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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q/A
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 1998
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
of incorporation or organization) Identification Number)
2250 East Imperial Highway, Suite 1200, El Segundo, California 90245
(Address of principal executive offices)
(310) 563-5500
(Registrant's telephone number, including area code)
N/A
(Former name, former address and former fiscal year, if changed since last
report)
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 [_]
As of November 12, 1998, 27,639,210 shares of common stock, par value $.01
per share, were outstanding.
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<PAGE>
TABLE OF CONTENTS
<TABLE>
<CAPTION>
Page
----
PART I--FINANCIAL INFORMATION
<C> <S> <C>
Item 1. FINANCIAL STATEMENTS
Consolidated Balance Sheets of Kilroy Realty Corporation as of
September 30, 1998 (Unaudited) and December 31, 1997........... 3
Consolidated Statements of Operations of Kilroy Realty
Corporation for the nine months ended September 30, 1998 and
the period February 1, 1997 to September 30, 1997 and the
Combined Statement of Operations of the Kilroy Group for the
period January 1, 1997 to January 31, 1997 (Unaudited)......... 4
Consolidated Statements of Operations of Kilroy Realty
Corporation for the three months ended September 30, 1998 and
1997 (Unaudited)............................................... 5
Consolidated Statements of Cash Flows of Kilroy Realty
Corporation for the nine months ended September 30, 1998 and
1997 (Unaudited)............................................... 6
Notes to the Kilroy Realty Corporation Consolidated and Kilroy
Group Combined Financial Statements (Unaudited)................ 7
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS.......................................... 13
PART II--OTHER INFORMATION
Item 1. LEGAL PROCEEDINGS.............................................. 22
Item 2. CHANGES IN SECURITIES.......................................... 22
Item 3. DEFAULTS UPON SENIOR SECURITIES................................ 22
Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS............ 22
Item 5. OTHER INFORMATION.............................................. 22
Item 6. EXHIBITS AND REPORTS ON FORM 8-K............................... 22
SIGNATURES..................................................... 24
</TABLE>
2
<PAGE>
PART I--FINANCIAL INFORMATION
ITEM 1. Financial Statements
KILROY REALTY CORPORATION CONSOLIDATED
BALANCE SHEETS
(in thousands, except share data)
<TABLE>
<CAPTION>
September 30, December 31,
1998 1997
------------- ------------
(unaudited)
<S> <C> <C>
ASSETS
------
INVESTMENT IN REAL ESTATE (Note 2):
Land and improvements............................. $ 236,474 $ 177,118
Buildings and improvements........................ 767,677 622,901
Land and construction in progress................. 128,007 34,671
---------- ---------
Total investment in real estate................. 1,132,158 834,690
Accumulated depreciation and amortization......... (139,170) (121,780)
---------- ---------
Investment in real estate, net.................. 992,988 712,910
CASH AND CASH EQUIVALENTS........................... 27,311 8,929
RESTRICTED CASH..................................... 6,296 5,680
TENANT RECEIVABLES, NET............................. 12,802 7,367
NOTES RECEIVABLE FROM RELATED PARTIES (Note 3)...... 6,655
ESCROW DEPOSITS..................................... 401 5,114
DEFERRED FINANCING AND LEASING COSTS, NET........... 13,019 13,053
PREPAID EXPENSES AND OTHER ASSETS, NET.............. 4,198 4,601
---------- ---------
TOTAL ASSETS.................................... $1,063,670 $ 757,654
========== =========
LIABILITIES AND STOCKHOLDERS' EQUITY
------------------------------------
LIABILITIES:
Mortgage debt..................................... $ 133,920 $ 131,363
Line of credit (Note 4)........................... 270,000 142,000
Accounts payable and accrued expenses............. 14,307 9,711
Accrued distributions (Note 7).................... 12,811 10,804
Rents received in advance and tenant security
deposits......................................... 13,836 11,441
---------- ---------
Total liabilities............................... 444,874 305,319
---------- ---------
COMMITMENTS AND CONTINGENCIES (Notes 2 and 3)
MINORITY INTERESTS (Note 5):
8.075% Series A Cumulative Redeemable Preferred
unitholders...................................... 73,718
Common unitholders................................ 68,680 55,185
---------- ---------
Total minority interests........................ 142,398 55,185
---------- ---------
STOCKHOLDERS' EQUITY (Note 6):
Preferred Stock, $.01 par value, 28,300,000 shares
authorized, none issued and outstanding..........
8.075% Series A Cumulative Redeemable Preferred
Stock, $.01 par value, 1,700,000 shares
authorized, none issued and outstanding..........
Common Stock, $.01 par value, 150,000,000 shares
authorized, 27,639,210 and 24,475,000 shares
issued and outstanding, respectively............. 276 245
Additional paid-in capital........................ 486,956 403,163
Distributions in excess of earnings............... (10,834) (6,258)
---------- ---------
Total stockholders' equity...................... 476,398 397,150
---------- ---------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY...... $1,063,670 $ 757,654
========== =========
</TABLE>
See accompanying notes to consolidated and combined financial statements.
3
<PAGE>
KILROY REALTY CORPORATION (the "Company") CONSOLIDATED AND
KILROY GROUP (Predecessor to the Company) COMBINED
STATEMENTS OF OPERATIONS
(in thousands, except share and per share data)
(unaudited)
<TABLE>
<CAPTION>
Kilroy Realty Corporation Kilroy
--------------------------- Group
Nine Months February 1, January 1,
Ended 1997 to 1997 to
September 30, September 30, January 31,
1998 1997 1997
------------- ------------- -----------
<S> <C> <C> <C>
REVENUES:
Rental income........................ $ 84,817 $ 35,878 $ 2,760
Tenant reimbursements................ 10,041 3,441 275
Interest income...................... 1,191 2,875
Other income......................... 941 454 18
---------- ---------- ----------
Total revenues..................... 96,990 42,648 3,053
---------- ---------- ----------
EXPENSES:
Property expenses.................... 13,812 5,999 625
Real estate taxes.................... 6,554 1,925 106
General and administrative........... 5,499 3,652 78
Ground leases........................ 854 670 64
Interest expense..................... 14,642 6,714 1,895
Depreciation and amortization........ 19,159 8,404 787
---------- ---------- ----------
Total expenses..................... 60,520 27,364 3,555
---------- ---------- ----------
INCOME (LOSS) BEFORE EQUITY IN (LOSS)
INCOME OF UNCONSOLIDATED SUBSIDIARY,
MINORITY INTERESTS AND EXTRAORDINARY
GAIN.................................. 36,470 15,284 (502)
EQUITY IN (LOSS) INCOME OF
UNCONSOLIDATED SUBSIDIARY............. (24) 187
---------- ---------- ----------
INCOME (LOSS) BEFORE MINORITY INTERESTS
AND EXTRAORDINARY GAIN................ 36,446 15,471 (502)
---------- ---------- ----------
MINORITY INTERESTS:
Distributions to 8.075% Series A
Cumulative Redeemable Preferred
unitholders......................... (3,704)
Minority interest in earnings........ (4,093) (2,231)
---------- ---------- ----------
Total minority interests........... (7,797) (2,231)
---------- ---------- ----------
INCOME (LOSS) BEFORE EXTRAORDINARY
GAIN.................................. 28,649 13,240 (502)
EXTRAORDINARY GAIN..................... 3,204
---------- ---------- ----------
NET INCOME............................. $ 28,649 $ 13,240 $ 2,702
========== ========== ==========
Net income per common share--basic..... $ 1.07 $ 0.82
========== ==========
Net income per common share--diluted... $ 1.07 $ 0.81
========== ==========
Weighted average shares outstanding--
basic................................. 26,770,445 16,162,243
========== ==========
Weighted average shares outstanding--
diluted............................... 26,865,274 16,246,435
========== ==========
</TABLE>
See accompanying notes to consolidated and combined financial statements.
4
<PAGE>
KILROY REALTY CORPORATION CONSOLIDATED
STATEMENTS OF OPERATIONS
(in thousands, except share and per share data)
(unaudited)
<TABLE>
<CAPTION>
Three Months Ended
September 30,
----------------------
1998 1997
---------- ----------
<S> <C> <C>
REVENUES:
Rental income........................................ $ 30,369 $ 16,418
Tenant reimbursements................................ 3,768 1,631
Interest income...................................... 308 900
Other income......................................... 74 158
---------- ----------
Total revenues..................................... 34,519 19,107
---------- ----------
EXPENSES:
Property expenses.................................... 4,775 2,724
Real estate taxes.................................... 2,800 998
General and administrative........................... 1,797 1,477
Ground leases........................................ 259 206
Interest expense..................................... 5,263 2,637
Depreciation and amortization........................ 6,740 3,660
---------- ----------
Total expenses..................................... 21,634 11,702
---------- ----------
INCOME BEFORE EQUITY IN INCOME OF UNCONSOLIDATED
SUBSIDIARY AND MINORITY INTERESTS..................... 12,885 7,405
EQUITY IN INCOME OF UNCONSOLIDATED SUBSIDIARY.......... 1 52
---------- ----------
INCOME BEFORE MINORITY INTERESTS....................... 12,886 7,457
---------- ----------
MINORITY INTERESTS:
Distributions to 8.075% Series A Cumulative
Redeemable Preferred unitholders.................... (1,450)
Minority interest in earnings........................ (1,451) (977)
---------- ----------
Total minority interests........................... (2,901) (977)
---------- ----------
NET INCOME............................................. $ 9,985 $ 6,480
========== ==========
Net income per common share--basic..................... $ 0.36 $ 0.34
========== ==========
Net income per common share--diluted................... $ 0.36 $ 0.34
========== ==========
Weighted average shares outstanding--basic............. 27,647,688 18,931,522
========== ==========
Weighted average shares outstanding--diluted........... 27,647,688 19,025,714
========== ==========
</TABLE>
See accompanying notes to consolidated and combined financial statements.
5
<PAGE>
KILROY REALTY CORPORATION CONSOLIDATED AND KILROY GROUP COMBINED
STATEMENTS OF CASH FLOWS
(unaudited, in thousands)
<TABLE>
<CAPTION>
Nine Months Ended
September 30,
--------------------
1998 1997
--------- ---------
<S> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income.............................................. $ 28,649 $ 15,942
Adjustments to reconcile net income to net cash provided
by operating activities:
Depreciation and amortization.......................... 19,159 9,191
Provision for bad debts................................ 652 172
Restricted stock compensation.......................... 405 315
Extraordinary gain..................................... (3,204)
Minority interest in earnings.......................... 4,093 2,231
Accrued distributions to 8.075% Series A Cumulative
Redeemable Preferred unitholders...................... 757
Other.................................................. (262) (128)
Changes in assets and liabilities:
Tenant receivables..................................... (6,087) (894)
Deferred financing and leasing costs, net.............. (401) (2,481)
Prepaid expenses and other assets, net................. 561 (6,676)
Accounts payable and accrued expenses.................. 4,596 2,180
Accrued cost of option buy-out and tenant
improvements.......................................... (1,390)
Rents received in advance and tenant security
deposits.............................................. 2,395 1,087
--------- ---------
Net cash provided by operating activities............. 54,517 16,345
--------- ---------
CASH FLOWS FROM INVESTING ACTIVITIES:
Expenditures for rental properties...................... (216,168) (349,212)
Expenditures for land and construction in progress...... (65,353)
Disbursements for notes receivable to related parties... (6,655)
Net change in escrow deposits........................... 4,713 (1,179)
Net investment in and advances to unconsolidated
subsidiary............................................. (382) (454)
--------- ---------
Net cash used in investing activities................. (283,845) (350,845)
--------- ---------
CASH FLOWS FROM FINANCING ACTIVITIES:
Net proceeds from issuances of common stock............. 82,146 543,764
Net proceeds from issuance of 8.075% Series A Cumulative
Redeemable Preferred Units............................. 72,961
Net borrowings on line of credit........................ 128,000
Proceeds from issuance of mortgage debt................. 5,000 98,000
Principal payments on mortgage debt..................... (2,443) (219,406)
Finance costs........................................... (1,335) (3,989)
Restricted cash......................................... (616) (4,634)
Distributions paid...................................... (36,003) (11,125)
Deemed and actual contributions from partners, net...... 6,780
--------- ---------
Net cash provided by financing activities............. 247,710 409,390
--------- ---------
Net increase in cash and cash equivalents................ 18,382 74,890
Cash and cash equivalents, beginning of period........... 8,929
--------- ---------
Cash and cash equivalents, end of period ................ $ 27,311 $ 74,890
========= =========
SUPPLEMENTAL CASH FLOW INFORMATION:
Cash paid for interest................................. $ 19,281 $ 10,980
========= =========
Distributions paid to 8.075% Series A Cumulative
Redeemable Preferred unitholders...................... $ 2,947
=========
NON-CASH TRANSACTIONS:
Accrual of distributions payable (Note 7).............. $ 12,811 $ 10,576
========= =========
Issuance of common units of the Operating Partnership
to acquire properties (Note 2)........................ $ 16,031 $ 3,979
========= =========
Issuance of note payable to acquire properties......... $ 6,650
=========
</TABLE>
See accompanying notes to consolidated and combined financial statements.
6
<PAGE>
KILROY REALTY CORPORATION CONSOLIDATED AND KILROY GROUP COMBINED
NOTES TO FINANCIAL STATEMENTS
Nine Months Ended September 30, 1998 and 1997
(Unaudited)
1. Organization
Kilroy Realty Corporation (the "Company") develops, owns, and operates
office and industrial real estate, primarily in Southern California. The
Company commenced operations in January 1997 and operates as a self-
administered real estate investment trust ("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 of the properties
contributed to the Company in connection with its formation, the formation of
Kilroy Realty, L.P. (the "Operating Partnership") and completion of the
Company's initial public offering ("IPO") (collectively the "Formation
Transactions") on January 31, 1997. As of September 30, 1998, the Company's
stabilized portfolio consisted of 77 office buildings and 83 industrial
buildings, which encompassed approximately 5.4 million and 5.7 million
rentable square feet, respectively, and was 94.9% occupied. The Company owns
its interests in all of the properties through the Operating Partnership and
Kilroy Realty Finance Partnership, L.P. and conducts substantially all of its
operations through the Operating Partnership. The Company owned an 87.4%
general partnership interest in the Operating Partnership as of September 30,
1998.
The majority of the Company's properties are located in Southern California.
The ability of the tenants to honor the terms of their respective leases is
dependent upon the economic, regulatory and social factors affecting the
communities and industries in which the tenants operate.
Basis of Presentation
The accompanying interim financial statements have been prepared by the
Company's management in accordance with generally accepted accounting
principles and in conjunction with the rules and regulations of the Securities
and Exchange Commission ("SEC"). Certain information and footnote disclosures
required for annual financial statements have been condensed or excluded
pursuant to SEC rules and regulations. Accordingly, the interim financial
statements do not include all of the information and footnotes required by
generally accepted accounting principles for complete financial statements. In
the opinion of management, the interim financial statements presented herein
reflect all adjustments of a normal and recurring nature which are considered
necessary for a fair presentation of the results for the interim periods
presented. The results of operations for the interim period are not
necessarily indicative of the results that may be expected for the year ended
December 31, 1998. These financial statements should be read in conjunction
with the audited consolidated financial statements and the notes thereto
included in the Company's Annual Report on Form 10-K for the year ended
December 31, 1997.
New Accounting Pronouncement
In June 1998, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 133 "Accounting for Derivative Instruments
and Hedging Activities" ("SFAS 133"). SFAS 133 is effective for fiscal years
beginning after June 15, 1999 and requires all derivatives to be recorded on
the balance sheet at fair value as either assets or liabilities depending on
the rights or obligations under the contract. SFAS 133 also establishes
"special accounting" for the following three classifications of hedges: fair
value, cash flow and net investment in foreign operations. Management believes
the adoption of SFAS 133 will not have a material impact on the Company's
financial position or results of operations.
7
<PAGE>
KILROY REALTY CORPORATION CONSOLIDATED AND KILROY GROUP COMBINED
NOTES TO FINANCIAL STATEMENTS--(Continued)
Nine Months Ended September 30, 1998 and 1997
(Unaudited)
2. Property Acquisitions
During the nine months ended September 30, 1998, the Company acquired
through a series of transactions 51 acres of undeveloped land, 23 office
buildings and 15 industrial buildings in California and Nevada, as follows:
<TABLE>
<CAPTION>
Date Number of Acreage/Square Location of Purchase Price
Description Acquired Buildings Footage Property (in millions)
----------- -------- --------- ----------------- ---------------- --------------
<S> <C> <C> <C> <C> <C>
Undeveloped land........ 3/98 2 acres San Diego, CA $ 1.7
Undeveloped land........ 4/98 13 acres San Diego, CA 9.5
Undeveloped land........ 4/98 4 acres San Diego, CA 1.8
Undeveloped land........ 4/98 18 acres Calabasas, CA 2.9
Undeveloped land........ 5/98 4 acres San Diego, CA 2.6
Undeveloped land........ 7/98 2 acres San Diego, CA .5
Undeveloped land........ 7/98 8 acres San Diego, CA 5.4
----------------- ------
Subtotal undeveloped
land................. 51 acres 24.4
Office building......... 1/98 1 48,000 sq. ft. Los Angeles, CA 7.6
Office buildings........ 1/98 4 149,000 sq. ft. Fullerton, CA 10.6
Office building......... 1/98 1 70,000 sq. ft. Santa Monica, CA 16.6
Office buildings........ 2/98 2 79,000 sq. ft. Anaheim, CA 7.1
Office building......... 3/98 1 82,000 sq. ft. Carlsbad, CA 10.5
Office buildings........ 3/98 2 200,000 sq. ft. San Diego, CA 29.5
Office building......... 3/98 1 41,000 sq. ft. Camarillo, CA 5.0
Office building......... 4/98 1 69,000 sq. ft. San Diego, CA 7.3
Office buildings........ 4/98 7 411,000 sq. ft. San Diego, CA 54.5
Office building......... 6/98 1 46,000 sq. ft. San Diego, CA 6.2
Office building......... 6/98 1 39,000 sq. ft. San Diego, CA 5.2
Office building......... 6/98 1 45,000 sq. ft. San Diego, CA 3.9
Industrial buildings.... 1/98 9 143,000 sq. ft. Irvine, CA 12.6
Industrial buildings.... 1/98 3 234,000 sq. ft. San Jose, CA 27.9
Industrial building..... 2/98 1 75,000 sq. ft. Reno, NV 6.9
Industrial building..... 4/98 1 84,000 sq. ft. Anaheim, CA 6.2
Industrial building..... 5/98 1 52,000 sq. ft. Tustin, CA 3.5
--- ----------------- ------
Subtotal office and
industrial buildings. 38 1,867,000 sq. ft. 221.1
------
Total...................................................................... $245.5
======
</TABLE>
These acquisitions were funded primarily with existing working capital and
borrowings on the Company's revolving credit facility. The Operating
Partnership issued 496,220 common limited partnership units valued at
approximately $13.5 million in connection with the acquisition of two office
buildings located in San Diego, California and one industrial building located
in Reno, Nevada from entities controlled by Richard S. Allen, (together, "The
Allen Group") a member of the Company's board of directors. An Executive Vice
President of the Company who was previously a member of The Allen Group
received 158,495 of the total 496,220 units. The 496,220 units were valued
based upon the Company's average closing common share price for the three-week
period preceding the acquisition date. The acquisitions of the three buildings
were based upon arms length negotiations.
In April 1998, 18 acres of undeveloped land in Calabasas, California were
acquired from a partnership controlled by John B. Kilroy, Sr. and John B.
Kilroy, Jr., the Company's Chairman and its President and Chief Executive
Officer, respectively, in exchange for $346,000 in cash and the issuance of
90,787 common limited partnership units of the Operating Partnership valued at
$2.5 million. These units were valued based upon the Company's average closing
common share price for the ten trading days preceding the acquisition date.
The acquisition was based upon arms length negotiations. The land is part of a
66 acre development site in Calabasas, California which is presently entitled
for over one million rentable square feet of office, retail and hotel
8
<PAGE>
KILROY REALTY CORPORATION CONSOLIDATED AND KILROY GROUP COMBINED
NOTES TO FINANCIAL STATEMENTS--(Continued)
Nine Months Ended September 30, 1998 and 1997
(Unaudited)
development. The Company presently plans to develop 210,000 rentable square
feet of office property on the 18 acres it acquired. The infrastructure
improvements on the land were financed with Mello Roos bonds which have a
current principal balance of approximately $15.4 million. Principal and
interest on the bonds will be charged to the Company and other owners through
property tax bills through 2008 based on the relative value of land and
buildings on the site. Based on the planned development of the total site, the
Company's obligation for its portion of the development site is estimated at
$8.2 million but may vary depending on the actual size and number of buildings
built. The costs are currently capitalized as development costs and will be
charged to operations upon the completion of construction.
3. Notes Receivable from Related Parties
On May 7, 1998 the Company entered into an agreement to loan up to $8.5
million to a limited partnership controlled by Richard S. Allen, a member of
the Company's board of directors. Advances on the note will be used for
infrastructure improvements on land in San Diego which secures the note.
Pursuant to a separate agreement with the borrower, the Company will acquire a
50% interest in the land upon the completion of all infrastructure
improvements. Interest accrues on all outstanding borrowings at a rate of
LIBOR plus 1.85% (7.23% at September 30, 1998) and the note and accrued
interest are due upon the acquisition of the 50% interest in the land by the
Company. At September 30, 1998, $4.4 million was outstanding on the note.
On May 22, 1998 the Company entered into an agreement to loan up to $2.3
million to a limited liability company also controlled by Richard S. Allen.
Advances on the note will be used for tenant improvements and upgrades to a
building in San Diego. The note is secured by the pledge of membership
interests in the limited liability company. Pursuant to a separate agreement
with the borrower, the Company will acquire the building on or before June 30,
1999, subject to the completion of improvements. The note and accrued interest
are payable upon the acquisition of the building by the Company. Interest
accrues on all outstanding borrowings at a rate of prime plus 1.00% (9.25% at
September 30, 1998). At September 30, 1998, $2.3 million was outstanding on
the note.
4. Line of Credit
On February 24, 1998, the Operating Partnership converted its previous $250
million secured revolving credit facility into a $350 million unsecured line
of credit (together with the previous line of credit, the "Credit Facility").
The new Credit Facility matures in February 2000, and bears interest at either
LIBOR plus 1.00%, LIBOR plus 1.13%, or LIBOR plus 1.25%, (6.63% at September
30, 1998) depending on the Company's leverage ratio at the time of borrowing.
Borrowings outstanding at September 30, 1998 were $270 million. Availability
under the Credit Facility at September 30, 1998 was $76.1 million based on the
value of the Company's pool of unencumbered assets. The fee for unused funds
is 0.25% based on outstanding balances. The total interest expense capitalized
for the three-and nine-month periods ended September 30, 1998 were $2.2
million and $6.2 million, respectively.
In July 1998, the Company entered into two interest rate cap agreements with
a total notional amount of $150 million to effectively limit interest expense
for borrowings on the Credit Facility during periods of increasing interest
rates. The agreements have LIBOR based cap rates of 6.50% and expire in July
2000. The Company's exposure is limited to the $176,000 cost of the cap
agreements, which the Company is amortizing over the term of the Credit
Facility. The amortization of the cost of the cap agreements is included as a
component of interest expense in the consolidated statement of operations.
9
<PAGE>
KILROY REALTY CORPORATION CONSOLIDATED AND KILROY GROUP COMBINED
NOTES TO FINANCIAL STATEMENTS--(Continued)
Nine Months Ended September 30, 1998 and 1997
(Unaudited)
5. Minority Interests
On February 6, 1998, the Company issued 1,200,000 8.075% Series A Cumulative
Redeemable Preferred Units, representing limited partnership interest 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 $1.6 million, for the repayment
of borrowings outstanding on the Credit Facility. On April 22, 1998 the
Company issued an additional 300,000 Preferred Units for a gross contribution
to the Operating Partnership of $15.0 million. The Company used the
contribution proceeds, less applicable transaction costs and expenses of
$412,000, 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 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.
6. Stockholders Equity
In January 1998, the Company filed a "shelf" registration statement on Form
S-3 with the Securities and Exchange Commission ("SEC") which registered $400
million of equity securities of the Company. The registration statement was
declared effective by the SEC on February 11, 1998. Through November 12, 1998
the Company completed four underwritten offerings aggregating 3,012,326 shares
of common stock and two direct placements aggregating 161,884 shares of common
stock resulting in aggregate net proceeds of $82.1 million. The Company used
such net proceeds to repay borrowings under the Credit Facility.
In October 1998, the Company adopted a Preferred Share Purchase Rights Plan
(the "Rights Plan") under which stockholders of record on October 15, 1998
received one Right for each share of the Company's outstanding common stock.
Each Right, which entitles its holder to buy one one-hundredth of a share of
voting preferred stock at an exercise price of $71.00, becomes exercisable,
subject to limited exceptions, if a person or group acquires 15% or more of
the Company's common stock or announces a tender offer for 15% or more of the
Company's common stock. Upon such event, each Right entitles its holder to
purchase, at the Right's then exercise price, a number of shares of the
Company's common stock equal to the market value at that time of twice the
Right's exercise price. Rights held by the acquirer will become void and will
not be exercisable upon the announcement of the acquisition. In the event that
the Company is acquired in a merger or other business combination, each Right
entitles its holder to purchase, at the Right's then current exercise price, a
number of shares of the acquiring company's common stock equal to the market
value at that time of twice the Right's exercise price. The Rights Plan
expires October 2, 2008. The Board may elect to redeem the Rights at $.001 per
Right.
As a result of the capital transactions discussed above and the issuance of
587,007 common limited partnership units of the Operating Partnership in
connection with the acquisition of certain properties during 1998 (Note 2),
the Company owned an 87.4% general partnership interest in the Operating
Partnership as of September 30, 1998.
10
<PAGE>
KILROY REALTY CORPORATION CONSOLIDATED AND KILROY GROUP COMBINED
NOTES TO FINANCIAL STATEMENTS--(Continued)
Nine Months Ended September 30, 1998 and 1997
(Unaudited)
7. Subsequent Events
Subsequent to September 30, 1998, the Company acquired two office buildings
located in San Diego, California totaling approximately 116,000 rentable
square feet from an entity controlled by Richard S. Allen, a member of the
Company's board of directors. The acquisition of the two properties was
financed with approximately $16.7 million of borrowings on the Credit Facility
and the issuance of 207,649 common limited partnership units of the Operating
Partnership valued at approximately $5.0 million based on a unit price
predetermined by the parties involved. An Executive Vice President of the
Company who was previously a member of The Allen Group received 144,821 of the
total 207,649 units. The 207,649 units were recorded by the Company at
approximately $4.6 million based on the Company's closing share price on the
acquisition date. The acquisition of the two properties was based upon arms
length negotiations. The $16.7 million of borrowings on the Credit Facility
were drawn prior to the acquisition and are included in outstanding borrowings
at September 30, 1998.
In October 1998, the Credit Facility was amended to include construction in
progress in the value of the Company's unencumbered assets and to modify
certain financial covenants. The agreement was also amended such that the
Credit Facility may bear interest at LIBOR plus 1.38%, depending on the
Company's leverage ratio at the time of borrowing.
On October 12, 1998 distributions of $12.8 million were paid to stockholders
and common unitholders of record on September 30, 1998.
8. Earnings Per Share
Basic earnings per share is computed by dividing net income by the weighted-
average number of common shares outstanding for the period. Diluted earnings
per share is computed by dividing net income by the sum of the weighted-
average number of common shares outstanding for the period plus the assumed
exercise of all dilutive securities. The following table reconciles the
numerator and denominator of the basic and diluted per-share computations for
net income.
<TABLE>
<CAPTION>
Nine Months Ended Period February 1, 1997 through
September 30, 1998 September 30, 1997
----------------------------------- -----------------------------------
Income Shares Per Share Income Shares Per Share
(Numerator) (Denominator) Amount (Numerator) (Denominator) Amount
----------- ------------- --------- ----------- ------------- ---------
(in thousands except share and per share data)
<S> <C> <C> <C> <C> <C> <C>
Basic................... $28,649 26,770,445 $1.07 $13,240 16,162,243 $0.82
Effect of dilutive
securities:
Stock options......... 94,829 84,192 (.01)
------- ---------- ----- ------- ---------- -----
Diluted................. $28,649 26,865,274 $1.07 $13,240 16,246,435 $0.81
======= ========== ===== ======= ========== =====
<CAPTION>
Three Months Ended Three Months Ended
September 30, 1998 September 30, 1997
----------------------------------- -----------------------------------
Income Shares Per Share Income Shares Per Share
(Numerator) (Denominator) Amount (Numerator) (Denominator) Amount
----------- ------------- --------- ----------- ------------- ---------
(in thousands except share and per share data)
<S> <C> <C> <C> <C> <C> <C>
Basic................... $ 9,985 27,647,688 $0.36 $ 6,480 18,931,522 $0.34
Effect of dilutive
securities:
Stock options......... 94,192
------- ---------- ----- ------- ---------- -----
Diluted................. $ 9,985 27,647,668 $0.36 $ 6,480 19,025,714 $0.34
======= ========== ===== ======= ========== =====
</TABLE>
11
<PAGE>
KILROY REALTY CORPORATION CONSOLIDATED AND KILROY GROUP COMBINED
NOTES TO FINANCIAL STATEMENTS--(Continued)
Nine Months Ended September 30, 1998 and 1997
(Unaudited)
At September 30, 1998, Company employees and directors held options to
purchase 1,493,000 shares of the Company's common stock that were antidilutive
to the diluted earnings per share computation. These options could become
dilutive in future periods if the average market price of the Company's common
stock exceeds the exercise price of the outstanding options.
9. Unaudited Pro Forma Condensed Consolidated Financial Information
The accompanying unaudited pro forma information for the nine months ended
September 30, 1998 and 1997 are presented as if the acquisitions described in
Note 2 to the financial statements had occurred on January 1, 1997. Such pro
forma information is based upon the consolidated statements of operations of
the Company for the nine months ended September 30, 1998 and the period from
February 1, 1997 to September 30, 1997 and the combined statement of
operations of the Kilroy Group for the period January 1, 1997 to January 31,
1997, and should be read in conjunction with the consolidated and combined
financial statements and the notes thereto.
This unaudited pro forma condensed consolidated information does not purport
to represent what the actual results of operations of the Company would have
been assuming such property acquisitions had been completed as set forth
above, nor do they purport to predict the results of operations for future
periods.
Pro Forma Income Statement
(in thousands, except share and per share data)
<TABLE>
<CAPTION>
Nine Months Nine Months
Ended Ended
September 30, September 30,
1998 1997
------------- -------------
<S> <C> <C>
Total revenues...................................... $ 100,292 $ 58,678
========== ==========
Net income before extraordinary items............... $ 28,634 $ 11,883
========== ==========
Net income.......................................... $ 28,634 $ 15,087
========== ==========
Net income per common share-basic................... $ 1.07 $ .93
========== ==========
Net income per common share-diluted................. $ 1.07 $ .93
========== ==========
Weighted average shares outstanding-basic........... 26,770,445 16,162,243
========== ==========
Weighted average shares outstanding-diluted......... 26,865,274 16,246,435
========== ==========
</TABLE>
12
<PAGE>
ITEM 2. 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 notes thereto appearing elsewhere in this report.
Overview and Background
Kilroy Realty Corporation (the "Company") develops, owns, and operates
office and industrial real estate, primarily in Southern California. The
Company commenced operations in January 1997 and operates as a self-
administered real estate investment trust ("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 its formation,
the formation of Kilroy Realty, L.P. (the "Operating Partnership") and
completion of the Company's initial public offering ("IPO") (collectively the
"Formation Transactions") on January 31, 1997. The Company owns its interests
in all of the properties through the Operating Partnership and Kilroy Realty
Finance Partnership, L.P. and conducts substantially all of its operations
through the Operating Partnership. The Company owned an 87.4% general
partnership interest in the Operating Partnership as of September 30, 1998.
Results of Operations
During 1997, the Company acquired 96 office and industrial buildings
totaling 2.2 million and 3.7 million rentable square feet, respectively, for
an aggregate acquisition cost of $507 million. During the nine months ended
September 30, 1998, the Company acquired 38 office and industrial buildings
totaling 1.3 million and 588,000 rentable square feet, respectively, for a
total purchase price of $221 million. Operating results for acquired
properties are included in the consolidated financial statements of the
Company subsequent to their respective acquisition dates.
As a result of the properties acquired subsequent to September 30, 1997,
rentable square footage in the Company's portfolio of stabilized properties
increased 4.2 million rentable square feet, or 60.9% to 11.1 million rentable
square feet at September 30, 1998 compared to 6.9 million rentable square feet
at September 30, 1997. As of September 30, 1998, the Company's portfolio of
stabilized properties was comprised of 77 office properties encompassing 5.4
million rentable square feet and 83 industrial properties encompassing 5.7
million rentable square feet. The Company's stabilized portfolio consists of
all of the Company's office and industrial properties with the exception of
properties and projects included in construction in progress. With respect to
properties developed by the Company, the Company's policy is to include
properties in its stabilized portfolio upon the earlier of one year from the
date of substantial completion or the date such property reaches stabilized
occupancy of 95.0%. The portfolio occupancy rate at September 30, 1998 was
94.9%, with the office and industrial properties 94.8% and 95.0% occupied,
respectively, as of such date.
13
<PAGE>
Three Months Ended September 30, 1998 compared to Three Months Ended September
30, 1997
<TABLE>
<CAPTION>
Three months
ended
September 30,
---------------
(in thousands)
1998 1997
------- -------
<S> <C> <C>
REVENUES:
Rental income................................................ $30,369 $16,418
Tenant reimbursements........................................ 3,768 1,631
Interest income.............................................. 308 900
Other income................................................. 74 158
------- -------
Total revenues............................................. 34,519 19,107
------- -------
EXPENSES:
Property expenses............................................ 4,775 2,724
Real estate taxes............................................ 2,800 998
General and administrative................................... 1,797 1,477
Ground leases................................................ 259 206
Interest expense............................................. 5,263 2,637
Depreciation and amortization................................ 6,740 3,660
------- -------
Total expenses............................................. 21,634 11,702
------- -------
INCOME BEFORE EQUITY IN INCOME OF UNCONSOLIDATED SUBSIDIARY AND
MINORITY INTERESTS............................................ $12,885 $ 7,405
======= =======
</TABLE>
Total revenues increased $15.4 million, or 80.7% to $34.5 million for the
three months ended September 30, 1998 compared to $19.1 million for the three
months ended September 30, 1997. Rental income increased $14.0 million, or
85.0% to $30.4 million for the three months ended September 30, 1998 compared
to $16.4 million for the three months ended September 30, 1997. Of this
increase, $7.4 million was generated by properties acquired during 1997,
subsequent to June 30, 1997 (the "Third and Fourth Quarter 1997
Acquisitions"), and $5.5 million was generated from properties acquired during
the nine months ended September 30, 1998 (the "1998 Acquisitions"). The
remaining $1.1 million increase in rental income was generated by properties
owned at July 1, 1997 and still owned at September 30, 1998 (the "Same Store
Properties") and represents a 7.5% increase in rental income for the Same
Store Properties. The increase is primarily the result of leasing activity at
the SeaTac Office Center, including a lease for 211,000 rentable square feet
with The Boeing Company, which was effective January 1, 1998 (the "Boeing
Lease"). In addition, during the second quarter of 1998, the Company leased
46,000 rentable square feet at the La Palma Business Center which was vacant
at September 30, 1997. Excluding the Boeing lease, occupancy remained
consistent and average rent per square foot increased 4.4% for the Same Store
Properties for the three months ended September 30, 1998 compared to the three
months ended September 30, 1997.
Tenant reimbursements increased $2.1 million, or 131.0% to $3.7 million for
the three months ended September 30, 1998 compared to $1.6 million for the
three months ended September 30, 1997. Of this increase $1.6 million was due
to tenant reimbursements from the Third and Fourth Quarter 1997 Acquisitions
and the 1998 Acquisitions. The remaining increase of $0.5 million was
generated by the Same Store Properties, of which $0.3 million represents
tenant reimbursements under the Boeing Lease. Interest income decreased $0.6
million or 65.8% to $0.3 million for the three months ended September 30,
1998, compared to $0.9 million for the three months ended September 30, 1997,
due to interest earned on the proceeds from the sale of 10,000,000 shares of
common stock at $25.50 per share in August 1997 (the "August 1997 Offering").
After the repayment of borrowings on the line of credit and the purchase of
pending acquisitions, there were $146 million of proceeds remaining from the
August 1997 Offering.
Total expenses increased $9.9 million, or 84.9% to $21.6 million for the
three months ended September 30, 1998 compared to $11.7 million for the three
months ended September 30, 1997. Property expenses increased $2.1 million, or
75.3% to $4.8 million and real estate taxes increased $1.8 million, or 180.6%
to $2.8 million for
14
<PAGE>
the three months ended September 30, 1998 compared to $2.7 million and $1.0
million, respectively for the three months ended September 30, 1997. Of the
collective increase of $3.9 million in property expenses and real estate
taxes, $2.0 million was generated by the Third and Fourth Quarter 1997
Acquisitions and $1.2 million was generated from the 1998 Acquisitions. The
remaining $0.7 million increase was generated from the Same Store Properties
and is primarily due to management more aggressively allocating expenses which
may be reimbursable by tenants to the property level, and also reflects the
annual increase in property taxes. General and administrative expenses
increased $0.3 million, or 21.7% to $1.8 million for the three months ended
September 30, 1998 compared to $1.5 million for the three months ended
September 30, 1997, due to increased management and administrative costs
associated with the increased portfolio size. Interest expense increased $2.6
million, or 99.6% to $5.2 million for the three months ended September 30,
1998 compared to $2.6 million for the three months ended September 30, 1997,
primarily due to interest paid on an additional $128 million of borrowings on
the Company's unsecured revolving credit facility during 1998 and $32.9
million of mortgage debt assumed in connection with fourth quarter 1997
acquisitions. The Company's weighted average interest rate decreased 0.88% to
7.31% at September 30, 1998 compared to 8.19% at September 30, 1997.
Depreciation and amortization expense increased $3.1 million, or 84.2% to $6.7
million for the three months ended September 30, 1998 compared to $3.6 million
for the same period in 1997, primarily due to depreciation on the 1997 and
1998 Acquisitions.
Net income before extraordinary gains increased $5.5 million, or 74.0% to
$12.9 million for the three months ended September 30, 1998 compared to $7.4
million for the three months ended September 30, 1997. The increase is due
primarily to an increase in rental income and tenant reimbursements of $14.0
million and $2.1 million, respectively, offset by an increase in property
expenses of $2.1 million, an increase in real estate taxes of $1.8 million, an
increase in interest expense of $2.6 million and an increase in depreciation
and amortization of $3.1 million.
Nine Months Ended September 30, 1998 compared to Adjusted Nine Months Ended
September 30, 1997
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 items as if the IPO had been consummated on January 1, 1997. The
following sections discuss the results of operations as adjusted.
<TABLE>
<CAPTION>
Nine months ended
September 30,
---------------------
(in thousands)
1998 1997
------- -------------
(as adjusted)
<S> <C> <C>
REVENUES:
Rental income.......................................... $84,817 $38,638
Tenant reimbursements.................................. 10,014 3,716
Interest income........................................ 1,191 3,361
Other income........................................... 941 472
------- -------
Total revenues....................................... 96,990 46,187
------- -------
EXPENSES:
Property expenses...................................... 13,812 6,624
Real estate taxes...................................... 6,554 2,031
General and administrative............................. 5,499 4,015
Ground leases.......................................... 854 734
Interest expense....................................... 14,642 7,480
Depreciation and amortization.......................... 19,159 9,191
------- -------
Total expenses....................................... 60,520 30,075
------- -------
INCOME BEFORE EQUITY IN INCOME OF SUBSIDIARY, MINORITY
INTERESTS AND EXTRAORDINARY GAIN........................ $36,470 $16,112
======= =======
</TABLE>
15
<PAGE>
Total revenues increased $50.8 million, or 110.0% to $97.0 million for the
nine months ended September 30, 1998 compared to $46.2 million for the nine
months ended September 30, 1997. Rental income increased $46.2 million, or
119.5% to $84.8 million for the nine months ended September 30, 1998 compared
to $38.6 million for the nine months ended September 30, 1997. Of this
increase, $32.3 million was generated by properties acquired during 1997
subsequent to the IPO on January 31, 1997 (the "1997 Acquisitions") and
$11.7 million was generated from the 1998 Acquisitions. The remaining $2.2
million increase in rental income was generated by properties owned at the IPO
and still owned at September 30, 1998 (the "Existing Properties") and
represents a 6.9% increase in rental income for the Existing Properties. The
increase is primarily the result of leasing activity at the SeaTac Office
Center, including the Boeing Lease which contributed $1.6 million of the
increase in rental revenue. The remainder of the increase is primarily
attributable to owning the seven properties acquired in connection with the
IPO for a full nine months in 1998. Excluding the Boeing Lease, occupancy
remained consistent and average rent per square foot increased 2.6% for the
Existing Properties for the nine months ended September 30, 1998 compared to
the nine months ended September 30, 1997.
Tenant reimbursements increased $6.3 million, or 170.2% to $10.0 million for
the nine months ended September 30, 1998 compared to $3.7 million for the nine
months ended September 30, 1997. Of this increase, $4.5 million was
attributable to tenant reimbursements from the 1997 and 1998 Acquisitions and
$1.8 million was generated by the Existing Properties, of which $1.0 million
represents tenant reimbursements under the Boeing Lease. The remaining $0.8
million of the increase is primarily due to an increase in tenant billings
correlating with an increase in reimbursable property operating expenses.
Interest income decreased $2.2 million or 64.6% to $1.2 million for the nine
months ended September 30, 1998, compared to $3.4 million for the nine months
ended September 30, 1997, due to interest earned on the $116 million of net
IPO proceeds and the $146 million of net proceeds from the August 1997
Offering during the nine months ended September 30, 1997. Other income for the
nine months ended September 30, 1998 included $0.5 million in development
services fees, and also lease termination fees and property management fees.
Total expenses increased $30.4 million, or 101.2% to $60.5 million for the
nine months ended September 30, 1998 compared to $30.1 million for the nine
months ended September 30, 1997. Property expenses increased $7.2 million, or
108.5% to $13.8 million and real estate taxes increased $4.5 million, or
222.7% to $6.5 million for the nine months ended September 30, 1998 compared
to $6.6 million and $2.0 million, respectively for the nine months ended
September 30, 1997. Of the collective increase of $11.7 million in property
expenses and real estate taxes, $7.4 million was generated by the 1997
Acquisitions and $2.8 million was generated by the 1998 Acquisitions. The
remaining $1.5 million increase from the Existing Properties is primarily
attributable to management more aggressively allocating expenses which may be
reimbursable by tenants to the property level and also reflects the annual
increase in property taxes. General and administrative expenses increased $1.5
million, or 37.0% to $5.5 million for the nine months ended September 30, 1998
compared to $4.0 million for the nine months ended September 30, 1997, due to
increased management and administrative costs associated with the increased
portfolio size. Ground lease expense increased $0.1 million or 16.3% during
the nine months ended September 30, 1998 over the same period in 1997
primarily as a result of ground leases on two properties purchased subsequent
to the IPO. Interest expense increased $7.2 million, or 95.8% to $14.7 million
for the nine months ended September 30, 1998 compared to $7.5 million for the
nine months ended September 30, 1997, primarily due to interest paid on an
additional $128 million of borrowings on the Company's unsecured revolving
credit facility during 1998 and $32.9 of mortgage debt assumed in connection
with fourth quarter 1997 acquisitions. The Company's weighted average interest
rate decreased 0.88% to 7.31% at September 30, 1998 compared to 8.19% at
September 30, 1997. Depreciation and amortization expense increased $10.0
million, or 108.5% to $19.2 million for the nine months ended September 30,
1998 compared to $9.2 million for the same period in 1997, due to depreciation
on the 1997 and 1998 Acquisitions.
Net income before extraordinary gains increased $20.4 million, or 126.4% to
$36.5 million for the nine months ended September 30, 1998 compared to $16.1
million for the nine months ended September 30, 1997. The increase is due
primarily to an increase in rental income and tenant reimbursements of $46.2
million and $6.3 million, respectively, offset by an increase in property
expenses of $7.2 million, an increase in real estate taxes of $4.5 million, an
increase in interest expense of $7.2 million and an increase in depreciation
and amortization of $10.0 million.
16
<PAGE>
Liquidity and Capital Resources
In February 1998, the Company obtained a $350 million unsecured revolving
credit facility (the "Credit Facility"), which bears interest at a rate of
either LIBOR plus 1.00%, LIBOR plus 1.13% or LIBOR plus 1.25% (6.63% at
September 30, 1998) depending on the Company's leverage ratio at the time of
borrowing, 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 $76.1 million at September 30, 1998. In October 1998, the
Credit Facility agreement was amended to include construction in progress in
the value of the Company's unencumbered assets and to modify certain financial
covenants. The agreement was also amended such that the Credit Facility may
bear interest at LIBOR plus 1.38%, depending upon the Company's leverage ratio
at the time of borrowing. There were borrowings of $270 million outstanding at
September 30, 1998.
On January 31, 1998 the Company increased the amount of its $14.0 million
mortgage loan to $19.0 million and extended the maturity date to January 31,
2000. In addition, the Company repaid a $0.9 million promissory note in
January 1998. As of September 30, 1998 the Company's mortgage loans had a
weighted average interest rate of 8.19%.
In January 1998, the Company filed a "shelf" registration statement on Form
S-3 with the SEC which registered $400 million of equity securities of the
Company. The registration statement was declared effective by the SEC on
February 11, 1998. Through November 12, 1998 the Company completed four
underwritten offerings aggregating 3,012,326 shares of common stock and two
direct placements aggregating 161,884 shares of common stock with aggregate
net proceeds of $82.1 million. As of November 12, 1998, an aggregate of
$313 million of equity securities were issuable under the registration
statement. The Company, as general partner of the Operating Partnership and as
required by the terms and conditions of the Third Amended and Restated
Agreement of Limited Partnership of the Operating Partnership (the
"Partnership Agreement"), invested the net proceeds of such offerings in the
Operating Partnership, which used such net proceeds to repay borrowings under
the Credit Facility.
In February 1998, the Company issued 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 $1.6 million, for the repayment
of borrowings outstanding on the Credit Facility. On April 22, 1998 the
Company issued an additional 300,000 Preferred Units for a gross contribution
to the Operating Partnership of $15.0 million. The Company used the
contribution proceeds, less applicable transaction costs and expenses of $0.4
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 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 Redeemable Preferred Stock, beginning February 6, 2008 which may be
accelerated under certain circumstances.
Capital Expenditures
As of September 30, 1998, the Company had commenced development of
approximately 1.4 million and 300,000 rentable square feet of industrial and
office space, respectively, at a total budgeted cost of approximately $127
million. The Company has spent an aggregate of $84.0 million on these projects
as of September 30, 1998. The Company intends to finance the remaining $43.0
million of development costs with borrowings under the Credit Facility and
working capital.
At September 30, 1998, the Company had escrow deposits of $401,000 for the
contemplated acquisitions of two office buildings with 132,100 aggregate
rentable square feet. The aggregate acquisition cost of the buildings is
estimated to be approximately $21.5 million.
17
<PAGE>
Subsequent to September 30, 1998, the Company completed the acquisition of
two office buildings with 116,000 rentable square feet in the aggregate for a
purchase price of $21.3 million. The properties were acquired from an entity
controlled by Richard S. Allen a member of the Company's board of directors,
with borrowings on the Credit Facility and the issuance of 207,649 common
limited partnership units of the Operating Partnerships recorded at $4.6
million based on the Company's closing share price on the acquisition date. An
Executive Vice President of the Company who was previously a member of The
Allen Group, a group of affiliated real estate development and investment
companies based in Visalia, California ("The Allen Group"), received 144,821
of the total 207,649 units. The $16.7 million of borrowings on the Credit
Facility were drawn prior to the acquisition and are included in outstanding
borrowings at September 30, 1998.
In connection with an agreement signed in October 1997 with The Allen Group
the Company is committed to purchase two office properties totaling 254,000
rentable square feet for an aggregate purchase price of $40.1 million. The
Company intends to finance these acquisitions with borrowings on the Credit
Facility and the issuance of approximately $11.0 million of common limited
partnership units of the Operating Partnership. In addition, the original
agreement contemplated the acquisition by the Company of two industrial
buildings in San Rafael, California and Las Vegas, Nevada, respectively, and
one office building in Redwood City, California for an aggregate purchase
price of $22.8 million. Based on the current amended agreement, the Company is
no longer obligated to purchase these three non-strategic properties.
The transaction with The Allen Group also consists 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 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.
The Company believes that it will have sufficient capital resources to
satisfy its obligations and planned capital expenditures for the next twelve
months. The Company expects to meet its long-term liquidity requirements
including possible future development and property acquisitions, through
retained cash flow, long-term secured and unsecured borrowings, including the
Credit Facility, and the issuance of debt securities or the issuance of common
limited partnership units of the Operating Partnership.
Historical Cash Flows
The Company's net cash provided by operating activities increased $38.2
million or 233.5% to $54.5 million for the nine months ended September 30,
1998 compared to $16.3 million for the nine months ended September 30, 1997.
The increase is primarily due to the increase in net income resulting from the
1997 and 1998 acquisitions and increased property operating income generated
by the properties owned as of January 1, 1997. The increase was partially
offset by increased interest expense and general and administrative expenses.
Cash used in investing activities decreased $67.0 million or 19.1% to $284
million for the nine months ended September 30, 1998 compared to $351 million
for the nine months ended September 30, 1997. The decrease was due primarily
to the purchase of 38 office and industrial properties for $208 million (net
of $13.5 million of contributed value in exchange for which the Company issued
common limited partnership units of the Operating Partnership), the purchase
of 51 acres of undeveloped land for $21.9 million (net of $2.5 million of
contributed value in exchange for which the Company issued common limited
partnership units of the Operating Partnership), expenditures for construction
in progress of $43.4 million, and $8.2 million in additional tenant
improvements and capital expenditures for the nine months ended September 30,
1998 versus the purchase of 65 office and industrial properties for $280
million (net of $4.0 million of contributed value in exchange for which the
Company issued common limited partnership units of the Operating Partnership
and $6.7 million of debt issued), the purchase of 7 office and industrial
buildings for $58.0 million in connection with the IPO, the purchase of 25
acres of undeveloped land for $6.5 million, and $4.8 million in additional
tenant improvements
18
<PAGE>
and capital expenditures for the nine months ended September 30, 1997. Cash
provided by financing activities decreased $161 million or 39.5% to
$248 million for the nine months ended September 30, 1998 compared to $409
million for the nine months ended September 30, 1997. Cash provided by
financing activities for the nine months ended September 30, 1998 consisted
primarily of net proceeds from the issuance of 3,012,326 shares of common
stock through four underwritten offerings, the issuance of 161,884 shares of
common stock through two direct placements, the issuance of $75.0 million of
8.075% Series A Cumulative Redeemable Preferred Units of the Operating
Partnership and proceeds from the issuance of mortgage debt and net borrowings
on the Credit Facility, partially offset by distributions paid to stockholders
and minority interest holders. Cash provided by financing activities for the
nine months ended September 30, 1997 consisted of net proceeds from the
Company's IPO in January 1997, proceeds from the issuance of mortgage debt in
connection with the IPO, net borrowings on the line of credit and
distributions paid to stockholders and minority interest holders. The increase
in distributions of $24.9 million or 223.6% to $36.0 million for the nine
months ended September 30, 1998 from $11.1 million for the nine months ended
September 30, 1997 is due to a greater number of shares outstanding as well as
an increase in distribution rate to $1.22 per share for the nine months ended
September 30, 1998 from 1.03 per share for the nine months ended September 30,
1997.
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
interests of common 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 considers Funds from Operations an appropriate measure of performance
of an equity REIT because it is predicated on cash flow analyses. 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 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 Funds from Operations published by such other REITs. Funds from
Operations should not be considered as an alternative to net income (loss)
(computed in accordance with GAAP) as an indicator of the properties'
financial performance or to cash flow from operating activities (computed in
accordance with GAAP) as an indicator of the properties' liquidity, nor is it
indicative of funds available to fund the properties' cash needs, including
the Company's ability to pay dividends or make distributions.
The following table presents the Company's Funds from Operations for the
nine months ended September 30, 1998 and the period from February 1, 1997 to
September 30, 1997.
<TABLE>
<CAPTION>
Nine Months February 1,
Ended 1997 to
September 30, September 30,
1998 1997
------------- -------------
(in thousands)
<S> <C> <C>
Net income.......................................... $28,649 $13,240
Add:
Minority interest in earnings................... 4,093 2,231
Depreciation and amortization................... 19,159 8,404
Other........................................... 405 315
------- -------
Funds from Operations............................... $52,306 $24,190
======= =======
</TABLE>
19
<PAGE>
Inflation
The majority of the Company's tenant leases require tenants to pay most
operating expenses, including real estate taxes and insurance, and increases
in common area maintenance expenses, which reduce the Company's exposure to
increases in costs and operating expenses resulting from inflation.
Year 2000
The Year 2000 issue ("Y2K") refers to the inability of certain computer
systems, as well as certain hardware and equipment containing date sensitive
data, to recognize accurate dates commencing on or after January 1, 2000. This
has the potential to affect those systems adversely. In 1997 the Company's
Information Technology Committee, which is comprised of representatives from
senior management and various departments including accounting, property
management and information systems, identified three phases in the Company's
Y2K efforts: discovery and assessment, remediation and implementation, and
testing and verification. Although many of the phases are being completed
simultaneously, the following sections describe the activities that the
Company has or expects to perform to meet its Y2K objectives, as well as
management's assessment of the Company's risk of non-compliance.
The Company's State of Readiness
The initial phase of discovery and assessment consists of evaluating and
identifying all of the Company's information technology and non-information
technology systems that contain date sensitive data. The following summary
describes the classifications of systems that were identified and the
Company's current state of readiness for each classification.
Information Technology Systems
The Company's information technology systems fall into three general
categories: accounting and property management systems, network operating
systems, and desktop software. The Company replaced its accounting and
property management system, acquired all new network hardware and software,
and updated all of its desktop systems and software after its IPO in early
1997. The new accounting and property management system, which was tested upon
its implementation in 1997, and all the Company's network hardware and
software, desktop systems and software packages are Y2K compliant as asserted
by the software vendors. Management believes there is no material Y2K exposure
with respect to its information technology systems.
Non Information Technology Systems
Building Management Systems
The Company has identified five categories of building management systems
that could have potential Y2K exposure: building automation (e.g., HVAC),
security card access, fire and life safety, elevator, and office equipment.
During 1998, property management executives and personnel began gathering data
to identify all of the Company's Y2K sensitive building management systems and
to assess whether such systems are currently Y2K compliant or will need to be
modified or replaced. Management expects to complete the discovery and
assessment phase and be able to determine the Company's state of readiness as
to building management systems by May 1999. In addition management expects to
complete the remediation and implementation phase by September 1999 and the
testing and verification phase by the end of fiscal year 1999.
Costs to Address the Company's Y2K Efforts
Since the replacement of the accounting and property management system, the
acquisition of new network hardware and software and the installation of
updated desktop systems and software was performed as a result of the Company
becoming a public traded REIT and not in response to Y2K compliance issues,
and further, since phase 1 of the building management systems efforts are
being performed by 13 salaried Company
20
<PAGE>
employees who are not paid for overtime and who management expects will spend
10% of their annual working hours over a 2 to 3 year period focusing on Y2K
compliance issues, Y2K costs incurred to date have been minimal and have not
been material to the Company's financial position or results of operations.
While expected future costs, which will include costs to complete phases 2
and 3 for the building management systems, are not readily quantifiable at
this time, it is management's belief that a significant portion of such costs
will be treated as operating expenses and will be reimbursed to the Company
under most tenant leases. Consequently, management does not believe that such
expenses will have a material effect on the Company's financial position or
results of operations.
Efforts to Identify the Y2K Issues of Significant Third Parties
Due to the Company's diverse tenant base, the success of the Company's
business is not closely tied to the success of any one particular tenant. In
addition, the success of the Company's business is also not closely tied to
the operations of any one vendor, supplier or manufacturer. However, the
Company is in the process of surveying significant tenants, vendors, suppliers
and other relevant third parties, to determine that their systems will be Y2K
compliant and that the Company's normal operations will continue without
interruption. Management anticipates this project will be completed by
December 31, 1998.
The Risks of Y2K Non-Compliance
Management does not believe that the impact of the Y2K issue will have a
material adverse effect on the Company's financial condition or results of
operations. This belief is based upon both the analysis of the Company's Y2K
issues and the Company's assessment of the Y2K exposure related to tenants,
vendors, and other significant third parties as discussed above. No assurance
can be given about facts and resultant effects of Y2K issues unknown to the
Company at this time.
The Company's worst case Y2K scenario would be that the Company's
information and building management systems fail. In the event that the
Company's information systems fail, the Company would be forced to manually
perform its accounting and property management record-keeping functions until
the information systems could be restored. In the event that the Company's
building management systems fail, the Company's tenants would not have access
to or be able to conduct their normal business activities at the Company's
properties until the building management systems could be restored. These
events could have a material adverse effect on the Company's financial
position and results of operations.
Developing Contingency Plans
The Company does not currently have a contingency plan in place in the event
of a Y2K failure. Such a contingency plan is expected to be developed by the
end of the third quarter 1999.
21
<PAGE>
PART II--OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
During the nine months ended September 30, 1998, no legal proceedings were
initiated against or on behalf of the Company, the adverse determination of
which would have a material adverse effect upon the financial condition and
results of operations of the Company.
ITEM 2. CHANGES IN SECURITIES
Subsequent to September 30, 1998, the Operating Partnership issued 207,649
common limited partnership units issued at an aggregate value of $5.0 million
to an entity controlled by Richard S. Allen, a member of the Company's board
of directors, in exchange for two office buildings totaling approximately
116,000 rentable square feet in San Diego, California. An Executive Vice
President of the Company who was previously a member of The Allen Group
received 144,821 of the total 207,649 units. The 207,649 units were recorded
by the Operating Partnership at approximately $4.6 million based on the
Company's closing share price on acquisition date. These units were issued in
reliance on an exemption registration requirement pursuant to Regulation D
under the Securities Act of 1933 as amended.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES--None
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS--None
ITEM 5. OTHER INFORMATION--None
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
<TABLE>
<CAPTION>
Exhibit
Number Description
------- -----------
<C> <S>
4.1 Rights Agreement, dated as of October 2, 1998 between Kilroy Realty
Corporation and ChaseMellon Shareholder Services, L.L.C., as Rights
Agent, which includes the form of Articles Supplementary of the Series
B Junior Participating Preferred Stock of Kilroy Realty Corporation as
Exhibit A, the form of Right Certificate as Exhibit B and the Summary
of Rights to Purchase Preferred Shares as Exhibit C.(1)
10.1 First Amendment to Third Amended and Restated Agreement of Limited
Partnership by Kilroy Realty Corporation, as general partner of Kilroy
Realty, L.P., dated as of October 2, 1998.(1)
10.2 Amended and Restated Revolving Credit Agreement, dated as of October
8, 1998 among Kilroy Realty, L.P., Morgan Guaranty Trust Company of
New York, as Bank and as Lead Agent for the Banks, and the Banks
listed therein.(3)
10.3 Amended and Restated Guaranty of Payment, dated as of October 8, 1998,
between Kilroy Realty Corporation and Morgan Guaranty Trust Company of
New York.(3)
10.4 Contribution Agreement, dated October 21, 1997 by and between Kilroy
Realty, L.P. and Kilroy Realty Corporation and The Allen Group and the
Allens.(2)
10.5 Amendment to the Contribution Agreement, dated October 14, 1998, by
and between Kilroy Realty, L.P. and Kilroy Realty Corporation and The
Allen Group and the Allens, dated October 21, 1997.(3)
27.1 Financial Data Schedule.(3)
99.1 Press Release of Kilroy Realty Corporation, dated October 2, 1998.(1)
</TABLE>
- --------
* Filed herewith.
22
<PAGE>
(1) Previously filed as Exhibits 4.1, 10.1, and 99.1, respectively, to the
Current Report on Form 8-K (No. 1-12675) dated October 2, 1998 and
incorporated herein by reference.
(2) Previously filed as Exhibit 2.1 to the Current Report on Form 8-K (No. 1-
12675) dated October 29, 1997 and incorporated herein by reference.
(3) Previously filed as Exhibits 10.2, 10.3, 10.5 and 27.1, respectively, to
the Company's Form 10-Q (No. 1-12675), for the quarterly period ended
September 30, 1998, and incorporated herein by reference.
(b) Reports on Form 8-K.
The Company filed a Current Report on Form 8-K, dated October 2, 1998, in
connection with the adoption of the Preferred Share Purchase Rights Plan.
23
<PAGE>
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed
on its behalf by the undersigned, thereunto duly authorized on March 24, 1999.
Kilroy Realty Corporation
By: /s/ John B. Kilroy, Jr.
-------------------------------------
John B. Kilroy, Jr.
President and Chief Executive
Officer
By: /s/ Richard E. Moran Jr.
-------------------------------------
Richard E. Moran Jr.
Executive Vice President and Chief
Financial Officer
By: /s/ Ann Marie Whitney
-------------------------------------
Ann Marie Whitney
Vice President and Controller
24
