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Kimco Realty Corporation (NYSE:KIM)

Q4 2007 Earnings Call

February 6, 2008 11:00 am ET

Executives

Barbara Pooley - VP of IR

Milton Cooper - Chairman and CEO

Dave Henry - CIO

Mike Flynn - Vice Chairman and President

Mike Pappagallo - CFO

David Lukes - EVP

Analysts

Christine McElroy - Banc of America

Dave Fick - Stifel Nicolaus

Christeen Kim - Deutsche Bank

Ambika Goel - Citigroup

Michael Mueller - JP Morgan

Thomas Baldwin - Goldman Sachs

Jeff Donnelly - Wachovia

Jeffrey Spector - UBS

Steve Sakwa - Merrill Lynch

Steven Rodriguez - Lehman Brothers

Jim Sullivan - Green Street Advisors

Rich Moore - RBC Capital Markets

Operator

Good morning, ladies and gentlemen, and welcome to the Kimco's fourth quarter Earnings Call. Please be aware that today's conference is being recorded. As a reminder, our lines are in a muted status to prevent background noise. After the speakers' remarks, there will be a formal question-and-answer session. (Operator Instructions) At this time, it is my pleasure to introduce today's speaker, Ms. Barbara Pooley. Please go ahead, ma'am.

Barbara Pooley

Thank you, Anthony. Thank you all for joining the fourth quarter 2007 Kimco earnings call. With me in the call this morning are Milton Cooper, Chairman and CEO; Dave Henry, Chief Investment Officer; Mike Flynn, Vice Chairman and President; Mike Pappagallo, Chief Financial Officer; and David Lukes, Executive Vice President. Other key executives are also available to take your questions at the conclusion of our prepared remarks.

As a reminder, statements made during the course of this call represent the company and management's hope, intentions, beliefs, expectations or projections of the future which are forward-looking statements. It is important to note that the company's actual results could differ materially from those projected in such forward-looking statements. Information concerning factors that could cause actual results to differ materially from those forward-looking statements is contained in the company's SEC filings.

During this presentation, management may make reference to certain non-GAAP financial measures that we believe help investors better understand Kimco's operating results. Examples include but are not limited to funds from operations and net operating income. Reconciliations of these non-GAAP financial measures are also available on our website.

Finally, during the Q&A portion of the call, we request that you respect the limit of two questions with appropriate follow-up, so that all of our callers have an opportunity to speak with management. Feel free to return to the queue if you have additional questions.

I'll now turn the call over to Mike Pappagallo.

Mike Pappagallo

Thank you, Barbara, and good morning. As unsettling of feeling as we had during the third quarter earning season with the industry reporting good earnings in the face of a nasty credit market and investors running for the hills, the last three months have created even more heartburn as stock prices has decoupled from all reasonable estimates of asset value.

The Kimco team like all REIT management has another challenge to deal with. To not allow an avalanche of negative sentiment and the piling on effects of bad news and its effect on stock prices to distract us from pursing our strategies for long-term growth and value. For sure, the current market and economic conditions are not good and wants skillful navigation, which compels us to use our flexible business model for maximum advantage.

At this juncture, we continue to be focused primarily on protecting and maximizing cash flow from existing assets, maintaining balance sheets flexibility and carefully evaluating opportunities, so as to allocate our investment dollars to capture returns that compensate us for an increasing risk premium attached to our capital costs.

First, some comments on 2007. It was an outstanding year from a financial and operational standpoint as evidenced by growth and our investment platforms in both the US and Mexico, and capturing handsome profits in our capital services business. We finished the year as expected with a 17% year-over-year increase in FFO per share to $2.59, which is at the upper range of guidance provided to the investment and analyst community throughout much of 2007 and at the full-year consensus.

With respect to some of the notes this morning about the fourth quarter consensus mix, I just wanted to point out the difference between $2.59 and the nine-month FFO of $2.06 comes to $0.53. It is unfortunate that the first [quarter $0.45] is mathematically challenged.

Acquisition volume excluding transfer of the money between Kimco and the joint venture has exceeded $2.2 billion. We started 10 new Mexican developments with an estimated project cost of $275 million as well as 11 US projects with an estimated cost of $225 million. Like the rest of the market, our US activity was skewed to the first half of the year, whereas the Mexico investment program continued at an even pace throughout the year.

As to our current focus, allow me to comment further on each of the three areas I mentioned a minute ago. First, with respect to our existing asset base, I would underscore the stability in quality of the portfolio. Occupancy closed the year at 96.3%, internal growth for the quarter was 4.1% representing the eight quarter in a row of 4% of better same store growth, spread on new leases for the quarter was over 23% and when combined with renewals showed growth of over 13%.

We'd be kidding ourselves to pretend that a recession in the US will not have an affect on portfolio occupancy and rollover, but we feel it will be limited because of the quality and diversity of that portfolio and generally below market grant positions.

Another reason to be confident that we can withstand economic stress in the US is the balance sheet flexibility and liquidity we have in place, resulting from the actions taken over the past few months to extend our various credit facility and bolster our equity base with the new preferred stock series. But also benefiting from the actions taken over the past few years to space out debt maturities on both the Kimco balance sheet as well as our joint ventures and fund programs.

Our annual debt maturities, as a percentage of total debt outstanding range between 8% and 11% per year over the next three years, which includes the pro rata portion of the debt in our joint ventures, also, the maturating debt that is of the non-recourse mortgage variety. The loan-to-value of the mortgage is to be refinanced are only about 45%, giving us further confidence of the ability to access external capital even if the CNBS market remains in a deep freeze during an extended period of time. And the final point, using the liquidity to invest wisely and opportunistically will require us to be both patient and move quickly at the same time.

We feel very confident about our ability of our portfolio and our recurring management fee stream to withstand its downturn. We're also encouraged by our non-US business activity and potential. We're patient and discipline will be required as in the core asset-oriented investment funds in the US as well as ground-up development.

Countering that are the opportunities in new investments in prepriced debt and equity, where we can use our experience and relationships to evaluate the long-term value of the underlying assets or business and to move quickly to capitalize on any mispricing.

Finally, at the 2008 earnings guidance, we previously offered a range of $2.70 to $2.78 per share representing an increase of between 4% and 7% and we are maintaining those estimates. As always, the variable is a nature and extended transactional activity mostly in our capital services business. We recognize that our estimate always contemplates the realization of embedded value in our asset base, in retailer services Kimco Select and Preferred Equity and other trading activity.

A dramatic example this past year included $78 million contribution to FFO from our investment in Albertson's or almost $0.30 per share, which was significantly more than we expected from the first year of this investment. Recognizing that the earnings growth comes from the combination of our in-place shopping center holdings, funds management, new business generation, profits from merchant building and the capital services business, we had outlined each of the major assumptions in our earnings press release that build to this estimate essentially breaking down the EBITDA components between the major sources with relative contributions from in-place cash flow streams versus new business generation and other transactional activity.

Regardless of our new business and transaction related activities pan out, I'm particularly confident by the fact that what flows from our in-place asset base well exceeds what's required lets pay our dividend and to continue to grow at overtime. Our business is truly structured towards once called Income Plus and we have every confidence that with our access to capital relationships and track record that profitable new business generation will continue.

With that, I'll turn it over to Dave.

Dave Henry

Thanks, Mike. Before reviewing some of our new business accomplishments during the quarter, I'd like to take a minute and expand on one of Mike's themes, the relative stability of the net operating income of neighborhood and community shopping centers.

With darkening economic clouds, analysts and investors are focused on retail as being particularly vulnerable to a slowdown in consumer spending. We are asked with great frequency about signs of retail weakness and associated cash flows. As someone who has spent most of his career lending and investing all types of real estate properties and geographic areas, I sincerely believe that neighborhood and community shopping centers represent an attractive defensive property type during economic downturns. With relatively long leases and what Milton likes to say bond-like characteristics, shopping centers are relatively well positioned in tough times.

Hotels have to lease up every knife. Self-storage customer average four months. Apartments have 12 months leases and suburban office and industrial tenants generally have intermediate term leases of five to ten years. On the shopping centers side, anchor tenants signed 15 to 20 year leases with multiple options and annual rollover is usually only 3% to 5% of the portfolio.

In our case, we have closed the 14,000 leases with an average remaining lease term of 7 years without options and 22 years including options. Approximately 70% of our tenants by square footage are regional or national companies. Home Depot, our largest tenant and many others have strong balance sheets and will continue to pay rent regardless of a decline in their same-store sales.

In our portfolio, we are also heavily focused on neighborhood and community shopping centers or big-box discount centers, where our tenants tend to sell basic goods and services. The local grocery store, drug store, barber shop, pizza parlor, drycleaner, regional banks, Starbucks and Delhaize will all perform relatively better than high end merchants of luxury goods in an economic downturn.

On Tuesday, this week, the New York Times published the front page article, which highlighted this concept by saying “The return to realty is on vivid display at shopping centers, where consumers used to trading up to higher priced stores are now heading to discounters. Wal-Mart and T.J. Maxx are thriving but business has slowed at Coach, Tiffany and Williams-Sonoma".

Today's Wall Street Journal also chimed in by saying "some retailers are expected to fare better than others discounters, wholesale clubs and off-price retailers should outperform as consumer seek bargains". At Kimco, our tenants are largely in the business of selling staples and are oriented to local neighborhoods and trade areas.

While, not immune from the effects of a possible recession, Kimco enters this downturn with record portfolio of occupancy, long leases with many below markets rents and a focus on neighborhood and discount retail tenants, which will all stand us in good stead. It is also worth mentioning that less than 5% of our FFO is related to our merchant building activities in KDI.

Turning to new business, we are very excited about our new strategic alliance with Valad Property Group in Australia. The company is a blue chip organization, which is significantly undervalued and quite frankly unappreciated due to the very public problems swirling around Centro. Number two, our joint venture with RioCan in Canada in 2001, we are joining forces with a high quality firm in a new international market that what we believe is an opportune time. Like Canada and Mexico, we like the long term prospects of quality real estate in Australia and we particularly like the funds management business, which has successfully grown.

Kimco has a long record of investing in the debt and equity of public companies, which are also our joint venture partners. In Canada, in addition to our RioCan equity investment, we have purchased convertible debt and/or equity in other public platforms such as Plazacorp, Sterling Centrecorp and Whiterock.

In Mexico, we continue to have an equity interest in the formally public company, G. Accion. In our new Valad partnership, we see a terrific opportunity to accelerate our assets under management by teaming up with their fund's management platforms in both Australia and the UK. As we move towards the commingled funds model ourselves, we have much to learn from Valad, which has successfully introduced many value add and Core Plus Funds across the world.

With our emphasis on the US, Canada and Latin America and with Valad's focus on Europe and Asia, we believe there is a wonderful opportunity to cross-sell fund products and form relationships with new investment partners. The Valad team is first class and the company was a terrific customer of GE Real Estate while I was there.

Two members of GE Real Estate Australian office in 2000 are now Senior Executives of Valad and I strongly believe our organizations will work well together and enhance our respective business models. We are committed to truly making this a great deal for both Valad and Kimco.

In Mexico, our strong momentum continues and we had a record number of closings during the quarter. It is great to see the local operating partnerships we have formed over the past six years, delivering opportunities across the board. As we've previously mentioned, retail in Mexico is largely at development opportunity due to the lack of existing high quality shopping centers.

As such, it has taken us years to form the right relationships with tenants, local development partners and land owners. We are now seeing these relationships deliver real results and FFO income. Across Mexico, we now own equity interest in a 140 properties comprising 21 million square feet. While competition is coming, we continue to feel very good about our head start and our strong pipeline.

As a final new business comment, I'd like to point to Kimco Select, Kimco Retailer Services and Kimco Preferred Equity as businesses that should benefit from additional opportunities if the economy slows substantially. In preferred equity, we are already seeing better pricing and more opportunities as some of the traditional mezzanine competitors drop out of the market.

In retailer services, our recent investments albeit modest and the bankruptcies of Levitz and Sofa Express illustrate the types of opportunities that may arise for us if major retailers have increasing difficulties. Kimco has a long track record of being opportunistic in difficult times and we have the experience and expertise in the bankruptcy process to successfully underwrite these opportunities.

Thank you. And now I would like to turn to Milton.

Milton Cooper

Well, thanks, Dave. I will be very, very brief. Notwithstanding with current credit prices and problems in the banking systems, there is substantial liquidity worldwide and there is substantial demand for hot assets. It is my view that this liquidity coupled with long, relatively low long-term interest rates will keep cap rates low for quality assets. I also believe that these disconnect between the market price of REIT shares and the underlying value of the real estate that REITs owned cannot continue forever.

Two other comments. We were successful in establishing Mexico Land Fund which was very well received by investors. We have launched a fund to invest in real estate in Latin America other than Mexico, and this also is being very well received. Secondly, I am delighted that we will be establishing a strategic relationship with Valad.

We have enormous respect for Steve Day and I've always said that if I give you a $1 and you give me a $1, we each at the end of the transaction have $1. But if I give you an idea and you give me an idea at the end the exchange, we each have two ideas. And so it will be with Steve in Valad and Kimco. And I think good things will come.

And finally, the current economic environment, I was a child in the great depression and it always pains me on a personal level to see unemployment and the difficulties. On the other hand, we have been through many cycles and have always done well in times of stress. We have the liquidity and talent to seize opportunities and I am confident we will continue to deliver the goods.

Now, if you let us know what's on your mind, we'll be happy to respond.

Barbara Pooley

Operator, we are ready to take questions.

Question-and-Answer Session

Operator

(Operator Instructions). Our first question comes from Christine McElroy with Bank of America.

Christine McElroy - Bank of America

Dave, you talked about the defensive nature of the shopping centers, but just with regard to small shops, have you had or do you expect an up tick in store closings and bankruptcies in some of the local or regional tenants, those that are less well capitalized?

Dave Henry

Well, we're certainly starting with a record occupancy for us, 96% plus. And we haven't seen it yet in either delinquencies or bankruptcies or shop closings. But I would expect from a common sense perspective, if the recession grows then we will see some of that, but right now, we have not seen it.

Christine McElroy - Bank of America

Okay. And then, just on your development pipeline. Can you talk about your future pipeline, do you see your pace of development activity changing over the next few years? And have there been any changes in your views on where to develop and what types of centers to build?

Dave Henry

Well, in terms of our current pipeline, it's fair to say it is significantly slower than it was at this time last year. We're screening opportunities a little more selectively. We're staying away from some of the larger mixed used projects whether dependent upon a residential developer, and in effect, we're going back to some of the basics.

So, I'd say in all fairness our pipeline is significantly less than it was this time last year. Most of our development right now is in Latin America, Mexico. We continue to see great opportunities with wonderful partners. And I expect in 2008, our development activity will grow in Mexico and it will drop in the US.

Christine McElroy - Bank of America

Great, thank you.

Operator

Our next question comes from Nathan Isbee with Stifel Nicolaus.

Dave Fick - Stifel Nicolaus

Hi, it's Dave Fick here with Nathan Isbee. David, we had a chance of (inaudible) on the last call and obviously very interesting investment for you with a very high yield. Can you talk a little more about their intent to use the proceeds beyond initially just paying down debt?

Dave Henry

Well, David exactly initially they will pay down the debt. And then they will redraw that overtime to meet their own capital budget needs. For us, it's more than just what we think is a good investment in a good company that's been beaten down because of the Centro controversy.

We truly believe that marrying up with them and teaming up with them in the funds management, that we can both enhance each other. They have investors that we don't have. We have investors they don’t have. They have funds, and commingled, and joint venture opportunities that we don't see and vice versa.

So, we are accelerating our plans to work with them. We've been talking with them for quite a while and we really feel that, long-term, both of our successes are tied to the funds management business. It will help grow our assets under management worldwide by teaming up with them. And in many cases, I was very serious they are ahead of us in some of their fund products. And so, we're excited about this opportunity and they are very good people that I've known for a long-time and we're going to make this work on both sides.

Dave Fick - Stifel Nicolaus

Great, thank you. The reserve you took on the two preferred equity investments, can you walk through those and also discuss anything else that you might have on your watch list there?

Mike Pappagallo

David, actually those reserves were part of our retailer services businesses, which essentially is just our compliment of mortgages and the debt component of our marketable securities. And for us it was just a reevaluation knowing that there are sub economic times here of providing some reserves against potential uncollectability. Certainly I’m not implying that there are problems in the portfolio. But it certainly made sense with what's ahead of us to establish some reserves for accounts, treating it like a financing portfolio, which is what it is.

And just for the other question, there is another reserve on the operating statement, which relates specifically to our development business. And again we're evaluating and reevaluating the timeframes for the completed development. We took a look at some of the non-retail components of some of our larger programs. We did an evaluation of recoverability and in few cases we decided to prudently take reserve, recognizing that the timing and extent of some of these projects were going to dry out longer than anticipated.

But really that was the long and short a bit, trying to acknowledge that there are going to be some tough economic times and that we really needed to review all of our assets conservatively, evaluate them for full collectability and recoverability.

Dave Fick - Stifel Nicolaus

Do you anticipate readdressing and adjusting those reserves on a quarterly basis? And are there any development projects where you might have abandoned the majorities at some point?

Dave Henry

The evaluation process is something which is integral to our controlled framework that we've been doing every quarter. So, at this point we feel we are in a good spot relative to our evaluation. But because of that very point, David, we will continue to evaluate. We'll monitor all of our projects in our financing assets and if we see that there is additional reserves that are required, we'll take them, we'll disclose them.

But I certainly don't see any material issues there. We are not abandoning any development projects. We are just taking a fresh look at all of our underlying assumptions in terms of length, and carry cost, and profitability, of non-retail components from residential developers, and the like, and just reassessing the carrying cost.

Dave Fick - Stifel Nicolaus

Right. Last question, do you anticipate given the current environment being able to perhaps step up your opportunistic lending business?

Dave Henry

Yes, we do, David and we're already seeing that the number of inquiries have ramped up greatly, and some of our competition that quite frankly, we [lost view] to over the last couple of years. They are not in the market right now. So, not only do we think we are going to get better pricing. We think we are going to see more opportunities this coming year.

Dave Fick - Stifel Nicolaus

Thank you.

Operator

Our next question comes from Christeen Kim with Deutsche Bank.

Christeen Kim - Deutsche Bank

Hey, good morning. Going back to the development pipeline, I mean based on the progress you are making by the end of 2009, 2010, could it be almost completely Mexico, maybe some sprinklings of Chile and Brazil, and almost no US?

Dave Henry

No. I don't think that's the case. We still have wonderful joint venture partners across the country that continues to show us opportunities and we will do them selectively. We are taking a harder look at development yield. But in general, these yield are still have a nice margin, if you can develop to a 9% to 10% and still sell the centers at 7%, you've got a nice built-in margin. And we're just going to careful that these projects are largely pre-leased and relatively simple projects. But we like the business, we're committed to the business and we anticipate that KDI will continue to be a very important part of our business model.

Christeen Kim - Deutsche Bank

Are the 12% to 16% yields in Mexico pretty sustainable for the next few years or so?

Dave Henry

Well, the 16%, probably a little high today. I'd say in most of the new projects we’re approving, the unleveraged development yield is somewhere between 12% and 14%.

Christeen Kim - Deutsche Bank

Great. And then, last question David, you mentioned that on Valad, they are already ahead of you guys in some of their fund products. Could you maybe speak about what they are doing differently from what you are doing now?

Dave Henry

Well, as a very general comment, we have emphasized core real estate in our joint venture and our funds. We've bought stabilized properties on behalf of investors like Prudential and NGE and others. What Valad has focused on is what the market wants today, which is value-added funds, development funds, opportunities to make higher returns. We have started down that path ourselves with the Mexican land fund and some of the other commingled funds we're introducing.

But when I say, they are ahead of us, are only to the extent that they have developed these value-added products and higher returns real estate products for years now. And they have the investors already for those funds, we're just entering that.

Christeen Kim - Deutsche Bank

Great. Thank you.

Operator

Our next question comes from Jonathan Litt with Citigroup.

Ambika Goel - Citigroup

Hi, this is Ambika with Jon. Can you comment on a demand for core product? Last time we spoke, you mentioned that there is a lot of liquidity but it's currently on the sidelines, are you seeing more a pickup in that demand?

Dave Henry

It's mix. I think it's fair to say that, in general, the core buyer has slowed down. Many investors that were active and very strong buyers of core real estate are on the sidelines and waiting to see which way cap rates are going to go. There is a general concern that the cap rates will move up and mark-to-market problems. So we do have investors that have told us for the time being, on the core side, that they are on the sidelines.

Having said that, we have sold some of our KDI projects recently to core buyers, so we know they are out there. CalSTRS, for example, bought one of our projects recently. So we know that there are core buyers out there and cap rates on first class product continue to be in the sixes. That's for sure. But I think it's also fair to say that core real estate doesn't hold tremendous appeal on a lower returns of core real estate, don't hold tremendous appeal ahead over the last couple of years.

Ambika Goel - Citigroup

Okay. Great. And then given the condition in the current market, could we see investments like the Valad investment in other regions and could you specify what other regions you are looking at?

Dave Henry

Well, obviously, we have invested across the board and we continue to like being opportunistic and working with good companies, whether they are public or private. So we'll certainly look for these kind of opportunities. To-date we have stayed in the Americas, Canada, and South America, and Latin America. Australia is a new territory for us. Europe remains intriguing to some respects. We are not quite ready to go to India or China or anything like that, but we'll look over time.

Ambika Goel - Citigroup

Can you talk a little further about what exactly is a looking appealing in Europe? Yes that's the thing.

Dave Henry

Well, as everybody has followed that the UK and other markets have had a severe price adjustment in terms of real estate and public companies that own real estate. So by definition, Europe has become more intriguing there was perhaps six months ago.

Ambika Goel - Citigroup

Okay. Thank you.

Operator

Our next question comes from Michael Mueller with JP Morgan.

Michael Mueller - JP Morgan

I have a couple of numbers questions. First, Mike, I was wondering looking at the interest dividend and the other income line that went close to zero this quarter, what happened sequentially?

Mike Pappagallo

The primary reason there is that we have no marketable security gains, and some other reserves that I have alluded to before are placed in that category at that line item. So it kind of brought that down to virtually a nil result for this quarter, versus sequential prior quarter in last year's quarter.

Michael Mueller - JP Morgan

Okay. And then I know you are breaking guidance out in terms of in-place and then incremental business, can you put it in terms of Kimco capital services as a whole and just in 2007 KCS did ‘x’ millions of dollars, and we're looking at a range of extra ‘y’ or something for 2008, is it possible to break it out that way?

Mike Pappagallo

I'll break it out in too much detail. We'll probably go past the hour, I'm only paying for an hour over here, but I guess in looking at Kimco capital services, it really encompasses those three primary businesses, and incorporates both recurring income flow as well as the transactional related activity. You are really probably talking in total on an EBITDA basis about $250 million of the $1 billion of EBITDA. And as you look into 2008, there will be an increase, but it will be shifted much more towards the recurring flow as opposed to the transactional.

I think one of the things, we pointed out in the guidance range is that the comparable number for our new business and transaction related activities is slightly lower in 2008 than we had planned, that we had showed for 2007. And the shift is that we are getting more flow in that Kimco Capital Services business, primarily because of the In-Town Suites transaction and the Triple Net lease portfolio transaction that we had closed during the summer of 2007.

So, there is certainly an increase overall. But there is a shift from transactions to recurring. And that's not to say the transactional activity is not insignificant because we've laid it all out in the press release. But we're definitely shifting towards the recurring path even in the KCS business.

Michael Mueller - J.P. Morgan

Okay, that's really helpful. Thanks.

Operator

Our next question comes from [Thomas Baldwin] with Goldman Sachs.

Thomas Baldwin - Goldman Sachs

Good morning guys. Overall acquisitions trended downwards over the course of 2007. Can we expect volume to tick back up in 2008 or is it safe to say that given the challenges in the market, acquisitions volumes both for your investment management programs as well as for the operating portfolio will be substantially lower this year than last year.

Dave Henry

Well, it's certainly early. But if we look at activity today it will be significantly lower than what we've accomplished last year. Very early last year, we closed the Crow portfolio so that within in our numbers for last year, even though that was really a 2006 transaction.

So, I'd anticipate the market continues to be a little frozen with sellers wanting yesterday's cap rates and buyers wanting tomorrow's cap rates, and the difficulty in the debt markets and so forth. I think the number of transactions will be a lot less. And on the institutional side, they are still trying to figure out exactly the level of volume they want. So, at least based on our current institutional partnerships, we'd anticipate a lower level of acquisition volume, and I think Mike's probably dialed in at the lower end.

Mike Pappagallo

Yeah. I made a comment in the last conference call that the look of the new business generation is probably going to be very different in 2008 than it was in 2007, and just using the example of the part of the large transaction with the dollars out, mainly the convertible instrument that we funded, that's 200 million Australian. That's going to be I think a little bit more typical at least for the next few months of the type of investment profile that we see and not the aggregation of traditional core product for our investment management programs and the like.

But today's point it is still early. There are a lot of things that are going on across all of our business activity, and as we sit here a year from now the profile may be very different than even I'm thinking about now. Clearly in the short-term, you are not going to see a lot of what we call the bread and butter core acquisition for our core fund programs.

Thomas Baldwin - Goldman Sachs

Thanks Mike. Thanks, Dave. One more question you guys mentioned on the call that only about 5% of your FFO comes from merchant building. But, as I look at your supplemental, it looks like your current development pipeline is pretty heavily weighted towards merchant building. Can you talk about the decision making process surrounding developing for your operating portfolio versus developing on a merchant building basis, and whether the market, in terms of demand doesn't meet your expectations? Whether there would be a willingness to take some of that merchant building product and contribute it to your operating portfolio?

Dave Henry

It's really rather simple. In the US, our KDI business model is a merchant building business model. That’s the only thing that has changed a little bit as we've looked at some of those projects and sold them into some of our joint ventures, that we have with institutional partners. But in general, these are joint venture partnerships with local developers that are built on a merchant building basis.

So when they are finished they are sold, win, lose or draw. They are sold and the only thing that's changing is some of the better projects, where we can negotiate and buyout our partner at a good price. Then, we will spin them into some of our longer-term joint ventures, so that we get both building the development gain, if you will, as well as keep the asset long-term under an asset management basis.

In Mexico it's really a build and hold strategy. We do not intend to sell our properties there. We like the FFO income and as we've pointed out before, the leases in Mexico have the upside of cost of living increases. They have percentage of rent, things that we don't have in the US, which is a much flatter income stream. For now, I think that the KDI model is still a merchant build model and Mexico is a build and hold.

Mike Pappagallo

It is possible that if we view development as a much longer process, we may create a development fund for investors, whose timeframe will be much longer, that's one of the things that will constantly explore and modify as the circumstances require.

Thomas Baldwin - Goldman Sachs

Thanks very much for that color.

Operator

Our next question comes from Jeff Donnelly with Wachovia.

Jeff Donnelly - Wachovia

Good morning, guys. I guess a question actually for Dave and Milton on capital allocation, I'd love to hear from both of you on it and how you think about real estate returns? I guess from my perspective, there has been somewhat of a long standing difference of opinion between the two of you around how you guys think about cap rate.

So I think Milton in the past has said that he felt that the industry would be low borrowing cost, and it continues to plays down with pressure on cap rates. And Dave, I think you always kind of felt real estate retains in cyclical trades. How have your views changed and what is driving your capital allocation decision right now? How are you guys thinking about allocating money, given that in the past you've had different views?

Milton Cooper

I guess if you start with the premise that my job is to invest, many people trust us with it as spreads of the cost of capital. If particularly if we feel that cap rate will not substantially increase and that there won't be that spread, what we have done is we've shifted to being an investor manager, with a combination of the fees and the return in excess of our cost of capital.

So, I think that Dave and I really are on the same page on that. And then what we're doing in allocating capital, if we can find equity yields, is putting debt instruments where the underlying real estate is, and we can invest at yields in the teams. We're seeking those too. So we're going to be fast with our footwork, and real estate can take all different forms. Dave?

Dave Henry

Jeff, we are in treated agreement that in the future because of our cost of capital, I mean we're 70% equity, only 30% debt. We have to manage money for other institutions that have a lower cost of capital. Some of those institutions may want core stabilized shopping centers at today's cap rate, and we will do our very best to find the very best properties for them and manage them, and try to increase that income.

Others may want higher yielding products, as Milton mentioned, possibly even development, and we will try to form funds in joint ventures for those institutions. But we're both very much agreed, notwithstanding where the cycles go, notwithstanding where the cap rates go in the credit market, that our long-term business is managing other people's money.

Jeff Donnelly - Wachovia

I guess a follow-up to that. I would have expected, Dave, in this environment, you guys might have announced plans to maybe explore a large fund focused on assisting distressed retailers, as some of you have done in the past, or over leveraged retailers which maybe is your preferred equity business. Is it the right time for trying to do a specialized vehicle like that, and how deep is the interest in that niche right now?

Dave Henry

Well, historically, we've made so much money in those distressed opportunities, including Albertsons that we prefer to keep those for our own shareholders. Longer term, yes, we might look at something like that, but we've done such a good job making money for our shareholders in those very much distressed situations, and they are such higher yielding products that for now we are going to do that for our shareholders.

Jeff Donnelly - Wachovia

A question for Mike, retailers are voluntarily and involuntarily rationalizing their existing store base. Can you give us little more detail on what your expectations are for occupancy lease termination fee income and maybe bad debt expense for 2008 versus 2007?

Mike Pappagallo

At this point and looking at the projections for 2008, we just can't look at it from an occupancy and same-store growth perspective. And so, the same-store growth that we are expecting at above 4% incorporates what may happen in terms of some small retailers shifting out or rolling out, and the down type of potentially putting new ones in. So our occupancy level does not appreciate really at all.

And in fact the organic growth of the same-store growth is due to leases that already been signed up. And it just the question of either started, or will be started soon, for reasonable expectations on what the rollover is and the renewal rates.

So there is nothing terribly significant with respect to our expectations of the future either for good or for bad because a lot of what 2008 is all about, is already been somewhat accounted for.

Jeff Donnelly - Wachovia

Do you know modeling deterioration in your occupancy; you had loss of tenants per se?

Mike Pappagallo

No. I mean, there is always going to be expectations of tenants leaving and the down time. And along the margin, we have increased the amount of downtime in terms of that rollover. But we're not expecting any significant deterioration in occupancy or declines in rents.

Because remember Jeff, I mean, as a basic principle, most of the rents that are rolling over our home market, and it always been that shock absorber, that cushion, dynamic, that we and others in the neighborhood and community shopping centers sector have experienced.

So, that's why we feel confident that we're not going to take any sort of significant hit on our portfolio even if there is downturn, we built in those expectations and we still feel pretty good about where our growth trend is going to be for 2008 on the core portfolio.

Jeff Donnelly - Wachovia

Thanks, guys.

Operator

(Operator Instructions) Our next question comes from Jeffrey Spector with UBS.

Jeffrey Spector - UBS

Good morning. Dave you mentioned the cap rates for first quality product is in the six digits. It seems a little high according to the transactions I've seen. Can you comment on that a little further? And then I guess, just give us a feel for how far that cap rate has moved from peak pricing?

Dave Henry

Well, I think it's fair to say cap rates have moved even for the highest quality. But we've seen transactions closed at in the lower six levels. We've sold them ourselves and we compete for high quality properties. It is fair to say that the total number of transactions, the volume of transactions has gone way down.

I mentioned the CalSTRS sale we recently did that was in Boise, Idaho in the low sixes. So in first class retail it's selling in the low sixes at Boise, Idaho, that still gives us some confidence that there are core buyers at these lower cap rates. We don't know what tomorrow will bring, and it's fair to say that the debt markets are in turmoil and people are having trouble borrowing, so that may have an impact. But for now we can't tell you that cap rates have increased substantially on first class real estates, we haven't seen it.

Jeffrey Spector - UBS

Okay that helps thanks. And then can you talk a little bit more about Canada?

Dave Henry

Sure, Canada it remains a country in which we want to continue to invest capital for the long-term and in ways, it's much stronger than the US. They've a surplus, they've a trading surplus. They have a relatively strong economy. The only thing that's hurting them a little bit today is their strong Canadian dollar, which is what hurts their exports a little bit.

But their markets especially in retail are very strong with high occupancy. The RioCan portfolio was about 99% occupied. We've had great rent growth up there. We've got some strong relationships and strong joint venture partners. We announced going over 10% equity ownership in Plazacorp. We like those people a lot, and are looking at actively looking at deals with them as well as Sandalwood and some others.

So, we continue to look opportunistically. Their credit markets have changed a bit. Their CMBS market has totally disappeared, its rather amazing. So, that should lead to some opportunities for us. We have an office there, we have people there, and our job is to find some opportunities to continue to put money in Canada.

Jeffrey Spector - UBS

Great.

Dave Henry

It's a long-term market for us.

Jeffrey Spector - UBS

Great, thank you.

Operator

Our next question comes from Steve Sakwa with Merrill Lynch.

Steve Sakwa - Merrill Lynch

Thank you, good morning. Dave, could you just elaborate a little bit more on sort of the Valad acquisition and sort of maybe how it came about timing. Who approached whom and how much due diligence did you really get to do before you decided to make investment?

Dave Henry

Okay. Well, it goes back 10 or 11 years, when Steve Day and Valad were customers of mine at GE, and they were our largest customer for a period of time in Australia. And our transactions were very successful and very profitable to GE. We did participating loans with them and they bought B office buildings in Sydney and other markets, and created value by making them A buildings over time.

About three years ago, I ran into Steve Day in London at a UBS conference. We started talking. We bought a few shares of Valad and I expressed our interest in maybe doing something bigger with him overtime. Milton and I both talked to Steve about a year ago at the City Corp conference in Florida, and I think we both continued to get comfortable with them and also expressed the desire to do something with them a year ago. In December, this was after the Centro situation, and their stock had been fumbled. Steve didn't reach out to me and we started talking about a possible transaction. That's how it came about.

In terms of due diligence, we did quite an extensive amount of due diligence and we sincerely believe the company is undervalued in many respects and we are very comfortable with our debt instrument and the upside probability embedded in the conversion feature, and an added plus is the fact that we are going to learn together and grow together on our commingled funds business.

For me, it's a wonderful opportunity to get back together again with a good customer, who really knows what he is doing in a good international market. I mean, Australia is very similar to Canada. It's a resource rich country with good economic long-term prospects, landlord friendly laws, English speaking, so forth. So, it's a good country for us to go to.

Steve Sakwa - Merrill Lynch

Yeah. I guess from an evaluation standpoint it looks like a very good deal for you. I guess, the question from their point is can they put that money to work accretively over time? I guess, time will tell?

Milton Cooper

Don't be fooled by the 9.5% interest rate too much. Interest rates are a lot higher in Australia. So for them they are not losing that much for paying down some of their short-term debt temporarily, while they look for their for longer term opportunity. They have a business plan and they have a good business plan.

The Scarborough acquisition was something quite frankly, that was impressive. They bought a money management business managed towards Europe and the UK with many existing institutional customers, good customers. They have the products and those customers wanted the value-added products.

I saw it when we introduced our Mexican Land Fund, this is what institutional investors and real estate want today. They want a higher yield. They are saying if they are going to stay in real estate, they are willing to take a little more risk, but they want the higher yield. Those are the products that Valad already has. Those are products that we're trying to introduce ourselves.

Steve Sakwa - Merrill Lynch

Okay. Thanks. Just a follow-up on a comment that Mike made. It sounds like you are not pursing core acquisitions, but looking for some other potential opportunities, like Valad. Is it fair to say that there are other potentials like this, maybe in the works? And if so, would they be more domestic focused or internationally focused?

Milton Cooper

Let me take a stab at that. We are not exiting the core acquisition market at all. We have a number of good customers and including FCB Bank Group, we continue to look actively for portfolios for them. Europeans look at our cheap dollar and say, “maybe it's not a bad time to buy”. So we do have customers that are looking for core real estate.

We just are acknowledging that the level of that activity will be a lot lower than the $6 billion we did in 2006, and so forth. It's reasonable to assume that the level of activity is going to be lower. But it still represents a business for us, we have an acquisition team that's out in the market, we see most things today, and we have some good partners. So that's going to continue to be an activity for us.

I think Mike was just commenting that when you see big dollars of our own capital being put to work, it may be more situations like this, even when in our core real estate, or core investment, is a relatively low 15% or so. So we're not putting a lot of our own dollars to work even when we have heavy acquisition of core real estate.

Steve Sakwa - Merrill Lynch

I guess is it fair to assume that other opportunities like this are being pursued or is this really viewed as one-off tight investment?

Milton Cooper

I tried to explain that Valad was very similar to things we've done in the past with RioCan, with G.Accion and others. So we continue to always look for good partners and good deals.

Mike Pappagallo

I don't want to comment. Next question?

Barbara Pooley

We have two more.

Operator

And our next question comes from Steven Rodriguez with Lehman Brothers.

Steven Rodriguez - Lehman Brothers

Dave, just a follow-up question on Valad. You've mentioned that you've been looking for opportunities that were obviously constraining on Latin America domestically, but are you precluded from looking at any of Valad's concentrations, whether they are in Australia or Europe or anywhere in Asia?

Dave Henry

No, one of the things in addition to sharing institutional investors and products is the idea of co-investing with them. In fact, we are going to look at some co-investment opportunities with them in Australia as well as Europe and some other market. So, yes, we fully intend to use their expertise to look at opportunities in the markets that they have experienced it.

Steven Rodriguez - Lehman Brothers

Is there any one market that you are favoring more, Europe versus Asia? Or it could be either one?

Dave Henry

Well, as we mentioned Australia has intrigued us. It's a good time to invest there, and the UK as well.

Steven Rodriguez - Lehman Brothers

Okay. Great. Thanks.

Operator

And it appears that our final question comes from Jim Sullivan with Green Street Advisors.

Jim Sullivan - Green Street Advisors

David, with respect to the merchant building business you talked about, developing to 2009, selling in 2007 creating a sizeable margin. With respect to that, when I look at your KDI margin for the quarter its something under 10%, which seems surprisingly low especially since the majority of the proceeds came from neighborhood, I think you said that cap rate was on the low sixes. Can you comment on the margins in KDI for the quarter?

Dave Henry

You have to understand a couple of things, and Mike can jump on me if I don't say I am exactly right. But first of all, ours is a joint venture model. We do not get 100% of the profits. We share those profits with a partner generally 50-50. We get our capital back, we get a preferred return on that capital and then we split the profit.

Secondly, these are done in our TRS subsidiary and there are taxes that need to be paid on the gain. So the net amount that actually we book at income may look like a smaller margin, but that doesn't change the fact that these projects are built at 9% plus and being sold at 7% and less.

Mike Pappagallo

I think Dave distinctly summarized the economics of the deal. Its one of the reasons why merchant development is not significantly large contributed to yield, over FFO based. But as Milton suggested earlier, it's a business we still want and like to be in. And we feel that overtime it will continue to add the raw material into our investment management programs. That's our business model.

Jim Sullivan - Green Street Advisors

And so after your partners, participation after tax is 10% margins? Or what should we expect from what you have in your pipeline today?

Dave Henry

Now remember the reason we are very comfortable giving half of the profits to a partner. The partner is the guy that finds the opportunity, generally buys the land, carries the land, takes the land through an entitlement process, gets an anchored lease, the lease in place, all before we fund. So, we believe we've much less risk with our joint venture model.

Plus we're teaming up with people that have experience and expertise in their local markets. And, we don't believe that we can parachute into Tuscan, Arizona and know all about developing in that market. We much rather team up with somebody, who has been in Tuscan for decades. And so, we like our joint venture model and that's the economics of it at the end of the day.

Jim Sullivan - Green Street Advisors

My second question relates to your record high occupancy was that something you achieved deliberately in the expectation of a slowing economy. And maybe can you share your philosophy with respect to increasing occupancy versus the alternative perhaps to be more aggressive on rent growth?

Dave Henry

Well, obviously it's an objective across the board for us to have the highest possible occupancy. Vacant space is something that's not producing income. So, we're very focused on it. It is fair to say that we've had some benefit in terms of our occupancy and our record occupancy, by deliberately over the past several years, selling down the bottom part of our portfolio.

Historically, we were never particularly good sellers. We thought, we could operate everything ourselves. But beginning two years ago, we intentionally focused on selling the bottom parts of our portfolio and luckily we sold them into a very hot market and we are now seeing the benefit of selling some of our more problem properties that had lower occupancies. They are not in our portfolio anymore.

So, we've got a better portfolio with higher occupancy because we've sold some of the bottom half.

Mike Pappagallo

Even if there is any thought that we are somehow giving away space to popup in the occupancy number to make a nice headline, I'd dispel any concern that you might have. Our job here is revenue maximization and that's a combination of getting vacant space leased and trying to get the highest rents possible.

Jim Sullivan - Green Street Advisors

Okay, thank you.

Operator

And it appears we've time for one final question from Rich Moore with RBC Capital Markets.

Rich Moore - RBC Capital Markets

Hi, good morning guys. Actually a quick follow-up to what Jim was asking. Are you offering any concessions for any tenants that are in place currently, not new leases but currently in place? Are they looking for concessions for new guys, I mean, kind of whimpering that it is a tough environment and they like to get something from you?

David Lukes

I think anytime the….

Mike Pappagallo

David Lukes…

David Lukes

Anytime the newspapers say that retail sales are down some of the local retailers call and say my sales are down. So, it's a fairly common event, and it usually happens every time there is news of some submarket type issues. But the reality is, for a landlord to offer concessions for in-place tenants, usually requires that they show you their sales for the last year or two. There has been more requests in the last 60 days than they were in the 60 days prior to that. But when you sort through the real ones they are pretty few and far between.

And the only ones where a concession is made in the last 30 days, would be shops that are fairly smallest square footage, and they happened to be in a center that was relying heavily on some housing growth. And as you all know, our portfolio was primarily in matured markets and it's really not very much in the high growth residential market. So, because of that, the shops spaces and the anchors are fairly stable and it tends to be more of an inventorial portfolio than it does new product portfolio.

Barbara Pooley

Thanks.

Dave Henry

I think, we are….

Barbara Pooley

Thanks to everybody for participating today and as a reminder, our supplemental is on our website.

Operator

That does conclude today's conference call. You may now disconnect.

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