Kilroy Realty Corporation (KRC) Q1 2015 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen and welcome to the Q1 2015 Kilroy Realty Corp. Earnings Conference Call. My name is Alisa and I will be your operator for today. At this time, all participants are in listen-only mode. [Operator Instructions] And as a reminder, this call is being recorded for replay purposes. I’d now like to turn the call over to Mr. Tyler Rose, Executive Vice President and Chief Financial Officer. Please proceed, sir.

Good morning, everyone. Thank you for joining us. On the call with me today are John Kilroy, Jeff Hawken, Eli Khouri, David Simon, Heidi Roth, Bob Paratte and Michelle Ngo. At the outset, I need to say that some of the information we will be discussing is forward-looking in nature. Please refer to our supplemental package for a statement regarding the forward-looking information in this call and in the supplemental. This call is being telecast live on our website and will be available for replay for the next seven days both by phone and over the Internet. Our press release and supplemental package have been filed on a Form 8-K with the SEC and both are also available on our website. John will start the call with a review of the first quarter. Jeff will address conditions in our markets and I will finish up with financial highlights and updated earnings guidance for 2015. Then we will be happy to take your questions. John?

Thanks, Tyler. Hello, everyone. Thank you for joining us today. We had a strong first quarter at KRC and a good start to the year. We signed more than 400,000 square feet of leases in our stabilized portfolio and boosted occupancy to north of 96%. We added another top entertainment company to our list of tenants at our Columbia Square development project in Hollywood, we completed the acquisition of our first development opportunity in the South Lake Union submarket of Seattle, we continue to be on track for our 2015 delivery of $590 million of the $1.1 billion of development that we currently have on the construction and we closed on $170 million of dispositions through April and have another $163 million of non-strategic assets in escrow to sell later this year. Let's take a look at some of the details. We are off to a solid start in leasing, signing the 402,000 square feet in our stabilized portfolio. Rents were up 19% on a cash basis and 27% on a GAAP basis. At March 31, our stabilized portfolio was 96.1% occupied and 97.4% leased. We currently have 300,000 square feet of letters of intent in our core portfolio. This is another significant year for our development program. We have $1.1 billion under construction, with the office component 85% leased. We have scheduled to deliver $590 million of that product in 2015 to four tenants, adding 950,000 square feet to our portfolio. With average initial cash yields of 8%, the incremental value creation is substantial. Here is a quick review of our under construction projects. 350 Mission is our 30-storey $280 million LEED Platinum-designed class and concrete office tower in San Francisco's SOMA district. The project is 100% leased to Salesforce and is projected to be delivered late in the fourth quarter. 333 Brannan Street is our LEED Platinum-designed $105 million 6-storey brick and concrete office property, also located in SOMA. It is 100% leased to Dropbox and is projected to be delivered late in the fourth quarter. Crossing/900 is our LEED Gold-certified $190 million two building midrise office project located in Redwood City. The entire project is 100% leased to Fox and the first of the two office buildings is projected to be delivered early in the fourth quarter. The Heights at Del Mar is our LEED Gold-certified $45 million 3-storey office building in Coastal San Diego. It is immediately adjacent to our proposed land for sale mixed-use project. We expect to complete construction on the base building by the end of the year and are currently in negotiations with multiple tenants for the project's 75,000 square feet. And Columbia Square is our LEED Gold-certified $440 million mixed-use project at Hollywood. The historic office component is fully leased in NeueHouse and is projected to be delivered at the end of the second quarter. In addition, earlier this month, we signed a 10.5-year lease with an internationally known entertainment company for 34,000 square feet of the Columbia Square's new office component. That company will be moving its headquarters to Columbia Square and the lease commencement is projected to be mid 2016. They will occupy the new studio building in its entirety and approximately 23,000 square feet of the Viacom building. This is the third major entertainment company to lease office space at the project and another demonstration of the closing importance of both location and work environment for tenants in this creative industry. With this transaction, Columbia Square's overall 480,000 square feet office component is now 66% leased and we continue to have meaningful discussions with a wide range of tenants for the remainder of the office project. Finally, Columbia Square's 200-unit 20-storey residential tower will the tapped out in June and is projected to be ready for occupancy in spring of next year. We are also making progress on our near-term development pipeline. We expect to begin construction next month on the Exchange on 16th, our fully entitled contemporary office campus in the Mission Bay submarket of San Francisco. The project will total approximately 700,000 square feet in four buildings and represents a total investment of approximately $450 million. The entire Mission Bay area with a mix of residential, commercial, entertainment, health and retail components is one of the most compelling submarkets in this city. We are seeing significant interest in this project with one significant LOI placed and several very serious negotiations in progress. Just in the past two weeks, we have made four presentations for additional requirements totaling over 2,000,000 square feet. There continues to be a sense of urgency by prospective San Francisco tenants to find big boxes space in a market that has become increasingly constrained. In the first quarter, we acquired 333 Dexter, a full city block in the vibrant South Lake Union submarket of Seattle along with three smaller adjacent land sites that are collective lease owned for approximately 700,000 square feet. The existing zoning permits office, residential and some retail. We paid approximately $50 million for the property or roughly $71 per square foot, or rather per FAR foot. We project preliminary development cost to be in the $350 million to $400 million range depending on the eventual project size and product mix. Subject to market conditions, the application process and final permits we expect to be under construction next year with delivery as early as 2018. On the one for sale front, we received approval in February by supermajority of the City Council for our 1,400,000 square feet mixed-use development. As anticipated, the nearby property owners initiated sequel litigation in gathering signatures to put the project on next year ballot. We're committed to successfully developing one for sale as envisioned and between now and the election, we will continue to educate voters on the merits of the mixed-use projects. The fourth near-term development project is our 475,000 square foot mixed-use Academy Square project in Hollywood. The entitlement work continues to progress on schedule and while we don't expect to complete the process until the end of the year, we are already in discussions with several prospective tenants for material portions of the office space. In summary, our near-term pipeline includes the Exchange, 333 Dexter, one for sale and the Academy. These projects have a total estimated investment of approximately $1.5 billion to $2 billion over the next few years, subject to entitlements and market conditions. Further out in the horizon is our Flower Mart project located in Central SOMA. We believe that this project represents one of the most compelling development opportunities on the West Coast. With a world-class design location near the future Central Subway, historical significance with the inclusion of the wholesale flower market, all coupled with an attractive land base, the Flower Mart project provides us with the opportunity to create significant value over the next few years. While we are early in the entitlement process, we are making good progress and moving along as planned, more to come. On the disposition front, we continue to make good progress on the sale of non-strategic assets. In January, we completed the sale of land parcel in Ervine for total proceeds of approximately $26 million. Earlier this month, we completed the first of two phases of a nine property San Diego portfolio sales, generating gross proceeds of approximately $95 million. We are in escrow on the second phase, which is expected to generate gross proceeds of approximately $163 million with closing later in the second quarter. And earlier this week, we completed the sale of Redmond, Washington property for total proceeds of approximately $51 million. In aggregate, excluding the land sales, the three property transactions included then buildings, totaling over 1,000,000 square feet and gross proceeds of approximately $309 million. The first year of cash cap rate is in the mid 4% range. Including the land sale, we are on track to sell roughly $335 million by the middle of the year. In summary, we continue to be focused on capturing the embedded rent growth and occupancy upside in our core portfolio, selling non-strategic properties to fund new state-of-the-art work environments, delivering our under construction projects on time and on budget, and building our pipeline of future value creation opportunities. With that, I will turn the call over to Jeff for a review of our markets. Jeff?

Thanks John, hello everyone. Through the first quarter of the year, our West Coast real estate markets continued to demonstrate significant strength, with net positive job growth in every region. The San Francisco Bay Area saw its unemployment rate fall 130 basis points year over year to 3.5%, boosted by strong job growth of 4.4%, almost twice that of the national average. Economic conditions are also robust in Greater Seattle. Unemployment fell to 4.2% in March, with job growth at 3.6%, also substantially above the national average. In Southern California, employment has now surpassed the pre-recession peak and is benefiting from a record demand from tourist, expanding foreign trade, growing technology, entertainment and media sectors and a return to construction activity. Let's take a look at each markets starting with San Francisco. The San Francisco Bay Area is once again forecasted to outperform most US real estate markets in 2015. Rental growth remains strong as supply of large blocks of space remains limited and demand continues to grow. Class A direct vacancy remains effectively 0% in the SOMA district, 9.5% in the South Financial district and 5.3% in the Silicon Valley markets, excluding San Jose. We are currently 99.2% leased in the Bay Area. Greater Seattle saw a surge of leasing activity this past quarter. Google, Facebook and Amazon continue to grow at absorbed space, helping King County achieve a 24-year milestone for immigration with approximately 64,000 new driver licenses issued. This is translating to meaningful growth in our Seattle markets as we're seeing both local companies expand and immigration from other markets. Facebook is a good example of this. Facebook moved into Seattle five years ago with less than 50 employees. Recently, the company announced it is establishing a regional headquarters for 2000 employees in South Lake Union, signing a long-term lease for approximately 280,000 square feet in a project currently under construction down the street from our new 333 Dexter project. In our primary Seattle submarkets of Bellevue and South Lake Union, Class A direct vacancy rates are now 5.5% and 6.2%, respectively. Our Seattle portfolio is currently 98.4% leased. San Diego is off to a good start this year, driven by strong diversification of its economy including scientific R&D, tourism, defense, and professional services. Year over year, San Diego has created more than 40,000 jobs, a similar number to that of San Francisco. The county's 3.1% job growth rate surpasses that of the nation by 80 basis points. We are hopeful that continued healthy job growth coupled with a limited number of Class A space options translates to attractive build-to-suit opportunities in the near future. In our Del Mar and Sorrento Mesa submarkets, Class A direct vacancy rates are now 8% and 5.8% respectively. Our San Diego portfolio is currently 96.8% leased. Los Angeles continues to strengthen, driven by the creative industries of technology, media, and entertainment. Growth varies throughout Los Angeles and West Side and Hollywood continue to see the largest rent increases. In West Los Angeles, the vacancy rate is 12.4% and in Hollywood, it is 6.5%. Across our Los Angeles portfolio, we are now 95.4% leased. Looking at the overall portfolio, we now estimate that our rents are greater than 10% below market. We are meeting 2015 expirations total approximately 867,000 square feet with only four expirations greater than 50,000 square feet, two of which are in San Diego, the other two are in Seattle and San Francisco. That’s an update on our markets. Now, Tyler will cover financial results in more detail. Tyler?

Thanks, Jeff. FFO was $1.01 per share in the first quarter and includes $0.19 gain related to the land sale. FFO was up $0.03 over our internal focused from earlier than expected occupancies, better core results and one-time items. We ended the quarter with stabilized occupancy at 96.1%, up from 94.4% at the end of the fourth quarter. Including held of sale properties, first quarter occupancy would have been 95.2%. Our same-store GAAP NOI increased 5.8% in the first quarter. As we previewed in our initial 2015 guidance, our adjusted GAAP same-store NOI growth was effectively flat. This was driven by free rent on two large leases in the stabilized portfolio, offset by the increase in occupancy and rents. Cash same-store results are projected to improve as the year progresses. From a capital outflow perspective, in the first quarter, we acquired the 333 Dexter development site for approximately $49 million and repaid $26 million secured loan. To fund these transactions, we completed the dispositions as John mentioned that totaled $172 million and issued $115 million of equity under our ATM program. Taking into account these transactions, we currently have $135 million drawn under our back line. Now, let's discuss our updated guidance for 2015. To begin, let me remind you that we approach our near-term performance forecasting with a high degree of caution given all the uncertainties in today's economy. Our internal forecasting guidance reflects the information and market intelligence as we know it today and a significant shift in the economy, our market tenant demand, construction cost and new office supply going forward could have a meaningful impact on our results in ways not currently reflected in our analysis. Projected revenue recognition dates for new development are subject to several factors that we can't control including the timing of tenant occupancies. With those caveats our assumptions for the remainder of 2015 are as follows. As always, we don’t forecast any potential acquisitions or acquisition-related expenses. We anticipate remaining 2015 development spending on our fixed projects under construction and the Exchange to be approximately $400 million. John provided the detailed delivery timing for 2015. We continue to make good progress on the disposition front and we will continue to evaluate additional dispositions depending on market conditions, which could result in additional dilution to our earnings. We expect straight line rent for the year to be approximately $50 million, of which roughly a half is attributable to development projects that are scheduled to be delivered this year. In the first quarter, straight-line rent was $19 million and was primarily due to [indiscernible] on the LinkedIn and Synopsis development projects as well as two large leases in our stabilized portfolio. For the remainder of the year, we expect straight line rent to average approximately $10 million per quarter. Last quarter, we projected that our 2015 cash same-store growth would be in the 2.5% to 3.5% range. We’ve increased the lower end of that range and now project adjusted same-store cash NOI growth of 3% to 3.5%. We also project that our year-end occupancy at approximately 94%. We’re now saying that will be in the mid-94% range. You will note in our first quarter results that our FAD payout ratio was very strong at roughly 51%. This is driven by lower CapEx and the Orange County land sale. CapEx is expected to be weighted towards the back end of the year and we continue to project 2015 FAD payout ratio of approximately 80% to 85%, assuming everything else stays the same. Last quarter, we provided 2015 FFO per share guidance of $3.17 to $3.37 with the midpoint of $3.27. Given the $0.03 of better than expected first quarter performance, coupled with $0.02 of projected improved results for the balance of the year, we are increasing the midpoint $0.05 and providing updated 2015 guidance of $3.25 to $3.39 per share with the midpoint of $3.32 per share. That’s the latest news from KRC. Now, we’ll be happy to take your questions, operator?

[Operator Instructions] And your first question comes from the line of Craig Mailman of KeyBanc.

Tyler, on guidance, I think last quarter you said dispositions would be about $0.11 of dilution. Is that still the same? I guess, with the timing on those sales in line with what you guys have expected?

Yeah, roughly. The second tranche obviously has enclosed that, but given the current planning that roughly on track.

Just curious the depth of the bidding pool in the San Diego sales and make up maybe of the potential buyers?

We designed a portfolio that has multiple options, so we had sub portfolio options, full portfolio options, we ended up with a good handful of full portfolio buyers in the teens in terms of bidders who are bidding on the sub portfolios. It was very deep, very broad, but that market for – and people trying to buy for the debt was also very deep and very broad. We also intended to get the product out in the market during what we saw was the void and product availability on the West Coast, which we hit very cleanly. And so we had all of the institutional people focused on and we executed, in my view, we slightly exceeded our own internal expectations on this. And we had options between portfolio and sub portfolio buyers.

John, just curious your comments on the Exchange, it sounds like you guys have a lot of activity, one LOI, and you made mention of the fact that people are getting a little anxious about space availability. In light of that, are you guys bumping asking rents relative to pro forma there?

Yeah, but I won’t get into too greater specifics, because all our competitors listen to us and so do tenants.

And I guess just lastly, bigger picture, I know it’s speculation at this point, but what do you think a potential Salesforce take out, meaning for the San Francisco market, given their activity over the past two years?

Well, how can you know, but remember what anybody is buying, if Marc Benioff and the Board decides to sell, which is a big question and as far be it for me, I don’t know the answer to that, but what somebody is buying are the people. It’s the people that make the company and the people out here. So I wouldn’t think that somebody would buy them and move them some place, what they have, the very thing that creates the company.

And your next question comes from Gabriel Hilmoe of UBS.

Tyler, just on the occupancy guidance, given where you were at quarter end, the 96% level, and I think one of the larger move out this year was in San Diego in the second quarter and I’m guessing that building will be sold. Can you just help bridge to the mid 94% for this year just on some of the ins and outs?

I think Jeff is going to take that question.

So with the expirations we have for the balance of the year, 867,000 square feet, we’ve got approximately 200,000 square feet of move outs we know about in the second half of the year. A lot of that is already been re-leased, but it will take time to re-tenant the space. So that’s where 200,000 square feet on our base portfolio is probably 150 basis points or so. So I’d say just from 96.1% to sort of the mid 94%s.

And then just on the 3% to 3.5% cash same-store NOI guidance, that does number include the flat adjusted results in the first quarter, is that an adjusted number?

That is an adjusted number. It includes flat first quarter. The numbers, as I mentioned, will get stronger as the year progresses and as some free rent burns off.

And then maybe just last one from me, for John or David, just on Hollywood, just curious if you see a bigger opportunity there to potentially assemble more sites in your term, or is Columbia Square and Academy kind of it for right now?

Look, there’s a lot of activity in Hollywood, we are doing well with our project in Columbia Square. You guys are familiar with the Academy, which we feel good about, coming out early 2016, given what’s going on with Columbia Square. We are constantly looking at opportunities there, all sorts of competitors out there looking at opportunities as well, land prices have gone up. But what I can say is, along the margin lie on the ground and we like the location in Hollywood.

One last comment about that, this is an interesting point, I was with a group yesterday, a foreign, not European group that has several billion dollars in real estate in the United States and wants to put $10 billion more out and they said to me their three top markets to put money out are, in no particular order, San Francisco, Seattle and Hollywood, which that was going to fund.

And your next question comes from the line of Jamie Feldman of Bank of America Merrill Lynch.

I am hoping you can talk a little bit more about the portfolio sale in San Diego. I guess first, what is to say about your views on San Diego longer term and your portfolio – your desire to be concentrated there? And then secondly, what else you consider in the portfolio non-core whether in San Diego or not that we might see more at large portfolios like this?

With regard to San Diego, when somebody asked, probably you, I don’t know, five, six years ago and many times since and before we went to Northern California and Seattle, the question used to be what do you see five years old or thereabouts in regards to the make-up of the portfolio. And I used to say well, in an ideal world, it’s probably 50% Northern California and beyond and 50% Southern California and San Diego is sort of – whatever it was at the time, is sort of X and it’s probably somewhere between 80% X and 120% X at any given time depending upon what we sell and depending upon what we develop for buy. And I think that’s right, Jamie, we sold now better part of a billion dollars in San Diego over the last couple of years. We sold stuff that either we couldn’t really create more value because there were long term leases, the medical office buildings as an example or that they didn’t fit into our long-term thinking as being strategic assets that were big enough and urban enough, or urbanesque enough. We see ourselves growing through development in San Diego and we’re hopeful now that with what we’ve seen in the way of increased leasing activity and increased job growth and the capacity of available Class A space that that’s going to translate like it did back in 2000, roughly, to increase demand for new facilities. And we are well positioned for that. So we are already looking at a couple of additional development opportunities there within the landholdings that we have. So I see us growing principally by development in San Diego and the final part of your question with regard to what might be non-strategic to sell there or elsewhere we are always reviewing our portfolio. We have some assets that we may sell, probably more one-offs. We have some tenants that want to buy some assets from us that we are entertaining discussions, that doesn’t mean we will necessarily do it. So I would say that – I’m not giving you a specific answer because I just don’t know at this point.

And then I guess within San Diego, you shrank your footprint in UTC and Sorrento Mesa, you’re now in Del Mar, is that a call on the submarkets as well?

UTC, we have one asset left I think in UTC, which is the Town Center Drive building where we intend to build 150,000 foot building and that could get underway later this year. But I don’t want to say it’s a bad market, it’s a good market, we just don’t have any material holdings of the kind of product that we want to own for the long term there. The I-15 market, the one and two storey stuff that we’ve sold, we just didn’t feel was a strategic and it wasn’t a meaningful part of the business, same thing with some of the one and two storey stuff in Sorrento Mesa. We think there might be an opportunity to do something in a Class A build in Sorrento Mesa later this year. Del Mar has always been our favorite market and we are seeing a continued flow of legal and wealth management firms into that market. It’s the market that I think I achieves the highest rents and we’re the biggest player there and we have the last big development opportunity there. So I think that you will see us, in development over the next couple of years, if things go right, you’ll see us develop in a big way in Del Mar. You will see is developed in a smaller but firmly meaningful way in Sorrento Mesa and then maybe 150,000 square feet in UTC. We look at all the markets, but those are the ones that really make sense from our perspective.

And then finally, can you give us more color on what’s going on in the LA office market outside of Hollywood and where it feels you are in the cycle in terms of potential rent growth?

LA fragmented as we talk about all the time, you got the west side, you got Santa Monica continues to remain tight and strong, rents continue to grow in a positive direction. With the absorption of the balance of the space down in Playa with Google buying the 12 acres in second of the last million square feet that can be developed there, that is extremely tight now. The Beverly Hills market remains strong, there are some pockets in Brentwood, some smaller user sell, it’s a tale of several markets. If you’re out in the – over the hill and places like that, growth is much more tempered, where the media, technology, entertainment related companies in the kind of space and in the kind of environments that they want to be in, markets are strong and rents and landlords are pushing them to the positive direction.

Are you seeing a rent spike in those west side markets or just gradual increase?

Particular buildings that have attributes that a lot of these users want, we are seeing some good pushing the rent, whether you call it spike or not, whether it’s, 6%, 7%, 8%, 9%, 10% from where it was a year, year and a half ago I think that’s fair. But it really is very building specific market specific. Again, like we talked about, environments and where these tenants want to be and how they want to live and work every day is really important and people are paying for that.

And your next question comes from the line of Michael Bilerman of Citi.

Maybe we can switch gears to the Seattle sale, when you bought that asset, you talked about it being off market at 6.4% yield with the chances of rolling rents upwards. It doesn’t seem like the incremental price appreciation there was that big. Could you just talk to us about the process there and sort of what’s happening with that asset?

On the original premise, it was on the transportation, was to get Microsoft either to renew or to get – if Microsoft did not renew to get a partner of Microsoft who is interested in being in the middle of their campus there. We did end up renewing Microsoft early. After that, there wasn’t a lot of additional value for us to add. What we have done over that when compared to anything else that you’ve seen, is take out and outsize the amount of cash flow along the way. But as you know, the things very closer in, as we defined our strategy to be closer in, even though it’s on the transportation line, the rate of appreciations of things very close in has been faster than that. And we looked at this thing and thought that we weren’t going to add a lot of value with this 7%, I mean the 7-year renewal and that we would be better off bringing that money closer in to the type of environments that we’re really, really focused on at this point. They performed well, good cash flow, not as much appreciation, it’s something sitting right in San Francisco for sure.

I would say the other thing about that is also, kind of relative to Jamie’s question, some of the smaller buildings, 100,000 square foot buildings and whatever in San Diego, and unless these buildings are part of a larger campus where we have more critical mass, we’ve come to the conclusion over the last few years is that is not generally as valuable as bigger buildings or a campus where you have critical mass because most of these tenants nowadays want to see a path to expand. And with that building, it was only 107,000 square feet and we really couldn’t offer that. So you’ve seen a trend in the stuff we’ve sold not only that which we may not have much more value that we can reap, but also getting out of the smaller buildings. And I think that’s going to continue to be a trend.

Tyler, I think you mentioned that there were some one-time items in 1Q, could you tell us what those were?

Yeah, it was about $0.01 and it was related to some collection and some insurance proceeds.

And your next question comes from Vance Edelson of Morgan Stanley.

Could you share your thoughts on the outlook for the Bellevue market? There is quite a bit of new office supply coming on over the next two, three years and very little of its pre-leased from what we're hearing. So I'm just looking for your thoughts on Bellevue's ability to absorb, does the recent surge of leasing activity there put your mind at ease on that?

Look, the big picture trajectory there we still like a lot, there’s been few thousand, high quality apartments built there and there’s another 5,000 units in the pipeline, many under construction. There’s a major transportation benefit coming that’s still underway, the light rail that connects this to all of the eastern suburban communities as well as linking it to downtown. And so that piece of the trajectory we really like. And you if you look at what’s happened of all the folks who come in from out east and other places concur [indiscernible] Expedia, who is now doing something different, I think, as people know. It continues to be a good trend. They will, like every market, ebb and flow over time. We still think it’s the kind of market that has the density, that has the amenities, that has housing options and it’s livable and walkable, that modern tenants and the millennial workforce wants to be a part of. So we feel good about that. I think with respect to the recent things that have occurred there, a couple of things. One is that a lot of the development pipeline has actually already been converted to residential, for example if you look at the former vacant site and the adjacent church site, which were both supposed to be office buildings and about 1.5 million square feet, both of those were bought by offshore investors who have already converted them to residential, high quality residential towers, which we think helps the office market. There are some things that are quasi underway which I think had pulled back in terms of actually delivering anything speculative. But I think when you have a little pullback in the market, it does cause people who might otherwise go speculative to pull back a little bit. But one of the values of Bellevue is that you have been able to add products, so tenants have been able to grow there and it continues to attract people from outlying areas. So it’s a mixed blessing at times you can add supply. We feel great about the overall trajectory there long-term and that’s what attracted us there to begin with and we still, I personally and I think the rest of us see a lot of value there.

And then shifting gears, could you help us think about which of your markets are currently being the most attractive for finding acquisition candidates on the combination of the fundamental strengths and being markets where pricing is still reasonable. There's Seattle kind of topped the list for having the right combination of fundamentals and reasonable pricing and maybe if you could just kind of rank order the other markets for us?

I rank them all as very difficult to buy the kind of product that Kilroy wants to own for the long-term. You can always find junk and you can always go outside of our circle in terms of the places you don’t really want to be that are more peripheral and find something, but that’s not our daily work. We said I think two, three years ago, I think it was in 2013 we said, hey, it’s going to be tough to find any meaningful amount of acquisitions and we were able to. Last year, we did what $200 million or so, Eli, and this year we’ve done one little one, $100 million, or that was at the end of last year, sorry, Chesapeake. We look at everything, it’s really hard to find stuff. Now, there are some big portfolios that are going to come up that we are looking at, what not, in various regions, but it could be that they get priced to the moon and we are not prepared to – even if we like something, we are not prepared to pay up to a point where we don’t feel we really can add any value. Right now, if you look at our development, we have $1.1 billion underway, of that round number is $920 million of it is office. We’re building the office to an 8% initial return on cost unlevered and we’re building the apartment component which is the balance, 6.7% initial yield. That’s a lot better place for us to put our money than it is in buying stuff at 3% or 4%.

And then lastly, maybe for David with Columbia Square office space now 85% leased and the market very strong, you guys mentioned a lot of ongoing conversations, I'm wondering if the structural vacancy, so to speak realistically be zero, in other words, how do you like your chances for full year leasing up the building versus some sort of say 95% occupancy that will become accustomed to?

I think the product that we put out there has been extremely attracted to a great roster of tenants [indiscernible] to date and a tenant that we haven’t announced who it is, but another quality entertainment tenant. And I think coupled with the retail along with the apartments, we’re seeing the best of the best users that want to be in that market, whether they are consolidating from Burbank in the west side kind of Viacom who brought MTV from the west side and BT from the west side, or their new potential companies that are coming into Hollywood. So we are getting the best roster people coming through and we have a lot of – what I’ve always talked about, smaller 10, 15, 20s that are very good local companies as well as some big national names as well. So whether we’re at 95%, 98%, hard to say, but it feels pretty good that we’re going to be stabilized in a very good position by the end of the year.

And your next question comes from the line of Nick Yulico of UBS.

Just going back, can you go over again what is the $0.05 guidance raise attributable to?

So we were $0.03 ahead on our internal forecast for the first quarter, which was earlier than expected occupancy, just better core results in general with rent growth and lower expenses, and $0.01 of one-time items. So that’s the $0.03 for the quarter and then we said in addition some of that will carry through the remainder of the year. So we will pick up another $0.02 through the remainder of the year. So the $0.03 plus $0.02 gets to the $0.05.

And the occupancy relates to the development assets delivered last year?

When you say the occupancy...

No. You said that there was $0.03 in the first quarter was mostly due to earlier occupancy, I think?

It doesn’t relate to development, it’s related to the CLS portfolio where tenants moved in earlier than we had anticipated.

So these were leases on last year and they just took occupancy earlier. I’m just showing actually how that could have really like raised your guidance for the year much, I mean was it that meaningful of change and when...

It doesn’t raise our guidance for the year, that’s why the first quarter is up $0.03, but what flows through the remainder of the year is $0.02, which is unrelated to that increased occupancy, it’s more on core results. That was the other point that I mentioned in the $0.03.

And then on the next wave of development pipeline, the Seattle project, Exchange and Academy, which sounds like all of those you’re starting, you’re planning to start in the next year or less and on spec it sounds like, how do you weigh, storing these projects on spec and also taking sort of spec balance sheet risk today, maybe you can talk a little bit about how you expect to fund those projects and how early you might look to put some sort of capital on place for those projects?

Well, it’s still the first part, which is you called them spec, I think with the Exchange, we’re going to see that project at least before it’s even completed. That’s my guess based upon what we are doing right now. With the Academy, we are not going to start construction till the first quarter of next year and that’s assuming the market is right and so forth. That project breaks down in round numbers to 270,000 square feet of office, about 30,000 square feet or thereabouts of retail and roughly 250,000 square feet apartment units. We already have the office space in negotiation, the entirety of it. The retail is going to be – I think the apartment is going to be a winner. So it’s true if we build the apartments, you don’t pre-lease those, the retail would be largely pre-leased and we are not going to – I’ve always said, we’re not going to go start $1 billion worth of spec development, we are just not going to do it. So this is our forecast we’ve given you with regard to our near-term development pipeline in terms of dollar amounts and square footage and likely start dates, but imposed on that is our historic discipline of making sure that we have substantial amounts of pre-leasing maybe not in each project, but across whatever we have underway. And we will continue to do that. I just don’t have the stomach to go do $1 billion worth of spec stuff. With regard to the funding, Tyler, you can cover that.

I think the funding strategy will be similar. We’ve always said we’re going to do our balance of dispositions. With obviously the $300 million of debt, we’re going to do a bond deal related this year to take out an older bond deal and probably raise a little bit more and then some equity. We did $115 million of ATM in the first quarter, we will continue to manage those three sources of capital going forward to keep our balance sheet strong.

I guess on the equity component, how do you balance doing an equity overnight deal versus continuing to do stuff on the ATM, particularly based on now the volatility we're seeing for REIT stock prices?

I mean we think about that all the time and the ATM has been very useful for us. It’s a very efficient way of raising capital. I think if there was a big transaction or development opportunity that came along where we’re going to start something, we would certainly look at offering, but there is no plan to do at this point.

And your next question comes from Brendan Maiorana of Wells Fargo.

John, so at One Paseo, I think you said, it goes – is it definitive that it goes to a ballot for voters and that is next year. So assuming you're successful at the ballot box, when is sort of the earliest of timing for the project now?

Remember, what we said before is that we weren’t challenged that we could start as early as the beginning of next year. We have been challenged, so assuming we win that and it would be basically a year later, plus or minus. I want to point out that this, I’d call referendum and what the City of San Diego has, it’s a very low threshold, you have to gather 33,000 signatures in order to call for a referendum and they got more than that. We received the 7/2 supermajority at the City Council, every business group is in favor of this thing. We really have a shopping center owner that doesn’t want a competition and he’s made that abundantly clear and we’re going to cream again in the polls.

Probably for Tyler, John mentioned I think a mid fours year one cap rate on the dispositions, but I think there is some pending vacancy that happens in that portfolio. So that's probably a forward number relative to kind of recent run rate either this past quarter or a past couple of quarters, is that mid fours cap rate a fair run rate as well or is it higher than that?

That’s sort of the 2015 impact on a calendar year basis for that portfolio. So it’s one year cash flow. So you can either go back in time a year, you can go forward. If that space were to be leased up, my guess is like a six cap, but for us it’s been running in that range because there’s been vacancy in that portfolio for a while.

So even if you went back, there's been vacancy – I mean there is expected to be vacancy, but there has been vacancy in that portfolio, so it’s sort of turned...

Right.

And straight-line rent and we talked a little bit about this last quarter, but it seems to be a topic of discussion for you guys often, because it's been high in the past couple of quarters, it's going to move down. But as we think about your straight-line rent adjustment, where do you think that normalizes to kind of either compared to total rents or percent of NOI or something like that?

Of the $10 million a quarter for the next three quarters, about half of that is development related and half of that is in the stabilized portfolio. So my gut tells me that if you strip out the development which will burn away, we are always going to have $5 million or $6 million a quarter of straight-line rent, so $20 million a year on a run rate, but that does move around a bit. And that’s 5% of revenues or something like that.

And then just last one, probably for Eli. Just a follow-up on Bellevue, I think Expedia has announced plan that they're going to move into Seattle and there's maybe some press articles that Valve was thinking about that too, I think you've got some exposure with each of those tenants. Can you just refresh our memory as to any near-term expirations for either of those two and if there's any updated plans with either of those tenants in your building?

So Valve and Expedia don’t actually happen until 2018, Valve is the first quarter and Expedia is the fourth quarter of 2018, so it’s ways out.

Okay, great. Thank you.

I would just add to that. Expedia moving out is in our view an opportunity for us because their rent is extremely low, extremely low.

It’s over 50% growth with the current market from where Expedia is right now.

And they wouldn't move. They would need until 2018 right, because they've got to redo the campus that they're buying in Seattle, is that right?

Is that right, Rob?

Yes, that’s correct.

Just a comment about Bellevue, because we watch it, we’re surprised that three people would say that they’re going to build buildings all at once [indiscernible] building is under construction. The Camphor project is really three components. It’s resi, it’s retail and it’s office. And we don’t know for sure, but what we’ve heard is they’re going to build – they got to build the parking structure to accommodate all three uses, the resi market is strong, the retail market is strong and they will see what they are going to do on the office. So I don’t know whether that gets built all at once or not, that’s to be determined. I don’t have personal knowledge of that. With regard to the third component, that’s what, Schnitzer. And they’re going hold, they’re careful people, they’re not going to go ahead and do...

Unless it’s a strong situation.

Yeah, we’ll see what happens there, but the way we’ve been managing this is we’ve taken care of most of the 2016 and 2017 expirations, we are working on the 2018 expirations. We thing we have quite a bit of upside and the rent growth in both of those assets up there, as you know, at 20, rather over skyline which is the building we bought and modernized. That building has become a really hot commodity with the tech community and so forth because of the improvements we’ve made to it. So I don’t want to be [indiscernible] you never like to see a lot of square footage come on a market that isn’t leased, we’ll see how much of that actually comes on stream and we’re very vigilant with regard to our portfolio in that market.

And I believe with respect to Valve, they didn’t make an announcement there was market that other people were speculating. And the Expedia thing was unique, because the Amgen campus where they went is really kind of a unique facility. That to me is kind of a one-off, very Expedia specific, granular decision. Not really indicative of any macro trends.

Your next question comes from the line of Jed Reagan of Green Street Advisors.

On One Paseo, just want to clarify, is there still a chance that the City Council could sort of revisit their approvals in the next few months and maybe take matters into their own hands, I'd heard that they are re-convening on the topic and so just wanted to ask about that.

The way it works, Jed, is that once the register of voters vote, what do they call it, certifies the thing that just happen on the votes. In my understanding the City Council has to take action within 10 days and their options, and I’m not an expert at this by any stretch of the imagination, but my understanding is their options are, they can do something which includes calling for an election. So more to come on that. I got to tell you that it’s pretty pathetic what we have here in California in this CEQA thing, as most people know, it cost about $38 to file a lawsuit and we feel we’re very protected on this CEQA based upon all the different law firms that are all tied on that process for us. So we think we win there and we plan on winning the election if it goes there, I’m very upset with the guy across the street, he just doesn’t want to have the competition and I think he is crazy.

And can you split out the cap rate kind of the mid-four cap rate you talked about, can you split that out between the recent sales in San Diego and Seattle? And then on the San Diego stuff, can you just compare the asset quality for the Sorrento Mesa stuff you sold versus what you still own in that submarket today?

I’ll tell you one thing about splitting that, first of all we have a pending transaction which is non-refundable, but not closed and I prefer not to comment further to. I think when we issue our next set of financials, that will all come through in a usable way. And the second part of the question about the quality of what’s left versus what we’ve sold here, maybe we have some of the similar quality and we have predominantly things of a much better quality overall in our San Diego portfolio.

I’d say, Jed, that the – here is something that’s going on, a lot of you, a lot of the analysts that’d be on this call and others have written about this at length, and I’ve certainly talked about it over the years at length, there’s just been a huge transformation in the way people are using space and if you have parking at four per thousand in a market that’s got to be six per thousand and you can’t get it, then that asset has some liabilities. If you have one and two-storey tilt up which is most of the stuff we’ve sold, and it’s smaller, you can’t provide scale and a path to grow to accommodate people’s future expansions, you probably don’t have the best particular asset, at least from our thinking. If you have assets that are more geared towards the way people used to use an office than the way people might be using office in the future and currently, then you’re going to have a lot of CapEx. One of the things that I’ve been pretty outspoken about over the course of all the NAREIT interviews and so forth over the years is I absolutely hated the CapEx that we had to go through in San Diego. And a lot of these two storey buildings and one storey buildings, every time a tenant moves out, the next guy seems to want to move the lobby or move a stairway or move the bathrooms or do something and invariably end up with disproportionately high CapEx and I don’t like that trend. So that’s the kind of stuff we’ve set to sell. That doesn’t mean there aren’t great assets for people to own, they just don’t fit any longer into our longer-term plan. Part B?

So what's left in Sorrento Mesa at this point where do you – much less of that remaining and more kind of higher density stuff?

Like I said, we still have some of that stuff, but most of the stuff we have we really like the [indiscernible] remember, we sold the stuff that FPL had been in UTC last year. And I think it was last year, wasn’t it?

Yeah.

Yeah, we sold that. We had lease on the table with people, but we sold it because when we took a look at it, we didn’t really create that much additional value and it wasn’t a very good return, in our view on the CapEx that we had to put in to make that lease. We said, hey, let’s just move on. I don’t want to see our management tied up in a bunch of little buildings, I want to see them tied up and use their brainpower, our collective brainpower on bigger assets that can create a lot more value. So those were all the forces and more that have gone into our decision as to what to sell and what to keep.

And can I add just one more thing, which is in allocation of capital, getting the maximum return, one of the things going on, Jed, right now is that the people buying these things are getting very, very cheap and much, much higher LTVs on the debt that generate the returns that they’re doing. And we can take that same capital and deploy it in our portfolio because we can’t use that kind of debt to generate the returns that they might for that, but get better returns on that same asset based in other places in our portfolio, redeploying it into our development pipeline and so forth. And so to me, increasing the rate of return on the portfolio with the same amount of capital base with an ultimate upgrade and product on long term trajectory and we should be doing that and that’s not to despair if the assets and their usability in any way whatsoever.

I guess just last one from me, there's been some chatter recently about more sublease space in the market in San Francisco and just curious if that's something that concerns you and if you're seeing any of that in your portfolio?

We are not concerned about the amount of sublease space we see in the market, we monitor it very closely. In fact, most of that sublease space is the result of tech companies that are outgrowing premises that are in and moving to either larger premises or more modern work space.

Back in the early 2000s, the amount of sublease space in the market was approximately, what is it today?

It was close to 6 million square feet back in the – actually over 6 million square feet back in the .com...

Plus or minus 10%.

Right. And today it’s about 1 million square feet.

And your next question comes from the line of John Guinee of Stifel.

We have a question for Eli, question for David Simon, and a question for Tyler. First Eli, do you remember what you paid for the first two San Francisco assets, I think it was 303 Second Avenue in 100 1st and have those doubled in value yet? Second for David Simon, if the shoes were on the other foot [indiscernible] federal realty were developing at One Paseo, would you guys be suing them and taking it to a ballot? And then Tyler, what are you thinking about the dividend?

Tyler, why don’t you go first and then we’ll.

I think our thoughts on the dividend, as you know, the trend on coverage is we’re certainly getting better. As I mentioned, we think we will be at a payout of 80% to 85%, we’re not going to comment too much on it, my guess is the Board will start looking at that towards the end of the year and hopefully we will continue to drive that payout ratio a little bit lower before we make the decision.

No taxable income issues?

Well, potentially I mean that’s a separate issue. I mean, I don’t think we’re going to raise the dividend to cover gains on property sales. There always is the possibility of a special dividend which is something that we might do to see, given the gains we are going to have on the dispositions and the lack of opportunities to acquire on a 10/31 basis. So yeah, there is definitely potential for a special dividend.

Okay.

You are right, I appreciate the softball question. But 303, we’re in for under $400 million, we bought it in the threes and put a bunch of capital into it and that thing has doubled in value and I think the same is true, again we’re in under $400 million, here we’re sitting in 100 1st and its doubled as well on a completely unlevered basis. I would say the same is true for 201 third, and I can go through a lot and it’s in that range, okay. I mean, those were great deals. Those were wonderful deals. And great timing and the market has been very kind to us as well.

I’ll answer the question, John, on One Paseo in terms of wood we have sued somebody else, I mean this guy, he has got a shopping center that’s a couple hundred thousand feet, he wants to build it more. It’s a nice shopping center, it’s a little bit longer than the two. I don’t think we heard his retail at all with the 250 that we were approved for in retail. I wouldn’t have sued – what was your question, Heines or something like that was building it, would we – Kilroy, if we own the shopping center across the street sued her, or if we own the property, and we own the property next to One Paseo at the Heights, absolutely. I mean, from our standpoint, everything we’ve been told and believe and by our consultants it’s one of the most underserved retail communities in California and it’s one of the highest wealth areas in California. So from a retail standpoint, I think it’s complementary. From the standpoint of the amenities that that project will provide to all of the underlying office buildings in the area, of which we’re the largest owner but others own them as well, it’s going to be terrific. From a standpoint of the homeowners, they end up with something that’s truly a town center with a lot of amenities. And from a standpoint of the business community, having 600 apartment units, it’s going to be terrific because there is – one thing that it just shown is there is abundantly clearance, that there is a shortage of apartment availability in these markets to service the office users and the millennials and so forth. There has been two instances where we have sued somebody or threatened a lawsuit against somebody, I don’t think [indiscernible] lawsuit. But one was across from our headquarters that’s a media center and people wanted to take it from the existing zoning to put in an acute care hospital that would have had a traffic count that would have destroyed the entire business community for multiple intersections with City Council of Los Angeles disapproved that project. And that is the project site that had some specific part where [Right Games] is headquartered. So that was an appropriate use. The second was in El Segundo, where we put up millions of dollars to fund a public right of way and donated land for a use and then the city and another developer got together and changed the plan and we thought that was inappropriate, given the fact that we contributed so much money for a different plan that we would have never contributed, so we thought we were a bit abused. Those are the two instances where we’ve had in 45 years of being in business and 65 years of the company, the two instances in which we challenged somebody across the street. So I think this guy is crazy, I hope he is going to lose, it’s our plan to make him lose when it goes to a city if that’s what happens. But it is one of the issues that you are confronted with when you develop in California.

And your next question comes from the line of [Venkat] of Deutsche Bank.

Looks like construction costs increased about 2% to 3% for a few of your projects and just wondering is that indicative of the overall market and is that being mainly driven by wage inflation?

I can take that, John. In our markets, we are seeing cost increases year over year anywhere from 4% to 6%, it’s mainly driven by labor costs, lack of skilled labor continues to be an issue. That’s kind of where most of the cost. All our underwriting takes into account kind of increased cost, we’re pretty conservative in the underwriting and in fact in some of the past deals, we’ve overestimated cost increases. And we have a good pulse on the market given all the products we are doing. So we’re constantly looking and understanding where the cost potential, whether its commodities or labor come into play, but that’s what’s driving it now.

Thank you. I’d now like turn the call over to Tyler Rose for closing remarks.

Thank you for joining us today. We appreciate your interest in KRC. Bye.

Thank you. Ladies and gentlemen, thank you for your participation in today’s conference. This concludes the presentation. You may now disconnect. Good day.