ITEM 1.
BUSINESS
The Company
Kilroy Realty Corporation (the “Company”) is a real estate investment trust, or REIT, which owns, operates, develops, and acquires Class A suburban office and industrial real estate in key suburban submarkets, primarily in Southern California, that the Company believes have strategic advantages and strong barriers to entry. The Company was incorporated in September 1996 in Maryland and commenced operations upon the completion of its initial public offering in January 1997.
As of December 31, 2003, the Company’s stabilized portfolio of operating properties was comprised of 82 office buildings (the “Office Properties”) and 50 industrial buildings (the “Industrial Properties,” and together with the Office Properties, the “Properties”), which encompassed an aggregate of approximately 7.3 million and 4.9 million rentable square feet, respectively. As of December 31, 2003, the Office Properties were approximately 87.6% leased to 282 tenants and the Industrial Properties were approximately 94.5% leased to 73 tenants. All but five of the Properties are located in Southern California.
The Company’s stabilized portfolio excludes development and redevelopment projects currently under construction, or in pre-development, 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. The Company had one office lease-up property at December 31, 2003, encompassing an aggregate of approximately 209,000 rentable square feet. As of December 31, 2003, the Company had two office redevelopment properties under construction which when completed are expected to encompass an aggregate of approximately 316,100 rentable square feet. In addition, as of December 31, 2003, the Company owned approximately 58.1 acres of undeveloped land upon which the Company currently expects to develop an aggregate of approximately 1.1 million rentable square feet of office space during the next three to five years, depending upon market conditions. All of the Company’s lease-up properties and in-process development and redevelopment projects are located in the Los Angeles and San Diego regions of Southern California. All of the Company’s undeveloped land parcels are located in Southern California in the San Diego region.
The Company owns its interests in all of the Properties through Kilroy Realty, L.P., a Delaware limited partnership (the “Operating Partnership”) and Kilroy Realty Finance Partnership, L.P., a Delaware limited partnership (the “Finance Partnership”). The Company conducts substantially all of its activities through the Operating Partnership in which, as of December 31, 2003, it owned an approximate 87.2% general partnership interest. The remaining 12.8% limited partnership interest in the Operating Partnership was owned by certain of the Company’s executive officers and directors, certain of their affiliates, and other outside investors. As the sole general partner of the Operating Partnership, the Company has control over the management of the Operating Partnership, which owns 114 of the Company’s 132 Properties. The remaining properties are owned by the Finance Partnership. 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. 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, as of December 31, 2003, was owned 99.0% by the Operating Partnership and 1% by the Company. On January 1, 2004, KSLLC became a wholly-owned subsidiary of the Operating Partnership. Unless otherwise indicated, all references to the Company include the Operating Partnership, the Finance Partnership, KSLLC, Kilroy Realty Finance, Inc. and all other wholly-owned subsidiaries, which include Kilroy Realty Partners L.P. (“KRPLP”), Kilroy Realty TRS, Inc., Imperial & Sepulveda, L.P. and Imperial Partners 25, L.P. Imperial & Sepulveda, L.P. and Imperial Partners 25, L.P. were dissolved during the year ended December 31, 2003.
The following diagram illustrates the structure of Kilroy Realty Corporation and its subsidiaries as of December 31, 2003:
In 1999, the Company, through the Operating Partnership, became a 50% managing member in two limited liability companies (the “Development LLCs”), which were formed to develop two multi-phased office projects in San Diego, California. The Allen Group, a group of affiliated real estate development and investment companies based in San Diego, California, was the other 50% member of the Development LLCs. On March 25, 2002, the Company acquired The Allen Group’s interest in the assets and assumed The Allen Group’s proportionate share of the liabilities of the Development LLCs (see Notes 3 and 12 to the Company’s consolidated financial statements). Subsequent to this transaction, the Development LLCs were liquidated and dissolved. The Development LLCs were consolidated for financial reporting purposes prior to their dissolution on March 25, 2002 because the Company controlled all significant development and operating decisions.
Website Access
The Company makes its periodic and current reports available on its website at www.kilroyrealty.com after these materials are filed with the Securities and Exchange Commission. The Company’s corporate governance guidelines, code of business conduct and ethics, charters of the Audit, Executive Compensation and Nominating/Corporate Governance committees of the Board of Directors are also available on the Company’s website and available in print to any security holder upon request.
Current Year Highlights
The Company continued to successfully attain its primary business objectives including growth in Funds From Operations, as defined by the National Association of Real Estate Investment Trusts (“FFO”), by accomplishing the following during the year ended December 31, 2003 (see “Item 7: Management’s Discussion and Analysis of Financial Condition and Results of Operations-Non-GAAP Supplemental Financial Measure: Funds From Operations” for further discussion of Funds From Operations, including a reconciliation of the Company’s GAAP net income to Funds From Operations):
·
Achieved 22.8% growth in net income per common share (diluted), with net income per common share (diluted) at $1.78 for the year ended December 31, 2003 compared to $1.45 for the year ended December 31, 2002.
·
Achieved a 52.6% total common annual stockholder return (annual appreciation of the quoted common share price plus dividends paid during the year), the highest since the Company’s IPO in 1997.
·
Successfully repositioned and commenced leasing of the five office buildings at Kilroy Centre Del Mar and two office buildings at Del Mar Corporate Center. These properties were previously leased to Peregrine Systems, Inc. and Brobeck, Phleger & Harrison, LLP, two tenants that defaulted on and then terminated their respective leases in 2002 and 2003. As of the date of this report, in aggregate, these seven buildings were 79% occupied and the Company has executed leases for 91% of their space.
·
Successfullly reached an agreement with Peregrine Systems, Inc. following its bankruptcy, which ultimately produced a $21.3 million settlement payment, of which the Company received $18.3 million in 2003.
·
Executed leases on approximately 1.4 million rentable square feet of office and industrial space in the stabilized portfolio, including both renewals and leases to new tenants. The Company’s average rental rate increase was 7.0% on a GAAP basis and 4.3% on a cash basis for leases that commenced during the year ended December 31, 2003.
·
Added to the Company’s stabilized portfolio three office development buildings encompassing approximately 399,100 rentable square feet at a total current estimated investment of $135.3 million. These properties were 62% committed at December 31, 2003.
·
Added to the Company’s stabilized portfolio one office redevelopment building and one redevelopment life science building encompassing an aggregate of approximately 156,400 rentable square feet at a total current estimated investment of $33.5 million. These properties were 55% committed at December 31, 2003.
·
Increased stockholder value and continued improvement of the quality of the Company’s portfolio through the reinvestment of approximately $34.1 million of capital obtained from the sale of non-strategic assets into assets the Company is developing or redeveloping in Southern California. The weighted average age based on rentable square feet of the Company’s office portfolio is down from 21 years at the time of its IPO to 12 years as of December 31, 2003.
·
Completed a public offering of 1,610,000 shares of 7.80% Series E Cumulative Redeemable Preferred Stock.
·
Executed new secured debt financing that provided the Company with approximately $80.0 million in available proceeds at an annual fixed interest rate of 3.8%. The Company’s total debt as a percentage of total market capitalization was approximately 38.5% at December 31, 2003. See “Item 7: Management’s Discussion and Analysis of Financial Condition and Results of Operations-Liquidity and Capital Resources” for presentation of the Company’s market capitalization. The Company’s total debt and the liquidation value of its preferred equity as a percentage of total market capitalization was approximately 46.6% at December 31, 2003. The Company’s weighted average interest rate was 5.3% excluding loan fees and 5.9% including loan fees at December 31, 2003.
Business and Growth Strategies
Growth Strategies. The Company believes that a number of factors and strategies will enable it to continue to achieve its objectives of long-term sustainable growth in net operating income, defined as operating revenues less property and related expenses (property expenses, real estate taxes, provision for bad debts and ground leases) before depreciation, and FFO as well as maximization of long-term stockholder value including: (i) the quality and location of the Company’s Properties; (ii) the Company’s ability to efficiently manage its assets as a low cost provider of commercial real estate due to its core capabilities in all aspects of real estate ownership including property management, leasing, marketing, financing, accounting, legal administration, construction management and new development; (iii) the Company’s existing substantial development pipeline established over the past several years; (iv) the pursuit of redevelopment opportunities in land-constrained markets; and (v) the Company’s access to development and leasing opportunities as a result of its extensive experience and significant working relationships with major Southern California corporate tenants, municipalities and landowners given the Company’s over 55-year presence in the Southern California market. Management believes that the Company is well positioned to continue to capitalize on existing opportunities because of its extensive experience in its submarkets, its seasoned management team and its proven ability to efficiently develop, acquire, lease and manage office and industrial properties.
Operating Strategies. The Company focuses on enhancing long-term growth in net operating income and FFO from its Properties by: (i) maintaining higher than average regional occupancy rates; (ii) maximizing cash flow from its Properties through active leasing, early renewals, and effective property management; (iii) structuring leases to maximize returns and internal growth; (iv) managing portfolio credit risk through effective underwriting including the use of credit enhancements and collateral support to mitigate portfolio credit risk; (v) managing operating expenses through the efficient use of internal management, leasing, marketing, financing, accounting and construction management functions; (vi) maintaining and developing long-term relationships with a diverse tenant base; (vii) managing its Properties to offer the maximum degree of utility and operational efficiency to tenants; (viii) continuing to effectively manage capital improvements to enhance its Properties’ competitive advantages in their respective markets and improve the efficiency of building systems; and (ix) attracting and retaining motivated employees by providing financial and other incentives to meet the Company’s operating and financial goals.
Development Strategies. The Company and its predecessors have developed office and industrial properties, including more recently high technology facilities, primarily located in Southern California, for its own portfolio and for third parties, since 1947. Over the past several years, the Company has established a substantial development pipeline in its target markets. The Company’s future development pipeline includes 58.1 acres of undeveloped land which can support future development of approximately 1.1 million rentable square feet, which the Company expects to develop over the next three to five years, depending on market conditions. The Company’s strategy with respect to development is to: (i) maintain a disciplined approach to development by focusing on pre-leasing, phasing and cost control; (ii) continue to execute the Company’s build-to-suit program where it develops properties leased by specific tenants providing for lower risk development; (iii) evaluate redevelopment opportunities in land-constrained markets since such efforts generally achieve similar returns to new development with reduced entitlement risk and shorter construction periods; (iv) be the premier low-cost provider of two- to four-story campus style office buildings in Southern California; and (v) reinvest capital from dispositions of non-strategic assets into new, state-of-the-market development assets with higher cash flows and rates of return.
The Company may engage in the additional development or redevelopment of office and/or industrial properties, primarily in Southern California, when market conditions support a favorable risk-adjusted return on such development or redevelopment. The Company’s activities with third-party owners in Southern California are expected to give the Company further access to development opportunities. There can be no assurance, however, that the Company will be able to successfully develop or redevelop any of the properties or that it will have access to additional development or redevelopment opportunities.
Financing Strategies. The Company’s financing policies and objectives are determined by the Company’s Board of Directors. The Company’s goal is to limit its dependence on leverage and maintain a conservative ratio of debt to total market capitalization. This ratio may be increased or decreased without the consent of the Company’s stockholders and the Company’s organizational documents do not limit the amount of indebtedness that the Company may incur. The Company’s funding strategies are to: (i) maintain financial flexibility and the ability to access a variety of capital sources; (ii) maintain a staggered debt maturity schedule to limit risk exposure at any particular point in the capital and credit market cycles; (iii) complete financing in advance of the need for capital; and (iv) manage interest rate exposure.
The Company intends to utilize one or more sources of capital for future growth, which may include borrowings under the Company’s unsecured credit facility, the issuance of debt or equity securities and other bank and/or institutional borrowings and disposition of non-strategic assets. There can be no assurance, however, that the Company will be able to obtain capital on terms favorable to the Company or at all.
Significant Tenants
As of December 31, 2003, the Company’s ten largest office tenants represented approximately 29.7% of total annual base rental revenues, defined as annualized monthly contractual rents from existing tenants at December 31, 2003 determined on a straight-line basis over the term of the related lease in accordance with GAAP, and its ten largest industrial tenants represented approximately 8.1% of total annual base rental revenues. Of this amount, its largest tenant, The Boeing Company, leased an aggregate of approximately 846,800 rentable square feet of office space under eight separate leases, representing approximately 7.5% of the Company’s total annual base rental revenues at December 31, 2003. One of these leases encompassing approximately 293,300 rentable square feet at a building in El Segundo, California is scheduled to expire July 2004. The Boeing Company has also informed the Company that it intends to exercise its option to early terminate another lease in El Segundo, California encompassing approximately 7,800 rentable square feet in November 2004. The base periods for the remaining leases for The Boeing Company expire at various dates between August 2005 and March 2009. See additional discussion under “Item 1: Business Risks-The Company may be unable to renew leases or re-let available space” and under “Item 7: Management’s Discussion and Analysis of Financial Condition and Results of Operations-Factors Which May Influence Future Results of Operations.”
The Company’s ten largest office tenants, based on annualized base rental revenues at December 31, 2003, are: The Boeing Company, AMN Healthcare, DirecTv, Inc., Diversa Corporation, Epson America, Inc., Fair Isaac & Company, Fish & Richardson, Newgen Results Corporation, SCAN Health Plan and Epicor Software Corporation. The Company’s ten largest industrial tenants, based on annualized base rental revenues, are: Celestica California, Inc., Qwest Communications Corporation, Mattel, Inc., Packard Hughes Interconnect, Targus, Inc., NBTY Manufacturing, LLC, United Plastics Group, Inc., Kraft Foods, Inc., Extron Electronics, Inc. and Ricoh Electronics. See additional discussion of significant tenants and Recent Information Regarding Significant Tenants under “Item 7: Management’s Discussion and Analysis of Financial Condition and Results of Operations.” For further discussion on the composition of the Company’s tenant base, see “Item 2:
ITEM 2.
PROPERTIES
General
As of December 31, 2003, the Company’s portfolio of stabilized operating properties was comprised of 82 Office Properties and 50 Industrial Properties which encompassed an aggregate of approximately 7.3 million and 4.9 million rentable square feet, respectively. The Properties include four properties that the Company developed and stabilized during 2003 encompassing an aggregate of approximately 399,100 rentable square feet and two properties that were redeveloped by the Company and stabilized in 2003 encompassing 156,400 rentable square feet. As of December 31, 2003, the Office Properties were approximately 87.6% leased to 282 tenants and the Industrial Properties were 94.5% leased to 73 tenants. All but five of the Properties are located in Southern California.
The Company’s stabilized portfolio of operating properties consists of all of the Company’s Office and Industrial Properties, excluding properties recently developed by the Company that have not yet reached 95% occupancy and are within one year following substantial completion (“lease-up properties”) and development and redevelopment projects currently under construction or in pre-development. The Company had one office lease-up property at December 31, 2003, encompassing an aggregate of approximately 209,000 rentable square feet and two office redevelopment properties encompassing approximately 316,100 rentable square feet. All of the Company’s development, redevelopment projects and lease-up properties are located in Southern California.
In general, the Office Properties are leased to tenants on a full service gross basis and the Industrial Properties are leased to tenants on a triple net basis. Under a full service lease, the landlord is obligated to pay the tenant’s proportionate share of real estate taxes, insurance and operating expenses up to the amount incurred during the tenant’s first year of occupancy (“Base Year”) or a negotiated amount approximating the tenant’s pro rata share of real estate taxes, insurance and operating expenses (“Expense Stop”). The tenant pays its pro rata share of increases in expenses above the Base Year or Expense Stop. Under a triple net lease, tenants pay their proportionate share of real estate taxes, operating costs and utility costs.
The Company believes that all of its Properties are well maintained and do not require significant capital improvements. As of December 31, 2003, the Company managed all of its Properties through internal property managers.
The Office and Industrial Properties
The following table sets forth certain information relating to each of the stabilized Office and Industrial Properties owned as of December 31, 2003. The Company owns all of its interests in the Office and Industrial Properties through the Operating Partnership and the Finance Partnership. The seven office buildings located at Kilroy Airport Center, Long Beach, and the three office buildings located at the SeaTac Office Center, all are held subject to leases for the land on which the properties are located which expire in 2084 and 2062 (assuming the exercise of the Company’s options to extend such leases), respectively.
(1)
Based on all leases at the respective properties in effect as of December 31, 2003.
(2)
Calculated as base rent for the year ended December 31, 2003, determined in accordance with GAAP, and annualized to reflect a twelve-month period. Unless otherwise indicated, leases at the Industrial Properties are written on a triple net basis and leases at the Office Properties are written on a full service gross basis, with the landlord obligated to pay the tenant’s proportionate share of taxes, insurance and operating expenses up to the amount incurred during the tenant’s first year of occupancy (“Base Year”) or a negotiated amount approximating the tenant’s pro rata share of real estate taxes, insurance and operating expenses (“Expense Stop”). Each tenant pays its pro rata share of increases in expenses above the Base Year of Expense Stop.
(3)
Calculated as Annual Base Rent divided by net rentable square feet leased at December 31, 2003.
(4)
The four properties at 5151-5155 Camino Ruiz were built between 1982 and 1985 and the leases are written on a triple net basis.
(5)
For this property, leases of 11,000 rentable square feet are written on a triple net basis.
(6)
For this property, the lease is written on a triple net basis.
(7)
For this property, leases of 7,000 rentable square feet are written on a modified gross basis and leases of 2,000 rentable square feet are written on a full service basis.
(8)
For this property, the leases are written on a modified gross basis.
(9)
The leases for this property are written on a modified net basis, with the tenants responsible for their pro rata share of common area expenses and real estate taxes.
(10)
For this property, leases of 26,000 rentable square feet are written on a modified gross basis and leases of 61,000 rentable square feet are written on a triple net basis.
(11)
This property was renovated into a data center in 2000.
(12)
For this property, a lease of 100,000 rentable square feet is written on a modified net basis and another 44,000 rentable square foot lease is written on a triple net basis.
(13)
The seven properties at the Brea Industrial Complex were built between 1981 and 1988. For these properties, leases of 210,000 rentable square feet are written on a triple net basis, 60,000 rentable square feet are on a modified gross basis, and 6,000 rentable square feet are written on a gross basis.
(14)
For this property, leases of 109,000 rentable square feet are written on a modified net basis, leases of 33,000 rentable square feet are written on a triple net basis, and leases of 37,000 rentable square feet are written on a modified gross basis.
(15)
The six properties at the Garden Grove Industrial Complex were built between 1971 and 1985. For these properties, leases of 191,000 rentable square feet are written on a triple net basis, 45,000 rentable square feet are written on a modified gross basis, and 40,000 rentable square feet are written on a gross basis.
(16)
This industrial property was originally designed for multi-tenant use and currently is leased to a single tenant and utilized as an indoor multi-vendor retail marketplace.
Development and Redevelopment
The following tables set forth certain information regarding the Company’s lease-up and in-process office development and redevelopment projects as of December 31, 2003. See further discussion regarding the Company’s projected development and redevelopment trends under “Item 7: Management’s Discussion of Financial Condition and Results of Operations-Factors Which May Influence Future Results of Operations-Development and redevelopment programs.”
Development Projects
(1)
Based on management’s estimation of the earlier of stabilized occupancy (95.0%) or one year following the date of substantial completion.
Redevelopment Projects
(1)
Based on management’s estimation of the earlier of stabilized occupancy (95.0%) or one year following the date of substantial completion.
(2)
Represents total capitalized costs at the commencement of redevelopment.
Tenant Information
The following table sets forth information as to the Company’s ten largest office and industrial tenants as of December 31, 2003, based upon annualized rental revenues at December 31, 2003.
(1)
Determined on a straight-line basis over the term of the related lease in accordance with GAAP.
(2)
Represents date of first relationship between tenant and the Company or the Company’s predecessor.
(3)
The Boeing Satellite Systems, Inc. leases of 65,447, 293,261, 113,242, 101,564 and 7,791 net rentable square feet expire October 2005, July 2004, March 2009, January 2006 and November 2004, respectively. The Boeing Commercial Airplane Group lease of 211,139 net rentable square feet at SeaTac Office Center expires in December 2007. The Boeing Capital Corporation and Boeing Realty Corporation leases at Kilroy Airport Center, Long Beach of 43,636 and 10,725 net rentable square feet expire in September 2005 and August 2005, respectively. See additional discussion on The Boeing Company under “Item 7: Management’s Discussion and Analysis of Financial Condition and Results of Operations-Factors Which May Influence Future Results of Operations.”
(4)
The Diversa Corporation leases of 76,246 and 60,662 net rentable square feet expire in November 2015 and March 2017, respectively.
(5)
The Epson America, Inc. leases of 136,026 and 26,826 net rentable square feet expire in October 2009.
(6)
The United Plastics Group, Inc. leases of 144,000 and 44,000 rentable square feet expire in December 2006 and January 2005, respectively.
(7)
The Extron Electronics leases of 100,000 and 57,730 net rentable square feet expire in April 2005 and February 2005, respectively.
At December 31, 2003, the Company’s tenant base was comprised of the following industries, based on Standard Industrial Classifications, broken down by percentage of total portfolio base rent: services, 41.0%; manufacturing, 28.2%; finance, insurance and real estate, 15.0%; transportation, communications and public utilities, 8.3%; wholesale trade, 3.9%; government, 1.3%; retail trade, 1.2%; construction, 0.9%; and agriculture, forestry and fishing, 0.2%. Following is a list comprised of a representative sample of 25 of the Company’s tenants whose annual base rental revenues were less than 1.0% of the Company’s total annual base revenue at December 31, 2003:
A & J Manufacturing Co.
Kaiser Foundation Health Plan
Snap-On Tools Company
Anheuser Busch Properties
Kraft Foods, Inc.
Southland Office Interiors
Blue Cross of California
Mercury Technology Group, Inc.
StarMed Staffing Group
Bullet Distribution, Inc.
Merrill Lynch & Co.
Twentieth Century Fox Film
Chagal Communications, Inc.
Motivation Realty Corp.
Wells Fargo Bank
Clifford Chance
New Mode Sports Wear
Wells Fargo Home Mortgage, Inc.
Det Norske Veritas
Pickford Real Estate, Inc.
Winstar Wireless, Inc.
Eva Airways
Plastic Industries Company, Inc.
Fandango, Inc.
Pleasant Holidays, LLC
Lease Expirations
The following table sets forth a summary of the Company’s lease expirations for the Office and Industrial Properties for each of the ten years beginning with 2004, assuming that none of the tenants exercise renewal options or termination rights. See further discussion of the Company’s lease expirations under “Item 1: Business-Business Risks.”
(1)
Includes tenants only. Excludes leases for amenity, retail, parking and month-to-month tenants. Some tenants have multiple leases.
(2)
Based on total leased square footage for the respective portfolios as of December 31, 2003.
(3)
Determined based upon aggregate base rent to be received over the term divided by the term in months multiplied by 12, including all leases executed on or before January 1, 2004.
(4)
Excludes space leased under month-to-month leases and vacant space at December 31, 2003.
Secured Debt
At December 31, 2003, the Operating Partnership had 15 secured mortgage and construction loans outstanding, representing aggregate indebtedness of approximately $526 million, which were secured by certain of the Properties and development projects (the “Secured Obligations”). See “Item 7: Management’s Discussion and Analysis of Financial Condition and Results of Operations-Liquidity and Capital Resources” and note 10 to the Company’s consolidated financial statements included with this report. Management believes that, as of December 31, 2003, the value of the properties securing the respective Secured Obligations in each case exceeded the principal amount of the outstanding obligation.
ITEM 3.
ITEM 3.
LEGAL PROCEEDINGS
As previously reported, in March 2003, one of the Company’s former tenants, EBC I, formerly known as eToys, Inc. (“eToys”) filed a lawsuit in the Superior Court of the State of California against the Company seeking return of the proceeds from two letters of credit previously drawn down by the Company. The tenant originally caused its lenders to deliver an aggregate of $15 million in letters of credit to secure its obligations under its lease with the Company and also to secure its obligations to repay the Company for certain leasing and tenant improvement costs. EToys defaulted on its lease and other obligations to the Company in January 2001 and subsequently filed for bankruptcy in March 2001. Management strongly disagrees with the points outlined in the suit and is vigorously defending itself against the claim. However, if eToys were to prevail in this action, it could have a material adverse effect upon the financial condition, results of operations and cash flows of the Company.
Other than routine litigation incidental to the business, the Company is not a party to, and its properties are not subject to, any other legal proceedings which if determined adversely to the Company, would have a material adverse effect upon the financial condition, results of operations and cash flows of the Company.
ITEM 4.
ITEM 4.
SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of stockholders during the fourth quarter of the year ended December 31, 2003.
PART II
ITEM 5.
ITEM 5.
MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The Company’s common stock is traded on the New York Stock Exchange (“NYSE”) under the symbol “KRC.” The following table illustrates the high, low and closing prices by quarter during 2003 and 2002 as reported on the NYSE. On December 31, 2003, there were approximately 217 registered holders of the Company’s common stock.
The Company pays distributions to common stockholders quarterly each January, April, July and October at the discretion of the Board of Directors. Distribution amounts depend on the Company’s FFO (as defined on page 30), financial condition and capital requirements, the annual distribution requirements under the REIT provisions of the Internal Revenue Code of 1986, as amended, and such other factors as the Board of Directors deems relevant.
During 2003, the Company issued 82,439 shares of common stock in redemption of 82,439 common limited partnership units of the Operating Partnership by limited partners. The issuance was not dilutive to capitalization or distributions as the common shares were issued on a one-for-one basis pursuant to the terms set forth in the partnership agreement of the Operating Partnership, and the partnership units share in distributions with the common stock.
ITEM 6.
ITEM 6.
SELECTED FINANCIAL DATA
Kilroy Realty Corporation Consolidated
(in thousands, except per share, square footage and occupancy data)
(1)
Certain line items within the Statements of Operations Data do not equal the amounts reported on the Company’s annual reports filed in previous years on Form 10-K. The variance is a result of the reclassification of the net income and net gain on the disposition of operating properties sold subsequent to December 31, 2001 to discontinued operations in accordance with SFAS 144 “Accounting for the Impairment of Disposal of Long-Lived Assets” (see Note 22 in the Company’s consolidated financial statements). In addition, certain prior year amounts have been reclassified to conform to the current year’s presentation.
(2)
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 a perspective not immediately apparent from net income. In addition, management believes that FFO provides useful information to the investment community about the Company’s financial performance when compared to other REITs since FFO is generally recognized as the industry standard for reporting the operations of REITs.
However, FFO should not be viewed as an alternative measure of the Company’s operating performance since it does not reflect either depreciation and amortization costs or the level of capital expenditures and leasing costs necessary to maintain the operating performance of the Company’s properties, which are significant economic costs and could materially impact the Company’s results of operations.
Non-cash adjustments to arrive at FFO were as follows: in all periods, depreciation and amortization and net gain (loss) from dispositions of operating properties; in all periods except 2003 and 2002, non-cash amortization of restricted stock grants; and in 2001, cumulative effect of change in accounting principle. For additional information, see “Non-GAAP Supplemental Financial Measure: Funds From Operations” including a reconciliation of the Company’s GAAP net income available to common stockholders to FFO for the years ended December 31, 2003, 2002, 2001, 2000 and 1999.
ITEM 7.
ITEM 7.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion relates to the consolidated financial statements of the Company and should be read in conjunction with the financial statements and notes thereto appearing elsewhere in this report. Statements contained in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” that are not historical facts may be forward-looking statements. Such statements are subject to certain risks and uncertainties, which could cause actual results to differ materially from those projected. Some of the enclosed information presented is forward-looking in nature, including information concerning development timing and investment amounts. Although the information is based on the Company’s current expectations, actual results could vary from expectations stated here. Numerous factors will affect the Company’s actual results, some of which are beyond its control. These include the timing and strength of regional economic growth, the strength of commercial and industrial real estate markets, competitive market conditions, future interest rate levels and capital market conditions. You are cautioned not to place undue reliance on this information, which speaks only as of the date of this report. The Company assumes no obligation to update publicly any forward-looking information, whether as a result of new information, future events or otherwise except to the extent the Company is required to do so in connection with its ongoing requirements under Federal securities laws to disclose material information. For a discussion of important risks related to the Company’s business, and an investment in its securities, including risks that could cause actual results and events to differ materially from results and events referred to in the forward-looking information, see the discussion under the caption “Business Risks” in “Item 1 - Business” and under the caption “Factors Which May Influence Future Results of Operations” below. In light of these risks, uncertainties and assumptions, the forward-looking events discussed in this report might not occur.
Overview and Background
Kilroy Realty Corporation (the “Company”) owns, operates, and develops office and industrial real estate, primarily in Southern California. The Company operates as a self-administered real estate investment trust (“REIT”). The Company owns its interests in all of its properties through Kilroy Realty, L.P. (the “Operating Partnership”) and Kilroy Realty Finance Partnership, L.P. (the “Finance Partnership”) and conducts substantially all of its operations through the Operating Partnership. The Company owned an 87.2% and 86.6% general partnership interest in the Operating Partnership as of December 31, 2003 and 2002, respectively.
Critical Accounting Estimates
The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses for the reporting periods. Certain accounting policies are considered to be critical accounting estimates, as they require management to make assumptions about matters that are highly uncertain at the time the estimate is made and changes in the accounting estimate are reasonably likely to occur from period to period. Management believes the following critical accounting policies reflect the Company’s more significant judgments and estimates used in the preparation of the consolidated financial statements. For a summary of all the Company’s significant accounting policies see note 2 to the Company’s consolidated financial statements.
Evaluation of asset impairment. The Company evaluates a property for potential impairment whenever events or changes in circumstances indicate that its carrying amount may not be recoverable. In the event that these periodic assessments reflect that the carrying amount of a property exceeds the sum of the undiscounted cash flows (excluding interest) that are expected to result from the use and eventual disposition of the property, the Company would recognize an impairment loss to the extent the carrying amount exceeded the estimated fair value of the property. The estimation of expected future net cash flows is inherently uncertain and relies on subjective assumptions dependent upon future and current market conditions and events that affect the ultimate
value of the property. It requires management to make assumptions related to future rental rates, tenant allowances, operating expenditures, property taxes, capital improvements, occupancy levels, and the estimated proceeds generated from the future sale of the property.
The Company had not recorded any such impairment losses at December 31, 2003, 2002 and 2001. However the Company’s estimate of future cash flows are subject to revision as management’s assessment of market conditions changes. If the Company determines it is necessary to recognize a material impairment loss the Company’s financial position, and results of operations may be adversely affected.
Allowances for uncollectible current tenant receivables and unbilled deferred rents receivable. Tenant receivables and unbilled deferred rent receivables are carried net of the allowances for uncollectible tenant receivables and unbilled deferred rent. Management’s determination of the adequacy of these allowances requires significant judgments and estimates.
Current tenant receivables consist primarily of amounts due for contractual lease payments, reimbursements of common area maintenance expenses, property taxes and other expenses recoverable from tenants. Management’s determination of the adequacy of the allowance for uncollectible current tenant receivables is performed using a methodology that incorporates both a specific identification and aging analysis and includes an overall evaluation of the Company’s historical loss trends and the current economic and business environment. The specific identification methodology relies on factors such as the age and nature of the receivables, the payment history and financial condition of the tenant, the Company’s assessment of the tenant’s ability to meet its lease obligations, and the status of negotiations of any disputes with the tenant. The Company’s allowance also includes a reserve based on historical loss trends not associated with any specific tenant. This reserve as well as the Company’s specific identification reserve is reevaluated quarterly based on economic conditions and the current business environment.
Unbilled deferred rents receivable represents the amount that the cumulative straight-line rental income recorded to date exceeds cash rents billed to date under the lease agreement. Given the longer-term nature of these types of receivables, management’s determination of the adequacy of the allowance for unbilled deferred rents receivables is based primarily on historical loss experience. Management evaluates the allowance for unbilled deferred rents receivable using a specific identification methodology for the Company’s significant tenants assessing the tenants’ financial condition and its ability to meet its lease obligations. In addition, the allowance includes a reserve based upon the Company’s historical experience and current and anticipated future economic conditions that is not associated with any specific tenant.
Management’s estimate for the required allowances is reevaluated quarterly as economic and market conditions and the creditworthiness of the Company’s tenants change. During the fourth quarter of 2003, the Company’s accounts receivable aging and collection of outstanding tenant receivables improved, and as a result, the Company did not increase its provision for bad debts. This is the first quarter in approximately three years that the Company did not record a provision for bad debts, and management cannot yet determine if this will be a trend in 2004. For the years ended December 31, 2003, 2002 and 2001 the Company recorded a provision for bad debts and unbilled deferred rents of approximately 0.8%, 3.4%, and 1.9% of recurring revenue. Of the provision of 3.4% recorded for the year ended December 31, 2002, approximately 1.8% related specifically to reserves recorded for receivables from Peregrine Systems, Inc. (“Peregrine”) the Company’s second largest tenant at December 31, 2002. The Company’s reserve levels will fluctuate based on the economy and/or if the Company experiences an increased or decreased incidence of bad debts. If the Company experiences increased levels of bad debt expense or if the Company experiences write-offs in excess of its allowances, the Company’s financial position, revenues and results of operations would be adversely affected.
Depreciable lives of leasing costs. The Company incurs certain capital costs in connection with leasing its properties. These leasing costs primarily include lease commissions and tenant improvements. Leasing costs are amortized on the straight-line method over the shorter of the estimated useful life of the asset or the estimated
remaining term of the associated lease, ranging from one to 15 years. Management reevaluates the remaining useful life of these costs as the creditworthiness of the Company’s tenants change. If management determines that the estimated remaining life of the respective lease has changed, the Company adjusts the amortization period and, therefore, the depreciation expense recorded each period may fluctuate. If the Company experiences increased levels of amortization or depreciation expense due to changes in the estimated useful lives of leasing costs, the Company’s financial position, and results of operations may be adversely affected.
Factors Which May Influence Future Results of Operations
Rental income. The amount of net rental income generated by the Company’s Properties depends principally on its ability to maintain the occupancy rates of currently leased space and to lease currently available space, newly developed or redeveloped properties and space available from unscheduled lease terminations. The amount of rental income generated by the Company also depends on its ability to maintain or increase rental rates in its submarkets. Negative trends in one or more of these factors could adversely affect the Company’s rental income in future periods.
Rental rates. The Company’s average rental rate increase was 7.0% on a GAAP basis and 4.3% on a cash basis for leases executed during the year ended December 31, 2003. The change in rents on a cash basis is calculated as the change between the stated rent for a new or renewed lease and the stated rent for the expiring lease for the same space, whereas change in rents on a GAAP basis compares the average rents over the term of the lease for each lease. For the leases scheduled to expire in 2004, management believes the rental rates on average are approximately 10% to 15% above current average quoted market rates, primarily related to one lease. Management believes that the average rental rates for all of its Properties generally are equal to the current average quoted market rate, although individual Properties within any particular submarket presently may be leased above or below the rental rates within that submarket. The Company cannot give any assurance that leases will be renewed or that available space will be re-leased at rental rates equal to or above the current rental rates.
Scheduled lease expirations. In addition to the 1,177,952 square feet of currently available space in the Company’s stabilized portfolio, leases representing approximately 10.1% and 12.1% of the square footage of the Company’s stabilized portfolio are scheduled to expire during 2004 and in 2005, respectively. The leases scheduled to expire in 2004 and the leases scheduled to expire in 2005 represent approximately 1.2 million square feet of office space, or 15.2% of the Company’s total annualized base rent, and 1.2 million square feet of industrial space, or 5.0% of the Company’s total annualized base rent, respectively. The Company’s ability to release available space depends upon the market conditions in the specific submarkets in which the Properties are located.
Los Angeles County submarket information. There have been modest signs of improvement in market conditions in the Los Angeles County submarket in the third and fourth quarters of 2003 based on reports of positive absorption and decreased levels of direct vacancy as well as an increased level of interest in leasing opportunities at the Company’s properties. At December 31, 2003, the Company’s Los Angeles stabilized office portfolio was 82.5% occupied with approximately 563,200 rentable square feet available for lease. Further, leases representing an aggregate of approximately 485,500 and 199,500 rentable square feet are scheduled to expire during 2004 and 2005, respectively, in this submarket as of December 31, 2003.
The Los Angeles stabilized portfolio includes two office development projects, encompassing approximately 284,300 rentable square feet, that were previously in the lease-up phase and added to the stabilized portfolio during 2003, since one year had passed following substantial completion. One of the projects is located in West Los Angeles. This project encompasses approximately 151,000 rentable square feet and was 48% occupied as of December 31, 2003. As of December 31, 2003, the Company had executed leases or letters of intent for 61% of the rentable square feet at this project. While leasing activity in the West Los Angeles submarket continues to be irregular, management has seen increased interest at the Company’s projects and continues to make progress leasing the buildings. Overall the Company’s West Los Angeles stabilized office properties were 78% occupied as of December 31, 2003, with approximately 150,300 rentable square feet available for lease.
The other Los Angeles County office project is located in El Segundo. This project encompasses approximately 133,300 rentable square feet and was approximately 5% occupied as of December 31, 2003. As of December 31, 2003, the Company had executed leases or letters of intent for 31% of the rentable square feet at this project. The El Segundo submarket remains the Company’s most significant leasing challenge, although management has recently seen modest signs of improvement. In February 2004, the Company executed a seven-year lease for approximately 29,000 rentable square feet at this development project, commencing in the second quarter of 2004. Overall the Company’s stabilized El Segundo office properties were 84% occupied as of December 31, 2003, with approximately 136,700 rentable square feet available for lease. In addition, in 2003, the Company began the redevelopment of an office building in El Segundo, encompassing approximately 248,100 rentable square feet which was not pre-leased as of December 31, 2003. The building is located in the same complex as one of the stabilized development projects discussed above. The Company expects to complete the redevelopment of this building in the second quarter of 2004. In addition, of the 485,500 rentable square feet scheduled to expire in 2004 in the Los Angeles submarket, one lease encompassing approximately 293,300 rentable square feet is located in El Segundo.
San Diego County submarket information. As of December 31, 2003, the Company’s San Diego office portfolio was 92.3% occupied with approximately 235,800 rentable square feet available for lease. At December 31, 2003, the Company had one office development project in lease-up encompassing an aggregate of approximately 209,000 rentable square feet. This project was 84.1% leased at December 31, 2003. As of December 31, 2003, leases representing an aggregate of approximately 50,900 and 277,200 rentable square feet were scheduled to expire during 2004 and 2005, respectively, in this submarket. In addition, in 2003, the Company began the redevelopment of one office building in the San Diego region, which was not pre-leased as of December 31, 2003. The Company completed this project, which encompasses approximately 68,000 rentable square feet, in January 2004.
Orange County submarket information. As of December 31, 2003, the Company’s Orange County properties were 94.9% occupied with approximately 232,200 rentable square feet available for lease. As of December 31, 2003, leases representing an aggregate of approximately 478,400 and 556,100 rentable square feet were scheduled to expire during 2004 and 2005, respectively, in this submarket.
Sublease space. Of the Company’s leased space at December 31, 2003, approximately 760,200 rentable square feet, or 6.2% of the square footage in the Company’s stabilized portfolio was available for sublease, of which approximately 5.1% was vacant space and the remaining 1.1% was occupied. Of the approximately 760,200 rentable square feet available for sublease, approximately 69,000 rentable square feet represents leases scheduled to expire in 2004 and 2005. As of December 31, 2002, approximately 1,090,600 rentable square feet, or 8.8% of the square footage in the Company’s stabilized portfolio was available for sublease, of which 4.7% was vacant and 4.1% was occupied. Of the total 6.2% of rentable square feet available for sublease at December 31, 2003, approximately 4.5% is located in Orange County, of which 3.9% represents space available in two Orange County industrial buildings, and approximately 1.2% is in San Diego County.
Negative trends or other events that impair the Company’s ability to renew or release space and its ability to maintain or increase rental rates in its submarkets could have an adverse effect on the Company’s future financial condition, results of operations and cash flows.
Recent information regarding significant tenants
The Boeing Company. As of December 31, 2003, the Company’s largest tenant, The Boeing Company, leased an aggregate of approximately 847,000 rentable square feet of office space under eight separate leases, representing approximately 7.5% of the Company’s total annual base rental revenues. One of the leases for a building located in El Segundo, encompassing approximately 293,300 rentable square feet, is scheduled to expire in July 2004. The Boeing Company has also informed the Company that it intends to exercise its option to early terminate another lease in El Segundo, California encompassing approximately 7,800 rentable square feet in November 2004. The other six leases are scheduled to expire at
various dates between August 2005 and March 2009. The Boeing Company previously had another lease, at 909 N. Sepulveda Boulevard in El Segundo, California, encompassing approximately 248,150 rentable square feet that expired on February 28, 2003. The Boeing Company vacated this building upon lease expiration. This building was subsequently moved to the Company’s redevelopment portfolio.
Peregrine Systems, Inc. As previously reported, Peregrine, the Company’s second largest tenant at December 31, 2002, filed for bankruptcy in September 2002. Peregrine had leased four office buildings in a five-building complex totaling approximately 424,400 rentable square feet under four separate leases. Peregrine was also committed to lease the fifth building, encompassing approximately 114,800 rentable square feet, which was completed in the third quarter of 2002. Peregrine surrendered this fifth building back to the Company in June 2002. In July 2003, the bankruptcy court approved Peregrine’s plan of reorganization. Under terms of the plan of reorganization and in accordance with a settlement agreement previously approved by the bankruptcy court, the Company received a payment in the third quarter of 2003 of approximately $18.3 million and is scheduled to receive four additional payments of approximately $750,000, each to be paid annually over the next four years.
As part of the bankruptcy court’s approval of Peregrine’s reorganization plan, the court approved Peregrine’s rejection of three of its leases with the Company. The bankruptcy court also approved Peregrine’s continuation, in part, of the fourth lease. Under the revised terms of this lease, Peregrine continues to lease approximately 104,500 square feet of this 129,680 square foot building. Including the 104,500 rentable square feet leased to Peregrine, occupancy in this complex was 82.3% as of the date of this report, and the Company has executed leases for 99% of the space in this complex which encompasses an aggregate of approximately 539,200 rentable square feet.
Brobeck, Phleger & Harrison, LLP. Brobeck, Phleger & Harrison, LLP (“Brobeck”) dissolved in February 2003 and as a result the Company terminated the two leases Brobeck had with the Company encompassing 161,500 aggregate rentable square feet. The Company is currently pursuing legal action against Brobeck. As of the date of this report, the Company has executed leases for 66% of the space in these buildings.
Although the Company has been able to mitigate the impact of tenant defaults on its financial condition, revenues and results of operations, the Company’s financial condition, results of operations and cash flows would be adversely affected if any of the Company’s other significant tenants fail to renew their leases, renew their leases on terms less favorable to the Company or if any of them become bankrupt or insolvent or otherwise unable to satisfy their lease obligations.
Development and redevelopment programs. Management believes that a portion of the Company’s potential growth over the next several years will continue to come from its development pipeline. However, during 2003 and 2002, the Company scaled back its development activity as result of the economic environment and its impact on the Company’s ability to lease projects within budgeted timeframes. As a result, the Company will most likely not be able to sustain historical levels of growth from development in the near future.
As of December 31, 2003, the Company had one office development property in lease-up encompassing an aggregate of approximately 209,000 rentable square feet which was 84% leased and is expected to stabilize in the third quarter of 2004. The Company did not have any development projects under construction at December 31, 2003. See additional information regarding the Company’s development portfolio under the caption “Development and Redevelopment” in this report. At December 31, 2003, the Company owned approximately 58.1 acres of undeveloped land upon which the Company currently expects to develop an aggregate of approximately 1.1 million rentable square feet of office space within the next three to five years.
Management believes that another source of the Company’s potential growth over the next several years will come from redevelopment opportunities within its existing portfolio. Redevelopment efforts can achieve
similar returns to new development with reduced entitlement risk and shorter construction periods. The Company’s in-process redevelopment portfolio included two office projects, encompassing approximately 316,100 rentable square feet, which are expected to stabilize in the first and second quarters of 2005 and were not pre-leased as of December 31, 2003. This redevelopment portfolio included one life science conversion project in North San Diego County and another project in which the Company is performing extensive interior refurbishments at an office building in El Segundo that had been occupied by a single tenant for approximately 30 years. See additional information regarding the Company’s in-process redevelopment portfolio under the caption “Development and Redevelopment” in this report. Depending on market conditions, the Company will continue to pursue future redevelopment opportunities in its strategic submarkets where no land available for development exists.
The Company has a proactive planning process by which it continually evaluates the size, timing and scope of its development and redevelopment programs and, as necessary, scales activity to reflect the economic conditions and the real estate fundamentals that exist in the Company’s strategic submarkets. However, the Company may not be able to lease committed development or redevelopment properties at expected rental rates or within projected timeframes or complete projects on schedule or within budgeted amounts, which could adversely affect the Company’s financial condition, results of operations and cash flows.
Other Factors. The Company’s operating results are and may continue to be affected by uncertainties and problems associated with the deregulation of the utility industry in California since 94.6% of the total rentable square footage of the Company’s stabilized portfolio is located in California. Energy deregulation has resulted in higher utility costs in some areas of the state and intermittent service interruptions. In addition, primarily as a result of the events of September 11, 2001, the Company’s annual insurance costs increased across its portfolio by approximately 14% during 2002 and approximately 11% during 2003. As of the date of this report, the Company had not experienced any material negative effects arising from either of these issues because approximately 66% (based on net rentable square footage) of the Company’s current leases require tenants to pay utility costs and property insurance premiums directly, thereby limiting the Company’s exposure. The remaining 34% of the Company’s leases provide that the tenants reimburse the Company for these costs in excess of a base year amount.
In addition, the California State legislature is currently evaluating split tax roll legislation, which if enacted, would have a material effect on the Company’s operating results. If the current initiative is passed, the tax rate on commercial property in California would be increased by 55%, which would result in significant increases in real estate taxes for the Company’s properties located in California.
Incentive Compensation. The Company has long-term incentive compensation programs that provide for cash and stock compensation to be earned by the Company’s executive officers if the Company attains certain performance measures that are based on annualized shareholder 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 closing price per share of the Company’s common stock at the end of each quarter. Potential future increases in the price per share of the Company’s common stock and the resultant cumulative annualized shareholder return calculations will cause an increase to general and administrative expenses and a corresponding decrease to net income available to common shareholders. Management cannot predict the amounts that will be ultimately recorded in future periods related to these plans since they are significantly influenced by the Company’s stock price and market conditions.
Results of Operations
As of December 31, 2003, the Company’s stabilized portfolio was comprised of 82 office properties (the “Office Properties”) encompassing an aggregate of approximately 7.3 million rentable square feet, and 50 industrial properties (the “Industrial Properties,” and together with the Office Properties, the “Properties”), encompassing an aggregate of approximately 4.9 million rentable square feet. The Company’s stabilized
portfolio of operating properties consists of all the Company’s Properties, and excludes properties recently developed or redeveloped by the Company that have not yet reached 95.0% occupancy and are within one year following substantial completion (“lease-up” properties) and projects currently under construction.
As of December 31, 2003, the Office and Industrial Properties represented 81.7% and 18.3%, respectively, of the Company’s annualized base rent. For the year ended December 31, 2003, average occupancy in the Company’s stabilized portfolio was 91.2%. As of December 31, 2003, the Company had approximately 1,177,458 square feet of space in its stabilized portfolio available for lease.
The following table reconciles the changes in the rentable square feet in the Company’s stabilized portfolio of operating properties from December 31, 2002 to December 31, 2003. Rentable square footage in the Company’s portfolio of stabilized properties decreased by an aggregate of approximately 0.1 million rentable square feet, or 1.1%, to 12.2 million rentable square feet at December 31, 2003, as a result of the activity noted below.
(1)
The Company adopted Statement of Financial Accounting Standards No. 144 “Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFAS 144”) on January 1, 2002. In accordance with the implementation provisions of SFAS 144, the operating results and gains or (losses) on property sales of real estate assets sold subsequent to December 31, 2001 are included in discontinued operations in the consolidated statement of operations. The Rental Operations discussion for the year ended December 31, 2003 and 2002 does not include operating results for properties disposed of subsequent to December 31, 2001.
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 21 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.”
Year Ended December 31, 2003 Compared to Year Ended December 31, 2002
The following table reconciles the Company’s Net Operating Income by segment to the Company’s net income available to common shareholders for the years ended December 31, 2003 and 2002.
(1)
In accordance with SFAS 144 “Accounting for the Impairment or Disposal of Long-Lived Assets,” the net income and the net gain on disposition of properties sold subsequent to January 1, 2002 are reflected in the consolidated statement of operations as discontinued operations for all periods presented. The net gain on dispositions of operating properties for the year ended December 31, 2002 relates to the disposition of an office property the Company sold in the fourth quarter of 2001. This additional gain had previously been reserved for financial reporting purposes until certain litigation associated was resolved in the second quarter of 2002.
Rental Operations
Management evaluates the operations of its portfolio based on operating property type. The following tables compare the Net Operating Income from continuing operations, for the Office Properties and for the Industrial Properties for the years ended December 31, 2003 and 2002.
Office Properties
(1)
Stabilized office properties owned at January 1, 2002 and still owned at December 31, 2003.
Total revenues from Office Properties increased $24.3 million, or 14.7% to $189.7 million for the year ended December 31, 2003 compared to $165.4 million for the year ended December 31, 2002. Rental income from Office Properties increased $4.1 million, or 2.9% to $149.2 million for the year ended December 31, 2003 compared to $145.1 million for the year ended December 31, 2002. This increase was primarily attributable to an increase of $10.9 million in rental income generated by the office properties developed and redeveloped by the Company in 2003 and 2002 (the “Office Development Properties”), offset by a decrease of $2.5 million, or 1.9% related to the Core Office Portfolio, and a decrease of $4.3 million in rental income attributable to the office properties that were taken out of service and moved from the Company’s stabilized portfolio to the redevelopment portfolio during 2003 (“Office Redevelopment Properties”). The decrease in the Core Office Portfolio was primarily attributable to a decline in occupancy in this portfolio. Average occupancy in the Core Office Portfolio declined 1.3% to 89.4% for the year ended December 31, 2003 as compared to 90.7% for the year ended December 31, 2002.
Tenant reimbursements from Office Properties decreased $1.1 million, or 6.2% to $16.6 million for the year ended December 31, 2003 compared to $17.7 million for the year ended December 31, 2002. A decrease of $1.4 million attributable to the Office Redevelopment Properties was partially offset by a increase of $0.2 million attributable to the Office Development Properties and an increase of $0.1 million, or 0.6% in tenant reimbursements generated by the Core Office Portfolio. Other property income from Office Properties increased $21.3 million or 824.0% to $23.9 million for the year ended December 31, 2003 compared to $2.6 million for the year ended December 31, 2002. Other property income for the year ended December 31, 2003, included an $18.0 million lease termination fee related to a settlement with Peregrine Systems, Inc. In accordance with the settlement agreement approved by the bankruptcy court, the Company received a payment of $18.3 million in 2003 and is scheduled to receive four additional payments of approximately $750,000 each to be paid annually over the next four years. The future payments were recorded at their net present value which was approximately $2.6 million. The lease termination fee of $18.0 represents the $18.3 million payment plus the $2.6 million net present value of the future payments, offset by $2.9 million in receivables and other costs and obligations associated with the leases. The future payments were reserved for financial reporting purposes at December 31,
2003 through the provision for bad debts. After the impact of the reserve, the Company recognized a net lease termination fee of $15.4 million. Also during the year ended December 31, 2003, the Company recognized a $4.3 million net lease termination fee resulting from the early termination of leases at a building in San Diego. The remaining amounts in other property income from Office Properties for both periods consisted primarily of lease termination fees, management fees and tenant late charges.
Total expenses for Office Properties increased $0.2 million, or 0.3% to $46.6 million for the year ended December 31, 2003 compared to $46.4 million for the year ended December 31, 2002. Property expenses from Office Properties increased $4.0 million, or 14.6% to $31.1 million for the year ended December 31, 2003 compared to $27.1 million for the year ended December 31, 2002. This increase was primarily attributable to higher repairs and maintenance in the Core Office Portfolio, which was due to non-recurring expenditures at one complex of buildings. Real estate taxes increased $0.7 million, or 6.0% to $12.8 million for the year ended December 31, 2003 as compared to $12.1 million for the year ended December 31, 2002. Real estate taxes for the Core Office Portfolio increased $0.1 million, or 0.1% for the year ended December 31, 2003 compared to the same period in 2002. Of the remaining increase of $0.6 million in real estate taxes, an increase of $1.2 million attributable to the Office Development Properties was partially offset by a decrease of $0.6 million attributable to the Office Redevelopment Properties. The provision for bad debts decreased $4.5 million, or 77.4% for the year ended December 31, 2003 as compared to the year ended December 31, 2002. The decrease was primarily due to a change in the provision related to the Company’s leases with Peregrine. For the year ended December 31, 2003, the Company recorded a provision of approximately $2.6 million related to the future settlement payments to be received from Peregrine, and reversed a provision for bad debts and unbilled deferred rents receivable of approximately $3.1 million related to the Company’s leases with Peregrine as a result of the settlement with Peregrine in July 2003. During 2002, the Company recorded a provision for bad debts and unbilled deferred rents receivable of approximately $3.8 million specifically related to receivables from Peregrine. The remaining decrease is due to an improvement in the Company’s accounts receivable aging and collections of outstanding tenant receivables during 2003. Management cannot yet determine if this is a trend. The Company evaluates its reserve for unbilled deferred rent on a quarterly basis. Ground lease expense remained consistent for the year ended December 31, 2003 compared to the same period in 2002.
Net Operating Income, as defined, from Office Properties increased $24.1 million, or 20.3% to $143.1 million for the year ended December 31, 2003 compared to $118.9 million for the year ended December 31, 2002. An increase of $16.0 million was attributable to the Core Office Portfolio which was primarily due to the Peregrine lease termination fee. The remaining increase of $7.1 million was primarily attributable to the Office Development Properties that were added to the Stabilized Portfolio.
Industrial Properties
(1)
Stabilized industrial properties owned at January 1, 2002 and still owned at December 31, 2003.
Total revenues from Industrial Properties decreased $0.7 million, or 1.8% to $38.1 million for the year ended December 31, 2003 compared to $38.8 million for the year ended December 31, 2002. Rental income from Industrial Properties decreased $0.8 million, or 2.4% to $34.1 million for the year ended December 31, 2003 compared to $34.9 million for the year ended December 31, 2002. Rental income generated by the Core Industrial Portfolio decreased $1.2 million, or 3.3% for the year ended December 31, 2003 as compared to the year ended December 31, 2002. This decrease was primarily attributable to a decrease in occupancy in this portfolio. Average occupancy decreased 1.3% to 96.2% for the year ended December 31, 2003 compared to 97.5% for the year ended December 31, 2002. The net decrease in rental income from the Core Industrial Portfolio was partially offset by an increase of 0.4 million from the one property acquired during 2002 (“Industrial Acquisition”).
Tenant reimbursements from Industrial Properties remained consistent for the year ended December 31, 2003 compared to the year ended December 31, 2002. Other property income from Industrial Properties increased $0.1 million for the year ended December 31, 2003 which was attributable to lease terminations fees in the Core Industrial Portfolio. Other income for both periods is primarily comprised of miscellaneous lease termination fees and tenant late charges.
Total expenses from Industrial Properties decreased $1.1 million, or 15.4% to $5.9 million for the year ended December 31, 2003 compared to $7.0 million for the year ended December 31, 2002. Property expenses from Industrial Properties decreased $0.2 million, or 7.9% for the year ended December 31, 2003 compared to the year ended December 31, 2002. This decrease was primarily attributable to lower repairs and maintenance costs in the Core Industrial Portfolio for the year ended December 31, 2003 compared to the same period in 2002. Real estate taxes decreased $0.1 million or 3.2% for the year ended December 31, 2003 compared to the year ended December 31, 2002. This decrease was attributable to the refunds received for real estate taxes successfully appealed by the Company in 2003 at buildings in the Core Industrial Portfolio. The provision for bad debts decreased $0.7 million, or 73.0% for the year ended December 31, 2003 compared to the same period in 2002. During the year ended December 31, 2003, the Company decreased its reserve for bad debts and unbilled deferred rent specifically related to the Company’s watchlist tenants due to improvement in the collection of tenant receivables. The Company evaluates its reserve levels on a quarterly basis.
Net Operating Income, as defined, from Industrial Properties increased $0.3 million, or 1.2% for the year ended December 31, 2003 compared to the year ended December 31, 2002. Net operating income for the Core Industrial Portfolio increased $0.1 million, or 0.4% for the year ended December 31, 2003 compared to the same period in 2002 and an increase of $0.2 million was generated by the Industrial Acquisition.
Non-Property Related Income and Expenses
Interest income decreased $0.3 million, or 61.8% to $0.2 million for the year ended December 31, 2003 compared to $0.5 million for the year ended December 31, 2002. This decrease was primarily attributable to a general decrease in interest rates.
General and administrative expenses increased $6.5 million, or 52.4% to $19.1 million for the year ended December 31, 2003 compared to $12.6 million for the year ended December 31, 2002. This increase was primarily due to an increase in accrued incentive compensation and was driven by a special long-term incentive plan for the Company’s executives for which the amount payable under the plan is based on the Company’s absolute and relative shareholder returns. (See note 16 to the Company’s consolidated financial statements for further discussion about the program.) The plan is accounted for using variable plan accounting which requires the Company to record the cumulative charge to the income statement based on the closing share price for the period. The quoted share price of the Company’s common stock reached its highest quarter-end closing price at December 31, 2003. For fiscal year 2003 the Company achieved a 52.6% total annual common stockholder return (annual appreciation of the quoted common share price plus dividends paid during the year), the highest since its initial public offering in 1997. The total compensation expense related to this award will be recorded over the three-year performance period and will be paid out if the specified performance measures are attained at the end of this period in December 2005. Management cannot predict the amounts that will be recorded in future periods related to this plan as it is based on the Company’s closing stock prices and related cumulative shareholder return calculations at the end of each period.
The increase in general and administrative expenses was also due to higher legal, reporting and public company costs incurred in connection with compliance with new requirements imposed by the Sarbanes-Oxley Act of 2002 and the New York Stock Exchange. The increases in general and administrative expenses were partially offset by the reversal of a $0.5 million reserve in connection with the Peregrine settlement agreement. The Company had initially recorded this reserve in the second quarter of 2002 for costs the Company paid for the fifth and final building that was to be lease to Peregrine. This building was surrendered to the Company in June 2002.
Net interest expense decreased $2.0 million, or 5.6% to $33.4 million for the year ended December 31, 2003 compared to $35.4 million for the year ended December 31, 2002. Gross interest and loan fee expense, before the effect of capitalized interest and loan fees, decreased $4.2 million, or 8.6% to $45.2 million for the year ended December 31, 2003 from $49.4 million for the year ended December 31, 2002, due to an overall decrease in the Company’s weighted average annual borrowing rates. Throughout 2002, the Company’s weighted average interest rate decreased from 6.8% at December 31, 2001 to 5.3% at December 31, 2002. In contrast, the Company’s weighted average interest rate remained relatively consistent throughout 2003. The Company’s weighted average interest rate was 5.3% at both January 1, 2003 and December 31, 2003. Total capitalized interest and loan fees decreased $2.2 million, or 15.9% to $11.8 million for the year ended December 31, 2003 from $14.0 million for the year ended December 31, 2002, primarily due to lower average balances eligible for capitalization during the year ended December 31, 2003 as compared to December 31, 2002.
Depreciation and amortization decreased $2.6 million, or 4.3% to $56.2 million for the year ended December 31, 2003 compared to $58.8 million for the year ended December 31, 2002. During the year ended December 31, 2002 the Company recorded accelerated depreciation and amortization charges of approximately $5.3 million for previously capitalized leasing costs related to the Company’s leases with Peregrine. The Company did not record a similar charge in 2003. This decrease was partially offset by an increase attributable to the development properties completed and stabilized since December 31, 2002.
Income from Continuing Operations
Income from continuing operations before net gains on dispositions and minority interests increased $22.2 million or 49.9% to $66.7 million for the year ended December 31, 2003 compared to $44.5 million for the year ended December 31, 2002. The increase was primarily due to the increase in Net Operating Income from the Office Properties of $24.4 million.
Year Ended December 31, 2002 Compared to Year Ended December 31, 2001
The following table reconciles the Company’s Net Operating Income by segment to the Company’s net income for the years ended December 31, 2002 and 2001.
Rental Operations
Management evaluates the operations of its portfolio based on operating property type. The following tables compare the Net Operating Income from continuing operations for the Office Properties and the Industrial Properties for the years ended December 31, 2002 and 2001.
Office Properties
(1)
Stabilized office properties owned at January 1, 2001 and still owned at December 31, 2003.
Total revenues from Office Properties increased $5.2 million, or 3.2% to $165.4 million for the year ended December 31, 2002 compared to $160.2 million for the year ended December 31, 2001. Rental income from Office Properties increased $7.8 million, or 5.7% to $145.1 million for the year ended December 31, 2002 compared to $137.3 million for the year ended December 31, 2001. The increase was primarily attributable to an increase of $9.2 million in rental income was generated by the office properties developed by the Company in 2002 and 2001 (the “Office Development Properties”). This increase was offset by a decrease of $0.9 million attributable to the office properties sold during 2001, net of the office property acquired in 2001 (the “Net Office Dispositions”) and a decrease of $0.5 million or 0.4% related to the Core Office Portfolio. This decrease in the Core Office Portfolio was primarily attributable to a decline in occupancy in this portfolio.
Tenant reimbursements from Office Properties increased $1.1 million, or 5.7% to $17.7 million for the year ended December 31, 2002 compared to $16.6 million for the year ended December 31, 2001. An increase of $0.7 million, or 4.4% in tenant reimbursements was generated by the Core Office Portfolio. This was primarily due to the reimbursement of property expenses at one property at which the previous tenant paid the expenses directly. An increase of $0.5 million generated by the Office Development Properties was offset by a decrease of $0.1 million attributable to the Net Office Dispositions. Other property income from Office Properties decreased $3.6 million or 58.5% to $2.6 million for the year ended December 31, 2002 compared to $6.2 million for the year ended December 31, 2001. During the year ended December 31, 2001 the Company recognized a $5.4 million lease termination fee from eToys. During the year ended December 31, 2002 the Company recognized lease termination fees of $1.2 million and $0.7 million resulting from the early termination of leases at two buildings in San Diego. The remaining amounts in other property income from Office Properties for both periods consisted primarily of lease termination fees, management fees and tenant late charges.
Total expenses for Office Properties increased $5.0 million, or 12.2% to $46.4 million for the year ended December 31, 2002 compared to $41.4 million for the year ended December 31, 2001. Property expenses from Office Properties increased $1.3 million, or 4.9% to $27.2 million for the year ended December 31, 2002 compared to $25.9 million for the year ended December 31, 2001. An increase of $0.6 million in property expenses was attributable to the Core Office Portfolio. This increase was primarily attributable to the Company paying property expenses directly for one property at which the previous tenant paid the expenses directly. An increase of $0.9 million generated by the Office Development Properties was offset by a decrease of $0.2 million attributable to the Net Office Dispositions. Real estate taxes increased $1.0 million, or 9.5% to $12.1 million for the year ended December 31, 2002 as compared to $11.1 million for the year ended December 31, 2001. Real estate taxes for the Core Office Portfolio increased $0.8 million, or 9.1% for the year ended December 31, 2002 compared to the comparable period in 2001. This increase was primarily due to refunds received for prior year real estate taxes successfully appealed by the Company during the year ended December 31, 2001. An increase of $0.3 million attributable to the Office Development Properties was partially offset by a decrease of $0.1 million attributable to the Net Office Dispositions. The provision for bad debts increased $2.9 million, or 97.9% to $5.8 million for the year ended December 31, 2002 compared to $2.9 million for the year ended December 31, 2001. During 2002, the Company increased its reserve for unbilled deferred rents specifically related to the Company’s watchlist tenants. The Company evaluates its reserve levels on a quarterly basis. Ground lease expense decreased $0.2 million, or 10.2% for the year ended December 31, 2002 compared to the same period in 2001. Ground lease expense for the Core Office Portfolio decreased $0.1 million, or 9.9% for the year ended December 31, 2002 compared to the comparable period in 2001. During the second quarter of 2002 the Company renegotiated the ground leases at Kilroy Airport Center Long Beach resulting in a reduction of annual ground lease expense and simultaneously exercised the options to extend the ground leases for an additional fifty years. The ground leases now expire in July 2084.
Net Operating Income, as defined, from Office Properties increased $0.2 million, or 0.1% to $118.9 million for the year ended December 31, 2002 compared to $118.7 million for the year ended December 31, 2001. A decrease of $0.8 million attributable to the Core Office Portfolio was offset by an increase of $1.7 million in the Office Development Properties and decrease of $0.7 million in Net Office Dispositions.
Industrial Properties
(1)
Stabilized industrial properties owned at January 1, 2001 and still owned at December 31, 2003.
Total revenues from Industrial Properties decreased $3.3 million, or 7.8% to $38.9 million for the year ended December 31, 2002 compared to $42.2 million for the year ended December 31, 2001. Rental income from
Industrial Properties decreased $2.9 million, or 7.7% to $34.9 million for the year ended December 31, 2002 compared to $37.8 million for the year ended December 31, 2001. Rental income generated by the Core Industrial Portfolio increased $0.6 million, or 1.7% for the year ended December 31, 2002 as compared to the year ended December 31, 2001. This increase was primarily attributable to holdover rent received at one property in the Orange County Portfolio. Average occupancy in the Core Industrial Portfolio decreased 0.6% to 97.2% for the year ended December 31, 2002 compared to 97.8% for the year ended December 31, 2001. The $0.7 million increase in rental income generated by the Core Industrial Portfolio was offset by a decrease of $4.3 million in rental income attributable to the seventeen industrial buildings sold during 2001 (the “Industrial Dispositions”). An increase of $0.3 million was attributable to the one industrial building acquired during the year ended December 31, 2002 (the “Industrial Acquisition”).
Tenant reimbursements from Industrial Properties decreased $0.2 million, or 5.6% to $3.8 million for the year ended December 31, 2002 compared to $4.0 million for year ended December 31, 2001. An increase of $0.3 million, or 8.5% generated by the Core Industrial Portfolio, was offset by a decrease of $0.5 million attributable to the Industrial Dispositions. Other property income from Industrial Properties decreased $0.2 million, or 73.7% to $89,000 for the year ended December 31, 2002 compared to $0.3 million for the year ended December 31, 2001. During the year ended December 31, 2001, the Company received $0.3 million in forfeited escrow deposits on four properties for which the pending sale did not occur. These properties were subsequently sold during the fourth quarter of 2001.
Total expenses from Industrial Properties increased $0.2 million, or 2.8% to $7.1 million for the year ended December 31, 2002 compared to $6.9 million for the year ended December 31, 2001. Property expenses from Industrial Properties increased $0.4 million, or 15.8% to $3.0 million for the year ended December 31, 2002 compared to $2.6 million for the year ended December 31, 2001. An increase of $0.9 million in property expenses for the Core Industrial Portfolio was offset by a decrease of $0.5 million attributable to the Industrial Dispositions. The increase in the Core Industrial Portfolio is primarily due to the Company paying property expenses directly at one property at which the previous tenant paid the expenses directly. The tenant defaulted and the lease was terminated in July 2002. Real estate taxes decreased $0.5 million, or 13.7% to $3.0 million for the year ended December 31, 2002 compared to $3.5 million for the year ended December 31, 2001. Real estate taxes for the Core Industrial Portfolio decreased $0.1 million for the year ended December 31, 2002 compared to the same period in 2001, and the remaining decrease of $0.4 million was attributable to the Industrial Dispositions. The provision for bad debts increased $0.2 million, or 23.4% to $1.0 million for the year ended December 31, 2002 compared to $0.8 million for the year ended December 31, 2001. During 2002, the Company increased its reserve for unbilled deferred rents specifically related to the Company’s watchlist tenants. The Company evaluates its reserve levels on a quarterly basis.
Net Operating Income, as defined, from Industrial Properties decreased $3.5 million, or 9.9% to $31.8 million for the year ended December 31, 2002 compared to $35.3 million for the year ended December 31, 2001. Net operating income for the Core Industrial Portfolio decreased $0.1 million, or 0.5% for the year ended December 31, 2002 compared to the same period in 2001. An increase of $0.3 million attributable to the Industrial Acquisition was offset by a decrease of $3.7 million attributable to the Industrial Dispositions.
Non-Property Related Income and Expenses
Interest income decreased $0.5 million, or 50.2% to $0.5 million for the year ended December 31, 2002 compared to $1.0 million for the year ended December 31, 2001. A decrease of approximately $184,000 was attributable to interest earned on restricted cash balances held at Qualified Intermediaries, as defined by Section 1031 of the Internal Revenue Code, in January 2001, which were used in a tax deferred property exchange. The Company did not have any cash balances at Qualified Intermediaries in 2002. The remaining decrease was primarily attributable to a general decrease in interest rates.
General and administrative expenses increased $0.9 million, or 7.4% to $12.6 million for the year ended December 31, 2002 compared to $11.7 million for the year ended December 31, 2001. For the year ended December 31, 2002, the Company recorded a $0.5 million charge to general and administrative expenses for costs the Company paid for the fifth and final building that was to be leased to Peregrine. Peregrine surrendered the building back to the Company in June 2002, at which time it was still under construction and was not yet included in the Company’s portfolio of stabilized operating properties. The remaining increase was primarily due to the non-cash amortization of the restricted stock grants that were granted in February 2002.
Net interest expense decreased $5.6 million, or 13.7% to $35.4 million for the year ended December 31, 2002 compared to $41.0 million for the year ended December 31, 2001. Gross interest expense, before the effect of capitalized interest, decreased $5.2 million or 9.6% to $49.4 million for the year ended December 31, 2002 from $54.6 million for the year ended December 31, 2001 primarily due to a decrease in the Company’s weighted average interest rate. The Company’s weighted average interest rate decreased to 5.3% at December 31, 2002 compared to 6.8% at December 31, 2001. Total capitalized interest and loan fees increased $0.4 million or 3.0% to $14.0 million for the year ended December 31, 2002 from $13.6 million for the year ended December 31, 2001 primarily due to higher average balances eligible for capitalization during the year ended December 31, 2002 as compared to the same period in 2001.
Depreciation and amortization increased $8.4 million, or 16.6% to $58.8 million for the year ended December 31, 2002 compared to $50.4 million for the year ended December 31, 2001. During the year ended December 31, 2002 the Company recorded accelerated depreciation and amortization charges of approximately $5.3 million for previously capitalized leasing costs related to the Company’s leases with Peregrine Systems, Inc. In addition, there was an increase attributable to the development properties completed and stabilized since December 31, 2001.
Income From Continuing Operations
Income from continuing operations before net gain on dispositions and minority interests decreased $7.4 million or 14.3% to $44.5 for the year ended December 31, 2002 compared to $51.9 million for the year ended December 31, 2001. The decrease was primarily due to the decrease in Net Operating Income from the Industrial Properties of $3.5 million, an increase in depreciation and amortization expense of $8.4 million offset primarily by an decrease in interest expense of $5.6 million.
Building and Lease Information
The following tables set forth certain information regarding the Company’s Office and Industrial Properties at December 31, 2003:
Occupancy by Segment Type
Leasing Activity by Segment Type
For the year ended December 31, 2003
(1)
Represents leasing activity for leases commencing during the period shown, including first and second generation space, net of month-to-month leases. Excludes leasing on new construction.
(2)
Calculated as the change between GAAP rents for new/renewed leases and the expiring GAAP rents for the same space.
(3)
Calculated as the change between stated rents for new/renewed leases and the expiring stated rents for the same space.
(4)
Calculated as the percentage of space either renewed or expanded into by existing tenants at lease expiration.
Liquidity and Capital Resources
Current Sources of Capital and Liquidity
The Company seeks to create and maintain a capital structure that allows for financial flexibility and diversification of capital resources. The Company’s primary source of liquidity to fund distributions, debt service, leasing costs and capital expenditures is net cash from operations. The Company’s primary sources of liquidity to fund development and redevelopment costs, potential undeveloped land and property acquisitions, temporary working capital and unanticipated cash needs are the Company’s $425 million unsecured revolving line of credit, proceeds received from the Company’s disposition program and construction loans. As of December 31, 2003 and 2002, the Company’s total debt as a percentage of total market capitalization was 38.5%
and 46.3%, respectively. As of December 31, 2003 and 2002 the Company’s total debt plus preferred equity as a percentage of total market capitalization was 46.6% and 55.7%, respectively.
As of December 31, 2003, the Company had borrowings of $235 million outstanding under its unsecured revolving line of credit (the “Credit Facility”) and availability of approximately $84.2 million. The Credit Facility bears interest at an annual rate between LIBOR plus 1.13% and LIBOR plus 1.75% (2.66% at December 31, 2003), depending upon the Company’s leverage ratio at the time of borrowing, and matures in March 2005. The fee for unused funds ranges from an annual rate of 0.20% to 0.35% depending on the Company’s leverage ratio. The Company expects to use the Credit Facility to finance development and redevelopment expenditures, to fund potential acquisitions and for other general corporate uses.
The Company has the ability to issue up to an additional $273 million of equity securities under a currently effective shelf registration statement.
Factors Which May Influence Future Sources of Capital and Liquidity
In February 2004, the Company borrowed $81 million under a mortgage loan that is secured by four office properties in a five-building complex and requires interest-only payments based on a variable annual interest rate of LIBOR plus 1.75% through July 2004. Beginning in August 2004 through August 2012, the scheduled maturity date, the loan requires monthly principal and interest payments based on a fixed annual interest rate of 5.57%. The Company used a portion of the proceeds to repay an outstanding mortgage loan with a principal balance of $20.3 million that was scheduled to mature in June of 2004. The remainder of the proceeds was used primarily to repay borrowings under the Credit Facility. The Company has also received a commitment from a financial institution for a $34 million mortgage loan that will be secured by the fifth building in the complex. The loan will be co-terminus with and have similar terms as the new $81 million loan with a final fixed annual interest rate of 4.95%. The closing of this loan is subject to customary conditions and is expected to occur in the first quarter of 2004. The Company intends to use the proceeds to repay borrowings under the Credit Facility.
In March 2004, the Company amended the terms of its Series A Preferred Units to reduce the distribution rate, extend the redemption date to September 30, 2009, and create a right of redemption at the option of the holders in the event of certain change of control events, certain repurchases of the Company’s publicly registered equity securities, an involuntary delisting of the Company’s common stock from the NYSE or a loss of REIT status. Commencing March 5, 2004, distributions on the Series A Preferred Units will accrue at a rate of 7.45% per annum. Prior to March 5, 2004, distributions on the Series A Preferred Units accrued at a rate of 8.075% per annum (see note 13 to the Company’s consolidated financial statements).
The Company has a fixed rate mortgage loan, with a principal balance of $74.8 million as of December 31, 2003. After January 2005, the mortgage note is subject to increases in the effective annual interest rate to the greater of 10.35% or the sum of the interest rate for U.S. Treasury Securities maturing 15 years from the reset date plus 2.00%. The contractual maturity date of this loan is February 2022, however the Company intends to refinance the debt in the second half of 2004 without any prepayment penalty. The Company has restricted cash balances, which totaled an aggregate of $8.3 million as of December 31, 2003, that are held as credit enhancements and as reserves for property taxes, capital expenditures and capital improvements in connection with this loan. When the Company repays the loan, the restricted balances that are outstanding at that time will become available as unrestricted funds to the Company.
In 2003 and 2002, the Company used proceeds from dispositions of operating properties of approximately $34.1 million and $46.5 million, respectively, to fund a portion of its development and redevelopment activities and its share repurchase program. The Company currently expects that it could dispose of approximately $20 million to $50 million of non-strategic assets in 2004; however management is also evaluating other financing sources to fund its development and redevelopment activities.
The composition of the Company’s aggregate debt balances at December 31, 2003 and 2002 were as follows:
(1)
At December 31, 2003 and 2002, the Company had an interest-rate swap agreement, which expires in January 2005, to fix LIBOR on $50 million of its variable rate debt at 4.46%.
(2)
At December 31, 2003 and 2002, the Company had an interest-rate swap agreement, which expires in November 2005, to fix LIBOR on $50 million of its variable rate debt at 2.57%.
(3)
At December 31, 2003 and 2002, the Company had interest-rate swap agreements, which expire in December 2006, to fix LIBOR on $50 million of its variable rate debt at 2.98%.
(4)
At December 31, 2003 and 2002, the Company had interest-rate cap agreements, which expire in January 2005, to cap LIBOR on $100 million of its variable rate debt at 4.25%.
The percentage of fixed rate debt to total debt at December 31, 2003 and 2002 does not take into consideration the portion of variable rate debt capped by the Company’s interest-rate cap agreements. Including the effects of the interest-rate cap agreements, the Company had fixed or capped approximately 85.7% and 76.7% of its total outstanding debt at December 31, 2003 and 2002, respectively.
At December 31, 2003, 47.1% of the Company’s total debt, before the effect of hedging instruments, required interest payments based on LIBOR rates. During 2003, one-month LIBOR decreased from 1.38% at January 2, 2003 to 1.12% at December 31, 2003, a rate lower than it has been since the time of the Company’s IPO. Although the interest payments on 85.7% of the Company’s debt are either fixed, or hedged through the employment of interest-rate swap and cap agreements at December 31, 2003, the remaining 14.3% of the Company’s debt is exposed to fluctuations of the one-month LIBOR rate. The Company cannot provide assurance that it will be able to replace its interest-rate swap and cap agreements as they expire and, therefore, the Company’s results of operations could be exposed to rising interest rates in the future.
The following table lists the derivative financial instruments held by the Company as of December 31, 2003 and 2002:
Following is the Company’s total market capitalization as of December 31, 2003:
(1)
Value based on $50.00 per share liquidation preference.
(2)
Value based on $25.00 per share liquidation preference.
(3)
Value based on closing share price of $32.75 at December 31, 2003.
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 December 31, 2003 and provides information about the minimum commitments due in connection with the Company’s ground lease obligations and capital commitments at December 31, 2003. The table does not reflect available maturity extension options.
(1)
As of December 31, 2003, 72.6% of the Company’s debt was contractually fixed or constructively fixed through interest-rate swap agreements. (See notes 10 and 12 to the Company’s consolidated financial statements for details of the Company’s fixed rate debt and interest rate swap agreements.) The information in the table above reflects the Company’s projected interest rate obligations for these fixed-rate payments based on the contractual interest rates, interest payment dates and scheduled maturity dates. The remaining 27.4% of the Company’s debt bears interest at variable rates and the variable interest rate payments are based on LIBOR plus a spread that ranges from 1.40% to 1.85%. Management cannot reasonably determine the future interest obligations on its variable rate debt as management cannot predict what LIBOR rates will be in the future. As of December 31, 2003, LIBOR was 1.12%.
(2)
Represents scheduled interest payments for the Company’s total outstanding fixed-rate debt as of December 31, 2003 based on the contractual interest rates, interest payment dates and scheduled maturity dates. See note 10 to the Company’s consolidated financial statements for details of the Company’s fixed-rate debt.
(3)
The Company has a fixed-rate mortgage with a principal balance of $74.8 million as of December 31, 2003 that it intends to refinance in the second half of 2004. This schedule includes the scheduled interest payments for this loan through January 2005 and does not reflect this potential prepayment. For further discussion on this loan see “Item 7: Management’s Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources.”
(4)
Represents the scheduled interest payments for the Company’s total outstanding interest rate swap agreements as of December 31, 2003, based on the contractual interest rates, interest payment dates and maturity dates. The interest payments are reported at the gross amount and do not reflect the offsetting variable payment to be received from the counterparty. The Company employs derivative instruments for hedging purposes only and does not hold interest rate swaps for speculative purposes. These cash flow hedges effectively convert a portion of the Company’s variable-rate debt to fixed-rate debt. The Company had interest-rate swap agreements with a total notional amount of $150 million as of December 31, 2003. See note 12 to the Company’s consolidated financial statements for details of the Company’s interest-rate swap agreements.
(5)
The Company has noncancelable ground lease obligations for the SeaTac Office Center in Seattle, Washington expiring in December 2032, with an option to extend the lease for an additional 30 years; and Kilroy Airport Center in Long Beach, California with a lease period for Phases I, II, III and IV expiring in July 2084.
(6)
See discussion under “Capital Commitments.”
The Credit Facility and certain other secured debt agreements contain covenants and restrictions requiring the Company to meet certain financial ratios and reporting requirements. Some of the more restrictive covenants include minimum debt service coverage ratios, a maximum total liabilities to total assets ratio, a maximum total secured debt to total assets ratio, 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 and restrictions could result in the full or partial principal balance of the associated debt becoming immediately due and payable. The Company was in compliance with all its covenants at December 31, 2003. In addition, the Company’s construction loan, which is due September 2004, has a limited recourse provision that holds the Company liable up to approximately $14.3 million plus any unpaid accrued interest.
Capital Commitments
As of December 31, 2003, the Company had one development project and two redevelopment projects that were either in lease-up or under construction. These projects have a total estimated investment of approximately $145 million. The Company has incurred an aggregate of approximately $114 million on these projects as of December 31, 2003, and currently projects it could spend approximately $25 million of the remaining $31 million of presently budgeted development costs during 2004, depending on leasing activity. In addition, the Company had two development projects and one redevelopment project that were added to the Company’s stabilized portfolio of operating properties in the second and third quarters of 2003, which had not yet reached stabilized occupancy as of December 31, 2003. Depending on leasing activity, the Company currently projects it could spend approximately $10 million for these projects during 2004. The Company also estimates it could spend an additional $9 million on other development projects in 2004, depending upon market conditions. The Company intends to finance these costs from among one or more of the following sources: borrowings under the Credit Facility and the existing construction loan, proceeds from the Company’s disposition program, the potential issuance of additional equity securities and working capital. See additional information regarding the Company’s in-process development and redevelopment portfolio under the caption “Development and Redevelopment Programs” in this report.
As of December 31, 2003, the Company had executed leases that committed the Company to $8 million in unpaid leasing costs and tenant improvements and the Company had contracts outstanding for approximately $1 million in capital improvements at December 31, 2003. In addition, for 2004, the Company plans to spend approximately $18 million to $22 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 90% of its REIT taxable income (excluding capital gains) on an annual basis in order to qualify as a REIT for federal income tax purposes. Accordingly, the Company intends to continue to make, but has not contractually bound itself to make, regular quarterly distributions to common stockholders and common unitholders from cash flow from operating activities. All such distributions are at the discretion of the Board of Directors. The Company may be required to use borrowings under the Current 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 2003. The Company considers market factors and Company performance in addition to REIT requirements in determining its distribution levels. Amounts accumulated for distribution to shareholders 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 February 10, 2004, the Company declared a regular quarterly cash dividend of $0.495 per common share payable on April 16, 2004 to stockholders of record on March 31, 2004. This dividend is equivalent to an annual rate of $1.98 per share. In addition the Company is required to make quarterly distributions to its Series A and Series D Preferred unitholders and Series E Preferred Stockholders, which in aggregate total approximately $13 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 believes that it will have sufficient capital resources to satisfy its liquidity needs over the next twelve months. The Company estimates it will have a range of approximately $325 million to $363 million of available sources to meet its short-term cash needs as follows: estimated availability of approximately $84 million under its Credit Facility, $115 million of proceeds from new secured debt, estimated operating cash flow ranging from $98 million to $106 million, anticipated proceeds from dispositions of non-strategic assets ranging from $20 million to $50 million, and approximately $8 million from the release of restricted cash during 2004. The Company estimates it will have a range of approximately $213 million to $226 million of commitments and capital expenditures over the next twelve months comprised of the following: $74 million in secured debt principal repayments; planned expenditures for in-process development, stabilized development and new development projects ranging from $35 million to $44 million; $9 million of committed costs for executed leases and capital expenditures; budgeted capital improvements, tenant improvements and leasing costs for the Company’s stabilized portfolio ranging from approximately $18 million to $22 million, depending on leasing activity. In addition, based on the Company’s annualized dividends for the first quarter of 2004, the Company may distribute approximately $77 million to common and preferred stockholders and common and preferred unitholders in 2004. There can be, however, no assurance that the Company will not exceed these estimated expenditure and distribution levels or be able to obtain additional sources of financing on commercially favorable terms, or at all.
The Company expects to meet its long-term liquidity requirements, which may include property and undeveloped land acquisitions and additional future development and redevelopment activity, through retained cash flow, borrowings under the Credit Facility, additional long-term secured and unsecured borrowings, dispositions of non-strategic assets, issuance of common or preferred units of the Operating Partnership, and the
potential issuance of debt or equity securities. The Company does not intend to reserve funds to retire existing debt upon maturity. The Company will instead, seek to refinance such debt at maturity or retire such debt through the issuance of equity securities, as market conditions permit.
Historical Recurring Capital Expenditures, Tenant Improvements and Leasing Costs
The following tables set forth the capital expenditures, tenant improvements and leasing costs, excluding expenditures that are recoverable from tenants, for renewed and re-tenanted space within the Company’s stabilized portfolio for the three years ended December 31, 2003 on a per square foot basis.
(1)
Includes only tenants with lease terms of 12 months or longer. Excludes leases for amenity, parking, retail and month-to-month tenants.
Capital expenditures may fluctuate in any given period subject to the nature, extent, and timing of improvements required to be made to the Properties. During 2003, the Company performed lobby and common area improvements at one complex of properties in El Segundo, California. The Company anticipates this level of capital expenditures will continue during 2004 for various improvements at other properties. The Company believes that all of its Office and Industrial Properties are well maintained and do not require significant capital improvements.
Tenant improvements and leasing costs may also fluctuate in any given year depending upon factors such as the property, the term of the lease, the type of lease, the involvement of external leasing agents and overall
market conditions. As several of the properties the Company disposed of during 2003 and 2002 were non-strategic multi-tenant office projects, which historically were re-leased at lower tenant improvement and leasing costs, the Company experienced increased tenant improvement and leasing costs per square foot in 2003. The Company anticipates that this trend will continue in 2004.
Off-Balance Sheet Arrangements
As of December 31, 2003, the Company does not have any off-balance sheet transactions, arrangements or obligations, including contingent obligations.
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 $4.3 million, or 4.3% to $95.9 million for the year ended December 31, 2003 compared to $100.3 million for the year ended December 31, 2002. The decrease was primarily attributable a decrease in average occupancy. For the year ended December 31, 2003, average occupancy was 91.2% as compared to 93.9% for the year ended December 31, 2002. This decrease was partially offset by a net increase in cash received from tenants for lease termination fees of approximately $11.0 million during the year ended 2003 as compared to 2002. This net increase was primarily a result of the $18.3 million payment the Company received from Peregrine in the third quarter of 2003. In December 2002, the Company received a $4.6 million cash payment for a lease termination, which was included as deferred income on the Company’s balance sheet as of December 31, 2002. The Company recognized the corresponding $4.3 million net lease termination fee in January 2003, the lease termination date, and included the amount in other property income for the year ended December 31, 2003.
Net cash used in investing activities decreased $17.6 million, or 25.7% to $50.8 million for the year ended December 31, 2003 compared to $68.4 million for the year ended December 31, 2002. The decrease was primarily attributable to a decrease in development spending offset by lower net proceeds received from the disposition of operating properties used to fund a portion of the development costs. The Company scaled back its development activity during the last two years as a result of the economic environment and the related impact on leasing. Management will continue to position the Company to take advantage of development, redevelopment, acquisition and disposition opportunities as they arise. Development spending for future periods will depend on economic conditions and opportunities to commit to new development projects on a pre-leased basis. The Company currently expects that it will continue to fund a portion of its development and redevelopment activities with disposition proceeds; however management will also evaluate and consider other sources of financing.
Net cash used in financing activities increased $18.5 million, or 56.7% to $60.0 million for the year ended December 31, 2003 compared to $32.5 million for the year ended December 31, 2002. This increase was primarily attributable to a $41.1 million decrease in net borrowing activity in 2003 as compared to 2002, which was mainly due to the Company scaling back its development activity as discussed in the paragraph above. This increase was partially offset by the decrease in share repurchase activity. In 2003, the Company did not repurchase any shares under its share repurchase program. In 2002, the Company had repurchased 508,200 shares of common stock under this program for an aggregate price of $11.4 million. The increase in cash used in financing activities was also partially offset by the higher volume of stock option exercises in 2003 as compared to 2002. In 2003 the Company received $13.4 million in proceeds for the issuance of 664,528 shares in connection with the exercise of stock options as compared to $4.2 million in proceeds the Company received in 2002 for the issuance of 208,381 shares issued in connection with stock option exercises.
Non-GAAP Supplemental Financial Measure: Funds From Operations
Management believes that 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
NAREIT. The White Paper defines FFO as net income or loss computed in accordance with 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 a perspective not immediately apparent from net income. In addition, management believes that FFO provides useful information to the investment community about the Company’s financial performance when compared to other REITs since FFO is generally recognized as the industry standard for reporting the operations of REITs.
However, FFO should not be viewed as an alternative measure of the Company’s operating performance since it does not reflect either depreciation and amortization costs or the level of capital expenditures and leasing costs necessary to maintain the operating performance of the Company’s properties, which are significant economic costs and could materially impact the Company’s results from operations.
The following table presents the Company’s Funds from Operations, by quarter, for the years ended December 31, 2003, 2002, 2001, 2000 and 1999:
(1)
Reported amounts are attributable to common shareholders and common unitholders.
(2)
Commencing January 1, 2002 non-cash amortization of restricted stock grants is not added back to calculate FFO.
(1)
Reported amounts are attributable to common shareholders and common unitholders.
(2)
Commencing January 1, 2002 non-cash amortization of restricted stock grants is not added back to calculate FFO.
Inflation
The majority of the Company’s leases require tenants to pay most operating expenses, including real estate taxes, utilities, insurance, and increases in common area maintenance expenses. The effect of such provisions is to reduce the Company’s exposure to increases in costs and operating expenses resulting from inflation.
New Accounting Pronouncements
On January 1, 2003, the Company adopted the provisions of SFAS 145, Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections (“SFAS 145”). The most significant provisions of this statement relate to the rescission of Statement No. 4 “Reporting Gains and Losses from Extinguishment of Debt.” SFAS 145 also amends other existing authoritative pronouncements to make
various technical corrections, clarify meanings or describe their applicability under changed conditions. Under SFAS 145, any gain or loss on extinguishment of debt that was classified as an extraordinary item in prior periods presented that does not meet certain defined criteria must be reclassified. The adoption of this statement did not have a material effect on the Company’s results of operations or financial condition.
On January 1, 2003, the Company adopted the provisions of SFAS 146, “Accounting for Costs Associated with Exit or Disposal Activities” (“SFAS 146”). SFAS 146 addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies Emerging Issues Task Force Issue No. 94-3 “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity.” SFAS 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred. The adoption of this statement did not have a material effect on the Company’s results of operations or financial condition.
On January 1, 2003, the Company adopted the initial recognition and measurement provisions of Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others” (“FIN 45”). FIN 45 significantly changes the current practice in the accounting for, and disclosure of, guarantees. Guarantees and indemnification agreements meeting the characteristics described in FIN 45 are required to be initially recorded as a liability at fair value. FIN 45 also requires a guarantor to make significant new disclosures for virtually all guarantees even if the likelihood of the guarantor having to make payment under the guarantee is remote. The Company adopted the disclosure provisions of FIN 45 as of December 31, 2002. The adoption of the provisions of this interpretation did not have a material effect on the Company’s results of operations or financial condition.
In January 2003, the FASB issued FASB Interpretation No. 46, “Consolidation of Variable Interest Entities” (“FIN 46”). FIN 46 clarifies the application of Accounting Research Bulletin No. 51, “Consolidated Financial Statements” and provides guidance on the identification of entities for which control is achieved through means other than voting rights (“variable interest entities” or “VIEs”) and how to determine when and which business enterprise should consolidate the VIE. This new model for consolidation applies to an entity in which either: (1) the equity investors (if any) lack one or more characteristics deemed essential to a controlling financial interest or (2) the equity investment at risk is insufficient to finance that entity’s activities without receiving additional subordinated financial support from other parties. In December 2003, the FASB published a revision to FIN 46 (“FIN 46R”) to clarify some of the provisions of the interpretation and defer the effective date of implementation for certain entities. The provisions of FIN 46R are effective for the first reporting period ending after December 15, 2003 for entities considered to be special-purpose entities. The provisions for all other entities subject to FIN 46R are effective for financial statements of the first reporting period ending after March 15, 2004. On February 1, 2003, the Company adopted the provisions of this interpretation, which did not have a material effect on the Company’s results of operations or financial condition.
In April 2003, the FASB issued SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities” (“SFAS 149”). SFAS 149 amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments imbedded in other contracts and for hedging activities under SFAS No. 133 “Accounting for Derivative Instruments and Hedging Activities.” The provisions of SFAS 149 are generally effective for contracts entered into or modified after June 30, 2003 and for hedging relationships designated after June 30, 2003. The adoption of this statement did not have a material effect on the Company’s results of operations or financial condition.
In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity” (“SFAS 150”). SFAS 150 establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. The statement is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. The adoption of this statement did not have a material effect on the Company’s results of operations or financial condition.
On July 31, 2003, the SEC issued a clarification of Emerging Issues Task Force Topic D-42, “The Effect on the Calculation of Earnings per Share for the Redemption or Induced Conversion of Preferred Stock” (“Topic D-42”). Topic D-42 provides, among other things, that any excess of the fair value of the consideration transferred to the holders of preferred stock redeemed over the carrying amount of the preferred stock should be subtracted from net earnings to determine net earnings available to common stockholders in the calculation of earnings per share. The SEC’s clarification of the guidance in Topic D-42 provides that the carrying amount of the preferred stock should be reduced by the related issuance costs.
The July 2003 clarification of Topic D-42 was effective for the Company beginning with the quarter ending September 30, 2003. The Company redeemed all of the outstanding 9.375% Series C Cumulative Redeemable Preferred Units (“Series C Preferred Units”) in November 2003 with the net proceeds from its 7.80% Series E Cumulative Redeemable Preferred Stock offering, which closed on November 21, 2003 (see Notes 13 and 14). This redemption resulted in a $0.9 million charge in 2003 relating to the initial issuance costs of the Series C Preferred units.
In December 2003, the FASB issued SFAS No. 132, “Employers’ Disclosures about Pensions and Other Postretirement Benefits,” to improve financial statement disclosures for defined benefit plans. This standard requires that companies provide more details about their plan assets, benefit obligations, cash flows, benefit costs and other relevant information. SFAS No. 132 is effective for fiscal years ending after December 15, 2003, and for quarters beginning after December 15, 2003. The adoption of this statement did not have a material effect on the Company’s results of operations or financial condition.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The primary market risk faced by the Company is interest rate risk. The Company mitigates this risk by maintaining prudent amounts of leverage, minimizing interest expense while continuously evaluating all available debt and equity resources and following established risk management policies and procedures which include the periodic use of derivatives. The Company’s primary strategy in entering into derivative contracts is to minimize the variability that changes in interest rates could have on its future cash flows. The Company generally employs derivative instruments that effectively convert a portion of its variable rate debt to fixed rate debt. The Company does not enter into derivative instruments for speculative purposes.
Information about the Company’s changes in interest rate risk exposures from December 31, 2002 to December 31, 2003 is incorporated herein by reference from “Item 7: 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 December 31, 2003 and 2002. All of the Company’s interest rate sensitive financial and derivative instruments are held for purposes other than trading. For debt obligations, the table presents principal cash flows and related weighted average interest rates or the interest rate index by contractual maturity dates with the assumption that all debt extension options will be exercised. The interest rate spreads on the Company’s variable rate debt at December 31, 2003 and 2002 ranged from LIBOR plus 1.40% to LIBOR plus 1.85%. For the interest rate cap and swap agreements, the table presents the aggregate notional amount and weighted average interest rates or strike rates by contractual maturity date. The notional amounts are used solely to calculate the contractual cash flow to be received under the contract and do not reflect outstanding principal balances at December 31, 2003 and 2002. The table also presents comparative summarized information for financial and derivative instruments held at December 31, 2002.
Interest Rate Risk Analysis-Tabular Presentation
(dollars in millions)
ITEM 8.
ITEM 8.
FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
See the index included at “Item 15. Exhibits, Financial Statement Schedules, and Reports on Form 8-K.”
ITEM 9.
ITEM 9.
CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES
The Company maintains disclosure controls and procedures that are designed to ensure that information required to be disclosed in the Company’s Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commissions rules and forms, and that such information is accumulated and communicated to the Company’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.
As of December 31, 2003, the end of the fiscal year covered by this report, the Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and the Company’s Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures. Based on the foregoing, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective at the reasonable assurance level.
There have been no significant changes in the Company’s internal control over financial reporting or identified in connection with the evaluation referenced above that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information required by Item 10 is incorporated by reference to the Company’s definitive proxy statement for its annual stockholders’ meeting presently scheduled to be held on May 18, 2004.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information required by Item 11 is incorporated by reference to the Company’s definitive proxy statement for its annual stockholders’ meeting presently scheduled to be held on May 18, 2004.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
AND RELATED STOCKHOLDER MATTERS
The information required by Item 12 is incorporated by reference to the Company’s definitive proxy statement for its annual stockholders’ meeting presently scheduled to be held on May 18, 2004.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by Item 13 is incorporated by reference to the Company’s definitive proxy statement for its annual stockholders’ meeting presently scheduled to be held on May 18, 2004.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
The information required by Item 14 is incorporated by reference to the Company’s definitive proxy statement for its annual stockholders’ meeting presently scheduled to be held on May 18, 2004.
PART IV
ITEM 15.
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a)(1) and (2) Financial Statements and Schedules
The following consolidated financial information is included as a separate section of this annual report on Form 10-K:
All other schedules are omitted since the required information is not present in amounts sufficient to require submission of the schedule or because the information required is included in the financial statements and notes thereto.
(3) Exhibits
*
Filed herewith

Management contract or compensatory plan or arrangement.
(1)
Previously filed as an exhibit to the Registration Statement on Amendment No. 3 to Form S-11 (No. 333-15553).
(2)
Previously filed as an exhibit on Form 8-K as filed with the Securities and Exchange Commission on February 11, 1998.
(3)
Previously filed as an exhibit to the Registration Statement on Amendment No. 1 to Form S-3 (No. 333-72229).
(4)
Previously filed an exhibit on Form 8-K as filed with the Securities and Exchange Commission on December 11, 1998.
(5)
Previously filed as an exhibit on Form 10-K for the year ended December 31, 1999.
(6)
Previously filed as an exhibit to the Registration Statement on Form S-3 (No. 333-34638).
(7)
Previously filed an exhibit on Form 8-A as filed with the Securities and Exchange Commission on October 24, 2003.
(8)
Previously filed as an exhibit on Form 8-K/A as filed with the Securities and Exchange Commission on December 19, 1997.
(9)
Previously filed as an exhibit on Form 8-K as filed with the Securities and Exchange Commission on October 8, 1998.
(10)
Previously filed as an exhibit on Form 10-K for the year ended December 31, 2000.
(11)
Previously filed as an exhibit to the Registration Statement on Amendment No. 2 to Form S-11 (No. 333-15553).
(12)
Previously filed as an exhibit to the Registration Statement on Form S-11 (No. 333-15553).
(13)
Previously filed as an exhibit to the Registration Statement on Amendment No. 5 to Form S-11 (No. 333-15553).
(14)
Previously filed as an exhibit to the Registration Statement on Amendment No. 4 to Form S-11 (No. 333-15553).
(15)
Previously filed as an exhibit on Form 8-K as filed with the Securities and Exchange Commission on June 6, 1997.
(16)
Previously filed as an exhibit on Form 8-K as filed with the Securities and Exchange Commission on July 15, 1997.
(17)
Previously filed as an exhibit on Form 8-K as filed with the Securities and Exchange Commission on July 3, 1997.
(18)
Previously filed as an exhibit on Form 10-Q for the quarter ended September 30, 1997.
(19)
Previously filed as an exhibit on Form 8-K as filed with the Securities and Exchange Commission on November 21, 1997.
(20)
Previously filed as an exhibit on Form 8-K as filed with the Securities and Exchange Commission on December 29, 1997.
(21)
Previously filed as an exhibit on Form 10-Q for the quarter ended September 30, 1998.
(22)
Previously filed as an exhibit on Form 10-Q for the quarter ended September 30, 1999.
(23)
Previously filed as an exhibit on Form 10-K for the year ended December 31, 2001.
(24)
Previously filed as an exhibit on Form 10-Q for the quarter ended March 31, 2002.
(b) Reports on Form 8-K
The Company filed a Current Report on Form 8-K dated October 27, 2003, under Items 9 and 12, in connection with its third quarter 2003 earnings release and attached to such report its third quarter 2003 Supplemental Financial Report.
The Company filed a Current Report on Form 8-K dated November 21, 2003, under Item 5, in connection with the issuance of 1,610,000 shares of its 7.80% Series E Cumulative Redeemable Preferred Stock.
The Company filed a Current Report on Form 8-K dated December 15, 2003, under Item 5, to update its historical financial statements for the fiscal year ended December 31, 2002, included in the Company’s Annual Report on Form 10-K for such year and the accompanying selected financial data for certain discontinued operations, and to reissue the Management’s Discussion and Analysis of Financial Condition and Results of Operations also included in that Form 10-K.
SIGNATURES
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 March 11, 2004.
KILROY REALTY CORPORATION
By:
/s/ JOHN B. KILROY, JR.
John B. Kilroy, Jr.
President and Chief Executive Officer
POWER OF ATTORNEY
KNOW ALL MEN BY THESE PRESENTS, that we, the undersigned officers and directors of Kilroy Realty Corporation, hereby severally constitute John B. Kilroy, Sr., John B. Kilroy, Jr., Jeffrey C. Hawken, Richard E. Moran Jr. and Ann Marie Whitney, and each of them singly, our true and lawful attorneys with full power to them, and each of them singly, to sign for us and in our names in the capacities indicated below, the Form 10-K filed herewith and any and all amendments to said Form 10-K, and generally to do all such things in our names and in our capacities as officers and directors to enable Kilroy Realty Corporation to comply with the provisions of the Securities Exchange Act of 1934, as amended, and all requirements of the Securities and Exchange Commission, hereby ratifying and confirming our signatures as they may be signed by our said attorneys, or any of them, to said Form 10-K and any and all amendments thereto.
Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
KILROY REALTY CORPORATION
CONSOLIDATED FINANCIAL STATEMENTS AS OF DECEMBER 31, 2003 AND 2002
AND FOR THE THREE YEARS ENDED DECEMBER 31, 2003
Page
Independent Auditors’ Report
Consolidated Balance Sheets as of December 31, 2003 and 2002
Consolidated Statements of Operations for the Years ended December 31, 2003, 2002 and 2001
Consolidated Statements of Stockholders’ Equity for the Years ended December 31, 2003, 2002 and 2001
Consolidated Statements of Cash Flows for the Years ended December 31, 2003, 2002 and 2001
Notes to Consolidated Financial Statements
Schedule of Valuation and Qualifying Accounts
INDEPENDENT AUDITORS’ REPORT
To the Board of Directors and Stockholders of Kilroy Realty Corporation:
We have audited the accompanying consolidated balance sheets of Kilroy Realty Corporation (the “Company”) as of December 31, 2003 and 2002 and the related consolidated statements of operations, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2003. Our audits also included the financial statement schedule listed in the index at Item 15. These financial statements and the financial statement schedule are the responsibility of the management of the Company. Our responsibility is to express an opinion on these financial statements and the financial statement schedule based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2003 and 2002, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2003 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly in all material respects, the information set forth therein.
As discussed in Notes 2 and 22 to the financial statements, the Company changed the presentation of the results of operations and realized gains and losses from properties disposed of in accordance with the adoption of Statement of Financial Accounting Standard 144 “Accounting for the Impairment or Disposal of Long-Lived Assets” during the year ended December 31, 2002.
DELOITTE & TOUCHE LLP
Los Angeles, California
February 25, 2004
KILROY REALTY CORPORATION
CONSOLIDATED BALANCE SHEETS
(in thousands, except share data)
See accompanying notes to consolidated financial statements.
KILROY REALTY CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except share and per share data)
See accompanying notes to consolidated financial statements.
KILROY REALTY CORPORATION
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
(in thousands, except share and per share data)
See accompanying notes to consolidated financial statements.
KILROY REALTY CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
See accompanying notes to consolidated financial statements.
KILROY REALTY CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Three Years Ended December 31, 2003
1. Organization and Ownership
Kilroy Realty Corporation (the “Company”) owns, operates and develops office and industrial real estate located in California, Washington and Arizona. The Company, which qualifies and operates as a self-administered real estate investment trust (“REIT”) under the Internal Revenue Code of 1986, as amended, commenced operations upon the completion of its initial public offering in January 1997. The Company is the successor to the real estate business of the Kilroy Group, which consisted of the combination of Kilroy Industries (“KI”) and various entities, the properties of which were under the common control of KI and/or its stockholders, including the Company’s Chairman of the Board of Directors, John B. Kilroy, Sr., and the Company’s President and Chief Executive Officer, John B. Kilroy, Jr.
As of December 31, 2003, the Company’s stabilized portfolio of operating properties was comprised of 82 office buildings (the “Office Properties”) and 50 industrial buildings (the “Industrial Properties,” and together with the Office Properties, the “Properties”) which encompassed approximately 7.3 million and 4.9 million rentable square feet, respectively, and was 90.3% occupied. The Company’s stabilized portfolio of operating properties excludes properties currently under construction or “lease-up” properties. The Company defines “lease-up” properties as properties recently developed or redeveloped by the Company that have not yet reached 95% occupancy and are within one year following substantial completion. At December 31, 2003, the Company had one office property encompassing an aggregate of approximately 209,000 rentable square feet, which was in the lease-up phase. In addition, as of December 31, 2003, the Company had two office redevelopment properties under construction, which when completed are expected to encompass an aggregate of approximately 316,100 rentable square feet. All of the Company’s development, redevelopment and lease-up projects are located in Southern California.
The Company owns its interests in all of the Properties through Kilroy Realty, L.P. (the “Operating Partnership”) and Kilroy Realty Finance Partnership, L.P. (the “Finance Partnership”). The Company conducts substantially all of its activities through the Operating Partnership in which, as of December 31, 2003 and 2002, it owned an 87.2% and 86.6% general partnership interest, respectively. The remaining 12.8% and 13.4% common limited partnership interest in the Operating Partnership as of December 31, 2003 and 2002, respectively, was owned by certain of the Company’s executive officers and directors, certain of their affiliates, and other outside investors (see Note 13). Kilroy Realty Finance, Inc, (“Finance Inc.”), a wholly-owned subsidiary of the Company, is the sole general partner of the Finance Partnership and owns a 1% general partnership interest. The Operating Partnership owns the remaining 99% limited partnership interest.
In 1999, the Company, through the Operating Partnership, became a 50% managing member in two limited liability companies (the “Development LLCs”), which were formed to develop two multi-phased office projects in San Diego, California. The Allen Group, a group of affiliated real estate development and investment companies based in San Diego, California, was the other 50% member of the Development LLCs. On March 25, 2002, the Company acquired The Allen Group’s interest in the assets and assumed The Allen Group’s proportionate share of the liabilities of the Development LLCs (see Note 13). Subsequent to this transaction, the Development LLCs were liquidated and dissolved. The Development LLCs were consolidated for financial reporting purposes prior to their dissolution on March 25, 2002 since the Company controlled all significant development and operating decisions.
KILROY REALTY CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
2. Basis of Presentation and Significant Accounting Policies
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.
Significant Accounting Policies:
Operating properties-Operating properties are carried at the lower of historical cost less accumulated depreciation or estimated fair value. The cost of operating properties includes the purchase price or development costs of the properties. Costs incurred for the acquisition, renovation and betterment of the operating properties are capitalized to the Company’s investment in that property. Maintenance and repairs are charged to expense as incurred. The Company’s stabilized portfolio of operating properties consists of all of the Company’s Office and Industrial Properties, excluding properties currently under construction or lease-up properties. Lease-up properties are included in land and improvements and building and improvements on the consolidated balance sheets.
A property is evaluated for potential impairment whenever events or changes in circumstances indicate that its carrying amount may not be recoverable. In the event that periodic assessments reflect that the carrying amount of a property exceeds the sum of the undiscounted cash flows (excluding interest) that are expected to result from the use and eventual disposition of the property, the Company would recognize an impairment loss to the extent the carrying amount exceeded the fair value of the property. The Company estimates the fair value using available market information or other industry valuation techniques such as present value calculations. The Company had not recorded any impairment losses for the years ended December 31, 2003, 2002 and 2001.
Depreciation and amortization of buildings and improvements-The cost of buildings and improvements are depreciated on the straight-line method over estimated useful lives of 25 to 40 years for buildings and the shorter of the lease term or useful life, ranging from one to 15 years, for tenant improvements. Depreciation expense for buildings and improvements for the three years ended December 31, 2003, 2002 and 2001, was $47.5 million, $46.8 million, and $41.9 million, respectively.
Construction in progress-Project costs clearly associated with the development and construction of a real estate project are capitalized as construction in progress. In addition, interest, loan fees, real estate taxes, general and administrative expenses that are directly associated with and incremental to the Company’s development activities, and other costs are capitalized during the period in which activities necessary to get the property ready for its intended use are in progress, including the pre-development and lease-up phases. Once the development and construction of the building shell of a real estate project is completed, the costs capitalized to construction in progress are transferred to land and improvements and buildings and improvements on the consolidated balance sheets as the historical cost of the property.
Cash and cash equivalents-The Company considers all money market funds with an original maturity of three months or less at the date of purchase to be cash equivalents.
Restricted cash-Restricted cash consists of cash held as collateral to provide credit enhancement for the Company’s mortgage debt, cash reserves for property taxes, capital expenditures and tenant improvements.
KILROY REALTY CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Revenue recognition-In accordance with Statement of Financial Accounting Standards No. 13, “Accounting for Leases,” minimum annual rental revenue is recognized on a straight-line basis over the term of the related lease. Tenant reimbursement revenue, which is comprised of additional amounts recoverable from tenants for common area maintenance expenses and certain other recoverable expenses is recognized as revenue in the period in which the related expenses are incurred.
Allowances for uncollectible tenant receivables and unbilled deferred rent-Tenant receivables and unbilled deferred rent receivables are carried net of the allowances for uncollectible current tenant receivables and unbilled deferred rent. Management’s determination of the adequacy of these allowances is based primarily upon evaluations of historical loss experience, individual receivables, current economic conditions, and other relevant factors. The allowances are increased through the provision for bad debts.
Deferred leasing costs-Costs incurred in connection with property leasing are capitalized as deferred leasing costs. Deferred leasing costs consist primarily of leasing commissions which are amortized on the straight-line method over the lives of the leases which generally range from one to 15 years. Management re-evaluates the remaining useful lives of leasing costs as the creditworthiness of the Company’s tenants and economic and market conditions change. If management determines the estimated remaining life of the respective lease has changed, the Company adjusts the amortization period.
Deferred financing costs-Costs incurred in connection with debt financing are capitalized as deferred financing costs. Deferred financing costs consist primarily of loan fees which are amortized using the effective interest method over the terms of the respective loans.
Derivative financial instruments-The Company is exposed to the effect of interest rate changes in the normal course of business. The Company mitigates these risks by 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 volatility that changes in interest rates could have on its future cash flows. The Company employs derivative instruments that are designated as cash flow hedges, including interest rate swaps and caps, to effectively convert a portion of its variable-rate debt to fixed-rate debt. The Company does not enter into derivative instruments for speculative purposes.
On January 1, 2001, the Company adopted Statement of Financial Accounting Standards (“SFAS”) 133, “Accounting for Derivative Instruments and Hedging Activities,” as amended by SFAS 138, “Accounting for Certain Derivative Instruments and Certain Hedging Activities” (collectively, “SFAS 133”). SFAS 133 establishes accounting and reporting standards for derivative instruments. Specifically, SFAS 133 requires the Company to recognize all of its derivatives as either assets or liabilities on the Company’s consolidated balance sheet at fair value and to defer the related gains or losses on these contracts in stockholders’ equity as a component of accumulated other net comprehensive income or loss. To the extent that any of these contracts are not perfectly effective in offsetting the change in the value of the interest payments being hedged, changes in fair value relating to the ineffective portion of these contracts would be recognized in earnings (see Note 12). In the event that the Company were to terminate a derivative contract before its maturity date and the forecasted hedged transactions (e.g., the interest payments on the variable rate debt) were still probable to occur, the gains or losses deferred in accumulated other net comprehensive loss (“AOCL”) associated with the terminated contract would remain in AOCL upon the termination and would be reclassified into earnings in the same period in which the hedged transactions affect earnings. If the forecasted hedged transactions were no longer probable to occur, the gains or losses deferred in AOCL would be recognized in earnings immediately upon termination of the derivative contract.
KILROY REALTY CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
In connection with the adoption of SFAS 133 on January 1, 2001, the Company recorded a $1.4 million cumulative effect of change in accounting principle to record an existing cap agreement at fair market value. Upon adoption, the Company also recorded a $2.0 million non-cash charge to other comprehensive loss to record the Company’s swap on the balance sheet at fair market value. The Company determines fair value based upon valuations obtained from an independent third-party for its outstanding interest rate swap and cap agreements at each balance sheet date. Valuations provided by the independent third-party are calculated using standard industry valuation procedures and rely on real-time market inputs consistent with valuation methods and data inputs employed by financial institutions and other market participants.
Minority interests-Minority interests represent the preferred and common limited partnership interests in the Operating Partnership and interests held by The Allen Group in the Development LLCs prior to their dissolution on March 25, 2002 (see Note 13). Net income is allocated to the common limited partners of the Operating Partnership (“Minority Interest of the Operating Partnership”) based on their ownership percentage of the Operating Partnership. The ownership percentage is determined by dividing the number of common limited partnership units held by the Minority Interest of the Operating Partnership by the total common limited partnership units outstanding. The issuance of additional shares of common stock or common limited partnership units results in changes to the Minority Interest of the Operating Partnership percentage as well as the total net assets of the Company. As a result, all common capital transactions result in an allocation between the stockholders’ equity and Minority Interest of the Operating Partnership in the accompanying consolidated balance sheets to account for the change in the Minority Interest of the Operating Partnership ownership percentage as well as the change in total net assets of the Company.
Other property income-Other property income primarily includes revenue earned from lease termination fees (see Note 20). For the year ended December 31, 2001, other property income also included approximately $0.8 million related to forfeited escrow deposits on four properties for which the pending sale did not occur.
Income taxes-The Company has elected to be taxed as a REIT under Sections 856 through 860 of the Internal Revenue Code of 1986, as amended (the “Code”). To qualify as a REIT, the Company must distribute annually at least 90% of its adjusted taxable income, as defined in the Code, to its shareholders and satisfy certain other organizational and operating requirements. The Company generally will not be subject to federal income taxes if it distributes 100% of its taxable income for each year to its shareholders. If the Company fails to qualify as a REIT in any taxable year, it will be subject to federal income taxes (including any applicable alternative minimum tax) on its taxable income at regular corporate rates and may not be able to qualify as a REIT for four subsequent taxable years. Even if the Company qualifies for taxation as a REIT, it may be subject to certain state and local taxes on its income and property, and to federal income taxes and excise taxes on its undistributed taxable income. The Company believes that it has met all of the REIT distribution and technical requirements for the years ended December 31, 2003, 2002 and 2001 and was not subject to any federal income taxes (see Note 24 for tax treatment of the Company’s distributions). Management intends to continue to adhere to these requirements and maintain the Company’s REIT status.
In addition, any taxable income from the Company’s taxable REIT subsidiary, which was formed in August 2002, is subject to federal, state, and local income taxes. For the year ended December 31, 2003, the taxable REIT subsidiary did not have any GAAP or taxable net income and therefore did not incur any income tax expense.
Reclassifications-Certain prior year amounts have been reclassified to conform to the current year’s presentation.
KILROY REALTY CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Use of estimates-The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reported periods. Actual results could differ from those estimates.
Fair value of financial instruments-The Company calculates the fair value of financial instruments using available market information and appropriate present value or other valuation techniques such as discounted cash flow analyses. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. The derived fair value estimates cannot always be substantiated by comparison to independent markets and in many cases, could not be realized in immediate settlement of the instrument. Fair values for certain financial instruments and all non-financial instruments are not required to be disclosed. Accordingly, the aggregate fair value amounts presented do not represent the underlying value of the Company at December 31, 2003 and 2002.
Concentration of credit risk-127 of the Company’s total 132 Properties are located in Southern California. The ability of the tenants to honor the terms of their respective leases is dependent upon the economic, regulatory and social factors affecting the communities in which the tenants operate.
As of December 31, 2003, 2002 and 2001, the Company’s ten largest office tenants represented approximately 29.7%, 32.2% and 34.6% of total annual base rental revenues and its ten largest industrial tenants represented approximately 8.1%, 8.9% and 9.1%, respectively, of total annual base rental revenues. Of this amount, the Company’s largest tenant, The Boeing Company, accounted for approximately 7.5%, 9.5% and 10.9% of the Company’s total annual base revenues, for the years ended December 31, 2003, 2002 and 2001, respectively. At December 31, 2003 and 2002, the Company had $0.6 million and $0.2 million, respectively, in outstanding receivables from this tenant which were primarily reimbursement billings.
The Company has cash in financial institutions which is insured by the Federal Deposit Insurance Corporation (“FDIC”) up to $0.1 million per institution. At December 31, 2003 and 2002, the Company had cash accounts in excess of FDIC insured limits.
Adoption of Stock Option Accounting
In December 2002, the Financial Accounting Standards Board, (“FASB”) issued SFAS 148, “Accounting for Stock-Based Compensation-Transition and Disclosure” (“SFAS 148”). SFAS 148 amends SFAS 123 “Accounting for Stock-Based Compensation” (“SFAS 123”) to provide alternative methods of transition for an entity that voluntarily adopts the fair value recognition method of recording stock option expense. SFAS 148 also amends the disclosure provisions of Statement 123 and APB Opinion No. 28. “Interim Financial Reporting” to require disclosure in the summary of significant accounting policies of the effects of an entity’s accounting policy with respect to stock options on reported net income and earnings per share in annual and interim financial statements.
At December 31, 2003, the Company had one stock option and incentive plan, which is described more fully in Note 16. Effective January 1, 2002, the Company voluntarily adopted the fair value recognition provisions of SFAS 123, prospectively for all employee stock option awards granted or settled after January 1, 2002. Under the fair value recognition provisions of SFAS 123, total compensation expense related to stock options is determined using the fair value of the stock options on the date of grant. Total compensation expense is then recognized on a straight-line basis over the option vesting period
KILROY REALTY CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
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.” As a result, no stock option expense is reflected in 2001 net income, as all stock options granted under the plan had an exercise price equal to the market value of the underlying common stock on the date of grant. 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.
The Company did not issue any options in 2003. The fair value of each option grant issued in 2002 and 2001 is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions (amounts shown as 2002 and 2001, respectively): (a) dividend yield of 7.03% for both years, (b) expected volatility of the Company’s stock of 24.6% and 24.8%, (c) risk free interest rate of 4.88%, and 4.47%, and (d) expected option life of seven years. The effects of applying the fair value provisions of SFAS 123 are not representative of the effects on net income and disclosed pro forma net income for future years because options vest over three years as discussed in Note 16 and additional awards can be made in future years.
Recent Accounting Pronouncements
On January 1, 2003, the Company adopted the provisions of SFAS 145, Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections (“SFAS 145”). The most significant provisions of this statement relate to the rescission of Statement No. 4 “Reporting Gains and Losses from Extinguishment of Debt.” SFAS 145 also amends other existing authoritative pronouncements to make various technical corrections, clarify meanings or describe their applicability under changed conditions. Under SFAS 145, any gain or loss on extinguishment of debt that was classified as an extraordinary item in prior periods presented that does not meet certain defined criteria must be reclassified. The adoption of this statement did not have a material effect on the Company’s results of operations or financial condition.
On January 1, 2003, the Company adopted the provisions of SFAS 146, “Accounting for Costs Associated with Exit or Disposal Activities” (“SFAS 146”). SFAS 146 addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies Emerging Issues Task Force Issue No. 94-3 “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity”. SFAS 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred. The adoption of this statement did not have a material effect on the Company’s results of operations or financial condition.
KILROY REALTY CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
On January 1, 2003, the Company adopted the initial recognition and measurement provisions of Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others” (“FIN 45”). FIN 45 significantly changes the current practice in the accounting for, and disclosure of, guarantees. Guarantees and indemnification agreements meeting the characteristics described in FIN 45 are required to be initially recorded as a liability at fair value. FIN 45 also requires a guarantor to make significant new disclosures for virtually all guarantees even if the likelihood of the guarantor having to make payment under the guarantee is remote. The Company adopted the disclosure provisions of FIN 45 as of December 31, 2002. The adoption of the provisions of this interpretation did not have a material effect on the Company’s results of operations or financial condition.
In January 2003, the FASB issued FASB Interpretation No. 46, “Consolidation of Variable Interest Entities” (“FIN 46”). FIN 46 clarifies the application of Accounting Research Bulletin No. 51, “Consolidated Financial Statements” and provides guidance on the identification of entities for which control is achieved through means other than voting rights (“variable interest entities” or “VIEs”) and how to determine when and which business enterprise should consolidate the VIE. This new model for consolidation applies to an entity in which either: (1) the equity investors (if any) lack one or more characteristics deemed essential to a controlling financial interest or (2) the equity investment at risk is insufficient to finance that entity’s activities without receiving additional subordinated financial support from other parties. In December 2003, the FASB published a revision to FIN 46 (“FIN 46R”) to clarify some of the provisions of the interpretation and defer the effective date of implementation for certain entities. The provisions of FIN 46R are effective for the first reporting period ending after December 15, 2003 for entities considered to be special-purpose entities. The provisions for all other entities subject to FIN 46R are effective for financial statements of the first reporting period ending after March 15, 2004. On February 1, 2003, the Company adopted the provisions of this interpretation, which did not have a material effect on the Company’s results of operations or financial condition.
In April 2003, the FASB issued SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities” (“SFAS 149”). SFAS 149 amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments imbedded in other contracts and for hedging activities under SFAS No. 133 “Accounting for Derivative Instruments and Hedging Activities.” The provisions of SFAS 149 are generally effective for contracts entered into or modified after June 30, 2003 and for hedging relationships designated after June 30, 2003. The adoption of this statement did not have a material effect on the Company’s results of operations or financial condition.
In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity” (“SFAS 150”). SFAS 150 establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. The statement is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. The adoption of this statement did not have a material effect on the Company’s results of operations or financial condition.
On July 31, 2003, the SEC issued a clarification of Emerging Issues Task Force Topic D-42, “The Effect on the Calculation of Earnings per Share for the Redemption or Induced Conversion of Preferred Stock” (“Topic D-42”). Topic D-42 provides, among other things, that any excess of the fair value of the consideration transferred to the holders of preferred stock redeemed over the carrying amount of the preferred stock should be subtracted from net earnings to determine net earnings available to common stockholders in the calculation of earnings per share. The SEC’s clarification of the guidance in Topic D-42 provides that the carrying amount of the preferred stock should be reduced by the related issuance costs.
KILROY REALTY CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
The July 2003 clarification of Topic D-42 was effective for the Company beginning with the quarter ending September 30, 2003. The Company redeemed all of the outstanding 9.375% Series C Cumulative Redeemable Preferred Units (“Series C Preferred Units”) in November 2003 with the net proceeds from its 7.80% Series E Cumulative Redeemable Preferred Stock offering, which closed on November 21, 2003 (see Notes 13 and 16). This redemption resulted in a $0.9 million charge in 2003 relating to the initial issuance costs of the Series C Preferred units.
In December 2003, the FASB issued SFAS No. 132, “Employers’ Disclosures about Pensions and Other Postretirement Benefits,” to improve financial statement disclosures for defined benefit plans. This standard requires that companies provide more details about their plan assets, benefit obligations, cash flows, benefit costs and other relevant information. SFAS No. 132 is effective for fiscal years ending after December 15, 2003, and for quarters beginning after December 15, 2003. The adoption of this statement did not have a material effect on the Company’s results of operations or financial condition.
3. Dispositions and Acquisitions
Dispositions
During the year ended December 31, 2003, the Company sold the following properties:
During the year ended December 31, 2003, the Company recorded a net gain of approximately $3.6 million in connection with the sale of these properties. The Company used the net proceeds to fund its development and redevelopment programs, pay down principal on mortgage loans and repay borrowings under the Credit Facility (defined in Note 11). The net income and the net gain on disposition for these properties have been included in discontinued operations for the years ended December 31, 2003, 2002 and 2001 (see Note 22).
KILROY REALTY CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
During the year ended December 31, 2002, the Company sold the following properties:
During the year ended December 31, 2002, the Company recorded a net gain of approximately $6.6 million in connection with the sale of these properties. The Company used the net proceeds to fund its development program, finance the Company’s share repurchase program (see Note 14) and repay borrowings under the Credit Facility (defined in Note 11). The net income and the net gain on disposition for these properties have been included in discontinued operations for the years ended December 31, 2002 and 2001 (see Note 22).
During the year ended December 31, 2001, the Company sold the following properties:
KILROY REALTY CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
During the year ended December 31, 2001, the Company recorded a net gain of approximately $4.7 million in connection with the sale of these properties. The Company used the net proceeds to fund its development program and repay borrowings under the Credit Facility (defined in Note 11). During the year ended December 31, 2002, the Company recognized a gain of approximately $896,000 related to the disposition of an industrial property in Irvine, California that the Company sold in October 2001. This additional gain had previously been reserved for financial reporting purposes until certain contingencies associated with the disposition were resolved. The net income and the net gain on disposition for these properties have been included in continuing operations for the years ended December 31, 2002 and 2001 as it relates to properties sold prior to the prospective adoption of SFAS 144 (see Note 22).
Acquisition of Industrial Property
In August 2002, the Company acquired one industrial property, including undeveloped land adjacent to one of the Company’s stabilized redevelopment projects, located in Santa Ana, California (see Note 4), from an unaffiliated third party for approximately $8.1 million. The property encompasses approximately 107,000 rentable square feet and was 100% leased as of December 31, 2003.
Acquisition of Minority Interest in Development LLC Properties
On March 25, 2002, the Company acquired The Allen Group’s interest in the assets of the Development LLCs which included nine San Diego office properties encompassing approximately 848,300 rentable square feet, and three San Diego development sites, encompassing approximately 11.9 acres (see Notes 1 and 13).
4. Development and Redevelopment Projects
Stabilized Development Projects
During the year ended December 31, 2003, the Company added the following three development projects to the Company’s stabilized portfolio. All of these projects were completed in 2002 and in the lease-up phase as of December 31, 2002.
(1)
Percentage committed includes executed leases and letters of intent, calculated on a square footage basis.
KILROY REALTY CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
During the year ended December 31, 2002, the Company added the following six development projects to the Company’s stabilized portfolio:
Lease-Up Projects
The Company completed the following office development project in 2003, which was in the lease-up phase at December 31, 2003:
(1)
Based on Management’s estimation of the earlier of the stabilized occupancy (95%) or one year from the date of substantial completion.
(2)
Percentage committed includes executed leases and letters of intent, calculated on a square footage basis.
Redevelopment Projects Under Construction
During the year ended December 31, 2003, the Company reclassified the following two properties out of the Company’s stabilized portfolio and into the Company’s redevelopment portfolio. The Company is converting one of these properties from office space to life science space and is performing extensive interior refurbishments at the other property since it had been occupied by a single tenant for approximately 30 years.
(1)
Based on Management’s estimation of the earlier of the stabilized occupancy (95%) or one year from the date of substantial completion.
KILROY REALTY CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Completed Redevelopment Projects
During the year ended December 31, 2003, the Company added the following two redevelopment projects to the Company’s stabilized portfolio:
(1)
Percentage committed includes executed leases and letters of intent, calculated on a square footage basis.
(2)
This project was in the lease-up phase as of December 31, 2002.
(3)
The Company started the redevelopment of this building and reclassified this property out of the Company’s stabilized portfolio and into the Company’s redevelopment portfolio in the first quarter of 2003.
(4)
The Company converted approximately 48,500 square feet of this building to life science space at the request of the tenant. The remainder of the space was leased to another tenant and the lease expired in November 2003.
5. Current Receivables
Current receivables consisted of the following at December 31:
6. Deferred Rent Receivables
Deferred rent receivables consisted of the following at December 31:
7. Deferred Leasing Costs
Deferred leasing costs are summarized as follows at December 31:
KILROY REALTY CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
8. Charge for Previously Capitalized Leasing Costs
In 2002, Peregrine Systems, Inc. (“Peregrine”) leased four office buildings totaling approximately 423,900 rentable square feet under four separate leases. Peregrine had filed a voluntary petition for relief under Chapter 11 of the bankruptcy code on September 22, 2002. Peregrine had advised the Company that it likely would not need all of the buildings upon resolution of its financial issues, therefore, during the year ended December 31, 2002, the Company recorded a $5.3 million charge to depreciation and amortization for leasing commissions and certain tenant improvements that were previously capitalized in connection with the leases with Peregrine. In addition, the Company recorded a $0.5 million charge to general and administrative expenses for costs the Company paid for a fifth and final building that was to be leased to Peregrine. Peregrine surrendered this building back to the Company in June 2002, at which time it was still under construction and was not yet included in the Company’s portfolio of operating properties (see Note 20).
9. Deferred Financing Costs
Deferred financing costs are summarized as follows at December 31:
KILROY REALTY CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
10. Secured Debt
The following table sets forth the composition of the Company’s secured debt at December 31:
(a)
After January 2005, the mortgage note is subject to increases in the effective annual interest rate to the greater of 10.35% or the sum of the interest rate for U.S. Treasury Securities maturing 15 years from the reset date plus 2.00%. The contractual maturity date is February 2022, however the Company intends to refinance the debt prior to January 2005 without any prepayment penalty.
(b)
The variable interest rates stated as of December 31, 2003 and 2002 are based on the last repricing date during the respective periods which vary based on the terms of each note. The repricing rates may not be equal to LIBOR at December 31, 2003 and 2002.
(c)
This construction loan has a limited recourse provision that holds the Company liable for up to approximately $14.3 million plus any unpaid accrued interest.
(d)
The maturity of this loan may be extended for up to one year.
(e)
The maturity of this loan may be extended for up to two one-year periods.
KILROY REALTY CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
The Company’s secured debt was collateralized by 73 operating properties and one in process development project at December 31, 2003 with a combined net book value of $681 million and 79 operating properties and one in process development project at December 31, 2002 with a combined net book value of $614 million. As of December 31, 2003 and 2002, the Company’s secured debt had a weighted average interest rate, excluding loan fees, of 5.78% and 5.97%, respectively.
At December 31, 2003, eleven of the Company’s secured loans contained restrictions that would require the payment of prepayment penalties for the acceleration of outstanding debt. The mortgage notes payable are secured by deeds of trust on certain of the Company’s properties and the assignment of certain rents and leases associated with those properties.
Certain secured debt agreements contain restrictive covenants including minimum debt yields and debt service coverage ratios. The Company was in compliance with all of the covenants at December 31, 2003 and 2002.
Scheduled contractual principal payments for the above secured debt at December 31, 2003, assuming the Company does not exercise any of the extension options, were as follows:
11. Unsecured Line of Credit
In March 2002, the Company obtained a $425 million unsecured revolving credit facility (the “Credit Facility”) with a bank group led by J.P. Morgan Securities, Inc. to replace its previous $400 million unsecured revolving credit line which was scheduled to mature in November 2002. The Company repaid its $100 million unsecured debt facility, which was scheduled to mature September 2002, with borrowings under the Credit Facility. As of December 31, 2003, the Company had borrowings of $235.0 million outstanding under the Credit Facility and availability of approximately $84.2 million. The Credit Facility bears interest at an annual rate between LIBOR plus 1.13% and LIBOR plus 1.75% (2.66% and 2.92% at December 31, 2003 and 2002, respectively), depending upon the Company’s leverage ratio at the time of borrowing, and matures in March 2005. The fee for unused funds ranges from an annual rate of 0.20% to 0.35% depending on the Company’s leverage ratio. The Company expects to use the Credit Facility to finance development and redevelopment expenditures, to fund potential acquisitions and for other general corporate uses.
The Credit Facility and certain other secured debt arrangements contain covenants requiring the Company to meet certain financial ratios and reporting requirements. Some of the more restrictive financial covenants include a minimum debt service coverage ratio, a maximum total liabilities to total assets ratio, a maximum total secured debt to total assets ratio, 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. The Company was in compliance with all of its debt covenants at December 31, 2003 and 2002.
KILROY REALTY CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Total interest and loan fees capitalized for the years ended December 31, 2003, 2002 and 2001 were $11.8 million, $14.0 million and $13.6 million, respectively.
12. Derivative Financial Instruments
As of December 31, 2003 and 2002, the Company reported liabilities of $2.7 million and $3.7 million, respectively, reflecting the fair value of its interest rate swap agreements which are included in other liabilities in the consolidated balance sheets. As of December 31, 2003 and 2002, the Company reported assets of $4,000 and $0.2 million reflecting the fair value of its interest rate cap agreements which are included in deferred financing costs in the consolidated balance sheets (see Note 9).
The following table sets forth the terms and fair market value of the Company’s derivative financial instruments at December 31:
The instruments described above have been designated as cash flow hedges. The Company uses these instruments to hedge the interest rate risk associated with a portion of its pool of outstanding variable-rate debt that is equal in principal amount to the notional amount of the Company’s outstanding derivative instruments. (See Notes 10 and 11 for a discussion of the Company’s outstanding variable rate and fixed rate debt.) The significant terms of the Company’s pool of outstanding variable-rate debt, which include the LIBOR index and the repricing dates, have been set to effectively match the terms of the Company’s hedging instruments. The Company’s strategy is to effectively convert a portion of its variable-rate debt to fixed-rate debt.
During 2002, the Company paid a $2.4 million premium to enter into two interest rate cap agreements, which represented the fair market value at the inception of the agreements. This premium is being amortized into earnings over the term of the cap agreements using the caplet value approach.
As of December 31, 2003 and 2002, the balance in accumulated net other comprehensive loss was $4.4 million and $5.8 million, respectively, relating to the net decrease in the fair market value of the derivative instruments outstanding at the end of each period. For the years ended December 31, 2003, 2002 and 2001, the Company did not record any gains or losses attributable to cash flow hedge ineffectiveness since the terms of the Company’s derivative contracts and debt obligations were and are expected to continue to be effectively matched. Amounts reported in accumulated other comprehensive loss will be reclassified to interest expense as interest payments are made on the Company’s variable-rate debt. During the year ending December 31, 2004, the Company estimates that it will reclassify approximately $4.5 million to interest expense.
KILROY REALTY CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
13. Minority Interests
Common Limited Partnership Unitholders
The Company owned an 87.2% and 86.6% general partnership interest in Operating Partnership as of December 31, 2003 and 2002, respectively. The remaining 12.8% and 13.4% common limited partnership interest as of December 31, 2003 and 2002, respectively, was owned by certain of the Company’s executive officers and directors, certain of their affiliates, and other outside investors in the form of common limited partnership units. The common limited partnership units are redeemable at the option of the unitholders. Upon receipt of the notice of redemption, the Company may elect, subject to certain limitations, to exchange the common limited partnership units for shares of the Company’s common stock on a one-for-one basis or cash equal to the fair market value at the time of redemption.
During the years ended December 31, 2003 and 2002, 82,439 and 222,270 common limited partnership units of the Operating Partnership were exchanged into shares of the Company’s common stock on a one-for-one basis, respectively. Of these common limited partnership units exchanged in 2003 and 2002, 25,299 and 177,563, respectively, common limited partnership units were owned by a partnership affiliated with The Allen Group. Neither the Company nor the Operating Partnership received any proceeds from the issuance of the common stock to the common limited partnership holders.
Preferred Unitholders
As of December 31, 2003 and 2002, the Company had issued and outstanding 1,500,000 8.075% Series A Cumulative Redeemable Preferred units (the “Series A Preferred units”) and 900,000 9.250% Series D Cumulative Redeemable Preferred units (the “Series D Preferred units”) representing preferred limited partnership interests in the Operating Partnership with a liquidation value of $50.00 per unit. The Series A and Series D Preferred units, which may be called by the Operating Partnership at a price equal to the liquidation value on or after February 6, 2003 and December 9, 2004, respectively, have no stated maturity or mandatory redemption and are not convertible into any other securities of the Operating Partnership. The Series A and Series D Preferred Units are exchangeable at the option of the majority of the holders for shares of the Company’s 8.075% Series A Cumulative Redeemable Preferred stock beginning February 6, 2008 and the Company’s 9.250% Series D Cumulative Redeemable Preferred beginning December 9, 2009, respectively, or earlier under certain circumstances.
Each series of preferred units may be exchanged for shares of a corresponding series of preferred stock of the Company’s preferred stock at the election of 51% of the holders of the applicable series of preferred units:
(i) if distributions on the applicable series have not been timely made for any six prior quarters, or the Operating Partnership is likely to become a publicly traded partnership for federal income tax purposes;
(ii) if, prior to the tenth anniversary of their date of issuance, the respective class of preferred units would not be considered “stock and securities” for federal income tax purposes; and
(iii) at any time following the tenth anniversary of their date of issuance.
In addition, each series of preferred units may also be exchanged for shares of a corresponding series of the Company’s preferred stock if either the Operating Partnership or the initial holder of the preferred units believes, based upon the opinion of counsel, that the character of Operating Partnership’s assets and income would not allow it to qualify as a REIT if it were a corporation. In lieu of exchanging preferred units for preferred stock, the Company may elect to redeem all or a portion of the respective series of preferred units for cash in an amount equal to $50.00 per unit plus accrued and unpaid distributions. Each series may only be exchanged in whole, but not in part, and each exchange is subject to the REIT ownership limits contained in the Company’s charter.
KILROY REALTY CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
As of December 31, 2002, the Company also had issued and outstanding 700,000 9.375% Series C Cumulative Redeemable Preferred units (the “Series C Preferred units”), representing preferred limited partnership interests in the Operating Partnership with a liquidation value of $50.00 per unit. In November 2003, the Operating Partnership redeemed all 700,000 outstanding Series C Preferred Units with proceeds from a public offering for 1,610,000 shares of its 7.80% Series E Cumulative Redeemable Preferred Stock (see Note 14.) In 2003, the Company recorded a $0.9 million charge relating to the initial issuance costs of the redeemed units.
The Company makes quarterly distributions to the preferred unitholders each February, May, August and November. The following table sets forth the accrued distributions payable to preferred unitholders that is included in the Series A, Series C and Series D Preferred unit balances on the balance sheet at December 31, 2003 and 2002:
Development LLC’s
On March 25, 2002, the Company acquired The Allen Group’s minority interest in the assets and assumed The Allen Group’s proportionate share of the liabilities of the Development LLCs. The net consideration was approximately $40.9 million. The acquisition was funded with $2.2 million in cash and 1,398,068 common limited partnership units of the Operating Partnership valued at $38.7 million based upon the closing share price of the Company’s common stock as reported on the New York Stock Exchange. In connection with the acquisition, the Company recognized $3.9 million of preferred return income that had been previously earned but fully reserved for financial reporting purposes until the acquisition was complete and the related litigation between the parties was settled. The preferred return investment earned a 12.5% annual rate of return. In connection with the acquisition, the Company repaid three construction loans, which were secured by certain of the Development LLC properties.
14. Stockholders’ Equity
Preferred Stock
In November 2003, the Company completed a public offering for 1,610,000 shares of its 7.80% Series E Cumulative Redeemable Preferred Stock (“Series E Preferred Stock”). The Series E Preferred Stock has a liquidation preference of $25.00 per share and may be redeemed at the option of the Company on or after November 21, 2008, or earlier under certain circumstances. Dividends on the Series E Preferred Stock are cumulative and will be payable quarterly in arrears on the 15th day of each February, May, August and November. The Series E Preferred Stock has no stated maturity and will not be subject to mandatory redemption or any sinking fund. The Company used the net proceeds from the offering to redeem all outstanding Series C Preferred Units (see Note 13).
KILROY REALTY CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Restricted Shares
In February 2004, 2003 and 2002, the Company’s Compensation Committee granted an aggregate of 111,159, 118,733 and 81,729 restricted shares, respectively, of the Company’s common stock to certain executive officers and key employees. In 2003, the Company’s Executive Compensation Committee granted an aggregate of 4,945 restricted shares of the Company’s common stock to non-employee board members as part of the board members’ annual compensation and one newly elected board member’s initial equity award. The restricted shares are subject to restrictions determined by the Company’s Compensation Committee. The restricted shares have the same dividend and voting rights as common stock, are legally issued and outstanding, and are included in the Company’s calculation of weighted average diluted outstanding shares at December 31, 2003, 2002 and 2001 (see Note 16 for the terms of the restricted stock grants and the related amortization of compensation expense).
Exchange of Common Limited Partnership Units
During 2003 and 2002, 82,439 and 222,270 common limited partnership units of the Operating Partnership were exchanged into shares of the Company’s common stock, respectively (see Note 13). Neither the Company nor the Operating Partnership received any proceeds from the issuance of the common stock to the common limited partnership unitholders.
Share Repurchases
During the year ended December 31, 2003, the Company accepted the return, at the current quoted market price, of 78,630 shares of its common stock from certain key employees in accordance with the provisions of its incentive stock plan to satisfy minimum statutory tax-withholding requirements related to restricted shares that vested during this period.
In November 2002, the Company’s Board of Directors authorized the repurchase of an additional one million shares under its existing common stock share repurchase program. This action increased the total authorized shares under this program to an aggregate of four million shares. During the year ended December 31, 2002, the Company repurchased 508,200 shares of its common stock in open market transactions for an aggregate price of $11.4 million, or $22.39 per share. The Company did not repurchase any shares during the years ended December 31, 2003 and 2001. Repurchases were funded primarily through proceeds received from the Company’s disposition program, working capital and borrowings on the Company’s Credit Facility. As of December 31, 2003, an aggregate of 1,227,500 shares remained eligible for repurchase under this program.
Dividend Reinvestment and Direct Purchase Plan
The Company has a Dividend Reinvestment and Direct Purchase Plan (the “Plan”) designed to provide the Company’s stockholders and other investors with a convenient and economical method to purchase shares of the Company’s common stock. The Plan consists of three programs that provide existing common stockholders and other investors the opportunity to purchase additional shares of the Company’s common stock by reinvesting cash dividends or making optional cash purchases within specified parameters. Depending on the program, the Plan acquires shares of the Company’s common stock from either new issuances directly from the Company, from the open market or from privately negotiated transactions. As of December 31, 2003, no shares had been acquired under the Plan from new issuances.
KILROY REALTY CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Registration Statements
In 2003, the SEC declared effective the Company’s registration statement on Form S-3, which registered the potential issuance and resale of up to a total of 1,398,068 shares of the Company’s common stock that may be issued in redemption of 1,398,068 common limited partnership units of the Operating Partnership previously issued in connection with the acquisition of the minority interest in the Development LLC properties (see Notes 2 and 13). In 2002, the SEC declared effective the Company’s registration statement on Form S-3, which registered the potential issuance and resale of up to a total of 1,133 shares of the Company’s common stock in exchange for 1,133 common limited partnership units of the Operating partnership previously issued in connection with a related party acquisition. The common limited partnership units may be exchanged at the Company’s option into shares of the Company’s common stock on a one-for-one basis. Neither the Company nor the Operating Partnership will receive any proceeds from the issuance of the common stock resulting from any such exchange.
The Company has the ability to issue up to an additional $273 million of equity securities, available as of the date of this report, under a currently effective “shelf” registration statement.
Accrued Distributions
Accrued distributions at December 31, 2003 and 2002, consisted of the following amounts payable to registered common stockholders of record holding 28,209,213 and 27,419,880 shares of common stock, respectively, common unitholders holding 4,154,313 and 4,236,752 common limited partnership units of the Operating Partnership, respectively, and registered preferred stockholders of 1,610,000 and zero shares of Series E Preferred Stock, respectively:
15. Future Minimum Rent
The Company has operating leases with tenants that expire at various dates through 2018 and are either subject to scheduled fixed increases or adjustments based on the Consumer Price Index. Generally, the leases grant tenants renewal options. Leases also provide for additional rents based on certain operating expenses. Future minimum rent under operating leases, excluding tenant reimbursements of certain costs, as of December 31, 2003, are summarized as follows:
KILROY REALTY CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
16. Employee Retirement and Stock Option and Incentive Plans
Retirement Savings Plan
The Company has a retirement savings plan designed to qualify under Section 401(k) of the Internal Revenue Code (the “401(k) Plan”). The 401(k) Plan allows participants to defer up to sixty percent of their eligible compensation on a pre-tax basis, subject to certain maximum amounts allowed by the Internal Revenue Code. The 401(k) Plan provides for a matching contribution by the Company in an amount equal to fifty-cents for each one dollar of participant contributions up to a maximum of five percent of the participant’s annual salary. Participants vest immediately in the amounts contributed by the Company. Employees of the Company are eligible to participate in the 401(k) Plan on the first day of the month after three months of service. For each of the years ended December 31, 2003, 2002, and 2001, the Company contributed $0.3 million to the 401(k) Plan.
Stock Option and Incentive Plan
The Company has established a stock option and incentive plan (the “Stock Plan”) for the purpose of attracting and retaining officers and key employees, under which restricted shares or stock options may be granted. The Stock Plan authorizes the issuance of 3,000,000 shares of common stock of the Company. The Compensation Committee, comprised of three Directors who are not officers of the Company, determines compensation, including awards under the Stock Plan, for the Company’s executive officers.
In February 2002, the Company’s Compensation Committee approved two new programs under the Stock Plan for the future potential issuance of restricted shares of common stock and one program under the Stock Plan for the potential payment of cash to certain key employees as part of their annual and long-term incentive compensation. The number of shares that will ultimately be issued and the amount of cash that will ultimately be paid under these programs will be contingent upon both the Company and the individuals meeting certain financial, operating and development performance targets during each fiscal year. The awards are payable at the discretion of the Compensation Committee. The restricted stock awards will vest over different periods depending upon the specific program and will be expensed over the performance and vesting periods.
In February 2004, the Company’s Compensation Committee granted an aggregate of 111,159 restricted shares of common stock to certain executive officers and key employees. Compensation expense for the restricted shares is calculated based on the closing per share price of $34.85 on the February 10, 2004 grant date and is amortized on a straight-line basis over the performance and vesting period. Of the shares granted, 21,234 vest over a one-year period, 68,403 vest over a two-year period and 21,522 vest over a four-year period. The Company recorded approximately $1.1 million in compensation expense related to this restricted stock grant during the year ended December 31, 2003.
In February 2003, the Company’s Compensation Committee granted an aggregate of 118,733 restricted shares of common stock to certain executive officers and key employees. Compensation expense for the restricted shares is calculated based on the closing per share price of $21.63 on the February 10, 2003 grant date and is amortized on a straight-line basis over the performance and vesting period. Of the shares granted, 25,903 vest over a one-year period and 92,830 vest over a two-year period. The compensation expense related to this restricted stock grant was approximately $1.0 million for both years ended December 31, 2003 and 2002.
In February 2002, the Company’s Compensation Committee granted an aggregate of 81,729 restricted shares of common stock to certain executive officers. Compensation expense for the restricted shares is calculated based on the closing per share price of $25.74 on the February 26, 2002 grant date and is amortized on a straight-line basis over the performance and vesting period. Of the shares granted, 20,541 vested over a one-
KILROY REALTY CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
year period and 61,188 vest over a two-year period. The compensation expense related to this restricted stock grant was approximately $0.9 million and $1.1 million for the year ended December 31, 2003 and 2002, respectively.
In March 2003, the Company’s Executive Compensation Committee implemented a special long-term compensation program for the Company’s executive officers that provides for cash compensation to be earned at the end of a three-year period if the Company attains certain performance measures based on annualized total shareholder returns on an absolute and relative basis. The targets for the relative component require the Company to obtain an annualized total return to stockholders that is at or above the 70th percentile of annualized total return to stockholders achieved by members of a pre-defined peer group during the same three-year period. The amount payable for the absolute component is based upon the amount by which the annualized total return to stockholders over the three-year period exceeds 10%. Amounts paid under the special long-term compensation program are payable at the discretion of the Executive Compensation Committee. During the year ended December 31, 2003, the Company accrued approximately $5.9 million of compensation expense related to this plan.
Board Compensation
In May 2003, the Company’s Executive Compensation Committee granted an aggregate of 3,945 restricted shares of the Company’s common stock to non-employee board members as part of the board members’ annual compensation. In July 2003, the Company’s Executive Compensation Committee granted 1,000 shares to the Company’s newly elected board member representing his initial equity award. The restricted stock was granted under the Company’s 1997 Stock Option and Incentive Plan in accordance with the Company’s new Board of Directors compensation plan. The new Board of Directors compensation plan was approved by the Board of Directors in May 2003. Compensation expense for the 3,945 and 1,000 restricted shares is calculated based on the closing per share price of $25.38 and $28.48 on the respective May 8, 2003 and July 24, 2003 grant dates and is being amortized over the respective two-year and four-year vesting periods. The Company recorded compensation expense of approximately $35,000 related to these restricted stock grants during the year ended December 31, 2003.
Stock Options
At December 31, 2003, 2002 and 2001, an aggregate of 214,714, 1,167,272 and 1,436,341 options were exercisable for shares of the Company’s common stock at a weighted average exercise price of $23.86, $23.30 and $23.15, respectively. The weighted average exercise price of the options outstanding at December 31, 2003, 2002 and 2001 was $24.09, $23.40 and $23.22, respectively, with weighted average remaining contractual lives of 4.9 years, 5.0 years and 6.0 years, respectively. Stock options vest at 33 1/3% per year over three years beginning on the first anniversary date of the grant and are exercisable at the market value on the date of the grant. The term of each option is ten years from the date of the grant.
KILROY REALTY CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
The Company’s stock option activity is summarized as follows:
Effective January 1, 2002, the Company voluntarily adopted the fair value recognition provisions of SFAS 123, prospectively for all employee awards granted, modified, or settled after January 1, 2002 (see Note 2). Accordingly, the Company recorded approximately $26,000 and $23,000 of compensation expense for the years ended December 31, 2003 and 2002, respectively. This compensation expense relates to the Company’s grant of 25,000 stock options to the Company’s non-employee Directors, which occurred in February 2002.
17. Commitments and Contingencies
Operating leases-The Company has noncancelable ground lease obligations on the SeaTac Office Center in Seattle, Washington expiring December 2032, with an option to extend the lease for an additional 30 years; and Kilroy Airport Center, Long Beach, California with a lease period for Phases I, II, III and IV expiring in July 2084. On the Kilroy Airport Center and the SeaTac Office Center ground leases, rentals are subject to adjustments every five years based on the Consumer Price Index.
During the year ended December 31, 2002 the Company renegotiated the ground leases at Kilroy Airport Center, Phases I, II, and III in Long Beach, California, resulting in a reduction of annual ground lease expense of approximately $0.3 million. The ground lease obligation will be subject to fair market value adjustments every five years. The Company also exercised the option to extend the ground leases for an additional fifty years. The ground leases now expire in July 2084 as discussed above.
During the year ended December 31, 2003, the Company renegotiated the ground lease at Kilroy Airport Center, Phase IV in Long Beach, California. The Company leases this land, which is adjacent to the Company’s other properties at Kilroy Airport Center, Long Beach, for future development opportunities. The ground lease term was extended to July 2084 subject to the Company’s right to terminate this lease upon written notice to the landlord on or before October 2007. Should the Company elect not to terminate the lease, the ground lease obligation will be subject to a fair market rental adjustment upon the completion of a building on the premises or in October 2007, whichever occurs first, and at scheduled dates thereafter.
KILROY REALTY CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
The minimum commitment under these leases at December 31, 2003 was as follows:
Litigation-With exception of the lawsuit disclosed in Note 20, neither the Company nor any of the Company’s Properties are presently subject to any material litigation nor, to the Company’s knowledge, is any material litigation threatened against any of them which if determined unfavorably to the Company would have a material adverse effect on the Company’s cash flows, financial condition or results of operations. The Company is party to litigation arising in the ordinary course of business, none of which if determined unfavorably to the Company, individually or in the aggregate, is expected to have a material adverse effect on the Company’s cash flows, financial condition or results of operations.
Environmental Matters-The Company follows the policy of monitoring its Properties for the presence of hazardous or toxic substances. While there can be no assurance that a material environmental liability does not exist, the Company is not currently aware of any environmental liability with respect to the Properties that would have a material effect on the Company’s financial condition, results of operations and cash flows. Further, the Company is not aware of any environmental liability or any unasserted claim or assessment with respect to an environmental liability that the Company believes would require additional disclosure or the recording of a loss contingency.
18. Related-Party Transactions
As part of the Company’s marketing strategy, KSSLC had an agreement with TradeWind Navigation, Inc., a company owned solely by John B. Kilroy, Sr., to charter a sailing vessel for 26 weeks during the year. The Company used the sailing vessel in its marketing efforts by sponsoring broker events. During the years ended December 31, 2003, 2002 and 2001, KSLLC paid TradeWind Navigation, Inc. approximately $94,000, $0.3 million and $0.3 million, under this agreement. This agreement was terminated in April 2003.
In July 2002, KAICO, a partnership owned by John B. Kilroy, Sr., the Chairman of the Company’s Board of Directors, John B. Kilroy, Jr. the Company’s President and Chief Executive Officer, and certain other Kilroy family members, received a $1.4 million net insurance payment for earthquake related damage to three buildings in an office complex the Company acquired from KAICO in a series of transactions from May 2000 through January 2001. In connection with the acquisition, KAICO and the Company agreed that KAICO would be entitled to retain all claims under policies of insurance in effect with respect to these properties, with the exception that KAICO transferred to the Company the rights to any claims under any insurance policy that related to the portion of the complex known as 909 Sepulveda Boulevard. Of the total $1.4 million payment, $1.2 million related to claims for 955 and 999 Sepulveda Boulevard and $0.2 million related to claims for 909 Sepulveda Boulevard. Based on the agreement between KAICO and the Company discussed above, the $0.2 million that related to 909 Sepulveda Boulevard was paid to a wholly-owned subsidiary of the Company in July 2002.
KILROY REALTY CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
At December 31, 2002, other assets include a note receivable and accrued interest totaling approximately $0.2 million due from a Senior Vice President of the Company. The officer repaid the principal and interest balance in full in June 2003. The note, which was issued in November 2000, accrued interest at 8% and was secured by real property owned by the officer.
19. Fair Value of Financial Instruments
The carrying amounts of the Company’s cash and cash equivalents, restricted cash and accounts payable approximate fair value due to their short-term maturities. The carrying amounts of the Company’s variable-rate secured debt and outstanding borrowings on the Credit Facility approximate fair value since the interest rates on these instruments are equivalent to rates currently offered to the Company (see Notes 10 and 11).
For fixed-rate secured debt, the Company estimates fair value by using discounted cash flow analyses based on borrowing rates for similar types of borrowing arrangements. The fair value of the Company’s fixed-rate secured debt was approximately $414 million and $359 million at December 31, 2003 and 2002, respectively. See Note 10 for further detail on the Company’s secured debt and Note 12 for the fair value of the Company’s derivative instruments.
20. Lease Termination Fees
Peregrine Systems, Inc.
Under the terms of Peregrine’s plan of reorganization and in accordance with a settlement agreement approved by the bankruptcy court in July 2003, the Company received a payment in the third quarter of 2003 of approximately $18.3 million and is scheduled to receive four additional payments of approximately $750,000 each to be paid annually over the next four years resulting from Peregrine’s early termination of leases it had with the Company. In connection with the settlement agreement, the Company reduced its allowance for unbilled deferred rents by approximately $2.0 million for amounts specifically related to the terminated Peregrine leases, and reversed a $0.5 million reserve previously charged to general and administrative expenses for costs the Company paid for the fifth building that was to be leased to Peregrine (see Note 8). The Company then recorded a net lease termination fee of $18.0 million representing the $18.3 million payment received in the third quarter of 2003 plus the $2.6 million net present value of the payments to be received in the future, offset by $2.9 million of receivables and other costs and obligations associated with the leases. In addition, the Company increased its provision for bad debts by $2.6 million to reserve the portion of the lease termination fee that related to the future annual payments.
eToys, Inc.
In January 2001, one of the Company’s tenants, eToys, Inc. (“eToys”) defaulted on its lease and, thereafter, declared bankruptcy on March 7, 2001. Prior to the eToys’ bankruptcy filing, the Company drew $15.0 million under two letters of credit which were held as credit support under the terms of the lease and as security for the related tenant improvements and leasing commissions. In May 2001, the United States Bankruptcy Court for the District of Delaware approved a stipulation rejecting the eToys’ lease. The Company recorded a net lease termination fee of $5.4 million representing the $15.0 million of letter of credit proceeds offset by $9.6 million of accounts receivable and other costs and obligations associated with the lease.
In August 2002, EBC I, formerly known as eToys, filed a lawsuit in the Superior Court of the State of Californnia against the Company seeking return of the proceeds from two letters of credit previously drawn down by the Company. The tenant originally caused its lenders to deliver an aggregate of $15 million in letters of credit to secure its obligations under its lease with the Company and also to secure its obligations to repay the Company
KILROY REALTY CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
for certain leasing and tenant improvement costs. eToys defaulted on its lease and other obligations to the Company in January 2001 and subsequently filed for bankruptcy in March 2001. Management strongly disagrees with the points outlined in the suit and is vigorously defending itself against the claim. However, if EBC I were to prevail in this action, it could have a material adverse effect upon the financial condition, results of operations and cash flows of the Company.
Other Significant Lease Termination Fees
In January 2003, the Company recognized a $4.3 million net lease termination fee resulting from the early termination of a lease at an office property in Sorrento Mesa, California, which encompasses approximately 68,000 rentable square feet. Subsequent to the termination of this lease, this property was moved to the Company’s redevelopment portfolio (see Note 4) since the Company is repositioning it for life science use.
21. Segment Disclosure
The Company’s reportable segments consist of the two types of commercial real estate properties for which management internally evaluates operating performance and financial results: Office Properties and Industrial Properties. The Company also has certain corporate level activities including legal administration, accounting, finance, and management information systems which are not considered separate operating segments.
The Company evaluates the performance of its segments based upon net operating income. Net operating income is defined as operating revenues (rental income, tenant reimbursements and other property income) less property and related expenses (property expenses, real estate taxes, and ground leases) and excludes interest income and expense, depreciation and amortization, and corporate general and administrative expenses. The accounting policies of the reportable segments are the same as those described in the Company’s summary of significant accounting policies (see Note 2). There is no intersegment activity.
KILROY REALTY CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
The following tables reconcile the Company’s segment activity to its consolidated results of operations and financial position as of and for the years ended December 31, 2003, 2002 and 2001.
(1)
All operating revenues are comprised of amounts received from third-party tenants.
(2)
In accordance with SFAS 144 “Accounting for the Impairment or Disposal of Long-Lived Assets,” the net income and the net gain on disposition of properties sold subsequent to January 1, 2002 are reflected in the consolidated statement of operations as discontinued operations for all periods presented. The net gain on dispositions of operating properties for the year ended December 31, 2002 relates to the disposition of an office property the Company sold in the fourth quarter of 2001. This additional gain had previously been reserved for financial reporting purposes until certain litigation associated was resolved in the second quarter of 2002.
KILROY REALTY CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(1)
Includes land, buildings and improvements, undeveloped land and construction in progress, current receivables, deferred rents receivable, and deferred leasing costs, all shown on a net basis.
(1)
Total consolidated capital expenditures are equal to the same amounts disclosed for total reportable segments.
KILROY REALTY CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
22. Discontinued Operations
In accordance with SFAS 144, the net income and the net gain on dispositions of operating properties sold subsequent to December 31, 2001 are reflected in the consolidated statement of operations as discontinued operations for all periods presented. For the years ended December 31, 2003, 2002 and 2001, discontinued operations related to the seven office buildings that the Company sold in 2003 (see Note 3). For the years ended December 31, 2002 and 2001, discontinued operations also related to the 12 industrial and five office buildings that the Company sold in 2002 (see Note 3). In connection with the disposition of one of the buildings sold in 2003 and one of the buildings sold in 2002 the Company repaid approximately $8.0 million and $4.1 million, respectively, in principal of a mortgage loan partially secured by these properties. The related interest expense was allocated to discontinued operations. The following table summarizes the income and expense components that comprise discontinued operations:
The following table summarizes the total income from discontinued operations by the Company’s reportable segments:
KILROY REALTY CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
23. Earnings Per Share
Basic earnings per share is computed by dividing net income by the weighted-average number of common shares outstanding for the period. Diluted earnings per share is computed by dividing net income by the sum of the weighted-average number of common shares outstanding for the period plus the assumed exercise of all dilutive securities. The Company does not consider common limited partnership units of the Operating Partnership to be dilutive securities since the exchange of common limited partnership units into common stock is on a one for one basis and would not have any effect on diluted earnings per share. The following table reconciles the numerator and denominator of the basic and diluted per-share computations for net income for the years ended December 31, 2003, 2002 and 2001:
At December 31, 2003, Company employees and directors held no options to purchase shares of the Company’s common stock that were antidilutive to the diluted earnings per share computation.
KILROY REALTY CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
24. Tax Treatment of Distributions
The following table reconciles the dividends declared per common share to the dividends paid per common share during the years ended December 31, 2003, 2002 and 2001 as follows:
The income tax treatment for distributions reportable for the years ended December 31, 2003, 2002, and 2001 as identified in the table above, was as follows:
(1)
2003 Capital Gains are comprised of approximately $0.014 in Qualified 5-Year Gains and approximately $0.027 in Post May 5th Capital Gain Distributions. 2002 and 2001 Capital Gains are comprised entirely of 20% Rate Gains.
25. Quarterly Financial Information (Unaudited)
Summarized quarterly financial data for the years ended December 31, 2003 and 2002 was as follows:
(1)
The summation of the quarterly financial data may not equal the annual number reported on the consolidated statement of operations due to rounding differences.
(2)
See Note 21 for definition of Net Operating income.
KILROY REALTY CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(1)
The summation of the quarterly financial data may not equal the annual number reported on the consolidated statement of operations due to rounding differences.
(2)
See Note 21 for definition of Net Operating income.
The quarterly financial information does not equal the amounts reported on the Company’s quarterly reports on Form 10Q due to the reclassification of the net income and net gains on the dispositions of operating properties sold subsequent to December 31, 2001 to discontinued operations, in accordance with SFAS 144 (see Note 22).
26. Subsequent Events
On January 16, 2004, aggregate distributions of $16.0 million were paid to common stockholders and common unitholders of record on December 31, 2003.
On February 10, 2004, the Company’s Board of Directors declared a regular quarterly cash dividend of $0.495 per common share payable on April 16, 2004 to shareholders of record on March 31, 2004.
On February 10, 2004, the Company’s Board of Directors also declared a dividend of $0.4875 per share on the Company’s Series E Preferred Stock payable on May 14, 2004 to preferred stockholders of record on May 1, 2004.
On February 17, 2004, aggregate distributions of $0.7 million were paid to preferred stockholders of record on February 1, 2004 for the period commencing on and including November 21, 2003 and ending on and including February 14, 2004.
On February 17, 2004, aggregate distributions of $2.6 million were paid to the Series A and Series D Preferred unitholders.
In February 2004, the Company borrowed $81 million under a mortgage loan that is secured by four office properties in a five-building complex and requires interest-only payments based on a variable annual interest rate of LIBOR plus 1.75% through July 2004. Beginning in August 2004 through August 2012, the scheduled maturity date, the loan requires monthly principal and interest payments based on a fixed annual interest rate of 5.57%. The Company used a portion of the proceeds to repay an outstanding mortgage loan with a principal balance of $20.3 million that was scheduled to mature in June of 2004. The remainder of the proceeds was used primarily to repay borrowings under the Credit Facility. The Company has also received a commitment from a financial institution for a $34 million mortgage loan that will be secured by the fifth building in the complex. The loan will be co-terminus with and have similar terms as the new $81 million loan with a final fixed annual interest rate of 4.95%. The closing of this loan is subject to customary conditions and is expected to occur in the first quarter of 2004. The Company intends to use the proceeds to repay borrowings under the Credit Facility.
On March 5, 2004, the Company amended the terms of its Series A Preferred Units to reduce the distribution rate and extend the optional redemption date to September 30, 2009. Commencing March 5, 2004, distributions on the Series A Preferred Units will accrue at a rate of 7.45% per annum.
KILROY REALTY CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
27. Schedule of Rental Property
KILROY REALTY CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
KILROY REALTY CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
KILROY REALTY CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(1)
Represents date of construction or acquisition by the Company, or the Company’s Predecessor, the Kilroy Group.
(2)
These costs represent infrastructure costs incurred in 1989.
(3)
These properties secure a $74.8 million mortgage note.
(4)
These properties secure a $86.8 million mortgage note.
(5)
These properties secure a $43.6 million mortgage note.
(6)
These properties secure a $12.3 million and a $6.3 million mortgage note.
KILROY REALTY CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(7)
These properties secure a $79.6 million mortgage note.
(8)
These properties secure a $20.3 million mortgage note, which was subsequently paid off in February 2004.
(9)
These properties secure a $31.0 million mortgage note.
(10)
These properties secure a $11.0 million mortgage note.
(11)
These properties secure a $25.6 million mortgage note.
(12)
These properties secure a $17.7 million mortgage note.
(13)
These properties secure a $29.0 million mortgage note.
(14)
These properties secure a $4.4 million mortgage note.
(15)
These properties secure a $4.8 million and a $78.4 million mortgage note.
The aggregate gross cost of property included above for federal income tax purposes, approximated $1.6 billion as of December 31, 2003.
The following table reconciles the historical cost of the total investment in real estate, net from January 1, 2001 to December 31, 2003:
The following table reconciles the accumulated depreciation from January 1, 2001 to December 31, 2003:
KILROY REALTY CORPORATION
SCHEDULE II-VALUATION AND QUALIFYING ACCOUNTS
Year ended December 31, 2003, 2002 and 2001
(in thousands)
EXHIBIT INDEX
*
Filed herewith

Management contract or compensatory plan or arrangement.
(1)
Previously filed as an exhibit to the Registration Statement on Amendment No. 3 to Form S-11 (No. 333-15553).
(2)
Previously filed as an exhibit on Form 8-K as filed with the Securities and Exchange Commission on February 11, 1998.
(3)
Previously filed as an exhibit to the Registration Statement on Amendment No. 1 to Form S-3 (No. 333-72229).
(4)
Previously filed an exhibit on Form 8-K as filed with the Securities and Exchange Commission on December 11, 1998.
(5)
Previously filed as an exhibit on Form 10-K for the year ended December 31, 1999.
(6)
Previously filed as an exhibit to the Registration Statement on Form S-3 (No. 333-34638).
(7)
Previously filed an exhibit on Form 8-A as filed with the Securities and Exchange Commission on October 24, 2003.
(8)
Previously filed as an exhibit on Form 8-K/A as filed with the Securities and Exchange Commission on December 19, 1997.
(9)
Previously filed as an exhibit on Form 8-K as filed with the Securities and Exchange Commission on October 8, 1998.
(10)
Previously filed as an exhibit on Form 10-K for the year ended December 31, 2000.
(11)
Previously filed as an exhibit to the Registration Statement on Amendment No. 2 to Form S-11 (No. 333-15553).
(12)
Previously filed as an exhibit to the Registration Statement on Form S-11 (No. 333-15553).
(13)
Previously filed as an exhibit to the Registration Statement on Amendment No. 5 to Form S-11 (No. 333-15553).
(14)
Previously filed as an exhibit to the Registration Statement on Amendment No. 4 to Form S-11 (No. 333-15553).
(15)
Previously filed as an exhibit on Form 8-K as filed with the Securities and Exchange Commission on June 6, 1997.
(16)
Previously filed as an exhibit on Form 8-K as filed with the Securities and Exchange Commission on July 15, 1997.
(17)
Previously filed as an exhibit on Form 8-K as filed with the Securities and Exchange Commission on July 3, 1997.
(18)
Previously filed as an exhibit on Form 10-Q for the quarter ended September 30, 1997.
(19)
Previously filed as an exhibit on Form 8-K as filed with the Securities and Exchange Commission on November 21, 1997.
(20)
Previously filed as an exhibit on Form 8-K as filed with the Securities and Exchange Commission on December 29, 1997.
(21)
Previously filed as an exhibit on Form 10-Q for the quarter ended September 30, 1998.
(22)
Previously filed as an exhibit on Form 10-Q for the quarter ended September 30, 1999.
(23)
Previously filed as an exhibit on Form 10-K for the year ended December 31, 2001.
(24)
Previously filed as an exhibit on Form 10-Q for the quarter ended March 31, 2002.