Kilroy Realty Corp Q3 FY2024 Earnings Call

Hello everyone, and thank you for joining the KRC 3Q '24 Earnings Conference Call. My name is Harry, and I'll be coordinating your call today. All lines are currently in listen-only mode, and there'll be an opportunity for Q&A after management's prepared remarks. It's now my pleasure to hand you over to your host Taylor Friend, Senior Vice President, Capital Markets and Treasurer to begin. Please go ahead.

Good morning everyone. Thank you for joining us. On the call with me today are Angela Aman, CEO; Jeffrey Kuehling, EVP, CFO; and Eliott Trencher, EVP, CIO. In addition, Justin Smart, President; and Rob Paratte, EVP, Chief Leasing Officer, will be available for Q&A. 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 webcast live on our website and will be available for replay for the next 8 days. 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. Angela will start the call with a strategic overview and quarterly highlights, Eliott will discuss our recent capital allocation activities with the transaction market outlook, and Jeffrey will discuss our financial results and provide you with updated 2024 guidance. Then we will be happy to take your questions. Angela?

Thanks Taylor. I'm pleased to report on a strong quarter of execution as we continue to navigate a challenging but steadily recovering operational environment. Kilroy's high-quality, well-amenitized portfolio, differentiated tenant relationships, experienced and talented team, strong balance sheet and robust liquidity profile uniquely position this platform to capitalize on the recovery that continues to take hold across our markets. Our third quarter financial and operational results speak to this dynamic. FFO for the third quarter was $1.17 per share, a sequential increase of $0.07 due to a combination of recurring and non-recurring items, which Jeffrey will cover in a few minutes. Based on our strong third quarter performance and outlook, for the balance of the year, we increased our full year FFO guidance by $0.15 per share at the midpoint of the range. During the period, we signed approximately 436,000 square feet of leases, including 209,000 square feet of short-term leases. In addition, we also signed a 110,000 square foot short-term lease related to the DermTech bankruptcy. The short-term leasing activity this quarter was predominantly comprised of renewals for tenants that will be vacating or significantly downsizing in the portfolio in the near-term. Excluding short-term transactions, the weighted average lease term on executed deals was approximately 5.5 years with cash leasing spreads of approximately 7%. Notable transactions this quarter included the previously announced 118,000 square foot SAP renewal in Bellevue, Washington and a new 28,000 square foot lease with NVIDIA in South Lake Union. Recent leasing activity in conjunction with an early rent commencement on a previously executed new lease drove a 75 basis point increase in the midpoint of our average occupancy guidance to 84%. As SAP, NVIDIA and late stage deals in our future pipeline highlight, we continue to see robust demand in Bellevue and are beginning to see signs of a pickup in demand in South Lake Union and Seattle. Amazon's recent 5-day return to office announcement is further accelerating the dynamics that we have seen in the Pacific Northwest over the course of 2024 and is the latest in a series of announcements from major West Coast employers that had worked hard to embrace remote work, only to arrive at the conclusion that in-person collaboration is the most effective way to enhance innovation and productivity and build a differentiated culture that drives long-term sustainable performance. In San Diego, where physical occupancy has been at pre-pandemic levels for some time, we continue to experience strong demand. And recently, we have seen a notable uptick in interest from existing tenants looking to expand within our portfolio. In several instances, this demand is coming from tenants that previously downsized, but are now realizing that they underestimated their utilization and optimal real estate requirements and are looking for opportunities to course correct. In Los Angeles, while aggregate demand remains soft, we continue to execute well, driving improvements in sequential occupancy in each of our submarkets. Of note, we continue to see solid activity in Long Beach and have recently seen a nice uptick in interest in Culver City, driven by professional service and technology tenants. And in San Francisco, we remain encouraged by ongoing improvements in physical occupancy, foot traffic and the overall vibrancy of the city. The momentum being created by the continued growth and evolution of the AI industry has been and will continue to be a significant catalyst for this market. The Bay Area commands by far the highest proportion of AI-related VC investment in the country, which is actively driving significant levels of new business formation, a very positive longer-term trend for this market. While to date many early stage AI tenants have focused their real estate searches on sublease space that is immediately available for occupancy, it's worth noting that approximately half of the remaining available sublease space in the market has lease expirations prior to the end of 2026, limiting the attractiveness of the space to many users. As a result, prospective tenants are shifting their focus to direct deals and we're working hard to capitalize on this dynamic by leveraging our well-developed and thoughtfully executed spec suites program. As it relates to Kilroy Oyster Point in South San Francisco, we're excited to begin delivering the second phase of this extraordinary campus next month. In early 2024, we described a meaningful acceleration in tour activity off of a very low 2023 base. That higher level of interest in tour activity has remained relatively consistent throughout 2024. But over the last 2 to 3 months, we've seen a crystallization of this demand as tour activity has expanded to include a much wider range of potential tenants and these tenants appear more prepared to execute. Recently, we have spent time on-site with early and late stage life science companies, research institutions, technology companies and other more traditional office users. While there's no question that the deal process has become significantly elongated, we remain highly convicted in the quality of what we are delivering and its unique ability to cater to a wide range of highly discerning tenants. While Eliott will discuss the transaction market in more detail in a moment, I will note that the environment is clearly evolving. Financing markets, while still challenging, are improving, leading more sellers to test the market. As a result, Eliott and his team are spending more time evaluating actionable deals through a disciplined risk-adjusted return framework, while also making good progress on the land sales discussed last quarter. In addition, I'm delighted to announce our recent acquisition of Junction at Del Mar, a 104,000 square foot, 2 building campus located strategically adjacent to Kilroy's One Paseo mixed-use project in the Del Mar Heights submarket of San Diego. While a small transaction, this deal represents an excellent value proposition for the company, increasing our presence in one of our strongest existing submarkets and achieving a very compelling risk-adjusted return on an as-is basis with additional potential upside from longer-term redevelopment and integration with One Paseo. Before turning the call over to Eliott, I want to take a moment to thank the entire Kilroy team for the hard work, dedication, and flexibility I've seen every day since joining this platform. It has been gratifying to see the way this organization confronts challenges, leans into opportunities, and embraces change, and I'm excited to see what we can deliver together in 2025.

Thanks, Angela. As Angela mentioned, at the end of the quarter, we acquired Junction at Del Mar in San Diego, our first acquisition since 2021. This opportunity was attractive because of the premier location, additional scale and a strong submarket, ability for Kilroy to uniquely add value, in-place income and lease term. The buildings are adjacent to our One Paseo campus and by consolidating ownership, we can drive value creation through better integration to the nearly 700,000 square feet of office and retail we have next door. The purchase price was $35 million which equates to approximately $335 per square foot or a low double-digit stabilized yield. The project is 96% leased to a variety of tenants with a weighted average term of over 4.5 years. In the few weeks since we have closed on the deal, we have seen good interest in the remaining vacancy at terms consistent with our underwriting. Longer-term and depending on market conditions, we may consider additional redevelopment opportunities onsite. Turning to land sales, we are working on monetizing several parcels in our future development pipeline. Strategically, the rationale is threefold. First, after thorough evaluation, we believe that the highest and best use of these particular sites is something other than office and life science, and as a result, our resources are better focused elsewhere. Second, these sales help right-size our land bank for the current environment. And finally, it allows us to raise attractively priced capital to be acquisitive when appropriate. We have advanced negotiations with multiple sophisticated groups that support our thesis behind the re-entitlement, but as previously discussed it will take longer to realize proceeds. To put some numbers around this, the two deals furthest along are projected to generate in excess of $150 million and we hope to have more to discuss in future quarters as these transactions advance. Bigger picture, the capital markets continue to strengthen as lending is up year-over-year driven by a strong recovery in the CMBS market and that improving leasing market that allows buyers and sellers to underwrite more thoughtfully. As a result, transaction volume has increased compared to last year and high-quality office and life science opportunities are starting to surface. To this end, there have been a few core office deals trade in our markets at cap rates ranging from the mid-6% to low-7% range. In summary, as we demonstrated this quarter, we are prepared to transact when the right deal comes along and we're hopeful that we can find additional opportunities as both a buyer and a seller in the coming quarter. With that, I will turn the call over to Jeffrey.

Thanks, Eliott. Since joining Kilroy in late August, I've spent my time getting to know our team and portfolio and I'm excited to work closely with Angela and the rest of the executive team to deliver value and drive outperformance going forward. FFO was $1.17 per diluted share in the third quarter and was impacted by several one-time items totaling approximately $0.05 per share, including $2.6 million of bankruptcy settlement income, $2.2 million of restoration fee income and $1.4 million related to real estate tax appeals. Cash same-property NOI growth was 2.7% in the third quarter, including a 230 basis point impact related to the aforementioned one-time items. In terms of our forward outlook, we've increased 2024 guidance for same-property NOI growth to a range of minus 2% to minus 1.5%, a 175 basis point increase at the midpoint of the range. Our improved outlook is driven by the increase in our full year average occupancy projection, which Angela discussed earlier, the cash impact of our non-recurring items in the third quarter, and cash restoration fee income expected in the fourth quarter. In addition, we have updated our 2024 FFO guidance range to $4.38 to $4.44 per share, representing an increase of $0.15 at the midpoint. The revised guidance reflects our updated same-property NOI growth and G&A guidance, as well as the expected contribution of our Junction at Del Mar acquisition in the fourth quarter. Our G&A guidance range was narrowed and lowered by $1 million at the midpoint, reflecting a variety of ongoing G&A initiatives that have refocused resources across the platform with the goal of improving the efficiency and effectiveness of our G&A spend. The midpoint of our updated full year FFO guidance implies fourth quarter FFO of $1.03 per share, a $0.14 decrease from the third quarter. To bridge there, subtract $0.05 related to the previously discussed one-time items in the third quarter, $0.04 related to lower sequential GAAP and net operating income due primarily to fourth quarter anticipated move outs, $0.03 related to lower interest income, net of lower interest expense and $0.02 related to the timing of G&A spend. Turning to development activity as Angela highlighted, we're excited to be approaching the delivery of Kilroy Oyster Point in the fourth quarter of this year, as the project was the primary driver of our development spending during 2024. We expect development spending to moderate in 2025 pending future TI capital outlays. As a reminder, for KOP Phase 2, interest capitalization will cease at the earlier of tenant occupancy or one year from base building completion, which is expected to predominantly occur in the fourth quarter of 2025. With respect to the future development pipeline, as Elliott highlighted, we continue to work towards the monetization of several parcels that we now believe have the highest and best use outside of the company's core competencies. As we continue to evaluate and begin executing on a disposition program to maximize shareholder value, the continued capitalization of interest may not be appropriate in all cases. As our disposition plans gain traction, we will be able to provide more detail on what this will mean for 2025, but we do currently expect that capitalized interest will be lower next year. Finally, from a balance sheet perspective, we are exceptionally well positioned with $1.7 billion of available liquidity. While we'll use cash on hand in the fourth quarter to repay our scheduled bond maturity, we still expect to end the year with significant cash on hand and a fully undrawn credit facility, providing us with ample flexibility and capacity to navigate a dynamic operational, transactional and capital markets environment for 2025. With that, we're happy to take your questions.

Our first question today will be from the line of Nick Yulico with Scotiabank.

Thanks. I guess first question, if you could just talk a little bit more about Oyster Point Phase 2 and you mentioned some traditional office users potentially being candidates. If you could just talk about what dynamic is making that potential for the project? And then also in terms of the tenants in the first phase, whether any of them might be expansion candidates for Phase 2?

Yes. Thanks, Nick. I'll start and then I'll turn it over to Rob to provide a few more specifics. I would just say, as I mentioned in my prepared remarks, we're really convicted about the quality of what we're delivering in Oyster Point. And the closer we get to delivery of that project, the more you can see sort of the unique attributes of the campus, the amenities that we're putting in there and that's certainly improving sort of the relevancy on the tours, just what this project is and what it will be to the tenants that end up locating here. In terms of the demand I mentioned or tour and interest activity we've seen from traditional office users, I think it's really just a reflection of the quality of the project that's being delivered and the fact that we have, as you know, in Phase 1, an office tenant already that's very successful and very happy at the project as well. So I don't think there's anything more to it than that. It's really just a very high-quality project delivering with a really fantastic amenity package.

Hi, Nick. I guess I'd say also kind of going off Angela's comments, the landscaping is now, I'd say about 2/3s of the way installed and that makes a huge difference in the project and we're now for the first time presenting inside our fully fitted out conference center. So our prospects really get a sense of what it's going to be like at Oyster Point. And I think kind of going further on the demand and what we're seeing, as I've said before, we're delivering into a really positive environment. VC funding for the quarter is at $2.6 billion. In the year-to-date, the number is about $9.9 billion which is about $1 billion more than the quarter before. So we're seeing an improved funding environment, which is leading to more demand. Demand has remained steady at about 2.8 million square feet. And I think for us particularly at Oyster Point, one of the things we're seeing is larger format tenants coming into the market, and a good proportion of them are larger than 44,000 feet, which is a single floor for us. So all things are coming together. It's a really busy place right now, and are sort of going off what Angela said also, our tour activity and presentations have accelerated in the last month to 6 weeks.

Yes. And just on the second part of your question in terms of the 2 tenants we have in Phase 1 and the likelihood that either of them expands into Phase 2. I would just say we've got 2 very successful tenants in Phase 1 of the project, both of whom I believe are extraordinarily happy at Oyster Point. And I would say I do think there is long-term expansion potential for one or both of those tenants. At this point, my expectations would be that that's most likely for phases beyond Phase 2.

Okay. Thanks. That's helpful. Second question is just on the short-term leases. So I know you talked about that, saying many cases it could be tenants leaving in the future or downsizing in the future. So is there a way to just put some numbers around this? When we look at the short-term leases that were announced year-to-date, it looks like it's about 340,000 square feet 2% of the portfolio, I imagine. I think there was also some short-term leases last year. So we're just trying to understand like how much of that occupancy benefit, I guess is in this year or maybe even helped with some of the occupancy guidance revision higher, but we should think about as at some point next year, it's occupancy that could go away.

Yes, thanks, Nick. I appreciate it. I'll say a couple of things. Number one, anything that we've disclosed as a short-term renewal is already reflected in the lease expiration schedule you see in the supplemental. So you have full visibility to all of those short-term renewal activity. So during the quarter, the short-term activity we announced was primarily related to one large renewal for Capital One on a short-term basis in San Francisco. That's going to extend that maturity just a couple of months, so it's still a 2024 expiration, but again reflected in the lease expiration schedule you see. The only thing that was significantly different than that kind of activity are really two things that varied from that. Were first, the larger format short-term lease we announced I believe in the first quarter of this year, which is 75,000 to 100,000 square feet? That took occupancy this quarter. We'll be exiting the portfolio in the fourth quarter of this year. And then the second more unusual transaction was the new lease we signed with a successor entity DermTech this quarter. That's going to keep them in occupancy through this year and to mid-first quarter next year. And that's one where we do expect a vacate or a significant downsize, but are in discussions with them now.

Great. Thanks for taking my question. Could you provide some color on your decision to acquire Del Mar? It seems like the market is pretty tight. Is there any kind of long-term plans to maybe integrate with One Paseo there? That'd be great.

Yes. I'll make a few comments and then turn it over to Eliott for additional commentary. But this is located really adjacent to our One Paseo project, which is an incredibly successful mixed-use project that the company has developed. And I would say there are strategic benefits longer term as we think about how this site could potentially be redeveloped and further integrated with One Paseo. But as I think you also heard Eliott really highlight in his prepared remarks, this was also a very attractive deal on an as-is basis if there's no redevelopment play given the cap rate that it was acquired at, and lease term we have with existing tenants and just really how tight that submarket is. As we mentioned, it's one of our most successful submarkets in the portfolio. We ourselves are 97%, 97.5% leased in Del Mar. And as Eliott highlighted, this acquisition was 96% leased as well. So it's both good income on an as-is basis with yes, sort of a strategic potential longer-term benefit through redevelopment and further integration with One Paseo.

Yes, Upal, as we sort of touched on, I mean, this really checks so many boxes for us as an acquisition. We know the market incredibly well. We know the micro location very well. Having so much scale next door allows us to take advantage of that, and whether that's as we think about how tenants grow in our portfolio or if there are expenses that we can manage, and then there's also something to say for the brand that we have as a company created at One Paseo. And the more we can do to extend that brand and integrate adjacent properties, we think is very additive.

Yes, so this is Elliot, I'll take that. The reason they went into the TI ready phase is because the cold shells essentially complete and it is tech; it's more of a technical timeline that we've hit. And so now that we've hit that point in time, our 12-month clock begins for lease up. And then at that point, the properties will go into the operating portfolio, capitalization will cease and they will be integrated into our occupancy statistics, et cetera. As far as the leasing market around that, Rob, if you want to touch on that.

Yes. As kind of going off what Elliot said, as the, building has delivered or starting to deliver and the tenant improvements are starting for the spec labs, it's increased our activity there. And as you recall, we did this, we made this decision to move to life science, because it gives us a wider net to cast. Although there are a lot of tech companies in the neighborhood, there's also a lot of life science in the area. So we're seeing a good amount of interest on the project. We just had a relatively large broker event last week that was very well attended.

And then just the last piece of your question on the timing on 4690, as you may recall last year we had a tenant, Sorrento Therapeutics that was supposed to take that space and declared bankruptcy. We then pivoted and readjusted our design to go from a single tenant use to a multi-tenant use. As we sort of worked through that, it just took a little bit longer in developing those plans and that was the one quarter delay.

You talked a lot about the land parcels. So related to that, I wanted to ask about Flower Marts. Clearly, the pandemic interrupted the plans you had to develop mixed-use space with a lot of office there. But in the past, I think you guys have excluded it from any land parcels you're evaluating for disposition. So can you talk about what the plan is there? Can you adjust the property mix to lean more towards residential or retail? And then, lastly, I believe you're capitalizing interest there. Is there any clear answer to when that could cease?

Yes, thanks Blaine. I'll say a few things about Flower Mart. This is a really exceptional assemblage of property in the city of San Francisco. Very well located, accessible, and zoned for pretty high density, and so at the right time, I think there's a lot of reason to be enthusiastic about how Flower Mart ultimately gets developed. Given where the market is right now, that's unlikely to be in the near-term. And certainly, we're going through an extended process of really understanding what all of our options there and making sure that we're on a path that will ultimately maximize value, through whatever eventual outcome that is. I note that right now, we're still working on completing our work at the wholesale flower mart and moving the flower vendors over. So we're still at that stage of the project, but actively working on longer term design and density considerations at Flower Mart. The things that make this site challenging, I think in the near term are just making sure while it sounds like a good idea to pivot to alternative uses, I think we have to be really mindful of the fact that we do have such significant density approved at the site. And there are a number of other plans that might be more actionable in the short term that would really impair the eventual ultimate value and realization at Flower Mart. And so those are things that we have to be mindful of. As we continue to work through our plans for that site, we'll have better clarity on sort of what timelines look like for those different plans and what that means for interest capitalization.

Okay, great. That's great color. Just for my second question, another kind of high-level one. Over the years, Kilroy and in particular John has been very vocal about the need for political reform on the West Coast and now we're also facing a presidential election that's highly controversial. So I guess from both angles here, Angela, how are you feeling about the political and business environment on the West Coast? I guess, have you seen any improvements in the short time that you've been there? And I'd also be interested in any potential implications you think there could be from the San Francisco election and maybe even federal election if you have any view there.

Yes. I'll make a few comments. Obviously, as you point out, the company has been very politically aware over time and politically active in the markets we operate in, really championing great policy, both from a business perspective, but also just from a quality of life and safety perspective as well. And that's been a huge focus of the company's efforts over the last few years. I would say we have seen, not just during my time, but over the last probably 18 to 24 months, a real improvement in many of the markets we operate in. That's absolutely true in San Francisco, but it's true in our other markets as well like Seattle and Los Angeles to varying degrees. We are continuing to monitor all of the election activity really closely. We do feel like what's happening in San Francisco will continue given the way that the mayoral race and the Board of Supervisor races are shaping up and do feel like we'll continue on the path we've been on, which is to some degree more moderate policies that again continue to focus on quality of life and safety issues in the cities and really bringing back employees and residents and really just continuing to improve the overall vibrancy of those markets.

Great. Thank you. Angela, you mentioned in your opening remarks recovery, but you also said subtle recovery. In New York City, I'm sure you're aware, I mean, I think one of the key catalysts was companies finally deciding to stop producing space. How would like, I guess, by market, where does that stand? Where do you think that stands in San Francisco or LA or Seattle versus New York City given everyone's trying to compare?

Yes. Thanks, Jeff. I mean, I'll say a few things. Number one, I think important commentary made in the prepared remarks was just around some of the recent return to office announcements we've seen. And what I really tried to highlight there is what we're seeing in this phase of the return to office dynamic is companies that had worked really hard to embrace remote work as a consistent and significant part of their workplace environment that are moving back to environments, in particular, in Amazon's 5-day announcement that represents sort of pre-pandemic norms. And so I think that's certainly a very helpful dynamic overall. I also pointed out particularly in the San Diego market. But I'll turn it over to Rob to talk more broadly about what we're seeing in other markets, that we have recently seen a pretty significant uptick in terms of tenants looking to expand within the portfolio. And then in several instances, and I do think this is a sign of things to come, we're seeing tenants who had reduced space or were actively planning on reducing space in 2025 come back and sort of begin conversations with us because they believe they've overshot those reductions. And now that they're getting people back into the office more consistently, they have a better sense of what their ultimate utilization of real estate requirements are and are realizing that they're a little bit different. And that is I'll turn it over to Rob. But we've certainly seen that dynamic not necessarily within our portfolio but within the broader markets we operate in as people would put sublease space on the market and pulled some back as their plans kind of shift and change.

Yes, Jeff, I want to add that there is a noticeable positive change in the streetscape across all the markets where we operate. For instance, in Bellevue, with Amazon as a major employer, there will be about 25,000 Amazon employees returning to the office over the next two years, which is encouraging. When companies bring people back to work, it benefits retail and supports the businesses with their employees, and we're witnessing this happen in Seattle. Additionally, the City of Seattle and King County are requiring employees to return to the office three days a week starting in November, which will add approximately 13,000 more people working in downtown Seattle, a very positive development. In San Francisco, Salesforce has recently implemented a return to office policy that is being phased in over the next few months, especially since our headquarters office is centrally located in the Salesforce campus. There are new restaurants opening, and overall, San Francisco is experiencing a revival in retail that wasn’t here a year ago. In Los Angeles, particularly in Culver City, Hollywood, and the Westside, people have returned to work, and conditions continue to improve. We're starting to see larger transactions emerging in areas like Playa Vista, which had been slow recently. San Diego, as Angela mentioned, has also been progressing well, and Austin has been a leader in the gradual return to office.

Thank you very helpful. My second question is on external growth. I guess acquisitions versus development, Junction at Del Mar. I mean is this I guess, can you talk a little bit more, Angela, about your strategy over the next few years. Have you changed that external growth strategy from the past a little bit? And is Junction at Del Mar a good example of what we should expect more out of Kilroy and including of course, you discussed the land sales.

Yes. I don't know that there have been huge changes in how we'll approach capital allocation going forward. I mean, I think this is, as we pointed out in the prepared remarks, a real focus on risk-adjusted returns and just making sure we're continuing to deploy capital at levels that represent returns to the company and to our shareholders that are above our cost of capital. It's really no more complicated than that. The Junction at Delmar, I think was a really fantastic transaction where we're underwriting as Elliot mentioned in his remarks, a low double-digit stabilized yield translating into kind of a mid-teens IRR, and even at discounting cost of capital today. I think that transaction makes sense all day long. And then you layer on top of that potential future redevelopment down the road. I think it's a very compelling deal. Now, I'll be at a very small size at $35 million, but I think it made both financial and strategic sense for the company. I don't think that's necessarily anything dramatically different from what the company would've done historically. We're going to evaluate a wide range of transactions in our markets and I think being very focused on risk-adjusted returns, how we're underwriting cashless streams going forward, how we're thinking about the conviction we have in different submarkets that we operate in today regarding lease up and the timing of that lease up and things like that. And just trying to make sure that we're continuing to put capital to work in ways that all that benefit the shareholders.

You mentioned the short-term leases and the sublease space in the portfolio. As we look ahead over the next couple of years, the lease expiration schedule is set to increase significantly. Angela, could you share your comfort level regarding the possibility of another decline in occupancy in the coming years? Additionally, how should we approach the expected absorption of upcoming lease expirations?

Yes, I mean, I'll talk about it a few ways and we can talk longer term about 2026 and sort of how we're positioning for the lease expirations that are coming in that year. But look, we were pleased to report an increase in sequential occupancy in the third quarter. The teams are working really hard across the entirety of the portfolio to prioritize occupancy and getting tenants in and rent-paying as quickly as we can. And that came through in some of the deals announced this quarter and also some of the early revenue recognition or early occupancy that we reported that helped drive the occupancy number as well. So I'm pleased to see that sequential increase in occupancy. Obviously, the full year occupancy guidance does point to deceleration of that occupancy level in the fourth quarter and that will have something to do with both the short-term Capital One extension we talked about earlier. They will vacate in the fourth quarter as I previously mentioned, and that shorter-term new lease deal that we had announced in the first quarter took occupancy this quarter and will vacate the portfolio next quarter. In addition to a move-out from Microsoft or LinkedIn in the Bay Area. So some pressure in fourth quarter. What we had pointed to in 2025 in particular and have continued to point people to is that that is overall a lighter expiration year for the company and it is a more granular pool. So, until this quarter, and I'll put one caveat on that, we have had no lease expiration in 2025 greater than a 100,000 feet. With the shorter-term DermTech deal that was signed this quarter, they will vacate the portfolio in the first quarter significantly downsizing, and as I mentioned, we're in conversations with them now to understand what that looks like, but there will be some space from that 110,000 square foot short-term renewal coming back to us in the middle of the first quarter. So that's the only real update there. So 2025, again, the move-outs feel certainly an easier hill to climb than 2024 was, but you're appropriately sort of keying in on 2026 being a larger expiration year. And I will just say Rob and team have been very focused on the 2026 expirations really since I joined the company back at the beginning of 2024 and are making good progress in conversations with many of those tenants already. Rob?

Yes. I would just add a little more color to that. On the last earnings call, we discussed that tenants now sort of in general are starting to look out further than just their upcoming expiration and that's being borne out in what we're doing in 2026. And I would say right now, we have good confidence in the discussions we're having and we're having discussions on over half the space that is expiring in 2026 and these are relatively longer-term transactions as well. So not the short term that you have seen in the past.

Great. Thanks. Just wanted to get some more color on the leasing numbers this quarter. Obviously, rent spreads and retention rates were higher relative to 2Q, but you saw noted jump in TIs as well. Can you give us any sense on maybe how this has impacted net effective rents? Are you seeing a greater ability to maybe push face rents, but you have to sacrifice more in TIs to get deals done? Just curious on any color there. That would be helpful.

Yes. I mean, I'll let Rob come in a minute. But I guess what I would say is, one quarter data point doesn't lead to a trend line necessarily. I would say there were a couple of deals in the pipeline or in the deals reported this quarter that just based more on condition of the space than on market dynamics drove that number to be a little bit higher. And certainly, we're in a competitive market environment, but I don't really think that's what drove the number this quarter as opposed to just the condition of the space and more of a mix issue than market or trend issue.

Yes, and Angela hit the nail on the head, Michael. It's the condition of the space in 2 cases, which were relatively large. The space hadn't been redone for over 10 years by 2 different tenants. And so to put that in perspective, post-pandemic there was no remodeling done to reflect a new modern work environment, so it necessarily means tenant improvements are going to be higher. Then one more piece I'd add is that there involves some corridor work, which we always kind of we assess that as part of the TI work even though it's separating 2 spaces.

Appreciate the color there, Rob. And then just going back to your commentary maybe specifically on LA, it seems like look, might be a little bit better, but obviously we've heard about the issues that the film and TV industry has had there. I know studios don't directly impact your business, but can you give us a sense? Do you need to see an accelerated recovery within that industry to drive additional demand for office space?

Yes, there's no doubt that would be beneficial. As we noted in our prepared remarks, the LA market has been soft, but the team is performing exceptionally well in this challenging environment. We're also encouraged by the stability in Long Beach, where we've observed an increase in average deal size, which is promising. Additionally, we're seeing renewed interest in Culver City, particularly from professional services and technology tenants returning to the market. This is an encouraging trend as well.

Yes. I’d like to add a couple more points, Michael. Recently, Governor Newsom signed a bill that effectively doubles the incentives for the film industry to produce in California, particularly in Hollywood. This is a positive step forward, especially considering we’ve noticed increased tenant activity in addition to what Angelo mentioned about Century City; we’re also seeing growth in Culver City and Beverly Hills. There are signs of larger deal activity, at least in Playa Vista. Overall, things seem to be improving. In our LA portfolio, we have executed 59 deals year-to-date, totaling nearly 425,000 square feet. Our team in LA has been very active, focusing on smaller deals. Nonetheless, our tour activity is increasing, and we are optimistic about the developments in the competitive markets around us.

Thank you. Good morning everyone. I’d like to clarify the lease expiration schedule. I believe there are three significant move-outs expected in the fourth quarter, which suggests an exit rate of over 90%. I wanted to confirm if that’s accurate. Additionally, regarding Tony’s question about 2025, aside from DermTech, are there any other notable move-outs you are currently aware of within the 750,000 square feet set to expire?

Yes. Regarding the fourth quarter, I believe the most significant move out will be KOP 1 in San Francisco, as previously mentioned. We have a couple of extra months from one of the short-term renewals reported this quarter, which will contribute to the fourth quarter move out. Additionally, we signed a shorter-term new lease in the first quarter of this year, took occupancy in the third quarter, and it will also be a move out in the fourth quarter. This involves some short-term deals amounting to around 100,000 square feet expected to vacate in the fourth quarter. Moreover, the Microsoft or LinkedIn lease in the Bay Area, approximately 76,000 square feet, represents another significant factor for the fourth quarter. Looking ahead to 2025, you rightly point out the DermTech lease, which is 110,000 square feet and will be moving out around mid-Q1 of next year. Furthermore, there is another large lease in that expiration pool for next year, which is also set to expire in Q1 at about 80,000 square feet, and we are currently in discussions regarding that; I anticipate it will result in a vacate, and it poses a notable downside. It will be quite close together. Jeffrey's comments intended to indicate that it will mostly happen in the fourth quarter of 2025. One of the buildings may finish base building completion in the first quarter of 2025, which would delay the interest capitalization clock until the first quarter of 2026. However, we're really discussing potentially just a one-quarter difference.

On the land sales of $150 million in proceeds, can you discuss what the earnings impact may be? I think you're going to have some capitalized interest coming off. I don't know what the book value of the land is, but if there's going to be a gain, are you going to include that in earnings and timing? Do you expect this to be realized in 2025?

Yes, I’ll share some insights, and then Eliott can contribute if he has anything else to add. Regarding the earnings impact for 2025, I would refer back to Jeffrey’s comments. Not all the parcels in the future land pipeline are being capitalized from our side; some are ours. The timing and the plans we are working on for each of these parcels are important. We need a bit more time to advance some of these potential dispositions and refine our plans before we can be more specific about what this means for 2025. Jeffrey's comments underscored this. Overall, I would anticipate that capitalized interest will be slightly lower in 2025. Additionally, based on the deals that are more advanced, we do expect some gains in that portfolio, but these gains would not be reflected in FFO.

Regarding the timing of the re-entitlement process, it will take a considerable amount of time, and it is challenging to predict the exact duration. However, you should not anticipate anything before the end of 2025. We expect these events to occur in phases towards the end of 2025, throughout 2026, and potentially some extending into 2027.

Thank you for tackling the multi-part question. My second question is on KOP 2, just going back to potentially signing traditional office users or tech users. How does that impact the cost or the expected yield of the project if you have to convert that lab space back to office? And does that impact leasing at all? Do you expect biotech or pharma users to be kind of turned off if there's a corporate tenant in there?

I believe it ultimately depends on the scale and how the campus comes together as a whole. I don't see leasing to some office tenants as a detriment to the rest of the campus. We didn't face that issue during Phase 1. Regarding your question about costs related to the project that might need to be removed to accommodate that use, we don't have that issue with two of the three buildings. Keep in mind, we've only developed the lab space for the spec suites in one of the three buildings, so there’s a lot of vacant space that could support those other users. Discussing the overall deal economics right now would be premature.

The last thing I'd add to that is that both Cito and Stripe cohabitate and it works really well. So as Angela said, we've got a lot of space that can be used as office that's in shell condition. And we have spec lab space that's intended to be spec lab space and not converted back to office.

Office capital markets are currently facing challenges due to a general lack of debt availability. However, it appears that conditions are improving in the leasing sector, and there is hope that this will eventually lead to a more favorable capital markets environment. As you evaluate the current operating portfolio and its positioning in the submarket, is there interest in reducing the portfolio and selling properties in markets that you no longer consider core?

Yes. Look, I think all of our plans, as it relates to market positioning and some market positioning are things we're actively talking about. As we've pointed out, the transaction market has been really, really slow this year. So executing on anything, it's been more academic than something we can really do in practice. But we're thinking about the portfolio holistically all the time and trying to make sure that we're putting ourselves in a position to continue to move the portfolio in directions that we think will do the best job of helping us build a durable and resilient cash flow stream that with significant growth in the future. And so that's how all of the potential dispositions and acquisitions will kind of be viewed through that lens.

I appreciate the comment, Angela. And then maybe just a small one on the acquisition. You guys talked about a low double-digit stabilized yield. But given the near 5-year WAULT, is it safe to say that the sort of going in yield is close to that? Or are there sort of below-market rents that are sort of bringing you guys that low stabilized double-digit yield?

So Dylan, this is Eliott. I have two comments. First, we believe the rents are currently below market. Second, as Angela mentioned earlier, we expect a mid-teens internal rate of return. Therefore, we don’t anticipate that this will be an investment that deteriorates over time.

I think, Angela, back in the prepared remarks, you gave some commentary on the sublease market in San Francisco, how it's becoming less competitive or at least a large portion of it. Wondering if you can talk a little bit more on sublease space more broadly? But then in San Francisco, kind of how competitive is it? And are you seeing that kind of detract from conversations that you or other landlords might be having on direct leasing?

Yes, I'll start and then I'll hand it over to Rob. As mentioned earlier, it has been very competitive over the past few years, particularly with demand coming from tenants in the AI sector. Many of these startups need space they can occupy quickly and do not have the time or resources for a lengthy build-out process. The sublease spaces cater to that need. However, as we approach lease expirations, the overall sublease market in San Francisco reveals a mix of obsolete spaces and large-format or full-floor areas that do not align with the requirements of some tenants, especially those in AI. Additionally, more than half of the total sublease space in the market has upcoming lease expirations. With each passing day, this space becomes less competitive as tenants cannot fully utilize it. Our team is effectively engaging with tenants who have near-term needs that may have previously focused on sublease options, encouraging them to consider the available sublease spaces in the market and exploring ways we can position them attractively to meet the demand amid these dynamics and future trends.

Yes, to provide a bit more detail, in San Francisco specifically regarding sublease space, many emerging AI companies prefer short-term leases, typically looking for terms of around three years or longer. As more sublease space gets absorbed, projections suggest that by 2027, the vacancy rate in San Francisco should return to a more typical level, estimated between 10% and 15%, with some of the previously subleased space shifting to direct leasing. In our other markets, like Seattle, around 15% to 20% of the market consists of sublease space, but it's important to consider the lease terms in that space, with shorter leases being less appealing than longer ones. It seems we are fortunate in that tenants have stopped listing their spaces for lease, entering a more stable phase, and that available space is being absorbed.

Starting with Angela, following up on the sublease versus direct question. You had mentioned in your prepared remarks Kilroy expanding its spec suites offering to meet demand for more direct space from tenants. Beyond the spec suites that you're building at KOP in Phase 2, how much are you looking to add in other markets? And what type of upfront investment does this require compared to traditional office TIs?

Look, we're leaning in a little bit, but I want to be clear as I was in my prepared remarks that this is sort of leveraging thoughtfully executed and well-designed program the company has had in place for some time. I don't think this is a significant departure, but there are markets based on where we're seeing demand. In particular, in San Francisco, given new business formation, particularly on the AI side and what their requirements are, then it makes sense for us to do a little bit more on the spec suite side. We're probably talking about an inventory increase of a few spec suites at any given time. This is not like a major strategic shift. But hopefully, what you take away from that is just we're being very thoughtful and very aware of where the demand is coming from in each of our markets, and trying to figure out how we can position ourselves to capture as much of that as possible.

The short answer is yes. What we've tried to do is collaborate with identified groups to ensure that we are not making changes in isolation, and that impacts the timeline we discussed.

Thank you. And with no further questions in the queue, this will conclude the KRC 3Q '24 Earnings Conference Call. Thank you to everyone who is able to join us today. You may now disconnect your lines.