Kilroy Realty Corporation and Kilroy Realty, L.P. — Q3 2018 Form 10-Q
Reporting period: Three and nine months ended September 30, 2018. Kilroy is a West Coast office and mixed-use REIT; the Operating Partnership owns and operates substantially all of its real estate. The Company held an approximately 98% interest in the Operating Partnership.
Business and portfolio
- The stabilized portfolio comprised 104 office buildings with 13.9 million rentable square feet, 93.5% occupied and 96.6% leased at quarter-end, plus a 200-unit residential property.
- Two development projects totaling approximately 1.15 million square feet were in the tenant-improvement phase; three projects totaling approximately 956,000 square feet were under construction. The seven-site future pipeline represented approximately 80 acres.
- In January, Kilroy acquired three South San Francisco office buildings for $111.0 million; in June, it acquired the adjacent 39-acre Kilroy Oyster Point development site for approximately $308.2 million.
Financial performance and position
| Metric | Q3 2018 | Q3 2017 | Nine months 2018 | Nine months 2017 |
|---|---|---|---|---|
| Total revenue | $186.6 million | $181.5 million | $556.5 million | $541.4 million |
| Net income | $38.3 million | $75.5 million | $111.0 million | $148.1 million |
| Net income available to common stockholders | $34.4 million | $66.6 million | $98.2 million | $122.7 million |
| Diluted earnings per share | $0.33 | $0.67 | $0.97 | $1.23 |
| Net operating income (NOI), as defined by the Company | $131.0 million | $129.5 million | $393.2 million | $385.5 million |
| Funds From Operations (FFO) | $94.2 million | $89.5 million | $279.2 million | $260.2 million |
| Cash from operating activities | — | — | $317.2 million | $276.5 million |
- Revenue increased 2.8% in both the quarter and year-to-date periods. NOI increased 1.2% in Q3 and 2.0% year to date; FFO increased approximately 5.2% and 7.3%, respectively.
- Lower GAAP net income primarily reflects the absence of 2017 property-sale gains: $37.3 million in Q3 and $39.5 million for the first nine months. The 2017 comparisons also included preferred dividends and costs related to redeeming preferred securities.
- Q3 property and real estate tax expenses rose year over year. General and administrative expense increased 32.8% in Q3 and 29.4% year to date, including higher legal costs, stock compensation and other compensation costs. Interest expense declined, in part because more interest was capitalized to development projects.
- At September 30, total assets were $7.56 billion, total liabilities $3.49 billion, and cash and cash equivalents $86.5 million. Gross debt principal was $2.89 billion, including $330 million drawn on the revolving facility; $420 million of that facility remained available. Debt was 28.2% of total market capitalization, and 83.4% of debt was fixed rate.
- Operating cash flow increased, while investing cash use rose to $805.4 million, reflecting acquisitions, development and property expenditures and no disposition proceeds in the period. Financing provided $507.9 million, principally through borrowings and equity issuance. The common dividend declared was $0.455 per share for Q3.
Changes, outlook and material matters
- Same-store occupancy averaged 92.9% in Q3 versus 94.3% a year earlier; quarter-end stabilized occupancy was 93.5%, compared with 95.2% at December 31, 2017. Management reported that portfolio cash rents were approximately 19% below current average market rents, while noting that future leasing rates and occupancy are uncertain.
- Q3 same-store NOI improved 2.3%; year-to-date same-store NOI rose 3.1%. The Company cited higher rental income from new leases and renewals, partly offset by property expenses, taxes and bad-debt provisions.
- A $7.0 million increase in the bad-debt provision related primarily to one tenant; its lease represented approximately 1% of annualized base rental revenue. Management warned that the tenant’s obligations could be reduced or extinguished and that further provision may be required.
- Management expected to fund development and other needs through operating cash flow, credit facilities, debt or equity issuance, dispositions and potential strategic ventures. It anticipated approximately $375 million of additional disposition capital for the remainder of 2018, but cautioned that timing and completion were uncertain. No specific earnings or FFO guidance is provided in the supplied filing text.
- Development spending remained substantial: three projects under construction had an estimated total investment of approximately $1.1 billion, with $424 million of additional commitments at quarter-end; two tenant-improvement projects had an estimated total investment of approximately $840 million, with $172 million of additional commitments. A further $323 million of construction-project commitments was expected to be spent through 2019.
- Subsequent to quarter-end, the Operating Partnership issued $200 million of 4.35% senior notes due 2026 and used proceeds to repay revolving-credit borrowings; the reported revolver balance after the transaction was approximately $165 million. A $47.4 million distribution payment was made on October 17.
- Environmental remediation liabilities were approximately $79.6 million, primarily for development sites; management said additional costs could arise but were not reasonably estimable. Other commitments for operating properties and development projects were approximately $776.5 million, excluding ground leases. Future minimum undiscounted ground-lease payments totaled $248.6 million.
- The Company said adoption of the new lease standard on January 1, 2019 was expected to materially affect its financial statements, including expensing certain leasing costs previously capitalized and recognizing ground-lease right-of-use assets and liabilities. Management reported compliance with debt covenants and effective disclosure controls; the filing reported no material changes to previously disclosed risk factors and no legal proceeding believed likely to have a material adverse effect.
Important facts for investors to verify
- Tenant credit and collection risk, particularly the tenant behind the $7.0 million bad-debt provision, and any subsequent changes in receivables or lease obligations.
- Leasing progress and occupancy across regions, including the 2019 lease-expiration exposure and whether below-market leases can be renewed or re-leased at anticipated rates.
- Development budgets, completion and stabilization dates, pre-leasing, remaining commitments, environmental remediation costs and the ability to fund the pipeline without weakening liquidity.
- Debt maturities, variable-rate exposure, covenant headroom and refinancing needs; the filing estimates a 100-basis-point LIBOR increase would raise annual interest expense by approximately $4.8 million before capitalization.
- Disposition assumptions and capital availability, along with potential dilution and settlement economics for the 5-million-share forward equity offering and remaining at-the-market program capacity.
- The actual effect of 2019 lease-accounting adoption on reported expenses, assets and liabilities. FFO and NOI are supplemental, non-GAAP measures and should be assessed alongside GAAP results and property-level capital needs.