Kilroy Realty Corporation (KRC) Earnings Call Transcript & Summary

Angela Aman. This session is for Citi clients only, and disclosures have been made available at the corporate access desk. To ask a question, you can raise your hand or go to LiveQA and enter code GPC26 to submit questions. Angela, we will now turn it over to you to introduce your company and team, provide any opening remarks and tell the audience the top reasons and investors should buy your stock today, and then we can get into the Q&A.

Thank you. Thank you all for joining us today. We're happy to be here. My name is Angela Aman. I'm the CEO of Kilroy Realty. Kilroy is a premier owner of high-quality office and life science assets up and down the West Coast and in Austin, Texas. We're uniquely positioned to benefit from some of the trends associated with AI and emerging technologies that are really taking hold across our markets and driving a significant amount of leasing demand today. I'm joined today by Jeffrey Kuehling, our Chief Financial Officer; Eliott Trencher, our Chief Investment Officer; Rob Paratte, our Chief Leasing Officer; and Doug Bettisworth, our Head of Investor Relations. I think in addition to what I mentioned earlier, which is what's happening with AI across West Coast markets and the fact that companies like Kilroy, in particular, are uniquely positioned to benefit from some of these short, medium and longer-term trends. There are a number of other things as a company I would also point to as significant reasons to buy the stock today, including a long-term track record of successful capital allocation across cycles. What's happening in West Coast markets right now certainly has presented interesting opportunities for us as a company, both in terms of disposition activity and in very select circumstances in terms of acquisition activity as well. Given some of the recent market movement, we also have a whole new host of capital allocation alternatives available to us as it relates to stock buybacks at very attractive and accretive levels, particularly as fundamentals continue to inflect across our West Coast markets and the transaction market continues to improve across all of our markets as well. And then the last thing I would point to is as we look at those -- the inflection of those fundamentals as it relates to '25, '26 and into 2027, we're in a very favorable position in terms of the amount of leasing that's been done, particularly over the last 12 to 18 months, much of which is scheduled to come online throughout the course of 2026 and into 2027. So we have a significant tailwind from leases that have been signed, but have not yet commenced and will be commencing over the coming years. It's going to be a significant source of growth for the company going forward.

And maybe just can we start off with -- could you provide just any color on kind of what you're seeing across the markets through the first quarter, where are you seeing the most strength, where you're seeing the weakness?

Sure. I'll jump in and start, and then I'm going to turn it over to Rob to give a little bit more color on some of the high-level trends I'll sort of discuss as we walk through our markets. San Francisco, the Bay Area overall is our largest market at right around 50% of our square footage or ABR. It's also the market that's seen the most significant improvement in fundamentals over the last 12 months without question. We've seen and continue to talk about some of the exciting trends we've witnessed in that market as the radius in which tenants are looking to occupy space has continued to expand. You've got tremendous amounts of new business formation and growth occurring in the city of San Francisco, but really across the Bay Area. Over the last couple of quarters, we talked about the improvement in fundamentals from historical or legacy large users of space in the market. As they stopped putting additional space onto the market, either in terms of direct vacancy or sublease space. And over the last quarter or 2, we started to see some of those traditional Big Tech users who had significant amounts of space on the sublease-market begin to pull space off of the sublease-market, which is an incredibly positive trend as it relates to the overall health of the San Francisco Bay Area. Over the last few months, we've seen Google pull over 1 million square feet of sublease space off the market in Silicon Valley. So again, pointing to some very positive trends in terms of how new users are utilizing space across the market, but also some of those legacy companies that have been an overhang in terms of how the market has performed from a fundamental perspective, really reengaging with their real estate and bringing people back in to occupy space that they didn't expect to occupy before. So really positive trends in San Francisco. We're seeing some pretty similar trends actually in the Pacific Northwest, in particular, in Bellevue. We've seen a lot of companies, a lot of names that have been high-growth companies in the San Francisco market begin to take space in Bellevue really to tap into what is a significant tech talent base in the Bellevue market and the Seattle market overall. Bellevue is pretty tight from an availability standpoint, certainly within our own portfolio or the market at large. And so you're starting to see some of those positive fundamentals and dynamics spill over to the Seattle side as well. We have one asset in Seattle that's got a fair amount of vacancy. It's called West8. It's an asset that we had done a major repositioning on a couple of years ago. And we just in the last quarter or 2 started to see some of those really positive dynamics play out. We signed about 74,000 square feet of new leases at West8 in the fourth quarter, and the pipeline behind that is very strong as well. So as I mentioned in a moment, I'll let Rob sort of unpack some of what we're seeing in the Seattle market in more detail. San Diego has been a consistently strong market for us. The bulk of our San Diego portfolio is in the Del Mar submarket, which has been extraordinarily strong and where we have significant market presence that allows us to really drive occupancy and rate in that market. So we've seen consistently good performance and fundamentals out of San Diego. Austin, we have one large asset in that market, and we've consistently worked at leasing that asset up and had some big wins over the last quarter or 2. So good progress there as well. And then we have the Los Angeles portfolio, which we've been candid about historically has been more of a challenge given the overall market dynamics. I would say for us as a company, however, and our feeling about sort of the pace or trajectory of leasing activity in the Los Angeles market, it's improved dramatically over the last couple of quarters. And that's both because I do think fundamentals are starting to firm up to some degree in different submarkets within Los Angeles for different reasons, but also because it's one of the markets we've been the most intentional in, in terms of capital allocation. We sold a small asset in Santa Monica towards the beginning of 2025. In the fourth quarter, we sold our lowest quality asset in the Hollywood submarket, and we bought one asset in Beverly Hills, which along with Century City are the 2 best-performing submarkets in the greater Los Angeles market. So we have seen from an activity perspective, an occupancy perspective, an execution perspective, a rent perspective, a significant improvement. But I will acknowledge it's 2 things: one, some improvement in the market and then some very intentional capital allocation work that we've done in that market as well.

I'll just add a couple of points to underscore what Angela said. Bellevue speaks for itself. We continue to see positive Net Effective Rent Growth. I think the thing that's really interesting about Seattle is that in the last 90 days or so, we've seen a lot more activity at West8. As Angela mentioned, we did a 2-floor law firm deal, moving them from the CBD to our West8 project, and that's just the start of the momentum we're seeing. And I think what's particularly notable is the new-to-market tenants that we're seeing and that we're talking to. So there's more to come on West8, but Pacific Northwest is sort of following a little bit behind, but the same sort of trend San Francisco hit on. Angela said most of it. I'll just underscore a couple of points. Everybody hears about the 30% availability rate in San Francisco. Of that 30%, 50%, I said this on the earnings call and emphasized it. I'll say it again, 50% of that 30% that's on the market has not transacted since 2023 or later, and that's either because it's functionally obsolete or the landlord cannot fund tenant improvements or a combination of both. So that 15% is something that we don't compete with and we've really had strong leasing success. The other thing I'd hit on is that Silicon Valley has also made a pretty dramatic in '25 recovery, but I emphasize that it's on transit-centric lines like especially the Caltrain line. So for example, our Crossing 900 project in Redwood City, we did a significant mark-to-market downsizing Box and putting Davis Polk law firm in. And there's more activity like that in Redwood City, but again, you have to be on a rail line or on a major freeway. Los Angeles, I would say we have really excited about Maple. We've surpassed Eliott's underwriting and lease-up assumptions just in terms of the activity we had, and it's a really high-barrier market. You can't build the type of asset we have with the amount of parking we have, and it's very attractive to residents in and around Beverly Hills and it provides a different sort of experience than high-rise in Century City. And Century City is arguably the strongest market in L.A. Just touching on San Diego quickly. I wish we had more space there. One Paseo continues to set rental record highs for North County, San Diego, actually last time for the entire San Diego office market. Austin, we know we continue to have really steady net rents. They are still above our underwriting. It's just a little bit slower in terms of transactions, but we don't have big blocks of contiguous space left. So we're making very good progress. The last one I'll hit on is Oyster Point in South San Francisco. There's about 2 million square feet of activity right now in the Bay Area market. We're talking to about 30% of that. And of the availability that's in the market, a lot of it has been absorbed just like San Francisco. So the good quality sublease space is gone and now you have non-contiguous blocks that are various vintages and configurations. So across our platform, the flight to quality continues to be a factor, but we're also seeing tenants by and large, in expansionary mode, and we're reaping the benefits of that as we continue to focus on executing quickly and efficiently.

I think in that, you kind of mentioned large tenant activity is up. Are those -- are you seeing conversions from tours to signed leases on the large tenant kind of side? Or are they -- is it more of just the increase in tour activity that you're seeing for now?

It's definitely -- conversions are happening. It depends on the tenant. They can happen very quickly. AI companies are very nimble and move quickly, especially when they need space and they keep growing. Basic technology companies that aren't necessarily AI also tend to move quickly. And then you have -- I'm using San Francisco as an example, you have a large component of FIRE category tenants. And depending on the tenant and whether their lease is expiring in the near term, they can move quickly or they can move more like a bank or an insurance company would, but just a little more slowly. But definitely -- and that's not just San Francisco in terms of converting tours to LOIs or leases. We're seeing it across the spectrum.

Yes. I think 2 of the largest leases we signed last year, which would be the Harvey AI deal we did in the city of San Francisco at 93,000 feet and then the backfill for NeueHouse in Hollywood were both deals that sort of began their infancy and got executed within the same quarter. So we have seen in certain circumstances, things move very quickly with tenants being very willing to act and to execute. Across the board, if we step back and just think about all that new business formation and growth we're seeing in the city of San Francisco, one of the most interesting dynamics is the sense of urgency a lot of these earlier-stage companies have to get into space that's ready to go plug-and-play space. So that's where, as an example, the Harvey AI deal, we had space that had come back to us from a financial services tenant that was fully built out and furnished and they could get into occupancy very, very quickly. That gave us a huge competitive advantage on that deal. We've been intentional at building out in certain circumstances where we believe it's warranted spec suites that can really service some of those earlier-stage companies, and we can have inventory that's ready to go for them. So in certain circumstances where you really can meet the needs of the tenant in terms of speed to occupancy, not just speed to lease execution, but speed to occupancy, you can get things executed really across our markets quite quickly now.

And then kind of the leasing pipeline, how much of that is kind of that spec suites leasing that you kind of alluded to versus the kind of larger spaces?

Spec suites is a factor, but it's much more targeted in terms of where we're using it. It doesn't -- it's sort of not a blanket strategy. We have not rent out and built spec suites across the entirety of the portfolio. It's really been sort of a thoughtful exercise to think about where we have vacancy and where we think that vacancy would be best positioned for the kinds of tenants who are looking for spec suites in the market. So 201 Third is one of the best examples within the city of San Francisco where we've done that. That depends on the size of the floor plate for that asset, amenities we already have in the building that can help support that spec suites activity and where the pace of leasing is. So that project has been highly successful. We're still under construction on a full floor of spec suites with some shared amenities. And we leased all 4 or 5 of the spec suites before we finish construction of the spec suites, fully executed deals before we finish construction. Again, just speaking to the sense of urgency you're seeing in a market like San Francisco to get into that kind of space that's plug-and-play and ready to go. Spec suites have obviously been very helpful in our lease-up at KOP. We've done several spec suites deals. We still have basically 2 half floors of spec suites remaining, and that's been a key differentiator to some, certainly not all, but some of the leasing traction we've had at KOP. And with the Nautilus acquisition in San Diego that we announced this quarter in Torrey Pines, we had communicated on the call that we think a smart, disciplined spec suites initiative there will be very impactful for leasing as well. So -- it has been a real contributor to securing some of those deals and making things move faster and really meeting the demand that's in the market today for speed to occupancy, but it has been a targeted strategic approach as opposed to running out and building spec suites everywhere and hoping for the best.

I don't really have sorry, we used to the live mic the entire time. I don't have much to add to that. I mean I think what's different from a year ago is that, yes, there's a lot of demand for spec suites and they lease quickly, but we're also seeing larger tenants in the market, larger than we've seen in quite a while. So a lot of our pipeline right now are 50,000 feet or bigger. So -- and those tenants tend to be -- larger tenants tend to be more willing to and have the capacity to hire architects, build out space the way they want it.

Yes. And the time -- I mean, not to keep coming back to 201 Third, but it is an asset that's really uniquely positioned for us in San Francisco today where we have the vacancy, and it's very much in that radius where tenants want to occupy. We still have some remaining vacancy at that building. And given the success I just mentioned on the spec suites program, the next logical step would be to keep going with another floor of spec suites, but we have enough demand from larger users, we think, may be executable that we're being patient as we think about what the right outcome is for remaining vacancy at that building.

And then I think you've talked about kind of the second quarter of this year being kind of the low point for occupancy. What kind of level of expiration on the -- what kind of level of execution on the expiration schedule kind of gives you confidence that, that will kind of be the trough? And then what target retention rate do you need to kind of hit to achieve kind of the guidance?

Yes. So what we discussed on the earnings call, not in the Q4 call, but really the Q3 call is that we are expecting very little in terms of additional retention out of the 2026 lease expiration pool in order to hit the guidance numbers we gave this most recent quarter. When you step all the way back to the end of 2024 to get sort of a complete population of the 2026 lease expirations, we had about 1.9 million square feet of leases expiring in 2026. We are down to 1 million square feet at this point. And really all of those, that 900,000 feet or so have all been re-leased or handled through disposition activity, primarily to owner-occupiers. So that gets us pretty close to, let's call it, a 40% to 50% retention rate, even if we renew nothing else in the 2026 pool. 40% to 50% retention rate overall on what was the original 1.9 million square feet of 2026 lease expirations. That is very strong performance. That 40% to 50% is effectively in line with the company's historical pre-pandemic averages for retention. Now because it's split between renewals that were done during 2025 and space that's going to come back to us in 2026, that doesn't immediately show up in the reported retention statistics, but that's why we feel like it's so important to quantify that for you on the earnings call and help you understand, if you look at the complete population, it was a very strong retention experience. So that's very positive. But to answer your question directly, we're expecting very little in terms of additional retention in the 2026 pool to achieve the guidance numbers we've laid out.

And then maybe just touching on it since it's been very topical over the past couple of weeks. But what is your kind of view on AI in terms of job growth and space needs? Is that coming up at all in conversations with tenants as they think about their future space needs? Or do you still view it as kind of a net demand driver, especially for markets like San Francisco?

Yes. We view it as a net demand driver given where our markets are, in particular. There's without question going to be disruption that occurs across the broader employment landscape as a result of AI. But when we look at sort of the new business formation and growth that's occurring within our markets and some of the signals we've seen that I pointed to recently from Big Tech users pulling space off the sublease market, I think the solidification of fundamentals and real estate utilization in the San Francisco Bay Area is very, very telling right now. That disruption, if you think about it from a national perspective, there's no question that disruption is not going to be felt equally across markets. And I very much believe it was the first point I gave at the beginning about why investors should be interested in our stock is that our markets and this portfolio from a quality perspective is uniquely positioned to be a net beneficiary from some of those trends. None of us have a crystal ball and know exactly how this is going to play out, but we feel very confident that our innovation-driven markets, the amount of VC funding that's going into our markets and sort of on the ground, the real estate fundamentals and dynamics are supportive to continued growth in 2026 and beyond.

Maybe just switching topics a little bit. kind of what -- you brought KOP 2 to 44% leased. It sounds like there's good activity on kind of the back and you kind of gave the mid-5% range on the yield. What are your -- kind of your expectations for leasing for that project in 2026?

Yes. We feel great about the pipeline and sort of how it's shaped up. We've done a great job at back -- we had significant executions, as you point out, during 2025, far exceeding the 100000-square-feet goal we established for ourselves by leasing 384,000 square feet at KOP 2 last year. I've been really encouraged by the way the team has continued to execute at that project and has more than backfilled the pipeline we had prior to some of those executions. So we've got good traction across the board. Also at a moment in time when sentiment is significantly improving for life science companies. where life science companies are finding it easier to raise VC capital, particularly if they do have some AI angle to their story or their business strategy. So we've seen significant capital inflows improving. We've also seen capital recycling within the sector with significant M&A transactions and the IPO market reopening for many of those companies as well. So there's just really great fundamentals occurring. And one statistic or chart we just added to the investor deck that we posted this morning that specifically really benefits a project like KOP is that we're seeing tenants over the last really 2 quarters across the market be more willing to relocate to get space that best fits their business strategy and needs going forward. That hasn't been true for many years, where the boards of many of these companies and their investors, their funding sources have been very much in a risk-off strategy, let's take the short-term renewal, let's try to make it work in the space we have for as long as possible. And that dynamic has really shifted over the last 2 quarters. So I think that will be significantly to a project like KOP's benefit, and we're seeing that in the pipeline today as well.

And then just some clarification on kind of the yield metrics that you gave on the 4Q call. How much of the kind of yield compression is attributable to kind of higher-than-expected TIs and concessions versus lower kind of base rents?

Nearly all of it was on the capital side, capital for individual deals, but also just carry costs given that the lease-up time line here has taken longer than expected.

And then you've kind of maintained flexibility with Flower Mart. Can you kind of give us an update on how you're thinking about that opportunity for Kilroy?

Yes. The Flower Mart project, which for those of you who aren't familiar, is a 7-acre site in the Central SoMa District of San Francisco that's entitled for a very high-density primarily office development program. So 2.4 million square feet of office entitlements in the Central SoMa District. Starting, I gosh, probably about a year ago, we began a very intentional effort with the city to explore whether or not we can get greater flexibility around our entitlements and greater flexibility around the development agreement we have with the city. The goal of our efforts is to get to sort of get flexibility under the high-density entitlement plan we have that would enable us to execute a mix of different uses on the site. So that could look like a mix of office and residential as an example, a full residential plan, a mix of institutional and office or residential uses, just broad flexibility around the mix of uses that we could build at that site. And then also, as it relates to the development agreement to explore whether or not we can get some flexibility around certain of the design elements that are required by our original development agreement in order to effectively be able to phase the project from an execution standpoint. So right now, we have some limitations that would effectively mean it's very difficult from an economic standpoint to do a Phase I, Phase II, Phase III at that project as you build it out. We've also been very intentional about wanting to explore this flexibility without giving up the high-density office plan we have in place, given that San Francisco has historically been a market that comes back very quickly when it comes back. And I think that's part of what you're hearing Rob and I talk about in terms of the dynamics in that market today. So the last thing we wanted to do is get to the end of a re-entitlement process for different uses only to find out that the original office program or commercial program we had in place would have been the right one. The city under the Mayor and his leadership has been very open and communicative and constructive as it relates to what we're trying to accomplish on the site. We still have additional work to do, but things continue to move forward. And we are highly convicted that wherever we end up on this project, we're going to be creating significant value from shareholders through that additional flexibility and optionality.

And then I guess, is kind of the capital plan in the near term focused on entitlements or redesign or premarketing to like potential tenants? Or just how are you thinking about that space right now?

There's very little capital we're spending at the Flower Mart right now, but our efforts, our time, energy, resources is spent really on all 3. It's working with the city on the re-entitlement plan. It's understanding where development economics would be for any of these uses or any mix of these uses and having continued and ongoing conversations with potential users of the space down the road. We have really been approaching this project sort of as a full company effort across the development team, the leasing team, the investment team, trying to make sure that we're acting with a high degree of urgency and driving towards the best possible outcome for shareholders at the site.

And then you ceased kind of the capitalization in June. Are you kind of prepared to kind of carry that full expense load indefinitely? Or would you consider a JV or a sale? Or are any of those options, anything you're exploring?

Everything is on the table, right? As it always should be, I think, in terms of how do we know where we're at right now in terms of the amount that's been spent on this project, the entitlements we have today. I'm highly confident that we are on the right path in terms of more flexibility around those entitlements and potentially getting approved a broader mix of uses and the ability to phase the project. We'll be open to lots of different execution paths for that project as we get more clarity around some of these components. And I guess that's where I'd leave it. Yes, we're open to lots of potential different outcomes there.

Maybe switching to kind of some of the capital rotation you've done. You sold the KSS and Sunset Media and you bought Nautilus and Maple Plaza. I guess, I think you've described these as neutral to NAV, but maybe kind of dilutive in the near term to FFO. How long is the runway to get those acquisitions accretive to earnings?

Yes. I don't know that that's how we've described it actually. I'd say it's accretive to NAV. It's probably neutral-ish to earnings in the near term, but I'll let Eliott jump in here.

Yes. I think that what you might be referring to is when we looked at what historical cash flows were at some of the assets that we're selling. And we're not convinced that, that's the right way to evaluate it. When we're making these decisions, we're looking at what the forward-looking earnings or cash flow impact is and several of the properties that we sold, there was a fair amount of lease rollover that would impact the yield on cost. So -- and then you layer on that we're executing on some land sales, it's a lot more -- it's a lot less negative to FFO than you may think. I think that it's a lot more beneficial to cash flow. And when we evaluate the CapEx impact and CapEx as a percentage of NOI, and we went through some of the stats on the earnings call, it was pretty high on the properties that we sold, and we think it's going to be much more in line with our portfolio averages on the assets that we acquired. So we kind of view this as good NAV growth, minimal earnings impact and good cash flow growth.

Yes. I'd say just from an IRR -- from an IRR perspective, just to tie together what Eliott said, the acquisitions we've been underwriting things in the low to mid-teens from a forward IRR perspective. Some of the assets we sold over the last couple of years have been in the mid-single digit to maybe the higher single digit from a forward IRR perspective. So the amount of cash flow growth we're generating through that trade, I think, is really significant for shareholders. It's going to show up in the long-term durability and growth of cash flow stream.

You -- can you talk a little bit about what makes kind of the Nautilus acquisition attractive, just kind of given market views on life science and the softness in demand that we've seen kind of there today?

Yes. What we really like about that transaction is there's 2 pieces. There's the submarket, the Torrey Pines submarket, which we think is best-in-class submarket for life science, very supply-constrained over a long period of time, has the lowest vacancy, highest rents in the entire San Diego region. It has that critical mass that you really look for in any life science location with clustering from different institutions and commercial companies that really have developed an ecosystem there. So it has a really good track record as a submarket. And then the asset itself is a top-notch asset. It's a multi-tenant property that's been pretty well invested in over the years, had an institutional owner that has performed very well over their ownership. And it's got amenities from in-place food and fitness and outdoor spaces and frankly, everything you look for. So when we step back and we say, what are we trying to do with our capital, we're trying to allocate it to really high-barrier markets that have performed over time and really good assets within those submarkets. And so we think that Nautilus fits both of those descriptions. There has been some noise in the life science market. But frankly, the execution that we've had at KOP 2 demonstrates that high-quality assets can perform. And so we're confident we have about 50,000 square feet to lease there that we'll be able to execute at Nautilus as well.

Yes. I'd really emphasize that. I think sentiment, we've been acutely aware of some of the challenges in life science over the last few years, particularly at KOP with lease-up. We really believe there is a shift happening right now from a life science sentiment standpoint and the tenant willingness to execute, as I sort of talked about earlier. We've seen that at KOP 2. We've taken care of about half of that vacancy. As we're talking to tenants in the market, the tone and sentiment around their businesses, their ability to secure funding, the broader environment around that in terms of the IPO market, the secondary market, M&A activity in the space has all really changed the way tenants are approaching the real estate decisions. And we feel all things considered being in sort of the best cluster in the San Francisco market, which we believe is South San Francisco and Oyster Point, in particular, the best clusters in the San Diego market in Torrey Pines and Del Mar positions us uniquely well to capture some of that momentum shift that we see occurring in life science right now.

Real quick, some of our rapid-fire property sector have more or fewer or the same number of companies a year from now.

Sorry, what was that?

More, fewer the same number of Office REITs a year from now.

Fewer.

And then Net Effective Rent Growth for office in '27.

3%.

Thank you.