Earnings Call Transcript - KRC Q3 2020

Operator, Operator

Good afternoon, and welcome to the Third Quarter of 2020 Kilroy Realty Corporation Earnings Conference Call. I would now like to turn the conference over to Tyler Rose, Executive Vice President and CFO. Please, Tyler, go ahead.

Tyler Rose, CFO

Good morning, everyone. Thank you for joining us. On the call with me today are John Kilroy and several other 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 third-quarter highlights and an update on our market conditions. I will discuss the third-quarter financial results. Then we'll be happy to take your questions. John?

John Kilroy, CEO

Hey, thanks, Tyler, and hello everyone. Thank you for joining us today. This is our third call during the COVID period. I don't think any of us thought at the outset that we would still be in the pandemic at this point. But having said that, we continue to perform well and remain optimistic about the future. Here at KRC, we remain focused on several key areas that position us well to play both defense and offense over the coming months and years. These include maintaining a strong financial foundation, proactively managing lease expirations and our stabilized portfolio, executing our under-construction development projects, positioning our future development for starts, working with governmental agencies to influence policy as much as possible, and preparing for a post-COVID future, which includes continuously enhancing the quality of our portfolio from a sustainability and wellness perspective. And while we believe we are doing well in all these areas, we also continue to do well both financially and operationally. Here are third-quarter highlights. We ended the quarter with $1.4 billion of liquidity. This includes the successful completion of a $425 million green bond offering in August. Our under-construction development is now fully funded with cash on hand. Our high-quality tenant profile continues to demonstrate its value. Overall rent collection in the third quarter exceeded 96% with office and life science rent collection north of 98%. These strong rent collection levels have remained consistent across the seven months of the pandemic as our well-capitalized technology and life science tenant base continues to outperform. We continue to make progress in addressing our near-term lease expirations, signing renewal leases in our stabilized portfolio during the quarter on approximately 115,000 square feet. While leasing volumes were light, rental rates on these leases were up 15% on a cash basis and 34% on a GAAP basis. Our average annual lease expirations through 2023 now stands at approximately 6.5%. With the exception of a fourth-quarter expiration this year, we do not have any expirations greater than 60,000 square feet through the end of 2021. Leasing activity continues to be impacted by shelter-in-place regulations that make it difficult to tour. In development, our $1.9 billion of construction projects remains on track with the expected delivery of the Netflix On Vine office project in the fourth quarter. When stabilized, the pipeline is expected to generate $140 million of annualized cash net operating income. That's an update on the quarter. Moving forward, while it's still early days in understanding the pandemic's lasting impact, we do see some important themes developing. These include the physical makeup of commercial workspace in the industries that drive its use. The first theme is life science. It's not a secret that the life science industry is positively impacted by COVID, and we believe it will continue to benefit for the foreseeable future. We see investment in life science averaging $20 billion annually for the past five years, healthcare expenditures have risen to approximately 20% of the annual GDP as our nation's population ages, and the FDA has become increasingly proactive in driving new drug development. The pandemic is moving more private and public investment into the sector and encouraging the creation of a range of new startups. We believe they will want to locate their labs and their talent in current life science clusters. Looking at the West Coast markets we serve, current square footage dedicated to life science use totals about 20 million square feet with direct vacancy rates that range from 2% to 3%. We estimate current demand in these markets to have approximately 5.5 million square feet. We've been building the capabilities to serve this market for more than two decades and are well-positioned to continue to capitalize on opportunities. Today, our pro forma life science footprint, which includes existing properties, life science capable assets, and entitled life science development totals approximately 5 million square feet. We have the third largest portfolio of life science and healthcare tenants among publicly traded REITs as a percentage of total base rent. Several life science tenants within the KRC portfolio continued to do quite well, including Neurocrine, our largest San Diego tenant, which last quarter had two medicines approved by the FDA. And LabCorp, a South San Francisco tenant, reported strong earnings last quarter, driven by increased COVID-19 testing volume. We believe our life science portfolio deserves more appreciation as it is essentially fully leased with strong tenants such as Acadia, Stanford University, and 23andMe. Recent market activity highlights our portfolio's embedded value in addition to the strong valuation of the BioMed recapitalization, the sale of the Genesis buildings located on the west side, the non-traditional side of the 101 Freeway in South San Francisco for approximately $1,275 per square foot is a great comp for the Kilroy Oyster Point, particularly given that these buildings are not as ideally located or as modern. KOP is our 39-acre, 2.5 million square foot life science development project in South San Francisco. We are in construction on Phase 1, a 650,000 square foot project that is 100% leased and built with state-of-the-art life science infrastructure. It will have a total basis of approximately $865 per square foot and is clearly worth substantially more today. KOP Phase 2 through 4 are fully entitled for another 2 million square feet of lab space and office space. We currently are seeing strong interest in KOP Phase 2 from a variety of tenants and are looking carefully at the possibility of the Phase 2 start sometime next year. To quantify, Phase 2 is approximately 900,000 square feet, and we have considerably more interest with active discussions than we do square footage. The second theme is wellness. We have been in constant contact with our tenant base since the pandemic began. The leaders of these entities are focused on physical design, space and adaptability, environmental health, safety and comfort, and increasing square footage per worker. While some of these concerns are driven by short-term needs, we believe that workspace wellness is an issue that is here to stay. We will see a large premium placed on office properties that can provide larger, more light-filled floor plates, greater flexibility in the layout traffic flow and use of interior spaces, stronger integration of workspace with the outdoor world and nature, and top-quality state-of-the-art operating systems that not only protect but enhance employees' health. Hence, we want to partner with well-capitalized landlords who are willing to and able to invest in both innovative design and advanced infrastructure in their development. We believe these trends will give KRC a big competitive advantage in our markets. Our existing portfolio is among the youngest and best designed to meet these needs. We've been a leader in understanding and adopting design practices and systems that enhance the wellness of our buildings' occupants. And we now have the highest number of Fitwel certified properties of any company in the world. We have deep experience in pursuing new development concepts, integrating the best, most innovative thinking in sustainability and wellness. We believe that these attributes make KRC a top partner of choice going forward. Let me wrap up with a few additional thoughts on today's markets and what may lie ahead. Amidst all the uncertainty in 2020, it remains clear that technology, media, and life science will still be the growth engine of our economy. Many companies in these industries continue to thrive in what is an otherwise challenging time, and the biggest concentration of these sectors is on the West Coast and in our markets. We remain confident that the cluster of intellectual capital, top-notch universities, and a good quality of life found in our markets is tough to replicate and is a differentiating factor for Kilroy. I don't have a crystal ball, but from continued discussions with our customers, I'm fairly confident that companies, both large and small, established and startups are going to want to bring their people together in communal workspaces when the pandemic has passed. Having been through a few cycles, I cannot stress enough the importance of leadership teams during down cycles for the companies as well as municipalities. While good times are a rising tide that lifts all boats, markets like these are best suited for those with high conviction, a track record of success, and the ability to adapt. Last cycle, we believed we differentiated ourselves from the competition through our entry into San Francisco and Seattle, and we look forward to the challenge of differentiating ourselves again in this cycle, and I'm confident we will. We have never been better positioned. Our stabilized portfolio is young, modern, sustainable, and leads the world in wellness. Our expirations are limited, our tenant base is largely healthy, well-capitalized, and poised for further growth. Our under-construction development projects are fully funded at 90% leased, our future development pipeline is diversified across product types as well as markets and has a very attractive basis, and our balance sheet is solid with significant liquidity, low leverage, and no near-term maturities. Now I'm going to turn the call back to Tyler.

Tyler Rose, CFO

Thanks, John. For the quarter, we reported FFO of $0.99 per share as we continue to see the positive contribution from development. Third quarter FFO benefited from a full quarter contribution of 49% of 333 Dexter in Seattle, as well as incremental GAAP revenue from the office space at our One Paseo mixed-use project in Del Mar. Third quarter FFO also included a $0.02 per share allowance related to our ongoing assessment of tenant credit and collectability of rent. Looking at same-store operating results, cash same-store NOI increased 3.8% in the quarter, largely driven by higher rental rates in the burn-off of free rent. GAAP same-store NOI declined 1.9%, primarily due to prior year one-time payments. At the end of the third quarter, our stabilized portfolio was 92.2% occupied and 95.5% leased. As John mentioned, in August, we completed a $425 million public offering of 12-year unsecured green bonds with an annual interest rate of 2.5%. This was our second green bond offering. We used a portion of the proceeds to fully repay a $150 million term loan facility. With those transactions completed, our liquidity today stands at approximately $1.4 billion, including approximately $685 million in cash and $750 million available under our revolver. Our net debt to third quarter annualized EBITDA is 5.6 times. We are again not providing specific earnings guidance this quarter, but I 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. From a Proposition 15 perspective, we have made a $0.07 per share investment in defeating this property tax increase initiative. This includes $0.03 of expenses already incurred in quarters two and three and $0.04 that will show up in our fourth-quarter G&A. We project remaining 2020 development spending to be between $100 million to $200 million. We are in advanced discussions on the sale of a building in the San Francisco Bay Area for approximately $75 million, with expecting closing later this quarter. As a side note, from a valuation standpoint, while there haven't been a lot of transactions, we've recently seen several trades at strong valuations. These include a multi-tenant building in Seattle at $1,000 per foot, a multi-tenant building in Santa Monica for $1,800 per foot, and several trades in San Francisco ranging from $1,000 to $1,300 per foot. So we will continue to evaluate disposition opportunities as appropriate. We remain in close discussions with our retail tenants to understand their financial condition. As you may recall, over the last two quarters, we established a 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 rental deferral for these tenants is approximately $1.5 million. Non-contractual parking income totaled approximately $1.5 million of NOI per month. We expect to receive about a third of this amount until the shelter-in-place rules are lifted. At One Paseo and Del Mar, as of October, we commenced revenue recognition on 59% of the 285,000 square foot office project. We expect to commence revenue recognition on the remaining leased office space in phases throughout the remainder of this year. Also at One Paseo, in July, we delivered 146 residential units. This was the third and final phase. As a reminder, we delivered the first phase, which included 237 units, late last year, and the second phase, which included 225 units, earlier this year. In total, the 608-unit project is now 51% leased, and we've seen leasing momentum pick up over the last month. We expect the commencement of revenue recognition on the Netflix On Vine Office project next month. With respect to the residential portion, Living On Vine, it is on target for delivery in the first quarter of 2021. That completes my remarks. Now we'll be happy to take your questions. Operator?

Operator, Operator

We will now begin the question-and-answer session. Our first question comes from Manny Korchman with Citi. Please, Mr. Manny, you may proceed.

Michael Bilerman, Analyst

Thank you. It's Michael Bilerman here with Manny. John, good morning out there. I want to come back to your opening comments where you talked about how this has gone longer than all of us certainly had hoped earlier in the year. You commented that you remain very optimistic about the future. I'm wondering if you can dig into that a little more because it feels as though the number of tenants in your markets coming out and talking about either a permanent work from home or a hybrid solution and also letting their employees work from anywhere in the future despite some of the benefits that you talked about in terms of the intellectual capital, the university systems, and the quality of life, though that I think will be a little bit debatable right now on the coast. But all of those elements you have, what gives you the confidence that they're going to come back to communal spaces? How do you think those spaces are going to evolve in the markets that you operate in?

John Kilroy, CEO

That's a long question, Michael. So if I forget a few pieces in my response, please ask again. Well, this COVID situation, nobody knew how long it was going to go, and we heard a lot about, it's going to be over in how many months, and of course it hasn't happened that way. Nobody knows how long it's going to go. What I'm encouraged by is we're seeing people really want to get back to work, whether it's Kilroy or whether it's our tenants. What we're hearing is that people are frustrated about working from home. Some people like it, for sure. But we're also hearing that productivity is down 50% as a result of working from home. Now that is not going to be universal to every single company because we hear a lot of things that you see in the news and so forth. And a lot of times the headlines are pretty drastic, and then you read further on, and they say, well, we had to provide the work from home until July of 2021 or whatever the date might be because people need to make plans for their apartments, they need to make plans for their daycare, they need to make plans, and people are concerned about their workforce. So they're giving them as much flexibility as possible. With regard to the issue of quality of life, I will freely admit the quality of life in some of the cities like LA and San Francisco, obviously other cities across the country and basically the big liberal states or the big liberal cities have issues and they have to resolve them. But on a positive side, we're now seeing the number of tents in San Francisco, which increased dramatically, now be reduced with plans by the city to further reduce them and get the homeless off the streets into shelters. That's going to take time, but it's a positive thing that companies can see that the cities are making progress. And in LA, they're doing the same thing. They came out rather robustly about saying, we're going to make shelters available, you're going to have to get off because the city is all now recognized that their revenue base is going to be totally messed up if these companies leave, and they're starting to respond to the market forces that we all learned in Economics 101. So I'm optimistic about those things. I'm always a little pessimistic about policies of politicians because, as everybody knows on this call, I have a strong disdain for politicians, almost universally. Nobody would hire any of these people. And yet, they think they know better. But now what we're seeing in varying degrees of success or veracity is politicians say, hey, we've got to straighten this out. So that is a positive shift. What I'm also seeing is in the case of Prop 15, which would reverse for commercial properties Prop 13 projections, we've seen that go from approximately a 20-point positive spread for yes votes on Prop 15 to now it is running behind for no votes on 15. That has been the result of a lot of people, not just in the real estate industry, but primarily getting together and raising $75 million, $80 million, whatever it is, to get out the real and true information of what a yes vote on Prop 15 would do. That coalition, I have a meeting later this week with some of the most powerful people in the state that want to join together, and Kilroy has been one of many forces that have been promoting this to have a coalition of businesspeople from the real estate and other industries to influence the policymakers. I haven't seen that in 20 years in California. So there are some positive things. With regard to quality of life, the quality of life in some cases has gotten better because there have been some reductions in the residential rents and so forth in some of these markets. So it's a bit of fits and starts, but I'm seeing some of the green shoots that I didn't see before. If we have real problems? No question about it. With regard to demand, while we are not seeing a lot of multi-tenant, unless their leases are coming due, talk about significant increases in space. We are seeing some really big deals, that Rob can cover, that are being transacted for all of our markets, and we have negotiations or discussions with both tech and life science with regard to a number of our markets for development. So those are all positive. I have to look at things as a leader of a company hopefully as a glass half full rather than a glass half empty. I'm feeling better about what I'm seeing now than I was three months ago because first you have to have people that agree there is a problem, and then they want to work together to address the problem, and that it's vitally important to do so. That was not the reality three or six months ago. I think once this election that's just such a mess gets behind us, I think people will hopefully come together and not just be as pessimistic as we've seen in this cycle and others. Those are kind of my thoughts based upon interactions with others. And with regard to space per person, what we're hearing is that, and Rob, correct me if I'm wrong on this, we're looking at roughly a 30% to 40% increase in space per person from what the trend was pre-COVID. Now who knows how that will play out. Whether we'll see 30% of people work from home and then there is 30% more space per person, I can't tell you how that's going to work out. It will work out, and we'll see it over time. Did I hopefully capture everything you asked?

Michael Bilerman, Analyst

Yes. That's impressive, John. And I give you a heads up on the question. So thank you for that.

John Kilroy, CEO

You're welcome. I want to emphasize that the role of the modern CEO in real estate has changed significantly from what we used to do. We are now deeply involved in the political landscape. I won't name names, but you will hear from other calls involving some West Coast and East Coast REITs. We are all discussing our frustrations, and we are becoming more assertive.

Operator, Operator

Our next question comes from Nick Yulico with Scotiabank. Please Nick, go ahead.

Nick Yulico, Analyst

Thanks. John, I guess, I'm curious what your thoughts are right now about looking at pieces of portfolio and seeing them as candidates for asset sales or additional joint ventures? I mean, you have done that in the past. You haven't bought back much stock historically. Would you look at that, I know you have a program in place. Would you consider increasing or even maybe if you did some more asset sales, preserving some capital, putting that aside to fund future development of Oyster Point so you don't have to do, let's say, another forward equity deal right now? And where your stock price is?

John Kilroy, CEO

I have no interest in selling stock at these prices. Regarding the development program, we had initially forecasted pre-COVID that the only project we might initiate in 2021 would be Oyster Point Phase 2, and that plan is still on track. We believe Phase 2 will make sense soon given the significant demand we're experiencing. We are currently engaged in early stage negotiations and proposals for large amounts of space, ranging from 300,000 to 500,000 square feet. I'm optimistic about these developments. I also want to emphasize that we have a favorable land basis at the Flower Mart, which I have mentioned could be significant in the next cycle, though I will not move forward with the Flower Mart until we have more clarity. It would be unwise to proceed without that clarity given the significant investment involved. As for asset sales, our efforts have been hindered by the building we are selling in the Bay Area, which is a strong structure valued around $900 per square foot. Unfortunately, regulations have made it difficult to conduct tours of many properties. However, that building was available for tours and was on the market before COVID hit. When it comes to recapping or selling projects, we always consider those options. I am open to various possibilities and have no emotional attachment to any specific building, regardless of its appeal. We have multiple options available for us. Tyler can provide more details on funding for Phase 2, which addresses part of your question. Did I cover everything, Nick?

Nick Yulico, Analyst

I guess just a follow-up is on the tenant side, if you could just talk about how those discussions are going? Your renewals this quarter did have a shorter lease term, averaging 17 months. What kind of drove that? Should we think that that continues over the next couple of quarters, shorter-term renewals as tenants kind of figure out what their space needs are? Also, are you seeing any increase in sub-lease space within your own portfolio? Thanks.

John Kilroy, CEO

Rob, do you want to cover those, please?

Rob Paratte, COO

This is Rob Paratte. Good afternoon, everyone. So the first part of your question relating to tenant sentiment and what's going on with renewals across the board and across, I mean across the country, really tenants are paying rents based on flexibility. They are looking for ways to avoid making long-term decisions while they try to figure out how to get their workforces back. As John said earlier, a lot of tenants have plans to come back in June, July, sometimes it's later summer of '21. With that kind of lead time, it's much harder for them to predict when they're going to have their full workforces back. So flexibility is key, and we've always worked very closely with our tenants. Frankly, it's one of the ways we keep our renewal rates so high is working with them when the markets are very tight and finding alternatives for them. In uncertain markets, we also work with them. So I think the trend of short-term renewals will continue. I don't know how long that will continue because oftentimes that kind of flexibility comes with a cost because as you look at these expirations that will happen, whether it's 17 months or 24 months or 36 months out, they are likely to be expiring in what's an improving economy, because we're not going to be in the situation we are today forever. I always look at that as something that if I were a tenant, I'd keep my eye on because eventually demand will increase. And when it does come back, these expirations are going to be impacted. As we've mentioned with respect to sub-lease space specifically in our portfolio, there is some sub-lease space that's been put on the market. It's been well publicized. Excuse me. As Tyler has talked about on past calls, we tend to have a smaller tenant component in the Los Angeles area. We have had some sub-lease space occur down there. But if you look at Kilroy's overall tenant base, which is extremely strong in terms of the large tech that we have, none of the large tech companies have put any sub-lease space on the market in our portfolio.

Operator, Operator

Our next question comes from Steve Sakwa with Evercore. Please Steve, you may proceed.

Steve Sakwa, Analyst

Tyler, I know you took a small charge this quarter. As I look at the supplemental, you collected 98% of the rents in Q3. So the 2% that sort of wasn't collected, is that sort of part of the recent write-offs? Does that sort of limit the risk going forward, or is that 2% still unaccounted for and possibly future write-offs?

Tyler Rose, CFO

In terms of the calculations for the quarter and for October, we are still collecting rents for October, so that figure may increase. However, that's a separate calculation. Regarding the reserves, we are focusing on tenants who have been struggling and haven't paid. Out of the $0.02 we wrote off, approximately 60% was set aside as reserves for those tenants we were concerned about, while 40% was allocated for cash collections and writing off straight-line rent. Thus, it was divided 60-40, with 50% of that amount related to office space. So, it's broken down into several different components.

Steve Sakwa, Analyst

I guess, I'm just trying to assess, I know you can't take write-offs just to generically take write-offs. I'm just trying to get a sense for the amount of other problems that you're sort of monitoring. Are you sort of at this point toward the tail end of that or are there still other retailers or co-working tenants that are in the portfolio that you still have kind of some issues over?

Tyler Rose, CFO

I mean, it's hard to say. Obviously, we hope we're at the tail end. You can see how the numbers have trended from the first quarter to the second quarter to the third quarter, down every quarter. So we don't see anything else coming. I mean, there are some tenants in our portfolio, more on the retail side, in the gym side that we're watching and the co-working tenants who we continue to watch, but we don't anticipate a lot of the problems. But those are the types of tenants where we're watching.

Steve Sakwa, Analyst

And then I guess John or Rob, I don't know the last time you guys did 8,000 feet of new leasing. I know San Francisco has just turned on the ticket to allow non-essential businesses to come back. The tech companies have obviously given people months and months, if not quarters, to get back to work. So is it your belief that until the buildings are really more at 50%, 60% occupancy and you've got most of the folks back that new leasing just remains kind of a lull here?

John Kilroy, CEO

I'm sure Rob will have some comments. By the way I'm off mute, right?

Tyler Rose, CFO

Yes.

John Kilroy, CEO

I've been checking in on things. I've found myself speaking without realizing I was on mute in many meetings recently. I apologize for that. You're correct, Steve. People are starting to return to work in San Francisco and traffic is picking up. During my visits to the city recently, I noticed actual traffic, even though there weren't as many pedestrians as before. A month ago, the streets were almost empty. Now, there’s traffic on the 101 Freeway over the Golden Gate Bridge and congestion on the Bay Bridge. I saw traffic in Oakland near the airport too, which I hadn't seen in months. Things are improving with the plan to allow 25% of the workforce back in San Francisco. People will gradually return to work, though this won't happen instantly. There's still some fear regarding COVID; while some people are concerned, others aren't as much. It will take time to adjust. It's tough to identify a clear trend right now without sufficient data, so it's more of a feel for the situation, but I view it positively. It's possible that in some areas, depending on new case numbers, we might see some easing of restrictions after the election. There's a lot of political maneuvering involved. Rob, do you have anything to add?

Rob Paratte, COO

Steve, the only thing I'd add to that is that, if you go back to May and June, corporate real estate executives' sentiment was, I wouldn't say negative, but they were very concerned because they were looking at a tidal wave coming at them, which is how do we bring people back to work. They were thinking people would be back by June or July. They just had this tsunami coming at them. Today, they have plans in place. Every company we're talking to has some form of plan in place. They're actually in a lot of cases bringing people back into the office, smaller groups of people that have been asking to come in. So, I think once sentiment gets to that point that we're talking about now where they can take their eye off how to get people back in, I do think you're going to start seeing especially the larger companies look at how to secure longer-term requirements. I can't name names, but the company that we know quite well has hired 1,000 engineers since COVID started and they're going to need to put those engineers somewhere. In Hollywood, production is back on stage again. So you've got, Sony and Netflix in production. For every production job, the statistic is there are seven support jobs. So that's going to start impacting, we think, demand for office space there. Lastly, life science hasn't missed a beat. In fact, there is more demand for life science and discussions in life science are going on throughout our markets, which is really exciting for us to be working on.

Steve Sakwa, Analyst

Last question. John, you mentioned Flower Mart probably next cycle at this point. I just want to make sure, are there any issues or requirements on Kilroy that kind of start at some point given that you've got your Prop M or at this point, you've got your allocation and now it just becomes when it's economical for you to start?

John Kilroy, CEO

We have a unique development agreement that provides us with additional time to initiate our project, which essentially begins with laying a foundation. I'm not concerned about any limitations or potential delays we might face. The city is anticipating substantial revenue and numerous job opportunities from the Central SoMa area. They have invested in the Central SoMa subway and are planning various developments, including significant development fees from the Flower Mart and nearby projects. It's essential for them to secure that revenue eventually to support affordable housing and transportation initiatives. I believe they will be very cooperative in this matter. I'm not worried about this aspect at all, Steve.

Operator, Operator

Our next question comes from Craig Mailman with KeyBanc Capital Markets. Please Craig, go ahead.

Craig Mailman, Analyst

Clearly, life science continues to be a strong suit for the office sector. You have some projects ready to go. There has been talk about conversions. Are you concerned at all about an increase in supply in the near to medium term with everyone getting on the bandwagon?

Tyler Rose, CFO

You want me to touch on that, John?

John Kilroy, CEO

I may be on mute now.

Tyler Rose, CFO

Craig, I'll address that. Many of the conversions happening are simply that, conversions. Entrepreneurs are taking older office buildings and transforming them into what they hope will be successful life science projects. This is a challenging path. Issues like ceiling heights and the capacities of mechanical and HVAC systems can pose significant challenges, and modern life science companies seek top-notch, state-of-the-art facilities. Additionally, where we are seeing conversions, they are typically not in the key markets where we operate, such as Seattle, South San Francisco, or San Diego. It's certainly a trend; life science is a hot topic across the board. However, I believe these conversions represent a distinctly different product category compared to prime life science projects like Kilroy Oyster Point or our portfolio in San Diego.

Craig Mailman, Analyst

I don't know if John is still on, but he mentioned that you need to move into San Francisco after the financial crisis and have been opportunistic in the past. You've discussed possibly bringing your expertise to another market in this cycle. It seems that your knowledge in life sciences could translate into other markets. I'm curious, given the lack of distressed opportunities so far, if this is something you are considering as the pandemic continues and potentially creates opportunities for you to enter a new market in life sciences specifically.

Tyler Rose, CFO

John, have you come back? No. Eliott, why don't you cover that?

Eliott Trencher, Analyst

Hey, Craig. It's Eliott Trencher. Yeah, I'd say that is on our radar screens. We like the life science business and we're prepared to grow it if we see the right opportunity. But similar to what happened last cycle, where we didn't make our first acquisition until 2010, we're going to be patient. We're going to look at everything and move when we think it's appropriate.

Craig Mailman, Analyst

Any changes to yields on your residential projects that are under development just given the softening in the residential market?

Eliott Trencher, Analyst

I think it's fair to say that rents are down a little bit from earlier this year for sure. So I think that's a reasonable assumption on your part.

Operator, Operator

Our next question comes from Jamie Feldman with Bank of America. Please Jamie, go ahead.

Jamie Feldman, Analyst

I think you said earlier in your comments there are some pretty large deals floating around some of the markets. Can you just provide some more color on the size of those, the markets they're in, and maybe even the timing on when those tenants would actually do something?

Rob Paratte, COO

Starting with Seattle, there has been significant activity in that market over the last 45 days. Facebook, Google, and Amazon all secured space in 2020 during the pandemic. For instance, Facebook acquired the REI buildings in Eastern Bellevue at a strong cap rate. Amazon signed a 2 million square foot lease in Bellevue. Other renewal activities also contribute to a positive outlook for the Bellevue market. In San Francisco, which has had the most restrictive shutdown in the U.S., we are just beginning to see a 25% return to work. Life science has been a standout sector. As John mentioned, we have more interest than available space in Phase 2 at Oyster Point, and we are actively discussing opportunities with several companies, which makes me optimistic about that phase as well as the office life science market at Oyster Point. Additionally, there has been considerable activity in Hollywood and Culver City, where companies like Netflix, Amazon, and Apple are exploring expansions. Recently, Netflix expanded by approximately 300,000 square feet between Hollywood and Burbank, signaling strong demand in those submarkets. Furthermore, there has been some expansion on the West side as well, with Facebook taking about 85,000 square feet on the west side of Vista. San Diego has gained traction, with Apple expanding its presence there. Major tech firms are recognizing the potential of San Diego, and we are witnessing significant interest and activity in that area. Lastly, similar to South San Francisco, the life science market in San Diego is extremely tight, with high demand from life science companies.

Jamie Feldman, Analyst

Okay, that's helpful. I wanted to get your thoughts on the Dropbox announcement for the Dropbox Studios layout. Does that change how you would be designing buildings going forward? I just wanted to get your reaction in terms of does that something you think more tenants will be doing going forward?

Rob Paratte, COO

Is John on the call? I don’t want to jump in, John. I think many companies are experimenting at the moment, and the news reflects that. A few months ago, companies were announcing permanent work-from-home policies, but even those have revisited their decisions. Companies are now focused on how to adjust the workspace—tech companies have always offered flexibility to their employees. They’ve never mandated that people work in a specific location. Even before the pandemic, if a Google employee wanted to work in Austin, they would facilitate that. Flexibility has always been crucial. These companies are trying to figure out how to make the workspace safe, even with a vaccine, and how to boost productivity. Microsoft’s CEO Satya Nadella has been vocal about his concerns regarding the work-from-home trend and its impact, particularly regarding employee burnout and increased work hours. He is focused on productivity. Their workspace strategies now aim to enhance the social connections that they have invested so much in through hiring practices. Specifically, this may involve creating more areas for gathering and collaboration rather than rigid workstations. Numerous studies by various researchers have examined these trends globally. I may have used more time than intended, but I believe you will witness substantial changes in how office spaces are utilized and how companies will manage bringing employees back, with a focus on flexibility. We know that teams focused on product development will need to come into the office on specific days or during certain months, and the challenge lies in accommodating this with global teams converging at a central location. The studio concept seems to be shifting toward a layout that resembles hospitality rather than just fixed workstations or benches.

Jamie Feldman, Analyst

And do you think the design or the exchange lends itself to that or if you think it would be different?

Rob Paratte, COO

I do. I think one of the hallmarks of the exchange like Flower Mart are the large floor plates, and that's what you really need to accommodate. What I'm about is a large floor plate where if you have 70,000 feet, you can segment that floor into different functions. The architects refer to it as different neighborhoods, so different things happen in that space. It may be different departments that are working in those different segments or it may be a team that's working on software or trying to hack a database or what have you, where it takes collaboration and complex problem-solving and how does that work and flow. You're not truly segmenting this space with hard walls; you're making a space that again fits more into the hospitality arena. The best example I can use is how you've seen hotel lobbies modified to become gathering and meeting areas instead of just a place to check in.

Tyler Rose, CFO

Just as an aside, John is trying to get back on the call, but for some technical reason, he can't. So we'll just keep going. Hopefully, we'll get him back on as soon as possible. Operator, keep going.

Operator, Operator

Yeah, sure. Thank you. Our next question comes from Blaine Heck with Wells Fargo. Please Blaine, go ahead.

Blaine Heck, Analyst

Great, thanks. Probably for Rob or John, if he comes back. Clearly, there hasn't been a lot of leasing going on, but I'm wondering if you guys can give us any sense of how much you think net effective rents have declined from pre-pandemic levels in each of your markets? What has been the impact of sub-lease space on asking rents, especially in San Francisco and LA where you guys have the majority of your expirations next year?

Rob Paratte, COO

The challenge with determining net effective rents and their current status is the lack of sufficient data points. Only a limited number of new leases have been executed recently, particularly in the last three to four months. As John mentioned earlier, it is very difficult to finalize transactions without face-to-face interactions. In San Francisco, for example, recent renewals such as Goldman Sachs renewing their lease at 555 California at over $117 per foot fully serviced indicate that premium buildings in prime locations are not experiencing significant rent declines. Sub-lease space typically trades at a discount. Companies with employees working from home and leases expiring in the next year or two should consider sub-leasing to reduce losses or offset rental costs. I monitor sub-lease space across various markets, focusing on San Francisco. Currently, the reported figure is about 6.5 million square feet, but it may be closer to 7 million. Most of this space, approximately 80%, is in the financial district and mid-market areas. Half of the sub-lease space is set to expire in 2023. Therefore, if you are a tenant with space on the market set to expire this year, competing with direct and long-term sub-lease spaces will require significant price reductions. Some of this short-term sub-lease space may transition into flexible spaces as companies resume operations while maintaining social distancing. We have engaged in discussions regarding these trends. There is a general figure for the market, but it is essential to clarify the nuances within sub-lease spaces. We monitor this closely, considering both our tenants and market conditions. Lastly, regarding our Kilroy portfolio, we have very little space available for direct leasing. We only have a 6% roll in 2023, with the largest vacancy being 60,000 square feet across the portfolio. It is difficult to provide a precise answer about direct net effective rents, as the situation for sub-lease spaces varies widely based on type and conditions.

Blaine Heck, Analyst

Tyler, just looking at same-store cash NOI for the quarter, it seems as though the reduction in expenses was the major driver of the positive results. I just wanted to ask if all of that expense reduction was related to lower utilization in your office buildings or whether there were any other expense savings that you think could carry forward in kind of a more normal environment?

Tyler Rose, CFO

Yes. The reason wasn't totally related to expenses, in fact, not hardly at all because, if you noticed, tenant reimbursements were down by approximately the same amount. So we just didn't recover the offset of that. So it wasn't really related to expenses as much as it was related to higher rents and the burn-off of free rent. There is less occupancy in the buildings, and so we are having less expenses, but we're not benefiting from that as much as we are benefiting from the higher rents.

Blaine Heck, Analyst

Got it. Thanks.

Tyler Rose, CFO

John, are you back? No. Okay.

John Kilroy, CEO

Tyler, can you hear me?

Tyler Rose, CFO

Yeah. Now we can hear you.

John Kilroy, CEO

Okay. Sorry, everybody. I've been hearing classical music. It's been very frustrating because I've connected now for the fourth time. I can hear everybody, but nobody could hear me until this moment. I apologize. This is a good reflection of working from home.

Operator, Operator

Okay, thanks. Our next question comes from John Kim with BMO. Please John, go ahead.

John Kim, Analyst

Thanks. Good morning. John, regarding your comments on life science as a growing trend. Do you have updated views on whether or not Flower Mart could be developed as a life science asset?

John Kilroy, CEO

Sure. I mean, I don't know that it would make sense, but we could see it. It's interesting. Everybody is on the bandwagon, as Rob said about life science. If anybody knows where Richmond is in the Bay Area, it's on the north and east side of Marin. It is where Standard Oil has the big refinery and they paid all the citizens that live there several thousand dollars a year because of health concerns. There are two old malls that have failed. They are now being marketed as life science projects that can accommodate several million square feet. You can call a donkey a horse, but it doesn't make it a horse. I think what we're seeing right now is everybody is trying to say life science is hot. So let's convert everything, let's try to redesignate every property in every city and everywhere as life science. You're going to hear a lot of that, and a lot of it's just total nonsense. With regard to the Flower Mart, sure, we could do that. I don't know that life science wants to be there, but we certainly could.

John Kim, Analyst

In your brief absence on the call, Eliott mentioned that you may be looking to enter other biotech markets. I'm wondering if the main rationale for that is that it would give you some operational advantages to have a more national biotech platform or do you see development opportunities on the East Coast that are as attractive as the West Coast?

John Kilroy, CEO

I'd like to answer that, but I'm not going to because as you know, everybody that's in life science is going to be listening to what we have to say, and I'm not going to talk about any strategic thoughts that we have. But know that we are focused on life science. We are focused on looking, and we have been looking for a number of years at a couple of different markets. I don't want to be buying at the top of the market unless we believe rents are going to go up substantially and so forth. I want to make sure that if we move into a market that we can have the scale that allows us to do the kind of things that we do at Kilroy well, which requires talented people and requires the scale to make that happen. So more to come. Nothing imminent, but we're very focused.

Tyler Rose, CFO

Just to set the record straight. I don't think Eliott said that we're actively looking at other markets, to be clear. I think he said...

John Kilroy, CEO

When I say actively, I mean we are active in evaluating other markets. We are not active in executing any strategy for another market.

Tyler Rose, CFO

Right.

John Kim, Analyst

That makes sense. Okay. Tyler, you mentioned a $75 million asset sale. I was wondering if you could provide any color on the sale? Was it a non-core asset, or did you just find opportunistic pricing? Can you give any guidance on expected cap rates on the sale?

Tyler Rose, CFO

I think we've mentioned it briefly. It was a marketing process that began before COVID and started earlier this year. John indicated it was approximately a $900 per foot transaction. We won't provide further comments since we haven't finalized the deal yet and are still under confidentiality. We aim to close within the next month or so, at which point we can share more details. However, we are limited in what we can discuss regarding the transaction until it is completed.

Operator, Operator

Our next question comes from Omotayo Okusanya with Mizuho. Please Omotayo, you may proceed.

Omotayo Okusanya, Analyst

Yes. Good morning to you all over there on the West Coast. John, just one for you. A quite a few polls out there regarding Prop 13, but the one you just mentioned is the first one I have ever heard of that has the yes votes behind the no votes. I'm curious if you could talk to us a little bit about that poll and kind of the number of firms involved in it? Why you have more confidence in that one versus some of the other polls that have Prop 15 passing?

John Kilroy, CEO

Well, because most of the polls are slanted and I don't think they're accurate. The groups that we're working with have had historically the most accurate polls on these issues, and that's the data I'm looking at. I can't tell you the names of them. But it's a close race, for sure. This demonstrates in California just how complicated it is because we have a heavily biased state government. It's all Democrat; Democrat Governor, Democrat Attorney General, Democrat Senate, Democrat Assembly. They had gone out with a description of Prop 15 that is remarkably obscure as to how it was approved by the attorney general, and it misled people. When you read it, it sounds good. It sounds like 40% is going to schools, some of the other percentage is going to governments. But when asked the question of whether this money is going to the unsustainable pension funds or to the classrooms, they wouldn't answer. What does that tell you? As people learn more about that, it has changed. We see a struggle that many of us have that are fighting these issues is that we're battling what I consider to be a fairly corrupt machine of misinformation to the voters. We see that same kind of thing on both sides with regard to the national election. The polls are often biased. I'm not a pollster, so I can't go much further than that. We've seen this major shift. It's close, but we are seeing again almost every week. I'm cautiously optimistic that Prop 15 will get defeated. Cautiously optimistic.

Operator, Operator

Our next question comes from Daniel Ismail with Green Street. Please Daniel, go ahead.

Daniel Ismail, Analyst

Great. Thank you. John, I want to circle back to some comments you mentioned about productivity being down for the term working from home. In your discussions with tenants, are you noticing any distinctions among industries, larger or smaller firms, or geographies where you're noticing more of those concerns regarding productivity come up?

John Kilroy, CEO

Well, consider this. In the production and entertainment sectors, if you're unable to go to work, your output significantly suffers. Many of the large tech companies that Rob mentioned are experiencing noticeable drops in productivity. I heard a story from one of our executives in San Diego. She and her husband remodeled their house, enjoying their time with their children and pets, thinking it was great. Months later, she believed she could work from home indefinitely. However, once she returned to the office a few months later when San Diego reopened, her perspective changed; she decided she never wanted to work from home again. It's difficult to separate work from home life—you're constantly on call, dealing with kids on Zoom, barking dogs, and limited conversation with your spouse. I believe anthropologists will find this period fascinating when looking back 10 or 20 years from now, as the social consequences, especially for children and executives, may be shocking. While I'm not citing exact figures, I've heard from the head of a major psychiatric department that divorces have increased by 34%, drug and alcohol use is rising, and suicide rates are also up. These trends indicate widespread unhappiness. The belief that everyone can happily work from home is unrealistic.

Daniel Ismail, Analyst

And then just a quick follow-up on the Long Beach expiration. Any update there in terms of backfilling that space or long-term plans with that property?

Rob Paratte, COO

We are currently working on a medium refresh of the property, which includes landscaping and updating the lobbies. Regarding the vacancy, I don’t want to provide too many details due to ongoing discussions, but I recently had a call with a reputable company that is considering our transaction and will present it to their executive team at the end of November. We are optimistic about our chances with them, even though they may not take all the space. This reflects the demand we have. However, the process is taking longer than anticipated because it is time-consuming to coordinate discussions on renewal, potential relocation, and costs with all the different teams involved. I am personally optimistic about the future of our Long Beach location. It is a top-tier asset in that submarket, ideally located between Los Angeles and Orange County. This prime positioning explains why we have a strong lineup of national companies with regional offices looking to settle there.

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. Please, Mr. Tyler.

Tyler Rose, CFO

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

Operator, Operator

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