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(ARDEN REALTY, INC. LOGO)



Securities and Exchange Commission

Washington, D.C. 20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13
OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarter ended March 31, 2004

Commission file number 1-12193

ARDEN REALTY, INC.

(Exact name of registrant as specified in its charter)
     
Maryland   95-4578533
(State or other jurisdiction of incorporation or organization)   (I.R.S. Employer Identification No.)

11601 Wilshire Boulevard,
4th Floor
Los Angeles, California 90025-1740

(Address and zip code of principal executive offices)

Registrant’s telephone number, including area code: (310) 966-2600

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes [x]       No [  ]

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).

Yes [x]       No [  ]

As of May 5, 2004 there were 65,504,754 shares of the registrant’s common stock, $.01 par value, issued and outstanding.



 


ARDEN REALTY, INC.
FORM 10-Q
TABLE OF CONTENTS

         
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 Exhibit 31.1
 Exhibit 32.1

 


Table of Contents

Part I. FINANCIAL INFORMATION

Item 1. Financial Statements

Arden Realty, Inc.

Consolidated Balance Sheets
(in thousands, except share amounts)
                 
    March 31,   December 31,
    2004
  2003
    (unaudited)        
Assets
               
Investment in real estate:
               
Land
  $ 467,216     $ 467,216  
Buildings and improvements
    2,123,691       2,122,216  
Tenant improvements and leasing commissions
    347,075       345,604  
 
   
 
     
 
 
 
    2,937,982       2,935,036  
Less: accumulated depreciation and amortization
    (465,799 )     (455,261 )
 
   
 
     
 
 
 
    2,472,183       2,479,775  
Properties under development
    77,778       75,627  
Land available for development
    23,731       23,723  
Properties held for disposition, net
    8,103       67,574  
 
   
 
     
 
 
Net investment in real estate
    2,581,795       2,646,699  
Cash and cash equivalents
    11,784       4,707  
Restricted cash
    21,030       19,694  
Rent and other receivables, net of allowance of $3,956 and $4,041 at March 31, 2004 and December 31, 2003, respectively
    5,745       3,688  
Deferred rent, net of allowance of $2,178 and $2,216 at March 31, 2004 and December 31, 2003, respectively
    43,508       44,203  
Prepaid financing costs, expenses and other assets, net of accumulated amortization of $14,767 and $13,781 at March 31, 2004 and December 31, 2003, respectively
    20,984       22,442  
 
   
 
     
 
 
Total assets
  $ 2,684,846     $ 2,741,433  
 
   
 
     
 
 
Liabilities
               
Mortgage loans payable
  $ 563,377     $ 564,829  
Unsecured lines of credit
    96,000       161,000  
Unsecured term loan
    125,000       125,000  
Unsecured senior notes, net of discount
    501,005       498,952  
Accounts payable and accrued expenses
    60,633       54,317  
Security deposits
    22,484       22,321  
Dividends payable
    33,080       32,535  
 
   
 
     
 
 
Total liabilities
    1,401,579       1,458,954  
Minority interest
    71,546       72,194  
Stockholders’ Equity
               
Preferred stock, $.01 par value, 20,000,000 shares authorized, none issued
           
Common stock, $.01 par value, 100,000,000 shares authorized, 65,504,754 and 64,425,450 issued and outstanding at March 31, 2004 and December 31, 2003, respectively
    656       646  
Additional paid-in capital
    1,234,911       1,225,192  
Deferred compensation
    (15,197 )     (14,952 )
Accumulated other comprehensive loss
    (8,649 )     (601 )
 
   
 
     
 
 
Total stockholders’ equity
    1,211,721       1,210,285  
 
   
 
     
 
 
Total liabilities and stockholders’ equity
  $ 2,684,846     $ 2,741,433  
 
   
 
     
 
 

See accompanying notes to consolidated financial statements.

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Arden Realty, Inc.

Consolidated Statements of Income
(in thousands, except per share data)
(unaudited)
                 
    Three Months Ended
    March 31,
    2004
  2003
Property revenues
  $ 104,479     $ 100,976  
Property operating expenses
    34,097       31,343  
 
   
 
     
 
 
 
    70,382       69,633  
General and administrative expenses
    4,484       3,590  
Interest expense
    23,313       23,035  
Depreciation and amortization
    30,276       28,408  
Interest and other income, net
    (766 )     (104 )
 
   
 
     
 
 
Income from continuing operations before minority interest
    13,075       14,704  
Minority interest
    (1,382 )     (1,438 )
 
   
 
     
 
 
Income from continuing operations
    11,693       13,266  
Discontinued operations, net of minority interest
    739       2,811  
Gain (loss) on sale of discontinued properties
    6,429       (639 )
 
   
 
     
 
 
Net income
  $ 18,861     $ 15,438  
 
   
 
     
 
 
Basic net income per common share:
               
Income from continuing operations
  $ 0.18     $ 0.21  
Income from discontinued operations
    0.11       0.03  
 
   
 
     
 
 
Net income per common share- basic
  $ 0.29     $ 0.24  
 
   
 
     
 
 
Weighted average number of common shares – basic
    64,813       63,040  
 
   
 
     
 
 
Diluted net income per common share:
               
Income from continuing operations
  $ 0.18     $ 0.21  
Income from discontinued operations
    0.11       0.03  
 
   
 
     
 
 
Net income per common share- diluted
  $ 0.29     $ 0.24  
 
   
 
     
 
 
Weighted average number of common shares- diluted
  $ 65,228     $ 63,126  
 
   
 
     
 
 

See accompanying notes to consolidated financial statements.

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Arden Realty, Inc.

Consolidated Statements of Cash Flows
(in thousands)
(unaudited)
                 
    Three Months Ended
    March 31,
    2004
  2003
Operating Activities:
               
Net income
  $ 18,861     $ 15,438  
Adjustments to reconcile net income to net cash provided by operating activities:
               
Minority interest, including discontinued operations
    1,568       1,498  
(Gain) loss on sale of discontinued properties
    (6,429 )     639  
Depreciation and amortization, including discontinued operations
    30,332       29,622  
Amortization of loan costs
    1,079       946  
Non-cash compensation expense
    746       389  
Changes in operating assets and liabilities:
               
Rent and other receivables
    (2,057 )     (642 )
Deferred rent
    (1,637 )     (118 )
Prepaid financing costs, expenses and other assets
    (533 )     (1,494 )
Accounts payable and accrued expenses
    1,641       3,280  
Security deposits
    271       (128 )
 
   
 
     
 
 
Net cash provided by operating activities
    43,842       49,430  
 
   
 
     
 
 
Investing Activities:
               
Improvements to commercial properties
    (24,786 )     (19,482 )
Proceeds from sale of properties
    67,884       31,943  
 
   
 
     
 
 
Net cash provided by investing activities
    43,098       12,461  
 
   
 
     
 
 
Financing Activities:
               
Repayments of mortgage loans
    (1,452 )     (749 )
Proceeds from unsecured lines of credit
    40,000       36,500  
Repayments of unsecured lines of credit
    (105,000 )     (49,500 )
Proceeds from issuance of common stock
    22,391       64  
Distributions to preferred operating partnership unit holders
    (1,078 )     (1,078 )
Increase in restricted cash
    (1,336 )     (3,090 )
Distributions to minority interests
    (853 )     (867 )
Dividends paid
    (32,535 )     (31,806 )
 
   
 
     
 
 
Net cash used in financing activities
    (79,863 )     (50,526 )
 
   
 
     
 
 
Net increase in cash and cash equivalents
    7,077       11,365  
Cash and cash equivalents at beginning of period
    4,707       4,063  
 
   
 
     
 
 
Cash and cash equivalents at end of period
  $ 11,784     $ 15,428  
 
   
 
     
 
 
Supplemental Disclosure of Cash Flow Information:
               
Cash paid during the period for interest, net of amounts capitalized
  $ 22,032     $ 23,555  
 
   
 
     
 
 

See accompanying notes to consolidated financial statements.

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Arden Realty, Inc.

Notes to Consolidated Condensed Financial Statements
March 31, 2004
(unaudited)

1. Description of Business

     The terms “Arden Realty”, “us”, “we” and “our” as used in this report refer to Arden Realty, Inc. Through our controlling interest in Arden Realty Limited Partnership, or the Operating Partnership, and our other subsidiaries, we own, manage, lease, develop, renovate and acquire commercial office properties located in Southern California. As of March 31, 2004, our portfolio was comprised of 128 primarily suburban office properties, consisting of 210 buildings with approximately 18.6 million net rentable square feet, including one development project with approximately 283,000 net rentable square feet currently under lease-up. As of March 31, 2004, our operating portfolio was 88.7% occupied.

     The minority interests at March 31, 2004 consist of limited partnership interests in the Operating Partnership of approximately 2.5%, exclusive of ownership interests of the Operating Partnership’s preferred unit holders.

2. Summary of Significant Accounting Policies

     Basis of Presentation

     The accompanying consolidated financial statements include the accounts of Arden Realty, Inc., the Operating Partnership, and our subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation.

     We consolidate all entities for which we have controlling financial interest as measured by a majority of the voting interest. For entities in which the controlling financial interest is not clearly indicated by ownership of a majority of the voting interest, we would consolidate those entities that we control by agreement. We would also consolidate all variable interest entities for which we were the primary beneficiary.

     Except for minority interests in the Operating Partnership, Arden Realty and the Operating Partnership currently own 100% of all of our consolidated subsidiaries and do not have any unconsolidated investments other than an investment in the securities of a non-publicly traded company. This investment represents approximately 2.9% of the total equity outstanding for this particular company as of the date of this report. (See Note 4). Because we do not control this company contractually nor exert significant influence over its operating and financial policies, we account for this investment under the cost method of accounting.

     Interim Financial Data

     The accompanying consolidated condensed financial statements should be read in conjunction with our 2003 Annual Report on Form 10-K as filed with the Securities and Exchange Commission. The accompanying financial information reflects all adjustments, which are, in our opinion, of a normal recurring nature and necessary for a fair presentation of our financial position, results of operations and cash flows for the interim periods. Interim results of operations are not necessarily indicative of the results to be expected for the full year.

     Reclassifications

     Certain prior year amounts have been reclassified to conform with the current period presentation.

3. Property Dispositions

     On February 4, 2004, we sold an approximate 133,000 square foot retail property located in Riverside County for a sales price of approximately $17.0 million. The terms of this sale included an approximate $800,000 guarantee for the future rent and retenanting costs, if necessary, for certain tenants in this property. In addition, we recorded a $400,000 environmental reserve related to the future completion of an environmental review. We recognized this sale net of the guarantee and environmental reserve and will record any subsequent amounts recovered over the next twelve months.

     On March 16, 2004, we sold an approximate 162,000 square foot office property located in Los Angeles County for a gross sales price of approximately $52.5 million.

     The net proceeds from these dispositions were used to reduce the outstanding balance on our Wells Fargo unsecured line of credit.

4. Non-Real Estate Investments

     Included in our other assets balance at March 31, 2004 is a 2.7 million passive investment in the securities of a non-publicly traded company formed in 2000 to provide distributed energy generation to commercial real estate owners. On March 8, 2004, we received information from the company that they are currently assessing their business and financing strategies. The ultimate outcome of their analysis on the company’s operations and the recoverability of our investment is currently uncertain. No adjustments have been made in these financial statements as a result of this uncertainty.

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5. Outstanding Indebtedness

     A summary of our outstanding indebtedness as of March 31, 2004 and December 31, 2003 is as follows:

                                                 
                    Stated Annual                
                    Interest Rate at           Number of    
    March 31,   December 31,   March 31,   Rate   Properties    
Type of Debt
  2004
  2003
  2004
  Fixed/Floating
  Securing Loan
  Maturity
    (in thousands)                                
Mortgage Loans Payable:
                                               
Fixed Rate
                                               
Mortgage Financing I(1),(2)
  $ 175,000     $ 175,000       7.52 %   Fixed     18       6/04  
Mortgage Financing III(3)
    134,159       134,544       6.74 %   Fixed     22       4/08  
Mortgage Financing IV(3)
    109,654       109,960       6.61 %   Fixed     12       4/08  
Mortgage Financing V(3)
    105,306       105,899       6.94 %   Fixed     12       4/09  
Mortgage Financing VI(3)
    21,533       21,578       7.54 %   Fixed     3       4/09  
Activity Business Center(3)
    7,364       7,394       8.85 %   Fixed     1       5/06  
145 South Fairfax(3)
    3,901       3,912       8.93 %   Fixed     1       1/27  
Marin Corporate Center(3)
    2,690       2,724       9.00 %   Fixed     1       7/15  
Conejo Business Center(3)
    2,636       2,669       8.75 %   Fixed   (Note 4)     7/15  
Conejo Business Center(3)
    1,134       1,149       7.88 %   Fixed   (Note 4)     7/15  
 
   
 
     
 
                                 
 
    563,377       564,829                                  
Unsecured Lines of Credit:
                                               
Floating Rate
                                               
Wells Fargo - $310 mm(1)
    86,000       158,000       3.25 %   LIBOR + 1.00% (Notes 5,6)           4/06  
City National Bank - $20 mm(1)
    10,000       3,000       2.13 %   (Note 7)           8/04  
 
   
 
     
 
                                 
 
    96,000       161,000                                  
Unsecured Term Loan:
                                               
Fixed Rate
                                               
Wells Fargo - $125 mm(1)
    125,000       125,000       4.14 %   Fixed (Note 8)           6/06  
Unsecured Senior Notes:
                                               
Fixed Rate
                                               
2005 Notes(9)
    199,897       199,872       8.88 %   Fixed           3/05  
2007 Notes(9)
    151,903       149,907       7.00 %   (Note 10)           11/07  
2010 Notes(9)
    49,755       49,744       9.15 %   Fixed           3/10  
2010 Notes(9)
    99,450       99,429       8.50 %   Fixed           11/10  
 
   
 
     
 
                                 
 
    501,005       498,952                                  
 
   
 
     
 
                                 
Total Debt
  $ 1,285,382     $ 1,349,781                                  
 
   
 
     
 
                                 


(1)   Requires monthly payments of interest only, with outstanding principal balance due upon maturity.
 
(2)   This mortgage financing was repaid in full on April 9, 2004 with proceeds from our unsecured lines of credit.
 
(3)   Requires monthly payments of principal and interest.
 
(4)   Both mortgage loans are secured by the Conejo Business Center property.
 
(5)   This line of credit also has an annual 20 basis point facility fee on the entire $310 million commitment amount.
 
(6)   In 2002, we entered into interest rate swap agreements that fixed the interest rate on $50 million of the outstanding balance on this line of credit at 4.06% through April of 2006.
 
(7)   In December 2003, we expanded this line of credit to $20 million at an interest rate of LIBOR + 1.00% or Prime Rate – 1.875%.
 
(8)   In 2002, we entered into interest rate swap agreements that fixed the interest rate on the entire balance of this loan at approximately 3.64% in 2003, 4.25% in 2004, 4.75% in 2005 and 4.90% in 2006.
 
(9)   Requires semi-annual interest payments only, with principal balance due upon maturity.
 
(10)   During the fourth quarter of 2003, we entered into interest rate swap agreements to float the interest rate on $100 million of the outstanding balance of these notes at a rate of LIBOR + 3.1% through November of 2007. Including these swap agreements, the effective interest rate on these notes was approximately 5.32% as of March 31, 2004.

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6. Interest Rate Swap Agreements

     We have entered into interest rate swap agreements to effectively convert floating rate debt into fixed rate debt, to convert fixed rate debt to floating rate debt and to lock the current Treasury rate in anticipation of future debt issuances. Net amounts received or paid under these agreements are recognized as an adjustment to interest expense when such amounts are incurred or earned. Our objective in using interest rate swap agreements is to manage our exposure to interest rate movements.

     During 2002, such agreements were used to fix the floating interest rate associated with $50 million of the Wells Fargo unsecured line of credit and the entire $125 million balance of the unsecured term loan. Since June of 2003, we have also entered into $150 million of forward-starting swaps that effectively fixed the 10-year Treasury rate at an average rate of approximately 4.1% for borrowings that are anticipated to occur in 2004 to refinance some of our scheduled debt maturities. The forward-starting interest rate swaps were entered into at current market rates and, therefore, had no initial cost.

     In October and November of 2003, we also entered into reverse interest rate swap agreements to float $100 million of the fixed interest rate associated with the 7.00% senior unsecured notes due in November of 2007. Under these reverse swaps, we will receive interest at a fixed rate of 7.00% and pay interest at a variable rate averaging six-month LIBOR in arrears plus 3.10%. The interest rate swaps mature at the same time the notes are due. These swaps qualify as fair value hedges for accounting purposes. Net semi-annual interest payments will be recognized as increases or decreases in interest expense. The fair value of the interest rate swaps will be recognized on our balance sheet and the carrying value of the senior unsecured notes will be increased or decreased by an offsetting amount.

     Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities” (SFAS 133), as amended and interpreted, establishes accounting and reporting standards for derivative instruments and for hedging activities. The accounting for changes in the fair value of derivatives depends on the intended use of the derivative and the resulting designation. Derivatives used to hedge the exposure to changes in the fair value of an asset, liability, or firm commitment attributable to a particular risk, are considered fair value hedges. Derivatives used to hedge the exposure to variability in expected future cash flows, or other types of forecasted transactions, are considered cash flow hedges.

     For derivatives designated as fair value hedges, changes in the fair value of the derivative and the hedged item related to the hedged risk are recognized in earnings. For derivatives designated as cash flow hedges, the effective portion of changes in the fair value of the derivative is initially reported in other comprehensive income (loss), outside of earnings and subsequently recognized to earnings when the hedged transaction affects earnings.

     Under SFAS 133, our $175 million in floating-to-fixed swaps and our $150 million in forward-starting swaps outstanding as of March 31, 2004 are classified as cash flow hedges with their fair value of approximately $8.6 million reported in accumulated other comprehensive loss on our balance sheet. The estimated fair value of these interest rate swap agreements are dependent on changes in market interest rates and other market factors that affect the value of such agreements. Consequently, the estimated current fair value may significantly change during the term of the agreements. Any estimated gain or loss from these agreements will be amortized into earnings as we recognize the interest expense for the underlying floating-rate loans at the fixed interest rate provided under our agreements in the case of the fixed-to-floating swaps or as part of interest expense for future borrowings in the case of the forward starting swaps. If the underlying debt related to these swaps were to be repaid prior to maturity, we would recognize into interest expense any unamortized gain or loss at the time of such early repayment.

     Under SFAS 133, our $100 million in fixed-to-floating hedges are classified as fair value hedges with their fair value of approximately $2.5 million reported in both the unsecured senior notes and prepaid financing costs, expenses and other assets line items on our balance sheet. The estimated fair value of these interest rate hedge agreements are dependent on changes in market interest rates and other market factors that affect the value of such agreements. Consequently, the estimated current fair value may significantly change during the term of the agreements. Any estimated gain or loss from these agreements will be amortized into earnings as we recognize the interest expense for the underlying fixed-rate loan at the floating interest rate provided under our agreements in the case of the floating-to-fixed hedges. If the underlying debt related to these hedges were to be repaid prior to maturity, we would recognize into interest expense any unamortized gain or loss at the time of such early repayment.

7. Stockholders’ Equity and Minority Interests

     A common Operating Partnership unit, or common OP Unit, and a share of our common stock have essentially the same economic characteristics as they share equally in the total net income or loss and distributions of the Operating Partnership. A common OP Unit may be redeemed for cash or, at the election of the Operating Partnership, for shares of our common stock on a one-for-one basis.

     Our minority interest balance includes $50 million of 8.625% Series B Cumulative Redeemable Preferred Operating Partnership Units, or Preferred OP Units. These Preferred OP Units were issued in September of 1999, are callable by us after September 2004 and are exchangeable after ten years by the holder into our 8.625% Series B Cumulative Redeemable Preferred Stock, on a one-for-one basis. The Preferred OP Units and Series B Cumulative Redeemable Preferred Stock have no stated maturity or mandatory redemption and are subordinate to all debt.

     During the three months ended March 31, 2004, we issued a total of 1,023,304 common shares relating to exercises of stock options.

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     On February 27, 2004, we issued a total of 38,000 restricted stock awards to several key executive officers and employees. Holders of these shares have full voting rights and will receive any dividends but are prohibited from selling or transferring unvested shares. The fair market value on the date of the grant for these restricted shares was $31.60. These restricted shares vest equally over three years.

     On March 18, 2004, we declared a quarterly dividend of $0.505 per share to stockholders of record on March 31, 2004. For the three months ended March 31, 2003, we declared a quarterly dividend of $0.505 per share.

8. Revenue from Rental Operations and Property Expenses

     Revenue from rental operations and property expenses for properties held for use are summarized as follows (in thousands):

                 
    Three Months Ended
    March 31,
    2004
  2003
Revenue from Rental Operations:
               
Scheduled cash rents
  $ 90,532     $ 88,170  
Straight-line rents
    892       379  
Tenant reimbursements
    4,753       6,037  
Parking, net of expenses
    5,700       5,123  
Other rental operations
    2,602       1,267  
 
   
 
     
 
 
 
    104,479       100,976  
 
   
 
     
 
 
Property Expenses:
               
Repairs and maintenance
    11,341       10,038  
Utilities
    7,567       7,883  
Real estate taxes
    8,021       7,276  
Insurance
    2,061       2,074  
Ground rent
    125       42  
Administrative
    4,982       4,030  
 
   
 
     
 
 
 
    34,097       31,343  
 
   
 
     
 
 
 
  $ 70,382     $ 69,633  
 
   
 
     
 
 

9. Income from Taxable REIT Subsidiary

     Beginning in the first quarter of 2004, we have reclassified for financial presentation purposes the operating results of Nextedge, our taxable REIT subsidiary, or TRS, in our consolidated statements of income from general and administrative expenses to interest and other income, net. Nextedge provides energy consulting services to commercial real estate owners. The following is a breakdown of the components of interest and other income, net, for each of the periods presented (in thousands):

                 
    Three Months Ended
    March 31,
    2004
  2003
Net income (loss) from TRS
  $ 638     $ (28 )
Interest and other income
    128       132  
 
   
 
     
 
 
 
  $ 766     $ 104  
 
   
 
     
 
 

10. Stock Option Plan

     Beginning on January 1, 2003, we adopted the provisions of SFAS No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure” under which we began expensing the costs of new stock options granted to employees in 2003 in accordance with SFAS No. 123, “Accounting for Stock-Based Compensation.” We used the Black-Scholes option valuation model to estimate the fair value of the stock options granted. During the three months ended March 31 2004 and March 31, 2003, we expensed approximately $8,000 of stock option based employee compensation costs.

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     The following table reflects pro forma net income and earnings per share had we elected to expense all options granted prior to 2003 assuming the fair value method and using the Black-Scholes option valuation model (in thousands, except per share amounts):

                 
    Three Months Ended
    March 31,
    2004
  2003
Net income available to common stockholders, as reported
  $ 18,861     $ 15,438  
Stock based employee compensation costs for options granted prior to 2003 assuming fair value method
    (77 )     (264 )
 
   
 
     
 
 
Net income available to common stockholders, as adjusted
  $ 18,784     $ 15,174  
 
   
 
     
 
 
Earnings per share:
               
Basic as reported
  $ 0.29     $ 0.24  
 
   
 
     
 
 
Basic as adjusted
  $ 0.29     $ 0.24  
 
   
 
     
 
 
Diluted as reported
  $ 0.29     $ 0.24  
 
   
 
     
 
 
Diluted as adjusted
  $ 0.29     $ 0.24  
 
   
 
     
 
 

11. Comprehensive Income

     Comprehensive income represents net income, plus the results of certain non-shareholders’ equity changes not reflected in the Consolidated Statements of Income. The components of comprehensive income are as follows (in thousands):

                 
    Three Months Ended
    March 31,
    2004
  2003
Net income
  $ 18,861     $ 15,438  
Other comprehensive loss:
               
Unrealized derivative loss on cash flow hedges
    (8,048 )     (1,097 )
 
   
 
     
 
 
Comprehensive income
  $ 10,813     $ 14,341  
 
   
 
     
 
 

12. Commitments and Contingencies

     We are presently subject to various lawsuits, claims and proceedings arising in the ordinary course of business, none of which if determined unfavorably to us is expected to have a material adverse effect on our cash flows, financial condition or results of operations. There were no material changes in our legal proceedings during the three months ended March 31, 2004.

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Overview

     The following discussion relates to our unaudited consolidated financial statements included herein, which should be read in conjunction with the financial statements and related notes thereto included elsewhere in this Form 10-Q and in our 2003 Annual Report on Form 10-K.

     This form 10-Q, including the documents incorporated herein by reference, contains forward-looking statements within the meaning of Section 27A of the Securities Act and Section 21E of the Exchange Act pertaining to, among other things, our future results of operations, cash available for distribution, acquisitions, lease renewals, property development, property renovation, capital requirements and general business, industry and economic conditions applicable to us. Also, documents we subsequently file with the SEC and incorporated herein by reference will contain forward-looking statements. Actual results could differ materially from those projected in the forward-looking statements as a result of the risk factors set forth below and the matters set forth or incorporated in this form 10-Q generally. We caution you, however, that this list of factors may not be exhaustive, particularly with respect to future filings.

     We are a self-administered and self-managed real estate investment trust that owns, manages, leases, develops, renovates and acquires commercial properties located in Southern California. We are managed by 7 senior executive officers who have experience in the real estate industry ranging from 12 to 34 years and who collectively have an average of 18 years experience. We perform all property and development management, accounting, finance and acquisition/disposition activities and a majority of our leasing transactions with our staff of approximately 300 employees.

     As of March 31, 2004, we were Southern California’s largest publicly traded office landlord as measured by total net rentable square feet owned. As of that date, our portfolio was comprised of 128 primarily suburban office properties, consisting of 210 buildings with approximately 18.6 million net rentable square feet, including one development project with approximately 283,000 net rentable square feet currently under lease-up. As of March 31, 2004 and March 31, 2003, our operating portfolio was 88.7% and 89.7% occupied, respectively.

Business Strategy

     Our primary business strategy is to actively manage our portfolio to seek to achieve gains in rental rates and occupancy, control operating expenses and maximize income from ancillary operations and services. When market conditions permit, we may also selectively develop or acquire new properties that add value and fit strategically into our portfolio. We may also sell existing properties and place the proceeds into investments we believe will generate higher long-term value.

     We continue to seek to build a tenant base of smaller, diverse companies that limits our exposure to any single tenant or industry. Smaller tenants typically translate into shorter-term leases. Shorter-term leases provide greater opportunity for renewing a substantial portion of our portfolio at higher rental rates each year during strong markets, but create challenges to maintain occupancy and rates when markets weaken. The average term of our leases is 4 to 5 years, resulting in approximately 15% to 20% of our leases expiring annually.

     We closely monitor our operating expenses and capital expenditures to sustain or improve operating margins and dividend coverage. We may defer discretionary operating expenses and capital expenditures until market conditions improve.

Current Economic Climate

     Our short and long-term liquidity, ability to refinance existing indebtedness, ability to issue long-term debt and equity securities at favorable rates and our dividend policy are significantly impacted by the operating results of our properties, all of which are located in Southern California. Our ability to lease available space and increase rates when leases expire is largely dependent on the demand for office space in the markets where our properties are located. We believe current uncertainty over the national and Southern California economic environment is exerting downward pressures on the demand for Southern California commercial office space. We are experiencing continued downward pressures on occupancy and rental rates and upward pressures on leasing costs due to several factors, including, among others, the following:

    Non-farm job growth in Southern California, which we believe to be a leading indicator of office demand, was negative in 2003 and in the first three months of 2004 and is largely dependent on improved economic activity;
 
    Rental rates decreased in 2003 and are expected to decrease further in 2004 due to the state of the local economy and competition from other office landlords;
 
    Tenant concessions for new and renewal leases have increased in some submarkets in 2003 and are expected to further increase in 2004 due to competition from other office landlords;
 
    Some tenants are under-utilizing their existing space and can therefore expand internally before they need new space;
 
    Sublease space is impacting vacancy and rental rates in some submarkets; and
 
    Over-building has increased vacancy rates in some submarkets.

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     According to published reports, overall market rental rates in Southern California increased about 1% during the three months ended March 31, 2004. Given the current trends, including the expected continued occupancy pressures and aggressive pricing from competing office landlords and sublease space, we expect market rates will remain flat to down by approximately 1% in the second quarter of 2004. Although concessions declined during the three months ended March 31, 2004, we expect concessions in either free rent or higher tenant improvement allowances to continue until market vacancies decline to a level where landlords regain pricing power.

     The timing and extent of future changes in the national and local economy and their effects on our properties and results of operations are difficult to accurately predict. It is possible, however, that these national and regional issues may more directly affect us and our operating results in the future, making it more difficult for us to lease and renew available space, to increase or maintain rental rates as leases expire and to collect amounts due from our tenants. For additional information, see “Risk Factors – Further declines in the economic activity of Southern California will adversely affect our operating results,” “– The financial condition and solvency of our tenants may reduce our cash flow,” and “– Rising energy costs and power outages in California may have an adverse effect on our operations and revenue,” in our 2003 Annual Report on Form 10-K.

Critical Accounting Policies

     Refer to our 2003 Annual Report on Form 10-K for a discussion of our critical accounting policies, which include, among other things, revenue recognition, allowance for doubtful accounts and depreciation. There have been no material changes to these policies in 2004.

Off-Balance Sheet Arrangements

     As of March 31, 2004, there are no off-balance sheet transactions, arrangements or obligations (including contingent obligations) that have, or are reasonably likely to have a current or future material effect on our financial condition, changes in the financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.

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RESULTS OF OPERATIONS

     Our financial position and operating results primarily relate to our portfolio of commercial properties and income derived from those properties. Therefore, the comparability of financial data from period to period will be affected by the timing of property developments, acquisitions and dispositions.

Comparison of the three months ended March 31, 2004 to the three months ended March 31, 2003
(in thousands, except number of properties and percentages):

                                 
    Three Months Ended            
    March 31,
           
                            Percent
    2004
  2003
  Change
  Change
Total Portfolio:
                               
Revenue from rental operations:
                               
Scheduled cash rents
  $ 90,532     $ 88,170     $ 2,362       3 %
Straight-line rents
    892       379       513       135  
Tenant reimbursements
    4,753       6,037       (1,284 )     (21 )
Parking, net of expense
    5,700       5,123       577       11  
Other rental operations
    2,602       1,267       1,335       105  
 
   
 
     
 
     
 
     
 
 
Total revenue from rental operations
    104,479       100,976       3,503       3  
Property expenses:
                               
Repairs and maintenance
    11,341       10,038       1,303       13  
Utilities
    7,567       7,883       (316 )     (4 )
Real estate taxes
    8,021       7,276       745       10  
Insurance
    2,061       2,074       (13 )     (1 )
Ground rent
    125       42       83       198  
Administrative
    4,982       4,030       952       24  
 
   
 
     
 
     
 
     
 
 
Total property expenses
    34,097       31,343       2,754       9  
 
   
 
     
 
     
 
     
 
 
Property Operating Results(1)
    70,382       69,633       749       1  
General and administrative
    4,484       3,590       894       25  
Interest expense
    23,313       23,035       278       1  
Depreciation and amortization
    30,276       28,408       1,868       7  
Interest and other income, net
    (766 )     (104 )     662       637  
 
   
 
     
 
     
 
     
 
 
Income from continuing operations before minority interest
  $ 13,075     $ 14,704     $ (1,629 )     (11 )%
 
   
 
     
 
     
 
     
 
 
Discontinued operations, net of minority interest
  $ 739     $ 2,811     $ (2,072 )     (74 )%
 
   
 
     
 
     
 
     
 
 
Number of Properties:
                               
Disposed of during period
    (2 )     (1 )                
In service at end of period
    127       135                  
Net Rentable Square Feet:
                               
Disposed of during period
    (295 )     (140 )                
In service at end of period
    18,341       18,992                  
Same Store Portfolio(2):
                               
Revenue from rental operations
  $ 102,141     $ 100,897     $ 1,244       1 %
Property expenses
    33,310       31,216       2,094       7  
 
   
 
     
 
     
 
     
 
 
 
  $ 68,831     $ 69,681     $ (850 )     (1 )%
 
   
 
     
 
     
 
     
 
 
Straight-line rents
  $ 396     $ 357     $ 39       11 %
 
   
 
     
 
     
 
     
 
 
Number of non-development properties
    126       126                  
Average occupancy
    89.4 %     89.8 %                
Net rentable square feet
    18,239       18,239                  


(1)   Property Operating Results is commonly used by investors to evaluate the performance of REITs, to determine trends in earnings and to compute the fair value of properties as it is not affected by (1) the cost of funds of the property owner or (2) the impact of depreciation and amortization expenses as well as gains or losses from the sale of operating real estate assets that are included in net income computed in accordance with Generally Accepted Accounting Principles, or GAAP. The first factor is commonly eliminated from net income because it is specific to the particular financing capabilities and constraints of the owner. The second factor is commonly eliminated because it may not accurately represent the actual change in value in real estate properties that results from use or changes in market conditions. We believe that eliminating these costs from net income gives investors an additional measure of operating performance that, when used as an adjunct to net income computed in accordance with GAAP, can be a useful measure of our operating results.

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    Property Operating Results captures trends in occupancy rates, rental rates and operating costs. However, Property Operating Results excludes general and administrative costs, interest expense, interest income, depreciation and amortization expense and gains or losses from the sale of properties, changes in value in our real estate properties that result from use or permanent impairment to carrying costs as stipulated by GAAP, the level of capital expenditures and leasing costs necessary to maintain the operating performance of our properties, all of which are significant economic costs. Therefore, Property Operating Results may fail to capture significant trends which limits its usefulness.
 
    Property Operating Results is a non-GAAP measure of performance. Property Operating Results is not a substitute for net income as computed in accordance with GAAP. It excludes significant expense components such as depreciation and amortization expense and financing costs. This measure should be analyzed in conjunction with net income and cash flow from operating activities as computed in accordance with GAAP. Other companies may use different methods for calculating Property Operating Results or similarly entitled measures and, accordingly, our Property Operating Results may not be comparable to similarly entitled measures reported by other companies that do not define the measure exactly as we do.
 
    The following is a reconciliation of net income computed in accordance with GAAP to Property Operating Results (in thousands):

                 
    Three Months Ended March 31,
    2004
  2003
Net income
  $ 18,861     $ 15,438  
Add:
               
General and administrative expense
    4,484       3,590  
Interest expense
    23,313       23,035  
Depreciation and amortization
    30,276       28,408  
Minority interest
    1,382       1,438  
Loss on sale of discontinued properties
          639  
Less:
               
Interest and other income, net
    (766 )     (104 )
Gain on sale of discontinued properties
    (6,429 )      
Discontinued operations, net of minority interest
    (739 )     (2,811 )
 
   
 
     
 
 
Property Operating Results
  $ 70,382     $ 69,633  
 
   
 
     
 
 

(2)   Consists of non-development properties classified as part of continuing operations and owned for the entirety of the periods presented.

VARIANCES FOR RESULTS OF OPERATIONS

     Our Property Operating Results for the three months ended March 31, 2004 compared to the same period in 2003 were primarily affected by our acquisitions, dispositions and development activities since January 1, 2003.

     As a result of these changes within our portfolio of properties since January 1, 2003, we do not believe the Property Operating Results presented above are comparable from period to period. Therefore, in the table above, we have also presented the Property Operating Results for our same store portfolio.

Revenue from Rental Operations

     The increase in revenue from rental operations for the total portfolio was primarily due to the approximate 101,000 square foot acquisition we made in December of 2003, consisting of an office property in San Diego County and revenues from our 6100 Center Drive development property as it reaches stabilization and from scheduled rent bumps in our existing leases that were partially offset by the decline in average occupancy.

     The increase in revenue from rental operations for the same store portfolio was primarily due to an approximate $1.7 million increase in other rental operations, a $500,000 increase in parking income and a $300,000 increase in cash rents, all of which were partially offset by a $1.3 million decrease in tenant reimbursements. The increase in other rental operations was primarily related to higher lease termination fees in 2004 as well as lower reserves for tenant receivables as a result of a reduced level of defaults. The increase in parking income is primarily due to an increase in demand for monthly parking spaces in 2004 in some of our buildings. The increase in cash rents was primarily related to scheduled rent increases in existing leases that were partially offset by the 0.4% decrease in average occupancy for these properties. The decrease in tenant reimbursements was primarily due to 2002 reconciliation adjustments recognized in the first quarter of 2003 and the 0.4% decrease in average occupancy in 2004.

Property Expenses

     The increase in property expenses for the total portfolio was partially due to the property acquired in December 2003 and the stabilization of our 6100 Center Drive development property.

     The increase in property expenses for the same store portfolio was primarily due to an approximate $1.2 million increase in repairs and maintenance, a $900,000 increase in property administrative expense and a $500,000 increase in real estate taxes, all of which were partially offset by an approximate $500,000 decrease in utilities expense. Repairs and maintenance increased primarily due to higher contractual costs for engineering and other contract services as well as the timing of certain projects. Property administrative expense increased primarily due to higher personnel costs from annual merit increases and employee non-recurring separation costs while real estate taxes increased due to the timing of final reassessments and property tax refunds received in the first quarter of 2003 for certain properties. Utilities expense decreased due to lower usage in the first quarter of 2004 due in part to the decline in average occupancy.

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General and Administrative

     General and administrative expenses as a percentage of total revenues were approximately 4.2% for the three months ended March 31, 2004 as compared to approximately 3.4% for the same period in 2003. The $900,000 increase in general and administrative expenses was primarily related to higher personnel costs associated with annual merit increases and non-cash compensation expense associated with restricted stock grants issued in 2004 and 2003 as well as higher corporate governance costs in 2004.

Interest Expense

     Interest expense increased approximately $300,000, or 1%, during the three months ended March 31, 2004 as compared to the same period in 2003. This increase was primarily due to lower capitalized interest in 2004, partially offset by lower outstanding debt balances in 2004 as a result of paydowns of our unsecured lines of credit with proceeds from dispositions. Capitalized interest was lower in 2004 as we stopped capitalizing interest on our 6100 Center Drive development property in May 2003.

Depreciation and Amortization

     Depreciation and amortization expense increased by approximately $1.9 million, or 7%, during the three months ended March 31, 2004 as compared to the same period in 2003, primarily due to depreciation related to a property acquired in December 2003 and depreciation related to capital expenditures, tenant improvements and leasing commissions placed in service subsequent to the first quarter of 2003.

Interest and Other Income, net

     Beginning January 1, 2004, we reclassified the operating results of Nextedge, our taxable REIT subsidiary, or TRS, that provides energy consulting services to commercial real estate owners from general and administrative expenses into the interest and other income line item to more clearly present our general and administrative costs as well as the operating results of Nextedge. We also reclassified the operating results of our TRS in the first quarter of 2003 to conform to the 2004 presentation.

     Interest and other income, net increased by approximately $700,000 for the three months ended March 31, 2004 as compared to the same period in 2003, primarily due to net income recognized by Nextedge from a consulting and installation project completed during the first quarter of 2004.

LIQUIDITY AND CAPITAL RESOURCES

Cash Flows

     Cash provided by operating activities decreased by approximately $5.6 million to $43.8 million for the three months ended March 31, 2004 as compared to $49.4 million for the same period in 2003. This decrease was primarily due to the loss of operating cash flows from ten properties sold since the beginning of 2003 as part of our capital recycling program, partially offset by the increased cash flows from a property acquired in the fourth quarter of 2003 and our development property currently being stabilized.

     Cash provided by investing activities increased by approximately $30.6 million to $43.1 million for the three months ended March 31, 2004 as compared to $12.5 million for the same period in 2003. This increase was primarily due to the proceeds from two properties sold in the first quarter of 2004 versus only one property sold in the first quarter of 2003.

     Cash used in financing activities increased by approximately $29.4 million to $79.9 million for the three months ended March 31, 2004 as compared to $50.5 million for the same period in 2003. This increase was primarily due to higher net repayments in 2004 on our unsecured lines of credit from proceeds generated from our capital recycling program.

Available Borrowings, Cash Balance and Capital Resources

     Our Operating Partnership has an unsecured line of credit with a total commitment of $20 million from City National Bank. This line of credit accrues interest at LIBOR + 1.00% or the City National Bank Prime Rate less 0.875% and is scheduled to mature on August 1, 2004. Proceeds from this line of credit are used, among other things, to provide funds for tenant improvements and capital expenditures and provide for working capital and other corporate purposes. As of March 31, 2004, there was $10 million outstanding on this line of credit and $10 million was available for additional borrowings.

     Our Operating Partnership also has an unsecured line of credit with a group of banks led by Wells Fargo. This line of credit provides for borrowings up to $310 million with an option to increase the amount to $350 million and bears interest at a rate ranging between LIBOR + 0.80% and LIBOR + 1.25% (including an annual facility fee ranging from 0.15% to 0.40% based on the aggregate amount of the line of credit) depending on the Operating Partnership’s unsecured debt rating. This line of credit matures in April 2006. In addition, as long as the Operating Partnership maintains an unsecured debt rating of BBB-/Baa3 or better, the agreement contains a competitive bid option, whereby the lenders may bid on the interest rate to be charged for up to $150 million of the unsecured line of credit. The Operating Partnership also has the option to convert the interest rate on this line of credit to the higher of Wells Fargo’s prime rate or the Federal Funds rate plus 0.5%. As of March 31, 2004, $86 million was outstanding on this line of credit and $224 million was available for additional borrowings.

     As of March 31, 2004, we had approximately $32.8 million in cash and cash equivalents, including $21.0 million in restricted cash. Restricted cash consisted of $13.7 million in interest bearing cash deposits required by five of our mortgage loans payable and $7.3 million in cash impound accounts for real estate taxes and insurance as required by several of our mortgage loans payable.

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     We entered into $150 million of forward-starting swaps during 2003 to effectively fix the 10-year Treasury rate at an average rate of approximately 4.1% for borrowings that are anticipated to occur in 2004 to refinance some of our scheduled debt maturities. The forward-starting interest rate swaps were entered into at current market rates and, therefore, had no initial cost.

     In October and November of 2003, we also entered into reverse interest rate swap agreements to float $100 million of the fixed interest rate associated with the 7.00% senior unsecured notes due in November of 2007. Under these reverse swaps, we will receive interest at a fixed rate of 7.00% and pay interest at a variable rate averaging six-month LIBOR in arrears plus 3.10%. These interest rate swaps mature at the same time the notes are due.

     We expect to continue meeting our short-term liquidity and capital requirements generally through net cash provided by operating activities and proceeds from our unsecured lines of credit. We believe the foregoing sources of liquidity will be sufficient to fund our short-term liquidity needs over the next twelve months, including recurring non-revenue enhancing capital expenditures, tenant improvements and leasing commissions.

     We expect to meet our long-term liquidity and capital requirements such as scheduled principal repayments, development costs, property acquisitions, if any, and other non-recurring capital expenditures through net cash provided by operations, refinancing of existing indebtedness and the issuance of long-term debt and equity securities.

Capital Recycling Program

     On February 4, 2004, we sold an approximate 133,000 square foot retail property located in Riverside County for a sales price of approximately $17.0 million. The terms of this sale included an approximate $800,000 guarantee for the future rent and retenanting costs, if necessary, for certain tenants in this property. In addition, we recorded a $400,000 environmental reserve related to the future completion of an environmental review. We recognized this sale net of the guarantee and environmental reserve and will record any subsequent amounts recovered over the next twelve months.

     On March 16, 2004, we sold an approximate 162,000 square foot office property located in Los Angeles County for a gross sales price of approximately $52.5 million.

     The net proceeds from these dispositions were used to reduce the outstanding balance on our Wells Fargo unsecured line of credit.

Debt Summary

     Following is a summary of scheduled principal payments for our total debt outstanding as of March 31, 2004 (in thousands):

         
Year
  Amount
2004
  $ 190,110 (1)
2005
    207,470  
2006
    225,859 (2)
2007
    160,918  
2008
    230,985  
2009
    112,550  
2010
    150,565  
2011
    710  
2012
    768  
2013
    845  
Thereafter
    4,602  
 
   
 
 
Total
  $ 1,285,382  
 
   
 
 


(1)   Includes the $175 million Mortgage Financing 1 loan which was repaid in full on April 9, 2004 with proceeds from our unsecured lines of credit.
 
(2)   Includes $86 million outstanding on our Wells Fargo unsecured line of credit.

     Following is certain other information related to our outstanding indebtedness as of March 31, 2004:

Unsecured and Secured Debt:

                                 
                    Weighted   Weighted
                    Average   Average
    Balance
  Percent
  Interest Rate(1)
  Maturity (in years)
    (000’s)                        
Unsecured Debt
  $ 722,005       56 %     7.00 %     2.9  
Secured Debt
    563,377       44       7.37       3.2  
 
   
 
     
 
     
 
     
 
 
Total Debt
  $ 1,285,382       100 %     7.16 %     3.1  
 
   
 
     
 
     
 
     
 
 

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Floating and Fixed Rate Debt:

                                 
                    Weighted   Weighted
                    Average   Average
    Balance
  Percent
  Interest Rate(1)
  Maturity (in years)
    (000’s)                        
Floating Rate Debt(2)
  $ 146,000       11 %     4.69 %     3.0  
Fixed Debt(3)
    1,139,382       89       7.48       3.1  
 
   
 
     
 
     
 
     
 
 
Total Debt
  $ 1,285,382       100 %     7.16 %     3.1  
 
   
 
     
 
     
 
     
 
 


(1)   Includes amortization of prepaid financing costs.
 
(2)   Includes $100 million of fixed rate debt that has been converted to floating rate through interest rate swap agreements.
 
(3)   Includes $175 million of floating rate debt that has been fixed through interest rate swap agreements.

     Total interest incurred and the amount capitalized was as follows (in thousands):

                 
    Three Months Ended March 31,
    2004
  2003
Total interest incurred
  $ 23,469     $ 24,270  
Amount capitalized
    (156 )     (1,235 )
 
   
 
     
 
 
Amount expensed
  $ 23,313     $ 23,035  
 
   
 
     
 
 

   Consolidated Income Available for Debt Service and Compliance with Principal Financial Covenants

     Consolidated Income Available for Debt Service is a non-GAAP measurement of our performance and liquidity. Consolidated Income Available for Debt Service is presented below because this data is used by investors and our management as a supplemental measure to (a) evaluate our operating performance and compare it to other real estate companies, (b) determine trends in earnings, (c) determine our ability to service debt and (d) determine our ability to fund future capital expenditure requirements. As discussed more fully below, Consolidated Income Available for Debt Service is also used in several financial covenants we are required to satisfy each quarter under the terms of our principal debt agreements.

     Consolidated Income Available for Debt Service permits investors and management to view income from our operations on an unleveraged basis before the effects of non-cash depreciation and amortization expense. By excluding interest expense, Consolidated Income Available for Debt Service measures our operating performance independent of our capital structure and indebtedness and, therefore, allows for a more meaningful comparison of our operating performance between quarters as well as annual periods and to compare our operating performance to that of other companies, and to more readily identify and evaluate trends in earnings.

     The usefulness of Consolidated Income Available for Debt Service is limited because it does not reflect interest expense, taxes, gains or losses on sales of property, losses on valuations of derivatives, asset impairment losses, cumulative effect of a change in accounting principle, extraordinary items as defined by GAAP and depreciation and amortization costs. These costs have been or may in the future be incurred by us, each of which affects or could effect our operating performance and ability to finance our investments at competitive borrowing costs, successfully maintain our REIT status, and acquire and dispose of real estate properties at favorable prices to us. Some of these costs also reflect changes in value in our properties that result from use or changes in market conditions and the level of capital expenditures and leasing costs necessary to maintain the operating performance of our properties. Due to the significance of the net income components excluded from Consolidated Income Available for Debt Service, this measure should not be considered an alternative to (and should be considered in conjunction with) net income, cash flow from operations, and other performance or liquidity measures prescribed by GAAP. This measure should also be analyzed in conjunction with discussions elsewhere in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” regarding the items eliminated in the calculation of Consolidated Income Available for Debt Service.

     The reader is cautioned that Consolidated Income Available for Debt Service, as calculated by us, may not be comparable to similar measures reported by other companies (under names such as or similar to Consolidated Income Available for Debt Service, EBITDA or adjusted EBITDA) that do not define this measure exactly the same as we do.

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     The following is a reconciliation of net cash provided by operating activities and net income computed in accordance with GAAP to Consolidated Income Available for Debt Service (in thousands):

                 
    Three Months Ended
    March 31,
    2004
  2003
Net cash provided by operating activities
  $ 43,842     $ 49,430  
Add:
               
Interest expense
    23,313       23,035  
Less:
               
Amortization of loan costs and fees
    (1,079 )     (946 )
Amortization of deferred compensation
    (746 )     (389 )
Changes in operating assets and liabilities:
               
Rent and other receivables
    2,057       642  
Deferred rent
    1,637       118  
Prepaid financing costs, expenses and other assets
    533       1,494  
Accounts payable and accrued expenses
    (1,641 )     (3,280 )
Security deposits
    (271 )     128  
 
   
 
     
 
 
Consolidated Income Available for Debt Service
  $ 67,645     $ 70,232  
 
   
 
     
 
 
                 
    Three Months Ended
    March 31,
    2004
  2003
Net Income
  $ 18,861     $ 15,438  
Add:
               
Interest expense
    23,313       23,035  
Depreciation and amortization
    30,276       28,408  
Minority interest
    1,382       1,438  
Minority interest from discontinued operations
    186       60  
Depreciation from discontinued operations
    56       1,214  
Loss on sale of discontinued properties
          639  
Less:
               
Gain on sale of discontinued properties
    (6,429 )      
 
   
 
     
 
 
Consolidated Income Available for Debt Service
  $ 67,645     $ 70,232  
 
   
 
     
 
 

     Consolidated Income Available for Debt Service is also presented because it is used in ratios contained in the principal financial covenants of the Indenture governing our publicly traded senior unsecured notes and our Credit Agreement with a syndicate of banks led by Wells Fargo. As of March 31, 2004, our senior unsecured notes represented approximately 39% of our total outstanding debt and amounts outstanding under our Wells Fargo unsecured line of credit represented approximately 7% of our total outstanding debt. The Consolidated Income Available for Debt Service ratios and the other ratios reported below are part of financial covenants we are required to satisfy each fiscal quarter. We believe information about these ratios is useful to (1) confirm that we are in compliance with the financial covenants of our principal loan agreements, (2) evaluate our ability to service our debt, (3) evaluate our ability to fund future capital expenditures, and (4) compare our ratios to other real estate companies, including other REITs, that present the same ratios.

     If we were to fail to satisfy these financial covenants, we would be in default under the terms of the Indenture for the senior unsecured notes and/or the Wells Fargo Credit Agreement. A default under those agreements could accelerate the obligation to repay such debt and could cause us to be in default under our other debt agreements. Depending on the circumstances surrounding such acceleration, we might not be able to repay the debt on terms that are favorable to us, or at all, which could have a material adverse affect on our financial condition and our ability to raise capital in the future.

     The reader is cautioned that these ratios, as calculated by us, may not be comparable to similarly entitled ratios reported by other companies that do not calculate these ratios exactly the same as we do. These ratios should not be considered as alternatives to the ratio of earnings to fixed charges.

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     The following table summarizes the principal ratios contained in the financial covenants of our senior unsecured notes and Wells Fargo unsecured line of credit as of March 31, 2004 (in thousands, except percentage and covenant ratio data):

         
Net investment in real estate
  $ 2,581,795  
Cash and cash equivalents
    11,784  
Restricted cash
    21,030  
Accumulated depreciation and amortization
    465,799  
 
   
 
 
Total Gross Assets
  $ 3,080,408  
 
   
 
 
Gross Value of Unencumbered Assets
  $ 1,734,956  
 
   
 
 
Mortgage loans payable(1)
  $ 563,377  
Unsecured lines of credit
    96,000  
Unsecured term loan
    125,000  
Unsecured senior notes, net of discount
    501,005  
 
   
 
 
Total Outstanding Debt
  $ 1,285,382  
 
   
 
 
Consolidated Income Available for Debt Service(2)
  $ 269,950  
 
   
 
 
Interest incurred(2)
  $ 95,462  
Loan fee amortization(2)
    (3,722 )
 
   
 
 
Debt Service(2)
  $ 91,740  
 
   
 
 
             
Covenant Ratios
  Test
  Actual
Ratio of Consolidated Income Available for Debt Service to Debt Service
  Greater than 1.5     2.9  
Ratio of Consolidated Income Available for Debt Service to interest expense
  Greater than 2.0     3.0  
Ratio of Consolidated Income Available for Debt Service to fixed charges(3)
  Greater than 1.75     2.2  
Total Outstanding Debt/Total Gross Assets
  Less than 60%     42 %
Secured Debt/Total Gross Assets
  Less than 40%     18 %
Gross Value of Unencumbered Assets/Unsecured Debt
  Greater than 150%     240 %


(1)   Represents 10 secured loans that are secured by 71 properties in our portfolio.
 
(2)   Represents amounts for the most recent four consecutive quarters. Loan fee amortization excludes discount amortization on senior unsecured notes.
 
(3)   Fixed charges consist of interest costs, whether expensed or capitalized, principal payments on all debt, an amount equal to $0.3125 per quarter multiplied by the weighted average gross leaseable square feet of the portfolio at the end of the period and preferred unit distributions.

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Funds from Operations

     The following table reflects the calculation of our funds from operations for the three months ended March 31, 2004 and 2003 (in thousands):

                 
    Three Months Ended March 31,
    2004
  2003
Funds From Operations:(1)
               
Net income
  $ 18,861     $ 15,438  
Depreciation and minority interest from discontinued operations
    242       1,274  
(Gain) loss on sale of discontinued properties
    (6,429 )     639  
Depreciation and amortization
    30,276       28,408  
Minority interest
    1,382       1,438  
Distribution on Preferred Operating Partnership Units
    (1,078 )     (1,078 )
 
   
 
     
 
 
Funds From Operations(2)
  $ 43,254     $ 46,119  
 
   
 
     
 
 
Weighted average common shares and Operating Partnership units outstanding – Diluted
    66,910       64,843  
 
   
 
     
 
 


(1)   We believe that funds from operations, or FFO, is a useful supplemental measure of our operating performance. We compute FFO in accordance with standards established by the White Paper on FFO approved by the Board of Governors of the National Association of Real Estate Investment Trusts, or NAREIT, in April 2002. The White Paper defines FFO as net income or loss computed in accordance with generally accepted accounting principles, or GAAP, excluding extraordinary items, as defined by GAAP, and gains and losses from sales of depreciable operating property plus real estate-related depreciation and amortization and after adjustments for unconsolidated partnerships and joint ventures.
 
    We believe that FFO, by excluding depreciation costs, the gains or losses from the sale of operating real estate properties and the extraordinary items as defined by GAAP, provides an additional perspective on our operating results. However, because these excluded items have a real economic effect, FFO is a limited measure of performance.
 
    FFO captures trends in occupancy rates, rental rates and operating costs. FFO excludes depreciation and amortization costs and it does not capture the changes in value in our properties that result from use or changes in market conditions or the level of capital expenditures and leasing costs necessary to maintain the operating performance of our properties, all of which are significant economic costs. Therefore, its ability to measure performance is limited.
 
    Because FFO excludes significant economic components of net income determined in accordance with GAAP, FFO should be used as an adjunct to net income and not as an alternative to net income. FFO should also not be used as an indicator of our financial performance, or as a substitute for cash flow from operating activities determined in accordance with GAAP or as a measure of our liquidity. FFO is not by itself indicative of funds available to fund our cash needs, including our ability to pay dividends or service our debt.
 
    FFO is used by investors to compare our performance with other REITs. Other REITs may use different methods for calculating FFO and, accordingly, our FFO may not be comparable to other REITs.
 
(2)   Includes $746,000 and $389,000 in non-cash compensation expense for the three months ended March 31, 2004 and 2003, respectively.

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Portfolio and Lease Information

     The following tables set forth certain information regarding our properties as of March 31, 2004.

PORTFOLIO SUMMARY
As of March 31, 2004

                                                                 
                                                    Property Operating
                                                    Results(1)
    Number of   Number of   Approximate Net   Three Months Ended
Location
  Properties
  Buildings
  Rentable (Sq. Ft.)
  March 31, 2004
                                                    (in thousands and
                                                    unaudited)
    Total
  % of Total
  Total
  % of Total
  Total
  % of Total
  Total
  % of Total
Los Angeles County
                                                               
West(2)
    29       23 %     31       15 %     4,720,354       26 %   $ 26,851       38 %
North
    27       21 %     43       21 %     3,149,186       17 %     10,331       15 %
South
    16       13 %     21       10 %     3,057,925       17 %     9,504       13 %
 
   
 
     
 
     
 
     
 
     
 
     
 
     
 
     
 
 
Subtotal
    72       57 %     95       46 %     10,927,465       60 %     46,686       66 %
Orange County
    23       18 %     56       27 %     3,676,119       20 %     11,699       17 %
San Diego County
    26       20 %     41       19 %     2,958,628       16 %     9,489       13 %
Ventura/Kern Counties
    6       5 %     17       8 %     778,363       4 %     2,508       4 %
 
   
 
     
 
     
 
     
 
     
 
     
 
     
 
     
 
 
Total
    127 (3)     100 %     209 (3)     100 %     18,340,575 (3)     100 %   $ 70,382       100 %
 
   
 
     
 
     
 
     
 
     
 
     
 
     
 
     
 
 


(1)   Excludes the operating results of two properties sold in the first quarter of 2004 and one property currently classified as held for disposition. The operating results for these properties are reported as part of discontinued operations in our quarterly operating results.
 
(2)   Includes a retail property with approximately 37,000 net rentable square feet.
 
(3)   Including one development property currently under lease-up, our total portfolio consists of 128 properties with 210 buildings and approximately 18.6 million rentable square feet.

PORTFOLIO OCCUPANCY AND IN-PLACE RENTS
As of March 31, 2004

                                 
    Percent   Percent   Annualized Base Rent
Location
  Occupied
  Leased
  Per Leased Square Foot(1)
                    Portfolio   Full Service
                    Total
  Gross Leases(2)
Los Angeles County
                               
West
    91.2 %(3)     94.6 %(3)   $ 27.84     $ 27.85  
North
    88.3 %     90.0 %     21.79       22.73  
South
    86.3 %     88.3 %     19.03       20.11  
 
   
 
     
 
     
 
     
 
 
Subtotal
    89.0 %     91.5 %   $ 23.75     $ 24.51  
Orange County
    90.3 %     91.1 %     18.72       21.78  
San Diego County
    83.5 %     89.3 %     19.40       23.92  
Ventura/Kern Counties.
    97.0 %     97.7 %     18.89       19.36  
 
   
 
     
 
     
 
     
 
 
Total/Weighted Average
    88.7 %     91.4 %   $ 21.83     $ 23.75  
 
   
 
     
 
     
 
     
 
 


(1)   Based on monthly contractual base rent under existing leases as of March 31, 2004, multiplied by 12 and divided by leased net rentable square feet; for those leases where rent has not yet commenced or which are in a free rent period, the first month in which rent is to be received is used to determine annualized base rent.
 
(2)   Excludes 33 properties and approximately 3.6 million square feet under triple net and modified gross leases.
 
(3)   Excludes a 283,000 net rentable square foot development property under lease-up that is currently 88% leased and 66% occupied as of April 27, 2004.

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TEN LARGEST TENANTS
As of March 31, 2004

                                                 
            Weighted   Percentage of   Percentage of            
            Average   Aggregate   Aggregate            
            Remaining   Portfolio   Portfolio           Annualized
    Number of   Lease Term   Leased   Annualized   Net Rentable   Base Rent
Tenant
  Locations
  in Months
  Square Feet
  Base Rent(1)
  Square Feet
  (in thousands)
State of California
    22       47       2.27 %     2.23 %     381,044     $ 8,161  
Vivendi Universal
    2       73       1.38 %     2.18 %     231,681       7,980  
University of Phoenix
    5       43       0.98 %     0.97 %     163,556       3,546  
Ceridian Corporation
    2       73       0.91 %     0.96 %     152,071       3,507  
Atlantic Richfield
    1       30       0.86 %     0.84 %     143,885       3,061  
Haight, Brown & Bonesteel, LLP
    1       88       0.37 %     0.73 %     61,399       2,689  
State Compensation Insurance Fund
    1       48       0.68 %     0.72 %     113,513       2,656  
Westfield Corporation
    1       97       0.58 %     0.72 %     97,142       2,626  
Boeing
    2       19       1.62 %     0.70 %     272,013       2,565  
Salomon Smith Barney
    5       44       0.45 %     0.65 %     75,194       2,368  
 
   
 
     
 
     
 
     
 
     
 
     
 
 
Total/Weighted Average(2)
    42       51       10.10 %     10.70 %     1,691,498     $ 39,159  
 
   
 
     
 
     
 
     
 
     
 
     
 
 


(1)   Annualized base rent is calculated as monthly contractual base rent under existing leases as of March 31, 2004 multiplied by 12; for those leases where rent has not yet commenced or which are in a free rent period, the first month in which rent is to be received is used to determine annualized base rent.
 
(2)   The weighted average calculation is based on net rentable square footage leased by each tenant.

LEASING ACTIVITY

         
    Three Months Ended
    March 31, 2004
Net Absorption (square feet)
    (270,195 )
 
   
 
 
Gross New Leasing Activity (square feet)
    597,230  
 
   
 
 
Retention Rate
    54.4 %
 
   
 
 
Cash Rent Growth(1):
       
Expiring Rate
  $ 23.12  
 
   
 
 
New / Renewed Rate
  $ 20.51  
 
   
 
 
Decrease
    (11.3 )%
 
   
 
 
GAAP Rent Growth(2):
       
Expiring Rate
  $ 22.29  
 
   
 
 
New / Renewed Rate
  $ 22.19  
 
   
 
 
Decrease
    (0.4 )%
 
   
 
 
Weighted Average Lease Term in Months
    48  
 
   
 
 
Tenant Improvements and Commissions (per square foot):
       
New(3)
  $ 20.34  
 
   
 
 
Renewal
  $ 7.85  
 
   
 
 
Capital Expenditures (per square foot):
       
Recurring
  $ 0.07  
 
   
 
 
Non-recurring
  $ 0.03  
 
   
 
 


(1)   Represents the difference between initial market rents on new and renewed leases as compared to the expiring cash rents on the same space.
 
(2)   Represents estimated cash rent growth adjusted for straight-line rents.
 
(3)   Excludes development space.

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PORTFOLIO DIVERSIFICATION
As of March 31, 2004

                         
                    Percentage of
            Occupied   Total
    NAICS   Square   Occupied
North American Industrial Classification System Description
  Code
  Feet
  Portfolio
Professional, Scientific, and Technical Services
    541       4,230,166       26.04 %
Finance and Insurance
    521-525       2,638,793       16.25 %
Information
    511-519       1,714,889       10.56 %
Manufacturing
    311-339       1,361,066       8.38 %
Health Care and Social Assistance
    621-624       1,087,379       6.69 %
Administrative and Support and Waste Management and Remediation Services
    561-562       730,177       4.50 %
Public Administration
    921-928       737,833       4.54 %
Educational Services
    611       686,744       4.23 %
Real Estate, Rental and Leasing
    531-533       811,035       4.99 %
Wholesale Trade
    423-425       551,309       3.39 %
Transportation and Warehousing
    481-493       395,776       2.44 %
Arts, Entertainment, and Recreation
    711-713       317,788       1.96 %
Construction
    236-238       284,455       1.75 %
Accommodation and Food Services
    721-722       177,529       1.09 %
Other Services (except Public Administration)
    811-814       262,357       1.62 %
Retail Trade
    441-454       110,943       0.68 %
Mining
    211-213       70,641       0.43 %
Management of Companies and Enterprises
    551       29,741       0.18 %
Utilities
    221       8,975       0.06 %
Agriculture, Forestry, Fishing and Hunting
    111-115       6,065       0.04 %
Other – Uncategorized
          29,015       0.18 %
 
           
 
     
 
 
 
            16,242,676       100 %
 
           
 
     
 
 

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LEASE EXPIRATIONS - ANNUAL
As of March 31, 2004

                                                     
                                                2009 and
        2004
  2005
  2006
  2007
  2008
  Thereafter
Los Angeles County:
                                                   
West
  Expiring SF(1)     398,141       674,324       518,602       601,133       511,844       1,689,767  
 
  % of Leased SF(2)     2.38 %     4.03 %     3.09 %     3.59 %     3.05 %     10.08 %
 
  Rent per SF(3)   $ 28.41     $ 28.86     $ 28.94     $ 28.91     $ 30.21     $ 32.89  
North
  Expiring SF(1)     414,515       404,441       428,133       458,041       596,062       504,110  
 
  % of Leased SF(2)     2.47 %     2.41 %     2.56 %     2.73 %     3.56 %     3.01 %
 
  Rent per SF(3)   $ 21.17     $ 23.17     $ 24.22     $ 22.61     $ 24.61     $ 22.35  
South
  Expiring SF(1)     296,285       743,713       319,654       243,098       408,052       673,331  
 
  % of Leased SF(2)     1.77 %     4.44 %     1.91 %     1.45 %     2.44 %     4.02 %
 
  Rent per SF(3)   $ 19.16     $ 15.79     $ 22.48     $ 22.93     $ 21.78     $ 22.10  
 
       
 
     
 
     
 
     
 
     
 
     
 
 
Subtotal –
Los Angeles County
  Expiring SF(1)     1,108,941       1,822,478       1,266,389       1,302,272       1,515,958       2,867,208  
 
  % of Leased SF(2)     6.62 %     10.88 %     7.56 %     7.77 %     9.05 %     17.11 %
 
  Rent per SF(3)   $ 23.23     $ 22.26     $ 25.71     $ 25.58     $ 25.74     $ 28.51  
Orange County
  Expiring SF(1)     453,018       612,580       791,568       563,351       282,407       555,855  
 
  % of Leased SF(2)     2.70 %     3.65 %     4.72 %     3.36 %     1.69 %     3.32 %
 
  Rent per SF(3)   $ 16.87     $ 20.62     $ 20.15     $ 18.59     $ 20.56     $ 23.54  
San Diego County
  Expiring SF(1)     284,218       591,729       427,391       235,538       249,858       778,475  
 
  % of Leased SF(2)     1.70 %     3.53 %     2.55 %     1.41 %     1.49 %     4.65 %
 
  Rent per SF(3)   $ 20.10     $ 19.02     $ 23.49     $ 22.90     $ 25.22     $ 23.01  
All Others
  Expiring SF(1)     135,188       166,966       181,951       50,642       74,604       139,783  
 
  % of Leased SF(2)     0.81 %     1.00 %     1.09 %     0.30 %     0.44 %     0.83 %
 
  Rent per SF(3)   $ 18.66     $ 20.10     $ 20.58     $ 19.77     $ 21.48     $ 18.58  
 
       
 
     
 
     
 
     
 
     
 
     
 
 
Total Portfolio
  Expiring SF(1)     1,981,365       3,193,753       2,667,299       2,151,803       2,122,827       4,341,321  
 
       
 
     
 
     
 
     
 
     
 
     
 
 
 
  % of Leased SF(2)     11.83 %     19.06 %     15.92 %     12.84 %     12.67 %     25.91 %
 
       
 
     
 
     
 
     
 
     
 
     
 
 
 
  Rent per SF(3)   $ 21.02     $ 21.23     $ 23.35     $ 23.32     $ 24.84     $ 26.56  
 
       
 
     
 
     
 
     
 
     
 
     
 
 


(1)   Represents the rentable square footage of expiring leases. For 2004, represents expirations from April 1, 2004 through December 31, 2004, not including month-to-month tenants.
 
(2)   Percentage of total rentable square footage expiring during the period.
 
(3)   Represents annualized ending cash rents of expiring leases.

LEASE EXPIRATIONS - NEXT FOUR QUARTERS
As of March 31, 2004

                                     
        Q2-04
  Q3-04
  Q4-04
  Q1-05
Los Angeles County:
                                   
West
  Expiring SF(1)     65,338       162,536       170,267       124,650  
 
  % of Leased SF(2)     0.39 %     0.97 %     1.02 %     0.75 %
 
  Rent per SF(3)   $ 26.99     $ 27.59     $ 29.73     $ 28.49  
North
  Expiring SF(1)     61,396       121,169       231,950       62,365  
 
  % of Leased SF(2)     0.36 %     0.72 %     1.39 %     0.37 %
 
  Rent per SF(3)   $ 23.74     $ 23.22     $ 19.43     $ 23.22  
South
  Expiring SF(1)     91,826       138,327       66,132       109,358  
 
  % of Leased SF(2)     0.55 %     0.83 %     0.39 %     0.65 %
 
  Rent per SF(3)   $ 18.36     $ 18.82     $ 21.00     $ 17.67  
 
       
 
     
 
     
 
     
 
 
Subtotal –
Los Angeles County
  Expiring SF(1)     218,560       422,032       468,349       296,373  
 
  % of Leased SF(2)     1.30 %     2.52 %     2.80 %     1.77 %
 
  Rent per SF(3)   $ 22.45     $ 23.46     $ 23.39     $ 23.39  
Orange County
  Expiring SF(1)     100,416       127,374       225,228       148,446  
 
  % of Leased SF(2)     0.60 %     0.76 %     1.34 %     0.89 %
 
  Rent per SF(3)   $ 20.68     $ 19.39     $ 13.76     $ 18.94  
San Diego County
  Expiring SF(1)     74,280       117,518       92,420       144,966  
 
  % of Leased SF(2)     0.44 %     0.70 %     0.56 %     0.86 %
 
  Rent per SF(3)   $ 20.99     $ 24.37     $ 13.94     $ 21.90  
All Others
  Expiring SF(1)     10,257       27,275       97,656       44,137  
 
  % of Leased SF(2)     0.07 %     0.16 %     0.58 %     0.26 %
 
  Rent per SF(3)   $ 18.20     $ 19.33     $ 18.53     $ 19.67  
 
       
 
     
 
     
 
     
 
 
Total Portfolio
  Expiring SF(1)     403,513       694,199       883,653       633,922  
 
       
 
     
 
     
 
     
 
 
 
  % of Leased SF(2)     2.41 %     4.14 %     5.28 %     3.78 %
 
       
 
     
 
     
 
     
 
 
 
  Rent per SF(3)   $ 21.64     $ 22.70     $ 19.41     $ 21.75  
 
       
 
     
 
     
 
     
 
 


(1)   Represents the square footage of expiring leases, not including month-to-month tenants.
 
(2)   Percentage of total rentable square footage expiring during the period.
 
(3)   Represents annualized ending cash rents of expiring leases.

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DEVELOPMENT SUMMARY
As of March 31, 2004

                                                                         
                                                    Estimated        
                                                    Year 1        
                                                    Stabilized        
            Costs                                   Cash Property   Estimated   Estimated
            Incurred   Estimated   Percent   Shell   Estimated   Operating   Year 1   Year 1
    Square   To Date   Total Cost(1)   Leased at   Completion   Stabilization   Results   Annual   Annual
Property
  Feet
  (in thousands)
  (in thousands)
  4/27/04
  Date
  Date
  (in thousands)
  Cash Yield
  GAAP Yield(2)
Howard Hughes Center:
                                                                       
6100 Center Drive
    283,000     $ 77,778     $ 81,500       88 %   2nd Qtr 2002   2nd Qtr 2004   $ 6,450       7.9 %     8.9 %
 
   
 
     
 
     
 
     
 
   
 
 
 
     
 
     
 
     
 
 


(1)   Estimated total cost includes purchase and closing costs, capital expenditures, tenant improvements, leasing commissions and carrying costs during development, as well as an allocation of land and master plan costs. We have entitlements to construct an additional approximately 475,000 net rentable square feet of office space and have two parcels entitled for hotel developments for up to 600 hotel rooms at the Howard Hughes Center.
 
(2)   Estimated Year 1 Annual GAAP Yield includes an adjustment for straight-line rents.

     In addition to the property above, we have preliminary architectural designs completed for additional build-to-suit projects at the Howard Hughes Center totaling approximately 475,000 net rentable square feet of office space. We also have construction entitlements at the Howard Hughes Center for up to 600 hotel rooms. Build-to-suit projects consist of properties constructed to the tenant’s specifications in return for the tenant’s long-term commitment to the property. We do not intend to commence construction on any additional build-to-suit or multi-tenant projects at the Howard Hughes Center until development plans and budgets are finalized with terms allowing us to achieve yields commensurate with the project’s development risk.

     In addition to our development at the Howard Hughes Center, we have completed preliminary designs and are marketing an approximate 170,000 square foot build-to-suit office building at our Long Beach Airport Business Park. Also, as part of our Gateway Towers acquisition in August 2002, we acquired a 5-acre developable land parcel in Torrance, California that we intend to market for a build-to-suit office building. We currently do not intend to commence construction on these projects until build-to-suit tenant leases are signed with terms allowing us to achieve yields commensurate with the project’s development risk.

     We expect to finance our development activities over the next 24 months through net cash provided by operating activities, proceeds from asset sales, proceeds from our unsecured lines of credit or other secured borrowings.

Item 3. Quantitative and Qualitative Disclosure about Market Risk

     Market risk is the exposure or loss resulting from changes in interest rates, foreign currency exchange rates, commodity prices and equity prices. The primary market risk to which we are exposed is interest rate risk, which is sensitive to many factors, including governmental monetary and tax policies, domestic and international economic and political considerations and other factors that are beyond our control.

Interest Rate Risk

     In order to modify and manage the interest characteristics of our outstanding debt and limit the effects of interest rates on our operations, we use a variety of financial instruments, including interest rate swaps, caps, floors and other interest rate exchange contracts. The use of these types of instruments to hedge our exposure to changes in interest rates carries additional risks such as counter-party credit risk. We do not enter into any transactions for speculative or trading purposes. During 2002, we entered into interest rate swap agreements fixing the interest rates on variable debt with notional amounts totaling $175.0 million. During 2003, we entered into $150 million of forward-starting swap agreements fixing the 10-year Treasury rate for borrowings that are anticipated to occur in 2004 to refinance some of our scheduled debt maturities. In October and November of 2003, we also entered into reverse interest rate swap agreements to float $100 million of the fixed interest rate associated with the 7.00% senior unsecured notes due in November 2007.

     Some of our future earnings, cash flows and fair values relating to financial instruments are dependent upon prevailing market rates of interest, such as LIBOR. Based on interest rates and outstanding balances as of March 31, 2004, a 1% increase in interest rates on our $146.0 million of floating rate debt would decrease annual future earnings and cash flows by approximately $1.5 million and would not have an impact on the fair value of the floating rate debt. Conversely, a 1% decrease in interest rates on our $146.0 million of floating rate debt would increase annual future earnings and cash flows by approximately $1.5 million and would not have an impact on the fair value of the floating rate debt. The weighted average interest rate on our floating debt as of March 31, 2004 was 4.69%.

     Our fixed rate debt totaled $1,139.4 million as of March 31, 2004 with a weighted average interest rate of 7.48% and a total fair value of approximately $1,210.7 million. A 1% decrease in interest rates would increase the fair value of our fixed rate debt by approximately $32.8 million and would not have an impact on future earnings and cash flows. A 1% increase in interest rates would decrease the fair value of our fixed rated debt by approximately $31.3 million and would not have an impact on future earnings and cash flows.

     These amounts are determined by considering the impact of hypothetical interest rates on our borrowing cost. These analyses do not consider the effects of the reduced level of overall economic activity that could exist in that environment. Further, in the event of a change of this magnitude, we would consider taking actions to further mitigate our exposure to the change. Due to the uncertainty of the specific actions that would be taken and their possible effects, however, this sensitivity analysis assumes no changes in our capital structure.

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Item 4. Controls and Procedures

     We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and our Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, our management was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Our disclosure controls and procedures are designed to provide a reasonable level of assurance of reaching our desired disclosure control objectives. Also, we have an investment in an unconsolidated entity. Because we do not control or manage this entity, our disclosure controls and procedures with respect to such entity is necessarily substantially more limited than those we maintain with respect to our consolidated subsidiaries.

     As required by SEC Rule 13a-15(b), we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the first quarter of 2004 covered by this report. Based on the foregoing, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective and were operating at the reasonable assurance level.

     There has been no change in our internal controls over financial reporting during our most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal controls over financial reporting.

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Part II OTHER INFORMATION

Item 1. Legal Proceedings

     We are presently subject to various lawsuits, claims and proceedings arising in the ordinary course of business, none of which if determined unfavorably to us is expected to have a material adverse effect on our cash flows, financial condition or results of operations. There were no material changes in our legal proceedings during the three months ended March 31, 2004.

Item 2. Changes in Securities — None

Item 3. Defaults Upon Senior Securities — None

Item 4. Submission of Matters to a Vote of Security Holders — None

Item 5. Other Information — None

Item 6. Exhibits and Reports on Form 8-K

  (a)   Exhibits

     
10.46*
  Second Amended and Restated Agreement of Limited Partnership of Arden Realty Limited Partnership, dated September 7, 1999, filed as an exhibit to Arden Realty’s quarterly report on Form 10-Q filed with the Commission on November 15, 1999.
 
   
10.47*
  Admission of New Partners and Amendment to Limited Partnership Agreement entered into as of the 20th day of December, 2000, by and between Arden Realty Limited Partnership and the persons identified as the “New Partners” therein, filed as an exhibit to Arden Realty Limited Partnership’s annual report on Form 10-K filed with the Commission on March 30, 2001.
 
   
10.48*
  Second Amendment to Limited Partnership Agreement entered into as of September 13, 2003, by Arden Realty Limited Partnership, filed as an exhibit to Arden Realty Limited Partnership’s quarterly report on Form 10-Q filed with the Commission on November 13, 2003.
 
   
31.1
  Officers’ certifications pursuant to Rule 13a–14(a) or Rule 15d–14(a).
 
   
32.1
  Officers’ certifications pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.(1)


(*)   Incorporated by reference.
 
(1)   In accordance with SEC Release No. 33-8212, the following exhibit is being furnished, and is not being filed as part of this Report or as a separate disclosure document, and is not being incorporated by reference into any Securities Act of 1933 registration statement.

  (b)   Reports on Form 8-K

     On February 5, 2004, we filed a report on Form 8-K (Item 12) relating to our financial information for the quarter ended December 31, 2003 as presented in a press release dated February 4, 2004 attached to the report.

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SIGNATURES

     Pursuant to the requirements of the Securities and Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

             
    ARDEN REALTY, INC.
 
           
Date: May 7, 2004
  By:   /s/ Andrew J. Sobel    
     
 
   
      Andrew J. Sobel    
      Executive Vice President - Strategic Planning and Operations    
 
           
Date: May 7, 2004
  By:   /s/ Richard S. Davis    
     
 
   
      Richard S. Davis    
      Senior Vice President and Chief Financial Officer    

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