Kilroy Realty Corporation (KRC) Earnings Call Transcript & Summary

Good afternoon, and welcome to the Kilroy Realty Corporation June 2020 Company Update Conference Call. [Operator Instructions] Please also note today's event is being recorded. At this time, I'd like to turn the conference call over to Steve Sakwa, Head of Real Estate Research at Evercore ISI. Please go ahead.

Thanks, and good afternoon, everybody. I would like to thank you for joining us for this Kilroy Realty presentation. We've got several members of management that I just wanted to quickly highlight who's on the call before turning the phone over to John. Joining us is John Kilroy, who's Chairman and CEO; Tyler Rose, who is EVP and CFO; Rob Paratte, EVP, Leasing and Business Development; Michelle Ngo, SVP, Treasurer; and Eliott Trencher, SVP, Corporate Strategy. I do have a series of questions that I'm going to go through, but I'd like John to maybe just give a quick state of the union on the company's business since they first reported Q1 earnings, and then we'll delve right into Q&A. John?

Okay. Well, thank you, Steve, and thanks to all who are on the call joining us today. For those of you who follow our company, you know that we operate from a core set of business principles that emphasize financial strength, top-quality markets and assets and strong credit tenants. We have $1.4 billion of liquidity, limited lease expirations, a highly sustainable young portfolio with an average age of 10 years, no near-term debt maturities and a well-capitalized tenant base. Three highlights that I'd like to point out: We have the premier portfolio of West Coast office buildings that is well positioned to manage through near-term issues and outperform over time; we have a development program that is well leased, fully funded and set up to create significant value; we have a long track record of strong performance and value creation. We've grown FFO per share by more than 75% since 2010, almost 3x the peer group average. NAV share has grown 175% since 2010, almost 3x the peer group. Leverage has declined from 7x to 6x. And I think we're poised to deliver strong FFO, dividend, same-store and NAV growth over the coming years. I'll turn it back over to you, Steve.

Thanks, John. It's a good intro. Obviously, there's going to be a lot to cover here in just 30 minutes. So just quickly starting. I know that one of everybody's favorite topics is just kind of rent collections and sort of the status of tenants. So before we get into kind of a discussion with you and Rob on maybe tenant demand, let's just quickly talk on rent collections, where some of the trouble spots might be. I know there's not a lot in the portfolio, how you're dealing with those issues and then we'll maybe move into a leasing discussion.

Yes, this is Tyler. Maybe I can jump in on the collections question. So last quarter, we announced April collections of 96% on the office side and 93% total. We've actually improved those April numbers all the way up to 99% on the office side and 96% total. And then May, it was tracking very closely to April. We're currently at 96% on the office side, 93% total. That includes about 87% on the residential front and then only 22% on the retail front. But again, as we disclosed previously, we gave 90% of our retail tenants rent relief program, so that 22% basically includes all those relief programs. And going forward into June, we'll see how we go. It's a little too early to tell for June. In terms of your question on tenant issues, the numbers are slightly lower than April. But in general, all of our larger and bigger tenants are doing fine. We are seeing a little bit of distress on the smaller office tenants. We're working through some issues with them. But again, at 96% collections, it's -- so far, it's a fairly immaterial problem. So I'll pass it back to you, Steve.

Okay. And then, Tyler, just before we move maybe to Rob and John on leasing. Just in terms of like regional differences, is there anything noticeable on the collection side or maybe where the stress is taking place? Is it a bit more San Francisco driven, given there's more VC tenants there versus, say, Seattle or down in San Diego or LA? Just is there any regional sort of color you can provide?

Yes. So really, only about 5% of our tenants are VC funded or PE funded. So that's a fairly small piece of our portfolio. But on the regional side, I'd say, Los Angeles is actually the region that has the weakest collection data. And part of that is we have more multi-tenant property in Los Angeles, as we have some smaller tenants. We -- as we talked about on our last call, we have a larger co-working tenant in Hollywood that is struggling. So it's been Los Angeles where we've seen the weakest data.

Okay. And then maybe shifting gears. I mean, I know in talking to lots of our broker contacts, kind of the new leasing discussion has been really quiet and really the focus for most landlords has been on tenant renewals. So Rob or John, can you maybe just sort of talk about the discussions you're having with tenants today? One, about renewals; and then to the extent if there is any real discussion about new leasing activity, if you can share that with us, that would be great.

Rob, do you want to take that one?

Sure. This is Rob Paratte. Thank you, Steve. So let me just start with our leasing activity at Kilroy for April and May. Currently, we have -- or we have in discussions or have signed over 200,000 square feet of leases, 65% of that is new transactions and 35% are renewals. The average term is roughly around 7 years, and those reflect a cash rent increase of 11% and GAAP rents of 20%. So we're pleased with the activity we have portfolio-wide. And I would just say that I would -- in the past 2 weeks, particularly optimism in each of our markets has ticked up, I would say measurably, I wouldn't say it's over the top, but optimism from brokers as well as just the tone of tenants seems more balanced and more looking toward the future as opposed to everything being status quo.

And maybe just to circle up, Rob, on that 65% of the 200,000 would you describe those as all sort of pre-COVID type deals that had started before the pandemic and sort of got to the finish line more recently? Or do you actually have some vintage leases in there that could have started post or that is too recent to have gotten anything from start to finish?

No. Some started before the COVID crisis, but a couple of them are new within the shelter-in-place we've been operating under.

And is there anything you could maybe provide on just maybe how the discussions morphed or changed from your perspective? The cash spreads, I know, bounce around a bit, up 11%. Memory serves me is probably on the lower end of where you've done some deals. So I'm just wondering, does that reflect a more challenged environment where that just kind of lease specific deals that brought those spreads in? Just maybe any color you can give on how you think rents might have changed in your marketplace?

Yes. I mean, I wouldn't -- I'm not going to get into specific transactions, but in general, and again, I'd say, market to market, meaning Seattle, San Francisco, LA to San Diego, we're not seeing retrades of transactions, and our competitors are holding the line on concessions as well. So I think we feel generally pretty good about the stability of the markets. And there were 5 leases in San Francisco alone that were renewals, all of which were over $100 a foot, fully serviced gross in the second quarter. One of them was in the first quarter, but second quarter of 2020. Some of those did start in November and December. So I think the fact that they haven't retraded illustrates that tenants are needing to either stay in the buildings they're in and figure out their social distancing, which may mean, in some cases, a net increase in space. It all depends on the company.

I'd add to that, Steve, this is John speaking, that one of the things that I think we'll see is a trend that has been going on for a number of years, pre-COVID, I think, will accelerate, and that is a flight to quality. And by that, I mean, buildings that really have all the modern systems, the bigger floor plates, to the extent they have roof decks or terraces and things like that, that are tenant controllable, but give the outside space to their student body, I think those things are -- those kinds of buildings at the right location are going to be the real winners over time. And I think the older stock where you have elevator lobbies that are less distance or less separation, same thing with bathrooms, many of the other things with older systems and so forth and smaller floor plates, I think those buildings are going to be challenged.

Okay. Well, I have a few questions that I want to sort of segue into. But maybe because you're talking about older buildings, John, and your newer portfolio, maybe help us just understand what changes or investments Kilroy has to make, if any, to kind of bring back all of your tenants and workforce, not just your own workforce, but all your tenants in a safe and sound manner. Are there things that you had to do to the buildings or plan to do the buildings to -- whether it's temperature scanning or things with filters or air quality? Just help us understand what Kilroy has to do here.

Yes. Well, we had a task force that we immediately assembled. One principal overriding objective was to work with our tenants, our partners and to understand what their protocols will be. And that's been an ongoing discussion. And obviously, it's evolved a lot over the last couple of months. So if you think about Kilroy, we have within the portfolio, putting aside the resi and the retail, but with regard to the office, we have 2 types of buildings. One are that they're multi-tenant and the other where it's basically the tenant occupies the entire building. And in the latter category, we are not putting up CapEx dollars and so forth for the tenants that are doing that themselves. And that many of them have adapted -- adopted scanning and other procedures that we can get into at length if you want to. On the multi-tenant buildings and in all our buildings, we're making sure that we have very stringent protocols. We've hired a hygienist, an industrial hygienist that works with the company and works with our teams. We have made sure that all the systems, all the surfaces and everything else have been thoroughly cleaned, pursuant to the regulations and probably above that. We have trained our parking lot tenants. We've trained our janitorial staff, our day porters, our own individual people, our managers, et cetera, with regard to the protocols. We've created distancing procedures and whatnot and frequency or number of people capacity-wise in elevators and so forth. In terms of cost, I don't see a meaningful increase in operating costs nor in CapEx cost, although we have made some changes of things we have under construction, some at the bequest of the tenants that have leased those buildings. And in some cases, with regard to the residential and so forth that we have underway at On Vine. But I think we will -- in my view, we will be the leader or one of the leaders in how to deal with this distancing requirement. And what we're hearing from some of our tenants is that they're not just thinking about during this COVID period. But remember, there's been 19 COVIDs of various forms, not all of them hitting in the United States and certainly none as severe as this one has hit the United States, but there have been 19 of them over the next 10 years. So some of the bigger tenants are really thinking about, okay, we're dealing with this now, but what are we going to be dealing with later and how should space be designed and configured and operated such that they've got the best possible mousetrap for the future.

Okay. Maybe switching gears a little bit, John. Obviously, the work-from-home situation has gotten fairly high-profile from some of the larger tech firms and even one large financial service firm. Right now, it seems to be discussion as opposed to permanent decision-making. But I'm just wondering, how are you sort of thinking about this potential shift? And how should investors sort of be thinking about the work-from-home and what some of these larger CEOs have been talking about?

Yes. Well, Rob and I'll probably tag-team this a little bit, but let me give you an overview. Again, through, as you know, as we've spoken on previous calls, Kilroy spends an awful lot of time dealing with its tenants and prospective tenants with regard to what they're doing, what they're thinking, how they're going about this. And obviously, there's been a lot of chatter and speculation amongst analysts or investors or brokers or whoever. It seems like there's no shortage of opinions and many of them conflict. So I'm not going to deal with the chatter. But I will say this, that there will definitely be a noticeable increase in the amount of square feet per person; said in another way, a reduction in density. And we're already talking with a number of tenants within our portfolio that want more space in order to create the distancing that they want to have. And so I think that will be a trend. There also will be workplace flexibility will become more commonplace. There's no question about that. But we think it -- and what we're hearing, it works with the office, not in place of the office. That means that people will be allowed, in some cases, to work-from-home more frequently. There may be -- certainly during this transitionary period where people are getting back to the office. There's move-in sequencing and so forth. And where the essential people have to come in or people that have particular issues at home that need to be able to work from the office as opposed to the home, all that kind of stuff is underway and is going to evolve over the course of the next several months. But after talking with many of our tenants, we believe the office remains central to their real estate strategy. Given collaboration and innovation and production, company culture, higher productivity and quality control and some of the employees -- many employees like to be in the office. A matter of fact, there was a study that was recently done and just released by Gensler, which is probably, I believe, the biggest architectural firm in the world and does so much work with the innovative tech clients. And their pool after talking with their customer base says that only 12% of the people don't want to return to the office. I know recently, one of the major brokerage firms released a report where they had interviewed something like 40,000 clients and found the same kind of statistics that somewhere north of 80% wanted to get back to the office as soon as possible. So I don't think that the data is sufficient that we can predict any kind of long-term absolute trends, but I do think flexibility will be granted to more people. I think that's a good thing. We are already doing that. Many of our customers were as well. And as I say, everyone will have their own anecdotes from their personal work-from-home experience, but ultimately, employers are going to have to make these decisions based upon what is in the best interest of their company. And many of our tenants right now are telling us that they can't wait to return to the office. I know that's been the case. We've done our own survey with Kilroy people, and it's the same kind of statistic. Rob, I don't know if you want to add -- yes, go ahead.

Well, no, I was just going to say, to the extent that some of your tenants obviously densified their space very dramatically and maybe need to kind of undensify, do you get the sense that, that will ultimately lead to more square footage needs? Or will sort of the permanent part of their workforce work from home and that will allow them to give more space per person without actually taking more square footage?

I don't think anybody can answer that with any degree of clarity and certainty at this point, Steve. I'm not going to say that it's going to result in net increase of square footage leased, and I'm not going to say that it's going to go negative. I just don't know. I -- on the optimistic side, you could say that everybody needs more space, they're going to have to lease more space. But I think that's probably too optimistic. What we have found, which is an interesting trend with some of our tech companies that are always trying to hire more people, is that they want to be in clusters of buildings or in individual buildings that they can control themselves. And for satellite offices, you're more in a multi-tenant environment, and those buildings are going to have to comply with the protocols of those tenants, so they're not going to renew their terms. So work-from-home has actually been a benefit to some companies because I'll just use -- say, you're in some place in North Dakota and there's 10 people that are programmers that are good, and you're not going to go build an office for that. But you can -- if you can hire those people remotely for jobs that don't require a lot of collaboration, you just were able to access another source of labor. So there's some good things, for sure, that companies will find by work-from-home. But I think with most of our clientele, what we're hearing is they want to get back. I just can't tell you whether it's a net increase or decrease in space. I am quite confident, however, that the older stock of buildings that don't comport -- you've heard me speak on this in conference calls and past conferences, I think the older stock, there's an acceleration of the obsolescence of many of the older buildings.

Okay. I know we don't have a lot of time left. We got about 7 minutes left. Let me just quickly delve into capital deployment. You guys, obviously, John, you mentioned, have a very active development pipeline. You've got 6 office projects today, which total about 2.2 million feet there, just over 90% leased, which, as you mentioned earlier, does reduce the near-term risk for investors. You do have one building, downtown San Diego, which today is 0% leased. So not to pick on that one small building, but just sort of what were the prospects like for that building sort of pre-COVID? And what sort of demand do you see for that building today? And are you making any changes to that building in light of the pandemic?

You want to take that one, Rob?

Sure. So let me start pre-COVID. We had a top -- not a topping off, but we basically broke ground; meaning, above the surface of the parking garage late last year. And we had -- in San Diego, pre-leasing is a still a challenge depending on the location in the submarket you're in. So we started generating, I'd say, a pretty good amount of interest from a couple of events and broker tours that we had. So we had, pre-COVID, probably 7 or 8 large users looking at it that range from fire category to technology companies. Some tenants were smaller that could have occupied half the building, say. And what we're tracking now, I mean, it's interesting, San Diego has fared better than some of the other submarkets in terms of just activity and people expressing interest in moving forward with the future. So we're tracking right now 43 deals in the San Diego downtown submarket, which does extend a little bit to UTC. And of those 43 deals, I would say probably more than half would be suitable candidates for 2100 Kettner. And that building, I'll let John touch on because John is also working toward a lot of our future development in terms of what enhancements we're going to make. But suffice to say, the design already had included in it things like outdoor stairs, which are going to become more and more, I think, popular or demanded by tenants. Meaning, that in order to go, say, from the second floor to the third floor, you can use an external steer upside in the air as opposed to taking an elevator. So I think the horizontal nature of the project, not being a high-rise and the modern HVAC systems, which are above code in terms of air changes and fresh air are the types of things that we've implemented there. And I'll turn it over to John for more of the future.

Yes. Well, I'd say the other thing is we're not making a lot of changes to Kettner. It already had all the bells and whistles. And I think that's what -- something that's kind of unique about Kilroy is that you mentioned, Steve, the average age of the portfolio is 10 years. The reality is, is that we saw the trends in terms of what tenants were doing and some of that was driven by density. And as we talked about on this call, density will back off a little bit, but the characteristics of the buildings that we've been developing are pretty much -- were spot on with what we're hearing people want. I think the trend -- the other trend here will be that many of bigger companies are going to want to not only control their own building, but when they are in a cohabitating with a multi-tenant building, one of the concerns we're hearing about is the number of elevator stops that they're going to have to have before they get to their floors. And Kettner is kind of ideal. It's a 4-story building, big floor plates, lots of outside deck space, rooftop decks, operable windows, outside stairways, all the mechanical and so forth that Rob mentioned. I think that building is going to be fantastic. In terms of the question, is there anything else we're doing to our buildings, we are already the leader in sustainability. We're already the leader in WELL and we're already the leader in Fitwel. And we're going to continue to emphasize all those things. We already probably own more rooftop decks and terraces in our buildings than our peers, and we're going to continue with that trend. That's something that people very much want. And so I feel pretty good about our portfolio. We are spending a little bit here and there on some of the buildings, particularly on the residential, just to deal with the issue of elevator usage and regulation. We're going to -- where you don't -- nontouch elevators. Basically, you have a fob and you don't have to touch a button. We're doing that in our office buildings as well and a bunch of other things like that just so people will feel more and more comfortable.

Okay. Well, we got 2 minutes here, John, and this is a much longer than 2 minute answer. But you've got a lot of regulatory issues in California. Obviously, Prop 13 is going to be coming on the ballot here. Does -- do you view that as any different today than you did maybe before? And California is about 88% of your NOI and Seattle is 12%. And do you think about diversity and looking at new markets at all? I realize it's a lot to tack on the 2 minutes here but...

Yes. Well, let me go through it really quickly. I mean, in California, New York, these big, popular states have lots of challenges, and they've not been always good steward of the taxpayers. So I'm always concerned about nutty or negative ordinances or new rules or whatever. We have the split roll coming up. The statistics right now suggest that split roll will not happen, but we have a vigorous campaign, we and others, other REITs as well as private industry and real estate owners on that. We are -- look, we've always been looking at other areas. I'm not going to tell you all our competitors, which ones, but let's say that we have been and Eliott Trencher on the call is in charge of that. And we've looked at our -- these other markets, many of the ones you've mentioned. For us to be there, we need to be there in scale so that we can operate the kind of -- have the kind of operation that we have in our other regions and whatnot. So more to come, nothing imminent. But despite the regulatory environment, our markets are home to many of the world's most innovative and successful businesses and offers an irreplaceable quality of life, which attracts some of the best and brightest as well as having some of the best universities in the world. So I always worry about everything. It's the nature of being a CEO, I guess. But I don't see some kind of big move out. I do think that this regulatory environment is really bad for the country and for the various states in which we have some of these nutjobs running them.

All right. Well, we are literally out of time here. I think we just hit our 2:10 mark. So I want to thank everybody for joining us this afternoon. I want to thank John and the rest of the management team for sharing their insights on their markets and look forward to catching up with people throughout the rest of the conference. So thanks, and have a good day.

Thank you, Steve, and thank you, everybody, especially to tenants. Thank you. Bye-bye.

Ladies and gentlemen, that does conclude today's conference call. We do thank you for joining. You may now disconnect your lines.