Earnings Call Transcript - KRC Q2 2020

Operator, Operator

Good day and welcome to the Second Quarter 2020 Kilroy Realty Corporation Earnings Conference Call. All participants will be in listen-only mode. After today’s presentation, there will be an opportunity to ask questions. Please note this event is being recorded. I would now like to turn the conference over to Tyler Rose, Executive Vice President and Chief Executive Officer. Please, go ahead.

Tyler Rose, CEO

Good morning, everyone. Thank you for joining us. On the call with me today are John Kilroy and several other senior members of our management team who will be available for Q&A. At the outset, I need to say that some of the information we will be discussing is forward-looking in nature. Please refer to our supplemental package for a statement regarding the forward-looking information in this call and in the supplemental. This call is being telecast live on our website and will be available for replay for the next eight days, both by phone and over the internet. Our earnings release and supplemental package have been filed on a Form 8-K with the SEC and both are also available on our website. John will start the call with a look at our industry and markets, and then highlight second quarter activities and our priorities as we move through the second half of the year. I will review second quarter financial results, give an update on rent collections and then review our current financial position. Then we'll be happy to take your questions. We are, once again, calling in from different locations, so bear with us if there are any delays in our responses. John?

John Kilroy, CEO

Thank you, Tyler. Thanks everyone for joining us. We hope you are doing well in these extraordinary circumstances that we find ourselves today. It's not always easy to navigate. I've had to tell all my children, please disappear; daddy’s got a phone call right now. I'm sure many of you have to do the same. Here at KRC, we remain vigilant in guiding our organization through the current crisis and positioning it to outperform in the future. We are working from a strong foundation. Financially, we have $1.3 billion of liquidity, no near-term debt maturities and a well-capitalized tenant base. Our development projects are 90% leased and fully funded. Operationally, we have a well-designed, highly sustainable and young portfolio, and we continue to make great progress on reducing our exposure to lease expirations. We've reduced our average annual expirations through 2022 to 4%, or approximately 575,000 square feet, which compares to 6% at the beginning of the year and 5% as of last quarter. We've received a lot of questions in recent months about how the pandemic could affect our industry, our markets and our company. So before I get into second quarter highlights, let me share some observations and thoughts. We are in constant contact with our tenant base up and down the coast, and they are focused on reestablishing their work environment and getting back to the office, while at the same time protecting the safety of their employees. The next 12 months is likely to be a transition period. There is likely to be trial and error, experimentation and stops and starts as the pandemic runs its course. As businesses gain experience with what works best for them, the results could have some implications for our industry. For example, tenants will evaluate the quality of the physical workplace more than ever, with a particular focus on the ability to control their space, including lobbies, common areas and elevators, to minimize physical interaction with outsiders and enhance security. Buildings with fewer stories to minimize elevator usage, larger spaces with bigger floor plates, higher ceilings and larger commons areas to accommodate social distancing; more flexible spaces that allow for greater creativity in how interior office space is laid out and how traffic flow is directed; healthier spaces, including better HVAC systems, more natural light and fresh air, with increased access to roof decks and other outdoor spaces; and well-capitalized landlords willing to invest in people or infrastructure in their buildings in order to ensure a safe environment for all tenants. While some of these considerations are driven by short-term needs, it is our view that they have become industry norms continuing a flight to newer, higher quality properties and accelerating the obsolescence of older buildings. We believe these trends not only distinguish our portfolio from our peers but further validate our development strategy and our commitment to sustainability and wellness. Specifically, we have one of the youngest portfolios on the West Coast with an average age of 10 years. 43% of our portfolio is fit and well certified, the highest certification of any company in the world. 85% of our portfolio consists of low and mid-rise buildings. More than 90% of our buildings have large floor plates, allowing tenants greater flexibility for configuration. Approximately 90% of our portfolio offers rooftop decks and outdoor common areas. Another topic of discussion in this transition period is how prevalent work from home will become. It is still early, but our view is that workplace flexibility will become more common and it will be in conjunction with the office, not replace the office. We're seeing tenants study decreased density levels in the workspaces and consider additional kitchens, dining and common areas that require more space. From a broader perspective, the office, as we know, has been around as long as the modern corporation and the role it plays in uniting a workforce around a common set of goals is as essential as ever. And while offices have evolved as organizational needs have changed, the successful corporate cultures that are in place today underscore the importance of communal space and physical proximity. All of the most essential attributes to today's highly successful companies — effective collaboration, continued innovation, and higher productivity — benefit greatly from personal human interaction. A third question arising amid the crisis is how various real estate markets will perform. We believe that our West Coast markets are among the most attractive in the world. Amidst all the uncertainty over the last several months, one thing that has become clear is the strength and resiliency of the technology, media and life science companies that drive our markets. These companies continue to grow their revenue, are well capitalized and are positioned for growth. The NASDAQ is near an all-time high. The IPO market is open. And M&A has resumed with Amazon and Uber announcing high-profile deals in recent months. These key industries are concentrated in our markets, are hard to duplicate in other areas of the country and their success will help drive broader market recoveries. A recent Bloomberg analysis of the nation's 100 largest metro areas came to a similar conclusion. San Francisco, Silicon Valley and Seattle all ranked among the top five regions, best positioned for a relatively quick and strong recovery from the coronavirus recession. This strength is visible in our current tenant roster. Three quarters of our annual rental revenue comes from technology, life sciences and media companies. Most of them are publicly traded and investment-grade rated, all ranked among the world's most innovative and successful businesses and their collective presence is constantly attracting more innovation-driven firms building a deep reservoir of ideas and talent that is very difficult to replicate. Now moving to our second quarter highlights. Overall rent collection remained strong across the quarter and into July. The average second quarter rent collection rate for all of our properties was 95% and a strong 98% for office and life science. July's collection rate was also 95% across the portfolio and 97% for office and life science. Tyler will give a complete update in his remarks on these trends. We executed 286,000 square feet of leases in our stabilized portfolio. Approximately three-quarters were renewals and rental rates that were up 11% on a cash basis, and 30% on a GAAP basis. This included two larger renewals — one in San Diego for 119,000 square feet and one in the Bay Area up 37,000 square feet. With the exception of an expiring Long Beach lease in the fourth quarter of this year, we have no exploration larger than 65,000 square feet until 2022. At the end of June, our stabilized portfolio was 96% leased. We continue to execute on our $2 billion of construction projects. The total remaining construction spend across this pipeline is fully funded with existing liquidity, and the office and life science components of these projects are 90% leased. When stabilized over the next few years, the six projects will generate aggregate annualized cash net operating income of approximately $145 million. I want to give a shout-out to our development team as last month, the National Association for Industrial and Office Parks selected KRC as its 2020 Developer of the Year. This is the association's highest honor and a significant acknowledgment of our company's ongoing efforts to lead through innovation. On the disposition front, we selected a few smaller assets earlier in the year to dispose of. During the course of the year, we're unable to say exactly when these will take place because tours and lenders are unable to visit the buildings given the restrictions. To wrap up, let me reiterate a few points. Leasing activity has picked up a bit from March-April lows and we have not seen a material impact, if any, on economics. The company has never been better positioned to be both defensive as well as offensive. Our stabilized portfolio is young, modern, sustainable and leads the world in wellness. Our explorations are limited. Our tenant base is largely healthy, well-capitalized and poised for further growth. Our under-construction development projects are fully funded and 90% leased. Our future development pipeline is diversified across product types as well as markets and has an attractive basis. And our balance sheet is solid with significant liquidity, low leverage and no near-term debt maturities. Lastly, I want to recognize the entire Kilroy team who continue to do a phenomenal job whether it's working with our tenant partners, with the communities in which we operate, or on internal corporate functions. Thank you, all. Now I'll turn the call back to Tyler.

Tyler Rose, CEO

Thanks, John. For the quarter, we reported FFO of $0.78 per share. This reflects $0.17 per share in total severance costs and $0.05 per share related to our assessment of tenant credit and collectability of rent. Excluding the impact of these items, our underlying second quarter financial performance was solid with FFO at $1 per share. Turning to same-store results, cash NOI grew 10.9% and GAAP NOI was down 1.3% in the second quarter. Cash NOI growth was largely driven by higher rental rates and cash commencement of several large leases. GAAP NOI was impacted by the revenue reversals I just mentioned. Excluding the revenue reversal, same-store GAAP NOI was up close to 2%. At the end of the second quarter our stabilized portfolio was 92.3% occupied and 96% leased. Moving to our balance sheet, in April we completed a debt placement of $350 million, boosting our liquidity to $1.3 billion. That includes approximately $560 million in cash and $750 million available under our revolver. Our net debt in second quarter annualized EBITDA is 5.7 times, excluding the severance costs. This liquidity provides ample resources to fully fund our remaining $625 million of current development spending over the next two years. We also have plenty of room under our bank financial covenants with more than 60% cushion or approximately $250 million of NOI cushion. Now let me give you some color on rent collection in the second quarter and July to date. Across all property types, we collected 95% of second quarter contractual billing. This reflects an average collection rate of 98% from office, 88% from residential and 32% from retail. Across July, our collection rate currently stands at 95%. This reflects a collection rate of 97% from office, 87% from residential, and 46% from retail. Lastly, given the uncertainties generated by the coronavirus and its impact on the economy, we are not providing specific earnings guidance again this quarter. Instead, we can offer the following assumptions based on what we know today, that may be of use in assessing our potential earnings results for the remainder of the year. We project remaining 2020 development spending to be between $250 million to $300 million. Given the recent rollback on retail reopenings in our markets, we are currently in discussions with many of our retail tenants. As you may recall, last quarter we established a two-month retail rent relief program, which included approximately 90% of our retail tenants. This had a minor earnings impact. And from a cash perspective, one month of rent deferral for these tenants is approximately $1.5 million. We subsequently extended the rent relief program through July and expect to lengthen this program again. Non-contractual parking income totals approximately $1.5 million of NOI per month. We expect to receive about one-third of this amount until the shelter-in-place rules are lifted. At 333 Dexter in Seattle, we commenced revenue recognition on 312,000 square feet or 49% of the total project in June. The remaining phases are expected to come online next year. In July we commenced revenue recognition on another 36,000 square feet of space at One Paseo office in San Diego, bringing the total revenue commencement of this project to 20%. The project is leased to eight tenants, so we expect revenue recognition in phases throughout the remainder of this year. Also in July we delivered 146 residential units at One Paseo. This was the third and final phase. As a reminder, we delivered the first phase of 237 units late last year and the second phase of 225 units earlier this year. In total, the 608-unit project is now 38% leased, and we've seen leasing momentum pick up over the last month. We expect commencement of revenue recognition on the entirety of the Netflix On Vine project or 355,000 square feet of space at the end of the year. With respect to the residential portion, Living On Vine, that's scheduled for delivery in the first quarter of 2021. From a financing perspective, we take a conservative approach to managing our balance sheet and we will be nimble to ensure adequate liquidity or be opportunistic depending on market conditions. With respect to cash same-store NOI growth, we've had a very strong first half of the year at 12.9%. We don't expect the second half to be as strong given some one-time items in last year's numbers and the impact of the credit issues we have discussed. While it's difficult to estimate at this point, we expect the full year to be in the mid-single-digit range. Lastly, we project G&A of approximately $18 million per quarter for the remainder of the year. That completes my remarks. Now we'd be happy to take your questions.

Operator, Operator

We will now begin the question-and-answer session. The first question comes from Nick Yulico of Scotiabank. Please go ahead.

Nick Yulico, Analyst

Thank you. First, Tyler, I want to follow up on the same-store NOI number you mentioned, which I believe is in the mid-single-digit range for this year. I would like to clarify whether that figure is a cash number and if it excludes any impact from the tenant deferrals you provided.

Tyler Rose, CEO

It is a cash number. No, we're not excluding the deferral.

Nick Yulico, Analyst

Okay. So the deferral negatively impacts your reported same-store results?

Tyler Rose, CEO

That's right. Yes.

Nick Yulico, Analyst

Okay. That's helpful. And then I guess just going back to the leasing markets. Any more thoughts, John, on just how tech companies are changing their views? I know, particular Downtown San Francisco was a very hot market ahead of COVID. I heard rumblings of at least one larger tech company now not looking to do a lease in San Francisco this year now. Is behavior changing towards San Francisco or other of your markets on a relative basis, how would you rank the strength of your markets right now?

John Kilroy, CEO

I'm going to have Rob deal with that if I may. But before he starts in, I think it's safe to say that all companies are focused on what's COVID doing to their businesses. How is it impacting their real estate? How is it impacting their ability to get back to work? So anything and everything that can be put on pause generally is being put on pause, just as I'm sure it is in your family or your businesses it's just human nature. Rob, do you want to go through the markets here and start wherever you want at the last one?

Robert Paratte, CRO

Sure. Sure John. This is Rob Paratte. Hi, Nick. I'd start by saying if I want the Bay Area and Seattle together publicly traded tech companies as you know have led the stock market since the pandemic started. And those publicly traded tech companies, many of which are our tenants are pretty resilient. They are the industries that are expected to come out faster. Various sectors of the tech market like information services, software, publishing, scientific and R&D, all of those are going to be leaders when things normalize. A broader answer to your question about what companies are talking about and putting stakes on hold goes directly to what John said. The large company you mentioned in San Francisco that is on hold literally did that. It's on hold until they can ascertain a better forecast about when people do come back to work and how long that's going to take. I think it centers around when people can be vaccinated. It's one thing to get a vaccine. But people need to get vaccinated. Specifically up in Seattle, notwithstanding what I said about the stock market, Bellevue is going through a major transformation, continuing during this pandemic where space is being absorbed. Amazon just recently signed a two million square foot lease in Downtown Bellevue. They themselves are transforming that market by adding 15,000 employees to the Bellevue area. They’re not the only tech company there. We have Salesforce and Facebook. So I just think Seattle in itself will do well when things normalize and a lot of what I've just said applies to the Bay Area as well. When you layer in the Bay Area, the life science component where now demand is up to four million feet, so it's almost one million feet more than what we were tracking last quarter. Everything bodes well for a recovery when people can get back into work. As you know, California we've had several, in fact, most cities have had to dial back their reopenings, which has impacted touring. Touring was up in May and June. It has dialed back again particularly in Los Angeles and San Francisco. If you'd like, I'd just touch quickly on L.A. L.A. is doing well in certain submarkets like Hollywood and Culver City where there's pretty strong demand, record demand from content producers. So we feel very good about those two submarkets.

Nick Yulico, Analyst

If I could just follow up, the details about San Francisco are very helpful. The BART system was already operating at overcapacity before COVID, and now it's even more challenging to figure out how to get employees back to work in San Francisco using BART. Does this change the leasing dynamic? Could it lead larger tech companies to consider Oyster Point more seriously instead of Flower Mart?

Robert Paratte, CRO

Do you want me to handle that John?

John Kilroy, CEO

Yeah, go ahead.

Robert Paratte, CRO

I think companies will be looking at a variety of factors like that Nick. BART and Caltrain, which are major modes of mass transit in the Bay Area have undertaken really strict protocols in terms of cleaning and everything just like the New York subways. I think it's just too early to tell what modes of transportation people will use. Keep in mind a lot of the Bay Area, particularly San Francisco, employees are living in San Francisco. For most of the areas and neighborhoods that the tech workers are living in, it's not a far bike ride or walk to most office spaces.

Nick Yulico, Analyst

Okay. Thank you.

John Kilroy, CEO

I believe South San Francisco is really well-positioned. There is strong demand in the life sciences sector, and demand is also increasing from the tech industry. This trend isn’t new; even pre-COVID, we saw interest, as evidenced by Stripe's lease. The area is easily accessible from the city and from further south in the Valley. The Flower Mart won't come online for several years, but I believe it will perform well because it aligns perfectly with the type of space that companies are seeking. More updates will follow on that.

Operator, Operator

The next question comes from Emmanuel Korchman of Citi. Please go ahead.

Emmanuel Korchman, Analyst

Hey everyone. Rob, maybe this is one for you. In Hollywood, it looked like you had a pretty sizable decline in occupancy. I know on the last call, you talked about some co-working tenants that you're working through deals with. Is that vacancy related to that same co-working tenant? If not, can you give us some more color as to what drove that increased vacancy in Hollywood?

John Kilroy, CEO

Tyler, if you want to.

Tyler Rose, CEO

Yes, I can address that. It’s not related to the co-working tenant we mentioned last quarter. There is still an occupancy issue due to a marketing company in our Columbia Square project that recently filed for bankruptcy. This resulted in about a 50 basis point impact on our occupancy.

Emmanuel Korchman, Analyst

Great. Thank you. And then John, you talked about the resiliency of newer buildings or the demand that should be outside for newer buildings versus older ones. Can you possibly in some way address sort of the pricing gap between the two? Are tenants just going to lease more actively in the newer buildings because it fits their needs better, or is there going to be pricing that holds up in one class of buildings and less so on the other?

John Kilroy, CEO

Yes. I think, I've commented on this at least differentially in past calls and I'm happy to elaborate. My sense is that we are entering a period where there will be a more extreme recognition at sort of the haves and have nots. You either have the kind of buildings that the big companies want, and you will command a significant premium in rent. Or you don't have those kinds of buildings, and I think you're just subject to high tides. Because most companies, the big companies, if you're not the kind of product they want, they're not going to lease it at any rate.

Emmanuel Korchman, Analyst

Great. Thank you.

Operator, Operator

The next question comes from Steve Sakwa of Evercore. Please go ahead.

Steve Sakwa, Analyst

Thanks. I guess one question maybe a little difficult to answer today. But, how do you guys sort of look at your mark-to-market on the overall portfolio? I realize market rents are a bit of an enigma, but where would you sort of put that figure today?

Tyler Rose, CEO

Yes, this is Tyler. I'll start and then pass it over to Rob. Before this began, we were about 20% below market across all our markets, which was around 30% in San Francisco and varying amounts throughout the portfolio. Rob, I'll let you respond to any changes you think have occurred since then, if we have enough data points.

Robert Paratte, CRO

Hi Steve, it's Rob. I don't know if we have enough data points, but you heard on our first quarter call, the leasing activity that kind of bridged the second and first quarter. In San Francisco particularly, rates have held on direct space in Class A institutionally owned product. A lot of the leasing that was done in that time period Q1, Q2 was done at over $100 a foot fully serviced. So, those are pre-COVID rates or holding I would say in San Francisco and Seattle, although there just aren't that many data points. But if you look at some of the renewals we've done that John highlighted in his remarks, we've been able to increase our rental rates.

Steve Sakwa, Analyst

Okay. And then maybe sort of a two-parter. Just on the sublease in general, it's clear that San Francisco is seeing a pretty big uptick in sublease space. I know one of your large tenants, Dropbox, put close to 275,000 feet on the market, albeit for maybe a five-year period. So can you maybe just speak to the sublease market in general? And what sort of pressures you might see as more of that comes to market in places like San Francisco?

Robert Paratte, CRO

Certainly, Steve. Let me provide some statistics. The current sublease space available in the market is around five million square feet, with 2.3 million added during the COVID period. In comparison, the direct vacancy rate in San Francisco stands at approximately 5.4%, while sublease accounts for 2.5% of that total. In contrast to the dot-com bust, where the direct vacancy rate was 8.3% and sublease space was 6.8%, we are observing very different dynamics today. Of the sublease space added between April and June, the average lease term is approximately 2.5 years. According to JLL, about 30% of this space consists of what they call "lift and shift" space, indicating that tenants are moving to new facilities while subleasing their old ones. This 2.5-year lease term supports that notion. As I mentioned earlier, rental rates for Class A assets are holding steady at their first-year levels, which includes well-positioned sublease spaces such as the macys.com space. I prefer not to comment on specific tenants or the subleasing situation regarding Dropbox. Additionally, it's worth noting that 60% of the sublease space currently available in San Francisco will expire within the next three to four years. If this space remains unleased, it will revert to direct space. I firmly believe that with institutional landlords who possess quality Class A properties, there won't be significant pressure to reduce rates due to the limited direct inventory. Lastly, it's important to note that in the second quarter, 850,000 square feet of sublease space was either taken off the market by sub-landlords opting not to sublease or was actually sublet. There's movement happening, as many tenants are trying to navigate uncertainty. Having sublease options available for two to three years allows tenants the needed flexibility during this unpredictable period.

Steve Sakwa, Analyst

Okay. Thanks. And just last question. I mean John you mentioned you've only got about 4% of your space rolling through 2022. So, pretty minimal rollover exposure including up in San Francisco. But are you doing things differently today to address that? Are you trying to pull forward more things or are tenants coming to you more proactively? Where is that discussion?

John Kilroy, CEO

Yes Steve, we've always tried to manage things pretty well. You can't always do what you like. But in this case, we've had the view that let's work with tenants that want to extend early. There are just not enough data points really in some cases on some of the recent renewals. These tenants in one case had an option and in one case, I think didn't have an option, both wanted to stay. One tenant, the larger one, was very concerned about it going to arbitration because it could end up at a rate that could have gotten beyond their expectation. We decided to have a negotiated transaction where they could live with it and we could live with it. That just happened to be very circumstantial. We're not actively going out endeavoring to sign up people that have six years left on a lease to a 10-year lease. We're having some requests for that and we'll evaluate each one of those independently.

Steve Sakwa, Analyst

Okay. Thanks. That’s it for me.

Operator, Operator

The next question comes from John Kim of BMO Capital. Please go ahead.

John Kim, Analyst

Thanks. Good morning. I was wondering if you could share your views based on discussions you've had with tenants on the impact of this pandemic to the more secondary tech markets outside of the West Coast, whether or not you think tech tenants are going to expand further or conversely pulling back?

John Kilroy, CEO

Rob, do you want to cover that one? I'm not sure we have enough data.

Robert Paratte, CRO

Sure. Yes. It really hasn't come up in the conversations we've had, John. As I said earlier, every company I think John said this too is focused on how to get people back to work and the facilities they have. You've seen tech expand dramatically in other markets like Austin and back East, et cetera. That trend will likely not change because they can draw on talent from a wider network.

John Kim, Analyst

Based on the strong demand from life science tenants, can you discuss your willingness to start any spec development in life sciences, or maybe even convert some office plan development to life sciences?

John Kilroy, CEO

I don't know that we're looking at converting anything that's on the drawing boards. But as you know, many of our buildings that we have developed recently have been developed to be hybrid, where you could do life science or office. Dropbox was one; Stripe was another. The building that we leased at 9455, Towne Center down San Diego was recently occupied by a major tech company but it was designed for life science. We're doing more of that where we can go either way, where the market is robust for both kinds of users. But John, with regard to development, there's nothing that we can physically start before, I think it's the first quarter maybe the end of the first quarter next year, and that would be Phase 2 of Kilroy Oyster Point, which is life science. That's the next one up, again subject to market conditions and all the other things that we always talk about. We’re seeing strong demand from life science there, and we're seeing strong demand for tech there. That's likely to be the next start, again subject to market conditions. Phase 2 is three buildings, roughly 900,000 feet plus a parking structure. We have the entitlements in place. We're going through the building permit process now and we should be in a position if we want to start in the first quarter of next year.

John Kim, Analyst

Okay. And then finally, I realize it's a one-off event but the termination payment for Jeff Hawken was surprisingly high this quarter. I'm wondering if you could elaborate on how you and the Board concluded the amount?

John Kilroy, CEO

Yes. Well it was pursuant to the agreement. His agreement was entered into in 1996. It was a legacy contract and we paid what was pursuant to the contract. We heard very clearly from the marketplace that they want us to solve in essence to get rid of the contract. Jeff, rightfully so, was in a position where he didn't have to do anything. He had an evergreen contract with a stated amount in terms of what the payment was to get out of it. We went forward with him and concluded pursuant to the terms of the agreement. The Board didn't we didn't have any choices.

John Kim, Analyst

Are there any remaining legacy contracts like that?

John Kilroy, CEO

No, not in our company.

John Kim, Analyst

Okay. Great. Thank you.

John Kilroy, CEO

You’re welcome.

Operator, Operator

The next question comes from Blaine Heck of Wells Fargo. Please go ahead.

Blaine Heck, Analyst

Great. Thanks. Can you talk about any movement you're seeing in construction costs recently? Whether you think maybe the potential decreases in construction costs could keep pace with or even outpace any potential decreases in rents such that some of these future development projects can still pencil out to an acceptable yield or even maybe look better than what you might have had pro forma?

John Kilroy, CEO

Yes, it's a good question. We monitor that monthly with all the pricing we do with major contractors. The short accurate answer is I don't know. But we will – obviously time will tell. If you look at the construction starts around the country, they're down tremendously. If you look at the book of business that the major contractors have, they're down tremendously. If you look at the book of business that I forget the number of publications that our team monitors. There's a big contraction in construction starts and in projects that are being designed for the future, which, all of which would suggest that commodity pricing as well as labor will end up being less expensive. If history serves correctly, that's what we're likely to see. Your supposition about rental going down and construction costs going down and yield perhaps remaining the same. People like us make the decision if we're going to start something do we feel comfortable that the rents we need to have we can get. If we don't feel comfortable, we don't start. There's always the case where you start spec and find that the market's changed and you don't get what you want, and that can happen. I do think construction costs will go down. Labor never likes to talk about it going down because that's something they don't like to acknowledge. It's just too early to tell but many variables can throw these things off. If all of a sudden there is a massive infrastructure bill passed by the federal government, then commodity pricing is likely to not come down as much. Too many variables to give you a specific answer but I think it's a good question and one that we will continue to speak about on these calls.

Blaine Heck, Analyst

Got it. That's helpful. And I think that makes sense. A quick one for my second. Last quarter you guys mentioned being in discussions with a large credit tenant to backfill at least some of the 130,000 square foot move out in Long Beach. Just how have those discussions progressed? As negotiation stands now, what are the prospects of getting that backfilled quickly?

Robert Paratte, CRO

Hi, Blaine, it's Rob. I don't want to get into too many specifics because a lot of people listen in on these calls. We have discussions going on right now with three different entities for space in that vacancy. We feel good about the prospects for getting it leased up based on just the activity we see in the market. That's the best quality asset in the Long Beach market. It's well-recognized. Without predicting more, I just feel good about our prospects in terms of the activity we've got.

Operator, Operator

The next question comes from Jamie Feldman of Bank of America Merrill Lynch. Please go ahead.

James Feldman, Analyst

Thank you. I'm wondering have you guys thought about redesigning any of your future developments based on new wellness standards or just what you think tenants might want post-pandemic?

John Kilroy, CEO

We're constantly considering this, Jamie, and as I mentioned earlier, we are the world leader in wellness and sustainability. We likely also lead in rooftop decks. Our company has a culture and mission to deliver the best products that align with what people want, allowing us to adapt in a way that older buildings often cannot. We are actively pursuing this and have a skilled team both internally and externally that is focused on staying ahead of trends. We have structured discussions around our strategies and testing processes, which has greatly benefited Kilroy. Our commitment to sustainability and wellness has positioned us as leaders in those areas, and we're applying the same principles to enhance our relationships with tenants and facilitate their return to the workplace with necessary adjustments. We've made some changes to our developments, breaking larger projects into smaller increments of around 400,000 to 500,000 square feet instead of starting with a single large building of about 1,400,000 square feet. We continuously seek ways to offer more flexibility and options for our tenants. I noted in our last call that tenants are increasingly drawn to larger spaces where they can have total control over their environment, which is easier in a single-occupancy building rather than in a larger structure. As for our locations, we are primarily focused on low to mid-rise buildings and only have two structures that exceed 25 stories in our portfolio. We are addressing all the aspects you've mentioned.

James Feldman, Analyst

Okay. Do you think there's going to be a meaningful change to construction like the costs in terms of the types of goods you'll put in the buildings?

John Kilroy, CEO

That will cost more. You've seen our construction costs. If you were to look at other people's construction cost. But if you were to look at the supplementals to wherever you all look at to see what costs are for our buildings versus other buildings, I know we build to a higher level of quality than most of our competitors do. I'm not speaking if it was just about reason to be speaking about anybody who does the stuff we do with more flexibility and optionality. Our cost structure has been pretty much in line with most others. My dad used to say to me, there's engineering which is how you engineer costs out of something and there's art and that is how you end up building a better mousetrap while keeping it the same level of cost. Art is an artful thing and we do a pretty good job at it. We by no means build the cheapest buildings. As you've seen, almost always we've been the market leader on rent. It's because we're delivering what people want.

James Feldman, Analyst

That makes sense. At the beginning of the call you talked about having lots of conversations with tenants and what different tenants are thinking about. Would you say there's a meaningful difference between sectors in terms of who's thinking about work from home and who is thinking about the hybrid model? Any differentiation there?

John Kilroy, CEO

Well, life science people are trying to do life science from home right? That kind of speaks to itself. If you're a small tenant and you occupy 2,000 or 3,000 feet and you've got to work from home right now by law, why would you renew your lease? You just wait for it. There's always 2000 feet available somewhere. The smaller tenants are likely to be less inclined to renew leases than big tenants. But Rob why don't you take that one because you spend so much time?

Robert Paratte, CRO

Yes. Hi, Jamie. Just I think John hit the nail on the head. The smaller tenants are probably more susceptible to what's going on today and they can save money by not renewing lease. We're not really seeing a sector-by-sector change. Everybody is talking about, I think the fact is that work-from-home will be more acceptable and predominant than it had been in the past. It's going to be a blend of work-from-home and office. I know again I think I said this on our first quarter call but just our own employee base I know people are dying to get back to work. We're not really a tech company even though we work closely with them. A lot of tenants are trying to put programs together that make employees comfortable coming back to that workspace.

James Feldman, Analyst

Are you seeing any pickup in demand for offices closer to where people live like more of a distributed office footprint?

Robert Paratte, CRO

Yes, I think that's going to be a trend. That was a trend in the past and I think it's going to continue. No one, other than being shut in their apartments, none of the young tech employees in San Francisco are talking about moving out. They want to get back out with their friends and they want to get back to work from what we're hearing. A lot of the facilities managers and corporate real estate executives that John and I talked to are reluctant to put space on the sublease market because they need the flexibility. It's a combination of wanting to not lose space.

John Kilroy, CEO

We are currently in talks with several tenants from our portfolio who are looking to significantly expand. This need is partly due to an increase in their workforce and partly due to the reconfiguration of their existing spaces. I had a virtual lunch recently with someone from a company that just leased a whole building in one of our operating cities, which spans several hundred thousand square feet. They mentioned that due to the elevator situation in that high-rise, they now require double the space since their operational protocols cannot be met as it is. They expressed regret for not opting for a larger space initially. We anticipate mixed outcomes; some companies will postpone decisions they don't urgently need to make, while others will adjust their spaces in a manner that necessitates more room. At the same time, there may be companies that choose to downsize their footprint, reflecting a variety of approaches in this landscape. Everyone is eager to move past the COVID phase, especially those of us managing households with children at home, as there is a collective desire to return to normalcy.

James Feldman, Analyst

Okay. All right. Thanks for your thoughts.

John Kilroy, CEO

You’re welcome.

Operator, Operator

The next question comes from Dave Rodgers of Baird. Please go ahead.

Dave Rodgers, Analyst

Yeah. Good morning. Just a couple of cleanup questions for me. With regard to the severance John or Tyler, were there more than just Jeff in that number? I mean have you taken a little bit of a cut at just different parts of the organization if so where but just wanted to clarify on that versus just Jeff?

John Kilroy, CEO

Yes, we have decreased our workforce to some extent and we will continually aim to right-size. It’s always a difficult process. I am also involved in other organizations besides Kilroy. The significant challenge is that, unlike a football game where everything is defined – the distance to the goal line and the time allowed – with COVID, there are no clear endpoints or timelines. It's uncertain how long this situation will persist. It’s a serious matter, not a game. It raises the question of how to determine the right size for your organization. It's essential to ensure you have the necessary talent to be proactive and reactive while making slight adjustments to avoid being overstaffed.

Dave Rodgers, Analyst

Thanks for the color on that. Maybe for Rob, John. The utility or utilization of your office buildings today maybe was down in the low single digits at some point. Have you seen that recover at all or not? Where is that at today?

Robert Paratte, CRO

Hi, Dave. It has recovered. But keep in mind for most of California we had to as governor Newsom calls adjust the dimmer switch downward again. It changed again. In May and June there was definitely an uptick I’d say probably up to 25% to 35% occupancy just based on our parking garages and that sort of thing and part access information. In California right now spiking like New York was. People are not in office as much as they were, but they're definitely wanting to get back. It's a matter of feeling safe and also government restrictions. Same thing for LA.

Dave Rodgers, Analyst

Okay. And then I think Jamie asked a little bit about this. I don't want to be the dead horse. But on the new tenant activity, five deals I think you signed in the quarter about 10,000 square feet each. It sounds like you guys were saying nothing much to conclude from that. It's obviously a small subset. Is there any directionality from that that would kind of give you better clarity on where we're headed in the third quarter or beyond?

Robert Paratte, CRO

I believe that for the rest of the year and likely into the first quarter, there will be a greater focus on renewals rather than acquiring new space. However, this trend is very dependent on the market. For instance, in San Diego County, there were 40 deals involving over 20,000 square feet, and 80% of those were new deals, not renewals. This indicates net growth in San Diego. Other regions may primarily experience renewals. In San Francisco, the split is currently around 50% to 55% renewals as compared to new activity. It's important to note that market conditions vary greatly. In Hollywood and the entertainment sector, you will notice absorption.

Dave Rodgers, Analyst

All right. Thanks for that. And then maybe Tyler last question for you. On the tenant in Hollywood that you mentioned the marketing firm that went bankrupt that impact was that covered in the prior reserves, or did you take a special impact or were you able to go back and maybe get some kind of credit enhancement on that post their departure? Any thoughts around there would be helpful?

Tyler Rose, CEO

It didn't have a financial impact in the second quarter. But obviously going forward, assuming they don't recover, we'll have an impact in the second half of the year. From an earnings perspective there was really no material impact in the second quarter.

Dave Rodgers, Analyst

Okay. Thank you.

Operator, Operator

This concludes our question-and-answer session. I would like to turn the conference back over to Tyler Rose for any closing remarks.

Tyler Rose, CEO

Thank you for joining us today. We appreciate your continuing interest in KRC and we wish you all remain healthy and safe. Thank you very much.

Operator, Operator

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.