Business context and reporting period
Kilroy Realty Corporation and its operating partnership filed a combined Form 10-K for the fiscal year ended December 31, 2016. Kilroy is a REIT focused primarily on Class A office and mixed-use properties in coastal California and Greater Seattle; substantially all operations are conducted through the Operating Partnership.
At year-end, the stabilized office portfolio comprised 108 buildings and 14.0 million rentable square feet, 96.0% occupied and 97.0% leased. The company also had one 200-unit residential property, 46.0% occupied. The filing is annual, but reports fourth-quarter results separately.
Financial and operating performance
| Metric | 2016 | 2015 | Change |
|---|---|---|---|
| Revenue | $642.6 million | $581.3 million | +10.5% |
| Net income | $303.8 million | $238.6 million | +27.3% |
| Net income available to common stockholders | $280.5 million | $220.8 million | +27.0% |
| Diluted earnings per share | $2.97 | $2.42 | +22.7% |
| Net Operating Income (NOI) | $470.0 million | $422.0 million | +11.4% |
| Funds From Operations (FFO) | $333.7 million | $316.6 million | +5.4% |
| Cash from operating activities | $345.1 million | $272.0 million | +26.9% |
| Cash used in investing activities | $635.4 million | $262.8 million | Use increased |
| Cash from financing activities | $427.3 million | $23.5 million | Increase mainly from venture proceeds |
Revenue was primarily rental income and tenant reimbursements. NOI margin was approximately 73.1% in 2016 versus 72.6% in 2015, calculated as NOI divided by revenue. GAAP net income includes substantial real estate sale gains and should not be read as recurring operating profit alone.
Fourth-quarter 2016 revenue was $168.6 million, net income was $35.4 million, common-stockholder net income was $29.4 million, and diluted EPS was $0.29. In fourth-quarter 2015, revenue was $147.4 million, net income was $29.3 million, common-stockholder net income was $25.3 million, and diluted EPS was $0.27.
At December 31, 2016, cash and cash equivalents were $193.4 million and restricted cash was $56.7 million. The $600 million unsecured revolver was undrawn. After subsequent transactions and dividend payments, the company reported approximately $325 million of unrestricted cash as of February 13, 2017.
Debt was $2.32 billion net carrying value, or $2.33 billion aggregate principal before discounts, premiums and deferred financing costs. Debt represented 24.5% of total market capitalization; debt plus preferred equity represented 26.5%. Approximately 91.9% of debt was fixed-rate and 8.1% variable-rate. A 100-basis-point LIBOR increase was estimated to add about $1.9 million to annual interest expense, before capitalization. Debt covenants were met at year-end.
Material changes versus the prior comparable period
- NOI rose 11.4%; same-store NOI increased 4.6%, while newly stabilized development projects added $50.6 million of NOI.
- Stabilized office occupancy improved to 96.0% from 94.8%. Leasing activity included 1.3 million square feet of new and renewal leases; executed leases achieved 30.2% higher GAAP rents and 13.4% higher cash rents, on the company’s stated comparison basis.
- Three development projects totaling approximately 714,000 square feet entered the stabilized portfolio. The company acquired seven operating buildings for approximately $394.6 million and a development site, and sold six office buildings and five land parcels for gross proceeds of approximately $330.7 million.
- Cash flow from operations increased, while investing outflows grew with acquisitions and development spending. Financing cash flow benefited from approximately $453 million of contributions associated with strategic ventures.
- NBREM invested for a 44% interest in entities holding two San Francisco properties; Kilroy retained control and continued consolidating the properties. The transactions generated approximately $452.9 million of contributions, net of NBREM’s share of existing mortgage debt.
- 2016 GAAP income included $164.3 million of gains on sales of depreciable operating properties, versus $110.0 million in 2015. FFO, which excludes those gains, grew more slowly than GAAP net income.
Outlook, management commentary, risks and unusual items
- Management described 2016 as an exceptional year and cited strong leasing, development execution, capital access and capital recycling. Its stated priorities include sustained NOI and FFO growth, disciplined development, selective acquisitions and maintaining a conservative balance sheet; these are objectives, not earnings guidance.
- Three projects under construction represented estimated total investment of approximately $980 million, with completion dates extending through 2018. Management estimated $50–$200 million of potential additional development spending on pipeline projects it might commence during 2017, subject to market conditions. Stabilized-property capital improvements, tenant improvements and leasing costs were estimated at $25–$50 million for 2017, apart from existing commitments.
- Management anticipated $100–$300 million of additional disposition proceeds in 2017, with a midpoint of $200 million, including the $12.1 million property sale completed in January. Further sales and development starts depend on market conditions and other factors.
- Leases representing 8.2% of leased office area expire in 2017 and 10.4% in 2018; together, these leases represented 17.6% of annualized base rent. Management estimated portfolio cash rents were about 17% below market, and rents on 2017–2018 expirations about 8% below market, while noting results vary by property and market.
- Tenant and industry concentration are notable: the 15 largest tenants represented 37.3% of annualized base rent, and technology tenants represented 42%. Regional concentration exposes the company to California and Greater Seattle economic, regulatory and natural-disaster risks.
- Environmental remediation liabilities were accrued at $25.1 million, up from $20.9 million; additional costs at certain development sites were possible but not reasonably estimable. The filing also notes possible California tax assessments of up to $28.9 million, plus potential penalties and interest, relating to the NBREM venture transactions if authorities challenge the company’s position.
- Other key risks include lease renewal and re-leasing, development costs and entitlements, refinancing and interest rates, ground-lease obligations, and earthquake or other uninsured losses. Minimum ground-lease payments totaled $256.1 million; 14.4% of stabilized portfolio area was on leased land. Routine litigation was not expected to have a material adverse effect.
- The board declared a special $1.90-per-share dividend in addition to the regular $0.375 quarterly dividend, payable January 13, 2017. The annual declared amount of $3.375 per share includes that special dividend. In January 2017, the company also raised approximately $308.8 million net through a common-stock offering.
- Auditors issued unqualified opinions on the financial statements and internal controls; management reported effective disclosure controls and internal control over financial reporting.
Important facts for investors to verify
- Separate recurring property performance from the $164.3 million property-sale gains when assessing 2016 earnings; compare NOI and FFO on a consistent basis.
- Track lease commencements, renewals, tenant retention and actual cash rents against the disclosed 2017–2018 expirations and market-rent estimates.
- Confirm funding, leasing, construction costs and delivery timing for the approximately $980 million development program and potential 2017 starts.
- Review debt maturities and refinancing needs, including the sizable 2018 maturity, the delayed-draw $250 million notes due in 2027 and 2029, and the post-year-end cash and equity transactions.
- Monitor environmental remediation estimates, the potential tax assessment exposure from the NBREM transactions, ground-lease commitments, tenant concentration and the ability to sustain distributions.