preferred Stock will be cumulative and will be payable quarterly in arrears on the 15th day of each February, May, August and
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November. The Series E Preferred Stock has no stated maturity and will not be subject to mandatory redemption or any sinking fund. The closing of this offering is subject to customary conditions and is expected to occur on November 21, 2003. The Company intends to use the net proceeds from the offering to redeem all outstanding Series C Preferred Units (see Note 6).
8. Ground Lease Obligations
During the nine months ended September 30, 2003, the Company renegotiated one of the ground leases at Kilroy Airport Center in Long Beach, California. The Company leases this land, which is adjacent to the Company’s other properties at Kilroy Airport Center, Long Beach, for future development opportunities. The ground lease term was extended to July 2084 subject to the Company’s right to terminate this lease upon written notice to the landlord on or before October 2007. Should the Company elect not to terminate the lease, the ground lease obligation will be subject to a fair market rental adjustment upon the completion of a building on the premises or in October 2007, whichever occurs first, and at scheduled dates thereafter.
9. Lease Termination Fees
On July 18, 2003, the bankruptcy court approved Peregrine Systems Inc.’s (“Peregrine”) plan of reorganization. As previously reported, Peregrine had filed a voluntary petition for relief under Chapter 11 of the bankruptcy code on September 22, 2002. Under the terms of the plan of reorganization and in accordance with a settlement agreement previously approved by the bankruptcy court, the Company received a payment in the third quarter of 2003 of approximately $18.3 million and is scheduled to receive four additional payments of approximately $750,000 each to be paid annually over the next four years. The Company reduced its allowance for unbilled deferred rents by approximately $2.0 million for amounts specifically related to the terminated Peregrine leases as of June 30, 2002. The Company also reversed a $0.5 million reserve previously charged to general and administrative expenses for costs the Company paid for the fifth and final building that was to be leased to Peregrine, but was surrendered to the Company in June 2002. During the third quarter of 2003, the Company recorded a net lease termination fee of $18.0 million representing the $18.3 million payment received in the third quarter of 2003 plus the $2.6 million net present value of the payments to be received in the future offset by $2.9 million of receivables and other costs and obligations associated with the lease. In addition, the Company also increased it provision for bad debts by $2.6 million to reserve the portion of the lease termination fee that related to the future annual payments.
During the first quarter of 2003, the Company recognized a $4.3 million net lease termination fee resulting from the early termination of a lease at an office property in Sorrento Mesa, California, which encompasses approximately 68,000 rentable square feet. Subsequent to the termination of this lease, this property was moved to the Company’s redevelopment portfolio (see Note 3) since the Company is repositioning it for life science use.
10. Segment Disclosure
The Company’s reportable segments consist of the two types of commercial real estate properties for which management internally evaluates operating performance and financial results: Office Properties and Industrial Properties. The Company also has certain corporate level activities including legal administration, accounting, finance and management information systems, which are not considered separate operating segments.
The Company evaluates the performance of its segments based upon net operating income. Net operating income is defined as operating revenues (rental income, tenant reimbursements and other property income) less property and related expenses (property expenses, real estate taxes, ground leases and provision for bad debts) and does not include interest income and expense, depreciation and amortization and corporate general and administrative expenses. There is no intersegment activity.
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Office Properties:
Operating revenues(1)
Property and related expenses
Net operating income, as defined
Industrial Properties:
Total Reportable Segments:
Reconciliation to Consolidated Net Income:
Total net operating income, as defined, for reportable segments
Other unallocated revenues:
Other unallocated expenses:
General and administrative expenses
Income from continuing operations before minority interests
Minority interests attributable to continuing operations
(Loss) income from discontinued operations
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11. Discontinued Operations
In accordance with the SFAS 144 “Accounting for the Impairment or Disposal of Long-Lived Assets,” the net income and the net gain on dispositions of operating properties sold subsequent to December 31, 2001 are reflected in the consolidated statement of operations as discontinued operations for all periods presented. For the three and nine months ended September 30, 2003 and 2002, discontinued operations related to seven office buildings that the Company sold during the nine months ended September 30, 2003 (see Note 2). For the three and nine months ended September 30, 2002, discontinued operations also related to the 12 industrial and five office buildings that the Company sold in 2002. In connection with the disposition of one of the buildings sold in 2003 and one of the buildings sold in 2002 the Company repaid approximately $8.0 million and $4.1 million, respectively, in principal of a mortgage loan partially secured by these properties. The related interest expense was allocated to discontinued operations. The following table summarizes the income and expense components that comprise discontinued operations for the three and nine months ended September 30, 2003 and 2002:
REVENUES:
Other property income
EXPENSES:
Provision for bad debts
Income from discontinued operations before net (loss) gain on disposition of discontinued operations and minority interests
12. Earnings Per Share
Basic earnings per share is computed by dividing net income by the weighted-average number of common shares outstanding for the period. Diluted earnings per share is computed by dividing net income by the sum of the weighted-average number of common shares outstanding for the period plus the number of common shares issuable assuming the exercise of all dilutive securities. The Company does not consider common units of the Operating Partnership to be dilutive since any issuance of shares of common stock upon the redemption of the common units would be on a one-for-one basis and would not have any effect on diluted earnings per share. The following table reconciles the numerator and denominator of the basic and diluted per-share computations for net income.
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Numerator:
Net income from continuing operations
Discontinued operations
Net income—numerator for basic and diluted earnings per share
Denominator:
Basic weighted-average shares outstanding
Effect of dilutive securities-stock options and restricted stock
Diluted weighted-average shares and common share equivalents outstanding
Basic earnings per share:
Diluted earnings per share:
At September 30, 2003, Company employees and directors held options to purchase 3,000 shares of the Company’s common stock that were antidilutive to the diluted earnings per share computation. These options could become dilutive in future periods if the average market price of the Company’s common stock exceeds the exercise price of the outstanding options.
13. Subsequent Events
On October 17, 2003, aggregate distributions of approximately $16.0 million were paid to common stockholders and common unitholders of record on September 30, 2003.
In October 2003, the Company priced a public offering for 1,610,000 shares of its 7.80% Series E Cumulative Redeemable Preferred Stock (see Note 7).
On October 22, 2003, the Operating Partnership notified the holders of its Series C Preferred Units that it intends to redeem all 700,000 outstanding Series C Preferred Units on November 24, 2003 (see Notes 6 and 7).
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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion relates to the consolidated financial statements of the Company and should be read in conjunction with the financial statements and notes thereto appearing elsewhere in this report. Statements contained in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” that are not historical facts may be forward-looking statements. Such statements are subject to certain risks and uncertainties, which could cause actual results to differ materially from those projected. Some of the information presented is forward-looking in nature, including information concerning projected future occupancy rates, rental rate increases, project development timing and investment amounts and the anticipated issuance of Series E Preferred Stock. Although the information is based on the Company’s current expectations, actual results could vary from expectations stated in this report. Numerous factors will affect the Company’s actual results, some of which are beyond its control. These include the timing and strength of regional economic growth, the strength of commercial and industrial real estate markets, competitive market conditions, future interest rate levels and capital market conditions. You are cautioned not to place undue reliance on this information, which speaks only as of the date of this report. The Company assumes no obligation to update publicly any forward-looking information, whether as a result of new information, future events or otherwise, except to the extent the Company is required to do so in connection with its ongoing requirements under Federal securities laws to disclose material information. For a discussion of important risks related to the Company’s business and an investment in its securities, including risks that could cause actual results and events to differ materially from results and events referred to in the forward-looking information contained in this report, see the discussion under the caption “Business Risks” in the Company’s annual report on Form 10-K for the year ended December 31, 2002 and under the caption “Factors Which May Influence Future Results of Operations” below. In light of these risks, uncertainties and assumptions, the forward-looking events contained in this report may not occur.
Overview and Background
Kilroy Realty Corporation (the “Company”) owns, operates, and develops office and industrial real estate, primarily in Southern California. The Company operates as a self-administered real estate investment trust (“REIT”). The Company owns its interests in all of its properties through Kilroy Realty, L.P. (the “Operating Partnership”) and Kilroy Realty Finance Partnership, L.P. (the “Finance Partnership”) and conducts substantially all of its operations through the Operating Partnership. The Company owned an 86.9% general partnership interest in the Operating Partnership as of September 30, 2003.
As of September 30, 2003, the Company’s stabilized portfolio was comprised of 82 office properties (the “Office Properties”) encompassing an aggregate of approximately 7.3 million rentable square feet, and 50 industrial properties (the “Industrial Properties,” and together with the Office Properties, the “Properties”), encompassing an aggregate of approximately 4.9 million rentable square feet. The Company’s stabilized portfolio of operating properties consists of all the Company’s Properties, and excludes properties recently developed or redeveloped by the Company that have not yet reached 95.0% occupancy and are within one year following substantial completion (“lease-up” properties) and projects currently under construction.
As of September 30, 2003, the Office and Industrial Properties represented 80.4% and 19.6%, respectively, of the Company’s annualized base rent. For the three months ended September 30, 2003, average occupancy in the Company’s stabilized portfolio was 90.2%. As of September 30, 2003, the Company had approximately 1,241,000 square feet of space in its stabilized portfolio available for lease.
Factors Which May Influence Future Results of Operations
Rental income. The amount of net rental income generated by the Company’s Properties depends principally on its ability to maintain the occupancy rates of currently leased space and to lease currently available space, newly developed or redeveloped properties and space available from unscheduled lease terminations. The amount of rental income generated by the Company also depends on its ability to maintain or increase rental
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rates in its submarkets. Negative trends in one or more of these factors could adversely affect the Company’s rental income in future periods.
Rental rates. The Company’s average rental rate increase was 1.6% on both a GAAP basis and on a cash basis for leases executed during the nine months ended September 30, 2003. The change in rental rates for leases executed during the three months ended September 30, 2003 was 2.2% on a cash basis and a negative 0.3% on a GAAP basis. The change in rents on a cash basis is calculated as the change between the stated rent for a new or renewed lease and the stated rent for the expiring lease for the same space, whereas change in rents on a GAAP basis compares the average rents over the term of the lease for each lease. Management believes that the average rental rates for all of its Properties generally are equal to the current average quoted market rate, although individual Properties within any particular submarket presently may be leased at above or below the rental rates within that submarket. The Company cannot give any assurance that leases will be renewed or that available space will be re-leased at rental rates equal to or above the current rental rates.
Scheduled lease expirations. In addition to the 1,241,000 square feet of currently available space in the Company’s stabilized portfolio, leases representing approximately 1.7% and 10.2% of the square footage of the Company’s stabilized portfolio are scheduled to expire during the remainder of 2003 and in 2004, respectively. The leases scheduled to expire in the remainder of 2003 and the leases scheduled to expire in 2004 represent approximately 0.7 million square feet of office space, or 10.1% of the Company’s total annualized base rent, and 0.5 million square feet of industrial space, or 2.3% of the Company’s total annualized base rent, respectively. For the leases scheduled to expire in the remainder of 2003 and in 2004, management believes the rental rates on average are 10 to 15% above current average quoted market rates, which is primarily related to one lease expiring in 2004. The Company’s ability to release available space depends upon the market conditions in the specific submarkets in which the Properties are located.
Los Angeles County submarket information. Leasing in the Los Angeles County submarket continues to be challenging as a result of the soft demand for office and industrial space combined with the current availability of space, both directly and through sub-leases. Consequently, management cannot predict when the Company will see significant positive leasing momentum or a change in demand for office space given the level of direct vacancy and concentration of sublease space currently available in this submarket. At September 30, 2003, the Company’s Los Angeles stabilized office portfolio was 82.2% occupied with approximately 574,900 rentable square feet available for lease. This includes two office development projects, encompassing approximately 284,700 rentable square feet, that were previously in the lease-up phase and added to the stabilized portfolio during 2003 since one year had passed following substantial completion. As of September 30, 2003, these buildings were 15.6% occupied. The Company has an executed lease for approximately 34,600 rentable square feet at one of these buildings commencing in the fourth quarter of 2003. In addition, during the first quarter of 2003, the Company began the redevelopment of an office building encompassing approximately 248,100 rentable square feet which was not pre-leased as of September 30, 2003. The building is located in El Segundo and is in the same complex as one of the stabilized development projects discussed above. The Company expects to complete the redevelopment of this building in the first quarter of 2004. See additional information regarding this in-process redevelopment project under the caption “Development and Redevelopment” in this report. Further, leases representing an aggregate of approximately 111,700 and 457,000 rentable square feet are scheduled to expire during the remainder of 2003 and in 2004, respectively, in this submarket as of September 30, 2003.
San Diego County submarket information. As of September 30, 2003, the Company’s San Diego office portfolio was 91.5% occupied with approximately 260,000 rentable square feet available for lease. At September 30, 2003, the Company had one office development project in lease-up encompassing an aggregate of approximately 209,000 rentable square feet. This project was 84.1% leased at September 30, 2003. As of September 30, 2003, leases representing an aggregate of approximately 42,200 and 61,400 rentable square feet were scheduled to expire during the remainder of 2003 and in 2004, respectively, in this submarket. In addition, during the first quarter of 2003, the Company began the redevelopment of one office building in the San Diego region, which was not pre-leased as of September 30, 2003. The Company expects to complete this project, which encompasses approximately 68,000 rentable square feet, in the fourth quarter of 2003.
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Orange County submarket information. As of September 30, 2003, the Company’s Orange County properties were 94.5% occupied with approximately 254,100 rentable square feet available for lease. As of September 30, 2003, leases representing an aggregate of approximately 25,000 and 472,400 rentable square feet were scheduled to expire during the remainder of 2003 and in 2004, respectively, in this submarket. In addition, as of September 30, 2003, the Company had one redevelopment property that was previously in the lease-up phase and was added to the stabilized portfolio during the quarter ended September 30, 2003 since one year had passed following substantial completion. This property, which encompasses approximately 77,000 rentable square feet, was 17% leased at September 30, 2003. The Company has executed leases for an additional 24% of the space in this building commencing in the fourth quarter of 2003.
Sublease space. Of the Company’s leased space at September 30, 2003, approximately 915,200 rentable square feet, or 7.5% of the square footage in the Company’s stabilized portfolio was available for sublease, of which approximately 6.3% was vacant space and the remaining 1.2% was occupied. Of the total 7.5% of rentable square feet available for sublease at September 30, 2003, approximately 4.5% is located in Orange County, of which 3.9% represents space available in two Orange County industrial buildings, and approximately 2.4% is in San Diego County.
Negative trends or other events that impair the Company’s ability to renew or release space and its ability to maintain or increase rental rates in its submarkets could have an adverse effect on the Company’s future financial condition, results of operations and cash flows.
Recent information regarding significant tenants
The Boeing Company. As of September 30, 2003, the Company’s largest tenant, The Boeing Company, leased an aggregate of approximately 0.8 million rentable square feet of office space under eight separate leases, representing approximately 7.8% of the Company’s total annual base rental revenues. One of the leases for a building located in El Segundo, encompassing approximately 293,300 rentable square feet, is scheduled to expire in July 2004. The other seven leases are scheduled to expire at various dates between August 2005 and March 2009. The Boeing Company previously had another lease, at 909 N. Sepulveda Boulevard in El Segundo, California, encompassing approximately 248,150 rentable square feet that expired on February 28, 2003. The Boeing Company vacated this building upon lease expiration. This building was subsequently moved to the Company’s redevelopment portfolio.
Peregrine Systems, Inc. As previously reported, Peregrine Systems, Inc. (“Peregrine”), the Company’s second largest tenant at December 31, 2002, filed for bankruptcy in September 2002. Peregrine had leased four office buildings in a five-building complex totaling approximately 423,900 rentable square feet under four separate leases. Peregrine was also committed to lease the fifth building, encompassing approximately 114,800 rentable square feet, which was completed in the third quarter of 2002. Peregrine surrendered this fifth building back to the Company in June 2002. In July 2003, the bankruptcy court approved Peregrine’s plan of reorganization. Peregrine had filed a voluntary petition for relief under Chapter 11 of the bankruptcy code on September 22, 2002. Under terms of the plan of reorganization and in accordance with a settlement agreement previously approved by the bankruptcy court, the Company received a payment in the third quarter of 2003 of approximately $18.3 million and is scheduled to receive four additional payments of approximately $750,000, each to be paid annually over the next four years.
As part of the bankruptcy court’s approval of Peregrine’s reorganization plan, the court approved Peregrine’s rejection of three of its leases with the Company. The bankruptcy court also approved Peregrine’s continuation, in part, of the fourth lease. Under the revised terms of this lease, Peregrine continues to lease approximately 78,000 square feet of this 129,680 square foot building. Including the 78,000 rentable square feet leased to Peregrine, as of the date of this report, the Company has executed leases or letters of intent for 93% of the space in this five-building complex, which encompasses an aggregate of approximately 538,700 rentable square feet.
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Brobeck, Phleger & Harrison, LLP. Brobeck, Phleger & Harrison, LLP (“Brobeck”) dissolved in February 2003 and as a result the Company terminated the two leases Brobeck had with the Company encompassing 161,500 aggregate rentable square feet. One of the buildings totaling approximately 72,300 rentable square feet was re-leased on an interim basis to one tenant in conjunction with a longer-term lease at another one of the Company’s buildings. The interim lease terminated August 31, 2003. The Company has executed a fifteen-year lease with another tenant for the same 72,300 square foot building and approximately 23,900 rentable square feet in the adjacent 89,200 rentable square foot building, which is expected to commence in the fourth quarter of 2003.
Although the Company has been able to mitigate the impact of tenant defaults to its financial condition, revenues and results of operations, the Company’s financial condition, results of operations and cash flows could be adversely affected if the Company is unable to re-lease the remaining space vacated by Brobeck on a long-term basis. In addition, the Company’s financial condition, results of operations and cash flows would be adversely affected if any of the Company’s other significant tenants fail to renew their leases, renew their leases on terms less favorable to the Company or if any of them become bankrupt or insolvent or otherwise unable to satisfy their lease obligations.
Bad Debt Expense. The Company’s net income could also be adversely affected if the Company experiences increases in its incidence of bad debt expense. Although the Company has stringent lease underwriting standards and continually evaluates the financial capacity of both its prospective and existing tenants to proactively manage portfolio credit risk, downturns in tenants’ businesses may weaken tenants’ financial conditions and could result in additional defaults under lease obligations. During 2001 and 2002, the Company experienced an increased incidence of bad debts as a result of the general decline in the national and regional economy and its effect on the collection of outstanding receivable balances. Although to date in 2003 the Company has not experienced the same level of incidence of bad debts, the Company’s reserve levels will fluctuate in the future based on the state of the economy and/or if the Company continues to experience an increased incidence of bad debts. If the Company experiences continued or increased levels of bad debt expense, the Company’s financial condition, results of operations and cash flows would be adversely affected.
Development and redevelopment programs. Management believes that a significant source of the Company’s potential growth over the next several years will continue to come from its development pipeline. However, given the current economic environment in the Company’s development submarkets, the Company will most likely not be able to attain historical levels of growth from development in the near future. As of September 30, 2003, the Company had one office development property in lease-up encompassing an aggregate of approximately 209,000 rentable square feet which is expected to stabilize in the third quarter of 2004. The Company did not have any development projects under construction at September 30, 2003. See additional information regarding the Company’s in-process development portfolio under the caption “Development and Redevelopment” in this report. In addition, as of September 30, 2003, the Company owned approximately 58.1 acres of undeveloped land upon which the Company currently expects to develop an aggregate of approximately 1.1 million rentable square feet of office space within the next three to five years.
Management believes that another source of the Company’s potential growth over the next several years will come from redevelopment opportunities within its existing portfolio. Redevelopment efforts can achieve similar returns to new development with reduced entitlement risk and shorter construction periods. As of September 30, 2003, the Company’s in-process redevelopment portfolio included two office projects, encompassing approximately 316,100 rentable square feet, which are expected to stabilize in 2004 and the first quarter of 2005. This redevelopment portfolio included one life science conversion project in North San Diego County and another project in which the Company is performing extensive interior refurbishments at an office building in El Segundo that had been occupied by a single tenant for approximately 30 years. See additional information regarding the Company’s in-process redevelopment portfolio under the caption “Development and Redevelopment” in this report. Depending on market conditions, the Company will continue to pursue future redevelopment opportunities in its strategic submarkets where no land available for development exists.
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The Company has a proactive planning process by which it continually evaluates the size, timing and scope of its development and redevelopment programs and, as necessary, scales activity to reflect the economic conditions and the real estate fundamentals that exist in the Company’s strategic submarkets. However, the Company may not be able to lease committed development or redevelopment properties at expected rental rates or within projected timeframes or complete projects on schedule or within budgeted amounts, which could adversely affect the Company’s financial condition, results of operations and cash flows.
Other Factors. The Company’s operating results are and may continue to be affected by uncertainties and problems associated with the deregulation of the utility industry in California since 94.6% of the total rentable square footage of the Company’s stabilized portfolio is located in California. Energy deregulation has resulted in higher utility costs in some areas of the state and intermittent service interruptions. In addition, primarily as a result of the events of September 11, 2001, the Company’s annual insurance costs increased across its portfolio by approximately 14% during 2002 and approximately 11% during the nine months ended September 30, 2003. As of the date of this report, the Company had not experienced any material negative effects arising from either of these issues because approximately 68% (based on net rentable square footage) of the Company’s current leases require tenants to pay utility costs and property insurance premiums directly, thereby limiting the Company’s exposure. The remaining 32% of the Company’s leases provide that the tenants reimburse the Company for these costs in excess of a base year amount.
In addition, the California State legislature is currently evaluating split tax roll legislation, which if enacted, would have a material effect on the Company’s operating results. If this legislation is passed, the Company’s properties would be subject to full market value appraisals on a cyclical basis, which could result in significant increases in real estate taxes for the Company’s properties located in California. Under the current tax laws, the enrolled values of the Company’s properties can only be increased a maximum of 2% annually.
Results of Operations
The following table reconciles the changes in the rentable square feet in the Company’s stabilized portfolio of operating properties from September 30, 2002 to September 30, 2003. Rentable square footage in the Company’s portfolio of stabilized properties decreased by an aggregate of approximately 0.6 million rentable square feet, or 4.7%, to 12.2 million rentable square feet at September 30, 2003, compared to 12.8 million rentable square feet at September 30, 2002 as a result of the properties sold and properties transferred to the redevelopment portfolio subsequent to September 30, 2002, net of the development and redevelopment projects completed and added to the Company’s stabilized portfolio of operating properties subsequent to September 30, 2002.
Total at September 30, 2002
Properties added from the Development and Redevelopment Portfolio
Properties transferred to the Redevelopment Portfolio
Dispositions(1)
Remeasurement
Total at September 30, 2003
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Comparison of the Three Months Ended September 30, 2003 to the Three Months Ended September 30, 2002
Management internally evaluates the operating performance and financial results of its portfolio based on Net Operating Income for the following segments of commercial real estate property: Office Properties and Industrial Properties. The Company defines Net Operating Income as operating revenues from continuing operations (rental income, tenant reimbursements and other property income) less property and related expenses from continuing operations (property expenses, real estate taxes, provision for bad debts and ground leases). The Net Operating Income segment information presented within this Management’s Discussion and Analysis consists of the same Net Operating Income segment information disclosed in Note 10 of the Company’s consolidated financial statements in accordance with Statement of Financial Accounting Standards No. 131 “Disclosures about Segments of an Enterprise and Related Information.” The following table reconciles the Company’s Net Operating Income by segment to the Company’s net income for the three months ended September 30, 2003 and 2002.
Three Months
Ended
September 30,
Net Operating Income, as Defined:
Office Properties
Industrial Properties
Total portfolio
Net Operating Income, as defined for reportable segments
Other expenses:
Income from continuing operations before minority interest
Income from discontinued operations
Net Income
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Rental Operations
Management evaluates the operations of its portfolio based on operating property type. The following tables compare the net operating income for the Office Properties and for the Industrial Properties for the three months ended September 30, 2003 and 2002.
Operating revenues:
Property and related expenses:
Total revenues from Office Properties increased $20.0 million, or 49.2%, to $60.5 for the three months ended September 30, 2003million compared to $40.5 million for the three months ended September 30, 2002. Rental income from Office Properties increased $2.3 million, or 6.2% to $38.5 million for the three months ended September 30, 2003 compared to $36.2 million for the three months ended September 30, 2002. Rental income generated by office properties owned and stabilized at January 1, 2002 and still owned and stabilized at September 30, 2003(the “Core Office Portfolio”) increased $0.7 million, or 2.2% for the three months ended September 30, 2003 as compared to the three months ended September 30, 2002. This increase is primarily due to an increase in occupancy in this portfolio. Excluding the four buildings previously leased to Peregrine, average occupancy in this portfolio increased 0.5% to 92.9% for the three months ended September 30, 2003 as compared to 92.4% for the three months ended September 30, 2002. The remaining $1.6 million increase was attributable to a $2.6 million increase in rental income generated by the office properties developed by the Company in 2002 and 2003 (the “Office Development Properties”) which was offset by a decrease of $1.0 million attributable to the office properties that were taken out of service and moved from the Company’s stabilized portfolio to the redevelopment portfolio during 2002 and 2003 (the “Office Redevelopment Properties”).
Tenant reimbursements from Office Properties decreased $0.6 million, or 13.8% to $3.6 million for the three months ended September 30, 2003 compared to $4.2 million for the three months ended September 30, 2002. This decrease of $0.6 million was attributable to the Office Redevelopment Properties. Tenant reimbursements from the Core Office Portfolio remained consistent for the two comparable periods. Other property income from Office Properties increased approximately $18.3 million to $18.4 million for the three months ended September 30, 2003 compared to $157,000 for the three months ended September 30, 2002. Other property income for the three months ended September 30, 2003, included a $18.0 million lease termination fee related to a settlement with Peregrine Systems, Inc. In accordance with the settlement agreement the Company received a payment of $18.3 million in the third quarter and is scheduled to receive four additional payments of approximately $750,000 each over the next four years. The future payments were reserved for financial reporting
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purposes at September 30, 2003 through the provision for bad debts. After the impact of the reserve, the Company recognized a net lease termination fee of $15.4 million. Other property income for the three months ended September 30, 2002 consisted primarily of lease termination fees and tenant late charges.
Total expenses from Office Properties increased $2.7 million, or 24.0% to $14.1 million for the three months ended September 30, 2003 compared to $11.4 million for the three months ended September 30, 2002. Property expenses from Office Properties increased $1.1 million, or 15.7% to $7.9 million for the three months ended September 30, 2003 compared to $6.8 million for the three months ended September 30, 2002. An increase of $0.9 million or 14.6% was generated by the Core Office Portfolio. This increase was primarily attributable to an increase in repairs and maintenance expenditures in this portfolio. An increase of $0.6 million in property expenses was attributable to the Office Development Properties, which was primarily due to an increase in variable expenses related to lease-up of this portfolio. This $1.5 million increase from the Core Office Portfolio and Office Development Properties was offset by a decrease of $0.4 million attributable to the Office Redevelopment Properties. Real estate taxes increased $0.1 million, or 3.5% for the three months ended September 30, 2003 as compared to the same period in 2002. Real estate taxes for the Core Office Portfolio remained consistent at $2.7 million for the three months ended September 30, 2003 compared with the three months ended September 30, 2002. The provision for bad debts increased $1.5 million, or 130.2%, for the three months ended September 30, 2003 as compared to the three months ended September 30, 2002. An increase of $2.6 million was related to the reserve for the future payments under the Peregrine settlement agreement. This was offset by a decrease of $0.9 million which was primarily related to a provision for unbilled deferred rent specifically related to receivables from Peregrine the Company recorded in the third quarter of 2002. See further discussion of Peregrine under “Recent Information Regarding Significant Tenants.” The Company evaluates its reserve for unbilled deferred rent on a quarterly basis. Ground lease expense for Office Properties remained consistent for the three months ended September 30, 2003 compared to the same period in 2002.
Net operating income, as defined, from Office Properties increased $17.2 million, or 59.1% to $46.4 million for the three months ended September 30, 2003 compared to $29.2 million for the three months ended September 30, 2002. Of this increase, $16.5 million was generated by the Core Office Portfolio which was due primarily to the Peregrine lease termination fee and $1.6 million was attributable to the Office Development Properties. This $18.1 million increase was offset by a decrease of $0.9 million attributable to the Office Redevelopment Properties.
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Total revenues from Industrial Properties increased $0.1 million, or 0.9% to $9.6 million for the three months ended September 30, 2003 compared to $9.5 million for the three months ended September 30, 2002. Rental income from Industrial Properties remained consistent at approximately $8.6 million for the three months ended September 30, 2003 compared to the three months ended September 30, 2002. Rental income generated by industrial properties owned and stabilized at January 1, 2002 and still owned and stabilized at September 30, 2003. (the “Core Industrial Portfolio”) remained consistent at approximately $8.4 million for the three months ended September 30, 2003 as compared to the three months ended September 30, 2002.
Tenant reimbursements from Industrial Properties increased $0.2 million, or 17.9% to $1.0 million for the three months ended September 30, 2003 compared to $0.8 million for three months ended September 30, 2002. This increase was primarily attributable to a common area maintenance reconciliation credit given to a tenant that early terminated at one of the Core Industrial Portfolio buildings during the three months ended September 30, 2002. Other property income from Industrial Properties remained consistent for the three months ended September 30, 2003 compared to the three months ended September 30, 2002.
Total expenses from Industrial Properties decreased $0.4 million, or 23.0% to $1.2 million for the three months ended September 30, 2003 compared to $1.6 million for the three months ended September 30, 2002. Property expenses from Industrial Properties decreased $0.2 million, or 34.9% to $0.4 million for the three months ended September 30, 2003 compared to $0.6 million for the three months ended September 30, 2002. This decrease was primarily attributable to a decrease of $0.2 million in the Core Industrial Portfolio which was primarily due to non-recurring expenses incurred during the three months ended September 30, 2002. Real estate taxes for the Total Industrial Portfolio and the Core Industrial Portfolio remained consistent at approximately $0.8 million for the three months ended September 30, 2003 compared to the three months ended September 30, 2002. The provision for bad debts decreased $0.1 million, or 73.4%, compared to the same period in 2002. During the three months ended September 30, 2002, the Company increased its reserve for unbilled deferred rent specifically related to the Company’s watchlist tenants. The Company evaluates its reserve levels on a quarterly basis.
Net operating income, as defined, from Industrial Properties increased $0.4 million, or 5.9% to $8.3 million for the three months ended September 30, 2003 compared to $7.9 million for the three months ended September 30, 2002. Net operating income for the Core Industrial Portfolio increased $0.4 million, or 5.8% for the three months ended September 30, 2003 compared to the same period in 2002.
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Non-Property Related Income and Expenses
General and administrative expenses increased $1.8 million, or 62.7%, to $4.8 million for the three months ended September 30, 2003 compared to $3.0 million for the three months ended September 30, 2002. This increase was primarily due to an increase in accrued incentive compensation and higher legal, reporting and public company costs in connection with compliance with new requirements imposed by the Sarbanes-Oxley Act of 2002 and the New York Stock Exchange.
Net interest expense remained consistent at $8.9 million for the three months ended September 30, 2003 compared to the three months ended September 30, 2002. Gross interest and loan fee expense, before the effect of capitalized interest, decreased $1.0 million, or 7.9% to $11.4 million for the three months ended September 30, 2003 from $12.3 million for the three months ended September 30, 2002, primarily due to a decrease in the Company’s weighted average interest rate. The Company’s weighted average interest rate decreased to 5.4% at September 30, 2003 compared to 6.0% at September 30, 2002. Total capitalized interest and loan fees decreased $1.0 million, or 28.0% to $2.5 million for the three months ended September 30, 2003 from $3.5 million for the three months ended September 30, 2002, primarily due to lower average construction in progress balances.
Depreciation and amortization increased $0.3 million, or 2.1% to $14.6 million for the three months ended September 30, 2003 compared to $14.3 million for the three months ended September 30, 2002. The increase was attributable primarily to the development properties completed since September 30, 2003.
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Comparison of the Nine Months Ended September 30, 2003 to the Nine Months Ended September 30, 2002
Management internally evaluates the operating performance and financial results of its portfolio based on Net Operating Income for the following segments of commercial real estate property: Office Properties and Industrial Properties. The Company defines Net Operating Income as operating revenues from continuing operations (rental income, tenant reimbursements and other property income) less property and related expenses from continuing operations (property expenses, real estate taxes, provision for bad debts and ground leases.) The Net Operating Income segment information presented within this Management’s Discussion and Analysis consists of the same Net Operating Income segment information disclosed in Note 10 of the Company’s consolidated financial statements in accordance with Statement of Financial Accounting Standards No. 131 “Disclosures about Segments of an Enterprise and Related Information.” The following table reconciles the Company’s Net Operating Income by segment to the Company’s net income for the nine months ended September 30, 2003 and 2002.
Income from continuing operations before net gain on dispositions and minority interests
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Management evaluates the operations of its portfolio based on operating property type. The following tables compare the net operating income for the Office Properties and for the Industrial Properties for the nine months ended September 30, 2003 and 2002.
Total revenues from Office Properties increased $23.3 million, or 19.1% to $145.2 million for the nine months ended September 30, 2003 compared to $121.9 million for the nine months ended September 30, 2002. Rental income from Office Properties increased $2.9 million, or 2.7% to $109.4 million for the nine months ended September 30, 2003 compared to $106.5 million for the nine months ended September 30, 2002. Rental income generated by the Core Office Portfolio decreased $1.4 million, or 1.4% for the nine months ended September 30, 2003 as compared to the nine months ended September 30, 2002. This decrease was primarily attributable to a decrease in occupancy. Average occupancy in the Core Office Portfolio decreased 2.2% to 89.1% for the nine months ended September 30, 2003 as compared to 91.3% for the nine months ended September 30, 2002. An increase of $7.1 million in rental income generated by Office Development Properties, was offset by a decrease of $2.8 million attributable to the Office Redevelopment Properties.
Tenant reimbursements from Office Properties decreased $1.2 million, or 8.7% to $12.6 million for the nine months ended September 30, 2003 compared to $13.8 million for the nine months ended September 30, 2002. A decrease of $0.6 million, or 4.9% was attributable to the Core Office Portfolio and was primarily due to the collection of prior year tenant reimbursements during the nine months ended September 30, 2002 that were reserved for financial reporting purposes. A decrease of $0.9 million in tenant reimbursements from the Office Redevelopment Properties was offset by an increase of $0.3 million generated by the Office Development Properties. Other property income from Office Properties increased approximately $21.6 million to $23.2 million for the nine months ended September 30, 2003 compared to $1.6 million for the nine months ended September 30, 2002. Other property income for the nine months ended September 30, 2003, included a $18.0 million lease termination fee related to a settlement with Peregrine Systems, Inc. In accordance with the settlement agreement previously approved by the bankruptcy court, the Company received a payment of $18.3 million in the third quarter and is scheduled to receive four additional payments of approximately $750,000 each to be paid annually over the next four years. The future payments were reserved for financial reporting purposes at September 30, 2003 through the provision for bad debts. After the impact of the reserve, the Company recognized a net lease termination fee of $15.4 million. During the nine months ended September 30, 2003, the Company also recognized a $4.3 million net lease termination fee resulting from the early termination of leases at a building in San Diego.
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Total expenses from Office Properties increased $0.9 million, or 2.7% to $35.0 million for the nine months ended September 30, 2003 compared to $34.1 million for the nine months ended September 30, 2002. Property expenses from Office Properties increased $2.7 million, or 13.1% to $23.0 million for the nine months ended September 30, 2003 compared to $20.3 million for the nine months ended September 30, 2002. An increase of $2.4 million was generated by the Core Office Portfolio. This increase was primarily attributable to legal expenses incurred related to tenant defaults and higher repairs and maintenance. Real estate taxes increased $0.2 million, or 2.3% to $9.3 million for the nine months ended September 30, 2003 as compared to $9.1 million for the nine months ended September 30, 2002. Real estate taxes for the Core Office Portfolio decreased $0.3 million, or 3.3% to $7.9 million for the nine months ended September 30, 2003 compared to $8.2 million for the comparable period in 2002. This decrease was due to refunds received for real estate taxes successfully appealed by the Company in 2003. An increase of $0.8 million attributable to the Office Development Properties was offset by a decrease of $0.3 million attributable to the Office Redevelopment Properties. The provision for bad debts decreased $1.9 million or 51.4% for the nine months ended September 30, 2003 as compared to the nine months ended September 30, 2002. The decrease was primarily due to a change in the provision for unbilled deferred rents receivable. For the nine months ended September 30, 2003, the Company reversed a provision for unbilled deferred rent related to the Company’s leases with Peregrine as a result of the settlement with Peregrine in July 2003. See further discussion of Peregrine in “Factors Which May Influence Future Results of Operations—Recent Information regarding Significant Tenants—Peregrine Systems, Inc.” During 2002, the Company recorded a provision for unbilled deferred rent specifically related to receivables from Peregrine. The Company evaluates its reserve for unbilled deferred rent on a quarterly basis. Ground lease expense for Office Properties decreased $0.1 million, or 6.3% for the nine months ended September 30, 2003 compared to the same period in 2002. This decrease was attributable to the Core Office Portfolio. During 2002 the Company renegotiated the ground lease at its portfolio of properties in Long Beach which resulted in a reduction of annual ground lease expense.
Net operating income, as defined, from Office Properties increased $22.3 million, or 25.4% to $110.1 million for the nine months ended September 30, 2003 compared to $87.8 million for the nine months ended September 30, 2002. An increase of $15.8 million was attributable to the Core Office Portfolio which was primarily due to the Peregrine lease termination fee and an increase of $6.5 million was attributable to the Office Development and Redevelopment Properties. The increases are primarily due to other income and the lease termination fee.
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Total revenues from Industrial Properties decreased $0.6 million, or 2.3% to $28.8 million for the nine months ended September 30, 2003 compared to $29.4 million for the nine months ended September 30, 2002. Rental income from Industrial Properties decreased $0.8 million, or 2.9% to $25.7 million for the nine months ended September 30, 2003 compared to $26.5 million for the nine months ended September 30, 2002. Rental income generated by the Core Industrial Portfolio decreased $1.1 million, or 4.3% for the nine months ended September 30, 2003 as compared to the nine months ended September 30, 2002. This decrease was primarily attributable to a decrease in occupancy in this portfolio. Average occupancy decreased 1.2% to 96.8% for the nine months ended September 30, 2003 compared to 98.0% for the nine months ended September 30, 2002. The net decrease in rental income from the Core Industrial Portfolio was partially offset by an increase of $0.3 million from the one industrial acquisition.
Tenant reimbursements from Industrial Properties remained consistent for the nine months ended September 30, 2003 compared to nine months ended September 30, 2002. Other property income from Industrial Properties increased $0.1 million for the nine months ended September 30, 2003.
Total expenses from Industrial Properties decreased $0.6 million, or 12.7% to $4.0 million for the nine months ended September 30, 2003 compared to $4.6 million for the nine months ended September 30, 2002. For the nine months ended September 30, 2003, property expenses increased $0.1 million or 6.0% compared to the same period in 2002. This increase in property expenses was primarily attributable to a non-recurring increase in HVAC costs at one property in the Core Industrial Portfolio. Real estate taxes decreased to $0.1 million, or 2.6%, for the nine months ended September 30, 2003 compared to the nine months ended September 30, 2002. This decrease was attributable to the refunds received for real estate taxes successfully appealed by the Company in 2003 at several buildings in the Core Industrial Portfolio. The provision for bad debts decreased $0.6 million, or 69.8% for the months ended September 30, 2003 compared to the same period in 2002. During the nine months ended September 30, 2002, the Company increased its reserve for bad debts and unbilled deferred rent specifically related to the Company’s watchlist tenants. The Company evaluates its reserve levels on a quarterly basis.
Net operating income, as defined, from Industrial Properties decreased $0.1 million for the nine months ended September 30, 2003 compared to the nine months ended September 30, 2002. Net operating income for the Core Industrial Portfolio decreased $0.4 million, or 1.6% for the nine months ended September 30, 2003 compared to the same period in 2002, which was partially offset by an increase of $0.3 million from the one industrial acquisition.
General and administrative expenses increased $3.1 million, or 32.5%, to $12.7 million for the nine months ended September 30, 2003 compared to $9.6 million for the nine months ended September 30, 2002. This increase was primarily due to an increase in accrued incentive compensation and higher legal, reporting and public company costs in connection with compliance with new requirements imposed by the Sarbanes-Oxley Act of 2002 and the New York Stock Exchange. The increase was partially offset by the reversal of a $0.5 million reserve in connection with the Peregrine settlement agreement. The Company had initially recorded this reserve in the second quarter of 2002 for costs the Company paid for the fifth and final building that was to be lease to Peregrine. This building was surrendered to the Company in June 2002. See further discussion regarding this agreement under the caption “Factors Which May Influence Future Results of Operations—Recent information regarding significant tenants—Peregrine Systems, Inc.”
Net interest expense decreased $2.7 million, or 10.0% to $24.1 million for the nine months ended September 30, 2003 compared to $26.8 million for the nine months ended September 30, 2002. Gross interest and loan fee expense, before the effect of capitalized interest, decreased $3.5 million, or 9.5% to $33.9 million for the nine months ended September 30, 2003 from $37.4 million for the nine months ended September 30, 2002, primarily due to a decrease in the Company’s weighted average interest rate. The Company’s weighted average interest
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rate decreased to 5.4% at September 30, 2003 compared to 6.0% at September 30, 2002. Total capitalized interest and loan fees decreased $0.8 million, or 8.4% to $9.8 million for the nine months ended September 30, 2003 from $10.6 million for the nine months ended September 30, 2002, primarily due to a decrease in the Company’s weighted average interest rate and lower average construction in progress balances.
Depreciation and amortization decreased $3.1 million, or 7.0% to $41.5 million for the nine months ended September 30, 2003 compared to $44.6 million for the nine months ended September 30, 2002. A decrease of $5.3 million due to a charge in the second quarter 2002 for previously capitalized leasing costs related to the Company’s leases with Peregrine was partially offset by an increase attributable to the development properties completed and stabilized since September 30, 2002.
Building and Lease Information
The following tables set forth certain information regarding the Company’s Office Properties and Industrial Properties at September 30, 2003:
Occupancy by Segment Type
Los Angeles
Orange County
San Diego
Total Portfolio
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Lease Expirations by Segment Type
Year of Lease Expiration
Annual BaseRent UnderExpiringLeases
(in 000’s)(3)
Remaining 2003
2004
2005
2006
2007
2008
Total Office
Total Industrial
Leasing Activity by Segment Type
For the Three Months Ended September 30, 2003:
For the Nine Months Ended September 30, 2003:
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Development and Redevelopment
The following tables set forth certain information regarding the Company’s lease-up and in-process office development and redevelopment projects as of September 30, 2003. See further discussion regarding the Company’s projected development and redevelopment trends under the caption “Factors Which May Influence Future Results of Operations—Development and redevelopment programs.”
Development Projects
Project Name/ Submarket
Costs
as ofSeptember 30,2003
PercentageLeased
Projects in Lease-Up:
12400 High BluffDel Mar, CA
Projects Under Construction
None
Total in-Process Development Projects
Redevelopment Projects
Project Name/Submarket
Total Costs
PercentLeased
as ofSept. 30,2003
Projects Under Construction:
5717 Pacific Centre Blvd. Sorrento Mesa, CA
909 Sepulveda Blvd. El Segundo, CA
Total in-Process Redevelopment Projects
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Liquidity and Capital Resources
Current Sources of Capital and Liquidity
The Company seeks to create and maintain a capital structure that allows for financial flexibility and diversification of capital resources. The Company’s primary source of liquidity to fund distributions, debt service, leasing costs and capital expenditures is net cash from operations. The Company’s primary sources of liquidity to fund development and redevelopment costs, potential undeveloped land and property acquisitions, temporary working capital and unanticipated cash needs are the Company’s $425 million unsecured revolving line of credit, proceeds received from the Company’s disposition program and construction loans. As of September 30, 2003, the Company’s total debt as a percentage of total market capitalization was 41.2%. As of September 30, 2003, the Company’s total debt plus cumulative redeemable preferred units as a percentage of total market capitalization was 49.7%.
As of September 30, 2003, the Company had borrowings of $222 million outstanding under its unsecured revolving line of credit (the “Credit Facility”) and availability of approximately $112.3 million. The Credit Facility bears interest at an annual rate between LIBOR plus 1.13% and LIBOR plus 1.75% (2.87% at September 30, 2003), depending upon the Company’s leverage ratio at the time of borrowing, and matures in March 2005. The fee for unused funds ranges from an annual rate of 0.20% to 0.35% depending on the Company’s leverage ratio. The Company expects to use the Credit Facility to finance development and redevelopment expenditures, to fund potential acquisitions and for other general corporate uses.
Factors Which May Influence Future Sources of Capital and Liquidity
In October 2003, the Company priced a public offering for 1,610,000 shares of its 7.80% Series E Cumulative Redeemable Preferred Stock (“Series E Preferred Stock”). The Series E Preferred Stock has a liquidation preference of $25.00 per share and may be redeemed at the option of the Company on or after November 21, 2008, or earlier under certain circumstances. Dividends on the Series E Preferred Stock will be cumulative and will be payable quarterly in arrears on the 15th day of each February, May, August and November. The Series E Preferred Stock has no stated maturity and will not be subject to mandatory redemption or any sinking fund. The closing of this offering is subject to customary conditions and is expected to occur on November 21, 2003. The Company intends to use the net proceeds from the offering to redeem all outstanding 9.375% Series C Cumulative Redeemable Preferred Units.
Taking into account the impact of preferred equity offering, the Company may issue up to an additional $273 million of equity securities under a currently effective registration statement as of the date of this report .
In 2002 and 2001, the Company used proceeds from dispositions of operating properties of approximately $46.5 million and $64.8 million, respectively, to fund a portion of its development activities and its share repurchase program. During the nine months ended September 30, 2003, the Company disposed of seven office properties for an aggregate sales price of approximately $35.7 million. The Company, however, cannot provide assurance that it will successfully complete this level of dispositions in future periods. In the event the Company is unable to successfully dispose of properties, the Company’s cash flow could be adversely affected, and the Company’s leverage could increase.
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The Company’s secured debt was comprised of the following at September 30, 2003 and December 31, 2002:
Mortgage note payable, due April 2009, fixed interest at 7.20%,monthly principal and interest payments
Mortgage loan payable, due August 2008, fixed interest at 3.80%,monthly principal and interest payments
Mortgage note payable, due January 2012, fixed interest at 6.70%,monthly principal and interest payments
Mortgage note payable, due February 2005, fixed interest at 8.35%,monthly principal and interest payments(a)
Mortgage note payable, due October 2003, interest at LIBOR plus 1.75%,(3.19% at December 31, 2002), monthly interest-only payments(b)
Mortgage loan payable, due January 2006, interest at LIBOR plus 1.75%,(2.87% and 3.17% at September 30, 2003 and December 31, 2002, respectively), monthly interest only payments(b)
Mortgage loan payable, due December 2005, interest at LIBOR plus 1.40%,(2.52% and 2.82% at September 30, 2003 and December 31, 2002, respectively), monthly interest only payments(b)(e)
Mortgage note payable, due May 2017, fixed interest at 7.15%,monthly principal and interest payments
Construction loan payable, due September 2004, interest at LIBOR plus 1.85% (2.97% and 3.23% at September 30, 2003 and December 31, 2002, respectively)(b)(c)(d)
Mortgage note payable, due June 2004, interest at LIBOR plus 1.75%,(2.87% and 3.13% at September 30, 2003 and December 31, 2002, respectively), monthly principal and interest payments(b)
Mortgage loan payable, due August 2007, fixed interest at 6.51%,monthly principal and interest payments
Mortgage loan payable, due November 2014, fixed interest at 8.13%,monthly principal and interest payments
Mortgage note payable, due December 2005, fixed interest at 8.45%,monthly principal and interest payments
Mortgage note payable, due November 2014, fixed interest at 8.43%,monthly principal and interest payments
Mortgage note payable, due October 2013, fixed interest at 8.21%,monthly principal and interest payments
Mortgage loan payable, due August 2007, fixed interest at 7.21%,monthly principal and interest payments
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The following table sets forth certain information with respect to the Company’s aggregate debt composition at September 30, 2003 and December 31, 2002:
Weighted-Average
Interest Rate
Secured vs. unsecured:
Secured
Unsecured
Fixed rate vs. variable rate:
Fixed rate(1)(2)(3)(5)
Variable rate(4)
Total Debt
Total Debt Including Loan Fees
Contractual Obligations, Capital Commitments and Other Liquidity Needs
The following table provides information with respect to the maturities and scheduled principal repayments of the Company’s secured debt and Credit Facility at September 30, 2003, and provides information about the minimum commitments due in connection with the Company’s ground lease obligations at September 30, 2003. The table does not reflect available debt extension options.
Secured Debt
Credit Facility
Ground Lease Obligations
The Credit Facility and certain other secured debt agreements contain covenants and restrictions requiring the Company to meet certain financial ratios and reporting requirements. Some of the more restrictive covenants include minimum debt service coverage ratios, a maximum total liabilities to total assets ratio, a maximum total secured debt to total assets ratio, a minimum cash flow to debt service and fixed charges ratio, a minimum consolidated tangible net worth and a limit of development activities as compared to total assets. Non-compliance with any 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. The Company was in compliance with all its covenants at September 30, 2003. In addition, the Company’s construction loan, which is due September 2004, has a limited recourse provision that holds the Company liable up to approximately $14.3 million plus any unpaid accrued interest.
In addition to the contractual obligations listed above, the Company also has outstanding capital commitments for development and redevelopment costs, capital expenditures, tenant improvements and leasing
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costs, as discussed further below, which are incurred as part of the Company’s normal course of business as an owner and developer of office and industrial properties. The timing of payment for these commitments is conditioned upon the execution and completion of services under third party vendor contracts in the ordinary course of business.
As of September 30, 2003, the Company had one development project and two redevelopment projects that were either in lease-up or under construction and have a total estimated investment of approximately $144 million. The Company has incurred an aggregate of approximately $111 million on these projects as of September 30, 2003. The Company currently projects it could spend approximately $6 million of the remaining $33 million of presently budgeted development costs during the remainder of 2003, depending on leasing activity. In addition, the Company had two development projects and one redevelopment project that were added to the Company’s stabilized portfolio of operating properties in the second and third quarters of 2003 which had not reached stabilized occupency as of September 30, 2003. Depending on leasing activity, the Company currently projects it could spend approximately $5 million for these projects during the remainder of 2003. The Company intends to finance these costs from among one or more of the following sources: borrowings under the Credit Facility and the existing construction loan and working capital. See additional information regarding the Company’s in-process development and redevelopment portfolio under the caption “Development and Redevelopment Programs” in this report.
As of September 30, 2003, the Company had executed leases that committed the Company to approximately $7 million in unpaid leasing costs and tenant improvements, and the Company had contracts outstanding for approximately $0.5 million in capital improvements at September 30, 2003. In addition, for the remainder of 2003, the Company currently projects it could spend approximately $0.5 million to $1 million in capital improvements, tenant improvements and leasing costs for properties within the Company’s stabilized portfolio, depending on leasing activity. Capital expenditures may fluctuate in any given period subject to the nature, extent and timing of improvements required to maintain the Company’s properties. Tenant improvements and leasing costs may also fluctuate in any given period depending upon factors such as the type of property, the term of the lease, the type of lease, the involvement of external leasing agents and overall market conditions.
The Company is required to distribute 90% of its REIT taxable income (excluding capital gains) on an annual basis in order to qualify as a REIT for federal income tax purposes. Accordingly, the Company intends to continue to make, but has not contractually bound itself to make, regular quarterly distributions to common stockholders and common unitholders from cash flow from operating activities. All such distributions are at the discretion of the Board of Directors. The Company may be required to use borrowings under the Credit Facility, if necessary, to meet REIT distribution requirements and maintain its REIT status. The Company has historically distributed amounts in excess of its taxable income, resulting in a return of capital to its stockholders, and currently is projected to have the ability to not increase its distributions to meet its REIT requirements for 2003. The Company considers market factors and Company performance in addition to REIT requirements in determining its distribution levels. Amounts accumulated for distribution to stockholders are invested primarily in interest-bearing accounts and short-term interest-bearing securities, which are consistent with the Company’s intention to maintain its qualification as a REIT. Such investments may include, for example, obligations of the Government National Mortgage Association, other governmental agency securities, certificates of deposit and interest-bearing bank deposits. On September 9, 2003, the Company declared a regular quarterly cash dividend of $0.495 per common share payable on October 17, 2003 to stockholders of record on September 30, 2003. This dividend is equivalent to an annual rate of $1.98 per share. In addition, the Company is required to make quarterly distributions to its Series A, Series C and Series D Preferred unitholders, which in aggregate total approximately $14 million of annualized preferred dividends.
In December 1999, the Company’s Board of Directors approved a share repurchase program, pursuant to which the Company is authorized to repurchase up to an aggregate of three million shares of its outstanding common stock. On November 21, 2002, the Company’s Board of Directors authorized the repurchase of an additional one million shares. An aggregate of 1,227,500 shares currently remain eligible for repurchase under
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this program. The Company’s policy is to make repurchases in open market transactions at the discretion of the Board of Directors and to finance repurchases through working capital, borrowings on the Credit Facility and from real property dispositions.
The Company believes that it will have sufficient capital resources to satisfy its capital and liquidity needs during the remainder of 2003. The Company currently estimates that it will have a projected range of approximately $134 million to $135 million of available sources to meet its short-term cash needs as follows: estimated availability of approximately $112 million under the Credit Facility; and estimated operating cash flow for the remainder of 2003 ranging from $22 million to $23 million. The Company currently estimates that it will have a projected range of approximately $40 million to $41 million of commitments and capital expenditures during the remainder of 2003, comprised of the following: $2 million in secured debt principal repayments; $11 million of currently projected expenditures for development and redevelopment expenditures; $8 million of committed costs for executed leases and capital expenditures; and budgeted capital improvements, tenant improvements and leasing costs for the Company’s stabilized portfolio ranging from approximately $0.5 million to $1 million, depending on leasing activity. In addition, the Company will distribute approximately $19 million to its stockholders and common and preferred unitholders for the remainder of 2003. There can be, however, no assurance that the Company will not exceed these estimated expenditure and distribution levels or be able to obtain additional sources of financing on commercially favorable terms or at all. The Company believes that it will have sufficient capital resources to satisfy its capital and liquidity needs during the next twelve months.
The Company expects to meet its long-term liquidity requirements, which may include property and undeveloped land acquisitions and additional future development and redevelopment activity, through retained cash flow, borrowings under the Credit Facility, additional long-term secured and unsecured borrowings, dispositions of non-strategic assets, issuance of common units of the Operating Partnership and the potential issuance of debt or equity securities. The Company does not intend to reserve funds to retire existing debt upon maturity. The Company will instead seek to refinance such debt at maturity or retire such debt through the issuance of equity securities, as market conditions permit.
Historical Cash Flows
The principal sources of funding for development, redevelopment acquisitions and capital expenditures are cash flow from operating activities, the Credit Facility, secured and unsecured debt financing and proceeds from the Company’s dispositions. The Company’s net cash provided by operating activities increased $15.9 million, or 24.0%, to $82.3 million for the nine months ended September 30, 2003, compared to $66.4 million for the nine months ended September 30, 2002. The increase was primarily attributable to the $18.3 million payment the Company received in the third quarter of 2003 in connection with the Peregrine settlement agreement. See further discussion regarding this agreement under the caption “Factors Which May Influence Future Results of Operations—Recent information regarding significant tenants—Peregrine Systems, Inc.”
Net cash used in investing activities decreased $48.1 million, or 60.9% to $30.8 million for the nine months ended September 30, 2003 compared to $78.9 million for the nine months ended September 30, 2002. Cash used in investing activities for the nine months ended September 30, 2003 consisted primarily of expenditures for development and redevelopment projects of $47.2 million, $17.7 million for tenant improvements and capital expenditures offset by $34.1 million in net proceeds from the sale of seven office buildings. Cash used in investing activities for the nine months ended September 30, 2002 consisted primarily of expenditures for development projects of $63.7 million, $11.6 million for tenant improvements and capital expenditures and $2.2 million of cash paid toward the purchase of The Allen Group’s minority interest in Development LLCs offset by $6.2 million in net proceeds from the sale of one office property.
Net cash provided by financing activities decreased $57.1 million, or 977.7% to $51.2 million net cash used in financing activities for the nine months ended September 30, 2003 compared to $5.8 million net cash provided by financing activities for the nine months ended September 30, 2002. Cash used by financing activities for the nine months ended September 30, 2003 consisted primarily of $83.8 million used for principal payments on secured debt
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and the repayment of one mortgage loan that was schedule to mature in October 2003, $47.1 million in distributions paid to common stockholders and common unitholders and $33.0 million in net repayments on the Credit Facility partially offset by $105.2 million of net proceeds from the issuance of new mortgage debt and additional funding under a construction loan and $11.1 million in proceeds received in connection with the exercise of stock options. Cash provided by financing activities for the nine months ended September 30, 2002 consisted primarily of $257.7 million of net borrowings under the Credit Facility and net proceeds from the issuance of mortgage debt and $4.2 million in proceeds received in connection with the exercise of stock options partially offset by $206.3 million in principal payments on the secured the debt, the repayment of the unsecured term facility and four construction loans and $47.9 million in distributions paid to common stockholders, common unitholders and minority interests.
Non-GAAP Supplemental Financial Measure: Funds From Operations
Management believes that Funds From Operations (“FFO”) is a useful supplemental measure of the Company’s operating performance. The Company computes FFO in accordance with the White Paper on FFO approved by the Board of Governors of the National Association of Real Estate Investment Trusts (“NAREIT”). The White Paper defines FFO as net income or loss computed in accordance with generally accepted accounting principles (“GAAP”), excluding extraordinary items, as defined by GAAP, and gains and losses from sales of depreciable operating property, plus real estate related depreciation and amortization (excluding amortization of deferred financing costs and depreciation of non-real estate assets), and after adjustment for unconsolidated partnerships and joint ventures. Other REITs may use different methodologies for calculating FFO, and accordingly, the Company’s FFO may not be comparable to other REITs.
Because FFO excludes depreciation and amortization, gains and losses from property dispositions and extraordinary items, it provides a performance measure that, when compared year over year, reflects the impact to operations from trends in occupancy rates, rental rates, operating costs, development activities, general and administrative expenses and interest costs, providing perspective not immediately apparent from net income. In addition, management believes that FFO provides useful information to the investment community about the Company’s financial performance when compared to other REITs since FFO is generally recognized as the industry standard for reporting the operations of REITs.
However, FFO should not be viewed as an alternative measure of the Company’s operating performance since it does not reflect either depreciation and amortization costs or the level of capital expenditures and leasing costs necessary to maintain the operating performance of the Company’s properties, which are significant economic costs and could materially impact the Company’s results from operations.
The following table reconciles the Company’s FFO to the Company’s GAAP net income for the three and nine months ended September 30, 2003 and 2002.
Adjustments:
Net gains on dispositions of operating properties
Funds From Operations
Inflation
The majority of the Company’s tenant leases require tenants to pay most operating expenses, including real estate taxes, utilities, insurance and increases in common area maintenance expenses, which reduces the Company’s exposure to increases in costs and operating expenses resulting from inflation.
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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The primary market risk faced by the Company is interest rate risk. The Company mitigates this risk by maintaining prudent amounts of leverage, minimizing capital costs and interest expense while continuously evaluating all available debt and equity resources and following established risk management policies and procedures, which include the periodic use of derivatives. The Company’s primary strategy in entering into derivative contracts is to minimize the variability that changes in interest rates could have on its future cash flows. The Company generally employs derivative instruments that effectively convert a portion of its variable rate debt to fixed rate debt. The Company does not enter into derivative instruments for speculative purposes.
Information about the Company’s changes in interest rate risk exposures from December 31, 2002 to September 30, 2003 is incorporated herein by reference to “Item 2: Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources” above.
Tabular Presentation of Market Risk
The tabular presentation below provides information about the Company’s interest-rate sensitive financial and derivative instruments at September 30, 2003 and December 31, 2002. All of the Company’s interest-rate sensitive financial and derivative instruments are held for purposes other than trading. For debt obligations, the table presents principal cash flows and related weighted average interest rates or the interest rate index by contractual maturity dates with the assumption that all extension options will be exercised. The interest rate spreads on the Company’s variable rate debt ranged from LIBOR plus 1.40% to LIBOR plus 1.85% at September 30, 2003 and December 31, 2002. For the interest rate cap and swap agreements, the table presents the aggregate notional amount and weighted average interest rates or strike rates by contractual maturity date. The notional amounts are used solely to calculate the contractual cash flow to be received under the contract and do not reflect outstanding principal balances at September 30, 2003 and December 31, 2002. The table also presents comparative summarized information for financial and derivative instruments held at December 31, 2002.
Interest Rate Risk Analysis—Tabular Presentation
(dollars in millions)
Liabilities:
Unsecured line of credit:
Variable rate
Variable rate index
Secured debt:
Fixed rate
Average interest rate
Interest Rate Derivatives Used to Hedge Variable Rate Debt:
Interest rate swap agreements:
Notional amount
Fixed pay interest rate
Variable receive rate index
Interest rate cap agreements:
Cap rate
Forward rate index
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ITEM 4. CONTROLS AND PROCEDURES
The Company maintains disclosure controls and procedures that are designed to ensure that information required to be disclosed in the Company’s Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms and that such information is accumulated and communicated to the Company’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate, to allow for timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.
As of September 30, 2003, the end of the quarter covered by this report, the Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and the Company’s Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures. Based on the foregoing, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective at the reasonable assurance level.
There have been no significant changes in the Company’s internal controls or in other factors that could significantly affect the internal controls subsequent to the date the Company completed its evaluation.
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PART II—OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
As previously reported, in March 2003, one of the Company’s former tenants, EBC I, formerly known as eToys, Inc. (“eToys”) filed a lawsuit in the Superior Court of the State of California against the Company, seeking return of the proceeds from two letters of credit previously drawn down by the Company. The tenant originally caused its lenders to deliver an aggregate of $15 million in letters of credit to secure its obligations under its lease with the Company and also to secure its obligations to repay the Company for certain leasing and tenant improvement costs. eToys defaulted on its lease and other obligations to the Company in January 2001 and subsequently filed for bankruptcy in March 2001. Management strongly disagrees with the points outlined in the suit and intends to vigorously defend itself against the claim. However, if eToys were to prevail in this action, it could have a material adverse effect upon the financial condition, results of operations and cash flows of the Company.
Other than ordinary routine litigation incidental to the business, the Company is not a party to, and its properties are not subject to, any legal proceedings which if determined adversely to the Company, would have a material adverse effect upon the financial condition, results of operations and cash flows of the Company.
ITEM 2. CHANGES IN SECURITIES
During the three months ended September 30, 2003, the Company redeemed 5,000 common limited partnership units of the Operating Partnership in exchange for shares of the Company’s common stock on a one-for-one basis. The 5,000 common shares issued in connection with these redemptions were issued pursuant to an effective registration statement.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES—None
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS—None
ITEM 5. OTHER INFORMATION—None
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
(b) Reports on Form 8-K
The Company filed a Current Report on Form 8-K dated July 28, 2003, in connection with its second quarter 2003 earnings release.
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Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized on November 4, 2003.
/s/ JOHN B. KILROY, JR.
John B. Kilroy, Jr.
President and Chief Executive Officer
(Principal Executive Officer)
By:
/s/ RICHARD E. MORANJR.
Richard E. Moran Jr.
Executive Vice President and Chief Financial Officer (Principal Financial Officer)
/s/ ANN MARIEWHITNEY
Ann Marie Whitney
Senior Vice President and Controller
(Principal Accounting Officer)
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