Kilroy Realty Corp Q1 FY2023 Earnings Call

Good afternoon, and thank you for attending today's Kilroy Realty Corporation First Quarter 2023 Earnings Conference Call. My name is Danielle, and I will be the moderator for today's call. It is now my pleasure to hand the conference over to our host, Bill Hutcheson, Senior Vice President of Investor Relations and Capital Markets. Bill, you may now proceed.

Thank you. Good morning, everyone. Thank you for joining us. On the call with me today are John Kilroy, our Chairman and CEO; Justin Smart, our President; Rob Paratte, our Chief Leasing Officer and Senior Advisor to the Chairman; and Eliott Trencher, our CIO and CFO. 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 our first quarter highlights. Then Elliott will discuss our financial results and provide you with our updated guidance. Then we'll be happy to take your questions. John?

Thank you, Bill. Hello, everyone, and thanks for joining us. First and foremost, while we're seeing strong signs in the economy and remain optimistic, we would like to acknowledge that we are still facing cyclical and secular headwinds. The macro environment today, I would define as lacking certainty. Sentiment is challenged in financial stocks, such as Silicon Valley Bank, and the crisis related to that continues to dominate headlines in many areas. From a real estate perspective, we have seen the implications of the current economic backdrop translate into near-term obstacles. There has been a reduction of liquidity in the investment sales market, downward pressure on leasing fundamentals as tenants delay space requirement decisions, and a pullback in financing and investment activity within the banking and venture capital community. However, despite these macroeconomic challenges, we are proud to announce that we delivered a strong quarter and record FFO per share. Elliot will go through the quarter in more detail when he gets to his remarks. Shifting to our markets, we would like to highlight some encouraging trends and what we see on the ground in each of our regions. As we discussed on prior calls, physical occupancy in our portfolio continues to trend up, and the share of job postings that are remote has been trending down. Austin and San Diego continue to lead the way with respect to physical occupancy, with over 70% at quarter end. These markets continue to edge closer to pre-pandemic levels. San Francisco, a region which admittedly has been lagging in regards to return to office, saw its highest quarterly increase of over 6% in physical occupancy since the start of the pandemic. The widespread return to office announcements from top tech firms have translated to noticeable increases in physical occupancy in our San Francisco portfolio, and we expect this trend to continue. Los Angeles and Seattle both saw positive physical occupancy trends during the quarter, increasing to approximately 50% and 40%, respectively. This reflects another encouraging update for our markets, and we anticipate this trend to accelerate as more return to office mandates are implemented. The antidotes back up our portfolio data. Recently, JPMorgan told senior bankers to be in the office five days a week; Amazon's three-day-a-week policy is set to begin next month, and others are following suit. Many companies are realizing the inefficiencies of remote work and are starting to demand change. As Amazon's CEO, Andy Jassy, wrote in his recent shareholder letter, we've become convinced that collaborating and inventing is easier and more effective when we're working together and learning from one another. And I can tell you, at Kilroy, we feel exactly the same way. The actions of these companies and others across various business sectors, including Apple, Disney, Starbucks, Deloitte, Capital One, and many others, highlight the long-term importance of the office in increasing productivity and enhancing collaboration and culture. As the return to office continues and companies have real data to support the power of in-person work, our portfolio is well-positioned to capitalize on the resurgence of demand in light of quality dynamics. As evidenced, since the end of the fourth quarter, we signed approximately 338,000 square feet of leases with an average term of approximately five years. Many of those had no CapEx. In Austin, we signed another lease at Indeed Tower for 20,000 square feet with a national wealth management firm, bringing our occupancy to 74%. We have had great touring activity in the building, and demand for space in Indeed Tower has increased over the last couple of quarters, which we expect to yield positive results. We have also executed notable leases across our Bay Area and San Diego portfolios. In San Diego, we leased a 65,000 square foot new lease with MediaTek USA and a 25,000 square foot renewal with Intrepid Studios. In the Bay Area, we leased a 50,000 square foot new lease with Reddit and a 65,000 square foot renewal with 23 in May. Innovation continues to happen in our markets. The ecosystems on the West Coast took many decades to build and continue to have all the ingredients for success. Engineering, computer science, and medical students are attracted to world-class universities like Stanford, Cal Berkeley, and UCSD. The most prestigious venture capital funds are headquartered in Menlo Park, and the biggest technology companies in the world are based in San Francisco and Silicon Valley. This recipe results in the formation of new innovative companies, such as fintech, social media, self-driving cars, and more recently, artificial intelligence. The Bay Area, in particular, has been the birthplace of many of these businesses, and AI is no exception as over 40% of AI companies are based in the region. While it's still early days in terms of this translating to demand for office, the bigger takeaway is that innovative companies still want to be in the city, particularly in the San Francisco Bay Area. Moving on to Life Science, there continue to be long-term themes that have prevailed, which bear mentioning. 2013 marked the beginning of a 10-year run that radically reshaped Life Science as we see it today. The critical driving factors defining this burgeoning industry include an aging population, improved FDA approval processes, rapid M&A activity, and the availability of funding to catalyze research and development activities. After record years of venture capital funding in 2021 and 2022, these funds still maintain large levels of dry powder with some deals getting done, but not all at the clip we have recently witnessed. That said, we believe increased capital will eventually be deployed as business conditions improve and will provide a powerful boost to the Life Science ecosystem. The acceleration of technological advances within the Life Science space is creating breakthroughs, pushing the frontier of what can be accomplished. Breakthroughs like gene therapies, mRNA, and immunotherapy are in the midst of rapid change that will redefine the art of what is possible. Additionally, we believe the convergence of artificial intelligence and technology companies focused in the Life Science space will move the needle even further. These types of hybrid companies are in their infancy and have yet to mature completely. Kilroy has high conviction in the underlying long-term Life Science fundamentals and will play the long game as we increase our exposure to the sector. As a reminder, Life Science will make up more than 20% of our NOI after KOP Phase 2 delivers. Over time, we expect this number to grow to over 30% as we develop future Life Science projects. Zooming out to our platform and current mentality, we at Kilroy have built a company that is positioned for both offense and defense. This has not been accomplished overnight but is a core principle of our strategy spanning across cycles. As we sit here today, Kilroy has one of the strongest balance sheets in our sector, highlighted by a moderate leverage profile, robust liquidity, and limited term debt maturities. Our portfolio is young and modern, comprised of high-quality, well-located assets that we believe will prove to be resilient over time. Lastly, the management team at Kilroy is cycle-tested, managing through periods of economic uncertainty, and has a proven ability to take advantage of market conditions as they unfold. We remain opportunistic in our ability to create value for our shareholders, as we have done through previous cycles. As we think about how to move through the current downturn, I would like to share with you how we have positioned the company in this current environment. In previous downturns, Kilroy has emerged stronger. A case in point is the steps we took during the Great Financial Crisis of 2008 and 2009, which led to a total transformation of the company. We enhanced the quality of our assets and pursued product expansion in new high-growth markets, creating significant value for our shareholders. And we are not done yet. We are focused on actions to ensure that we emerge from the current downturn in a place of strength, maintaining a strong balance sheet and opportunistically evaluating alternative sources of capital to enhance our already significant liquidity position, providing certainty to our tenant base in today's environment. Prospective tenants are increasingly evaluating landlord capabilities and financial strength. Tenants want to know that their landlords have the financial capacity to fulfill their needs and obligations while being able to provide an exceptional level of service. Positioning our assets to be top-tier choices when the time comes for tenants to make leasing decisions is another important focus. If there are 20 or more choices in the market, we intend to be one of the top three. Heightening our focus on driving organizational efficiencies and reducing our capital spend where appropriate and positioning the company for its next significant moment is critical. Periods of change always present opportunities, and we intend to be opportunistic when the time is right. In summary, our strategy is based on maintaining best-in-class real estate, disciplined capital allocation, a fortress balance sheet, and the team to execute. We have adhered to this simple, effective approach over multiple cycles that have given us the ability to play defense on the downside while maintaining the wherewithal to be opportunistic when it makes sense. And lastly, as I'm sure you all saw, last month, I announced my retirement effective at the end of the year. 2023 marks my 28th year as CEO of Kilroy Realty and 54th of the company, including its predecessor. I've dedicated my career to Kilroy, and I'm pleased to be able to retire with the company having the best portfolio amongst our peers, an impressive capital allocation track record, a solid balance sheet, and very importantly, a deep and talented team. I'm confident we all have the pieces in place to continue executing at the level investors have come to expect from Kilroy. As a significant shareholder, I'm incredibly invested in the continued success of the company. That completes my remarks, and I'll turn it over to Elliot.

Thank you, John. FFO was $1.22 per share in the first quarter, marking the highest quarterly FFO in the company's history. This reflects an increase of about $0.05 from the previous period, largely attributed to a full quarter of revenue from the Indeed lease in Austin. Our results featured both positive and negative nonrecurring items, which mostly balanced each other out. On a same-store basis, cash NOI for the first quarter rose impressively by 16%, which includes around $12 million in tenant restoration payments for two properties. Excluding this nonrecurring revenue, same-store NOI would have increased roughly 9%. The strong same-store performance is due to the burn-off of free rent at Phase 1 of KOP in South San Francisco and increased parking income. GAAP same-store NOI rose about 2% after accounting for the nonrecurring items. By the end of the quarter, our stabilized portfolio was about 90% occupied and 92% leased. The decline from the previous quarter was due to previously announced move-outs, including a downsizing by DIRECTV. Leasing spreads during the quarter were negative 4% on a cash basis, driven by one lease in San Francisco. If we exclude this lease, spreads would have increased approximately 8% on a cash basis. Our net debt to first quarter annualized EBITDA remained around six times. I want to highlight that we have no debt maturities until December 2024, and our interest rate exposure is limited, with over 90% of our debt being fixed. As John mentioned, our liquidity is strong at $1.6 billion, consisting of $330 million in cash, $170 million in future term loan proceeds, and $1.1 billion available on our line of credit. One note for modeling: during the final week of the quarter, we drew down $150 million in term loan proceeds per the terms of the agreement. Therefore, the first quarter interest expense run rate needs adjustment if you are using it as a baseline for projecting the remainder of the year. Our projected capital needs for the rest of the year range between $325 million and $425 million for development. Obligations for 2024 include a $425 million debt maturity in December along with any additional development expenses. Our net liquidity is strong, but we will not hesitate to enhance it if attractive opportunities arise. Before we discuss guidance, I want to highlight additional disclosures in our supplemental materials on pages 14 through 16, where we feature four properties not included in the same-store pool. Consistent with our long-standing policy, we add properties to the same-store pool once they have been part of the stabilized portfolio for a full calendar year. Hence, these four properties will enter at the beginning of 2024. As of the first quarter of 2023, the same-store pool accounted for 93% of our stabilized square footage. Now, let's turn to our guidance for 2023. As always, we do not anticipate any acquisitions, and we continue to expect dispositions to range between $0 and $200 million. Our approximately 50,000 square foot Life Science redevelopment at Executive Drive in San Diego was fully leased to Sorrento Therapeutics, but they have recently filed for bankruptcy and rejected the lease. Consequently, this building is now projected to enter our stabilized portfolio in 2024. We expect to draw down the remaining $170 million from our term loan over the next two quarters. As I mentioned earlier, development expenditures for the rest of the year are projected to be between $325 million and $425 million. Considering approximately $75 million spent in the first quarter, the full-year estimate of $400 million to $500 million indicates a roughly 10% decline in spend compared to our initial projections. Our expectations for same-store cash NOI remain unchanged, projected at 0% to 2%, and average occupancy is anticipated to be between 86.5% and 88%. We foresee additional G&A costs of $8 million to $14 million related to contractual obligations linked to accelerated share vesting tied to an executive retirement. Other than that, there are no changes to our G&A estimates. In summary, our original FFO guidance for 2023 was $4.40 to $4.60, with a midpoint of $4.50 per share. While most of our underlying assumptions remain the same, we are updating our range to account for one-time G&A costs of approximately $0.10 at the midpoint. This adjustment brings our updated range to $4.30 to $4.50, with a midpoint of $4.40. If not for the G&A adjustment, our FFO guidance would have remained the same. To clarify, guidance suggests average quarterly FFO of around $1.06 per share for the rest of the year, which is $0.16 lower than the first quarter. To account for this $0.16 gap, we deduct a net $0.10 due to lower occupancy projections for 2023, factoring in our move-outs and move-ins, including the West 8th move-out in Seattle, effective at the end of April. We also subtract $0.06 for various other factors, particularly the nonrecurring G&A costs and increased interest expenses from the remaining draws on our term loan. Regarding the timing throughout the year, the second quarter will be higher than the third and fourth quarters due to one month of Amazon's impact and the projected timing of drawing down the remaining term loan balance. That concludes my remarks, and we are now ready to take your questions. Danielle?

The first question comes from Nick Yulico of Scotiabank. Please proceed.

Thank you. My first question is about the current leasing activity in South San Francisco. Could you provide more details on this? Should we expect a longer leasing timeline for Phase 2? Additionally, regarding the possibility of starting NOI, if a lease is finalized this year, when would be the earliest we could see some NOI revenue from that?

Sure, Nick. This is Rob Paratte. Let me provide some background on South San Francisco. We have three buildings currently under construction, totaling about 863,000 square feet. These buildings are specifically designed for Life Science use but can accommodate both single users and multiple tenants. Given the situation with SVB and the overall economy, decision-making has certainly slowed down. The average deal size has decreased, but currently, there are 36 requirements in the market that account for approximately 2.3 million square feet, a drop from about 3.7 million square feet before the recent economic challenges. We anticipate that deal sizes will remain smaller, with the average now around 65,000 square feet. Each floor offers 44,000 square feet, although some available spaces are only 20,000 square feet. Our buildings can accommodate larger tenants with configurations of 44,000 square feet on one floor or 1.5 floors for those in the 60,000-foot range, which enhances efficiency for tenants. While we market the project to attract a single large user, we expect leasing to be a multi-tenant, floor-by-floor approach. There are still significant tenants in the market, despite what you might read in the news. Additionally, there's an increase in sublease space available, particularly concentrated between Sierra Point and Oyster Point, with Oyster Point being the prime area. While there are usable sublease options, they tend to be in smaller sizes of around 18,000 to 20,000 square feet, with no large contiguous spaces available. In summary, while the process may take longer, there are still deals to be made. Even though VC funding has slowed, it's important to note that Silicon Valley Bank isn't the only lender in this space; many private equity firms, including Blackstone, have stepped in. So, as John has often mentioned, there's no need to rush into decisions.

With regard to, Nick, this is John speaking. Specifically to, does it change our stabilization dates? Just to remind everybody, that there are three buildings, and they sort of stagger a little bit. But the first building is scheduled to be completed as a shell in mid-'24 and they sort of roll after that, the other two. And then it's a year out from those dates that we anticipate stabilization pursuant to our pro forma. We don't see anything at this point that changes those dates. I mean, obviously, we'll update if we do, but we think those are probably still pretty good dates.

Thank you, John and Rob. My second question is about maintaining a strong balance sheet and exploring alternative sources of capital. Could you elaborate on what that might entail and what factors will influence that decision-making? Is it related to a slower leasing process at Kilroy Point? Are you considering asset sales to improve liquidity due to potential delays in NOI there? How should we view possible sales, joint ventures, and the types of assets you might be considering? What would prompt those actions?

Well, as you know, we have a tremendous amount of liquidity and a great balance sheet and very little debt that's coming due. Eliott can give you the specifics. But we're going to remain flexible as we always do. We purposefully built the company to ensure that we have plenty of liquidity and a great balance sheet if we ended up facing headwinds, and we do have headwinds. I've always said that we're going to play offense, but first, in order to play offense, you've got to be able to play defense. So I think we're really well positioned. We don't feel like we have our backs against the wall on any of that. As things sort themselves out, we think that there'll be a much better-functioning debt market, which will help the buyer market. As you know, last year, we decided not to proceed with some of the disposition activity that we had forecast just because we felt the pricing would be better if we waited. So do you want to cover Elliot in terms of potential sources? There's a lot.

Yes. And Nick, just to add to that, what we were trying to convey is, we feel really good about where we are liquidity-wise, but that doesn't mean we're just going to sit here and wait. The way that we've gotten to this position is by being opportunistic. We didn't have to raise the term loan last year. We saw what we thought was an attractive opportunity, and we pursued it. And that's our mentality this year as well; we don't feel compelled to do anything. But as we evaluate our alternatives, if there is something that's appealing and could be on the secured side, unsecured side, sales side, or venture side. If we see something that we think is attractive and helps the long-term situation for the company, we'll pursue it.

Thanks. Just one last one. John, you've outlined very well, and congratulations on the retirement. You outlined the reasons why you decided to retire. But I guess I'm just wondering about the consideration to make that announcement before lining up the successor? Maybe you could just outline some of the thinking on that. Thanks.

Yes. Well, at the Board level, we talked about this a lot. The reality is that unless you have a specific individual that you have designated to be internally or externally for the position, you could wait. If you're going to go through a process, it's going to get out. It just is going to get out today. Probably the fastest way to get something around is to tell somebody it's a secret. And so our view is we want to be very transparent. We have some great candidates internally, and we may find some great candidates externally. In order for that process to go about efficiently, it means that we want our senior management team to be involved in it. We concluded that it was best practices to be transparent. So that's what we did. We want to make sure we have plenty of time to go through the process and whatnot. And if you've come to know anything about Kilroy, we kind of tell it like it is and as early as we think it's appropriate to do so. Once I've made my decision, basically, it was time to tell people. It's a better swing situation; what's a great time to leave? For me, I have a lot of things as I put forth in my letter that I want to do in my life including sports and whatnot. I want to spend time with my grandchildren, who live in different countries. So I want to make sure I have time for that, and I think this is a good process.

The next question comes from Georgi Dinkov of Mizuho. Please proceed.

Hi. Thank you for taking my question. Could you please walk us through known move-outs in the next 12 months? And in terms of your top tenants with expirations in '24 and '25, do you see any early termination risk?

So this is Elliott. We've touched on a few of the known move-outs and we'll highlight the major ones. We've got Amazon that we've talked about at West 8th moving out in the second quarter. We talked about Pac-12 moving out in the Bay Area in the third quarter. And then there's Riot, which is still TBD for a fourth quarter expiration. In 2024, we have two move-outs over 100,000 feet, both of which are TBD in terms of how those play out, and we have none in 2025 over 100,000.

Great. Thank you. And just one more question on Austin. Given the high sublet space, do you see any downside risk in terms of early terminations?

Austin, our building is brand new, and all the leases either just started or will start when the tenant improvements are done, and there's no termination right. So I don't see any termination risk at all. I might point out that I didn't mention in my comments that we've been exceeding our pro forma rents quite substantially there. So I think all systems are go for Indeed Tower.

Thank you. The next question comes from John Kim of BMO. Please proceed.

Thank you. Good morning, and John, congratulations on building a great real estate company. I was wondering if you could discuss how involved you plan to be going forward with Kilroy; if you plan to remain as Chairman? And any characteristics you could share as far as your preference for a successor?

Somebody smarter than me. I'm always considered smart, as you know. So, John, I can't really go into detail about the search and the candidates who might be here. My thoughts on teamwork have always been clear, whether it's in successful sailing ventures or at Kilroy. One of the advantages of having a strong, cohesive team is the ability to discuss potential leaders, either from within or externally, which strengthens the overall process. More details will follow on that. Concerning my ongoing role, I will remain as Chairman and continue to serve on the Board. I'm a significant shareholder and will likely talk to people from time to time. I expect to receive occasional inquiries about whether certain decisions are right or wrong, and I'm open to those discussions, although the outcomes are still to be determined. I believe we have an excellent management team, and reflecting on my sailing experience, when I was the captain, I would listen to my fellow watch captain. Occasionally, I would overrule them, which could create a bit of tension because having two captains on deck can be challenging. Trust is essential. I think we have a fantastic team that collaborates effectively, and while I am available for input, I'm confident that most decisions will be made here, and I may occasionally need to make the final call. Generally, those decisions are reached by consensus fairly quickly.

The next question comes from Camille Bonnel of Bank of America. Please proceed.

Curious to get your latest thoughts on the transaction market and views on pricing for office. We understand there's a lot going on in the negotiation process, but we're seeing more headlines out there about bids for assets valuing offices anywhere from 20%, 50%, to 80% down from pre-pandemic levels, particularly in the West Coast market. So just given that many of these transactions are still pending, I wanted to get your perspective on how much we should really be reading into this?

Well, this is John. I've made it clear in various conferences and public statements that around 70% of the office stock in the United States is either obsolete or approaching obsolescence. If a building is vacant and nobody wants it, its value may only reflect the land value minus demolition costs. I can't comment without specific details. Regarding the decline in valuations, that's expected when interest rates rise and cap rates increase. Yes, values are down, and the market isn't functioning as we'd like until interest rates and debt availability stabilize. High-quality assets in prime locations will see less of a decline compared to those in less desirable areas or of lower quality. Many properties have come onto the market that we wouldn't consider because they were already poor choices. Some assets have been pulled from the market because they didn't receive satisfactory bids, especially those with significant capital expenditure requirements. Price discovery is challenging without transaction volume. It's important to note that having an older building isn't necessarily a bad thing. For instance, Vornado's post office project leased to Meta is a prime example of an older building that meets a company's needs quite well. However, buildings from the '60s and '70s with lower ceilings and poor elevators are tougher to improve and represent declining assets. Additionally, those with heavy project-level debt and short loan terms face difficulties. For example, if you need to invest $50 million in capital improvements but have only two years left on a loan at a significantly lower interest rate than current rates, you might want to renegotiate rather than invest. There are many factors at play, including older properties losing value, rising interest rates impacting the debt market, and entities carrying excessive debt. We have minimal debt at our property level, own strong modern assets, and believe we are in a solid position, though the market may continue to be volatile.

I appreciate the color. And on a separate topic, it was touched on a bit earlier around the sublease space you see in the market. But could you talk about what that activity is within the portfolio? And has there been any material pickup in any of your markets over the quarter?

Yes, we have about 1.5 million square feet of available sublease space in our entire portfolio. What we've noticed is that the best sublease space in any market is getting taken quickly. For instance, at 350 Mission last year, Salesforce subleased to both Yelp and Sephora, and that space moved fast. As John mentioned earlier, in Seattle, 82% of the leasing activity in the quarter involved Class A space, while Class B space is struggling. This trend will continue. High-quality sublease space will be absorbed quickly, and eventually, we will turn back to more direct Class A space in the market over time.

One of the challenges with sublease space is its complexity. For instance, if a tenant has 100,000 square feet of direct obligation left on a lease for three to five years with options to renew, and then there’s a subtenant looking to lease 20,000 square feet with similar renewal options, the primary tenant may hesitate to grant those options because it could create additional obligations for them. The specific characteristics of the building, not only its quality but also the structure of the primary tenant’s lease with the landlord, can complicate matters. If the space is ready to go and priced attractively for a short-term need, it can be a great opportunity. However, the situation is usually more intricate than that.

Thank you for the explanation and taking my question.

Thank you. The next question comes from Tayo Okusanya of Credit Suisse. Please proceed.

Good morning, everyone. Let me add my congratulations on your retirement, John, and I can bet we'll still be hearing much more from you going forward. My question has to do more with occupancy guidance for the year. I'm just trying to understand what's going into that number, whether it's just the new and move out and whether there's some type of buffer in that number for anything else that may be coming? And I ask that in the context of trying to understand what your watch list looks like today, given some of the incremental challenges in the tech and biotech industries right now.

Tayo, it's Eliott. Similar to what we talked about last quarter, the occupancy guidance factors in the move-outs and the move-ins that we projected, and the big ones are the ones we've talked about earlier, like Amazon, Pac-12, et cetera. We do have some move-ins. Those are weighted towards the later part of the year. So as we think about the average occupancy, we dropped a little bit in the first quarter. We expect to drop more in the second quarter because that's when Amazon will happen. It gets a little bit steadier in the back half of the year. But that's really what's driving it. Regarding your second question about the watch list, the majority of our watch list is still concentrated around retail tenants, although we have seen a modest uptick in our office and life science tenants; it still makes up a pretty small part of the overall portfolio.

But is there any factoring of some of those that may be on the watch list and ultimately become a move out or something like that?

No. We obviously see a range of outcomes, but we don't project watch list tenants leaving the portfolio.

Thank you. The next question comes from Dylan Burzinski of Green Street. Please proceed.

Hi, guys. Thanks for taking the question. Just curious because I know face rents have been able to hold steady over the last several years. So just given that availability rates across most of your markets are rising and leasing backdrop is likely weakening. Do you see a scenario playing out where we actually start to see pressure on face rents in 2023?

Yes. This is John speaking. I think that's a good question. I remind you that it will be played out for sure. The concessions can change the amount of TI you put up, for example. So net effective rents may deteriorate, which is likely if we continue to see this thing persist. But against that backdrop, that's also a question of how much availability is there. And so having gone through this for a long time, I always say that more availability is not generally a good thing unless you're a tenant. On the other hand, we have this other factor that has become so important, which is about attracting and retaining the right people. It has become more binary. This building fits and I'll pay up for it, while other buildings, even though they're cheaper, I don't want them. This has always been a factor among different qualities or locations. But now it's become a much bigger factor with regard to just what people want for their work environment. I mentioned in my prepared remarks that we want to be one of the three or four different buildings that are shown. If you've got 20 vacant possibilities in the market, you're not going to visit all those buildings. You're going to visit one, two, or three, and you want to ensure you present yourself well so people can see that it's a plug-and-play option, and that's what we do really well. We feel that we're going to continue to do well. How it plays out on rates? I don't know. I've seen less resistance to paying higher rates in this last year or two than I had anticipated. I can't tell you if that holds.

That's helpful. Thanks. And then just maybe one bigger picture one because I think in the last several conference calls, you guys have mentioned AI as a potential positive for San Francisco leasing activity. But I guess just from looking at what the technology will be used for, right, the displacement of white-collar jobs could also be viewed as a potential risk to future office demand?

Yes. I think you're right. I think that takes a long time. I'm not an expert in this area; I have a lot of friends that are and some of them are extremely well-known in the space. It seems to me that I'm not an expert in this; I think what's going to happen is back-office jobs are going to be affected. Anything that's mostly processed and not creative is going to be materially impacted. That's what's going to happen first. You can get into moral discussions about it, which I don't want to do. The nature of technology is that it's disruptive. If you want to make money from it, you figure out how to utilize it; if you're in the real estate business, you figure out how you present yourself as a property of choice. How big it's going to be? I don't know. Everything I hear is that it's going to be huge. It's still very early; how do you know?

Dylan, this is Eliott. One thing I'd add to that is when you look at a lot of the innovations that came from places like the Bay Area, you could argue that some of that should have displaced jobs, white-collar jobs as well. What often winds up happening is it just makes it more efficient for people and allows them to innovate in different ways. If you think about AI helping an engineer, that engineer can be a lot more productive. The realm of options or possibilities that they can innovate has grown exponentially, which allows for a greater multiplier effect. It could actually really go the other way where it helps more innovation, more company growth, et cetera.

Well, that's exactly what's happened over the last 20 years. All these technologies that came along that were going to put everybody out of work actually went the other way and became the biggest consumers of office space and the biggest hirers. If I knew the answer to that question, I'd be investing in a different area.

There are currently no additional questions registered at this time. So I will pass the conference back over to Mr. Hutcheson for any closing remarks.

Danielle, thank you for your assistance today, and thank you, everyone, for joining us. We appreciate your continued interest in Kilroy.

And with that, we will conclude today's conference call. Thank you for participating. You may now disconnect your lines.