In a year marked by financial and economic uncertainty, we focused on the fundamentals of our business and positioned KRC for the future. Jeffrey C. Hawken, Executive Vice President and Chief Operating Officer Tyler H. Rose, Executive Vice President and Chief Financial Officer
Jeffrey C. Hawken, Executive Vice President and Chief Operating Officer Tyler H. Rose, Executive Vice President and Chief Financial Officer
To Our Shareholders spc
spc John B. Kilroy, Jr., President & Chief Executive Officer, Kilroy Realty Corp
spc John B. Kilroy, Jr., President & Chief Executive Officer, Kilroy Realty Corp

Economic challenges that began in 2008 continued to be the theme in 2009. It was a year marked by uncertainty and economic contraction and while we were financially well-positioned going into the downturn, we took additional measures in 2009 to solidify our balance sheet and position KRC for the future. By the end of the year we began to see some improvement in the markets and delivered a surprisingly robust fourth quarter leasing performance. The year ahead promises to be equally challenging for Southern California commercial real estate, and we remain focused on the fundamentals of our business.

A Fourth-Quarter Leasing Surge…
Our persistent focus on leasing throughout 2009 paid big dividends in the fourth quarter. We delivered one of the strongest quarterly performances in our history as a public company, executing more than 1.1 million square feet of new or renewing leases in just three months. That number exceeded our results for the first three quarters of the year combined, boosting total executed leases for all of 2009 to two million square feet.

Our fourth-quarter leasing activity was deep and broad-based, reaching into nearly every corner of our portfolio. Transactions included new and renewal leases in roughly equal numbers, and split about half and half between office and industrial space. Overall, we completed 53 transactions during the quarter, converting every letter of intent outstanding at the beginning of the period into an executed lease.

So far, this accelerated pace has continued into the new year. Through the first four weeks of 2010, we’ve executed leases on over 100,000 square feet of space and have letters of intent on an additional 200,000
square feet.

…Caps a Challenging Year.
Notwithstanding our recent leasing success, 2009 will be remembered as one of the most challenging years of the past several decades for commercial real estate. The combination of highly constrained credit and deeply uncertain economic conditions affected tenants and landlords alike. Most businesses remained extremely reluctant to commit to new real estate obligations. Many real estate owners struggled to recapitalize balance sheets. And nearly everyone in our industry struggled with persistent, downward pressure on commercial occupancies, rental rates and asset values.

KRC was not immune. Occupancy in our stabilized portfolio declined steadily in each quarter of 2009 before stabilizing in the fourth quarter at 82.8%, down more than six percentage points from year-end 2008. Largely as a result of lower average occupancy, revenues declined 3.4% to $279.4 million in 2009. Same-store net operating income fell 9.2% on a GAAP basis and 12.1% on a cash basis. Funds from operations were off 6% to $107.2 million, or $2.60 per diluted share.

Across the year, our rental rates on new and renewing leases commencing in 2009 largely increased, with office rents up 15% on a GAAP basis and 6.5% on a cash basis, while industrial rents were up 9% on a GAAP basis and down 5.4% on a cash basis.

However, this trend reversed on leases signed in the fourth quarter. Across the 1.1 million square feet of leases executed during the period, average rents declined 4% on a GAAP basis and 15% on a cash basis. The direction of rental rates in 2010 remains uncertain.

Quality Drives Our Leasing Success…
While economic conditions appeared to improve as 2009 came to a close, we believe the momentum in our leasing program at KRC has more to do with the quality of our portfolio, the attractiveness of our markets, and the stability of our financial position than with any definitive change in overall market conditions.

In fact, last year’s difficult operating environment underscored, once again, the value of quality assets—supported by solid execution and financial strength—in challenging times.

The sight of landlords in extreme financial distress has produced a clear and potentially long-lasting differentiation in the marketplace between companies with sound balance sheets and access to capital, and those operating under significant financial constraints. Both tenants and brokers are demonstrating a new awareness of the value of a financially sound landlord.

Meanwhile, businesses are increasingly viewing today’s lower rental rates as an opportunity to ‘trade up’ to a better quality property, relocate to a more attractive market, or consolidate their real estate footprint in a more efficient manner.

Based on these criteria, KRC brings formidable advantages to what remains a highly competitive leasing environment. Our portfolio is largely constituted of young, thoughtfully designed and highly amenitized properties, all located in desirable and historically economically vibrant submarkets of Southern California.

Many of our recently developed office campuses in San Diego and West Los Angeles have won prestigious TOBY (The Office Building of the Year) awards, the real estate industry’s most comprehensive award program, including two in 2009 and 13 over the past four years.

To these property advantages, we bring KRC’s relentless focus on excellence—in leasing, property management, tenant relations, and long-term planning—and our commitment to a financially sound and conservatively managed capital structure.

…While Financial Strength Helps Ensure a Bright Future.
Access to capital is always least available and most valuable at inflection points in real estate cycles. We took several important steps during 2009 to ensure our continuing financial stability and strengthen our ability to capitalize on emerging acquisition and development opportunities as this cycle proceeds.

In June, we issued just over 10 million shares of common stock for total net proceeds of $192 million. And in November, we completed a $173 million, five-year exchangeable note offering at an interest rate of 4.25%. The proceeds from both these transactions allowed us to pay down our credit line and repurchase a portion of our outstanding exchangeable notes under financially advantageous terms.

We ended 2009 with just under $100 million outstanding on our $550 million credit line. We recently provided notice to exercise the one-year extension option on this line, moving its maturity forward to April 2011. And we recently completed a new $71 million mortgage financing to replace a maturing mortgage financing.

Reducing our leverage and broadening our financial flexibility in preparation for whatever we encounter down the road—whether challenge or opportunity—underscores the conservative, long-term approach we take to every aspect of our business at KRC.

Given the unprecedented events of the past two years and the continued uncertainty surrounding future economic conditions, we’re not ready to forecast when a recovery may take hold. Any sustained improvement in commercial real estate is usually preceded by job growth, which we have yet to see in our markets. We’re preparing for another choppy year in Southern California real estate, and we’ll continue to focus on the fundamentals of our business—a strong leasing effort, financial strength and liquidity, disciplined cost control, pursuing acquisitions when it makes sense, and the ongoing enhancement of entitlements associated with our land pipeline.

Looking backing over the past year, I think it’s fair to say that KRC has captured more than its share of leasing opportunities amid some of the worst market conditions we’ve experienced in decades. Looking forward, I am confident that we will continue to successfully lease our properties when those same markets recover, capturing opportunities for profitable long-term growth on behalf of our shareholders.

As always, I thank you for your continued support. 

John B Kilroy, Jr.

John B. Kilroy, Jr.

Chairman and CEO