UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
For the quarterly period ended September 30, 2005
OR
For the transition period from to
Commission file number 1-12675
KILROY REALTY CORPORATION
(Exact name of registrant as specified in its charter)
12200 W. Olympic Boulevard, Suite 200, Los Angeles, California 90064
(Address of principal executive offices)
(310) 481-8400
(Registrant’s telephone number, including area code)
N/A
(Former name, former address and former fiscal year, if changed since last report)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes x No ¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
As of November 7, 2005, 28,923,325 shares of common stock, par value $.01 per share, were outstanding.
EXPLANATORY NOTE
As previously reported by Kilroy Realty Corporation (the “Company”) on Forms 8-K filed with the Securities and Exchange Commission on October 25, 2005 and October 31, 2005, the Company determined that its hedge designation memos for six interest rate swap and two interest rate cap agreements entered into by the Company in 2000 and 2002 do not meet the technical requirements to qualify for hedge accounting treatment in accordance with Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”). Prior to entering into each of these agreements, the Company engaged an independent consulting firm specializing in derivatives to advise the Company with respect to derivatives and hedging matters. The Company consulted closely with the independent derivatives specialist during its preparation of the formal designation of the instruments to ensure that each instrument qualified for hedge accounting treatment under SFAS 133 and the related accounting guidance. Although both the Company and the independent derivatives specialist believed the designation documentation met the requirements under SFAS 133 at the time the derivative transactions were entered into, the Company subsequently determined that the designation documentation does not meet the technical requirements under SFAS 133 to qualify for hedge accounting treatment. As a result, the Company is restating its consolidated financial statements for the three and nine months ended September 30, 2004 in this Form 10-Q and will be filing amendments to its Annual Report on Form 10-K/A for the year ended December 31, 2004 and its Quarterly Reports on Form 10-Q/A for the quarters ended March 31, 2005 and June 30, 2005 to mark all of these instruments to market and to recognize the impact of this mark to market adjustment in the statement of operations for each affected period, rather than through other comprehensive income.
In addition, based on a recent related review of the Company’s accounting treatment for tenant improvements reimbursed by the tenant, the Company is also restating its financial statements to record a capital asset and related depreciation for leasehold improvements constructed by the Company that are reimbursed by tenants, with a corresponding liability for deferred revenue, which will be amortized into rental revenue over the lives of the related leases. In connection with the restatement, certain other immaterial adjustments have also been recorded.
For a more detailed description of the restatement, see Note 14 to the consolidated financial statements included in this Report.
QUARTERLY REPORT FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2005
TABLE OF CONTENTS
Item 1.
FINANCIAL STATEMENTS (unaudited)
Consolidated Balance Sheets as of September 30, 2005 and December 31, 2004 (As Restated, see Note 14)
Consolidated Statements of Operations for the Three and Nine Months Ended September 30, 2005 and 2004 (As Restated, see Note 14)
Consolidated Statement of Stockholders’ Equity for the Nine Months Ended September 30, 2005 (As Restated, see Note 14)
Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2005 and 2004 (As Restated, see Note 14)
Notes to Consolidated Financial Statements
Item 2.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Item 3.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Item 4.
CONTROLS AND PROCEDURES
LEGAL PROCEEDINGS
UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
DEFAULTS UPON SENIOR SECURITIES
SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Item 5.
OTHER INFORMATION
Item 6.
EXHIBITS
SIGNATURES
2
PART I—FINANCIAL INFORMATION
CONSOLIDATED BALANCE SHEETS
(unaudited, in thousands, except share data)
(As Restated,
see Note 14)
REAL ESTATE ASSETS (Notes 2, 3 and 4):
Land and improvements
Buildings and improvements, net
Undeveloped land and construction in progress
Total real estate held for investment
Accumulated depreciation and amortization
Total real estate assets, net
CASH AND CASH EQUIVALENTS
RESTRICTED CASH
CURRENT RECEIVABLES, NET
DEFERRED RENT RECEIVABLES, NET
NOTE RECEIVABLE (Note 3)
DEFERRED LEASING COSTS AND OTHER RELATED INTANGIBLES, NET
DEFERRED FINANCING COSTS, NET (Note 6)
PREPAID EXPENSES AND OTHER ASSETS
TOTAL ASSETS
LIABILITIES:
Secured debt (Note 5)
Unsecured senior notes
Unsecured line of credit (Note 5)
Accounts payable, accrued expenses and other liabilities (Note 8)
Accrued distributions (Note 13)
Rents received in advance, tenant security deposits and deferred revenue
Total liabilities
COMMITMENTS AND CONTINGENCIES (Note 9)
MINORITY INTERESTS (Note 7):
7.45% Series A Cumulative Redeemable Preferred unitholders
Common unitholders of the Operating Partnership
Total minority interests
STOCKHOLDERS’ EQUITY (Note 8):
Preferred stock, $.01 par value, 21,840,000 shares authorized, none issued and outstanding
7.45% 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
9.25% Series D Cumulative Redeemable Preferred stock, $.01 par value,1,000,000 shares authorized, none issued and outstanding
7.80% Series E Cumulative Redeemable Preferred stock, $.01 par value,1,610,000 shares authorized, issued and outstanding
7.50% Series F Cumulative Redeemable Preferred stock, $.01 par value,3,450,000 shares authorized, issued and outstanding
Common stock, $.01 par value, 150,000,000 shares authorized,28,923,325 and 28,548,597 shares issued and outstanding, respectively
Additional paid-in capital
Deferred compensation
Distributions in excess of earnings
Total stockholders’ equity
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY
See accompanying notes to consolidated financial statements.
3
CONSOLIDATED STATEMENTS OF OPERATIONS
(unaudited, in thousands, except share and per share data)
REVENUES (Note 10):
Rental income
Tenant reimbursements
Other property income
Total revenues
EXPENSES (Note 10):
Property expenses
Real estate taxes
Provision for bad debts
Ground leases
General and administrative expenses (Note 8)
Interest expense
Depreciation and amortization
Total expenses
OTHER INCOME AND EXPENSE
Net settlement receipts (payments) on interest rate swaps
Gain (loss) on derivative instruments
Interest and other income
Total other income (expense)
INCOME FROM CONTINUING OPERATIONS BEFOREMINORITY INTERESTS
MINORITY INTERESTS:
Distributions on Cumulative Redeemable Preferred units
Minority interest in loss (earnings) of Operating Partnership attributable to continuing operations
INCOME FROM CONTINUING OPERATIONS
DISCONTINUED OPERATIONS (Note 11)
Revenues from discontinued operations
Expenses from discontinued operations
Net gain on disposition of discontinued operations
Impairment loss on property held for sale
Minority interest in earnings of Operating Partnershipattributable to discontinued operations
Total income from discontinued operations
NET INCOME
PREFERRED DIVIDENDS
NET INCOME AVAILABLE FOR COMMON STOCKHOLDERS
(Loss) income from continuing operations per common share—basic (Note 12)
(Loss) 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
4
CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY
Preferred
Stock
Deferred
Compensation
AccumulatedNet Other
Comprehensive
Income
Total
Number
of Shares
Common
Additional
Paid-inCapital
BALANCE AT DECEMBER 31, 2004 (as previously reported)
Prior period restatement adjustments (see Note 14)
BALANCE AT DECEMBER 31, 2004 (as restated, see Note 14)
Net income
Issuance of restricted stock (Note 8)
Forfeiture of restricted stock
Exercise of stock options
Non-cash amortization of restricted stock
Repurchase of common stock (Note 8)
Redemption of common limited partnership units of the Operating Partnership (Note 7)
Stock option expense (Note 1)
Adjustment for minority interest (Note 1)
Preferred dividends
Common dividends declared ($1.53 per share)
BALANCE AT SEPTEMBER 30, 2005
5
CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited, in thousands)
See Note 14)
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
Net gain on disposition of operating properties
Minority interest in earnings of Operating Partnership
Non-cash amortization of restricted stock grants
Non-cash amortization of deferred financing costs
Non-cash amortization of deferred revenue for reimbursement of tenant improvements
(Gain) loss on derivative instruments
Net settlement (receipts) payments on interest rate swaps
Amortization of above/below market rents, net
Decrease in provision for uncollectible tenant receivables
Increase in provision for uncollectible deferred rent receivables
Depreciation of furniture, fixtures and equipment
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 development and redevelopment projects and undeveloped land
Acquisition of an operating property and undeveloped land
Net proceeds received from dispositions of operating properties
Increase in escrow deposits
(Increase) decrease in restricted cash
Net cash settlement receipts (payments) on interest rate swaps
Net cash used in investing activities
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from issuance of secured debt
Proceeds from issuance of unsecured senior notes
Net borrowings (repayments) on unsecured line of credit
Principal payments on secured debt
Distributions paid to common stockholders and common unitholders
Financing costs
Proceeds from exercise of stock options
Distributions paid to preferred stockholders and preferred unitholders
Net cash used in 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 of $6,475 and $5,263 at September 30, 2005 and 2004, respectively
NON-CASH TRANSACTIONS:
Accrual of distributions payable to common stockholders and common unitholders (Note 13)
Note receivable received in connection with the disposition of an operating property
Receipt of stock in connection with a lease termination fee
6
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Three and Nine months ended September 30, 2005 and 2004
(unaudited)
Organization
Kilroy Realty Corporation (the “Company”) owns, operates and develops office and industrial real estate, primarily in Southern California. The Company operates as a self-administered real estate investment trust (“REIT”). As of September 30, 2005, the Company’s stabilized portfolio of operating properties consisted of 84 office buildings (the “Office Properties”) and 48 industrial buildings (the “Industrial Properties”), which encompassed an aggregate of approximately 7.8 million and 4.7 million rentable square feet, respectively, and was 92.8% occupied. The Company’s stabilized portfolio of operating properties consists of all of the Office Properties and Industrial Properties and excludes properties currently under construction and “lease-up” properties.
The Company defines “lease-up” properties as properties recently developed or redeveloped by the Company that have not yet reached 95% occupancy and are within one year following substantial completion. Lease-up properties are reclassified to land and improvements and building and improvements from construction in progress on the consolidated balance sheets upon building shell completion. As of September 30, 2005, the Company did not have any properties in the lease-up phase. As of September 30, 2005, the Company had two development properties under construction, which when completed are expected to encompass approximately 103,300 rentable square feet. The Company had no redevelopment properties under construction as of September 30, 2005.
The Company owns its interests in all of its Office Properties and Industrial Properties through Kilroy Realty, L.P. (the “Operating Partnership”) and Kilroy Realty Finance Partnership, L.P. (the “Finance Partnership”) and conducts substantially all of its operations through the Operating Partnership. The Company owned an 88.6% general partnership interest in the Operating Partnership as of September 30, 2005. Kilroy Realty Finance, Inc., a wholly-owned subsidiary of the Company, is the sole general partner of the Finance Partnership and owns a 1.0% general partnership interest in the Finance Partnership. The Operating Partnership owns the remaining 99.0% limited partnership interest of the Finance Partnership. The Company conducts substantially all of its development services through Kilroy Services, LLC (“KSLLC”), which is a wholly-owned subsidiary of the Operating Partnership. Unless otherwise indicated, all references to the Company include the Operating Partnership, the Finance Partnership, KSLLC and all wholly-owned subsidiaries of the Company.
Basis of Presentation
The consolidated financial statements of the Company include the consolidated financial position and results of operations of the Company, the Operating Partnership, the Finance Partnership, KSLLC and all wholly-owned subsidiaries. All significant intercompany balances and transactions have been eliminated in the consolidated financial statements.
The Company consolidates all variable interest entities (“VIE”) in which it is deemed to be the primary beneficiary in accordance with the FASB Interpretation No. 46R (“FIN 46R”). As of September 30, 2005, the Company consolidated one VIE in connection with an agreement entered into in September 2005 to facilitate a 1031 tax-deferred property exchange. Under the terms of the agreement, the Company is obligated to purchase the operating property held by the VIE within 180 days of the acquisition of the property to complete the exchange. The Company retains all rights to appreciation and all exposure to depreciation in the value of the property during the period it is held by the VIE. The impact of consolidating the VIE is to increase the Company’s total real estate asset balance by approximately $24 million at September 30, 2005. The acquisition
7
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
of the operating property was funded with borrowings under the Company’s Credit Facility (defined in Note 5). As of June 30, 2005, the Company had also consolidated a VIE as a result of an agreement entered into in May 2005 to facilitate a 1031 tax-deferred property exchange. This exchange was completed in July 2005, at which point the Company no longer had an interest in the entity.
Net income after preferred distributions and preferred dividends is allocated to the common limited partners of the Operating Partnership (“Minority Interest of the Operating Partnership”) based on their ownership percentage of the Operating Partnership. The common limited partner ownership percentage is determined by dividing the number of common units held by the Minority Interest of the Operating Partnership by the total common units outstanding. The issuance of additional shares of common stock or common units results in changes to the Minority Interest of the Operating Partnership percentage as well as the total net assets of the Company. As a result, all capital transactions result in an allocation between stockholders’ equity and the minority interest held by common unitholders of the Operating Partnership in the accompanying consolidated balance sheets to account for the change in the Minority Interest of the Operating Partnership ownership percentage as well as the change in total net assets of the Company.
The accompanying interim financial statements have been prepared by the Company’s management in accordance with accounting principles generally accepted in the United States of America (“GAAP”) and in conjunction with the rules and regulations of the Securities and Exchange Commission (“SEC”). Certain information and footnote disclosures required for annual financial statements have been condensed or excluded pursuant to SEC rules and regulations. Accordingly, the interim financial statements do not include all of the information and footnotes required by GAAP for complete financial statements. In the opinion of management, the accompanying interim financial statements reflect all adjustments of a normal and recurring nature which are considered necessary for a fair presentation of the results for the interim periods presented. However, the results of operations for the interim periods are not necessarily indicative of the results that may be expected for the year ending December 31, 2005.
Reclassifications
Certain prior period amounts have been reclassified to conform to the current period’s presentation.
Recent Accounting Pronouncements
In December 2004, the FASB issued Statement 123 (revised), “Share-Based Payment” (“FAS 123R”). FAS 123R requires that all share-based payments to employees, including grants of employee stock options, be recognized in the income statement based on their fair values. The new standard will be effective as of the beginning of the first fiscal year beginning after June 15, 2005. The adoption of this statement is not expected to have a material effect on the Company’s results of operations or financial condition.
In March 2005, the FASB issued Interpretation No. 47, “Accounting for Conditional Asset Retirement Obligations” (“FIN 47”). FIN 47 clarifies guidance provided in FASB Statement No. 143, “Accounting for Asset Retirement Obligations.” The term asset retirement obligation refers to a legal obligation to perform an asset retirement activity in which the timing and/or method of settlement are conditional on a future event that may or may not be within the control of the entity. Entities are required to recognize a liability for the fair value of a conditional asset retirement obligation when incurred if the liability’s fair value can be reasonably estimated. FIN 47 will be effective as of the end of the first fiscal year ending after December 15, 2005. The adoption of the interpretation is not expected to have a material effect on the Company’s results of operations or financial condition.
8
Stock Option Accounting
Effective January 1, 2002, the Company voluntarily adopted the fair value recognition provisions of SFAS 123, “Accounting for Stock-Based Compensation” (“SFAS 123”) prospectively, for all employee stock option awards granted or settled after January 1, 2002. Under the fair value recognition provisions of SFAS 123, total compensation expense related to stock options is determined using the fair value of the stock options on the date of grant. Total compensation expense is then recognized on a straight-line basis over the option vesting period. All of the Company’s outstanding stock options were fully vested as of February 2005.
Prior to 2002, the Company accounted for stock options issued under the recognition and measurement provisions of APB Opinion 25 “Accounting for Stock Issued to Employees” and related interpretations. The following table illustrates the effect on net income and earnings per share if the fair value based method had been applied to all outstanding and unvested awards in each period.
Net income available for common stockholders, 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 available for common stockholders
Net income per common share:
Basic—as reported
Basic—pro forma
Diluted—as reported
Diluted—pro forma
In May 2005, the Company acquired an office property in Brea, California from an unaffiliated third party for a purchase price of $7.3 million. The building, which encompasses approximately 45,900 rentable square feet, was 100% leased as of September 30, 2005.
In June 2005, the Company acquired approximately 11.3 acres of undeveloped land located in San Diego County, California from an unaffiliated third party for approximately $24.0 million.
In September 2005, the Company acquired an industrial property in San Diego, California from an unaffiliated third party for a purchase price of approximately $24 million. The property includes a 20-acre land site and one building, which encompasses approximately 303,000 rentable square feet. Upon acquisition, the Company executed a one-year lease with the seller to continue to occupy the entire building through September 2006. The lease also includes a three-month extension option. The Company will recognize approximately $1.4 million in rental revenue during the next year in connection with this lease. At the termination of the lease, the Company plans to redevelop the site and currently anticipates developing approximately 600,000 to one million square feet of office space. The site includes entitlements to build approximately 1.8 million square feet of office and light industrial space. These acquisitions were each funded with borrowings under the Company’s Credit Facility (defined in Note 5).
9
During the nine months ended September 30, 2005, the Company sold the following properties:
Address / City
2501 Pullman/1700 Carnegie
Santa Ana, CA
525 North Brand
Glendale, CA
5115 North 27th Avenue
Phoenix, AZ
2260 E. El Segundo Blvd
El Segundo, CA
The Company sold four buildings in March 2005 through a portfolio transaction to an unrelated third party for an aggregate gross sales price of $38.7 million. The Company recorded a net gain of approximately $5.8 million in connection with the disposition. The Company sold the one industrial property in July 2005 to an unrelated third party for a gross sales price of $22.5 million, which consisted of an $11.25 million cash payment and an $11.25 million note receivable from the buyer. The note bears interest at an annual rate of 7.0%, requires monthly principal and interest payments based on a 30-year amortization period, and matures in July 2012. In addition, the principal and any accrued and unpaid interest may be prepaid in whole or in part at any time without penalty or premium. As partial consideration for the sale, the Company will also participate in certain future profits from the operation or sale of the property as set forth in a profit participation agreement, without risk of loss or further continuing involvement. The contingent future profits will be recognized in the period they are realized. The Company recorded a net gain of approximately $17.8 million in connection with the disposition. The Company used the net cash proceeds from the sale of these properties to fund its development program and to repay borrowings under the Credit Facility (defined in Note 5). The net income and the net gain on disposition for these properties have been included in discontinued operations for the three and nine months ended September 30, 2005 and 2004 (see Note 11).
Stabilized Redevelopment Projects
During the nine months ended September 30, 2005, the Company added the following redevelopment projects to the Company’s stabilized portfolio:
Address / Submarket / City
5717 Pacific Center Blvd.
Sorrento Mesa
San Diego, CA
909 N. Sepulveda Blvd.
10
Unsecured Line of Credit
As of September 30, 2005, the Company had borrowings of $199.0 million outstanding under its revolving unsecured line of credit (the “Credit Facility”) and availability of approximately $226.0 million. The Credit Facility bears interest at an annual rate between LIBOR plus 1.00% and LIBOR plus 1.70% depending upon the Company’s leverage ratio at the time of borrowing (4.97% at September 30, 2005), and matures in October 2007 with an option to extend the maturity for one year. The fee for unused funds ranges from an annual rate of 0.20% to 0.30% depending on the Company’s leverage ratio. The Company expects to use the Credit Facility to finance development and redevelopment expenditures, to fund potential acquisitions and for other general corporate uses.
Secured Debt
In June 2005, the Company borrowed $35.5 million under a mortgage loan that is secured by eleven properties, requires interest-only payments based on a variable annual interest rate of LIBOR plus 0.90% (4.67% at September 30, 2005) and matures in July 2008. The loan has two one-year extension options and allows for partial recourse, up to 25% of the principal balance of the loan. The Company used a portion of the proceeds to repay an outstanding mortgage loan with a principal balance of $29 million that was scheduled to mature in December 2005. The remainder of the proceeds was used primarily to repay borrowings under the Credit Facility.
Debt Covenants and Restrictions
The Credit Facility, the unsecured senior notes and certain other secured debt arrangements contain covenants and restrictions requiring the Company to meet certain financial ratios and reporting requirements, including a maximum total debt to total assets ratio, a maximum total secured debt to total assets ratio, a maximum dividend payout ratio, minimum debt service coverage and fixed charge coverage ratios, minimum consolidated tangible net worth and a limit of development activities as compared to total assets. The Company was in compliance with all of its debt covenants at September 30, 2005.
Capitalized Interest and Loan Fees
Total interest and loan fees capitalized for the three months ended September 30, 2005 and 2004 were $2.6 million and $2.1 million, respectively. Total interest and loan fees capitalized for the nine months ended September 30, 2005 and 2004 were $6.8 million and $5.7 million, respectively.
The following table sets forth the terms and fair market value of the Company’s derivative financial instruments at September 30, 2005:
Interest rate swap
Total included in deferred financing costs
11
In January 2005, the Company’s interest-rate swap agreement to fix LIBOR on $50 million of its variable-rate debt at 4.46% expired.
Minority interests represent the common and preferred limited partnership interests in the Operating Partnership. The Company owned an 88.6% and 87.7% general partnership interest in the Operating Partnership as of September 30, 2005 and 2004, respectively.
During the nine months ended September 30, 2005, 272,249 common limited partnership units of the Operating Partnership were redeemed for shares of the Company’s common stock on a one-for-one basis. Neither the Company nor the Operating Partnership received any proceeds from the issuance of the common stock in exchange for common limited partnership units.
In February 2005, the Company’s Executive Compensation Committee granted an aggregate of 101,112 restricted shares of common stock to certain executive officers and key employees. Compensation expense for the restricted shares is calculated based on the closing price per share of $41.35 on the February 23, 2005 grant date. Of the shares granted, 18,139 vest at the end of a one-year period, 61,812 vest in equal annual installments over a two-year period and 21,161 vest in equal annual installments over a five-year period. The Company recorded approximately $0.4 million and $0.3 million in compensation expense related to these restricted stock grants during the three months ended September 30, 2005 and 2004, respectively and $1.0 million during each of the nine months ended September 30, 2005 and 2004.
In May 2005, the Company’s Executive Compensation Committee granted an aggregate of 2,694 restricted shares of the Company’s common stock to non-employee board members as part of the board members’ annual compensation plan. Of the shares granted, 1,350 vest at the end of a one-year period and 1,344 vest at the end of a two-year period. Compensation expense for the restricted shares is calculated based on the closing per-share price of $44.56 on the May 17, 2005 grant date. The Company recorded approximately $15,000 and $22,000 related to these restricted stock grants during the three and nine months ended September 30, 2005, respectively.
In March 2003, the Company’s Executive Compensation Committee approved a special long-term compensation program for the Company’s executive officers. The program provides for cash compensation to be earned at December 31, 2005 if the Company attains certain performance measures based on annualized total stockholder returns on an absolute and relative basis. The amount payable for the absolute component is based upon the amount by which the annualized total return to stockholders over the period exceeds 10%. The targets for the relative component require the Company to obtain an annualized total return to stockholders that is at or above the 70th percentile of annualized total return to stockholders achieved by members of a pre-defined peer group during the same three-year period, and includes additional incentives for annualized total return to stockholders that is at or above the 80th percentile. Compensation expense under this program is accounted for using variable plan accounting. The Company estimates the amount to be paid based on the average closing share price of the Company’s common stock as reported on the New York Stock Exchange (“NYSE”) for the last ten days of the period, and records compensation expense equal to that portion of the total compensation applicable to the portion of the performance period that has elapsed through the end of the period. Under the absolute portion of the plan, for every $1 change in the Company’s ten-day average closing stock price, the total payable over the three-year term of the plan changes by approximately $1.7 million. During the three months ended September 30, 2005 and 2004, the Company accrued approximately $13.9 million and $5.8 million, respectively, and during the nine months ended September 30, 2005 and 2004, the Company accrued $28.1 million and $10.7
12
million, respectively, of compensation expense related to this plan, which is included in general and administrative expenses. The total amount accrued relating to the plan was $52.5 million as of September 30, 2005, which is included in accounts payable, accrued expenses and other liabilities.
During the nine months ended September 30, 2005, the Company accepted the return, at the current quoted market price, of 41,379 shares of its common stock from certain key employees in accordance with the provisions of its incentive stock plan to satisfy minimum statutory tax-withholding requirements related to restricted shares that vested during this period.
In January 2005, the Company paid $1.8 million pursuant to a court approved settlement agreement related to a lease termination that occurred in 2001. The amount was previously recorded as a charge to other property income during the third quarter of 2004.
13
The Company’s reportable segments consist of the two types of commercial real estate properties for which management internally evaluates operating performance and financial results: Office Properties and Industrial Properties. The Company also has certain corporate level activities, including legal, accounting, finance and management information systems, which are not considered separate operating segments.
The Company evaluates the performance of its segments based upon Net Operating Income. Net Operating Income is defined as operating revenues (rental income, tenant reimbursements and other property income) less property and related expenses (property expenses, real estate taxes, ground leases and provision for bad debts) and does not include interest and other income, interest expense, depreciation and amortization and general and administrative expenses. There is no intersegment activity.
Office Properties:
Operating revenues(1)
Property and related expenses
Net Operating Income, as defined
Industrial Properties:
Total Reportable Segments:
Reconciliation to Consolidated Net Income Available to Common Stockholders:
Total Net Operating Income, as defined, for reportable segments
Unallocated other income (expense):
Other unallocated expenses:
General and administrative expenses
Income from continuing operations before minority interests and preferred dividends
Minority interests attributable to continuing operations
Income from discontinued operations
Net income available to common stockholders
14
In accordance with SFAS 144 “Accounting for the Impairment or Disposal of Long-Lived Assets,” the net income or loss and the net gain or loss on dispositions of operating properties sold and classified as held for sale are reflected in the consolidated statements of operations as discontinued operations for all periods presented. For the three and nine months ended September 30, 2005 and 2004, discontinued operations included the net income or loss and the net gain on sale of the five buildings sold during the nine months ended September 30, 2005. For the three and nine months ended September 30, 2004, discontinued operations also included the net income, the impairment loss and net gain or loss on sale of the two properties sold in 2004. The following table summarizes the income and expense components that comprise discontinued operations for the three and nine months ended September 30, 2005 and 2004:
REVENUES:
EXPENSES:
(Loss) income from discontinued operations before minority interests
Impairment loss
Minority interest in earnings of Operating Partnership attributable to discontinued operations
15
Basic earnings per share is computed by dividing net income or loss by the weighted-average number of common shares outstanding for the period. Diluted earnings per share is computed by dividing net income or loss by the sum of the weighted-average number of common shares outstanding for the period plus the number of common shares issuable assuming the exercise of all dilutive securities. The Company does not consider common units of the Operating Partnership to be dilutive since any issuance of shares of common stock upon the redemption of the common units would be on a one-for-one basis and would not have any effect on diluted earnings per share. The following table reconciles the numerator and denominator of the basic and diluted per-share computations for net income.
Numerator:
Income from continuing operations
(Loss) income from continuing operations available for common stockholders
Discontinued operations
Net income available for common stockholders—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:
Net income available for common stockholders
Diluted earnings per share:
For the three months ended September 30, 2005, the effect of the assumed exercise of the 78,000 outstanding stock options and the effect of the 155,309 unvested shares of restricted stock were not included in the earnings per share calculation as their effect is antidilutive to the loss from continuing operations available for common stockholders.
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On October 18, 2005, aggregate dividends and distributions of approximately $16.6 million were paid to common stockholders and common unitholders of record on September 30, 2005.
On October 3, 2005, the Company borrowed from the Credit Facility to repay an outstanding mortgage loan with a principal balance of $9.8 million that was scheduled to mature in December 2005.
As of the date of this report, the Company is in escrow to sell an industrial property, which encompasses approximately 77,000 rentable square feet and is located at 2265 E. El Segundo. The sale is expected to close in the fourth quarter of 2005 or the first quarter of 2006. The Company expects to record a gain in connection with the disposition.
Derivative Instruments
Subsequent to the issuance of the Company’s interim consolidated financial statements for the three and nine months ended September 30, 2004, the Company determined that its hedge designation memos for six interest rate swap and two interest rate cap agreements entered into by the Company in 2000 and 2002 do not meet the technical requirements to qualify for hedge accounting treatment in accordance with Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”). Prior to entering into each of these agreements, the Company engaged an independent consulting firm specializing in derivatives to advise the Company with respect to derivatives and hedging matters. The Company consulted closely with the independent derivatives specialist during its preparation of the formal designation of the instruments to ensure that each instrument qualified for hedge accounting treatment under SFAS 133 and the related accounting guidance. Although both the Company and the independent derivatives specialist believed the designation documentation met the requirements under SFAS 133 at the time the derivative transactions were entered into, the Company has subsequently determined that the designation documentation does not meet the technical requirements under SFAS 133 to qualify for hedge accounting treatment. As a result, the Company has restated its consolidated financial statements for the three and nine months ended September 30, 2004 to mark all of these instruments to market and to recognize the impact of this mark to market adjustment in the statement of operations for each period, rather than through other comprehensive income.
Leasehold Improvements Paid by Tenants
The Company restated its consolidated financial statements to record a capital asset and related depreciation for leasehold improvements constructed by the Company that are reimbursed by tenants, with a corresponding liability for deferred revenue, which will be amortized into rental revenue over the life of the related leases.
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The Company also determined that certain immaterial costs that were previously capitalized and depreciated in subsequent periods should have been expensed. The restated financial statements include an adjustment for these amounts. The following tables summarize the effects of the above mentioned changes on the Company's consolidated financials statements:
Consolidated Balance Sheet
ASSETS
Deferred leasing costs and other related intangibles, net
LIABILITIES AND STOCKHOLDERS’ EQUITY
Minority Interests: Common unitholders of the Operating partnership
Accumulated net other comprehensive income
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Consolidated Statements of Operations
Three Months Ended
September 30, 2004
Nine Months Ended
OTHER INCOME AND EXPENSE:
Net settlement payments on interest rate swaps
(Loss) gain on derivative instruments
INCOME FROM CONTINUING OPERATIONS BEFORE MINORITY INTERESTS
Minority interest in earnings of Operating Partnership attributable to continuing operations
Income from continuing operations per common share—basic
Income from continuing operations per common share—diluted
Net income per common share—basic
Net income per common share—diluted
Consolidated Statement of Cash Flows
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The following discussion relates to the consolidated financial statements of the Company and should be read in conjunction with the financial statements and notes thereto appearing elsewhere in this report. Statements contained in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” that are not historical facts may be forward-looking statements. Such statements are subject to certain risks and uncertainties, which could cause actual results to differ materially from those projected. Some of the information presented is forward-looking in nature, including information concerning projected future occupancy rates, rental rate increases, project development timing and investment amounts. Although the information is based on the Company’s current expectations, actual results could vary from expectations stated in this report. Numerous factors will affect the Company’s actual results, some of which are beyond its control. These include the timing and strength of regional economic growth, the strength of commercial and industrial real estate markets, competitive market conditions, fluctuations in availability and cost of construction materials and labor resulting from the effects of recent natural disasters and increased worldwide demand, future interest rate levels and capital market conditions. You are cautioned not to place undue reliance on this information, which speaks only as of the date of this report. The Company assumes no obligation to update publicly any forward-looking information, whether as a result of new information, future events or otherwise, except to the extent the Company is required to do so in connection with its ongoing requirements under federal securities laws to disclose material information. For a discussion of important risks related to the Company’s business and an investment in its securities, including risks that could cause actual results and events to differ materially from results and events referred to in the forward-looking information contained in this report, see the discussion under the caption “Business Risks” in the Company’s annual report on Form 10-K, as amended, for the year ended December 31, 2004 and under the caption “Factors That May Influence Future Results of Operations” below.
Impact of Restatements
Management’s Discussion and Analysis of Financial Condition and Results of Operations has been updated to reflect the restatements for the three and nine months ended September 30, 2004. For a more detailed description of the restatements, see Note 14 to the accompanying consolidated financial statements included in this Form 10-Q.
Overview and Background
Kilroy Realty Corporation (the “Company”) owns, operates, and develops office and industrial real estate, primarily in Southern California. The Company operates as a self-administered real estate investment trust (“REIT”). The Company owns its interests in all of its properties through Kilroy Realty, L.P. (the “Operating Partnership”) and Kilroy Realty Finance Partnership, L.P. (the “Finance Partnership”) and conducts substantially all of its operations through the Operating Partnership. The Company owned an 88.6% and 87.7% general partnership interest in the Operating Partnership as of September 30, 2005 and 2004, respectively. The Company conducts substantially all of its development services through Kilroy Services, LLC, which is a wholly owned subsidiary of the Operating Partnership.
Factors That May Influence Future Results of Operations
Rental income. The amount of net rental income generated by the Company’s properties depends principally on its ability to maintain the occupancy rates of currently leased space and to lease currently available space, newly developed or redeveloped properties and space available from unscheduled lease terminations. The amount of rental income generated by the Company also depends on its ability to maintain or increase rental rates in its submarkets. Negative trends in one or more of these factors could adversely affect the Company’s rental income in future periods.
Rental rates. For leases that commenced during the three months ended September 30, 2005, rental rates increased 12.6% on a GAAP basis, and 1.7% on a cash basis. Rental rates for leases that commenced during the
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nine months ended September 30, 2005 increased 1.8% on a GAAP basis, and decreased 7.5% on a cash basis. The change in rental rate on a cash basis is calculated as the change between the initial stated rent for a new or renewed lease and the ending stated rent for the expiring lease for the same space, whereas the change in rental rate on a GAAP basis compares the average rents over the term of the lease for each lease. Both calculations exclude leases for which the space was vacant longer than one year. Rental rates for the nine months ended September 30, 2005 were significantly impacted by one lease the Company renewed, during the second quarter of 2005, with a tenant located in one office complex in Seattle, Washington which had a decrease in the rental rate of 62.0% and 63.6% on a GAAP and cash basis, respectively. The substantial decline in rental rates was mainly attributable to the prior lease having a term of approximately twenty-five years. Since this lease had periodic rent escalations and the lease term was longer than the Company’s average lease term, the ending rental rate was significantly above market. Excluding this lease, the change in rental rates for the nine months ended September 30, 2005 would have been an increase of 7.8% on a GAAP basis and a decrease of 2.5% on a cash basis. Management believes that the average rental rates for its properties are approximately at the current average quoted market rates, although individual properties within any particular submarket presently may be leased above or below the current quoted market rates within that submarket. The Company cannot give any assurance that leases will be renewed or that available space will be re-leased at rental rates equal to or above the current quoted market rates.
Scheduled lease expirations. In addition to the 906,000 square feet of currently available space in the Company’s stabilized portfolio, leases representing approximately 0.8% and 9.6% of the leased square footage of the Company’s stabilized portfolio are scheduled to expire during the remainder of 2005 and 2006, respectively. The leases scheduled to expire during the remainder of 2005 and the leases scheduled to expire in 2006 represent approximately 0.6 million square feet of office space, or 6.3% of the Company’s total annualized base rent, and 0.7 million square feet of industrial space, or 2.3% of the Company’s total annualized base rent, respectively. Management believes that the average rental rates for leases scheduled to expire during the remainder of 2005 and 2006 are slightly above the current average quoted market rates. The Company’s ability to re-lease available space depends upon the market conditions in the specific submarkets in which the properties are located.
Submarket Information
Los Angeles County. There continue to be signs of improvement in market conditions in the overall Los Angeles County region in 2005, based on third-party reports of positive net absorption and decreased levels of direct vacancy as well as an increased level of interest in leasing opportunities at the Company’s properties. Most notable have been the improvements seen in the West Los Angeles and Long Beach submarkets. The El Segundo submarket remains the Company’s most significant leasing challenge. However, management has begun to see signs of improvement in the region. At September 30, 2005, the Company’s Los Angeles stabilized office portfolio was 88% occupied with approximately 376,000 vacant rentable square feet as compared to 91% occupied with approximately 257,100 vacant rentable square feet at December 31, 2004. The decrease in occupancy was primarily attributable to one redevelopment project that was added to the stabilized portfolio during the third quarter of 2005 since one year had passed following substantial completion. As of the date of this report, the Company had executed leases or letters of intent for approximately 49% of the space, 19% of which was occupied as of that date. The building is located in a two-building office complex in the El Segundo submarket. As noted above, the El Segundo submarket is the Company’s most significant leasing challenge, as vacancy rates remain the highest in the region. However, the Company’s leasing efforts continue to show progress with several new office leases signed during the year in this office complex and at other properties in this submarket. The other building in this office complex, which encompasses approximately 127,900 rentable square feet, was approximately 88% leased as of September 30, 2005 compared to 37% as of December 31, 2004. Management expects conditions in the El Segundo submarket to continue to improve given the strength in the neighboring submarkets. As of September 30, 2005, leases representing an aggregate of approximately 26,300 and 223,000 rentable square feet are scheduled to expire during the remainder of 2005 and 2006, respectively, in the Los Angeles County submarket.
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San Diego County. San Diego County remains one of the strongest markets in Southern California real estate based on third-party reports of positive absorption, increased rental rates and growing tenant demand. The Company continues to expand its presence in this market by aggressively seeking and obtaining development and redevelopment opportunities in the region. See additional information regarding the Company’s development projects under the caption “—Development and redevelopment programs.” As of September 30, 2005, the Company’s San Diego stabilized office portfolio was 92% occupied with approximately 285,300 vacant rentable square feet compared to 97% occupied with approximately 102,300 vacant rentable square feet as of December 31, 2004. The decrease in occupancy is partially attributable to one redevelopment project, encompassing approximately 68,000 rentable square feet, that was previously in the lease-up phase and was added to the stabilized portfolio during the first quarter of 2005 since one year had passed following substantial completion. In August 2005, the Company executed a lease for 100% of this space, which is scheduled to commence per the lease agreement in December 2005. The decrease in occupancy is also attributable to lease expirations at two buildings in the Sorrento Mesa submarket, which were previously 100% occupied. One of the buildings, encompassing approximately 130,000 rentable square feet, was 11% occupied and the other building, encompassing approximately 63,400 rentable square feet was vacant as of September 30, 2005. There are no leases scheduled to expire during the remainder of 2005 and leases representing an aggregate of approximately 499,700 rentable square feet are scheduled to expire during 2006 in this region.
Given the geographic concentration of the Company’s development program in San Diego County, the Company’s operating results may be affected by the city of San Diego’s current financial difficulties and ongoing investigations with respect to the city’s finances, which affect San Diego’s ability to finance capital projects and may impact real estate development, costs of development and market conditions in this important submarket. As of the date of this report, the Company has not experienced any material effects arising from this situation.
Orange County. As of September 30, 2005, the Company’s Orange County properties were 98% occupied with approximately 106,400 vacant rentable square feet as compared to 99% occupied with approximately 35,200 vacant rentable square feet as of December 31, 2004. As of September 30, 2005, leases representing an aggregate of approximately 54,700 and 339,000 rentable square feet were scheduled to expire during the remainder of 2005 and 2006, respectively, in this region.
Sublease space. Of the Company’s leased space at September 30, 2005, approximately 742,300 rentable square feet, or 5.9%, of the square footage in the Company’s stabilized portfolio was available for sublease, as compared to 435,200 rentable square feet, or 3.5% at December 31, 2004. Of the 5.9% of available sublease space in the Company’s stabilized portfolio as of September 30, 2005, approximately 3.6% was vacant space and the remaining 2.3% was occupied. Approximately 55% and 42% of the available sublease space as of September 30, 2005 is located in the San Diego and Orange County submarkets, respectively. Of the approximately 742,300 rentable square feet available for sublease at September 30, 2005, none is scheduled to expire in 2005. Approximately 20,800 rentable square feet represents leases scheduled to expire during 2006.
Negative trends or other events that impair the Company’s ability to renew or re-lease space and its ability to maintain or increase rental rates in its submarkets could have an adverse effect on the Company’s future financial condition, results of operations and cash flows.
Recent Information Regarding Significant Tenants
The Boeing Company. As of September 30, 2005, the Company’s largest tenant, The Boeing Company, leased an aggregate of approximately 777,000 rentable square feet of office space under five separate leases, representing approximately 5.1% of the Company’s total annual base rental revenues. In April 2005, The Boeing Company extended, renewed or otherwise modified three of its existing leases. It extended one lease, which was scheduled to expire in January 2006, at a building located in El Segundo, encompassing approximately 101,000 rentable square feet. The extended lease expires in January 2007 and can be terminated by either party with 60-days advance notice anytime after April 30, 2006. The Boeing Company also renewed one lease at a building located in Anaheim, encompassing approximately 65,500 rentable square feet. The lease, which was originally scheduled to
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expire in October 2005, was extended through October 2010. In addition, an amendment was signed for a lease in Long Beach whereby The Boeing Company reduced its rentable square feet from 43,600 rentable square feet to 15,500 rentable square feet. This lease expired on September 30, 2005. Furthermore, one lease, encompassing approximately 211,100 rentable square feet, is scheduled to expire in December 2007; however, under the terms of the lease, The Boeing Company has the right to terminate this lease effective December 31, 2006 by giving the Company written notice one year in advance. The remaining two leases for approximately 286,000 and 113,000 rentable square feet are scheduled to expire on July 31, 2007 and March 31, 2009, respectively.
Intuit, Inc. As of September 30, 2005, Intuit, Inc. (“Intuit”), the Company’s sixth largest tenant, leased an aggregate of approximately 278,700 rentable square feet of office space under four separate leases, representing approximately 2.4% of the Company’s total annual base rental revenues. In March 2005, the Company executed a ten-year lease agreement with Intuit for approximately 365,000 rentable square feet of additional space. Under this agreement, Intuit will lease three of the four buildings in an office complex that the Company has committed to develop in the 56 Corridor submarket in San Diego County. See additional information regarding the Company’s development projects under the caption “—Development and redevelopment programs.” In November 2005, Intuit exercised its option to lease the fourth building. Of the currently occupied space, one of the leases, encompassing approximately 212,000 rentable square feet, is scheduled to expire in April 2007. In connection with the new lease agreement, Intuit has the option to remain in approximately 141,000 rentable square feet of this space until it can occupy the new buildings, which is expected to be in the third quarter of 2007. In addition, Intuit has extended its lease for the remaining 71,000 rentable square feet until August 2009. Intuit also has two leases in Calabasas which encompass an aggregate of approximately 63,000 rentable square feet and executed a third lease in October 2005 for approximately 28,000 rentable square feet, which will commence in December 2005. All three leases are scheduled to expire in July 2014. The last lease with Intuit is located in Long Beach and encompasses approximately 3,000 rentable square feet. This lease is scheduled to expire in December 2005. Upon commencement of the new San Diego lease, Intuit is projected to become the Company’s largest tenant based on its percentage of the Company’s total annual base rental revenues.
Development and redevelopment programs. Management believes that a significant portion of the Company’s potential growth over the next several years will continue to come from its development pipeline. The Company has continued to aggressively seek and obtain development opportunities in the San Diego County region, as it remains one of the strongest markets in Southern California. The Company has made significant progress in expanding its development program in 2005 through new lease transactions and targeted acquisitions as summarized below.
In March 2005, the Company committed to develop a four-building office complex in the 56 Corridor submarket of San Diego County. As of the date of this report, the Company has pre-leased all four buildings, or 100% of the rentable square feet, to a single tenant. See additional information under the caption “—Recent Information Regarding Significant Tenants—Intuit, Inc.” The Company began construction on the first phase of the project in the third quarter of 2005 and expects to complete the buildings, which will encompass an aggregate of approximately 466,000 rentable square feet, in the third quarter of 2007. The project has a total estimated investment of approximately $145 million. In June 2005, the Company acquired approximately 11.3 acres of undeveloped land located immediately adjacent to this project. The land site includes entitlements to build approximately 350,000 rentable square feet of office space.
In June 2005, the Company executed a lease agreement with a single tenant for a new three-building corporate headquarters in its Innovation Corporate Center, located in the San Diego County I-15 Corridor submarket. Two of the buildings, encompassing an aggregate of approximately 103,000 rentable square feet, are currently under construction and are scheduled to be completed in the fourth quarter of 2005. The Company plans to commence construction on the third building, which will encompass approximately 75,000 rentable square feet, in the first quarter of 2006. The total estimated investment for the three buildings is approximately $43 million.
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In September 2005, the Company purchased a fully-entitled 20-acre land site, which includes a 303,000 square foot building, located in the San Diego County I-15 Corridor submarket. The Company executed a one-year lease with the seller to continue to occupy 100% of the space through September 2006. The lease also includes a three-month extension option. At the termination of the lease, the Company plans to redevelop the site and currently anticipates developing approximately 600,000 to one million square feet of office space. The site includes entitlements to build approximately 1.8 million square feet of office and light industrial space.
The Company also owns approximately 49.5 acres of undeveloped land, including the 11.3 acres acquired in June 2005, upon which the Company currently expects to develop an aggregate of approximately 1.1 million rentable square feet of office space within the next three to five years. All of the Company’s undeveloped land is located in San Diego County. See additional information regarding the Company’s development portfolio under the caption “Development” in this report.
Management believes that another possible source of the Company’s potential growth over the next several years is redevelopment opportunities within its existing portfolio. Redevelopment efforts can achieve similar returns to new development with reduced entitlement risk and shorter construction periods. Depending on market conditions, the Company will continue to pursue future redevelopment opportunities in its strategic submarkets where no land available for development exists. The Company had no redevelopment properties under construction as of September 30, 2005.
The Company has a proactive planning process by which it continually evaluates the size, timing, costs and scope of its development and redevelopment programs and, as necessary, scales activity to reflect the economic conditions and the real estate fundamentals that exist in the Company’s strategic submarkets. However, the Company may be unable to lease committed development or redevelopment properties at expected rental rates or within projected timeframes or complete projects on schedule or within budgeted amounts, which could adversely affect the Company’s financial condition, results of operations and cash flows.
Other Factors. The Company’s operating results are and may continue to be affected by uncertainties and problems associated with the deregulation of the utility industry in California, since 95.7% of the total rentable square footage of the Company’s stabilized portfolio is located in California. Energy deregulation has resulted in higher utility costs in some areas of the state and intermittent service interruptions. In addition, primarily as a result of the events of September 11, 2001, the Company’s annual insurance costs increased across its portfolio by approximately 14%, 11% and 12% during 2002, 2003 and 2004, respectively. However, insurance costs have remained relatively constant for the nine months ended September 30, 2005 as compared to the same period in 2004. As of the date of this report, the Company has not experienced any material effects arising from either of these issues.
In addition, the California State legislature is currently evaluating split tax roll legislation, which if enacted, could have a material effect on the Company’s operating results. If this initiative is passed as currently proposed, the tax rate on commercial property in California would increase, which would result in significant increases in real estate taxes for the Company’s properties located in California, having an adverse impact on net income.
Incentive Compensation. The Company has long-term incentive compensation programs that provide for cash and stock compensation to be earned by the Company’s senior officers if the Company attains certain performance measures that are based on annualized stockholder returns on an absolute and a relative basis as well as certain other financial, operating and development targets. As a result, accrued incentive compensation in future periods is affected by the ten-day average closing price per share of the Company’s common stock at the end of each quarter. Future increases or decreases in the price per share of the Company’s common stock and the resultant cumulative annualized stockholder return calculations will cause an increase or decrease to the quarterly adjustment of the amount accrued relating to this program, resulting in an increase or decrease to general and administrative expenses and a corresponding decrease or increase to net income available to common
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stockholders. Under the absolute component of a special long-term plan for the Company’s executive officers, every $1 change in the Company’s ten-day average closing stock price equates to an approximate $1.7 million change in the total amount payable at the end of the three-year term of the plan (see Note 8 to the Company’s consolidated financial statements for further discussion about the program). Management cannot predict the amounts that will ultimately be recorded in future periods related to these programs since they are significantly influenced by the Company’s stock price and market conditions.
Results of Operations
As of September 30, 2005, the Company’s stabilized portfolio was comprised of 84 office properties (the “Office Properties”) encompassing an aggregate of approximately 7.8 million rentable square feet, and 48 industrial properties (the “Industrial Properties,” and together with the Office Properties, the “Properties”), encompassing an aggregate of approximately 4.7 million rentable square feet. The Company’s stabilized portfolio of operating properties consists of all the Properties, and excludes properties recently developed or redeveloped by the Company that have not yet reached 95.0% occupancy and are within one year following substantial completion (“lease-up” properties) and projects currently under construction.
As of September 30, 2005, the Office and Industrial Properties represented 84.2% and 15.8%, respectively, of the Company’s annualized base rent. For the three months ended September 30, 2005, average occupancy in the Company’s stabilized portfolio was 93.9% compared to 93.2% for the three months ended September 30, 2004. As of September 30, 2005, the Company had approximately 906,000 rentable square feet of vacant space in its stabilized portfolio compared to 830,900 rentable square feet as of September 30, 2004.
The following table reconciles the changes in the rentable square feet in the Company’s stabilized portfolio of operating properties from September 30, 2004 to September 30, 2005. Rentable square footage in the Company’s portfolio of stabilized properties increased by approximately 0.5 million to 12.5 million at September 30, 2005, compared to 12.0 million at September 30, 2004.
Total at September 30, 2004
Acquisitions
Properties added from the Redevelopment Portfolio
Dispositions(1)
Remeasurement
Total at September 30, 2005
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Comparison of the Three Months Ended September 30, 2005 to the Three Months Ended September 30, 2004
Management internally evaluates the operating performance and financial results of its portfolio based on Net Operating Income for the following segments of commercial real estate property: Office Properties and Industrial Properties. The Company defines Net Operating Income as operating revenues from continuing operations (rental income, tenant reimbursements and other property income) less property and related expenses from continuing operations (property expenses, real estate taxes, provision for bad debts and ground leases). The Net Operating Income segment information presented within this Management’s Discussion and Analysis consists of the same Net Operating Income segment information disclosed in Note 10 of the Company’s consolidated financial statements in accordance with Statement of Financial Accounting Standards No. 131 “Disclosures about Segments of an Enterprise and Related Information.” The following table reconciles the Company’s Net Operating Income by segment to the Company’s net income available to common stockholders for the three months ended September 30, 2005 and 2004.
Net Operating Income, as defined:
Office Properties
Industrial Properties
Total portfolio
Net Operating Income, as defined for reportable segments
Other expenses:
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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, 2005 and 2004.
Operating Revenues:
Rental Income
Tenant Reimbursements
Other Property Income
Property Expenses
R/E Taxes
Provision
Ground Leases
Net Operating Income
Total revenues from Office Properties increased $5.5 million, or 12.1%, to $51.3 million for the three months ended September 30, 2005 compared to $45.8 million for the three months ended September 30, 2004. Rental income from Office Properties increased $4.1 million, or 9.6%, to $46.3 million for the three months ended September 30, 2005 compared to $42.2 million for the three months ended September 30, 2004. Rental income generated by the Core Office Portfolio increased $0.8 million, or 2.1%, for the three months ended September 30, 2005 compared to the three months ended September 30, 2004. The increase in the Core Office Portfolio is primarily due to an increase in occupancy. Average occupancy in the Core Office Portfolio increased 0.6% to 93.1% for the three months ended September 30, 2005 compared to 92.5% for the same period in 2004. The remaining $3.3 million increase in rental income was attributable to a $2.6 million increase in rental income generated by the two office buildings acquired by the Company in the fourth quarter of 2004 and one office building acquired by the Company in the second quarter of 2005 (the “Office Acquisition Properties”), a $0.4 million increase in rental income generated by the office development property that was added to the stabilized portfolio in the third quarter of 2004 (the “Office Development Property”) and a $0.3 million increase in rental income generated by the office redevelopment properties that were completed during 2004 and added to the stabilized portfolio in 2005 (the “Office Redevelopment Properties”).
Tenant reimbursements from Office Properties increased $1.0 million, or 25.7%, to $4.8 million for the three months ended September 30, 2005 compared to $3.8 million for the three months ended September 30, 2004. Of this increase, $0.8 million was generated by the Core Office Portfolio due to an increase in occupancy in this portfolio, as mentioned above, and an increase in reimbursable expenses. Of the remaining increase of $0.2 million in tenant reimbursements, $0.1 million was attributable to the Office Development Property and $0.1 million was attributable to both the Office Redevelopment Properties and the Office Acquisition Properties. Other property income from Office Properties increased approximately $0.5 million, or 168.0%, for the three months ended September 30, 2005 compared to the same period in 2004. Other property income for the three months ended September 30, 2004 included a $1.8 million charge related to a proposed settlement for
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outstanding litigation offset by $1.3 million of other income related to a lease termination in 2001. This additional income had previously been reserved for financial reporting purposes until certain contingencies with the lease termination had been resolved. Other income for both periods consisted primarily of lease termination fees and other related income associated with early lease terminations within the Core Office Portfolio.
Total expenses from Office Properties increased $2.2 million, or 19.2%, to $13.4 million for the three months ended September 30, 2005 compared to $11.2 million for the three months ended September 30, 2004. Property expenses from Office Properties increased $2.3 million, or 29.5%, to $10.1 million for the three months ended September 30, 2005 compared to $7.8 million for the three months ended September 30, 2004. An increase of $1.6 million, or 21.5%, was generated by the Core Office Portfolio. This increase was primarily attributable to an increase in repairs and maintenance expenditures and an increase in variable operating expenses related to the increase in occupancy. Of the remaining increase of $0.7 million in property expenses, $0.4 million was attributable to the Office Acquisition Properties, $0.2 million was attributable to the Office Redevelopment Properties and $0.1 million was attributable to the Office Development Property. Real estate taxes from Office Properties decreased $0.2 million, or 5.9%, for the three months ended September 30, 2005 as compared to the same period in 2004. This decrease was primarily due to refunds received in 2005 for prior years’ real estate taxes, which were successfully appealed. The provision for bad debts from Office Properties remained consistent for the three months ended September 30, 2005 compared to the three months ended September 30, 2004. The Company evaluates its reserve levels on a quarterly basis. Ground lease expense for Office Properties increased $0.1 million, or 22.8%, to $0.4 million for the three months ended September 30, 2005 compared to $0.3 million for the three months ended September 30, 2004.
Net Operating Income, as defined, from Office Properties increased $3.4 million, or 9.7%, to $37.9 million for the three months ended September 30, 2005 compared to $34.5 million for the three months ended September 30, 2004. Of this increase, $0.9 million was generated by the Core Office Portfolio primarily due to an increase in occupancy in this portfolio as mentioned above. Of the remaining increase of $2.5 million, $1.9 million was generated by the Office Acquisition Properties, $0.3 million was generated by the Office Redevelopment Properties and $0.3 million was generated by the Office Development Property.
Operating revenues:
Property and related expenses:
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Total revenues from Industrial Properties increased $0.4 million, or 4.0%, to $9.1 million for the three months ended September 30, 2005 as compared to $8.7 million for the three months ended September 30, 2004. Rental income from Industrial Properties increased $0.2 million, or 2.2%, to $8.0 million for the three months ended September 30, 2005 compared to $7.8 million for the three months ended September 30, 2004. This increase was primarily due to an increase in occupancy. Average occupancy in the Industrial Properties increased 1.1% to 97.4% for the three months ended September 30, 2005 as compared to 96.3% for the three months ended September 30, 2004.
Tenant reimbursements from Industrial Properties increased $0.2 million, or 20.6%, to $1.0 million for the three months ended September 30, 2005 compared to $0.8 million for the three months ended September 30, 2004. This increase is primarily associated with an increase in occupancy in this portfolio and a subsequent increase in reimbursable expenses. Other property income from Industrial Properties remained consistent during the three months ended September 30, 2005 as compared to the same period in 2004.
Total expenses from Industrial Properties increased $0.2 million, or 12.0%, to $1.4 million for the three months ended September 30, 2005 compared to $1.2 million for the three months ended September 30, 2004. Property expenses from Industrial Properties increased $0.2 million, or 34.7%, to $0.7 million for the three months ended September 30, 2005 compared to $0.5 million for the three months ended September 30, 2004. This increase is mainly attributable to an increase in repairs and maintenance expenditures. Real estate taxes from Industrial Properties remained consistent at approximately $0.7 million during the three months ended September 30, 2005 compared to the same period in 2004. The provision for bad debts from Industrial Properties decreased $0.1 million for the three months ended September 30, 2005 compared to the three months ended September 30, 2004. The Company evaluates its reserve levels on a quarterly basis.
Net Operating Income, as defined, from Industrial Properties increased $0.2 million, or 2.8%, to $7.7 million for the three months ended September 30, 2005 compared to $7.5 million for the three months ended September 30, 2004.
Non-Property Related Income and Expenses
General and administrative expenses increased $9.0 million, or 95.8%, to $18.4 million for the three months ended September 30, 2005 compared to $9.4 million for the three months ended September 30, 2004. The increase was primarily due to an $8.5 million increase in the charge for accrued incentive compensation and was driven by a special long-term incentive plan for the Company’s executive officers for which the amount payable under the plan is based on the Company’s absolute and relative stockholder returns (see Note 8 to the Company’s consolidated financial statements for further discussion about the program). Compensation expense under this program is accounted for using variable plan accounting. The Company estimates the amount to be paid based on the average closing share price of the Company’s common stock as reported on the NYSE for the last ten days of the period, and records compensation expense equal to that portion of the total compensation applicable to the portion of the performance period that has elapsed through the end of the period. The increase in the charge for accrued incentive compensation is due to the increase in the share price of the Company’s common stock at the end of the third quarter of 2005 as compared to the end of the second quarter of 2005 and the resultant cumulative adjustment recorded as of September 30, 2005 for the change in estimated compensation expense attributable to prior periods. The amounts accrued in future periods related to this plan will increase and decrease as the ten-day average price per share of the Company’s common stock at the end of each period increases or decreases. The remaining increase is primarily due to an increase in reporting, public company and payroll related expenses.
Net interest expense increased $1.0 million, or 11.2%, to $9.6 million for the three months ended September 30, 2005 as compared to $8.6 million for the three months ended September 30, 2004. Gross interest and loan fee expense, before the effect of capitalized interest and loan fees, increased $1.5 million, or 14.0%, to $12.2 million for the three months ended September 30, 2005 compared to $10.7 million for the three months
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ended September 30, 2004 due to a higher average outstanding debt balance and increasing interest rates during the three months ended September 30, 2005 as compared to the three months ended September 30, 2004. Total capitalized interest and loan fees increased $0.5 million, or 25.9%, to $2.6 million for the three months ended September 30, 2005 compared to $2.1 million for the three months ended September 30, 2004. This increase is primarily due to higher average construction in progress balances eligible for capitalization during the three months ended September 30, 2005 as compared to the three months ended September 30, 2004.
Depreciation and amortization increased $1.3 million, or 8.9%, to $16.2 million for the three months ended September 30, 2005 compared to $14.9 million for the three months ended September 30, 2004. This increase was mainly attributable to depreciation and amortization generated by the Office Acquisition Properties.
Other income and expense increased approximately $1.3 million, or 167.6%, to $0.5 million of income for the three months ended September 30, 2005 compared to $0.8 million of expense for the three months ended September 30, 2004. The increase in income was primarily due to a $0.9 million decrease in net cash settlement payments on the Company’s interest rate swap agreements as a result of a change in the composition of the Company’s derivative instruments and increasing interest rates. The Company had four outstanding interest rate swaps during 2004 with an aggregate notional amount of $150 million and a weighted average fixed swap rate of 3.34%. One of these interest rate swaps, which had a notional amount of $50 million and fixed swap rate of 4.46%, expired in January 2005. The remaining three instruments, which have an aggregate notional amount of $100 million and a weighted average interest fixed swap rate of 2.78%, expire in the fourth quarter of 2005 and in 2006.
Comparison of the Nine months ended September 30, 2005 to the Nine Months Ended September 30, 2004
The following table reconciles the Company’s Net Operating Income by segment to the Company’s net income for the nine months ended September 30, 2005 and 2004.
Reconciliation to Consolidated Net Income:
Total other income
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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, 2005 and 2004.
Total revenues from Office Properties increased $18.4 million, or 13.6%, to $153.5 million for the nine months ended September 30, 2005 compared to $135.1 million for the nine months ended September 30, 2004. Rental income from Office Properties increased $15.8 million, or 13.0%, to $138.0 million for the nine months ended September 30, 2005 compared to $122.2 million for the nine months ended September 30, 2004. Rental income generated by the Core Office Portfolio increased $5.1 million, or 4.5%, for the nine months ended September 30, 2005 as compared to the nine months ended September 30, 2004. The increase in the Core Office Portfolio is primarily due to an increase in occupancy. Average occupancy in the Core Office Portfolio increased 3.4% to 94.0% for the nine months ended September 30, 2005 compared to 90.6% for the same period in 2004. The remaining $10.7 million increase in rental income was attributable to a $7.1 million increase in rental income generated by the Office Acquisition Properties, a $2.3 million increase in rental income generated by the Office Redevelopment Properties and a $1.3 million increase in rental income generated by the Office Development Property.
Tenant reimbursements from Office Properties increased $2.2 million, or 17.8%, to $14.7 million for the nine months ended September 30, 2005 compared to $12.5 million for the nine months ended September 30, 2004. Tenant reimbursements generated by the Core Office Portfolio increased $1.2 million, or 9.5%, to $13.5 million for the nine months ended September 30, 2005 compared to $12.3 million for the nine months ended September 30, 2004. This increase is mainly attributable to the increase in occupancy in the Core Office Portfolio noted above. The remaining increase in tenant reimbursements is attributable to an increase of $0.7 million generated by the Office Redevelopment Properties, an increase of $0.2 million generated by the Office Development Property and an increase of $0.1 million generated by the Office Acquisition Properties. Other property income from Office Properties increased approximately $0.3 million, or 95.2%, to $0.7 million for the nine months ended September 30, 2005 compared to $0.4 million for the nine months ended September 30, 2004. Other property income for the nine months ended September 30, 2004 included a $1.8 million charge related to a proposed settlement for outstanding litigation offset by $1.3 million of other income related to a lease termination in 2001. This additional income had previously been reserved for financial reporting purposes until certain contingencies with the lease termination had been resolved. Other income for both periods consisted primarily of lease termination fees and other related income.
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Total expenses from Office Properties increased $6.4 million, or 18.4%, to $41.1 million for the nine months ended September 30, 2005 compared to $34.7 million for the nine months ended September 30, 2004. Property expenses from Office Properties increased $4.7 million, or 20.2%, to $28.2 million for the nine months ended September 30, 2005 compared to $23.5 million for the nine months ended September 30, 2004. An increase of $3.2 million, or 14.1%, was generated by the Core Office Portfolio. This increase was primarily attributable to an increase in repairs and maintenance expenditures and an increase in variable operating expenses related to the increase in occupancy. Of the remaining increase of $1.5 million in property expenses, $1.0 million was attributable to the Office Acquisition Properties, $0.3 million was attributable to the Office Redevelopment Properties and $0.2 million was attributable to the Office Development Property. Real estate taxes from Office Properties increased $0.7 million, or 6.4%, for the nine months ended September 30, 2005 as compared to the same period in 2004. Real estate taxes for the Core Office Portfolio decreased $0.2 million, or 2.0%, for the nine months ended September 30, 2005 compared to the nine months ended September 30, 2004. This decrease was primarily due to refunds received in 2005 for prior years’ real estate taxes, which were successfully appealed. An increase of $0.9 million in real estate taxes was attributable to an $0.8 million increase from the Office Acquisition Properties and a $0.1 million increase from the Office Development Property. The provision for bad debts from Office Properties increased $0.7 million for the nine months ended September 30, 2005 compared to the nine months ended September 30, 2004. During the nine months ended September 30, 2005, the Company increased its reserves for certain tenants on the Company’s watchlist that the Company closely monitors because the tenant may be experiencing financial difficulties or are consistently late in paying outstanding balances. The Company evaluates its reserve levels on a quarterly basis. Ground lease expense for Office Properties increased $0.3 million, or 26.3%, to $1.3 million for the nine months ended September 30, 2005 compared to $1.0 million for the nine months ended September 30, 2004.
Net Operating Income, as defined, from Office Properties increased $12.0 million, or 12.0%, to $112.4 million for the nine months ended September 30, 2005 compared to $100.4 million for the nine months ended September 30, 2004. Of this increase, $3.1 million was generated by the Core Office Portfolio primarily due to an increase in occupancy in this portfolio as mentioned above. Of the remaining increase of $8.9 million, $5.3 million was generated by the Office Acquisition Properties, $2.6 million was generated by the Office Redevelopment Properties and $1.0 million was generated by the Office Development Property.
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Total revenues from Industrial Properties increased $1.0 million, or 3.8%, to $27.2 million for the nine months ended September 30, 2005 as compared to $26.2 million for the nine months ended September 30, 2004. Rental income from Industrial Properties increased $0.5 million, or 1.9%, to $24.1 million for the nine months ended September 30, 2005 compared to $23.6 million for the nine months ended September 30, 2004. This increase was primarily due to an increase in occupancy. Average occupancy in the Industrial Properties increased 0.9% to 95.9% for the nine months ended September 30, 2005 as compared to 95.0% for the nine months ended September 30, 2004.
Tenant reimbursements from Industrial Properties increased $0.5 million, or 18.3%, to $3.1 million for the nine months ended September 30, 2005 compared to $2.6 million for the nine months ended September 30, 2004. This increase is primarily associated with an increase in occupancy in this portfolio and a subsequent increase in reimbursable expenses. Other property income from Industrial Properties increased $0.1 million during the nine months ended September 30, 2005 as compared to the same period in 2004. Other property income for both periods consisted primarily of lease termination fees.
Total expenses from Industrial Properties increased $0.5 million, or 12.5%, to $4.3 million for the nine months ended September 30, 2005 compared to $3.8 million for the nine months ended September 30, 2004. Property expenses from Industrial Properties increased $0.4 million, or 24.4%, to $2.1 million for the nine months ended September 30, 2005 compared to $1.7 million for the nine months ended September 30, 2004. This increase is mainly attributable to an increase in repairs and maintenance expenditures. Real estate taxes from Industrial Properties increased $0.1 million, or 3.9%, to $2.2 million for the nine months ended September 30, 2005 compared to $2.1 million for the nine months ended September 30, 2004. The provision for bad debts remained consistent for the nine months ended September 30, 2005 as compared to the nine months ended September 30, 2004. The Company evaluates its reserve levels on a quarterly basis.
Net Operating Income, as defined, from Industrial Properties increased $0.5 million, or 2.3%, to $23.0 million for the nine months ended September 30, 2005 compared to $22.5 million for the nine months ended September 30, 2004.
General and administrative expenses increased $18.9 million, or 84.5%, to $41.2 million for the nine months ended September 30, 2005 compared to $22.3 million for the nine months ended September 30, 2004. The increase was primarily due to a $17.9 million increase in the charge for accrued incentive compensation and was driven by a special long-term incentive plan for the Company’s executive officers for which the amount payable under the plan is based on the Company’s absolute and relative stockholder returns (see Note 8 to the Company’s consolidated financial statements for further discussion about the program). Compensation expense under this program is accounted for using variable plan accounting. The Company estimates the amount to be paid based on the average closing share price of the Company’s common stock as reported on the NYSE for the last ten days of the period, and records compensation expense equal to that portion of the total compensation applicable to the portion of the performance period that has elapsed through the end of the period. The increase in the charge for accrued incentive compensation is due to the increase in the share price of the Company’s stock at the end of the third quarter of 2005 as compared to the share price at December 31, 2004 and the resultant cumulative adjustment recorded as of September 30, 2005 for the change in estimated compensation expense attributable to prior periods. The amounts accrued in future periods related to this plan will increase and decrease as the ten-day average price per share of the Company’s common stock at the end of each period increases or decreases. The remaining increase is primarily due to an increase in reporting, public company and payroll related expenses.
Net interest expense increased $3.7 million, or 14.7%, to $28.7 million for the nine months ended September 30, 2005 compared to $25.0 million for the nine months ended September 30, 2004. Gross interest and loan fee expense, before the effect of capitalized interest and loan fees, increased $4.8 million, or 15.6%, to $35.5 million for the nine months ended September 30, 2005 compared to $30.7 million for the nine months
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ended September 30, 2004 due to a higher average outstanding debt balance and increasing interest rates during the nine months ended September 30, 2005 as compared to the nine months ended September 30, 2004. Total capitalized interest and loan fees increased $1.1 million, or 19.3%, to $6.8 million for the nine months ended September 30, 2005 as compared to $5.7 million for the nine months ended September 30, 2004. This increase is primarily due to higher average construction in progress balances eligible for capitalization during the nine months ended September 30, 2005 as compared to the nine months ended September 30, 2004.
Depreciation and amortization increased $6.2 million, or 14.2%, to $49.7 million for the nine months ended September 30, 2005 compared to $43.5 million for the nine months ended September 30, 2004. An increase of $1.5 million was generated by the Core Office Portfolio. This increase is mainly attributable to expenditures incurred subsequent to September 30, 2004 for capital and tenant improvements. Of the remaining $4.7 million increase in depreciation and amortization, $3.6 million was generated by the Office Acquisition Properties, $0.9 million was generated by the Office Redevelopment Properties and $0.2 million was generated by the Office Development Property.
Total other income increased approximately $0.7 million, or 344.7%, to $0.9 million for the nine months ended September 30, 2005 compared to $0.2 million for the nine months ended September 30, 2004. The increase in income was primarily due to a $2.5 million decrease in net cash settlement payments on the Company’s interest rate swap agreements as a result of a change in the composition of the Company’s derivative instruments and increasing interest rates. The Company had four outstanding interest rate swaps during 2004 with an aggregate notional amount of $150 million and a weighted average fixed swap rate of 3.34%. One of these interest rate swaps, which had a notional amount of $50 million and fixed swap rate of 4.46%, expired in January 2005. The remaining three instruments, which have an aggregate notional amount of $100 million and a weighted average interest fixed swap rate of 2.78%, expire in the fourth quarter of 2005 and in 2006. This increase was offset by a decrease in the non-cash gain recorded as a result of the change in the fair value of the derivative instruments. The gain was $1.6 million higher during the nine months ended September 30, 2004 as compared to the same period in 2005.
Building and Lease Information
The following tables set forth certain information regarding the Company’s Office Properties and Industrial Properties at September 30, 2005:
Occupancy by Segment Type
Los Angeles
Orange County
San Diego
Total Office
Total Industrial
Total Portfolio
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Lease Expirations by Segment Type
Year of Lease Expiration
Remaining 2005(4)
2006
2007
2008
2009
2010
Leasing Activity by Segment Type
For the Three months ended September 30, 2005:
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For the Nine months ended September 30, 2005:
Development
The following table sets forth certain information regarding the Company’s in-process and committed office development projects as of September 30, 2005. See further discussion regarding the Company’s projected development and redevelopment trends under the caption “Factors That May Influence Future Results of Operations—Development and redevelopment programs.”
Development Projects
Project Name / Submarket / City
Projects Under Construction:
ICC–15231 Avenue of ScienceI-15 CorridorSan Diego, CA
ICC–15253 Avenue of ScienceI-15 CorridorSan Diego, CA
Subtotal
Committed Projects:
ICC–15333 Avenue of ScienceI-15 CorridorSan Diego, CA
Santa Fe Summit—Phase I56 CorridorSan Diego, CA
Total In-Process and Committed 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 revolving unsecured line of credit, proceeds received from the Company’s disposition program and construction loans. As of September 30, 2005, the Company’s total debt as a percentage of total market capitalization (presented under “—Factors That May Influence Future Sources of Capital and Liquidity”) was 29.1%. As of September 30, 2005, the Company’s total debt plus preferred equity as a percentage of total market capitalization was 36.1%.
As of September 30, 2005, the Company had borrowings of $199.0 million outstanding under its revolving unsecured line of credit (the “Credit Facility”) and availability of approximately $226.0 million. The Credit Facility bears interest at an annual rate between LIBOR plus 1.00% and LIBOR plus 1.70%, depending upon the Company’s leverage ratio at the time of borrowing (4.97% at September 30, 2005), and matures in October 2007 with an option to extend the maturity for one year. The fee for unused funds ranges from an annual rate of 0.20% to 0.30% depending on the Company’s leverage ratio. The Company expects to use the Credit Facility to finance development and redevelopment expenditures, to fund potential acquisitions and for other general corporate uses.
Factors That May Influence Future Sources of Capital and Liquidity
The Company has a special long-term incentive compensation program that provides for cash compensation to be earned by the Company’s executive officers if the Company attains certain performance measures based on annualized total shareholder returns on an absolute and a relative basis. Under the absolute portion of the program, for every $1 change in the Company’s ten-day average closing stock price, the total payable over the three-year-term of the program changes by approximately $1.7 million. If the Company’s ten-day average closing stock price at December 31, 2005 is the same as the Company’s ten-day average closing share price at the end of the third quarter of 2005, management estimates that the Company could make payments under this program in the first quarter of the 2006 fiscal year of approximately $58 million. As of September 30, 2005, the Company had accrued a total of $52.5 million relating to this program relating to the portion of the performance period that has elapsed through the end of the quarter, which is included in accounts payable, accrued expenses and other liabilities. (See Note 8 to the Company’s consolidated financial statements and “—Non-Property Related Income and Expenses” above for further discussion about the special long-term incentive compensation program).
The Credit Facility, unsecured senior notes, 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 a maximum total debt to total assets ratio, a maximum total secured debt to total assets ratio, a maximum dividend payout ratio, minimum debt service coverage and fixed charge coverage ratios, a minimum consolidated tangible net worth and a limit of development activities as compared to total assets. Non-compliance with one or more of the covenants or 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, 2005.
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The following table sets forth certain information with respect to the Company’s aggregate debt composition at September 30, 2005 and December 31, 2004:
Secured vs. unsecured:
Secured
Unsecured
Fixed-rate vs. variable-rate:
Fixed-rate(1)(2)(3)(4)
Variable-rate
Total debt
Total debt including loan fees
Following is the Company’s total market capitalization as of September 30, 2005:
Debt:
Secured debt
Unsecured line of credit
Equity:
7.450% Series A Cumulative Redeemable Preferred Units(1)
7.800% Series E Cumulative Redeemable Preferred Stock(2)
7.500% Series F Cumulative Redeemable Preferred Stock(2)
Common units outstanding(3)
Common shares outstanding(3)
Total equity
Total Market Capitalization
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Contractual Obligations
The following table provides information with respect to the maturities and scheduled principal repayments of the Company’s secured debt and Credit Facility and scheduled interest payments of the Company’s fixed-rate debt and interest-rate swap agreements at September 30, 2005 and provides information about the minimum commitments due in connection with the Company’s ground lease obligations and capital commitments at September 30, 2005. The table does not reflect available maturity extension options.
Fiscal Years
2006-2007
Principal payments—secured debt
Principal payments—Credit Facility(1)
Principal payments—unsecured senior notes
Interest payments—fixed-rate debt(2)
Interest payments—interest-rate swaps(2)(3)
Ground lease obligations(4)
Capital commitments(5)
Capital Commitments
As of September 30, 2005, the Company had two development projects under construction with a total estimated investment of $23 million. In addition, the Company also intends to begin construction in 2005 on two additional development projects. These additional development projects have a total estimated investment of approximately $165 million. The Company has incurred aggregate costs of approximately $43 million on all of these projects as of September 30, 2005, and currently projects it could spend approximately $10 million of the remaining $145 million of presently budgeted development costs during the remainder of 2005, depending on leasing activity. In addition, the Company had two redevelopment projects that were added to the Company’s stabilized portfolio in 2005, which had not yet reached stabilized occupancy as of September 30, 2005. Depending on leasing activity, the Company currently projects it could spend approximately $2 million for these projects during the remainder of 2005. One office encompasses approximately 68,000 rentable square feet and
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was vacant and the other office encompasses approximately 242,000 rentable square feet and was approximately 19% occupied as of September 30, 2005. See additional information regarding the Company’s in-process development and redevelopment portfolio under the caption “—Development” above.
As of September 30, 2005, the Company had executed leases that committed the Company to $17 million in unpaid leasing costs and tenant improvements and the Company had contracts outstanding for approximately $1 million in capital improvements at September 30, 2005. In addition, during the remainder of 2005, the Company plans to spend approximately $2 million to $6 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.
Other Liquidity Needs
The Company is required to distribute at least 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 distributions are at the discretion of the Company’s 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 has the ability to not increase its distributions to meet its REIT requirements for 2005. 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 19, 2005, the Company declared a regular quarterly cash dividend of $0.51 per common share, which was paid on October 18, 2005 to stockholders of record on September 30, 2005. This dividend is equivalent to an annual rate of $2.04 per share. In addition the Company is required to make quarterly distributions to its Series A Preferred unitholders and Series E and Series F Preferred Stockholders, which in aggregate total approximately $15 million of annualized preferred dividends and distributions.
The Company’s Board of Directors has approved a share repurchase program, pursuant to which the Company is authorized to repurchase up to an aggregate of four million shares of its outstanding common stock. An aggregate of 1,227,500 shares currently remain eligible for repurchase under this program. The Company may opt to repurchase shares of its common stock in the future depending upon market conditions. The Company did not repurchase shares of common stock under this program during the nine months ended September 30, 2005.
The Company believes that it will have sufficient capital resources to satisfy its liquidity needs over the next twelve-month period. The Company expects to meet its short-term liquidity needs, which may include principal repayments of its debt obligations, capital expenditures, cash payments for incentive compensation and distributions to common and preferred stockholders and unitholders, through retained cash flow from operations and borrowings under the Credit Facility.
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,
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dispositions of non-strategic assets, issuance of common or preferred units of the Operating Partnership, and the potential issuance of debt or equity securities of the Company. The Company does not intend to reserve funds to retire existing debt upon maturity. The Company presently expects to refinance such debt at maturity or retire such debt through the issuance of equity securities, as market conditions permit.
Off Balance Sheet Arrangements
As of September 30, 2005, the Company did not have any off-balance sheet transactions, arrangements or obligations, including contingent liabilities.
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 decreased $3.1 million, or 3.3%, to $89.6 million for the nine months ended September 30, 2005 compared to the $92.7 million for the nine months ended September 30, 2004. The decrease is primarily attributable to an approximate $5.5 million decrease in reimbursements received from tenants for leasehold improvements constructed by the Company. The initial cash expenditures for the leasehold improvements are reflected in cash used in investing activities. This decrease was partially offset by an increase in average occupancy in the Core Office Portfolio. For the nine months ended September 30, 2005, average occupancy in this portfolio was 94.0% as compared to 90.6% for the nine months ended September 30, 2004.
Net cash used in investing activities increased $43.5 million, or 439.3%, to $53.4 million for the nine months ended September 30, 2005 compared to $9.9 million for the nine months ended September 30, 2004. The increase was primarily attributable to the acquisition of two operating properties and undeveloped land during the nine months ended September 30, 2005, partially offset by higher sales proceeds from the disposition of operating properties during the nine months ended September 30, 2005 compared to the nine months ended September 30, 2004.
Net cash used in financing activities decreased $56.7 million, or 63.6%, to $32.4 million for the nine months ended September 30, 2005 compared to $89.1 million for the nine months ended September 30, 2004. This decrease was primarily attributable to a $60.2 million increase in net borrowing activity for the nine months ended September 30, 2005 compared to the nine months ended September 30, 2004. The increase in borrowing activity is mainly due to the financing of the land and property acquisitions during the nine months ended September 30, 2005.
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 on operating performance not immediately apparent from net income. In addition, management believes that FFO provides useful information to the
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investment community about the Company’s operating 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 available for common stockholders for the three and nine months ended September 30, 2005 and 2004.
Adjustments:
Net gain on dispositions of operating properties
Funds From Operations(1)
Inflation
Since 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, the Company does not believe its exposure to increases in costs and operating expenses resulting from inflation is material.
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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. Although the Company’s derivative instruments do not qualify for hedge accounting since the original designation memos did not meet the technical requirements of SFAS 133, the Company’s derivatives are intended to manage the Company’s exposure to interest rate risk. The Company believes the derivatives are highly effective in offsetting the variable rate cash flows of its debt from an economic perspective. 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, 2004 to September 30, 2005 is incorporated into this Item 3 by reference to “Item 2: Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources”.
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, 2005 and December 31, 2004. 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. The interest rate spreads on the Company’s variable-rate debt ranged from LIBOR plus 1.00% to LIBOR plus 1.40% at September 30, 2005 and were LIBOR plus 1.10% at December 31, 2004. For the interest-rate 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, 2005 and December 31, 2004. The table also presents comparative summarized information for financial and derivative instruments held at December 31, 2004.
Interest Rate Risk Analysis—Tabular Presentation
($ in millions)
Liabilities:
Unsecured debt:
Variable-rate index
Fixed-rate
Average interest rate
Secured debt:
Interest Rate Derivatives:
Interest-rate swap agreements:
Notional amount
Fixed-pay interest rate
Variable receive rate index
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The Company maintains disclosure controls and procedures that are designed to ensure that information required to be disclosed in its reports under the Securities Exchange Act of 1934, as amended, is processed, recorded, summarized and reported within the time periods specified in the SEC’s rules and forms and that such information is accumulated and communicated to management, including its Chief Executive Officer and Chief Financial Officer, as appropriate, to allow 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.
On October 19, 2005, the Company determined that it is required to restate previously issued financial statements of the Company for the fiscal years ended December 31, 2002, 2003 and 2004 and for the related interim periods. The restatement is necessary because the Company determined that its hedge designation memos do not meet the technical requirements to qualify for hedge accounting treatment in accordance with Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”). During 2000 and 2002, the Company entered into six interest rate swap and two interest rate cap agreements. Prior to entering into these agreements, the Company engaged an independent consulting firm specializing in derivatives to advise the Company with respect to derivatives and hedging matters. The Company consulted closely with the independent derivatives specialist during its preparation of the formal designation of the instruments to ensure that each of the instruments qualified for hedge accounting treatment under SFAS 133 and the related accounting guidance. Although both the Company and the independent derivatives specialist believed the designation documentation met the requirements under SFAS 133 at the time the derivative transactions were entered into, the Company has subsequently determined that the designation documentation does not meet the technical requirements under SFAS 133 to qualify for hedge accounting treatment. As a result, the Company is restating the Company’s financial statements for the three and nine months ended September 30, 2004 in this Form 10-Q and will be filing amendments to its Annual Report on Form 10-K/A for the year ended December 31, 2004 and its Quarterly Reports on Form 10-Q/A for the quarters ended March 31, 2005 and June 30, 2005 to mark all of these instruments to market and to recognize the impact of this mark to market adjustment in the statement of operations for each affected period, rather through other comprehensive income.
The required restatement caused management to conclude that the Company had a material weakness in its internal control over financial reporting because, although there were no deficiencies in the design of the controls in place with respect to the Company’s derivative and hedging activities, the controls over the formal designation of its derivative and hedging instruments did not operate effectively to identify improvements to the documentation that were deemed necessary to ensure qualification for hedge accounting treatment under SFAS 133 and related accounting guidance.
As required by SEC Rule 13a-15(b), the Company carried out an evaluation, under the supervision and with the participation of management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the disclosure controls and procedures as of the end of the quarter covered by this report, which included consideration of the required restatement. Based on the foregoing evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were not effective at the reasonable assurance level as of the end of the quarter covered by this report.
In light of this conclusion, the Company performed additional review and analysis to ensure its consolidated financial statements are prepared in accordance with generally accepted accounting principles. Accordingly, management believes that the financial statements included in this report fairly present in all material respects our financial condition, results of operations and cash flows for the periods presented.
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Changes in Internal Control Over Financial Reporting
During the quarter covered by this report, in connection with the discovery of certain errors and related restatements in August 2005 and a consequent conclusion that the Company had a material weakness in its internal control over financial reporting, as described in the Company’s Form 10-Q filed with the Securities and Exchange Commission for the quarter ended June 30, 2005, the Company effected changes in the Company’s internal control over financial reporting. Specifically, the Company implemented procedures to more formally document and review the technical analysis of all relevant accounting literature that is performed to evaluate the accounting treatment and presentation and disclosure requirements for significant and/or non-routine transactions. This review is now performed both when a transaction is completed for the first time and when a similar repeat transaction is completed, if it is significant. Management believes these enhanced procedures provide additional internal control over financial reporting and improve the ability of management to identify any potential accounting implications prior to and during the comprehensive review of the Company’s consolidated financial statements. In addition, the Company implemented a more comprehensive review of the consolidated statements of cash flows. As previously reported, management believes these changes remediated the material weakness that led to the August 2005 restatements.
In connection with the Company’s conclusion that a further restatement is necessary to address a required change in the Company’s accounting for derivative instruments and hedging activities, management reassessed the Company’s internal control over financial reporting. As a result of this reassessment, management determined that, although there were no deficiencies in the design of the controls in place with respect to the Company’s derivative and hedging activities, the Company had a further material weakness in its internal control over financial reporting because the controls over the formal designation of its derivative and hedging instruments did not operate effectively to identify improvements to the documentation that were deemed necessary to ensure qualification for hedge accounting treatment under SFAS 133 and related accounting guidance. Accordingly, the Company has implemented procedures requiring, in the event that the Company has derivative transactions that it believes qualify for hedge accounting, close consultation with the Company’s independent derivatives specialist during its initial preparation of the formal designation of the instruments to ensure that each of the derivative instruments qualifies for hedge accounting treatment, consistent with the Company’s past practice. In addition, the Company will communicate with its independent derivatives specialist on a quarterly basis going forward from the time a derivative instrument qualifies for hedge accounting to review the Company’s designation documentation to ensure that the instrument continues to qualify for hedge accounting. Management believes these changes remediate the material weakness that led to the further restatement to mark the Company’s interest rate cap and interest rate swap agreements to market and to recognize the impact of this mark to market adjustment in the statement of operations for each affected period.
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PART II—OTHER INFORMATION
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 or cash flows of the Company.
Description
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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 7, 2005.
By:
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