Kilroy Realty Corporation (KRC) Q2 2018 Earnings Report, Transcript and Summary

Good afternoon, and welcome to the Second Quarter Kilroy Realty Corporation Earnings Conference Call. [Operator Instructions] Please note that today’s event is being recorded. I would now like to turn the conference over to Tyler Rose, Executive Vice President and Chief Financial Officer. Mr. Rose, please go ahead.

Good morning, everyone. Thank you for joining us. On the call with me today are John Kilroy, Jeff Hawken, David Simon, Steve Rosetta, Heidi Roth, Tracy Murphy, Rob Paratte, Elliott Trencher 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 eight days both by phone and over the internet. Our earnings 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 second quarter, Jeff will discuss conditions in our key markets, and I’ll finish up with financial highlights and review of our updated 2018 earnings guidance that was published yesterday in our earnings release. Then we will be happy to take your questions. John?

Thanks, Tyler, and hello everyone. Thank you for joining us. We continue to see very healthy conditions across our West Coast markets, with the second quarter setting an all-time high for us in terms of leasing volume. We signed new or renewing leases on more than 1.3 million square on our stabilized portfolio, with rents up 30% on a GAAP basis and 10% on a cash basis. We leveraged the strength of our existing portfolio to create a new 375,000 square foot headquarters for GM Cruise, combining buildings in San Francisco’s most sought-after technology corridor into an urban campus. We made substantial progress and backfilling in our major 2018 and 2019 lease expirations. We have commenced an improvement work on both 100 Hooper, our 400,000 square foot project in SOMA, and The Exchange, our 750,000 square foot project in Mission Bay. We completed our acquisition of Kilroy Oyster Point, a premier waterfront life science development opportunity located in South San Francisco, and we are making progress on all our capital recycling plants. We are now non-refundable on the sale of our Bay Area office campus for $160 million. Now let’s get into the details. Our second quarter leasing activity hit record levels, with improving fundamentals in each of our markets, transactions were spread throughout our portfolio and negotiations were fast and efficient, some in record time. This was demonstrated by a 12-year lease we signed in June with a software company for just over 100,000 square feet at our 250 Brannan Street property in San Francisco. The tenant moved quickly to secure sufficient workspace to accommodate its growth plans. And rent was up substantially over the prior lease, 50% on a cash basis and 100% on a GAAP basis, generating approximately $2.5 million in higher cash NOI on a stabilized basis. The quality of this and similar transactions we’ve completed and the speed with which we have been able to execute them, speaks volumes about the depth of demand in our markets, the competition for space among tenants, the limited availability of large blocks of space in prime locations and the attractive value proposition offered by our properties. The evolution of our portfolio into a younger, higher quality and more sustainable set of properties is giving us what we believe is a clear advantage in the market. It’s also providing an opportunity for us to adapt quickly to emerging market trends. One example is our recent lease transaction with GM Cruise. Looking within our existing portfolio, we were able to assemble properties and combine them with an acquisition to create a compelling urban campus for GM’s self-driving car unit in the heart of San Francisco’s major technology corridor. The new campus encompasses three properties, two existing KRC properties, 301 and 333 Brannan and a third 345 Brannan, which we are under contract to acquire later this year. These three buildings are classic examples of work environments that help attract and retain the modern workforce. They have open floor plans with top gardens and meeting areas, street-level integration with neighborhood retail and fully sustainable operating systems. We believe this transaction solidly demonstrates how we harvest opportunities within our portfolio to create meaningful value, both by increasing cash flow. Stabilized cash NOI from the three buildings will increase by $5 million in 2020. And by building strong relationships with high-growth tenants. Portfolio quality has also been an important factor in our ability to backfill our large lease expirations this year and next. We have made great strides on our major 2018 and 2019 expirations. We have now backfilled nearly 70% of the four major 2018 expirations, and for 2019, we have reduced the five expirations greater than 75,000 square feet to just one. Moving to development. As we’ve reported at our recent Investor Day, we completed the acquisition of Kilroy Oyster Point development site in South San Francisco. As most of you know, we have been expanding our market presence and management expertise in life science for some time. It’s a natural extension of our platform and one of the key industry’s driving growth and innovation in our economy. Kilroy Oyster Point covers almost 40 acres of waterfront property. The site is fully entitled for 2.5 million square feet of office and lab space and is located in the premier West Coast market for health care, life science and biotechnology industries. It is situated on the preferred northern corridor and at the front door to the existing ferry service. The project will include four phases, with a total of 11 buildings, providing flexibility and optionality in terms of timing. Phase 1 is currently planned for three buildings, totaling approximately 600,000 square feet. With regard to our ongoing development program, as I mentioned, we are in the TI phase on both 100 Hooper and The Exchange. The construction continues to progress on time and on budget on all of our projects, including 333 Dexter, Academy on Vine, and One Paseo. These three under construction projects total just under 1 million square feet of office space, 120,000 square feet retail space, 608 residential units. Together, they represent a total estimated investment of $1.1 billion or approximately 10% of our enterprise value. At One Paseo, the retail component is now 70% leased, with additional transactions in varying stages of documentation that would increase this percentage to over 90%. Retail grand opening is scheduled for next spring. We have also now commenced construction on all of the remaining residential units. The apartments will be delivered in phases beginning mid next year. With the retail and residential components creating energy and buzz in the community as well as providing the amenities that the modern tenant wants, respective office tenants are now showing significant interest in our to-be-built 270,000 square foot office project. Given the strong pre-leasing activity, market rental rates at all-time highs combined with no competing supply, we are evaluating when we should start the office component of One Paseo. Let me finish with a quick update on capital recycling. We are now non-refundable on the sale of a multi-building campus in Northern California for $160 million. We expect to close this disposition in the fourth quarter. We are also at various stages of the sales process on several other assets and expect to be within our previously stated range for the year. To summarize, let me leave you with four messages. First, fundamentals in our markets are strengthening, not softening, and our young modern portfolio is ideally positioned to capture that demand. While it’s difficult to forecast precisely, we and the brokerage community predict continued rent increases in all of our markets over the next few years. Second, our capital allocation strategy remains focused on development, which is both increasing FFO and creating long-term value. With the developments mentioned above, we expect FFO to grow by 25% by 2020. Third, we will stay disciplined in managing the risk of the company. And fourth, with the capital market transactions that Tyler will discuss, in addition to our ongoing dispositions, we continue to fund our growth conservatively and economically. That completes my remarks. Now I’ll turn the call over to Jeff for a closer look at our markets. Jeff?

Thanks, John. Hello, everyone. Conditions in our West Coast markets remain strong. While technology, media, health care and life science industries have been driving economic growth, generating new businesses and competing for ideas and talent, we are pleased to see that there is more broad-based growth with the fire category now expanding as well. The results are declining vacancy rates, rising rents, larger and longer average lease commitments and, in some cases, more rapid lease execution. Now, let me review each market in more detail, I’ll begin in San Francisco. Large leasing activity dominated headlines with four leases greater than 100,000 square feet signed. Three of these deals were Kilroy deals, including GM Cruise, Nektar Therapeutics, and the recent deal John discussed earlier at 250 Brannan. Currently, there’s only one Class A contiguous block of space greater than 100,000 square feet remaining in the south of market area today, and brokers are reporting that there are currently 24 companies looking for at least that much space in the city. This dynamic is reflected in vacancy rates. In San Francisco’s SOMA, South Financial and Mission Bay District, Class A direct vacancy rates were 2.8%, 7% and 0.6% respectively. In South San Francisco, the life science vacancy rate was 2%. In Silicon Valley, Class A direct vacancy was 6.8%. We are currently 98.2% leased in the Bay area. Our in-place rents for the region are approximately 31% below market. Conditions in Seattle echoed that of San Francisco. Leasing activity remains robust, as large blocks of space continued to be spoken for by expanding tenants. Brokers are reporting that there are several 100,000 square feet-plus users in the market, and these tenants are currently seeking over 4 million square feet of space. The continued strong performance in the region is reflected in the numbers, as we saw rents increase and vacancy rates continue to decline. Class A direct vacancy in both South Lake Union and Bellevue is 4%. Our Seattle portfolio is currently 95.2% leased. Our in- place rents were approximately 11% below market. In San Diego, activity has picked up significantly, driving the vacancy rate down to 10%, the lowest levels since 2010. Positive net absorption totaled 565,000 square feet. Class A direct vacancy in Del Mar, with the region's highest asking rents, was 13.3%. Our San Diego portfolio is currently 99.2% leased, and our San Diego in-place rents are approximately 6% above market. In Los Angeles, employment and entertainment, digital media, gaming, fashion and related fields recently hit a 10-year high. Netflix, Amazon and Apple have all established their own entertainment studios and are actively recruiting local talent. The state has encouraged growth by expanding film and TV tax incentives. Class A direct vacancy in West L.A. was 5.4%, West Hollywood was 7.3%, and Hollywood was 8.4%. Our Los Angeles portfolio is currently 95.2% leased. In-place rents are approximately 8% below market. On a portfolio-wide basis, our estimated average in-place rents are 16% below market. As John discussed, the record-breaking lease activity we completed have significantly reduced our future expirations. With the completion of 145,000 square foot General Atomics lease in San Diego, major 2018 expirations now consist of just the second Bridgepoint building and a portion of the Del Mar Corporate Center both in San Diego. Of the five 2019 expirations greater than 75,000 square feet we have last quarter, we have completed the releasing on four them, leaving only a 75,000 square foot building in Sunnyville, where the list rate is more than 50% below market. That’s a snapshot of our markets. Now Tyler will cover our financial results in more detail. Tyler?

Thanks, Jeff. FFO was $0.86 per share in the second quarter. There were several in and outs this quarter. First, FFO includes a $0.05 per share charge for bad debt expense, $0.07 related to one tenant with which the company has an ongoing discussion, partially offset by a bad debt reversal of $0.02 related to our lease assignment. Second, it also includes $0.05 per share of higher SG&A, $0.02 primarily related to professional services fees associated with a legal matter, and $0.03 of non-cash related to stock compensation, amortization and the mark-to-market adjustment on a deferred cash program. And third, other income was up $0.03 a share from lease termination fees, although half of that was offset in revenues from the write-off of deferred rents related to those lease terminations. With regard to the $0.07 reserve, given that we are in discussions with the tenant, we're not able to provide its name or location. But we can say that this is a reserve, not a write-off, and it's possible that we could take this back over time. The tenant is still on full occupancy, but has certain credit issues, and we are derisking our position. The space is very high quality and rents are well below market. We hope you appreciate that this is all we can say at this time. Moving on. Same-store NOI continued to grow in the second quarter, driven largely by higher rental rates. For the second quarter, cash same-store increased 5.1% and 1.7% on a GAAP basis. The GAAP number includes the bad debt expense. It's a non-cash reserve. For the first half, GAAP NOI was up 3.6% and cash NOI was up 5%. We were also active in the capital markets. In May, we completed a $250 million private placement of 8-year senior unsecured notes in two tranches, with three- and six-month delay draw options, respectively. The first tranche was for $50 million of 4.3% notes, which we drew down earlier this month. The second tranche is for $200 million of 4.35% notes. We are required to draw these funds by mid-October. We also issued approximately $100 million of common stock in May, using the remaining capacity of our $300 million ATM program. In June, we established a new ATM program, with a $500 million capacity and raised $26 million. We currently have $460 million available on our credit facility, which is expandable by $600 million under an accordion feature for a total availability of $1 billion. Our debt-to-EBITDA at quarter-end was approximately 6.5 times, adjusted for the bad debt expense. Now, let’s discuss our updated 2018 guidance provided in yesterday’s earnings. To begin, let me remind you that we approach our near-term performance forecasting with high degree of caution given all the uncertainties in today’s economy. Our current guidance reflects information and market intelligence as we know it today. Any significant shifts in the economy or markets and the demand construction costs and new supply going forward could have a meaningful impact on the results in ways not currently reflected in our analysis. Projected revenue recognition days are subject to several factors that we can't control, including the timing of tenant occupancies. With those caveats, our updated assumptions for 2018 are as follows: our disposition guidance range remains $250 million to $750 million; we anticipate the remaining 2018 development spending to be approximately $250 million to $300 million; we continue to project revenue recognition from the Adobe lease at 100 Hooper later in the fourth quarter and no contribution from the Dropbox lease in 2018. Dropbox is expected to take occupancy in three phases, starting mid-next year into 2020. As we reported at our Investor Day, we expect that given these development deliveries funded on a leverage-neutral basis, our FFO will grow by approximately 25% by the end of 2020. And while the quarter had lots of ins and outs, given stronger core results in the second quarter, including strong same-store results, we're increasing our projected 2018 same-store cash NOI growth from a range of 0% to 1%, to a new range of 1% to 2%. We are maintaining our year-end office occupancy range of 94% to 95%, and we are maintaining our annual guidance, adjusted down for the bad debt reserve. Specifically, last quarter, we provided earnings guidance for 2018 of $3.49 to $3.64 per share with a midpoint of $3.57 per share. We are updating that midpoint of our guidance to $3.52 per share, with the range of $3.47 to $3.57 per share, reflects the impact of the $0.05 of net bad debt expense. Higher G&A is essentially offset by the better core results. That's the latest news from KRC. Now we'll be happy to take your questions. Operator?

[Operator Instructions]. First question today comes from Craig Mailman with KeyBanc Capital Markets. Please go ahead.

Good afternoon. I know you’re limited on what you can talk about with the troubled tenant. But just curious if you could give some background on sort of what triggered you guys to take the reserve and whether this has kind of prompted you guys to go back to the portfolio and whether there's any more companies that are potentially on credit watch list?

Yeah. I mean, we can’t really say much more, as I said already. And as I said in my prepared remarks, it was related to credit issues with the tenant, and that's really all I'm going to comment on. I think, your other question on other tenants in the portfolio, actually, we have very few credit issues, if any at all, of significance. So we're really good on that front. So this is not a pervasive issue.

Okay. And the legal matter that kind of hit G&A this quarter, is it related to this tenant? Or is it something separate? And is this more ongoing? Or just one-time in the quarter?

Yeah. This is Jeff. It’s not related to this tenant, it's the G&A relates to our defense costs in connection with the millennial towel matter in San Francisco.

Is there going to be – kind of what should we expect going forward?

In terms of – we obviously don't know, from a legal perspective, the cost. We do have built into our forecast some costs assumed for the project for the legal cost, but obviously, we're not going to reveal what those are, but we do have some budgeted money for that.

Okay. And then justly, you guys did kind of use the ATM, even though you have a fair amount of – just curious kind of thought process there, given where the stock is trading relative to consensus NAV.

Yeah. We’ve always said we’re going to raise capital in different sources, and we're going to keep – going to be conservative and then take opportunities to raise money both through equity, through dispositions and through debt. And we took the opportunity to raise a little bit of capital, $100 million or so at that price, and we felt the projects we're investing in are accretive on that basis, and so we feel comfortable doing that.

Okay. Thank you.

Next question comes from Manny Korchman with Citi. Please go ahead.

Hi, just a follow-up on Craig’s question on the G&A. You said you had a budgeted amount, has that budget changed between the time you gave guidance in 1Q and your current guidance? I guess, said differently, how should we think about G&A for this year and for what it's worth next, even though you haven't given guidance there, especially around this legal item?

Yeah. So, for this year, for the second half, we do expect it to come down a little bit, and in – on a run rate basis per quarter, sort of in the $17.5 million, $18 million range per quarter for the remainder of the year. It’s too early to comment on 2019.

And Jeff, just looking at the larger mature – or expirations you had in 2018 and 2019, I think you're kind of 70% done with the 2018. What are the prospects for the others? And when should we expect announcement there?

The remaining vacancy we’ve got in Seattle is actually in Bellevue, and both of those spaces are committed and we're in the final stages of documentation. In San Diego, between Bridgepoint and the Del Mar Corporate Center, we have about 65,000 square feet of activity between the two of them. Again, some in documentation, some in discussion. So we feel really good about the activity we've got on both those projects.

Thanks, guys.

The next question comes from Jamie Feldman with Bank of America Merrill Lynch. Please go ahead.

Great, thank you. Just a follow-up in the last question, so the 65,000 square feet in San Diego, so what is that lead left with the lease?

We have – so we’ve got, hold on a second – we’ve got 114 left at Bridgepoint. So if we take the leasing we have there, who probably got two thirds of it in different stages of activity. And at Del Mar Corporate Center, we have 82,000 square feet left roughly. And again, probably, over half of that is committed in different stages. And I'd say, with Del Mar Corporate Center, the more One Paseo comes to fruition, now that you can see it and drive it and all that sort of thing, it really is causing an uptick in the activity around our portfolio there

Okay. And then you said Seattle is pretty much fully leased or will soon be fully leased.

Yeah.

Okay. And then Tyler, just on the charge, I mean, what would it take for you to reverse the charge?

We’re really not going to talk about the specifics of what the charge specifically is. Obviously, there’s deferred rent, there’s some straight-line rent, there’s TI cost, so in that number. But obviously, if the tenant chose better credit, then we would evaluate that on a quarterly basis.

Okay. And then, I guess, just bigger picture. I mean, with Dexter and The Academy not leased yet, you started talking about Oyster Point, you’re talking about the office at One Paseo, just kind of thoughts on both funding needs over the next year? And also, just your appetite for speculative development risks? And how you’re thinking about it?

This is John, let me talk about the appetite perspective. I know I sound like a broken record because every time I’ve been asked this question, I’ve had basically the same answer. No matter what the properties were, they were under construction or we were contemplating building over the course of the last eight years. I don’t see us starting big spec projects without having made progress on the existing ones we have, unless they’re already leased, which was the case with Hooper and Exchange. And we have strong prospects across the portfolio, both on a multi-tenant and full building basis for both of those projects you mentioned. So you’re going to just see more of the same. Remember that One Paseo – excuse me, The Exchange, we just – excuse me, I get all these projects mixed up. The Academy, we just started the beginning of this year and has a couple more years to completion. And 333 Dexter has about 18 months more before we have the shell complete. We feel that in both markets, the rents are going up pretty substantially. So we have that tension between when we want to lease them and starting other buildings and how we achieve the best possible financial results with regard to increasing rents. So more to come, Jamie.

And Jamie, on the funding front, on The Exchange and Hooper, we have about $200 million to spend to complete. And on the rest of the projects under construction, about $500 million over the next couple of years. So that’s $700 million. We obviously have the disposition. We were now non-refundable on. We do have a private placement that we’re going to draw down in October. We’re going to have more dispositions. And there’ll be other funding activity as well. So we’re going to continue to fund it as we go and knock it out of our skis.

Okay. And then, just my last question. What’s your appetite for WeWork or other types of co-working tenants at some of these projects?

Yes, I’ll answer that. This is John again. We haven’t done any co-work of any magnitude, if at all. We’ve had many, many opportunities, whether it was The Exchange or whether it was Hooper or whether it’s been properties in other markets. Not saying we won’t, just hasn’t been our preference. I don’t know that it will be our preference.

Okay. All right. Thank you.

The next question comes from John Guinee with Stifel. Please go ahead.

Great, thanks. Tyler, I think you had mentioned this during the Investor Day, and then, I think, maybe John mentioned it earlier today, but do you think you can get a 25% increase in your FFO between now and year-end 2020, which is 10 quarters? It’s very impressive to get you up to $1.10 a quarter to $1.12 a quarter by late 2020. Can you give a little more color in what the main drivers of that might be in as much detail as possible?

Yes, well, if you remember back at the Investor Day, we put a chart up on the board which showed the various boxes of that, the stabilized portfolio growth, the new development, what’s under construction, what’s being delivered – over $1 billion of development coming online. So without going through an excruciating detail on the call, I think I can point you to that deck, which is on our website. But it shows the various components of that, and it’s obviously offset by dispositions. And it’s obviously everything else being equal, no other changes to the structure, but it basically walks through our – the various components.

If you do something that significant, make sure you’re the first speaker next time, okay, instead of the fourth hour.

The next question comes from Tom Catherwood with BTIG. Please go ahead.

Thanks. Back to the leasing on the 2018 expirations. Lot of positive commentary about what you’ve taken down so far, but if we look at the midpoint of guidance, it implies roughly $0.86 each quarter in the third, fourth quarter, give or take, which would suggest a roll down from where we are now. So can you kind of walk through the ins and the outs that you have in the second half of the year? And kind of obviously, you backfilled the space, but what’s the lag between when the expirations happen and when the new leases commence?

Well, it’s a good question. Actually, the third quarter occupancy is going to dip slightly because we have the Delta Dental move-out. So and then we expect that to pop back up in the fourth quarter when Okta is scheduled to move in, in that space. So there are ins and outs and the timing. Bridgepoint had an exploration in July, and General Atomics is taking that space, and then there’s another Bridgepoint expiration in the fourth quarter. So there are lots of ins and outs, but the good news is we’re backfilling that quickly. And I can let Rob talk about how long it usually takes between when someone moves out and when we get someone coming back in.

Yes. I mean, generally, again, it depends on the market. But in San Diego and those submarkets, it’s probably anywhere from minimum of three months to six months probably, depending on the level of tenant improvement work and other factors with respect to the tenant.

Okay. But with, like, for example, let’s take the General Atomics, Bridgepoint backfill, is that – it’s already signed, but is that six months from when Bridgepoint leaves to when you guys start revenue recognition?

I think – this is Jeff again. That one commences in September. So I think there’s roughly about three months of downtime from when we got the space back to when they’re going to fit the space and move in, so on the shorter side.

Okay. So we get a pickup then through the back half of the year?

Yes, on that project.

Okay. And then, going over to the Brannan Street buildings 301, 333 and 345, obviously, you’ve got the termination and releasing there. Are you guys putting any incremental capital into those assets? I mean, like, obviously, other than the purchase price? And what’s the lag between Dropbox’s termination and revenue recognition from GM Cruise?

On the last question, we expect Dropbox to be moving out mid-next year. And Cruise will be moving out in late next year. So it’s still not crystal clear exactly the timing, but it could be two, three months of downtime on that lease. In terms of the CapEx, Rob?

It’s really just tenant improvements as part of the transaction.

So this is, being that they’re all relatively new buildings, very new buildings, just a standard TI package there? Or was it smaller because they’re so modern?

Well, the 333 and 345 are the newer buildings. And the TI package is lower, the 301 is older build out, so that’s going to have a higher tenant improvement associated with it.

This is John. The TI packages on the newer buildings, remember, these are long-term leases. The TI package, correct me if I’m wrong, Rob, on the 333, 345, were much less, roughly one-third of current market. And the TI package on 301, which is a historic build, I don’t know if it’s historic in the register, but it’s an older building but very cool, which people like. The TI package there was still well below current market. So the economics are pretty terrific.

Got it. And last one for me, maybe John, sticking with you. In regards to Central SOMA plan, it looks like the Board of Supervisors has begun the review. Do you have a sense of timing on that? And if the approval comes through, kind of what are the next steps in the rezoning process?

Yes. Well, the Central, as I said at our Investor Day, that they were scheduled in July to approve the Central SOMA plan. It’s already been approved by the planning department, but that they could be delayed because there were four – three or four appeals and they want to make sure that they respond to those appeals properly to defeat them. And that it could be delayed. And they don’t have a meeting, they have a recess in August. So it’s going to come back in September, and we expect it to be approved then. We don’t expect any delays with regard to its implementation. And assuming it is approved in this third quarter, they will have roughly, given the October allocation of 875,000 square feet, they’ll have roughly 3 million square feet in the pool by the end of the year. And we would expect the allocations at that time into the year, early first quarter.

Got it. Thanks, guys.

The next question comes from John Kim with BMO Capital Markets. Please go ahead.

Thank you. On the reserve that you made this quarter, can you discuss what industry the tenant is in?

No.

I was really asking more about life sciences because that’s been a major push for you and you had a major development opportunity at Oyster Point, and whether or not this particular incident would impact your decision to move forward with some developments or the timing of it?

The answer to that is no. It has no impact anything to developments of existing tenant, that’s just gone through a recap.

Okay. I think, Jeff, in your prepared remarks, you mentioned that leasing in the fire industry has picked up. Can you discuss what markets you were referring to? And is this specifically fin tech? Or is it more broad-based among traditional fire tenants?

Yes, John, this is Rob. Particularly in San Diego, there’s an uptick in fire category tenants. And in the North County, where we’re based, that’s pretty prevalent. I think, also, we're seeing that in San Francisco and have seen that over the past eight months or so, where if you look at a lot of the composition of the Salesforce Tower leasing, those are expansions of primarily fire category tenants. So L.A., kind of centered more in downtown, where we don't have assets in terms of fire category. And Seattle has actually had some good activity as well in their downtown market from fire category.

Okay, great. Thank you.

The next question comes from Daniel Ismail with Green Street Advisors. Please go ahead.

Hey guys, good morning. Curious to get your thoughts on Proposition C in San Francisco and its potential impact on the market and your portfolio? And curious if you hear any feedback you received from tenants?

This is John, let me deal with the first one. I haven't heard anything, to my knowledge, from tenants. Rob, correct me if you've heard anything. But as of a week or so ago, we hadn't heard any noise from tenants. Secondly, with regard to – I'll let Tyler talk about the impact. Our reading is based upon lots of conversations with people that were both pro-Prop C and anti-Prop C, that both sides of the aisle is a feeling that this will be ruled unconstitutional and therefore nullified. Now we can only tell you what we've been hearing, but it's interesting when the proponents of Prop C are saying that. With regard to the impact, Tyler, do you want to cover that?

Yes. The impact for 2019, based on our estimates at this point, would be that it would impact our numbers by about $0.015 a share.

That’s helpful. Thanks. Any timing as to – is there any current legal proceedings currently ongoing with Prop C?

This is John again. We can find that out. I don't know at the top of my head. But you can imagine, there's a lot of people that are fighting it. But I can't tell you about the lawsuit.

You spoke earlier on the rent growth in your market. Curious to see your thoughts on how concessions trended year-to-date?

This is Rob, I'll tackle that and anyone else can jump on also. But again, in all the markets we're in, really, is in the landlord's favor. And so concessions are not increasing by any means, and tenant improvements typically come up in that sort of discussion. The only increase related to tenant improvement is really driven by the cost of building out space, just labor and materials and that sort of thing. But free rent and the other types of concessions are probably at minimums.

Great. Thanks guys.

The next question comes from Rob Simone with Evercore ISI. Please go ahead.

Hey guys, thanks for taking the question. Just a quick housekeeping item on my end. So some of your peers have began to share selectively what their views were for the – from the potential impact of when lease accounting changes. And I was just wondering if – I know it's early, obviously, but I was wondering if you guys had formed any internal views on what that could be next year?

Yes. We're still working through that. It's a complicated analysis. And it can be impacted by how you structure your compensation and lots of different things. And as you know, it's sort of a noneconomic change. But right now, if we were to look at it completely without adjusting anything on the compensation front, it could be as much as $0.07 to $0.10 a share. Obviously, that would improve our yields because most – a lot of that cost is development capitalization, where that would now be expensed. And they would – it would be helping our returns on our development. But – and that's an early number, or that's an early range, so more to come on that.

Thanks, Tyler. I appreciate it.

The next question comes from Steve Sakwa with Evercore ISI. Please go ahead.

Just wanted to see if you guys could discuss maybe a little bit construction costs and what you're seeing. Obviously, it's pretty fluid on tariffs, but I'm just curious, John, as you're looking out at some of these new projects, whether it be Oyster Point or now One Paseo on the office front, how are you guys thinking about construction cost? And how might that impact the returns?

Steve, I can't – I mean, obviously, we don't have a crystal ball, Justin Smart and his group follow this thing about as closely as they do anything. And I was talking with him at length the other day, and he says, "Look, steel is the issue that is the most prevalent. And the implications on cost are somewhere in the neighborhood of 2% to 3% when it rattles through the building because the building is not all made of steel." And we've been experiencing, depending upon our markets, San Francisco, Seattle and so forth, sort of anywhere from 3% to 6% increases on certain commodities over the course of the last several years. So we baked all that into the pro formas. And as we have seen by the deliveries we've done and by our comments today with regard to that, which is it's under construction, we've adequately provided for potential cost increases. Will it be a little bit more tricky, depending on what happens with tariffs and so forth? Probably. So what are the impacts? Yield-wise, we've seen sort of around that high 7, low 8 on average return – unlevered return on the office properties. Could that impact it by 10, 20 basis points? Sure. But I don't have any reason to believe it will or it won't, but we've also seen rental rate increases, so – that have sort of outpaced that increase in construction cost. I do think this, that the bigger issue, the question – if I was on your side of the fence, the question I'd be asking is, what's the premium for quality properties in more modern properties versus the older properties that are less desirable? And I think what will happen is the tenants, I believe, the modern, particularly tech, entertainment-type tenant, is going to be a little insensitive to the parallel increases in rent because they're going to go for the right kind of product versus existing product if it doesn't meet their physical criteria. But this is going to play out over time. I think we're in a good shape with regard to the very extensive contingencies and cost structuring that we do in our pro formas.

Okay. And then, maybe just to circle back to the, I guess, the 333 Dexter and The Academy, just in terms of kind of tenant demand and expectations. I mean, how do you sort of handicap or kind of lay out the timeline, do you think, for getting kind of leasing done at one or both of those projects?

Rob, do you want to take that?

Sure. Hi, Steve. Let's talk about Dexter. So just to frame it up, we started construction on Dexter a year ago. We've got about 18 months left for shell and core delivery. There are a number of single user tenants in that market. But I think what's pretty amazing are the number of good credit, large tenants that aren't full building users that we're seeing. And I think what's clear is the Seattle has come onto its own now in terms of where the talent, the software engineers that companies want, not only in the Bay Area but other parts of the state. And so we're seeing an activity level that has increased quite a bit, and it's interesting to me because it's not just the area of focus. So I guess, more to come is what I'd say. I don't want to predict the future for you, but we're feeling really good about it. And with Academy, as John said, we started that in January. And again, there's just so much – there's such a fundamental change going on in the entertainment industry and the number of activity levels between full building users and smaller tenants is, again, pretty dynamic. And just as statistic, HBO typically spend – or just the last year spent $2 billion on content. Netflix spent $8 billion or spending $8 billion this year. Now with AT&T Time Warner taking over HBO, there's something that's going to happen there to close that $6 billion gap, and it's going to happen in Hollywood. There's no question about that. So we're seeing a lot of really interesting activity and it just goes on and on between Disney and other companies in the content and media space.

Okay. Thank you.

This concludes our question-and-answer session. I would like to turn the conference back over to Tyler Rose for any closing remarks.

That's the latest news from KRC. And we thank you for joining us today. We appreciate your interest in KRC.