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KRC > SEC Filings for KRC > Form 10-Q on 31-Jul-2013All Recent SEC Filings

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Form 10-Q for KILROY REALTY CORP


31-Jul-2013

Quarterly Report


ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS
The following discussion relates to our consolidated financial statements and should be read in conjunction with the financial statements and notes thereto appearing elsewhere in this report. The results of operations discussion is combined for the Company and the Operating Partnership because there are no material differences in the results of operations between the two reporting entities.
Statements contained in this "Item 2: Management's Discussion and Analysis of Financial Condition and Results of Operations" that are not historical facts may be forward-looking statements. Forward-looking statements include, among other things, statements or information concerning projected future occupancy and rental rates, lease expirations, debt maturity, potential investments, strategies such as capital recycling, development and redevelopment activity, projected construction costs, dispositions, future incentive compensation, pending, potential or proposed acquisitions and other forward-looking financial data, as well as the discussion below under the captions "-Factors That May Influence Future Results of Operations," "-Liquidity and Capital Resource of the Company," and "-Liquidity and Capital Resources of the Operating Partnership." Forward-looking statements can be identified by the use of words such as "believes," "expects," "projects," "may," "will," "should," "seeks," "approximately," "intends," "plans," "pro forma," "estimates" or "anticipates" and the negative of these words and phrases and similar expressions that do not relate to historical matters. Forward-looking statements are based on our current expectations, beliefs and assumptions, and are not guarantees of future performance, results or events. Forward-looking statements are inherently subject to uncertainties, risks, changes in circumstances, trends and factors that are difficult to predict, many of which are outside of our control. Accordingly, actual performance, results and events may vary materially from those indicated in the forward-looking statements, and you should not rely on the forward-looking statements as predictions of future performance, results or events. Numerous factors could cause actual future performance, results and events to differ materially from those indicated in forward-looking statements. For a discussion of those risk factors, see the discussion below as well as "Item 1A: Risk Factors" and "Item 7: Management's Discussion and Analysis of Financial Condition and Results of Operations" in the Company's and the Operating Partnership's annual report on Form 10-K for the year ended December 31, 2012 and their respective other filings with the SEC. All forward-looking statements are based on currently available information and speak only as of the date of this report. We assume no obligation to update any forward-looking statement that becomes untrue because of subsequent events, new information or otherwise, except to the extent we are required to do so in connection with our ongoing requirements under federal securities laws.

Overview and Background
We are a self-administered REIT active in office submarkets along the West Coast. We own, develop, acquire and manage real estate assets, consisting primarily of Class A properties in the coastal regions of Los Angeles, Orange County, San Diego County, the San Francisco Bay Area and greater Seattle, which we believe have strategic advantages and strong barriers to entry. We own our interests in all of our properties through the Operating Partnership and the Finance Partnership and conduct substantially all of our operations through the Operating Partnership. We owned a 97.7%, 97.6% and 97.6% general partnership interest in the Operating Partnership as of June 30, 2013, December 31, 2012 and June 30, 2012, respectively. All our properties are held in fee except for the 11 office buildings that are held subject to long-term ground leases for the land.


Factors That May Influence Future Results of Operations Acquisitions. During the six months ended June 30, 2013, we acquired two office buildings in one transaction for approximately $170.0 million (see Note 2 to our consolidated financial statements included in this report for more information). During 2012, we acquired 14 office buildings in seven transactions with an aggregate purchase price of approximately $674.0 million and six development and redevelopment opportunity projects in six transactions with an aggregate purchase price of approximately $340.3 million. We generally finance our acquisitions through proceeds from the issuance of debt and equity securities, borrowings under our revolving credit facility, proceeds from our capital recycling program and the assumption of existing debt.
As a key component of our growth strategy, we continually evaluate acquisition opportunities (including undeveloped land, development and redevelopment opportunities and office properties) as they arise. As a result, at any point in time we may have one or more potential acquisitions under consideration that are in varying stages of evaluation, negotiation or due diligence review, which may include potential acquisitions under contract. As of the date of the filing of this report, we were in negotiations to acquire an additional operating property. We cannot provide assurance that we will acquire this property. In the future, we may enter into agreements to acquire other properties, either as wholly-owned properties or through joint ventures, and those agreements typically will be subject to the satisfaction of closing conditions. We cannot provide assurance that we will enter into any agreements to acquire properties or that the potential acquisitions contemplated by any agreements we may enter into in the future will be completed. Costs associated with acquisitions accounted for as business combinations are expensed as incurred, and we may be unable to complete an acquisition after making a nonrefundable deposit or incurring acquisition-related costs. In addition, acquisitions are subject to various other risks and uncertainties. During the three and six months ended June 30, 2013, we expensed approximately $0.2 million and $0.8 million, respectively, of third-party acquisition costs, and we anticipate that we will incur additional third-party acquisition costs throughout 2013 as we pursue other potential acquisitions. We expect that we will have increased our focus on the acquisition of undeveloped land and development and redevelopment opportunities during 2013.
Undeveloped Land / Formation of New Consolidated Subsidiary. On June 27, 2013, the Company entered into an agreement with an unaffiliated third party and formed a new consolidated subsidiary, Redwood City Partners, LLC. In connection with this formation transaction, the Company acquired a 0.35 acre land site, completing the first phase of the land assemblage for its plans to develop an approximate 300,000 square foot office project in Redwood City, California. (See Note 2 to our consolidated financial statements included in this report for more information).
Capital Recycling Program. As part of our current and ongoing strategy, we continuously evaluate opportunities for the potential disposition of properties and undeveloped land in our portfolio with the intent of recycling the proceeds generated from the disposition of non-strategic properties into capital to fund new operating and development acquisitions, development and redevelopment expenditures, to repay long-term debt and for other general corporate purposes. As part of our capital recycling strategy, we intend, when practical, to enter into Section 1031 Exchanges to defer some or all of the taxable gains, if any, on the sales for federal and state income tax purposes.
In connection with this strategy, during the three months ended June 30, 2013, we completed the sale of one office building located in Calabasas, CA for a gross sales price of approximately $14.7 million (see Note 2 to our consolidated financial statements included in this report for more information). In addition, we anticipate that we could dispose of approximately $150 million - $300 million of additional operating properties and/or undeveloped land during the next 12 -18 months in connection with our capital recycling program.
The timing of any potential future disposition transactions will depend on market conditions and other factors, including but not limited to our capital needs and our ability to defer some or all of the taxable gains on the sales. We cannot assure that we will dispose of any additional properties or that future acquisitions and/or dispositions, if any, will qualify as Section 1031 Exchanges.
Leasing Activity and Changes in Rental Rates. The amount of net rental income generated by our properties depends principally on our ability to maintain the occupancy rates of currently leased space and to lease currently available space, newly developed or redeveloped properties, newly acquired properties with vacant space, and space available from unscheduled lease terminations. The amount of rental income we generate also depends on our ability to maintain or increase rental rates in our submarkets. Negative trends in one or more of these factors could adversely affect our rental income in future periods. The following tables set forth certain information regarding leasing activity for our stabilized portfolio during the three and six months ended June 30, 2013.


                  Information on Leases Commenced and Executed

                              For Leases Commenced
                               1st & 2nd Generation(1)                                             2nd Generation(1)
                                                                                                                                         Weighted
                         Number of                 Rentable                                                                              Average
                         Leases(2)              Square Feet(2)       TI/LC per Sq.    Changes in       Changes in        Retention      Lease Term
                      New        Renewal      New        Renewal        Ft.(3)        Rents(4)(5)     Cash Rents(6)      Rates(7)      (in months)
Three Months Ended
June 30, 2013         23             23     254,029      419,236     $     31.37          17.3 %            10.9 %         76.3 %              65
Six Months Ended
June 30, 2013         42             39     378,567      586,242           28.69          16.9 %              11 %         49.1 %              64



                            For Leases Executed(8)
                 1st & 2nd Generation(1)                                                         2nd Generation(1)
                                                                                                                              Weighted
                     Number of Leases(2)         Rentable Square Feet(2)                                                       Average
                                                                             TI/LC per      Changes in       Changes in      Lease Term
                      New            Renewal         New         Renewal     Sq. Ft.(3)     Rents(4)(5)     Cash Rents(6)    (in months)
Three Months
Ended
June 30, 2013          23                23         138,438     419,236     $    24.87          16.8 %            11.8 %            56
Six Months Ended
June 30, 2013          53                33         435,256     524,548          23.92          16.4 %            11.5 %            55


_______________________


(1) First generation leasing includes space where we have made capital expenditures that result in additional revenue generated when the space is re-leased. Second generation leasing includes space where we have made capital expenditures to maintain the current market revenue stream.

(2) Represents leasing activity for leases that commenced or signed during the period, including first and second generation space, net of month-to-month leases. Excludes leasing on new construction.

(3) Amounts exclude tenant-funded tenant improvements.

(4) Calculated as the change between GAAP rents for new/renewed leases and the expiring GAAP rents for the same space. Excludes leases for which the space was vacant longer than one year or vacant when the property was acquired.

(5) Excludes commenced and executed leases of approximately 144,000 and 133,000 rentable square feet, respectively, for the six months ended June 30, 2013, for which the

space was vacant longer than one year or being leased for the first time. Space vacant for more than one year is excluded from our change in rents calculations to provide a
meaningful market comparison.
(6) Calculated as the change between stated rents for new/renewed leases and the expiring stated rents for the same space. Excludes leases for which the space was vacant longer than one year or vacant when the property was acquired.

(7) Calculated as the percentage of space either renewed or expanded into by existing tenants or subtenants at lease expiration.

(8) For the three months ended June 30, 2013, 16 leases totaling approximately 107,000 rentable square feet were signed but had not commenced as of June 30, 2013. For the six months ended June 30, 2013, 21 leases totaling approximately 267,000 rentable square feet were signed but had not commenced as of June 30, 2013.

As of June 30, 2013, we believe that the weighted average cash rental rates for our stabilized portfolio, including recently acquired operating properties are approximately at the current average market rental rates, although individual properties within any particular submarket presently may be leased either above, below, or at the current market rates within that submarket, and the average rental rates for individual submarkets may be above, below, or at the average cash rental rate of our portfolio.
In general, market rental rates increased in the majority of our submarkets over the last several quarters. Our rental rates and occupancy are impacted by general economic conditions, including the pace of regional economic growth and access to capital. Therefore, we cannot give any assurance that leases will be renewed or that available space will be re-leased at rental rates equal to or above the current market rates. Additionally, decreased demand and other negative trends or unforeseeable events that impair our ability to timely renew or re-lease space could have further negative effects on our future financial condition, results of operations, and cash flows.
Scheduled Lease Expirations. The following table sets forth certain information regarding our lease expirations for our stabilized portfolio for the remainder of 2013 and the next five years.


                             Lease Expirations(1)
                            Number of                                                        % of Total       Annualized Base
                            Expiring        Total        % of Total     Annualized Base   Annualized Base     Rent per Sq. Ft.
Year of Lease Expiration     Leases      Square Feet   Leased Sq. Ft.      Rent (2)           Rent (2)              (2)

Remainder of 2013                 38       297,142          2.6 %       $       7,079          1.8 %         $          23.82
2014                             107     1,239,703         10.4 %              35,144          9.2 %                    28.35
2015                             103     1,674,497         14.1 %              48,656         12.8 %                    29.06
2016                              80       929,278          7.8 %              25,757          6.7 %                    27.72
2017                              88     2,084,102         17.5 %              63,848         16.6 %                    30.64
2018                              56     1,664,913         14.0 %              63,943         16.7 %                    38.41
Total                            472     7,889,635         66.4 %       $     244,427         63.8 %         $          30.98


________________________


(1) The information presented for all lease expiration activity reflects leasing activity through June 30, 2013 for our stabilized portfolio. For leases that have been renewed early or space that has been re-leased to a new tenant, the expiration date and annualized base rent information presented takes into consideration the renewed or re-leased lease terms. Excludes space leased under month-to-month leases, intercompany leases, vacant space, and lease renewal options not executed as of June 30, 2013.

(2) Annualized base rent includes the impact of straight-lining rent escalations and the amortization of free rent periods and excludes the impact of the following: amortization of

deferred revenue related tenant-funded tenant improvements, amortization of above/below market rents, amortization for lease incentives due under existing leases, and
expense reimbursement revenue. Additionally, the underlying leases contain various expense structures including full service gross, modified gross and triple net. Percentages
represent percentage of total portfolio annualized contractual base rental revenue. For additional information on tenant improvement and leasing commission costs incurred by
the Company for the current reporting period, please see further discussion under the caption "Information on Leases Commenced and Executed."

In addition to the 1.3 million rentable square feet, or 9.3%, of currently available space in our stabilized portfolio, leases representing approximately 2.6% and 10.4% of the occupied square footage of our stabilized portfolio are scheduled to expire during the remainder of 2013 and in 2014, respectively. The leases scheduled to expire during the remainder of 2013 and in 2014 represent approximately 1.5 million rentable square feet of office space or 11.0% of our total annualized base rental revenue. We believe that the weighted average cash rental rates are slightly under the current average quoted market rates for leases scheduled to expire during the remainder of 2013 and 2014, although individual properties within any particular submarket presently may be leased either above, below, or at the current quoted market rates within that submarket, and the average rental rates for individual submarkets may be above, below, or at the average cash rental rate of our overall portfolio. Our ability to re-lease available space depends upon both general market conditions and the market conditions in the specific regions in which individual properties are located.
Redevelopment Projects
We believe that a portion of our potential long-term future growth will continue to come from redevelopment opportunities both through acquired properties and within our existing portfolio. Redevelopment opportunities are those projects in which we spend significant development and construction costs on existing or acquired buildings pursuant to a formal plan, the intended result of which is a higher economic return on the property. As of June 30, 2013, we had two redevelopment projects in lease-up.
3880 Airport Way, Long Beach, submarket of Los Angeles, on which we commenced redevelopment in the third quarter of 2011. This lease-up property, encompassing approximately 98,000 rentable square feet, was 50% leased prior to the commencement of redevelopment which was done in two phases. Redevelopment on the first half, which was leased, was completed during the second quarter of 2012, and redevelopment on the second half was completed in the fourth quarter of 2012. The lease-up project will have a total estimated investment of approximately $19.9 million upon completion, including the $6.3 million net carrying value of the project at the commencement of redevelopment.

360 Third Street, South of Market Area, submarket of San Francisco, on which we commenced redevelopment in the fourth quarter of 2011. Redevelopment for this project was completed in the first quarter of 2013. The lease-up project, which encompasses approximately 410,000 rentable square feet, will have a total estimated investment of approximately $185.0 million at completion, including the $88.5 million net carrying value of the project at the commencement of redevelopment plus $27.5 million that we expect to pay in 2013 to acquire the land that is currently subject to a ground lease. As of June 30, 2013, the project is 85% leased and 55% occupied.

In-Process and Future Development Pipeline We believe that a portion of our long-term future growth will also come from the completion of our under construction and in-process projects as well as executing on our future development pipeline, subject to market conditions. During 2012, we increased our focus on value-add and highly accretive development opportunities and expanded our future development pipeline through targeted acquisitions of development opportunities on the West Coast.


We have a proactive planning process by which we continually evaluate the size, timing, costs and scope of our development program and, as necessary, scale activity to reflect the economic conditions and the real estate fundamentals that exist in our strategic submarkets. We expect to proceed in our development program with discipline and will be pursuing opportunities with attractive economic returns, in locations with transportation and retail amenities and in markets with strong fundamentals and visible demand. We plan to develop in phases as appropriate and we strongly favor starting projects that are pre-leased.
As of the date of this report, our near-term development pipeline consisted of the following five projects under construction and the projects that we may commence construction on in the second half of 2013.
690 E. Middlefield Road, Mountain View, California, which we acquired in May 2012. We acquired the project for $84.0 million, comprised of a cash purchase price of $74.5 million plus $9.5 million of assumed leasing commissions and other net accrued liabilities. The development project, which is 100% pre-leased to Synopsys, Inc., has a total estimated investment of approximately $196.9 million and is expected to encompass approximately 341,000 rentable square feet upon completion. Construction is currently in process and is expected to be completed in the first quarter of 2015.

331 Fairchild Drive, Mountain View, California, which we acquired in December 2012 and is 100% pre-leased. We acquired the project for $18.9 million plus $2.9 million of development costs reimbursed to the seller and are developing an approximately 88,000 square foot building for Audience, Inc. The development project has a total estimated investment of approximately $45.1 million. Construction is currently in process and is expected to be completed in the fourth quarter of 2013.

350 Mission Street, South of Market Financial District, San Francisco, California, which we acquired in October 2012. Shortly after acquisition, we pre-leased the entire project to salesforce.com, inc. and are currently planning to develop an approximately 400,000 square foot, 27 story office tower that adapts our open-plan workspace concepts to a high-rise office environment. The property is expected to be LEED platinum certified and the first ground up development property in the city expected to receive this designation. The development project has a total estimated investment of approximately $254.7 million. We are currently pursuing entitlements to increase this project to a 30-story office tower, which would increase the estimated rentable square feet and total estimated investment. Construction is currently in process and is expected to be completed in the first quarter of 2015.

555-599 N. Mathilda Avenue, Sunnyvale, California, which we acquired in December 2012. The project, which is comprised of one operating property and a future development site, is 100% pre-leased. Our plan at this project is to continue operating the existing building and develop an approximately 587,000 square foot office complex for LinkedIn, Inc., the tenant in the current existing building. The development project has a total estimated investment of approximately $312.9 million. Construction is currently in process and is expected to be completed in the third quarter of 2014.

Columbia Square, in Hollywood, California, which we acquired in September 2012. This project is a historical media campus located in the heart of Hollywood, two blocks from the corner of Sunset Boulevard and Vine Street. The site is fully entitled for the development of an 875,000 rentable square foot office, retail and multi-family mixed use project under a 15-year development agreement that includes three existing buildings. During the second quarter we commenced redevelopment of the three existing historical buildings, which encompass approximately 100,000 rentable square feet. Additionally, we are planning to develop approximately 575,000 square feet of office, retail and residential space in multiple phases. We currently expect to invest an additional $306.5 - $316.5 million for a total estimated investment of approximately $380 - $390 million. Our plan is to create a mixed-use campus that preserves the historical character while establishing a new center for entertainment and media companies.

333 Brannan Street, South of Market Area, San Francisco, California, which we acquired in July 2012. We continue to make good progress on the entitlements for this project and could be ready to begin construction in the fourth quarter of 2013. We currently expect to develop an approximately 170,000 rentable square foot office building on this site that will include all the features, amenities and systems that tech and media tenants need. We currently expect to invest an additional $74.1 - $79.1 million for a total estimated investment of approximately $95 - $100 million.

Redwood Towers, in Redwood City, California. In June 2013 we entered into an agreement with a local partner and acquired a 0.35 acre land site, completing the first phase of the land assemblage for our plans to develop an approximate 300,000 square foot office project. We currently expect a total estimated investment for the project of $175 - $180 million.


In the future, we may also enter into agreements to acquire other development or redevelopment opportunities, either as wholly-owned properties or through joint ventures and those agreements typically will be subject to the satisfaction of closing conditions. In addition, as of June 30, 2013, we had additional undeveloped land holdings, located primarily in various submarkets in San Diego County with an aggregate cost basis of approximately $291.0 million. This increase in our development and redevelopment activities will continue to cause an increase in the average development asset balances qualifying for interest and other carry cost capitalization in future periods. During the three and six months ended June 30, 2013, we capitalized interest on in process development projects, redevelopment projects in lease-up, and development pipeline projects with an aggregate cost basis balance of approximately $795.8 million at June 30, 2013, as it was determined these projects qualified for interest and other carry cost capitalization under GAAP. For the three and six months ended June 30, 2013, we capitalized $8.5 million and $16.2 million, respectively, of interest to our qualifying redevelopment and development projects. For the three and six months ended June 30, 2012, we capitalized $4.3 million and $8.2 million, respectively, of interest to our qualifying redevelopment and development projects. For the three and six months ended . . .

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