Given the turmoil that shook credit markets and the economy in 2008, KRC turned in a strong performance in many respects, most notably leasing. But 2009 promises to be even more challenging and we remain carefully focused on the fundamentals of our business: leasing success, financial strength and tenant service.

A Stand-Out Performance in Leasing. Throughout 2008, we capitalized on our portfolio's strengths, including highly desirable locations in coastal Southern California and recently developed, richly amenitized properties, to attract new tenants and retain existing ones.   

By year-end, we had executed new or renewing leases on more than 2.1 million square feet of space-a 25% increase over 2007 resultsat rental rates that exceeded existing lease terms by 25% on a GAAP basis and 9% on a cash basis. This effort reduced by almost half the roughly two million square feet of space in our stabilized portfolio that was set to expire in 2009.

Our leasing success, coupled with contributions from recently completed development projects, contributed to improvement in several financial measures. Total revenues in 2008 rose 12.2%, to $290 million and funds from operations grew 7.6%, to $119 million, or $3.42 per share. Across our entire stabilized portfolio, office rents increased 36% on a GAAP basis and 18% on a cash basis. Industrial rents rose 24% on a GAAP basis and 1% on a cash basis.

Occupancy Nonetheless Declined Throughout the Year. As economic uncertainty deepened in 2008, businesses postponed almost all non-essential real estate decisions.  

We felt the impact in a steadily declining occupancy rate in our stabilized portfolio. By year-end, our stabilized occupancy was just over 89%, down nearly five percentage points from the beginning of 2008. Most of the change occurred in office occupancy, which fell to 86% at year-end. Industrial occupancy held steady at 96%.  

Largely as a result of lower occupancy, our operating profits noticeably weakened as we approached the end of 2008. For the year, same store net operating income was flat on a GAAP basis and up 3.1% on a cash basis. But both figures were negative in the fourth quarter.  

Disciplined Execution in Development Increased Our Portfolio. We delivered just over 560,000 square feet of new and newly redeveloped office space to our stabilized portfolio during the year. These five projects represent an aggregate investment of approximately $163 million and are currently 75% leased.

In the third quarter, Scripps Health took occupancy of a newly developed, 146,000 square-foot office and medical facility in our Innovation Corporate Center, located along the I-15 corridor in the Rancho Bernardo submarket of San Diego County.

The redevelopment of a 107,000 square-foot office building at Kilroy Airport Center in El Segundo was also added to the stabilized portfolio in the third quarter. DirecTV, an existing tenant, expanded into the entire space.

In the fourth quarter, we delivered a third office building totaling 148,000 square feet at our Kilroy Sabre Springs office campus located at the intersection of the I-15 corridor and Route 56, east of Del Mar. The new building is 100% leased to Bridgepoint Education.

We also stabilized our newly renovated two-building office campus at Sabre Springs Corporate Center in Rancho Bernardo and a newly developed office building in our Sorrento Gateway campus during the fourth quarter, while completing construction on our one remaining committed development project, a medical office building also located in Sorrento Gateway. These three projects together total approximately 210,000 square feet and are the focal point of our development leasing program in 2009.

Future development opportunities will come from our pipeline of just over 116 acres of entitled land located in five highly attractive submarkets of coastal San Diego. This year, we expect to focus our development efforts on the enhancement of these properties' entitlement rights-reaching for the broadest and most flexible range of potential uses to capture opportunities as they emerge.

Financial Strength Proved to be an Invaluable Asset. During a year marked by increasingly dysfunctional credit markets, we learned the real value of our long-standing commitment at KRC to financial strength and conservative leverage. Throughout 2008, we managed our balance sheet with an emphasis on simplicity, transparency and liquidity.

We ended the year with just under $300 million of committed available debt capacity on our $550 million credit line. This line runs to April 2010 with a one-year extension option to April 2011. We have only one loan maturing in 2009, a $75 million ten-year mortgage that will likely be paid off using our credit line.

Looking Forward: Challenging Markets Favor Quality Assets. With our national and regional economies mired in recession and most credit markets still severely constrained, we've now entered a much more difficult period for commercial real estate in Southern California. Lease negotiations are likely to remain slow and protracted. Businesses will demonstrate extreme caution in taking on new real estate obligations. Landlords may experience serious credit issues among existing tenants.

At this point in a real estate cycle, quality assets, supported by solid execution and financial strength, inevitably outperform.

At KRC, we approach 2009 from a position of strength. Our portfolio is largely constituted of young, thoughtfully designed and highly amenitized properties, all located in very desirable and historically economically vibrant submarkets of Southern California.

To these property advantages, we bring KRC's relentless focus on excellence-in leasing, in property management, in tenant relations, in long-term planning.

Our top priority this year is to once again out-perform the market in leasing. We will use our portfolio advantages to capture demand as it materializes, and to strengthen and possibly expand our relationships with existing tenants.

We will continue to emphasize liquidity, disciplined cost control and conservative leverage in all of our financial decisions. We want plenty of dry powder as the business cycle evolves and new development or acquisition opportunities emerge.

And we will, of course, remain vigilant to potential problems that may develop in our stabilized portfolio, acting with speed and care to minimize their impact.

Given the unprecedented nature and heightened uncertainties associated with our current economic situation, resilience is perhaps the most valuable asset a business can have today. I am confident that KRC has the necessary resilience, whatever the new year brings. I see it in the quality of our assets, the strength of our financial position, and the talent and experience of our management team.

As always, I thank you for your continued support. 

Cordially,

John B. Kilroy, Jr.

Chairman and CEO