Landlord Kilroy Realty Corp. has assets in some of the strongest-performing office markets in Southern California and despite nagging concerns on Wall Street, its portfolio is beginning to pay off.

During the first quarter ended March 31, Kilroy properties were 94 percent leased and the company inked a significant deal to build a new office campus near Del Mar for software developer Intuit Inc.

“We have solid positions in some of the best markets in the country,” said John B. Kilroy Jr., the company’s president and chief executive, during a conference call with analysts and investors last week. “While some quarters will be better than others, we’re felling pretty good right now.”

Last week Kilroy reported first quarter net income available to common shareholders of $12.7 million, more than double the $6 million reported in the year-ago first quarter.

Kilroy’s funds from operations, a broadly watched measure of cash flows for publicly held real estate investment trusts, rose to $25 million from $20.9 million in the year-ago period. (FFO excludes asset sales and other items, giving investors a better picture of the health of the rental market.)

Despite the operational improvement, Kilroy stock hasn’t been made any durable headway. At $43.58 on April 27, it was up just 3.2 percent so far this year, as it bounced around between $39 and $44.

Part of the reason may be a controversial long-term incentive plan, which rewards the top five executives as Kilroy’s stock price rises. For every $1 Kilroy’s stock increases, the incentive plan decreases earnings available to common stockholders by 5 cents a continuing concern to some analysts.

The arrangement has made Kilroy’s stock “volatile,” Banc of America Securities analysts Ross Nussbaum and John P. Kim wrote in a recent report. “We believe (Kilroy) is likely to announce a less onerous and volatile plan within the next few months, but its current plan may create earnings volatility until its expiration at Dec. 31, 2005,” they wrote.

Improving picture


Despite their concerns, Nussbaum and Kim raised their rating on Kilroy to “hold” from “sell” after a survey of Los Angeles commercial brokers painted a generally rosy picture of the Los Angeles County office market.

Forty percent of Kilroy’s assets are in Los Angeles County, where its office buildings and industrial properties stretch from the South Bay to the northern San Fernando Valley. (It also has significant holdings in San Diego and Orange counties.)

“While San Diego has been (Kilroy’s) strongest market in recent quarters, we believe office owners in L.A. are also in a position to drive rents with lower tenant concessions,” Nussbaum and Kim wrote.

Up to now, L.A. hasn’t been a sweet spot for Kilroy. Its occupancy rates in L.A., at 88.8 percent, were lower than in Orange County (98.3 percent) and San Diego (94.3 percent) during the first quarter.

That’s about par with an L.A. County occupancy rate averaging 86 percent, according to Grubb & Ellis Co. However, vacancy rates have been improving in L.A. for several quarters, and John Kilroy, echoing the widespread view of local brokers, believes the market is picking up steam.

“There are more deals in the market than we have seen in recent quarters,” Kilroy said on the call. “We continue to make progress in each submarket and we are off to a good start this year.”

In the first three months of the year, office vacancy rates dropped in all of L.A.’s submarkets: downtown, Wilshire Center, San Gabriel Valley, Tri-Cities, West L.A., North L.A County and the South Bay.

Average asking rents countywide remained flat at $2.45 a foot, 3 cents higher than the asking rents during the same period a year ago.

Meanwhile, few of L.A.’s submarkets have new office buildings under construction, except for West L.A. where there’s nearly 1 million square feet of new space coming online. With additional office supply constrained, commercial brokers believe rents could increase between 4 percent and 7 percent by year’s end.

Focused further south


Until now, Kilroy’s attention has been on shedding underperforming assets and building up its portfolio in more desirable markets.

In December, Kilroy announced a rare acquisition, spending $98 million for a San Diego business park renamed Kilroy Sabre Springs. The park came with development rights for a six-story building with 149,000 square feet.

In the last three months, the company sold buildings in Santa Ana, Glendale and Phoenix with a combined 305,000 square feet for $38.7 million a gain of $5.8 million.

The highlight of the company’s first quarter came in March, when software developer Intuit signed a 10-year lease for a new regional corporate headquarters in Santa Fe Summit, a four-building campus Kilroy is building east of Del Mar on State Route 56 in San Diego County.

“It’s certainly an exciting transaction for us,” Kilroy told analysts. “It also represents an easterly extension of the Del Mar office segment, which we already dominate.”

Intuit is taking three of the four planned buildings in the 466,000-square-foot business park, and the company has certain expansion rights for the fourth building.

Meanwhile, Mountain View-based Intuit is moving from 212,000 square feet of space it has in two buildings Kilroy owns in San Diego’s Governor Park submarket. Intuit occupies those buildings with below-market rents, and Kilroy said it stands to gain from re-leasing the space.

“We’ve made calculated judgments for when and where new demand would arrive,” Kilroy said, “culminating in this new wave of growth for us.”