Kilroy Realty Corp Q2 FY2023 Earnings Call

Hello, and welcome to the Kilroy Realty Corporation 2Q '23 Earnings Conference Call. My name is Elliot, and I'll be coordinating your call today. I would like to hand over to Bill Hutcheson, SVP of Investor Relations and Capital Markets. The floor is yours. Please go ahead.

Good morning, everyone. Thank you for joining us. On the call with me today are John Kilroy, Chairman and CEO; Justin Smart, our President; Rob Paratte, 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. The 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 second quarter highlights. Justin will review our in-process development pipeline, and Eliott will discuss our financial results and provide you with our updated guidance. Then we will be happy to take your questions. John?

Thank you, Bill. Hello, everybody. Thanks for joining us today. As you saw in the press release we issued last night, we recently closed on a $375 million secured financing on a portion of our One Paseo campus in the Del Mar submarket of San Diego. The loan has an 11-year term. It bears interest at 5.9% on a fixed rate, interest-only basis. We ran a competitive process that had a multitude of premier life insurance companies interested in providing the debt, and we're fortunate to execute with a terrific partner in New York Life that originated the entire loan. One Paseo is a world-class mixed-use campus, spanning across 36 acres. As a reminder, the portion of One Paseo that we financed is on 23 acres delivered in phases from 2019 to 2021 and comprises roughly 290,000 square feet of office, 95,000 square feet of high-end retail, and over 600 luxury apartments. On prior calls, we've talked about the flight to quality dynamic occurring in the leasing market. It is increasingly evident that this theme is also prevalent across the capital markets and it played to our favor in our One Paseo transaction. Lenders are still open for business on competitive terms for the highest quality properties, and One Paseo certainly fits that description. Occupancy is approximately 95% across the entire project, with market-leading rents on the office, residential, and retail. Consistent with our strategy, Kilroy places a premium on optionality. While our existing liquidity position is strong, we decided that being opportunistic in raising incremental capital today would result in better risk-adjusted execution as we pre-fund future needs and position for future opportunities. The additional liquidity we secured at an attractive rate bolsters our ability to play defense in a softer environment while affording us the option to go on offense when market conditions improve. Eliott will go through what this means for our sources and uses in his remarks. Shifting to the economy, we are increasingly seeing more green shoots. Inflation is cooling, and the labor market appears to be healthy. Near-term recession probabilities have been reduced, and the idea of a soft landing is becoming more plausible. Strategic deal flow is accelerating, and while not at the pricing we like, it is encouraging to see more transactions getting done. On the leasing front, while deals are taking longer, there is increased tour activity amongst tenants. Large-cap tech companies, which have been laying off employees, are showing signs of stabilizing as stock prices have meaningfully outperformed and job postings are starting to slowly increase. Lastly, innovation is alive and well and continues to flourish in markets like ours with the right talent base and infrastructure. While markets change based on where we are in the cycle, the three pillars of our strategy have stayed constant: high-quality properties, strategic capital allocation, and a fortress balance sheet. This simple approach allows us to play offense in good times and defense in challenging times. We believe there will be opportunities in the future, and we are taking steps to ensure that we are ready when the time comes. Our goal remains the same: to own and operate the highest quality portfolio of mixed-use office and life science properties clustered in innovative, supply-constrained markets. Turning to office fundamentals, in-person work continues to pick up momentum as major employers require their people to return to the office. Recent announcements from Meta, Google, and AT&T, amongst many others, demonstrate that management teams see the benefits the office has on productivity, collaboration, and culture building. The data is backing up the narrative, as the percentage of job postings that are remote has declined by 900 basis points since 2022. As we've been saying, the key is getting employees back to the office; with more commuters and foot traffic, our cities are starting to come back to life. Seattle is a prime example, as Amazon employees have been crowding the streets of South Lake Union and the Denny Regrade since May. Looking at a recent study, Amazon commissioned for these two submarkets which is where most of our Seattle properties are located, foot traffic is up 82%. Restaurant activity is up 86%, and hotel demand from Amazon alone was 26,500 room nights in May 2023, a 130% increase over the prior two years. This activity not only brings vibrancy to the neighborhood but also enhances safety. Physical occupancy at Kilroy's portfolio is up 800 basis points from the beginning of the year and over 500 basis points from just last quarter. Our parking income is also a beneficiary, with NOI up approximately 20% compared to the first half of last year. Turning to second quarter results, we signed a total of 285,000 square feet of leases, similar to last quarter, with cash leasing spreads up roughly 2.5%. Activity was robust in our Los Angeles portfolio, where we transacted 160,000 square feet of leases headlined by a 50,000 square foot renewal and expansion with LeBron James' media company UNINTERRUPTED at our Columbia Square project in Hollywood. We also signed a 25,000 square foot new lease with Edelman, a world-renowned public relations company at the same project. Our Hollywood portfolio is now 91% leased. Many of you have toured our mixed-use project at Columbia Square and understand the world-class quality of the project, which has led to our recent success. And in Long Beach, we continue to make progress on our recently renovated Aero project. During the second quarter, a major financial service firm committed to taking 25,000 square feet of the campus, bringing it to 89% leased. Aero has taken a slightly different path to ultimately achieve similar results. The seven-building campus developed by Kilroy in phases, beginning in the late '80s through the early 2000s, was redeveloped in 2020 after the move-out of a major tenant. We spent roughly $20 per square foot improving and updating the lobbies and outdoor amenities. Since we commenced the improvement project, we have leased over 450,000 square feet and have achieved rents roughly $7 higher per square foot than pre-renovation. To remind everyone, we are in the process of rolling out a similar plan at our West 8th project in Seattle, and the early market feedback is encouraging, with tour activity up significantly. In summary, both Columbia Square and Aero are examples of best-in-class projects that are achieving solid capture rates and attracting world-class tenants across various sectors. The life science business remains well-positioned with healthy secular tailwinds. The population continues to age, new drugs continue to be approved, with 2023 on track to exceed last year's levels. Total funding during the second quarter approached $40 billion, increasing 15% from the first quarter. During the second quarter, we signed a 25,000 square foot extension with Neurocrine Biosciences, a life science tenant in Del Mar, and we continue to have several prospects during the second phase of Kilroy Oyster Point in South San Francisco. As a reminder, our Kilroy Oyster Point project is not projected to stabilize until 2025 or about two years from today. We are pleased with our second quarter operating results and believe we are well positioned for continuing success. As we think about the future, Kilroy is focused on the things we can control and well positioned to be opportunistic when the time comes. Our primary focus for the balance of the year is leasing. The current environment will separate winners and losers through a combination of patience and strategically positioning our assets to be top-tier choices for tenants. We believe the Kilroy platform is well positioned to create alpha as we lease up the portfolio. In addition, we are committed to maintaining our top-notch balance sheet and robust liquidity profile, as we demonstrated with the One Paseo loan. As a reminder, over the last year, inclusive of the One Paseo financing, Kilroy has secured approximately $900 million of fresh capital at a blended rate in the high 5% range. I would also like to acknowledge that none of what we do would be possible without a best-in-class team. We have a deep and talented group of professionals that has been critical to our success. We are going to continue to invest in our human capital while also striving for ways to get better, always trying to get better. I want to personally thank all of my teammates at Kilroy for their hard work and dedication. To wrap up my remarks, we are encouraged by the green shoots we are seeing. There continues to be more activity across leasing, investments, and finance for the best-in-class product that Kilroy is known for, whether it's new tenants entering the market, existing tenants looking to renew and expand, our strategic transactions being made, the common theme is preferential demand for well-located high-quality assets. Fundamentally, we expect this trend to continue and the Kilroy platform could not be better positioned. At some point, there will be a time to play offense. When that time comes, Kilroy will adhere to its core principles. We will allocate capital into acquiring, developing, and redeveloping premier assets in the right markets that will outperform well into the future while always maintaining a strong balance sheet. That completes my remarks. Now I'll turn the call over to Justin.

Thank you, John. As of the end of the second quarter, our in-process development totaled approximately $1.8 billion, with about $590 million left to fund, the majority of which is for the second phase of our Kilroy Oyster Point Life Science Development in South San Francisco. In April, the core and shell of our fully leased development project at 9514 Towne Centre Drive in the UTC submarket of San Diego was completed. The building is in the tenant improvement phase, and we commenced revenue recognition in July, a few months earlier than anticipated. As we have discussed on prior calls, Indeed Tower is also expected to enter the operating portfolio in the fourth quarter of 2023. So as we enter 2024, our in-process development pipeline is expected to be approximately $1 billion, the smallest it has been since 2016. All three current pipeline projects are life science. Supply remains something of a bright spot for the market nationally. There have been roughly five million square feet of new office starts year-to-date, which represents a roughly 75% decline from the two-year trailing average. In addition, roughly 15 million square feet of office has been converted or demolished year-to-date. The net of these two has reduced the national office stock by 10 million square feet. Said another way, as demand for high-quality space surges, there is currently little new product in the pipeline to be delivered over the near term, creating a future shortage of high-quality product that tenants want. As many of you know, our strategy has been focused on the high end of the market. As John referenced, it is increasingly clear that there is a significant bifurcation between high and low-quality office buildings. We expect more of the low-quality and obsolete properties to be converted or repurposed where possible. According to JLL, 17% of total U.S. vacancy is derived from approximately 1% of office buildings, highlighting the outsized challenges for owners of commodity product. The outperformance of high-end product is not unique to the office sector. Luxury hotels have generated better RevPAR growth than the overall market since 2020, and Class A apartments have had better absorption than the overall market every year for the past decade. Focusing on premier product has been a pillar of our strategy for many years, and it has proven to generate better results over the long term. That said, we are excited about our future land bank comprised of eight development projects totaling eight million square feet across our five markets. From a product-type perspective, these projects will be approximately 30% life science, 20% residential, and 50% office. We continue to advance design and entitlements on these future projects so that we are prepared to be first movers when market conditions warrant.

Thank you, Justin. FFO was $1.19 per share in the second quarter, a $0.03 decline from the first quarter, mainly due to Amazon's move-out in Seattle. This was partially offset by higher interest income. The second quarter results also include roughly $0.03 of positive nonrecurring items tied to termination fees and restoration payments. On a same-store basis, second quarter cash NOI was up roughly 3%, driven by free rent burn-off at the first phase of Kilroy Oyster Point in South San Francisco. GAAP same-store NOI was down roughly 2%. At the end of the quarter, our stabilized portfolio was approximately 87% occupied and 89% leased. The decrease from the prior quarter was due to previously disclosed move-outs. Net debt to second quarter annualized EBITDA was about 6x. Our liquidity remains robust, and after accounting for the proceeds from the One Paseo financing, we have roughly $1.9 billion in total capacity, comprised of $1.1 billion on our line of credit and $830 million of cash and marketable securities, which includes $170 million available under our term loan facility. In total, our available cash is sufficient to cover the majority of our near-term development spend and address our next bond maturity in December 2024. Our dividend is incredibly well covered with a payout ratio of approximately 50% of FAD through the first half of the year. By putting in place an 11-year mortgage, we maintain a well-laddered maturity schedule with an average duration of six years. Now that proceeds to the December 2024 bond maturity have been identified, our next maturity is not until October of 2025. We are focused on keeping liquidity high and leverage low, and are thrilled we could boost our liquidity on efficient terms via the One Paseo loan. Now let's discuss our 2023 guidance. As always, no acquisitions are forecasted, and we continue to expect dispositions to be between $0 and $200 million. We anticipate drawing down the remaining $170 million from our term loan during the third quarter. The loan for One Paseo closed in late July, and we expect to keep most of the cash available on the balance sheet. From an FFO perspective, the interest income we generate from the cash will mitigate much of the incremental interest expense. As Justin mentioned, 9514 Towne Centre Drive stabilized in the third quarter of this year, one quarter earlier than anticipated, and 4690 Executive Drive is expected to stabilize in the fourth quarter of next year, one quarter later than previously estimated. Indeed Tower is still projected to enter the stabilized pool in the fourth quarter of this year. Development spend for the remainder of the year is expected to be $250 million to $300 million. When factoring in the roughly $175 million of spend in the first half of the year, the full-year estimate is now $425 million to $475 million, with a midpoint unchanged from last quarter. Capitalized interest for the next two quarters is expected to remain around the second quarter run rate. No change to our G&A estimate. We are tightening the range for full-year average occupancy to 86.75% to 87.75%, with no change to the 87.25% midpoint. Cash same-store NOI is now projected to be 1.5% to 2.5%, a 100 basis point increase at the midpoint due to better-than-anticipated parking revenue and some nonrecurring income. In summary, our prior 2023 FFO guidance was $4.30 to $4.50, with a midpoint of $4.40 per share. Based on our performance to date, we are adjusting and tightening the range to between $4.43 and $4.53. The new midpoint of $4.48 represents roughly a 2% increase from the prior guidance. The biggest drivers behind the increase are higher interest income, better parking revenue, and earlier revenue recognition for our 9514 Towne Centre Drive development. These are partially offset by additional interest expense from the One Paseo financing. To provide further clarity, our updated midpoint implies average quarterly FFO of roughly $1.04 per share for the back half of the year, which is $0.15 lower than the second quarter. To bridge the gap on the $0.15, we subtract $0.03 for the nonrecurring items I mentioned earlier. Next, we back out a net $0.05 due to lower occupancy, which factors in our move-outs and move-ins. Finally, we subtract $0.07 for various other items, most notably, the dispositions and additional interest expense. That completes my remarks. Now we will be happy to take your questions.

Thank you. Our first question comes from Nick Yulico with Scotiabank. Your line is open.

Thanks, hi everyone. Just in terms of the second half of the year, I want to make sure we had some of the moving parts, right, in terms of occupancy impact. So I think you previously said Pac-12 was a move-out in July, that was about 114,000 square feet. And then I wasn't sure if you have an update on Riot Games, where I guess there was a partial expiration in July and some additional expiration in November. Any update there?

Yes. Nick, this is Rob. I hope you're doing well. It's hard to get very specific with Riot Games. We're having a variety of discussions on different floors that they lease from us, both in '23 and '24. And I just can't predict ultimately how much space they'll take, but we are in contact with them and continue to have negotiations ongoing.

Okay. Thanks. And then I guess in terms of South San Francisco, maybe you could talk a little bit more, Rob, about the demand you're seeing in that market. I know you turned one of the buildings into multi-tenant for KOP Phase 2. Maybe you could talk about leasing demand there for smaller users versus larger tenants where it sounds like the larger tenant demand is a little bit slower. Maybe you're more active on the other tenant base.

Sure. There's not a lot of change between Q1 and Q2 in terms of just the number of tenants in the market and kind of the basic market fundamentals. There's about 2.5 million square feet of demand in the market. A portion of that is on hold but is supposed to be coming back towards the later part of this year. I think notably, a handful of younger companies are getting funding rounds, which we hadn't seen in Q1. So companies like Backsight, Hexagon Bio, and Septerna have gotten funding rounds completed recently. Since we did announce the multi-tenanting of one of our three buildings, our tour activity has picked up and interest, meaning people are wanting to see the space and wanting to understand what's in it. We're exchanging plans with a couple of companies right now in terms of the technical capabilities of the space. So overall, as I said in the first quarter, we're pleased given the overall environment with the activity we have. And we still, as John said in his comments, we have two years until we're actually complete.

All right. Thanks, Rob. Appreciate it.

Our next question comes from Steve Sakwa with Evercore ISI. Your line is open.

Yes, thanks. I don't know, Eliott or Rob, if you could maybe just talk about maybe the next 18 months and some of the, I guess more pronounced maybe known move-outs, just kind of remind us what you know is to be vacating over the next, say, through the end of '24?

Steve, it's Eliott. I'll start. We've talked about the expirations over 100,000 feet for the balance of this year. There are two, there's Pac-12, which as everyone knows, is moving out. And there's Riot, which Rob just addressed next year. We also have two, one in the Bay Area, one in Seattle, and those are both TBD in how they play out. In 2025, we do not have any expirations over 100,000.

Thanks for the update. I wanted to follow up on the general and administrative expenses. You performed better than we anticipated this quarter. Can you clarify what your overall expectations are for G&A in dollar terms, including the costs related to John's retirement? Will these expenses be evenly distributed between Q3 and Q4, or will they be more concentrated in Q4?

Yes. The overall figure, including the retirement charges, will range from 90 at the low end to 104 at the high end, consistent with our previous discussion last quarter. Regarding how this will unfold for the rest of the year, part of it will continue to be amortized. We amortized a portion slightly in the first quarter, but there was a significant increase in the second quarter. So far, we've accounted for about $0.03 of the $0.10 related to the retirement charges. This will be similar in the third quarter and slightly higher in the fourth quarter, depending on performance.

Thank you.

We now turn to Blaine Heck with Wells Fargo. Your line is open.

Great, thanks. Good morning out there. Just to clarify on the occupancy guidance. I'm assuming current guidance assumes Riot stays in place, but I wanted to clarify that. And then also, what does guidance assume with respect to Indeed Tower when it comes into the operating portfolio later this year? Is that held at the current lease rate? Or is there additional leasing factored in there?

Yes. So Blaine, we don't typically talk about assumptions for particular tenants. And so I think on Riot, there's not much more we can say beyond what Rob mentioned. For Indeed, you're correct, it is going to come in, in the fourth quarter. We anticipate that it comes in at the current levels. So that will weigh on the occupancy in the fourth quarter, and that obviously also impacts the average number as well.

Okay. Thanks, Eliott. And then a second question, maybe a high-level question for John. There was a lot of optimism earlier this year after the midterm elections, which were, I think, generally seen as a step in the right direction for San Francisco. Can you just talk about any improvement you've seen or signs of improvement to come with respect to crime, homelessness and just overall creating a bit of a more hospitable business environment?

I tend to share a story. If you've ever participated in an intervention for someone struggling with alcoholism or drug addiction, you know that real progress only happens when they hit rock bottom and decide to change. That mirrors the current situation in San Francisco. People from diverse political, economic, and demographic backgrounds are frustrated and have started to take action. There’s a real possibility of changing the majority on the Board of Supervisors in the upcoming elections, and the outlook is promising. There’s also a chance to remove some ineffective judges. While I won't elaborate on specific political dynamics, it's important to note that over the last few years, a wide coalition has emerged, including CEOs from various sectors, school officials, and others representing a broad demographic. The atmosphere is shifting. Additionally, state law enforcement is now able to take actions in San Francisco that local authorities cannot, and federal involvement is also increasing. While this may sound concerning, I believe these efforts will lead to improvement. It will be a challenging process that won't occur overnight. Recently, I attended a meeting with a diverse group of business leaders, and there was a unanimous commitment to funding and actively engaging in remedial efforts for what has become a challenging situation. I am more optimistic now than I have been in the past two or three years. There is a sense that victory is on the horizon, though it may take longer than expected and will involve struggles. I see positive signs in the streets. As people return to work, the atmosphere is becoming more lively with more activity in buildings and bustling restaurants. While some businesses reliant solely on the office workforce have closed, there is an overall sense of a brighter future. In summary, I'm feeling more hopeful now than I have in the last three years, as I witness significant positive developments.

Very helpful. Thanks, John.

You're welcome.

Our next question comes from Michael Griffin with Citi. Your line is open.

Great. Thanks. I wanted to touch on retention for a bit. I know it was lower similar to the last quarter. As we look to the back half of the year, is the expectation for this retention rate to stay low or, John, you're talking about some of those green shoots we potentially see in an uptick in these retention levels?

Yes. Some of the larger tenants are still uncertain about their plans. I can't predict retention levels. You’re young, and I believe you have kids, while I have six, most of whom are grown. It feels like a game of shoots and ladders. We’ll continue to see progress, but we’ll also face longer periods of challenges. Over time, I expect improvement, but it won't happen instantly. I don’t see us returning to the conditions of 2019, especially not in San Francisco. Interestingly, some tenants who vacated are now considering moving back into buildings. This isn’t limited to San Francisco; it’s a broader trend. There’s a lot of waiting and planning happening. We’re actively engaging with clients as they rethink their options. For example, with Columbia Square and Hollywood, we hadn't seen any leasing activity for two years, and now there’s a sudden surge in interest. What changed? It coincides with a significant strike in the entertainment industry. People are increasingly optimistic and are bringing employees back to work, with plans to expand. These dynamics can shift rapidly. I’ve mentioned before that during various downturns, Silicon Valley was seen as having a surplus of supply, and within two years, options dwindled significantly. While I can’t predict a similar scenario in the next couple of years, I do think it will happen gradually as more people return to work and innovation continues to thrive. Many new companies are being established. If I could forecast this accurately, I wouldn’t be in this business; I would be in venture capital.

Great. Thanks. Maybe expanding on that green shoot opportunity you talked about. I think we've heard more about AI driving space requirements, particularly in San Francisco. I mean, how big can you quantify this as a long-term driver in the market? Any color you have around that would be helpful?

Yes. There is a tenant in one of our buildings that subleased 50,000 square feet to an AI company. There are significant investments being made in AI by major players who have not yet announced their involvement. The potential for growth is uncertain, but those within the industry, especially established companies, believe it could be vast. It's reminiscent of past innovations like Uber and Airbnb, which initially faced skepticism but ultimately transformed their respective markets. With AI, the possibilities are extensive, impacting a wide range of sectors, both positively and negatively. While many are optimistic about rapid growth, historically, such developments tend to evolve gradually. Most tech firms typically start with small office spaces, growing from 5,000 to 10,000 square feet, and eventually scaling up to 400,000 square feet or more. Even a few of these expansions can significantly influence the market, but the extent of that change is still uncertain.

Got you. Well, that's it for me. Thanks for the time.

Yes. Thanks a lot.

We now turn to Caitlin Burrows with Goldman Sachs. Your line is open.

Hi, good morning. Maybe a follow-up question on the One Paseo deal. Given that only 5% of your debt or so was secured as of 2Q, can you just go through what drove the strategy for this property? And under what situations going forward you expect to use additional secured versus unsecured strategies?

Yes. I'll start, and then Eliott may want to give some comments. Caitlin, we're sort of agnostic. As you know, we haven't been big users of secured debt. What drove this is if we take a look at bond debt, it was considerably more expensive. Obviously, our goal was simply to pre-fund any of the commitments that we have, whether it's development or loans that come due and take that off the table. We had 18 months, I think, before the bond deal in next year comes up. Now it goes out to 25%, so it's 30 months or so for the next tranche. We had some development; we were already pre-funded. We think there's going to be an opportunity to play offense here. We're not exactly sure when and how that's going to play out. Our view is we're just sort of pre-positioning for success. We've got best-in-class product; we are in a terrific financial position that we can take care of whatever our obligations are as they come up. We're in a very strong financial position to play offense. We have the ability to start new products as it's needed. As Justin pointed out, we think there's going to be a real shortage. That’s what drove that transaction; it was just the most efficient way to go. Eliott, I don't know whether you have further comments.

No, I think that's all spot on. In terms of do we do more of these? I mean, who knows? We certainly like the efficiency of the bond market. But there's a time in place where secured debt makes sense, and we thought this was it. This is not an indication of a bigger shift in strategy.

Got it. Okay. And then maybe just on return to work and office utilization. You gave some details on year-to-date improvement up 800 basis points and up 500 basis points from last quarter. I guess, could you go through how you measure that? And do you have any visibility to what could happen over the next, say, three to six months?

You want to deal with that, Eliott?

Yes, sure. So Caitlin, we have a process where we go through each of our markets and do a combination of survey data with our tenants and card reading data with our tenants. We sort of triangulate all of it to put it together and track this information monthly. That's our process. It's generally tracked the Castle data up until recently where the Castle data had sort of flatlined, but we continue to see increases in our portfolio. It's a little tough to predict exactly how it will pan out, but we think that all of the announcements that we've referenced earlier, in particular, in the Bay Area and Seattle are good leading indicators that we should still continue to make progress on the physical occupancy.

I'd add a little comment that's just interesting. As you can well imagine, we deal with a number of architectural firms that not only deal with us but deal with other developers, particularly a lot of users. One of the things they're saying is that they're not real busy on new buildings, but they're very busy on reconfiguring space for tenants. I was talking with one a few weeks ago in Seattle, who's been active all over the Western United States. The comment that was made is that they're doing a third thing for the same tenant on a major campus; they keep trying to figure out how to add more capacity for more people because their numbers keep changing. What has sort of happened at least in some of these companies is they were wondering whether people were going to come back to work, they wanted people to come back to work. Now they're coming back to work. Now they're coming back to work more, and they're coming back at higher rates. In some cases, people have slowed down the back-to-work re-entry in terms of making giving time to reconfigure their space to bring more people back to work. Those are just some anecdotal comments, but it's happening in real-time.

Thanks.

You're welcome.

We now turn to Vikram Malhotra with Mizuho. Your line is open.

Thanks so much for taking the question. Just going back to sort of the green shoots comment. I guess we've heard from a couple of multi-family players that they're seeing a bit more, I guess, they're themselves seeing green shoots and more traffic. You talked a little bit about the AI trajectory or potential, I should say there. But could you maybe just elaborate a bit more on, like, say, the office, the pipeline you're looking at? What sort of tenant types, the size requirements? If you could break that up sort of between strictly office and then life sciences?

Yes. You want to take that, Rob?

Sure. Let me make a couple of just general comments about what we're seeing and give you sentiment in terms of the tenant markets. Real estate, we've said this before, is a very local business. Even though headlines nationally say demand is off and less than we'd like, we're seeing positive absorption play out in our portfolio in cities like Seattle, Hollywood, and Long Beach, as John has mentioned. Another note I think I'd make is that while the overall market experienced negative absorption, the newest and best buildings have actually experienced over 100 million square feet of positive absorption in the last two years. A note that's really important about the Bay Area is that VC funding overall is down. Everyone knows that and reads it. But Bay Area companies took more than half of the funding nationally. That's about $20 billion. So we're expecting to see more demand come out of that sort of investment. The transaction pace remains somewhat slow, but it's picked up, and tenants are really seeking flexibility in their lease terms and in how they utilize space, not only their space but our space, meaning our common areas, our decks, et cetera. The mix, I'd say, portfolio-wide is somewhat balanced between technology and professional services and banking firms. That's particularly true in San Francisco, where you have about one-third of the demand right now; there's about 4.5 million square feet of demand. About one-third of that is from technology. The other one-third of that is from professional services, banking, et cetera. Everybody is talking about AI. You just mentioned that. Right now, in San Francisco, there's about 750,000 square feet of AI demand. Those tenants have started out probably in the fourth quarter of last year and the first quarter of this year in the 5,000-foot range, and they've now grown to about 10,000 to 15,000 feet. On the AI front, as John said, it's very difficult to predict where that goes. We track closely what the big FAANG companies and the level below the FAANG companies are doing regarding AI, because those companies will span a lot of companies over the next two years.

I think there was also a question about the mix...

Yes. Any green shoots in terms of life sciences more specifically?

Yes. As I mentioned, the VC funding that the Bay Area commanded over 50% nationally, and I mentioned earlier, several firms that we didn't see in Q1 got funding just recently in Q2. When you get that sort of investment, then demand typically follows. It doesn't follow immediately, as boards of life science companies are still trying to keep people or companies within the space they have rather than taking new. But that said, as I said at Oyster Point, we're pleased with the activity we're seeing both in a larger tenant format as well as multi-tenant, meaning a floor, 40,000 to 80,000-foot tenant range.

Great. And then just one clarification on sublet trends across San Francisco and perhaps the broader Bay Area. Some of my recent conversations suggested that sublet volumes are likely to moderate or decline from the high levels we have seen. I'm curious if you have observed any trends in real time that would indicate sublet space is being taken off the market more quickly.

Yes, I hesitate to make predictions because something could change at any moment. However, it seems that in the Bay Area, particularly with sublease space, the trend of big tech companies giving back office space has leveled off. There have even been discussions about some tenants possibly considering taking some of that space back off the market. We observed a similar situation during the pandemic when tenants opted to remove subleased space they were not using. Although the numbers increased this quarter regarding available sublease space, I believe we have reached a plateau. It's important to differentiate between high-quality Class A sublease space and what I would categorize as second and third tier space, which will face significant challenges during this period. Activity in that lower tier space is unlikely.

Thank you.

Our next question comes from Dylan Burzinski with Green Street. Your line is open.

Hi, guys. Thanks for taking the question. Just going back to your comments on being patient regarding going on offense and potentially looking at acquisitions. Could you guys help us give us a sense for some of the data points or things you're looking at to sort of start that network?

We are considering various factors based on the information we have and our relationships with tenants. This includes their thoughts on current conditions. There may be confusion regarding early transactions as we notice properties that were previously unattractive in 2018 or 2019 are now coming back on the market due to failed financial structures. Many of these properties lack quality and will likely be broken up. We expect to see transactions happening at very low rates for properties that require significant capital expenditures. Purchasing such properties could still lead to losses. Our focus remains on making profitable investments. We are interested in quality products at favorable rates with significant upside, but we also need to see a more stable market. Looking back to 2010, when we entered the San Francisco market and acquired properties at low prices with moderate yields, we did not foresee significant yield increases until later. During that period, many others were hesitant, lacking the financial resilience to capitalize on opportunities. We anticipate a similar situation now, but there is much product we are not interested in due to location or condition. We will only consider certain properties if they offer a valuable land play or development opportunity. Our goal is to see more stability in the capital markets before making acquisitions. We want to ensure we are financially prepared and not under pressure to make decisions. As I mentioned earlier, our position is strong, and we have a robust development pipeline unlike anything we've seen after past recessions. We believe we are well-positioned financially and have the right products for the market. While the outcome remains uncertain, we will look for opportunities just as we have in the past, coming through downturns successfully. There isn't a strict guideline for navigating these changes, as that would eliminate opportunity. It will likely involve unique situations instead of large portfolio acquisitions, as the landscape has shifted significantly. Many Class B properties that were previously anticipated to remain relevant are now outdated. More updates will follow.

Appreciate that thorough detail, John. I guess just one more. Are you able to share the underwritten LTV and debt yield at One Paseo?

We can't share that. But what we can say is that given the nature of the partner, you can assume that this was underwritten conservatively.

Awesome. Thank you.

We now turn to Peter Abramowitz with Jefferies. Your line is open.

Yes, thank you. Just a modeling question I wanted to clarify. So does the One Paseo deal take the need for term loan proceeds off the table sort of near or medium-term, at least through the rest of this year?

The term loan was structured to allow us 12 months to access the cash. If we decide against it, the proceeds will no longer be available. However, as mentioned in our formal remarks, we expect to utilize the remaining $170 million of cash from the term loan by the end of the third quarter. For modeling purposes, we have a spread of SOFR plus 100 based on our reinvestment options. In the past three months, the rates for reinvesting capital have increased, resulting in only modest dilution.

Got it. Thank you. And then one more on Life Science. So there's a pretty meaningful amount of new supply coming to South San Francisco right now. Maybe not as much San Diego. Could you just talk about what you're seeing on the ground in terms of how rents are moving and how the new supply is affecting your conversations with potential tenants, particularly at Oyster Point?

Rob, do you want to cover that?

Sure, this is Rob. First, let's clarify the market. We are in Oyster Point, which is a very specific submarket in South San Francisco. I refer to it as the Main and Main of the life science sector in the Bay Area. There is less product available in this area, with about a little over 0.5 million square feet we're competing against. New construction and rental rates have not significantly declined. There are other spaces in South San Francisco, and as I mentioned, different submarkets exist. One notable submarket to the north is Sierra Point, which has different fundamentals and is generally preferred by us and many of the larger tenants as well.

Got it. That's helpful. Thank you.

Our final question comes from Neil O'Connell with Bank of America. Your line is open.

Hi, I'm sorry. Can you hear me?

Hello, yes.

Hello? Hi, sorry. The name was wrong. It's Camille Bonnel from Bank of America. Many of my questions have already been addressed. So just one for me. Eliott, your update around parking revenues, adding positively to the core operating outlook, does that only reflect the utilization that you're seeing today? Just given that a number of larger companies are starting to implement that return to work over the summer and into the fall. Does it mean that if these trends continue to improve, we'll see further upside to guidance from this income stream?

To the first part of your question, yes, this reflects what we've seen to date. To the extent that utilization continues to get better, then we hope that that continues to translate to better parking revenue.

Okay. Perfect. Thank you.

This concludes our Q&A. I'll now hand back to Bill Hutcheson, SVP of Investor Relations and Capital Markets for closing remarks.

Great, Elliott. Thank you for coordinating the call. Thank you, everyone, for joining us today. We appreciate your continued interest in Kilroy. Have a good day.

Ladies and gentlemen, today's call has now concluded. We'd like to thank you for your participation. You may now disconnect.