Earnings Call Transcript - HPP Q2 2023

Operator, Operator

Good morning, and welcome to the Hudson Pacific Properties Second Quarter 2020 Conference Call. All participants will be in listen-only mode. Please note, this event is being recorded. I would now like to turn the conference over to Laura Campbell, Executive Vice President, Investor Relations and Marketing. Please go ahead.

Laura Campbell, Executive Vice President, Investor Relations and Marketing

Good morning, everyone. Thanks for joining us. With me on the call today are Victor Coleman, CEO and Chairman; Mark Lammas, President; Harout Diramerian, CFO; and Art Suazo, EVP of Leasing. Yesterday, we filed our earnings release and supplemental on an 8-K with the SEC, and both are now available on our website. Our audio webcast of this call will be available for replay on our website. Some of the information we'll share on the call today is forward-looking in nature. Please reference our earnings release and supplemental for statements regarding forward-looking information as well as a reconciliation of non-GAAP financial measures used on this call. Today, Victor will discuss macro conditions in relation to our business. Mark will provide detail on our office and leasing operations and development, and Harout will review our financial results and 2023 outlook. Thereafter, we'll be happy to take your questions. Victor?

Victor Coleman, CEO and Chairman

Thanks, Laura. Good morning, everybody, and thanks for joining our call. During the second quarter, we worked diligently to position Hudson Pacific optimally as we continue to navigate the unprecedented confluence of an unfavorable macroeconomic environment, the lingering impacts of remote work, and most recently, a historic and prolonged studio union strike. Office fundamentals across the West Coast markets remained challenged in the second quarter with gross leasing either flat or decelerating quarter-over-quarter, sublease activity either stable or rising and negative net absorption in all but Vancouver. As expected, studio production in Los Angeles slowed significantly, with shoot days in the quarter falling 60% to 70% year-over-year for TV comedies and dramas, and 20% to 25% across film, unscripted TV commercials, and photo shoots. Our focus in this environment remains on occupancy preservation and expense reductions, both at the corporate level and within our office and studio portfolios as well as proactively managing our balance sheet. Mark and Harout will be discussing our progress on all these fronts in detail. But beyond today's challenges are a variety of bright spots emerging that have the potential to shift the dynamics around our business and provide for significant upside and opportunity specific to Hudson Pacific as we move to 2023 and beyond. On the office front, according to a recent JLL study, the broader U.S. office market is starting to show some signs of recovery. To-date, the West Coast has lagged due to big tech rightsizing and tenants broadly staying cautious, but with mounting data pointing to historic declines in innovation, productivity, and human capital development, big tech has taken notice. The ten largest tech companies now have concrete hybrid attendance policies impacting most of the workforce with the focus shifting into enforcement. These policy changes are starting to make a positive contribution to Hudson Pacific's portfolio. As a sign of reintegration year-to-date, parking revenue was up in our portfolio 18% compared to last year, including 25% in San Francisco and 15% in Seattle, where Amazon returned to work May 1. More recently, Amazon asked employees to move closer to team hubs or apply for new jobs within the company, or they will be considered to have voluntarily resigned. Furthermore, office demand increased quarter-over-quarter in both Seattle and in the Bay Area, increasing 18% in Seattle, 25% in San Francisco, and 11% across the Peninsula and Silicon Valley. As we've communicated in the past, upon reintegration, tenants often realize that they don't have enough workspace or conference rooms to comfortably accommodate employees on peak days. And given the growth in tech workforce through the pandemic for paying tenants, even net of layoffs, we're conservatively estimating a 45% increase in headcount. Reintegration could begin to place expansionary pressures specific to our tenants and our markets. Couple this with the slowing of new office deliveries and accelerated conversions of older office space assets to non-office space uses, and we will see vacancy rates begin to turn as we approach year-end. We continue to believe in our markets driven by tech and media, and we're positioning ourselves for significant growth for the long term. Although in its infancy, AI promises a wave of innovation and growth not seen since the advent of the Internet or the smartphone. Once again, the Bay Area, more specifically San Francisco, is the cradle for this groundbreaking industry, and our portfolio is well located to benefit from its growth. VC funding to generate AI in the first five months of the year grew 650% in the city, with companies there garnering 90% of the global AI-related funding. This is translating into office demand, and there are currently nine requirements, totaling 870,000 square feet in the city. We're optimistic that AI and relative service industry growth will begin to alleviate the lack of large square footage requirements and serve as a catalyst for sustained, positive net absorption, especially in the Bay Area. Now turning to our studios, while the directors reached a new contract in June, the actors joined with the writers on strike in mid-July. This is the first time since the 1960s that both unions have been on strike simultaneously, and that strike lasted 22 weeks. We're hopeful all parties will reach a fair agreement soon, although it appears currently, they remain far apart on important issues like streaming residuals, AI, and writers' rooms. The simultaneous strikes mean that previously written production activity that could still be filmed is now on pause. However, we're nine weeks into the strike relative to an average strike of 14 weeks, and we continue to expect a significant ramp in production post-strike, likely experienced following COVID, but it's going to take time to fully reengage. While studios have strategically spread out new releases, they could face significant shortfalls in 2024 if production isn't up and running before the fall. Netflix, for instance, recently affirmed its intent to maintain content spend through '24 at levels in line with 2022, albeit with some lumpiness post-strike similar to coming out of COVID. Comcast too noted a relative increase in content spend likely in '24. With subscriber growth and engagement across multiple broadband applications trending up, the underlying demand drivers for production remain strong. A strike of this magnitude, while impactful, is rare and has historically proven to be relatively short-term in nature. Over the first half of the year, we've made significant enhancements to our studio cost structure. These equated to a $12 million annual savings around labor and fixed operating expenses as well as another $15 million of savings attributable to deferred capital expenditures. While we'll continue to evaluate additional operating and capital adjustments, we'll do so in a manner that weighs short-term cost savings against capitalizing on long-term value creation. Not all industry players have the ability to make this trade-off, which could present a compelling opportunity for us post-strike. We'll also be able to fully capitalize on the economies of scale from our now fully integrated service acquisitions post-strike, and we expect these synergies will result in approximately $15 million of additional annual NOI in a normal operating environment. Despite these current challenges, we've thus far been able to navigate the ever-changing landscape in a manner that speaks to the well-located portfolio we've assembled, our diversified asset classes, and the fortitude and experience of the entire Hudson Pacific team. We understand this will take time to overcome, but we believe in our strategy and our long-term positioning, which sets us up to generate even stronger results in the coming quarters. With that, I'm going to turn it over to Mark.

Mark Lammas, President

Thanks, Victor. We have signed approximately 50 office leases, roughly 50% new deals, totaling just over 400,000 square feet in the quarter. The average lease size was approximately 7,000 square feet, and 50% of that activity was in the San Francisco Bay Area. Small and midsized tenants in tech and other industries continue to drive the preponderance of activity across our markets. GAAP and cash rents were approximately 4% and 8% lower, respectively, on backfill and renewal leases, with the change largely driven by a few midsized leases, both new and renewal across the Peninsula, Silicon Valley, and in Vancouver. Our in-service portfolio ended the quarter at 87% leased, off about 170 basis points compared to the first quarter, due primarily to the move-out of midsized tenants in those same markets. Our leasing economics improved across the board quarter-over-quarter, with net effective rents up close to 9% to $44 per square foot. Tenant improvement and leasing commission costs improved close to 50%, down to $6 per square foot per annum, and lease terms increased by six months, or 13%, to 48 months. In terms of our two larger 2023 expirations, we're still negotiating a renewal of our 140,000 square foot tenant in Seattle at Met Park North, whose lease expires in late November. We're in discussions with two requirements that could potentially partially backfill the 469,000 square foot block lease at 1455 Market in San Francisco, which expires at the end of September—one for approximately 25,000 square feet, the other for approximately 275,000 square feet, with additional tenant interest behind these. Regarding our remaining 2023 expirations overall, which are about 5% below market, we have 50% coverage, that is deals and leases, LOIs or proposals with another 5% in discussions. Outside of the two large expirations I mentioned, the average expiring lease size is roughly 5,000 square feet. We're staying creative and flexible as we work to boost occupancy, and even as the growing number of tenants commit to a three to five-day in-office schedule thus far, they continue to transact very slowly. Our current leasing pipeline totals 2 million square feet, slightly above our last call. Even with continued leasing, that pipeline includes over 285,000 square feet of deals and leases. We also have close to 1.2 million square feet of vacant space across our portfolio, roughly on par with this time last year, although down from last quarter. We did see an increase in both aggregate and average square footage of requirements for our assets across the Peninsula and Silicon Valley. This coincides with the rise in early interest we have seen more broadly in the Bay Area and Seattle, even as the timeline for getting leases across the finish line remains unpredictable. Turning to the studios, our in-service studio stages remained well leased at 95.7% on a trailing 12-month basis and 94.1% on a trailing 3-month basis due to the preponderance of long-term leases of greater than one year. On a trailing 3-month basis, we actually experienced a 490 basis point increase in lease percentage at our Quixote studios. This was largely due to the commencement of a handful of long-term leases on our Central Valley and recently delivered North Valley facilities as well as a general influx of short-term, non-strike-impacted production, such as commercials and photo shoots. This activity led to an additional $1 million of rental and lighting and group revenue quarter-over-quarter at our Quixote Studios. However, revenue from pro supplies, transportation, and other services was off by approximately $4 million in aggregate, even as we still had activity from non-strike-impacted production, such as music festivals and other large-scale events. That said, we expect these service-related categories to be further impacted given seasonality and the expanded strike as long as it continues. Throughout our portfolio, we're continuing to limit capital improvements until we have certainty around demand. This includes staying conservative on new developments. We do, however, have two in-process developments close to completion. We're on track to deliver our state-of-the-art Sunset Glenoaks studio in Los Angeles by year-end, as expected, pending receipt of Department of Water and Power permits. We've continued to tour major production companies despite the strike. We anticipate leveraging a more traditional show-by-show sales model or at least a portion of the facility, which we will be able to execute to the fullest extent post-delivery. There is no directly competitive supply for this project, which has a delivery date potentially well-timed to capture pent-up demand post-strike. In Seattle, Washington 1000 is also on track and should deliver in the first quarter of next year. While we expect even greater interest once the project is complete, we're already in early discussions with three tenants, each with requirements over 100,000 square feet. As Victor mentioned, Amazon's push earlier this year to bring employees back at least three days a week and more recently telling workers to return to its main hub has accelerated return to work for many local businesses. Washington 1000 will be one of the nicest buildings in the city and is the only new product of its kind under development. Our all-in basis is only $640 per square foot, representing as much as a 30% to 40% discount to comparable trade.

Harout Diramerian, CFO

Thanks, Mark. Our second quarter 2023 revenue was $245.2 million compared to $251.4 million in the second quarter of last year, primarily due to Qualcomm and other tenant move-outs, as well as the sales of office properties, including Skyport Plaza and 10900 to 10950 Washington. Our second quarter FFO, excluding specified items, was $34.5 million or $0.24 per diluted share compared to $74.6 million or $0.51 per diluted share a year ago. Specified items in the second quarter consisted of transaction-related income of $2.5 million or $0.02 per diluted share, which includes the lowering of accruals for future earnouts related to our Zio Studio Services acquisition. Prior period property tax reimbursement of $1.5 million or $0.01 per diluted share, a deferred tax asset write-off expense of $3.5 million or $0.02 per diluted share, and a gain on debt extinguishment, net of taxes of $7.2 million or $0.05 per diluted share. Prior year second quarter specified items consisted of transaction-related expenses of $1.1 million or $0.01 per diluted share and prior period property tax expense of $500,000 or $0.01 per diluted share. The year-over-year decrease in FFO is attributable to the aforementioned office tenant move-outs and asset sales, as well as higher studio production costs and higher studio operating expenses associated with the Quixote acquisition, along with increased interest expenses. Our second quarter AFFO was $31.1 million or $0.22 per diluted share compared to $60.3 million or $0.41 per diluted share, with the decrease largely attributable to the aforementioned items affecting FFO. Our same-store cash NOI grew to $127.6 million, up 4.7% from $121.9 million, with same-store cash OpEx NOI up 5.1%, largely driven by significant office lease commencements at One Westside and Harlow. During the second quarter, we repaid the Quixote note for $150 million, at a $10 million discount on the principal balance with funds from our unsecured revolving credit facility. At the end of the quarter, we had $581.2 million of total liquidity, comprised of $109.2 million of unrestricted cash and cash equivalents and $472 million of undrawn capacity on our unsecured revolving credit facility. We have additional capacity of $122.4 million under our One Westside and Sunset Glenoaks construction loan. At the end of the second quarter, our company's share of net debt to the company's share of undepreciated book value was 38.7%, and 85.3% of our debt was fixed or capped. We remain focused on deleveraging. This quarter, our Board reduced our quarterly common stock dividend to $0.135 per share, which resulted in an additional $17.9 million of cash flow savings this quarter. We also continue to selectively explore asset sales. We currently have three deals under contract, including two office assets and one land parcel, which could collectively generate over $100 million in gross proceeds within the next several months. We're also in negotiations to sell two more office assets, with the pricing and timing of which are under discussion. Regarding our upcoming maturities, we only have one small maturity remaining in 2023. Our $50 million private placement note is due next month, which we will pay with our line of credit. We have two maturities in 2024. Blackstone is leading discussions around the extension of our Bentall Centre loan, which matures in July 2024, of which our 20% ratable share is $100.5 million. We've received indicative terms and are now formally commencing discussions around refinancing our One Westside/Westside Two loan, which matures in December 2024, of which our 75% ratable share is $243.5 million. In 2025, 96% of our indebtedness does not mature until the final two months of the year, and three of our four 2025 maturities, comprising nearly two-thirds of the maturing amount, are secured by high-quality assets, including 1918, Element LA, and Sunset Glenoaks, the first two of which have high-credit single-tenant occupancy with the remaining lease terms into 2030. Sunset Glenoaks should be stabilized and fully operational as a state-of-the-art studio campus before its 2025 maturity. Our fourth and final 2025 maturity consists of a $259 million prior placement loan that matures in December 2025. While this is still nearly 2.5 years out, we're focused on ensuring that we have capital available ahead of repayments. Turning to outlook, due to continued uncertainty around the duration of the studio union-related strikes, we're continuing to withhold our 2023 FFO outlook and studio-related assumptions, while providing certain assumptions related to our office outlook, including reaffirming our office same-store cash NOI growth projection range from 1% to 2%. This range includes the impact of a block lease expiration in September 2023 but does not include any of the aforementioned potential dispositions. We continue to expect FFO to be negatively impacted as long as the strike persists. As always, our 2023 outlook excludes the impact of any opportunistic and not previously announced acquisitions, dispositions, financings, and capital market activity. Now we're happy to take your questions.

Operator, Operator

Thank you. Our first question today comes from the line of Alexander Goldfarb with Piper Sandler. Alexander, please go ahead. Your line is now open.

Alexander Goldfarb, Analyst

Hey, good afternoon, or good morning, out there. And again, thanks for moving the call time to avoid the overlap. So two questions. First, it sounds like the sales so far are not contemplating One Westside. I don't know if One Westside is in the potential for additional for sale. But Harout, when you think about all the assets that you guys may sell, what is the NOI impact that we should think about? And then more to Victor's opening comment on corporate expense, if you're selling a bunch what does this mean about the need to reduce the cost structure of the company overall?

Harout Diramerian, CFO

So let me answer the first question, which is, we're not going to provide any NOI detail yet, primarily because the sales are uncertain. Once we have confirmation of the sales and feel confident, we will share all the relevant details around them. Doing that is not appropriate at this time. As far as the G&A goes, I think we said before, we constantly look for ways to reduce our costs and reevaluate them. Depending on the sales and the impact, which will also prompt our ability to reevaluate G&A. They are always being evaluated and thought through.

Alexander Goldfarb, Analyst

Okay. The second question is on Hollywood. Clearly, I mean, you guys benefit from owning independent studios, which is good. But when we think about some of the headlines we read, Disney and others who are talking about trouble with their screen productions or streaming services, how do you weigh over investment in streaming or ways that Hollywood may retrench after some tough goes with the resurge demand once the strike ends? Just trying to figure out, are we back to the races? Or is Hollywood reconsidering how much it puts into its production investments, just given some of the headlines we've read recently?

Victor Coleman, CEO and Chairman

So Alex, as I mentioned in my prepared remarks, what we've found among the bigger streaming entities to date is that they are on budget, at least as we know through '24 to spend at or more than their run rate has been in the past. This includes Netflix, Apple, Amazon, Disney, and Comcast. I think it's approximately a 2% increase year-over-year. I believe this will probably be greater given the fact that they're not spending money currently due to being on strike. You will see a massive ramp-up afterward. I believe, as we mentioned, that there will be some form of consolidation, although what that looks like we can only speculate, I don't think it's going to impact stage use and the production use because there is still a very limited number of stages, and demand is much higher than the available stages during peak periods. Jeff, do you have any comments on that?

Jeff Stotland, Industry Expert

No. The only thing I would add, Alex, is that it's clear with all the streamers that original production drives a lot of subscriber growth, and it also mitigates their churn. So it's a key economic ingredient in their playbooks. Even if consolidation occurs, they all know they must invest in original content production. Hopefully, we'll benefit from that.

Alexander Goldfarb, Analyst

Okay, thank you.

Operator, Operator

The next question comes from Blaine Heck with Wells Fargo. Blaine, please go ahead. Your line is open.

Blaine Heck, Analyst

Great, thanks. Just to follow up on the sales, Victor. You guys have talked openly about evaluating dispositions recently, indicating there are no sacred cows within the portfolio. Harout's commentary was helpful, but just more generally, can you talk about what you've learned about the investment sales market throughout this process, whether there's more interest in certain segments of the market? And just as you've gone through the process, has the composition of the bucket of assets up for disposition changed based on what you've learned?

Victor Coleman, CEO and Chairman

Yes. The three assets that we have under contract right now consist of two individual assets and one parcel of land. Demand for those has been relatively high, mainly from smaller user or owner-user or family office-type investors. The other couple of assets we're working on now have more of an institutional play and change of use play. The drive we're looking at right now has not explored true institutional ownership sales for larger assets, as this is not part of the game plan with the assets we’re discussing right now. The bottom line is that activity is relatively good. Clearly, financing around those assets is a hurdle. The size of the assets from our standpoint and the type of buyer is primarily determined by access to liquidity and capital.

Blaine Heck, Analyst

All right. Great. That's helpful. And then just taking a step back on the studios, Victor, can you talk a little more about any insight you have into the negotiations regarding the writers' and actors' strikes? What’s your best guess, or what are you hearing from any insiders regarding how long these strikes could last based on the current negotiation state?

Victor Coleman, CEO and Chairman

Listen, what we're hearing is that there are substantial hurdles on the table that need to be resolved, notably writers' rooms, the issue around AI—an undeterminable issue that complicates negotiations—and the residual issues. A couple of the agreements surrounding healthcare and the perks are relatively agreed upon. The fact that discussions are happening helps expedite the process because now there's an additional constituent group involved, with thousands more people compared to the previous 3,000 writers involved in the earlier negotiations. What we heard last night was that they're returning to the table on Friday. The writers haven't been at the table for quite some time, and I believe that’s a positive sign. In terms of what we're hearing on the ground, we don't have a seat at the table, but we have a network that provides us with information. We think settlement could start as soon as September or possibly by year-end. Every passing day reveals more strain on various industry segments, and individuals who work in the industry are also affected, which is becoming noticeably damaging. Everyone is aware of that, and we hope for a resolution sooner rather than later.

Blaine Heck, Analyst

Great. Thanks, Victor.

Victor Coleman, CEO and Chairman

Thank you, Blaine.

Operator, Operator

The next question comes from Nick Yulico with Scotiabank. Nick, please go ahead. Your line is now open.

Nick Yulico, Analyst

Thanks. I guess just going back to the asset sales, is there anything you can provide us regarding a view of if you reach a certain level of asset sales this year, what that would do to improve your debt-to-EBITDA metric, which went up again this quarter?

Mark Lammas, President

Addressing that is a bit outside the range of what we want to talk about right now. But ultimately, it will improve it over the long term, which is our main focus: deleveraging. We are using various tools to achieve this goal. Not only focusing on debt-to-EBITDA, but also on covenant calculations—these are important metrics that we are closely monitoring. In fact, this quarter was in line with our projections, and we aren't at risk of breaking any of them. However, like we said earlier, the deleveraging remains a top priority for the company.

Victor Coleman, CEO and Chairman

Yes. To add to that, the assets that are in escrow or under contract and the other two we're talking about—none of those assets currently have debt. So effectively, all proceeds from those sales will go toward paying down current debt. We are not getting rid of existing encumbered debt on any assets at this stage, so that will be quite helpful.

Harout Diramerian, CFO

To address your EBITDA comment, I want to clarify that it’s being artificially reduced by the strike. Thus, it doesn't reflect a normalized net debt-to-EBITDA ratio as a result of the strike; it is being artificially inflated.

Nick Yulico, Analyst

I wasn't sure if there was a specific target you're trying to achieve with that metric, realizing that the EBITDA for the studio business is uncertain given the ongoing strike. Also, with some move-outs still anticipated for the second half of the year, is there a sort of plan in place to reach that target?

Mark Lammas, President

Yes, there’s a plan in place: the goal is to get it lower. We're following through with our announced disposition goals. One of the asset sales is land, which improves our debt-to-EBITDA since there’s no associated EBITDA and all proceeds go toward debt reduction. Our goal is to get that metric improved. We’ve always aimed to keep it below seven times debt-to-EBITDA. We recognize that tenants are rolling out, and there are other variables affected, like the studio and the strike which are out of our control. However, with everything we can control, we are diligently working to improve that metric.

Nick Yulico, Analyst

Okay, thanks. One other question, if I could, regarding Silicon Valley and considering your portfolio there. Historically, there were discussions that it could benefit from additional ancillary services supporting the large tech community there. Given that large tech is currently on hold with leasing, how is this affecting the smaller ancillary companies that support tech? Or is it mainly that large tech is slowing down in Silicon Valley?

Victor Coleman, CEO and Chairman

I think the impact is not as severe as we initially thought, to be frank. As demonstrated in our numbers, the majority of our leases in the Peninsula and the Valley are from smaller tenants. We have a few tenants in the 50,000 square foot range, but the majority are between 5,000 to 20,000 square feet, and our numbers from this quarter indicate a lot of activity in those markets. The physical occupancy in the Valley and Peninsula has increased significantly, which has translated into more inquiries and tours.

Art Suazo, EVP of Leasing

Correct, the answer lies in how tenants are determining their workspace needs. The return-to-office initiative is currently a focal point, and they're enforcing these mandates, recognizing how much space they will require for a rightsize. We see this happening across both larger and smaller users.

Nick Yulico, Analyst

Okay, thanks. That's helpful.

Victor Coleman, CEO and Chairman

Thanks, Nick.

Operator, Operator

The next question comes from Michael Griffin with Citi. Michael, please go ahead. Your line is now open.

Michael Griffin, Analyst

Great, thanks. I wondered if you could expand on what you mentioned in the release about extended times for decisions to be made on leases. Is this just a function of space takers being more hesitant to take space? Is it supply? Any incremental commentary you could provide would be helpful.

Victor Coleman, CEO and Chairman

Yes. It’s difficult to pinpoint, as every situation is unique. We have seen tenants negotiate aggressively and we are waiting on lease signings. For example, we have two substantial leases that have been fully negotiated for months, both international and domestic. I think the current hesitation stems from a need now versus a future need. The decision-making process reflects this. The landscape has changed so rapidly recently with return-to-work policies and companies implementing more stringent measures. The next phase involves enforcement. This enforcement will typically coincide with lease executions—something that we are approaching. Companies are recognizing their needs now and then executing leases as indicated in Amazon’s latest communication that you must be close to your current office or apply for another job.

Art Suazo, EVP of Leasing

Yes. We've seen early projections from tenants across our portfolio. There’s been a spike in tours, and that early activity is likely to translate into actual transactions downstream. They are already considering this in context of their return-to-work strategies.

Michael Griffin, Analyst

Great, thanks. One last question regarding the writers' strike. With ongoing negotiations, is there a worry that if this prolongs into the latter part of the year, it could lead to a slower ramp-up of production into 2024 due to the seasonal nature of this business?

Victor Coleman, CEO and Chairman

That’s a great question. I think we’re confident that when this ends, the ramp-up will be significant and rapid. We've seen this before after COVID, with spectacular ensuing results. I’d caution that it won’t be as simple as switching on production the next day. This industry requires time to regroup; they will need scripts, sets, and talent to move ahead, and that takes time. The industry is preparing behind the scenes, and I believe when it’s up and running, we will see exponential benefits. The timing is uncertain, but we expect a rather swift ramp-up thereafter.

Michael Griffin, Analyst

Thanks for your insight.

Victor Coleman, CEO and Chairman

Thanks, Michael.

Operator, Operator

The next question comes from John Kim with BMO Capital Markets. John, please go ahead. Your line is now open.

John Kim, Analyst

Good morning. With the repayments of the Quixote note, you now have $528 million outstanding on the line. How do you plan to pay that down? Will it be through disposition proceeds? I'm uncertain if the assets are enough to fully pay that down, or will it be through free cash flow or long-term debt refinancing?

Mark Lammas, President

Yes. I think the first two options you mentioned will contribute to that payment along with the dividend cuts. Expect to see cash flow and dividend coverage continuing to improve, especially as studio operations normalize. That net cash flow—net of debt and dividends—will be allocated either toward capital needs that would have required the line's usage or to reduce it. Depending on the time frame we’re looking at, asset sales will also help reduce the line balance. It may also be possible to access the secured markets to reduce this if capital markets are favorable and the secured debt costs are attractive, but excess cash flow and asset sales will be our primary focus for debt reduction.

John Kim, Analyst

Okay. Some of the multifamily companies this quarter talked about property tax relief in Seattle. I don't think we've heard you or other office companies mention this, but do you see a similar trend in Seattle, or just general property tax alleviation?

Victor Coleman, CEO and Chairman

Yes. We're closely monitoring this in all our markets. We have seen favorable resetting of valuations and property tax benefits to the company across all assets in California and Washington. Our team is proactive in optimizing these benefits, and we anticipate seeing some favorable impacts in the upcoming quarters. We've already achieved some wins, and we expect those wins will positively influence our bottom line by reducing expenses related to taxes and possibly yielding rebates across the board.

John Kim, Analyst

Okay. Victor, you mentioned AI demand and potential opportunities. Have you talked to tenants in your portfolio, either direct or sublease, and can you quantify the current level of demand?

Victor Coleman, CEO and Chairman

As I mentioned in my prepared remarks, San Francisco is leading the demand for AI, currently at almost 900,000 square feet. We've seen some deals finalized—for example, Hayden, an AI company that signed for 42,000 square feet, and Hive, another AI company that took about 60,000 square feet. There’s another 800,000 square feet worth of activity in the pipeline. Some of this demand has been for sublease spaces while others are direct deals. We’re quantifying this demand at around 600,000 square feet of net absorption. As previously mentioned, we anticipate that ancillary companies servicing the AI firms will also see growth. We're optimistic about the potential impact, and we are observing a number of active tenants in the marketplace.

John Kim, Analyst

That's great insight. Thank you.

Victor Coleman, CEO and Chairman

Thanks, John.

Operator, Operator

The next question comes from Julien Blouin with Goldman Sachs. Julien, please go ahead. Your line is open.

Julien Blouin, Analyst

Yeah, thank you for taking my questions. Harout, could you explain what's causing the increase in the interest expense guidance? Is it just the forward curve going up and the impact on floating rate debt, and the interest rate cap expirations you have coming up this quarter?

Harout Diramerian, CFO

It’s a combination of factors, but you hit on a couple of them. One is the increase in the forward curve. Although this doesn't directly improve interest expenses, it does contribute positively to us as we pay off the Quixote loan with a $10 million savings. However, the cost of that loan—compared to the current curve—has caused an increase in interest expenses.

Julien Blouin, Analyst

Got it. That makes sense. I was encouraged to hear that the covenants were aligned with your projections. It sounds like you don't foresee any issues there. Can you clarify the deterioration in the unsecured indebtedness to unencumbered asset value? When you say you don't expect any issues, does that assume a certain length of the strike? Or is there a minimum level of leasing or tenant retention through the end of '24 that you see as necessary?

Mark Lammas, President

Yes, the deterioration is a combination of the increase in the unsecured debt balance stemming from the repayment of the Quixote loan, which became unsecured upon repayment. There are almost 40 assets that are considered in the unencumbered asset calculation and some increased in the quarter while some decreased. The net decline was around $112 million. We have stress tested this metric, including for a protracted strike through ‘24. Even in the most impacted quarter, we remain more than 300 basis points above the threshold. I should mention that neither of the studios, nor 1455—which I believe some may focus on due to the block expiration—affect those valuations directly. There is an indirect effect due to cash flow: to the extent we generate cash flow from the studios, it will be used to repay debt, which will improve that metric over time. We accounted for a protracted strike and all known move-outs as far as we can project through the end of '24.

Julien Blouin, Analyst

Got it. That's very helpful. Thank you.

Victor Coleman, CEO and Chairman

Thanks, Julien.

Operator, Operator

The next question comes from Camille Bonnel with Bank of America. Camille, please go ahead. Your line is open.

Camille Bonnel, Analyst

Hello. I wanted to follow up on a comment regarding mark-to-market opportunities being around 5% for 2023 expirations. Given the negative cash rent spreads on the leases you've signed so far, has this aligned with your expectations, considering you're still observing positive rent growth and net effective rent growth?

Mark Lammas, President

Yes. Our mark on the remaining '23 expirations remains a positive 5%. A couple of deals account for that negative 8% drag in the March market: the Rivian 60,000 square foot extension through '28, where we hit peak market rents in Palo Alto. We’re grateful for that significant extension, but it reflects current market conditions, resulting in that negative 18% mark. We also did a three-month extension with Luminor, which also dampened that number a bit. If you consider only those two deals, you would essentially come out flat on mark-to-market. Thus, our remaining expirations are in line with our expectations for the quarter, and we still anticipate a mark of around 5%.

Art Suazo, EVP of Leasing

Additionally, both of those yields were in the same market where we achieved peak rents, and we’re now adding market rent, which is also quite healthy, significantly below the mark.

Camille Bonnel, Analyst

So within that market and considering that demand remains below expectations for stronger pricing power, do you believe these negative rent growth trends will persist over the next 18 months? Or do you have any insights regarding whether we're nearing a bottom?

Mark Lammas, President

Our numbers reflect refreshed market leasing assumptions and we update those constantly. Our projections show a positive outlook for the remainder of '23; we essentially anticipate flat on '24 expirations, and a slight positive for '25. Looking through the lens of our assets and associated assumptions, we believe we are nearing a bottom in the market.

Camille Bonnel, Analyst

Thank you.

Victor Coleman, CEO and Chairman

Thanks, Camille.

Operator, Operator

The next question comes from Dylan Burzinski with Green Street. Dylan, please go ahead. Your line is open.

Dylan Burzinski, Analyst

Thanks for taking the question. Regarding big tech leasing, I appreciate your insights so far, but one of your peers noted not expecting big tech leasing to recover even next year. I'm curious if that's your stance as well, and if so, what do you believe will ultimately bring them back to leasing more space?

Victor Coleman, CEO and Chairman

I don't know what other landlords are saying. We're seeing activity in big tech in certain markets. A decision tree is made regarding how space will be utilized, and companies are actively searching for accommodations. Clearly, we're seeing a flight to quality; our higher-quality assets experience the most activity, and there is tech activity around them. I'm not going to claim big tech is not returning or that they won't soon. What we know is that our tour numbers are higher than they have been previously, reflecting that activity. Amazon, for instance, has recently shifted its workforce back to its hubs.

Art Suazo, EVP of Leasing

It's not just big tech; we are also witnessing similar trends from companies like AT&T and Farmers. This shift is gradually becoming apparent.

Dylan Burzinski, Analyst

Appreciate those comments. Any noticeable trends regarding changes in space layouts during discussions?

Victor Coleman, CEO and Chairman

We are tracking this in real time. We’ve seen an increase in conference room facilities and space allocated per employee. That figure has increased, with more space allocated per person compared to past trends. The numbers now reflect closer to an average of 165-200 square feet per employee, whereas it was previously around 120 square feet. This trend appears consistent, driven by demands for more amenities and premium locations and quality.

Dylan Burzinski, Analyst

Thanks for those comments.

Victor Coleman, CEO and Chairman

You too, Dylan.

Operator, Operator

The next question comes from Ronald Kamdem with Morgan Stanley. Ronald, please go ahead. Your line is open.

Ronald Kamdem, Analyst

Hey, returning to leasing. I appreciate the helpful details provided on the 2023 expirations and the Amazon deal. Any updates on Nutanix space and the towers at Shore Center coming due in 2024? Can you shed any light on the negotiations there?

Art Suazo, EVP of Leasing

Certainly. Nutanix is recalling some space as part of a contractual agreement, extending their lease for 215,000 square feet for an additional seven years. Their contractual giveback amounts to 51,000 square feet, and we already have leases in place for half of that space. We’re currently marketing the remaining space. As for the next large piece in '23, which is up in May, we’re actively searching for a backfill user but haven’t yet secured one, though we are actively touring the space.

Ronald Kamdem, Analyst

Got it. And what about Poshmark?

Art Suazo, EVP of Leasing

Yes, we are currently in negotiations with them. They occupy three floors, and presently we are negotiating for two floors as they evaluate their preferred footprint.

Ronald Kamdem, Analyst

Got it. And regarding the 2 million square feet in the pipeline, can you thematically break that down for us? Is it primarily AI, financial services, tech, and can you provide more detail?

Art Suazo, EVP of Leasing

I'm unable to dissect it that way. However, based on my general sense regarding that 2 million square feet, it’s risen by 100,000 square feet quarter-over-quarter after leasing 400,000 square feet. The early interest in leasing we've talked about is indeed becoming tangible and is yielding results for our pipeline, which bodes well. Given our market, I would estimate around 60-65% of that pipeline consists of tech tenants. However, I can’t break it down further to AI versus hardware or software.

Ronald Kamdem, Analyst

Got it. Thank you very much.

Victor Coleman, CEO and Chairman

Thanks, Ron.

Operator, Operator

This concludes our question-and-answer session. I would like to turn the conference back over to Victor Coleman, Chairman and CEO, for any closing remarks.

Victor Coleman, CEO and Chairman

Thank you so much for participating in this quarter's call, and we'll speak to you all in the next quarter.

Operator, Operator

The conference has now concluded. You may now disconnect.