Good day, and welcome to the Third Quarter 2021 Kilroy Realty Corporation Earnings Conference Call. [Operator Instructions] Please note, this event is being recorded. I would now like to turn the conference over to Michelle Ngo, Senior Vice President, Chief Financial Officer and Treasurer. Please go ahead.

Good morning, everyone. Thank you for joining us. On the call with me today are John Kilroy, Tyler Rose, Rob Paratte and Eliott Trencher. 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 on this call and in the supplemental. This call is being telecast live on our website and will be available for replay for the next 8 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 an update on our market conditions and review our operational and strategic activities. I will discuss third quarter financial results and provide you with updated earnings guidance for 2021. Then we'll be happy to take your questions. John?

Thanks, Michelle. Hello, everybody. Thank you for joining us today. I'll start with some macroeconomic comments before getting into our leasing and capital allocation. It's been just over 1.5 years since the pandemic began, and we are really starting to see the revitalization of cities across the West Coast. City drillers are returning to their urban apartments and once again embracing city life. After a tough 2020, residential net absorption is approaching 100,000 units in our 5 markets driven in large part by high-density areas like Hollywood, South of Market, Downtown Seattle and Downtown Austin. Restaurants, bars, coffeehouses are full, concerts and sporting events have returned and slowly but surely, more companies are coming back to the office. The recent easing of the San Francisco mask mandate is another step in the right direction that we believe will continue to encourage more infers and gatherings and collaborations. The technology and life science companies that make up so much of our portfolio continue to thrive. Stock prices are near all-time highs and VC fundraising is on track for a record year, which is translating into a war for talent, growth in job postings and additional real estate procurement. Improving market conditions helped to drive a strong and productive leasing quarter for Kilroy. We signed more leases in the third quarter than the first 2 quarters of 2021 combined. Since the second quarter, we have signed just under 600,000 square feet of development, new and renewal leases. For the 510,000 square feet in the stabilized portfolio that were signed, GAAP rents were up on average 26% and cash rents were up 14%. Additionally, we have a number of leases under documentation. And in Austin, we're very encouraged with the market and our early-stage lease negotiations. A few facts according to recent reports…

Thank you, John. FFO was $0.98 per share in the third quarter. Quarter-over-quarter, the $0.10 increase was largely driven by the acquisitions to date, NOI contribution from our One Paseo office and our residential projects as well as $0.015 of lease termination fees. On a year-over-year basis, as a reminder, the sale of the exchange had an impact of approximately $0.13 of FFO per share. On a same-store basis, third quarter cash NOI was up 16.6%, reflecting strong rent growth and a $17 million cash termination payment. GAAP same-store NOI was up 3.2%. This termination payment is related to the new 12-year lease we executed at 12400 High Bluff for 182,000 square feet of space. On an earnings basis, approximately $7 million, which is a net amount after lease write-offs, will be amortized over the next 3 years. $700,000 of it was included in the third quarter. Adjusted for termination payments, same-store cash NOI was 3.7% and same-store GAAP NOI was up 2.2%. At the end of the third quarter, our stabilized portfolio was 91.5% occupied and 93.9% leased. Third quarter occupancy was down 30 basis points from the prior quarter, driven by approximately 90,000 square feet of move-outs, offset by the West 8th acquisition and the Cytokinetics lease at KOP 1, which was added to the stabilized portfolio at the end of the quarter. Revenue recognition for 100% of this 235,000 square foot building commenced October 1. Turning to the balance sheet. After funding the West 8th acquisition for $490 million, issuing $450 million of green bonds, which closed October 7 and the redemption of $300 million of 3.8% bonds, which was completed earlier in the week, our liquidity today stands at approximately $1.5 billion, including $390 million in cash and full availability of the $1.1 billion under the…

[Operator Instructions] The first question comes from Nick Yulico from Scotiabank.

Maybe just first question, if Rob could perhaps go through some of the leasing dynamics you're seeing in your markets?

Sure. Nick, and hello, everybody. Let me start with some highlights that I think may address questions that others have. And there are 4 key ones I'd like to make. What we're seeing on the ground and this isn't necessarily just strictly our 5 markets that we operate in, I think it's a national trend. But the office will remain the center of the work ecosystem. It may change in its configuration, but it's going to remain the place where people come to conduct meetings and collaborate. And we're seeing companies, both our clients and others spending a lot of money on their office space. So I think that's one important point. Hybrid work is going to be given. We know that. The third point I'd make is that the net impact of hybrid work, we think, is going to be minimal in terms of space demand reduction or footprint shrinkage. Recently, CBRE conducted a survey nationally of 185 companies and only 9% of those surveyed expect to experience a decrease in square footage. So I think that's really telling. And as John alluded to in his comments, health, safety and wellness are going to continue to be a very high importance to employees. So you will see a flight to quality, as we've talked about, to buildings that provide that sort of outdoor space stairwells where you can walk rather than take elevators, et cetera. Going into the markets, just some overall general again, highlights, true activity across our 5 markets has continued to increase particularly in San Francisco, restaurants, retail and hospitality are visibly improved in terms of just sheer numbers of people in the streets and bars and restaurants. Driving in this week to San Francisco it's truly amazing at 08:00 or 8:30 in the morning, seeing…

That's very helpful. Just on Oyster Point, can you remind us, I guess, 2 things. One, can you just give us a feel for where market rents are right now? And then separately, remind us how on Phase 1, the rest of the NOI is going to flowing from a GAAP standpoint over the next couple of quarters?

Yes, Nick. I'll handle the first one. I don't want to pinpoint because the market is moving and it's moving in the right direction. But safe to say, I think rents are achieving $7 net right now and will exceed that just based on the absorption that's going on in the activity.

Yes. Nick, with respect to KOP Phase 1 and the remaining revenue commencement. We said Cytokinetics commenced in early October and Stripe who occupies the remaining 2 buildings will come online in November.

The next question comes from Manny Korchman with Citi.

Maybe as you expand the development pipeline, have you seen any issues with the supply chain disruption or especially since I feel like some of it's coming a little bit faster than you expected?

Yes. Manny, this is John. We obviously have a group that monitors all of that stuff. And there are some disruptions for sure. We made it a decision at Kilroy a couple of years ago that we were going to reduce our dependence upon offshore suppliers as much as we could possibly do. And we have, but we are still dependent because of steel, we don't fabricate any steel in China, but you have to buy the bulk steel, bring it here. We're very focused on what we can control. And so as you probably know, there's a lot of ships that are at anchor waiting to unload all of our ports, and we've been very focused on making sure that the stuff we have coming from offshore is going to ports that don't have the jam up that L.A. has as an example. In regards to delivery of things, we forecast everything that takes longer. And with regard to construction costs, we've been forecasting anywhere from 5% to 6% per annum increases across the board and cost, and we've done better than that. Everything that we have under development right now has been bought. Things that we are going to start, we will buy. We've had pretty good luck in that regard. We've been able to deliver everything at or below what we forecasted. But we're keeping a close eye. We've had to make some selections of alternative materials in a few cases to make sure that we don't have a supply problem. So that's kind of a general comments and more to come, but we do have a pretty robust risk management function within our construction development activities.

And Michelle, going back to your prepared remarks, you spoke about 1 large vacate in, I think you said early '22. If I look at your exploration schedule for '22. If that vacates in the first quarter, it seems like those rents are sort of well below the rest of your portfolio. And I'm wondering if this tenant falls into that? Or otherwise, if you could just give us some more details on the move out?

Yes, Rob, I don't know if you have any color on the move-outs. But I guess with respect to market rents, I'd say last quarter, we said across our portfolio, rents are about 15% below market. I think in looking at '22 explorations, it's in that 20% to 25% below market range.

Yes, Manny, this is Rob. Just a little more color. We've anticipated this vacate. We've been talking to the tenant off and on, some of their work is related to the government and contracting. And so we are pursuing and have activity sort of in a wide variety of sizes, somewhere from 50,000 feet to in excess of 100,000 feet. So given we haven't gotten the space back yet, we're already working on some things and feel pretty good about it. There's a lot of activity, as John said in his comments, just a lot of activity out in that corridor right now.

And Michelle, just from a modeling perspective, can you be more specific on the timing we should assume for next year?

It's in the first quarter.

The next question comes from Jamie Feldman of Bank of America.

Great. Just to confirm what was the size of the San Diego move out?

It's about 125,000 to 130,000 square feet.

Okay. And then I guess, thinking about next year, it sounds like you think nothing else sizable?

No. That was the only sizable one.

Okay. Just looking at -- first of all, I'd like the revised supplemental, so thanks for freshening it up. It's great. Page 30 to have the future development pipeline. I'm just curious what your thoughts are given the multiyear lead time to get something built. What are your thoughts on starting incremental projects now? It seems like you guys think the markets are starting to recover.

Well, this is John. We are -- as I mentioned in my comments, we will be starting phase -- the first phase of what -- of the 2 phases that remain at Santa Fe Summit, that's about 300,000 square feet. So we have 2 -- we have 2 phases there for 600,000 feet. It could be that we start both if we have -- if we've leased 1 of the phases. So that will -- that's going to commence next year. We've got a few other things that we're looking at, but nothing to announce at this point from an entitlement standpoint. We did receive all our entitlements now for the Flower Mart, we were able to revise the phasing and whatnot on that project to be roughly plus or minus 500,000 square feet per increment, which is very good. But we don't have any plans to start that right away. We want to see the market solidify here in San Francisco. And then we have our SIX0 project up in Seattle, but that, I think, is about a year away from being able to start. We do have a little project I failed to mention that is on 26th Street in Santa Monica. It's an existing building of about 40,000 square feet that will be remodeled and then about another roughly 100,000 square feet plus or minus in 2 adjacent buildings that we're receiving approval on and that will be sort of a low rise, very modern campus, and we could end up starting that next year, which we'd be inclined to do because we already have pretty strong demand for it. So that's sort of the development view that we have right now. We are readying Phase 3 and 4 of Kilroy Oyster Point, and we're not ordering material, but we are -- want to be in a position to start that as soon as we made some leasing progress at KOP 2.

Okay. And I mean, the announcements of expansion in Austin just continue. Any latest thoughts on how you can grow there beyond indeed?

I don't want to share them publicly for competitive reasons because it is a competitive market, but Elliot and his team have been working on a number of things there. And we're hopeful that we're going to be able to complete some other things, maybe as early as this quarter, but maybe it will be next year. But you're quite right. I mean what we see there is that it sort of reminds me, Jamie, of when we bought Oyster Point and Cambridge was at sort of $90 triple net and Oyster Point area was sort of at $55, $56, $57 triple net. And we said we think the same -- these are the same tenants. They're going to end up paying more like Cambridge prices in due course, and that's exactly what's happened at Oyster Point, and now Cambridge, as you know, is well north of $100 triple net. And it's the same tenants that are paying higher rents around the world that are moving into Austin and at least in the big tech. I think there's going to be a lot of lift. We're not really interested in older product that doesn't meet the demands and needs of the modern tenant unless it's an old building with a lot of floor height that we can convert. So we are scouring the market regularly. We're in negotiations all the time. Nothing now to report, but hopefully, something will break loose here in the next few quarters.

The next question comes from Derek Johnston with Deutsche Bank.

L.A. L.A. remains a bit of a hole in the portfolio and really what otherwise is pretty well occupied. I think it's around 87%. What do you see going on in that market? And what's it going to take to get back to the 90s or maybe even 95% or higher basically in line with your other core markets?

Yes. This is John. I'm going to turn it over to Rob here in a minute. But if you look at L.A., there are a lot of big tenants and there are a lot of small tenants. And small tenants have lagged in this pandemic area for obvious reasons. It's easier for them to move into the home or move into wherever they're moving. There are more of those kinds of spaces available. But we are seeing really strong signs of life. The big users, as Rob pointed out, are making moves forward. We're seeing a lot more requests for proposals. We've done an awful lot of little deals recently. And Rob, do you want to add a little bit more color on that?

Yes. I guess what I would say, Derek, is that L.A. is such a large market when you really look at it, considering it can run from Long Beach all the way up to Thousand Oaks and Carlsbad -- excuse me, and Calabasas. And so it is a function of very many submarkets. We don't focus on downtown L.A. West L.A., as I said in my comments earlier, did have quite a bit of space on the market between 2100 Colorado and Santa Monica Business Park and the water garden. But particularly at Santa Monica Business Park and Colorado they've had significant absorption. And the gaming industry is actually coming out of sort of from the background now competing with tech companies for space on the West side. So we're seeing, I guess, I would say, Culver and Hollywood have been fairly stable throughout the pandemic because of all the film production and those locations are just attractive to the media companies. And I think what's happened is that West L.A. and particularly deeper into the West side like Santa Monica, you're starting to see that increase in activity. And it's starting at the big tenant level like the names I went through. But to John's point, smaller-sized firms are now starting to surface. They really didn't -- when you look about it, if you're -- if a city is shut down and you're not going into the office and you don't have to do something with a lease, you're not going to do it and they haven't for about 1.5 years. But we're starting to see more activity in that smaller...

Well, if you look at, as an example, our Tribeca West project, which is very much geared towards shorter term production directors, all that movie content stuff. A lot of those people could go to work last year. Now all of a sudden, our occupancy is increasing substantially. So as things loosen up, people get back to work, they need space to work and they lease space. So that's a good trend. That's what we're saying.

All right. Great color. Last one. So looking at some office companies that have already reported so far, they seem to have been able to drive longer-term commitments from the tenants. I know you guys were always a little lighter on term historically. But is this like a California thing or a tech issue? And could you share any insight on when you think your lease terms will return to like the 7- to 10-year levels? And what...

Well, I don't know how you're getting that statistic and Michelle or Rob, you can help me, but I think Kilroy has had amongst the longest term leases because we do so much with big companies, and those are generally anywhere from 10 to 16, 17 years. So I'm not quite sure where that's coming from. And so...

Derek, this is Tyler. I think what you're looking at is the lease term on some of our renewals within the high 4-year range. But if you take into consideration the leases we signed in San Diego, which are not in that category, those were averaging over 11 years. So the average lease term for what we actually leased last quarter was 9.5 years. So it's still in line with what we've been doing. It's a little hard to follow in those numbers.

The next question comes from Steve Sakwa with Evercore ISI.

I was just wondering maybe, Rob, if you could maybe touch a little bit on the life science demand, specifically in South San Francisco. I realize that KOP 2 doesn't have steel coming out of the ground. But maybe what are your expectations on timing? And maybe you or John could just address the broader infrastructure issues in South San Francisco and how you guys sort of think about mass transit, getting everybody that's going to be coming to that entire area as Genentech looks to double their footprint and you and many of your peers look to continue to add density to South San Francisco?

Yes. I look at this a little bit as fly fishing, Steve, you've dangled the fly out there, but I'm not going to snap at the fly with respect to timing and what we're doing and when we'll be able to announce something. But I would say that demand in the market, even though there's been tremendous absorption in the market today, demand is still tracking at about 4 million square feet. So as space gets absorbed, there's new demand appearing. So that's a very positive sign. As I mentioned earlier, rental rates are on the move, and we're very pleased by that. So -- and then with respect to the second part of your question, we are in a lot of discussions with not only our existing tenants, but potential tenants and others that are our neighbors on a variety of transportation solutions and ideas. And so it's something that everyone in Oyster Point, and frankly, everyone in an urban area is going to have to address at some point, it's circulation and moving people around. But I think 1 of the best assets we have is the Bay and Genentech, as an example, has a very significant robust ferry service that they run throughout the Bay Area.

Okay. And maybe piggybacking off 1 other question on Austin and just your desire to grow down there. I guess, John, have you gotten closer to formalizing or finalizing who might be running that region and sort of how you think about whether it's an internal external candidate?

Yes. We have identified and it's somebody from within that will be running it from an asset management standpoint, from a leasing standpoint. Obviously, Rob has the all-event responsibility and has a very firm handle on that. We have 1 of our top leasing people from this area here in San Francisco, who is responsible for the leasing currently at indeed tower. As we expand our platform there, we're obviously going to need more bodies and we're working on that. We've been going through that process. Nothing to announce right now. But we're very actively looking not only to have the management team that we want, and we have some really good candidates where we've been interviewing candidates now for several months, right, Rob?

Yes. yes.

And we're down to a couple 3 that we think could end up being very senior to our efforts there. The underwriting with regards to all the math, the investment leads and so forth, that's Elliott and his team, Jeff Jesse, 1 of his young superstars is very involved in everything to do at Austin. So we're going to have a great team, and we're going to have the kind of team we've had in our other areas, which is capable of acquisitions, dispositions if and when that becomes appropriate, obviously, development and then managing, and we're spending a lot of time with our tenant base, many of whom are in Austin and growing in Austin and have future plans to grow in Austin about what we're doing and so forth. And I think that's encouraging. So more to come.

Okay. And then maybe just last question, John, on the Flower Mart. I know there's some flexibility on that site, but how do you sort of think about the toggling between office and residential and would you look to maybe shrink the office component, add residential to maybe jump start that project? Or how do you sort of think about that moving forward?

Yes. Well, our basis is pretty attractive. And I've always said that we're not going to be doing stupid things in the short-term that impact negatively the long term. You're quite right, we can do residential. The key was to get the entitlements for the office. We now have the largest entitled property. I think in recent history, if not ever, in San Francisco for office, 7 acres, roughly 2.5 million square feet. You can go from office to resi. You can't with prop in, go from resi to office. So we sort of have an ideal menu, if you will, and we have a big enough site and 3 major streets. So we can slice and dice as we want to. As I started to say earlier, the with -- there's been a lack of clarity for sure with regard to when things are going to roll back in San Francisco. We're seeing the apartments come back with a vengeance. And my understanding is they're getting record rates. And once again, it's tough to find apartments. And one of the things that's happened in apartments is that where sometimes kids were loading up 3 or 4 people to a 2 bedroom. They don't want to do that anymore. They want greater distance. So what Rob talked about a greater amount of square feet per person in office, it's sort of the same thing happening in residential. So we're going to see how this plays out here probably over this next -- there's no time line, but over the next several quarters, and we'll make a decision how we want to do things. But we like optionality. And whether it's our property up in the SIX0, up in Seattle or whether it's the Flower Mart or whether it's the 2 blocks we own in East Village in San Diego. We have the ability to go office. We have the ability to go residential. We have the ability to go some combination thereof, and we have the ability to add retail if we want. So we have lots of flexibility.

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

I wanted to follow up on Derek's question on lease terms because if you look on Page 18 of your supplement on leases executed, most of these leases were new leases, and average lease term is about 4.3 years. So I was wondering if leases have come down on term, if there's been any month-to-month that's in there that's driving that number down?

Again, the redevelopment leases that we signed in San Diego are not in that category. So those are the leases in our stabilized portfolio. So when you add in the leases that are not in that category, it's 9.5-year average.

Yes. And just to clarify. So the lease numbers include the redevelopment leases, but the lease economics that you see in the weighted average term does not reflect the term of the 3 redevelopment leases, which are on average about 12 years.

Right. So you have some redevelopment in life science leases that are long-term and then you have others that are the tenant is committing on a shorter term basis?

Right.

That's correct.

Okay. Rob, you mentioned in your prepared remarks -- or sorry, in an answer, the bifurcation between trophy and Class B performance. I know most of your portfolio is Class A and trophy and that's what we focus on. But what percentage of your portfolio do you think is in that other category?

I don't think we have any -- I mean I'm drinking the kool-aid, but I don't think we have any beer. Certainly no obsolete projects. And as John said, we've got probably the youngest portfolio in the REIT industry. So I don't think we have any.

Can you also comment on sublease space in your portfolio? I know you talked about the market overall, but what's in your -- in the Kilroy portfolio?

Yes. Probably the largest piece of sublease space is the 350 Mission sales force sublease. A good portion of that has recently been absorbed and they're continuing to market the balance of the space. I'm not sure today whether they intend to take some of that off the market and occupy because they're -- as you know, they're downtown campus here right outside John's office, multiple buildings have a lot of people back in at work. And we know they've also started bringing sales teams back in on a mandatory basis here and there for meetings. So more to come on that, but that's the largest.

The next question comes from Blaine Heck with Wells Fargo.

Just one for me, probably for John or Rob. During the pandemic, obviously, office leasing activity was down everywhere, but maybe focusing on the Bay Area, it seemed like the valley did a little bit better than San Francisco CBD, where you saw, obviously, a lot of the sublease space flood the market. You guys talked about the CBD market showing some encouraging signs lately, which is great. But how do you think about any differences in the recovery in the valley versus San Francisco CBD in particular?

Yes. Blaine, we're actually really -- the valley is very interesting because there's been a tremendous amount of activity. And again, it's 1 of the themes that we've said continually on our calls and investor meetings is that there's the haves and have-nots in the valley, and it really depends where property is located in proximity to both the major freeway arteries that run to the Bay -- to San Francisco, but also Caltrain. And there are some really significant transactions that have happened in the last 3 to 4 months, Apple being brought probably primary at over 500,000 feet of new absorption, but there are other fan companies that are expanding significantly there. Sony has done another large requirement in the valley. And at least our experience with the valley and as it relates to San Francisco, as these markets sort of operate in tandem, and what's happened in past cycles where there's been major absorption in the valley, there is a spillover effect to San Francisco. And so we're starting to watch for that now in the CBD of San Francisco. But the valley, if you just take a step back, San Francisco was more shut down, as I've said before, than any city in the country. It's starting to open up. The valley was nowhere near as restrictive. And so demand and activity have continued to increase.

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

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

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.