Kilroy Realty Corporation (KRC) Earnings Call Transcript & Summary

[Audio Gap] A.M. session here at Citi's 2022 Global Property CEO Conference. I'm Manny Korchman with Citi Research. We're pleased to have with us Kilroy Realty CEO, John Kilroy. This session is for investing client -- for Citi investing clients only. If media or other individuals are on the line, please disconnect now. Disclosures are available on the webcast and at the AV desk. For those joining us here today in person to ask management any questions, please step up to one of the mics. We have located in the center aisle of the room. Give me a heads up if you want to do that, please. If you're joining us from online or in the room, you can type the questions into a live QA portal for those online question on the screen. Everyone else, there's QR codes going around. Those will come to me anonymously and we'll do our best to ask them during the session. With that housekeeping out of the way, and as you guys settle in there, John, I'll turn it over to you to introduce Kilroy and any of the members of management that are there with you today, and then we'll take it to phone Q&A.

Okay, Manny. Good to see you. Nice to see everybody in person. It's thankfully, we're all back together. To my right is Rob Paratte, he's our Executive Vice President in charge of leasing and deals with our major tenant relationships. To my left is a combo now. He's our -- Eliott Trencher, our Executive Vice President, recently appointed as Interim CFO, and he's also our Chief Investment Officer; and to my far left is our President, Tyler Rose. We're supposed to do...

Sorry -- thanks for that John. What are the top 3 reasons an investor should buy Kilroy stock today instead of any other listed property company?

Well, I think allocation of capital. With regard to what we're doing now, we have a fabulous development pipeline. It's producing extraordinary returns, best-in-class product and best-in-class markets. I think it's a real differentiator. We moved into Austin recently. That's another example of an area where we're allocating capital. And you may have seen in our deck that we published this morning, we have entered into escrow. Actually, we signed a PSA gone hard, and we'll be closing later this week on a property -- a major property for a 500,000 square foot ground-up development in the domain area of Austin. So I think we're going to end up between Indeed Tower, which we bought less than a year ago in the CBD. And with this new asset, I think we're going to end up with the 2 best assets in all of Greater Austin. And then the second thing is a best-in-class portfolio, where our portfolio is about 10 to 11 years old on average. It is the type of product that people want to be in. We've talked about this a lot over the years as well as here at the Citi conference, and we're seeing that tenants are definitely gearing themselves up to the quality space and moving into the quality space because it's what their people want. And lastly is improving fundamentals in all of our markets at varying rates, we're seeing increased demand, increased rental rates, increased valuations for high-quality space. The activity is on the rise. We're seeing that in all of our markets, and particularly, in life science, but also now in office and in apartments. So those are the 3 reasons.

Thanks. John, as people do their screens here on office, they still think of you as largely a West Coast company, maybe California company, probably less so an Austin company. Just using that sentiment or that investor mindset for a second, how bad are things in California? And should people really be worried?

Well, if you look at San Diego, it was a sleepy a few years back. Now it's become a tech mega. Obviously, it's always been life science. That market is on fire. High -- rents are going up exponentially. Demand is extraordinary, and it's a very well-run city as good schools as all that sort of stuff. In LA, it's always been a tale of multiple cities within the greater LA area. And the West side and Hollywood have tended to be the best places to be along with Culver City. Obviously, on the west side, if you have a lot of amenities and whatnot. You do have some homeless issues and some lawlessness issues throughout California. This is a result of very bad policy. But happily, what we're now seeing -- then I want to just cover an San Francisco. San Francisco has had a couple of big whacks. One is homelessness and lawlessness Obviously, it's been the most rigid city, I think, probably in the country on COVID, that is now -- that latter part is now changing. A number of major tech companies have come out and supported Mayor Breed. They've said that they're going to start refilling their buildings here soon, and that's a very positive sign. With regard to the lawlessness issue, there are 2 recalls going on, one for the district attorney of San Francisco and the other for the district attorney for the County of Los Angeles. And I think we're going to be successful in those efforts. And that is as a result, not of some right wing group or some whatever group, it is a coalition of people that are just better businesses, homeowners, small business owners, school, attendees, teachers, et cetera. You just can't have lawlessness. And so you have to have people to prosecute the laws and whatnot. And that is definitely changing. And I think you're going to see some very positive things happen in upcoming elections. And for those of you who may have noticed, they just threw out 3 crazy people from the school board up in San Francisco, 78% of residents that vote in San Francisco. So you can't do that with other than a broad coalition. So I think that's what's really positive. And we are seeing -- and Rob can talk later about the fact that people are really beginning to reoccupy and whatnot. I think that's going to change things dramatically.

So a couple of hours ago, I guess, at this point, Marc Holliday from SL Green spoke about that less of a correlation between sort of that occupancy and tenant leasing trends and desires. Are you seeing the same? Do we need people to reoccupy to get leasing up again?

I'm sorry, the last part of the question, I didn't get.

Do we need -- does occupancy in the office buildings need to come back before sort of more leasing decisions are made?

Go ahead, Rob.

The answer is yes and no. We have in our portfolio at Kilroy in the Silicon Valley and San Francisco I'm talking about. We have activity now that's expansionary and tenants are sort of, I'd say, in the 25% reoccupancy mode in the Bay Area right now. That said, there are companies, some of whom we're talking to that have already made plans or are thinking about 25, 26, 27 because one thing, Manny, as you've heard us say on earnings calls and meetings like this over time, tech even in 2020 and the depths of 2020, tech had record-breaking hiring, and they've continued on that trend. And so we believe that once people are back in the office, and it's the first time during the pandemic that executives, the tech companies actually have conviction about bringing their employees back. It's not you're coming back sort of in May, you're getting a notice saying, you come back 3 days a week or in Microsoft's case one day a week and then you ramp up. So I think it's sort of a confluence of you continue hiring, but you start bringing people back in, you have a much better idea of what your footprint is. And therefore, I believe, in cities, even San Francisco, you'll start to see demand pick up.

What's Kilroy's work-from-home or work-from-office policy right now?

We work from the office. But we've always had as a company way before COVID, we've had at the discretion of supervisors. So they can adjust people's schedules. I mean, after all, people have kids and sports, they have parents, perhaps that live in home, they have special needs, children, whatever it might be. So we've always had a degree of flexibility. But inherently, we're an office company. Now we have changed 1 or 2 of our offices around a little bit, and we're going to change our Westside Media Center Office, which is our headquarters. We're going to move our corporate headquarters out of there into Santa Monica to one of our buildings that's coming back because we can then move it into brand-new space rather than try to redo the space as we occupy it. It was funny to think that we moved in there 15 years ago or so, it was the most modern sort of techy kind of cool space and now you look at it and you say like we ourselves have been a little bit in the dark ages at our corporate offices, but our policy is work from home. And I can tell you that our people are so excited to be back in the office. San Diego, we had to shut down for a while because of the rules, but it's been open for quite some time and the energy level in that office is amazing. The energy level is pretty good in all our offices, but where you have these policies by politicians that have been really harsh understandably, the energy level is less. But it's interesting. In San Francisco, our parking garage at our office and some of our other garages is now back to almost full revenue. And so people are in the city. It's interesting. They're in the restaurants, not all of them. They're in the bars, they're in the places of worship. They're in the sporting places. They're even in the concert halls and in many cases, in the movie theaters, but they haven't been required to come back to work. And I think there are a lot of folks, frankly, I don't want to say it this by anybody here, of course, but I think there's a lot of people that do more than work during working hours when they work from home. Eliott has got interesting story about that, but you can tell it later. Not about Eliott, about someone else he's related to. Just got the notice, works for a big tech company in New York, and he's been living in his spare bedroom for the last year. He just got the notice, you will be in the office 3 days a week, and you will be back by what is in April...

April 3.

April 3 or you will not have a job and all of this said, oh, my golly, I've got to go to work. Yes.

Rob, maybe this is one for you. It's coming from the Live QA site here. Given your focus on tech or at least your interactions at tech, what is the change post COVID? How much less occupancy your company is assuming? And then how are they altering or fine-tuning their space to match that?

So it's a good question. We've spent a lot of time talking with our clients as well as prospects about that. And CD, just to start with the statistics, CD surveyed over 800 companies in the U.S. about their growth needs, their need for space, are they giving back and less than 7% of those 800 companies said, we're going to need less space. So it's either stable or growing. And as I said earlier, there's massive hiring that's continuing to go on in life science and office as it relates to tech. So I think that's kind of the bottom line in terms of how the space will get it toward.

It's interesting, Manny, and the group, some of the biggest tech companies and others that aren't as big have been consuming massive amounts of new space. If you look at Facebook or Meta just took 500,000 or 600,000, 700,000 feet. It was a remaining big block in Austin. They've taken another big spaces around. You've seen Amazon take big spaces in various markets and Microsoft and many others. So while they've not been back to work, they've been consuming huge amounts of new space. And you notice what I said, new space it's space that works for their population. I've spoken for years about the decline of a lot of the older buildings. And I think COVID has just accelerated that obsolescence. You've mentioned Marc Holliday, look at one band and how the leasing they've done all through COVID. And it's been at the expense of a lot of older buildings that just don't -- doesn't -- do not comport to people's new needs.

The last thing I'd say on that, touching on what John said is that there is a transition going on. It's been going on during the pandemic, but tenants with leases in place are reconfiguring their space, and they're reconfiguring it to spread people out, not so much because of social distancing concerns as part of it, but more about quality of life for the workforce. And a big component of every office floor we're seeing and the companies we're talking to is what I would call the hospitality component of that floor where there's areas to gather socially, have beverages, hang out after work. And so if you couple that with the massive hiring we've been talking about, we don't see a decrease in need for space. Right now, I hate for telling the future, but this quarter, thus far, we have more activity. We're in more discussions this quarter than we had any quarter in 2021 and over 95% of those discussions are expansionary.

An interesting thing about modern office space. It's the meeting room is no longer always a conference room. It's more like a living room. Sometimes they're big, sometimes they're small. Sometimes they're set up differently or reconfigured even daily. Indeed, which is the latest, greatest, biggest building that we bought that's in Austin, they have 9 floors. Their top 3 floors are all amenity space. And then they have amenity space, obviously, on the 6 floors where they actually office. But it's all geared towards attracting and retaining and creating a really pleasant fun hip workplace environment. This business of the benches and so forth that we saw for so long where everybody sort of rammed in like this. And you're doing and talking on the phone, and I can't hear myself, think and reminds me of that -- we've lost Manny, I think. We lost him.

Yes. I'll actually be able to take over from Manny while we try to get him connected again, guys. I guess, switching the conversation towards the Austin deal that you announced today, right, can you just talk about sort of the growth strategy there in Austin, some details about the project that you'll be doing there as well?

I'm not sure I heard all that correctly, Bill. Let me start, and then I'll have Eliott follow up. Our strategy on Austin was a similar strategy to what we have when we moved into San Francisco, when we moved into Hollywood, when we moved into Seattle. And that is have critical mass, have super assets that you can add value to if you're buying them, immediately get into good development where we really know what we're doing. I think we offer a better mousetrap. And I think in this kind of environment, we create more value there because we get better returns and generally have a lower cost in terms of cost per square foot. Austin was exactly that case. We tried for 5 years, we looked at that market. We looked at buildings. We looked at companies, we looked at any number of opportunities. We looked at development sites, and then we found an off-market deal in Indeed Tower, which was the largest -- it's the largest building. It was the largest office deal ever done. And I might point out that was an off-market deal. And if we looked at it, Indeed Tower that's about 11 or 12 years old, over in the domain with a much lower rent sold at a cap rate that was considerably lower than what we paid. We think we made about $125 million on that purchase alone and the rents have skyrocketed. We underwrote to 43. We're now doing deals in the low to mid-50s. So we like that. So we've been looking through every kind of opportunity, and we came upon the steel that is in the deck. It was formerly known as Arena Tower. We're not going to call it Arena Tower because it's next to Major League Soccer and those are called stadiums, and not called arenas. But in any event, that was an off-market deal. We bought the land for $40 million. It's already entitled. It's already has building permits and we're ready to go. We'll be under construction by midyear. And so those folks spend probably $8 million on design and on permitting and caring and all the rest. So we'll have an asset that will be in for about $700 a foot, you want to take over from there?

Yes. We think all in, we'll be in the low $700s a foot. And as John referenced, you've seen trades literally down the block that were much closer to $800 a foot for older product. So we think it just kind of is a testament to the value creation through our development strategy. And in terms of the bigger picture, as it relates to Austin, CBD is a market that we've been focused on because it has a lot of the characteristics of the West Coast markets. It's got a public transportation. There's an amenity base there. It's walkable, and there are some supply constraints, believe it or not, even though it is Texas. We think that this site that we bought by the Domain has a lot of those similar characteristics. You have the amenity based at the Domain Mall, the restaurants, there's 4,000 apartments nearby, there's almost 1,000 hotel rooms. And so we're right next to all of that. So you have the amenity piece. You have the validation from large-cap technology. It's a 3 million square foot Class A market that's 99% leased today with anchors such as Amazon and Meta, Indeed as well and Expedia. So there's a lot of validation that gives us comfort in a project of this size of about 500,000 square feet. But we have our own identity because we're literally catty corner from the Domain. So we're not sort of bound by the constraints of the Domain, but we think we can drift off of the benefits of it. So it kind of brings the best of all worlds.

Got it. Thank you. And then just on -- just touching on Austin as well, I think if I'm not mistaken, Rob, you were leading the leasing efforts just for now. Is there any plan to add on another person, the leasing head down there? Or what's just sort of the strategy on that side?

Yes, we have plans. We, in fact, hired somebody who is an executive at Lionstone, who has a background in leasing and acquisitions. His first day actually is today. He's rolling his sleeves up already, but we're really happy about hiring this individual. We also have moved one of our senior asset managers from Los Angeles who wanted to move to Austin. So we -- part of our retention of our employees is letting people have mobility. So one of our key people in LA has relocated to Austin to run the asset management function, and we're going to continue with those 2 there to grow our team the way we've done in every market within it.

Got it. And then if we can change the conversation towards just the life science development aspect of the piece, right. I know you guys delivered some stuff at Oyster Point 1, and you're working on 2 and sort of progressing along that. Can you guys just update us on sort of what the status is on the overall project and sort of what that looks?

Let me just put in context for everybody. So at Oyster Point, it's called Kilroy Oyster Point, it's a city of South San Francisco. It has a mile of frontage. It's not all straight, but on the bay, it's next to Genentech and all the major companies. It's the largest project there. We can do over 3 million square feet. We delivered 600 -- roughly 700,000 feet fully leased just recently. We're under construction with approximately 900,000 feet in 3 buildings. We have a number of phases to go, of course. And then we also have quite a bit of life science down in San Diego. So you want to take Oyster Point and can take...

Sure. So as we've said numerous times, the market there is probably the hottest market on the West Coast next to San Diego and Oyster Point. Right now, there are 61 active requirements that total about 3.6 million square feet in the market. Average tenant size in that market is about 57,000 square feet. They have kept life science companies have continued to hire during the pandemic as well. Genentech recently has begun moving their people back into the labs and office, which they hadn't done prior. So we're very excited about that activity coming back to the market. We have literally, it feels like Austin sometimes, we have tours or presentations every other week. We have one I'm going back to California on Thursday to do a major presentation for life science users. So we couldn't be more pleased. Rent growth is up over 15% from last year on deals that are being signed. Our steel is just coming out. We have our cores up. But once we start getting framing and steel really on the skyline, activity will pick up. And the last thing I'd finish with, which is terrific for us, is that we have the sweet spot of delivery, where we're delivering in the fourth quarter of 2023 and there's no meaningful competition on either side of us in that window. So we feel very confident about our chances of success there. And actually, it's borne out by the activity we have going on today.

By the way, you're talking about rent growth, when we underwrote and got really enthused about assembling Oyster Point, we looked at what the rents were in South San Francisco at that time, and they were in the high $50s. We sort of forecast that we get into the early $60s. But our thesis was pretty simple. A lot of the same companies and the same kinds of users that are in South San Francisco are in Cambridge at the time Cambridge was in the $85 triple net range. You know where it's gone. It's blown way past $100 now. And the city of South San Francisco, you're going to see a triple-net very soon. So we're pretty enthused about our position there. And then San Diego?

As far as San Diego go is on the demand side, it's been very strong as well. In San Diego, kind of ground zero has been Torrey Pines historically, it has -- Torrey Pines is full, spilled over into UTC. UTC is effectively full, and now it's going into other places. One thing that you've heard us talk about in the past is the conversions that are happening and how maybe we're a little cautious about some of that. Now with that said, we announced previously that we are converting 3 of our properties in UTC and Del Mar life science. The important difference is we leased all 3 of our properties before we spent the dime converting them. So we've derisked our conversion. We've proven out that the quality that we have on the office side does lend itself to life science. We had studied where the demographics for life science talents are in the San Diego area, and they're concentrated. There is a pocket downtown, but there's a big concentration in Del Mar along the 56 Corridor. And that kind of gave us comfort that you will see demand for life science come to Del Mar, and we started studying our buildings to figure out which of those lend themselves to conversion. So when the time came, we were prepared. Now fast forward, you've seen some of that demand kind of continue to go across the 56 Corridor and a 500,000 square foot tenant has just signed the lease on the 56. And for those that are familiar with life science, the cluster model is very much built on that anchor and the virtuous cycle can start once you have that validation. So we've seen that. It gave us comfort as we think about the land that we have along the 56 that it could work for life science, and we've positioned ourselves accordingly.

The last thing I'd add to what Eliott said both at Oyster Point and in the San Diego life science markets of Torrey Pines and UTC, specifically and Oyster Point, all 3 markets, vacancy is less than 2%. So that's what's partially driving the move in San Diego into the corridors, Eliott's talking about. But again, in his point about clustering the sweet spot for life science really is the Oyster Point submarket, both in terms of access and for us, it's the scalability that we can provide a growing company.

Got it. Thanks, guys. And then just a question that we've been asking in each of these sessions so far today. We were just wondering, what is the biggest growth opportunity that you believe the market is not giving you credit for today?

I'm sorry, you're not coming in very clear so.

I'm sorry. What is the biggest growth opportunity that you believe the market is not giving you today?

Yes. I think it's our development pipeline. Nobody has a robust development pipeline. There's not another office company that's public that I know of in the United States that has the pipeline we have in the markets you want to be this geared towards the types of tenants that are really leasing space. And there's huge value creation there. Just think of what we did with the exchange, which was 750,000 feet that we had $560 million, $570 million invested in Dropbox, a noncredit tenant was the tenant had 11 years left on the lease or whatever it was. And we sold it for just under $1,600 a square foot, the highest price ever in San Francisco. We doubled the value and I think we ended up with something like 11-or-so-percent average return unlevered for the 2 years during safe harbor. The other thing would be our mark-to-market is changing pretty drastically. We say that's about 15%, but rents are going up quite a bit. And I think that where rents go, they don't go to the moon, but they're going there in certain markets. So I think there's an embedded into Kilroy, some pretty strong growth. And then it's just back to the quality of the portfolio, which nobody has the modern portfolio at scale that we do, and it's exactly the kind of portfolio. In most cases, that the new tenant, their tenants want to be in. And as Eliott mentioned, while Del Mar has been a life science community for some period of time, there was nothing that was available. As soon as UTC and Torrey Pines couldn't accommodate anymore, we found that we could take those facilities, some of which were 10 or 15 years old that we own that comported themselves very nicely to life science and Eliott gave you the math. So I think there's 3 areas there, not 2 that are pretty significant.

Got it. Thanks, guys. And then, Manny, I think we have you back online or no.

Hopefully.

Welcome back. How's it when you worked from home?

Exactly. I was just trying to prove out, John, that work from anywhere doesn't always work. It's -- I need to go get the delivery now. Dropped the Internet, what can we do. I actually had a question similar to that and going back to the point made earlier, Eliott, your friend who is sleeping on your couch. He gets us this letter from his boss saying, come in or you're terminated. Let's relate that back to this question of what was his first reaction? Is it move to New York? Or is it -- I'm going to find a job to let me say here?

I'm going to get Eliott so much trouble for having brother in the face, sorry, buddy.

No worries. I think everyone there is figuring it out, honestly. And you have to go back. If you want a job, you got to go back to where your job is. Now different companies, I think, have different approaches to this. And I think what we've seen from a lot of the large cap tech, and Rob could probably speak to this as well, is creating different hubs across the country. Maybe you can live here, maybe you can live there. It has to be where there's a cluster because of the benefit of having different folks together and the importance of how that kind of drives business that they're not going to let people live anywhere. But if there's a critical mass. And by the way, those critical masses overlap very much with a lot of the markets that we're in, maybe that's a slightly different story.

And I guess outside of Austin, are you guys blanket to that at all? What are the sort of clusters outside of San Francisco and LA and Seattle and San Diego and Austin are you looking at?

Well, we didn't move to Austin, just buy a building and now we're developing a building, and we didn't move to Austin just to be in Austin. I think you'll see us in other areas in due course. One of the reasons that we peaked our interest about Austin was the vast number of tech companies that we regularly talk with and Rob meets with them all the time and what were some of the things they were saying about -- that led us to go to Austin.

All right. There's the belt. But for years, as we looked at Austin, our clients as well as others kept asking when are you coming to us. And it really -- there's a time gap between a lot of the product that's in the Austin market, meaning there's a lot of it that was built in the late '90s and 2000, and then there's a big gap to modern office buildings and Indeed Tower was so attractive to us because it was the type of thing Kilroy would build, and that gave us the foundation and foothold. So growth is going to continue in Austin. There's been massive absorption downtown between Meta and TikTok recently, almost 1 million square feet in the last 90 days. So it's a great market. We see a lot more potential for growth in terms of our clients and companies moving into the city.

What about your rapid fire question?

We'll get there. We have 4 and 1 second left.

Oh, I thought we're done. What was that bell -- cutting me off from wanting that.

That we just didn't want to hear. On the new land site and pardon me if I missed this while I was disconnected. But on the new land site in Austin, you guys are going full spec there. You typically haven't been a spec developer unless you had a tenant in your back pocket that you weren't really spec or you really thought the demand was going to be there by the time you deliver, which one of those is it here?

It's spec, and we do -- sorry to correct you, but the vast majority, like 80%, 90% of the development we have done, which is $5 billion or $6 billion in this cycle has been spec. It's just leased during construction. And I have no doubt that this building is going to do very well. It's going to be the best building in the Domain with more bells and whistles and it's in a great location with great amenities and the demand characteristics are there are just fantastic.

And then in terms of it, you keep saying it's in the Domain, I looked at the map, it looks like it's across the street from the Domain, there's another...

That's what Eliott said.

There's another developer we've been following for a long time that has faced across the street from the Domain, and that across the street has been a big issue for them. Why do you think it will be different here? Why do you think you're more sort of Domain proximate than maybe you really are?

Do you want to take that?

Yes. I think that what we really looked at here is a few things. One, we're right next to the soccer stadium. The soccer stadium has a lot of life to it, it brings a lot of energy to the area and it makes it a little bit more of a walkable amenitized location than a typical suburban location. It also is going to be walkable to transit because of the soccer stadium. So when we think about what -- and it's going to be brand new with all the bells and whistles, as John said, that has -- that we brought in other markets. So it really -- it's not about whether it's inside the walls of the Domain or outside, it's about what the Domain represents. The Domain is a very centralized location, and it has an amenity base there. And we're able to leverage both of those. We're also going to be able to leverage the soccer stadium and the transit to build what we think will be a successful project.

Right next to the soccer station or the soccer stadium, they all have a mixed-use development that's retail, apartments, a hotel and some office space. It's literally just adjacent to us. So we think we're pretty well positioned.

And now to the rapid fire. What will same-store NOI growth be for the office sector overall in 2023?

3%.

What will the 10-year treasury yield be a year from today?

2.25.

And where will -- will your property sector have more or fewer public companies a year from now?

Fewer.

Great. Well, we have 45 seconds left, so I'll ask one more question. Just where are we on the CFO search?

Well, Michelle, as you know, resigned, she took a position with a private company that's doing pretty exciting stuff, they do ski areas and golf courses and marinas and all sorts of things. We were sorry to see her go. She's been with us for 17 years. She's been a terrific asset. And when we began to think about succession for Tyler, we thought of 3 candidates, one of whom was Michelle, another woman in our office and Eliott. Eliott, when he joined from Cohen & Steers, my goal was to have him be the next CFO. And then we made him CIO, and he liked that so much. He didn't want to be the CFO. Now he gets to be both. We will start a process we determine exactly what we need. And we'll have a CFO that is geared towards the Kilroy that you're saying now, which is bigger and more markets and so forth.

Thanks, everyone. Thank you, John.

Manny, good to see you. Thank you, everybody.

Thank you.