Kilroy Realty Corp Q4 FY2021 Earnings Call

Hello and welcome to the Q4 2021 Kilroy Realty Corporation Earnings Conference Call. My name is Alex and I'll be coordinating the call for today. I will now hand over to your host, Michelle Ngo, Chief Financial Officer. Over to you Michelle.

Good morning, everyone. Thank you for joining us. On the call with me today are John Kilroy, Tyler Rose, Robert Paratte, Eliott Trencher, and Bill Hutcheson, Senior Vice President of Investor Relations and Capital Markets. Our recent addition to the team, welcome Bill. At the outset I need to say that some of the information we will be discussing during this call 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 eight 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 highlights from 2021 and where we stand today, then move to operational and strategic activities going forward. I will discuss fourth quarter financial results and provide you with initial earnings guidance for 2022. Then we'll be happy to take your questions, John.

Thank you, Michelle. Hello, everyone. Thank you for joining us today. We've always believed that dislocations in the market bring opportunities, and last year we executed on several large opportunities, which I'll discuss later. We had disruptions to normal work life created by the pandemic, accelerated changes already underway, and we saw all of our key strategies validated. Location, product design, an age, tenant base, wellness, and sustainability have all become vital ingredients in modern high-quality properties. As the economy experienced this surge through 2021, we remained steadfast in our core principles of creating value for our shareholders through developments, executing leases, recycling capital into higher growth projects, all while maintaining a strong balance sheet and elevating our leadership position in ESG. I'm proud of our team for delivering a strong performance on all fronts. Now one month into the new year, evidence continues to grow that COVID is fast becoming a manageable virus. Underlying economic conditions in our markets continue to improve and the trends that drove market success last year remain firmly in place. Urban neighborhoods that are highly amenitized continue to attract younger, educated workers, which has translated into record residential leasing and all-time high rental rates in some markets including our One Paseo living project in San Diego where we are fully occupied. Leasing continues to accelerate at our recently completed Jardine in Hollywood where we are now just under 85% leased up from around the mid 60s last quarter. Major technology and media companies competing for talent continued to expand, bidding up rents for premium quality workspace that addresses new design, wellness, and sustainability requirements. We continue to see big tech, including Google, Meta, Apple, TikTok, and many others committing to expanding their real estate footprint in our markets. The continued path of flight to newer, higher-quality office properties is supported by record rental rates and price per square foot on investment activities in our markets. Demand for life science facilities and lab space continues to grow. Vacancy rates are less than 2% and lower rates are approaching or have exceeded prior records in our markets. VC funding continues to flow into the innovation-driven companies and startups in West Coast markets, and Austin received a disproportionate share of record funding in 2022; life science funding was also at record levels. Demand for talent, demand for space, and strong funding continued to underpin the premium asset valuation for high quality in our markets. In light of these drivers, we believe our portfolio operating platform and development pipeline will continue to differentiate KRC as the best-in-class owner, operator, and developer in our markets. Our stabilized portfolio has grown in quality and value. At an average age of 11 years, our office, life science, and mixed-use portfolio is among the youngest portfolios, featuring adaptable spaces that meet our tenants' evolving needs. Flexible, multi-use spaces that offer natural light, fresh air, and outdoor access are also key elements in our industry-leading portfolio in terms of wellness and sustainability measures. Our portfolio of more than 1,000 luxury residential units in Hollywood and San Diego are performing quite well. We've limited near-term explorations that average 7.1% annually through 2025, and our stabilized portfolio was 93.9% leased. Our in-process development program is well-positioned to drive growth and long-term value creation. We have $2.3 billion in various stages of construction, and 45% is comprised of life science. Once stabilized, we expect this pipeline to generate approximately $165 million of cash NOI annually. With the exception of KOP Phase 2, which commenced last year, we expect the NOI to come online within the next 24 months. Our future development pipeline is well-diversified by market and product type, spanning the most attractive sub-markets along the West Coast, including our SIX0 project in Seattle, the Flower Mart in San Francisco, Kilroy Oyster Point Phases 3 to 5 in South San Francisco, and our East Village and Pacific Avenue sites in San Diego. Our strong basis gives us the flexibility to be patient and start construction when conditions are favorable. Our rapidly expanding life science platform has positioned KRC as a leading player in the West Coast's most sought-after life science markets. In South San Francisco, we recognized the tremendous potential value of what is now Kilroy Oyster Point early on. The 50-acre waterfront property purchased in 2018 will encompass roughly 3 million square feet of state-of-the-art lab space when fully built out. It will represent a total investment of more than $3 billion and is expected to generate an overall cash yield of approximately 7%. Our first development phase at KOP was fully leased within two quarters of our construction start, and we fully stabilized in the fourth quarter. We believe we have created about twice the value of our original investment. The second phase, totaling just under 900,000 square feet, is currently under construction. We expect vertical construction to commence this quarter in San Diego County, the West Coast's second-largest life science market, driven by the region's top universities and medical research centers. We're now operating with frictional vacancy rates with rents reaching historic heights in UTC, Torrey Pines, and Del Mar. The path of growth is now moving further North East on the 56 corridor where our Santa Fe Summit development site is entitled to approximately 625,000 square feet of life science space in two phases. We expect to initiate construction in late spring or early summer of this year, with delivery scheduled in approximately 24 to 30 months. In summary, our total life science and healthcare portfolio on properties we now own will be approximately 5.5 million square feet when completed and fully leased, which will more than double our revenues from life science and healthcare tenants from 17% to more than 30%, all else being equal. Our entry into Austin, which I hope will be an important new market for our continued growth, came with our $580 million acquisition of Indeed Tower in the second quarter of last year. This acquisition allowed us to grow earnings and will give us the opportunity to create value through additional lease-up. Indeed Tower is a fantastic, new, well-located asset that has created a high-visibility platform for our future growth in the Southwest region. Austin is a city with all the characteristics and growth potential that we look for, resembling what we saw in San Francisco in 2010, Seattle in 2011, and Hollywood in 2012. There is a broad technology presence, a young educated workforce, and it is in the early stages of tremendous growth as companies move into the office market. Leasing activity is nearing pre-pandemic levels, and rents continue to escalate. Many major technology companies we work with have established or are planning to expand our footprint in the city. Our strong balance sheet gives us an important advantage when opportunities arise. We are able to act quickly, close transactions in a timely manner, and our fiscal management has allowed us to increase our dividend for six years in a row, the most recent being a 4% increase in 2021. That represents a cumulative 48.6% increase since the first quarter of 2016. Lastly, our determination to lead our industry in establishing and meeting increasingly ambitious ESG standards continues to prove its value to our company, our tenants, and our employees. This focus has made us a more innovative, forward-looking company. Time and time again, the industry has recognized us as a leader in sustainability. While we're proud of these accomplishments, we will continue to look for new and better ways to engage our communities and minimize our environmental impact. In closing, let me share our five key objectives for 2022: first, complete the lease of our remaining in-process development projects, as we prepare for new development starts when appropriate, including Santa Fe Summit; second, continue to maximize the value of our operating portfolio by proactively managing lease expirations and boosting sustainability and wellness; third, look for unique external growth opportunities as we monitor market dynamics and evaluate our capital allocation decisions; fourth, maintain our conservative financial foundation with sufficient liquidity from various sources to allow us to grow; and fifth, continue to work with government agencies and others to positively influence public policy. Once again, we are entering a new year that is sure to be filled with unique challenges and opportunities. We are well positioned to capitalize on opportunities that arise and continue to build a strong, flexible organization capable of delivering long-term value for our shareholders. That completes my remarks. Now I will turn the call back over to Michelle.

Thank you, John. FFO was $1.05 per share in the fourth quarter, which included a negative $0.11 of early debt redemption costs and positive $0.06 of one-time items related to real estate tax adjustments, repayment of owed rents, and the lease termination fee at 12400 High Bluff Drive in San Diego that we discussed last quarter. Adjusted for this net $0.05, our fourth-quarter FFO per share of $1.10 is $0.12 higher than last quarter, largely driven by the acquisition of West 8 and revenue commencement at Kilroy Oyster Point Phase one. This adjusted FFO per share is a 12% increase year-over-year. On a same-store basis, fourth-quarter cash NOI was up 9.8% and 6.1% adjusted for $5.5 million of one-time items related to repayment of owed rents and lease termination fees. The positive growth is driven by higher rents on commenced leases and the burn-off of free rent. GAAP same-store NOI was up 10.5% or 3.5% adjusted for $6 million of one-time items in the fourth quarter and $3.5 million of COVID-19 related charges in 2020. At the end of the fourth quarter, our stabilized portfolio was 91.9% occupied and 93.9% leased. Turning to the balance sheet, after the sale of Sabre Springs Corporate Center for $37 million, our liquidity today stands at approximately $1.4 billion, including $290 million in cash and full availability of $1.1 billion under the revolver. Our current in-process development and redevelopment program, along with the soon-to-commence Santa Fe Summit is funded through year-end with cash on hand and projected dispositions. Our net debt to Q4 annualized EBITDA was 5.8 times. Lastly, as John mentioned, our expirations over the next five years remain modest. Specifically, in 2022, we have approximately 585,000 square feet, or 4% of lease expirations remaining. We had a 145,000 square-foot tenant in San Diego vacate its space at the end of January. In the third quarter, we have a 65,000 square-foot exploration in Los Angeles. It is too soon to tell whether this tenant will renew for a portion or all of the space or vacate entirely. In 2023, the largest expiration is for our recently acquired West 8th project in Seattle, where we underwrote both a renewal and a vacate scenario, but more to come. Now, let's discuss our '22 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 of the uncertainties in today's economy, our current guidance reflects information and market intelligence as we know it today. Any COVID-related impact 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. Productive 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 2022 are as follows. As always, we don't forecast acquisitions. We assume $200 million to $500 million of disposition proceeds. Capital interest is expected to be approximately $70 million to $80 million. G&A is expected to be approximately $82 million to $87 million. Same-store cash NOI growth is expected to be between 4.5% and 5.5%. We expect year-end occupancy of approximately 91% to 92% for the office portfolio, and north of 90% for the residential portfolio. Our guidance assumes a steady increase in transient parking revenues starting in the summer. As we've said on prior calls, we expect to pick up about a million dollars of revenues a month when we get back to pre-COVID levels. We expect to commence revenue recognition for the following office and life science projects within the following time frames. At 333 Dexter, we expect the remaining 51% of the 635,000 square foot project to come online by the third quarter. At 2100 Kettner, we're expecting leasing activity on half the project or approximately 100,000 square feet by year-end. Across our three life science redevelopment projects, we expect about 250 of the total 330,000 square feet to come online by early fourth quarter. We anticipate development spending of $550 million to $650 million on our in-process development and redevelopment projects, including the commencement of Santa Fe Summit. Taking into account all these assumptions, we project 2022 FFO per share to range between $4.35 to $4.55, with a midpoint of $4.45. This midpoint would imply a year-over-year FFO increase of 13% when you add back the debt redemption costs and one-time items in Q4 2021. This increase is the second highest earnings growth across the past ten years. To help walk you to this $4.45 midpoint, we start with our adjusted fourth quarter FFO per share run rate of $1.10 or $4.40 on an annualized basis. We subtract $0.12 of NOI from the midpoint of our projected dispositions in 2022 and the sale of Sabre Springs Corporate Center in December of 2021. We have $0.13 from development and redevelopment projects coming online. Lastly, we expect a net positive $0.04 from various items, including pickup from our stabilized portfolio and lower G&A. That completes my remarks. Now we'll be happy to take your questions, Operator.

Thank you. We will now proceed to the Q&A. Our first question for today comes from Nick Yulico from Scotiabank. Nick, your line is now open.

Thanks. Hi everyone. Maybe a question for John or Rob. Could you just talk a little bit about the latest on tenants returning to your portfolio? Parts of the West Coast have been slower than some other cities because of tough decision-making or government mandates. Maybe you could just talk about what you're hearing from tenants on that side and then also how it's affecting leasing activity in your markets.

Do you want to take that one?

Sure. Hi Nick, how are you? Let me touch on three macro points related to your question because there are various factors at play. For the first time since the pandemic began, large employers have started to share formal plans for employees to return to the office, communicating this in writing as well as in town hall meetings. If you look at major tech companies like Amazon, Microsoft, and Meta, they have different models for how staff will come back. However, despite the Omicron variant, they are indicating that parts of their workforce will return around mid to late February, March, and April. They seem to express this with more certainty than before, based on our conversations. Interestingly, some companies have stopped trying to predict return dates and are instead focusing on discussions about bringing their teams back. Secondly, many executives we've spoken with have conducted surveys among their employees, revealing a noticeable difference in attitude and productivity between those who have returned to the office and those who have not. They are working on making their office spaces more appealing to encourage employees to return. A recent workplace survey by Gensler of 575 companies indicated that two-thirds are planning to implement flexible work policies, but only 9% are willing to give employees complete control over where and how long they work from home. And I think the third point I'd like to make to address your question is, we're embarking now on what I would call the great experiment between working from home and the office. What we're hearing from our clients, as well as prospects, is that the majority of employers that we're talking to are not discussing a reduction in their footprint despite work from home, despite some functions that may be able to work from home. They are predicting either a stable footprint or growing footprint. They're focused on providing hospitality-like amenities, as we've discussed before. It really comes down to the core of, actually, John's philosophy on development; we are seeing a flight to quality. This flight to quality is happening not only in our portfolio but nationally. For example, 400,000 feet with creative artists in Century City consolidating into new development, Sephora and Yelp consolidating into our 350 Mission sublease space that Salesforce had on the market that's over 300,000 feet. With that backdrop, I'd say, we are encouraged about what we’re seeing in terms of activity and the conversations we're having. Omicron, no doubt, did slow down tour activity but things are picking up in Q1 already.

Thank you, Rob, that's helpful. My second question is regarding the guidance for occupancy. Looking at the range, there's a slight drop in occupancy in the midpoint this year. We discussed this earlier, and the San Diego move-out is one factor. Can you provide insight into how you're approaching the lease numbers in your portfolio? Should we expect more confidence in the leased rate increasing this year, even if the actual occupancy remains unchanged?

Let me try to address that in two ways. One, let me just talk about the last quarter. This is really interesting. It goes back to some of the comments I made earlier. At the end of the last quarter, and this is really from Thanksgiving through the end of December, we signed three significant leases: 80,000 feet with a media company in Southern California, a 71,000 square foot lease with a major technology company, and a 38,000 square foot lease with a life science company in the Bay Area. We also signed our first two leases in Austin at above our underwriting. That literally, Nick, is from November to December in the midst of Omicron. I'm encouraged that that momentum has continued. I'm optimistic about the amount of activity that we have across our platform right now, including Austin, where it seems like every week we're getting RFPs and requests for information on the building. We have a fairly significant amount of leasing activity proposals, that sort of thing, that we're working on right now and have been working on in January. So I do think as momentum picks up, as some of the factors I addressed earlier take hold, we'll see that growth throughout the year. Of course, there's always the lag between a lease being executed and then physical occupancy of the space.

Okay. Thank you.

Thanks, Nick.

Thank you Nick. Our next question comes from John Kim from BMO Capital Markets. John, your line is now open.

Thank you. I'm looking at your lease expirations for '22 and you have a footnote that you have 215,000 square feet that have already been addressed through leased and signed. Are any of those going to be occupied this year in contributing to FFO or are those of 2023 commencement dates?

Yes. The roughly 200,000 that's leased but not yet occupied will likely come in towards the end of the year, the fourth-quarter.

Okay. That's helpful. John, you mentioned that one of your objectives for the year is to search for unique external growth opportunities. Could you elaborate on that? Does it involve complex development opportunities, or when you say it's unique, are you referring to a new market or a new asset type? Any comments you can provide would be appreciated.

We always evaluate various markets before making decisions. Currently, we don't have any specific insights to share. However, we experienced dollar growth last year and are pleased with our acquisitions. We are actively seeking new opportunities in Austin, and we plan to provide updates in the next quarter or two. Our approach has typically involved purchasing buildings, often a few at a time, where we can add value and ensure we have the necessary infrastructure for growth. You can expect a similar strategy in Austin with Kilroy. We've made significant hires in that market and will share more details in the upcoming quarter. We aim to operate as a development company there, as we do in all our markets. We're excited about the growth potential in Austin and are exploring numerous opportunities there, so our next announcement should likely come from that market.

Thanks for the color.

You're welcome.

Thank you, John. Our next question comes from Manny Korchman from Citi. Manny, your line is now open.

Hey, it's Michael Bilerman here with Manny. John, I wonder if you can just step back a little bit and just think about capital raising plans as you move forward with sort of sights on additional external growth. You think back the last two years, that February 2020 well-timed offering at $86 gave you $500 million in liquidity. Over the course of the pandemic, you used the asset sale market to produce even more liquidity, which has allowed you to do a number of the developments and acquisitions that you've talked about. So I'm curious how going forward you think about your capital raising plans. I know Hutch is now around the table. Has that changed at all? As you look at the capital markets now, you've put some in place that seat IR and capital markets. Has your thinking evolved around capital raising and how you want to execute it? Will it be more self-funding? Or do you think about raising leverage? Whether you think about raising more equity? Just how your thoughts have changed.

Well, yes, those are all good points, Michael and hello and Happy New Year. We're happy to have Hutch onboard, we figured it'd be a great addition; certainly provides a lot of additional character to the organization. We're not interested in selling stock at the share price that we have today. We do think we're going to see a recovery in share prices as the back-to-work accelerates, and this COVID starts to diminish in people's minds. All signs seem to indicate that these things are going to be happening. But I don't see selling stock. In terms of leverage, I'm a big leverage guy if you know. We've forecasted $300 million to $500 million of asset sales. I think that that's imminently doable and we always look at what product that might qualify for that, where we're either where it's non-strategic or where we may not be able to add a lot of value, sort of like we came to the conclusion for the exchange. So, we're going to stay in a very conservative leverage position. We will be very prudent with regard to any equity that we issue in the future. I think there are plenty of ways to look forward with what our funding requirements will be; some more to come.

John, how do you plan to integrate a capital markets position for the first time after 20 years, considering it was previously handled by the CFO and treasurer? What are your expectations for this change over the next 12 months?

That's a good question too. We’ve been debating that for some period of time. Our enterprise has grown. We recognize that there are a lot more investors out in the REIT space. Some are dedicated, some are not. Maybe we think a lot of the analysts have a lot more to do than they used to. They're covering a lot more companies. We obviously have greater geographic region now. And so that generally means that there's increased communication requirements. By having Hutch, I think we end up with an individual who not only knows the industry very well, knows the markets very well, knows many of the investors extremely well, but is a great communicator. What we intend to do is to be in front of people more, explaining our story and making sure that people have a complete understanding of the things we're doing. We're pretty excited about all the opportunities we have, some of which we can't really talk about on these calls. I think that will be a great ambassador.

Great. See you next month in Florida.

Okay. Great. Well, thank you.

Thank you Manny. Our next question comes from Steve Sakwa from Evercore ISI. Steve, your line is open.

Yes, thanks. Good morning out there. John, I guess first question, San Francisco's certainly been probably the slowest large city to get back to the office and crime and homelessness have certainly become a bigger problem. I'm just curious, the discussions that you're having with city officials to improve quality of life there in order to make the RTO process more memorable to people.

Well, I figured somebody would ask this question and I always have an opinion about politics and politicians. I think we're making progress, Steve. It sometimes looks slow but if we take a look at the root cause of a lot of this stuff, it's both in Los Angeles and in San Francisco and it's prevalent in some of the other big cities in the country in which we don't operate. We have district attorneys that came in talking about reform and what they have done in the case of San Francisco with Chesa Boudin, and in the case of Los Angeles with George Gascon. In both cases, we have people that are not enforcing the laws, allowing things like smashing grab, where you can go in and steal under $900 and they won’t prosecute you, so the stores don't even try to prevent it. We've just created a terrible situation. People are fed up. We have to unite folks that want to fight these issues and there are recall campaigns for both these district attorneys, both Chesa Boudin in San Francisco and George Gascón in Los Angeles. It is a massive coalition of homeowners, small business people, larger businesses, existing politicians, former members of their staff, the sheriff going away in the case of Los Angeles, and a number of city council people, all of whom have come out against these figures. We have a recall campaign in both cases, Kilroy is involved in that as are many of our peers, as are many others from other businesses, homeowner groups, etc. We're hoping to throw these bums out. So I think the thing that’s really very, very positive is that, this isn’t a democratic effort or a republican effort or an independent effort. It is an effort by a broad coalition of people who want lawfulness and the enforcement of laws. I'm convinced these two will be thrown out and if they're not thrown out now, they'll be thrown out in the general election when it comes up; the recall that’s qualified in San Francisco. The election will be in June. The job approval rating for Chesa Boudin is under a negative 67% the last time I looked. Gascón down in Los Angeles has been in a very similar situation. So market forces are dealing with this. It's not as efficient as we’d like. We are seeing improvement in San Francisco and Los Angeles, particularly in terms of homelessness in many communities but it needs to go further. So that's what's happening. I'm spending a fair amount of time on this as are my counterparts and some of the other public real estate companies and private real estate companies, but I have to say this is a very broad coalition of business owners, and some religious groups; just people are fed up.

I appreciate that detailed answer, John. I'm curious if you or Rob could comment on how the current situation is affecting the leasing discussions you're having. There seems to be potential for improvement, but if these issues aren't resolved until the middle of the year, it could slow down leasing progress until the second half of the year or even into next year. Are you concerned about delays in the leasing recovery in downtown San Francisco?

Well, let me give you a couple of points there. I’m going to go between the two cities now. Look at our new 20-some story luxury apartment building, part of the Netflix campus in Hollywood. We projected that would be 20% occupancy by the end of this year; it came on spring mid-year and it’s now 85% occupied at the highest rents ever. I’m not saying it doesn’t influence leasing, but notwithstanding that we're making good progress. Rob, would you talk to the bigger point and specifically San Francisco with Steve?

Sure, Steve. We are seeing momentum picking up on the leasing front. As I mentioned earlier, Sephora and Yelp subleasing at our 350 Mission space, those two transactions total 300,000 feet. The Chime deal at 101 California happened at the end of last year. No doubt the question you raised and John's answer are very serious considerations. Thus far, it hasn't slowed deal momentum. In fact, I think on the last investor call we had with you, you had asked about Autodesk and their announcement in January of this year that they were vacating a 117,000 square feet at 300 Mission. Apparently right now that space is fully committed to another tenant, so that's 100,000 feet that's in play, literally two to three weeks after a tenant announces they’re not going to occupy the space. We’re definitely not out of the woods but momentum is picking up and again, speaking with our competitors that have view space, quality space, and top-floor space in the Bay, they are starting to talk in proposals of 10% to 20% over pre-COVID rates for that trophy quality space. So, in a very tight segment of the San Francisco market, I think it’s pretty encouraging. If you're in a class B, C situation where you don’t have the amenities, you don't have the common areas, that space is not moving. Or if you have a lot of second-generation space, it's not moving. The tenants are looking for plug-and-play and looking for quality.

Great. And then just one cleanup item for Michelle. Thanks for all the detail on the guidance. I guess the one number that I didn't hear was your expectation for straight-line rent and FAS 141 income within the guidance for 2022. Do you have a range for that?

Yeah, I think for straight-line rent, it will be somewhere between $40 million to $50 million. And I think on FAS 141, it shouldn't be too dissimilar to our 2021 range.

Great. That's it for me. Thanks.

Thank you. Our next question comes from Jamie Feldman from Bank of America. Jamie, your line is now open.

Thanks for taking my question. I’ve been listening to the comments on the call and noting how tenants are seeking new high-amenity spaces, whether through new developments or redevelopments. I’d like to hear your thoughts on what the development cycle might look like across your markets, assuming we move past COVID and things begin to reopen. Do you believe there will be more opportunities than before, considering tenants are interested in new, unique buildings? I’m curious about what you see on the horizon, especially since Kilroy has historically been ahead of the trend with these types of assets.

Well, Jamie, it's a bit premature to make those kinds of predictions due to the current volatility and the various COVID variants we've encountered. However, I find it encouraging that people are making significant commitments to substantial spaces. This bodes well for us given our development capabilities and land positions. There will be a continued preference for spaces that may not necessarily be brand new but that have the right location, features, and amenities. We are experiencing strong demand in our markets, like the Bay Area and San Diego, where life science and technology sectors are competing for similar types of buildings and locations, as well as the amenities needed to attract and retain talent. For instance, our project at Oyster Point has attracted interest from both tech and life science sectors. We possess some of the largest entitled properties in the state regarding what we can develop. The environment is ideal for outdoor spaces, and there's likely to be a trend toward having spaces that allow people a degree of control and assurance in their working conditions. There's a growing emphasis on wellness, and Kilroy owns more well buildings than anyone in the world apart from the U.S. government. We anticipated this trend, and we are now seeing a demand for sustainability, wellness, and higher ceiling heights. If you own a building without these features, it’s a cause for concern. The obsolescence of older office spaces is something I've talked about for the last decade, and it's now accelerating rapidly. I believe this will result in more modern spaces being constructed because we will see a division between buildings that function well and those that do not. Some buildings can be redeveloped, but many cannot. Therefore, we are likely to see an increase in development activities.

And when you think about your markets, are there some that you think have more obsolete space than others?

I believe we haven't acquired any buildings outside of our target markets in the 12 years we've operated in San Francisco. Instead, our strategy has focused on positioning ourselves with shorter buildings that feature higher ceiling heights and desirable amenities. I expect the area in Central SoMa, where the Flower Mart is located, will become a significant part of San Francisco's development. However, I don't think the projects there are ready to proceed just yet, as we need to wait for the situation in San Francisco to stabilize over the next year or two. We are already in discussions about a new building we’re developing in Santa Monica, which recently received approval. It's a smaller project of about 150,000 to 175,000 square feet across two or three buildings. Although we haven't started marketing it and have kept it relatively quiet, we already have interest from several tenants currently in older office spaces in the area who prefer more modern facilities. I anticipate seeing a similar trend in Austin, which is experiencing significant population growth and has many older and some good buildings. There will likely be opportunities for substantial developments there, and this trend will likely occur nationwide. In New York, for example, it's clear that renters are choosing to occupy the latest and most modern buildings, as they aim to attract and retain their most valuable asset: their employees.

I thank you for that. If I could just ask a follow-up on San Francisco. It looks like your percent leased declined to 93.9% from 96.6% this quarter. You've got next year about 3.5% of your revenues expiring in San Francisco. I just want to get your thoughts on that. That seems to be kind of a deterioration in the percent leased there and then how comfortable are you with the explorations coming next year given market conditions?

Jamie, I can start on the percentage leased in San Francisco. I think in the fourth quarter that declined because there was a tenant that terminated its lease early, which contributed to some of the one-time income that we picked up; that was one specific tenant related to credit.

And we're in renewal discussions with that Bob’s won back.

Okay. And then the 2023 expirations, I know it's a ways out, but any discussions already of potential move-outs or nothing to report just yet?

Again, the 2023 expirations, the largest one is related to the West 8th acquisition in Seattle. And like I mentioned in my comments, it's too soon to tell whether or not they will renew or stay. But we did underwrite both scenarios and we're comfortable with both.

Sorry, I was focusing specifically on CBD San Francisco. It looks like you’re getting 3.5% of your revenues in '23 to expire in San Francisco?

There wasn't anything that's large. I think it's all 25,000 to 50,000 square foot leases. But Rob, I know you and the team have been working to early renew.

Yeah, we have discussions going on, Jamie, on a good portion of that '23.

Thank you, Jamie. Our next question comes from Blaine Heck of Wells Fargo. Blaine, your line is now open.

Great, thanks. Good morning out there. Maybe for John or Rob, it's great to hear that the discussion seems very positive with your tenants but I wanted to see if you can talk specifically about lease negotiations and any differences you might be seeing in your lease contracts relative to what was being negotiated and agreed on prior to the pandemic. Are there additional expansion or contraction clauses? Any additional optionality on early terminations or extensions, or even differences in the lease term that tenants are willing to agree to?

Hi Blaine, this is Rob. It's interesting we're not seeing much discussion or change in terms of things like contraction or terminations. We typically avoid those in our leases and are known for that. I think especially if you have ground-up development, that's just not a wise path to go down. I think others owners feel that way too. It's interesting in certain discussions we're having, timing is probably the most important point that's raised by the tenant, meaning they want to be in their space, and they want to be in it soon. We have a deal we're working on now where we're using our development construction team to help expedite permitting, so this tenant can be in place by September. The deal's not signed yet, but that's the focal point. It's not so much what's the rent or what's my term. I think the other component that comes up, particularly if you have a standalone building is, okay if I lease in your building, how do I grow? Where do I grow? If I outgrow that building, if I take the whole thing, what do you have around me where I can expand? That trend started a little bit in 2019, but it seems to be popping up depending on the size of the space and the tenant you're talking to. The tenant improvement discussion because of cost escalation, that sort of thing, is really one component of an overall negotiation that's driven by rent and corresponding capital investment. Luckily, in the markets we're in, we have the ability to raise our rents to meet or exceed forecasted prices.

Okay, great. That's helpful color. John, can you just talk about the dispositions you guys have targeted and whether there's any color you can give us on which properties they are—whether there are common themes, like selling out of a particular submarket or selling lower-quality assets? Any guideposts around pricing would be helpful as well.

I'm not going to specify which buildings, but there's always been a consistent approach at Kilroy: if an asset does not align with our strategy, it becomes a candidate for potential sale. There are instances where we have concluded that we can't add value to an exceptional and strategically important building. Last year's exchange would be a prime example of that. We routinely review our portfolio to identify which assets might be candidates for sale. Elliot can discuss that process, but he won't go into detail about specific properties. We prefer not to disclose which assets we are considering selling until we have definitively made that decision, as it could affect our relationships. Elliot, do you have anything to add? Regarding pricing guidelines, we can't provide information on pricing until we know which asset will be involved. Generally, pricing tends to be robust across all our markets. Elliot, would you like to add anything to that?

There isn't much more to say beyond that. We are examining various markets. You won't see us completely exit any market, but we are selectively evaluating opportunities that align with the reasons John mentioned.

Yes. If you look at the Sabre Springs project that we sold, it's a property that was until the bowling was nice, that wasn't really the quality building that we specialized in anymore. We didn't see how it added much to us. The people that bought it I'm sure are going to do well with it. But it's a smaller asset. It's a good example of something that just wasn't really any longer in Kilroy's wheelhouse.

Okay, great. That's helpful. One more quick one if I can. Can you guys give an update on your estimated mark-to-market for the entire portfolio and maybe even on a market-by-market basis, if you have that detail?

Yes. Hi, Blaine. Similar to the third quarter, we’re estimating the portfolio is roughly 15% below market. By market, San Diego’s about 20% below market. LA’s about 15%, and San Francisco and Seattle are about 10% to 15% below market.

Great. Thank you all.

Thank you. Our next question comes from Craig Mailman from KeyBanc Capital Markets. Craig, your line is now open.

Hey, everyone. Just a couple of quick ones here. Just Michelle, maybe following up on the disposition question. Could you give us a sense of that 12% drag from disposes? What would that be either on timing or cadence or if you have an annualized number of what that $0.12 would be?

Yeah, we assume the midpoint of that in the mid-year.

Okay. And that includes Sabre Springs also?

We sold Sabre Springs around the middle of December, which had an approximate impact of $0.02 for the year 2022.

Thank you. And then just the last one from me. As we think about occupancy, I know you mentioned a 145,000 square foot tenant that vacated. So should we think about it that Q1 kind of dips to the midpoint of your guidance and then stays there, as the 500,000 or so trickles through the portfolio? Or do you have any other smaller known move-outs to add up that will impact given quarters?

Yeah, I think you're right. The first quarter will dip due to the San Diego exploration. And then we have some development projects coming online in the third quarter that I mentioned with 333 Dexter. Some smaller move-outs that I mentioned in LA will also dip further impacted by 2100 Kettner coming online.

Okay. Perfect. Thank you.

Our next question comes from Vikram Malhotra from Mizuho. Vikram, your line is now open.

Good morning. Thanks for taking the question. I just wanted to go back to the relative markets and your positioning. You talked about the quality divide quite a bit through all the markets. But just two specific questions. One, can you talk about relative pricing power in each of your office locations? And related to that, is there something different about the San Francisco City / Peninsula recovery, this cycle versus prior cycles in your mind?

Hi Vikram, this is Rob. Let me address the pricing power question first. The two or three markets where we have the strongest pricing power are the Bellevue-Seattle Market, the Oyster Point Life Science Market where John mentioned our 50-acre site with 3 million square feet, and I shouldn't forget Austin either. We have pricing power there, as well as in San Diego due to the combination of life science and technology in that area. So, it's really San Diego, Austin, Oyster Point in the Bay Area, and the Seattle-Bellevue Market. Now, I'll move on to the second part of your question.

Yeah. Just on San Francisco. I mean it's historically bounced back faster and quicker than I guess, other markets. Is there something different in your mind about specifically San Francisco, the recovery this time?

Yeah. You're right; it's bounced back frequently and other downturns. I think the crux of that there's two points. I think one is that the city, more than any city in the country, we've said before was shut down more so than other cities and longer. That's behind us now. Secondly, I think it's really been impacted by technology. Employers are not really pushing their employees to come back to work or putting more formalized plans in place. As I said earlier, I think now that they're announcing plans and shortening the time-frame for people to come back, that that will improve. But what’s interesting is if you compare Silicon Valley and San Francisco, they have often worked in tandem. So when you have large headquarter expansions in Silicon Valley, there's usually a subsequent spillover into San Francisco, just because there are so many employees that work in the city. In San Francisco, the cycle has lagged, but I think it's because of the reason I mentioned earlier, being shut down, and employers not really bringing people back in. But the last piece is anecdotal, but if you look at every bar and restaurant in San Francisco, they're jam-packed and full. So I don't get why people can go out eating and drinking, but they can’t be in the office.

Fair enough. Maybe turning to Austin, you referenced potentially some opportunities in the next one or two quarters on the development side. Can you maybe remind us of are there specific submarkets you're exploring within Austin? And maybe just remind us of the grand vision over there in terms of how large would you want your portfolio over there to be?

John, you want me to take that one?

Eliott, you want to take that one? Yeah.

Sure. So Vikram, there’s no magic number for how large we want to be. We want to do deals that we think are smart deals. If that means we're 2 million square feet, great. If that means we're 3 million square feet, that's great too. We're not going to anchor ourselves to a particular number. As far as the parts of the market that we're focused on, obviously the CBD, we're in D Tower and the surrounding areas around the CBD. We also like the area in and around the domain, as well as some others.

Okay, great. And sorry, just one last clarification. Michelle, maybe the mark-to-market you referenced; I just want to confirm that's a cash mark-to-market?

That's correct, yes.

Okay. Thank you.

Thank you. Our next question comes from Michael Carroll of RBC Capital Markets. Michael, your line is now open.

Thanks. Can you give us some color on your life science views in San Diego? I know a number of your projects are just north of the traditional core markets and you're indicating that the market is starting to move upwards given the tight market overall. How quickly is this migration occurring and how attractive are these submarkets today?

You want to take that one?

Sure. I can start with pitch-in, John. As we've said before, Torrey Pines was the initial life science submarket in San Diego, and that quickly filled up. That's traditionally been the basis of life science. The UTC submarket sprouted relatively recently, and because it's such an attractive location in terms of housing as well as just access and amenities, it became attractive to life science because it was the next, natural geographic spot to locate. But it also became very attractive to technology. I would say that to your question, the migration is happening very quickly. We have seen a lot of life science, as we've mentioned in our Del Mar Heights and Del Mar One Paseo office campus. That trend is continuing. As John has mentioned before, you're seeing it out into the I-56 and I-15 corridor; on the West Coast, you have really the Oyster Point location as the life science hub, and you've got San Diego as a life science hub, and both are thriving. So I think you're going to see a lot of expansions in new moves into submarkets within San Diego, where there's housing, where there are amenities, and where they have the type of projects that these companies want. I think the last thing I'd say is that tech is really adding pressure to life science to act more quickly. Life science typically has been slower to act compared to other companies leasing space just by nature of their character.

Okay, great. And with regard to Santa Fe Summit, I know this is a near-term start in the first half of this year, I believe you guys are targeting. Can you talk a little bit about that? What are you waiting for to break ground? Are you looking for some pre-leasing, some entitlements, or just getting things ready to break ground right now?

Yeah, we're ready. We're negotiating the contracts that will be under construction. I think it’s next quarter. We have the permits in hand. We'll start with a guaranteed max price on the contractor; all the architecture is done and permitted. So we're full steam ahead.

And are the underwritten rents similar to the core markets, just given what you're indicating that people are moving north?

I'm not going to get into what the rents are and give out that information to brokers or whatever. But let's just say that it is a better value than what leases are going for in the core of Torrey in UTC, but it is also going to produce a much better yield and developers are getting there.

Okay, great thanks, John.

You're welcome.

Thank you, Michael. Our next question comes from Caitlin Burrows from Goldman Sachs. Caitlin, your line is now open.

Hi, good morning there. Maybe just following up on the point from earlier that some office buildings won't make it. When you think about the vacancy in lower quality properties in San Francisco or otherwise, what do you think ultimately happens to this product? Does it remain office with low rents? Does it get converted or does it get redeveloped? And if so, do you think that’s something Kilroy would be interested in participating in?

Yeah. I'm not going to say never because I've learned that’s a bad thing to say, but a lot of the stuff that’s over— for example, the north side of the market. A lot of that is just dark, smaller floor plates, lower ceiling height spaces in an area that isn’t amenitized well. I think does it become residential? Probably, that’s what will happen. Or does it become some kind of boutique office space with smaller tenants? That could be the case, but I don’t really worry about it too much because we're not actively seeking to be there. I do think there is a real bifurcation and I've been talking about this for 10 years. What’s funny is, for the last 10 years, I've been talking about office obsolescence in the country, what the modern office building is going to look like, what kind of amenities it’s going to have, sustainability, wellness—all these things are now being discussed like they just came up. Some people have been talking about it for sure, while many are just now discovering them. But these trends have been going on, and if you look at them, if there are fewer and fewer people, ultimately there’s going to be a discussion about electric vehicles versus gasoline-powered vehicles. So people are making big bets on electricity because they're saying gasoline is killing the environment. So where do you want to make your bet? That does not say gasoline-powered cars are going away anytime soon, but they are diminishing. There are political and public policies encouraging that. If you think back now and take that same sort of thinking to office space. I don't want to invest in things that are going to go bad; I want to invest in things that are going to get better. I want to invest in the markets where there is energy and creativity and a multiplication of employers, thereby greater demand for rents.

Got it. And then maybe just a question on lease execution volumes, as you mentioned. A lot of the trends in tenant demand do seem to be towards the higher-quality, newer, highly amenitized buildings. But it does look like Kilroy's execution volume is still below the 2017 and 2018 average levels. So just wondering, is there something that’s causing that? And could you go through your expectation for how and when it could recover?

Rob, it’s you?

Yes. Caitlin, as I mentioned earlier, our activity for the first quarter, particularly in January, is building on the momentum we saw in December 2021. I feel confident about our current position and what lies ahead. The years 2017 and 2018 were exceptional, marking a peak across all our markets. Unfortunately, the pandemic severely impacted us, nearly halting leasing activities in 2020. However, we gradually bounced back in 2021, finishing the fourth quarter on a solid note. I anticipate increased activity and volume for several reasons across different markets. San Francisco is welcoming employees back to work, and in the San Diego area, the life science and technology sectors are in competition for space. New companies continue to emerge; for instance, the two companies I announced that have signed leases are entering Austin for the first time. We are also observing ongoing activity in Seattle, and Bellevue remains highly sought after. In Bellevue, due to a tight market, tenants are starting to explore options in downtown Seattle. There is considerable fundamental strength across our markets, but it will take time this year for that strength to translate into leases.

All right. Okay. Thank you.

Thanks, Caitlin.

Thank you, Caitlin. This concludes today's Q&A session. I will hand back over to Michelle Ngo for any closing remarks.

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

Thank you for joining today's call. You may now disconnect.