By Allison Landa

Diverse, vibrant Southern California market buoys Kilroy Realty

Ambiguity is not in Kilroy Realty Corporation's (NYSE: KRC) portfolio. Since its inception in 1947, the Los Angeles-based company has maintained a consistent business focus: office and industrial holdings in strong Southern California submarkets. And like its region of choice, Kilroy builds its success on ambition and diverse character.

KILROY REALTY CORPORATION

HEADQUARTERS: 12200 West Olympic Boulevard, Suite 200, Los Angeles, CA 90064 PHONE: 310-481-8400 WEB SITE: www.kilroyrealty.com PRESIDENT & CEO: John B. Kilroy, Jr. EXECUTIVE VP & COO: Jeffrey C. Hawken EXECUTIVE VP & CFO: Richard E. Moran Jr. TICKER SYMBOL: KRC 52-WEEK HIGH: $39.14 (10/4/04) 52-WEEK LOW: $27.35 (10/24/03) CLOSING PRICE 2003: $32.75 CORE MARKETS: Office and industrial properties primarily in Southern California.

John Kilroy, Sr. started his company in Orange County, buying orange groves and developing them into major defense plants. In the 57 years since its inception, Kilroy has expanded both north and southward. In addition to Orange County, it now has a major presence in Los Angeles and San Diego; its properties are evenly split in thirds between the three regions. Kilroy maintains 78 percent of its holdings in the office market, with the remaining 22 percent in the industrial sector.

Today, Kilroy's son John Kilroy, Jr. is at the company's helm. Under his leadership as president and chief executive officer, the company has maintained its focus on suburban submarkets in burgeoning parts of Southern California. As of August 2004, Kilroy's portfolio consisted of 82 office buildings and 50 industrial buildings, totaling a respective 7.3 million and 4.9 million rentable square feet. Development is Kilroy's primary activity—though the company has also been known to play in the acquisitions market—and it currently has 1.2 million square feet in the pipeline. Nearly half of the square footage in development is dedicated to one project: Santa Fe Summit, located along North San Diego County's burgeoning State Route 56 corridor. Also known as the Ted Williams Parkway, the route links Kilroy's holdings in coastal Del Mar with the inland bedroom community of Rancho Bernardo.

Kilroy made its first San Diego purchase in 1996 and went public less than a year later. Going public, Kilroy Jr. says, was essential to continued expansion.

"It was pretty clear to us that we had reached a size as a family company that meant we either had to go quite a bit bigger, or we were really not going to be able to grow any further," he says. "It was also a wonderful way to create liquidity for family members, and to broaden and diversify our portfolio."

At Home in San Diego

Today, San Diego is at the forefront of the expansion era launched by Kilroy's public offering seven years ago. Lauded by company executives as a vibrant market high in demand and increasingly tight on space, "America's Finest City" finds itself in the center of Kilroy's vision.

"San Diego has a unique situation," Kilroy, Jr. says. "It's in one of the most desirable areas from a climate standpoint. Second, it's unique because it has the concentration of research facilities like Scripps Hospital, as well as the university system, so you have a tremendous amount of companies that are highly diversified. The medical-research industry is just growing like mad, you have all types of defense contractors, service companies, financial institutions both low and high-tech."

Kilroy's San Diego portfolio consists of slightly more than 3 million square feet, spread evenly throughout its three main submarkets: Rancho Bernardo, Del Mar and the Sorrento Mesa area near the University of California campus. Currently all properties in Rancho Bernardo are fully leased, while Del Mar is 99 percent leased and Sorrento Mesa is 98 percent full. According to Kilroy, Jr., his firm owns a third of the Del Mar office submarket, an appealing coastal location widely considered one of the strongest submarkets in the country. Kilroy's Del Mar tenants include credit-scoring firm Fair Isaac and the Hastings law firm.

Steve Sakwa, first vice president at Merrill Lynch, says the company is experiencing stagnation on the San Diego redevelopment front. "While underlying demand appears to be improving in Kilroy's core California markets ... the company's redevelopment pipeline gained little traction on the leasing front during the quarter," Sakwa wrote after Kilroy released second-quarter earnings for 2004. He noted that a new 67,995 square-foot life-science building in the Sorrento Mesa submarket—completed during the first quarter—still remains zero percent leased, although the company was in discussions with multiple tenants.

“It was pretty clear to us that we had reached a size as a family company that meant we either had to go quite a bit bigger, or we were really not going to be able to grow any further.” —JOHN KILROY, JR.

Steve Scott, Kilroy's senior vice president of development in the San Diego office, says the company's strategy revolves around a well-delineated focus. "We've made a very deliberate and strategic investment to focus on the high-barriers-to-entry coastal and inland communities," he says. "If you look at the characteristics of these places, the economic demographics are generally above average, the school districts, the decision-makers, are also above average. If you look at other infrastructure, housing, retail, services, quality of life, again, I would say they're above average. We're always assessing and analyzing whether we should invest in other submarkets and we'll continue to do that, but I think until the characteristics of those other submarkets closely resemble our existing submarkets, we'll probably not be active investors there."

Kilroy's suburban concentration is very deliberate, according to Scott. Potential tenants want to locate near where most of their employees live, avoiding traffic and other urban nuisances as best they can—and this drives the decision to locate in more residential areas as opposed to a city's downtown.

The characteristics that make San Diego appealing also make it vulnerable. As one of the nation's largest cities—and in particular, a place with a significant military presence—it's considered a potential target for terrorist attacks. As displayed so graphically with the World Trade Center, this brand of tragedy holds major concern for commercial real estate players.

"Obviously, we have terror concerns," Scott says. "Security is a huge issue. Is San Diego a strategic location for that type of activity? I don't know, but I do know as an owner-operator, we're analyzing new tenants for what they do. We definitely look at those types of issues and assess the risks."

Scott says the tenuous economy holds other concerns for Kilroy. "There's constant economic change, capital market changes, and political changes," he says. "We're very conservative when it comes to developing. We always try and look cautiously ahead, but also build in as much flexibility as we can when it comes to any of our transactions."

Trouble in El Segundo

One current sore spot in Kilroy's portfolio is the El Segundo/Los Angeles Airport submarket. More urban than most of the company's other holdings, El Segundo was also one of Kilroy's first areas of development in the early 1950s.

"New business formation is happening, but it's tending to happen in the more suburban markets," says Jay Leupp, managing director and head of U.S. equity research at RBC Capital Markets. "I think that the biggest challenges will be harvesting rent growth in the El Segundo market and the other LAX office and industrial markets. Those are the weakest markets in Southern California, but they're also markets where Kilroy still has a significant operating position."

The company has 10 properties totaling 1,282,940 square feet in El Segundo. Most of those were developed or acquired during the 1970s and 1980s. In 2002, Kilroy renovated a nine-story building, adding space for a grand total of 133,339 square feet. Today only 41, 265 of those square feet are occupied.

"We're always assessing and analyzing whether we should invest in other submarkets and we'll continue to do that, but I think until the characteristics of those other submarkets closely resemble our existing submarkets, we'll probably not be active investors there.” —STEVE SCOTT

Still, Kilroy, Jr. expresses confidence that conditions are improving, despite a rocky last few years. "El Segundo's vacancy rate has been in the mid-20 percent range," Kilroy, Jr. says. "In the last couple of quarters it has dropped and we're beginning to see meaningful demand. It's sluggish in comparison (to other holdings), but to put it in perspective, there was essentially no demand in 2002, and so far in 2004 we've seen more than two times the demand from last year. We think that will clean up in the next few years."

The company's other Los Angeles submarkets are Hawthorne, Santa Monica, West Los Angeles, the Long Beach Airport, Calabasas, and Agoura. In Orange County—where most of Kilroy's industrial holdings lie—the submarkets are Anaheim, Fullerton, Brea and West County/Garden Grove. Kilroy also has scattered holdings in Ventura County, Arizona and Washington State.

David AuBuchon, analyst with A.G. Edwards, lauds the San Diego office market as comparable to Manhattan and downtown Washington D.C. It's a region, he says, where barriers to entry, low vacancy rates and high demand make commercial owners such as Kilroy fortunate. "Southern California is definitely more diversified than it was even 10 years ago," he says. "It's just a much more diversified group—entertainment, tech, defense, a lot of companies involved in foreign trade, which helps out the industrial side of Kilroy's portfolio."

Southern California is doing better than the average national vacancy rate of 17 percent, AuBuchon says: with Los Angeles at less than 14 percent, Orange County at 12.7 percent, and San Diego close to 11 percent, "it's just a healthier market."

Developing Shareholder Value

Development is the lifeblood of Kilroy's business. Right now the company is particularly bullish about developing in San Diego, which it sees as one of the nation's top office markets. His company tends to identify a region's key development sites, Kilroy says, and then go about "buying as much as we can."

This was exactly how Kilroy entered the San Diego market in 1996. They bought the Allen Group, which had developed more than 3 million square feet of mostly suburban San Diego office space, and used the acquisition as a springboard to make additional purchases in the region. This buy-and-expand tactic harkens back to Kilroy's roots, when in the 1950s the elder John Kilroy snapped up orange groves and built upon them major defense plants.

AuBuchon says most of Kilroy's product is internally developed rather than acquired. Within the last six years, the company has completed more than $700 million in new development.

"They have made numerous acquisitions as well, but particularly over the last three to four years, they've developed most of the additions to their portfolio. As a result, the portfolio in terms of age is much younger than (the typical) office REIT because of that development angle," AuBuchon says.

Generating its own product brings its own inherent challenge, AuBuchon says. "It's obviously riskier than holding the portfolio," he says. "You have to do a little more work, but work is typically value-add. And this is where the company brings value to shareholders—recognizing trends in the marketplace, tying up land, buildings having (long-term tenant relationships). It's going to help complement growth in the existing portfolio, and they'll hopefully see higher occupancy and higher rates."

Kilroy plans to maintain its focus on development, and to expand the current development pipeline. The company's diverse holdings set it apart, Kilroy, Jr. says. "That's one of the things that separates us from Southern California indigenous REITs—we've been active in both office and industrial for over 50 years, and we've been active in development and acquisitions, with a particular emphasis on development," he says.

That development is concentrated in locations accessible to residential areas, promoting Kilroy's "work-where-you-live" motif. "We're looking at the best quality of life, the highest estimated revenue per employee, the best operating margins," Scott says. "When we look at markets to invest in, it's really from an end-users perspective."

Proceeding With Caution

The future is not without potential pitfalls for Kilroy. AuBuchon says the company will need to keep working toward higher occupancy rates and higher rents as the regional economy continues to grow.

However, Kilroy's challenges are less regional than portfolio-specific, AuBuchon says. The company faced a legal skirmish with eToys when the troubled e-tailer went bankrupt, bailing out of its 151,000 square-foot Santa Monica space and claiming Kilroy did not make a reasonable effort to fill the space. Tech-related legal firm Brobeck, Phleger & Harrison dissolved, forcing Kilroy to fill the 162,000 square feet it left vacant in Del Mar. Peregrine Systems also filed bankruptcy while occupying 423,900 square feet in Del Mar, resulting in a $21 million settlement in favor of Kilroy after Peregrine tried to reject multiple leases.

But, AuBuchon says, Kilroy filled that space not long after it came back on the market. "Because of the qualities of its submarkets, Kilroy backfilled that space in a pretty rapid fashion, faster than what the market certainly expected," he says.

UPSIDE-DOWNSIDE Samplings of what analysts are saying about Kilroy Realty Corporation KeyBanc Capital Markets Rating: HOLD (8/10/04) 12-Month Projected Target Price: NA "Looking forward, we expect that the majority of growth for KRC will come from developments, rather than acquisitions, due to the high prices currently being paid for acquisition properties. We also expect that higher interest expense from the company's fixing of floating rate debt, while a strategic positive, will offset some of the positive Southern California office market fundamentals in the company's earnings results near term." Friedman, Billings, Ramsey & Co. Rating: MARKET PERFORM (7/28/04) 12-Month Projected Target Price: $34.00 "Our $34 price target represents a 10 percent premium to our net asset value based on estimated 2005 EBITDA (after capex). Kilroy's presence in strong markets, particularly San Diego, and leasing prowess are likely to lead to solid FFO growth in 2005. However, at the current share price ($34.47), we believe the stock reflects this growth." Prudential Equity Group, LLC Rating: UNDERWEIGHT (7/29/04) 12-month Projected Target Price: $26.00 "We believe there are three primary risks specific to our Kilroy estimates. First, the company's narrow geographic concentration in Southern California exposes the company to a regional economic environment that could lag a recovery in the national economy.... Second, the company has had an above-average level of tenant failure.... Third, the company has a larger-than-average development pipeline and management expects development activity to increase in the near future." RBC Capital Markets Rating: OUTPERFORM (7/28/04) 12-month Projected Target Price: $37.00 "San Diego, where 43 percent of Kilroy's office assets and effectively all of its 1.1 million square foot future development pipeline resides, is among the strongest office markets in the nation...We believe Kilroy's geographic concentration in Southern California, coupled with the likelihood of increased external growth prospects will cause its earnings growth to accelerate, and to exceed most of its peers beginning in 2005."

And while it has had its hiccups, AuBuchon says rising economic tides, high demand and low supply in Southern California mean that Kilroy's future is looking positive. "The market is moving with them, not against them," AuBuchon says. "They're not fighting a bad market. Southern California is in the initial stages of a very healthy, long growth cycle. They're going to be able to take advantage of that raw material and to build lots of space, and hopefully give back to shareholders."

Kilroy Jr. says he'll continue to stake the familiar territory that's brought the company from 1947 to today. "We're very focused," he says. "What we told investors that we would do before the IPO is exactly what we've done. When it makes sense to acquire, we'll acquire. When it makes sense to develop, we will. When it doesn't, we don't. We haven't endeavored to be the biggest—we've endeavored to be the best, and to take advantage of the best points of the cycle."