Kilroy Realty Corporation (KRC) Earnings Call Transcript & Summary

Good morning, everyone. This is Jamie Feldman, the office REIT analyst on BofA's U.S. REIT team. I'm joined today by Elvis Rodriguez and Nicole Phang on our team, and we want to welcome you to this Bank of America Global Real Estate Conference Virtual Roundtable discussion with the senior management team from Kilroy Realty. Kilroy is a West Coast-focused office REIT and developer. Joining us today from Kilroy are John Kilroy, Chairman and CEO; Tyler Rose, Executive Vice President and Chief Financial Officer; Rob Paratte, Executive Vice President, Leasing and Business Development; Michelle Ngo, Senior Vice President and Treasurer; and Eliott Trencher, Corporate Strategist. We have a large global audience joining us today, so management will spend the first 5 to 10 minutes providing an introduction to the company and update on operating conditions. We'll then move on to Q&A, and we hope to make this an interactive session. [Operator Instructions] I'll now turn the discussion over to John to get us started.

Okay. Well, thank you, Jamie, and welcome, everyone, from wherever you are, and I hope you're doing well under these trying times and staying healthy. Just a little bit about Kilroy. I think probably everybody on the call knows us, but in case there's somebody who doesn't, as Jamie said, we're on the West Coast. That's the state of Washington; Seattle, Bellevue area in the Northwest. The San Francisco Bay Area; Los Angeles, Hollywood area and Coastal San Diego. It's -- Jamie, you mentioned that we're primarily focused on office, but we have become a -- both ownership management and development of office, but we're also a developer of a growing life science portfolio that we'll talk about in a moment. We've had a multi-decade experience in owning, developing, acquiring and managing real estate assets. We have a $10 billion investment-grade enterprise. We're a member of the S&P 400 MidCap Index. Our portfolio of stabilized assets is approximately 14 million square feet that are 96% leased. We believe we're standing on a strong foundation, ready to play defense and offense as we have in the past. We have historically developed when it made sense, where there's visible demand, and where yields were significantly above acquiring. We have acquired when that made sense. We've sold assets to redeploy the proceeds into development acquisitions or other activities. So we play the cycle, and we have a long history of playing with cycle quite effectively. Our portfolio is a state-of-the-art portfolio. Let me just explain what I mean by that. It's really designed for the future. We've been the leader in developing the modern office space platform with all the physical things that the tenants want. It's a young portfolio. It's approximately 10 years old. It's very modern, it's sustainable and it is the highest-rated portfolio other than the United States government and Fitwel buildings. So we think we're -- what we were doing before COVID was the right thing, and it turns out to be the very right thing given COVID. We serve a strong technology, media and knowledge-based tenants. We're the world leader, as I said, in healthy buildings. Our development program is 90% leased and fully funded. We have $2 billion under construction, we -- a pro forma that it will generate $145 million in NOI as it comes on stream. And with the exception of a building that we started just last year, 2100 Kettner in Downtown San Diego, all of the other portion of the $2 billion, the 90% will be online by year-end of 2021. I mentioned we have a growing life science portfolio. On a pro forma basis, that represents about 5 million square feet when built out. We -- the next likely start for Kilroy on any development activity is our Kilroy Oyster Point project in the city of South San Francisco. That would be the Phase 2. Our Phase 1 at KOP is underway. It's fully leased. It's 660,000 square feet. It represents an investment of $570 million, which is about $870 a square foot. It will -- it delivers the end of 2021. I mentioned it's fully leased and the yield is about 7.5% ROC unlevered. The second phase will be an investment of approximately $850 million. And while I can't give you a specific yield because it hasn't been leased yet, hasn't started yet, we believe the yields will be in our historical range, and so call that roughly 7% projected. We have $1.6 billion of liquidity with low leverage. Our net debt-to-EBITDA is 5.8x. We have no debt maturities until 2023, and we have limited expirations, which obviously is a very good thing in these uncertain times. We have an average over the next 3.5 years of 6% per year rolling. We have no expirations greater than 60,000 square feet until 2022. And we're poised to deliver strong FFO, dividend, same-store and NAV growth over the coming years. So with that, Jamie, I think that gives you the intro you asked for, and we're happy to take any questions, so fire away.

Perfect. I guess to get to probably the hottest topic right now, at least for the West Coast office REITS, it's just the Bay Area. A lot of headlines are on work from home. We saw Pinterest walk away from their lease with Alexandria at -- in South of -- in SOMA. Can you just kind of give us the update from your perspective of what's happening in San Francisco? And what we should expect to see or what you expect to see over the next year or so?

Okay. Rob, you want to cover that please?

Sure. If everybody -- thank you, Jamie, for hosting this. By the way, we always enjoy it. If you look on our deck on Page 21, this is just a snapshot from a series of interviews we've done with corporate real estate executives over the last 30 days. And you're right to point out the Pinterest transaction. We do look at that as a one-off just in terms of San Francisco and SOMA. To date, if you look at our portfolio as well as just large tech in general, there have not been the large layoffs or talks about giving back space. And in fact, in these conversations we've had over the past 30 days, people are -- companies are, despite the headlines, are working feverishly to bring people back to the office. So in certain examples, 1 company, I just can't mention names, but 1 company in particular, is bringing about 10% of its workforce back to the office in January despite what headlines say about coming back in July. And that 10% that's coming back is from demand of the employees themselves wanting to get out of the work-from-home scenario. They feel that they're not able to collaborate, develop, do what they do in remote locations. So in that one particular example, people are coming back to work, January, assuming it's safe. The only comment we've heard in probably 15 of these interviews about coming back to cities and going back to work, the only complaint really is the lack of amenities, meaning there's really no food service right now, particularly in San Francisco and L.A. I think in New York, in Midtown, you're probably experiencing the same thing. So if we can ramp up in cities, in urban areas, the amenities that these young creative workers were used to having at their fingertips, I think that there will be a bigger push to come back to the office. And the last thing I'd say, you all know in New York, JPMorgan announced that it's bringing all of its traders back September 21. And other companies are doing the same thing. And I think that JPMorgan move is very significant and will migrate across the country.

And as companies think about bringing employees back or just as they think about their longer-term space decisions, what do you think we'll see in terms of appetite for CBD San Francisco specifically versus other parts of the Bay Area given the community?

Well, yes, it's an interesting question. I mean I think no doubt, we know for a fact that work from home will continue to be a component of the new office workers' lifestyle. But we also feel that San Francisco has a lot of positive attributes to it. It just needs to open up again. I mean I think San Francisco and L.A. have probably been the most stringent in terms of just literally closing down. And San Francisco, for example, the mayor has decided not to open certain businesses that could be open despite the governor allowing such things. So they're taking a very stringent view of that, and it does impact the -- what you feel is the lifestyle. But I can just tell you both in Los Angeles and in San Francisco, if you look at the restaurants and the creativity they've put into outdoor dining and accommodating this new temporary situation we have, the demand is over the top. I mean it's very hard to get reservations these days because the weather is nice and people are wanting to get out. So back to your question, Jamie, I think San Francisco, will continue to attract tech. These young graduates that are coming out of the best schools in the country and particularly in the Bay Area, we're just not going to settle for their first job experience being somewhere in the suburbs. And that's echoed also in these interviews we've had. Companies are here and there, looking at suburbs just because of employee requests, but their main focus in operations will continue to be urban and San Francisco as long as there are employees there that they can hire.

I think a point here, Jamie, if I may, Rob, with regard to this -- and I don't want nor -- we don't want in any way, shape or form to downplay the significance of COVID and its impact on people getting back to work nor the impact on the use of public transportation and so forth. All those things need to be addressed, and I'm confident they will be. There's nothing that's going to be better than having a vaccine, of course. And as we've learned more medically about the virus, we're seeing more and more places beginning to open up. It's a start. It's by no means back to normal. But I would point out, I think it's always important to think of things a little bit in a historical context on the resiliency of office space and the office culture. And we've had many -- numerous natural disasters, the earthquake, that pancake, the freeway there along the waterfront, which became one of the more robust areas in San Francisco, similarly down in L.A. We had the September 11 terrorist attacks, then many were worried that companies would be too afraid to work in high rises in urban areas. And what ensued is that time heals and the urban landscape attracted millennials and other users. And we had the dot-com boom of the late 1990s and early 2000s, and the predictions were that teleconferencing would be the future of work. And what happened is that the folks that do social media and all the development of all these amazing technologies became the biggest consumers of office space. And office environments, of course, have evolved into live, work, play culture. And some of that has to come back because restaurants haven't been open. So we have a job cut out for all of us. And of course, now with the COVID-19 pandemic, the headlines of work from home replacing the office, I don't believe that our interview with our clients doesn't suggest that. We know that there are a lot of headlines that people grab on to generally out of context of the comments that were made. Our prediction, as Rob said, is that work from home and workplace flexibility will be important and will work with the office and not replace it. So that's just a little bit of a historical context. Obviously, time will tell.

So maybe just to talk about what you're seeing on the ground. Can you talk about the lease discussions you're having? And what that tells you about where tenants may want space? And also, any change to the space design or layouts to offer a more flexible work plan for people?

You want to deal with that, Rob?

Sure. Well, without a doubt, the life science sector is the hot commodity these days. And I'm not going to go into details or predictions about outcomes, but we've have had, in the quarter, very active discussions on a variety of our properties on the life science front. I would say, secondly, the Bellevue office market is probably the strongest office market in the country right now. Amazon, as you know, has taken another 2 million square feet in that market and is moving 10,000 employees into that area. There's also other technology activity in the Bellevue market. San Francisco and L.A. are hampered, as I said, by these shutdowns. However, particularly in L.A., you are seeing what I would call green shoots in terms of the content producers actually being able to get back to work, creating content, and that's just going to have a spillover effect to more content. One media company told me they're going to double down on production over the next 18 months to the tune of about another $2 billion of content, and that's going to have a spillover effect on office support and that sort of thing. So I think both San Francisco and L.A. are going to be dependent again on when things open. San Diego has the benefit of, I think, out of most cities in California probably being the most flexible in terms of reopening. And it has a very strong life science base, which we are a party to with our portfolio in San Diego. And as you've seen over the last year or 2, Jamie, Big Tech has made a move into San Diego and continues to look and expand there. So that's my overall view of what's going on. And in terms of just space itself, there is a lot of head-scratching going on, to be honest, in terms of our tenant base in terms of what is the best use of space going forward. We know for certain, one thing is that distancing between teammates will be increased. And companies are doing that just as a -- I think a reaction as to the very high densities they had over the last 4 or 5 years. And I think as John has mentioned in previous comments on earnings calls, et cetera, particularly the large companies are going to be more concerned than ever about controlling their own environment, having their own lobbies and security protocols, hygiene protocols and that sort of thing. And I think lastly, one of the hallmarks of Kilroy has been the use of outdoor areas, because of benefiting from our West Coast weather. So we have a lot of ample roof decks. 90% of our projects have outdoor roof decks. We have plazas that are inviting and people use as alternate workspaces, and we're hearing more and more that, that sort of outdoor experience is something tenants on the West Coast are really going to put a premium on.

All right. Just to go back to San Francisco for one second. Just -- I mean what do you read into the Pinterest lease cancellation? And I know that it sounds like they just needed some more time to figure out the future, but what does that tell you about the market and about tenant abilities to make long-term decisions right now?

You want me to answer that, John?

Yes, go ahead. I might have...

Again, I can't comment on Pinterest and their motivations beyond what has been in the press and that sort of thing. They do intend to grow, which they've stated even after this transaction. So I really can't say beyond what you just outlined, Jamie. It is -- I think it gives them time and I think a lot of companies are looking at -- they're not making long-term commitments right now. It's pretty tough to do that in this environment. So I expect a year from now, things will be a lot more clear, and you will see demand come back.

Jamie, I'd just add to this that the transformation of the modern office space was well underway over the last 10 years. And as I mentioned, we've been the leader in that, I think. And I think this COVID has just simply accelerated that. The physicality of space, bigger floors, higher ceiling heights, the alternative forms of vertical transportation, more controlled areas, controlled inside, controlled outside, controlled lobbies. Most of that means you've got to have buildings that had a lot of features designed in place. Many of the older stock buildings just simply don't work with the numerous things that Rob and I both outlined. So I think that look -- there'll be a -- and I think I mentioned this on our last conference call, I'm thinking that there is likely to be some real winners and some real losers in this. And I think if you have the kinds of buildings that people really want and need and demand now, you're going to be a winner. I think if you don't, you're going to be a loser. There's going to be a real bifurcation. The impact on development, certainly, I don't see anybody. Now I can't speak for others. I can only speak for Kilroy. I don't see anybody that has acquired sites and that has Prop M entitlements, starting an office building in the current circumstances without a pre-lease. And maybe some will. We won't. I've always said far from what we're going to have, whatever phases we start substantially pre-leased before we start. And I think the impact of COVID has been to delay all that. Now I'm glad we have the low land basis we do. And we've always said that project could be the next cycle. But I think it would be foolhardy until there's more clarity to go start a major spec building in the city of San Francisco.

Okay. That makes sense. I guess shifting gears to your comments on life science. It seems like a lot of investors and operators are focusing on that property type right now. How do you think about the risk of supply across the markets where you're more active?

Yes. Well, if you look in San Diego, it's very hard to find any space. Any properties that have come up that have older buildings in sort of the sweet spot of where life science likes to be have traded at amazing premiums. And there's just -- it's a limited supply. We have a couple of smaller sites that we are going through entitlements on right now that are in the UTC area. In the city of South San Francisco, we own -- I think that the Kilroy Oyster Point project is probably the largest entitled life science project on the West Coast. I mean somebody can say, yes, they're going to convert a shopping center into a life science in Richmond where no life science company would ever go and say they're bigger, but that'd be kind of a stretch. The -- we control the lion's share of the entitlements in the city of South San Francisco, other than Genentech that has entitlements, where they're going to build on their own property for themselves. And if we look at that market, it is supply constrained. And we also think, to your point, it's a very favorite sector right now. You noticed recently that Ventas bought a significant portfolio life science project, which were primarily converted office buildings on the nontraditional side of the 101 Freeway, where life science hasn't really gone. And I think they paid $1,275 a square foot. That was $1 billion acquisition around terms and a low 4% cap rate, and that isn't the traditional premium life science location like we have over KOP or some of the others have that have recently been developed. So I think we're going to do very well in that project. That is the sweet spot on the West Coast. And while others have bought some, what I would consider to be very inferior locations with their thought that they'll develop, they're years behind us assuming they get entitlements.

Okay. Did you consider that portfolio?

No, I wouldn't have bought that.

Okay. And then as we think about net effective rents across the markets and sublease space, it seems to have come on at least the second quarter and even July numbers look like -- or September numbers look like it's still picking up in a lot of markets. Can you talk about where you think net effective rents have moved across your markets?

Sure. Jamie, it's Rob again. Let's start with Bellevue. Net effective rents will move up as a result of Amazon and the absorption they're creating. There's just very little Class A office space in the market. There is some sublease space, but the space, as I would say, in general, throughout any market in the country, the space that's built out in a way that tenant -- modern tenants want to use it will be the first to be absorbed. And if you add in John's comment earlier about that space being in a building that has other features that are attractive to modern tenants, the Class A flight to quality is going to happen and is happening based on the demand we see in Bellevue. San Francisco, I just don't think there are enough data points to point to, Jamie. If you look at, as we've mentioned in our past earnings calls, over the past half year, some of the renewals that were done or all the renewals actually that were done in the Bank of America Tower at 555 California, One Market Plaza, with Morgan Lewis. All those deals held their pre-COVID rental rates. I think in terms of concessions going forward in San Francisco, you may see a little bit more free rent. We're not seeing softening in rent other than sublease space. But again, like I said, there's just not enough data points to predict where actual market rents are today. Los Angeles, again, very big, fragmented market in Hollywood and in Culver City, where we're focused. Although we do focus on the Westside, but the Westside is very tight. There hasn't been material sublease space in our view that causes us concern, and you have some big users that are in the market right now looking for space. And San Diego, again, as we mentioned, is extremely tight in the submarkets we're in, primarily due to 2 factors. One is life science, and one is just Big Tech coming in. So if you look at San Diego and UTC, for example, just the life science vacant -- the UTC overall vacancy is 2.7%, and that's continued to trend down. So we don't dismiss sublease space. We track it carefully. We watch it in San Francisco. But as we've said on other calls, you have to take -- if you look at 6.2 million square feet of total sublease space in the city, you really have to look at it in terms of what was pre-COVID, what was post-COVID. How much of that is small block space, meaning less than 50,000 feet? There's close to 1 million feet of that in the market right now. There's also a very large component that has term less than 3 years. And another fact that this doesn't get reported that much is there's almost 300,000 feet of sublease space this quarter thus far that will be taken off sublease market or absorbed. So I'm not saying things are rosy, but you really need to look beyond just the gross statistic of sublease percentages.

Okay. And then shifting gears a little bit here. I mean John, you've never been one to shy away from your views of the political environment. When you think about some of the fiscal issues facing the markets you're in, from the pandemic and the challenges and taxes increasing, what's your outlook here? And what are the conversations that tenants are having about why they may or may not want to grow in some of these markets? And what do you think these cities have to do to get -- to kind of stay healthy and continue to get demand?