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.
As of December 31, 2004, the Company’s stabilized portfolio of operating properties was comprised of 84 office buildings (the “Office Properties”) and 49 industrial buildings (the “Industrial Properties,” and together with the Office Properties, the “Properties”), which encompassed an aggregate of approximately 7.7 million and 4.6 million rentable square feet, respectively. As of December 31, 2004, the Office Properties were approximately 94.0% leased to 312 tenants and the Industrial Properties were approximately 95.5% leased to 67 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 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. At December 31, 2004, the Company had two redevelopment properties encompassing an aggregate of approximately 309,600 rentable square feet, each of which was in the lease-up phase. As of December 31, 2004, the Company had two office development properties under construction, which when complete are expected to encompass an aggregate of approximately 103,300 rentable square feet. In addition, as of December 31, 2004, the Company owned approximately 56.8 acres of undeveloped land upon which the Company currently expects to develop an aggregate of approximately 1.2 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 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, 2004, it owned an approximate 87.7% general partnership interest. The remaining 12.3% 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. 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”) 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, 2004:
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, and 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, which were as follows:
·
Increased occupancy in the Company’s stabilized portfolio by more than 4% to 94.6% at December 31, 2004 compared to 90.3% at December 31, 2003. Average occupancy for the Company’s stabilized portfolio for the year ended December 31, 2004 was 92.3% as compared to 91.2% for the year ended December 31, 2003.
·
Achieved a 37.6% total common annual stockholder return (based on the increase in the quoted common price per share plus dividends paid during the year).
·
Executed leases on approximately 1.9 million rentable square feet of office and industrial space in the stabilized portfolio, including both renewals and leases to new tenants.
·
Completed a $98 million acquisition of two office buildings and a development site in the I-15 corridor submarket of San Diego.
·
Added to the Company’s stabilized portfolio one office development building encompassing approximately 208,500 rentable square feet at a total estimated investment of $62.4 million. This property was 100% leased at December 31, 2004.
·
Commenced construction on two office buildings that will encompass an aggregate of approximately 103,300 rentable square feet at total current estimated investment of $23.0 million.
·
Increased stockholder value and continued improvement of the quality of the Company’s portfolio through the reinvestment of approximately $35 million of capital obtained from the sale of non-strategic assets into assets the Company is developing or redeveloping in Southern California.
·
Completed an $86 million public offering of 3,450,000 shares of 7.50% Series F Cumulative Redeemable Preferred Stock.
·
Reduced the annual distribution rate on the Series A Cumulative Preferred units from 8.075% to 7.450% as of March 5, 2004.
·
Renewed the $425 million unsecured revolving credit facility that was scheduled to mature in March 2005. As part of the renewal the interest-rate spread over LIBOR was lowered to a range of 1.0% to 1.7%. In addition the renewal added an expansion option that can increase the amount available under the line by as much as $125 million and extended the maturity for three years with an additional one-year extension option.
·
Completed two secured and two unsecured debt financings that provided the Company with approximately $259 million in net proceeds and extended the weighted-average maturity of the Company’s debt portfolio. The Company used the net proceeds from the new debt financings, which have maturity dates between 2010 and 2014, to repay two mortgage loans and one construction loan that were scheduled to mature in 2004 and the first quarter of 2005.
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 Funds From Operations (“FFO”), as defined by the National Association of Real Estate Investment Trusts (“NAREIT”), 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 through its seasoned management team with 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
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 interests in collateral 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 primarily located in Southern California 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 56.8 acres of undeveloped land which can support future development of approximately 1.2 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 significant working relationships with tenants, municipalities, and landowners 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. 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 utilizes multiple sources of capital including 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, 2004, the Company’s ten largest office tenants represented approximately 28.9% of total annual base rental revenues, defined as annualized monthly contractual rents from existing tenants at December 31, 2004 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 8.0% of total annual base rental revenues. Of this amount, its largest tenant, The Boeing Company, leased an aggregate of approximately 831,300 rentable square feet of office space under seven separate leases, representing approximately 6.2% of the Company’s total annual base rental revenues at December 31, 2004. In April 2004, The Boeing Company renewed one lease for a building located in El Segundo, encompassing approximately 286,200 rentable square feet, which was scheduled to expire in July 2004. Under the terms of the amended lease, the rental rate decreased 25% on a cash and GAAP basis and the lease is now scheduled to expire in July 2007. An additional lease with The Boeing Company encompassing approximately 211,100 rental square feet, is scheduled to expire in December 2007; however, under the terms of the lease, The Boeing Company has the right to terminate this lease effective December 31, 2006. The other five leases are scheduled to 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 That May Influence Future Results of Operations.”
The Company’s ten largest office tenants, based on annualized base rental revenues at December 31, 2004, are: The Boeing Company, AMN Healthcare, DirecTv, Inc., Fish & Richardson, Diversa Corporation, Intuit, Inc., Epson America, Inc., Fair Isaac & Company, Peregrine Systems, Inc. and Newgen Results 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, NBTY Manufacturing,
LLC, United Plastics Group, Inc., Kraft Foods, Inc., Targus, Inc., Extron Electronics, Inc. and Ricoh Electronics. For further discussion on the composition of the Company’s tenant base, see “Item 2:
ITEM 2. PROPERTIES
General
As of December 31, 2004, the Company’s portfolio of stabilized operating properties was comprised of 84 Office Properties and 49 Industrial Properties which encompassed an aggregate of approximately 7.7 million and 4.6 million rentable square feet, respectively. The Properties include one property that the Company developed and stabilized during 2004 encompassing an aggregate of approximately 208,500 rentable square feet. As of December 31, 2004, the Office Properties were approximately 94.0% leased to 312 tenants and the Industrial Properties were 95.5% leased to 67 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 or redeveloped 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. The Company had two office development properties under construction at December 31, 2004, encompassing an aggregate of approximately 103,300 rentable square feet and two office redevelopment properties in lease-up encompassing approximately 309,600 rentable square feet. All of the Company’s redevelopment, development 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, 2004, 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, 2004. 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, 2004.
(2)
Calculated as base rent for the year ended December 31, 2004, 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, 2004.
(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 6,900 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, leases of 37,000 rentable square feet are written on a modified gross basis and leases of 39,000 rentable square feet are written on a triple net basis.
(9)
For this property, the leases are written on a modified gross basis.
(10)
For this property, leases of 243,000 rentable square feet are written on a triple net basis and a lease of 90,000 rentable square feet is written on a gross basis.
(11)
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.
(12)
For this property, leases of 55,000 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.
(13)
This property was renovated into a data center in 2000.
(14)
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.
(15)
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 and 66,000 rentable square feet are written on a modified gross basis.
(16)
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.
(17)
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.
(18)
For this property, leases of 25,000 rentable square feet are written on a full service gross basis and leases of 49,000 rentable square feet are written on a triple net basis.
(19)
For this property, a lease of 15,000 rentable square feet is written on a modified gross basis and a lease of 31,000 rentable square feet is written on a triple net basis.
(20)
For this property, a lease of 102,000 rentable square feet is written on a triple net basis and leases of 18,000 rentable square feet are written on a full service gross basis.
(21)
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, 2004. 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 That 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, 2004, based upon annualized rental revenues at December 31, 2004.
(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, 286,151, 113,242 and 100,978 net rentable square feet expire October 2005, July 2007, March 2009 and January 2006, 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)
Annual base rental revenues for DirecTV, Inc. reflects the straight-line rent to be recorded under the terms of a new lease signed in December 2004.
(5)
The Diversa Corporation leases of 76,246 and 60,662 net rentable square feet expire in November 2015 and March 2017, respectively.
(6)
The Intuit, Inc. leases of 49,055, 212,214 and 2,957 net rentable square feet expire in July 2014, April 2007 and December 2005, respectively.
(7)
As of December 31, 2004, the Mattel, Inc. leases of 192,053 and 7,500 net rentable square feet were scheduled to expire in October 2005 and January 2005, respectively. In January 2005, the expiration date for the lease of 192,053 net rentable square feet was extended to October 2010.
(8)
The United Plastics Group, Inc. leases of 144,000 and 44,000 rentable square feet expire in December 2006 and January 2005, respectively.
(9)
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, 2004, 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, 52.5%; manufacturing, 24.7%; finance, insurance and real estate, 14.8%; transportation, warehousing and public utilities, 2.9%; wholesale and retail trade, 2.5%; government, 1.3%; construction, 1.1%; 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, 2004:
Altour International, Inc.
Dowling & Yahnke, LLP
Nanogen, Inc.
Anacomp
Encore Media Corporation
NBTY Manufacturing, LLC
Aon Service Corporation
Epson America, Inc.
Northwest Airlines, Inc.
Arinc, Inc.
Equant Operations, Inc.
Southland Industries, Inc.
Bizrate.com
Graphic Resources Corporation
Turf Star, Inc.
Bodies in Motion
Harris Corporation
West Coast Dialysis, Inc.
Capital Products, Inc.
i2 Technologies US, Inc.
Western Federal Credit Union
Comstream Corporation
KB Home Coastal, Inc.
Cox PCS Assets, LLC
Morgan Sheet Metal, Inc.
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 2005, 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, 2004.
(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 December 31, 2004.
(4)
Excludes space leased under month-to-month leases and vacant space at December 31, 2004.
Secured Debt
At December 31, 2004, the Operating Partnership had 14 outstanding mortgage loans, representing aggregate indebtedness of approximately $490 million, which were secured by certain of the Properties (the “Secured Obligations”). See Note 10 to the Company’s consolidated financial statements included with this report. Management believes that, as of December 31, 2004, 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
In January 2005, the Company settled its previously disclosed litigation with EBC I, formerly known as eToys, Inc.
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, 2004.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
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 2004 and 2003 as reported on the NYSE. On December 31, 2004, there were approximately 214 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 under “Item 7: Management’s Discussion of Financial Condition and Results of Operations-Non-GAAP Supplemental Financial Measures: Funds From Operations.”), 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 2004, the Company issued 165,171 shares of common stock in redemption of 165,171 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 21 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, minority interest in earnings of the operating partnership, depreciation and amortization and net gain (loss) from dispositions of operating properties; in 2001 and 2000, 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, 2004, 2003, 2002, 2001 and 2000.
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 That 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 87.7% and 87.2% general partnership interest in the Operating Partnership as of December 31, 2004 and 2003, respectively.
Critical Accounting Policies
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 included elsewhere in this report.
Property Acquisitions-In accordance with Statement of Financial Accounting Standard No. 141, Business Combinations (“SFAS 141”), the Company allocates the purchase price of acquired properties to land, buildings and improvements and identified tangible and intangible assets and liabilities associated with in-place leases (including tenant improvements, unamortized leasing commissions, value of above and below-market leases, acquired in-place lease values, and tenant relationships, if any) based on their respective estimated fair values. The fair value of the tangible assets of the acquired properties considers the value of the properties as if vacant as of the acquisition date. Management must make significant assumptions in determining the value of assets and liabilities acquired. Using different assumptions in the allocation of the purchase cost of the acquired properties would affect the timing of recognition of the related revenue and expenses.
Amounts allocated to land are derived from comparable sales of land within the same region. Amounts allocated to buildings and improvements, tenant improvements and unamortized leasing commissions are based on current market replacement costs and other market rate information.
The amount allocated to acquired in-place leases is determined based on management’s assessment of current market conditions and the estimated lease-up periods for the respective spaces. The amount allocated to acquired in-place leases is included in deferred leasing costs and other related intangible assets in the balance sheet and amortized as an increase to amortization expense over the remaining non-cancelable term of the respective leases.
The value allocable to the above or below market component of an acquired in-place lease is determined based upon the present value (using a discount rate which reflects the risks associated with the acquired leases) of the difference between (i) the contractual rents to be paid pursuant to the lease over its remaining term, and (ii) management’s estimate of the rents that would be paid using fair market rental rates over the remaining term of the lease. The amounts allocated to above or below market leases are included in other assets or other liabilities in the balance sheet and are amortized on a straight-line basis as an increase or reduction of rental income over the remaining non-cancelable term of the respective leases.
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 current tenant receivables and deferred rent receivables. 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.
Deferred rent receivables represent 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 deferred rent receivables is based primarily on historical loss experience. Management evaluates the allowance for deferred rent receivables using a specific identification methodology for the Company’s significant tenants assessing the tenants’ financial condition and their ability to meet their 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 and the
year ended December 31, 2004, the Company’s accounts receivable aging and collection of outstanding tenant receivables improved, and as a result, the Company decreased its provision for bad debt. No assurance can be given that this trend will continue in 2005. For the years ended December 31, 2004, 2003 and 2002 the Company recorded a provision for bad debts and deferred rent of approximately 0.4%, 0.8%, and 3.4% 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”). Peregrine, the Company’s second largest tenant at December 31, 2002, had filed for bankruptcy in September 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.
Evaluation of asset impairment. Operating properties are carried at the lower of historical cost less accumulated depreciation or estimated fair value. Properties held for sale are reported at the lower of the carrying value or the fair value less estimated cost to sell. The Company evaluates an operating 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 and the estimation of a property’s fair value are inherently uncertain and rely 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’s estimate of future cash flows are subject to revision if management’s assessment of market conditions or intent to hold the property changes.
In the first quarter 2004, the Company reclassified one of its office properties as held for sale and recorded a $0.7 million impairment loss to reflect the property on the balance sheet at its estimated fair market value less selling costs. The Company subsequently sold the property in May 2004. The Company did not record any impairment losses during the years ended December 31, 2003 or 2002. 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.
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 and economic and market conditions change. If management determines that the estimated remaining life of the respective lease has changed, the Company adjusts the amortization period and, accordingly, the depreciation expense recorded each period may fluctuate. If the Company experiences increased levels of amortization or depreciation expense due to decreases in the estimated useful lives of leasing costs, the Company’s financial position, and results of operations may be adversely affected.
Factors That May Influence Future Results of Operations
Rental income. The amount of net rental income generated by the Company’s Properties depends principally on its ability to maintain the occupancy rates of currently leased space and to lease currently available space, newly developed or redeveloped properties and space available from unscheduled lease terminations. The amount of rental income generated by the Company also depends on its ability to maintain or increase rental rates in its submarkets. Negative trends in one or more of these factors could adversely affect the Company’s rental income in future periods.
Rental rates. For leases that commenced during the year ended December 31, 2004, the change in rental rate was a decrease of 6.9% on a GAAP basis, and a decrease of 9.2% on a cash basis. The change in rental rate on a cash basis is calculated as the change between the initial stated rent for a new or renewed lease and the ending stated rent for the expiring lease for the same space, whereas the change in rental rate on a GAAP basis compares the average rents over the term of the lease for each lease. Both calculations exclude leases for which the space was vacant longer than one year. The decrease in rental rates on a GAAP basis was primarily due to two leases the Company renewed during 2004. The first was a renewal with The Boeing Company which was signed during the second quarter of 2004 with a decrease in rental rate of 25% on both a GAAP and cash basis. See additional discussion of The Boeing Company under “-Recent information regarding significant tenants.” The second lease was with DirecTV and was signed during the fourth quarter of 2004 with a decrease in rental rate of 15% on a GAAP basis. Although the renewals with The Boeing Company and DirecTV resulted in a reduction in rental rates, both leases were extended by three years. Excluding these two leases, the change in rental rates on a GAAP basis would have been an increase of 7.3% for the year ended December 31, 2004. The change in rental rates on a cash basis would have been a decrease of 4.0%. Management believes that the average rental rates for its Properties are approximately at the current average quoted market rates, although individual Properties within any particular submarket presently may be leased above or below the current quoted market rates within that submarket. The Company cannot give any assurance that leases will be renewed or that available space will be re-leased at rental rates equal to or above the current quoted market rates.
Scheduled lease expirations. In addition to the 667,800 square feet of currently available space in the Company’s stabilized portfolio, leases representing approximately 11.4% and 10.3% of the leased square footage of the Company’s stabilized portfolio are scheduled to expire during 2005 and 2006, respectively. The leases scheduled to expire in 2005 and the leases scheduled to expire in 2006 represent approximately 1.3 million square feet of office space, or 13.2% of the Company’s total annualized base rent, and 1.2 million square feet of industrial space, or 4.8% of the Company’s total annualized base rent, respectively. The Company has either renewed or re-leased approximately 626,400, or 48%, of the net rentable square feet scheduled to expire in 2005 as of the date of this report. Management believes that the average rental rates for leases scheduled to expire during 2005 are approximately at the current average quoted market rates. The Company’s ability to release available space depends upon the market conditions in the specific submarkets in which the Properties are located.
Submarket Information
Los Angeles County. There have been modest signs of improvement in market conditions in the overall Los Angeles County region during the last year and a half based on third-party 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. Most notable have been the improvements seen in the West Los Angeles and Long Beach submarkets. Conversely, the El Segundo submarket remains the Company’s most significant leasing challenge as management continues to see only mild signs of improvement in this region. At December 31, 2004, the Company’s Los Angeles stabilized office portfolio was 91% occupied with approximately 257,100 vacant rentable square feet as compared to 83% occupied with approximately 563,200 vacant rentable square feet at December 31, 2003. As of December 31, 2004, leases representing an aggregate of approximately 134,300 and 367,500 rentable square feet are scheduled to expire during 2005 and 2006, respectively, in this region.
The Los Angeles stabilized portfolio includes two office buildings that were developed by the Company, encompassing approximately 284,300 rentable square feet. These buildings were previously in the lease-up phase and were added to the stabilized portfolio during 2003, since one year had passed following substantial completion. One of the buildings is located in West Los Angeles. This building encompasses approximately 151,000 rentable square feet and was 69% occupied as of December 31, 2004. As of December 31, 2004, the Company had executed leases for 95% of the rentable square feet at this building compared to 61% as of December 31, 2003.
The other stabilized office building is located in a two-building complex in the El Segundo submarket. This building encompasses approximately 133,300 rentable square feet and was approximately 37% occupied as of December 31, 2004. The Company had executed leases or letters of intent for 56% of the rentable square feet at this building as of December 31, 2004, compared to 31% as of December 31, 2003. Within the same complex in El Segundo, the Company had one office redevelopment project encompassing approximately 241,600 rentable square feet. This project was in the lease-up phase and was 19% leased as of December 31, 2004.
San Diego County. San Diego County remains the strongest market in Southern California real estate based on reports of positive absorption, increased rental rates and growing tenant demand. As of December 31, 2004, the Company’s San Diego stabilized office portfolio was 97% occupied with approximately 102,300 vacant rentable square feet. This includes one office development project, encompassing approximately 208,500 rentable square feet, that was previously in the lease-up phase and added to the stabilized portfolio during the third quarter of 2004. As of December 31, 2004, this building was 100% occupied. In January 2004, the Company completed the redevelopment of one office building encompassing approximately 68,000 rentable square feet. The Company also commenced construction on the third phase of a development project in July 2004, which will encompass an aggregate of approximately 103,000 rentable square feet. These development and redevelopment projects were not leased as of December 31, 2004. Further, leases representing an aggregate of approximately 274,800 and 210,200 rentable square feet were scheduled to expire during 2005 and 2006, respectively, in this region. Of the 274,800 rentable square feet scheduled to expire in 2005, approximately 72,600, or 26%, has either been renewed or re-leased as of the date of this report. See additional information regarding the Company’s development projects under the caption “-Development and redevelopment programs” below.
Orange County. As of December 31, 2004, the Company’s Orange County properties were 99% occupied with approximately 35,200 vacant rentable square feet. As of December 31, 2004, leases representing an aggregate of approximately 620,400 and 399,400 rentable square feet were scheduled to expire during 2005 and 2006, respectively, in this region. Of the 620,400 rentable square feet scheduled to expire in 2005, approximately 383,300, or 55% has either been renewed or re-leased as of the date of this report.
Sublease space. Of the Company’s leased space at December 31, 2004, approximately 435,200 rentable square feet, or 3.5%, of the square footage in the Company’s stabilized portfolio was available for sublease, as compared to 760,200 rentable square feet, or 6.2% at December 31, 2003. Of the 3.5% of available sublease space in the Company’s stabilized portfolio as of December 31, 2004, approximately 3.0% was vacant space and the remaining 0.5% was occupied. Of the approximately 435,200 rentable square feet available for sublease at December 31, 2004, approximately 48,500 and 2,500 rentable square feet represents leases scheduled to expire during 2005 and 2006, respectively.
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, 2004, the Company’s largest tenant, The Boeing Company, leased an aggregate of approximately 831,300 rentable square feet of office space under seven separate leases, representing approximately 6.2% of the Company’s total annual base rental revenues. In April 2004, the Boeing Company renewed one lease for a building located in El Segundo, encompassing approximately 286,200 rentable square feet, which was scheduled to expire in July 2004. Under the terms of the amended lease, the rental rate decreased 25% on a cash and GAAP basis and the lease is now scheduled to expire in July 2007. One lease encompassing approximately 211,100 rental square feet is scheduled to expire in December 2007; however, under the terms of the lease, The Boeing Company has the right to terminate this lease on December 31, 2006. The other five leases are scheduled to expire at various dates between August 2005 and March 2009. See discussion regarding the Company’s third largest office tenant, Direct TV, Inc., under “-Rental rates.”
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. 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. However, as San Diego County remains the strongest market in Southern California, the Company commenced construction in July 2004 on the third phase of its Innovation Corporate Center, which is located in the San Diego County I-15 Corridor submarket. The first two phases of the development project are 100% leased and encompass an aggregate of approximately 289,000 rentable square feet. The third phase will include two office buildings and will encompass an aggregate of approximately 103,000 rentable square feet and has a total estimated investment of approximately $23.0 million. The Company does not have any lease commitments for these buildings as of the date of this report. However, tenant demand in this submarket is currently strong, and management believes the prospects of leasing the project are also strong.
The Company also owns approximately 56.8 acres of undeveloped land upon which the Company currently expects to develop an aggregate of approximately 1.2 million rentable square feet of office space within the next three to five years. All of the Company’s undeveloped land is located in San Diego County. See additional information regarding the Company’s development portfolio under the caption “Development and Redevelopment” in this report.
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 redevelopment portfolio includes one life science conversion project in North San Diego County and another project in which the Company performed extensive interior refurbishments at an office building in El Segundo that had been occupied by a single tenant for approximately 30 years. These projects, which encompass approximately 309,600 rentable square feet, were completed in 2004 and are expected to be added to the stabilized portfolio in the first and third quarters of 2005. As of December 31, 2004, the property in El Segundo was 19% leased and the property in North San Diego County had not been leased. 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 be unable to lease committed development or redevelopment properties at expected rental rates or within projected timeframes or complete projects on schedule or within budgeted amounts, which could adversely affect the Company’s financial condition, results of operations and cash flows.
Other Factors. The Company’s operating results are and may continue to be affected by uncertainties and problems associated with the deregulation of the utility industry in California since 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, approximately 11% during 2003 and approximately 12% during 2004. As of the date of this report, the Company had not experienced any material negative effects arising from either of these issues.
Incentive Compensation. The Company has long-term incentive compensation programs that provide for cash and stock compensation to be earned by the Company’s senior officers if the Company attains certain performance measures that are based on annualized 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. Future increases or decreases in the price per share of the Company’s common stock and the resultant cumulative annualized shareholder return calculations will cause an increase or decrease to general and administrative expenses and a corresponding decrease or increase to net income available to common shareholders. Under the absolute component of a special long-term plan for the Company’s executive officers, every $1 change in the Company’s stock price equates to an approximate $1.7 million change in the total amount payable at the end of the three-year term of the plan (see Note 15 to the Company’s consolidated financial statements for further discussion about the program). Management cannot predict the amounts that will be ultimately recorded in future periods related to these programs since they are significantly influenced by the Company’s stock price and market conditions.
Results of Operations
As of December 31, 2004, the Company’s stabilized portfolio was comprised of 84 office properties (the “Office Properties”) encompassing an aggregate of approximately 7.7 million rentable square feet, and 49 industrial properties (the “Industrial Properties,” and together with the Office Properties, the “Properties”), encompassing an aggregate of approximately 4.6 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, 2004, the Office and Industrial Properties represented approximately 84% and 16%, respectively, of the Company’s annualized base rent. For the year ended December 31, 2004, average occupancy in the Company’s stabilized portfolio was 92% compared to 91% for the year ended December 31, 2003. As of December 31, 2004, the Company had approximately 667,810 square feet of vacant space in its stabilized portfolio compared to 1,177,458 square feet as of December 31, 2003.
The following table reconciles the changes in the rentable square feet in the Company’s stabilized portfolio of operating properties from December 31, 2003 to December 31, 2004. Rentable square footage in the Company’s portfolio of stabilized properties increased by an aggregate of approximately 0.1 million rentable square feet, or 0.7%, to 12.3 million rentable square feet at December 31, 2004, as a result of the activity noted below.
(1)
In accordance with Financial Accounting Standards No. 144 “Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFAS 144”) the operating results and gains or (losses) on property sales of real estate assets sold are included in discontinued operations in the consolidated statement of operations.
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 20 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, 2004 Compared to Year Ended December 31, 2003
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, 2004 and 2003.
Rental Operations
Management evaluates the operations of its portfolio based on operating property type. The following tables compare the net operating income for the Office Properties and for the Industrial Properties for the year ended December 31, 2004 and 2003.
Office Properties
(1)
Office properties owned and stabilized at January 1, 2003 and still owned and stabilized at December 31, 2004.
Total revenues from Office Properties decreased $1.5 million, or 0.8%, to $184.7 million for the year ended December 31, 2004 compared to $186.2 million for the year ended December 31, 2003. Rental income from Office Properties increased $19.7 million, or 13.5%, to $165.7 million for the year ended December 31, 2004 compared to $146.0 million for the year ended December 31, 2003. Rental income generated by the Core Office Portfolio increased $9.7 million, or 7.2%, for the year ended December 31, 2004 compared to the year ended December 31, 2003. This increase is primarily due to an increase in occupancy in this portfolio. Average occupancy in the Core Office Portfolio increased 3.9% to 93.6% for the year ended December 31, 2004 compared to 89.7% for the same period in 2003. The remaining $10.0 million increase for the Office Properties was attributable to a $10.1 million increase in rental income generated by the office properties developed by the Company in 2003 and 2004 (the “Office Development Properties”) which was offset by a decrease of $0.1 million attributable to the office properties that were taken out of service and moved from the Company’s stabilized portfolio to the redevelopment portfolio during the first quarter of 2003 and the second quarter of 2004 (the “Office Redevelopment Properties”).
Tenant reimbursements from Office Properties increased $1.5 million, or 9.1%, to $17.9 million for the year ended December 31, 2004 compared to $16.4 million for the year ended December 31, 2003. Tenant reimbursements generated by the Core Office Portfolio increased $1.1 million, or 7.0%, for the year ended December 31, 2004 compared to the year ended December 31, 2003. This increase is primarily attributable to the increase in occupancy in this Portfolio, as noted above. The remaining increase in tenant reimbursements is attributable to an increase of $0.6 million in the Office Development Properties partially offset by a decrease of $0.2 million in the Office Redevelopment Properties. Other property income from Office Properties decreased approximately $22.7 million to $1.2 million for the year ended December 31, 2004 compared to $23.9 million for the year ended December 31, 2003. 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 an initial payment of $18.3 million from Peregrine in 2003 and $750,000 in 2004. The Company is scheduled to receive three additional payments of approximately $750,000 each to be paid annually over the next three years. The future payments
were recorded at their net present value which was approximately $2.6 million as of the date of the settlement. 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. Other property income for the year ended December 31, 2003 also included a $4.3 million lease termination fee resulting from the early termination of leases at a building in San Diego, California. Other property income for the year ended December 31, 2004 included $1.9 million of other income related to a lease termination in 2001. The $1.9 million had previously been reserved for financial reporting purposes until certain contingencies associated with the lease termination had been resolved. This income was partially offset by a $1.8 million charge related to the settlement of outstanding litigation. The remaining balance in other property income for the year ended December 31, 2004 is mainly comprised of lease termination fees.
Total expenses from Office Properties increased $3.5 million, or 7.8%, to $48.1 million for the year ended December 31, 2004 compared to $44.6 million for the year ended December 31, 2003. Property expenses from Office Properties increased $2.8 million, or 9.4%, to $32.2 million for the year ended December 31, 2004 compared to $29.4 million for the year ended December 31, 2003. An increase of $0.8 million, or 2.9%, was generated by the Core Office Portfolio. This increase was primarily attributable to an increase in property management expenses, utilities and janitorial and other contract services due to the increase in occupancy. The remaining $2.0 million increase in property expenses is attributable to the Office Development Properties due to an increase in variable operating expenses related to the increase in occupancy in this portfolio. Real estate taxes increased $1.1 million, or 8.7%, to $13.7 million for the year ended December 31, 2004 as compared to $12.6 million for the same period in 2003. Real estate taxes for the Core Office Portfolio decreased $0.1 million, or 0.7%, to $11.6 million for the year ended December 31, 2004 as compared to $11.7 million for the same period in 2003. The remaining increase of $1.2 million in property taxes was attributable to a $1.0 million increase in the Office Development Properties and a $0.2 million increase in the Office Redevelopment Properties. The provision for bad debts decreased $0.5 million, or 36.2%, for the year ended December 31, 2004 compared to the year ended December 31, 2003. The decrease was primarily due to a change in the provision related to the Company’s leases with Peregrine and a general improvement in the Company’s accounts receivable aging. The Company evaluates its reserve levels on a quarterly basis. Ground lease expense increased $0.1 million, or 8.1%, for the year ended December 31, 2004 compared to the same period in 2003.
Net Operating Income from Office Properties decreased $5.0 million, or 3.5%, to $136.6 million for the year ended December 31, 2004 compared to $141.6 million for the year ended December 31, 2003. Of this decrease, $7.3 million was attributable to the Core Office Portfolio and $5.4 million was attributable to the Office Redevelopment Properties, which was partially offset by an increase of $7.7 million attributable to the Office Development Properties. The overall decrease in Net Operating Income is primarily due to the significant lease termination fees received during 2003 related to the Peregrine settlement and another early lease termination.
Industrial Properties
(1)
The Total Industrial Portfolio is equivalent to the Company’s Core Industrial Portfolio at December 31, 2004, which represents properties owned and stabilized at January 1, 2003 and still owned and stabilized at December 31, 2004.
Total revenues from Industrial Properties remained consistent at $36.7 million for the year ended December 31, 2004 as compared to the same period in 2003. Rental income from Industrial Properties decreased $0.6 million, or 1.7%, to $32.3 million for the year ended December 31, 2004 compared to $32.9 million for the year ended December 31, 2003. This decrease was primarily due to a decline in occupancy in the Industrial Portfolio. Average occupancy in the Industrial Portfolio decreased 1.8% to 94.4% for the year ended December 31, 2004 compared to 96.2% for the year ended December 31, 2003.
Tenant reimbursements from Industrial Properties remained consistent at approximately $3.6 million during the year ended December 31, 2004 compared to the year ended December 31, 2003. Other property income from Industrial Properties increased $0.6 million, or 373.2%, to $0.7 million for the year ended December 31, 2004 compared to $0.1 million for the year ended December 31, 2003. This increase is primarily attributable to a $0.5 million lease termination fee the Company recorded in 2004 resulting from an early lease termination at a building in El Segundo.
Total expenses from Industrial Properties increased $0.5 million, or 8.6%, to $6.0 million for the year ended December 31, 2004 compared to $5.5 million for the year ended December 31, 2003. Property expenses from Industrial Properties increased by $0.4 million, or 16.9%, to $2.9 million for the year ended December 31, 2004 compared to $2.5 million for the year ended December 31, 2003. This increase was primarily attributable to an increase in repairs and maintenance costs for the year ended December 31, 2004 compared to the same period in 2003. Real estate taxes for the Industrial Properties increased $0.3 million, or 9.1%, for the year ended December 31, 2004 compared to the year ended December 31, 2003. This increase was primarily due to refunds received during the year ended December 31, 2003 for real estate taxes that were successfully appealed by the Company. The provision for bad debts decreased $0.2 million, or 71.2%, for the year ended December 31, 2004 compared to the year ended December 31, 2003. During the year ended December 31, 2004 the Company’s reserve requirement decreased due to the collection of previously reserved receivables. The Company evaluates its reserve levels on a quarterly basis.
Net Operating Income from Industrial Properties decreased $0.5 million, or 1.5%, to $30.6 million for the year ended December 31, 2004 compared to $31.1 million for the year ended December 31, 2003.
Non-Property Related Income and Expenses
Interest and other income increased $0.3 million, or 165.8%, to $0.5 million for the year ended December 31, 2004 compared to $0.2 million for the year ended December 31, 2003. This increase was primarily due to a $0.1 million net realized gain from the sale of stock that the Company received in satisfaction of a creditor’s claim under a lease that was terminated early (see Note 19 to the Company’s consolidated financial statements). Additionally, during the year ended December 31, 2004, the Company recorded $0.1 million in non-recurring interest earned in connection with the reimbursement of prior year supplemental property taxes.
General and administrative expenses increased $13.9 million, or 69.3%, to $34.0 million for the year ended December 31, 2004 compared to $20.1 million for the year ended December 31, 2003. The increase is primarily due to a $13.3 million increase in accrued incentive compensation and was driven by a special long-term incentive plan for the Company’s executive officers for which the amount payable under the plan is based on the Company’s absolute and relative shareholder returns (see Note 15 to the Company’s consolidated financial statements for further discussion about the program). Compensation expense under this program is accounted for using variable plan accounting. The Company estimates the amount to be paid based on the Company’s quoted closing stock price at the end of each period, and records compensation expense equal to that portion of the total compensation applicable to the portion of the performance period that has elapsed through the end of the period. The closing price per share for the Company’s common stock as of December 31, 2004 was $42.75 as compared to $32.75 as of December 31, 2003. The amounts recorded in future periods related to this plan will increase or decrease as the Company’s quoted price per share of the Company’s common stock at the end of each period increases or decreases.
Net interest expense increased $4.2 million, or 12.8%, to $37.6 million for the year ended December 31, 2004 compared to $33.4 million for the year ended December 31, 2003. Gross interest and loan fee expense, before the effect of capitalized interest and loan fees, increased $1.0 million, or 2.2% to $46.2 million for the year ended December 31, 2004 from $45.2 million for the year ended December 31, 2003. Total capitalized interest and loan fees decreased $3.2 million, or 27.1% to $8.6 million for the year ended December 31, 2004 from $11.8 million for the year ended December 31, 2003, primarily due to lower average balances eligible for capitalization during the year ended December 31, 2004 as compared to December 31, 2003.
Depreciation and amortization increased $3.2 million, or 5.8%, to $58.4 million for the year ended December 31, 2004 compared to $55.2 million for the year ended December 31, 2003. An increase of $3.4 million was attributable to the Office Development Properties, and an increase of $0.6 million was attributable to the Core Office Portfolio which was partially offset by a decrease of $0.8 million related to the Office Redevelopment Properties taken out of service in 2003.
Income from Continuing Operations
Income from continuing operations before minority interests decreased $26.5 million, or 41.3%, to $37.7 million for the year ended December 31, 2004 compared to $64.2 million for the year ended December 31, 2003. The decrease was primarily due to the decrease in Net Operating Income from the Office Properties due to the 2003 Peregrine settlement and due to the increase in general and administrative expenses.
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, 2004.
Total revenues from Office Properties increased $24.2 million, or 15.0%, to $186.2 million for the year ended December 31, 2003 compared to $162.0 million for the year ended December 31, 2002. Rental income from Office Properties increased $4.1 million, or 2.9%, to $146.0 million for the year ended December 31, 2003 compared to $141.9 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 $2.6 million, or 2.0% related to the Core Office Portfolio, and a decrease of $4.2 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 6.5%, to $16.4 million for the year ended December 31, 2003 compared to $17.5 million for the year ended December 31, 2002. A decrease of $1.4 million attributable to the Office Redevelopment Properties was partially offset by an increase of $0.3 million attributable to the Office Development Properties. Tenant reimbursements generated by the Core Office Portfolio remained consistent at $14.8 million for the year ended December 31, 2003 compared to the same period in 2002. Other property income from Office Properties increased $21.3 million, or 823.3%, 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 was 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. 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 decreased $0.5 million, or 1.0%, to $44.6 million for the year ended December 31, 2003 compared to $45.1 million for the year ended December 31, 2002. Property expenses from Office Properties increased $3.3 million, or 12.8%, to $29.4 million for the year ended December 31, 2003 compared to $26.1 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 $12.6 million for the year ended December 31, 2003 as compared to $11.9 million for the year ended December 31, 2002. Real estate taxes for the Core Office Portfolio increased $0.1 million, or 0.6%, 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 77.3%, 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. The Company evaluates its reserve for unbilled deferred rent and tenant receivables 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 from Office Properties increased $24.7 million, or 21.1%, to $141.6 million for the year ended December 31, 2003 compared to $116.9 million for the year ended December 31, 2002. An increase of $16.5 million was attributable to the Core Office Portfolio which was primarily due to the Peregrine lease termination fee. The remaining increase of $8.2 million was primarily attributable to the Office Development Properties.
Industrial Properties
(1)
Stabilized industrial properties owned at January 1, 2002 and still owned at December 31, 2004.
Total revenues from Industrial Properties decreased $0.8 million, or 2.2%, to $36.7 million for the year ended December 31, 2003 compared to $37.5 million for the year ended December 31, 2002. Rental income from Industrial Properties decreased $0.9 million, or 2.5%, to $32.9 million for the year ended December 31, 2003 compared to $33.8 million for the year ended December 31, 2002. Rental income generated by the Core Industrial Portfolio decreased $1.2 million, or 3.6%, 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 $0.3 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 lease termination fees and tenant late charges.
Total expenses from Industrial Properties decreased $1.2 million, or 17.7%, to $5.5 million for the year ended December 31, 2003 compared to $6.7 million for the year ended December 31, 2002. Property expenses from Industrial Properties decreased $0.4 million, or 12.6%, 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 3.4%, 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 73.2%, 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, from Industrial Properties increased $0.4 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 $7.2 million, or 55.8%, to $20.1 million for the year ended December 31, 2003 compared to $12.9 million for the year ended December 31, 2002. This increase was primarily due to a $7.1 million increase in accrued incentive compensation and was driven by a special long-term incentive plan for the Company’s executive officers for which the amount payable under the plan is based on the Company’s absolute and relative shareholder returns. (See note 15 to the Company’s consolidated financial statements for further discussion about the program.) Compensation expense under this program is accounted for using variable plan accounting. The Company estimates the amount to be paid based on the Company’s quoted closing stock price at the end of each period, and records compensation expense equal to that portion of the total compensation applicable to the portion of the performance period that has elapsed through the end of the period. The closing price per share for the Company’s common stock as of December 31, 2003 was $32.75 as compared to the initial stock price of $21.19 at plan inception. The amounts recorded in future periods related to this plan will increase or decrease as the Company’s quoted price per share of the Company’s common stock at the end of the period increases or decreases.
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 $2.7 million, or 4.6%, to $55.2 million for the year ended December 31, 2003 compared to $57.9 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 52.8%, to $64.2 million for the year ended December 31, 2003 compared to $42.0 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 $24.7 million.
Building and Lease Information
The following tables set forth certain information regarding the Company’s Office and Industrial Properties at December 31, 2004:
Occupancy by Segment Type
Leasing Activity by Segment Type
For the year ended December 31, 2004
(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. Excludes leases for which the space was vacant longer than one year.
(3)
Calculated as the change between stated rents for new/renewed leases and the expiring stated rents for the same space. Excludes leases for which the space was vacant longer than one year. The change in cash rents for two of the leases was calculated using the leases’ stabilized stated rent. The starting rents for these two leases were discounted for the first six months.
(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, 2004 and 2003, the Company’s total debt as a percentage of total market capitalization was 33.5% and 38.5%, respectively. As of December 31, 2004 and 2003 the Company’s total debt plus preferred equity as a percentage of total market capitalization was 41.9% and 46.6%, respectively.
As of December 31, 2004, the Company had borrowings of $167 million outstanding under its unsecured revolving line of credit (the “Credit Facility”) and availability of $258 million. The Credit Facility bears interest at an annual rate between LIBOR plus 1.00% and LIBOR plus 1.70% (3.50% at December 31, 2004), depending upon the Company’s leverage ratio at the time of borrowing, and matures in October 2007 with the option to extend the maturity for one year. The fee for unused funds ranges from an annual rate of 0.20% to 0.30% depending on the Company’s leverage ratio. The Company expects to use the Credit Facility to finance development and redevelopment expenditures, to fund potential acquisitions and for other general corporate uses.
The Company also has the ability to issue up to an additional $187 million of equity securities under a currently effective shelf registration statement.
Factors That May Influence Future Sources of Capital and Liquidity
The Company’s Credit Facility, unsecured senior notes, and certain other secured debt agreements contain covenants and restrictions requiring the Company to meet certain financial ratios and reporting requirements. Some of the more restrictive covenants include a maximum total debt to total assets ratio, a maximum total secured debt to total assets ratio, 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 debt covenants at December 31, 2004.
The composition of the Company’s aggregate debt balances at December 31, 2004 and 2003 were as follows:
(1)
At December 31, 2004 and 2003, the Company had an interest-rate swap agreement, which expired in January 2005, to fix LIBOR on $50 million of its variable rate debt at 4.46%.
(2)
At December 31, 2004 and 2003, 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, 2004 and 2003, the Company had two 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, the Company had interest-rate cap agreements to cap LIBOR on $100 million of its variable rate debt at 4.25%. These agreements were terminated in June 2004.
(5)
Excluding the $50 million interest-rate swap agreement that expired in January 2005, the Company’s fixed-rate debt as a percentage of total debt was 84.2% at December 31, 2004.
The percentage of fixed rate debt to total debt at December 31, 2003 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% of its total outstanding debt at December 31, 2003. The Company did not have any outstanding interest-rate cap agreements as of December 31, 2004.
At December 31, 2004, 28.3% of the Company’s total debt, before the effect of hedging instruments, required interest payments based on LIBOR rates. During 2004, one-month LIBOR increased from 1.12% at January 2, 2004 to 2.40% at December 31, 2004. Although the interest payments on 90.4% of the Company’s debt are either fixed, or hedged through the employment of interest-rate swap agreements at December 31, 2004, the remaining 9.6% of the Company’s debt is exposed to fluctuations of the one-month LIBOR rate. In addition, one of the Company’s interest rate swap agreements expired in January 2005. This agreement had a $50 million notional amount and after its expiration, the Company’s fixed rate debt as a percentage of total debt would have been 84.2% at December 31, 2004. The Company cannot provide assurance that it will be able to replace its interest-rate swap 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, 2004 and 2003:
(1)
The interest-rate cap agreements were terminated in June 2004.
Following is the Company’s total market capitalization as of December 31, 2004:
(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 $42.75 at December 31, 2004.
Contractual Obligations
The following table provides information with respect to the maturities and scheduled principal repayments of the Company’s secured debt, unsecured senior notes and Credit Facility and scheduled interest payments of the Company’s fixed-rate debt and interest-rate swap agreements at December 31, 2004 and provides information about the minimum commitments due in connection with the Company’s ground lease obligations and capital commitments at December 31, 2004. The table does not reflect available maturity extension options.
(1)
The Credit Facility has a one-year extension option.
(2)
As of December 31, 2004, 90.4% of the Company’s debt was contractually fixed or constructively fixed through 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 9.6% 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 1.00% to 1.70%. In addition, one of the Company’s interest rate swap agreements expired in January 2005. This agreement had a $50 million notional amount and after its expiration, the Company’s fixed-rate debt as a percentage of total debt would have been 84.2% at December 31, 2004. The interest payments on the Company’s variable-rate debt have not been reported in the table above because 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, 2004, one-month LIBOR was 2.40%. See additional information regarding the Company’s debt and derivative instruments under 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, 2003 to December 31, 2004 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, 2004 and 2003. All of the Company’s interest rate sensitive financial and derivative instruments are held for purposes other than trading. For debt obligations, the table presents principal cash flows and related weighted average interest rates or the interest rate index by contractual maturity dates. The interest rate spreads on the Company’s variable-rate debt were LIBOR plus 1.10% at December 31, 2004 and ranged from LIBOR plus 1.40% to LIBOR plus 1.85% at December 31, 2003. 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, 2004 and 2003. The table also presents comparative summarized information for financial and derivative instruments held at December 31, 2003.
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.”
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 its reports under the Securities Exchange Act of 1934 is processed, recorded, summarized and reported within the time periods specified in the SEC’s rules and forms and that such information is accumulated and communicated to management, including the Chief Executive Officer and Chief Financial Officer, as appropriate, to allow for timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.
As required by SEC Rule 13a-15(b), the Company carried out an evaluation, under the supervision and with the participation of management including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the disclosure controls and procedures as of the end of the quarter covered by this report. Based on the foregoing, the Chief Executive Officer and Chief Financial Officer concluded, as of that time, that the Company’s disclosure controls and procedures were effective at the reasonable assurance level.
There was no change in the Company’s internal control over financial reporting that occurred during the three months ended December 31, 2004 that has materially affected, or is reasonably likely to materially affect, the internal control over financial reporting. The Company may make changes in its internal control processes from time to time in the future.
Management’s Report on Internal Controls Over Financial Reporting
Internal control over financial reporting is a process designed by, or under the supervision of, the Chief Executive Officer and Chief Financial Officer and effected by the board of directors, management and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Internal control over financial reporting includes those policies and procedures that: (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of assets that could have a material effect on the financial statements.
Management is responsible for establishing and maintaining adequate internal control over financial reporting. The Company’s internal control over financial reporting is supported by written policies and procedures and by an appropriate segregation of responsibilities and duties. The Company has used the criteria set forth in the Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission to assess its internal control over financial reporting. Based upon this assessment, management concluded that internal control over financial reporting is operating effectively as of December 31, 2004. Deloitte & Touche LLP has audited the Company’s financial statements and has issued an attestation report on management’s assessment of internal control over financial reporting.
March 1, 2005
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of Kilroy Realty Corporation:
We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control over Financial Reporting, that Kilroy Realty Corporation (the “Company”) maintained effective internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.
A company’s internal control over financial reporting is a process designed by, or under the supervision of, the company’s principal executive and principal financial officers, or persons performing similar functions, and effected by the company’s board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, management’s assessment that the Company maintained effective internal control over financial reporting as of December 31, 2004, is fairly stated, in all material respects, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2004, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements and financial statement schedule as of and for the year ended December 31, 2004 of the Company and our report dated March 1, 2005 expressed an unqualified opinion on those consolidated financial statements and financial statement schedule.
DELOITTE & TOUCHE LLP
Los Angeles, California
March 1, 2005
ITEM 9B.
ITEM 9B. OTHER INFORMATION
None.
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 17, 2005.
As required by Section 303A.12 of the NYSE Listed Company Manual, the Company’s Chief Executive Officer made his annual certification to the NYSE on May 25, 2004 stating that he was not aware of any violation by the Company of the corporate governance listing standards of the NYSE. In addition, the Company has filed, as exhibits to this Annual Report on Form 10-K, the certifications of its Chief Executive Officer and Chief Financial Officer required under Section 302 of the Sarbanes Oxley Act of 2002 to be filed with the Securities and Exchange Commission regarding the quality of the Company’s public disclosure.
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 17, 2005.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
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 17, 2005.
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 17, 2005.
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 17, 2005.
PART IV
ITEM 15.
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES
(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 10-K for the year ended December 31, 2003.
(3)
Previously filed as an exhibit to the Registration Statement on Amendment No. 1 to Form S-3 (No. 333-72229).
(4)
Previously filed as an exhibit on Form 10-K for the year ended December 31, 1999.
(5)
Previously filed as an exhibit to the Registration Statement on Form S-3 (No. 333-34638).
(6)
Previously filed an exhibit on Form 8-A as filed with the Securities and Exchange Commission on October 24, 2003.
(7)
Previously filed as an exhibit on Form 8-A (No. 001-12675) as filed with the Securities and Exchange Commission on December 6, 2004.
(8)
Previously filed as an exhibit on Form 8-K as filed with the Securities and Exchange Commission on February 11, 1998.
(9)
Previously filed as an exhibit on Form 8-K/A as filed with the Securities and Exchange Commission on December 19, 1997.
(10)
Previously filed as an exhibit on Form 8-K as filed with the Securities and Exchange Commission on October 8, 1998.
(11)
Previously filed as an exhibit on Form 10-K for the year ended December 31, 2000.
(12)
Previously filed as an exhibit on Form 8-K filed with the Securities and Exchange Commission on August 11, 2004.
(13)
Previously filed as an exhibit on Form 8-K as filed with the Securities and Exchange Commission on December 9, 2004.
(14)
Previously filed as an exhibit to the Registration Statement on Amendment No. 2 to Form S-11 (No. 333-15553).
(15)
Previously filed as an exhibit to the Registration Statement on Form S-11 (No. 333-15553).
(16)
Previously filed as an exhibit to the Registration Statement on Amendment No. 5 to Form S-11 (No. 333-15553).
(17)
Previously filed as an exhibit to the Registration Statement on Amendment No. 4 to Form S-11 (No. 333-15553).
(18)
Previously filed as an exhibit on Form 8-K as filed with the Securities and Exchange Commission on June 6, 1997.
(19)
Previously filed as an exhibit on Form 8-K as filed with the Securities and Exchange Commission on July 15, 1997.
(20)
Previously filed as an exhibit on Form 8-K as filed with the Securities and Exchange Commission on July 3, 1997.
(21)
Previously filed as an exhibit on Form 10-Q for the quarter ended September 30, 1997.
(22)
Previously filed as an exhibit on Form 8-K as filed with the Securities and Exchange Commission on November 21, 1997.
(23)
Previously filed as an exhibit on Form 8-K as filed with the Securities and Exchange Commission on December 29, 1997.
(24)
Previously filed as an exhibit on Form 10-Q for the quarter ended September 30, 1998.
(25)
Previously filed as an exhibit on Form 10-K for the year ended December 31, 2001.
(26)
Previously filed as an exhibit on Form 10-Q for the quarter ended March 31, 2004.
(27)
Previously filed as an exhibit on Form 8-K filed with the Securities and Exchange Commission on October 22, 2004.
(b) Reports on Form 8-K
The Company filed a Current Report on Form 8-K dated October 25, 2004, under Item 2.02, in connection with its third quarter 2004 earnings release and attached to such report its third quarter 2004 Supplemental Financial Report.
The Company filed a Current Report on Form 8-K dated October 22, 2004, under Items 1.01 and 9.01, in connection with the renewal of its $425 million unsecured revolving credit facility.
The Company filed a Current Report on Form 8-K dated December 8, 2004, under Items 8.01 and 9.01, in connection with the issuance of 3,450,000 shares of its 7.50% Series F Cumulative Redeemable Preferred Stock.
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 1, 2005.
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, 2004 AND 2003
AND FOR THE THREE YEARS ENDED DECEMBER 31, 2004
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
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, 2004 and 2003, and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2004. 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 Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit 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, 2004 and 2003, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2004, 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.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial reporting as of December 31, 2004, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 1, 2005 expressed an unqualified opinion on management’s assessment of the effectiveness of the Company’s internal control over financial reporting and an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.
DELOITTE & TOUCHE LLP
Los Angeles, California
March 1, 2005
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, 2004
1. Organization and Ownership
Kilroy Realty Corporation (the “Company”) owns, operates, develops and acquires 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, 2004, the Company’s stabilized portfolio of operating properties was comprised of 84 office buildings (the “Office Properties”) and 49 industrial buildings (the “Industrial Properties,” and together with the Office Properties, the “Properties”) which encompassed approximately 7.7 million and 4.6 million rentable square feet, respectively, and was 94.6% 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, 2004, the Company had two office properties encompassing an aggregate of approximately 309,600 rentable square feet, which were in the lease-up phase. In addition, as of December 31, 2004, the Company had two office development properties under construction, which when complete are expected to encompass an aggregate of approximately 103,300 rentable square feet. All of the Company’s development and lease-up properties 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, 2004 and 2003, it owned an 87.7% and 87.2% general partnership interest, respectively. The remaining 12.3% and 12.8% common limited partnership interest in the Operating Partnership as of December 31, 2004 and 2003, respectively, was owned by certain of the Company’s executive officers and directors, certain of their affiliates, and other outside investors (see Note 12). 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. 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 1.0% 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 and all wholly-owned subsidiaries of the Company.
In 1999, the Company, through the Operating Partnership, became a 50% managing member in two limited liability companies (the “Development LLCs”), which were formed to develop two multi-phased office projects in San Diego, California. The Allen Group, a group of affiliated real estate development and investment companies based in San Diego, California, was the other 50% member of the Development LLCs. On March 25, 2002, the Company acquired The Allen Group’s interest in the assets and assumed The Allen Group’s proportionate share of the liabilities of the Development LLCs (see Note 12). 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. Properties held for sale are reported at the lower of the carrying value or the fair value less estimated cost to sell. 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.
An operating 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. In the first quarter of 2004, the Company recorded a $0.7 million impairment loss (see Note 3). The Company did not record any impairment losses during the years ended December 31, 2003 or 2002.
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, 2004, 2003 and 2002, was $50.0 million, $47.5 million, and $46.8 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. During the lease-up period, the Company depreciates costs associated with the portion of the project that is occupied.
Property acquisitions-In accordance with Statement of Financial Accounting Standard (“SFAS”) No. 141, Business Combinations (“SFAS 141”), the Company allocates the purchase price of acquired properties to land, buildings and improvement and identified tangible and intangible assets and liabilities associated with in-place leases (including tenant improvements, unamortized leasing commissions, value of above and below-market leases, acquired in-place lease values, and tenant relationships, if any) based on their respective estimated fair values. The fair value of the tangible assets of the acquired properties considers the value of the properties as if vacant as of the acquisition date.
KILROY REALTY CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Amounts allocated to land are derived from comparable sales of land within the same region. Amounts allocated to buildings and improvements, tenant improvements and unamortized leasing commissions are based on current market replacement costs and other market rate information.
The amount allocated to acquired in-place leases is determined based on management’s assessment of current market conditions and the estimated lease-up periods for the respective spaces. The amount allocated to acquired in-place leases is included in deferred leasing costs and other related intangible assets in the balance sheet and amortized as an increase to amortization expense over the remaining non-cancelable term of the respective leases.
The value allocable to the above or below market component of an acquired in-place lease is determined based upon the present value (using a discount rate which reflects the risks associated with the acquired leases) of the difference between (i) the contractual rents to be paid pursuant to the lease over its remaining term, and (ii) management’s estimate of the rents that would be paid using fair market rental rates over the remaining term of the lease. The amounts allocated to above or below market leases are included in other assets or other liabilities in the balance sheet and are amortized on a straight-line basis as an increase or reduction of rental income over the remaining non-cancelable term of the respective leases. As of December 31, 2004 and 2003, the Company had a net liability related to above and below market leases of $6.5 million and $0.5 million, respectively. Following is the estimated net amortization at December 31, 2004 for the next five years:
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.
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 and deferred rent receivables-Tenant receivables and deferred rent receivables are carried net of the allowances for uncollectible current tenant receivables and 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 or decreased through the provision for bad debts.
KILROY REALTY CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
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 straight-line method, which approximates 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.
The Company recognizes all of its derivatives as either assets or liabilities on the Company’s consolidated balance sheet at fair value and defers the related gains or losses on these contracts in stockholders’ equity as a component of accumulated net other 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 11). 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 net other 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.
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 12). Net income after preferred distributions is allocated to the common limited partners of the Operating Partnership (“Minority Interest of the Operating Partnership”) based on their ownership percentage of the Operating Partnership. The common limited partner ownership percentage is determined by dividing the number of common units held by the Minority Interest of the Operating Partnership by the total common units outstanding. The issuance of additional shares of common stock or common units results in changes to the Minority Interest of the Operating Partnership percentage as well as the total net assets of the Company. As a result, all common 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 amounts recorded in connection with lease terminations (see Note 19).
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
KILROY REALTY CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
annually at least 90% of its adjusted taxable income, as defined in the Code, to its stockholders 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 stockholders. 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, 2004, 2003 and 2002 and was not subject to any federal income taxes (see Note 23 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 years ended December 31, 2004, 2003 and 2002, 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.
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, 2004 and 2003.
Concentration of credit risk-128 of the Company’s total 133 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, 2004, 2003 and 2002, the Company’s ten largest office tenants represented approximately 28.9%, 29.7% and 32.2% of total annual base rental revenues and its ten largest industrial tenants represented approximately 8.0%, 8.1% and 8.9%, respectively, of total annual base rental revenues. Of this amount, the Company’s largest tenant, The Boeing Company, accounted for approximately 6.2%, 7.5% and 9.5% of the Company’s total annual base revenues, for the years ended December 31, 2004, 2003 and 2002, respectively. At both December 31, 2004 and 2003, the Company had approximately $0.6 million 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, 2004 and 2003, the Company had cash accounts in excess of FDIC insured limits.
KILROY REALTY CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Stock Option Accounting
At December 31, 2004, the Company had one stock option and incentive plan, which is described more fully in Note 15. Effective January 1, 2002, the Company voluntarily adopted the fair value recognition provisions of Statement of Financial Accounting Standard No. 123, Accounting for Stock-Based Compensation (“SFAS 123”), prospectively for all employee stock option awards granted or settled after January 1, 2002. Under the fair value recognition provisions of SFAS 123, total compensation expense related to stock options is determined using the fair value of the stock options on the date of grant. Total compensation expense is then recognized on a straight-line basis over the option vesting period.
Prior to 2002, the Company accounted for stock options issued under the recognition and measurement provisions of APB Opinion 25 “Accounting for Stock Issued to Employees and related Interpretations.” The following table illustrates the effect on net income and earnings per share if the fair value based method had been applied to all outstanding and unvested awards in each period.
The Company did not issue stock options in 2004 and 2003. The fair value of each option grant issued in 2002 is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions: (a) dividend yield of 7.03% (b) expected volatility of the Company’s stock of 24.6% (c) risk free interest rate of 4.88%, 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 15 and additional awards can be made in future years.
Recent Accounting Pronouncements
In April 2004, the Financial Accounting Standards Board (“FASB”) issued FASB Staff Position FAS 129-1, “Disclosure Requirements under FASB Statement No. 129, Disclosure of Information about Capital Structure, Relating to Contingently Convertible Financial Instruments” (“FSP FAS 129-1”). FSP FAS 129-1 provides guidance on disclosures of contingently convertible financial instruments, including those containing contingent conversion requirements that have not been met and are not otherwise required to be included in the calculation of diluted earnings per share. The statement was effective immediately, and applies to all existing and newly created securities. 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)
In December 2004, the FASB issued Statement 123 (revised), “Share-Based Payment” (“FAS 123(R)”). FAS 123 (R) requires that all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. The new standard will be effective in the first reporting period ending after June 15, 2005. The adoption of this statement is not expected to have a material effect on the Company’s results of operations or financial condition.
3. Dispositions and Acquisitions
Acquisition of Operating Properties and Undeveloped Land
In December 2004, the Company acquired a property in northern San Diego County from an unaffiliated third-party for a purchase price of $98.0 million. The acquisition included two office buildings, which encompass an aggregate of approximately 281,800 rentable square feet, and 4.0 acres of undeveloped land. The buildings were 90% leased as of the acquisition date. The Company paid $95.4 million in cash and assumed $2.6 million of outstanding obligations for tenant improvements relating to the acquired leases in satisfaction of the purchase price. The acquisition was funded with borrowings under the Company’s revolving unsecured credit facility.
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, 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, 2004.
Dispositions
During the year ended December 31, 2004, the Company sold the following properties:
The Company had classified the office property located in Riverside as held for sale as of March 31, 2004, and recorded a $0.7 million impairment loss in the first quarter of 2004 to reflect the property on the balance sheet at its estimated fair market value less selling costs.
KILROY REALTY CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
During the year ended December 31, 2003, the Company sold the following properties:
During the year ended December 31, 2002, the Company sold the following properties:
During the years ended December 31, 2004, 2003 and 2002, the Company recorded a net gain of approximately $6.1 million, $3.6 million, and $6.6 million, respectively, in connection with the sale of these properties. The Company used the net cash proceeds from the sale of these properties to fund its development and redevelopment programs, pay down principal on mortgage loans and to repay borrowings under the Credit Facility (defined in Note 10), and finance the Company’s share repurchase program (see Note 13). The net income and the net gain on disposition for these properties and the impairment loss have been included in discontinued operations for the years ended December 31, 2004, 2003 and 2002 (see Note 21).
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 this property has been included in continuing operations for the year ended December 31, 2002 as it relates to property sold prior to the prospective adoption of Statement of Financial Accounting Standard No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets (“SFAS 144”) (see Note 21).
KILROY REALTY CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
4. Development and Redevelopment Projects
Stabilized Development Projects
During the year ended December 31, 2004, the Company added the following development project to the Company’s stabilized portfolio. This project was completed in 2003 and in the lease-up phase as of December 31, 2003.
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.
Lease-Up Redevelopment Projects
During the year ended December 31, 2004, the Company completed the following redevelopment projects, which were in the lease-up phase as of December 31, 2004:
(1)
Based on management’s estimation of the earlier of stabilized occupancy (95%) or one year from the date of substantial completion.
KILROY REALTY CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Development Projects Under Construction
During the year ended December 31, 2004, the Company commenced construction on the following two development projects:
(1)
Based on Management’s estimation of the earlier of the stabilized occupancy (95%) or one year from the date of substantial completion.
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 and Other Related Intangibles
Deferred leasing costs and other related intangibles 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 19).
9. Deferred Financing Costs
Deferred financing costs are summarized as follows at December 31:
KILROY REALTY CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
10. Debt
Secured Debt
The following table sets forth the composition of the Company’s secured debt at December 31:
(a)
The variable interest rates stated as of December 31, 2004 and 2003 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, 2004 and 2003.
(b)
The Company repaid these loans in August 2004 with the proceeds from the issuance of the unsecured senior notes.
(c)
The Company repaid this loan in February 2004.
KILROY REALTY CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
The Company’s secured debt was collateralized by 64 operating properties at December 31, 2004 with a combined net book value of $610 million and 73 operating properties and one in-process development project at December 31, 2003 with a combined net book value of $681 million. As of December 31, 2004 and 2003, the Company’s secured debt had a weighted average interest rate, excluding loan fees, of 5.74% and 5.78%, respectively.
Unsecured Senior Notes
In August 2004, the Company issued two series of unsecured senior notes with an aggregate principal balance of $144 million. The Series A notes have an aggregate principal balance of $61 million and mature in August 2010. The Series B notes have an aggregate principal balance of $83 million and mature in August 2014. The Series A and Series B notes require semi-annual interest payments each February and August based on a fixed annual interest rate of 5.72% and 6.45%, respectively. The Company used the proceeds to repay a mortgage loan with an outstanding principal balance of $73.8 million that was scheduled to mature in January 2005 and a construction loan with an outstanding principal balance of $43.8 million that was scheduled to mature in September 2004. The remainder of the proceeds was used primarily to repay borrowings under the previous unsecured revolving credit facility.
Unsecured Line of Credit
In October 2004, the Company obtained a $425 million unsecured revolving credit facility (“the Credit Facility”) to replace its previous unsecured revolving credit facility that was scheduled to mature in March 2005. As of December 31, 2004, the Company had borrowings of $167.0 million outstanding under the Credit Facility and availability of approximately $258.0 million. The Credit Facility bears interest at an annual rate between LIBOR plus 1.00% and LIBOR plus 1.70% (3.50% at December 31, 2004) depending upon the Company’s leverage ratio at the time of borrowing, and matures in October 2007 with an option to extend the maturity for one year. The fee for unused funds ranges from an annual rate of 0.20% to 0.30% depending on the Company’s leverage ratio. The Company expects to use the Credit Facility to finance development and redevelopment expenditures, to fund potential acquisitions and for other general corporate uses.
Debt Covenants and Restrictions
The Credit Facility, the unsecured senior notes and certain other secured debt arrangements contain covenants and restrictions requiring the Company to meet certain financial ratios and reporting requirements. Some of the more restrictive financial covenants include a maximum total debt to total assets ratio, a maximum total secured debt to total assets ratio, a minimum debt service coverage and fixed charge coverage ratios, minimum consolidated tangible net worth and a limit of development activities as compared to total assets. The Company was in compliance with all of its debt covenants at December 31, 2004 and 2003.
At December 31, 2004, twelve 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.
Capitalized Interest and Loan Fees
Total interest and loan fees capitalized for the years ended December 31, 2004, 2003 and 2002 were $8.6 million, $11.8 million and $14.0 million, respectively.
KILROY REALTY CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Debt Maturities
Scheduled contractual principal payments for the above secured and unsecured debt at December 31, 2004, assuming the Company does not exercise any of the extension options, were as follows:
11. Derivative Financial Instruments
The following table sets forth the terms and fair market value of the Company’s derivative financial instruments at December 31:
In June 2004, the Company terminated two interest rate cap agreements. In accordance with SFAS 133, “Accounting for Derivative Instruments and Hedging Activities,” the cost deferred in accumulated net other comprehensive income/loss (“AOCL”) associated with the terminated contracts remained in AOCL upon termination because the Company will continue to make interest payments on the associated outstanding debt. The cost is being amortized into interest expense through January 2005, the remaining term of the interest-rate cap agreements.
The instruments described above have been designated as cash flow hedges. As of December 31, 2004 and 2003, the balance in AOCL was approximately a $0.3 million net gain and a $4.4 million net loss, respectively, relating to the net change in the fair market value of the derivative instruments since their inception. The difference between the total fair value and the balance in AOCL represents the deferred cost associated with the terminated interest-rate cap agreements. For the years ended December 31, 2004, 2003 and 2002, 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 AOCL will be reclassified to interest expense as interest payments are made on the Company’s variable-rate debt. During the year ending December 31, 2005, the Company estimates it will reclassify approximately $23,000 from AOCL to earnings as a decrease to interest expense.
KILROY REALTY CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
12. Minority Interests
Common Limited Partnership Unitholders
The Company owned an 87.7% and 87.2% general partnership interest in Operating Partnership as of December 31, 2004 and 2003, respectively. The remaining 12.3% and 12.8% common limited partnership interest as of December 31, 2004 and 2003, 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, 2004, 2003 and 2002, 165,171, 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, 2004 and 2003, the Company had issued and outstanding 1,500,000 Series A Cumulative Redeemable Preferred units (the “Series A Preferred Units”) representing preferred limited partnership interests in the Operating Partnership with a liquidation value of $50.00 per unit. 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 accrued at an annual rate of 7.45%. Prior to March 5, 2004, distributions on the Series A Preferred Units accrued at an annual rate of 8.075%. The Series A Preferred Units, which may be called by the Operating Partnership at a price equal to the liquidation value on or after September 30, 2009, have no stated maturity or mandatory redemption and are not convertible into any other securities of the Operating Partnership. The Series A Preferred Units are exchangeable at the option of the majority of the holders for shares of the Company’s 7.45% Series A Cumulative Redeemable Preferred stock (“Series A Preferred Stock”) beginning September 30, 2015 or earlier under certain circumstances.
The Series A Preferred Units may be exchanged for shares of Series A Preferred Stock at the election of 51% of the holders of Series A Preferred Units:
(i) if distributions on the 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 the preferred units would not be considered “stock and securities” for federal income tax purposes; and
(iii) at any time following September 30, 2015.
In addition, the Series A Preferred Units may also be exchanged for shares of Series A 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 Series A Preferred Units for cash in an amount equal to $50.00 per unit plus
KILROY REALTY CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
accrued and unpaid distributions. The Series A Preferred Units 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.
As of December 31, 2003, the Company also had issued and outstanding 900,000 9.25% 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. In December 2004, the Operating Partnership redeemed all 900,000 outstanding Series D Preferred Units with proceeds from a public offering for 3,450,000 shares of its 7.50% Series F Cumulative Redeemable Preferred Stock (see Note 13). In 2004, the Company recorded a $1.2 million charge relating to the initial issuance costs of the redeemed Series D Preferred Units.
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 13). In 2003, the Company recorded a $0.9 million charge relating to the initial issuance costs of the redeemed Series C Preferred 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 and Series D Preferred Unit balances on the balance sheet at December 31, 2004 and 2003:
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.
13. Stockholders’ Equity
Preferred Stock
In December 2004, the Company completed a public offering for 3,450,000 shares of its 7.50% Series F Cumulative Redeemable Preferred Stock (“Series F Preferred Stock”). The Series F Preferred Stock has a
KILROY REALTY CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
liquidation preference of $25.00 per share and may be redeemed at the option of the Company on or after December 8, 2009, or earlier under certain circumstances. Dividends on the Series F Preferred Stock are cumulative and will be payable quarterly in arrears on the 15th day of each February, May, August and November. The Series F 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 D Preferred Units (see Note 12).
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 12).
Restricted Shares
In February 2005, 2004, 2003 and 2002, the Company’s Compensation Committee granted an aggregate of 101,112, 111,159, 118,733 and 81,729 restricted shares, respectively, of the Company’s common stock to certain executive officers and key employees. In 2004 and 2003, the Company’s Executive Compensation Committee granted an aggregate of 3,684 and 4,945 restricted shares, respectively, of the Company’s common stock to non-employee board members as part of the board members’ annual compensation. 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, 2004, 2003 and 2002 (see Note 15 for the terms of the restricted stock grants and the related amortization of compensation expense).
Exchange of Common Limited Partnership Units
During 2004, 2003, and 2002 165,171, 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 12). 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 years ended December 31, 2004 and 2003, the Company accepted the return, at the current quoted market price, of 36,955 and 78,630 shares of its common stock, respectively, 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, 2004 and 2003. Repurchases were funded primarily through proceeds received from the Company’s disposition program, working capital and borrowings on the Company’s unsecured revolving credit facility. As of December 31, 2004, an aggregate of 1,227,500 shares remained eligible for repurchase under this program.
KILROY REALTY CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
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, 2004, no shares had been acquired under the Plan from new issuances.
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 12). 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 $187 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, 2004 and 2003, consisted of the following amounts payable to registered common stockholders of record holding 28,548,597 and 28,209,213 shares of common stock, respectively, common unitholders holding 3,989,142 and 4,154,313 common limited partnership units of the Operating Partnership, respectively, and registered preferred stockholders of 5,060,000 and 1,610,000 shares of preferred stock, respectively:
KILROY REALTY CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
14. Future Minimum Rent
The Company has operating leases with tenants that expire at various dates through 2021 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, 2004, are summarized as follows:
15. 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, 2004, 2003, and 2002, 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 2005, the Company’s Compensation Committee granted an aggregate of 101,112 restricted shares of common stock to certain executive officers and key employees. Compensation expense for the
KILROY REALTY CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
restricted shares is calculated based on the closing per share price of $41.35 on the February 23, 2005 grant date and is amortized on a straight-line basis over the performance and vesting period. Of the shares granted, 18,139 vest over a one-year period, 61,812 vest over a two-year period and 21,161 vest over a five-year period. The Company recorded approximately $1.4 million in compensation expense related to this restricted stock grant during the year ended December 31, 2004.
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 $1.4 million and $1.1 million in compensation expense related to this restricted stock grant during the years ended December 31, 2004 and 2003, respectively.
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 vested 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 $0.6 million, $1.0 million and $1.0 million for the years ended December 31, 2004, 2003 and 2002, respectively.
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-year period and 61,188 vested over a two-year period. The compensation expense related to this restricted stock grant was approximately $0.1 million, $0.9 million, and $1.1 million for the years ended December 31, 2004, 2003 and 2002, respectively.
In March 2003, the Company’s Executive Compensation Committee approved a special long-term compensation program for the Company’s executive officers. The program provides for cash compensation to be earned at December 31, 2005 if the Company attains certain performance measures based on annualized total shareholder returns on an absolute and relative basis. The amount payable for the absolute component is based upon the amount by which the annualized total return to stockholders over the period exceeds 10%. The targets for the relative component require the Company to obtain an annualized total return to stockholders that is at or above the 70th percentile of annualized total return to stockholders achieved by members of a pre-defined peer group during the same three-year period, and includes additional incentives for annualized total return to stockholders that is at or above the 80th percentile. Compensation expense under this program is accounted for using variable plan accounting. The Company estimates the amount to be paid based on the Company’s closing stock price at the end of each period, and records compensation expense equal to that portion of the total compensation applicable to the portion of the performance period that has elapsed through the end of the period. Under the absolute portion of the plan, for every $1 change in the Company’s stock price, the total payable over the three-year term of the plan changes by approximately $1.7 million. During the years ended December 31, 2004 and 2003, the Company accrued approximately $18.5 million and $5.9 million, respectively, of compensation expense related to this plan, which is included in general and administrative expenses. The total amount accrued relating to the plan was $24.4 million and $5.9 million as of December 31, 2004 and 2003, respectively.
KILROY REALTY CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Board Compensation
In May 2004 and 2003, the Company’s Executive Compensation Committee granted an aggregate of 3,684 and 3,945 restricted shares, respectively, of the Company’s common stock to non-employee board members as part of the board members’ annual compensation. Compensation expense for the 3,684 and 3,945 restricted shares is calculated based on the closing share price of $32.59 and $25.38 on the respective grant dates, and is being amortized over the two-year vesting periods. In July 2003, the Company’s Executive Compensation Committee granted 1,000 restricted shares of the Company’s common stock to the Company’s newly elected board member representing his initial equity award. Compensation expense for the 1,000 restricted shares is calculated based on the closing share price of $28.48 on the July 24, 2003 grant date and is being amortized over the four-year vesting period. The Company recorded compensation expense of approximately $94,000 and $35,000 related to these restricted stock grants during the years ended December 31, 2004 and 2003, respectively. The restricted stock was granted under the Company’s 1997 Stock Option and Incentive Plan in accordance with the Company’s Board of Directors compensation plan, as approved by the Board of Directors in May 2003.
Stock Options
At December 31, 2004, 2003 and 2002, an aggregate of 110,901, 214,714 and 1,167,272 options were exercisable for shares of the Company’s common stock at a weighted average exercise price of $23.99, $23.86 and $23.30, respectively. The weighted average exercise price of the options outstanding at December 31, 2004, 2003 and 2002 was $24.11, $24.09 and $23.40, respectively, with weighted average remaining contractual lives of 4.2 years, 4.9 years and 5.0 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.
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 $27,000, $26,000 and $23,000 of compensation expense for the
KILROY REALTY CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
years ended December 31, 2004, 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.
16. 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, 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.
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.
The minimum commitment under these ground leases at December 31, 2004 was as follows:
Litigation-With the exception of the settlement of the litigation disclosed in Note 19, 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
KILROY REALTY CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
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.
17. Related-Party Transactions
As part of the Company’s marketing strategy, KSLLC previously had an agreement, which terminated in April 2003, 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 and 2002, KSLLC paid TradeWind Navigation, Inc. approximately $94,000 and $0.3 million, under this agreement.
At December 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.
18. 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 Note 10).
For fixed-rate secured and unsecured 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 and unsecured debt was approximately $599 million and $414 million at December 31, 2004 and 2003, respectively. See Note 10 for further detail on the Company’s secured and unsecured debt and Note 11 for the fair value of the Company’s derivative instruments.
19. Other Property Income
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 was 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) in the second quarter of 2003. The Company then recorded a net lease termination fee of $18.0 million in the third quarter of 2003 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. During the third quarter of 2004, the Company reversed approximately $750,000 of the provision due to the collection of the first of the four annual installment payments due under the settlement agreement.
KILROY REALTY CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Other Significant Lease Termination Fees
Under the terms of a previous tenant’s plan of reorganization, the Company received shares of stock in the reorganized company in satisfaction of the Company’s creditor’s claim under the lease. This tenant had previously defaulted on its lease in 2001 and filed for bankruptcy in 2002. The Company recorded a net lease termination fee of approximately $0.5 million in January 2004, representing the fair value of the stock on the date of receipt. During the first quarter of 2004, the Company sold all of the shares, in a series of open market transactions, at an additional net gain of approximately $0.1 million. This gain is included in interest and other income on the Company’s consolidated statement of operations for the year ended December 31, 2004.
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 San Diego, California, which encompassed 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).
Other
During the year ended December 31, 2004, the Company recorded $1.9 million of other property income related to a lease termination that occurred in 2001. The additional income had previously been reserved for financial reporting purposes until certain contingencies associated with the lease termination had been resolved.
During the year ended December 31, 2004, the Company recorded a $1.8 million charge to other property income in connection with a proposed settlement of outstanding litigation relating to the same 2001 lease termination. The court approved this settlement agreement in January 2005.
20. Segment Disclosure
The Company’s reportable segments consist of the two types of commercial real estate properties for which management internally evaluates operating performance and financial results: Office Properties and Industrial Properties. The Company also has certain corporate level activities including legal administration, accounting, finance, and management information systems which are not considered separate operating segments.
The Company evaluates the performance of its segments based upon net operating income. Net operating income is defined as operating revenues (rental income, tenant reimbursements and other property income) less property and related expenses (property expenses, real estate taxes, ground leases and provisions for bad debts) and excludes interest and other income, interest 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, 2004, 2003 and 2002.
(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 rent receivable, and deferred leasing costs and other related intangible assets, 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)
21. 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, 2004, 2003 and 2002, discontinued operations included the net income, the impairment loss and the net gain or loss on sale of one office and one industrial building sold during the year ended December 31, 2004 (see Note 3). For the years ended December 31, 2003 and 2002, discontinued operations also included the net income and net gain or loss on sale of the seven office buildings that the Company sold in 2003 (see Note 3). For the year ended December 31, 2002, discontinued operations also included the net income and net gain or loss on sale of 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)
22. 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, 2004, 2003 and 2002:
At December 31, 2004 and 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. At December 31, 2002, Company employees and directors held options to purchase 941,092 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)
23. 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, 2004, 2003 and 2002 as follows:
The income tax treatment for the dividends to common stockholders reportable for the years ended December 31, 2004, 2003, and 2002 as identified in the table above, was as follows:
(1)
2004 Capital Gains are comprised entirely of 15% Rate Gains. 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 Capital Gains are comprised entirely of 20% Rate Gains.
The income tax treatment for the dividends to preferred stockholders reportable for the year ended December 31, 2004 was as follows:
24. Quarterly Financial Information (Unaudited)
Summarized quarterly financial data for the years ended December 31, 2004 and 2003 was as follows:
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 20 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 21).
25. Subsequent Events
On January 18, 2005, aggregate distributions of $16.1 million were paid to common stockholders and common unitholders of record on December 31, 2004.
On February 15, 2005, aggregate distributions of $0.8 million were paid to Series E preferred stockholders of record on February 1, 2005 for the period commencing on and including November 15, 2004 and ending on and including February 14, 2005.
On February 15, 2005, aggregate distributions of $1.2 million were paid to Series F preferred stockholders of record on February 1, 2005 for the period commencing on and including December 8, 2004 and ending on and including February 14, 2005.
On February 15, 2005, aggregate distributions of $1.4 million were paid to the Series A Preferred unitholders.
On February 23, 2005 the Company’s Compensation Committee granted restricted shares of common stock to certain executive officers and key employees (see Note 15).
KILROY REALTY CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
26. 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 $84.9 million mortgage note.
KILROY REALTY CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
(4)
These properties secure a $15.6 million mortgage note.
(5)
These properties secure a $78.2 million mortgage note.
(6)
These properties secure a $80.6 million mortgage note.
(7)
These properties secure a $31.0 million mortgage note.
(8)
These properties secure a $10.3 million mortgage note.
(9)
These properties secure a $24.4 million mortgage note.
(10)
These properties secure a $17.5 million mortgage note.
(11)
These properties are not included in the Company’s stabilized portfolio at December 31, 2004. Both properties were in the lease-up phase as of December 31, 2004 and included in land and improvements and buildings and improvements in the consolidated balance sheet (see Note 2).
(12)
This property secures a $33.9 million mortgage note.
(13)
These properties secure a $82.1 million mortgage note.
(14)
These properties secure a $29.0 million mortgage note.
(15)
This property secures a $3.0 million mortgage note.
The aggregate gross cost of property included above for federal income tax purposes, approximated $1.7 billion as of December 31, 2004.
The following table reconciles the historical cost of the total investment in real estate, net from January 1, 2002 to December 31, 2004:
The following table reconciles the accumulated depreciation from January 1, 2002 to December 31, 2004:
KILROY REALTY CORPORATION
SCHEDULE II-VALUATION AND QUALIFYING ACCOUNTS
Year ended December 31, 2004, 2003 and 2002
(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 10-K for the year ended December 31, 2003.
(3)
Previously filed as an exhibit to the Registration Statement on Amendment No. 1 to Form S-3 (No. 333-72229).
(4)
Previously filed as an exhibit on Form 10-K for the year ended December 31, 1999.
(5)
Previously filed as an exhibit to the Registration Statement on Form S-3 (No. 333-34638).
(6)
Previously filed an exhibit on Form 8-A as filed with the Securities and Exchange Commission on October 24, 2003.
(7)
Previously filed as an exhibit on Form 8-A (No. 001-12675) as filed with the Securities and Exchange Commission on December 6, 2004.
(8)
Previously filed as an exhibit on Form 8-K as filed with the Securities and Exchange Commission on February 11, 1998.
(9)
Previously filed as an exhibit on Form 8-K/A as filed with the Securities and Exchange Commission on December 19, 1997.
(10)
Previously filed as an exhibit on Form 8-K as filed with the Securities and Exchange Commission on October 8, 1998.
(11)
Previously filed as an exhibit on Form 10-K for the year ended December 31, 2000.
(12)
Previously filed as an exhibit on Form 8-K filed with the Securities and Exchange Commission on August 11, 2004.
(13)
Previously filed as an exhibit on Form 8-K as filed with the Securities and Exchange Commission on December 9, 2004.
(14)
Previously filed as an exhibit to the Registration Statement on Amendment No. 2 to Form S-11 (No. 333-15553).
(15)
Previously filed as an exhibit to the Registration Statement on Form S-11 (No. 333-15553).
(16)
Previously filed as an exhibit to the Registration Statement on Amendment No. 5 to Form S-11 (No. 333-15553).
(17)
Previously filed as an exhibit to the Registration Statement on Amendment No. 4 to Form S-11 (No. 333-15553).
(18)
Previously filed as an exhibit on Form 8-K as filed with the Securities and Exchange Commission on June 6, 1997.
(19)
Previously filed as an exhibit on Form 8-K as filed with the Securities and Exchange Commission on July 15, 1997.
(20)
Previously filed as an exhibit on Form 8-K as filed with the Securities and Exchange Commission on July 3, 1997.
(21)
Previously filed as an exhibit on Form 10-Q for the quarter ended September 30, 1997.
(22)
Previously filed as an exhibit on Form 8-K as filed with the Securities and Exchange Commission on November 21, 1997.
(23)
Previously filed as an exhibit on Form 8-K as filed with the Securities and Exchange Commission on December 29, 1997.
(24)
Previously filed as an exhibit on Form 10-Q for the quarter ended September 30, 1998.
(25)
Previously filed as an exhibit on Form 10-K for the year ended December 31, 2001.
(26)
Previously filed as an exhibit on Form 10-Q for the quarter ended March 31, 2004.
(27)
Previously filed as an exhibit on Form 8-K filed with the Securities and Exchange Commission on October 22, 2004.