Earnings Call Transcript - KRC Q2 2021

Operator, Operator

Good day, and welcome to the Second Quarter 2021 Kilroy Realty Corporation Earnings Conference Call. Please note this event is being recorded. I would now like to turn the conference over to Ms. Michelle Ngo, Chief Financial Officer. Please go ahead.

Michelle Ngo, CFO

Good morning, everyone. Thank you for joining us. On the call with me today are John Kilroy, Tyler Rose, Rob Paratte and Eliott Trencher. 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 on this call and in the supplemental. This call is being telecast live on our website and will be available for replay for the next 8 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 business conditions in our markets and then review our operational and strategic activities. I will discuss second quarter financial results and provide you with earnings guidance for 2021. Then, we'll be happy to take your questions. John?

John Kilroy, CEO

Thank you, Michelle. Hello, everybody. Thank you for joining us today. We've had an extremely active and productive period since our last call. We signed several large long-term leases at strong rental rates. We continue to expand our life science portfolio, and we've completed acquisitions that continue to position us for future growth. Before I review the acquisitions, let me share our view on current market conditions. I'm happy to report that Kilroy's workforce is fully back in the office, and we are excited that more and more of our tenants are joining us. It is clear the U.S. economy is rebounding more quickly than expected. Every week brings more tenant leasing discussions and more requests for property tours. We are seeing strong job creation, high levels of capital investment, continued expansion and healthy financial performance from our major tenants and increasingly so from our mid to smaller tenants. And we continue to see high-quality, well-located assets in our markets that are commanding strong valuations with record pricing. These factors are translating into increased leasing activity in office and residential as well as continued strength in our growing life science portfolio. Starting with office. Data on broader rent levels remains limited, but the information we do see suggests that office rents in our markets for premier quality properties and locations did not decline materially from pre-COVID levels. And some of our projects' rents are increasing once again. In San Diego, we recently executed the definitive agreement with a major technology company to develop and lease a 71,000 square foot office project in a market where rents have reached all-time highs, construction to commence later this year. We are also happy to report that the office component of our One Paseo project is now fully leased. The recent lease rates reflect all-time highs to the market and have risen approximately 25% from our original underwriting. One Paseo in the 21,000 square foot project demonstrates our ability to continue creating significant value by developing well-located world-class office projects. And finally, in Seattle, also in the second quarter, we signed a 57,000 square foot 7.5-year lease with a gaming company at our key center project at an all-time high level rate for the Bellevue market. The rent was 25% higher on a cash basis and 5% higher on a GAAP basis compared to the prior lease. Bellevue remains one of the strongest markets in the country, anchored by Amazon, but with plenty of depth from other technology and gaming companies. Moving to life science, fundamentals continue to outperform, starting in San Diego. Vacancy rates in Torrey Pines and University Town Center are incredibly low at less than 2% and rents are up 15% to 20% year-over-year and are at all-time highs. The lack of availability in these two submarkets has forced life science companies to expand into the adjacent areas of Serena Mesa, Del Mar Heights and along the 56 Freeway. As an example, earlier this month in Del Mar Heights, we signed a 10-year 96,000 square foot full building lease with DermTech, a publicly traded life science company at our 12340 El Camino Real property. The building will serve as the company's new headquarters, as it expands its footprint in the market. And we are in detailed negotiations on another 200,000 square feet of life science transactions also in Del Mar Heights. In UTC, we are in the final stages of lease negotiations with another publicly traded life science company for a 10-year 51,000 square foot full building lease at our 4690 Executive Drive project slated for redevelopment in early 2022. These transactions are in properties to be converted to life science and with mark-to-market rent increases of more than 50%, highlighting the low-risk, high-return conversion opportunities embedded in Kilroy's existing San Diego office properties. It is important to note that our success in these conversions is in part due to our intense focus on quality and buildings that had the right layout and physicality to accommodate different uses. As mentioned, life science demand is moving north to Del Mar Heights and east along the 56 Corridor, where a major life science company has committed to lease a 500,000 square foot spec project nearing completion in close proximity to our Santa Fe Summit development project. As a reminder, we have full entitlements to build between 600,000 and 700,000 square feet of life science products on Santa Fe Summit Phases 2 and 3. We are evaluating the commencement of construction on at least one phase for later this year. Moving to South San Francisco, life science fundamentals continue to tighten with vacancy rates less than 1.5% and rents at all-time highs. In June, we commenced construction on the second phase of our roughly 50-acre 3 million square foot Kilroy Oyster Point Life Science Campus. Phase 2 follows the successful leasing of Phase 1, a 570,656,000 square foot project that was fully leased 2 quarters after commencement. Phase 2 will include just under 900,000 square feet of space across 3 buildings and will represent a project total investment of $940 million. Approximately $160 million of that has already been invested. We believe we are ideally positioned with Phase 2 and are already in negotiations with several prospective tenants. In summary, we will be delivering 2.5 million square feet of state-of-the-art life science projects across San Diego and San Francisco in the next 5 to 30 months. This includes 4 projects in San Diego, Kilroy Oyster Point Phase 1 and Phase 2 in South San Francisco. And beyond those, Phases 3, 4, and 5 with Kilroy Oyster Point will expand our life science portfolio by an additional 1.5 million to 2 million square feet. Adding this all up and combining with our existing life science projects, we will have assembled a best-in-class life science portfolio of just under 6 million square feet with an average age of 3 years in the best locations. Upon full build-out, life science could be 25% to 30% of our total NOI. Now I'd like to provide an update on our residential portfolio. In San Diego, our One Paseo project of 608 units is now more than 93% leased, which is up from approximately 75% leased last quarter and exceeds our prior leasing guidance. Rent levels have increased 15% to 20% since the beginning of the year. And in Hollywood, our latest luxury tower, the Jardine, is now 30% leased just 2 months since its completion. To sum up our residential portfolio, we now have more than 1,000 luxury residential units between our 2 Hollywood projects and our San Diego One Paseo residential living. On the retail front, our rent and permit program ended in the second quarter, and we're seeing substantial pickup in people traffic as well as in leasing. To summarize our leasing performance, in the first quarter, we signed 200,000 square feet of leases, of which 2/3 were renewals. In the second quarter, we signed 220,000 square feet of leases, of which 2/3 were new leases. This is a good indication of a positive shift in market conditions. And so far this quarter, we signed and have commitments on 170,000 square feet of new leases. At this pace, we expect to return to our pre-COVID quarterly run rate later this year. With that update, let me review our capital allocation activities to date. To recap, in the first quarter, we completed the sale of the exchange for $1.08 billion or $1,440 per square foot, which was nearly twice our total investment. It was a record price for commercial real estate in San Francisco and provides us with substantial capital for new investment. To date, we have reinvested $680 million across 4 value-creating projects that provide a combination of accretion, leasing upside and development opportunity. As we previously reported, in late June, we closed on a $580 million acquisition of Indeed Tower, a newly constructed 734,000 square foot Class A office property located in the heart of Austin Central Business District. It is currently 57% leased with 42% of the space leased through 2034 to Indeed, an investment grade-rated global recruiting platform. The acquisition immediately established KRC as the fifth largest Class A office owner in the CBD with arguably the best building in the Greater Austin area and provides the opportunity to create additional value through the lease-up of the remaining space in a strong and geographically constrained market. We are excited about our expansion into Austin, a city with all the characteristics and growth potential that we look for when entering a new market. It has a young, well-educated population and contemporary urban culture that is very popular with this large number of millennial residents. Austin's broad technology presence is an attraction and strong advantage for us. We know these types of companies. We understand their space requirements, and we've already worked with many of them in developing or adapting properties to meet their needs. With the tech boom in Austin in its early stages, we see these trends continuing. Apple, Tesla, Google and many others are nearing completion of expanded office spaces, which will bring more jobs to the region and further enhance the technology ecosystem. The acquisition of Indeed Tower was the perfect way for Kilroy to enter the market. The 36-story property is a unique asset, a highly visible floor-sealing glass tower situated on a full city block. And in the several months since we began underwriting the opportunity, the market has only strengthened positioning us to exceed our yield expectations. To sum up, the acquisition places us in a state-of-the-art property in a premier submarket of one of the fastest-growing cities in the country that provides an excellent foundation for expanding the Greater Austin market and building a strong operating platform for further growth. It advances our opportunities to partner with many of the leading technology companies in the world. Our second investment during the quarter underscores our confidence in the vibrant Little Italy neighborhood of San Diego, just north of the city's Downtown. In June, we completed the acquisition of a land site at 2045 Pacific Highway for $42 million. This is a full city block directly adjacent to our 2100 Techno project and within walking distance of the Bay. It is currently entitled to up to 275,000 square feet of office space, and it will feature panoramic water views from every floor. Combined with our 2100 Techno project, it creates opportunities for us to offer greater scale and flexibility to the increasing number of companies attracted to this exciting area. Similar to the scale and flexibility that we created in Little Italy to enhance our land assemblage in the East Village with the acquisition of an $8.5 million land site earlier this year. With this site, we now control 2 full city blocks entitled for up to 1.2 million square feet of office or up to 1,000 residential units or some combination of the two. Our fourth investment was the purchase of a ground lease underlying our 491,000 square foot Key Center of office property in Bellevue, Washington for $47 million. The purchase price equated to $96 on a per building foot basis in a market where vacant land has traded for double this amount. The ground lease had a remaining term of 72 years and the ground lease payments were tied to the project's income, which would dramatically increase since the last adjustment. We have now eliminated that exposure as we saw with our recent gaming company leasing this building, rents continue to climb in Bellevue, especially for high-quality projects like Key Center. We completed the acquisition earlier this month. These 4 investments were all off-market and each case reflect our disciplined approach to capital allocation decisions and our continued commitment to position our company and our portfolio for the future. To wrap up, we had a very busy first half of the year. We sold a $1 billion asset and redeployed a portion of the proceeds into projects with meaningful upside and value creation potential. We are expanding our life science portfolio with state-of-the-art development and redevelopment projects that have the proper physicality and/or in the best locations. We are seeing strengthening fundamentals. And while we expect market conditions to ebb and flow, there is far more enthusiasm today than any time since the pandemic began. And finally, after years of evaluations, we've entered an exciting market by acquiring the best project in the city of Austin. That completes my remarks. Now I'll turn the call over to Michelle.

Michelle Ngo, CFO

Thank you, John. FFO was $0.88 per share in the second quarter, which was $0.05 higher than the midpoint of our guidance. $0.035 were due to better-than-expected operating results, including earlier than projected lease commencements and stronger leasing at One Paseo Residential, and $0.015 were due to one-time items, including repayment of owed rents and lease termination fees. We are also happy to report we did not have COVID-related charges in the second quarter. In our same-store results, second quarter cash NOI was up 4.9%, reflecting strong rent growth and the one-time items noted above, which contributed 130 basis points to cash NOI. GAAP same-store NOI was up 5.5%, which was driven by $4.5 million of revenue reversals in 2020, or 2.3%, excluding the prior year reversals. At the end of the second quarter, our stabilized portfolio was 91.8% occupied and 93.6% leased, which were both up 30 basis points from the prior quarter, reflecting additional lease commencement. Overall, rent collection in the second quarter was 97% with office and life science rent collections of 98%. Turning to the balance sheet. After funding the acquisitions that totaled approximately $680 million, our liquidity today stands at approximately $2 billion, including $860 million in cash and full availability of $1.1 billion under the new revolver. With respect to Indeed Tower, you will note that we included the project in our development pipeline with a total estimated investment of $680 million. This total reflects our purchase price of $580 million, which includes $35 million of tenant improvement credits related to in-place leases and an incremental $100 million of leasing and carry costs to stabilization. We have no material debt maturities until 2023. Our net debt to Q2 annualized EBITDA was 5.8x. Now let's discuss our 2021 guidance provided in yesterday's earnings release. To begin, let me remind you that we approach our near-term performance forecasting with a high degree of caution, given all the uncertainties in today's economy. Our current guidance reflects information and market intelligence as we know it today. Any COVID-related restrictions or significant shifts in the economy, our markets, tenant demand, construction costs and new supply going forward could have a meaningful impact on our results in ways not currently reflected in our analysis. Projected revenue recognition dates are subject to several factors that we can't control, including the timing of tenant occupancies. With those caveats, our assumptions for 2021 are as follows: cap interest is expected to be in the range of $77 million to $82 million, driven by the acquisition of Indeed Tower and 2045 Pacific Highway. We expect to end the year with net debt-to-EBITDA of approximately 6x. Same-store cash NOI growth is expected to be approximately 2% to 2.5% for the year. At this time, we expect revenue recognition on the remaining 51% of our 333 Dexter development in 2022, given tenant improvement work timing. We expect year-end occupancy of approximately 91.5% for the office portfolio and 75% to 80% for residential. Our guidance does not assume a material increase in transient parking. But as we've noted on prior calls, we expect to pick up roughly $1 million a month to get back to pre-COVID levels. We do not have any additional acquisitions in our budget. Taking into account all these assumptions, we project 2021 FFO per share to range between $3.71 to $3.82 with a midpoint of $3.77. To help you get to this midpoint, we deduct: first, first half actuals of $1.86 from the $3.77, which implies second half results of $1.91 or a $0.05 increase over the first half. The $0.05 are driven by the following major items: $0.13 of NOI loss from the sale of the exchange, offset by the following positive items; $0.10 from higher cap interest and NOI from the acquisitions of Indeed Tower, 2045 Pacific Highway and the Key Center ground lease; $0.05 from revenue recognition of KOP Phase 1 in the middle of the fourth quarter and another $0.03 from our stabilized portfolio, including contributions from One Paseo office and residential. Lastly, as a reminder, these assumptions reflect COVID restrictions and circumstances as of today. That completes my remarks. Now we'll be happy to take your questions.

Operator, Operator

And the first question will come from Nick Yulico with Scotiabank.

Nick Yulico, Analyst

Maybe first question for John or Rob. If you could just talk a little bit more about the activity of leasing in your markets for traditional office versus lab space, maybe if you can just go through some of your markets and talk about kind of stronger and weaker points, please.

John Kilroy, CEO

Go ahead, Rob.

Rob Paratte, Executive

Certainly. Let me discuss our markets, starting in San Francisco. Leasing activity for office space there has nearly tripled compared to the previous quarter. As John mentioned, the mood among brokers and tenants has significantly changed. Many tenants who paused their expansion plans during the pandemic are now revisiting those plans and returning to the market. In this quarter, San Francisco saw 15 transactions that exceeded 100,000 square feet, with 12 of those involving relocations or expansions. Currently, there are about 118 new tenant searches that have emerged in the last five weeks. JLL is monitoring around 2 million square feet of transactions that are in the letter of intent stage. While the sublease figure is still a daunting almost 9 million square feet in San Francisco, it's important to note that this data is somewhat retrospective, and there are signed transactions that tenants have yet to occupy, which will eventually reduce that number. A notable development is the Macy's.com space. This area was listed before the pandemic and recently signed a sublease for 106,000 square feet with Benchling, which is indicative of a relocation and expansion. This aligns with the ongoing theme from John about the flight to quality. The Macy's location is highly desirable, and its specifications match what tech companies are looking for. There is also another pending transaction, which we can't detail or name the company yet, but it's a tech expansion that should close in the third quarter. Moving on to Seattle, it seems to be becoming quite active, even more than San Francisco, with a 17% decline in available sublease space in the second quarter. Currently, there are about 196 active requirements in the market, and brokers are tracking approximately 4.4 million square feet of demand, which represents an 80% increase from the fourth quarter of 2020. A significant sign of Seattle's market health is the Rayonier Square project, which is fully leased by Amazon. They've been subleasing some of that space and have already signed leases for around 200,000 square feet this year, leaving only 150,000 square feet available. This reinforces the quality of the asset, its build-out, and the location. Before I leave the Bay Area, I want to address the life science sector, which remains very strong in the Oyster Point area. We're observing over 4 million square feet of tenant demand from developers who have visible projects nearing completion. Here, there are over 1 million square feet of potential transactions expected to be finalized between the third and fourth quarters. KOP has started its construction, and as it progresses, we anticipate similar activity at our developments. In Los Angeles, the market has mixed signals. However, leasing activity in the second quarter is approaching pre-pandemic levels, particularly evident in the Westside with significant expansions by Hulu, Snapchat, and others. Lastly, I want to mention San Diego briefly, as John covered it well. It's experiencing growth due to large tech companies and an expanding life science sector. Our 2100 Kettner project will be completed soon, and there’s increased tour activity from various tenants. This location is appealing not only to tech companies but also to more traditional tenants in the market. We are very satisfied with the activity there and are pleased that One Paseo is fully leased. That wraps up my market overview.

Nick Yulico, Analyst

Very helpful. My second question is a follow-up on the new leasing activity. I believe you mentioned earlier that two-thirds of the leasing in the second quarter comprised new leases. So it seems that new leasing activity has increased. I thought I heard you say that the second half of the year is getting closer to pre-COVID levels. I’m not sure if I understood that correctly. Could you clarify whether these comments are specifically about traditional office space and not including the lab space leasing you are accomplishing?

John Kilroy, CEO

Yes, my comments were focused on the square footage leased. We had been maintaining an annual run rate of over $2 million for the two or three years leading up to COVID. I can't recall the exact breakdown of that in terms of office, lab, or new space. However, I can confirm that leasing activity in San Diego has significantly increased. Aside from the Kettner project, which will be completed in about a month, every square foot we have either started construction on or already owns is leased.

Nick Yulico, Analyst

Okay. Great. Just a quick follow-up. I mean, does any of the recent news on Delta and now some more indoor mass potential in California, some delays in return to office? I mean does that maybe throw a bit of a slowdown into leasing in the market?

John Kilroy, CEO

How do we know? I can tell you that I am taking this call from our San Diego office, while others are in Westside Media. When you go to San Francisco, you see people on the street and in restaurants, which wasn't the case two months ago. Will there be a slowdown again because of Delta? That's uncertain. San Diego has been more open throughout the pandemic compared to the northern areas. People are wearing their masks, and the atmosphere is much more vibrant. I believe this will continue, but we just have to wait and see. That’s why I mentioned there will be some fluctuations. We can't predict definitively, but we can confirm that people are back to business. They are making deals and having regular meetings, tours, and expansion discussions. They are also sharing what they are doing in other cities like Austin. It's a completely different environment now. However, there is a chance things could slow down if the Delta variant escalates significantly. While the situation is currently looking positive, I'm cautious about making further predictions.

Operator, Operator

The next question will come from Manny Korchman with Citi.

Manny Korchman, Analyst

John, others, especially in the life science space, talk about the difficulty in conversions and how that's going to help to control some of the oversupply or potential oversupply in the space. You seem pretty confident in converting your spaces and building a whole lot of new life science. So can you help us think about either what we're missing or what they're missing in terms of supply and why supply from others doesn't really worry you?

John Kilroy, CEO

Well, you can never say supply from others doesn't worry us. What I've said in prior conference calls is that just because you call something life science or say you're going to convert it to 'life science', doesn't mean they'll come. I've seen a lot of people buy stuff down here in San Diego, for example, with the ideas that they're going to convert the live clients and we wouldn't touch it. We wouldn't touch it because the adjacencies are wrong or because the physicality of the buildings, even when you convert, doesn't lend itself to high-quality. If you think about life science, at least, the starts, which are always a different piece. But life science companies want the same thing that other technology companies want, they want a place where they can have more of a campus where they can have scalability, where they can have the amenities in the environment that attracts and retains the best people. And that's where we're very focused. When I mentioned the conversions in UTC and the conversions in Del Mar, those are already strong life science markets. So we just happen to have buildings that are relatively new that have the right kind of floor plates, the right kind of ceiling heights and structure and so forth that lend themselves in already established life science locations to be excellent candidates for conversion. I think there's a lot of people that are going to get their clocks cleaned that are playing this life science conversion game, a lot of them. I think there's been too much money raised in that space by a lot of companies that don't know what they're doing, and we get every day. I mean, almost everything we see with some old dog buildings that they've been flogging for the past 3 or 4 years and now all of a sudden, its a life science play. I just think there's going to be a lot of people that are going to get burned.

Manny Korchman, Analyst

That's what's driving the question. And then in terms of your own acquisitions, given that capital is chasing the life science space, maybe a little bit less capital chase in the office space, are you more focused on finding office opportunities to use the proceeds you have left to use up or do you think you might be actually end up buying some life science space?

John Kilroy, CEO

I don't believe we have acquired any life science properties since purchasing the Oyster Point Tech Center, which is adjacent to our Oyster Point development project that also included some life science elements. We bought it with the intention of repurposing it for a better use as a Phase 5. Other than that, please correct me if I'm wrong, Tyler or Eliott, but I don't think we've purchased any properties for life science or aimed at converting them to life science in the last five or six years. Have we?

Tyler Rose, Executive

Yes, that's right. I think the last acquisition, as you said, was Oyster Point Tech, which was in early 2018.

John Kilroy, CEO

Yes. My point, Manny, is that we are very selective about the locations we choose and the physical characteristics of the properties. What is advantageous for Kilroy is that we have consistently noted that the average age of our portfolio is under 10 years. We have been constructing buildings that possess the necessary structural integrity and floor height suitable for office spaces. Consequently, if these buildings are located in a life science market, they can be easily adapted since they are already close to meeting those needs. In contrast, the average office building presents numerous challenges when it comes to adding mechanical systems and accommodating floor loads, making them less suitable. However, I currently do not intend to acquire any existing life science properties.

Operator, Operator

The next question will come from Blaine Heck with Wells Fargo.

Blaine Heck, Analyst

Sorry about that. Can you hear me?

John Kilroy, CEO

We can hear you.

Blaine Heck, Analyst

Got you. Okay. So probably for John or Elliot, can you just talk about your appetite for additional investments in Austin at this point, whether you're looking for core acquisitions, value-add acquisitions or development opportunities and maybe even whether you're actively pursuing anything at this point?

John Kilroy, CEO

Yes. Do you want to take that one, Elliot?

Eliott Trencher, Executive

We are quite optimistic about the Austin market and are looking to expand our presence there. The types of deals we pursue vary widely. Most of our acquisitions focus on value-add opportunities or developments, although we have occasionally acquired core deals in the past. Currently, there are no immediate deals to discuss, but we anticipate continued growth in the area over the next several years.

Blaine Heck, Analyst

Great. That's helpful. And then just to follow up on that. Austin clearly fits the type of market you guys are interested in and a tenant profile that you guys know very well, but I think you could potentially argue the same for some other Sunbelt markets or submarkets. Can you talk about whether or not you have any interest in additional markets in the South or Southeast?

John Kilroy, CEO

This is John. We're going to be strategic when we believe it's best for our shareholders and when we see the right combination of demand and scale. With Indeed, as I mentioned earlier, we acquired a top-tier property. It's very much in line with what we do. Currently, if the property in question is rated a 10, I don't think there's anything rated a 7 in that city at the moment. There are some new buildings on the way, but we secured a property that truly represents our standards. In response to Elliott's comment, I don't foresee us purchasing core properties unless it involves a lease at a very low rent with significant future rent increase potential. For many years, we've focused on value-add opportunities, and development has been a key part of our strategy. I'm uncertain if we'll expand beyond Austin in the future. Right now, we're concentrated on the five markets we're operating in, with Austin being the latest. We're in the process of building a team there, making significant progress with both existing Kilroy employees transferring and new hires. You will see us actively involved in that market.

Blaine Heck, Analyst

Got it. Okay. That's really helpful color. And then maybe if I could sneak one more in, just shifting gears a little bit here. We've clearly seen an increase in the cost of materials and difficulty in procuring some of the raw materials for construction. Given that you guys are commencing on a pretty major project in KOP Phase 2, can you talk about how you guys are dealing with the cost side of things and making sure you have all of the materials to avoid delays?

John Kilroy, CEO

Yes. The costs of materials and labor have risen. One aspect we are monitoring is the impact of the infrastructure bill that Congress is considering. All these factors compete for essential supplies like hammers, concrete, and wire. We actively collaborate with our contractors, architects, and vendors to gather insights on what we should be anticipating. We include significant contingency plans and projected cost increases in our forecasts. Although I don't have COVID, I am experiencing my first cold in two years, so I apologize for any coughing. Our financial forecasts have been quite accurate, often leaning towards being overly conservative. While I can't predict specific fluctuations, I want to highlight that we've shifted to sourcing domestically as much as possible, moving away from reliance on suppliers in China. This approach enhances our control over the supply chain and gives us better visibility regarding costs. We have team members on factory floors where products like window walls or elevators are produced, ensuring we stay informed about schedules and progress. Our model for managing these challenges is quite advanced, and we expect it to evolve further. However, the competition for materials is intense, and the situation may be intensified by the infrastructure bill.

Operator, Operator

The next question will come from Steve Sakwa with Evercore ISI.

Steve Sakwa, Analyst

A lot of my questions have been asked and answered. But I guess I just wanted to circle back, John, to the land parcel you did in San Diego. I couldn't help from your comments if you thought that, that was important to control in order to land a larger tenant in Kettner or if that's just kind of complementary and you like the area and you think that will kind of be 2 different projects?

John Kilroy, CEO

I believe it's both, Steve. The Kettner project stands on its own and is currently attracting a lot of interest. If we decide to convert it into a multi-tenant building, I believe we could lease it out very quickly. Additionally, we have some significant potential tenants that are showing renewed interest. Larger tenants typically need more space, and we think this will positively influence the value of the Pacific Avenue property, which we refer to as the car wash. It’s important to note that there are only two office buildings that can be developed in Little Italy. I anticipate that 2100 Kettner will command some of the highest rents in the city. Our team, particularly our talented young professionals, made it possible for us to acquire this property, allowing us to work with a large company and provide them with increased scalability. This also means we can take advantage of the benefits that come from developing 2100 Kettner. So, it’s really a combination of both aspects.

Operator, Operator

The next question will come from Craig Mailman with KeyBanc Capital Markets.

Craig Mailman, Analyst

Michelle, maybe just on guidance. You noticed there's no acquisition assumed in guidance. Does that mean on the remaining $300 million, I know it's getting close to when you have to decide on the special dividend. Is that what's in the plan for the remainder of the proceeds that you guys had in shelter yet?

Tyler Rose, Executive

Yes. This is Tyler. Maybe I can take that. I mean we're still working through that. We have till the end of September to sort of finalize the 1031 plans and then there are other ways to shelter the gain as well. So more to come on that as we work through the year.

Craig Mailman, Analyst

Okay. John, you mentioned that 20% to 25% of the portfolio could be allocated to life sciences soon. You've achieved significant value creation so far, but it seems the stock is not receiving the same valuation as some others in the life sciences sector. What is the strategy for addressing that NAV discount if the allocation reaches 25% and how can you help investors understand the value of the life sciences segment?

John Kilroy, CEO

Yes. I think it's incumbent upon us to make sure that the investment community and the analyst community do give us recognition. We recognize that value, and I think they will. But we got to make sure they understand it. And I think if they take a look at the quality of the life science that we have, they're going to see that we're a notch above most.

Craig Mailman, Analyst

Would you ever spin it out or do something separate to realize that value?

John Kilroy, CEO

I'm not going to take a definitive stance, but we recently sold a modern office building in San Francisco that was only a few years old. If you had asked me a couple of years ago about the potential sale of that asset, I would have found it hard to believe, but things can change. Currently, our residential properties are trading in the 3s, and I believe our life science assets would also trade at a very low cap rate. Presently, the office sector is hesitant until there is more clarity on the demand for office space post-pandemic, which is causing a lag for office companies. However, we possess the best product in the market. There are no other publicly traded companies with a scale comparable to ours that can match the quality of our locations and the newness of our properties. I am confident that as we navigate through the next year or two, the value will reflect that quality.

Operator, Operator

The next question will come from Jamie Feldman with Bank of America.

Jamie Feldman, Analyst

I think, John, in your opening remarks, you had commented that you're increasingly seeing small tenants active in the market for leasing. Can you just talk more about maybe what's changed this quarter or even in the last month or so in terms of the types of tenants that are looking for space and in which markets?

John Kilroy, CEO

Okay. Rob, do you want to take that one?

Rob Paratte, Executive

Sure. Jamie, to begin with San Francisco, one of the most notable developments in the city is the significant activity among tenants, particularly those in the 15,000 to 35,000 square foot range. These smaller tenants had been largely inactive for about a year and a half, especially during the pandemic, but their renewed engagement is a key indicator for the future. Typically, if these tenants were facing lease expirations, they would opt not to renew and instead have their employees work from home. However, we are now witnessing an increase in market activity from these smaller tenants. Additionally, in our Long Beach project, we currently have around 46,000 square feet in leases under discussion, mainly with smaller tenants, and more than half of these agreements represent new deals rather than renewals. This trend reflects a resurgence in the smaller tenant market, encompassing not just tech and venture capital-backed firms but also various private sector companies like architects that utilize urban spaces.

Jamie Feldman, Analyst

Okay. Sticking with San Francisco, we keep hearing about safety issues, crime, and homelessness. Are tenants holding off to see if things improve, or is that not really impacting the leasing market at this point?

Rob Paratte, Executive

It's not affecting the leasing market. As people have mentioned, the city is much busier than it was six weeks ago. With more workers returning, this isn't limited to just San Francisco but includes other urban areas as well. The increase in workers is contributing to a displacement effect on the homeless, who are being moved out of the financial districts, likely on their own initiative. We haven't noticed any decline in activity; in fact, major tech companies like Google in San Francisco remain optimistic and are continuing to invest in space and expansions.

John Kilroy, CEO

I would like to offer a different perspective, Rob. We may not agree on everything. I believe the homelessness issue is a significant concern for many individuals. If those experiencing homelessness are encamped in front of your building, it will affect you. Rob is correct that while things have started to return to a semblance of normalcy, they are not completely back to normal, and the presence of homelessness has shifted to different areas. California has a critical problem with homelessness. This issue originated a few years ago when voters passed a proposition to decriminalize drug use, which resulted in the release of tens of thousands of drug users and sellers, many of whom ended up on the streets. The decriminalization of drug use has unfortunately also led to the decriminalization of drug sales. Additionally, we have district attorneys in Los Angeles and San Francisco who are, in my opinion, not acting wisely. Therefore, homelessness remains an issue we need to address. We are currently in the process of a recall election in California aimed at recalling Governor Newsom, which is set to be on the ballot in September. If the recall is successful, voters will concurrently elect a new governor. I believe we need to remove Newsom from office, as I do not think he is effective. We must tackle these issues. Jamie, the reality is that homelessness is a problem that affects us, even as we see increased leasing activity. I don't want to sugarcoat the issue; homelessness is a genuine challenge in this country, particularly in California.

Jamie Feldman, Analyst

All right. I appreciate your thoughts and hopefully, you can fix it everywhere, obviously, a major issue in a lot of cities. And then can you just talk about maybe the net effective rent side? I know markets are clearly stabilizing and even starting to improve. Are you seeing any change in the net effective rents? And can you talk maybe about how you think your mark-to-market looks now with competitive leasing spreads in the quarter?

Rob Paratte, Executive

Sure. Jamie, it's Rob again. Let's start with Bellevue. I think you're going to continue to see net effective rent growth probably in the mid- to high single digits. In Seattle, there is an opportunity for rent growth beginning in the CBD, particularly for high-quality space. In San Francisco, the situation is slightly declining overall, but the trophy quality assets, such as the Bank of America Center, Embarcadero Center, and One Market Plaza, have continued to transact during the pandemic at rental rates ranging from $112 to $115, which are pre-pandemic rates. For trophy quality spaces, these rates are stable and could potentially increase. There is a significant shortage of view space in San Francisco, creating high demand, which aligns with the comments about the flight to quality across all our markets. In Oyster Point, while I won't predict rent growth, with about 1 million square feet of transactions expected to close in the next two quarters, we anticipate continued pressure on rents. In Los Angeles, the market appears stable, with considerable activity on the Westside due to large movements from companies like Hulu and Snapchat. In San Diego, I prefer not to generalize about rent growth as it varies widely, but I expect significant rent growth in UTC and rental increases in Del Mar and Carmel Valley. As tenants move into the I-56 Corridor, we expect rent growth there as well. In Austin, there is noteworthy rent movement, as big tech companies are returning. Companies like Apple, Tesla, and Oracle, which already have major campuses, are now expanding their facilities. Thus, Austin should experience a considerable rise in rental rates, especially in the CBD, as young people are moving back into the Central Business District.

Eliott Trencher, Executive

Yes. And Jamie, you asked about mark-to-market. I think we said our overall portfolio pre-COVID was roughly 20% below market. Given the limited data points, but given the momentum in transactions, I think if we were to guess where it is today, we'd say it's plus/minus 15% or so.

Operator, Operator

The next question will come from Frank Lee with BMO.

Frank Lee, Analyst

Rob, you touched a bit about this, but I want to ask about tenant sentiment in Austin versus San Francisco. On one hand, you have like Austin leading the U.S. in terms of office utilization while SF is near the bottom. Are you seeing any notable trends in terms of how tenants are evaluating space needs or tenants making quicker decisions? I'm basically trying to get a sense that there's any significant correlation between higher utilization rates and leasing demand or timing?

Rob Paratte, Executive

I'm not really seeing the connection. The tenant sentiment in Austin is quite positive, and many of the tenants there also operate in the Bay Area, Silicon Valley, Seattle, New York, and other places. Large tech companies have a favorable outlook on Austin. During our discussions with clients while exploring Austin, all of them intend to stay and grow in the area. Interestingly, the Economic Development Corporation reports that there are 267 companies considering moving to or expanding in Austin from other regions. This indicates a vibrant and business-friendly market. We've found it relatively easy to engage with the local business community and identify the key players. We share John's enthusiasm about the positive outlook for Austin. However, regarding your question, I don't see a strong correlation between the two cities. In fact, the return to office in San Francisco has been slower compared to other urban areas, which affects how quickly tenants can evaluate their space requirements.

Frank Lee, Analyst

Okay. And then you mentioned the $170,000 of leasing already in the third quarter, is the majority of this quarter's leasing also largely new leases, maybe outside the life science deal at El Camino? And then do you have a sense that these new tenants are upgrading their spaces or just simply relocations?

Rob Paratte, Executive

Well, on the latter part of the question, they're upgrading their spaces. We're seeing tenants investing money, whether they're renewing or expanding, investing quite a bit of money into their premises. It's all about the one constant throughout everything has been recruiting and retention of talent. And the companies we talk to are essentially doubling down. There's a lot of news in the press about Google, et cetera, making major investments in their space to further make it attractive for people coming back to work.

Eliott Trencher, Executive

And Frank, regarding the 170 new leases signed so far this quarter, all of those are new leases.

Operator, Operator

The next question will come from Dave Rogers with Baird.

Dave Rogers, Analyst

Yes. Maybe John or Rob, I just had a question. You just talked about smaller leases being more active, larger tenants still a little bit more hesitant to make decisions. I guess, what gets those larger tenants to make decisions on the West Coast here in the near term? Is it COVID related? Is it something else? It seems like there's plenty of hiring that's been coming back. And then maybe the second part of that question is as you build bigger spaces, KOP Phase 2 and Kettner kind of north of $200,000, how do you think about kind of Flower Mart and where that then fits in, in the long run and when the demand comes back for something like that?

Rob Paratte, Executive

John, do you want me to take part of that or you?

John Kilroy, CEO

I don't think we intended to suggest that only the larger tenants are inactive while the smaller and mid-sized ones are active. My comments highlighted that many of the larger tenants are experiencing significant growth, but we are also beginning to see similar growth from mid-sized and smaller tenants. So Rob, feel free to continue.

Rob Paratte, Executive

Yes. I can't mention specific names, but large tech companies are focusing on expansion, especially in San Francisco. We discussed Seattle, and I believe there will be many announcements in the next quarter related to that. Additionally, companies are acknowledging the existence of a hybrid work model. However, hiring in the tech sector has continued during the pandemic. Companies want to assess how this impacts office layout, but they won’t be able to do so effectively until more people return to the workplace. The hybrid model can vary greatly, and as John mentioned, it will fluctuate. Nonetheless, week by week and month by month, more people are returning to the office and the cities.

Operator, Operator

This concludes our question-and-answer session. I would like to turn the conference back over to Michelle Ngo for any closing remarks. Please go ahead.

Michelle Ngo, CFO

Thank you for joining us today. We appreciate your interest in KRC. Goodbye.

Operator, Operator

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