Kilroy Realty Corporation

Kilroy Realty Corporation, a member of the S&P MidCap 400 Index, is a REIT active in major West Coast markets. Over 70 years, Kilroy has owned, developed, acquired and managed real estate assets primarily in the coastal regions of Los Angeles, Orange County, San Diego, the San Francisco Bay Area and Greater Seattle and 200 residential units located in the Hollywood submarket of Los Angeles.

Tyler H. Rose
Executive Vice President and Chief Financial Officer
Kilroy Realty Corporation
(310) 481-8400

John:  Thank you. My name is John Guinee. I'm with Stifel Nicolaus and we have a few people from Kilroy here. John Kilroy, wave, he's Chairman and CEO. We have Eli Khouri to the far right over there, CIO, and we have Tyler Rose, CFO to my immediate right. We also have in the audience Michelle Ngo and Mimi Ting. Did I get it correct? Then at Stifel Nicolaus, we have Aaron [Oselton 00:00:32] and Kyle McGrady. Thank you all for attending, and what I'd like to do is just, John's never done this before. He might find it a little bit difficult, but John, can you give us a quick 2-minute overview on Kilroy but not answering the other nine questions I'm going to ask you?

John:  Sure. We're West Coast based. We're headquartered in Los Angeles. We are in Seattle in a big way, both in the South Lake Union and Bellevue. In San Francisco, we've become the largest owner in the hot South of Market area, SOMA area, also down in the Peninsula, in Silicon Valley. We're in Los Angeles and in San Diego, and then we have one asset in Orange County. We acquire when it makes sense. We're a big developer. Right now, that's been our key thrust. We've got about 13 million square feet that we own right now. We fund our acquisitions and our development largely through recycling and selling other assets. We can talk about that later.

We have about $3.8 billion under development or in near term development.

John:  Good, good. John, and I had to tell you I'm just a big fan of the Kilroy organization for a number of reasons. One is John has surrounded himself by very, very talented people. Second, they have clearly a development focus and value creation focus and third, as much as anything else, they also are very active asset recyclers. John or Eli, could you kind of walk through when you think about the buy and hold mentality versus active asset recycling? What's the key hot buttons are for you?

John:  Do you want to take that, Eli?

Eli:  Why don't you start and I'll finish?

John:  It's real simple. There has been a gigantic transformation the way office space is used and in the way it's configured over the last decade, particularly over the last 5 years. We recognized that pretty early. We've sold off assets that we think don't have a lot of running room, that are not strategically important to us. There's been a clear movement towards urbanization, towards public transportation, towards the kind of urban amenities that the current workforce wants through densification and so forth. We've repositioned our existing portfolio, and in the assets we bought, we bought assets that comport with this new change and everything we develop is LEED Gold or LEED Platinum. Everything is designed to 8 to 10 people per 1,000 square feet. Everything is near public transportation.

That has been our terrific transformation for Kilroy. We also moved into Seattle and San Francisco over the last 5 years and become big operators there. In terms of selling assets and whatnot, the assets we've been selling, we sold industrial portfolio for $500 million or so. We've sold about $1.8 billion or so over the last few years. We have more that we're selling now. We've been selling properties that are smaller, that are more suburban in character or properties that we think have tapped down in value and we've been able to sell those at sort of early 5% cap rates and redeployed it into the brand and state of the art development that's been pre-leased and going in yields of 7 3/4% to 8% plus.

Taking all the property that may not have as long a runway, trading it into brand new state of the art property with about 250 or 350 basis points spread on the upside. That's been a good business for us. You want to talk about dispositions further?

Eli:  Yeah, just a couple of things. I mean I think that our disposition activity has been good for a lot of reasons. It's allowed us to really improve the multiple of the company by overall improving the quality of the company. It's allowed us to sell assets that are better off in the hands of somebody else at lower cap rates and make positive arbitrage trades, so we've traded, we've sold things and bought better quality, faster growing with faster growing incomes that generate a higher multiple or we've sold properties to fund our development pipeline and it's important for us to manage the denominator and the share count as well in order to drive per share growth and per share value.

Capital recycling is not something every REIT does and certainly not something every REIT does well, but I think it's something we've gotten pretty darn good at because it's a very intricate, assiduous, every single solitary day, having to be very flexible and pound them out in the right way at the right times to fit in with your other activities in your balance sheet management.

John:  Great, thank you. I'm going to jump around a little bit just to give a big picture, you can't talk about Kilroy without talking about the San Francisco market. John, when you jumped in that market maybe 5 years ago, it was a very different market. Paying $350, $400 a foot seemed like a lot of money. Did you ever think the market would do as well as it's done in the last 5 years?

Eli:  We didn't underwrite it to do as well as it's done so I guess the answer would be no, but as John mentioned, we bought 2.5 million, 3 million square feet and totally repositioned it to become the kind of assets that people really want to occupy and I think our base is under $400 a square foot for those acquisitions in a market that's trading at $800, $900 a square foot. That was a great trade. Then we quickly positioned ourselves to be developers in that area. We've got a lot of development going on in the Bay Area. We're doing Salesforce's new facility at 350 Mission Street, which is 450,000 square feet. I don't know how many millions of dollars it is.

We're doing Dropbox's new headquarters, Box's new headquarters. We just finished Synopsys' new headquarters and Audience's new headquarters. We're starting a $480 million project in Mission Bay later this month. It's one of the few zone properties in San Francisco, and we've assembled the Flower Mart, which is just between 5 and 6 acres on Brannan Street, which is the oddest street in the city. We'll be able to develop about 1.7 million square feet there in phases and our land basis on an FAR, foot price on the Flower Mart, is $45 a foot in a market that's trading at $200 to $300 in FAR foot. That was a pretty nice assembly.

John:  Either one, you talk a little bit backed up, rental rate growth, what people are willing to pay and as you get up into these high double digit numbers, do you think there's going to be pushback from the overall market, speaking San Francisco specifically?

Eli:  I'll speak to that first. We have not seen any pushback in the broad sense. There are individual companies, generally old line, very stable, low margin companies that have moved to other areas, but the big thing about the technology and media entertainment and the companies that serve those folks. It's all about attracting and retaining the best, the most important asset. That's our people. It's where those people want to live and the amenities they want, the public transportation they want. If you get that equation right, you have a pretty powerful negotiating tool, and John, in terms of rental rates, just to give you a couple of data points, when we moved to San Francisco, the first desk that we bought had average for full service rents of $32 per square foot.

That building today is getting well over $70 for a full service gross, so think about that. Operating costs are about $16 so it went from $16, triple that to mid-50s, triple that. That's great business. Every space that we have seen coming up, we've been able to release it at higher rates. We just did a deal with a company that leased the entirety of a building that's next to it, and we own the building that they're in, but they have leased the building. The entirety of the building is next to it at $83 full service gross and they have about a $14, $15 operating cost. That's $69, plus or minus, triple net plus parking, no resistance whatsoever.

They had to have the space. It's strategically important to them and on a cost per foot basis, think about this, we tended to think rent's on a cost per foot basis, but the way they think about is not rents per square foot. They think of it as rents per employee. If you have space that you rented for $40 and you had 4 people per 1,000 square feet and now your rate, renting it for $60 a square foot and you've doubled your occupancy to 8. Your cost per employee actually has gone down even though your rent went up by 50%. The way people are looking at rent is different, and the reason they view it differently is it's all about their most expensive cost, which is their employment.

80% to 85% of the costs of these companies is people. Real estate is about 5%, so who cares if it goes up to 6% or 7% if it can influence positively 10% or so on your 85%? The math, we're all math people in this room, this is about math. It doesn't sound as silly when you see rents go up and you understand the bottom line, the way people are thinking about things. It's actually a good time to be doing the kind of product that we are, which really comports with the kind of environments and the kind of physical characteristics that the modern employee wants.

Rent, it can't go to the sky, John for sure, but we projected it would go up 14% year over year, 14 over 13 on average. It exactly was that, 14%. Brokers are saying anywhere from around 15% plus or minus for San Francisco this year, and we're already seeing that. There are two places where a tenant can go at these 100,000 square feet in the city today. There's 17 tenants looking for 100,000 square feet or more in the city today. Those are just powerful, powerful characteristics that are playing to our strengths right now.

John:  We're going to talk a little bit more about San Francisco, then we're going to give Tyler a little bit of a chance to talk about the balance sheet, then we're going to move south. John, talk a little bit about how many square feet you have in the pipeline in San Francisco, how much competition is there out there and what do you think development costs are today?

John:  Well, we have 1.1 billion in our construction from San Diego to San Francisco today. Of that 1.1 billion, 950 million is office. It's 85% leased to date. With the deals we're working on right now, I expect that to be in the high 90s by the end of the year. The 150 million that is not offices is a luxury apartment building in Hollywood that we won't lease until it comes on stream next year. In terms of everything that we have under development in San Francisco, 350 Mission, 333 Brannan, Crossing 900 down in Redwood City is all 100% leased, above pro forma.

What we have, that's about 1.1 billion, 1.8 million square feet in round numbers. Near term, we'll start The Exchange in Mission Bay. That's $475 million. We have very good activity on that right now. We think we'll do a very substantial lease while we're on with construction. In 2016, we're going to do 333 Dexter in Seattle, again assuming all the things that we look at pre-leasing and macro conditions and so forth, we should have 333 Dexter at South Lake Union. That's a 2016 start. That's $375 million. The Academy in Hollywood, that's $300 million, that's a mixed use project and then One Paseo down in Del Mar, which we finally have come to agreement with the people that were opposed to us in the city. That will be about a $600 million project that we can do in multiple phases. That's mixed use, and then back to your actual question in San Francisco, beyond the $475 million Exchange at 16th in Mission Bay, we have the Flower Mart, that's projected to be a 2018 start.

We're building a new Flower Mart, which is a very important group to preserve in this city. We have the support of all the city powers to do that. We anticipate that we'll obtain entitlements for 1.5 million square feet of office, 125,000 square feet of Flower Mart and 38,000 square feet of retail. That's a $1 billion project that we can build in multiple phases. That's a project in which we have a $45 a square foot FAR [inaudible 00:14:09] basis, and that's what we've got going up down the coast, but that Flower Mart being in San Francisco. Between the Flower Mart and The Exchange at 16th, we'll add 1.5 billion roughly to our portfolio up there.

John:  Great segue. Tyler, how do you pay for this? What do you think in terms of -- talk about equity and talk about the preferred market and talk about the different ways to access the debt markets.

Tyler:  It is a combination of equity, debt and dispositions, probably 1/3, 1/3, 1/3. The preferred market we have, preferred debt but the rates right now are probably above 6% so we haven't been that interested in the preferred market debt right now that tenured debt's 4 4/10 for us roughly. We just got upgraded. We've done $200 million of equity over the last couple of quarters in the ATM so it's going to be a combination of those three buckets for us. Our leverage is in the mid-20s on a debt to market cap basis and mid-30s on a total asset basis, so we feel like we have a pretty strong balance sheet right now.

John:  Refresh my memory, I might have got this wrong but did you also issue some 15-year debt and then also talk about how you think about the dividend in this day and age.

Tyler:  Yeah, we issued 15-year debt for 4.25 earlier this year and on the dividend, our payout ratio is roughly 85% for this year, 80% to 85% on an FAD basis. We're comfortable with our dividend at that level. If we could lower our FAD payout ratio into the mid-70s, we might think about increasing the dividend, as John and Eli mentioned. We're selling properties, which could create some gains so there maybe a need to do a special dividend, it hasn't been determined yet, but on a general dividend basis, we're probably going to keep it where we are for the remainder of the year.

John:  Eli or John, talk a little bit about some of the markets that are off people's radar screen, but San Diego, Long Beach, West LA, major positions you might have in some of the other -- in this case, Southern California submarkets and then also touch on Seattle and Lake Union.

John:  We're going to share this, Eli. San Diego has been a laggard over the last 5 years. For a number of years, we were 100% out there and 5 or 6 million square feet and we were down I think at 78% through the depths of the recession. We had a lot of assets we had to reposition and whatnot. One of the reasons we sold off quite a bit of San Diego is that we just didn't feel that those assets, we want to get back 5 or 10 years from now and reposition them again. There are smaller assets, one of the problems with smaller assets, a tenant comes in, they want a new lobby, they want a new this, they want a new that. You end up with a lot more CapEx on a per square foot basis so we sold those off.

We think San Diego is now pretty well positioned. We don't forecast it's going to have nearly the amplitude of growth that we see in San Francisco or Seattle or that we're seeing in Hollywood but we do feel pretty strongly the debt markets, having a nice correction on the upside. Portfolio wise, we're about 10% or more below market on our existing rents, but in San Diego, we're probably 10% above although that market's recovering so we thing that comes into alignment. You mentioned Long Beach, we have 1 million square feet at Long Beach Airport that's just been a really strong asset for us, multitenant, serves both counties. We don't talk about Long Beach a lot but that's been a fantastic asset for us, has great transportation, characteristics, and then Eli maybe just talk a little bit about both Hollywood and Seattle, what we're seeing there and why we like those so much.

Eli:  Sure, I'll start with Seattle. From the East Coast here, I think it's kind of difficult sometimes for people to really understand what's so great about the Seattle market but we've made a lot of money there already for Kilroy with assets that we bought early at a very good basis with very strong follow on demand from there and the best market up there is South Lake Union, and really what's going on up there is its fantastic quality of life. You have the University of Washington there that is turning out some of the best engineers in the country. They have the best cloud-centric program in the country. You see all of the Bay Area.

You see the homegrowns there, the Amazons, the Microsofts, and you see everybody else moving up there as well. Facebook just opened a very large, took about 200,000 feet. Apple's opening an office up there. Google has a big presence up there and it's really important for a lot of these companies to have a dual presence in Seattle and San Francisco, and that's centered around South Lake Union, and again South Lake Union has transportation. It's a great walkable town. It's got fantastic amenities and it's got great office and a lot of the office product in that market is very modern because they're not like San Francisco in South Lake Union, where they had a bunch of narrow steel high rises that don't really work for today's tenants.

That continues to be a great market, a great region overall, a very dynamic growth rate, one of the best job growth rates in the country, one of the best places to live in the country and I think it's a little under understood from the East Coast.

I think Hollywood is another market that, with respect to millenials, it is really coming along. Millenials are coming to Hollywood over the beach, and we traditionally have been near the water in Los Angeles. That's been good, but Hollywood's a great market. There have been a lot of new multifamily units put up there. There's entertainment. There's the right ambiance. There is the whole base of amenities. The office product is now coming in behind it and as we started investing in Hollywood, what we're finding is that one of the things that has kept tenants out has been a dearth of high quality projects, so when we built Columbia Square, it's just an amazing project.

People have come to that very quickly and there's a demand to come to Hollywood if the product is there. We have the academy, which we can follow on, which again will be very modern, very alluring, very attractive project and the tenants that we're getting and John will talk about them, are quite amazing. It's in a very virtuous cycle. People are coming there. The employers are following there. The development that we're doing are there to take the jobs that want to come there. That brings more people. That brings more living. That brings more amenities and it's just building on itself and again, it has that characteristic of being a walkable, livable, live, work, play environment that we saw in South San Francisco and you see up in South Lake Union.

John:  Just to give people an overview of the West Coast, I think John you brought up a good point and that we're a long way away on the East Coast. The markets that are doing well are really, really doing well but there are a lot of secondary markets I've seen be off everybody's radar screen. Can you talk about some of the secondary markets, John or Eli, and what product and what markets don't seem to be getting any traction, don't seem to be getting any lift, whether it's the Bay Area secondary markets or Southern California secondary markets?

John:  Well, let's start with Southern California if we can. San Diego doesn't have the transportation, the high-speed rail and so forth that some of the other counties do, so it's very dependent upon freeways and upon buses. You have a view there towards the coast that we do, that it's the coastal markets where you have greater barriers in where people want to be and if you look at where -- we map out demographically where the workforce lives and where the workforce is likely to occupy our buildings live, amongst other things. That sort of Del Mar 56 Corridor, 70% of the tech workers in San Diego live within 5 miles of that area, 70%. That's the ground zero of where you want to be.

The further you get out of that area, by definition, the further away you are from where people live and the further you are from where the bosses live and the further you are from the best school system. That's San Diego. In Orange County, we only have one asset down in Orange County. We've always had a number of assets. We have one, Orange County's a great place. You just have to decide whether you want to compete with Don Bren in Irvine Company. I don't. I think it's a fool's game.

That's a good market to buy at the right time and sell at the right time, but owning over time, it's hard unless you have the very best buildings and we have one of the three best buildings in the county. It does real well at the airport. Orange County to me, Anaheim, those areas, they're not very exciting. We sold off that stuff. If you look at Los Angeles county, it's a huge county. We love Hollywood. We love the West Side. Not all buildings in those locations because there got to be buildings that work well for the modern workforce, we like the transportation that LA has where it has good transportation. By definition, it doesn't have particularly good transportation county-wide. The Valley, if you look at that area, San Fernando Valley, the Conejo Valley. We own a couple of assets at the Conejo Valley in West Lake and Calabasas, next to a lot of retail. They're next to high-end housing. They're relatively small projects. They stay extremely well-leased.

You look at Warner Center, places like that. We never bought an asset there, probably never will buy an asset there. It's a commodity, never really seems to go up in value, requires a lot of CapEx. If you read John's thesis about it's time to sell stuff because it goes bad, some of it goes bad, well that's the story in a lot of Southern California. There's a lot of markets in LA County that we just won't even look at. If you look at downtown, a lot of people talk it up. There are a couple of assets that perform pretty well. We vote with our investment dollars and we haven't invested anything downtown. We look at it all the time. We've got lot better rents. We've got lot lower operating costs in Hollywood. We've got lot better rents for lot lower operating costs at West LA and Santa Monica and so we'd rather be there.

The Bay Area, let's talk about that. Eli, you live up there. I live up there now but talk about just big picture the markets there.

Eli:  Sure, secondary markets you mean, yeah and I think one of the toughest markets to have come back is South San Jose, that used to be a lot of the networking and hardware areas that really isn't that much focused on the Bay Area and even downtown San Jose. Now there are parts of San Jose, north San Jose, the 237 Corridor that are very interesting, and for whatever reason, it's very attractive to the networking companies like Arista, like Cisco and so forth, but transitioning from that North San Jose to the South San Jose market is very, very difficult. It falls off very quickly. What used to be a great market for example, the San Jose Airport market, is now a tremendously challenged market and I owned a lot of that stuff or I didn't but as part of Spieker Properties, our company owned a lot at the San Jose Airport and we did very, very well at that up until we sold it into the 2000s.

I think it's in the range of, I don't want to say it is not the product that is appropriate for that today's users are really demanding. I think there's probably some interesting stuff. Oakland is coming around but there's not quite the scale there. That's a little bit like downtown Los Angeles, where it's very interesting but there isn't any material scale for these types of things over there. I think some of the -- now the Peninsula has done extremely well overall and I think there's probably some potential in the East Bay, the Walnut Creeks and places that are on the major transit stations that as some of these millenials grow older over time, they'll want to move to those communities and be able to get into the city rather than living in the city. Many of them will stay in the city but I think that's a good rundown of the Bay Area unless I'm missing some.

John:  Great, great. I just realized we've got about 3 minutes left. I didn't open it up for questions so I'll ask, I'm sorry Brett?

Brett:  No, go ahead.

John:  Anybody, I have a couple more but I'd love to hear from the audience. Anyone else want to jump in and ask a question to these guys? John, we've been on and particularly this is San Francisco, Silicon Valley. We've had a wonderful upswing, a wonderful up cycle. Cycles, by definition, don't last forever. Do you see an end in sight? How do you feel on the big picture?

John:  In our meetings today with investors, there's been a question that some of them laugh at but they go like, "What's the sublease situation?" Let me put that in perspective. In San Francisco, in 2001, there was 7 million square feet that was up for sublease. That was 9% of the stock. Stock's grown a lot today. Now it's at 1.4%, up from 1.2% last quarter. It's 1 million square feet. It's up for sublease today. Some of that stuff is like Schwab that had signaled some time ago they were going to get out of an asset, subleased it's 300,000 feet, so that's 30% of it. 10% is Salesforce. They've subleased a building that doesn't work for their people and they're moving into our new building.

I don't see any sublease overhang in San Francisco today. There was an article that came out in the business journal up there, which was an interview with a tenant rep broker who had his own motivations but I got to tell you, I think our markets are strengthening. You're right that trees don't grow in the sky and that's why we manage our balance sheet very conservatively and why we do so much pre-leasing.

John:  Good, good, okay, just one last question maybe for Eli, oh I'm sorry.

Speaker 6:  Yeah, actually a question for Eli. How does the Bay Area today and the demand compare to the 2000 dot-com bubble, not just in the demand but also in the quality of the tenants and their burn rates and what have you? Are these guys cash flowing?

Eli:  Yes, and it's an entirely different dynamic. I mean if you just look at one metric, which is revenue per employee or revenue per square foot of space being occupied compared to the space that was absorbed in the dot-come bubble. There's absolutely no comparison here. Most of these companies, first of all, it's very diverse. Part of what we're seeing here is the promise of the Internet and the sufficiency that came out of it being finally fulfilled and it was ahead of itself and there was a liquidity problem in the early 2000s that we went too far, too fast, but it really had the potential that everybody thought that it had. If you look what's going on in the Bay Area, there are so many different things happening and we talk about how many different businesses are really becoming technology businesses. For example is Macy's, their fulfillment and their e-commerce division, is that technology? That's retail that's using technology as a distribution channel.

We have a great company in one of our buildings called the Clima-Corp, which is a crop insurance company and an information product that used to be based in Kansas. They started to download a lot of satellite information, run really complicated algorithms. They needed engineers. They moved out here. They were invested by Google and then Monsanto bought them. It's a technology business but it's a crop insurance business. There's a secular change to all of these regular businesses who need to come to San Francisco or places like that to draw on technological talent to run businesses that are mainstream businesses in America that we're going to continue to do. I think that secular change is different than it was back then.

The venture capital investment levels are much different. I don't know, John. Is there more you want to add to that?

John:  No, no, I can go.

Eli:  Go ahead.

John:  We are out. We're over our limit. Any other questions, and if not, John, any closing comments?

John:  Unless there's any questions, so thank you for being with us. I think the real short story, way to think about Kilroy is we're opportunistic. We're very agile as a company. We've got a tremendous management team. I'm just one of many players that are fantastic. We take advantage of opportunities. We buy when it makes sense. We develop when it makes sense. We've long been known as terrific developers and we sell when it makes sense to pay for stuff and we do nothing when it makes sense to manage existing portfolio.

Think of the math on this, you sell assets that are non-strategic that probably don't have as much upside for 5-ish cap rates and you redeploy that into top-quality first-tier markets with top-quality new or repositioned product at 7 1/2% or 8% unleveraged yields and where the cap rates on those markets are lower than the cap rates of the markets in which we've been selling. We've done that in scale. We've done that in several billions of dollars of scale, and the math is pretty fantastic. Just run it out, think about it. In San Francisco right now, office buildings are selling at roughly 4% plus or minus, depending upon their capital needs. Apartments are selling, quality apartments, luxury apartments will be selling in the 3% range.

It's pretty terrific, the value creation. Everybody's worried about interest rates. We underwrite things based upon a lot of different things but one thing we will keep our minds on is the spread. The spread, you write about it all the time, John, if you can create a 250 basis point spread and move up the quality continuum, that's pretty terrific. We're doing better than the 250%, particularly when you look at the straight line yields. Thanks.

John:  Thank you, John. Thank you very much, Eli, Tyler, Mimi and Michelle. I thank everyone here for attending.