Kilroy Realty Corp Q3 FY2021 Earnings Call

Good day, and welcome to the Third Quarter 2021 Kilroy Realty Corporation Earnings Conference Call. Please note, this event is being recorded. I would now like to turn the conference over to Michelle Ngo, Senior Vice President, Chief Financial Officer and Treasurer. Please go ahead.

Good morning, everyone. Thank you for joining us. On the call with me today are John Kilroy, Tyler Rose, Rob Paratte, and Eliott Trencher. At the outset, I need to say that some of the information we will be discussing is forward-looking in nature. Please refer to our supplemental package for a statement regarding the forward-looking information on this call and in the supplemental. This call is being telecast live on our website and will be available for replay for the next 8 days, both by phone and over the Internet. Our earnings release and supplemental package have been filed on a Form 8-K with the SEC, and both are also available on our website. John will start the call with an update on our market conditions and review our operational and strategic activities. I will discuss third quarter financial results and provide you with updated earnings guidance for 2021. Then we'll be happy to take your questions. John?

Thanks, Michelle. Hello, everybody. Thank you for joining us today. I'll start with some macroeconomic comments before getting into our leasing and capital allocation. It's been just over 1.5 years since the pandemic began, and we are really starting to see the revitalization of cities across the West Coast. City dwellers are returning to their urban apartments and once again embracing city life. After a tough 2020, residential net absorption is approaching 100,000 units in our 5 markets driven in large part by high-density areas like Hollywood, South of Market, Downtown Seattle, and Downtown Austin. Restaurants, bars, coffeehouses are full, concerts and sporting events have returned, and slowly but surely, more companies are coming back to the office. The recent easing of the San Francisco mask mandate is another step in the right direction that we believe will continue to encourage more social interactions and collaborations. The technology and life science companies that make up so much of our portfolio continue to thrive. Stock prices are near all-time highs and VC fundraising is on track for a record year, which is translating into a war for talent, growth in job postings, and additional real estate procurement. Improving market conditions helped to drive a strong and productive leasing quarter for Kilroy. We signed more leases in the third quarter than the first 2 quarters of 2021 combined. Since the second quarter, we have signed just under 600,000 square feet of development, new, and renewal leases. For the 510,000 square feet in the stabilized portfolio that were signed, GAAP rents were up on average 26%, and cash rents were up 14%. Additionally, we have a number of leases under documentation. And in Austin, we're very encouraged with the market and our early-stage lease negotiations. A few facts according to recent reports about Austin, there are 185 people moving to Austin on average each day, and interest among companies wanting to move to Austin and those that want to expand in Austin is above pre-pandemic levels. Let's look at some of these transactions. In the office sector, we signed a long-term 71,000 square foot lease in the UTC submarket of San Diego. The lease is for a new development project, which we commenced construction on just last month. So now it's 100% leased just a month after starting construction. The competition between technology tenants and life science tenants remains healthy. Both sectors continue to grow and seek more modern, efficient work environments. In life science, the third quarter was particularly active for us. We signed 3 leases totaling 330,000 square feet of headquarters space with publicly traded companies in San Diego, including Tandem Diabetes Care, DermTech, and Sorrento Therapeutics. The mark-to-market rent increases on these 3 leases were approximately 45%, with an average term of approximately 12 years. In residential, we now have fully leased all 608 units in our One Paseo project at rent levels that have increased 25% since the beginning of the year. Jardine, our Hollywood luxury tower that was completed last quarter, is now more than 60% leased, well ahead of projections. With respect to leasing, I'd like to highlight the following trends, which we feel bode well for the future of our enterprise. Sentiment amongst corporate real estate executives is more positive than it has been in the past 18 months. We're experiencing significantly more tours and requests for proposals within our portfolio. This is both for existing and development projects, rental rates and strategically located modern buildings are on the rise as the result of tenants seeking the best space in the market. Vibrant and distinctive office, curated retail, and residential experiences are drawing a talented labor force back to metropolitan areas. Moving to our capital allocation activities. We made 2 significant announcements during the quarter. First, in September, we completed the off-market acquisition of West 8th in the Denny Regrade submarket of Seattle for $490 million. West 8th is a 539,000 square foot LEED platinum office tower situated on a full city block just steps from Amazon's 5 million square foot headquarters campus. We like the opportunity for a number of reasons. The location is terrific with unmatched transit access and proximity to numerous retail amenities, rents continue to increase in this submarket, and we see significant rental upside. Given the quality and condition of the building, we expect limited capital investment in any re-leasing scenario. Year-to-date, this brings our total acquisitions to $1.2 billion, which have been funded by our $1.1 billion dispositions. The second announcement relates to our continued allocation of capital to our life science platform. Earlier this year, we commenced construction on the second phase of our approximately 50-acre, 3 million square foot Oyster Point project, which is a life science campus in South San Francisco. KOP 2, which totals just under 900,000 square feet across 3 buildings, will be a home to numerous amenities that will serve all phases. We are particularly excited about Phase 2, given the strong demand, rising rental rates, and timing. No other competitive project will be delivering in this timeframe. We are in early discussions with multiple prospective tenants interested in securing major portions of the project and expect even more interest in the buildings once construction goes vertical in the first quarter of next year. In addition to KOP, we are expanding our San Diego life science significantly. Availability for top-tier space in the region's most sought-after life science submarkets is essentially nonexistent. Barriers to entry are high and rental rates are at historic levels. We are capitalizing on these dynamics in Del Mar, UTC, and the I-56 corridor, where we have modern, highly convertible assets and a land pipeline. In the UTC and Del Mar submarkets, as I noted in my earlier remarks, we signed 330,000 square feet of pre-leases across 3 buildings, which will be converted to life science use. Just a few miles east on the 56 corridor, we expect to commence construction next year on the first of 2 phases of our Santa Fe Summit project. Each phase consists of approximately 300,000 square feet. To summarize, we will deliver 2.5 million square feet of state-of-the-art life science facilities over the next 30 months. Over time, the 3 future phases of Kilroy Oyster Point will expand our life science portfolio by another 1.5 million to 2 million square feet. When completed, we have assembled a best-in-class life science portfolio in the strongest locations, which will total 5.5 million square feet with an average age under 5 years. With full build-out, life science and health care tenants will be 25% to 30% of our NOI. Lastly, delivering our in-process development and positioning our future development projects remains a high priority in our capital allocation strategy. We have $2.6 billion of in-process projects on track for completion over the next 2 years. This pipeline is 52% leased and 74% leased when excluding the just commenced KOP 2, which we started 5 months ago. They will generate approximately $170 million in incremental cash NOI when stabilized, which will grow our current annual NOI by more than 20%, all else being equal. The cost is fully funded through the year-end 2022. I'll wrap up with a few final observations. In nearly every conversation we were having these days with our tenants and potential tenants, one big theme emerges, companies want a work environment that attracts, excites, and motivates their workforce. They want location, scale, contemporary design, a healthy environment, and relaxed ambiance that will draw people in and support their creativity and productivity. This is the most profound impact the pandemic has had on the office sector, and we think KRC is well positioned to capitalize on these conditions. Over the last 10 years, we created the youngest best-in-class platforms across office, life science, and residential and we are poised to deliver strong growth and value creation over the coming decade. We're more encouraged every day about our market's recoveries. The reopening is going to happen in fits and starts, but it is happening. And a final comment on sustainability. In GRESB rankings, we have been named #1 in sustainability across all publicly traded companies across all asset classes in the Americas for the eighth year running. That completes my remarks. Now I'll turn it back over to Michelle.

Thank you, John. FFO was $0.98 per share in the third quarter. Quarter-over-quarter, the $0.10 increase was largely driven by the acquisitions to date, NOI contribution from our One Paseo office and our residential projects as well as $0.015 of lease termination fees. On a year-over-year basis, as a reminder, the sale of the exchange had an impact of approximately $0.13 of FFO per share. On a same-store basis, third quarter cash NOI was up 16.6%, reflecting strong rent growth and a $17 million cash termination payment. GAAP same-store NOI was up 3.2%. This termination payment is related to the new 12-year lease we executed at 12400 High Bluff for 182,000 square feet of space. On an earnings basis, approximately $7 million, which is a net amount after lease write-offs, will be amortized over the next 3 years. $700,000 of it was included in the third quarter. Adjusted for termination payments, same-store cash NOI was 3.7% and same-store GAAP NOI was up 2.2%. At the end of the third quarter, our stabilized portfolio was 91.5% occupied and 93.9% leased. Third quarter occupancy was down 30 basis points from the prior quarter, driven by approximately 90,000 square feet of move-outs, offset by the West 8th acquisition and the Cytokinetics lease at KOP 1, which was added to the stabilized portfolio at the end of the quarter. Revenue recognition for 100% of this 235,000 square foot building commenced on October 1. Turning to the balance sheet. After funding the West 8th acquisition for $490 million, issuing $450 million of green bonds, which closed on October 7, and the redemption of $300 million of 3.8% bonds, which was completed earlier in the week, our liquidity today stands at approximately $1.5 billion, including $390 million in cash and full availability of the $1.1 billion under the revolver. We have no material debt maturities until December 2024. Our net debt to Q3 annualized EBITDA was 6.7x, pro forma for the bond activities noted above, which should decline as we continue to deliver our lease development projects, all else being equal. Lastly, our expirations over the next 5 years remain modest with an annual average expiration of 7.2%, excluding any impact from DIRECTV. We do not have an update to provide on the DIRECTV matter at this time. In 2022, we only have 1 lease expiration greater than 100,000 square feet in San Diego. This tenant is likely to vacate in early 2022. Now let's discuss our 2021 guidance provided in yesterday's earnings release. To begin, let me remind you that we approach our near-term performance forecasting with a high degree of caution, given all the uncertainties in today's economy. Our current guidance reflects information and market intelligence as we know it today. Any COVID-related restrictions or significant shifts in the economy, our markets, tenant demand, construction costs, and new supply going forward could have a meaningful impact on our results in ways not currently reflected in our analysis. Projected revenue recognition dates are subject to several factors that we can't control, including the timing of tenant occupancies. With those caveats, our assumptions for 2021 are as follows. Cap interest is expected to be approximately $80 million. Same-store cash NOI growth is expected to be between 5% and 5.5% for the year. We expect year-end occupancy of approximately 91.5% for the office portfolio and north of 80% for residential. Our guidance does not assume a material increase in transient parking. But as we've noted on prior calls, we expect to pick up $1 million a month when we get back to pre-COVID levels. With respect to the 3 San Diego life science transactions, we will be adding them to the redevelopment portfolio and capping interest in phases as follows. On average, we are modeling 6 to 9 months of redevelopment, which are estimates based on what we know today and could be impacted by a variety of factors, including tenant modifications. At 12340 El Camino Real, which is 100% leased to DermTech, we expect to add this 96,000 square foot building to the redevelopment pipeline this quarter. At 12400 High Bluff, which is approximately 85% leased to Tandem Diabetes, we expect to add 75% of this 182,000 square foot lease to the redevelopment pipeline in late Q1 next year. At 4690 Executive Drive, which is 100% leased to Sorrento Therapeutics, we expect to add this 52,000 square foot lease to the redevelopment pipeline in 2 phases, half in late Q1 next year and the remainder in early 2023. We do not have any additional acquisitions in our forecast. Taking into account all these assumptions, we project 2021 FFO per share to range between $3.74 to $3.80 with a midpoint of $3.77. This updated midpoint is the same as our prior guidance, even after including the debt redemption costs of $0.115 in the fourth quarter. This is largely driven by the acquisition of West 8th, which contributed $0.06 to our results and earlier revenue recognition of Cytokinetics and better operating results, including $0.015 of lease termination fees, all totaling 5.5% or $0.55. Excluding the $0.115 of debt redemption cost, the midpoint of our guidance would have been up 3% or $3.89 of FFO per share. That completes my remarks. Now we'll be happy to take your questions.

The first question comes from Nick Yulico from Scotiabank.

Maybe just first question, if Rob could perhaps go through some of the leasing dynamics you're seeing in your markets?

Sure, Nick, and hello, everyone. I want to highlight some key points that may address your questions. First, the office will continue to be the center of the work ecosystem. While its configuration may change, it will remain a place for meetings and collaboration. We see companies, including our clients, investing significantly in their office spaces, which is an important observation. Hybrid work is a certainty moving forward. Thirdly, we believe the overall impact of hybrid work on space demand will be minimal, with a recent CBRE survey showing that only 9% of 185 companies expect a decrease in square footage. This is quite telling. Additionally, as John mentioned, health, safety, and wellness will continue to be very important to employees, leading to a preference for high-quality buildings that offer amenities like outdoor spaces and access to stairs over elevators. Now, regarding our markets, activity in our five markets has been on the rise, especially in San Francisco. There is a noticeable increase in foot traffic in restaurants, retail, and hospitality, demonstrating recovery. For instance, the parking garage we use is much busier than it was just a few months ago. Interestingly, despite debates about remote work, many of our clients have opened their offices voluntarily, which is evident in the bustling lobbies of buildings in San Francisco. In terms of office occupancy, Austin leads with nearly 50%, while San Francisco and San Jose are around 20%. However, these two markets are starting to pick up pace, particularly after San Francisco lifted its mask mandate. Real estate executives are currently focusing on what hybrid work models will look like and how they will affect future office space requirements. If we go through our markets, starting with San Diego, tech and local VC-backed companies are very active. Although categories like fire safety and legal requirements are emerging slowly, we are seeing an increase in activity, especially with 2100 Kettner, which has received significant interest recently. In Los Angeles, there is positive momentum, particularly in Culver City, Hollywood, and West L.A. The market is seeing a decrease in sublease space as it gets leased or removed from the market. The expansion of gaming, media, and tech companies in these areas is evidenced by absorption rates from companies like Apple, Roku, and others. Quality Class A assets are managing to hold onto their rates, even with some added concessions. San Francisco seems to be stabilizing, with a slight decrease in sublease space and encouraging activity in leasing, bringing us to the highest level since Q4 2019. We are optimistic about improving trends in the market. In South San Francisco, we're pleased with the strong demand for our recent projects, which are mostly leased or committed. Seattle continues to show strength, particularly in Bellevue, while sublease space is declining in the CBD, with rental rates of Class A products increasing. Our West 8th acquisition is attracting interest, which is promising. Lastly, in Austin, we have over 200,000 square feet of activity in our building, with two large pending transactions totaling over 900,000 square feet in the CBD, which is promising for our R&D tower. Overall, we feel positive about each submarket and the trends we're observing.

That's very helpful. Just on Oyster Point, can you remind us, I guess, 2 things. One, can you just give us a feel for where market rents are right now? And then separately, remind us how on Phase 1, the rest of the NOI is going to flow from a GAAP standpoint over the next couple of quarters?

Yes, Nick. I'll handle the first one. I don't want to pinpoint because the market is moving and it's moving in the right direction. But safe to say, I think rents are achieving $7 net right now and will exceed that just based on the absorption that's going on in the activity.

Yes, Nick. With respect to KOP Phase 1 and the remaining revenue commencement. We said Cytokinetics commenced in early October, and Stripe, who occupies the remaining 2 buildings, will come online in November.

The next question comes from Manny Korchman with Citi.

Maybe as you expand the development pipeline, have you seen any issues with the supply chain disruption, especially since I feel like some of it's coming a little bit faster than you expected?

Yes. Manny, this is John. We obviously have a group that monitors all of that stuff. And there are some disruptions for sure. We made a decision at Kilroy a couple of years ago that we were going to reduce our dependence upon offshore suppliers as much as we could possibly do. And we have, but we are still dependent because of steel; we don't fabricate any steel in China, but you have to buy the bulk steel, bring it here. We're very focused on what we can control. And so as you probably know, there's a lot of ships that are at anchor waiting to unload all of our ports, and we've been very focused on making sure that the stuff we have coming from offshore is going to ports that don't have the jam-up that L.A. has, as an example. In regards to delivery of things, we forecast everything that takes longer. And with regard to construction costs, we've been forecasting anywhere from 5% to 6% per annum increases across the board, and we've done better than that. Everything that we have under development right now has been bought. Things that we are going to start, we will buy. We've had pretty good luck in that regard. We've been able to deliver everything at or below what we forecasted. But we're keeping a close eye. We've had to make some selections of alternative materials in a few cases to make sure that we don't have a supply problem. So that's kind of a general comment, and more to come, but we do have a pretty robust risk management function within our construction development activities.

And Michelle, going back to your prepared remarks, you spoke about 1 large vacate in, I think you said early '22. If I look at your expiration schedule for '22, if that vacates in the first quarter, it seems like those rents are sort of well below the rest of your portfolio. And I'm wondering if this tenant falls into that? Or otherwise, if you could just give us some more details on the move out?

Yes, Rob, I don't know if you have any color on the move-outs. But I guess with respect to market rents, I'd say last quarter, we said across our portfolio, rents are about 15% below market. I think in looking at '22 explorations, it's in that 20% to 25% below market range.

Yes, Manny, this is Rob. Just a little more color. We've anticipated this vacate. We've been talking to the tenant off and on; some of their work is related to government contracting. We are pursuing and have activity sort of in a wide variety of sizes, somewhere from 50,000 feet to in excess of 100,000 feet. Given we haven't gotten the space back yet, we're already working on some things and feel pretty good about it. There's a lot of activity, as John said in his comments, just a lot of activity out in that corridor right now.

And Michelle, just from a modeling perspective, can you be more specific on the timing we should assume for next year?

It's in the first quarter.

The next question comes from Jamie Feldman of Bank of America.

Great. Just to confirm what was the size of the San Diego move out?

It's about 125,000 to 130,000 square feet.

Okay. And then I guess, thinking about next year, it sounds like you think nothing else sizable?

No. That was the only sizable one.

I appreciate the updated supplemental materials; they look great. On page 30, I see the future development pipeline. Considering the lengthy lead times for projects, what are your thoughts on initiating incremental projects now? It appears that you believe the markets are starting to recover.

Well, this is John. As I mentioned earlier, we will be starting the first phase of the two remaining phases at Santa Fe Summit, totaling about 300,000 square feet. There are two phases planned for 600,000 square feet, and we might begin both if we lease one of the phases. This will commence next year. We are considering a few other projects, but there is nothing to announce at this time regarding entitlements. We have received all our entitlements for the Flower Mart and have revised the phasing for that project to about 500,000 square feet per increment, which is positive. However, we don’t plan to start that immediately; we want to see the market stabilize in San Francisco first. We also have our SIX0 project in Seattle, which is likely a year away from starting. Additionally, there’s a project on 26th Street in Santa Monica, involving an existing building of about 40,000 square feet to be remodeled, along with approximately another 100,000 square feet in two adjacent buildings that we seek approval for. This will be a low-rise, modern campus that we could potentially start next year, as there is already strong demand for it. That summarizes our current development outlook. We are preparing for Phase 3 and 4 of Kilroy Oyster Point; while we are not ordering materials yet, we want to be ready to start once we make some leasing progress at KOP 2.

Okay. And I mean, the announcements of expansion in Austin just continue. Any latest thoughts on how you can grow there beyond Indeed?

I don't want to share them publicly for competitive reasons because it is a competitive market. But Elliot and his team have been working on a number of things there. We're hopeful that we're going to be able to complete some other things, maybe as early as this quarter, but maybe it will be next year. But you're quite right. I mean what we see there is that it sort of reminds me, Jamie, of when we bought Oyster Point, and Cambridge was at sort of $90 triple net, and the Oyster Point area was sort of at $55, $56, $57 triple net. We said we think these are the same tenants; they're going to end up paying more like Cambridge prices in due course, and that's exactly what's happened at Oyster Point. Now Cambridge, as you know, is well north of $100 triple net. It's the same tenants that are paying higher rents around the world that are moving into Austin, at least in the big tech. I think there's going to be a lot of lift. We're not really interested in older product that doesn't meet the demands and needs of the modern tenant unless it's an old building with a lot of floor height that we can convert. So we are scouring the market regularly. We're in negotiations all the time. Nothing now to report, but hopefully, something will break loose here in the next few quarters.

The next question comes from Derek Johnston with Deutsche Bank.

L.A. L.A. remains a bit of a hole in the portfolio and really what otherwise is pretty well occupied. I think it's around 87%. What do you see going on in that market? And what's it going to take to get back to the 90s or maybe even 95% or higher basically in line with your other core markets?

Yes. This is John. I'm going to turn it over to Rob here in a minute. But if you look at L.A., there are a lot of big tenants and there are a lot of small tenants. Small tenants have lagged in this pandemic area for obvious reasons. It's easier for them to move into the home or move into wherever they're moving. There are more of those kinds of spaces available. But we are seeing really strong signs of life. The big users, as Rob pointed out, are making moves forward. We're seeing a lot more requests for proposals. We've done an awful lot of little deals recently. And Rob, do you want to add a little bit more color on that?

Yes. L.A. is a vast market that spans from Long Beach to Thousand Oaks and Calabasas, encompassing many submarkets. We don't concentrate on downtown L.A., but West L.A. has had a significant amount of available space, especially between 2100 Colorado and Santa Monica Business Park and the Water Garden. Notably, Santa Monica Business Park and Colorado have seen significant absorption. The gaming industry is now emerging as a competitor with tech companies for space on the West side. Culver and Hollywood have remained quite stable throughout the pandemic due to ongoing film production, making those areas attractive to media companies. We're beginning to see increased activity in West L.A., particularly in deeper West side areas like Santa Monica, starting with larger tenants. However, smaller firms are also beginning to emerge. For about a year and a half, they have not made moves since there hasn't been a need to engage with leases while offices were closed. Now, we are starting to see more activity in that smaller segment.

If you look at, as an example, our Tribeca West project, which is very much geared towards shorter-term production directors, all that movie content stuff, (indiscernible) a lot of those people could go to work last year. Now all of a sudden, our occupancy is increasing substantially. As things loosen up, people get back to work, they need space to work and they lease space. So that's a good trend. That's what we're seeing.

All right. Great color. Last one. So looking at some office companies that have already reported so far, they seem to have been able to drive longer-term commitments from the tenants. I know you guys were always a little lighter on term historically. But is this like a California thing or a tech issue? And could you share any insight on when you think your lease terms will return to like the 7- to 10-year levels? And what...

Well, I don't know how you're getting that statistic, and Michelle or Rob, you can help me, but I think Kilroy has had amongst the longest term leases because we do so much with big companies, and those are generally anywhere from 10 to 16, 17 years. So I'm not quite sure where that's coming from. And so...

Derek, this is Tyler. I think what you're looking at is the lease term on some of our renewals within the high 4-year range. But if you take into consideration the leases we signed in San Diego, which are not in that category, those were averaging over 11 years. So the average lease term for what we actually leased last quarter was 9.5 years. So it's still in line with what we've been doing. It's a little hard to follow in those numbers.

The next question comes from Steve Sakwa with Evercore ISI.

I was just wondering maybe, Rob, if you could maybe touch a little bit on the life science demand, specifically in South San Francisco. I realize that KOP 2 doesn't have steel coming out of the ground, but maybe what are your expectations on timing? And maybe you or John could just address the broader infrastructure issues in South San Francisco and how you guys sort of think about mass transit, getting everybody that's going to be coming to that entire area as Genentech looks to double their footprint and you and many of your peers look to continue to add density to South San Francisco?

Yes. I look at this a little bit as fly fishing, Steve, you've dangled the fly out there, but I'm not going to snap at the fly with respect to timing and what we're doing and when we'll be able to announce something. But I would say that demand in the market, even though there's been tremendous absorption in the market today, demand is still tracking at about 4 million square feet. As space gets absorbed, there's new demand appearing. So that's a very positive sign. As I mentioned earlier, rental rates are on the move, and we're very pleased by that. With respect to the second part of your question, we are in a lot of discussions with not only our existing tenants, but potential tenants and others that are our neighbors on a variety of transportation solutions and ideas. It's something that everyone in Oyster Point, and frankly, everyone in an urban area is going to have to address at some point, it's circulation and moving people around. But I think 1 of the best assets we have is the Bay, and Genentech, as an example, has a very significant robust ferry service that they run throughout the Bay Area.

Okay. And maybe piggybacking off 1 other question on Austin and just your desire to grow down there. I guess, John, have you gotten closer to formalizing or finalizing who might be running that region and sort of how you think about whether it's an internal or external candidate?

Yes. We have identified, and it's somebody from within that will be running it from an asset management standpoint, from a leasing standpoint. Obviously, Rob has the all-event responsibility and has a very firm handle on that. We have 1 of our top leasing people from this area here in San Francisco, who is responsible for the leasing currently at Indeed Tower. As we expand our platform there, we're obviously going to need more bodies, and we're working on that. We've been going through that process. Nothing to announce right now. But we're very actively looking not only to have the management team that we want, and we have some really good candidates. We've been interviewing candidates now for several months, right, Rob?

Yes.

We're down to a couple of candidates that we think could end up being very senior to our efforts there. The underwriting with regards to all the math, the investment leads and so forth, that's Elliott and his team; Jeff Jesse, 1 of his young superstars, is very involved in everything to do at Austin. We're going to have a great team, and we are going to have the kind of team we've had in our other areas, which is capable of acquisitions, dispositions if and when that becomes appropriate, obviously development, and then managing, and we're spending a lot of time with our tenant base, many of whom are in Austin and growing in Austin and have future plans to grow in Austin about what we're doing and so forth. I think that's encouraging. So more to come.

Okay. And then maybe just last question, John, on the Flower Mart. I know there's some flexibility on that site, but how do you sort of think about the toggling between office and residential and would you look to maybe shrink the office component, add residential to maybe jump-start that project? Or how do you sort of think about that moving forward?

Our basis is quite appealing. I've consistently mentioned that we won't make short-term decisions that could harm our long-term goals. You're correct, we can engage in residential projects. The main objective was to secure entitlements for the office space. Currently, we possess one of the largest entitled properties, potentially the largest in recent history, in San Francisco for office development, encompassing 7 acres and approximately 2.5 million square feet. Transitioning from office to residential is feasible, while the opposite isn't possible. We have a prime selection of options and enough land across three major streets to be flexible in our approach. As I mentioned earlier, there’s been some uncertainty about when things will change in San Francisco. However, we are witnessing a significant resurgence in the apartment market, with reports of record rental rates and a scarcity of available apartments. Notably, while it was common for multiple tenants to share a 2-bedroom unit, there is a growing preference for more personal space. This mirrors what Rob mentioned about needing more square footage per person in office settings, which is occurring in residential areas as well. We intend to observe how this develops over the upcoming quarters, without a specific timeline, and decide on our next steps. We value having options. Whether it’s our property in Seattle, the Flower Mart, or our two blocks in East Village, San Diego, we are positioned to adapt between office and residential uses, or even a mix of both, and we also have the potential to include retail if desired. This gives us substantial flexibility.

The next question comes from John Kim with BMO Capital Markets.

I wanted to follow up on Derek's question on lease terms because if you look on Page 18 of your supplement on leases executed, most of these leases were new leases, and the average lease term is about 4.3 years. So I was wondering if leases have come down on term, if there's been any month-to-month that's in there that's driving that number down?

Again, the redevelopment leases that we signed in San Diego are not in that category. So those are the leases in our stabilized portfolio. So when you add in the leases that are not in that category, it's 9.5-year average.

Yes. And just to clarify. So the lease numbers include the redevelopment leases, but the lease economics that you see in the weighted average term do not reflect the term of the 3 redevelopment leases, which are on average about 12 years.

Right. So you have some redevelopment in life science leases that are long-term, and then you have others where the tenant is committing on a shorter term basis?

Right.

I don't believe we have any obsolete projects. As John mentioned, we likely have the youngest portfolio in the REIT industry, so I don't think there are any obsolete projects.

Can you also comment on the sublease space in your portfolio? I know you discussed the market overall, but what is within the Kilroy portfolio?

Yes. Probably the largest piece of sublease space is the 350 Mission Salesforce sublease. A good portion of that has recently been absorbed, and they're continuing to market the balance of the space. I'm not sure today whether they intend to take some of that off the market and occupy because they're, as you know, their downtown campus here right outside John's office, multiple buildings have a lot of people back in at work. We know they've also started bringing sales teams back in on a mandatory basis here and there for meetings. So more to come on that, but that's the largest.

The next question comes from Blaine Heck with Wells Fargo.

Just one for me, probably for John or Rob. During the pandemic, obviously, office leasing activity was down everywhere, but maybe focusing on the Bay Area, it seemed like the valley did a little bit better than San Francisco CBD, where you saw, obviously, a lot of the sublease space flood the market. You guys talked about the CBD market showing some encouraging signs lately, which is great. But how do you think about any differences in the recovery in the valley versus San Francisco CBD in particular?

Yes. The valley is very interesting because there's been a significant amount of activity. One theme we've consistently mentioned in our calls and investor meetings is the division between the haves and have-nots in the valley, which largely depends on property locations near major freeways leading to San Francisco and Caltrain. There have been notable transactions in the last few months, with Apple being a key player, absorbing over 500,000 square feet, along with other tech companies expanding. My experience suggests that the valley and San Francisco markets work together; historically, when there is substantial absorption in the valley, it tends to spill over into San Francisco. We are beginning to observe that in the central business district of San Francisco. Additionally, San Francisco faced significant shutdowns during the pandemic compared to the valley, which was less restrictive. Demand and activity in the valley have continued to rise.

This concludes our question-and-answer session. I would like to turn the conference back over to Michelle Ngo for any closing remarks.

Thank you for joining us today. We appreciate your continuing interest in KRC. Goodbye.

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.