Developer Saddled With Big Vacancy

The block-long Westside Media Center on Olympic Boulevard is a fitting symbol of an economy in retreat thanks in part to the lingering effects of the dot-com implosion.

While construction workers toil away on the project's $54 million, 156,000-square-foot third phase, to be completed early next year, not a single tenant deal has been signed, or is close to signing.

Meanwhile, the 156,000-square-foot second phase sits empty since eToys Inc. went bust and vacated it last spring. (The decades-old first phase is occupied by AT & T; National Digital Television.)

Owner/developer Kilroy Realty Corp. has been taking a $650,000 monthly hit as a result of its former tenant, and that exposure will double once the third phase is done, Kilroy representatives confirmed.

"Ooooff, that's painful," said Ian Strano, a veteran Westside broker with First Property Realty Corp.

"We're trying to stir up activity, to be attractive to potential tenants, but there has been progressively less demand this year," said Hunt Barnett, leasing agent for the Westside Media Center.

Indeed, the office vacancy rate in the West L.A./East Santa Monica submarket has skyrocketed from 2.7 percent a year ago to 15.3 percent as of Sept. 30, according to Grubb & Ellis Co. With available sublease space added in, the rate is above 20 percent, and climbing rapidly.

Against that backdrop, Kilroy must fill 312,000 square feet of space. It's a dilemma facing other major developers around Los Angeles stuck with surplus space as a result of the failure of so many Internet-related firms, along with the general slowing of the economy. eToys, arguably L.A.'s brightest Internet star just two years ago, landed with a thud when it could not generate enough revenues to bankroll what had become a costly operation.

Kilroy refused to let eToys cash out of its lease, waiting for it to default, and then drawing down the $15 million letters of credit that eToys had put up as collateral. The space has sat empty ever since.

Several brokers compared Kilroy's decision unfavorably to Arden Realty Inc., which faced a similar situation at its Howard Hughes Center in El Segundo.

Arden's dot-bomb, iXL, hit the wall just a few months after signing an expensive long-term lease. But Arden agreed to let iXL cash out, and then quickly re-leased that space at a somewhat lower rent to Havas Interactive, a unit of Vivendi Universal. Havas, now renamed Vivendi Universal Interactive Publishing, has greatly expanded and is now an anchor tenant at Howard Hughes Center.

Kilroy's decision to hold firm on its asking rents has generated some second-guessing in real estate circles, given the deterioration of Westside market conditions. Westside rents have been falling rapidly, as much as 15 to 25 percent since the Sept. 11 attacks, by some broker accounts.

"They're trying to get $3.25 a foot (per month) in a market that's more like $2.75 a foot," said one Westside tenant broker. "Tenants know the market is falling and that time is on their side. And landlords, including Kilroy, have been slow to adjust."

Kilroy Executive Vice President Hugh Greenup insisted that several possible deals are "under discussion now, some of which should be complete in the next 60 to 90 days."

That remains to be seen. And beyond filling space, Kilroy must also deal with the remnants of eToys. While the company is dead and gone, its bankruptcy case remains very much alive. The bankruptcy estate is contemplating a move to recoup some of the $15 million that Kilroy took when eToys went bust.

The money was in the form of two $7.5 million letters of credit that eToys put up as collateral to secure its $80 million, 11-year lease and tenant improvements.

Today, nine months after eToys' demise, several parties agree that Kilroy likely incurred at least $15 million in damages as a result of the e-tailer's collapse. But some of those parties argue that Kilroy did not exert a reasonable amount of effort to replace the tenant. Therefore, eToys' creditors should be entitled to a multimillion-dollar refund.

"There is no reason that claim could not be pursued by the estate," said Gregory Werkheiser, the Wilmington, Del. attorney handling eToys' bankruptcy. "I don't want to disclose confidential information about how we plan to proceed. A plan has not yet been filed with the court."

Kilroy's attorney, Anton "Tony" Natsis, said the developer is ready to do battle to keep its $15 million payout. "I suppose there is some chance (eToys' estate) would still like to fight about it, and that would be fine. We would be very comfortable doing that," Natsis said.

Company-wide performance

The publicly traded real estate investment trust, whose stock is traded on the New York Stock Exchange, has 963,500 square feet of projects under development in Southern California all scheduled for completion next year.

"It's pretty clear that Kilroy is having difficulty leasing up its new developments," said Lee Schalop, an analyst at Banc of America Securities LLC who this month downgraded Kilroy's stock from "buy" to "market perform." "That's the same as 'hold,'" Schalop said.

Kilroy reported third-quarter net income of $9.3 million, compared with $15.7 million in the year-earlier quarter. Its funds from operations were $20.5 million, down from $21.1 million.

Even so, the company has $36.5 million in cash, restricted and unrestricted, and almost twice as much in assets as in liabilities. Its stock last week was trading at $25 a share, firmly between its 52-week low of $22.80 and high of $29.25. And it has a 7.7 percent annual dividend yield.

And it's not as if the developer hasn't come close in finding tenants for the Westside Media Center.

A couple months ago, it was in advanced talks to lease an entire building to the Warner Music Group, with an option to expand into the second building as well, in a 300,000-square-foot-plus consolidation of Warner's Westside and Burbank music operations. (Sony Music and Universal Music Group already have consolidated their respective operations into projects about a mile west of Kilroy's Westside Media Center.)

But the Warner Music deal unraveled when parent company AOL Time Warner Inc. missed its second-quarter earnings target.

In the long run, Kilroy and its Westside Media Center will almost certainly weather the current storm. The future supply of Westside office space is severely constrained due to a lack of available land and growth restrictions. And demand will undoubtedly return, although probably not for months to come.

For reprint and licensing requests for this article, CLICK HERE.