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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
(MARK ONE)
[X]ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 1997
OR
[_]TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM TO
COMMISSION FILE NUMBER 1-12675
KILROY REALTY CORPORATION
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
MARYLAND 95-4598246
(STATE OR OTHER JURISDICTION (I.R.S. EMPLOYER IDENTIFICATION NUMBER)
OF INCORPORATION OR ORGANIZATION)
2250 EAST IMPERIAL HIGHWAY 90245
EL SEGUNDO, CALIFORNIA (ZIP CODE)
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)
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REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (310) 563-5500
SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:
TITLE OF EACH CLASS NAME OF EACH EXCHANGE ON WHICH REGISTERED
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Common Stock, $.01 par value New York Stock Exchange
SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT: None
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Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to
such filing requirements for the past 90 days. Yes [X] No [_]
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to
the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [_]
The aggregate market value of the shares of common stock held by non-
affiliates of the registrant was approximately $686,527,016 based on the
closing price on the New York Stock Exchange for such shares on March
18, 1998.
As of March 18, 1998, 26,199,888 shares of common stock, par value $.01 per
share, were outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Company's Proxy Statement with respect to its 1998 Annual
Meeting of Stockholders to be filed not later than 120 days after the end of
the registrant's fiscal year are incorporated by reference into Part III
hereof.
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TABLE OF CONTENTS
PAGE
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PART I
Item 1. Business...................................................... 1
Item 2. Properties.................................................... 7
Item 3. Legal Proceedings............................................. 16
Item 4. Submission of Matters to a Vote of Security Holders........... 16
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder
Matters....................................................... 17
Item 6. Selected Financial Data....................................... 18
Item 7. Management's Discussion and Analysis of Financial Condition
and Results of Operations..................................... 20
Item 7A. Quantitative and Qualitative Disclosures About Market Risks... 29
Item 8. Financial Statements and Supplementary Data................... 29
Item 9. Changes in and Disagreements with Accountants on Accounting
and Financial Disclosure...................................... 29
PART III
Item 10. Directors and Executive Officers of the Registrant............ 29
Item 11. Executive Compensation........................................ 29
Item 12. Security Ownership of Certain Beneficial Owners and
Management.................................................... 29
Item 13. Certain Relationships and Related Transactions................ 29
PART IV
Exhibits, Financial Statement Schedules, and Reports on Form
Item 14. 8-K........................................................... 30
i
PART I
ITEM 1. BUSINESS
GENERAL
Kilroy Realty Corporation (the "Company") was incorporated in September 1996
and commenced operations upon the completion of its initial public offering on
January 31, 1997. The Company was formed to continue and expand the real
estate business of Kilroy Industries, a California corporation ("KI"), and
certain of its affiliated corporations, partnerships and trusts (collectively,
the "Kilroy Group"). Since 1947, the Kilroy Group has been engaged in the
business of owning, acquiring, developing, managing and leasing principally
Class A suburban office and industrial buildings in select locations in key
suburban submarkets, primarily in Southern California. As of December 31,
1997, the Company's portfolio of properties (including properties owned by
Kilroy Realty, L.P. (the "Operating Partnership") and Kilroy Realty Finance
Partnership, L.P., a Delaware limited partnership (the "Finance Partnership")
included 55 suburban office buildings (the "Office Properties") encompassing
an aggregate of approximately 4.2 million rentable square feet and 67
industrial buildings (the "Industrial Properties" and, together with the
Office Properties, the "Properties") encompassing an aggregate of
approximately 5.0 million rentable square feet. All but 11 of the properties
are located in Southern California. In addition, as of December 31, 1997, the
Company had under development one office building and two industrial buildings
which when completed are expected to encompass approximately 140,000 and
680,000 rentable square feet, respectively. The Company operates as a self-
administered and self-managed real estate company and expects that it has
qualified and it will continue to qualify as a real estate investment trust
("REIT") for federal and state income tax purposes beginning with the year
ended December 31, 1997.
The Company conducts substantially all of its activities through the
Operating Partnership in which, as of December 31, 1997, it owned an
approximate 87.8% general partner interest and the remaining 12.2% limited
partnership interest in the Operating Partnership was owned by certain of the
Company's executive officers and directors, certain of their affiliates, and
other outside investors. As the sole general partner of the Operating
Partnership, the Company has control over the management of the Operating
Partnership which owns 105 of the 122 Properties. The remaining 17 Properties
are owned by the Finance Partnership, a limited partnership in which the
Company (through a wholly-owned subsidiary) owns a 1% sole general partnership
interest and the Operating Partnership owns a 99% limited partnership
interest.
The Company's strategy has been to own, develop, acquire, lease and manage
Class A suburban office and industrial properties in select locations in key
suburban submarkets, primarily in Southern California, which the Company
believes have strategic advantages compared to neighboring submarkets. The
Properties that are located in Los Angeles County, Orange County and San Diego
County are situated in locations which the Company believes are among the best
within key submarkets, offering tenants: (i) lower business taxes and
operating expenses than adjoining submarkets; (ii) access to highly skilled
labor markets; (iii) access to major transportation facilities such as
freeways and airports; and (iv) proximity to the Los Angeles-Long Beach port
complex, which presently ranks as the largest commercial port in the United
States.
The Company's major tenants include, among others, Hughes Electronics
Corporation's Space & Communications Company ("Hughes Space &
Communications"), a tenant since 1984, which is engaged in high-technology
commercial activities including satellite development and related applications
such as DirecTV. Other major tenants are The Boeing Company, Sony Music
Entertainment, Inc., M/R Systems Corporation, State of California (Caltrans),
Northwest Airlines, Inc., DeVry, Inc., Raytheon Company, ARCS Mortgage
Company, Best, Best & Krieger, Intuit, Inc., Mattel, Inc., Mazda Motor of
America, Inc., Kraft Foods, Inc. and Packard Hughes Interconnect.
BACKGROUND AND FORMATION OF THE COMPANY
The Company was formed to continue and expand the real estate business of
the Kilroy Group. On January 31, 1997, the Company completed an initial public
offering of 12,500,000 shares of $.01 par value common stock (the "Common
Stock"). The offering price was $23.00 per share resulting in gross proceeds
of
1
$287,500,000. On February 7, 1997, in connection with the offering, the
underwriters exercised an over-allotment option and pursuant to the terms of
such option, the Company issued an additional 1,875,000 shares of Common Stock
and received gross proceeds of $43,125,000. The issuance and sale of the
initial 12,500,000 shares of Common Stock and the additional 1,875,000 shares
of Common Stock are collectively referred to as the "IPO." The aggregate
proceeds to the Company from the IPO, net of underwriters' discount, advisory
fees and offering costs, were approximately $302,700,000.
BUSINESS AND GROWTH STRATEGIES
As of December 31, 1997, the Company (through its ownership interests in the
Operating Partnership and the Finance Partnership) owned 55 office buildings
encompassing an aggregate of approximately 4.2 million rentable square feet
and 67 industrial buildings encompassing an aggregate of approximately 5.0
million rentable square feet. All but 11 of the Properties are located in
Southern California. As of December 31, 1997, the Office Properties were
approximately 94.3% leased to 315 tenants and the Industrial Properties were
approximately 91.9% leased to 233 tenants.
The Company's ten largest office tenants represented approximately 31.8% of
total annual base rent at December 31, 1997 (giving pro forma effect to the
lease with The Boeing Company executed in June 1997 for 211,000 rentable
square feet), and its ten largest industrial tenants represented approximately
12.0% of total annual base rent at December 31, 1997. Of this amount, its
largest tenant, Hughes Space & Communications, currently leases approximately
405,000 rentable square feet of office space, representing approximately 9.6%
of the Company's total annual base rental revenues at December 31, 1997. The
base periods of the Hughes Space & Communications leases expire beginning in
January 1999.
The Company believes that a number of factors will enable it to achieve its
business objectives, including: (i) the opportunity to lease available space
at attractive rental rates because of increasing demand and, with respect to
the office properties, the present lack of new construction in the Southern
California submarkets in which most of the Properties are located; (ii) the
Company's ability to acquire properties with partnership units of the
Operating Partnership ("Units") (thereby deferring the seller's taxable gain),
which creates enhanced acquisition opportunities; (iii) the quality and
location of the Properties; and (iv) the Company's access to acquisitions and
development opportunities as a result of its significant relationship with
large Southern California corporate tenants, municipalities and landowners and
the Company's 50-year presence in the Southern California market. Management
believes that the Company is well positioned to capitalize on existing
opportunities because of its extensive experience in certain of its
submarkets, its seasoned management team and its proven ability to acquire,
develop, lease and efficiently manage office and industrial properties. In
addition, the Company believes that public ownership and its conservative
capital structure will provide new opportunities for growth.
Operating Strategies. The Company focuses on enhancing growth in cash
available for distribution from its Properties by: (i) maximizing cash flow
from the Properties through active leasing, contractual base rent increases to
market levels as leases expire and effective property management;
(ii) managing operating expenses through the use of in-house management,
leasing, marketing, financing, accounting, construction management and data
processing functions; (iii) maintaining and developing long-term relationships
with a diverse tenant group; (iv) attracting and retaining motivated employees
by providing financial and other incentives to meet the Company's operating
and financial goals; and (v) continuing to emphasize capital improvements to
enhance the Properties' competitive advantages in their respective markets.
Acquisition Strategies. The Company seeks to grow by acquiring additional
quality office and industrial properties, including properties that: (i) may
provide attractive initial yields with significant potential for growth in
cash flow from property operations; (ii) are strategically located, of high
quality and competitive in their respective submarkets; (iii) are located in
the Company's existing submarkets and/or in other strategic submarkets where
the demand for office and industrial space exceeds available supply; or (iv)
have been under-managed or are otherwise capable of improved performance
through intensive management and leasing that will
2
result in increased occupancy and rental revenues. The Company believes that
the Southern California market is an established and mature real estate market
in which property owners generally have a low tax basis (and, accordingly, the
potential for large taxable gains) in their properties. Management believes
that the Company's extensive experience, capital structure and ability to
acquire properties for Units, and thereby defer a seller's taxable gain, if
any, will enhance the ability of the Company to consummate transactions
quickly and to structure more competitive acquisitions than other real estate
companies in the market that lack its access to capital or the ability to
issue Units.
Development Strategies. The Company and its predecessors have developed
office and industrial properties, including high technology facilities,
primarily located in Southern California, for its own portfolio and for third
parties, since 1947. The Company currently owns an aggregate of approximately
77.5 acres of developable land, comprised of ten acres of developable land in
Brea, 15 acres in Foothill Ranch in Orange County, 32 acres in Anaheim, three
and one-half acres in Irvine, 12 acres in San Diego and five acres in
Camarillo. The Company is the master ground lessee of, and has sole
development rights to, the 24 acres of developable land entitled for office,
research and development, light industrial and other commercial projects at
Kilroy Airport Center Long Beach. All of the developable land is located in
Southern California. Management believes that the aggregate 77.5 acres of
developable land provide the Company with significant growth opportunities.
The Company began construction on approximately 820,000 rentable square feet
of office and industrial space in 1997 at a total budgeted cost of
approximately $56.4 million.
In January 1998, the Company exercised its option to purchase Calabasas Park
Centre, an 18-acre site in Calabasas, California, which is currently entitled
for over 312,000 rentable square feet of office space, for a purchase price of
$2.4 million (representing the accumulated costs of the sellers incurred to
date), plus the assumption of annual assessments in connection with
approximately $6.8 million of Mello-Roos financing obligations allocable to
the Property maturing in 2017, and cross-indemnity arrangements with
developers of other property within the applicable Mello-Roos district. The
Company expects to complete this acquisition by March 31, 1998 and to finance
the acquisition with borrowings under the Credit Facility or the issuance of
Common Units. The Company is purchasing Calabasas Park Centre from a
partnership owned and controlled by John B. Kilroy, Sr. and John B. Kilroy,
Jr. Such acquisition was unanimously approved by the Independent Committee of
the Board of Directors.
The Company may engage in the development of other office and/or industrial
properties primarily in Southern California submarkets when market conditions
support a favorable risk-adjusted return on such development. The Company's
activities with third-party owners in Southern California are expected to give
the Company further access to development opportunities. There can be no
assurance, however, that the Company will be able to successfully develop any
of the properties.
Financing Policies. The Company's financing policies and objectives are
determined by the Company's Board of Directors. The Company presently intends
to limit the ratio of debt to total market capitalization (total debt of the
Company as a percentage of the market value of issued and outstanding shares
of Common Stock, including interests exchangeable therefor, plus total debt)
to approximately 50%. However, such objectives may be altered without the
consent of the Company's stockholders, and the Company's organizational
documents do not limit the amount of indebtedness that the Company may incur.
At December 31, 1997, total debt constituted approximately 25.4% of the total
market capitalization of the Company. The Company intends to utilize one or
more sources of capital for future acquisitions, including development and
capital improvements, which may include undistributed cash flow, borrowings
under the credit facility, the issuance of debt or equity securities and other
bank and/or institutional borrowings. There can be no assurance, however, that
the Company will be able to obtain capital for any such acquisitions,
developments or improvements on terms favorable to the Company.
3
GOVERNMENT REGULATIONS
Many laws and governmental regulations are applicable to the Properties and
changes in these laws and regulations, or their interpretation by agencies and
the courts, occur frequently.
Costs of Compliance with Americans with Disabilities Act. Under the
Americans with Disabilities Act of 1990 (the "ADA"), all places of public
accommodation, are required to meet certain federal requirements related to
access and use by disabled persons. Compliance with the ADA might require
removal of structural barriers to handicapped access in certain public areas
where such removal is "readily achievable." Noncompliance with the ADA could
result in the imposition of fines or an award of damages to private litigants.
The impact of application of the ADA to the Company's properties, including
the extent and timing of required renovations, is uncertain. If required
changes involve a greater amount of expenditures than the Company currently
anticipates, the Company's ability to make expected distributions to
stockholders could be adversely affected.
Environmental Matters. Under various federal, state and local laws,
ordinances and regulations relating to the protection of the environment, an
owner or operator of real estate may be held liable for the costs of removal
or remediation of certain hazardous or toxic substances located on or in the
property. These laws often impose liability without regard to whether the
owner was responsible for, or even knew of, the presence of such hazardous or
toxic substances. The costs of investigation, removal or remediation of such
substances may be substantial, and the presence of such substances may
adversely affect the owner's ability to rent or sell the property or to borrow
using such property as collateral and may expose it to liability resulting
from any release of or exposure to such substances. Persons who arrange for
the disposal or treatment of hazardous or toxic substances at another location
may also be liable for the costs of removal or remediation of such substances
at the disposal or treatment facility, whether or not such facility is owned
or operated by such person. Certain environmental laws impose liability for
release of asbestos-containing materials into the air, and third parties may
also seek recovery from owners or operators of real properties for personal
injury associated with asbestos-containing materials and other hazardous or
toxic substances. In connection with the ownership (direct or indirect),
operation, management and development of real properties, the Company may be
considered an owner or operator of such properties or as having arranged for
the disposal or treatment of hazardous or toxic substances and, therefore,
potentially liable for removal or remediation costs, as well as certain other
related costs, including governmental penalties and injuries to persons and
property.
Certain of the Company's tenants routinely handle hazardous substances and
wastes as part of their operations on the Company's properties. Such tenants
are subject to environmental laws and regulations governing the use, storage,
handling and disposal of such materials and such laws and regulations also
could subject the Company to liability resulting from such activities. The
Company's leases generally provide that the tenant must comply with such laws
and regulations and indemnify the Company for any related liabilities. As a
result, the Company does not believe that such matters will have a material
adverse effect on its operations. The Company has not been notified by any
governmental authority, and is not otherwise aware, of any material
noncompliance, liability or claim relating to hazardous or toxic substances or
petroleum products in connection with any of its Properties.
All of the Properties have been subject to Phase I or similar environmental
assessments by independent environmental consultants. Phase I assessments are
intended to discover information regarding, and to evaluate the environmental
condition of, the surveyed property and surrounding properties. Phase I
assessments generally include an historical review, a public records review,
an investigation of the surveyed site and surrounding properties, and
preparation and issuance of a written report, but do not include soil sampling
or subsurface investigations. Such reports have revealed that some of the
Company's properties contain asbestos-containing materials, and that
historical operations at or in the vicinity of certain of the Properties,
including the operation of underground storage tanks, may have caused soil or
groundwater contamination on such properties. The Company's investigations
have revealed the presence of groundwater contamination at one of its
properties. Prior to the Company's ownership of this property, soil
remediation was conducted for which agency closures were issued. The Company
does not believe that further soil remediation will be required. The Company
has obtained
4
environmental insurance for soil and groundwater contamination at the site
which it believes will be sufficient to cover any potential liability relating
to such conditions. There can be no assurance, however, that such insurance
will be adequate to cover any potential liability or that any such liability
will not have a material adverse effect on the Company's financial condition
or results of operations taken as a whole.
None of the Company's environmental assessments of the other Properties has
revealed any environmental liability that the Company believes would have a
material adverse effect on the Company's financial condition or results of
operations taken as a whole, nor is the Company aware of any such material
environmental liability. Nonetheless, it is possible that the Company's
assessments do not reveal all environmental liabilities or that there are
material environmental liabilities of which the Company is unaware. Moreover,
there can be no assurance that (i) future laws, ordinances or regulations will
not impose any material environmental liability or (ii) the current
environmental condition of the Properties will not be affected by tenants, by
the condition of land or operations in the vicinity of the Properties (such as
the presence of underground storage tanks), or by third parties unrelated to
the Company. If compliance with the various laws and regulations, now existing
or hereafter adopted, exceeds the Company's budgets for such items, the
Company's ability to make expected distributions to stockholders could be
adversely affected.
The Company has entered into an agreement to purchase a 32-acre portion of a
100-acre property located in Burbank, California. The property, including the
portion being considered by the Company, is part of the San Fernando Valley
Superfund Site. Pursuant to agreements with the United States Environmental
Protection Agency and the California Environmental Protection Agency, the
current owner of the property has agreed to remediate certain groundwater and
soil contamination associated with the property. The Company has identified
residual soil contamination on the property and has conditioned its purchase
of the property on obtaining satisfactory environmental indemnification from
the current owner, as well as a commitment from the current owner to remediate
the residual soil contamination to a level acceptable to the Company.
EMPLOYEES
As of February 27, 1998, the Company (primarily through the Operating
Partnership and Kilroy Services, Inc. (the "Services Company")), employed 100
persons. The Company, the Operating Partnership and the Services Company
employ substantially all of the professional employees of the Kilroy Group
that were engaged in asset management and administration. As of February 27,
1998, the Operating Partnership employed 29 on-site building employees who
provided services for the Properties. The Company, the Operating Partnership
and the Services Company believe that relations with their employees are good.
BUSINESS RISKS
This document contains certain forward-looking statements (as such term is
defined in Section 27A of the Securities Act of 1933, as amended (the "1933
Act"), and Section 21E of the Exchange Act of 1934, as amended (the "1934
Act")) pertaining to, among other things, the Company's future results of
operations, cash available for distribution, property acquisitions, lease
renewals, increases in base rent, fee development activities, sources of
growth, planned development and expansion of owned or leased property, capital
requirements, compliance with contractual obligations and general business,
industry and economic conditions applicable to the Company. These statements
are based largely on the Company's current expectations and are subject to a
number of risks and uncertainties. Actual results could differ materially from
these forward-looking statements. Factors that can cause actual results to
differ materially include, but are not limited to, those discussed below.
Readers are cautioned not to place undue reliance on these forward-looking
statements, which speak only as of the date hereof. The following factors
should be considered in addition to the other information contained herein in
evaluating the Company and its business:
. limitations on the Company's ability to withdraw as general partner of
the Operating Partnership, to transfer or assign its interest in the
Operating Partnership without the consent of at least 60% of the common
limited partnership units (the "Common Units") and without meeting
certain criteria with respect to the consideration to be received by the
limited partners of the Operating Partnership who
5
were members of the Kilroy Group (the "Continuing Investors"), or to
dissolve the Operating Partnership or sell the Office Property located
at 2260 E. Imperial Highway, El Segundo, California, at Kilroy Airport
Center at El Segundo without the consent of more than 50% of the Common
Units held by limited partners (excluding Common Units held by the
Company), which may in each case result in the Company taking action
that is not in the best interest of all stockholders;
. taxation of the Company as a corporation if it fails to qualify as a
REIT for federal income tax purposes, the Company's liability for
certain federal, state and local income taxes in such event and the
resulting decrease in cash available for distribution;
. the inability of the Company to control the operations of the Services
Company, which could result in decisions that do not reflect the
Company's interest because the Company does not control the election of
directors or the selection of officers of the Services Company;
. a portion of the Company's anticipated cash flow may be generated from
development activities, which are partially dependent on the
availability of development opportunities, and are subject to the risks
inherent in development as well as general economic conditions and
limitations on such activities imposed by the requirements to qualify
and maintain status as a REIT, which in turn may negatively impact the
Company's ability to make distributions;
. geographic concentration of 111 of the 122 Properties in Southern
California, creating a dependence on demand for office, industrial and
retail space in such markets and increasing the risk that the Company
will be materially adversely affected by general economic conditions in
a single market;
. the Company's results of operations are dependent on certain key
tenants, particularly Hughes Space & Communications, which accounted for
approximately 14.7% of the Company's total base rental revenues for the
eleven months ended December 31, 1997, thereby increasing the potential
negative impact to the Company of downturns in the business of, or its
relationship with, such tenants. The base periods of the Hughes Space &
Communications' leases expire beginning in January 1999;
. the possibility that acquisitions of office or industrial properties
will fail to be consummated, or that any such acquired properties will
fail to perform in accordance with management's expectations, including
the possibility that estimates of the costs of improvements to bring an
acquired property up to standards established for the market position
intended for that property may prove inaccurate;
. the distribution requirements for REITs under federal income tax laws
may limit the Company's ability to finance future acquisitions,
developments and expansions without additional debt or equity financing
and may limit cash available for distribution;
. real estate investment considerations such as the effect of economic and
other conditions on real estate values, the general lack of liquidity of
investments in real estate, the ability of tenants to pay rents, the
possibility that leases may not be renewed or will be renewed on terms
less favorable to the Company, the possibility of uninsured losses,
including losses associated with earthquakes, the ability of the
Properties to generate sufficient cash flow to meet operating expenses,
including debt service, and competition in seeking properties for
acquisition and in seeking tenants, which, individually or in the
aggregate, may negatively impact the Company's ability to make
distributions;
. risks associated with debt financing, including the potential inability
to refinance mortgage indebtedness upon maturity and the potential
increase in the level of indebtedness incurred by the Company since its
organizational documents do not limit the amount of indebtedness which
the Company may incur, which may adversely affect the ability of the
Company to repay debt, particularly in the event of a downturn in the
Company's business;
. potential antitakeover effects of provisions generally limiting the
actual or constructive ownership by any one person or entity of Common
Stock to 7.0% of the outstanding shares, a classified board of directors
and other charters and statutory provisions and provisions in the
Operating Partnership's partnership agreement that may have the effect
of inhibiting a change of control of the Company or making it more
difficult to effect a change in management or limiting the opportunity
for stockholders to receive a premium over the market price for the
Common Stock;
6
. dependence on key personnel;
. the Company's cash available for distribution may be less than the
Company expects and may decrease in future periods from expected levels,
materially adversely affecting the Company's ability to make the
expected annual distributions;
. the Company's historical operating losses for financial reporting
purposes;
. the ability of the Company to incur more debt, thereby increasing its
debt service, which could adversely affect the Company's cash flow;
. the potential liability of the Company for environmental matters and the
costs of compliance with certain governmental regulations, which may
negatively impact the Company's financial condition, results of
operations and cash available for distribution;
. potential adverse effects on the value of the shares of Common Stock of
fluctuations in interest rates or equity markets, which may negatively
impact the price at which shares of Common Stock may be resold and may
limit the Company's ability to raise additional equity to finance future
development; and
. the possible issuance of additional shares of Common Stock, including
3,406,212 shares of Common Stock issuable upon exchange of Common Units
outstanding at December 31, 1997, which may adversely affect the market
price of the shares of Common Stock or result in dilution on a per share
basis of cash available for distribution.
ITEM 2. PROPERTIES
GENERAL
The Company (through the Operating Partnership and the Finance Partnership)
owned, as of December 31, 1997, 55 office properties encompassing an aggregate
of approximately 4.2 million rentable square feet and 67 industrial properties
encompassing an aggregate of approximately 5.0 million rentable square feet.
All but 11 of the Properties are located in Southern California suburban
submarkets (including a complex of three Office Properties located adjacent to
the Los Angeles International Airport and a complex of five Office Properties
located adjacent to the Long Beach Municipal Airport). The Company also owns
three office buildings located adjacent to the Seattle-Tacoma International
Airport in the State of Washington, five industrial buildings located in
Northern California, two industrial buildings located in Las Vegas, Nevada and
one industrial building located in Phoenix, Arizona. As of December 31, 1997,
the Office Properties were approximately 94.3% leased to 315 tenants and the
Industrial Properties were approximately 91.9% leased to 233 tenants. The
Company believes that all of its Properties are well-maintained and, based on
recent engineering reports, do not require significant capital improvements.
As of December 31, 1997, the Company in-house manages 33 of its 55 office
properties and 48 of its 67 industrial properties. The Company anticipates
that all of these properties will be in-house managed by December 31, 1998.
In addition, at December 31, 1997, the Company had one office and two
industrial properties under development which, when completed are expected to
encompass 140,000 rentable square feet and an aggregate of 680,000 rentable
square feet, respectively.
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 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.
7
THE OFFICE AND INDUSTRIAL PROPERTIES
The following table sets forth certain information relating to each of the
Properties owned as of December 31, 1997, unless indicated otherwise. This
table gives pro forma effect to the lease with The Boeing Company, entered
into in June 1997, as if such lease had commenced January 1, 1997. The Company
(through the Operating Partnership and the Finance Partnership) owns a 100%
interest in all of the Office and Industrial Properties other than Walnut Park
Business Center in which the Company owns an 87.7% interest as a tenant in
common and the five Office Properties located at Kilroy Airport Center
Long Beach and the three Office Properties located at the SeaTac Office
Center, each of which are held subject to ground leases expiring in 2035 and
2064 (assuming the exercise of the Company's options to extend such leases),
respectively.
YEAR NET PERCENTAGE ANNUAL
NO. OF BUILT/ RENTABLE LEASED AT BASE RENT AVERAGE BASE RENT
PROPERTY LOCATION BUILDINGS RENOVATED SQUARE FEET 12/31/97(1) ($000'S)(2) PER SQ. FT. ($)(3)
----------------- --------- --------- ----------- ----------- ----------- ------------------
OFFICE PROPERTIES:
Los Angeles County
Kilroy Airport Center at El
Segundo
2250 E. Imperial
Highway(4)............... 1 1983 291,187 96.6% 5,019 17.84
2260 E. Imperial
Highway(5)............... 1 1983 291,187 100.0% 7,448 25.58
2240 E. Imperial Highway
El Segundo,
California(6)............ 1 1983 118,933 100.0% 1,293 10.87
Kilroy Airport Center Long
Beach
3900 Kilroy Airport Way... 1 1987 126,840 94.9% 2,572 21.37
3880 Kilroy Airport Way... 1 1987 98,243 100.0% 1,286 13.09
3760 Kilroy Airport Way... 1 1989 165,278 92.7% 3,360 21.94
3780 Kilroy Airport Way... 1 1989 219,745 99.2% 4,881 22.39
3760 Kilroy Airport Way
Long Beach, California.... 1 1989 10,457 100.0% 81 7.75
185 S. Douglas Street
El Segundo,
California(7)............ 1 1978 60,000 100.0% 1,313 21.88
525 N. Brand Blvd.
Glendale, California...... 1 1990 43,649 96.8% 1,255 29.70
12312 W. Olympic Blvd.
Los Angeles,
California(8)............ 1 1950/1998 72,700 100.0%
2100 Colorado Avenue
Santa Monica,
California(7)(26)........ 3 1992 94,844 100.0% 2,816 29.69
1633 26th Street
Santa Monica,
California(7)............ 1 1972/1997 43,800 100.0% 799 18.24
3130 Wilshire Blvd.
Santa Monica,
California(26)........... 1 1969/1998 83,800 72.8% 600 9.83
23600-23610 Telo Avenue
Torrance, California(9)... 2 1984 79,967 51.9% 444 10.71
--- --------- ------
Subtotal/Weighted Average--
Los Angeles County........ 18 1,800,630 94.8% 33,167 19.43
--- --------- ------
Orange County
Pacific Park Plaza
Aliso Viejo,
California(10)(26)....... 5 1992 131,668 100.0% 1,703 12.93
La Palma Business Center
4175 E. La Palma Avenue
Anaheim, California....... 1 1985 42,790 89.4% 692 18.09
701-741 E. Ball Road
Anaheim, California(26)... 5 1986 114,498 85.6% 987 10.08
8101 Kaiser Blvd.
Anaheim, California....... 1 1988 60,177 100.0% 1,120 18.61
Anaheim Corporate Center
Anaheim,
California(11)(26)....... 4 1985 157,876 88.6% 1,071 7.66
8
YEAR NET PERCENTAGE ANNUAL
NO. OF BUILT/ RENTABLE LEASED AT BASE RENT AVERAGE BASE RENT
PROPERTY LOCATION BUILDINGS RENOVATED SQUARE FEET 12/31/97(1) ($000'S)(2) PER SQ. FT. ($)(3)
----------------- --------- --------- ----------- ----------- ----------- ------------------
601 Valencia Avenue
Brea, California(7).... 1 1982 60,755 100.0% 757 12.46
111 Pacifica
Irvine,
California(26)........ 1 1991 67,359 100.0% 1,128 16.75
9451 Toledo Way
Irvine, California(7).. 1 1984 27,200 100.0% 280 10.29
2501 Pullman
Santa Ana,
California(12)(26).... 2 1969/1988 124,921 100.0% 2,398 19.20
--- --------- ------
Subtotal/Weighted
Average--
Orange County.......... 21 787,244 95.0% 10,136 13.55
--- --------- ------
San Diego County
6220 Greenwich Drive
San Diego,
California(7)......... 1 1996 141,214 100.0% 1,914 13.55
6055 Lusk Avenue
San Diego,
California(7)......... 1 1997 93,000 100.0% 1,152 12.39
6260 Sequence Drive
San Diego,
California(7)......... 1 1997 130,000 100.0% 1,182 9.09
6290 Sequence Drive
San Diego,
California(7)......... 1 1997 90,000 100.0% 888 9.87
--- --------- ------
Subtotal/Weighted
Average--
San Diego County....... 4 454,214 100.0% 5,136 11.31
--- --------- ------
Other
26541 Agoura Road
Calabasas,
California(7)(26)..... 1 1988 90,878 100.0% 1,794 19.74
5151-5155 Camino Ruiz
Camarillo,
California(7)(13)..... 4 1982 276,216 100.0% 2,630 9.52
4351 Latham Avenue
Riverside, California.. 1 1990 21,930 100.0% 323 14.73
4361 Latham Avenue
Riverside,
California(14)........ 1 1992 31,425 100.0% 560 17.82
3750 University Avenue
Riverside, California.. 1 1982 124,609 99.4% 2,612 21.08
SeaTac Office Center
18000 Pacific Highway.. 1 1974 209,904 59.3% 1,966 15.79
17930 Pacific
Highway(15)........... 1 1980/1997 211,139 100.0% 2,172 10.29
17900 Pacific Highway
SeaTac, Washington..... 1 1980 111,387 82.3% 2,083 22.72
2829 Townsgate Road
Thousand Oaks,
California............ 1 1990 81,158 96.6% 1,961 25.01
--- --------- ------
Subtotal/Weighted
Average--Other......... 12 1,158,646 90.6% 16,101 15.34
--- --------- ------
SUBTOTAL/WEIGHTED
AVERAGE OFFICE
PROPERTIES............. 55 4,200,734 94.3% 64,540 16.30
=== ========= ======
INDUSTRIAL PROPERTIES:
Los Angeles County
Walnut Park Business
Center
Diamond Bar,
California............ 3 1987 165,420 100.0% 1,091 6.60
2031 E. Mariposa Avenue
El Segundo,
California............ 1 1954 192,053 100.0% 1,754 9.13
2260 E. El Segundo Blvd.
El Segundo,
California............ 1 1979 113,820 100.0% 547 4.81
2265 E. El Segundo Blvd.
El Segundo,
California............ 1 1978 76,570 100.0% 547 7.14
9
YEAR NET PERCENTAGE ANNUAL
NO. OF BUILT/ RENTABLE LEASED AT BASE RENT AVERAGE BASE RENT
PROPERTY LOCATION BUILDINGS RENOVATED SQUARE FEET 12/31/97(1) ($000'S)(2) PER SQ. FT. ($)(3)
----------------- --------- --------- ----------- ----------- ----------- ------------------
2270 E. El Segundo Blvd.
El Segundo,
California............ 1 1975 7,500 0.0%
--- -------
Subtotal/Weighted
Average--
Los Angeles County..... 7 555,363 98.6% 3,939 7.19
--- ------- -----
Orange County
3340 E. La Palma Avenue
Anaheim, California.... 1 1966 153,320 100.0% 967 6.31
1000 E. Ball Road
Anaheim, California.... 1 1956 100,000 100.0% 639 6.39
1230 S. Lewis Road
Anaheim, California.... 1 1982 57,730 100.0% 229 3.97
4155 E. La Palma Avenue
Anaheim,
California(16)........ 1 1985 74,618 100.0% 559 7.49
4125 E. La Palma Avenue
Anaheim,
California(16)........ 1 1985 69,472 41.4% 262 9.12
5325 East Hunter Avenue
Anaheim, California.... 1 1983 109,449 100.0% 596 5.45
3130-3150 Miraloma
Anaheim, California.... 1 1970 144,000 100.0% 667 4.63
3125 E. Coronado Street
Anaheim, California.... 1 1970 144,000 100.0% 852 5.92
5115 E. La Palma Avenue
Anaheim,
California(17)........ 1 1967/1998 291,146 0.0%
Brea Industrial
Properties
Brea, California(18)... 7 1981 276,278 100.0% 1,610 5.83
1675 MacArthur
Costa Mesa,
California............ 1 1986 50,842 100.0% 496 9.76
12681/12691 Pala Drive
Garden Grove,
California............ 1 1970 84,700 82.6% 477 6.81
Garden Grove Industrial
Properties
Garden Grove,
California(19)........ 6 1971 275,971 96.4% 1,403 5.28
12752-12822 Monarch
Street
Garden Grove,
California(16)........ 1 1970 277,037 100.0% 989 3.57
7421 Orangewood Avenue
Garden Grove,
California............ 1 1981 82,602 100.0% 570 6.90
12400 Industry Street
Garden Grove,
California............ 1 1972 64,200 100.0% 319 4.97
Giltspur Building
Garden Grove,
California............ 1 1974 110,220 100.0% 462 4.19
Gothard Business Park
Huntington Beach,
California(20)(26).... 3 1977 56,638 88.4% 341 6.81
17150 Von Karman
Irvine, California..... 1 1977 157,458 100.0% 1,072 6.81
184-220 Technology Drive
Irvine,
California(26)........ 10 1990 159,021 78.1% 1,097 8.84
9401 Toledo Way
Irvine, California..... 1 1984 244,800 100.0% 1,336 5.46
2055 S.E. Main Street
Irvine,
California(21)........ 1 1973 47,583 100.0% 304 6.39
Dimension Business Park
Lake Forest,
California(22)(26).... 2 1990 45,267 100.0% 414 9.15
1951 E. Carnegie
Santa Ana,
California(23)........ 1 1981 100,000 100.0%
10
YEAR NET PERCENTAGE ANNUAL
NO. OF BUILT/ RENTABLE LEASED AT BASE RENT AVERAGE BASE RENT
PROPERTY LOCATION BUILDINGS RENOVATED SQUARE FEET 12/31/97(1) ($000'S)(2) PER SQ. FT. ($)(3)
----------------- --------- --------- ----------- ----------- ----------- ------------------
14831 Franklin Avenue
Tustin,
California(21)........ 1 1978 36,256 100.0% 252 6.95
--- --------- ------
Subtotal/Weighted
Average--
Orange County.......... 48 3,212,608 87.7% 15,913 5.65
--- --------- ------
San Diego County
6828 Nancy Ridge Drive
San Diego, California.. 1 1982 39,669 100.0% 384 9.68
41093 County Center
Drive
Temecula, California... 1 1997 77,582 100.0% 534 6.88
--- --------- ------
Subtotal/Weighted
Average--
San Diego County....... 2 117,251 100.0% 918 7.83
--- --------- ------
Other
1840 Aerojet Way
Las Vegas, Nevada...... 1 1993 102,948 100.0% 492 4.78
1900 Aerojet Way
Las Vegas, Nevada...... 1 1995 106,717 100.0% 462 4.33
821 S. Rockefeller
Ontario, California.... 1 1990 153,566 100.0% 453 2.95
5115 N. 27th Avenue
Phoenix, Arizona(24)... 1 1962 130,877 100.0% 639 4.88
201 North Sunrise Avenue
Roseville,
California(25)(26).... 2 1981 162,203 100.0% 1,590 9.80
1961 Concourse Drive
San Jose,
California(26)........ 1 1984 110,132 100.0% 994 9.03
1710 Fortune Drive
San Jose,
California(26)........ 1 1983 86,000 100.0% 620 7.21
3735 Imperial Highway
Stockton, California... 1 1996 164,540 100.0% 1,134 6.89
4880 Colt Street
Ventura, California.... 1 1986 125,511 100.0% 548 4.37
--- --------- ------
Subtotal/Weighted
Average--Other......... 10 1,142,494 100.0% 6,932 6.07
--- --------- ------
SUBTOTAL/WEIGHTED
AVERAGE INDUSTRIAL
PROPERTIES............. 67 5,027,716 91.9% 27,702 5.99
=== ========= ======
TOTAL/WEIGHTED AVERAGE
ALL PROPERTIES......... 122 9,228,450 93.0% 92,242 10.75
=== ========= ======
- --------
(1) Based on all leases at the respective Properties in effect as of December
31, 1997.
(2) Base rent for the year ended December 31, 1997, determined in accordance
with generally accepted accounting principles ("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) Annual Base Rent divided by net rentable square feet leased at December
31, 1997.
(4) For this Property, a lease with Hughes Space & Communications for
approximately 96,000 rentable square feet, and with SDRC Software
Products Marketing Division, Inc. for approximately 6,800 rentable square
feet, are written on a full service gross basis except that there is no
Expense Stop.
11
(5) For this Property, the lease with Hughes Space & Communications is
written on a modified full service gross basis under which Hughes Space &
Communications pays for all utilities and other internal maintenance
costs with respect to the leased space and, in addition, pays its pro
rata share of real estate taxes, insurance, and certain other expenses
including common area expenses.
(6) For this Property, leases with Hughes Space & Communications for
approximately 103,000 rentable square feet are written on a full service
gross basis except that there is no Expense Stop.
(7) For this Property, the lease is written on a triple net basis.
(8) This Property was acquired in December 1997 and substantial capital
improvements are scheduled for completion in 1998. Percentage leased at
December 31, 1997 reflects space pre-leased to tenants with annual base
rent of $1,357,000.
(9) For this Property, the lease is written on a modified gross basis, with
the tenant paying its share of taxes and insurance above base year
amounts.
(10) For this Property, leases for approximately 65,000 rentable square feet
are written on a full service basis, with the tenants paying no expense
reimbursement, leases for approximately 38,000 rentable square feet are
written on a modified full service gross basis, and leases for
approximately 29,000 rentable square feet are written on a triple net
basis.
(11) For this Property, leases for approximately 70,500 rentable square feet
are written on a full service basis, with the tenants paying no expense
reimbursement, leases for approximately 48,500 rentable square feet are
written on a modified full service gross basis, and leases for
approximately 21,000 rentable square feet are written on a triple net
basis.
(12) For this Property, the lease is written on a full service basis, with the
tenant paying only its portion of property taxes above the base year
amount.
(13) The four Properties at 5151-5155 Camino Ruiz were built between 1982 and
1985.
(14) For this Property, a lease for 15,728 rentable square feet is written on
a triple net basis, and leases for 15,156 rentable square feet are
written on a modified full service gross basis.
(15) This table gives pro forma effect to the Boeing Lease for 211,000
rentable square feet on June 20, 1997, and providing for 100% occupancy
by December 31, 1997.
(16) The leases for this Industrial Property are written on a modified triple
net basis, with the tenants responsible for estimated allocated common
area expenses.
(17) This Property was acquired in October 1997 and substantial capital
improvements are scheduled for completion in 1998.
(18) The seven Properties at the Brea Industrial Properties were built between
1981 and 1988.
(19) The six Properties at the Garden Grove Industrial Properties were built
between 1971 and 1985.
(20) For this Property, leases for approximately 38,000 rentable square feet
are written on a modified full service gross basis, and leases for
approximately 12,000 rentable square feet are written on a full service
basis, with the tenants paying no expense reimbursement.
(21) For this Property, the lease is written on a full service gross basis.
(22) For this Property, leases for approximately 26,000 rentable square feet
are written on a full service basis, with the tenants paying no expense
reimbursement, and leases for approximately 19,000 rentable square feet
are written on a modified full service gross basis.
(23) For this Property, Percentage leased at December 31, 1997 reflects the
lease signed with Ricoh Electronics, Inc. during 1997 with annual base
rent of $780,000.
(24) 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.
(25) For this Property, approximately 115,500 rentable square feet are written
on a triple net basis and, approximately 46,500 rentable square feet are
written on a full service basis, with the tenants paying no expense
reimbursement.
(26) This Property was managed by third-party managers at December 31, 1997.
12
Significant Office Property
2260 E. Imperial Highway, El Segundo. Because the 1997 gross revenues for
the Office Property located at 2260 E. Imperial Highway at Kilroy Airport
Center in El Segundo were in excess of 10% of the aggregate gross revenues for
all Properties for the year ended December 31, 1997, additional information
regarding this Property is presented below.
The Office Property located at 2260 E. Imperial Highway had an occupancy
rate of 100.00% for each of the years ended December 31, 1993 through 1997. As
of December 31, 1997, Hughes Space & Communications occupied 100.00% of the
Property's 291,187 rentable square feet. Hughes Space & Communications
commenced occupancy of the entire building on August 1, 1984. This lease runs
through July 31, 2004 and has annual base rent of $7,448,340 per year, or
$25.58 per rentable square foot, with CPI adjusted increases in base rent
every two years. The next CPI adjustment is scheduled to occur on August 1,
1998 and provides for an increase in base rent to the extent that such CPI
adjustment exceeds a minimum floor of 1.86% compounded annually. The remaining
CPI adjustments scheduled for August 1, 2000 and August 1, 2002, respectively,
provide for similar increases to the extent that the CPI adjustment exceeds a
minimum floor of 3% compounded annually. The total annual rental income per
rentable square foot was $26.66, $24.59, $24.59, $25.00 and $25.58 for each of
the years ended December 31, 1993 through December 31, 1997, respectively.
The Company's tax basis in this Property for federal income tax purposes as
of December 31, 1997 was approximately $2.0 million, net of accumulated
depreciation and reductions in depreciable basis. For the 12-month period
ending December 31, 1997, the Company was assessed property taxes on the
Property at an effective annual rate of approximately 1.0%. Property taxes on
this Property for the 12-month period ending December 31, 1997, totaled
approximately $282,000. Management believes that the contribution of this
Property to the Operating Partnership in connection with the Formation
Transactions will cause this property to be reassessed to its fair market
value at date of contribution (January 31, 1997). The property has not been
reassessed as of December 31, 1997.
13
TENANT INFORMATION
The Company's tenants include significant corporate and other commercial
enterprises representing a range of industries including, among others,
satellite communications, manufacturing, entertainment, banking, insurance,
telecommunications, health care, computer software, finance, engineering,
technology, legal and accounting. The following table sets forth information
as to the Company's largest tenants based upon annualized rental revenues for
the year ended December 31, 1997.
PERCENTAGE OF
ANNUAL TOTAL BASE
BASE RENTAL RENTAL INITIAL LEASE LEASE EXPIRATION
REVENUES(1) REVENUES DATE(2) DATE
----------- ------------- -------------- ----------------
OFFICE TENANTS:
Hughes Aircraft
Corporation's Space &
Communications
Company(3)............. $8,808,149 9.6% August 1984 Various
The Boeing Company(4)(5)
....................... 4,376,620 4.7 February 1992 Various
Sony Music
Entertainment, Inc. ... 2,803,608 3.0 June 1997 December 2008
M/R Systems Corporation. 2,647,874 2.9 May 1997 April 2001
State of California
(Caltrans)............. 2,390,439 2.6 July 1997 February 1999
Northwest Airlines:
El Segundo............ 1,313,418 1.4 August 1978 February 2001
Seattle............... 712,502 0.8 May 1980 April 2005
Devry, Inc. ............ 2,048,525 2.2 November 1994 October 2009
Raytheon Company(6)..... 1,650,991 1.8 April 1996 Various
ARCS Mortgage Company... 1,268,872 1.4 April 1997 December 1998
Best, Best & Krieger.... 1,259,964 1.4 October 1997 September 2006
----------- ----
Total Office Properties. $29,280,962 31.8%
=========== ====
INDUSTRIAL TENANTS:
Intuit, Inc. ........... $ 1,911,474 2.1% November 1997 June 2004
Mattel, Inc. ........... 1,755,508 1.9 May 1990 October 2000
Mazda Motor of America,
Inc. .................. 1,628,882 1.8 July 1997 July 2000
Kraft Foods, Inc. ...... 1,132,149 1.2 November 1997 February 2006
Packard Hughes
Interconnect and
General Motors
Corporation............ 1,072,444 1.2 May 1997 January 2001
Ricoh Electronics,
Inc.(7)................ 779,915 0.9 October 1997 December 2007
Southern Plastic Mold,
Inc. .................. 773,626 0.8 September 1997 September 2003
Allen-Bradley Company,
Inc.................... 639,432 0.7 May 1992 April 1998
Cannon Equipment West,
Inc. .................. 595,998 0.7 August 1995 July 2003
MRJ Industries, Inc. ... 595,695 0.7 May 1997 May 2006
----------- ----
Total Industrial
Properties............. $10,885,123 12.0%
=========== ====
- --------
(1) Determined in accordance with GAAP.
(2) Represents date of first relationship between tenant and the Company or
the Company's predecessor, the Kilroy Group.
(3) Hughes Space & Communications leases of 291,187 and 103,035 net rentable
square feet expire July 2004 and January 1999, respectively. Leases with
other Hughes-affiliated entities of 7,515, 5,559 and 5,158 net rentable
square feet expire November 2001, December 1999 and November 1999,
respectively.
(4) Table gives pro forma effect to the lease with The Boeing Company for
211,000 rentable square feet at the SeaTac Office Center which was signed
in June 1997 and provided for 100% occupancy by December 31, 1997.
(5) The Boeing Company lease at SeaTac Office Center expires January 2002. The
Boeing Company (formerly McDonnell Douglas Corporation) leases at Kilroy
Airport Center Long Beach of 64,530, 24,536 and 17,921 net rentable square
feet expire January 2002, December 2000 and December 1999, respectively.
(footnotes continued on next page)
14
(6) Raytheon Company (formerly Hughes Aircraft Company) leases of 96,133 and
11,556 net rentable square feet expire October 2000, and a lease of 9,387
net rentable square feet expires January 2002.
(7) Table gives pro forma effect to the lease with Ricoh Electronics, Inc.
which was signed in October 1997. Due to tenant improvement delays, the
tenant moved in January 1, 1998.
LEASE EXPIRATIONS
The following table sets forth a schedule of the lease expirations for the
Office Properties for each of the ten years beginning with 1998, assuming that
none of the tenants exercise renewal options or termination rights.
AVERAGE ANNUAL
PERCENTAGE RENT PER NET
OF TOTAL LEASED RENTABLE
NET RENTABLE SQUARE FEET ANNUAL BASE SQUARE FOOT
NUMBER OF AREA SUBJECT REPRESENTED RENT UNDER REPRESENTED BY
EXPIRING TO EXPIRING BY EXPIRING EXPIRING EXPIRING
YEAR OF LEASE EXPIRATION LEASES(1) LEASES (SQ. FT.) LEASES(2) LEASES (000'S)(3) LEASES
- ------------------------ --------- ---------------- --------------- ----------------- --------------
1998.................... 85 386,047 9.9% $ 6,065 $15.71
1999.................... 65 555,118 14.2 8,585 15.47
2000.................... 42 323,596 8.3 5,633 17.41
2001.................... 37 795,438 20.4 11,819 14.86
2002.................... 23 221,005 5.7 4,163 18.84
2003.................... 6 233,907 6.0 2,623 11.21
2004.................... 9 462,766 11.8 9,896 21.38
2005.................... 5 182,983 4.7 2,331 12.74
2006.................... 4 134,924 3.4 2,802 20.77
2007 and beyond......... 13 610,797 15.6 9,908 16.22
--- --------- ----- -------
Total................... 289 3,906,581 100.0% $63,825
=== ========= ===== =======
- --------
(1) Includes office tenants only. Excludes leases for amenity, retail, parking
and month-to-month office tenants. Some tenants have multiple leases.
(2) Excludes all space vacant as of December 31, 1997 unless a lease for a
replacement tenant had been executed on or before January 1, 1998.
(3) Determined based upon aggregate base rent to be received over the term
divided by the term in months multiplied by 12, including all leases
executed on or before January 1, 1998. Certain leases became effective
subsequent to January 1, 1998.
15
The following table sets forth a schedule of the lease expirations for the
Industrial Properties for each of the ten years beginning with 1998, assuming
that none of the tenants exercise renewal options or termination rights:
PERCENTAGE OF
TOTAL LEASED AVERAGE ANNUAL
NET RENTABLE SQUARE FEET ANNUAL BASE RENT PER NET RENTABLE
NUMBER OF AREA SUBJECT REPRESENTED RENT UNDER SQUARE FOOT
EXPIRING TO EXPIRING BY EXPIRING EXPIRING REPRESENTED BY
YEAR OF LEASE EXPIRATION LEASES LEASES (SQ. FT.) LEASES(1) LEASES (000'S)(2) EXPIRING LEASES
- ------------------------ --------- ---------------- ------------- ----------------- ---------------------
1998.................... 84 858,812 19.0% $ 5,029 $5.86
1999.................... 48 512,809 11.3 3,017 5.88
2000.................... 26 686,656 15.2 4,965 7.23
2001.................... 19 851,310 18.8 5,232 6.15
2002.................... 7 189,458 4.2 1,584 8.36
2003.................... 5 387,966 8.6 1,445 3.72
2004.................... 2 134,873 3.0 927 6.87
2005.................... 2 148,476 3.3 944 6.36
2006.................... 6 534,900 11.8 3,867 7.23
2007 and beyond......... 4 215,776 4.8 1,407 6.52
--- --------- ----- -------
Total................. 203 4,521,036 100.0% $28,417
=== ========= ===== =======
- --------
(1) Excludes all space vacant as of December 31, 1997, unless a lease for a
replacement tenant had been executed on or before January 1, 1998.
(2) Determined based upon aggregate base rent to be received over the term
divided by the term in months multiplied by 12, including all leases
executed on or before January 1, 1998.
MORTGAGE DEBT
On December 31, 1997, the Operating Partnership had outstanding five
mortgage loans and one promissory note secured by certain of the Properties
representing aggregate indebtedness of approximately $131.4 million (the
"Secured Obligations"). See "Management's Discussion and Analysis of Financial
Condition and Results of Operations--Liquidity and Capital Resources" and Note
5 to the Company's combined and consolidated financial statements included
herewith. Management believes that as of December 31, 1997, the value of the
Properties securing the respective Secured Obligations in each case exceeded
the principal amount of the outstanding obligation.
ITEM 3. LEGAL PROCEEDINGS
Neither the Company nor any of the Properties is subject to any material
litigation nor, to the Company's knowledge, is any material litigation
threatened against any of them, other than routine litigation arising in the
ordinary course of business, which is expected to be covered by liability
insurance.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
The Company was organized in September 1996 and commenced operations on
January 31, 1997. No matters were submitted to a vote of stockholders during
the fourth quarter of the year ended December 31, 1997.
16
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The Company's common stock began trading on the New York Stock Exchange
("NYSE") on January 28, 1997, under the symbol "KRC." Because the Company's
Common Stock commenced trading on the NYSE on January 28, 1997, no sales
prices for the Company's Common Stock are available for periods prior to that
date. On March 18, 1998, the reported closing sale price on the NYSE was
$26.3125 per share and there were approximately 137 holders of record of
Common Stock.
The high, low and closing price per share of Common Stock for the period
ended March 31, 1997 and the three subsequent quarters of fiscal 1997 are as
follows:
COMMON
STOCK
DIVIDENDS
1997 HIGH LOW CLOSE DECLARED
---- ------ ------ ------ ---------
Period ended March 31....................... $28.13 $24.88 $26.63 $0.2583
Second quarter.............................. 26.63 23.13 25.25 0.3875
Third quarter............................... 27.00 24.00 27.00 0.3875
Fourth quarter.............................. 28.88 25.75 28.75 0.3875
Distributions will be paid on or about the 10th day of each January, April,
July and October to common stockholders at the discretion of the Board of
Directors and will depend on the funds from operations of the Company, its
financial condition, capital requirements, the annual distribution
requirements under the REIT provisions of the Internal Revenue code of 1986,
as amended (the "Code"), and such other factors as the Board of Directors
deems relevant.
During the last quarter of the fiscal year 1997, in connection with the
Contribution Agreement, dated October 31, 1997, by and among the Company, the
Operating Partnership and The Allen Group, a group of affiliated real estate
development and investment companies ("The Allen Group"), the Operating
Partnership issued 588,736 Common Units in the Operating Partnership with an
aggregate value of approximately $15,284,000 (based on the average closing
price per share of Common Stock on the NYSE for the period from July 14, 1997
to July 31, 1997 of $25.96) to five accredited investors in partial
consideration for the contribution of certain properties to the Operating
Partnership. The Common Units were issued in reliance upon an exemption from
registration provided by Regulation D under the Securities Act as a
transaction by an issuer not involving a public offering.
17
ITEM 6. SELECTED FINANCIAL DATA
THE COMPANY AND KILROY GROUP
(IN THOUSANDS, EXCEPT SQUARE FOOTAGE, SHARE AND OCCUPANCY DATA)
KILROY GROUP COMBINED
----------------------------------------------
KILROY
REALTY CORP.
CONSOLIDATED
FEBRUARY 1, JANUARY 1,
1997 TO 1997 TO YEAR ENDED DECEMBER 31,
DECEMBER 31, JANUARY 31, ----------------------------------
1997 1997 1996 1995 1994 1993
------------ ----------- ------- ------- ------- -------
STATEMENTS OF OPERATIONS
DATA:
Rental income............. $56,069 $2,760 $35,022 $33,896 $32,577 $35,599
Tenant reimbursements..... 5,600 275 3,380 3,002 1,643 4,916
Development and
management fees.......... 14 698 1,156 919 751
Sale of air rights........ 4,456
Lease termination fees.... 100 300 5,190
Interest income........... 3,571
Other income.............. 889 4 76 298 784 188
------- ------ ------- ------- ------- -------
Total revenues.......... 66,129 3,053 39,176 42,908 36,223 46,644
------- ------ ------- ------- ------- -------
Property expenses......... 8,770 579 6,788 6,834 6,000 6,391
Real estate taxes
(refunds)................ 3,048 106 1,301 1,416 (448) 2,984
General and
administrative expenses.. 4,949 78 2,383 2,152 2,467 1,113
Ground leases............. 938 64 768 789 913 941
Development expenses...... 46 650 737 468 581
Option buy-out cost....... 3,150
Interest expense.......... 9,738 1,895 21,853 24,159 25,376 25,805
Depreciation and
amortization............. 13,236 787 9,111 9,474 9,962 10,905
------- ------ ------- ------- ------- -------
Total expenses.......... 40,679 3,555 46,004 45,561 44,738 48,720
------- ------ ------- ------- ------- -------
Income (loss) before
equity in (loss) income
of subsidiary,
minority interest and
extraordinary gains...... 25,450 (502) (6,828) (2,653) (8,515) (2,076)
Equity in income (loss)
of subsidiary............ 23
Minority interest......... (3,413)
Extraordinary gains--
Extinguishment of debt... 3,204 20,095 15,267 1,847
------- ------ ------- ------- ------- -------
Net income (loss)....... $22,060 $2,702 $13,267 $12,614 $(6,668) $(2,076)
======= ====== ======= ======= ======= =======
SHARE DATA:
Weighted average shares
outstanding--basic....... 18,445
=======
Weighted average shares
outstanding--diluted..... 18,539
=======
Net income per common
share--basic............. $ 1.20
=======
Net income per common
share--diluted........... $ 1.19
=======
Distribution per common
share.................... $ 1.42
=======
DECEMBER 31,
--------------------------------------------------------------
KILROY REALTY CORP. KILROY GROUP COMBINED
CONSOLIDATED ------------------------------------------
1997 1996 1995 1994 1993
------------------- --------- --------- --------- ---------
BALANCE SHEET DATA:
Investment in real
estate, before
accumulated
depreciation and
amortization.......... $834,690 $ 227,337 $ 224,983 $ 223,821 $ 222,056
Total assets........... 757,654 128,339 132,857 143,251 148,386
Mortgage debt and line
of credit............. 273,363 223,297 233,857 250,059 248,043
Total liabilities...... 305,319 242,116 254,683 273,585 263,346
Minority interest...... 55,185
Total stockholders'
equity/(accumulated
deficit).............. 397,150 (113,777) (121,826) (130,334) (114,960)
18
KILROY REALTY
CORP.
CONSOLIDATED/
COMBINED YEAR KILROY GROUP COMBINED
ENDED YEAR ENDED DECEMBER 31,
DECEMBER 31, ------------------------------------------
1997 1996 1995 1994 1993
------------- --------- --------- --------- ---------
OTHER DATA:
Funds from
Operations(1)(2)....... $ 39,142 $ 5,433 $ 2,365 $ 1,447 $ 3,639
Cash flows from(2):
Operating activities... 28,928 5,520 10,071 6,607 11,457
Investing activities... (551,956) (2,354) (1,162) (1,765) 2,028
Financing activities... 531,957 (3,166) (8,909) (4,842) (134,858)
Office Properties:
Rentable square
footage............... 4,200,734 1,688,383 1,688,383 1,688,383 1,688,383
Occupancy.............. 94.3% 76.0% 72.8% 73.3% 81.0%
Industrial Properties:
Rentable square
footage............... 5,027,716 916,570 916,570 916,570 916,570
Occupancy.............. 91.9% 97.6% 98.4% 79.7% 77.6%
- -------
(1) As defined by the National Association of Real Estate Investment Trusts
("NAREIT"), "Funds from Operations" represents net income (loss) before
minority interest of unitholders (computed in accordance with GAAP),
excluding gains (or losses) from debt restructuring and sales of property,
plus real estate related depreciation and amortization (excluding
amortization of deferred financing costs and depreciation of non-real
estate assets) and after adjustments for unconsolidated partnerships and
joint ventures. Non-cash adjustments to Funds from Operations were as
follows: in all periods, depreciation and amortization; in 1996, 1995 and
1994, gains on extinguishment of debt; and in 1997, non-cash compensation.
Further, in 1996 and 1995, non-recurring items (sale of air rights and
option buy-out cost) were excluded. Management considers Funds from
Operations an appropriate measure of performance of an equity REIT because
industry analysts have accepted it as such. The Company computes Funds
from Operations in accordance with standards established by the Board of
Governors of NAREIT in its March 1995 White Paper, which may differ from
the methodology for calculating Funds from Operations utilized by other
equity REITs and, accordingly, may not be comparable to such other REITs.
Further, Funds from Operations does not represent amounts available for
management's discretionary use because of needed capital replacement or
expansion, debt service obligations, or other commitments and
uncertainties. See the notes to the financial statements of the Company
and the Kilroy Group. Funds from Operations should not be considered as an
alternative for net income as a measure of profitability nor is it
comparable to cash flows provided by operating activities determined in
accordance with GAAP.
(2) Funds from Operations is derived from the results of operations of Kilroy
Realty Corporation for the period February 1, 1997 to December 31, 1997.
Cash flow represents the cash flow of the Kilroy Group for the period
January 1, 1997 to January 31, 1997 and Kilroy Realty Corporation for the
period February 1, 1997 to December 31, 1997.
19
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 the combined financial statements of the Company's
predecessor, the Kilroy Group, and should be read in conjunction with the
financial statements and related notes thereto appearing elsewhere in this
report.
OVERVIEW AND BACKGROUND
The Company owns, operates and develops commercial and industrial real
estate, primarily in Southern California. The Company commenced operations in
January 1997 and has operated as a self-administered REIT. The Company
succeeded to the real estate business of the Kilroy Group, the Company's
predecessor, which had been engaged in the acquisition, management, financing,
construction and leasing of commercial and industrial properties. The combined
financial statements of the Kilroy Group comprise the operations, assets and
liabilities of the properties contributed to the Company in connection with
the Formation Transactions following the IPO on January 31, 1997 (see Note 1
to the Consolidated and Combined Financial Statements for a discussion of the
organization and formation of the Company). As of December 31, 1997, the
Company owned 55 office buildings and 67 industrial buildings, which
encompassed approximately 4.2 million and 5.0 million rentable square feet,
respectively, and were 93.0% leased. The Company owns its interests in all of
the Properties through the Operating Partnership and the Finance Partnership.
As a result of the Formation Transactions in the first quarter of 1997,
acquisitions during the year and a public offering of 10,000,000 shares of
common stock in August (the "August Offering"), the Company's total assets
increased to $757.7 million, including real estate assets of $712.9 million,
net of accumulated depreciation, as of December 31, 1997. The market
capitalization of the Company, based on the market value at December 31, 1997
of the 24,475,000 issued and outstanding shares of Common Stock, 3,406,212
Common Units and the $273.4 million of debt outstanding, was $1,075.0 million.
The Company's debt-to-total market capitalization ratio at December 31, 1997
was 25.4%.
Income is derived primarily from rental revenue (including tenant
reimbursements). As a result of the Company's acquisitions in 1997, the
financial data shows significant increases in total revenues and expenses for
the year ended December 31, 1997 compared to the years ended December 31, 1996
and 1995. For the foregoing reason, management does not believe the financial
data for the year ended December 31, 1997 is comparable to the year ended
December 31, 1996.
The Company anticipates that the most significant part of its revenue growth
in the next one to two years will come from additional acquisitions. However,
if the Southern California office and industrial rental market continues to
improve, then rental rate increases may become a more substantial part of its
revenue growth.
RESULTS OF OPERATIONS
The Company's management believes that in order to provide meaningful
historical analysis of the financial statements, certain adjustments must be
made to the historical Kilroy Group financial statements to make accounting
periods comparable. Accordingly, the results of operations for the period
January 1, 1997 to January 31, 1997 have been adjusted to reflect interest
income, general and administrative expenses, interest expense and
extraordinary gains as if the IPO had been consummated on January 1, 1997. The
following section discusses the results of operations as adjusted.
20
Adjusted Year Ended December 31, 1997 Compared to Year Ended December 31,
1996
YEAR ENDED
DECEMBER 31,
--------------------
1997 1996
------------ -------
(UNAUDITED,
AS ADJUSTED)
(IN THOUSANDS)
Revenues:
Rental income.......................................... $58,829 $35,022
Tenant reimbursements.................................. 5,875 3,380
Interest income........................................ 4,057
Development services................................... 14 698
Other income........................................... 893 76
------- -------
Total revenues....................................... 69,668 39,176
------- -------
Expenses:
Property expenses...................................... 9,349 6,788
Real estate taxes...................................... 3,154 1,301
General and administrative............................. 5,312 2,383
Ground leases.......................................... 1,002 768
Development expense.................................... 46 650
Option buy-out cost.................................... 3,150
Interest expense....................................... 10,504 21,853
Depreciation and amortization.......................... 14,023 9,111
------- -------
Total expenses....................................... 43,390 46,004
------- -------
Adjusted income (loss) before equity in income of
subsidiary, minority interest and extraordinary gains .. $26,278 $(6,828)
======= =======
Total revenues increased $30.5 million, or 77.8%, to $69.7 million for the
year ended December 31, 1997 compared to $39.2 million for the same period in
1996. Rental income increased $23.8 million, or 68.0%, to $58.8 million for
the year ended December 31, 1997 compared to $35.0 million for the same period
in 1996. This increase was due primarily to the purchase of 96 office and
industrial buildings encompassing an aggregate of 5.9 million rentable square
feet subsequent to the IPO. The following two paragraphs discuss the changes
in rental income resulting from the portfolio of properties which existed at
the IPO, and the subsequent acquisitions.
Rental income from office buildings increased $14.2 million or 32.5% to
$43.7 million for the year ended December 31, 1997 from $29.5 million for the
comparable period in 1996. This improvement was due to an increase of
2,464,000 square feet of office space under lease, from 1,284,000 square feet
at December 31, 1996 to 3,748,000 square feet at December 31, 1997 (excluding
the lease with The Boeing Company for 211,000 rentable square feet, which
provides for occupancy on December 31, 1997). Approximately 335,000 rentable
square feet of the increase reflects four office buildings acquired in
connection with the IPO and 2,065,000 rentable square feet represents 41
office buildings purchased subsequent to the IPO. The remaining increase in
office space under lease is primarily the result of leasing activity at Kilroy
Airport Center in El Segundo and Kilroy Airport Center Long Beach. However,
the increase in square footage under lease was offset by a decrease in average
rent per rentable square foot at Kilroy Airport Center in El Segundo, from
$21.34 per square foot for the year ended December 31, 1996 to $19.92 for the
same period in 1997, as a result of the re-negotiation and extension of a
lease with Hughes Space and Communications in November 1996. Average rent per
rentable square foot also decreased at Kilroy Airport Center Long Beach, from
$25.05 per rentable square foot for the year ended December 31, 1996 to $21.61
for the same period in 1997 due to the re-leasing of 20,000 square feet and
the lease-up of 24,000 square feet to McDonnell Douglas Corporation at a rate
substantially lower than under the previous leases.
21
Rental income from industrial buildings increased $9.6 million or 63.6% to
$15.1 million for the year ended December 31, 1997 compared to $5.5 million
for the same period in 1996. This improvement was due to an increase in
industrial space under lease from 894,000 square feet at December 31, 1996 to
4,622,000 square feet at December 31, 1997, an increase of 3,728,000 square
feet. The increase was due to the purchase of three industrial buildings in
connection with the IPO with approximately 380,000 square feet under lease at
December 31, 1997, and the purchase of 55 industrial buildings subsequent to
the IPO, with approximately 3,348,000 square feet under lease at December 31,
1997. The remaining increase was primarily attributable to the lease-up of
62,000 square feet of industrial space in the fourth quarter of 1996.
Tenant reimbursements increased $2.5 million or 73.8% to $5.9 million in
1997 from $3.4 million for the same period in 1996. The $2.5 million increase
was primarily due to tenant reimbursements from the office and industrial
buildings purchased in connection with the IPO and during the year ended
December 31, 1997. Interest income increased $4.1 million due to interest
earned on the $116.2 million of net IPO proceeds remaining after the purchase
of the properties and the repayment of debt in connection with the IPO, and
the $146.0 million of net proceeds from the August Offering remaining after
the repayment of borrowings on the Credit Facility. Other income for the year
ended December 31, 1997 includes $0.3 million in lease termination fees, $0.3
million in revenues which were previously written off as uncollectible, a $0.1
million gain on the sale of furniture and equipment, and $0.1 million in
property management fees. The decrease in development services of $0.7 million
is due to the services being performed by an unconsolidated subsidiary of the
Company since the IPO.
Expenses for the year ended December 31, 1997 decreased by $2.6 million, or
5.7%, to $43.4 million compared to $46.0 million for the year ended December
31, 1996. Property expenses and real estate taxes increased $2.6 million and
$1.9 million, respectively, primarily due to the properties purchased in
connection with the IPO and during the year ended December 31, 1997. General
and administrative expenses increased $2.9 million or 122.9% during the year
ended December 31, 1997 over the same period in 1996 due to the incremental
costs of operating a public company and the additional costs of operating a
larger portfolio of properties. Ground lease expense increased $0.2 million
during the year ended December 31, 1997 over the same period in 1996 primarily
as a result of ground leases on two of the buildings purchased in connection
with the IPO. Interest expense decreased $11.4 million, or 51.9%, to $10.5
million for the year ended December 31, 1997 from $21.9 million for the year
ended December 31, 1996, primarily as a result of the repayment of
$127.4 million in debt in connection with the IPO. In addition, the Company's
weighted average interest rate decreased 0.9% to 7.8% at December 31, 1997
compared to 8.7% at December 31, 1996.
Net income before extraordinary gains was $26.3 million for the year ended
December 31, 1997 compared to a $6.8 million loss for the same period in 1996.
The net change in net income before extraordinary gains of $33.1 million was
due primarily to the line items discussed above; an increase in rental income
of $23.8 million, an increase in interest income of $4.1 million, and a
decrease in interest expense of $11.4 million. In addition, there was a $3.2
million expense related to the option buy-out cost discussed below in the year
ended 1996. These changes were partially offset by the increases in expenses
discussed above.
Year Ended December 31, 1996 Compared to Year Ended December 31, 1995
Total revenues decreased $3.7 million, or 8.7%, for the year ended December
31, 1996 compared to the same period for 1995. Rental income increased $1.1
million, or 3.3%, to $35.0 million for the year ended December 31, 1996
compared to $33.9 million for the same period in 1995. Rental income from
Office Properties contributed by the Kilroy Group increased $0.8 million
during the year ended December 31, 1996 from the comparable period in 1995.
Such increase was due to office space under lease increasing from 1,222,000
square feet at December 31, 1995 to 1,284,000 square feet at December 31,
1996. The majority of this increase related to leasing at Kilroy Airport
Center Long Beach. There was no significant change in rent per net rentable
square foot for the year ended 1996 compared to the year ended 1995. Rental
income from Industrial Properties contributed by the Kilroy Group increased
$0.3 million during the year ended December 31, 1996 compared to the same
period in 1995. The increase resulted from a lease with a CPI increase and the
effect of the 2260 E. El Segundo Boulevard building being leased for the
entire twelve months ended December 31, 1996. Tenant reimbursements increased
to $3.4 million in 1996 compared to $3.0 million for 1995. The $0.4 million
increase was primarily due to increased billable operating expenses resulting
from new leases. Revenues for 1995
22
included a gain on the sale of air rights of $4.5 million at Kilroy Airport
Center in El Segundo. (See Note 2 to the Consolidated and Combined financial
statements.)
Expenses for the year ended December 31, 1996 increased by $0.4 million, or
1.0%, to $46.0 million compared to $45.6 million in 1995. During the year
ended December 31, 1996, the Company accrued the costs of an option buy-out of
$3.2 million for the cancellation of an option to purchase a 50.0% equity
interest in Kilroy Airport Center in El Segundo. Interest expense decreased
$2.3 million, or 9.6%, to $21.9 million in 1996 from $24.2 million in 1995,
primarily as a result of the forgiveness and restructuring of certain debt in
1995 and 1996.
Net income was $13.3 million for the year ended December 31, 1996 compared
to $12.6 million for the same period in 1995. The increase of $0.7 million is
due primarily to an increase in rental income of $1.1 million, a decrease in
interest expense of $2.3 million and an increase in extraordinary gains of
$4.8 million, less the nonrecurring option buy-out cost of $3.2 million for
1996 and the sale of air rights of $4.5 million in 1995.
LIQUIDITY AND CAPITAL RESOURCES
In February 1998, the Company obtained a $350.0 million unsecured revolving
credit facility (the "Credit Facility"), which bears interest at a rate that
ranges from LIBOR plus 1.00% to LIBOR plus 1.25% depending on the Company's
leverage ratios, and matures in February 2000. Availability under the Credit
Facility is dependent upon the value of the Company's pool of unencumbered
assets and was $128.9 million at February 27, 1998. There were borrowings of
$140.0 million outstanding at February 27, 1998.
In addition, the Company had debt outstanding as of December 31, 1997 of
$131.4 million, comprised of five mortgage loans in the amounts $83.1 million,
$14.0 million, $13.8 million, $11.7 million and $7.9 million, and a
$0.9 million promissory note. The $83.1 million mortgage loan requires monthly
principal and interest payments based on an interest rate of 8.35%, amortizes
over 25 years and matures in 2022. In February 2005, the interest rate resets
to the greater of 13.35% or the sum of the interest rate for U.S. Treasury
Securities maturing 15 years from the reset date plus 5.0%. The $14.0 million
mortgage loan requires monthly payments of interest computed at a variable
rate based on LIBOR plus 1.50%. In January 1998, the Company increased the
$14.0 million mortgage loan to $19.0 million and extended the maturity date to
January 31, 2000. The $13.8 million mortgage loan bears interest at 8.45% and
matures on December 1, 2005. The $11.7 million mortgage loan bears interest at
8.43% and matures on November 1, 2014. The $7.9 million mortgage loan bears
interest at 8.21% and matures on October 1, 2013. Principal and interest are
payable monthly on the $13.8 million, the $11.7 million and the $7.9 million
mortgage loans. The $0.9 million promissory note was repaid in January 1998.
In August 1997, the Company completed the August Offering of 10,000,000
shares of Common Stock. The offering price was $25.50 per share resulting in
gross proceeds of $255.0 million. The aggregate proceeds to the Company, net
of underwriter's discount and offering costs were approximately $241.0
million. The net proceeds were used to pay outstanding borrowings on the
Credit Facility and to fund acquisitions.
In January 1998, the Company filed a "shelf" registration statement on Form
S-3 with the Securities and Exchange Commission (the "SEC") which registered
$400.0 million of equity securities of the Company. The statement was declared
effective by the SEC on February 11, 1998. As of March 18, 1998, an aggregate
of $352.6 million of equity securities were issuable under the registration
statement.
In February 1998, the Company completed the issuance of 1,200,000 8.075%
Series A Cumulative Redeemable Preferred Units, representing limited
partnership interests in the Operating Partnership (the "Preferred Units"),
with a liquidation value of $50.00 per unit, in exchange for a gross
contribution to the Operating Partnership of $60.0 million. The Company used
the contribution proceeds, less applicable transactions costs and expenses of
approximately $1.6 million, for the repayment of borrowings outstanding on the
Credit Facility. The Preferred Units, which may be called by the Operating
Partnership at par on or after February 6, 2003, have no stated maturity or
mandatory redemption and are not convertible into any other
23
securities of the Operating Partnership. The Preferred Units are exchangeable
at the option of the majority of the holders, for shares of the Company's
8.075% Series A Cumulative Preferred Stock, beginning February 6, 2008 which
may be accelerated under certain circumstances.
In February 1998, the Company completed the public offering of 724,888
shares of Common Stock at a price of $27.50 per share. Net proceeds of
approximately $18.9 million were used to reduce the balance of the Company's
Credit Facility. The shares were deposited in a registered unit investment
trust comprised of a number of publicly-traded real estate investment trusts.
In February 1998, the Company completed the public offering of 1,000,000
shares of Common Stock at a price of $27.50 per share. Net proceeds of
approximately $26.1 million were used to reduce the balance of the Company's
Credit Facility. The shares were deposited in a registered unit investment
trust comprised of a number of publicly-traded real estate investment trusts.
Through December 31, 1997, the Company purchased 96 office and industrial
buildings for an aggregate acquisition cost of $507.4 million. The purchase
price for such properties was funded out of net proceeds from the IPO and the
August Offering, from borrowings on the Credit Facility, the issuance and
assumption of mortgage notes and the issuance of 753,838 limited partnership
units in the Operating Partnership. From January 1, 1998 through February 27,
1998, the Company purchased 22 office and industrial buildings for an
aggregate acquisition cost of $88.6 million. The acquisitions were funded from
borrowings on the Credit Facility.
The Company believes that it will have sufficient capital resources to
satisfy its obligations for the next twelve months. The Company expects to
meet certain of its long-term liquidity requirements, including the repayment
of long-term debt of $83.1 million (less scheduled principal repayments) in
2005 and possible property acquisitions and development, through long-term
secured and unsecured borrowings, including the Credit Facility, and the
issuance of debt securities or additional equity securities of the Company or,
possibly in connection with acquisitions of land or improved properties, the
issuance of units of the Operating Partnership.
CAPITAL EXPENDITURES
On October 31, 1997, the Company entered into an agreement with The Allen
Group, a group of affiliated real estate development and investment companies
based in Visalia, California ("The Allen Group"), to purchase through a series
of transactions office and industrial buildings with approximately 1,730,000
aggregate rentable square feet and develop approximately 750,000 rentable
square feet of office space for an aggregate purchase price of approximately
$300.0 million. The acquisition agreement with The Allen Group was based on
arms-length negotiations. Subsequent to the execution of the related
documentation, Richard S. Allen, the majority equity owner and Chief Executive
Officer of The Allen Group, was elected to serve as a director of the Company.
As of December 31, 1997, the Company completed the first phase of the
acquisitions from The Allen Group by acquiring four office and four industrial
buildings encompassing 907,000 aggregate rentable square feet for an aggregate
purchase price of approximately $80.0 million.
24
The second phase of such acquisitions is presently expected to consist of
the purchase of five office and three industrial properties located in
California and Nevada encompassing approximately 823,000 aggregate rentable
square feet and an estimated aggregate purchase price of approximately $120.0
million. The Company presently expects the acquisitions to occur during 1998,
pursuant to the completion of construction and/or stabilized occupancy of the
properties.
The third phase of the transaction with The Allen Group is presently
expected to consist of the development of two office projects in San Diego,
California with approximately 750,000 aggregate rentable square feet for an
estimated aggregate development cost of approximately $100.0 million. The
Company has agreed to purchase a 50% managing interest in the two projects
upon completion of all necessary entitlements and infrastructure and is
expected to manage the development of both projects. The Company has an option
to purchase The Allen Group's remaining interest in both projects for a
purchase price to be determined upon completion of the projects. The Company
presently expects development of the two office projects to commence during
the fourth quarter of 1998.
During 1997, the Company commenced development of approximately 820,000
rentable square feet of space at a total budgeted cost of $56.4 million. The
Company has spent an aggregate of $23.0 million on these projects as of
December 31, 1997. The Company intends to finance all development with
borrowings under the Credit Facility and working capital.
HISTORICAL RECURRING CAPITAL EXPENDITURES, TENANT IMPROVEMENTS AND LEASING
COSTS
The following tables set forth the non-incremental revenue generating
recurring capital expenditures (excluding expenditures that are recoverable
from tenants), tenant improvements and leasing commissions for renewed and
retenanted space incurred for the years ended December 31, 1997, 1996, and
1995 on a per square foot basis.
OFFICE PROPERTIES
YEAR ENDED DECEMBER
31,
----------------------
1997 1996 1995
------ ------- -------
CAPITAL EXPENDITURES:
Capital expenditures (in thousands)................... $ 479
Per square foot....................................... $ 0.16
TENANT IMPROVEMENT AND LEASING COSTS(1):
Replacement tenant square feet.......................... 17,068 161,827 118,819
Tenant improvements (in thousands)(2)................. $ 112 $ 1,809 $ 566
Per square foot leased................................ $ 6.56 $ 11.18 $ 4.76
Leasing commissions (in thousands)(3)................. $ 28 $ 379 $ 502
Per square foot leased................................ $ 1.64 $ 2.34 $ 4.22
Total per square foot................................. $ 8.20 $ 13.52 $ 8.99
Renewal tenant square feet.............................. 278,658 52,006
Tenant improvements (in thousands)(2)................. $ 1,474 $ 233
Per square foot leased................................ $ 5.29 $ 4.48
Leasing commissions (in thousands)(3)................. $ 354 $ 84
Per square foot leased................................ $ 1.27 $ 1.62
Total per square foot................................. $ 6.56 $ 6.10
Total per square foot per year.......................... $ 1.55 $ 3.86 $ 2.79
Average lease term...................................... 5.3 5.2 5.4
(footnotes continued on next page)
25
- --------
(1) Includes only office tenants with lease terms of 12 months or longer.
Excludes leases for amenity, parking, retail and month-to-month office
tenants.
(2) Equals work letter costs net of estimated profit and overhead. Actual
tenant improvements may differ from estimated work letter costs.
(3) Equals the aggregate of leasing commissions payable to employees and third
parties based on standard commission rates and excludes negotiated
commission discounts obtained from time to time.
INDUSTRIAL PROPERTIES
YEAR ENDED DECEMBER 31,
-----------------------
1997 1996 1995
------- ------- -------
CAPITAL EXPENDITURES:
Capital expenditures (in thousands).................. $ 336
Per square foot...................................... $ 0.11
TENANT IMPROVEMENT AND LEASING COSTS(1):
Replacement tenant square feet......................... 145,581 107,318 401,502
Tenant improvements (in thousands)(2)................ $ 507 $ 483
Per square foot leased............................... $ 4.72 $ 1.20
Leasing commissions (in thousands)(3)................ $ 157 $ 134 $ 422
Per square foot leased............................... $ 1.08 $ 1.25 $ 1.10
Total per square foot................................ $ 1.08 $ 5.97 $ 2.30
Renewal tenant square feet............................. 323,825
Tenant improvements (in thousands)(2)................ $ 8
Per square foot leased............................... $ 0.02
Leasing commissions (in thousands)(3)................ $ 73
Per square foot leased............................... $ 0.23
Total per square foot................................ $ 0.25
Total per square foot per year......................... $ 0.31 $ 0.89 $ 0.32
Average lease term..................................... 4.3 6.7 7.2
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(1) Includes only industrial tenants with lease terms of 12 months or longer.
(2) Equals work letter costs net of estimated profit and overhead. Actual
tenant improvements may differ from estimated work letter costs.
(3) Equals the aggregate of leasing commissions payable to employees and third
parties based on standard commission rates and excludes negotiated
commission discounts obtained from time to time.
Capital expenditures may fluctuate in any given period subject to the
nature, extent, and timing of improvements required to be made to the
Properties. The Company believes that all of its Properties are well-
maintained and, based on recent engineering reports, do not require
significant capital improvements.
Tenant improvements and leasing costs may also fluctuate in any given year
depending upon factors such as the property, the term of the lease, the type
of lease, the involvement of external leasing agents and overall market
conditions.
YEAR 2000
During 1997, the Company purchased and implemented a new accounting and
property management software system. The new system can recognize and
accommodate date fields for the year 2000 and beyond. The Company does not
anticipate that the effect of the year 2000 on the Company's computer software
will have a material effect on the Company's financial position or result of
operations.
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DISTRIBUTION POLICY
The Company makes quarterly distributions to stockholders from cash
available for distribution and, if necessary to satisfy distribution
requirements to maintain its status as a REIT, the Company may use borrowings
under its Credit Facility. All such distributions are at the discretion of the
Board of Directors. Amounts accumulated for distribution are invested
primarily in interest-bearing accounts and short-term interest-bearing
securities, which are consistent with the Company's intention to qualify for
taxation as a REIT. Such investments may include, for example, obligations of
the Government National Mortgage Association, other governmental agency
securities, certificates of deposit and interest-bearing bank deposits.
HISTORICAL CASH FLOWS
The principal sources of funding for acquisitions, development and capital
expenditures are the Credit Facility, public equity financing, cash flow from
operating activities and secured debt financings. The Company's net cash from
operating activities increased $23.4 million for the year ended December 31,
1997 compared to the same period in 1996, or from $5.5 million in 1996 to
$28.9 million in 1997. The increase was primarily due to the increase in net
income resulting from property acquisitions in 1997 and a decrease in interest
expense. Net cash used in investing activities increased $549.6 million to
$552.0 million for the year ended December 31, 1997 from $2.4 million for 1996
due primarily to the purchase of four properties acquired in connection with
the IPO for $58.2 million and 96 buildings subsequent to the IPO for an
aggregate cost of $507.4 million of which $60.4 million was acquired with debt
and units of the Operating Partnership. During 1997, the Company made an
investment in capital expenditures and tenant improvements of $6.9 million,
and land and construction in progress of $34.7 million. Of the total $6.9
million spent on tenant improvements and capital expenditures, $4.7 million
was spent on the repositioning of the office complex in Seattle, Washington,
$1.0 million was spent on revenue generating tenant improvements and capital
expenditures and $1.2 million was spent on recurring tenant improvements and
capital expenditures. Cash flows from financing activities increased
$535.2 million to $532.0 million for the year ended December 31, 1997 compared
to net cash used in financing activities of $3.2 million for 1996, due to net
proceeds from the IPO and August Offering of $543.7 million, net proceeds
received from borrowings (net of repayments) of $13.5 million, restricted cash
of $5.7 million, and net distributions of $15.2 million. In 1996, there were
net repayments of debt of $2.1 million and net distributions of $5.2 million.
FUNDS FROM OPERATIONS
Industry analysts generally consider Funds from Operations, as defined by
NAREIT, an alternative measure of performance for an equity REIT. Funds from
Operations is defined by NAREIT to mean net income (loss) before minority
interest of unitholders (computed in accordance with GAAP), excluding gains
(or losses) from debt restructuring and sales of 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. The Company
believes that in order to facilitate a clear understanding of the combined
historical operating results of the Company, Funds from Operations should be
examined in conjunction with net income (loss) as presented in the financial
statements included elsewhere in this report. The Company computes Funds from
Operations in accordance with standards established by the Board of Governors
of NAREIT in its March 1995 White Paper, which may differ from the
methodologies used by other equity REITs and, accordingly, may not be
comparable to that published by such other REITs. Funds from Operations should
not be considered as an alternative to net income (loss), as an indication of
the Company's performance or to cash flows as a measure of liquidity or the
ability to pay dividends or make distributions.
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The following table presents the Company's Funds from Operations for the
three quarters ended December 31, 1997, September 30, 1997 and June 30, 1997
and the period from February 1, 1997 to March 31, 1997.