Good day, and welcome to the Kilroy Realty Corporation Second Quarter 2019 Earnings Conference Call. [Operator Instructions] Please note, this event is being recorded. I would now like to turn the conference over to Tyler Rose, Executive Vice President and Chief Financial Officer. Please go ahead.

Good morning, everyone. Thank you for joining us. On the call with me today are John Kilroy; and several other senior members of our management team are all available for Q&A. 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 an update on conditions in our markets and a review of the second quarter, and I'll give you the financial highlights and discuss our updated 2019 earnings guidance. Then we'll be happy to take your questions. John?

Thanks, Tyler. Hello, everybody, and thank you for joining us. I'll begin today with a review of market conditions and follow with details of our recent leasing performance. Then I'll bring you up-to-date on our development and capital recycling activities. Conditions in our West Coast real estate markets remain very strong across a wide variety of industries. From Seattle to San Diego, the tight supply of available space, combined with significant demand for high-quality work environments, continued to drive rents. And Class A vacancy rates remain at frictional levels in all of our key markets. Technology continues to be a key driver. As I've said before, I believe we are still in the early innings of this new digital era. Advanced computing technologies, turbocharged by artificial intelligence, continued to influence health care, finance, retail and many other service industries that had proven difficult to disrupt in the past. Another key driver of demand has been life science. U.S. spending on health care exceeded $3.5 trillion in 2018, more than 18% of U.S. GDP. That spending represents a huge opportunity for life science enterprises, and it's driving new investment, new businesses and new collaborations. It is boosting demand and shrinking supply in traditional life science clusters, from coastal San Diego to Seattle, and we believe this growth story is still in the early stages. In addition, many of the majors we look to, to gauge the strength of the economic activity, remain healthy. West Coast job growth continues to surpass the rest of the nation. VC funding is at all-time highs. U.S. health care venture fundraising reached a record $21 billion in 2018. Big tech continues to buy little tech, which improves overall credit quality. And the IPO market is providing strong liquidity. On the ground, we're increasingly seeing a trend…

Thanks, John. FFO was $0.95 per share in the second quarter, which included the earlier-than-forecasted commencement of the first half of the Exchange. Same-store NOI in the quarter grew 4.7% on a GAAP basis and declined 5.6% on a cash basis. GAAP NOI growth was helped by a net $0.05 charge from bad debt in the prior year period. As we've discussed on earlier calls, cash NOI in the first half of the year has been impacted by a handful of large expirations, which have been largely re-leased but required some downtime for TIs. We expect cash NOI to resume growing in the second half and it will be roughly flat for the full year. At the end of the second quarter, our stabilized portfolio was 93.8% occupied and 97.2% leased. With our strong leasing activity through the first seven months of the year, we've effectively addressed all 2019 lease expirations with just 1.5% remaining. And over the next 15 months, we only have one expiration greater than 100,000 square feet to lease. As John mentioned, we estimate that our portfolio-wide average in-place rents remain 20% or more for the market. By region, in-place rents for San Francisco are approximately 31% below market. Los Angeles and Seattle's are 11% below market, and San Diego's are about 9% below market. Also, during the quarter, we increased our regular quarterly cash dividend by 6.6% to $0.485 per share or on an annualized rate of $1.94 per share. This represents close to a 30% increase over the past three years. Now let's move to the balance sheet. We drew down all the proceeds on the sale of $5 million shares of equity we had placed last August on a forward basis and used the roughly $350 million to pay down our bank line.…

[Operator Instructions] Our first question today will come from John Kim of BMO Capital Markets.

Congrats on the Apple lease at 333 Dexter. It looks like the stabilization date was moved back a couple of years. And I was wondering if you could discuss the timing of the FFO contribution of the asset.

Yes. So the projected -- it's going to be taken down in three phases starting in the second half of 2020 into 2022. We'll be providing more detail in that in the coming quarters.

And do you stop capitalizing interest when the occupancy takes place on a different basis?

Yes.

At the Flower Mart, it looks like there's some conflicting news items whether or not the Flower Mart is going to decide to stay in the project after you complete it. Can you just provide some -- any further clarity you have on that?

Yes, this is John, John. Yes, the Flower Mart came to us in the city and said that with all the buildings that are going on, us, KRE, everybody else in Central SOMA, that it's going to be changing the character of the area from industrial to much more upscale. We think maybe it would be better for us to go over to the produce mart that's going to be built. "Do you -- would you accommodate us?" We talked to the city, and they said, "Fine with us. You still get credit for saving the Flower Mart for the project, all the rest." And so they made very well movement there. They have the option to do that. That's been approved by the city and all its different components, including the supervisors in terms of supporting it. So we don't know whether they will come back or not. It doesn't cost us any more money because the money was already there. So -- and in fact, it would increase our leasable office square footage slightly if they did not come back. So more to come on that.

As far as the total cost, it looks like similar projects that you have are around the $850 range per square foot. Is that a good benchmark for the Flower Mart? And can you also provide an update on the litigation project?

Well, I can't talk about litigation. There is a variety of -- other than to say that its people are endeavoring to negotiate a successful completion, we're hopeful that it will happen, but I can't be coming -- because it is litigation, I can't get into the specifics of that. In terms of the cost, let's just say that we're in a very favorable cost basis, but we are in negotiation with a lot of different people for the Flower Mart and I don't want to talk about what the cost is. It's going to make -- it's good to be favorable.

Understood.

It's going to be favorable.

Got it. Thanks a lot.

The next question will come from Nick Yulico of Scotiabank. Please go ahead.

Just following up on Flower Mart. I guess can you give us a feel for where you think the demand is like in the city right now? And what are Class -- where have Class A market rents for new construction in the city risen to?

Yes. Well, demand is -- I don't think I've ever seen demand any stronger. As you have seen us announce over the past, I don't know, years' worth of conference calls, we've been leasing space of record rates for space that is -- isn't contiguous or space that may not be available other than in tranches over the next couple of years. And that's in older buildings like 303 and 360 and 201 and so forth and 101st. Rents in the Brannan Street Corridor for quality product is, let's just say, north of $80 triple net and I think moving higher.

Okay, that's very helpful. And then going back to the Oyster Point lease. Cytokinetics did file some information about it. And based on that rent, it looks like the project is already going to yield -- is already yielding over 7%. I mean how should we -- assuming you got similar rents for the rest of the space, I mean, how should we think about potential rent growth in that market and then also like future phases of construction cost? I mean is this a development that's going to get closer to an 8% yield over time?

I'm not going to put my neck out there because every time I do, you guys want to chop it off because something happens. But we think that the Phase 1 will exceed our pro forma expectations that we've talked about before. Future phases, we think, the rents will grow tremendously in that market. You heard us say before that the same tenants, types of tenants and many of the same names lease space in Cambridge, lease space in South San Francisco for the similar kinds of properties and operations. And if you take a look and draw a little bit of a forward thinking to where rents might go in South San Francisco, look at where they are in Cambridge. We think we're going to see big rent increases over the next number of years. And we think rents will escalate significantly in the future phases of KOP.

And just one last question on a lease that was signed. It looks like there's - the tenant is -- doesn't pay rent on the full amount of square footage in the first year. It pays a piece of that. I wasn't sure if that was because they are not taking all the space or if there was -- that was built in, in some like additional free rent component.

Tyler, do you want to handle that?

Michelle, go ahead.

Yes. No, I think they are taking the 160 in the first 12 months and then the remainder over time in the second year, the total 235.

Okay, thanks everyone. Thanks, Jeff.

The next question will come from Craig Mailman of KeyBanc Capital Markets. Please go ahead.

Tyler, just one quick one on guidance on the bond deal. Kind of what should we think about size and timing on that one?

Yes. I mean we're still working on it. I mean 350 to 400 maybe on size. And timing, maybe September is a kind of thing. Still working on it.

Okay. That's fair. And then, John, just going through your comments. Are you seeing more acquisition opportunities? Could you just kind of juxtapose that with that good development pipeline you have with Flower Mart and others? And kind of having to fund all this with where the equity is, maybe doing more -- mix more debt and dispose, kind of how the mix of capital allocation could go in the next 12 to 24 months.

Obviously, I mean, just on dispositions to begin with, we gave a guidance early in the year, as I think everybody remembers, is up between 150 and was it 350, Tyler?

Yes.

Yes. And we're at the lower end. And we explained before, that somebody asked us, we thought we'd be selling, we think we can create some significant value by repositioning them before we sell them. So that means there probably are more dispositions next year. In terms of acquisitions, I don't want people go out and think that we're going to become massive acquirers. We're not. But we are seeing a couple of assets that we think are extraordinarily well-positioned for huge increases in the future with -- that are currently accretive. And if we can be successful in acquiring those, then we think that's a good play for shareholders. Tyler, if you want to talk more about funding, if -- I think that was the second part of your question.

Yes. I mean in terms of the funding of the existing needs, 2019 is effectively taken care of with these dispositions that we're still doing and the ATM floor that we drew down in the first quarter. So 2019 checked off. And then for 2020, as we just talked about, we're looking at a potential bond deal that would prefund from the 2020 development spending. And then to the extent we do acquire something or decide to do more development, then we'll evaluate the other alternatives that we've always used, which is dispositions in that, and equity, we have a lot of debt capacity and there's also the joint venture alternative.

Okay. And then just, which I know because you don't want us to think you guys are buying too much, just order of magnitude maybe of what you guys think you could take down and maybe the spread between those types of stabilized yields versus what you're getting on your developments.

Well, as obviously, you're not going to get on anything you buy to reposition or that gets repositioned through the course of time. You're not going to get anywhere near the development yields. I don't want to get into the specific yields because we have deals in discussion and I just think that's inappropriate to talk about because people do listen or read these scripts that are competitors, and I just feel uncomfortable talking about it. But it is definitely safe to say that you're not going to go out and acquire high-quality, best-in-class assets and have them be anywhere near the yields that Kilroy has been able to achieve in this cycle, including currently in our development. So there's probably 250 basis points, plus or minus, and possibly more of the spread. But what I'm looking at is if you can end up with something that is slightly accretive that can become massively accretive a few years down the road, then I like that.

And what do you think -- and how much would you spend on this, just wide kind of goalpost?

Well, it would be a fraction of what we do from a development standpoint. What do we have, Tyler, right now? $2.2 billion, $2.5 billion of development underway. And I'm not talking about anything that the approach is even half of that.

Right. And then just one last one for me. I think, in the past, you said that even though you're going to get approvals on the Flower Mart, you still wouldn't start until kind of the lawsuits are settled. I'm just curious if that's still the case. And then just how it's looking from kind of a phased perspective. I know, in the past, you said maybe it would be two phases. Is there enough demand out there to just do it all at once and just kind of thoughts around that.

Yes. I think there's enough -- first of all, the entitlements that we have will be entitlements for what we call Phase I, which is everything but the Gateway building, which is roughly 350,000 square feet worth of leasable space. So we think it's likely that we will start -- it gets staggered a little bit between the blocks building the market-all building because the market-all building doesn't take as long to start. So it all doesn't technically start at the same time, but I think it will finish at the same time. In terms of demand, I -- there's very, very strong demand by major companies for all of it. And I'm talking about all of it, where there's companies that want all of it for themselves.

Okay, great, thanks.

Next question will come from Steve Sakwa of Evercore. Please go ahead.

John, I guess to kind of follow up on that point about the demand. Just help us understand how you sort of decided on Cytokinetics. And I realize it's a little bit more of a smaller biotech company, has a couple of drugs. It's not a traditional household name. It's certainly not an Apple from a credit perspective. So how did you guys go about sort of evaluating that company, kind of giving them part of Phase one. Given the kind of demand, it sounds like that's behind that.

I think it will become very clear in our next conference call.

Okay, all right, thank you.

Our next question will come from Jamie Feldman of Bank of America Merrill Lynch. Please go ahead.

I want to talk a little bit about rent growth. Can you just talk about, across your major markets, what you're seeing in terms of net effective rent growth and maybe how does it feel versus last year?

You want to cover that, Rob?

Sure. How you doing, Jamie? This is Rob Paratte, by the way. Starting with Seattle, we just see continued pressure on rents. So again, based on what brokers are forecasting for the year, for the remainder of this year, I wouldn't be surprised to see it in the double digits again in terms of net rent growth. The Seattle-Puget Sound area added over 43,000 jobs in the past 12 months. So there's, I think, this pent-up demand with a lot of employees in the area, plus people moving in, and I think tenants up there are pushing a lot of this rent growth as well as just occupancy. In San Francisco, I think, again, it will likely be. I mean brokers are predicting, and especially for larger transactions, that we'll be in the double digits again. So whether that's 10% or 12%, hard to say right now. But based on the demand we're seeing and the number of tenants that are in the market, it's looking like it will be at least as good as last year. And your question was, I'd say up and down the coast, how do the markets look, how does rent growth look. I'd say they look, in every case, better than they did last year. So it's a very dynamic time right now. In Los Angeles, probably in the -- just, again, depending on the submarket. I think in the west side of L.A. and Hollywood, you could start getting into double digit, but it's probably more, I'd say, safer to say 5% to 8% rent growth. And San Diego has really started humming well, I mean, just in terms of the amount of activity that is going on with tenants that are in the market, but also tenants that haven't yet come to the market that are looking. So we're seeing, particularly in San Diego, in the right submarkets, whether it's our Del Mar area where One Paseo is. Or for example, our Little Italy project, we're starting to see different types of techs. So I think rent growth, again, probably won't be in the double digits, but can certainly be in the mid-single digits.

Right, that's very helpful. And then as you think about we keep seeing more and more news coming out of San Jose and Silicon Valley, I guess Silicon Valley occupancy improving and San Jose, a lot of investment and housing and mixed-use, what are your thoughts on what's happening down there and your appetite to get even more involved?

In San Diego?

No. At Silicon Valley Peninsula, San Jose?

Yes. I think San Jose has got a lot of people that are assuming there's going to be tremendous growth, and there's -- in my mind, I like San Jose. I think it's a wonderful place. We've looked at it very thoroughly. We've had a lot -- we reviewed all our property, some of which have been bought by some of our peers. But there's no limitation on what you can build. Rentals don't just buy new construction. That doesn't mean that rents won't get there. But if you need a million square feet, they're probably 8 or 9 people you can talk to for that million square feet. So the scarcity factor is the demand/supply is -- balances not to our liking. At this point, that could change.

Okay. And then Tyler had mentioned one expiration over 100,000 square feet over the next 15 months. Can you talk about that lease and your prospects to either renew it or if you think it's a move-out?

Yes, it's going to be a move-out. And I think we'll move the rents up considerably by repositioning it. But it will take a little time. And that happens to be in a property that we were thinking about not remodeling anyway. And so it's part of a larger development at multiple buildings. So -- but they are moving out, Jamie.

Where is it and…

It's Kilroy -- I think we call it Kilroy Center, Long Beach.

And you're planning to keep the asset, not sell it?

I don't want to talk about what we might be doing with any particular asset until we announce it. We don't talk about it.

And then just bigger picture, when you guys -- it looks like you're very comfortable growing more in life science. What are you thinking on the regulatory environment and drug pricing and how that might impact this sector?

It's hard. I mean if you knew that, I wouldn't be in the real estate business, I'd be making that bet making zillions of dollars. So I don't mean to be flippant, but I don't know that anybody can make a call on that. I think you have to look at it. The fact is, our population is getting older. We got massive problems with diabetes and Alzheimer's and a variety of other things. It would bankrupt the country if we don't find new protocols to deal with and new drugs to deal with it, and so I think that we're going to find this area continuing to expand. I think it's -- technology is going to bring prices down and develop new remedies and whatnot. So I think it's pretty well-based that it's going to grow. Will drug prices tamp that down a little bit, I don't know how to predict that, Jamie.

Okay. I appreciate your thoughts. Thank you.

The next question will come from John Guinee of Stifel. Please go ahead.

A question for you. DIRECTV probably getting down below 10 years on the lease. Is that lease appreciably below, above or below market? And then I noticed that your residential deal on Vine is costing about $1 million a unit. Can you talk about what kind of yield you can get on $1 million a unit residential deal?

Yes. Well, I'll start -- I'll let Steve talk about resi, but let me talk about the DIRECTV. The rent is very, very, very significantly below market.

Okay. So all we need to know.

Okay. Steve, you want to talk about the resi?

Sure. John, yields on the resi buildings are in line with what other developers are delivering projects at, and we're not reporting those yields and breaking them out. But they are competitive, they are accretive, and they add an important value to these mixed-use projects.

Are you going vertical with steel and concrete in Hollywood and then doing a podium building in Del Mar? Is that what my guess is?

Yes.

Okay, thanks.

Our next question will come from Derek Johnston of Deutsche Bank. Please go ahead.

I know we touched on funding briefly, but I want it to be kind of direct. So what are the funding plans for Flower Mart specifically?

Well, we've talked about that before. And we have a lot of different ways of thinking about that. It's just a bigger project, but it's exactly the same as we've talked about with others, and that is we did -- we could venture it, we could add debt, we could add equity, any comp, we could do dispositions. We're totally flexible right now. I think we'll end up with a significant lease in due course, and then we will address our capital plan concurrently with announcing any lease.

Great. And just secondly and lastly, so what do you have left to lease in San Francisco this year given the truly full occupancy? And really, is there much juice left to squeeze out of this orange in San Francisco in the second half of '19?

Tyler?

Yes. I mean as I mentioned in my comments, there's very little left in 2019 in the Bay Area to lease. We're basically full. So rents are below market in our San Francisco portfolio, about 31%, but we can't capture too much of that as we're getting out in 2019.

Our next question will come from Blaine Heck of Wells Fargo. Please go ahead.

John, you talked about acquisitions. I think you were referring mostly to operating properties and value-add type deals. But I guess how are you thinking about your landholdings at this point? Obviously, you've got a lot of wood to chop with regards to Oyster Point and Flower Mart. But are you guys still actively looking for other sites for development down the road?

Well, yes, we are -- we look at everything, Blaine, as I think we've said multiple times over the years. We literally looked at everything, even whether it's a potential development, whether it's a potential acquisition. Part of that is market knowledge, part of it is what are others doing, what do they see that we don't and sometimes, we act on it. With regard to your -- specifically with regard to development sites, there are some sites that we like because they are right in our wheelhouse and they check all the boxes, and whether or not we'll be successful over time in acquiring some additional sites remains to be seen. With regard to the two big projects you mentioned at Oyster Point and the Flower Mart, first of all, Oyster Point, we're in -- we have entitlements for another couple of million square feet at Oyster Point. You have to go through a precise plan process, which takes about a year. We'll be submitting the precise plan for the subsequent phases at Oyster Point. It would be -- we'd be hard-pressed to be under construction in 15 months, assuming we wanted to start construction. I don't think we could start probably for another 15 months, plus or minus, there for the next phase. With regard to the Flower Mart, obviously, we've got to see the city solve the lawsuits. Hopefully, that happens over the course of the next six to 12 months. Then we got to move the Flower Mart off and then we start construction, so you know those are downstream. There could be -- we have 2100 Kettner down in San Diego, which Michelle, what's the -- forgive me, everybody, but I just can't remember the numbers on every single project. That's an incremental spend of how much, Michelle? 2100?

It's about $100 million.

$100 million?

About $100 million. Yes.

Yes. And we'll probably start that sometime in the next six months based upon what we're seeing for tenant demand. And then buying additional sites, we're always looking. We'll report on that when we think we're serious about something or we have something to announce.

All right. That's really helpful. And then it looks like capex per square foot and concessions in general were a little higher this quarter. Can you just talk about whether that was a mix issue. And I guess, maybe for Rob more generally, what are you seeing with respect to TIs and free rent in your markets?

Sure. I'll handle the last part of your question first, Blaine. With what's happening with the TI market is basically cost-driven, meaning that costs are higher just because labor, et cetera, materials, that kind of thing, just given the economy that we have. That said, with our new development particularly, the TI tends to be a little bit higher, but we're also getting higher rents for that. And it's also -- TIs are also driven largely by function of how long the lease terms are that you sign. So it's not -- in past markets and that sort of thing, TI becomes sort of a concession that gets increased. But that's not the case now. It's really -- they're all in different submarkets falling within a certain range depending on whether it's new construction or existing lease term and then the type of rent you're getting.

All right, that's helpful, thanks.

The next question will come from Michael Carroll of RBC Capital Markets. The next question will come from Manny Korchman of Citi.

John, can you talk about -- you talked about sort of an overlap between tech and life science tenants. Can you talk about your leasing approach to those two different constituencies and how you either make sure or don't make sure if there's overlap.

I'm sorry, Manny. The last part, how -- what was the last part of your question?

So how you manage the leasing process between those two somewhat different constituencies within the same assets. Well, remember that in the -- sometimes, we have the same assets. Sometimes, it's a multibuilding thing. All of that stuff, whether it was the Exchange or whether it's KOP or whether it's 9455, they're all designed structurally, mechanically, et cetera, floor loading, ceiling height, et cetera, for life science because they do have specific things that are important to them. However, what we're seeing with the major tech companies is they also need more mechanical, more ceiling height. And so it tends to fit pretty consistently between the two uses. In terms of mixing them in a building, as you know, there's various lab issues and so forth on lower floors versus higher floors and so forth. So we're very conscious of making sure that the different types of uses we might put into a project are compatible and not incompatible. And we have not had any resistance. The -- as I mentioned in my comments, all the space that we have underway for life science, we are negotiating -- in negotiations with life science companies and in many cases, with tech companies for the same space. And I like that because the tech companies push life science companies on rent.

And then can you just give us updated thoughts on your search for JV partners, either for existing assets or some of these large-scale developments?

Well, there's a lot of people out there that want to do ventures on existing projects and on life science projects, on the Flower Mart, on new -- other projects that we're doing. And so if we want to do that, unless there's some big change in the marketplace in a macro context, I think we have multiple candidates from which to choose with very favorable pricing. More to come.

Our next question will come from Dave Rodgers of Baird. Please go ahead.

Maybe John, maybe this dovetails a little bit with Manny's last question. But with regard to kind of pushing asset sales into next year and bringing the bond offering forward, what was the main driver in kind of pushing the asset sales back? And just kind of given the demand you're seeing for assets, would you want to get that done sooner rather than later? So were there any triggers kind of in the first half of the year that led you to kind of push that back a little bit?

Well, it's -- as I tried to explain it in previous conference calls, the mark-to-market, Dave, on these assets is far greater than what we thought it was, and we think we can significantly increase the value of them through repositioning. And then to dispose of those -- of the assets that we had sort of earmarked, we think it will translate to a much higher sale price. So that's -- it's as simple as that.

So same assets, just maybe investing some more capital, or is it more leasing when you talk about repositioning?

It's investing some capital, which will, we think, achieve significantly higher rents on the expirations that we see over the next year or so. Yes. And I think it translates to a lower cap rate because it puts the assets in a much better line.

Clear enough. And then is that a meaningful number in terms of the capex going into those for sale or potentially for JV assets?

It's not. Put it this way, the value creation versus the added increment of investment is an enormous positive return.

Okay, thank you.

Ladies and gentlemen, this will conclude our question-and-answer session. At this time, I'd like to turn the conference back over to Tyler Rose, Executive Vice President and Chief Financial Officer, for any closing remarks.

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

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