Earnings Call Transcript
KILROY REALTY CORP (KRC)
Earnings Call Transcript - KRC Q3 2025
Operator, Operator
Hello, everyone, and welcome to the KRC Third Quarter '25 Earnings Conference Call. My name is Emily, and I'll be coordinating your call today. I would now like to turn the call over to Doug Bettisworth, Vice President of Corporate Finance to begin. Please go ahead.
Douglas Bettisworth, Vice President of Corporate Finance
Good morning, everyone. Thank you for joining us. On the call with me today are Angela Aman, CEO; Jeffrey Kuehling, EVP, CFO and Treasurer; and Eliott Trencher, EVP, CIO. In addition, Justin Smart, President; and Rob Paratte, EVP, Chief Leasing Officer, will be available for Q&A. Please note 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 provide an update on our recent transaction activity and Jeffrey will discuss our financial results and provide you with updated 2025 guidance. Then we'll be happy to take your questions. Angela?
Angela Aman, CEO
Thanks, Doug, and thank you all for joining today's call. As we enter the final stretch of the year, Kilroy is capitalizing on accelerating momentum across our West Coast office and life science markets. The return to office continues to improve, supported by evolving workplace norms, shifting employer expectations, and recognition of the office as a driver of culture, collaboration, and innovation. These trends, combined with improving quality of life dynamics, are driving enhanced vibrancy, a resurgence in leasing activity, and a meaningful increase in institutional investor interest in high-quality West Coast commercial assets. At the same time, rapid advancements in artificial intelligence are reshaping demand across both the office and life science sectors, accelerating innovation and reinforcing the strategic importance of well-located real estate in concentrated tech and biotech hubs. Nowhere is this more evident than in the Bay Area. In the city of San Francisco alone, office demand has reached a post-pandemic high of nearly 9 million square feet, up from approximately 7 million square feet last quarter, with much of this demand being driven by AI and other technology companies. Importantly, the growth in demand statistics has persisted even if the pace of lease executions has significantly increased, with San Francisco leading all U.S. metros in office leasing growth over the last 12 months. Against this backdrop, I'm pleased to report another strong quarter of execution across our portfolio. During the quarter, we signed over 550,000 square feet of new and renewal leases, marking our highest third quarter of leasing activity and our strongest year-to-date performance in 6 years. Leasing momentum was robust in San Francisco with activity in the south of market or SOMA submarket particularly notable. Our SOMA assets continue to outperform with over 95,000 square feet of new and renewal leases executed this quarter and a growing forward pipeline, with tour activity in our SOMA assets up 170% year-over-year. At 201 Third Street, we signed a full floor lease with Tubi, a global streaming entertainment company for their new headquarters, marking the third consecutive quarter of major leasing at this property. Our continued success at 201 Third highlights the exceptional ability of our leasing, construction, and asset and property management teams to understand and meet the evolving needs of today's tenants, many of whom are prioritizing landlords that can deliver speed from lease execution through tenant occupancy. Encouragingly, as the San Francisco recovery continues to accelerate, we're now seeing this momentum expand to nearby assets in our portfolio, such as 360 Third Street, where we recently signed our first lease since 2022. While the recovery in San Francisco certainly deserves a significant amount of focus and attention, it's important to note that we're seeing improving dynamics across nearly all of our markets with tenants demonstrating greater conviction and willingness to execute. During the third quarter, capitalizing on this improved sentiment, we made important progress in addressing some of our largest remaining 2026 lease expirations. In San Diego, we completed a long-term renewal with Scripps for their entire 119,000 square foot lease at Kilroy Center Delmar. And at Long Beach, we executed a short-term renewal with SCAN for 87,000 of their approximately 220,000 square feet at Aero. While we anticipate that SCAN will vacate at the end of their extended term and relocate into owner-occupied space, the phasing of this move-out provides valuable near-term stability as we work to programmatically backfill. Subsequently, after quarter-end, we signed an additional 148,000 square feet of renewals related to 2026 lease expirations, as Jeffrey will detail in a moment. Taking into account the renewal signed subsequent to quarter-end, 2026 lease expirations now total approximately 970,000 square feet, reflecting a retention ratio of over 40% on the pool reported at the beginning of this year. Our leasing team has worked diligently to renew tenants as early as possible, and I'm very pleased with the progress we've made to date. That said, the pool of remaining renewal opportunities in 2026 is now much more limited. The path forward will require a greater emphasis on new leasing activity. As a result, we're approaching the remainder of this year with a clear focus on capturing growing demand across our markets and ensuring that our assets are well-positioned to outperform as momentum continues to accelerate. Turning to life science, we're encouraged by a variety of important signals that speak to the improving fundamentals we're seeing in our portfolio. The XBI is up more than 20% year-to-date, with strong broad-based performance from both large and small cap biotech companies, fueled in part by greater clarity on the regulatory backdrop for the sector and a variety of positive company-specific clinical trial and drug approval announcements. In addition, biotech M&A volume has accelerated with large pharmaceutical companies actively pursuing new pipelines to offset significant patent expirations over the coming years. Kilroy Oyster Point Phase 2, our premier development project in the heart of the South San Francisco life science ecosystem, is benefiting from this material improvement in sentiment and activity. We're pleased to report that we've signed 84,000 square feet of leases to date with well-established biotech companies. In addition to the 24,000 square foot lease with Color that was announced in September, last night, we announced the execution of a 44,000 square foot lease with MBC BioLabs and a 16,000 square foot lease with Acadia Pharmaceuticals. MBC BioLabs is the Bay Area's leading life science incubator and has helped launch more than 500 companies, collectively raising over $20 billion in capital. MBC's presence will help create a diversified tenant base of early-stage biotech companies at KOP, advancing our strategic goal of cultivating a dynamic innovation-driven life science ecosystem at Kilroy Oyster Point that will support the long-term growth and value creation of the project. MBC is expected to commence occupancy in the fourth quarter of 2026. Acadia Pharmaceuticals is a biopharmaceutical company committed to advancing therapies for underserved neurological disorders and rare diseases, and this recent execution marks Acadia's entry into the San Francisco Bay area. Already a valued Kilroy tenant in our San Diego portfolio, we're proud to expand our relationship as trusted partners. Acadia is expected to take occupancy in the second quarter of 2026. The future pipeline at KOP 2 is robust, and we're actively engaged with a variety of potential tenants, including several with larger format requirements. These discussions, though still early, reflect both an overall improvement in the life science market and a growing appreciation of Kilroy Oyster Point's purpose-built life science construction and market-leading amenities. Based on the status of current conversations, we believe that KOP 2 is now well-positioned to exceed our previously communicated goal of 100,000 square feet of lease executions by year-end, and we expect this project to be a meaningful contributor to the company's growth over the next several years. From a capital allocation perspective, we continue to be active and disciplined as we recycle capital with a focus on long-term cash flow growth and value creation. Our approach remains responsive to evolving dynamics in both the office and life science sectors, as well as shifts in the relative attractiveness of the submarkets in which we operate, staying agile and prioritizing opportunities that align with our long-term strategic vision for the portfolio. During the quarter, we completed the previously announced sale of a 4-building campus in Silicon Valley for gross sales proceeds of $365 million, and the acquisition of Maple Plaza, a Class A office campus in the iconic Beverly Hills submarket of Los Angeles for $205 million. Maple Plaza marks Kilroy's first investment in Beverly Hills, a highly sought-after, well-amenitized and supply-constrained environment with one of the lowest vacancy rates in the Greater Los Angeles market, and the asset has quickly become the strongest driver of leasing activity in our Los Angeles portfolio. Looking forward, expect us to continue to thoughtfully and strategically rotate capital out of assets where we believe value has been maximized, and as proceeds are realized, pursue a balanced mix of selective reinvestment opportunities and debt repayment, considering all redeployment alternatives with a focus on optimizing portfolio returns and maintaining a strong and flexible capital structure. With respect to future development pipeline, we continue to work through additional land parcel monetization and expect to have further announcements in the coming quarters. In addition, we've been hard at work on the Flower Mart project, which is our single largest investment in the future pipeline. As we pursue additional flexibility and optionality that will allow us to ultimately maximize value on the site while being responsive to the evolving needs of the San Francisco community. During September, as part of our redesign and reimagining of the Flower Mart project, we submitted 4 development scenarios to the City's Planning Department, each illustrating a potential path forward for the site, including a range of commercial and residential uses. Our conversations with the city to date have been constructive and encouraging, and while those discussions are still ongoing, we have now gained greater clarity on both the approval process and the timeline required to secure the optionality we're targeting. As a result, based on the best information available today, we expect interest and other expense capitalization to Flower Mart to continue through June 2026. We'll keep you updated on this assumption as appropriate. In conclusion, I want to thank the entire Kilroy team for an extraordinary effort this quarter as the pace of leasing and transaction activity have accelerated. I couldn't be any more pleased with the energy, enthusiasm, and execution that this team is delivering each and every day.
Eliott Trencher, EVP, CIO
Thanks, Angela. As Angela noted, fundamentals are accelerating across all of our markets, which is not only good for leasing, but also for transactions. Buyers are underwriting vacancy and rollover with more conviction, leading to deeper bidding pools, which in turn is giving sellers increased confidence they are transacting at market pricing. All of this is leading to more deals being marketed and closing. We have been fortunate to benefit from these trends as both a buyer and a seller. Starting with dispositions, we had a productive first 3 quarters of the year, closing on $405 million of previously disclosed sales. As we continue to evaluate dispositions, our strategy remains the same: monetizing properties in lower conviction locations at values that imply forward returns less than our cost of capital. We are fortunate to have the benefit of a strong balance sheet, meaning we are not going to sell at any price and instead, we'll only transact when a deal meets our rigorous thresholds. Turning to land sales, as previously discussed, we had $79 million under contract between 26th Street in Santa Monica and Santa Fe Summit in San Diego. Both buyers continue to advance their plans and the transactions will close upon receipt of entitlements, which we currently estimate to be mid-2026. We are making progress on additional land sales and remain on track to hit our goal of at least $150 million in gross proceeds. On the acquisition side, during the quarter, we bought Maple Plaza in Beverly Hills. Beverly Hills has many of the characteristics we look for in the submarket. It's centrally located within the west side of Los Angeles with proximity to decision-makers, amenities, and a diverse mix of tenants across multiple industries. Because it is centrally located, the barriers to entry are quite high, with cumulative new supply of only 260,000 square feet over the last 10 years. Additionally, 3 of the neighboring properties totaling roughly 400,000 square feet have been acquired by users in recent quarters, which has further reduced competitive supply and enhanced vibrancy in the micro market. Maple Plaza was recently renovated and amenitized, so there are no major capital projects required at this time. Our basis of roughly $670 per square foot is meaningfully below replacement costs, which we estimate to be roughly $1,200 per square foot. As we lease up vacancy, we anticipate a stabilized yield in the high single digits and an unlevered IRR in the low double digits. In the few weeks we have owned the building, leasing activity has been strong from a mix of new leasing from new and existing tenants, confirming our view on the market and our underwriting. We're very excited about this acquisition and believe the inflection of leasing fundamentals combined with below historical average interest in the office sector created a unique opportunity. We do not know how long a window like this will last or if other similar opportunities will present themselves since more capital is consistently coming into the office sector. However, we continue to evaluate the full spectrum of investment alternatives and will not be afraid to transact if we find something that meets our stringent criteria. With that, I will turn the call over to Jeffrey.
Jeffrey Kuehling, EVP, CFO and Treasurer
Thanks, Eliott. FFO for the quarter was $1.08 per diluted share, which includes approximately $0.03 per share of one-time items, including $0.02 per share related to real estate tax appeal wins and an additional $0.01 per share of non-cash income related to a reversal of straight-line bad debt expense. Cash same-property NOI growth for the third quarter was 60 basis points, with the previously mentioned real estate tax appeals contributing 150 basis points of growth. Occupancy statistics now reflect the recently stabilized redevelopment projects, 4400 Bahana Drive and 4690 Executive Drive, which represented a 50 basis point negative impact to occupancy during the third quarter. We expected that occupancy would dip on a sequential basis due to the redevelopment projects entering the stabilized pool and expected move-outs. However, occupancy improved modestly, ending at 81%, up from 80.8% at the end of the second quarter. The improvement relative to our prior expectations was a result of earlier than anticipated rent commitments totaling approximately 200,000 square feet, all of which were originally projected to take occupancy in the fourth quarter. At the end of the third quarter, the spread between leased and occupied space was 230 basis points, which represents meaningful embedded growth expected to materialize throughout the remainder of 2025 and into 2026. It's important to note that KOP 2 leasing activity is not included in this lease versus occupied spread and should be considered separately. We now anticipate that any improvement in occupancy in the fourth quarter will be modest due to the accelerated rent commencement activity that occurred in the third quarter. Additionally, our assumptions now reflect the bankruptcy-related October move-out of NeueHouse, a 95,000 square foot tenant at Columbia Square. While the departure is now reflected in our occupancy outlook, the space's high-quality build-out and historical significance are generating strong interest from prospective users and the team is working diligently to minimize downtime. Portfolio retention in the third quarter was approximately 60%, and year-to-date retention, including subtenants, stands at 39%. Following quarter-end, we executed a 79,000 square foot renewal with Ride Games at Westside Media Center and a 67,000 square foot lease with ByteDance, a current subtenant with a 2026 expiration at Key Center. While these recent transactions are not yet reflected in our operational metrics, we are very pleased with our leasing performance on 2026 expirations, which demonstrates strong momentum heading into next year. Turning to guidance, we raised our 2025 FFO outlook to a range of $4.18 to $4.24 per share, representing an $0.11 per share increase at the midpoint. This revision reflects several key updates to our expectations. We now anticipate approximately $0.05 of additional non-cash income driven by tenants taking occupancy earlier than expected in the previously mentioned straight-line bad debt reversal that occurred in the third quarter. Our updated same-property NOI guidance contributes an incremental $0.03 per share, while interest capitalization adjustments account for $0.02 per share. As Angela mentioned, we have also updated our assumptions for the Flower Mart project, which is now expected to cease capitalization in June 2026. With the progress made to date and the recent submission of our development applications, we're in a stronger position to find the process timeline and have updated our assumptions accordingly. As the reentitlement process advances, we anticipate reaching a point when we are short of executing a demand-driven development, all feasible progress that the project will be complete, at which time, capitalization will need to be suspended indefinitely. We will continue to revisit our assumptions and provide updates as new information becomes available. As it relates to Kilroy Oyster Point, we are making excellent progress on the lease-up of the project. Following the 84,000 square feet of lease executions to date in our healthy forward pipeline, it's appropriate to begin framing up the project's expected NOI and FFO impacts in 2026. Once the project transitions into the stabilized portfolio in January, capitalization will end and operating expenses, property taxes, and interest expense will be recognized through the income statement. During the third quarter, operating expenses and property taxes and KOP 2 totaled approximately $5 million, while capitalized interest totaled approximately $10 million, both of which are a reasonable quarterly run rate for next year. As tenants begin to take occupancy starting in the first half of 2026, the negative earnings impact from the projects will moderate before becoming a net contributor to growth in the coming years. With that, we're happy to answer your questions.
Operator, Operator
Our first question today comes from Nick Yulico with Scotiabank.
Nicholas Yulico, Analyst
So first question is, I guess, just turning towards some of the expirations you talked about getting addressed for 2026. And I know you had a higher also retention ratio this quarter. So at a high level, I mean, are there any sort of thoughts you can give us on like next year, how to think about retention for expirations and then also getting some benefit, as you talked about from commencing occupancy on that gap right now between signed, but not occupied space?
Angela Aman, CEO
Sure. Thanks, Nick. This is Angela. I'd start with sort of going back to where we started with the 2026 expiration pool at the beginning of 2025. We were showing about 1.9 million square feet, when you take into account all the leasing activity and renewal activity that's been completed through the third quarter and the almost 150,000 square feet of renewals that were signed subsequent to quarter-end. We're down to a remaining expiration pool in 2026 of about 970,000 square feet. As I mentioned earlier, I think there are limited opportunities for additional renewals out of that pool. So we do expect that you're going to see move-outs in 2026 for the majority of what's left in the 2026 expiration pool, and we'll need to offset that through new leasing, right, both through a combination of, as you point out, a pretty healthy spread between signed and commenced occupancy that's already been executed and then additional new leasing activity that can take effect during 2026. I think as we've talked about on prior calls, one thing I would note that's a little bit different in the current environment is across many of our markets, the interest that tenants have in getting into space as quickly as possible. We've seen that most notably in San Francisco, where there's a real demand, especially from some of the new business formation we're seeing in that market, to really compress the time between lease execution and occupancy commencement, but we've also seen it in other markets as well, including the Pacific Northwest and even in San Diego and Austin. So our spec suites program can be really meaningful in addressing some of that remaining exploration activity in 2026 or offsetting it. So that's what we're focused on right now, driving some additional renewals out of the '26 pool, but really focusing on new leasing, particularly the new leasing that can take occupancy during 2026.
Nicholas Yulico, Analyst
Okay. And then just second question is on San Francisco. If you could talk a little bit more about how you're seeing your space be competitive in the market versus other options? And then also sort of an update on competitive sublease space that's in the market, and sort of just sort of depth of the tenant pool there overall?
Angela Aman, CEO
Sure. Yes, I'll take the first part, and then going to turn it over to Rob to talk about some of the more specific dynamics in the market. But what we've continued to see in San Francisco is a real expansion of where tenants are looking for space in the market. And then again, a real priority on landlords who can move quickly and deliver certainty in terms of compressing that time period between lease execution and rent commencement. When we talk about sort of where tenants are looking in the market, that's where we've seen a pretty remarkable sea change in activity from where we were 9 to 12 months ago, that's really captured our SOMA assets and in particular, 201 Third, where as I mentioned earlier, we've now completed 3 consecutive quarters of major leasing at that property. We're now seeing that activity expand further into SOMA and into assets like 360 Third Street. So we've seen really sort of a healthy dynamic is where tenants are willing to look at expanded. And then again, I think our vacancies are really well positioned given that we're very focused on meeting those expectations and delivering space as quickly as possible.
Rob Paratte, EVP, Chief Leasing Officer
Thanks, Angela. Nick, it's Rob Paratte. I guess I'd make a couple of points about the market. One is that larger tenants in San Francisco are starting to come back to the market and are touring. We're also seeing that in Seattle. And I think one change we're noticing in our portfolio is that there's, I'd say, less demand for bargain space and more demand for impactful space. And that impactful space ties directly to the return to office phenomenon that you're seeing, where San Francisco particularly has dramatically improved in the past couple of quarters. AI demand continues to be a very strong driver in the market. There's about 1.5 million square feet of AI demand currently touring in San Francisco. And then relating to sublease space, over 2 million square feet of sublease space has been basically taken off the market through either going direct, taken off the market by the sublessor or being leased. And that's a notable number. And when you look at the Kilroy portfolio, we've had 200,000 square feet taken off the market this quarter by tenants. So all of that points to, I think, a sustained recovery as the office fundamentals are improving and showing signs of sustained recovery; we're already at pre-pandemic levels, as Angela pointed out in some of the statistics. So I'm pretty convinced that not only the momentum we're seeing here in Q4 will continue into Q1 and '26.
Operator, Operator
Our next question comes from Jana Galan with Bank of America.
Jana Galan, Analyst
Congrats on a great quarter. I wanted to follow up on the increased leasing outlook near term at KOP 2 and just kind of the current demand in tours, whether that continues to be more traditional biotech or it's kind of across the board?
Rob Paratte, EVP, Chief Leasing Officer
Sure. Let me outline our current status regarding life science at KOP in South San Francisco. In the third quarter, we signed just over 600,000 square feet of leases, which aligns with pre-pandemic levels. I can only comment on our project, but we are observing that the top projects in the market are experiencing the highest demand. Our dedicated life science team is adaptable, valuable, and quick to respond, which contributes to this momentum. This gives me confidence that the positive trend will persist into the fourth quarter and continue into the first quarter of 2026. Life science demand increased by over 20%, rising from 1.8 million square feet to 2 million square feet in Q3, which is another encouraging sign. One significant change we've noticed, as I mentioned earlier, is that large tenants are returning to the San Francisco market. Alongside life science demand, we are also observing improved demand in other sectors, including semiconductors, AI, and robotics. This trend is not limited to South San Francisco; it is moving down through the peninsula as well.
Angela Aman, CEO
Yes. I think Rob is really hitting on the right point. We're thrilled to be at the stage we are right now. We have 84,000 square feet of leases executed at KOP. As you've mentioned, we feel very well positioned to exceed our goal of 100,000 square feet by year-end, which we set last quarter. Additionally, we're pleased that the first wave of deals we're signing at KOP 2 has all been with biotech and biotech-related companies. This is a crucial aspect as we consider the future growth and development of this project in its later phases. We are intentionally creating the right life science ecosystem at the project to support that growth moving forward. Rob also noted an important point about the pipeline: there is still strong demand from biotech and biotech-related companies as we complete this project. We're also observing significant interest that gives us more leverage in leasing for the remainder of KOP 2 from other sectors beyond life science. Overall, this creates a healthy backdrop for leasing this project, ensuring it will contribute positively to growth in the coming years. We have many options and a lot of momentum. We are really pleased that with these initial leases being signed, we are taking the first steps toward building that dynamic life science ecosystem on site.
Jana Galan, Analyst
And just given kind of the improvement and diversity in activity across the portfolio, should we think about that there'll be less reliance on kind of the shorter-term leasing going forward?
Angela Aman, CEO
Yes. I mean this quarter, the shorter-term leasing, I think it was 129,000 square feet. Most of that was renewal activity. And I spoke to some of that in my prepared remarks. We're going to be flexible in this environment with tenants that need a little bit longer-term, even if they're vacating, just to give us additional opportunity and time to backfill some of that space. So there's probably some more of that short-term renewal activity over the coming quarters. I would say, as we think about the new leasing dynamic, we've signed very few new leases on a truly short-term basis. There continues in the city of San Francisco as we think about some of this new company formation and AI growth, specifically in the city of San Francisco, still a desire for leases that are shorter-term in nature than a traditional 10-year lease. So we are seeing that demand in sort of that 3- to 5-year window for many of these AI companies, but we do believe we're in a position to stretch those terms a little bit longer, where we can provide a reasonable path to growth and expansion for some of those tenants over the course of that term. They're prioritizing that flexibility as it relates to the shorter lease term because they do believe their businesses are going to grow and evolve, and they want to make sure that they can have space over the next 5 to 10 years that's going to meet their needs. So where we can provide that flexibility, we have a chance at getting those terms extended a little bit longer. But the truly short-term leases, again, have been almost all renewal activity. And that's, in many ways, just a normal recurring part of the business.
Operator, Operator
Our next question comes from Steve Sakwa with Evercore ISI.
Steve Sakwa, Analyst
Jeffrey, I don't know if you could provide a little bit more color on just the NeueHouse lease. I appreciate you for clarifying that, that really was, I guess, in the quarter-end occupancy and comes out in the fourth quarter, but could you maybe just help size up for us kind of what the rent contribution was from NeueHouse in the third quarter so we could just kind of adjust the revenues appropriately for that?
Angela Aman, CEO
Yes. We don't typically discuss individual rent commencements at the tenant level. The occupancy impact is about 50 to 60 basis points. The key point here is that we maintained our average occupancy guidance despite an unexpected impact in the fourth quarter of this year. Rob and the team will provide insights on the re-leasing situation for that space shortly. We're focused on re-leasing it as quickly as possible, as it has a high-quality build-out, and we believe there are opportunities to minimize downtime while we work on repositioning that space, which addresses some of your concerns.
Rob Paratte, EVP, Chief Leasing Officer
Steve, we began exploring options for the former NeueHouse space early on and I'm quite satisfied with the interest we’ve received from various sectors, including hospitality and entertainment. The space is exceptionally designed and we own all the furniture, fixtures, and equipment, which provides significant advantages from both an architectural perspective and in terms of existing facilities, such as multiple food and beverage options. Importantly, the historic studio, previously the CBS auditorium, accommodates up to 400 people, making it a unique offering in Hollywood that attracts attention and can generate revenue. We are currently engaging with a diverse group of interested parties.
Steve Sakwa, Analyst
And just any comment, Rob, just about kind of how the rent would maybe stack up to the prior rent? Would that be a roll up, roll down, flat?
Rob Paratte, EVP, Chief Leasing Officer
Hard to say, Steve. It depends. I mean, some of these uses may have more new for capital depending on if it moves toward hospitality. It's really going to be very deal specific, but it's quite unique space. And the thing I'd say is if you look in Hollywood to have historic space like this that ties back into the 30s and 40s and 50s at the prime of Hollywood, that cache carries a lot of value for future users.
Operator, Operator
Our next question comes from Seth Bergey with Citigroup.
Seth Bergey, Analyst
I guess the first one, just to go back to kind of the KOP leasing activity you've done. Can you provide a bit more color on kind of the lease economics you're achieving there? And maybe touch on kind of how those leases kind of compared to your initial underwriting?
Rob Paratte, EVP, Chief Leasing Officer
I'll start with the beginning that the lease economics vary between whether it's a spec lab or whether it's going from shell construction. So there's variability there. But we're very attuned to what the market is and happy with where we're achieving our rental rates. And TIs have no doubt gone up since we originally underwrote the project, but we're meeting the market in terms of where the demand is and providing that value that I mentioned earlier.
Angela Aman, CEO
Yes, I believe Rob has accurately categorized the situation. Rents have remained strong compared to our initial projections, even for the first few deals we are executing, which typically might come in slightly lower. So, rents are largely aligned with expectations. Capital expenditures are higher, which is a point we've mentioned in previous calls. I want to highlight that when you review our disclosures regarding lease executions for first-generation space, any agreements signed for spec suites include the full cost of the spec suite capital in the tenant improvement figures. This is important to note because spec suite deals are generally shorter-term, and that capital is intended to be easily reused for future tenants. This is a key consideration as you look at the tenant improvement figures in our supplemental materials and for upcoming spec suite deals.
Seth Bergey, Analyst
That's helpful. And then maybe for a second one. I believe in your prepared remarks, you mentioned 1.9 million square feet of '26 expirations that kind of need to be backfilled primarily kind of by new leasing activity. Can you just kind of quantify kind of what the tour activity you're seeing on those spaces and maybe kind of how it compares to last quarter or some way to benchmark it just kind of as you guys are seeing this recovery in demand?
Angela Aman, CEO
Yes. Let me make a point of clarification, and then I'll turn it over to Rob. But 1.9 million was the 2026 lease expiration tower we were facing at the beginning of 2025. Over the course of the last 3 quarters and with some renewal signed subsequent to quarter end, we're now down to 970,000 square feet of remaining 2026 lease expiration. So we've substantially addressed that original tower. That's translated into about a 40% retention on the original 1.9 million square feet, with additional vacancy or potential move-outs being addressed through disposition. So we've actually been very successful at addressing the original 1.9 million. I'd just say tour activity across the board and the pipeline across the board looks really very strong right now. And we mentioned specifically in San Francisco, a 170% increase in tour activity in our SOMA properties, in particular, where we do have vacancy. We're seeing really great momentum. But I'll let Rob comment on the broader pipeline and tour activity.
Rob Paratte, EVP, Chief Leasing Officer
Yes. Seth, I would add to what Angela mentioned by noting that the demand is increasing across the board beyond just the specific market we are discussing. Of the remaining 900,000 square feet, there is always a possibility that unexpected opportunities will arise, where someone may want to occupy the space temporarily or opt for a longer-term lease. However, as Angela pointed out, we have likely maximized our current opportunities. Nonetheless, we have developed marketing and business strategies for the remaining vacancy of 900,000 square feet, and we are proactively working to lease it out and are already in discussions regarding some of it.
Operator, Operator
Our next question comes from Anthony Paolone with JPMorgan.
Anthony Paolone, Analyst
I want to revisit the earlier question regarding KOP. First, what yield are you expecting on your costs based on the rental rates you're currently achieving? Secondly, can you confirm whether the $1.25 billion figure includes all expenses related to tenant improvements, leasing commissions, and prebuilts?
Angela Aman, CEO
Yes. I mean I'll make a couple of comments. We're 10% leased on this project right now, right? So we've got an 84,000 square foot lease on 875,000 square feet or thereabouts. So I think it's a little premature to talk to the total economics of the projects overall. I think as we continue to execute on this project and we demonstrate further progress on the leasing, it will be the right time to take a step back and talk about the overall economics of this project. But doing so on the first 3 leases that got executed is just a little bit premature. The numbers we have in the supplemental do reflect our original expectations as it related to capital. So at the right time, and again, as we get through additional leasing activity, we'll update as appropriate.
Anthony Paolone, Analyst
Okay. You mentioned that the capital is running slightly ahead of plan while rents are more or less in line. Does that mean we can expect an increase, or is it still too early to determine?
Angela Aman, CEO
It's still too early to tell. We'll continue to evaluate as we get additional leases signed and hope to have updates in the coming quarters.
Operator, Operator
Our next question comes from Brendan Lynch with Barclays.
Brendan Lynch, Analyst
You've mentioned some of the components that will feed into this, but guidance calls for a 1% contraction year-over-year, but same-property NOI was up 1.4% year-to-date. Maybe just walk us through some of the considerations that we should keep an eye on in the fourth quarter?
Jeffrey Kuehling, EVP, CFO and Treasurer
Yes. Thanks, Brendan. The big, I think, kind of bogey is just a difficult comp in the fourth quarter from last year. So we did recognize about $6.7 million of restoration fee income. So when you look at kind of the sequential decline, at least for the fourth quarter, you should see a pretty big run down or expect to see that.
Brendan Lynch, Analyst
Okay. That's helpful. You mentioned strength in all your markets. Can you provide more details specifically about Austin? It seems like there was significant leasing progress at the Indeed Tower. Additionally, could you give an update on the available ground floor space?
Rob Paratte, EVP, Chief Leasing Officer
Sure, Brendan. I wanted to discuss the ground floor space, which represents a significant achievement by our Austin team. They have successfully leased a historic stand-alone building on the project site. While we cannot reveal the tenant's name, I can share that they are a well-known and successful food and beverage operator with a history of launching startups and developing several chains. This amenity will not only serve the building’s tenants but is also expected to enhance foot traffic and demand along the Sixth Street corridor. Additionally, it’s a substantial amenity for the overall Austin Central Business District. This project was complex and took considerable time, as it involved a multi-floor historic building that was in shell condition, and it will truly become a remarkable space. I commend our Austin team for their perseverance and patience in executing this project. Regarding our office space, while I cannot comment on the competition, we have observed considerable activity in our spec suites, often leasing while still under construction. Although we have limited contiguous space available for larger tenants, we are actively marketing two floors. We are encouraged by the interest at Indeed Tower and believe that the new amenity will further boost activity, making this a sound long-term investment in the project.
Operator, Operator
Our next question comes from John Kim with BMO.
John Kim, Analyst
I had a couple of questions on your leasing pipeline at KOP 2. If you could maybe provide some more color on how large that pipeline is today versus last quarter or the last time you provided an update. And how many of these tenants are growing within the South San Francisco market versus just upgrading space within the market or musical chairs?
Rob Paratte, EVP, Chief Leasing Officer
John, it's Rob. I would say our demand has continued to increase, as we've observed a consistent rise in tour activity over the past three quarters. I want to emphasize my earlier point that we are confident in our pipeline for the remainder of Q4 and the executions that Angela mentioned. I believe our momentum is strong enough to anticipate a robust performance in Q1 and Q2, extending throughout the year. The project is generating interest from various entities throughout the Bay Area, so we have a focused marketing effort in place. While the majority of our activity is in the life science space due to its purpose-built nature, there is also interest from other sectors. Therefore, I am very confident in the pipeline we have. As for the second part of your question, were they seeking...
John Kim, Analyst
If they're seeking additional space within the market? Or is it just upgrading the space?
Rob Paratte, EVP, Chief Leasing Officer
It's both. It's leases expiring, plus they're seeking upgraded space.
Operator, Operator
Our next question comes from Upal Rana with KeyCorp.
Upal Rana, Analyst
I wanted to get your thoughts on your capital allocation strategy and priorities going forward, especially with the recent Maple Plaza acquisition and the expectation of getting the space back for next year?
Eliott Trencher, EVP, CIO
Paul, it's Eliott. I mean, as we mentioned, we're looking at all different alternatives that are out there. So our general alternatives are anything from investing in an asset, be that an office asset or life sciences asset or buying back stock, and we just sort of evaluate the opportunities as they present themselves. Overall, we've been encouraged at the types of opportunities that are out there and we're fortunate enough to be successful in closing on Maple Plaza. But we'll see. We'll see what else comes out, but we're definitely spending time looking at all of the above.
Angela Aman, CEO
Yes. And just to add to that, we're a net seller this year so far of about $200 million. We continue to evaluate what we think are a growing number of opportunities in the market. And then a point Eliott made earlier, which I just think is really important, is that we do think we're in a really unique window of time here where fundamentals from a leasing perspective are getting better across all of our markets, and we're still early in institutional investor interest coming back to the market. We're seeing it happen across San Francisco, certainly, but really in all of our West Coast markets. And that can change quickly and change the dynamic quickly in terms of what's actionable for us from an acquisition perspective, certainly helps us on the disposition side. So we'll continue to evaluate all opportunities and execute where we do feel like we're in a unique period of time where valuations are pretty compelling and compelling relative to other alternatives.
Upal Rana, Analyst
Okay. Great. That was helpful. And then as a follow-up, could you talk a little bit more about Flower Mart? And could you share any recent conversations you've had with the city on that project? You mentioned continuing GAAP interest there until June 2026, but any additional color there would be helpful.
Angela Aman, CEO
Yes, sure. I'll take it, and we can certainly dig more into it; Justin's here as well to talk about it to the extent you have follow-up questions. But as I mentioned in my script, we submitted to the planning department recently, I believe, in early September additional potential paths forward for the Flower Mart that included a broader mix of commercial and residential uses. We're going through the exercise of the planning department to understand sort of what's achievable on the site and how that would lay out and what the ultimate path forward will look like from an execution perspective. So as I said earlier, we're pretty early days in those conversations, but everything to date has been constructive and encouraging. And I think we are aligned with the city in ensuring that whatever ultimately gets approved here meets the needs of the San Francisco community as it continues to evolve.
Operator, Operator
Our next question comes from Caitlin Burrows with Goldman Sachs.
Caitlin Burrows, Analyst
I guess maybe just as a follow-up on the Flower Mart point. So it seems like over the, call it, year-to-date, the amount of activity that you've been able to continue doing has changed and your own expectations have changed. I guess, can you just go through like what those changes are and like the current expectation is for June 30? Like how much visibility do you have on that? Or is it kind of up to the city, and that's causing the changes, and kind of we'll see as it gets closer to June if that changes again?
Angela Aman, CEO
Thank you, Caitlin. As previously mentioned in our calls, our approach to the Flower Mart aims for increased flexibility and options to enhance the site's value, which is quite different from San Francisco's usual project approval process. Consequently, the timeline and future direction have not been entirely straightforward. We have made efforts to keep our investors informed about what we know at various stages and to adjust those expectations accordingly. With the submission of additional proposals to the planning department in September, we have gained more clarity on this part of the entitlement process, and we anticipate it will extend through the first half of 2026. As we progress and receive more information, we will continue to refine our assumptions.
Operator, Operator
Our next question comes from Michael Carroll with RBC.
Michael Carroll, Analyst
I wanted to quickly circle up on the Flower Mart. Are you able to have discussions with potential partners as you kind of reentitle that site if you're going to build resi and/or sell off certain sites? Or is it just too early to tell? You can't have those discussions because you just don't know what the city is going to be willing to give you yet?
Angela Aman, CEO
Yes. I think it's a little too early, right? I think if you take a look, and it's been reported in the press at our application to the planning department, you see a wide range of uses for different potential paths that include commercial, a full commercial program like we're currently entitled for, a fully residential program, and a mix of different uses on site as well. So I just think what we're looking for right now is making sure that we have all the flexibility and optionality with our existing entitlements and with the development agreement to execute on whichever one of those paths is ultimately going to maximize value for the site, but we need to get a little bit further through that process to better understand it and to continue to evaluate economics in the market as those shift and change as well to be able to really determine the best path forward. So stay tuned. We're continuing to work through it. I'm really pleased with the progress we've made to date, but we have some significant work still to do.
Operator, Operator
Our next question comes from Omo Okusanya with Deutsche Bank.
Omotayo Okusanya, Analyst
Just a quick one around just some of the quarterly numbers. Eliott, could you again just walk us through the straight-line bad debt reversal exactly what that was? And also what drove the fairly large increase in tenant reimbursements quarter-over-quarter?
Jeffrey Kuehling, EVP, CFO and Treasurer
Tayo, it's Jeffrey. Straight-line bad debt is just a function related to a tenant moving from cash to accrual. So we had to unwind the previous adjustment we made in the prior period. From the reimbursement income from our perspective, we look at it from a net number. So we'll take into consideration operating expenses and real estate taxes. And when we look sequentially Q2 to Q3, it's about a $1.5 million change. So it's not a huge driver quarter-over-quarter.
Omotayo Okusanya, Analyst
Got it. That's helpful. Regarding the potential office demand from AI, Angela made a few comments earlier. How should we consider the size of the opportunity for KRC? Is it possible that we might see some AI companies in the KOP Phase II cards? Can you help us understand how this might lead to new leasing opportunities?
Angela Aman, CEO
Yes. If you look at the current total requirements in the San Francisco market, it stands at about 9 million square feet, which is a significant increase from the 7 million square feet we had been covering for quite some time. A major factor behind this is the presence of AI-related companies, which now constitute over 30% of tenants in the market. While AI wasn't a major driver of leasing activity in our San Francisco portfolio in Q3, we still experienced broad demand from various users. This resurgence in the San Francisco market is evident, and even in Q2, when we signed a 93,000 square foot lease with Harvey AI, it showed that AI has been influential in driving leasing activity, particularly in our SOMA portfolio, and we expect this trend to continue. We've dedicated considerable effort to understand what these tenants require from landlords, particularly their need for immediate occupancy. This means getting tenants into spaces as quickly as possible, utilizing existing improvements like we did with Harvey AI, and creating spec suites to stay ahead of demand. All these strategies significantly enhance our ability to capture a larger share of AI demand going forward. In relation to KOP and other projects in our portfolio, including markets like Bellevue and South Lake Union, we're observing demand for space from AI tenants. We've made strides in the Pacific Northwest with AI-related leasing at KOP, and we will keep looking for ways to meet this demand while ensuring our tenant mix remains diverse and supports sustainable cash flow growth over time.
Operator, Operator
Our next question comes from Dylan Burzinski with Green Street Advisors.
Dylan Burzinski, Analyst
Eliott, just going back to your comments around sort of the capital markets and transaction environment improving, in terms of owners bringing their properties to market. Are you seeing more of these types of assets that are being brought to market, more similar in risk profile to Maple Plaza, or are you seeing more stabilized core deals coming to market? I guess just as you guys are evaluating these opportunities, given the existing level of vacancy in the market, are you guys more focused on maybe more stabilized type transactions, or is it really a project-level risk-reward analysis that you guys are doing?
Eliott Trencher, EVP, CIO
Yes. So we're really seeing all of the above, and we've seen core deals, core plus value-add and then heavy repositioning opportunities. And I think that speaks to just the overall trends. As far as where we try to spend our time, it's more bottoms up than top down. And we're looking at the dynamics of that particular asset in that particular submarket and then how it relates to other risks that are already existing in the portfolio. And so we want to make sure that we're smart and thoughtful about the kind of risk that we're taking and not necessarily doubling down on existing opportunities that already exist with vacancy that we had elsewhere in the portfolio. So in the instance of Maple, we were not in that submarket, but we spent a lot of time studying it and getting comfortable with the leasing trends, and we thought we could underwrite it in a way that gives us enough runway to be able to execute on a lease-up plan. And so far, we feel encouraged by what we see.
Angela Aman, CEO
Yes, I'd just add to that. I think our cost of capital has improved on both the debt and equity side over the last 3 to 6 months, which we're encouraged by. But we're still trading at a discounted cost of capital. And as a result, we're probably not the best buyer for truly core stabilized properties. We need to find opportunities where all of the core competencies on the Kilroy platform can be brought to bear to really drive value and create value through those acquisitions. I think we found that in the case of Maple Plaza, and that's how we're continuing to think through and look at opportunities across the board.
Operator, Operator
Our next question is a follow-up from Caitlin Burrows with Goldman Sachs.
Caitlin Burrows, Analyst
I feel we've talked a lot about the leasing volume, but not as much on the pricing side. So it looks like the leasing spreads you guys report did get better in the third quarter. I guess as you guys look out to 2026, do you have an idea of, if you think like the year-to-date results or the 3Q results would be more telling of what could happen in the future? Any comments on what you expect on like the pricing side?
Angela Aman, CEO
Yes, that's a great question, Caitlin. It’s a bit challenging to answer due to how we report our spreads. There isn't a set time frame for how long a space has been vacant, and we’re providing a comprehensive view. The outcome will depend on where new leasing activity occurs within our portfolio in 2026. Looking at the markets individually, we have some where we feel we are below market rates, and leasing activity in those areas should lead to positive spread dynamics. Then there are markets, such as San Francisco, where we may continue to see a decline in rents as we re-lease spaces. It’s important to note that San Francisco has faced significant challenges, especially over the past year, with a lot of vacancy that is beginning to be addressed. We are seeing improved stability in occupancy, which is evident through new leasing activity and the decrease of sublease space available. As occupancy begins to stabilize and improve, the market will gain more pricing power. I believe all the elements are aligning, including increasing demand for conditions to improve in San Francisco. However, the leases that are signed over the next year in that market are likely to show negative re-leasing spreads on average.
Operator, Operator
We have no further questions, and so this concludes our call. Thank you all for your participation. You may now disconnect your lines.