Kilroy Realty Corporation and Kilroy Realty, L.P. — Q3 2016 Form 10-Q
Reporting period: Three and nine months ended September 30, 2016. Kilroy is a West Coast office-focused REIT operating primarily through its Operating Partnership. Financial figures below are consolidated and in U.S. dollars; amounts are rounded.
Business context and operating performance
- At quarter-end, the stabilized office portfolio comprised 101 buildings and 13.6 million rentable square feet, 96.6% occupied, versus 94.8% at December 31, 2015. Portfolio occupancy averaged 96.1% in Q3 2016, compared with 95.8% in Q3 2015.
- Management reported continued demand and rent growth across West Coast markets, while noting that rental-rate growth was moderating in some markets. The portfolio’s weighted-average cash rents were estimated to be about 17% below current market rents.
- Q3 leasing activity produced a 12.1% increase in GAAP rents and a 0.9% increase in cash rents for qualifying commenced leases; nine-month increases were 23.7% and 10.3%, respectively. These measures exclude certain vacant or first-time-leased space.
Financial results and liquidity
| Metric | Q3 2016 | Q3 2015 | Nine months 2016 | Nine months 2015 |
|---|---|---|---|---|
| Total revenue | $168.3 million | $141.6 million | $473.9 million | $433.9 million |
| Net income | $56.4 million | $106.7 million | $268.4 million | $209.3 million |
| Net income available to common stockholders | $50.6 million | $101.4 million | $251.1 million | $195.5 million |
| Diluted earnings per share | $0.54 | $1.09 | $2.69 | $2.17 |
| Net operating income (NOI) | $122.9 million | $101.9 million | $346.8 million | $315.6 million |
| Funds from operations (FFO) | $88.5 million | $73.6 million | $249.5 million | $239.9 million |
- Q3 revenue rose 18.9% and NOI rose 20.6%; nine-month revenue increased 9.2% and NOI increased 9.9%. Approximate NOI margins were 73.0% and 72.0% for Q3 2016 and Q3 2015, and 73.2% and 72.7% for the respective nine-month periods.
- Q3 common earnings fell 50.1%, principally reflecting lower gains on property sales: $18.3 million in Q3 2016 versus $78.5 million in Q3 2015. Nine-month common earnings rose 28.4%, with gains on operating-property sales of $164.3 million versus $110.0 million. FFO, which excludes these gains, increased 20.3% in Q3 and 4.0% year to date.
- For the nine months, cash from operations was $252.6 million, investing used $124.2 million, and financing provided $65.6 million. Cash and cash equivalents were $250.5 million at September 30, 2016, up from $56.5 million at year-end; restricted cash was an additional $57.5 million.
- Debt was approximately $2.231 billion gross principal, or $2.217 billion net carrying value. Debt to total market capitalization was 24.8%; 91.5% of debt was fixed-rate. The $600 million revolving facility was undrawn, and the Operating Partnership reported compliance with its debt covenants.
- The common dividend declared was $0.375 per share for Q3, up from $0.350 a year earlier. The company said operating cash flow and available borrowing capacity were expected to support liquidity needs and distributions over the next 12 months, while noting there is no assurance capital sources will remain available.
Material changes, outlook, and notable items
- Growth in NOI reflected same-store improvement and the contribution from recently stabilized developments, partly offset by property dispositions. Two San Francisco office developments became stabilized during the first quarter; one operating-property acquisition in Mountain View added 114,175 square feet.
- The company sold six office properties and five land parcels for gross proceeds of approximately $330.7 million during the nine months. Sales generated $164.3 million of gains on operating properties. Approximately $48.4 million of proceeds remained with qualified intermediaries for potential tax-deferred exchanges.
- A third party acquired a 44% interest in the entity owning 100 First Street for a contribution of approximately $193.5 million including working capital. The company continued consolidating the property and recorded the transaction as an equity transaction, not a sale. A second tranche for 303 Second Street, involving a stated $261.5 million contribution, was expected to close November 30, 2016.
- Management expected to issue $250 million of privately placed notes by February 17, 2017: $175 million at 3.35% due 2027 and $75 million at 3.45% due 2029. None was outstanding at quarter-end. The next stated debt maturity was approximately $64.3 million in February 2017; management expected to refinance it with approximately $170 million of secured debt in Q4 2016.
- Development plans include one project under construction with estimated total investment of $485 million and a near-term pipeline estimated at $1.695 billion. Management anticipated potentially spending an additional $100–$350 million on pipeline projects starting in late 2016 and 2017, subject to market conditions, leasing, and approvals.
- The company estimated $160–$200 million of 2016 taxable gains from property sales that might not qualify for tax deferral. It said a special distribution may be needed to meet REIT distribution requirements and minimize taxes. It also anticipated possible redemption of some or all of its $200 million liquidation-preference Series G and H preferred stock on or after their respective 2017 redemption dates.
- Unusual items included $5.0 million of proceeds from settlement of a property-damage matter, recorded in Q3 other property income. Environmental remediation liabilities of $25.1 million were accrued; further costs related to certain development acquisitions were possible but not reasonably estimable. Total commitments for operating-property and development contracts and executed leases were approximately $379.4 million, excluding ground leases.
- Key risks cited include West Coast economic and property-market conditions, tenant defaults or non-renewals, leasing and occupancy, development costs and execution, financing availability and interest rates, environmental remediation, and joint-venture risks. The top 15 tenants accounted for 38.4% of annualized base rent; LinkedIn represented 5.3%. Management reported no material change to previously disclosed risk factors and no legal proceeding expected to have a material adverse effect.
Important facts for investors to verify
- Whether the expected November 2016 303 Second Street transaction closed as planned and how it affected ownership, debt, and cash flows.
- Whether the delayed-draw $250 million notes were issued by February 2017, and the outcome and financing terms for the 2017 debt maturity and preferred-stock redemption decisions.
- Whether projected taxable gains required a special distribution, and the final amount and tax treatment of that distribution.
- Whether development budgets, schedules, leasing commitments, and occupancy—particularly in lease-up projects—tracked management’s expectations.
- Whether reported NOI and FFO trends translated into sustainable cash generation after capital expenditures, tenant improvements, leasing costs, and distributions; both are supplemental, non-GAAP measures.
- Any increase in environmental remediation exposure, tenant concentration risk, or changes in covenant compliance and access to financing.