Good afternoon and welcome to the Kilroy Realty Corporation Fourth Quarter 2018 Earnings Conference Call. All participants will be in listen-only mode [Operator Instructions]. After today's presentation there will be an opportunity to ask questions [Operator Instructions]. Please note this event is being recorded.

I would now like to turn the conference over to Tyler Rose, Executive Vice President and Chief Financial Officer. Please go ahead..

Good morning everyone. Thank you for joining us. On the call with me today are John Kilroy and Jeff Hawken as well as other senior members of our management team who are 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 Web site 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 Web site.

John will start the call with our view of the fourth quarter and the year; Jeff will discuss the conditions in our key markets and I'll finish up with financial highlights and review of our initial 2019 earnings guidance that was published yesterday in our earnings release. Then we'll be happy to take your questions.

John?.

333 Dexter, a 650,000 square foot project in the South Lake Union Submarket of Seattle; One Paseo, a 1.1 million square foot mixed-use office, retail and residential project in coastal San Diego's Del Mar community and our Hollywood development of 570,000 square foot mixed-use project.

In Seattle, we continue to make progress on lease negotiations with several tenants at 333 Dexter. The strength of the market in Seattle remains robust and we expect to have a substantial leasing on this project by shell completion that is scheduled for later this year.

Also, I would like to bring you up to speed on the new tunnel that connects South Lake Union to the South end of the city. Just yesterday, SR-99 tunnel opened to traffic after five and a half years of construction, improving traffic flow and transforming the pedestrian environment around our 333 Dexter project.

Travel time from the South end of the city to the north end of the city is now estimated to be less than three minutes, that is a really big deal for our development and for South Lake Union.

At our One Paseo project, the retail space is essentially fully leased, marketing is underway for the 608 residential units to be delivered over the time beginning mid-summer and office pre-leasing activity is roughly 67%. The office component is commanding premium rents that are 25% to 30% higher than existing top of class product in the market.

With the Netflix lease down in place for all of the office space at our Hollywood development project, we commenced construction on the project's 193 residential units. We expect to deliver the office space to Netflix in mid-2020 and the residential tower later that year.

Taken together, these three projects represent a total estimated investment of over $1.5 billion, with an average delivery timeframe of early 2020. Upon stabilization, projected cash NOI is close to $100 million, with the product components to be 65% office and 35% residential and retail.

In terms of our development pipeline, we are making progress on both the Flower Mart and Kilroy Oyster Point. With regard to the Flower Mart, in early December, San Francisco's Board of Supervisors unanimously approved the Central SOMA Plan, which allows for Prop M allocations to be allocated this spring.

As anticipated, there have been a few lawsuits filed that opposes Central SOMA Plan and the timing on how those get sorted out is still unclear. We continue to see significant interest from a variety of large users in what is arguably one of the most sought-after commercial submarkets in the country.

At Kilroy Oyster Point, we are extremely well positioned with 2.5 million square feet of entitlements in the supply constrained market that has a vacancy rate of about 2%. We are in numerous discussions with potential tenants in connection with Phase 1, which includes three buildings totaling 600,000 square feet.

Wrapping up, we will be focused on three key objectives in 2019. First, execution in our development pipeline.

We continue to believe that development is the best way to create shareholder value at this point in the cycle and our focus is to ensure that our current projects deliver on time and on budget and we make progress in securing entitlements for the Flower Mart. Second, maximizing value in our stabilized portfolio.

This includes leasing up our vacancies, driving rents where possible and proactively addressing expirations. And third, maintaining a strong and flexible balance sheet. This includes keeping our metrics conservative and having access to multiple forms of capital. That completes my remarks.

Now, I'll turn the call over to Jeff for a closer look at our markets.

Jeff?.

Thanks, John. Hello, everyone. As John stated, conditions in our West Coast real estate markets remain healthy. Let's begin in San Francisco, which remains among the strongest commercial real estate market in the country. 2018 was a spectacular year in leasing large blocks of space.

There were 21 transactions greater than the 100,000 square feet, outpacing 2017's record of 18. This drove rent increases across the market and with no new product being delivered until 2023, we expect rents to continue to increase.

For the year, San Francisco delivered Class A rent growth of 12% year-over-year, more than twice the level the brokerage community had initially forecasted. In San Francisco's SOMA, South Financial and Mission Bay districts, Class A direct vacancy rates were 1.8%, 4.6% and 6.6%, respectively. In South San Francisco, life science vacancy rate was 2%.

And in Silicon Valley, Class A direct vacancy was 6.1%. We are currently 98.5% leased in the Bay Area and our in-place rents for the region are approximately 32% below market. In the Greater Seattle region, market conditions echo that of San Francisco.

The region's record-setting growth has shown no indications of slowing down, as the labor pool for the technology-focused workforce continues to migrate to Seattle. With limited supply, Class A rents hit a record high. Class A direct vacancy in South Lake Union is 1.7% and in Bellevue, it is 5.3%. Our Seattle portfolio is currently 97.7% leased.

Our in-place rents are approximately 10% below market. In San Diego, market fundamentals in 2018 outperformed a strong 2017 in terms of vacancy, net absorption and rental rates. This was driven by expansion in the technology, life science and financial services sector.

Most notably, Apple leased a 97,000-square foot project in University Town Center, deepening the technology concentration that already exists with major names like Amazon and Walmart Labs. The vacancy for competitive product in Del Mar was approximately 9%. Our San Diego portfolio is currently 90.9% leased.

We reported last quarter that our in-place rents were for the first time in 40 quarters at market. Rents have since continued to increase and we are now approximately 4% below market in San Diego. According to Crunchbase, Los Angeles is now ranked as the third largest ecosystem for start-ups in the nation.

The region had a sixth consecutive year of positive net absorption, generating all-time high rents as major tech media companies such as Netflix, HBO, Amazon, Facebook and Apple continue expand across the market. Class A direct vacancy in West LA was 6.5% and Hollywood was 7.9%.

Our Los Angeles portfolio is currently [96 point] [ph] in-place rents are approximately 13% below market. On a portfoliowide basis, our estimated average in-place rents were approximately 20% below market. That is the greatest differential in company history. We are in excellent shape on our 2019 expirations.

We have leased 929,000 square feet of the 1.4 million square feet set to expire in 2019, leaving only 4% remaining to be leased for this year and we are focused on getting ahead of future expirations with only two explorations greater than 100,000 square feet in 2020.

In 2019, we will see the benefit of some of the big leases we executed last year, including Amazon in Seattle and GM Cruise, DoorDash, Splunk and Nektar in San Francisco.

We do expect on average about three to four months of downtime associated with each of these leases when the prior tenant moves out and we complete tenant improvements for the new tenant. That's a snapshot of our markets and now Tyler will cover our financial results in more detail.

Tyler?.

the first phase in the third quarter, second phase at year-end and the third phase in 2020. Our forecast for year-end office occupancy is between 94% and 95%. We project positive GAAP, same-store NOI growth of 3% to 4%.

We expect flat cash same-store NOI this year given the downtime associated with TI buildout on some of the large move-ins Jeff discussed. The downtime will impact our same-store numbers in the first half of the year, but should be positive in the second half of the year. G&A is projected to be in the $81 million range.

As we previously reported, we expect to draw down on the equity forward by May. From a 2019 FFO perspective, our 4Q normalized run rate was $0.90 or $3.60 on an annualized basis.

We project the new lease accounting change will reduce FFO by approximately $0.09 per share, which will be partially reflected in G&A and partially in a new line item on our income statement. The dilution from our projected dispositions is estimated to be about $0.08 per share, subject to actual timing.

The impact from new development NOI including The Exchange, One Paseo retail and residential is estimated to be about $0.18 per share positive. And finally, the impact from GAAP same-store financing and other factors is estimated to be about $0.07 per share positive.

Taking all these assumptions into account, our initial earnings guidance for 2019 is $3.58 to $3.78 per share, with a midpoint of $3.68 per share. To put that into perspective, without the accounting change, our year-over-year FFO per share growth would be approximately 5%. That's the latest news from KRC. Now, we'll be happy to take your questions.

Operator?.

We will now begin the question-and-answer session. [Operator Instructions] The first question comes from Craig Mailman with KeyBanc Capital Markets. Please go ahead..

Hey, guys. On 333 Dexter, it sounds like you guys are in talks with potential tenants. I guess, I thought maybe a deal could have come together a little sooner given the quality of the product and the location.

Had people been waiting for the new connection to be completed or what do you think has kind of maybe delayed that a little bit relative to maybe Street expectations?.

Hi, Craig. This is Rob Paratte. I'll handle that. And thanks for the compliment on the project. It's really looking great now. The I-99 undergrounding project has been on people's minds and on radar screen for several years.

I think the great news is that, with very little hiccups and delays, it's opened relatively on time and that's a critical factor in everyone's assessing that project and what it means for 333 Dexter.

And to your point, we are pleased with the activity we have and I think depending on the tenant, it's very company specific and also dependent on size, just how long it takes from initial discussions to actually getting a lease executed..

And do you think -- I mean given kind of the tenants looking at it, how do you kind of envision that breaking out in terms of amount of tenants and kind of where you guys maybe on the demand versus availability?.

Yes. I don't want to comment on the mix and that sort of thing at this point..

Okay, fair. And then just on the Flower Mart, with the challenges from the community, kind of how has that changed maybe internally your view of commencement dates relative and maybe capital needs here, you guys have done a good job raising debt, equity and doing dispositions.

But I guess, as you guys are looking out at Oyster Point, Flower Mart beyond 2019. It looks like maybe I would've thought maybe dispositions would have ramped a little bit as you guys were able to pull it back in '18.

Is there some fluidity there in terms of disposition volumes, just given some of the timing?.

Well, yes, we try to -- it's John, we try to kind of do just in time when we can. In terms of the Flower Mart, almost every project in -- of substance in California gets a sequel lawsuit. It's just the way the homeowners and the various property owners deal with projects, it costs you, I think something like 30 bucks to file a lawsuit in California.

I have my own thoughts about how this is going to play out, I don't really want to err on publicly, because it is fluid. We're working with the city as are the other major developers that own properties in SOMA to try to get things resolved. I think they'll clearly get resolved, it's just a question of how long.

In terms of the timing, even if we expect to get our development agreement signed late sometime in the fourth quarter, that would permit us to start development. I don't think we want to start development with the lawsuits against Central SOMA.

It's not against our project, it's against some other projects and some other issues related to other projects in the area. I don't think we would want to start without those lawsuits being resolved, really sufficient clarity. Having said that, we never anticipated starting construction until we move the Flower Mart.

In the Flower Mart, we won't move until we get the development agreements signed. We'll continue with that. So, will this delay our start, from what we had projected, which was I believe end of '19, early or mid '20, I don't know.

With regard to Oyster Point, that's all entitled and there's no issues there at all with regard to entitlements and so, we'll go through that phase by phase. In terms of how that relates to dispositions and so forth, like I said, we'll look at dispositions or ventures with regard to our needs and Tyler does a pretty good job figuring that out.

So I think we're in really good shape across the board.

Anybody else?.

All right. That's helpful. Then I guess just a tag onto that last one.

You are kind of getting back the stock to where you guys did the Flower deal and just thoughts on cost of equity here relative to the yields versus dispose and the kind of the attractiveness of each of those capital sources?.

Tyler, you want to take that one?.

Yes. I mean, right now, we don't have the need for capital. So, we don't have to make that decision, but you're right, we have to balance the cost of equity versus the cost of debt versus the cost of joint ventures and the cap rates on dispositions, which still remain strong.

So, we don't need to make that decision today, but we will be following that as we go forward..

Great. Thank you..

The next question comes from Manny Korchman with Citi. Please go ahead..

Hi, guys. Maybe for Jeff or Tyler. When you think about the remaining expirations in 2019, got about 500,000 left.

How should we think about sort of retention on those and I think on the last call, you mentioned 175,000 square feet tenant as sort of the largest potential expiration, if that's one location and where is that at?.

Yes. So, this is Jeff. On the 2019, so again, we've got about 460,000 square feet remain on expirations, none of them are larger than 50,000 square feet and so we're in negotiations with a lot of the remaining tenants.

There's two or three, about 25% of the remaining, we know they'll vacate, but again they're all fairly small and spread across the portfolio..

Thanks. And Tyler, on the '19 disposition guidance, a few questions. One, how much of that is going to be JV versus outright sale.

And then just help us figure out sort of where timing and the yields will be on those planned dispositions?.

Yes. I mean, right now, we're not anticipating those will be ventures, so this will be straight sales, but obviously that could change. Timing would be sort of third quarter, mid-year to third quarter. And cap rates, we always are fairly conservative on our cap rates, we're probably in the low 6 to pick a number..

Okay. Thanks, guys..

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

Thank you.

I guess just sticking with the guidance first, Tyler, can you give us some thoughts on what AFFO and your dividend coverage looks like based on your outlook?.

Yes. So, our payout ratio based on our CapEx modeling at this point is sort of in the mid 80s..

And AFFO?.

We think of it as FAD, but yes, AFFO FAD..

Okay. Okay.

And then, can you help us think through just the pay or kind of quarterly what same-store looks like and what earnings looks like? Just how do we -- whether on a GAAP and cash basis, just what the -- as we go throughout the year, what the changes will be?.

Yes. As I said earlier, it will be negative in the first couple of quarters and positive in the second. I mean on a cash basis, it's roughly in the negative 5% range for the first two quarters and then positive 3% and 6% in the last two quarters. Those are the current estimates. But as you know, it's very hard to model same-store.

So those numbers will move around..

Okay.

And what about in terms of FFO?.

FFO quarterly guidance, we don't provide quarterly guidance..

By quarters? Okay..

We don't discuss. No..

And then, John, just thinking about the reserve for the retirement reserve. Two questions.

One is, can you just help us think through or give us your thoughts on that payment? And then, secondly, when you sit back and think about the next 10 years of this company, given you are thinking about retirement, how should we think about what Kilroy looks like over that period?.

Well, I'll let Tyler to answer the first part and I'll answer the second part.

Tyler?.

Yes. So, on the retirement accrual, basically under John's new employment contract, he would receive a cash payment if and when he retires. So it's a potential payment.

It's a non-cash charge at the moment under the accounting rules, potential payment upon retirement are accounted for differently than normal severance payments and so the bulk of the retirement payment is required to be expensed in the period the agreement is executed, so that's why it was expensed in the fourth quarter when the agreement was executed..

In terms of the second part of your question, Jamie, we've got a very robust succession planning going on for the last several years. We have a committee that's a Board committee that's on top of that and we deal with that at each Board meeting that relates to emergency situations whether it's me or anybody else as well as long-term.

We don't disclose who might be candidates for any particular position in regards to the succession. In regards to me, I just turned 70. I'm feeling pretty good. I think that most people who know me, I think I'm on top of my game and yet, this is a five-year extension. I had to make a decision on what I wanted to do.

The company obviously wanted me to stay. We've got a lot of big projects and things going on. And my hope is that we will, over the next few years, be able to determine who the next CEO will be, will I move to Chairman and we have a new CEO in five years. I can't tell you specifically how it's going to go.

But, I think to be very prudent for our shareholders and for all the stakeholders that we do business with and all the employees of Kilroy, it's important to have a plan. So that's where we're at and we have a lot of good candidates. I think the ideal person is probably a lot younger than me and a lot smarter than me and we'll find out who that is..

Okay. That's helpful. All right.

And then, I guess just a final question, what are you assuming for leasing spreads in '19 in the guidance?.

Well, I think Jeff went through the -- where we are by market. I mean we're 24% under market for our 2019 expirations..

Okay, all right. Thank you..

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

Well, thanks. I guess, the first, just a question on Oyster Point. John, trends in that market are very strong as you talked about, felt like this quarter you had announced a construction start there, yet you haven't.

So, I guess I'm just wondering what's holding you back at this point from starting the first phase there?.

Well, nothing is holding us back. We've been under construction with the site work and all the roads and all the rest. Originally, when we structured the purchase and the sale agreement, the previous owner was going to do that work. We took that work over them, got appropriate credit for the cost of that and for the timing and so forth.

But we are well under way with all that and we don't need to start yet. We have to make that decision fairly soon.

And Tracy is here with me, the delivery date assuming things just go seamlessly from the current site work and pre-development work to construction, to completion, the completion date for shell is scheduled -- would be scheduled for when?.

Roughly, quarter two 2021..

Yes. So, stay tuned..

Okay.

And in terms of M&A, do you feel like you need to get leasing done at Dexter before you start Oyster Point?.

No. I don't think the two are connected at all. Both are very strong markets, different kind of clientele. We're right in the catbird seat with regard to South San Francisco life science. I think we've got the best material site down there. Yes, of course, BioMed, Blackstone has been very successful.

They started their building just next door to us and leased it and they have another phase. So, between them and we, we think we sort of control that market..

Okay. It's helpful. Just one other question, Tyler, on the same-store NOI guidance. Trying to square that up with the occupancy guidance. I mean, I get it that there is move-ins, move-outs that are affecting the year and the cadence of the year.

But the occupancy guidance and it looks like it's showing an increase in occupancy by the end of the year, and struggling to see how that happens with a flat cash same-store NOI growth guidance. Thanks..

Yes. As I've mentioned, the flat is being driven by the first half of the year and it turns positive in the second half. So, I think that the projections assume that the occupancy improves in the third and fourth quarter..

Thank you..

The next question comes from John Guinee with Stifel. Please go ahead..

Great. Nice job, guys. Hey, Tyler, about eight months ago, at the June NAREIT, you gave a pro forma FFO of $4.46.

Assuming all the development hit, which is about a $1.10 a quarter by year-end 2020, is that still attainable?.

Well, remember that was all things being equal with the lease accounting change and other things, you have to adjust for that, but I think we still anticipate that same general growth of NOI on an annualized basis by the end of 2020 assuming that we've completed the development as we laid out and it's leased, Dexter is leased and so forth.

So, and again, this came up on the last call, but we have certain disposition and estimates in our numbers and to the extent we decide to sell more than our current plan or sell less, that could either increase or decrease the number and it's assuming leverages consistent and so forth.

So, I think we still anticipate strong pickup in NOI by that point, but it does move around and the lease accounting change will impact that..

And then, John, I think you'd mentioned that you think that you're going to get about $70 million of stabilized cash NOI for Dropbox plus Adobe at Hooper. Looks to us like that's about an eight plus yield on cost on a cash basis.

Is that an accurate way to look at it?.

Yes..

Okay.

And then, the last question is DIRECTV, how many years do you have left on that lease? And is that something that's pretty soon becomes decreases in value rapidly in the private market?.

No. I think the opposite. Tyler or Jeff, you can -- you remember better than I.

How many years are left on that lease? What's the number?.

Yes, September of '27..

Okay. So, there's roughly eight years left. Is that right? So, eight and a half years.

In terms of the rent, it's way below market and El Segundo has been a hotspot recently with the lack of available space on the west side and with the traffic patterns continuing to deteriorate, the South Bay isn't the greatest market when you get down south of El Segundo to the Harbor Freeway that area that we've never liked.

But El Segundo has become very strong both with regard to people trying to acquire product in the area as well as tenant demand, including a number of media tenants and so forth. So, I think our mark-to-market on that asset is, I'm looking at Steve, across from me, I don't know if you know it or Jeff, but the rent is really low there.

The mark-to-market -- the rent is very low in our project in El Segundo..

Okay.

Can you repeat that El Segundo as a hotspot?.

Well, relatively speaking, okay, John. I mean there's tall people in different cultures that aren't just tall than some of the people in other cultures. So, it's all relative, but El Segundo has now become a much stronger market that we've seen over the last 10 or 15 years.

So -- and I think that just I think -- so, we're kind of debating, we always take a look at all of our assets annually, try to assess the markets where they're going. And I've been pretty pleased with the data on El Segundo in terms of where rents have gone and where demand has gone.

Rob, I know the rents now in that market are getting to what in El Segundo or Jeff?.

Yes. There are -- 3.50 full service gross per month, so they're definitely have been increasing significantly..

And that's about $0.70 or so -- $0.60 more than what we've got with DIRECTV, I think..

All right. Thank you..

Yes..

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

I may be mistaken, but I think I'm pretty tall from my culture.

You had a busy leasing quarter and I realize that, but when the equity markets were in turmoil back in December, did you see any pullback in decision-making among any of your tech tenants that may have spilled over to this year?.

No. To the contrary, we do as I've mentioned many times before and Rob and others have mentioned, we have NDAs with quite a few people and when I say quite a few, I'm talking about dozens. And we share what we're doing, they share what they're doing and so forth. We've not seen any slowdown in people's rate of growth or their plans for growth.

We've seen people have a shift deciding that they want to grow in a market versus another market because of labor. But, we haven't really seen any decline and this from a trend standpoint, I think we're pretty well set up. If you look at the vacancy rates in most of our markets, they are really frictional. They are anywhere from 1% to 3% or 4%.

The one difference is our Del Mar market in San Diego, where the vacancy rate is higher, but if you break it down into the quality stuff, it's pretty low and we're seeing good demand up and down. I keep waiting for it to slow down and we just haven't seen it..

Okay. And on 100 Hooper and The exchange on the $70 million of stabilized NOI that you expect to get next year.

Can you just update us on what you expect will be contributed this year, a quarter?.

Yes. We didn't provide details by quarter. But as we said, our new development for 2019 will be generating $0.18 of effective FFO to the bottom-line or I should say NOI..

For 2019?.

Yes..

Okay.

And then Tyler, on the forward equity deal, is there any costs associated with waiting as far as when you execute the sale, in other words, are the proceeds dividend adjusted?.

Well, if we would have raised our dividend and when impacted, but if we don't change our dividend, then no, it has no cost..

So logically, would you just execute 12 months after the transaction?.

Yes. I mean it depends on the need for proceeds, if something came up earlier, we could draw down in pieces as well. So, it's sort of like an ATM, but at the moment, we are planning to draw it entirely in May..

Okay. Thank you..

The next question comes from Daniel Ismail with Green Street Advisors. Please go ahead..

Hey, guys, good morning.

Can you provide an update on yield expectations for the academy resi and office component at One Paseo?.

Academy resi and which?.

The office components in One Paseo?.

Yes. I don't want to get in related to office yields while releasing. It's not a very good thing from a competitive standpoint. So, forgive me for not answering that one.

On the resi, Tyler, where we are in the -- on Academy, we're sort of in the 60s range, is that right?.

Yes, 5% to 6% range..

Okay.

And maybe on Columbia Square resi, the drop in occupancy quarter-over-quarter, can you give us an update on your plans for that asset?.

Plans as in what?.

Just on explaining why the drop in occupancy quarter-over-quarter?.

Sorry, I think it's --.

Columbia Square..

Oh Colombia Square, Steve, I beg your pardon.

I thought you were saying One Paseo and I didn't get the connection, but Steve, you want to talk about One Paseo resi?.

Sure. Hi, Daniel. So, we went through a management change in the fourth quarter at that asset and we have also been decreasing our short-term stays in that asset and going to a more of a traditional apartment rental market for longer-term occupancy.

So, we had a near-term dip, but we anticipate that by year-end or Q3 of this year, we will be back around 95%..

Okay. That's helpful. Thanks. And maybe just last one.

Now, we're only about a month into 2019, but any commentary from tenants on Proposition C in San Francisco?.

You know, what's funny is that some of our biggest tenants have been really big supporters of that and I'm not hearing anything from anybody and we talk to them all the time.

Rob, do you want to add to that?.

Yes. No, I think the reality, Daniel, is that tenants that need to be in San Francisco factor in the cost of occupancy and cities like San Francisco and New York, et cetera are going to have those sorts of levies. So, I mean, we monitor it obviously, but we're not hearing any pushback or seeing any..

Okay. Great. Thanks, guys..

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

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

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