Kilroy Realty Corp (KRC) 2012 Q1 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the first-quarter 2012 Kilroy Realty Corporation earnings conference call. At this time, all participants are in a listen-only mode. Later, we will facilitate a question-and-answer session. (Operator Instructions) As a reminder, this conference is being recorded for replay purposes. I would now like to turn the call over to Mr. Tyler Rose, Chief Financial Officer. You may proceed.

Good morning, everyone. Thank you for joining us. On the call with me today are John Kilroy, our CEO; Jeff Hawken, COO; Eli Khouri, our CIO; Heidi Roth, our CAO; and Michelle Ngo, our Treasurer.

At the outset, I need to say that some of the information we will be discussing is forward-looking in nature. Please refer to our supplemental package for a statement regarding the forward-looking information in this call and in the supplemental. This call is being telecast live on our website and will be available for replay for the next seven days, both by phone and over the Internet. Our press release and supplemental package have been filed on Form 8-K with the SEC, and both are also available on our website.

John will start the call with an overview of the quarter and a look at our key markets. I will follow with financial highlights and updated earnings guidance for 2012. Then we will be happy to take your questions. John?

Thanks, Tyler, and hello, everyone. Thank you for joining us today. The first quarter was another active period for us at KRC. With our expanded West Coast platform and strengthened management team, we are making strong progress on all fronts. Our significant local experience, market knowledge, and key relationships in all of our core markets have positioned us to continue to create long-term value for the Company.

We are seeing this in additional value-add acquisition opportunities, continued success on the leasing front, and progress with capital recycling. In addition, with the expansion of our core develop competency along the West Coast, we are now pursuing select development opportunities. West Coast real estate markets, led by the Bay Area and Seattle, are all improving. We are seeing a decrease in both large blocks of available space and of quality space in all size groups. I will provide additional color on our markets later in the call.

In terms of new transactions, we are excited to announce that we are in escrow on two new opportunities, one is an acquisition and one is a development.

A few comments about the new acquisition. As you know, about a year ago, we purchased Key Center, one of the top office buildings in Bellevue, Washington. At the time, the market had a vacancy rate of approximately 16%. The market has improved substantially since then, with significant increased tenant activity and a current overall vacancy rate of 13.8%, and just under 10% in the key competitive set of high-tier buildings.

To take advantage of increased demand and strong momentum, we have just entered escrow to purchase a premier 408,000 square foot multi-tenant Bellevue office building, for approximately $186 million. This is both an opportunistic and a strategic play. It has a terrific location, immediately adjacent to both the transit station and the future light rail stop, and is not far from our Key Center building.

This opportunity represents another example of how we intend to capitalize on our ability to reposition property and move up rent through a comprehensive capital improvement and modernization program. We believe the building is ideally suited to accommodate both traditional office users as well as the strong tech and media tenant market.

With regard to new development, we are leveraging our experience and expanded platform to pursue a small number of select development opportunities in our markets that have visible demand. And given these opportunities, we have just entered into escrow to execute a fully leased Silicon Valley build-to-suit development project that will have a total estimated investment of approximately $200 million. This is an example of how we are using our development expertise to generate a yield that is 150 to 200 basis points above what we would have earned if we had purchased a completed fully leased core similar property.

We've been actively pursuing new opportunities in the best Silicon Valley markets, as global technology giants like Google in Mountain View, Facebook in Menlo Park, Apple in Cupertino, and Stanford in Palo Alto are acting as key anchors in each of these strengthening sub-markets. Facebook, for example, just received approval from the City of Menlo Park to expand its nine-building campus and is seeking approval to build five new buildings on an adjacent 22-acre parcel, which would allow them to increase overall campus capacity over 150% to 9,400 employees.

Also in the Bay area, as we previously reported, we completed our first acquisition in March with the purchase of Menlo Corporate Center, a seven-building 374,000 square foot office project. The 20-acre campus has one-quarter mile of freeway frontage on Highway 101, proximity to Caltrain, abundant parking, and has recently undergone $6 million in renovation. It is less than three miles from the Facebook campus. Purchase price was $163 million, with a projected stabilized return of approximately 7%.

At acquisition, the property was 79% occupied by 10 tenants, including Lucile Packard Children's Hospital at Stanford, ETRADE, and Allstate Insurance. In the two months since closing, we have moved the leasing percentage up 400 basis points to 83%, and are in numerous discussions on several other spaces at rents higher than our pro forma. We estimate that in-place rents are approximately 15% below market.

Both Menlo Corporate Center and our pre-leased development project are similar in that they are Class A campuses built for the modern workforce with irreplaceable Silicon Valley locations, close to transportation and amenities, in a market with a large inventory of older and obsolete properties.

Moving to our pending acquisition activity, at the time of our February equity offering, we had four transactions totaling $380 million in the pipeline. This included Menlo Corporate Center and a building in Seattle, a building in Los Angeles, and a building in San Diego.

In Seattle, we are in escrow to buy a 99% leased premier property in Lake Union area of Seattle. It is directly adjacent to Lake Washington. As leases roll over the next few years, we will be able to take advantage of in-place rents that are 30% below market. The purchase price is approximately $105 million.

In Los Angeles, we are in the final stages of closing the acquisition of a $78 million office building in a top entertainment sub-market. The timing depends on the assumption of a CMBS loan. With a renovation plan that will significantly upgrade this building and drive substantially higher rental, we see a tremendous value creation opportunity in that asset.

And in San Diego, given the complications between the seller and the lender, it is doubtful that the previously forecasted $34 million acquisition will occur.

From an operating perspective, we also made solid progress during the quarter. We signed new or renewing leases on 237,000 square feet of space, including a lease with QUALCOMM for 49,000 square feet in the Sorrento Mesa sub-market of San Diego.

We continue to make progress building our pipeline of LOIs that now totals approximately 1.1 million square feet. That is about 3 times what our typical first-quarter amount of LOIs has historically been. Approximately half of these LOIs are for office properties, and approximately one-third relate to new leasing.

We ended the first quarter with stabilized occupancy at 91.6%, up from 90.8% a year ago, and just below our year-end 2011 figure of 92.4%. The decline was partly due to a lease expiration of an industrial tenant and partly adding the 80% occupied Menlo Corporate Center to the stabilized portfolio.

While Tyler will review the details of our first-quarter financial transactions, I would like to point out that we remain committed to funding our growth in a disciplined and sustainable manner using conservative leverage, and making use of our property disposition and capital market opportunities.

On the capital recycling front, we are seeing tremendous interest in our industrial portfolio and expect to complete a transaction later this year. In addition, we have identified other non-strategic properties throughout our portfolio that we plan to sell in due course. Taken together, we could sell $500 million to $700 million of assets over the next year or so.

Now, let's take a closer look at our individual sub-markets, starting in San Diego, which now has experienced positive absorption for 10 straight quarters. We are seeing signs of rent growth in select sub-markets as the availability of large contiguous blocks of Class A space further declines. We are positioning ourselves to take advantage of our unique San Diego land position as the market improves.

Overall, San Diego demand is diversified across several industries, including technology, life science, finance, professional services, and healthcare. Also, the San Diego defense industry just got a big boost, with the announcement that 12 new major ships will now be based there. Our San Diego portfolio was 93% leased at the end of the quarter.

Moving up to Orange County, the industrial market continued to improve and experienced a third consecutive quarter of higher asking rents. The vacancy rate of 4.9% was the lowest since 2009. The Orange County office market had slightly negative absorption this quarter due to a large FDIC move out, but rents have stabilized. Overall, our Orange County office portfolio was 97% leased at the end of the quarter. The office portfolio was 94% leased, and the industrial portfolio was 97% leased.

Continuing north to the greater LA metro area, most of the strength is localized in key West Los Angeles sub-markets and in other select sub-markets that cater to the entertainment industry. Demand continues to be driven primarily by tech, media, and entertainment tenants. The South Bay markets of El Segundo and Long Beach both had positive net absorption in the quarter, and we are 95% leased on a combined basis in the South Bay.

At our West Side Media Center Campus in Los Angeles, the solid momentum from last quarter carried into 2012. The 39,000 square foot full-floor lease with Red Bull commenced, taking the project to 99% occupied. And at our Santa Monica Media Center, the 38,0000 square foot lease with Crispin Porter also commenced, taking that project to 100% occupied. Currently, we are 98% leased in our West LA buildings.

The 101 corridor office market had modestly positive absorption. We are 88% leased in our Calabasas properties, 91% leased in our Thousand Oaks property, and 15% leased in our 265,000 square foot complex in Camarillo.

Moving to Northern California, Sonoma, and the South Financial District, vacancy rates trended down further, and vacancy rates of 3.8% and 9.3% respectively. Rents in these two sub-markets are up approximately 75% on a triple net basis over the past two years. As I mentioned earlier, Peninsula and Silicon Valley fundamentals are also very strong, with combined absorption of approximately 10 million square feet in 2011, 18% higher than the 2001 peak.

Our San Francisco-Bay Area portfolio now represents approximately 22% of our pro forma annualized NOI. Overall, our stabilized Bay Area properties are 93 leased.

In Seattle, our currently owned East Side portfolio totals 900,000 square feet and these properties were 93% leased at the end of the quarter. With the completion of our new Bellevue and our pending Lake Union acquisitions, we will expand our position in the greater Seattle market to approximately 1.6 million square feet, producing 12% of our NOI on a pro forma basis.

We see a barbell in terms of Seattle's market fundamentals. At the one end is our East side market, primarily CBD Bellevue, and at the other end is South Lake Union. Both of these markets experienced significant positive absorption and have declining vacancy rates. In the middle is the traditional CBD, which continues to lag, but is doing better.

Large users in Bellevue have few remaining options, as only two blocks of space larger than 50,000 square feet remain on the market. Amazon continues to be a significant driver in the South Lake Union area and has recently announced plans to significantly increase its space.

In summary, given our expanded platform and expanded management team, we believe we are uniquely positioned on the West Coast to continue to capture acquisition and development opportunities that will generate strong returns. While pricing for core properties has become more challenging, we are finding opportunities to create value through lease-up asset repositioning and development.

And while there remains a variance in the speed with which West Coast markets are improving, they are all trending upward. We're particularly pleased with our growing position in the Bay Area and Seattle, which is now over one-third of our NOI on a pro forma basis. And, we remain committed to a disciplined approach and a strong balance sheet. That's an update on the quarter and our markets, Now Tyler will cover our financial results in more detail. Tyler?

Thanks, John. FFO was $0.49 per share in the first quarter. That includes a one-time, non-cash charge of $4.9 million, or $0.07 a share for the early redemption of our Series E and F preferred stock and approximately $0.005 for the acceleration of the dividend accrual. We also incurred approximately $0.02 of acquisition-related expenses, and $0.01 of dilution related to the 4.25% exchangeable notes that are now in the money.

We ended the first quarter with stabilized occupancy at 91.6%. As John mentioned, occupancy rose from 90.8% a year ago and it was down slightly from 92.4% at year-end 2011. First-quarter occupancy was reduced by an industrial move-out, the acquisition of the Menlo Corporate Center, and the expiration of the CareFusion lease, which has now been released to QUALCOMM.

By product type, our industrial portfolio occupancy was 97% at the end of the first quarter, up from 95.9% a year ago. Office occupancy was 90%, up from 89% a year ago. As of today, our operating portfolio is 93% leased, and given the recent pending acquisition, we are projecting a 92% occupancy for year-end, subject to the additional impact of any acquisitions and dispositions.

Same-store NOI continued to improve with GAAP NOI up 7.7% and cash NOI up 8.8% in the quarter. We estimate that rent levels in our overall portfolio are approximately 6% over market, down from 10% a year ago. We have approximately 850,000 square feet of remaining lease expirations this year, which we estimate at rent levels about 8% over market. As we've previewed last quarter, HP moved out of its space in Delmar at the end of April, and we are in discussions with several tenants to release that space.

Now, let me review our financial transactions in the quarter. In mid-February, we completed a public offering of approximately 9.5 million shares of common stock at a price of $42 per share, for net proceeds of approximately $382 million. We used the proceeds to fund the acquisition of Menlo Corporate Center and to pay down our line of credit.

In late March, we completed a public offering of 4 million shares of Series G redeemable preferred stock at a rate of 6 7/8% and generated net proceeds of approximately $96 million. Proceeds were used to redeem all the Series E and Series F preferred stock that had an average rate of 7.6%.

Also in late March, we closed a $150 million term loan facility with a group of 13 US and international banks. This is an unsecured facility with a four-year term and a one-year extension option. It bears interest at LIBOR plus 1.75%. We also have the option to increase the commitment by $100 million. The proceeds from this loan were used to pay off the 3.25% exchangeable notes that matured on April 15.

Taking into account all of our first-quarter acquisition, disposition and recent financial transactions, which include the repayment of exchangeable notes and the redemption of preferred stock, we have approximately $90 million of cash today. Our $500 million bank line is fully available, and our debt-to-market cap is approximately 32%.

In addition, we are working on a $97 million, 15-year mortgage that is expected to have an interest rate in the mid-4% range. The proceeds of this financing will pay off our only remaining 2012 debt maturity.

In terms of funding our new and pending transactions, the up-front investment is roughly $450 million. We will be assuming debt of $172 million, including $85 million for the new Bellevue property. With our cash and deposit balance of $115 million, the net funding requirement is approximately $165 million. While we will use our credit line initially, as we have said, we intend to fund our future growth on a leverage neutral basis, through a combination of dispositions and capital transactions.

Now, let's discuss updated guidance for 2012. To begin, let me remind you that we continue to approach our near-term performance, forecasting with a high degree of caution, given all the uncertainties in today's economy. Our internal forecasting and guidance reflect information and market intelligence as we know it today. Any significant shifts in the economy or our markets going forward could have a meaningful impact on our results in ways not currently reflected in our analysis.

With those caveats, our assumptions are as follows. Our guidance mid-point on last quarter's call was $2.48 per share. The net overall 2012 non-cash impact of the preferred offering is about $0.07 a share, $0.08 negative in the first quarter and $0.01 positive for the remainder of the year. Also, a higher share count due to being in the money on our 4.25% convertible debt results in about $0.02 additional cents of dilution.

Given our acquisition activity, we are now forecasting $0.05 a share of acquisition-related expenses. We are finding that in the cases in which we are assuming debt, it is not only more costly but takes substantially more time. And while we have dilution from these timing delays in relation to the February equity offering, all but $0.02 of that is offset by the positive impact of the pending and completed acquisitions and lower financing costs. And finally, our projections only have a partial-year impact from DIRECTV, TD Ameritrade and 370 Third Street, which will have a much larger contribution in 2013.

So taking all that into consideration, we are providing updated 2012 FFO guidance of $2.25 per share to $2.39 per share. That's the latest news from KRC. Now we will be happy to take your questions. Operator?

Thank you. (Operator Instructions) Our first question is from the line of Gabriel Hilmoe from UBS. You may proceed.

Just on the industrial portfolio, John, I know you said you expected something to probably get done later this year, but any color that you can provide on how the process is going and if this is expected to still be an outright sale or potential JV would be appreciated.

That's a good question. As we indicated over the last couple quarters we pursued a double dual track. One was do we do it in a venture in which we repatriate perhaps 90% of the dollars and then expand that platform with an investor, or do we sell?

In the former, we received very strong interest where we could do that, but at the end of the day, with all of the increased activity that we have at the Company, I think our inclination is to do an outright sale. We've not put the property on the market yet, have we Eli?

We have not, but it's ready to go on a moment's notice.

So, we will be doing that over the next quarter or so, and we expect to have very good results there.

Okay. And then, I may have missed this but did you give the yields on the Seattle and LA acquisitions?

No. I didn't. But, we certainly can. In Skyline, the building in Bellevue, it currently has a vacancy of about 10%. Its rents are about 10% plus below current average market, and we think with the extensive modernization and remodeling we will be doing there, we are going to move up rents very substantially.

But, based upon a more modest underwriting, we have a going-in cap rate on existing income of about 5%. We move that up substantially over the next couple of years with significant lease rollover and moving the rents up, and, we expect an IRR in the range of about 8%. That's, for a $186 million investment, about $454 a square foot. We think replacement is about 15% -- it's about 15% below replacement that we pay. Get about $535 a foot, although this site is killer with regard to transportation. You couldn't replace a building there, there is no site.

In the context of the Silicon Valley development, that's a slightly over -- it's about $200 million, or $580 a foot. It's a 15-year lease with 3% annual bumps. The going-in, first year cap rate is 6.4%. The straight line is roughly 8%, and the IRR is in the mid-8%s.

Okay. Thanks, guys.

Your next question is from the line of James Feldman, Bank of America. You may proceed.

Hi, Tyler, I was hoping we could walk through the guidance change again. I guess what I'm trying to figure out is what is core versus what's non-cash or acquisition expenses. So if we were to just do an apples-to-apples from your prior $2.48, can you walk us through that?

Well, yes. If you take out the $0.07 related to the preferred and the $0.05 of acquisition-related expenses, that's effectively $0.12. So you take the $2.48 minus the $0.12 and you get to $2.36. Right? Then you've got the $0.02 related to our convertible, so that's $2.34.

And then, as I mentioned, you've got a lot going on with the timing delay, given the equity offering, of the new acquisitions and the closing of the LA and the Seattle deal. So, it's not -- there's no easy answer to that question except that if you looked at those timing delays on their own, it's probably $0.06 or so of that. And, what I said is we are making up roughly $0.03 or $0.04 of that through core and through our new acquisitions, through lower financing costs. There's a lot moving around.

So, that brings you to a midpoint of $2.32, which we ranged around $0.07 on each side. So I don't know if that helps, but there is no simple answer to that question.

Okay. That's helpful, thank you. I guess, John, and I guess the entire team, you guys have done a good job buying this cycle. Can you give us a little sense of what's going on in your head in terms of what cap rates you're seeing that are keeping you away from still buying core? What returns you want to see on these value-add and just projections for development versus value-add and where you think your limits are for even that getting that too pricey?

Okay. I will predict the election, too. That's a lot, Jamie. But let's just start, and remind me if I miss one of these, and I might throw some of this to Eli.

With regard to the first question, I think was what yields are we walking away from, if you look at the SoMa area in San Francisco where we've got 2 million square feet or so, we have about a $350 -- mid-$300 -- under $350 acquisition. And fully loaded with all the improvements and all the rest, we are well under $400 a square foot.

And, what we are seeing now is the number of trades in that, some of which are in escrow, some of which are just finishing up selecting who the ultimate buyer is going to be. But they are very close and literally next door to a couple of our buildings, and those prices are anywhere from the mid-$600 range to as high as close to the $800 range. When you look at what that means in terms of yields, Eli, that's been producing yields that are --

Going-in yields of call it 4%, mid-4%s to low 4%s; projected IRRs in the low 6% overall.

And if you look at that, that's just not interesting to us at all. Love the buildings, we would've loved to have been the buyer, just couldn't get there for obvious reasons.

So, if we now look to the other side, what yields are -- and we are seeing that pattern in a number of different markets. So, if we buy a core building, it really has to have some value-add component, whether that's repositioning, whether it is renovation, whether it is moving rents up, because it is well below -- the rents are well below current market, and you can get to them reasonably soon. Obviously, we are not seeing a lot of that.

What we are seeing more is, I really think this market is now playing to Kilroy's skill sets. With the platform we have and with the competence, core competence we have in development throughout our platform, what we are seeing now is a number of folks come to us that have a value-added opportunity, and where we could put our skills into that. And if you think about it, if you are buying and you require project-level financing, it is very difficult to get financing on a value-added deal that is meaningful. So what we are seeing is opportunities in that particular area.

And we are also seeing it in the developments because a lot of development, even if it is pre-leased, it is very difficult to get the kind of financing -- anywhere near 100% financing. And if you take a look at the private equity guys, they extract a pretty big nickel to be your equity partner. So, we are seeing some opportunities in that space that we really like; one of them is the one we just announced.

And in terms of yields, from a development standpoint, we like anywhere from mid 6%s or above start, a straight line of 8% or better; IRRs in the high 8%s, 9%, 10%. And I think we are going to be able to improve the yields I just mentioned significantly in our own land bank with some of the deals that we are looking at right now where they are back to our more historical development yields of 8% plus or minus initial yields and a stronger straight line. What did I miss there, Jamie?

I think you said you were going to predict the election.

Yes. Well, it's going to be one guy or the other, but it's going to be a mess.

All right. Then just finally, who is the tenant for the build-to-suit?

We can't announce that yet because we have a confidentiality agreement with the folks, but we will be announcing that, when, Tyler or Eli?

I would call it mid-May.

Mid May. It is a credit tenant on a 15-year transaction.

All right. Thank you.

Your next question is from the line of Craig Mailman from KeyBanc Capital Markets. You may proceed.

I am just curious given the equity needs you guys have for the assets you have teed up, about $165 million. You already have about half of that in cash, and you guys are going out with the industrial portfolio. And it looks like you could do $500 million to $700 million. How do you think about the timing of potential dispositions and the mix of what you put on the market and anything around that?

Yes, that's a good question, because I think if the industrial sale was imminent, obviously we would use the capital from that to fund this latest round of acquisitions. As I said, we will use our line initially, and depending on how quickly the industrial sale gets done will impact how we proceed on other capital transactions, whether it is another bond transaction or another equity transaction or using our bank line for a longer period of time.

So that decision hasn't been made yet. It will depend on the next round of acquisitions, to the extent there are any, and the timing of the industrial sale. So, I can't be specific in terms of timing, but something like that.

And, have you guys already gone through the portfolio and picked out the other non-core assets that you're looking to sell at this point? Or, is that just a placeholder of what you could do over the next 12 months?

Well, it's both. We go through very rigorous analysis of all of our assets. And, I wish we had been as rigorous in that effort in the last cycle as we are today, because it's very, with Eli and his team they are on every building all the time. Where is the upside? Where do we call the asset? So we have a pool of properties that fits very nicely within the range that we gave. If -- depending upon how robust the markets are, that could be larger, and obviously, it is influenced by where we would put the proceeds.

Then, just lastly, it sounds like the development pipeline is heating up a bit. What does the pipeline look like in terms of total potential starts if all the stars aligned for you guys?

Do you mean this year?

This year or just the total pipeline that could happen through the mid-to-late 2013.

Well, it's very difficult to predict that because it depends upon leasing; it depends upon what is going on in the macro environment, and as Tyler pointed out and we all know this has been a crazy, volatile period over the last few years. So, there's so many factors that go into that. Based upon our discussions right now, again I don't want to forecast that, but we think it's going to increase.

And we are not going to do tons and tons of development everywhere, unless it is substantially pre-leased. We do see a few -- we really look at our segmentation analysis as to what is available in all of our markets, where rents are, what demand is, et cetera, to determine whether we should do any development that isn't pre-leased. We are not there yet. We see a couple small opportunities that we think might make sense.

But, in terms of starts, I think we've just got to go another quarter or so here to get our -- to get a better feel as to the many discussions we are having right now with tenants.

Great. Thank you.

Your next question is from the line of Josh Attie from Citi. You may proceed.

Can you talk more about the Silicon Valley development and what yield you expect on that project, and is that on land that you own?

It is on land we are buying, Josh. And, in terms of the yields, it's about a $200 million investment. Initial yield, first-year yield is 6.4%, straight line of 8%. It's a 15-year deal. The straight line of around 8% and IRRs we think that are north of there, mid-8%s.

When do you expect that project to open?

When does it come on stream?

Late 2014, early 2015, I believe.

And, what's the best way for us to think about the use of proceeds from some potential sale of the industrial portfolio? It's a lot of money that could come in at once, and I know your tax basis in those assets is relatively low. Is the only way to maximize the cash proceeds to reinvest it through acquisition?

I think that's very likely with -- you noted the gains that we already have built in those and doing 1031s and protecting those gains and distributions that would result from those. We have a very rigorous process here of arranging 1031 acquisitions -- 1031 transactions rather. We've done it on the last few that we've done.

With the industrial portfolio, we have two or three scenarios, contingency plans to -- depending on how the marketing goes, to have it occur in various closing tranches so it can line up. We're very, very mindful of dilution with respect to timing.

The ideal for us when we are doing a sale like this is to get the timing right, meaning we are bringing something in at the same time that it is going out. That with respect to yield, we are doing as well or better than we're doing on the incoming versus the outgoing. And, hopefully something -- the incoming has more upside and is more strategically suited to us.

So it is just a very rigorous, manual, every day. We have 1031 exchange meetings once or twice a week, and go through it in great detail. It's a very manual process, there is no -- it's like a long chess game. You have to just keep playing the game until its conclusion, and so far we've been able to navigate that very well. I'm very confident we'll be able to continue to navigate that well on all those particular considerations that we have to get right.

And is the most likely scenario that that gets sold as one portfolio? Or, is it possible that for some reason, you would break it up?

I think it's more likely to be one, but it could be broken up.

Okay. Thank you very much.

Your next question is from the line of Sri Nagarajan from Cantor. You may proceed.

A quick question on the development, John, you commented intriguingly on the existing land bank as opposed to land that you might be acquiring. If we were to obviously look at your land bank, it's mostly in San Diego. Could you just elaborate a little bit on the build-to-suit opportunities that have picked up since the last quarter?

Well, what we are seeing right now is, to give you an example, we have a 60,000 foot building in Sorrento Mesa. It is one of the few 60,000 foot buildings in the Greater Sorrento Mesa area; most of those are pretty old. Ours is in terrific shape.

We have got three tenants that want that building, so we're having discussions with two of them about building on Lot 2 at Sorrento Gateway for them. And, the yields are very attractive. With regard to other discussions we have on lot -- I think it is called Lot 8 in our -- what's it called? Lot 8?

PCC Lot 8.

PCC Lot 8 in Sorrento Mesa, we're having discussions on that one. And then we're having some discussions on some of the other sites.

So I think the way I look at this is we may end up building a couple of those buildings, probably with pre-leasing at least on one. But what I like is where rents have gone to and where competitive product, where there really isn't any.

And so I think we've got an opportunity right now that's very similar to what we had back in the early -- the late '99, '98, '99, and then early -- really '99 through 2003. We had a very similar market statistic, very little product that was high-quality, very good demand that was diversified, nobody building anything, and we see the same picture teeing up.

I can't get more specific than that, but I like that picture. And to put this in perspective, these are buildings that are in the anywhere from the $40 million overall investment to maybe twice that.

We also have a piece of property out in Rancho Bernardo. We thought we were going to do a deal with somebody that was very interested; they've elected to do something else. The company was bought by somebody else, and we now have interest for that particular site. We could be doing something there. So it's just too early to give you any real strong start date or dollar amounts or commitment to go forward, but I like the way things are shaping up.

Now with regard to the Bay Area where we don't -- we are having very -- a number -- a select number of discussions with developers who have worked hard to get their property in title, that have terrific sites, that can't get financing, and have tenants, and therein lies a great opportunity for Kilroy.

Right. John, just to elaborate a little bit on that, especially in the context of San Diego, are these new net expansions for a tenant or requiring new more space like a Facebook in the San Diego area, or are these just musical chairs of tenant upgrading their quality of the space? And then also if you could elaborate a little bit on the environment in the Bay Area, that would be appreciated.

Elaborate on the environment where?

Well, in the Bay Area, one could contrast that by saying there is a lot of net new demand in the Bay Area as opposed to San Diego. I just want to see your take on that.

Well the deals that we are talking about in San Diego are expansion, which I like a lot. But, and similarly up in the Bay Area, there is definitely expansion components for all expansion in the discussions we're having.

However, there are also those, and I don't want to -- there's been a lot of talk and a lot of reports that all you analysts have produced over the last couple years about the fact that there has been -- it has been unprecedented how low construction starts have been. And what has also happened is there are a lot of buildings every year that go into the obsolete category. Well, that has really piled up in some of these markets, and if you drive around Silicon Valley, you drive around some of the markets in San Diego, you see a lot of '70 and '80 product that is just not suitable for today's workforce.

And then you throw into that that increasingly decision-makers are wanting very high energy rated buildings. And Kilroy, I think has the largest, according to our Director of Sustainability, I think Kilroy has the largest percentage of LEED certified buildings in the public space in terms of office. And right behind that Energy Star rated space. And so we are finding that tenants really have a sustainability policy, and a lot of these old dogs you just can't remodel them to make them comply.

So I really like that trend, and we really get down, really bore into these markets and what is going on. And I think it's going to play well for our skill set.

That is very helpful, thanks for the color. One last question if I may, in terms of the competition that you're getting in a market that is well established like a SoMa market right now, what is the number of buyers who are bidding on an asset today versus where it was two years ago?

Well, Eli, you want to comment on that?

Yes. Well, it's a lot higher. First of all, you have a category of assets that have been trading in San Francisco which people are calling, instead of core, they need to go a level above that and they are calling it trophy or uber-core or whatever you want to call it. And pension funds are clustering around that activity.

The pension funds are basically in a battle with each other. One of them has to have it. They are knocking each other out. Those prices, as John mentioned, are in the $700, $800 ranges.

The number of people that might show up for an auction like that of truly -- you will get 20-plus, 30 bids on something like that. The number of people who are truly competitive are probably double-digits. And they can just drive those auctions to into the stratosphere.

If you take a level below that, we've seen a big bump in pricing in second-tier SoMa assets obviously as well. The number of competitors for that has gone up a lot. Not quite as much as it has for the category I just mentioned.

But as you get down to a certain level though where there is a major value-add component, a lot of that happens by virtue of relationships, by being on the ground, by knowing the right people, by getting first looks or getting the last look, things that people maybe can't get debt on. And we think we will still be able to find here or there that kind of opportunity, even in a highly competitive market like SoMa.

Maybe we will, maybe we won't, but we certainly will be able to contemplate that possibility whereas on the uber-core stuff we wouldn't be able to. Does that answer your question?

Yes. Thanks, that's very helpful. Thanks a lot.

Your next question is from the line of Chris Caton from Morgan Stanley. You may proceed.

John, you've covered a lot of ground, so if I ask a question you covered, please let me know here. But can you touch on the leasing market in San Francisco? You've got a couple of leasing objectives there, either for 370 Third, and also it seems like you got a little availability back in the first quarter. Can you talk about prospects in the San Francisco market for some of your availabilities?

Yes. Well, at 303 Second Street, we have just a terrific demand. I think we've got a couple of spaces around 10,000 square feet, and we are trading paper on both of those. We have some retail leasing. We just repositioned the ground floor plaza area and so forth, and we've got very strong interest in the limited retail that we have there.

At 201 Third Street, where Jeff -- what is our [person] that's leased on that now? While you're getting that, let me cover 100 First. We have leases, we are in leases or trading paper on every space at 100 First, and it's a very limited amount of square footage there that's available.

The big one is 370 Third, which is a total redevelopment and repositioning play. We're 37% leased with Pac-12 Enterprises and Comcast.

We thought we had a deal. We had a letter of intent for two -- there's four floors remaining. We thought we had a deal for two floors. We had a letter of intent. We got right down to signing the lease. Let's just say that there were some changes requested that we found unsuitable. The change to the credit profile and so forth, didn't like that. So we have those four floors available.

We think that with the improvements that we are making, which involve a roof tech -- deck patio, redoing portions of the exterior, the interior, generators, all the rest, but just the improvements that we are doing coupled with the lack of availability of large space, coupled with the increasing rents, that we are going to be able to move up, hopefully, projected yields on that building with the remodeling we are doing.

201, we are 97% leased. What we've been able to do there, Wells Fargo, when we bought the building, you might recall that the rents were about 50% of market or thereabouts on a bunch of the space. And what we've been able to do is take space back that was leased at -- what was the rent, Jeff, on the Wells Fargo space? In the 20s, and we've been able to take that back as we've had other tenants and move those rents up into the high 40s and 50.

So, I am very comfortable with where our leasing is in San Francisco, where the market is. And I wish we had bought 4 million square feet, but we've got 2 million.

And how is the redevelopment of 201 going? I saw you have the alley way there torn up. What's the -- how is the budget shaping up and the timeline shaping up to bring that up to where you have 303 Second?

I don't, Jeff, do you have the timing on that? I know we are underway and the budget, we are right on budget. And it's pretty terrific what we are going to be doing there. I think it's going to really make that building a spectacular keeper.

And as you know, on the other side of the public garage there, 680 Folsom is fully leased now that the TMG, Rockwood, I think it was, project to -- between Riverbed and Macys.com. And that building is going to be -- that's going to be a terrific, Class A building. So that whole block is just going to be spectacular. And with the improvements we're making in that building, I think we're going to be able to move rents even further.

I think the 201 Third is not a, quote, redevelopment property, but we are going to spend about $27 a foot roughly on our renovation plans. But it never comes out of the stabilized portfolio since it's almost fully leased.

Sure, and redoing anything to the exterior there, or did you elect not to do that?

We are not -- well, we are painting -- well yes. On the ground level, Starbucks is being totally repositioned. The lobbies are all being repositioned. We're putting in a large area. You know the building so well, Chris; if you go back into the lobby and you think of it as it goes back to that little alley, that space on the other side of the lobby there is going to become a big grand room, like a smaller version of what we have up at Key Center. And the tech and media and other tenants really like that kind of space.

It's going to have -- that alley way is going to be redone. The alley way that comes off of Third, and then the exterior above that level, the bottom level gets all new glass, paving and landscaping and so forth. It's going to be quite nice.

And then the space of second through 12 -- is that building 12 stories? I think it's 12 stories, I used to know how many stories every building was. I can't remember now. It is going to be repainted and cleaned up, and then we're going to do some signage. So, it's going to be a pretty nice renovation.

Thanks very much for the details.

Your next question is from the line of David Rodgers from RBC Capital Markets. You may proceed.

John, or Eli, is there any existing tax protection on the industrial portfolio, any or all of it?

Tax protection? I'm not sure.

You mean to unit holders?

Yes, right, exactly.

No.

Okay. And then Tyler, maybe can you give us an update on some of the deductions to get down to AFFO? I think you gave a little bit of a rundown on your expectation for the year, how those might compare as the year progresses to what we saw in the first quarter, and again as it relates to the dividend coverage?

Well, as you saw, we covered in the first quarter, I think our projections are the TIs and leasing commissions will increase here in the second and third quarters. And as I pointed out I think on last quarter's call, we still anticipate if nothing else changes, that will cover right on top of it for the year, but probably not again until the fourth quarter. So, the second and third quarters will have higher deductions, and really it is driven by TIs and leasing commissions, nothing else really is going on. So does that help?

It does. Last question, maybe John, some of these acquisitions that you've picked up or even the development that you're getting ready to start in Northern California, should we think about you as maybe over adding to the land position? Are there undisclosed land parcels that might give you some future opportunities for development or redevelopment?

And the one that comes to mind is the Menlo Corporate Center. With the excessive parking with high land prices, could you add structured parking, add buildings? Are these opportunities that you're uncovering as you get deeper into these buildings, or are we not that deep yet into the cycle?

Well, we're very reluctant. I always thought when a different company than ours, when they were buying stuff, I never could figure out their math. And what I finally figured out is that they were ascribing excessive development and big prices to that excessive development so that they could make their yields look pretty good on going-in acquisitions. That is a fool's game.

And, what you've seen with us, like when we bought the Yarrow Bay project, it had -- has another 100,000 square feet or so that we can build. We ascribed no land value to that. We've ascribed no land value at Menlo Corporate Center to any future development, even though that's a 23-acre site, a quarter of a mile or thereabouts on the freeway, which obviously could handle -- it is basically two-story product. And that could handle six-story product very easily.

But we're very reluctant to start ascribing land value to future development; we just think that's nutty at this point. Unless it really is truly a developed play.

Now with regard to the other part of your question, should you think about us adding land for future development. If you are talking about outright acquisitions, that has to be a very limited, select, just a killer site with visible demand where you really feel you have tremendous conviction and you don't have a lot of crazy entitlement process and so forth, unless you're stealing the land, and nobody's going to give it to you. So we're pretty conservative on that front.

Your next question is from the line of Michael Knott from Green Street Advisors. You may proceed.

John, can you talk a little bit or Eli, a little bit about the Lake Union deal and the economic profile there? I think you touched on it, but I don't think you --?

I think we did that in our -- when we did our equity offering, but Tyler, you want to -- you've got the schedule right there.

Yes. I think the going-in, in-place return is a mid 5% cap rate. Straight line is around 8% IRR. It's as high as 10% on this transaction.

Rents are well below market, around 20% -- I sorry, almost 30% below market. Does that help? We estimate replacement cost is about -- we're about 20% below replacement cost.

Okay, thanks. And then John, what about your plans for the LA region and portfolio with David Simon now in the fold?

Well, David, as you know, is a very seasoned, highly respected, very proven executive in LA for repositioning assets. I don't think there's anybody that I know that's done a better job. We're delighted that we are able to bring him aboard. We first brought him aboard thinking about the venture on the industrial, as well as LA. And let's just say that David has a lot of things -- a lot of balls in the air, and I think we're going to make real progress in Los Angeles; nothing to report at this point.

Any types of things in particular that you think he's thinking about or that you're thinking about?

Well, it's value-add stuff. It's value-add stuff. He has tremendous relationships. It's funny because we are headquartered in LA, but as a team, until David, it's probably the area where we are least connected to the areas you want to be.

With David, I think we've plugged -- not only plugged that, we've gone right if not to the top, real near the top. And you can imagine there is a lot of value-add opportunities in good markets, and those are the kinds of things that we are really looking at.

Okay, thanks for that color. Then last question, should we expect to see you guys bidding for what I believe is on the market just now, the former Maguire development down here in Orange County?

I don't think you're going to see us doing any development in Orange County. Now, I will never say never because there could be something that's preleased that has terrific yields and so forth.

Orange County has been a difficult market. We have a couple of great assets down there, and we think that if you're going to be in that market, you want to have outstanding assets that people want to be in, notwithstanding the economic conditions, and everything else tends to be a lot more commodity like.

That is our view. Others don't share that view, and they have done well or not done well.

As you know, the most of what we own in Orange County -- I mean, I asked Tyler, how can we be 94% leased in office and 97% leased in industrial and have our overall Orange County be 97%? He says because statistically, the industrial overwhelms the amount of square footage we have in office.

So, if we could buy a building that is in Fashion Island that's terrific and reposition it and so forth, we might look at that, but I am not holding my breath. I just don't see us being active unless there is a site that really is killer where you just think it's going to be a home run. And then I would plan on it being a double.

I'd also add that it's been a market where outsiders bringing in new capital have always been willing to pay prices that seem extremely rich relative to any fundamentals that have actually ever been experienced there. And when you've been a long-term knowledge participant in the market and watched some of the prices that get paid, you could be quizzical as to why somebody believes that the fundamentals are going to reach a point that justify the values. And that continues to be the case in some of the bidding that we see going on in Orange County right now, that the price per foot can be very high and the fundamentals necessary to support that just aren't there.

I presume, Michael, you're talking about the building that Rob developed that is now owned by a New York crowd that just went on the market on the freeway.

Yes, exactly.

Great building. Love the building. That would -- when we bought 2211 Michelson, we said there was two buildings that we thought stood above all others, and it was 2211 Michelson and whatever the address is on the subject building you're talking about. Love that building. I don't think we're going to be able to get in the ballpark.

Yes, I agree.

Okay.

If you're going to buy a building down there, that's probably the one you want to buy. Now I'm putting aside, Don Bren owns a lot of terrific assets, but he is not a seller.

Right. Okay, that's helpful. Thanks.

(Operator Instructions) Your next question is from the line of David AuBuchon from Robert W. Baird. You may proceed.

Just a few questions left here for me. Did you give the sub-market location of the development in Silicon Valley?

We did not. I just -- I think you'd figure it out in a heartbeat, and we have a confidentiality agreement until we conclude the transaction, so we did not. But let's just say it is one of the three best markets there.

Okay. And then, of the $500 -- the $200 million includes your land costs, correct? Do you have a land allocation for that?

We're really bound by a confidentiality agreement right now, so I can't get into that. We are happy to do that once we close.

Okay. Relative to potential development opportunity in SoMa and that surrounding area, do you feel like the market is strong enough for you to take some risk there and look at some development?

Which area was that, sorry?

SoMa.

Well, we look at everything. You can imagine between Eli officing up there and Mike Sanford, who runs that region for us, they literally look at every single thing. And if we find something we really like and we think really makes sense, we'll do it, all other things being equal. More to come on that, but we haven't pulled the trigger on any of that right now.

If I asked you rank the potential return -- risk return profile of development in your various markets, how would you list them in terms of best opportunity?

Well, in San Diego, with the things we're looking at it, if we achieve what we think, those are going to be very good yields. And on incremental, yield on incremental dollars, they're obviously very good because of the fact that we already own the land, and in some cases have plans or whatever.

But, I don't think we're seeing anything yet in Seattle that makes sense. We're looking at a bunch of stuff. There's been some land sites that have sold that were pretty frothy that we couldn't quite figure out how the math worked.

Right now I would look at there are some opportunities in the Valley, Silicon Valley, greater Silicon Valley. There may be opportunities in SoMa; we don't have one yet, and, in San Diego on a select basis.

And then in LA, at some point, you buy an asset that is a deep enough value-add play, David, it's really a development play and we see some opportunities there. But, it's not going -- it is not ground up at this point.

Right, and the LA deal that I think you mentioned it or disclosed it last quarter, and you said it is still going through the loan assumption process. Is that -- remind me, was that a value-add deal or is that stabilized?

Yes, it is. It's a building that we're buying. It's how many square feet, Eli?

About 200--

No, it's bigger than that.

300 --

325,000 square feet in round numbers. We're buying it for under $250 a foot. We're putting another $100 into it roughly.

Yes, we will be into it right around $300 a foot all-in.

Sorry, less than $100. We will be into it $300. We're in -- similar buildings at similar locations have traded in the $500 range recently, so we think there is real value there. It's been just a horribly mismanaged building.

Is it completely vacant?

Pardon me?

Is it completely vacant or what's the matter?

Oh, no, no, no. It mid-80%s, but the landlord didn't have any money to do improvement works, so they made stupid deals. There's big expirations coming up, so we are totally repositioning that building. The market has gotten stronger since we went into escrow.

We're a little annoyed that it has taken so long, but let just say that it's been one of those things that you have to have steady hand on the tiller to have navigated through all of the ownership and lender related issues. And we should get the thing closed here Eli, when?

I think we're six weeks or so.

Okay. So, if somebody would've told me in the beginning that it would've taken this long, I wouldn't have contemplated it, but nobody did. But it's going to be a great asset, and we think that the market has just gotten better and better as we've moved through the process.

Okay, and then you mentioned the San Diego deal just was done; you just felt like it just wasn't going to happen?

Yes. It's a small -- it was of those four things that made up about $370 million to $380 million. It was $34 million. That building was near one of our other buildings and it was a slam dunk. But the seller didn't have the deal that he thought he had, and he and the lender I guess are in some kind of protracted thing. It's just not big enough to fiddle with, you know what I mean?

Right.

It's -- if it comes back, we'll take a look at it again, but we've got bigger fish to fry.

Okay, and then just last question, Tyler, the DIRECTV and the TD Ameritrade leases, are those fully coming in in the fourth quarter of this year?

Well, DIRECTV, cash is being paid on that third building I think December 1. So, they're currently in free rent. The lease has started on that transaction, but from a revenue perspective --

It's not really -- they're doing TIs.

Yes, so we can't -- even though the free rent period has started, you can't book the revenue until they're ready for occupancy, which we expect sometime in the fourth quarter. The cash rent starts to come in December. For TD Ameritrade, I believe it's an August start, so they will be in fully roughly in the third quarter.

Excellent. Thank you.

Full rent for the fourth.

Right.

Your next question is from the line of Mitch Germain from JMP Securities. You may proceed.

John, any specific sub-markets in LA that you guys are focusing on?

No comment. Too competitive, and I don't want to -- it's competitive. I think it's just not going to serve us well to get into that until we have something tied up.

Right. Thank you.

At this time, I would like to turn the call back over to Mr. Tyler Rose for your closing remarks, sir.

Thank you for joining us today; we appreciate your interest in KRC.

And ladies and gentlemen, this concludes your presentation. You may now disconnect and have a great day.