Kilroy Realty Corporation (KRC) Earnings Call Transcript & Summary

Welcome to Citi's 2021 Virtual Global Property CEO conference. I'm Manny Korchman with Citi Research. And today, we're pleased to have with us Kilroy Realty and CEO, John Kilroy. This session is for Citi clients only. If media or other individuals are on the line, please disconnect now. Disclosures are available on the webcast. [Operator Instructions] John, I'll turn it over to you to introduce your management that's on with you, and then we'll take you with Q&A.

Okay. Great, Manny, thanks for having us. Welcome, everybody. With me today are Rob Paratte, who heads up all our leasing and tenant relationship activities, Michelle Ngo, our new CFO; and Tyler Rose, our President, previously CFO; and Eliott Trencher, our Chief Strategist, Chief Investment Officer.

Great. So John, coming out of the pandemic, if an investor were to choose one real estate stock to own, what are 3 reasons that stock should be Kilroy?

Well, thank you. First, I think we're smart capital allocators. Highly illustrative is the value in San Francisco that we've created through development. You saw the announcement earlier today on a roughly $700-some million investment, we created over $500 million of value with the sale of the Dropbox building. We're doing that throughout the portfolio. Secondly, significant embedded value and growth in our life science portfolio, we're moving that -- we're growing life science from its current 14% to 32% over the next few years. It's all brand new state-of-the-art product in the best markets. I think the mark-to-market of private value versus public value in our assets would be 1/3.

So obviously, the newest news to the street this morning was the sale of that Exchange on 16th. You talked about the $500 million of value creation. Now looking forward, what is the use of proceeds? I think in the release, you listed every possible use acquisition, specials, development, whatever it is. But where is your mind at on that?

Yes. Well, I don't know that we're going to see a lot of acquisition activity in the Bay Area or Seattle or L.A. in the near term. I am very bullish on what's happening in San Diego. I'm very bullish on what's happening with our leasing activities. We could have some acquisitions up our sleeves that we can talk about in subsequent quarters. We certainly have a major development program. We have KOP, Kilroy Oyster Point Phase 2, which is a $900 million, $750 million incremental spend. In South San Francisco, we're going to start that the middle of the year. We're also going to start roughly $100 million, $150 million of life science down in UTC area of San Diego. So we have a lot of prospective places to put the money. And as we listed, we always have the option to for returning it to shareholders. So we've got a lot of different things that we might be doing.

Life science has certainly been something we've talked a lot about in the office sector. You guys were early to that and doing it at scale. Do you think that others can compete if they don't do it at scale, if they don't sort of do it in these big clusters?

I think it's going to be very difficult, and we're seeing that right now. If you take a look at the folks that have been acquiring a lot of the assets that they're buying, to me are not first tier assets. There are some, but many that are not. The cap rates have been very low. I don't know where you create value with some of the things that we're seeing. And I might say, Manny, and you're right that it seems like every office developer, private and public, is now jumping on the life science bandwagon. It is really important to have -- to be in the clusters where people want to be and to be able to offer scale. Kilroy now with what we have embedded in the company, we'll have a 5.5 million square foot life science portfolio within the next few years. It's all essentially brand new, best-in-class, best locations. It's hard to imagine others having that kind of scales unless you have development and development sites are very difficult. All of the development that I mentioned are on properties that we own and control today.

Are you looking for additional sites to do more life science on? Or do you think it's going to be limited to UTC and KOP?

We're not looking at anything outside of the West Coast at this point, but we keep our eye on everything. There is quite a bit of frenzy and things that are for sale right now. And many of the things that are for sale are being marketed as life sciences, but they really aren't.

Someone in the question queue here is reminding me that we didn't go through the valuation side of the Exchange sale. And the question specifically is, to what degree is the valuation reflective of your broader portfolio? Rob, can you try to mute -- sorry, John, Rob, can you just try to mute? I think we're getting background noise here.

Yes. I'm not going to suggest that every asset we have is worth $1,440 a square foot. Some may be worth more, some may be worth less. But I think that the Exchange is illustrative in a couple of important areas: One, the investor community, and there is no shortage of money looking for significant assets, has finally aligned themselves to where the user community got to a few years ago, and that is high-quality facilities in the kind of workplace environment. And investors now are focused in -- from what we've seen on making sure they own facilities that are going to perform well over the term. So that obsolescence thing that we've all talked about before is alive and well in the investor mind. What was the second part of the question, sorry?

No, that was it. But I think we can go on with the same topic of just that the investors that were looking at that asset, how are they underwriting the fact that Dropbox has so publicly spoken about the fact that, that might not all be used and has placed on the sublease market?

I can't speak to the particular buyers view. They didn't share that with us. We're not able to disclose who they are, but they're a well-known entity. And that transaction, they're hard on with a lot of money, and we'll close later this month. But they did a thorough underwriting as did others that were interested in the property. And I think, again, it is -- the Exchange is an essentially's brand new state-of-the-art campus, we have a little mixed emotions about selling it because it is very -- it's a great building in a great location. It's simply that we couldn't add any more value over the next 12.5 years or whatever the tenant has left on it. I think they looked at it as a fabulous investment with a great yield.

Right. Just thinking about the broader San Francisco market. Obviously, an uptick in sublease supply. How quickly do you think that abates once people go back into their actual offices?

Yes. Rob, do you want to take that one?

Sure. I'll hit on a couple of points, Manny. Just year-to-date, since January, sub-lessors have taken about 350,000 feet off the market to use for their own purposes. So I think that reflects partially a return to work mentality. Over 50% of the sublease space, it's on the market in the city right now, has a term of about 3 years or less. And what I see with that is that if it doesn't lease, some of it -- it's spread throughout the city. Some of it's in less desirable segments of the market. Some of it may not lease for a long time because it's B and C type space. The better quality space like the Macy's.com space or the Uber space and Mission Bay will lease. And I think it's really a function of how quickly the vaccine takes hold and companies start coming back to work. We're actually now having discussions with corporate real estate executives that are now thinking about the future more than 6 months to a year out. They're actually thinking about where they need to expand, how they would expand and when they would expand. So that's -- that last part is very different than even 3 months ago. Hard to put a number to it, though.

And I guess, Rob, we have heard anecdotally that those large tech customers are now looking and saying, there is supply available, whereas there wasn't, call it, 18 months ago, and into a new sort of land grab, if you will, mentality. Is that accurate in what you're seeing?

Yes. I think it is. I think it is, Manny. There is a lot of tech that's located in B and C quality buildings in the south of market area that were never ever designed to be office buildings, but it suited their purposes, and it was available space. But because there is availability and some of the availability is high-quality space, you're going to see a flight to quality. And that's been one of our premises, both with direct space as well as indirect space. The best product, like what we have in our portfolio, is going to be what attracts the modern workforce.

And what do you think happens to some of that B and C stuff?

Hard to say. I mean, eventually, if the market gets tight like it was, then it gets reoccupied or it gets converted to a higher and better use housing or what have you, but a lot of it's in the deep south of market -- subsection of the market, not prime locations like Flower Mart or Brannan Street or 360 Third.

Earlier today, we hosted CBRE and their CEO said that he thinks that 15% of office space will be essentially obsolete or vacant or non-occupied, whatever term you want to use for that. Do you think that, that's in the right ballpark?

I can't -- is he talking about the Bay Area or San Francisco?

You tell me why is it coming from the Bay Area?

Yes. Let me chime in on that. I've been saying for a long time that there's been a major transformation the way people are using space. And we typically talk about workplace environment, not about office space. And that trend was well underway towards more modern, bigger floor plates and all the things, all the bells and whistles, as an example, that the exchange represents and the kind of product we focused on. COVID has simply accelerated that trend to where people are far more focused now on their people, their health of the people, the way they use space, the environment they create. And a lot of the older products that is smaller floor plates, lower ceiling heights, much of the stuff that was developed for a fire category type tenant in the '60s, '70s, '80s, a lot of that's just growing in obsolescence. And I don't know what you do with it. It will get repurposed somehow in some way, but it's going to be expensive to do it. There will be a lot of CapEx. I just don't think it's the place that we want to be, and we made a conscious effort to move away from that over the years. And that's why you see, with Kilroy, the kind of product that we develop, which is lower rise, bigger floor plate, higher ceiling heights, much more outdoor amenities and whatnot, and we think that's the place to be.

And that's -- you think that's consistent across your markets, John?

Yes, I do. I do.

I guess the other conversation we have with a lot of people are the news headlines of all these tech companies moving to the Sunbelt. Then you see the offsets of people doing the runs on the address change forms and saying, they haven't moved to the Sunbelt, they've just moved next door. What are your conversations leading you to believe?

You want to handle that, Rob?

Sure. The Bay Area of San Francisco particularly has been the focus on those headlines. And one of the slides in our deck that we've been using today shows what's really been happening, and almost 50% of the moves out of San Francisco have been within the suburbs around Bay Area. So Marin County, the East Bay, the Peninsula, and to me, that's not so much a function of the office is going to move. It's just the fact that people -- and it's probably pandemic driven, people are wanting to locate in the suburb. Whether that's a long-term trend or not, I can't say. But the other thing I'd say, Manny, is that if you look at tech over the last 4 to 5 years, every major tech company has spread out. They've gone to Seattle. They've gone to Austin. they've gone to Nashville. And I don't see that trend changing. They're going where the talent is and where their employees want to work. And there is still a large proportion of employees in San Francisco that want to live and work in the city. So that hasn't changed.

Lots of headlines out there on...

Yes. Definitely.

In terms of other dispositions that you guys might have growing, is there anything the plan was sort of the Exchange in the plan? Or was it somebody approached you on? Or maybe how it came together would be helpful to answer these questions.

Well, as we've often stated that we are going to look at the portfolio annually, if something is nonstrategic, it's likely that we'll sell it, recycle the capital. And we've also said when things -- when there is really no opportunity to add any additional value and where rents are already in place that are at-market or near at-market, then those become good candidates to sell, if you have a good use of proceeds. And with the Exchange, sort of bittersweet. It's a fabulous building. It'd be very hard to duplicate. We could add any more value for a number of years, and we're able to redeploy that, as I mentioned earlier, into things that we think will be -- create significant additional value and just think of Oyster Point, Kilroy Oyster Point Phase 2. As you know, we started Phase 1, which is roughly 650,000 feet. 6 months into it, we leased the entirety of it to 2 different tenants. We're in early-stage negotiations with significant -- with significantly more space being discussed than we are building in Phase 2. One of the things that we're hearing repeatedly from people is that they love Oyster Point because we have the ability to deliver scale and optionality for the future. And so people are looking at where they want to be, and how they're going to grow, and we have the large, I believe, the largest life science development project in the Western United States in the best market in the West Coast. And so we're pretty happy with that. So we'll we continue to look at where we create value. And on that note, we have in our slide deck that we published earlier this morning what our life science portfolio looks like and what it will look like in a few years as we develop -- the next couple of development starts in the company will be KOP Phase 2, $900 million, $750 million incremental spend that will deliver in roughly 33 months from now. And then a little building down in UTC, where we're also trading paper that will start later this year. And then thirdly, another building in UTC, which is currently an office building that has great bones that's surrounded by life science and that's about a $50-or-so million project, and we'll be doing that later this year. Those are 3 development, redevelopment programs for the next 12 months. And as -- I just want to make a comment, if I may, about life science. I know there have been a lot of folks talking about getting into that business, and you mentioned earlier about the need to have scale. The fact that you can get entitlements for life science doesn't mean people want to be there. I've looked at any number of buildings, including here in San Diego, where people are saying, hey, this is a life science conversion. And I won't dispute the fact that many -- much of it can be converted for a life science user. It's just that I don't think they'd go there. So why would you do it? So there is a word of caution out there, I think, for the investment community. It's just because it says life science doesn't mean it can be life science or should be.

Is that a location thing? Is that a pricing thing? Can you make up for the location thing with the pricing thing?

I don't think so. Maybe in a case here or there. Location-specific is very important. In the case of San Diego, what you see is, you had Torrey Pines, which is now around 1% or 2% vacant , and that moved to UTC, which is 1% or 2% vacant, very little development capability to develop for developers to do new product. Of course, some of the big companies like AREE and so forth have some sites. Then it jumped over the Sorrento Mesa. We're seeing it now move through Carmel Valley or Del Mar, where there really is any development site. And we're already in early-stage negotiation on Santa Fe Summit, where we can develop about 600,000 feet in 2 phases. So there is a migration. Now if you go to hither and yon and the fact that you can get entitlements and you may or may not have the physicality that life science wants. But will they jump to nontraditional clusters or the expansion or extension of those clusters? I wouldn't bet on.

I guess the question is, you're sort of starting to see the beginnings of that in Boston, where Cambridge is now flowing into Boston Proper or the Seaport or both. I guess the question is, does that theme work its way over into your markets or not? Does it work in Boston or not?

Yes. I mean, I think it has worked this way into our markets because it has gone Torrey Pine, UTC, Sorrento Mesa, 56. And I think it has happened in the Bay Area. If you look at what AREE is doing down San Carlos, I mean that's great. But you have sufficient mass and you have a location people want to be. To do one-offs hither and yon, I think, is a dangerous game to play.

There is a question here in the queue, I guess, referring earlier, you talked about employers locating where people want to be or where people want to work. And if people are increasingly wanting to be in the Sunbelt, does that mean that Kilroy takes a closer look at following them there?

I'm not sure that I would go so far as to say that people are going to be moving their -- moving meaning, moving out. I think that what we've seen and Rob mentioned is that big tech is moving -- is increasingly expanding into areas in where they have the workforce. Let me give you an example of the conversation I have with the CEO just last week, and it's the CEO of one of the biggest tech companies. And they're going to hire many thousands, not 25,000, not -- but greater than 5,000 new engineers. They said the only place they can get them in quantity of what they want is in the Bay Area. Now that doesn't mean there won't be educational engineer here or there, and it doesn't mean there aren't other kinds of employees that might not be in Austin or Tampa or wherever they might be. So I think the Sunbelt has a bright future, but I don't think it's because of mass migration out of the West Coast. I think it's additive too.

Well, I guess the question is, you're talking about mass demographic migration, people moving out of the West Coast and moving their families down to the Sunbelt. I guess, the...

I'm not talking about that. I want to make sure that that's not what you're talking about.

It looks like we're talking past each other. See, as those large tech employers think about those markets as potential ways of finding new talent versus talent leaving your markets and going there, is there an opportunity for you using sort of the tenant partnership to enter some of those markets? So not to say this would happen like Tesla announces they're going to Texas. Tesla calls Kilroy and says, help us build in Texas because you guys are really good developers. Is there a chance of that conversation happening, not the fact that people are moving their families out of California?

Yes. I think there could very well be, and we have had those inquiries of us. I think where Kilroy has a unique position is that because of our relationship with big tech up and down the West Coast, where they're generally centered. We've really developed partnerships with those folks, and I think if we wanted to, we could expand to other markets. I'm not saying we are, I'm just saying we could.

Michelle has been quiet the whole call. Michelle, with the cash on the balance sheet, the large development is probably not happening this year and then this -- the new cash coming in from the new disposition. When do you have to make that decision of whether or not you put that cash to work or distribute it to shareholders?

So we think it will probably be by year-end before we need to make any decisions on that.

So that would be a decision announcing a deal or that you'd be distributing. So we would know by year-end either way?

Correct.

Great. John, Flower Mart. I don't think we've talked about it yet.

No.

Anything new?

Well, we are fully entitled. We spent the last year or so being able to work towards a greater phasing optionality on the property before. We have 2.5 million square feet round numbers of office. One of the buildings is around 1 million square feet plus, and we've been able to work with the city to achieve phasing, which would allow us to build essentially 4 buildings plus or minus of 0.5 million square feet each, and they all work independently. So we have a greater optionality than we had before, and I'm happy about that. In terms of starting it, I don't see us starting the Flower Mart anytime soon. As we said last year, pre-COVID that we could potentially be underway with demolition by the end of this year or early next. I think that's probably delayed somewhat. I don't see any reason to go build spec office space in any office market right now in quantity. I put life science aside from that or in a different category, but I just don't see it yet. Let's have a few quarters of seeing where this is all going. And I might say that I've been very, very pleased with the discussions we've been having with our client base, and the outlook, I would say, is decidedly more optimistic. Frankly, any of the CEOs that I talk with are far more optimistic about returning to the office and growing and ramping up more so than I am. So I think we could see a faster -- as the world normalizes, I think we could see a faster ramp-up in demand than any of us might be thinking about. I'm not going to bet on that, I want to react to it. But we're already seeing this in some leading indicators our tour activity is off the charts compared to -- we're seeing more tours in the first 2 months of this year than we saw -- or the -- sorry, February and March of this year, then we saw of all of the last 10 months of last year. We're seeing more requests for proposals. We're in early stages, but seeing more discussions with regard to building facilities for people on sites that we own. While our executed leases are up over the fourth quarter, they're still not huge. But these signs all seem to me to indicate that people are excited about things getting back to normal. I know we at Kilroy are just being down here in San Diego, operating the last month or so out of this office where we have probably 40% or 50% workforce. It's amazing how much more smoothly your discussions and negotiations are when you can actually physically interact.

It makes far more fun conference, I'll tell you that.

It's easier to have a beer together. That's for sure.

So we've been asking everyone here, and I almost forgot, what are your top 3 priorities to improve your ESG score next year?

Well, it's really reducing the environmental impact of our construction materials and supply chain. We've been working on that for the last couple of years. We think there is a lot of opportunity there. Secondly, to address our tenant emissions like we've addressed our own, as you know, we're carbon neutral and well ahead of any of the government mandates by decades. And we'd like to see our tenants follow suit. And we're actually consulting with a lot of our tenants with our database, and how we're doing things and helping them to get there. The third is to continue to diversify our Board of Directors. As you saw, we added Louisa earlier this year, who's been a fantastic board member, and we're going to expand our Board further. And we have some particular requirements in California that we've got to meet. We'll meet those. But I'm pretty pleased with our initiatives in the ESG area.

Great. We're going to wrap with our rapid-fire questions here. When we are sitting physically together in Florida a year from now, what will be the one thing that will have surprised people the most about your business over the prior 12 months?

I think the pace at which physical occupancy of office space buildings have increased. I think that's going to be a headline.

So you think that the market is expecting what? And you think what is going to happen, just trying to pin a timeline on you?

Well, Manny, I don't know that I want to pin a timeline, but you ask me in a year. And I think what we're going to see is that office space is going to be reoccupied much faster than most of us thought.

I think a lot of people just to frame it from what I'm hearing is sort of that Labor Day is a big mark on the calendar is what people are thinking about, just if that's at all.

Yes. I think it's nice to have a mark on a calendar, but I would say, like a football game, the only mark that counts is the end zone. And where we are on Labor Day, may or may not be massively better. I kind of think about -- I've been thinking sort of about early next year. When I talk with any of our tenants, they're thinking second half. I don't know where it is. I think directionally, it's going in the right direction, the level of optimism. If it's a game of shoots and ladders, there weren't any ladders last year. This year, there are a lot of ladders, and I think the shoots are smaller.

What do you think your corporate travel budget will be next year as a rough percentage of 2019 numbers?

I'd say, plus or minus 90%.

Around 90%.

Around 90%, yes.

Okay. That will be a big.

No, no, no. Sorry, around 90 -- roughly 90%. How is that.

It's been a long day. I just want to make sure I'm hearing things right. What will same-store NOI growth be for the office sector overall, not your company in 2022?

3% to 4%.

And what will the 10-year treasury yield be one year from today?

2.5%.

Perfect. Thank you, everyone.

Thank you.

Enjoy the rest of the conference.

Look forward to seeing you in the flash next year.

I hope it's earlier than that, John.

Yes. I hope so too. Thank you very much. Appreciate it.

Thank you.