Kilroy Realty Corporation / Kilroy Realty, L.P. — 2018 Q2 Form 10-Q
Reporting period: Three and six months ended June 30, 2018. The unaudited filing covers the REIT and its operating partnership, which conducts substantially all operations. Kilroy focuses on Class A office and mixed-use properties in West Coast markets.
Financial performance and position
| Metric | Q2 2018 | Q2 2017 | Six months 2018 | Six months 2017 |
|---|---|---|---|---|
| Total revenue | $187.1m | $180.6m | $369.9m | $359.9m |
| Net income | $31.8m | $35.3m | $72.7m | $72.6m |
| Net income available to common stockholders | $27.5m | $29.8m | $63.8m | $56.2m |
| Diluted earnings per share | $0.27 | $0.30 | $0.63 | $0.56 |
| Net operating income (NOI), company-defined | $129.5m | $128.8m | $262.2m | $256.0m |
| Funds from operations (FFO) | $88.6m | $88.8m | $184.9m | $170.7m |
Q2 revenue rose 3.6%, while NOI increased 0.5%. Six-month revenue rose 2.8%, NOI rose 2.4%, and FFO rose 8.3%. Six-month common earnings benefited from the absence of 2017 preferred dividends and redemption costs; net income itself was nearly flat year over year. Q2 common earnings and EPS declined.
- Cash flow, first half: Operating cash flow was $188.8m, versus $178.4m; investing cash outflow was $664.3m, versus $216.0m; financing cash inflow was $459.5m, versus $183.3m. Cash and restricted cash ended at $50.8m, down from $66.8m at year-end 2017.
- Margins: NOI was approximately 69.2% of Q2 revenue versus 71.3% in Q2 2017, and 70.9% for the first half versus 71.1%. Higher bad-debt expense weighed on the Q2 comparison.
- Debt and liquidity: Gross debt was $2.81bn at June 30; debt represented 26.6% of total market capitalization. The company had $295m drawn on its $750m revolver, leaving $455m available, and had drawn its $150m term loan. Approximately 15.8% of debt was variable-rate. A 100-basis-point LIBOR increase was estimated to add about $4.5m to annual interest expense before capitalization.
- Balance sheet: Total assets were $7.38bn and total liabilities $3.32bn. The company reported compliance with debt covenants; covenant measures were comfortably within stated limits.
- Dividend: The board raised the quarterly common dividend 7.1% to $0.455 per share, payable July 18, 2018. The same distribution applied to common units.
Business and material changes
- At June 30, the stabilized office portfolio comprised 104 buildings and 13.9m rentable square feet; occupancy was 94.0% and leased percentage was 96.8%. Average stabilized portfolio occupancy during Q2 was 94.6%.
- Same-store NOI increased 1.7% in Q2 and 3.6% for the first half. New leases and renewals at higher rents supported revenue, but the Q2 bad-debt provision and higher property taxes and expenses offset gains.
- Acquired three South San Francisco office buildings for $111.0m and a nearby 39-acre development site for $308.2m. The site was fully entitled for an estimated 2.5m square feet; the filing also records assumed accrued and environmental liabilities related to the acquisition.
- Real estate assets held for investment, net, increased to $6.78bn from $6.15bn at year-end, largely reflecting acquisitions and development investment. The company had five in-process projects: two in tenant-improvement phase and three under construction.
- Raised $125.1m net from ATM equity sales during the first half. A new ATM program authorized up to $500m in gross sales, with approximately $473.4m remaining available at June 30.
Outlook, risks and unusual items
- Development and capital plans: Management estimated $5.0bn–$6.0bn of total investment to develop its seven-site future pipeline, subject to entitlements and market conditions. It anticipated potentially commencing projects requiring another $100m–$300m of spending in the remainder of 2018. It also estimated $250m–$750m of possible proceeds from dispositions during the remainder of 2018; neither activity is assured.
- Leasing: Management estimated portfolio cash rents were about 15% below current market rents overall. Leases representing 4.5% of occupied space were scheduled to expire in the remainder of 2018 and 11.6% in 2019. These estimates and future re-leasing outcomes are subject to market conditions.
- Tenant credit: A $5.6m Q2 bad-debt provision primarily reflected a $7.0m increase in the allowance for one tenant. The tenant represented approximately 1% of annualized base rent; the estimated possible loss range was $0–$13.9m. The company said further provisions could be required and the outcome of discussions was uncertain.
- Environmental and project commitments: Accrued environmental remediation liabilities were $68.8m; management warned costs could increase as projects progress. Contract and executed-lease commitments directly related to operating properties and developments were approximately $833.2m, excluding ground leases.
- Lease accounting: The company expected to adopt the new lease standard on January 1, 2019 and anticipated a material impact to financial statements and results from expensing certain leasing costs currently capitalized. It expected ground-lease right-of-use assets and liabilities on the balance sheet; undiscounted future minimum ground-lease payments were $249.9m.
- Other risks: Exposure includes interest-rate changes, tenant defaults, California and Washington real-estate conditions, development cost and schedule overruns, entitlement delays, environmental matters, financing availability, and REIT qualification. Management provided no formal earnings or FFO guidance in the presented filing text.
- Subsequent event: In July, the partnership issued $50m of 4.30% senior notes due 2026; the remaining $200m delayed-draw notes were required to be drawn by October 22, 2018. Management said the company was in compliance with debt covenants at quarter-end. No material litigation was reported.
Most important facts for investors to verify
- Progress and collectability of amounts due from the tenant associated with the $8.4m allowance, and whether additional bad-debt provisions or lease changes arise.
- Actual occupancy, leasing spreads, and renewals against upcoming 2018–2019 expirations, including whether signed-but-not-commenced leases begin as expected.
- Development budgets, leasing, entitlements, and delivery schedules, particularly for the large South San Francisco pipeline and projects under construction.
- Execution and timing of the expected acquisitions, dispositions, ATM equity sales, and delayed-draw notes—and their effect on leverage and dilution.
- Cash available after development spending, distributions, debt service, and environmental remediation; also monitor variable-rate debt exposure and covenant headroom.