Good day, and welcome to the Q1 2019 Kilroy Realty Corporation Earnings Conference Call. All participants will be in a listen-only mode. [Operator Instructions] Please note, today's 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, sir..

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 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 an update on our market conditions and review of the first quarter. Jeff will review operational highlights.

I will finish up with financial highlights, and a review of our updated 2019 earnings guidance that was published yesterday in our earnings release. Then, we will be happy to take your questions.

John?.

Thank you, Tyler. Hello, everyone. Thank you for joining us today. I will begin this morning with a review of our market conditions, which continue to drive strong leasing activity. Then I will summarize our first quarter results and finish with an update on our development projects.

Real estate fundamentals remain strong across our West Coast Markets, new supply is extremely limited and there are few land site suitable for near-term development. Demand remained solid up and down the West Coast and we are seeing more diversified demand, it's not just technology and media it's far more broad base.

These strong conditions have driven double-digit rent growth on a net basis across our key urban markets.

Among the biggest gains, South Lake Union rents are up more than 25% year-over-year, San Francisco rents are up 15%, vacancy rates are now below 6% in our urban markets and hitting record lows in some areas Bellevue is at 2.9%, San Francisco is at 4.4% and South San Francisco is about 2.5%.

And with very few large blocks of space available in our key markets, we expect the upward pressure on rents to continue. In fact, we are currently experiencing record high rents in most of our markets. Other indicators that we monitor including job postings and VC funding remained healthy.

Seattle and San Francisco Bay Area, continue to create new jobs at the fastest rate in the nation, led by big technology. In San Diego, job postings ticked up approximately 15% over the prior quarter. Capital raising also remained strong year-over-year, driven by steady VC funding and a dramatically stronger IPO market.

We also see support for continued regional strength in the robust levels of investment the key industries are making in their future. Global research and development spending across technology and life science approach $675 billion in 2018.

This level of spending is driving rapid innovation and the continued penetration of technology into the core operations of nearly all businesses.

The entertainment and media industries alone are expected to generate globally more than 2 trillion in revenues this year as digital content accelerates growth across the sector and we expect this to continue, we now have Disney and Fox and others to come, expanding into content streaming.

We think this will translate into significant increased demand for space. The unique characteristics of our West Coast markets continue to attract significant investor interest, we are seeing diverse capital sources, including sovereigns, private equity, large institutional funds and major family offices exploring purchases or joint ventures here.

There is particularly strong demand for high-quality well located assets with low CapEx requirements. Large investors seem to be shifting their preference toward high quality state-of-the-art newer assets, as investors have achieved strong returns from the West Coast investments.

The region should continue to attract more capital in all forms, creating a virtuous cycle of investment in growth. And we feel we are particularly well positioned given the young age of our modern portfolio. Now let's move on to first quarter results. We delivered another strong performance.

We signed new and renewing leases on just over 235,000 square feet of space in our stabilized and development portfolio with cash rents that were up 34% and GAAP rents that were up 50% from prior levels. Our stabilized portfolio is now 96% leased.

We estimate that rents across our portfolio are approximately 20% below market, which as we mentioned last quarter is the largest rent differential in company history. We debuted our One Paseo of mixed use development project in Del Mar with the community opening of the retail space that is now over 90% leased and over a third occupied.

With this strong momentum, we made further progress on leasing the office component, which is now more than 75% committed.

We commenced construction on two life science development projects, Phase 1 of Kilroy Oyster Point, a 630,000 square foot project in South San Francisco and our 9455, Town Center Drive building, a 160,000 square foot project in the University Town Center submarket in San Diego.

And last month, we were awarded the EPA's Energy Star Partner of the Year, for the sixth year in a row, as well as the EPA's highest honor Sustained Excellence. This underscores our continued commitment and sustainability and our leadership position as a global leader among all publicly traded real estate companies.

And just five weeks, subsequent to quarter-end, we signed an additional 520,000 square feet of new leasing and renewing leases with cash rents that were up 13% and GAAP rents that were up 34%. This activity included a 154,000 square foot 10-year renewal with Lucile Packard in the San Francisco Bay area.

In addition, three of the leases were expansion leases, one with 23andMe Oyster Point Tech Center and the other two were in San Diego. Across these three transactions, tenants roughly double their existing square footage. With 23andMe expansion, we are now 100% leased at our Oyster Point Tech Center.

This brings our total year-to-date leasing over 750,000 square feet. Turning to developments, we are making good progress in all of our current projects. In Hollywood, all components for a mixed-use project are scheduled for completion next year, both the office and the retail space are fully leased.

In Seattle at 333 Dexter, we continue to have meaningful leasing discussions and remain confident that we will be substantially leased before it's delivered later this year and at Delmar office space our One Paseo project is now 76% leased or committed and marketing is under way for the residential units that will begin delivering towards the third and fourth quarter.

Upon stabilization, these projects will generate an estimated cash NOI of approximately $90 million, 70% from office and 30% from residential retail. This is in addition to the projected stabilized NOI of $75 million from the three projects we have in the tenant improvement phase, including the exchange 100 Hooper and One Paseo retail.

Given our confidence and leasing of 333 Dexter, and against the backdrop of strong market fundamentals and growth in the biotechnology and healthcare industries, we moved ahead with two new projects in the first quarter.

At Kilroy Oyster Point, we commenced construction on Phase 1 of our 40 acre life science campus situated on the waterfront in South San Francisco. This phase encompasses 630,000 square feet of lab and office space in three buildings and has a total incremental investment of approximately $450 million.

We expect to deliver the project in the second half of 2021. Kilroy Oyster Point commands an extremely attractive location and one of the nation's largest and most dynamic [ph] life science clusters. Near-term demand in the area exceeds 2 million square feet, vacancy hovers at 2.5% and the existing supply is extremely limited.

We are in discussions with a handful of tenants for Phase 1. And in March, we commenced construction on a 160,000 square foot property in San Diego at 9455 Town Center in the UTC submarket, our expected incremental investment in the project is approximately $95 million with a scheduled delivery date of mid 2020.

The project is situated in the heart of the University Town Center, in close proximity to the new San Diego trolley service and the University of California San Diego. It's a key employment center for a range of technology and life science companies.

Demand for the life science and UTC market -- sub market is very strong with a vacancy rate of approximately 5% and limited new supply. Office fundamentals are similar evidenced by our vacancy rate of under 4%. While we forecast this building to be occupied by life science company, we’ve designed a flexible project that also appeals to office users.

As you recall, we took a similar approach to the exchange in San Francisco, creating the opportunity to make the best decision at the appropriate time. Lastly, with regards to the Flower Mart, we expect our Prop M allocation sometime this summer.

It's too soon to tell when the four secret challenges will be resolved, but 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. To fund our development, we remain committed to capital recycling.

This year we are targeting $150 million to $350 million of dispositions. We are currently in the market with two assets with a total value of approximately $150 million. To wrap up, let me iterate our focus on three key 2019 objectives that we communicated on our February call. First execution in our development pipeline.

During the quarter, we continued to make meaningful progress on leasing our development projects, including 333 Dexter and One Paseo and started two new projects Kilroy Oyster Point Phase 1 and our Town Center Drive building. 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, on budget and they achieve superior returns. We expect to make meaningful leasing progress in our development projects before year-end. 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 will turn the call over to Jeff, for more detail on operations.

Jeff?.

Thanks, John. Hello, everyone. Since John, has given you a good picture of conditions in our markets, I know most of you follow market statistics. I will focus my comments on updating you on lease expirations in the mark-to-market rental rates across our portfolio. I will begin with an update on lease expirations.

We’ve made a lot of progress on our remaining 2019 expirations. We now have leased approximately 65% or 549,000 square feet of the 856,000 square feet of 2019 expirations, that leaves a little over 300,000 square feet or approximately 2.5% of the core portfolio remaining this year.

None of the leases exceed 25,000 square feet and they’re spread across our four regions. In total, we estimate that our 2019 of lease expirations are approximately 24% below market. As we discussed last quarter, we had two lease expirations in 2020 that exceeded 100,000 square feet, one in Northern California and one in Southern California.

Two weeks ago, we signed a renewal on the Northern California property and Southern California we now expect the tenant to vacate on lease expiration in the fourth quarter of 2020. We have begun marketing of the space and plan to make good progress over roughly 18 months before expiration.

Average rents in our stabilized portfolio continue to provide upside opportunity. On a portfolio-wide basis, our estimated average in-place rents are approximately 20% below market. As John noted, the gap has never been larger in our history as a public company.

By region, our in-place rents for San Francisco are approximately 31% below market, Seattle is 14% below market, San Diego is 8% below market and Los Angeles is about 12% below market. Now Tyler, will cover our financial results in more detail.

Tyler?.

our targeted dispositions for 2019 remain in the range of $150 million to $350 million. With the commencement of construction at Oyster Point and UTC, we anticipate remaining 2019 development spending of $400 million to $500 million.

We expect to commence revenue recognition on our Dropbox lease at the exchange in three phases, the first phase in the third quarter, the second phase at year-end, and the third phase in 2020. Our forecast for year-end office occupancy is between 94% and 95%.

We expect 3% to 4% growth in GAAP same-store NOI for the full-year and flat results on a cash basis, with a negative impact largely incurred in the first half of the year. The impact of expensing internal leasing costs and third-party legal fees associated with the change in lease accounting, remains in the $0.08 to $0.10 range for the year.

$0.02 of this was incurred in the first quarter. Taking all these assumptions into account, our updated 2019 earnings guidance is $3.64 to $3.78 per share with a midpoint of $3.71 per share.

We are effectively increasing the midpoint of our range by $0.03 from last quarter, driven by the reversal of the bad debt provision for the improved tenant credit quality. That's the latest news from KRC. Now we will be happy to take your questions.

Operator?.

Thank you. [Operator Instructions] Today’s first question comes from Nick Yulico of Scotiabank. Please go ahead..

Great. Thank you. I just had a couple of questions here. First, on Oyster Point. Can you just talk a little bit more about the demand you are seeing in the market, whether market rents, you think have hit close to $6 net per month.

And then on the cost for the project, is there anything in the first phase, that’s impacted by, let's say, a higher amenity offering for tenants, which drove up the cost per square foot for the first phase?.

Hey, Nick. This is Tracy Murphy. I will try to take them in the order you gave them. So demand continues to be very strong in that market as everywhere in the Bay Area and across all of our markets, but it's just beyond about 2 million feet, specific to South San Francisco.

And rents, to answer your question haven't quite reached $72 annually, but they’ve been squarely sort of in the 65 or mid-60s sort of range from a class A perspective. And then total cost, I think John covered that in his comments, but the incremental spend on Phase 1 is roughly $450 million, call it $950 million all-in for Phase 1.

And on the amenities, we will have a pretty robust amenity package consistent with expectations for Class A project. And there will be a redundancy across phases that we’ve been thoughtful to plan that sort of holistically before we committed to dollars for amenities on Phase 1..

Okay. That's helpful. Thank you, Tracy.

John, I just want to -- just turn to San Francisco and the Central SoMA Plan litigation, which is under way, I mean, as -- is your intention there still to wait for that to get resolved, before you thought about starting Flower Mart even assuming if you got Prop M allocation?.

Well, I think we could start substructure and so forth, but we will take a look at that, Nick. I'm open minded, but I want to understand what the consequences could be given this particular litigation, which is more about blocking views -- not by us, but by others to some existing condo owners, those -- and then one neighborhood group.

I think one of the four is going to be solved here pretty soon. So we are pretty open minded, but I’m optimistic that these things get resolved, don't go the full distance to the court based upon the history in this city and based upon the history we’ve had elsewhere. But we are not the final arbiter of what happens, but we will keep open-minded..

I guess just one follow-up, John is, do you think that we could see more announcements that came on leasing for projects in that area where there's already been obviously one major lease that was done while this litigation was going on? Do you think there is a chance that other tenants could take leases ahead of this being resolved because …?.

Yes, I think there is a likelihood that there is going to be a really big one. That’s all I'm going to say..

Okay. Thank you very much..

And our next question today comes from Craig Mailman of KeyBanc Capital Markets. Please go ahead..

Hey, guys. Tyler, I just wanted to follow-up on the bad debt expense. I think 2Q '18, you guys, I think, it was $0.05 net, maybe $0.07 gross.

Is there any more bad debt related to the tenant that you reversed that could come in through the balance of the year, or is this it you guys think?.

Yes. No, there is a couple of pennies left of that reserve. So that could come over time to the extent we’ve a different view on the tenant..

Okay.

And they’re current on rent and everything, right?.

Yes..

Okay. And then just kind of the bigger picture thoughts here. You guys did additional forward equity here at a discount to NAV. You guys did the forward deal last year at a discount to NAV. But the sales market is still pretty robust and Park Tower went at a pretty nice cap rate here.

I mean, thoughts on accelerating dispositions above your guidance versus incremental equity offerings where the stock price today..

Yes. This is John. We look at all those things, more to come..

Okay. So would you be willing to take more dilution on equity versus the sales? I guess just high -- big picture, I know you guys have nice yields that you are getting on the development.

I mean, does the math continue to work to take the discount and then make it up over time, or are there better alternatives to that initial dilution?.

Tyler, you want to answer that?.

Yes. I mean, I think we do look at both alternatives in terms of funding and given that we had started Kilroy Oyster Point and 9455, we thought it was the right thing from a balance sheet perspective to use the ATM a bit more to help fund 2020. But you are right, we look at both dispositions and equity and evaluate how best to fund our growth.

But in either event, what we are building and the returns we are getting are very accretive in either event, so that’s where we stand on that..

Okay.

And then just on the forward ATM, when do you think the takedown of that roughly $100 million is?.

Probably 2020. We have flexibility and we can take it down in pieces or over time the -- as I said in my remarks, probably July for the forward we did last year and probably 2020 for the forward we just did..

Right. Great. Thank you..

And our next question today comes from Manny Korchman of Citi. Please go ahead..

Hey, everyone.

Tracy, Oyster Point, as you guys build that, do you think that leasing will come sooner and be more build to suit in nature or later, something like Dexter where you’ve competency at least that it will be closer to delivery and so you are building more of a generic spec project?.

You know, I would think of it more in the latter, Manny. I mean the market's really healthy and conversations continue to be healthy despite how early it is, but it's historically not really been a preleasing market, but we are pretty excited about our position in that market. And as John likes to say, more to come..

And then, maybe John specifically on 333 Dexter, I guess we keep asking the same question is why isn't it leased in such a hot market? Is there anything specific that’s holding things up, or is it just a matter of the tenant hasn't signed yet?.

No comments..

Thanks, everyone..

And our next question today comes from John Kim of BMO Capital Markets. Please go ahead..

Thank you.

At KOP, are you committed to have a life science tenant in that asset or is there flexibility for an office user [indiscernible] UTC?.

Hey, John, this is Tracy. I mean, we -- if you remember back to Exchange, we have a life science warm-up committed on Phase 1, so we think it's likely Phase 1 will go life science, but it does have the flexibility to accommodate either.

So I don't know if that gives you any clarity, but there is a lot of flexibility with the way we’ve designed it intentionally..

Is there a strong preference to have it life science just given the market, or is there greater demand or terminal value if it's an office tenant?.

This is John, John. We -- we are kind of agnostic in one sense, because we're looking at what’s best for value creation. On the other hand, we have multiple phases, and it makes sense for -- the latter phases are likely to be life science to make diverse phase life science.

We’ve had many inquiries from the tech community, not on the life science tech, and then we have, as Tracy said, a handful of significant deals that are pure life science. I think Phase 1 is likely to be life science. We could explore other opportunities and we will.

We want to keep our options open, but we are in the unique position of having one of the few really well located entitled sites for lots of square footage for 2.5, 2.7 million square feet, whatever it turns out to be there in the four phases. So more to come as we build the final phases.

I think we are going to do very well in Phase 1 with a number of life science companies that we are working with..

Okay. And then John, just another question on Flower Mart. There are local reports that the planning department will recommend 1.4 million square feet to be allocated to your development, which is a little bit less than you have in Phase 1.

Would you feel comfortable moving forward if you didn't get the full allocation of the Phase 1 part of the Flower Mart?.

I don't really want to get into that, John, because there is a lot of negotiations going on between the city and the various developers and so forth. I don't think it's prudent to answer that at this time..

Understood. Thank you..

And our next question today comes from Dave Rodgers of Baird. Please go ahead..

Yes, John, I wanted to follow-up on the asset sales. You did a good job in your comments talking about the demand for the highest quality assets and the net leased building.

What are you comfortable taking to market? You said you got a couple in the market now, will these be more non-core, or are you going to sell some of the better assets in the portfolio? How do you think about that today?.

Yes, I -- well, remember, to the issue of funding, just generally because dispositions typically are a source of funding for either acquisition or development as the case may be.

The -- there is -- as you know, there is debt, there is equity, there is joint venturing either of recapping existing assets or development joint venturing, and of course, there is dispositions.

And we’ve tried to make it clear over the years that we look at all four of those things in sort of harmony and what is the best for us at any particular time. Specific to the range, we've given a range of $150 million to $300 million -- or $450 million -- $350 million, excuse me, too many numbers in my head today.

And we are very confident on the $150 million. We are assessing a couple of other projects.

There was one that we thought we would sell, but when we take it -- when we really drill down into it, we think there is big upside given where rents have gone and where demand is, and we think there is probably 25%, 30%, maybe as much as 50% more value if we do some lease things in that one particular asset.

So I can't give you specifics at this point, but we are not going to sell -- I don't see us selling any particularly strong core assets at this point other than one of the ones that’s in the current $150 million. So we’ve got a long year ahead of us. We have a lot of initiatives.

And we are -- I mean, agnostic to tell you the truth, although when I see the rent increases that we are getting, for example, here in San Francisco, deals that we did just a couple of years ago or 1.5 years ago, now we are at rents that might be a third under today’s market in a market that's likely to escalate by another 20%, 30%, 40% over the next few years.

So those obviously wouldn't be great candidates. So it's -- the acceleration in the market rents and demand for space is making our calculation as to what assets to select to dispose of a little bit more difficult..

Appreciate all that added color. Maybe shifting to One Paseo.

The office leasing activity that you’ve done there, any more color that you can give on that and then the demand for the remainder of the space that you have under construction there?.

Sorry, was that One Paseo?.

Yes. Sorry..

Yes.

Okay, you want to cover that, Rob?.

Sure. Dave, this is Rob Paratte. As we said on our last earnings call, the leasing activity we’ve had on the office space, particularly, at One Paseo is unprecedented.

And I think what we’re seeing in San Diego, in general, is similar to the trends we are seeing in our other coastal markets on the West Coast, which is that along with fire category tenants, you’ve got technology tenants, life science tenants that are creating pressure in the market for the best-in-class office space.

So when you look at what One Paseo delivers to a modern tenant in terms of floor heights, light and air, that sort of thing, that’s what’s driving the market. Commodity space as it always does kind of lags the market. And we think -- I think what’s unique also about One Paseo particularly is that it is mixed use.

So you’ve got the residential, which is -- it's all going to add the additive. You’ve got residential, you’ve got this great retail where we are 96% committed now with many of the shops open and it's just creating a synergistic effect between the three components. So we are really excited about the activity we have.

We are excited about the types of tenants we are talking to, and I think it bodes well for this whole Del Mar's submarket in terms of just future rent growth and absorption..

Great. Last question for me, Jeff.

The 4Q '20 expiration sizing on that and how much work the building might need to re-tenant?.

So the one tenant that's going to be vacated in the fourth quarter 2020, it's about 135,000 square feet and we got 18 months, so we are pretty excited about the activity. And Rob and his team are actively involved in looking for new tenants..

Okay. Thank you, everyone..

And our next question today comes from Aaron Wolf with Stifel. Please go ahead..

Great. Thank you. John Guinee here. I guess, Tracy, two quick questions.

What’s your fully loaded price per square foot to develop Oyster Point and UTC? And how much more is that than generic office product?.

Okay, let's take that. So the first one on Kilroy Oyster Point. I think we kind of touched on that, the incremental spend is roughly $450 million, but per square foot, we are approximately $950 a foot, which is a little bit shy of where market is on a competitive basis, just based on our favorable land basis.

So we are in a good spot from an all-in cost basis on Kilroy Oyster Point. And then, I know I’m going to rely on Michelle for the total cost of 9455. I think we quoted $95 million on an incremental basis..

Right. And then the price per foot is about $775, that’s all-in..

Yes, so slightly different. You can see the difference of land basis and just construction costs, but they’re both very favorable in terms of the competitive set that they will plan so to speak as we lease up. And then your question on just the incremental difference between office and life science. I don't know that we've said, but it's pretty modest.

Some structural things that we do, but as you know about Kilroy, we do a lot of big floor plays, more rigid floor to accommodate tech and density. So for us, it's really modest..

Okay. And then Tyler, I think at the -- your Investor Day last June in New York City, you gave soft guidance of an ability to hit $1.10 or $1.20 a square foot in -- a share in FFO by year-end 2020.

Do you still feel good about that number?.

Yes. Taking all the other changes that have occurred like the lease accounting change and dispositions and staying leverage neutral and all that, we still feel we are in that ballpark, yes..

Great. Thank you..

And today's final question comes from Jason Green with Evercore. Please go ahead..

Just a question on dispositions. Given disposition guidance is unchanged from a modeling perspective, can you help us understand the expected cadence of dispositions through the year..

Roughly third quarter for those..

Got it. Thank you..

Thank you. 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. Bye-bye..

Thank you, sir. Today’s conference has now concluded. And we thank you all for attending today’s presentation. You may now disconnect your lines and have a wonderful day..