ITEM 1. BUSINESS
General
Kilroy Realty Corporation (the "Company") was incorporated in September 1996 and commenced operations upon the completion of its initial public offering in January 1997. The Company, which develops, owns, and operates office and industrial properties, primarily in Southern California, operates qualifies, and intends to continue to qualify as a self-administered and self-managed real estate investment trust ("REIT") for federal and state income tax purposes beginning with the year ended December 31, 1997. The Company is the successor to the real estate business of Kilroy Industries, a California corporation ("KI"), and certain of its affiliated corporations, partnerships and trusts (collectively, the "Kilroy Group"). Since 1947, the Kilroy Group has been engaged in the business of owning, acquiring, developing, managing and leasing principally Class A suburban office and industrial buildings in select locations in key suburban submarkets, primarily in Southern California. As of December 31, 1998, the Company's portfolio of properties (including properties owned by Kilroy Realty, L.P. (the "Operating Partnership") and Kilroy Realty Finance Partnership, L.P., a Delaware limited partnership (the "Finance Partnership")) included 80 office buildings encompassing approximately 5.6 million rentable square feet (the "Office Properties") and 84 industrial buildings encompassing approximately 6.2 million rentable square feet (the "Industrial Properties" and, together with the Office Properties, the "Properties"). All but 15 of the Properties are located in Southern California. As of December 31, 1998, the Office Properties were approximately 95.7% leased to 420 tenants and the Industrial Properties were approximately 96.0% leased to 253 tenants. In addition, as of December 31, 1998, the Company had under development six office buildings and two industrial buildings which when completed are expected to encompass approximately 544,000 and 390,000 rentable square feet, respectively.
The Company conducts substantially all of its activities through the Operating Partnership in which, as of December 31, 1998, it owned an approximate 86.8% general partnership interest. The remaining 13.2% limited partnership interest in the Operating Partnership was owned by certain of the Company's executive officers and directors, certain of their affiliates, and other outside investors. As the sole general partner of the Operating Partnership, the Company has control over the management of the Operating Partnership, which owns 147 of the Company's 164 Properties. The remaining 17 properties are owned by the Finance Partnership in which the Company (through a wholly-owned subsidiary) owns a 1.0% sole general partnership interest and the Operating Partnership owns a 99.0% limited partnership interest.
The Company's strategy has been to own, develop, acquire, lease and manage Class A suburban office and industrial properties in select locations in key suburban submarkets, primarily in Southern California, which the Company believes have strategic advantages compared to neighboring submarkets.
At December 31, 1998, the Company's ten largest office tenants represented approximately 26.2% of total annual base rent rental revenue, defined as annualized monthly contractual rents from existing tenants at December 31, 1998, determined in accordance with generally accepted accounting principles, and its ten largest industrial tenants represented approximately 10.2% of total annual base rental revenue. Of this amount, its largest tenant, Hughes Electronics Corporation's Space & Communications Company ("Hughes Space & Communications"), currently leases approximately 412,000 rentable square feet of office space, representing approximately 7.4% of the Company's total annual base rental revenues at December 31, 1998. The base periods of the Hughes Space & Communications leases expire in January and July 2004.
The Company's five largest office tenants, based on annual rental revenues, include: Hughes Space & Communications, a tenant since 1984, which is engaged in high-technology commercial activities including satellite development and related applications such as DirecTV; The Boeing Company; the State of California (Caltrans); Sony Music Entertainment, Inc. and Unisys Corporation. The Company's five largest industrial tenants, based on annualized rental revenues, include: Mattel, Inc.; Celestica, Inc.; Kraft Foods, Inc.; Omni-Pack and Mazda Motor of America, Inc. (See Item 2:
ITEM 2. PROPERTIES
General
As of December 31, 1998, the Company owned (through the Operating and Finance Partnerships) 80 Office Properties encompassing 5.6 million aggregate rentable square feet and 84 Industrial Properties encompassing 6.2 million aggregate rentable square feet. As of December 31, 1998, the Office Properties were approximately 95.7% leased to 420 tenants and the Industrial Properties were approximately 96.0% leased to 253 tenants. In addition, as of December 31, 1998, the Company had approximately 544,000 square feet of office space and 390,000 square feet of industrial space under construction. All of the Company's construction projects and all but 15 of the Company's Properties are located in Southern California.
In general, the Office Properties are leased to tenants on a full service gross basis and the Industrial Properties are leased to tenants on a triple net basis. Under a full service lease, the landlord is obligated to pay the tenant's proportionate share of taxes, insurance and operating expenses up to the amount incurred during the tenant's first year of occupancy ("Base Year") or a negotiated amount approximating the tenant's pro rata share of real estate taxes, insurance and operating expenses ("Expense Stop"). The tenant pays its pro-rata share of increases in expenses above the Base Year or Expense Stop. Under a triple net lease, tenants pay their proportionate share of real estate taxes, operating costs and utility costs.
The Company believes that all of its Properties are well maintained and, based on recent engineering reports, do not require significant capital improvements. As of December 31, 1998, the Company managed 75 of its 80 Office Properties and 77 of its 84 Industrial Properties through internal property managers.
The Office and Industrial Properties
The following table sets forth certain information relating to each of the Office and Industrial Properties owned as of December 31, 1998. The Company (through the Operating Partnership and the Finance Partnership) owns a 100% interest in all of the Office and Industrial Properties other than Walnut Park Business Center, in which the Company owns an 87.7% interest as a tenant in common, and the five office properties located at Kilroy Airport Center, Long Beach, three office properties located at the SeaTac Office Center, one office property located in Santa Monica, California and one office property located in San Diego, California, each of which are held subject to leases for the land on which the properties are located expiring in 2035, 2032, 2065 and 2043 (assuming the exercise of the Company's options to extend such leases), respectively.
- -------- (1) Based on all leases at the respective properties in effect as of December 31, 1998.
(2) Base rent for the year ended December 31, 1998, determined in accordance with generally accepted accounting principles ("GAAP") and annualized to reflect a twelve-month period. Unless otherwise indicated, leases at the Industrial Properties are written on a triple net basis and leases at the Office Properties are written on a full service gross basis, with the landlord obligated to pay the tenant's proportionate share of taxes, insurance and operating expenses up to the amount incurred during the tenant's first year of occupancy ("Base Year") or a negotiated amount approximating the tenant's pro rata share of real estate taxes, insurance and operating expenses ("Expense Stop"). Each tenant pays its pro rata share of increases in expenses above the Base Year of Expense Stop.
(3) Annual Base Rent divided by net rentable square feet leased at December 31, 1998.
(4) The four properties at 5151-5155 Camino Ruiz were built between 1982 and 1985.
(5) For this property, a lease with Hughes Space & Communications for approximately 96,000 rentable square feet, and with SDRC Software Products Marketing Division, Inc. for approximately 6,800 rentable square feet, are written on a full service gross basis except that there is no Expense Stop.
(6) For this property, the lease with Hughes Space & Communications is written on a modified full service gross basis under which Hughes Space & Communications pays for all utilities and other internal maintenance costs with respect to the leased space and, in addition, pays its pro rata share of real estate taxes, insurance, and certain other expenses including common area expenses.
(7) For this property, the lease is written on a triple net basis.
(8) For this property, leases with Hughes Space & Communications for approximately 103,000 rentable square feet are written on a full service gross basis except that there is no Expense Stop.
(9) For this property, the lease is written on a modified gross basis, with the tenant paying its share of taxes and insurance above base year amounts. (footnotes continued on next page)
(10) For this property, leases for approximately 65,000 rentable square feet are written on a full service basis, with the tenants paying no expense reimbursement, leases for approximately 38,000 rentable square feet are written on a modified full service gross basis, and leases for approximately 29,000 rentable square feet are written on a triple net basis.
(11) For this property, leases for approximately 70,500 rentable square feet are written on a full service basis, with the tenants paying no expense reimbursement, leases for approximately 48,500 rentable square feet are written on a modified full service gross basis, and leases for approximately 21,000 rentable square feet are written on a triple net basis.
(12) For this property, a lease for approximately 21,000 rentable square feet is written on a modified full service grass basis, and leases for approximately 11,000 rentable square feet are written on a triple net basis.
(13) For this property, the lease is written on a full service basis, with the tenant paying only its portion of real estate taxes above the base year amount.
(14) The leases for this property are written on a modified net basis, with the tenants responsible for their pro-rata share of common area expenses and real estate taxes.
(15) For this property, a lease for 60,840 rentable square feet is written on a triple net basis.
(16) For this property, a lease for 15,728 rentable square feet is written on a triple net basis, and leases for 15,156 rentable square feet are written on a modified full service gross basis.
(17) This property was 100% leased to one tenant in February 1999 with annual base rent of $0.1 million.
(18) The leases for this industrial property are written on a modified triple net basis, with the tenants responsible for estimated allocated common area expenses.
(19) The seven properties at the Brea Industrial Complex were built between 1981 and 1988.
(20) For this property, a lease for 14,700 rentable square feet commenced in February 1999 with annual base rent of $0.1 million resulting in total occupancy as of March 10, 1999 of 62.0%.
(21) The six properties at the Garden Grove Industrial Complex were built between 1971 and 1985.
(22) For this property, leases for approximately 38,000 rentable square feet are written on a modified full service gross basis, and leases for approximately 12,000 rentable square feet are written on a full service basis, with the tenants paying no expense reimbursement.
(23) For this property, the lease is written on a full service gross basis.
(24) For this property, leases for approximately 53,000 rentable square feet are written on a full service gross basis, with the tenants paying no expense reimbursement, leases for approximately 53,000 rentable square feet are written on a modified triple net basis with the tenants responsible for estimated allocated common area expenses.
(25) For this property, leases for approximately 26,000 rentable square feet are written on a full service basis, with the tenants paying no expense reimbursement, and leases for approximately 19,000 rentable square feet are written on a modified full service gross basis.
(26) This industrial property was originally designed for multi-tenant use and currently is leased to a single tenant and utilized as an indoor multi- vendor retail marketplace.
(27) For this property, leases for approximately 115,500 rentable square feet are written on a triple net basis and, leases for approximately 46,500 rentable square feet are written on a full service basis, with the tenants paying no expense reimbursement.
(28) This property was managed by third-party managers at December 31, 1998.
(29) This table does not include one industrial property with an aggregate 113,248 rentable square feet which was occupied at December 31, 1998. This property is part of a three building complex that was constructed by the Company. As substantial tenant improvements still needed to be completed at December 31, 1998, the complex is included in construction in progress at December 31, 1998.
Development Projects
The following table sets forth certain information as of December 31, 1998, relating to each of the Company's Development Projects which were either in the lease-up phase (construction was complete except for tenant improvements), under construction or scheduled to begin construction in the first quarter of 1999. The Company owns a 100% interest in all of the Development Projects other than 5010 Wateridge Vista Drive and Carmel Center Building 1, in which the Company will own a 50% interest.
- -------- (1) Based on management's estimation of the earlier of stabilized occupancy (95.0%) or one year from the date of substantial completion.
(2) Represents total projected development costs.
(3) Represents executed leases and signed letters of intent to lease at December 31, 1998.
(4) Represents projects being developed in conjunction with The Allen Group, a group of affiliated real estate and development companies based in Visalia, California. See separate discussion in Item 7: Management's Discussion and Analysis of Financial Condition and Results of Operations-- Capital Expenditures Section for further discussion.
Tenant Information
The following table sets forth information as to the Company's ten largest office and industrial tenants based upon annualized rental revenues for the year ended December 31, 1998.
- --------
(1) Determined in accordance with GAAP.
(2) Represents date of first relationship between tenant and the Company or the Company's predecessor, the Kilroy Group.
(3) Hughes Space & Communications leases of 291,187 and 103,035 net rentable square feet expire July 2004 and January 2004, respectively. Leases with other Hughes-affiliated entities of 7,515, 5,559 and 5,158 net rentable square feet expire November 2001, December 1999 and November 1999, respectively.
(4) The Boeing Company lease at SeaTac Office Center expires January 2002. The Boeing Company (formerly McDonnell Douglas Corporation) leases at Kilroy Airport Center Long Beach of 64,530, 24,536 and 17,921 net rentable square feet expire January 2002, December 2000 and December 1999, respectively.
(5) State of California leases of 124,921, 22,543, 21,781 and 11,425 net rentable square feet expire April 1999, December 2002, May 2009 and August 2000, respectively.
(6) Raytheon Company (formerly Hughes Aircraft Company) leases of 96,133 and 11,556 net rentable square feet expire October 2000, and a lease of 9,387 net rentable square feet expires January 2002.
(7) Extron Electronics leases of 100,000 and 57,730 net rentable square feet expire April 2005, and January 2005, respectively.
At December 31, 1998, the Company's tenant base was comprised of the following industries, broken down by percentage of total portfolio base rent: manufacturing, 40.5%; services, 21.7%; transportation, communications and public utilities, 14.1%; finance, insurance and real estate, 11.0%; retail trade, 4.4%; government, 4.1%; wholesale trade, 3.0%; construction, 1.1%; and agriculture, forestry and fishing, 0.1%. Following is a list comprised of a representative sample of 25 of the Company's tenants whose annual base rental revenues were less than 1.0% of the Company's total annual base revenue at December 31, 1998:
Lease Expirations
The following table sets forth a summary of the Company's lease expirations for the Office and Industrial Properties for each of the ten years beginning with 1999, assuming that none of the tenants exercise renewal options or termination rights.
(footnotes continued on next page)
- -------- (1) Includes tenants only. Excludes leases for amenity, retail, parking and month-to-month tenants. Some tenants have multiple leases.
(2) Based on total leased square footage for the respective portfolios as of December 31, 1998 unless a lease for a replacement tenant had been executed on or before January 1, 1999.
(3) Determined based upon aggregate base rent to be received over the term divided by the term in months multiplied by 12, including all leases executed on or before January 1, 1999.
Mortgage Debt
On December 31, 1998, the Operating Partnership had outstanding five mortgage loans representing aggregate indebtedness of approximately $133 million which were secured by certain of the Office and Industrial Properties (the "Secured Obligations"). See "Management's Discussion and Analysis of Financial Condition and Results of Operations--Liquidity and Capital Resources" and Note 6 to the Company's combined and consolidated financial statements included herewith. Management believes that as of December 31, 1998, the value of the properties securing the respective Secured Obligations in each case exceeded the principal amount of the outstanding obligation.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
Neither the Company nor any of the Company's Properties are subject to any litigation nor, to the Company's knowledge, is any litigation threatened against any of them which if determined adversely to the Company would have a material adverse effect on the Company's financial condition or results of operations. The Company is party to litigation arising in the ordinary course of business, all of which is expected to be covered by liability insurance.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of stockholders during the fourth quarter of the year ended December 31, 1998.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The Company's common stock began trading on the New York Stock Exchange ("NYSE") on January 28, 1997, under the symbol "KRC." Prior to January 28, 1997, there was no established public trading market for the Company's common stock. The following table illustrates the high, low and closing prices by quarter in 1998 and 1997, as reported on the NYSE. On March 10, 1999, there were approximately 235 registered holders of the Company's common stock.
The Company pays distributions to common stockholders on or about the 10th day of each January, April, July and October at the discretion of the Board of Directors. Distribution amounts depend on the Company's funds from operations, financial condition and capital requirements, the annual distribution requirements under the REIT provisions of the Internal Revenue Code of 1986, as amended (the "Code"), and such other factors as the Board of Directors deems relevant.
During the first and fourth quarters of fiscal year 1998, the Operating Partnership issued 703,869 common units of the Operating Partnership, valued by the Company at approximately $18.1 million (based on the Company's closing price per share of common stock on the NYSE), to entities controlled by Richard S. Allen, a member of the Company's Board of Directors at December 31, 1998, in partial consideration for the contribution of certain properties to the Operating Partnership. An Executive Vice President of the Company received 303,316 of the total 703,869 common units. The common units become convertible into shares of the Company's common stock, on a one-for-one basis, one year after issuance date. The common units were issued in reliance upon an exemption from registration provided by Regulation D under the Securities Act as a transaction by an issuer not involving a public offering.
During the second quarter of fiscal year 1998, the Operating Partnership issued 90,787 common units of the Operating Partnership, valued by the Company at approximately $2.5 million (based on the Company's closing price per share of common stock on the NYSE), to a partnership controlled by John B. Kilroy, Sr., the Company's Chairman of the Board of Directors, and John B. Kilroy, Jr., the Company's President and Chief Executive Officer, in partial consideration for the contribution of certain undeveloped land to the Operating Partnership. The common units may be exchanged, at the Company's option, into shares of the Company's common stock, on a one-for-one basis, one year after issuance date. The common units were issued in reliance upon an exemption from registration provided by Regulation D under the Securities Act as a transaction by an issuer not involving a public offering.
During the second and third quarters of 1998, the Company issued 1,200,000 and 300,000 8.075% Series A Cumulative Redeemable Preferred units, respectively, representing limited partnership interests in the Operating Partnership with a liquidation value of $50.00 per unit, in exchange for a gross contribution to the Operating Partnership of $60.0 million. The Series A 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 10 years from the date of issuance, or earlier under certain circumstances. The Series A Cumulative Redeemable Preferred units were issued in reliance upon an exemption from registration provided by Regulation D under the Securities Act as a transaction by an issuer not involving a public offering.
During the fourth quarter of 1998, the Company issued 700,000 9.375% Series C Cumulative Redeemable Preferred units, representing limited partnership interests in the Operating Partnership with a liquidation value of $50.00 per unit, in exchange for a gross contribution to the Operating Partnership of $35.0 million. The Series C Cumulative Redeemable Preferred units are exchangeable at the option of the majority of the holders, for shares of the Company's 9.375% Series C Cumulative Redeemable Preferred stock, beginning 10 years from the date of issuance, or earlier under certain circumstances. The Series A Cumulative Redeemable Preferred units were issued in reliance upon an exemption from registration provided by Regulation D under the Securities Act as a transaction by an issuer not involving a public offering.
During the first quarter of 1999, the Operating Partnership issued 119,460 common units of the Operating Partnership, valued by the Company at approximately $2.5 million (based on the Company's closing per share price of common stock on the NYSE), to entities controlled by Richard S. Allen, a member of the Company's Board of Directors at December 31, 1998, in partial consideration for the contribution of certain undeveloped land to the Operating Partnership. An Executive Vice President of the Company received 42,564 of the total 119,460 common units. The common units may be exchanged, at the Company's option, into shares of the Company's common stock, on a one- for-one basis, on or after October 31, 2000. The common units were issued in reliance upon an exemption from registration provided by Regulation D under the Securities Act as a transaction by an issuer not involving a public offering.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
Kilroy Realty Corporation and the Kilroy Group (in thousands, except per share, square footage and occupancy data)
- -------- (1) As defined by the National Association of Real Estate Investment Trusts ("NAREIT"), "Funds from Operations" represents net income (loss) before minority interest 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 adjustments for unconsolidated partnerships and joint ventures. Non-cash adjustments to arrive at Funds from Operations were as follows: in all periods, depreciation and amortization; in 1996, 1995 and 1994, gains on extinguishment of debt; and in 1998 and 1997, non-cash compensation. Further, in 1996 and 1995, non- recurring items (sale of air rights and option buy-out cost) were excluded. Management considers Funds from Operations an appropriate measure of performance of an equity REIT because it is predicated on cash flow analyses. 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 methodology for calculating Funds from Operations utilized by other equity REITs and, accordingly, may not be comparable to Funds from Operations reported by such other REITs. Further, Funds from Operations does not represent amounts available for management's discretionary use because of needed capital reinvestment or expansion, debt service obligations, or other commitments and uncertainties. See the notes to the financial statements of the Company and the Kilroy Group. 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 a measure or 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.
(2) Funds from Operations for 1997 is derived from the results of operations of Kilroy Realty Corporation for the period February 1, 1997 to December 31, 1997.
(3) Cash flow for 1997 represents the cash flow of the Kilroy Group for the period January 1, 1997 to January 31, 1997 and Kilroy Realty Corporation for the period February 1, 1997 to December 31, 1997.
ITEM 7.
ITEM 7. 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 related notes thereto. Statements contained in this "Management's Discussion and Analysis of Financial Condition and Results of Operations" that are not historical facts may be forward-looking statements. Such statements are subject to certain risks and uncertainties, which could cause actual results to differ materially from those projected. You are cautioned not to place undue reliance on these forward-looking statements.
Overview and Background
The Company, which owns, operates and develops office and industrial real estate, primarily in Southern California, commenced operations in January 1997 and operates as a self-administered REIT. The Company succeeded to the real estate business of the Kilroy Group, the Company's predecessor. The Kilroy Group had been engaged in the acquisition, management, financing, construction and leasing of office and industrial properties and providing development services to third party owners for a fee. 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 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 its Properties through the Operating Partnership and the Finance Partnership, and conducts substantially all of its operations through the Operating Partnership. The Company owned an 86.8% and 87.8% general partnership interest in the Operating Partnership as of December 31, 1998 and 1997, respectively.
The Company's revenue is derived primarily from rental income, including tenant reimbursements. While the Company's revenue growth in 1998 and 1997 was due primarily to the completion of $254 million and $507 million of acquisitions, respectively, the market for property acquisitions has become more competitive. As a result, management believes that the most significant part of the Company's revenue growth over the next two to three years will come from its substantial development pipeline. Management also believes that continued improvement of the real estate market in the Company's principal markets and the continued economic expansion of Southern California, which continues to lead the state in both job and economic growth, will result in strong demand for office and industrial space. Consequently, management currently expects that the Company's revenue in the next one to two years will also grow as a result of re-leasing, at higher lease rates, approximately 1.3 million square feet of office space and 1.5 million square feet of industrial space currently subject to leases expiring during the next two years. In addition, the Company intends to continue its leadership as a low cost operator through integrated operations and disciplined cost management.
Results of Operations
During the year ended December 31, 1998, the Company acquired 25 office and 16 industrial properties encompassing 1.4 million and 674,000 aggregate rentable square feet, respectively, for an aggregate acquisition cost of $254 million. In addition, the Company completed $70.7 million in property development consisting of the renovation of two buildings encompassing 369,000 rentable square feet, the construction of two buildings encompassing 345,000 rentable square feet and the construction of three buildings encompassing 379,000 rentable square feet which were completed except for tenant improvements at December 31, 1998. 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 the property reaches stabilized occupancy of 95.0%. During 1997, the Company acquired 41 office and 55 industrial properties encompassing 2.2 million and 3.7 million aggregate rentable square feet, respectively, for an aggregate acquisition cost of $507 million. Operating results for acquired properties and completed development properties are included in the consolidated financial statements of the Company subsequent to their respective acquisition or completion dates.
As a result of the 41 properties acquired subsequent to December 31, 1997 and the development of the five new properties completed in 1998, rentable square footage in the Company's portfolio of stabilized Properties increased 2.6 million rentable square feet, or 28.3%, to 11.8 million rentable square feet at December 31, 1998 compared to 9.2 million rentable square feet at December 31, 1997. As of December 31, 1998, the Company's portfolio of stabilized Properties was comprised of 80 Office Properties encompassing 5.6 million rentable square feet and 84 Industrial Properties encompassing 6.2 million rentable square feet. The portfolio occupancy rate at December 31, 1998 was 95.9%, with the Office and Industrial Properties 95.7% and 96.0% occupied, respectively, as of such date.
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 gains as if the Formation Transactions had been consummated on January 1, 1997.
Year Ended December 31, 1998 Compared to Year Ended December 31, 1997, as Adjusted
Rental Operations
Management evaluates the operations of its portfolio based on operating property type. The following tables compare the net operating income, defined as operating revenues less property and related expenses (property expenses, real estate taxes and ground leases) before depreciation, for the Office and Industrial Properties for the years ended December 31, 1998 and 1997. The 1997 results include the Company's results for the period February 1, 1997 to December 31, 1997 and the Kilroy Group's results for the period January 1, 1997 to January 31, 1997.
Total revenues from Office Properties increased $45.9 million, or 92.3% to $95.6 million for the year ended December 31, 1998 compared to $49.7 million for the year ended December 31, 1997. Rental income from office buildings increased $38.4 million, or 87.8% to $82.2 million for the year ended December 31, 1998 compared to $43.8 million for the year ended December 31, 1997. Of this increase, $13.3 million was generated by Office Properties acquired during 1998 (the "1998 Office Acquisitions") and $0.1 million was generated by the Office Properties developed in 1998 (the "1998 Office Development Properties"). In addition, $21.5 million of the increase was attributable to a full year of operating results for the Office Properties acquired during 1997, subsequent to the IPO on January 31, 1997 (the "1997 Office Acquisitions"). The remaining $3.5 million of the increase was generated by the 13 office properties owned at the IPO and still owned at December 31, 1998 (the "Existing Office Properties"), and represented a 10.0% increase in rental income for the Existing Office Properties. The increase generated by the Existing Office Properties was primarily the result of leasing activity at the SeaTac Office Center, including a lease for 211,000 rentable square feet with The Boeing Company (the "Boeing Lease"), which was effective January 1, 1998. Excluding lease-up at the SeaTac Office Center, occupancy remained consistent and the Existing Office Properties experienced an approximate 2.8% increase in rental income attributable to increases in rental rates.
Tenant reimbursements from Office Properties increased $5.1 million, or 93.1% to $10.6 million for the year ended December 31, 1998 compared to $5.5 million for year ended December 31, 1997. Of this increase, $1.2 million was attributable to the 1998 Office Acquisitions and the 1998 Office Development Properties, and $2.3 million was attributable to the 1997 Office Acquisitions. The remaining $1.6 million of the increase was generated by the Existing Office Properties, of which $1.2 million represented tenant reimbursements under the Boeing Lease. Other income from office buildings increased $2.4 million, or 494.1% to $2.9 million for the year ended December 31, 1998 compared to $0.5 million for the same period in 1997. The $2.4 million increase was primarily due to the recognition of a $1.9 million net lease termination fee on an office property in San Diego, California. This property was subsequently re-leased at higher rates for a longer term. In addition, in 1998 the Company earned a $0.5 million consulting fee for assisting an existing tenant with potential expansion plans.
Total expenses from Office Properties increased $11.6 million, or 94.7% to $23.8 million for the year ended December 31, 1998 compared to $12.2 million for the year ended December 31, 1997. Property expenses increased $7.9 million, or 92.3% to $16.4 million and real estate taxes increased $3.5 million, or 129.1% to $6.2 million for the year ended December 31, 1998 compared to $8.5 million and $2.7 million, respectively, for the year ended December 31, 1997. Of the collective increase of $11.4 million in property expenses and real estate taxes, $3.2 million was attributable to the 1998 Office Acquisitions and the 1998 Office Development Properties, and $6.6 million was attributable to a full year of operating results from the 1997 Office Acquisitions. The remaining $1.6 million of the increase at the Existing Office Properties was primarily due to the increase in variable costs associated with the lease-up of space, and an increase in real estate taxes at the SeaTac Office Center which resulted from the completion of substantial renovations. Ground lease expense increased $0.2 million for the year ended December 31, 1998 compared to the same period in 1997 primarily as a result of a full year of ground lease expense on two of the 1997 Office Acquisitions.
Net operating income, as defined, from Office Properties increased $34.4 million, or 91.6% to $71.9 million for the year ended December 31, 1998 compared to $37.5 million for the year ended December 31, 1997. Of this increase, $31.1 million was generated by the 1998 Office Acquisitions, the 1998 Office Development Properties and the 1997 Office Acquisitions. The remaining increase of $3.3 million was generated by the Existing Office Properties and represents an 11.2% increase in net operating income for the Existing Office Properties, which was primarily attributable to lease-up at the SeaTac Office Center.
Total revenues from Industrial Properties increased $21.9 million, or 128.4% to $38.9 million for the year ended December 31, 1998 compared to $17.0 million for the year ended December 31, 1997. Rental income increased $20.1 million, or 133.4% to $35.2 million for the year ended December 31, 1998 compared to $15.1 million for the year ended December 31, 1997. Of this increase, $3.4 million was generated by the Industrial Properties acquired during 1998 (the "1998 Industrial Acquisitions") and $2.1 million was generated by the Industrial Properties developed in 1998 (the "1998 Industrial Development Properties"). In addition, $14.0 million was attributed to a full year of operating results from the Industrial Properties acquired in 1997, subsequent to the IPO on January 31, 1997 (the "1997 Industrial Acquisitions"). The remaining $0.6 million of the increase was generated by the 11 industrial buildings owned at the IPO and still owned at December 31, 1998 (the "Existing Industrial Properties") and represented a 7.4% increase in rental income for the Existing Industrial Properties. The increase was primarily the result of the lease-up of 46,000 rentable square feet at the La Palma Business Center in the second quarter of 1998, which had been vacant since the second quarter of 1997. Excluding the lease-up at La Palma Business Center, occupancy and rental rates for the Existing Industrial Properties remained consistent.
Tenant reimbursements from Industrial Properties increased $2.0 million, or 126.7% to $3.5 million for the year ended December 31, 1998 compared to $1.5 million for year ended December 31, 1997. Of this increase, $0.4 million was attributable to the 1998 Industrial Acquisitions and the 1998 Industrial Development Properties, and $1.4 million was attributable to a full year of operating results from the 1997 Industrial Acquisitions. The remaining $0.2 million was attributable to the Existing Industrial Properties, of which $0.1 million represented an increase in tenant reimbursements at the La Palma Business Center due to lease-up of space, and $0.1 million correlated with the increase in real estate taxes reimbursable by tenants. Other income decreased $0.2 million, or 51.4% to $0.2 million for the year ended December 31, 1998 compared to $0.4 million for the same period in 1997. Other income for the year ended December 31, 1997 included $0.2 million related to receivables which were previously written off as uncollectible.
Total expenses from Industrial Properties increased $3.8 million, or 155.3% to $6.3 million for the year ended December 31, 1998 compared to $2.5 million for the year ended December 31, 1997. Property expenses increased $2.1 million, or 249.1% to $2.9 million and real estate taxes increased $1.7 million, or 107.3% to $3.3 million for the year ended December 31, 1998 compared to $0.8 million and $1.6 million, respectively, for the year ended December 31, 1997. Of the collective $3.8 million increase in property expenses and real estate taxes, $1.1 million was attributable to the 1998 Industrial Acquisitions and the 1998 Industrial Development Properties and $2.6 million was attributable to the 1997 Industrial Acquisitions. The remaining $0.1 million increase was attributable to the Existing Industrial Properties and was due to an increase in real estate taxes attributable to the reassessment of property values at the date of the IPO. Property expenses for the Existing Industrial Properties remained consistent for the year ended December 31, 1998 compared to the same period in 1997.
Net operating income, as defined, from Industrial Properties increased $18.0 million, or 123.8% to $32.6 million for the year ended December 31, 1998 compared to $14.6 million for the year ended December 31, 1997. Of this increase, $17.7 million was generated from the 1998 Industrial Acquisitions, the 1998 Industrial Development Properties and a full year of operating results from the 1997 Industrial Acquisitions. The remaining increase of $0.3 million was generated by the Existing Industrial Properties and represented a 4.3% increase in net operating income for the Existing Industrial Properties, which was primarily attributable to lease-up at the La Palma Business Center.
Non-Property Related Income and Expenses
Interest income decreased $2.4 million, or 58.1% to $1.7 million for the year ended December 31, 1998 compared to $4.1 million for the year ended December 31, 1997. The decrease was attributable to the interest earned in the prior year on the $116 million of net proceeds received from the Company's IPO on January 31, 1997 and the $146 million of net proceeds received from the Company's follow-on offering in August 1997 (the "August Offering"), which were invested in short-term investments and which the Company used for the acquisition of properties and repayment of indebtedness prior to January 1, 1998.
General and administrative expenses increased $2.4 million, or 45.7% to $7.7 million for the year ended December 31, 1998 compared to $5.3 million for the year ended December 31, 1997, due to increased management, administrative and personnel costs associated with the Company's increased portfolio size.
Interest expense increased $10.1 million, or 95.8% to $20.6 million for the year ended December 31, 1998 compared to $10.5 million for the same period in 1997, primarily due to a general increase in borrowings and higher monthly average outstanding balances under the Company's 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 0.5% to 7.3% at December 31, 1998 compared to 7.8% at December 31, 1997.
Depreciation and amortization expense increased $12.2 million, or 86.8% to $26.2 million for the year ended December 31, 1998 compared to $14.0 million for the same period in 1997. The increase was due to partial year depreciation on $254 million of 1998 Office and Industrial Acquisitions and a full year of depreciation on the 1997 Office and Industrial Acquisitions.
Net income for the year ended December 31, 1998 included a $1.7 million provision for potentially unrecoverable pre-development costs. The provision provides for costs incurred for development projects that the Company may at some point in the development process decide not to pursue. The provision was established by estimating probable exposures to these types of costs for each of the projects in the Company's development pipeline and applying a series of probability factors based on the Company's historical experience.
Net Income
Net income before equity in income of unconsolidated subsidiary, minority interests and extraordinary gains increased $23.7 million, or 90.3% to $50.0 million for the year ended December 31, 1998 from $26.3 million for the year ended December 31, 1997. The increase was primarily due to the increase in net operating income from the Office and Industrial Properties of $34.4 million and $18.0 million, respectively, which was primarily due to the acquisition of 1.4 million and 674,000 rentable square feet of office and industrial space, respectively, during 1998, and operating the 2.2 million and 3.7 million rentable square feet of office and industrial space acquired during 1997 for a full year in 1998. The increase in net operating income was offset by an increase in interest expense of $10.1 million and an increase in depreciation and amortization of $12.2 million.
Year Ended December 31, 1997, as Adjusted, Compared to Year Ended December 31, 1996
Rental Operations
The following tables compare the net operating income, as defined, for the Office and Industrial Properties for the years ended December 31, 1997 and 1996. The 1997 results include the Company's results for the period February 1, 1997 to December 31, 1997 and the Kilroy Group's results for the period January 1, 1997 to January 31, 1997.
Total revenues from Office Properties increased $16.7 million, or 50.6% to $49.7 million for the year ended December 31, 1997 compared to $33.0 million for the year ended December 31, 1996. Rental income from office buildings increased $14.2 million, or 48.1% to $43.8 million for the year ended December 31, 1997 from $29.6 million for the comparable period in 1996. This improvement was due to an increase of 2.5 million square feet of office space under lease, from 1.3 million square feet at December 31, 1996 to 3.8 million square feet at December 31, 1997, excluding the lease with The Boeing Company for 211,000 rentable square feet, which was effective January 1, 1998. Approximately 335,000 rentable square feet of the increase reflected four office buildings acquired in connection with the IPO on January 31, 1997 (the "IPO Office Properties") and 2.1 million rentable square feet represented the 41 office buildings purchased during 1997, subsequent to the IPO. The remaining increase in office space under lease was primarily the result of leasing activity at Kilroy Airport Center, El Segundo and Kilroy Airport Center, Long Beach. However, the increase in square footage under lease was offset by a decrease in average rent per rentable square foot at Kilroy Airport Center, El Segundo, from $21.34 per square foot for the year ended December 31, 1996 to $19.92 for the same period in 1997, as a result of the re-negotiation and extension of a lease with Hughes Space and Communications in November 1996. Average rent per rentable square foot also decreased at Kilroy Airport Center, Long Beach, from $25.05 per rentable square foot for the year ended December 31, 1996 to $21.61 for the same period in 1997 due to the re-leasing of 20,000 square feet and the lease-up of 24,000 square feet to McDonnell Douglas Corporation at a rate substantially lower than under the previous leases.
Tenant reimbursements from Office Properties increased $2.1 million, or 60.9% to $5.5 million for the year ended December 31, 1997 compared to $3.4 million for year ended December 31, 1996. The $2.1 million increase was primarily due to tenant reimbursements from the IPO Office Properties and the 41 office buildings acquired during 1997, subsequent to the IPO. Other income from the Office Properties for the year ended December 31, 1997 included $0.1 million in lease termination fees, a $0.1 million gain on the sale of furniture and equipment, and $0.3 million in property management fees.
Total expenses for the Office Properties increased $3.6 million, or 42.2% to $12.2 million for the year ended December 31, 1997 compared to $8.6 million for the year ended December 31, 1996. Property expenses
increased $2.0 million, or 31.1% to $8.5 million and real estate taxes increased $1.4 million, or 103.1% to $2.7 million for the year ended December 31, 1997 compared to $6.5 million and $1.3 million, respectively, for the year ended December 31, 1996, primarily due to the purchase of the IPO Office Properties and the 41 office buildings, all of which were acquired during 1997. Ground lease expense increased $0.2 million during the year ended December 31, 1997 compared to the same period in 1996 primarily as a result of ground leases on two of the buildings acquired in January 1997.
Net operating income, as defined, from Office Properties increased $13.1 million, or 53.5% to $37.5 million for the year ended December 31, 1997 compared to $24.4 million for the year ended December 31, 1996. This increase was primarily due to the purchase during 1997 of the IPO Office Properties and the 41 office buildings acquired during 1997, subsequent to the IPO.
Total revenues from Industrial Properties increased $11.2 million, or 193.1% to $17.0 million for the year ended December 31, 1997, compared to $5.8 million for the year ended December 31, 1996. Rental income from industrial buildings increased $9.6 million or 175.2% to $15.1 million for the year ended December 31, 1997 compared to $5.5 million for the same period in 1996. This improvement was due to an increase in industrial space under lease from 894,000 square feet at December 31, 1996 to 4.6 million square feet at December 31, 1997, an increase of 3.7 million square feet. The increase was due to the purchase of three industrial buildings in connection with the IPO on January 31, 1997 (the "IPO Industrial Properties") with approximately 380,000 square feet under lease at December 31, 1997, and the purchase of 55 industrial buildings subsequent to the IPO, with approximately 3.4 million square feet under lease at December 31, 1997. The remaining increase was primarily attributable to a full year of operating results from the lease-up of 62,000 square feet of industrial space in the fourth quarter of 1996.
For the year ended December 31, 1997, tenant reimbursements from Industrial Properties increased $1.2 million, or 362.2% to $1.5 million compared to $0.3 million for the year ended December 31, 1996. This increase was primarily due to tenant reimbursements from the IPO Industrial Properties and the 55 industrial buildings, all of which were acquired during 1997. Other income from the Industrial Properties for the year ended December 31, 1997 included $0.2 million in lease termination fees and $0.2 million in receivables previously written off as uncollectible.
Total expenses for the Industrial Properties increased $1.8 million, or 289.1% to $2.4 million for the year ended December 31, 1997 compared to $0.6 million for the year ended December 31, 1996. Property expenses increased $0.5 million, or 184.3% to $0.8 million and real estate taxes increased $1.3 million, or 379.6% to
$1.6 million for the year ended December 31, 1997 compared to $0.3 million and $0.3 million, respectively, for the year ended December 31, 1996, primarily due to the purchase of the IPO Industrial Properties and the 55 industrial buildings, all of which were acquired during 1997.
Net operating income, as defined, from Industrial Properties increased $9.4 million or 181.4% to $14.6 million for the year ended December 31, 1997 compared to $5.2 million for the year ended December 31, 1996. This increase was primarily due to the purchase of the IPO Industrial Properties and the 55 industrial buildings, all of which were acquired during 1997.
Non-Property Related Income and Expenses
Interest income increased $4.1 million due to interest earned on the $116 million of net proceeds received from the Company's IPO and the $146 million of net proceeds received from the August Offering, both of which were invested in short-term investments and which the Company used for the acquisition of Properties and repayment of indebtedness Prior to January 1, 1998.
Development services revenue and expenses decreased $0.7 million and $0.6 million, respectively, to $14,000 and $46,000, respectively, for the year ended December 31, 1997 compared to $0.7 million and $0.7 million, respectively, for the year ended December 31, 1996. On February 1, 1997, development services began to be performed by KSI.
General and administrative expenses increased $2.9 million, or 122.9% to $5.3 million during the year ended December 31, 1997 over the same period in 1996 due to the incremental costs of operating a public company and the additional management, administrative and personnel costs of operating a larger portfolio of properties.
Interest expense decreased $11.4 million, or 51.9%, to $10.5 million for the year ended December 31, 1997 from $21.9 million for the year ended December 31, 1996, primarily as a result of the repayment of $127 million in debt with the net proceeds of the IPO in January 1997. In addition, the Company's weighted average interest rate decreased 0.9% to 7.8% at December 31, 1997 compared to 8.7% at December 31, 1996.
Depreciation and amortization expense increased $4.9 million, or 53.9% to $14.0 million for the year ended December 31, 1997 compared to $9.1 million for the year ended December 31, 1996. The increase was due to partial year depreciation on the $507 million of property acquisitions in 1997.
Net Income
Net income before equity in income of unconsolidated subsidiary, minority interests and extraordinary gains was $26.3 million for the year ended December 31, 1997 compared to a $6.8 million loss for the same period in 1996. The net change in net income before extraordinary gains of $33.1 million was due primarily to the line items discussed above, an increase in net operating income from the Office and Industrial Properties of $13.1 million and $9.4 million, respectively, an increase in interest income of $4.1 million, a decrease in interest expense of $11.4 million and an increase in depreciation and amortization of $4.9 million. In addition, during the year ended December 31, 1996, there was a $3.2 million expense related to the accrued costs of an option buy-out for the cancellation of an option to purchase a 50.0% interest in Kilroy Airport Center, El Segundo.
Liquidity and Capital Resources
In February 1998, the Company increased its borrowing capacity and converted its previously secured line of credit into a $350 million unsecured revolving Credit Facility. The Credit Facility bears interest at a rate of either LIBOR plus 1.00%, LIBOR plus 1.13% or LIBOR plus 1.25% (6.81% at December 31, 1998), depending on the Company's leverage ratio at the time of borrowing, and matures in February 2000, with an option to extend for one year. The new Credit Facility replaced the Company's $250 million secured revolving credit
facility (the "Secured Credit Facility"). In October 1998, the Credit Facility agreement was amended to include construction in progress in the value of the Company's unencumbered assets, to modify certain financial covenants and to allow the Company to enter into separate construction financing arrangements. The agreement was also amended, while preserving the interest rate options discussed above, to provide that borrowings may bear interest at LIBOR plus 1.38%, depending upon the Company's leverage ratio at the time of borrowing. Availability under the Credit Facility depends upon the value of the Company's pool of unencumbered assets and was $77.0 million at December 31, 1998. At December 31, 1998 there were outstanding borrowings of $272 million and one letter of credit in the amount of $1.0 million drawn against available Credit Facility borrowings. The $1.0 million letter of credit was issued in connection with a signed commitment letter for a mortgage loan that the Company expects to complete in the first quarter of 1999 (see discussion below).
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 under 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 $0.2 million cost of the cap agreements, which the Company is amortizing over the term of the Credit Facility. The 1998 amortization was included as a component of interest expense in the consolidated statement of operations.
The Company had mortgage debt outstanding at December 31, 1998 and 1997 of $133 million and $131 million, respectively. At December 31, 1998, the Company's mortgage debt was comprised of five mortgage loans in the amounts of $82.0 million, $19.0 million, $13.4 million, $11.3 million, and $7.7 million. At December 31, 1997, the Company's mortgage debt was comprised of the same five mortgage loans in the amounts of $83.1 million, $14.0 million, $13.8 million, $11.7 million, and $7.9 million as well as a $0.9 million promissory note. On January 31, 1998, the Company increased the amount of its $19.0 million mortgage loan from $14.0 million to $19.0 million and extended the maturity date to January 31, 2000. In addition, the Company repaid the $0.9 million promissory note in January 1998. The $82.0 million mortgage loan requires monthly principal and interest payments based on an interest rate of 8.35%, amortizes over 25 years, and matures in February 2022. In February 2005, the interest rate resets to the greater of 13.35% or the sum of the interest rate for U.S. Treasury Securities maturing 15 years from the reset date plus 2.00%. The $19.0 million mortgage loan requires monthly payments of interest computed at a variable rate of LIBOR plus 1.50%. The $13.4 million mortgage loan bears interest at 8.45% and matures in December 2005. The $11.3 million mortgage loan bears interest at 8.43% and matures in November 2014. The $7.7 million mortgage loan bears interest at 8.21% and matures in October 2013. Principal and interest payments are payable monthly on the $13.4 million, 11.3 million, and $7.7 million mortgage loans. As of December 31, 1998 and 1997, the Company's mortgage loans had a weighted average interest rate of 8.22%.
In December 1998, the Company entered into a commitment letter with a lender for a mortgage loan collateralized by nine office and industrial properties. The commitment expires on March 24, 1999 and provides, subject to the completion of specified terms and conditions, for a mortgage loan with a principal balance of $95.0 million, monthly principal and interest payments based upon a fixed interest rate of 7.20% and a 25 year amortization schedule, and a maturity date of March 2009. The Company intends to use the proceeds from the $95.0 million mortgage loan to pay down outstanding borrowings on the Credit Facility. On February 8, 1999, the Company entered into a commitment letter with a lender for a mortgage loan collateralized by an office property and the related ground leases. The commitment has a term of 60 days and provides, subject to the completion of specified terms and conditions, for a mortgage loan with a principal balance of $30.0 million, monthly principal and interest payments based upon a fixed rate of 7.15% and an 18 year amortization period, and a maturity date of March 2018. The Company intends to use the proceeds from the $30.0 mortgage loan to repay the Company's existing $19.0 million mortgage loan. In connection with signing the commitment letter for the $95.0 million mortgage loan, the Company issued one letter of credit for $1.0 million in December 1998 and another letter of credit for $1.0 million in January 1999 to cover the deposit and application costs required by the mortgagor. Both letters of credit were issued against available Credit Facility borrowings and will expire upon the closing of the mortgage loan.
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 December 31, 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 $81.8 million. As of March 10, 1999, an aggregate of $313 million of equity securities were available for issuance under the registration statement. The Company, as general partner of the Operating Partnership and as required by the terms and conditions of the Operating Partnership's partnership agreement, contributed the net proceeds of such offerings to the Operating Partnership, which used the 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 "Series A 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 transaction costs and expenses of $1.7 million, for the repayment of borrowings outstanding under the Credit Facility. In April 1998, the Company issued an additional 300,000 Series A 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 under the Credit Facility. The Series A 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 Series A 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, or earlier under certain circumstances.
In November 1998, the Company issued 700,000 9.375% Series C Cumulative Redeemable Preferred units, representing limited partnership interests in the Operating Partnership (the "Series C Preferred units"), with a liquidation value of $50.00 per unit, in exchange for a gross contribution to the Operating Partnership of $35.0 million. The Company used the contribution proceeds, less applicable transaction costs and expenses of $0.9 million, for the repayment of borrowings outstanding under the Credit Facility. The Series C Preferred units, which may be called by the Operating Partnership at par on or after November 24, 2003, have no stated maturity or mandatory redemption and are not convertible into any other securities of the Operating Partnership. The Series C Preferred units are exchangeable at the option of the majority of the holders for shares of the Company's 9.375% Series C Cumulative Redeemable Preferred stock beginning November 24, 2008, or earlier under certain circumstances.
On March 10, 1999, the Company filed a registration statement on Form S-3 with the SEC which, in connection with the adoption of the Company's Dividend Reinvestment and Direct Purchase Plan (the "Plan"), registered 1,000,000 shares of the Company's common stock. The Plan, which is designed to provide the Company's stockholders and other investors with a convenient and economical method to purchase shares of the Company's common stock, consists of three programs: the Dividend Reinvestment Program (the "DRIP"), the Cash Option Purchase Plan (the "COPP") and the Waiver Discount Plan (the "WDP"). The DRIP provides existing common stockholders with the opportunity to purchase additional shares of the Company's common stock by automatically reinvesting all or a portion of their cash dividends. The COPP provides existing common stockholders and other investors with the opportunity to purchase additional shares of the Company's common stock by making optional cash purchases, at no discount to market, between $100 to $5,000 and $750 to $5,000, respectively, in any calendar month. The WDP provides existing common stockholders and other investors with the opportunity to purchase additional shares of the Company's common stock by making optional cash purchases, at a discount to market of up to 2.00% of the average per share price reported on the NYSE, of greater than $5,000 in any calendar month. The Plan will acquire shares of the Company's common stock from either new issuances directly from the Company, from the open market or from privately negotiated transactions, except for transactions executed under the WDP which will be purchased only from previously unissued shares of
common stock. Participation in the Plan is entirely voluntary, and can be terminated at any time. The Company intends to use the proceeds received from the Plan, less transaction costs, for development and investment activities, repayment of outstanding indebtedness and general corporate uses. This registration statement has not yet been declared effective by the SEC.
Capital Expenditures
As of December 31, 1998, the Company had approximately 544,000 and 390,000 rentable square feet of office and industrial space, respectively, under construction at a total budgeted cost of approximately $118 million. The Company has spent an aggregate of $41.4 million on these projects as of December 31, 1998. The Company intends to finance the remaining $76.4 million of development costs with borrowings under the Credit Facility and working capital. In addition, at December 31, 1998, the Company has also spent $60.5 million on land and pre-development costs for phased development projects which are planned for the next five years.
At December 31, 1998, the Company had escrow deposits of $0.4 million for the contemplated acquisition of one office building with 50,000 aggregate rentable square feet. The aggregate acquisition cost of the land and building is estimated to be approximately $9.0 million. The Company intends to finance the acquisition with borrowings under the Credit Facility and working capital.
In connection with an agreement signed in October 1997 with The Allen Group, a group of affiliated real estate development and investment companies based in Visalia, California ("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 under the Credit Facility and the issuance of approximately $11.0 million of common 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 provides for the development of two office projects in San Diego, California with up to 1.0 million aggregate rentable square feet for an estimated aggregate development cost of approximately $150 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. In January 1999, the Company purchased a managing interest in phase 1 of the first project for an aggregate purchase price of $2.1 million. The 2 acres of undeveloped land were acquired from an entity controlled by Richard S. Allen, a member of the Company's Board of Directors at December 31, 1998, with borrowings under the Credit Facility and the issuance of 7,771 common units of the Operating Partnership valued at $0.2 million based on the closing share price of the Company's common stock as reported on the NYSE. An Executive Vice President of the Company who was previously a member of The Allen Group received 5,400 of the total 7,771 common units. The Company has the option to purchase The Allen Group's remaining interest in both projects for a purchase price to be determined upon completion of the projects. Construction of phase 1 of both office projects commenced in the fourth quarter of 1998 and the total budgeted investment of phase 1 of both projects of $39.2 million is included in the total budgeted cost of $118 million discussed above.
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 units of the Operating Partnership.
Historical Recurring Capital Expenditures, Tenant Improvements and Leasing Costs
The following tables set forth the non-incremental revenue generating recurring capital expenditures, excluding expenditures that are recoverable from tenants, tenant improvements and leasing commissions for renewed and re- tenanted space incurred for the three years ended December 31, 1998, 1997, and 1996 on a per square foot basis.
- -------- (1) Includes only tenants with lease terms of 12 months or longer. Excludes leases for amenity, parking, retail and month-to-month tenants.
(2) Equals the aggregate of leasing commissions payable to employees and third parties based on standard commission rates.
Capital expenditures may fluctuate in any given period subject to the nature, extent, and timing of improvements required to be made to the Properties. The Company believes that all of its Office and Industrial Properties are well maintained and, based on recent engineering reports, do not require significant capital improvements.
Tenant improvements and leasing costs may also fluctuate in any given year depending upon factors such as the property, the term of the lease, the type of lease, the involvement of external leasing agents and overall market conditions.
Building and Lease Information
The following tables set forth certain information regarding the Company's Office and Industrial Properties at December 31, 1998: Occupancy by Segment Type
Lease Expirations by Segment Type
- -------- (1) Includes tenants only. Excludes leases for amenity, retail, parking and month to month tenants. Some tenants have multiple leases. (footnotes continued on next page)
(2) Based on total leased square footage for the respective portfolios as of December 31, 1998, unless a lease for a replacement tenant had been executed on or before January 1, 1999. (3) Determined based upon aggregate base rent to be received over the term, divided by the term in months, multiplied by 12, including all leases executed on or before January 1, 1999.
Leasing Activity by Segment Type For the year ended December 31, 1998
- -------- (1) The lease-up of 697,186 square feet to new tenants includes re-leasing of 273,580 square feet and first generation leasing of 423,606 square feet.
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 management 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.
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 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 publicly 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 employees who are not paid for overtime and who management expects will spend 10% of their annual working hours over a two to three 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 reimbursable 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 and 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 September 1999.
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.
Distribution Policy
The Company makes quarterly distributions to common stockholders from cash available for distribution and, if necessary to meet REIT distribution requirements and maintain its REIT status, may use borrowings under the Credit Facility. All such distributions are at the discretion of the Board of Directors. Amounts accumulated for distribution are invested primarily in interest-bearing accounts and short-term interest-bearing securities, which are consistent with the Company's intention to maintain its qualification as a REIT. Such investments may include, for example, obligations of the Government National Mortgage Association, other governmental agency securities, certificates of deposit and interest-bearing bank deposits.
Historical Cash Flows
The principal sources of funding for acquisitions, development and capital expenditures are the Credit Facility, public equity financing, cash flow from operating activities and secured debt financings. The Company's net cash provided by operating activities increased $44.5 million, or 153.8% to $73.4 million for the year ended December 31, 1998 compared to $28.9 million for the year ended December 31, 1997. The increase was primarily due to the increase in net income resulting from the 1998 Office and Industrial Acquisitions, a full year of operating results from the 1997 Office and Industrial Acquisitions and increased net operating income, as defined, generated by the Existing Office and Industrial Properties owned at the IPO and still owned at December 31, 1998. The increase was partially offset by increased interest expense and general and administrative expenses.
Cash used in investing activities decreased $208 million, or 37.7% to $344 million for the year ended December 31, 1998 compared to $552 million for the year ended December 31, 1997. The decrease was due primarily to the purchase of 25 Office and 16 Industrial Properties during 1998 for $236 million (net of $18.1 million of contributed value in exchange for which the Company issued common units of the Operating Partnership), the purchase of 56 acres of undeveloped land for $25.4 million (net of $2.5 million of contributed value in exchange for which the Company issued common units of the Operating Partnership), expenditures for construction in progress of $65.5 million, and $13.5 million in additional tenant improvements and capital expenditures for the year ended December 31, 1998 versus the acquisition of four Properties in connection with the IPO for an aggregate cost of $58.2 million, the acquisition of 41 Office and 55 Industrial Properties during 1997, subsequent to the IPO, for an aggregate cost of $488 million (net of $19.3 million of contributed value in exchange for which the Company issued common units of the Operating Partnership and $41.1 million of mortgage debt assumed in connection with acquisitions), the purchase of 50 acres of undeveloped land for $25.4 million, expenditures for construction in progress of $10.1 million, and $6.1 million in additional tenant improvements and capital expenditures for the year ended December 31, 1997.
Cash provided by financing activities decreased $264 million, or 49.7% to $268 million for the year ended December 31, 1998 compared to $532 million for the year ended December 31, 1997. Cash provided by financing activities for the year ended December 31, 1998 consisted primarily of $81.8 million in net proceeds from the issuance of 3,012,326 shares of common stock through four underwritten offerings and the issuance of 161,884 shares of common stock through two direct placements, the issuance of $75.0 million of 8.075% Series A Preferred units and $35.0 million of 9.375% Series C Preferred units (net of $3.0 million aggregate transaction costs), and net proceeds of $132 million from the issuance of mortgage debt and net borrowings on the Credit Facility, partially offset by $48.8 million in distributions paid to common stockholders and common unitholders. Cash provided by financing activities for the year ended December 31, 1997 consisted of $544 million in net proceeds from the Company's IPO in January 1997 and follow on offering in August 1997, proceeds of $98.0 million from the issuance of mortgage debt (of which $96.0 million was issued in connection with the IPO), and net proceeds of $142 million from borrowings under the Credit Facility, partially offset by
the repayment of $227 million of indebtedness (of which $219 million was repaid in connection with the IPO) and $21.7 million in distributions paid to common stockholders and common unitholders. The increase in distributions of $27.1 million, or 125.0% to $48.8 million for the year ended December 31, 1998 from $21.7 million for the year ended December 31, 1997 was due to a greater number of common shares and common units outstanding for the four quarters ended March 31, June 30, September 30 and December 31, 1998 versus the period from February 1 to March 31, 1997 and the three quarters ended June 30, September 30, and December 31, 1997, as well as an increase in the distribution rate to $1.62 per share for the year ended December 31, 1998 from $1.42 per share for the year ended December 31, 1997.
Funds from Operations
The Company considers 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 interest 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 (loss) 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, by quarter, for the year ended December 31, 1998 and the period from February 1, 1997 to December 31, 1997:
Inflation
The majority of the Company's leases require tenants to pay most operating expenses, including real estate taxes and insurance, and increases in common area maintenance expenses. The effect of such provisions is to reduce the Company's exposure to increases in costs and operating expenses resulting from inflation.
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 new accounting methodologies 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.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Since the Company's IPO in January 1997, management has executed a financial strategy which has positioned the Company to be flexible and responsive to the variations in the public and private financial markets. The principal objectives of the Company's current debt and capital management strategies are to maintain prudent amounts of leverage and to minimize capital costs and interest expense while carefully and continuously evaluating available debt and equity resources.
The primary market risk faced by the Company is the risk of interest rate fluctuations. More specifically, the primary market risk faced by the Company is market risk resulting from increasing LIBOR based interest rates since interest expense on $291 million of the Company's total $405 million of debt, including borrowings under the Credit Facility, are tied to a LIBOR based interest rate. As a result, the Company pays lower rates of interest in periods of decreasing interest rates and higher rates of interest in periods of increasing interest rates. To mitigate the effect of changes in interest rates on Credit Facility borrowings and in compliance with Credit Facility debt covenants, 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 under 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 $0.2 million cost of the cap agreements, which the Company is amortizing over the term of the Credit Facility. The unamortized cost at December 31, 1998 was $0.1 million.
The Company is also subject to market risk resulting from fluctuations in the general level of U.S. interest rates since $114 million of the Company's total $405 million of debt arrangements are established at a fixed weighted average interest rate of 8.39%, and since quarterly distributions of $1.5 million and $0.8 million paid to Series A Preferred unitholders and Series C Preferred unitholders, respectively, are calculated based upon a fixed rate of 8.075% and 9.375%, respectively. As a result, the Company will pay contractually agreed upon fixed rates of interest regardless of fluctuations in the general interest rate environment.
The table below provides information about the Company's interest rate sensitive financial and derivative instruments. All of the Company's interest rate sensitive financial and derivative instruments are designated as held for purposes other than trading.
For notes receivable from related parties, the table depicts the repayment of principal and accrued interest based upon the anticipated completion dates of the related projects. The table also presents the related interest rate indices for such notes receivable from 1999 through the repayment dates.
For the Credit Facility, the table presents the assumption that the outstanding principal balance at December 31, 1998 will be paid upon the Credit Facility's maturity in February 2000, and that the option to extend the term of the Credit Facility until February 2001 will not be exercised. The table also presents the related maximum interest rate index for outstanding Credit Facility borrowings in 1999 and 2000.
For variable rate mortgage debt, the table presents the assumption that the outstanding principal balance at December 31, 1998 will be paid upon maturity in January 2000. The table also presents the related interest rate index for outstanding variable rate mortgage debt borrowings in 1999 and 2000.
For fixed rate mortgage debt, the table presents the assumption that the outstanding principal balance at December 31, 1998 will be paid according to scheduled principal payments and that the Company will not prepay any of the outstanding principal balance. The table also presents the related weighted- average interest rate for outstanding fixed rate mortgage debt borrowings from 1999 through 2003 and thereafter.
For the Series A and Series C Preferred units, the table presents the assumption that the outstanding Preferred Units at December 31, 1998 will be exchanged into shares of the Company's 8.075% Series A and 9.375% Series C Cumulative Redeemable Preferred stock, respectively, in 2008 when the Preferred units become exchangeable at the option of the majority of the holders. The table also presents the related weighted-average interest rate for outstanding Preferred units from 1999 through the exchange date, however the same interest rates will apply when the Preferred units are exchanged into the Cumulative Redeemable Preferred stock.
For interest rate caps, the table presents notional amounts, average cap rates and the related interest rate index upon which cap rates are based, by contractual maturity date. Notional amounts are used solely to calculate the contractual cash flow to be received under the contract and do not reflect outstanding principal balances at December 31, 1998.
Interest Rate Sensitivity Analysis Financial Assets and Liabilities Outstanding Principal by Expected Maturity Date (dollars in thousands)
Interest Rate Sensitivity Analysis Financial Derivative Instruments Notional Amounts by Contractual Maturity (dollars in thousands)
Changes in Primary Risk Exposures
In December 1998 and February 1999, the Company signed commitment letters for two fixed rate mortgage loans that the Company expects to complete during the first and second quarters of 1999. The first mortgage loan is expected to have a principal balance of $95.0 million, monthly principal and interest payments based upon a fixed interest rate of 7.20% and a 25-year amortization schedule, and a maturity date of March 2009. The Company intends to use the proceeds from the new $95.0 million fixed rate mortgage loan to pay down outstanding borrowings on its existing variable rate Credit Facility. The second mortgage loan is expected to have principal balance of $30.0 million, monthly principal and interest payments based upon a fixed rate of 7.15% and an 18-year amortization schedule, and a maturity date of March 2018. The Company intends to use the proceeds from the new $30.0 million fixed rate mortgage loan to pay off its existing $19.0 million variable rate mortgage loan.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
See the index included at "Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K."
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information required by Item 10 is incorporated by reference from the Company's definitive proxy statement for its annual stockholders' meeting presently scheduled to be held on May 17, 1999.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information required by Item 11 is incorporated by reference from the Company's definitive proxy statement for its annual stockholders' meeting presently scheduled to be held on May 17, 1999.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by Item 12 is incorporated by reference from the Company's definitive proxy statement for its annual stockholders' meeting presently scheduled to be held on May 17, 1999.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by Item 13 is incorporated by reference from the Company's definitive proxy statement for its annual stockholders' meeting presently scheduled to be held on May 17, 1999.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a)(1) and (2) Financial Statements and Schedules
The following consolidated financial information is included as a separate section of this annual report on Form 10-K:
All other schedules are omitted since the required information is not present in amounts sufficient to require submission of the schedule or because the information required is included in the financial statements and notes thereto.
(3) Exhibits
- -------- *Filed herewith
(1) Previously filed as an exhibit to the Registration Statement on Form S-11 (No. 333-15553) as declared effective on January 28, 1997 and incorporated herein by reference.
(2) Previously filed as exhibit 10.11 and 10.12, respectively, to the Current Report on Form 8-K, dated May 22, 1997, and incorporated herein by reference.
(3) Previously filed as exhibit 10.57, 10.58 and 10.59, respectively, to the Current Report on Form 8-K, dated June 30, 1997, and incorporated herein by reference.
(4) Previously filed as exhibit 10.54, 10.59, 10.60, 10.61 and 10.62, respectively, to the Current Report on Form 8-K, dated June 30, 1997, and incorporated herein by reference.
(5) Previously filed as an exhibit to the Registration Statement on Form S-11 (No. 333-32261), and incorporated herein by reference.
(6) Previously filed as an exhibit on Form 10-Q, for the quarterly period ended September 30, 1997, and incorporated herein by reference.
(7) Previously filed as an exhibit to the Current Report on Form 8-K/A, dated October 29, 1997, and incorporated herein by reference.
(8) Previously filed as exhibit 10.70 and 10.71, respectively, to the Current Report on Form 8-K, dated November 7, 1997, and incorporated herein by reference.
(9) Previously filed as exhibit 10.70 to the Current Report on Form 8-K, dated December 17, 1997, and incorporated herein by reference.
(10) Previously filed as an exhibit to the Registrant's Current Report on Form 8-K dated February 6, 1998 and incorporated herein by reference.
(11) Previously filed as an exhibits to the Current Report on Form 8-K (No. 1- 12675) dated October 2, 1998 and incorporated herein by reference.
(12) Previously filed as an exhibit to the Current Report on Form 8-K (No. 1- 12675) dated October 29, 1997 and incorporated herein by reference.
(13) Previously filed as an exhibit to the Current Report on Form 8-K (No. 1- 12675) dated April 20, 1998 and incorporated herein by reference.
(14) Previously filed as an exhibit on Form 10-Q (No. 1-12675) for the quarterly period ended September 30, 1998 and incorporated herein by reference.
(15) Previously filed as an exhibit to the Current Report on Form 8-K (No. 1- 12675) dated November 24, 1998 and incorporated herein by reference.
(16) Previously filed as an exhibit to the Current Report on Form 8-K (No. 1- 12675) dated October 2, 1998 and incorporated herein by reference.
(17) Previously filed as an exhibit to the Registration Statement on Form S-11 (No. 333-15553) and incorporated herein by reference.
(b) Reports on Form 8K
The Company filed the Current Report on Form 8-K (No. 1-12675), dated November 24, 1998, in connection with the private placement of 700,000 9.375% Series C Cumulative Redeemable Preferred Units of Kilroy Realty, L.P.
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 17, 1999.
Kilroy Realty Corporation
/s/ John B. Kilroy, Jr. By: ___________________________________ John B. Kilroy, Jr. President and Chief Executive Officer
POWER OF ATTORNEY
KNOW ALL MEN BY THESE PRESENTS, that we, the undersigned officers and directors of Kilroy Realty Corporation, hereby severally constitute John B. Kilroy, Sr., John B. Kilroy, Jr., Jeffrey C. Hawken, Richard E. Moran Jr. and Ann Marie Whitney, and each of them singly, our true and lawful attorneys with full power to them, and each of them singly, to sign for us and in our names in the capacities indicated below, the Form 10-K filed herewith and any and all amendments to said Form 10-K, and generally to do all such things in our names and in our capacities as officers and directors to enable Kilroy Realty Corporation to comply with the provisions of the Securities Exchange Act of 1934, and all requirements of the Securities and Exchange Commission, hereby ratifying and confirming our signatures as they may be signed by our said attorneys, or any of them, to said Form 10-K and any and all amendments thereto.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
KILROY REALTY CORPORATION CONSOLIDATED AND KILROY GROUP COMBINED
FINANCIAL STATEMENTS AS OF DECEMBER 31, 1998 AND 1997 AND FOR THE THREE YEARS THEN ENDED
INDEPENDENT AUDITORS' REPORT
To the Board of Directors and Stockholders of Kilroy Realty Corporation:
We have audited the accompanying consolidated balance sheets of Kilroy Realty Corporation (the "Company") as of December 31, 1998 and 1997, the related consolidated statements of operations and shareholders' equity for the year ended December 31, 1998 and the period February 1, 1997 to December 31, 1997, and the combined statements of operations and accumulated deficit of the Kilroy Group (described in Note 1) for the period January 1, 1997 to January 31, 1997 and the year ended December 31, 1996; and the consolidated statements of cash flows for the years ended December 31, 1998 and 1997 and the combined statements of cash flows for the year ended December 31, 1996. Our audits also included the financial statement schedule listed in the index at Item 8. These financial statements and the financial statement schedule are the responsibility of the management of the Company. Our responsibility is to express an opinion on these financial statements and the financial statement schedule based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 1998 and 1997, and the results of operations and cash flows of the Company and the Kilroy Group for the respective stated periods in conformity with generally accepted accounting principles. Also in our opinion, such financial statement schedule, when considered in relation to the basic consolidated and combined financial statements taken as a whole, presents fairly in all material respects, the information set forth therein.
Deloitte & Touche LLP
Los Angeles, California March 10, 1999
KILROY REALTY CORPORATION
CONSOLIDATED BALANCE SHEETS (in thousands, except share data)
See accompanying notes to consolidated and combined financial statements.
KILROY REALTY CORPORATION CONSOLIDATED AND KILROY GROUP COMBINED
STATEMENTS OF OPERATIONS (in thousands, except share and per share data)
See accompanying notes to consolidated and combined financial statements.
KILROY REALTY CORPORATION
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
Year Ended December 31, 1998 and the Period February 1, 1997 to December 31, 1997 (in thousands, except share and per share data)
See accompanying notes to consolidated and combined financial statements.
KILROY GROUP
COMBINED STATEMENTS OF ACCUMULATED DEFICIT
January 1, 1997 to January 31, 1997 and the Year Ended December 31, 1996 (in thousands)
See accompanying notes to consolidated and combined financial statements.
KILROY REALTY CORPORATION CONSOLIDATED AND KILROY GROUP COMBINED
STATEMENTS OF CASH FLOWS
See accompanying notes to consolidated and combined financial statements.
KILROY REALTY CORPORATION CONSOLIDATED AND KILROY GROUP COMBINED
NOTES TO CONSOLIDATED AND COMBINED FINANCIAL STATEMENTS
Three Years Ended December 31, 1998
1. Organization and Formation Transactions
Kilroy Realty Corporation (the "Company") was incorporated in Maryland in September 1996 and commenced operations upon the completion of its initial public offering in January 1997. The Company, which develops, owns and operates office and industrial properties located in California, Washington, Nevada and Arizona, qualifies and operates as a self-administered real estate investment trust ("REIT") under the Internal Revenue Code of 1986, as amended.
The Company is the successor to the real estate business of the Kilroy Group, which consisted of the combination of Kilroy Industries ("KI") and various entities, the properties of which were under the common control of KI and/or its stockholders, including the Company's Chairman of the Board of Directors, John B. Kilroy, Sr., and the Company's President and Chief Executive Officer, John B. Kilroy, Jr. KI had historically been engaged in the acquisition, management, financing, construction and leasing of office and industrial properties and providing development services to third party owners for a fee. The accompanying combined financial statements of the Kilroy Group have been presented on a combined basis because of common ownership and management and because the entities were the subject of a business combination with the Company in 1997.
The Company completed its initial public offering of 12,500,000 shares of $.01 par value per share common stock ("common stock") on January 31, 1997. The offering price of $23.00 per share resulted in gross proceeds of $288 million. On February 7, 1997, the underwriters exercised their over-allotment option and, accordingly, the Company issued 1,875,000 additional shares of common stock and received gross proceeds of $43.1 million. The aggregate proceeds to the Company, net of underwriters discount and offering costs, were approximately $303 million. The initial public offering, including the exercise of the over-allotment option in connection therewith, is hereinafter referred to as the "IPO".
The following transactions occurred simultaneously with the completion of the IPO (collectively, the "Formation Transactions"):
. The Company consummated various purchase agreements to acquire four properties for approximately $58.2 million in cash.
. The Company became the sole general partner of Kilroy Realty, L.P. (the "Operating Partnership"). Upon completion of the IPO, the Company contributed substantially all of the net proceeds of the offering in exchange for an approximate 84.5% interest in the Operating Partnership. The Company also contributed cash to purchase 100% of Kilroy Realty Finance, Inc. ("Finance Inc."), which was formed to serve as the general partner of Kilroy Realty Finance Partnership, L.P. (the "Finance Partnership"). The Operating Partnership executed various option and purchase agreements whereby it issued 2,652,374 common limited partnership units in the Operating Partnership ("common units"), representing an approximate 15.5% partnership interest, to the continuing investors in exchange for interest in properties. The continuing investors included John B. Kilroy, Sr. and John B. Kilroy, Jr., certain Kilroy family members and certain entities owned by them. The Operating Partnership contributed certain properties to the Finance Partnership in exchange for a limited partnership interest therein. All properties acquired by the Company are held by or through the Operating Partnership or the Finance Partnership. Unless otherwise indicated, all references to the Company include the Operating Partnership, the Finance Partnership and Finance Inc.
. The Finance Partnership and the Operating Partnership borrowed $84.0 million and $12.0 million, respectively, under two mortgage loans.
KILROY REALTY CORPORATION CONSOLIDATED AND KILROY GROUP COMBINED
NOTES TO CONSOLIDATED AND COMBINED FINANCIAL STATEMENTS--(Continued)
. The Operating Partnership used a portion of the IPO proceeds and the proceeds of the new mortgage borrowings of $96.0 million to repay approximately $219 million of indebtedness.
. The Operating Partnership contributed certain assets valued at approximately $0.1 million to Kilroy Services, Inc., an unconsolidated subsidiary of the Company, ("KSI"), for 100% of its non-voting stock, representing a 5% ownership interest and a 95% economic interest in KSI. The voting common stock is owned entirely by John B. Kilroy, Sr. and John B. Kilroy, Jr.
The transfer of the properties and operating interests of affiliates of the Company to the Operating Partnership for cash or common units was accounted for at the historical cost of those interests.
In September 1998, the Company formed two limited liability companies, Kilroy Gateway Partners, L.L.C. and Kilroy Carmel Partners, L.L.C. (collectively, the "LLCs") to develop two office projects in San Diego, California in conjunction with The Allen Group, a group of affiliated real estate development and investment companies based in Visalia, California (see Note 12). At December 31, 1998, the Company owned a 100% interest in both of the LLCs.
As of December 31, 1998, the Company's stabilized portfolio consisted of 80 office buildings (the "Office Properties") and 84 industrial buildings (the "Industrial Properties," and together with the Office Properties, the "Properties"), which encompassed approximately 5.6 million and 6.2 million rentable square feet, respectively, and was 95.9% occupied. The Company owns its interests in all of its Properties through the Operating Partnership and the Finance Partnership, and conducts substantially all of its operations through the Operating Partnership. The Company owned an 86.8% and 87.8% general partnership interest in the Operating Partnership as of December 31, 1998 and 1997, respectively.
2. Basis of Presentation and Significant Accounting Policies
Basis of Presentation:
The consolidated financial statements of the Company include the consolidated financial position and results of operations of the Company, the Operating Partnership, the Finance Partnership and Finance Inc. The consolidated financial statements as of and for the year ended December 31, 1998 also include the consolidated financial position and results of operations of the LLCs. The operating results of the development services business conducted by KSI are accounted for under the equity method of accounting. All significant intercompany balances and transactions have been eliminated in the consolidated financial statements.
The combined financial statements of the Kilroy Group reflect a combination of real estate properties which were under the common control of KI and/or its stockholders, including John B. Kilroy, Sr. and John B. Kilroy, Jr., and which were contributed to the Operating Partnership for 2,652,374 common units upon consummation of the IPO. The Kilroy Group is considered the predecessor entity to the Company due to common ownership and management; therefore, its combined financial statements are presented for comparative purposes. All significant intercompany balances and transactions have been eliminated in the combined financial statements.
Significant Accounting Policies:
Rental properties--Rental properties are stated at the lower of historical cost less accumulated depreciation or estimated fair value. The cost of rental properties includes the purchase price or development costs of the properties. Costs incurred for the acquisition, renovation and betterment of the rental properties, excluding internal pre-acquisition costs related to the purchase of rental properties, are capitalized to the Company's investment in that property. Maintenance and repairs are charged to expense as incurred.
KILROY REALTY CORPORATION CONSOLIDATED AND KILROY GROUP COMBINED
NOTES TO CONSOLIDATED AND COMBINED FINANCIAL STATEMENTS--(Continued)
The Company evaluates fair value for financial reporting purposes on a property by property basis using future undiscounted cash flows, excluding interest charges. In the event that periodic assessments or other factors revealed a potential impairment condition, the Company would recognize an impairment loss to the extent the carrying amount exceeded the fair value of the property. The Company had not recorded any such impairment losses at December 31, 1998 and 1997.
Depreciation and amortization--The cost of buildings and improvements are depreciated on the straight-line method over estimated useful lives of 25 to 40 years for buildings and the shorter of the lease term or useful life, ranging from five to 20 years, for tenant improvements. Depreciation expense for buildings and improvements for the year ended December 31, 1998, the eleven months ended December 31, 1997, the one month ended January 31, 1997 and the year ended December 31, 1996 was $23.7 million, $11.5 million, $0.7 million and $7.9 million, respectively.
Construction in progress--Project costs clearly associated with the development and construction of a real estate project are capitalized as construction in progress. In addition, interest, real estate taxes and other costs are capitalized during the period in which activities necessary to get the property ready for its intended use are in progress. Once the development and construction of a real estate project are completed and the property is ready for its intended use, the costs capitalized to construction in progress are transferred to land and improvements and buildings and improvements as the historical cost of the property.
At December 31, 1998, construction in progress was carried net of a $1.7 million allowance for potentially unrecoverable pre-development costs. The allowance, which provides for costs incurred for development projects that the Company may at some point in the development process decide not to pursue, was established by estimating probable exposures to these types of costs for each of the projects in the Company's development pipeline. Management's determination of the allowance was calculated on a project by project basis using a series of probability factors based on the Company's historical experience. The allowance is increased by provisions charged against income. The allowance for potentially unrecoverable pre-development costs at December 31, 1998 is maintained at a level believed to be adequate by management.
Cash and cash equivalents--The Company considers all money market funds with an original maturity of three months or less at the date of purchase to be cash equivalents.
Restricted cash--Restricted cash consists of cash held as collateral to provide credit enhancement for the Company's mortgage debt and cash reserves for capital expenditures and tenant improvements.
Tenant receivables and related revenue recognition--Leases with tenants are accounted for as operating leases. Minimum annual rentals are recognized on a straight-line basis over the term of the related lease. Unbilled deferred rent receivables represent the amount that straight-line rental income exceeds rents currently due under the lease agreement. Included in tenant receivables are tenant reimbursements which are comprised of additional amounts receivable from tenants based on common area maintenance expenses and certain other expenses that are accrued in the period in which the related expenses are incurred.
Tenant receivables and unbilled deferred rent receivables are carried net of an allowance for uncollectible tenant receivables and unbilled deferred rent. Management's determination of the adequacy of the allowance is based upon evaluations of individual receivables, past loss experience, current economic conditions, and other relevant factors. The allowance is increased by provisions charged against income. The allowance for uncollectible tenant receivables and unbilled deferred rent is maintained at a level believed adequate by management to absorb potential losses from both current and deferred tenant receivables at December 31, 1998 and 1997.
KILROY REALTY CORPORATION CONSOLIDATED AND KILROY GROUP COMBINED
NOTES TO CONSOLIDATED AND COMBINED FINANCIAL STATEMENTS--(Continued)
Deferred financing and leasing costs--Costs incurred in connection with debt financing and property leasing are capitalized as deferred financing and leasing costs. Deferred financing costs include loan fees which are amortized using the effective interest method over the terms of the respective loans. Deferred leasing costs include leasing commissions which are amortized on the straight-line method over the initial lives of the leases which range from five to 10 years.
Development services--Development services revenues represent fees earned by the Kilroy Group for supervision services provided for building development of non-owned properties. Fees were typically a percentage of total development costs plus reimbursement for certain expenses. Unreimbursed expenses were recorded as development expenses and included items such as wages, equipment rental and supplies. The Company's development services have been performed by KSI since February 1, 1997.
Other income--Other income includes revenue earned from lease termination fees, overhead charges for construction management, and management fees. Included in other income for the year ended December 31, 1998 was a $1.9 million net lease termination fee on an office property in San Diego, California.
Option buy-out costs--In September 1996, the Kilroy Group amended the terms of certain of its lease agreements. Such amendments required the Kilroy Group to pay $3.2 million in consideration for the cancellation of an option to purchase a 50% equity interest in Kilroy Airport Center, El Segundo, which was reflected in the combined statement of operations for the year ended December 31, 1996. In November 1996, $2.3 million of the total liability of $3.7 million was paid by KI and its stockholders. In January 1997, $0.1 million of the amount was paid by the Kilroy Group and the remaining balance was paid by the Company with the proceeds from the IPO.
Extraordinary gains--On January 31, 1997, pursuant to a forbearance agreement with an insurance company, the Kilroy Group exercised the right to purchase a mortgage note payable with a principal balance of $20.2 million and $2.4 million of accrued interest for $16.1 million. The forgiveness resulted in an extraordinary gain of $3.2 million including the write-off of $1.3 million of deferred financing fees. During June 1996, a bank note with an aggregate principal balance of $16.5 million and $5.7 million of accrued interest was settled for $2.1 million. The forgiveness of $20.1 million was recorded as an extraordinary gain.
Property taxes--There were no delinquent property taxes at December 31, 1998 and 1997.
Income taxes--The Company believes it qualifies and intends to continue to qualify as a REIT under Sections 856 through 860 of the Internal Revenue Code of 1986, as amended (the "Code"), beginning with the taxable year ended December 31, 1997. As a REIT, the Company is generally not subject to corporate Federal income taxes so long as it distributes at least 95% of its taxable income to its stockholders and satisfies certain quarterly requirements of the Code relating to the composition of its income and assets. The Company had met all of its REIT distribution and technical requirements at December 31, 1998 and 1997. State income tax requirements are essentially the same as Federal tax requirements.
Fair value of financial instruments--The Company calculates the fair value of financial instruments using available market information and appropriate present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. In that regard, the derived fair value estimates cannot be substantiated by comparison to independent markets and in many cases, could not be realized in immediate settlement of the instrument. Fair values for certain financial instruments and all non-financial instruments are not required to be disclosed. Accordingly, the aggregate fair value amounts presented do not represent the underlying value of the Company at December 31, 1997 and 1998, respectively.
KILROY REALTY CORPORATION CONSOLIDATED AND KILROY GROUP COMBINED
NOTES TO CONSOLIDATED AND COMBINED FINANCIAL STATEMENTS--(Continued)
Derivative financial instruments--The Company's derivative financial instruments at December 31, 1998 consisted of two interest rate cap agreements with an aggregate notional amount of $150 million. The Company purchased the interest rate cap agreements to effectively limit interest expense exposure on borrowings under the Company's unsecured credit facility (the "Credit Facility") during periods of increasing interest rates. The Company did not have any derivative financial instruments at December 31, 1997.
The Company's interest rate cap agreements consist of agreements with other counterparties to receive, at specified intervals and over specified periods of time, payments equal to the excess, if any, between the hypothetical interest rate (cap rate) and the then current market rate of interest as calculated by reference to a specified notional amount and a specified interest rate index. The only amount the Company is obligated to pay is an initial premium, which is included in other assets and amortized to interest expense ratably over the remaining term of the Credit Facility. At the time the agreements were entered into, the cap rates exceeded market. The interest rate specified by the agreements have been and are expected to continue to be highly correlated with the cap rate. Interest payments to be received as a result of interest rate cap agreements are accrued in other assets and recognized as a reduction of interest expense related to the designated debt (the accrual accounting method). There were no payments from the interest rate cap agreements accrued at December 31, 1998 and 1997.
Upon termination of an interest rate cap agreement, any resultant gain, to the extent it represents the value attributable to the market rate of interest exceeding the cap rate (the intrinsic value) and assuming that outstanding borrowings under the Credit Facility continue to equal or exceed the notional amounts of the terminated interest rate caps, would be deferred in other liabilities and amortized over the remaining term of the cap agreement as a reduction of interest expense. Additional gains or losses would be recognized in earnings. Any notional amount of agreements in excess of outstanding borrowings under the Credit Facility would be marked to market with changes in market value recorded in other income or expenses.
Comprehensive income--The Company does not have any items which meet the definition of other comprehensive income as defined in Statement of Financial Accounting Standards No. 130 "Reporting Comprehensive Income." Consequently, the Company's net income is equal to its comprehensive income.
Use of estimates--The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reported periods. Actual results could differ from those estimates.
Reclassifications--Certain prior year amounts have been reclassified to conform to the current year's presentation.
Concentration of credit risk--149 of the Company's total 164 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 in which the tenants operate.
One office property tenant, Hughes Space & Communications, accounted for approximately 7.4% and 14.7% of the Company's total base rental revenues for the year ended December 31, 1998 and the eleven months ended December 31, 1997, respectively. At December 31, 1998 and 1997, the Company had no outstanding tenant receivables from this tenant.
The Company has cash in financial institutions which is insured by the Federal Deposit Insurance Corporation ("FDIC") up to $0.1 million per institution. At December 31, 1998 and 1997, the Company had cash accounts in excess of FDIC insured limits.
KILROY REALTY CORPORATION CONSOLIDATED AND KILROY GROUP COMBINED
NOTES TO CONSOLIDATED AND COMBINED FINANCIAL STATEMENTS--(Continued)
Recent accounting pronouncements--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 new accounting methodologies 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.
3. Property Acquisitions
During the year ended December 31, 1998, the Company consummated a series of transactions to acquire 25 office and 16 industrial buildings (collectively, the "1998 Acquisitions"), (see Notes 19 and 20) for an aggregate purchase price of approximately $236 million in cash and 703,869 common units of the Operating Partnership valued at approximately $18.1 million from entities controlled by Richard S. Allen, a member of the Company's Board of Directors at December 31, 1998 (see Note 13). The office and industrial buildings contain approximately 1.4 million and 674,000 of aggregate rentable square feet, respectively. The Company also consummated a series of transactions to acquire approximately 56 acres of undeveloped land for an aggregate purchase price of approximately $25.4 million in cash and 90,787 common units of the Operating Partnership valued at approximately $2.5 million from a partnership controlled by John B. Kilroy, Sr. and John B. Kilroy, Jr. (see Note 13). The 1998 Acquisitions were funded primarily with existing working capital and borrowings on the Credit Facility.
During the period February 1, 1997 to December 31, 1997, the Company consummated a series of transactions to acquire 41 office and 55 industrial buildings (collectively, the "1997 Acquisitions") for an aggregate purchase price of approximately $488 million in cash and 753,838 common units of the Operating Partnership valued at approximately $19.3 million. Of the total 753,838 common units issued in connection with building acquisitions, 588,736 were issued to Richard S. Allen, a member of the Company's Board of Directors at December 31, 1998, The Allen Group, a group of affiliated real estate development and investment companies based in Visalia, California, (together with Richard S. Allen, "The Allen Group"), and certain other executive officers of The Allen Group (see Note 13). In connection with the 1997 Acquisitions, the Company also assumed four mortgage notes totaling $40.2 million and issued a promissory note in the amount of $0.9 million. The office and industrial buildings contained approximately 2.2 million and 3.7 million of aggregate rentable square feet, respectively. The Company also consummated a series of transactions to acquire approximately 50 acres of undeveloped land for an aggregate purchase price of approximately $25.4 million in cash. The 1997 Acquisitions were funded primarily with existing working capital and borrowings on the Company's secured revolving credit facility.
4. Tenant Receivables
Tenant receivables consisted of the following at December 31:
KILROY REALTY CORPORATION CONSOLIDATED AND KILROY GROUP COMBINED
NOTES TO CONSOLIDATED AND COMBINED FINANCIAL STATEMENTS--(Continued)
5. Deferred Financing and Leasing Costs
Deferred financing and leasing costs are summarized as follows at December 31:
6. Mortgage Debt
Mortgage debt consisted of the following at December 31:
- -------- (a) The mortgage note is subject to increases in the effective interest rate to the greater of 13.35% or the sum of the interest rate for U.S. Treasury Securities maturing 15 years from the reset date plus 2.00%, beginning February 2005.
The Company's mortgage debt was secured by 24 properties at December 31, 1998 with a combined net book value of $166 million and 23 properties at December 31, 1997 with a combined net book value of $165 million. As of December 31, 1998 and 1997, the Company's mortgage debt had a weighted average interest rate of 8.22%.
Scheduled principal payments for the above mortgage loans at December 31, 1998 were as follows:
KILROY REALTY CORPORATION CONSOLIDATED AND KILROY GROUP COMBINED
NOTES TO CONSOLIDATED AND COMBINED FINANCIAL STATEMENTS--(Continued)
Two of the mortgage loans contain covenants restricting the sale of certain properties and requiring the Company to meet minimum debt service coverage ratios. All of the mortgage loans have financial reporting requirements. The mortgage notes payable are secured by deeds of trust on certain of the Company's Properties and the assignment of certain rents and leases associated with those Properties.
In December 1998, the Company entered into a commitment letter with a lender for a mortgage loan collateralized by nine office and industrial properties. The commitment expires on March 24, 1999 and provides, subject to the completion of specified terms and conditions, for a mortgage loan with a principal balance of $95.0 million, monthly principal and interest payments based upon a fixed interest rate of 7.20% and a 25 year amortization schedule, and a maturity date of March 2009. In connection with signing the commitment letter for the $95.0 million mortgage loan, the Company issued one letter of credit for $1.0 million in December 1998 and another letter of credit $1.0 million in January 1999 to cover the deposit and application costs required by the mortgagor. Both letters of credit were issued against available Credit Facility borrowings and will expire upon the closing of the mortgage loan.
On February 8, 1999, the Company entered into a commitment letter with a lender for a mortgage loan collateralized by an office property and the related ground leases. The commitment has a term of 60 days and provides, subject to the completion of specified terms and conditions, for a mortgage loan with a principal balance of $30.0 million, monthly principal and interest payments based upon a fixed rate of 7.15% and an 18 year amortization schedule, and a maturity date of March 2018.
7. Line of Credit
In February, 1998, the Company increased its borrowing capacity and converted its previously secured $250 million revolving credit facility into a $350 million unsecured revolving Credit Facility with a bank group led by Morgan Guaranty Trust Company of New York. The Credit Facility bears interest at a rate of either LIBOR plus 1.00%, LIBOR plus 1.13% or LIBOR plus 1.25% (6.81% at December 31, 1998), depending on the Company's leverage ratio at the time of borrowing, and matures in February 2000, with the option to extend for one year. In October 1998, the Credit Facility agreement was amended to include construction in progress in the value of the Company's unencumbered assets, to modify certain financial covenants and to allow the Company to enter into separate construction financing arrangements. The agreement was also amended, while preserving the interest rate options discussed above, to provide that borrowings may bear interest at LIBOR plus 1.38%, depending upon the Company's leverage ratio at the time of borrowing. The Credit Facility is used to finance property acquisitions and development and for general corporate uses. Availability under the Credit Facility depends upon the value of the Company's pool of unencumbered assets and was $77.0 million at December 31, 1998. The fee for unused funds is 0.20% based on outstanding balances. At December 31, 1998, there were borrowings of $272 million and one letter of credit in the amount of $1.0 million outstanding under the Credit Facility. The $1.0 million letter of credit was issued in connection with a signed commitment letter for a mortgage loan that the Company expects to complete in the first quarter of 1999 (see Note 6).
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 under 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 $0.2 million cost of the cap agreements, which the Company is amortizing over the term of the Credit Facility and which was included as a component of interest expense in the consolidated statement of operations. The $0.1 million unamortized balance of the cost of the cap agreements was included in other assets in the consolidated balance sheet at December 31, 1998.
As of December 31, 1997, the Company maintained a $250 million secured revolving credit facility (the "Secured Credit Facility") with a bank group led by Morgan Guaranty Trust Company of New York. The
KILROY REALTY CORPORATION CONSOLIDATED AND KILROY GROUP COMBINED
NOTES TO CONSOLIDATED AND COMBINED FINANCIAL STATEMENTS--(Continued)
Secured Credit Facility bore interest at rates that ranged from LIBOR plus 1.38% to LIBOR plus 1.50%, depending on the Company's leverage ratio at the time of borrowing, and was scheduled to mature on May 30, 1999, with the option to extend for one year. The Secured Credit Facility was used to finance property acquisitions and development and for general corporate uses. Availability under the Secured Credit Facility was dependent upon, amongst other things, the value of the Company's underlying collateral securing it and was $62.7 million at December 31, 1997. At December 31, 1997 the line of credit was secured by 66 properties with a combined book value of $358 million. The fee for unused funds was 0.25% based on outstanding balances. At December 31, 1997, there were borrowings of $142 million outstanding under the Secured Credit Facility.
The Credit Facility contains covenants requiring the Company to meet certain financial ratios and reporting requirements. Some of the more restrictive covenants include a minimum debt service coverage ratio, a maximum total liabilities to total assets ratio, a maximum total secured debt to total assets ratio, a minimum cash flow to debt service and fixed charges ratio, a minimum consolidated tangible net worth and a limit of development activities as compared to total assets. The Company was in compliance with all of the Credit Facility and Unsecured Credit Facility covenants at December 31, 1998 and 1997, respectively.
Interest capitalized for the year ended December 31, 1998 and the eleven months ended December 31, 1997 was $8.2 million and $1.5 million, respectively. There was no interest capitalized for the month of January 1997 and the year ended December 31, 1996.
8. Minority Interests
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 "Series A 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 transaction costs and expenses of $1.7 million, for the repayment of borrowings outstanding under the Credit Facility. In April 1998, the Company issued an additional 300,000 Series A 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 under the Credit Facility. The Series A 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 Series A 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, or earlier under certain circumstances.
In November 1998, the Company issued 700,000 9.375% Series C Cumulative Redeemable Preferred units, representing limited partnership interests in the Operating Partnership (the "Series C Preferred units"), with a liquidation value of $50.00 per unit, in exchange for a gross contribution to the Operating Partnership of $35.0 million. The Company used the contribution proceeds, less applicable transaction costs and expenses of $0.9 million, for the repayment of borrowings outstanding under the Credit Facility. The Series C Preferred units, which may be called by the Operating Partnership at par on or after November 24, 2003, have no stated maturity or mandatory redemption and are not convertible into any other securities of the Operating Partnership. The Series C Preferred Units are exchangeable at the option of the majority of the holders for shares of the Company's 9.375% Series C Cumulative Redeemable Preferred stock beginning November 24, 2008, or earlier under certain circumstances.
The Company makes quarterly distributions to the Series A and Series C Preferred unitholders on the 15th day of each February, May, August and November. Included in the Series A and Series C Preferred unit balances
KILROY REALTY CORPORATION CONSOLIDATED AND KILROY GROUP COMBINED
NOTES TO CONSOLIDATED AND COMBINED FINANCIAL STATEMENTS--(Continued)
on the balance sheet at December 31, 1998 were $0.8 million and $0.3 million of accrued distributions payable to the Series A and Series C Preferred unitholders, respectively.
During the year ended December 31, 1998, the Operating Partnership issued 794,656 common units of the Operating Partnership in connection with property and undeveloped land acquisitions (see Note 3). For the eleven months ended December 31, 1997, the Operating Partnership issued 3,406,212 common units of the Operating Partnership of which 2,652,374 were issued in connection with the Company's Formation Transactions on January 31, 1997 (see Note 1), and 753,838 were issued in connection with property acquisitions (see Note 3). As a result of the aforementioned transactions, the Company owned an 86.8% and 87.8% general partnership interest in the Operating Partnership as of December 31, 1998 and 1997, respectively.
9. Stockholders' Equity
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 December 31, 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 $81.8 million. As of March 10, 1999, an aggregate of $313 million of equity securities were available for issue under the registration statement. The Company, as general partner of the Operating Partnership and as required by the terms and conditions of the Operating Partnership's partnership agreement, contributed the net proceeds of the offerings to the Operating Partnership, which used the net proceeds to repay borrowings under the Credit Facility.
In October 1998, the Company adopted a Preferred Stock Purchase Rights Plan (the "Rights Plan") under which common 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.
In February 1999, the Company filed a registration statement on Form S-3 with the SEC which registered the potential issuance and resale of up to 2,817,476 shares of the Company's common stock to the identified holders of 2,817,476 common units of the Operating Partnership. The 2,817,476 common units, previously issued in connection with two 1997 transactions, may be exchanged, at the Company's option, on a one for one basis, into shares of the Company's common stock on or after January 31, 1999. Of the total previously issued 2,817,476 common units, 2,652,374 common units were issued in connection with the Company's Formation Transactions on January 31, 1997 (see Note 1), and 165,102 common units valued at approximately $4.0 million were issued in connection with property acquisitions in June 1997 (see Note 3). The Company and the Operating Partnership will not receive any of proceeds form the issuance of the common stock to the identified common unitholders. The registration statement has not yet been declared effective by the SEC.
KILROY REALTY CORPORATION CONSOLIDATED AND KILROY GROUP COMBINED
NOTES TO CONSOLIDATED AND COMBINED FINANCIAL STATEMENTS--(Continued)
On March 10, 1999, the Company filed a registration statement on Form S-3 with the SEC which, in connection with the adoption of the Company's Dividend Reinvestment and Direct Purchase Plan (the "Plan"), registered 1,000,000 shares of the Company's common stock. The Plan, which is designed to provide the Company's stockholders and other investors with a convenient and economical method to purchase shares of the Company's common stock, consists of three programs: the Dividend Reinvestment Program (the "DRIP"), the Cash Option Purchase Plan (the "COPP") and the Waiver Discount Plan (the "WDP"). The DRIP provides existing common stockholders with the opportunity to purchase additional shares of the Company's common stock by automatically reinvesting all or a portion of their cash dividends. The COPP provides existing common stockholders and other investors with the opportunity to purchase additional shares of the Company's common stock by making optional cash purchases, at no discount to market, between $100 to $5,000 and $750 to $5,000, respectively, in any calendar month. The WDP provides existing common stockholders and other investors with the opportunity to purchase additional shares of the Company's common stock by making optional cash purchases, at a discount to market of up to 2.00% of the average per share price reported on the NYSE, of greater than $5,000 in any calendar month. The Plan will acquire shares of the Company's common stock from either new issuances directly from the Company, from the open market or from privately negotiated transactions, except for transactions executed under the WDP which will be purchased only from previously unissued shares of common stock. Participation in the Plan is entirely voluntary, and can be terminated at any time. The registration statement has not yet been declared effective by the SEC.
In August 1997, the Company completed a follow-on public offering of 10,000,000 shares of common stock (the "August Offering"). The offering price was $25.50 per share resulting in gross proceeds of $255 million. The aggregate proceeds to the Company, net of underwriter's discounts and offering costs, were approximately $241 million. The proceeds were used to pay outstanding indebtedness and to fund acquisitions.
Accrued distributions at December 31, 1998 and 1997, consisted of the following amounts payable to registered common stockholders of record holding 24,639,210 shares and 24,475,000 shares of common stock, respectively, and common unitholders holding 4,200,868 and 3,406,212 common units of the Operating Partnership, respectively:
KILROY REALTY CORPORATION CONSOLIDATED AND KILROY GROUP COMBINED
NOTES TO CONSOLIDATED AND COMBINED FINANCIAL STATEMENTS--(Continued)
10. Future Minimum Rent
The Company has operating leases with tenants that expire at various dates through 2013 and are either subject to scheduled fixed increases or adjustments based on the Consumer Price Index. Generally, the leases grant tenants renewal options. Leases also provide for additional rents based on certain operating expenses. Future minimum rent under operating leases, excluding tenant reimbursements of certain costs, as of December 31, 1998, are summarized as follows:
11. Employee Retirement and Stock Option and Incentive Plans
Retirement Savings Plan
Effective November 1, 1997, the Company adopted a retirement savings plan designed to qualify under Section 401(k) of the Internal Revenue Code (the "401(k) Plan"). The 401(k) Plan allows participants to defer up to twenty percent of their eligible compensation on a pre-tax basis, subject to certain maximum amounts allowed by the Internal Revenue Code. The 401(k) Plan provides for a matching contribution by the Company in an amount equal to fifty-cents for each one dollar of participant contributions up to a maximum of five percent of the participant's annual salary. Participants vest immediately in the amounts contributed by the Company. Employees of the Company are eligible to participate in the 401(k) Plan when they meet certain requirements concerning minimum period of credited service. For the years ended December 31, 1998 and 1997, the Company contributed $0.2 million and $28,000, respectively, to the 401(k) Plan.
Stock Option and Incentive Plan
The Company has established a stock option and incentive plan (the "Stock Plan") for the purpose of attracting and retaining officers and key employees, under which restricted shares or stock options may be granted. The Stock Plan authorizes the issuance of 3,000,000 shares of common stock of the Company. As of December 31, 1998 and 1997, 100,000 shares have been issued as restricted shares of common stock and options to purchase 2,344,000 and 1,185,000 shares of common stock, respectively, have been granted to Directors, officers and employees under the Stock Plan. At December 31, 1998, 355,000 of the options were exercisable and had a weighted average exercise price of $23.59. There were no options exercisable at December 31, 1997. The weighted average exercise price of the options outstanding at December 31, 1998 and 1997 were $23.37 and $23.80, respectively, with a weighted average remaining contractual life of 9.1 and 9.2 years, respectively. Stock options vest at 33 1/3% per year over three years beginning on the first anniversary date of the grant and are exercisable at the market value on the date of the grant. The term of each option is ten years from the date of the grant.
KILROY REALTY CORPORATION CONSOLIDATED AND KILROY GROUP COMBINED
NOTES TO CONSOLIDATED AND COMBINED FINANCIAL STATEMENTS--(Continued)
The Company's stock option activity is summarized as follows:
Restricted stock is subject to restrictions determined by the Company's Compensation Committee. The Compensation Committee, comprised of two Directors who are not officers of the Company, determines compensation, including awards under the Stock Plan, for the Company's executive officers. The shares of restricted stock which have been granted, were sold at a purchase price equal to $0.01 and vest 20% per year over a five-year period. Restricted stock has the same dividend and voting rights as common stock and is considered to be currently issued and outstanding. Compensation expense is determined by reference to the market value of the Company's common shares and is being amortized on a monthly basis over the five-year vesting period. In connection with the IPO in January 1997, 100,000 shares of restricted stock were issued to an executive officer of the Company for a price of $1,000. Compensation expense relating to these shares was approximately $0.5 million and $0.4 million for the year ended December 31, 1998 and the eleven months ended December 31, 1997, respectively.
The Company has adopted the disclosure-only provisions of Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation" ("SFAS No. 123") and will continue to use the intrinsic value based method of accounting prescribed by Account Practice Bulletin opinion No. 25, "Accounting for Stock Issued to Employees." Accordingly, no compensation cost has been recognized for the options granted under the Stock Plan. Had compensation cost for the Company's Stock Plan been determined based on the fair value at the grant date consistent with the provisions of SFAS No. 123, the Company's net income and net income on a per share basis would have been adjusted to the pro forma amounts indicated below:
The fair value of each option grant issued in 1998 and 1997 is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions (amounts shown as 1998 and 1997, respectively): (a) dividend yield of 6.31% and 6.00%, (b) expected volatility of the Company's stock of 26.2% and 21.8%, (c) risk free interest rate of 4.73% and 5.44%, (d) expected option life of seven years. The effects of applying SFAS No. 123 may not be representative of the effects on disclosed pro forma net income for future years because options vest over several years and additional awards can be made each year.
KILROY REALTY CORPORATION CONSOLIDATED AND KILROY GROUP COMBINED
NOTES TO CONSOLIDATED AND COMBINED FINANCIAL STATEMENTS--(Continued)
12. Commitments and Contingencies
Escrow deposits--At December 31, 1998, the Company had escrow deposits of $0.4 million for the contemplated acquisition of one office building with approximately 50,000 aggregate rentable square feet. The aggregate acquisition cost of the land and building is estimated to be approximately $9.0 million. At December 31, 1997, the Company had escrow deposits of $5.1 million for contemplated acquisitions of approximately 886,000 aggregate rentable square feet of office and industrial buildings and 133 acres of undeveloped land. The Company acquired approximately 600,000 aggregate rentable square feet of office and industrial buildings for $94.7 million.
Operating leases-- The Company has noncancelable ground lease obligations on Kilroy Airport Center, Long Beach, California with an initial lease period expiring July 2035; the SeaTac Office Center in Seattle, Washington expiring December 2032, with an option to extend the lease for another 30 years; 12312 W. Olympic Boulevard in Santa Monica, California expiring in September 2011; and 9455 Towne Center in San Diego, California expiring in October 2043. On the Kilroy Airport Center and the SeaTac Office Center ground leases, rentals are subject to adjustments every five years based on the Consumer Price Index. On the 12312 W. Olympic Boulevard ground lease, rentals are subject to adjustments every year based on the Consumer Price Index. On the 9455 Towne Center ground lease, rentals are subject to 5% annual increases.
The minimum commitment under these leases at December 31, 1998 was as follows:
Purchase agreement-- 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 under the Credit Facility and the issuance of approximately $11.0 million of common 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 provides for the development of two office projects in San Diego, California with up to 1.0 million aggregate rentable square feet for an estimated aggregate development cost of approximately $150 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. Construction of phase 1 of both office projects commenced in the fourth quarter of 1998.
In January 1999, the Company purchased a managing interest in phase 1 of the first office project with The Allen Group for an aggregate purchase price of $2.1 million. The 2 acres of undeveloped land were acquired
KILROY REALTY CORPORATION CONSOLIDATED AND KILROY GROUP COMBINED
NOTES TO CONSOLIDATED AND COMBINED FINANCIAL STATEMENTS--(Continued)
from an entity controlled by Richard S. Allen, a member of the Company's Board of Directors at December 31, 1998, with borrowings under the Credit Facility and the issuance of 7,771 common units of the Operating Partnership valued at $0.2 million. An Executive Vice President of the Company who was previously a member of The Allen Group received 5,400 of the total 7,771 common units. The acquisition was based upon terms which the Company believes were similar to arms length negotiations. The 7,771 common units were valued based upon the closing share price of the Company's common stock. The Company has the option to purchase The Allen Group's remaining interest in both projects for a purchase price to be determined upon completion of the projects.
Litigation--The Company is subject to various legal proceedings and claims that arise in the ordinary course of business. These matters are generally covered by insurance. While the resolution of these matters cannot be predicted with certainty, management believes that the final outcome of such matters will not have a material adverse effect on the financial position or results of operations of the Company.
Environmental Matters--The Company follows the policy of monitoring its Properties for the presence of hazardous or toxic substances. The Company is not aware of any environmental liability with respect to the Properties that would have a material adverse effect on the Company's business, assets or results of operations. There can be no assurance that such a material environmental liability does not exist. The existence of any such material environmental liability would have an adverse effect on the Company's results of operations and cash flows.
13. Related-Party Transactions
During 1998, the Operating Partnership issued 703,869 common units of the Operating Partnership, recorded by the Company at approximately $18.1 million, in connection with the acquisition of four office buildings located in San Diego, California and one industrial building located in Reno, Nevada from entities controlled by Richard S. Allen, a member of the Company's Board of Directors at December 31, 1998. An Executive Vice President of the Company who was previously a member of The Allen Group received 303,316 of the total 703,869 common units. The acquisitions of the five buildings were based upon terms which the Company believes were similar to arms length negotiations. The 703,869 common units were valued based upon the closing share price of the Company's common stock.
In April 1998, the Company acquired 18 acres of undeveloped land in Calabasas, California from a partnership controlled by John B. Kilroy, Sr. and John B. Kilroy, Jr. in exchange for $0.4 million in cash and the issuance of 90,787 common limited partnership units of the Operating Partnership valued at $2.5 million. The acquisition was based upon terms which the Company believes were similar to arms length negotiations. The 90,787 common units were valued based upon the closing share price of the Company's common stock. The land is part of a 66-acre development site in Calabasas, California which is presently entitled for over 1.0 million rentable square feet of office, retail and hotel development. In February 1999, the Company sold 8 of the total 18 acres it acquired to the City of Calabasas for a total sales price of $1.4 million. The Company presently plans to develop 210,000 rentable square feet of office property on the remaining 10 acres it currently owns. The infrastructure improvements on the land were financed with Mello Roos bonds which were refinanced in February 1999. In connection with the refinancing, the portion of the original obligation balance that related to the 8 acres the Company sold to the City of Calabasas was defeased. The Mello Roos bonds currently have a principal balance of approximately $12.5 million. Principal and interest on the bonds will be charged to the Company and other owners through property tax bills through 2028 based on the relative value of land and buildings on the site. Based on the planned development of the total site, the Company's maximum obligation for its portion of the development site is estimated at $5.5 million but may decrease depending on the actual size and number of buildings built. The periodic Mello Roos assessments are currently capitalized as development costs and will be charged to operations upon the completion of construction.
KILROY REALTY CORPORATION CONSOLIDATED AND KILROY GROUP COMBINED
NOTES TO CONSOLIDATED AND COMBINED FINANCIAL STATEMENTS--(Continued)
In May 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 at December 31, 1998. Advances on the note will be used for infrastructure improvements on undeveloped land in San Diego that 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% (7.48% at December 31, 1998) and the note and accrued interest are due upon the acquisition of the 50% interest in the land by the Company. At December 31, 1998, $6.5 million was outstanding on the note.
In May 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% (8.75% at December 31, 1998). At December 31, 1998, $2.3 million was outstanding on the note.
Pursuant to management agreements, the Operating Partnership provides management and leasing services, and KSI provides development services with respect to two properties, each of which is beneficially owned by John B. Kilroy, Sr. and John B. Kilroy, Jr. The Operating Partnership recorded fees of $0.2 million and $0.1 million for year ended December 31, 1998 and the eleven months ended December 31, 1997, respectively, relating to the management and leasing services. KSI recorded fees of $0.1 and $0.2 million for year ended December 31, 1998 and the eleven months ended December 31, 1997, respectively, related to the development services.
On January 31, 1997, the Operating Partnership issued 2,652,374 common units to John B. Kilroy, Sr., John B. Kilroy, Jr., certain Kilroy family members and certain entities owned by them in connection with the Company's Formation Transactions (see Note 1).
During 1997, the Operating Partnership issued 588,736 common units of the Operating Partnership, valued by the Company at approximately $15.3 million, in connection with the acquisition of four office buildings located in San Diego, California and four industrial buildings located in Las Vegas, Nevada from The Allen Group. An Executive Vice President of the Company who was previously a member of The Allen Group, received 118,721 of the total 588,736 common units. The acquisition of the eight buildings was based upon terms which the Company believes were similar to arms length negotiations. The 588,736 common units were valued based upon closing share price of the Company's common stock.
In October 1997, KSI entered into a management agreement to manage the development of certain properties owned by entities under the common control of Richard S. Allen. At December 31, 1998 and 1997, KSI had a receivable balance of $0.2 million and $0.3 million, respectively, for management fees earned. The 1998 fees were paid in March 1999 and the 1997 fees were paid in January and February 1998 .
In December 1997, the Company purchased construction materials and architectural and engineering plans from John B. Kilroy, Sr. and John B. Kilroy, Jr. for approximately $3.0 million.
KILROY REALTY CORPORATION CONSOLIDATED AND KILROY GROUP COMBINED
NOTES TO CONSOLIDATED AND COMBINED FINANCIAL STATEMENTS--(Continued)
Through January 31, 1997, KI provided management, legal, accounting and general administrative services pursuant to agreements that provide for management fees based upon a percentage of gross revenues from the properties and reimbursement of other costs incurred by KI in connection with providing the aforementioned services. Kilroy Company ("KC"), an affiliated entity, provided marketing and leasing services through January 31, 1997. Charges by KC include leasing commissions paid to employees and outside leasing brokers as well as fees to cover its general administrative costs. Management fees are expensed as incurred and are included in property expenses. Leasing fees are capitalized and amortized over the life of the related leases. In addition, KI was a tenant at the Kilroy Airport Center, El Segundo and Kilroy Airport Center, Long Beach, under month-to-month basis leases. Charges for services provided by KI and KC and rental income from KI are summarized as follows:
14. Fair Value of Financial Instruments
The carrying amounts of the Company's cash and cash equivalents, restricted cash and accounts payable approximate fair value due to their short-term maturities. The carrying amounts of the Company's notes receivable from related parties, variable rate mortgage debt, and outstanding borrowings on the Credit Facility and Unsecured Credit Facility approximate fair value since the interest rates on these instruments are equivalent to rates currently offered to the Company.
For fixed rate mortgage debt, the Company estimates fair value by using discounted cash flow analyses based on borrowing rates for similar types of borrowing arrangements. The fair value of the Company's fixed rate mortgage debt was $121 million and $117 million at December 31, 1998 and 1997, respectively.
For the Series A and Series C Preferred units, the Company estimates fair value by using discounted cash flow analyses based on borrowing rates for similar types of fixed rate financial instruments. The fair value of the Series A and Series C Preferred units were $99.2 million at December 31, 1998.
For interest rate cap agreements, the carrying amount of $0.1 million, which is comprised of the unamortized premium the Company paid to enter into the agreements, approximates fair value since at December 31, 1998, the cap rates exceeded the market rate of the contractually specified interest rate indices.
15. Segment Disclosure
The Company's reportable segments consist of the two types of commercial real estate properties for which management internally evaluates operating performance and financial results: Office Properties and Industrial Properties. The Company also has certain corporate level activities including legal, accounting, finance, and management information systems which are not considered separate operating segments.
The Company evaluates the performance of its segments based upon net operating income. Net operating income is defined as operating revenues (rental income, tenant reimbursements and other property income) less property and related expenses (property expenses, real estate taxes, and ground leases) and does not include interest income and expense, depreciation and amortization, and corporate general and administrative expenses. The accounting policies of the reportable segments are the same as those described in the Company's summary of significant accounting policies (see Note 2). There is no intersegment activity.
KILROY REALTY CORPORATION CONSOLIDATED AND KILROY GROUP COMBINED
NOTES TO CONSOLIDATED AND COMBINED FINANCIAL STATEMENTS--(Continued)
The following tables reconcile the Company's segment activity to its consolidated results of operations and financial position as of and for the year ended December 31, 1998 and the period February 1, 1997 to December 31, 1997, and reconciles the Kilroy Group's segment activity to its combined results of operations for the period January 1, 1997 to January 31, 1997 and the year ended December 31, 1996.
- -------- (1) All operating revenues are comprised of amounts received from external tenants.
(2) Total consolidated revenues equals total operating revenues from reportable segments plus interest income and development services income.
KILROY REALTY CORPORATION CONSOLIDATED AND KILROY GROUP COMBINED
NOTES TO CONSOLIDATED AND COMBINED FINANCIAL STATEMENTS--(Continued)
- -------- (1) Total consolidated capital expenditures are equal to the same amounts disclosed for total reportable segments.
KILROY REALTY CORPORATION CONSOLIDATED AND KILROY GROUP COMBINED
NOTES TO CONSOLIDATED AND COMBINED FINANCIAL STATEMENTS--(Continued)
16. 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 Company does not consider common units of the Operating Partnership to be dilutive securities since the exchange of common units into common stock is on a one for one basis and would not have any effect on diluted earnings per share. The following table reconciles the numerator and denominator of the basic and diluted per-share computations for net income for the year ended December 31, 1998 and the eleven months ended December 31, 1997:
17. Quarterly Financial Information (Unaudited)
Summarized quarterly financial data for the year ended December 31, 1998 and the eleven months ended December 31, 1997 was as follows:
KILROY REALTY CORPORATION CONSOLIDATED AND KILROY GROUP COMBINED
NOTES TO CONSOLIDATED AND COMBINED FINANCIAL STATEMENTS--(Continued)
Primarily due to the issuance of 10,000,000 additional shares of common stock in connection with the August Offering, the sum of the quarterly earnings per share in 1997 varies from the annual earnings per share.
18. Subsequent Events
On January 6, 1999, dividends of $12.9 million were paid to common stockholders and common unitholders of record on December 31, 1998.
In January 1999, the Company purchased a 50% managing interest in the first phase of the first of two office development projects with The Allen Group for an aggregate purchase price of $1.9 million in cash and 7,771 common units of the Operating Partnership valued at approximately $0.2 million (see Note 12).
In January 1999, the Company issued a $1.0 letter of credit in connection with a signed commitment letter for a $95.0 mortgage loan (see Note 6).
In February 1999, the Company filed a pre-effective registration Statement on Form S-3 with the SEC which registered the potential issuance and resale of up to 2,817,476 shares of the Company's common stock to the identified holders of 2,817,476 common units of the Operating Partnership (see Note 9).
In February 1999, the Company sold 8 acres of undeveloped land located in Calabasas, California for a total sales price of approximately $1.4 million (see Note 13).
In February 1999, the Company acquired 3 acres of undeveloped land in San Diego, California for an aggregate purchase price of approximately $0.4 million in cash and 119,460 common units of the Operating Partnership valued at approximately $2.5 million from entities controlled by Richard S. Allen, a member of the Company's Board of Directors at December 31, 1998. An Executive Vice President of the Company received 42,564 of the total 119,460 common units. The acquisition was based upon terms which the Company believes were similar to arms length negotiations. The 119,460 common units were valued based upon the closing share price of the Company's common stock.
In March 1999, the Company filed a pre-effective registration statement on Form S-3 with the SEC which, in connection with the adoption of the Company's Dividend Reinvestment and Direct Purchase Plan, registered 1,000,000 shares of the Company's common stock (see Note 9).
KILROY REALTY CORPORATION CONSOLIDATED AND KILROY GROUP COMBINED
NOTES TO CONSOLIDATED AND COMBINED FINANCIAL STATEMENTS--(Continued)
19. Unaudited Pro Forma Condensed Consolidated Financial Information
The accompanying unaudited pro forma information for the years ended December 31, 1998 and 1997 are presented as if the 1998 Office and Industrial Acquisitions described in Note 3 had occurred on January 1, 1998 and as if the IPO and Formation Transactions described in Note 1, the August Offering described in Note 9, and the 1997 Office and Industrial Acquisitions described in Note 3 had occurred on January 1, 1997. Such pro forma information is based upon the consolidated financial statements of the Company for the year ended December 31, 1998 and the period from February 1, 1997 to December 31, 1997 and the combined financial statements of the Kilroy Group for the period January 1, 1997 to January 31, 1997.
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 the 1997 and 1998 Office and Industrial 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 (unaudited, in thousands, except share and per share data)
KILROY REALTY CORPORATION CONSOLIDATED AND KILROY GROUP COMBINED
NOTES TO CONSOLIDATED AND COMBINED FINANCIAL STATEMENTS--(Continued)
20. Schedule of Rental Property
KILROY REALTY CORPORATION CONSOLIDATED AND KILROY GROUP COMBINED
NOTES TO CONSOLIDATED AND COMBINED FINANCIAL STATEMENTS--(Continued)
KILROY REALTY CORPORATION CONSOLIDATED AND KILROY GROUP COMBINED
NOTES TO CONSOLIDATED AND COMBINED FINANCIAL STATEMENTS--(Continued)
KILROY REALTY CORPORATION CONSOLIDATED AND KILROY GROUP COMBINED
NOTES TO CONSOLIDATED AND COMBINED FINANCIAL STATEMENTS--(Continued)
KILROY REALTY CORPORATION CONSOLIDATED AND KILROY GROUP COMBINED
NOTES TO CONSOLIDATED AND COMBINED FINANCIAL STATEMENTS--(Continued)
- ------- (1) Represents date of construction or acquisition by the Company, or the Company's Predecessor, the Kilroy Group.
(2) These costs represent infrastructure costs incurred in 1989.
(3) This table does not include one industrial property with an aggregate 113,248 rentable square feet which was occupied at December 31, 1998. This property is part of a three building complex that was constructed by the Company. As substantial tenant improvements still needed to be completed at December 31, 1998, the complex was included in construction in progress at December 31, 1998.
The aggregate gross cost of property included above for federal income tax purposes, approximated $1.0 billion as of December 31, 1998.
The following table reconciles the historical cost of the total investment in real estate, net from January 1, 1996 to December 31, 1998:
The following table reconciles the accumulated depreciation from January 1, 1996 to December 31, 1998:
KILROY REALTY CORPORATION CONSOLIDATED AND KILROY GROUP COMBINED
SCHEDULE II--VALUATION AND QUALIFYING ACCOUNTS
Year Ended December 31, 1998, Period from February 1, 1997 to December 31, 1997, Period from January 1, 1997 to January 31, 1997 and the Year Ended December 31, 1996 (in thousands)
EXHIBIT INDEX
- -------- * Filed herewith
(1) Previously filed as an exhibit to the Registration Statement on Form S- 11 (No. 333-15553) as declared effective on January 28, 1997 and incorporated herein by reference.
(2) Previously filed as exhibit 10.11 and 10.12, respectively, to the Current Report on Form 8-K, dated May 22, 1997, and incorporated herein by reference.
(3) Previously filed as exhibit 10.57, 10.58 and 10.59, respectively, to the Current Report on Form 8-K, dated June 30, 1997, and incorporated herein by reference.
(4) Previously filed as exhibit 10.54, 10.59, 10.60, 10.61 and 10.62, respectively, to the Current Report on Form 8-K, dated June 30, 1997, and incorporated herein by reference.
(5) Previously filed as an exhibit to the Registration Statement on Form S-11 (No. 333-32261), and incorporated herein by reference.
(6) Previously filed as an exhibit on Form 10-Q, for the quarterly period ended September 30, 1997, and incorporated herein by reference.
(7) Previously filed as an exhibit to the Current Report on Form 8-K/A, dated October 29, 1997, and incorporated herein by reference.
(8) Previously filed as exhibit 10.70 and 10.71, respectively, to the Current Report on Form 8-K, dated November 7, 1997, and incorporated herein by reference.
(9) Previously filed as exhibit 10.70 to the Current Report on Form 8-K, dated December 17, 1997, and incorporated herein by reference.
(10) Previously filed as an exhibit to the Registrant's Current Report on Form 8-K dated February 6, 1998 and incorporated herein by reference.
(11) Previously filed as an exhibits to the Current Report on Form 8-K (No. 1- 12675) dated October 2, 1998 and incorporated herein by reference.
(12) Previously filed as an exhibit to the Current Report on Form 8-K (No. 1- 12675) dated October 29, 1997 and incorporated herein by reference.
(13) Previously filed as an exhibit to the Current Report on Form 8-K (No. 1- 12675) dated April 20, 1998 and incorporated herein by reference.
(14) Previously filed as an exhibit on Form 10-Q (No. 1-12675) for the quarterly period ended September 30, 1998 and incorporated herein by reference.
(15) Previously filed as an exhibit to the Current Report on Form 8-K (No. 1- 12675) dated November 24, 1998 and incorporated herein by reference.
(16) Previously filed as an exhibit to the Current Report on Form 8-K (No. 1- 12675) dated October 2, 1998 and incorporated herein by reference.
(17) Previously filed as an exhibit to the Registration Statement on Form S-11 (No. 333-15553) and incorporated herein by reference.