Kilroy Realty Corp (KRC) 2013 Q2 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the second-quarter 2013 Kilroy Realty Corporation earnings conference call. My name is Ayesha and I will be your coordinator for today's call. At this time all participants are in listen-only mode. Later we will conduct a question-and-answer session. (Operator Instructions) As a reminder, this call is being recorded for replay purposes. I would now like to turn the conference over to your host for today, Mr. Tyler Rose, Executive Vice President and Chief Financial Officer. You may proceed.

Good morning, everyone. Thank you for joining us. On the call with me today are John Kilroy, Jeff Hawken, Eli Khouri, David Simon, Heidi Roth, and Michelle Ngo. John and Eli are working on some Bay Area opportunities and are currently calling in from our San Francisco office.

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 the 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. Jeff will review conditions in our key markets, and I will finish up with financial highlights and updated earnings guidance for 2013. Then we will be happy to take your questions. John?

Thank you, Tyler. Hello, everyone, and thank you for joining us today. KRC had another strong and productive quarter as economic conditions and job growth continue to show steady improvement across our key West Coast markets.

We delivered another solid quarter in leasing, signing new or renewing leases on 578,000 square feet of space at rents that were 12% higher on a cash basis and 17% higher on a GAAP basis than rates in the expiring leases. We also have approximately 400,000 square feet of in-place letters of intent.

This leasing included early renewals with both Delta Dental in San Francisco and Microsoft in Seattle, thereby smoothing out near-term lease expirations. Overall, our stabilized portfolio is now 93.2% leased and 90.7% occupied.

We also collected a $5.2 million cash payment during the quarter related to the settlement of a claim for property damage that occurred several years ago at a San Diego property. We incurred the cost to repair the damage at the time and are just now being reimbursed for those costs. As Tyler will review in more detail later, we do expect to incur some additional legal costs related to this settlement in pursuing additional settlement claims.

On the development front, construction remains on schedule and on budget at our four 100% preleased San Francisco Bay Area projects. These developments total 1.4 million square feet, have a total projected investment of $810 million, and an average projected initial yield in the low to mid 7% range. We expect the first delivery in the fourth quarter.

These amounts reflect a 27-story project at 350 Mission Street. As we previously reported we are making good progress with the city to increase the entitlements by three floors, which salesforce would lease. This would increase our overall investment by approximately $25 million and our estimated overall project yield by about 30 basis points.

We initiated work at our Columbia Square mixed-use project in Hollywood during the quarter with the commencement of the renovation of the existing office buildings that total approximately 100,000 square feet. We are transforming the interiors of these historic buildings into state-of-the-art modern work environments, while maintaining the striking period architecture exteriors that have a deep historical connection to the early days of Hollywood television production.

We continue to be very bullish about the Hollywood market and are likely to start construction on the 350,000 square foot component and related subterranean parking this summer. That is office. Pre-leasing discussions for the office component continue to go well, as we are seeing significant interest from several prominent entertainment users for large amounts of space.

On the residential front we continue to make good progress in the project design phase and expect to start the residential tower in roughly 12 months. Upon completion, the overall Columbia Square project will have a total estimated investment of approximately $385 million.

In Northern California, we have made significant progress on our Redwood Towers development project in Redwood City. In June we executed a joint venture agreement with our local partner and acquired a small piece of land that will become part of the overall development site.

Just last week we obtained unanimous approval from the city council of Redwood City to purchase the remainder of the land and to proceed with the development of the two-building office complex, now named Crossing/900. It will total approximately 300,000 square feet and have a total estimated investment of approximately $180 million.

We expect to acquire the remainder of the land and commence construction later this year. Land cost on a combined basis for both parcels will total about $85 per FAR foot.

Crossing/900 has a highly desirable and visible location in Redwood City, a city that sits on the San Francisco Bay roughly midway between San Francisco and San Jose. The development site is also immediately adjacent to a Caltrain station and heavily used rail lines that connect San Francisco with submarkets of Silicon Valley.

Crossing/900 will be designed with all of the features that knowledge-based tenants seek in today's modern work environment and will be an ideal location for companies seeking to establish a new headquarters. Our leasing discussions there are going very well.

At our 333 Brannan Street project in SoMa submarket of San Francisco, we are completing the process of obtaining entitlements and finalizing our architectural and engineering planning for a 170,000 square foot modern brick and timber design building. We remain on track to start construction in the fourth quarter.

Preliminary project costs are estimated to be approximately $95 million. And again, we are having very good early leasing discussions on that property.

Moving to acquisitions, given highly competitive pricing conditions in most of our markets, year to date we have seen fewer opportunities to acquire assets that meet the needs of the modern tenant that are in the strategic locations that we are focused on and that will deliver the financial performance we require. Having said that, we are pursuing the acquisition of a terrific San Diego opportunity that includes two 100% leased existing modern office buildings and a land site for a future 90,000 square foot development opportunity.

We are already in discussions with a potential tenant to take the majority of the to-be-built building. The purchase price for both components is expected to be approximately $125 million, subject to certain closing conditions.

With regard to dispositions, we remain keenly focused on selling fully valued nonstrategic assets and recycling the capital into higher-value acquisition and development opportunities. To that end we completed the sale of an older, nonstrategic 90,000 square foot property located along the 101 Corridor in northern Los Angeles County for gross proceeds of about $15 million.

In addition, we are in the market with a portfolio of San Diego office buildings and are seeing strong interest from a large pool of potential buyers. We can sell these assets as a portfolio or in pieces.

We are also in discussions on several more sale transactions encompassing both buildings and land. The amount and timing of all these potential dispositions will depend on pricing and on our capital needs.

To wrap up, we continue to run our business and make decisions that we believe will build the long-term value of our portfolio and attract dynamic companies and their talented workforces. We are in an environment that plays to our strength and is aligned with our core strategies.

Our modern, high-quality portfolio, which is located in some of the best markets in the country, is well positioned to meet the continued demand for creative, collaborative, high-density office space. The vast majority of our properties have either been recently renovated or newly developed, and we continue to be among the leaders in owning and developing LEED and Energy Star certified buildings, which have become critical elements in attracting tenants.

San Francisco and Seattle remain ahead of the national economy as job growth and leading-edge productivity have benefited those office markets. San Francisco now has the lowest vacancy rate in the country.

In San Diego the market is not only benefiting from limited new office supply but also from economic conditions that have steadily improved. Unemployment has trended down; the housing market is steadily recovering; and telecom, technology, life science, and healthcare industries are all strengthening.

We are seeing continued strong momentum in coastal submarkets, with Class A asking rents of more than 8% year-over-year. Quality execution across our larger and stronger operating platform remains our key focus this year. We have a terrific team in place, and we are making clear progress on all of our strategic priorities.

With that, I will turn the call over to Jeff for a review of our markets. Jeff?

Thanks, John. Hello, everyone. As John noted, our key markets all exhibited economic growth and improving commercial real estate fundamentals last quarter. From Seattle South to San Diego, regional unemployment rates in our submarkets continue to decline while job growth remains steady.

Across California, unemployment has now dropped nearly 380 basis points over the last three years to 8.5% and the state has added more than 0.25 million new jobs over the last 12 months. Seattle continues to outperform and now has unemployment rate of 5.3%.

Real estate fundamentals also continue to strengthen, with the Bay Area reigning standout. In San Francisco, the office market absorbed over 175,000 square feet in the second quarter, bringing the year-to-date total close to 500,000 square feet. Vacancy rates in SoMa declined for the 12th consecutive quarter, and Bay Area median home prices rose 30% year-over-year.

We executed a 188,000 square foot early renewal with Delta Dental at 100 First Street building, pushing out the expiration three years to 2018 and increasing our cash rents by 26%. We had a tenant move out at our 250 Brannan Street property during the quarter, but already released that space for a September 1 occupancy.

Silicon Valley rents have now surpassed 2008 peak levels and are now the highest since 2001, primarily driven by the submarkets of Palo Alto, Mountain View, and Sunnyvale, where each has experienced market rent growth of more than 55% since 2010. We are currently 94% leased in the Bay Area.

Greater Seattle continues to have one of the strongest demographic profiles in the country, adding about 37,000 jobs over the past 12 months. At this current pace, economists expect the region will return to prerecession employment levels by year-end. In our primary submarkets of Bellevue and Lake Union, Class A vacancy rates declined to 6.5% and 4.2%, respectively, and rents have continued to increase.

We are currently 96% leased in our Seattle properties including the five-year extension of the 94,000 square foot Microsoft lease at our Westlake Terry building in South Lake Union.

Moving to Southern California, areas with a higher concentration of technology, entertainment, and media companies including Hollywood and West LA are among the region's top performers. In Hollywood, at our Sunset Media Center building, we have seen rents increase approximately 15% year-over-year as we recently renewed a lease with Nielsen and signed a new release with Film LA. We are 82% leased at this building and expect to drive both occupancy and rents as we complete our renovation.

Given the resurgence of institutional capital into the market, the energetic 24/7 live-work-play SoMa-like environment and limited supply of modern creative office place, we believe fundamentals in this market will continue to improve. Across our Los Angeles portfolio, we are now 92% leased.

That brings us to San Diego. Year-to-date job growth puts San Diego on track to create 30,000 new jobs in 2013, a pace that if realized would be the largest increase since 2000. San Diego median home prices increased 15% year-over-year and the office market absorbed 600,000 square feet in the second quarter, making the 15th consecutive quarter of positive net absorption. Our San Diego portfolio is 92% leased.

Companywide we now have 2013 lease expirations totaling less than 300,000 square feet. Across our entire stabilized portfolio, we estimate that current rent levels are roughly at market rates.

That's an update on our markets. I will pass the call to Tyler who will cover our financial results in more detail. Tyler?

Thanks, Jeff. FFO was $0.69 per share in the second quarter, which includes the receipt of a $0.07 share cash payment related to a property damage settlement that John mentioned. We ended the second quarter with stabilized occupancy at 90.7%, up from 90.3% at the end of the first quarter.

As we discussed on prior calls, our occupancy has declined from year-end 2012 largely as a result of a few large tenant new moveouts. We have executed leases on approximately 60% of this space. At the end of the second quarter our overall stabilized portfolio was 93.2% leased.

Same-store NOI in the second quarter increased 3.7% on a cash basis and declined 1.3% on a GAAP basis, after adjusting for the $0.07 a share cash payment. CapEx was higher in the quarter primarily related to leasing commissions on the early renewals we discussed, and other renewals and expansions in Los Angeles and San Francisco. We expect to be back to our $15 million run rate next quarter.

On the capital front during the quarter we raised approximately $19 million under our ATM program at an average gross price of $54.93. We estimate remaining 2013 development spending on our four under-construction projects -- Columbia Square, 333 Brannan, and Crossing/900 -- to be approximately $260 million.

As of today we have full availability on our bank line, approximately $60 million of unrestricted cash and no debt maturities until late 2014. We are now increasing our disposition target for the year to between $150 million to $300 million, with an average closing date in the middle of the fourth quarter.

Before reviewing updated 2013 guidance I want to remind you that we approach our near-term performance forecasting with a high degree of caution given all the uncertainty 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 for the remainder of 2013 are as follows. In terms of occupancy, we are maintaining our year-end projection in the high 92% range. As usual, occupancy projections are subject to potential future acquisitions and dispositions.

We are assuming we complete the $125 million San Diego acquisition that John mentioned in the early fourth quarter, with leverage-neutral financing. Also as John mentioned, we do expect higher legal fees in the second half, mostly related to the $0.07 a share cash payment we received in the second quarter.

While it is hard to predict these costs, we currently estimate they could total $1.01 to $0.03 a share. So for the year we currently estimate the net impact could be a positive $0.04 to $0.06 a share.

Taking all that together, we are maintaining our core FFO per share guidance range from last quarter, which was $2.46 per share to $2.60 per share, adding the $0.05 which is the midpoint of the potential benefit from the settlement, and then tightening the range a bit to get to updated 2013 FFO guidance of $2.53 per share to $2.63 per share.

That is the latest news from KRC. Now we will be happy to take your questions. Operator?

(Operator Instructions) Craig Mailman, KeyBank.

Hey, Tyler. Just following up on the guidance piece, just want to clarify. So no increase to the range? That is all due to this net benefit, nothing on the operations side?

Right, we are maintaining our core guidance from last quarter.

Okay, thanks. Then just on the development, it sounds like you guys have good traction on the few projects that you may start later this year and into next year. Just curious on the profile of the tenants you are talking to, and whether it's actual consolidations from other buildings. Or is this new demand that we are seeing?

Well, it is a combination of both. What that is, we've talked a lot about on these kinds of calls and in NAREIT and so forth is that tenants are looking to increase their efficiency to respond more to their tenants' requirements -- or rather, their workforce requirements for public transportation.

So you have a range of significant increases in requirements throughout our markets as well as those that are moving from buildings that are no longer suiting them as well as they once did and want to be in more modern, efficient buildings that have better public transportation.

So we are seeing a range of both. But overall we are seeing expansion.

Okay. Then just lastly, on the funding plans, you guys obviously bumped up the disposition target here. Tyler, just with what you guys have left to spend and what you could start, do you feel good that you just can fund that with dispositions here? Or would you look to possibly do some type of equity ahead of time just to have that funding in place?

Well, think what we have always said is we're going to manage our balance sheet appropriately. So a lot of it is going to be dispositions. We have used our ATM here a little bit in the first half of the year; we'll probably continue that to some extent.

We did a debt offering in January. So as we go through the process we will probably use the debt market to continue to do that. So we're going to use all the options going forward.

Great, thank you.

Gabe Hilmoe, UBS.

Thanks. I guess a question for Tyler. The new disposition guidance on the high end, does that include basically all of what is on the market in San Diego?

Well, we need to be careful about what we talk about in terms of the pricing of that portfolio, because we are in the market on it, so we don't specifically talk about the value of that portfolio. and Eli can comment more on the specifics.

But that portfolio in San Diego would be toward that higher end; and then it could even be higher than that if we find attractive pricing on other assets as well. So it is in that range of $150 million to $300 million. It could be more, could be less.

It depends, as John said in his comments, on pricing and our capital needs.

Okay.

So just, Gabe, on that, I want Eli to comment on that a little bit further, because while we are giving guidance of $115 million to $300 million, and as we said in our comments it could be more, would just add a little color here. With regard to San Diego and elsewhere in the market, it totals more than $300 million.

Yes, yes, I mean if we pulled the trigger on everything that is in the market it would end up being more than $300 million. And we are being very reserved and we are very sensitive to the fact that right now on San Diego we are just most actively in the market and we don't want to say anything that indicates any expectations other than letting the market drive that thing as hard and far as it will go. And we are getting very, very strong interest on it.

Okay. I don't know if you can answer this or not, but in terms of the assets that are on the market being discussed, does that include the Bridgepoint assets? And maybe can you remind us when that lease actually rolls?

This is John. No, it does not include the Bridgepoint assets. And, Jeff, I would have to defer to you with regard to when that Bridgepoint lease rolls.

Yes, the Bridgepoint lease rolls in 2019.

Okay, thank you.

Josh Attie, Citi.

Thank you. Why did the costs go up by $10 million at 333 Brannan? Was it just a change in the scope of the project?

And also if you could remind us what the net rents you are underwriting are, and if there is also a corresponding increase in the rents you are forecasting.

Yes, we haven't -- we are pretty conservative with regard to the rents. What has driven the cost increases is that we have made the strategic decision to go with a building that is the upper ends of Platinum. We are trying to go above Platinum.

I am not sure I have the terminology correct here, but think of something that is as close to zero carbon emission as one can possibly get. What has driven that is that -- and that adds quite a bit of cost.

But what has really caused us to try to go to that far extreme is that in the discussions we are having with a number of tenants, they value that very, very highly. So we think it translates into a much greater market receptivity for the property, and it should translate into higher rents. But at this point I am reluctant to forecast higher rents until we really get in greater discussions with those that we are now working with.

Do you think -- could you just remind us what comparable rents would be at nearby buildings? I think -- and this goes back several quarters.

Yes. Rents that we are doing at 250 Brannan, which is a 100-year-old building that we redid, were about $50 triple-net with 3% bumps.

That building didn't have this --?

No, that building was originally the Gallo Sausage manufacturing plant that was converted into a three-story office building. So it is a terrific, classic brick and timber building.

But this building at 333 Brannan will be a building capable of accommodating -- I think it is 13 people per 1,000 square feet with all the exiting and all of the floor loading and all of the mechanics and all of the things -- the restrooms, etc., that those kinds of folks, those high-density folks want. Whether it will be occupied to that high level of density, can't say.

It has a number of features that no other building in San Francisco -- or for that matter, most buildings -- I don't think there is many buildings in the country that will have what this building has. So we think that the incremental investment of $5 million plus is something that is going to make this building infinitely more valuable over time.

Okay, thanks. At NAREIT and also on the last call you talked about this building shadow pipeline of build-to-suit projects. I know you mentioned a couple of them in the prepared remarks. But maybe just -- how are things moving along in the last few months? Are there any deals that are coming closer to fruition?

Well, we have some very serious negotiations going on. I am a little bit reluctant to comment on these calls, because I can tell you that the brokerage community, the tenant community, and the competitor community, whether they are private or public, all listen to or read the transcripts on these calls. So I have -- I'm not trying to be cute, Josh, I just find it very difficult because we recently lost a deal because of something that people just got off our last conference call and they went in and made a silly deal.

So I just -- it is a very competitive environment out there. We think we are going to see some additional build-to-suit opportunities, but until they happen it is pretty hard to get too specific on these kinds of exchanges.

Okay. Totally understand. If I can just ask a separate question on -- this past quarter, a lot of the big real estate brokerage firms and research has this, when they talked about San Francisco a lot of them noted that the CBD had plateaued and that the market in the CBD at least was flat. What is your view of the San Francisco market, and how are things trending in your particular submarkets?

Well, if you -- one of our big objectives in San Francisco that we -- and frankly, throughout the Company, is we had that spike in 2015 expirations, and so Delta Dental was one of our key objectives in leasing that space. And we did a good job on that here at 100 First.

They are giving back a floor. We're going to be able to lease it at a much higher rate than the deal we did with them, we believe.

With regard to 360, we have very little vacant space in available in the market right now. And everything that we have had available in the market we have been able to lease up.

We are seeing very strong activity still at 360 Third. We just another deal over there. It's smaller tenants, sort of the 15,000 to 30,000 range that I would say has the most activity.

There are a number of buildings or requirements that are out there for 100,000 square feet. But as we have said on the last several calls, not seeing many requirements in the 500,000 square foot range in the city. So I think that it has taken a little bit of a breather compared to where it was in its robust leasing for the last few years, but there is still quite a bit of activity.

And on our buildings particularly we feel that we are very well positioned. We are feeling very strong with regard to the Redwood Towers building down in -- or rather the Crossing/900 as we now call it down in Redwood City, where we've got strong interest from legal firms as well as technology firms.

And with regard to 333 Brannan we think that is going to be such a terrific building, that brick and timber type building is more sought after by the technology type tenants than the vertical type buildings. So, I am still feeling very strong about the city. I think if you have got weaker product that is not as desirable, you are down on the food chain.

It sounds like you are happy with what is going on in your portfolio. I guess, would you agree with the characterization that the overall market is flattening out? Or do you have a different view?

I don't think we have had enough quarters to make that call, yet. But we have not seen as many of the big, big users in the market, so that is obviously a change; and that has been something that has been talked about now for two or three -- I guess at least a couple of quarters.

But if you look at the list of deals, there is still a huge amount of square footage that people are looking for. I think that you have heard me say before that if you have your father's office building that is not well suited to what people are now wanting, I think that you have problems.

So there is a combination. In terms of growth, has it slowed from where it was? Yes; but again, over a very small measuring period.

And I think what is extremely important is that you have buildings that the tenants really want. Not only locationally with all the benefits, but the physicality, the kinds of things I mentioned that we are going to in almost the extreme at 333 Brannan. That is what we have really focused on in our portfolio, is to make sure that we have the location and the physicality that this trend, which I think only increases in all our markets, is telling us is the way to go.

And if you violate that, I think you get into trouble over time.

John, I would just add that if you think about last year there were a couple times where there was a lot of activity in Q X; and in Q Y it dropped off; and then in Q Z it picked up again. So John's comment with respect to the short period of time, that has been typical. It is not uniform quarter after quarter.

And as he mentioned, the pipeline is very robust. So I would not draw a conclusion of momentum slowing at this point. It is very -- it is solid.

These things go up and down. Look at San Diego right now, we are seeing great momentum and we have always seen 15 quarters or so of positive absorption in San Diego Peary. We haven't seen the momentum we are seeing there now.

So these of things come and go in different markets, and I am quite pleased with the way we are positioned at this point.

Okay. Thank you very much.

Jamie Feldman, Merrill Lynch.

Great, thank you. I think you guys had commented that your mark-to-market for the portfolio versus market rents is flat. But can you talk about what you are expecting for the rest of the year and maybe into 2014?

I'm just trying to figure out where that number is coming from. Is it your total portfolio or is that what you are seeing the next couple of quarters or years?

Well, Tyler, why don't you take the way we're looking at it now, and I will deal with how I think we're going to see it trend.

Okay. Yes, I think the flat comment is the overall portfolio for all the years. So over the next couple years in our calculations of that we are slightly under market. There are some years out in the future where we are over market on some leases.

But the flat comment relates to the overall portfolio, not to the next couple years where we are under market.

What we are seeing, Jamie, as you can imagine, with now when we are building buildings we are obviously -- one could argue that is market at least for that kind of space that people want to move into. And with what we see as the momentum that is in our various markets, I would expect to see that we are going to be under market and maybe pretty substantially over the next couple years.

That remains to be seen. There is a lot of macro forces at work.

But replacement costs have gone up substantially. And as the markets tighten those rents are going to drive the underlying existing core portfolio.

So I guess, what are you guys assuming in your guidance for the back half of the year in terms of leasing spreads?

Tyler?

You mean in terms of rent growth on our portfolio?

Yes. I mean, is it sustainable, what you have done year to date? Or is something shifting?

Well, we don't have that many expirations remaining for the remainder of the year, and obviously -- but yes, I think the answer is yes. In general we expect to continue.

The rents have been up 10% to 17% I think we just reported in terms of the numbers. And for the expirations from this year, just the ones we have to accomplish as I mentioned a few minutes ago, we are slightly under market, maybe 3% to 5% for that.

But overall we think we can continue to generate over the next couple years that 10% growth on our rent. Obviously, as we sign leases which are under market, those now go to market, and that is why that number sort of trails along.

Great, okay. Then can you talk about any change you have seen in the investment market after the move in rates? Just any impact on valuation or different kinds of buyers looking at assets and maybe opportunities that might open up for you guys?

Yes, this is Eli. What I would say is there have been two phenomenons moving in slightly different directions. Everybody has noted the choppiness in the debt markets. But I would say everything I am looking at right now says that has stabilized and the debt markets are working well both in the life company, the bank, and the CMBS.

Offsetting and compensating for that choppiness is the fact that the amount of capital, the equity capital, is increasing, particularly from foreign capital sources along with the traditional capital sources of the pension, the private equity, and some REITs. You add on top of that the fact that there still is relatively very little product for sale relative to the appetite to purchase and the overall investment asset allocation demand for real estate.

So pricing has stayed very strong and I would say it is increasing, and we are seeing some migration from investors going to either secondary product or to secondary markets just due to that tough competition and that limited amount of product out there overall. As people will note, on the fixed market because of the Treasury the net effect of fixed for that core stuff is probably 90 bps up; but that has not affected overall core pricing.

Frankly, there has been a move down in the core from what was probably mid-6s to a 6 flat on unlevered core targets. So that is a quick overview of where it sits right now.

I noted that there may be more product to relieve some of that pressure in Q4. But that remains to be seen, how much comes and how much pressure there is on that, and where the debt market goes at that time, so.

How do you think the market has changed its underwriting outlook for rent growth?

It is very solid in all of our markets. Seattle and San Francisco, people are still very positive on where that is going to go. They are still writing substantial increases.

They have increased their increases in San Diego from what they had been doing historically at this point, as well in Los Angeles, both of which had been growing slowly and now seem to be getting a little bit of momentum.

Okay, great. Thank you.

Vance Edelson, Morgan Stanley.

Hi, thanks. The additional legal fees that you expect to incur post the settlement that you just received, does that mean that you are not satisfied and you're going back for more? Or is it that you expect to have to defend the settlement against the counterparties going to appeal?

It's -- we settled with some parties and we didn't settle with other parties.

Okay; so still more work to be done. Can you remind us what it would take to make you whole on that? You have $5 million so far. What would be the total amount you are aiming for?

I don't really -- I don't know that we disclose that. We are in the midst of a legal thing, so I don't want to get into too much -- I don't want to go down this road given the fact that it is legal in nature.

No problem. Then regarding the slower pace of acquisitions at least this quarter, and combined with the increase in the disposition target, sounds like this is mainly a matter of discipline and then perhaps lack of candidates. But does it suggest at all that you see this as the time to take your foot off the gas some in a bigger sense, the way you did in the mid-2000s, and maybe just capture the rent growth for now?

Well, you know, we talk a lot about location and physicality and tenant demand, as well as yields and so forth. And if we see product that we think is terrific product for the long term, that meets the needs of the modern tenant or that we can modify to meet the needs and so forth, and that we can underwrite in our fairly conservative way of underwriting things to produce the kinds of yields we like, then given everything else being equal we will continue to be acquirers.

You will see some of that, but I wouldn't say that we have our foot on the gas at all. We have our eyes very clearly on the road ahead and making sure that we are very discriminating in what we buy.

I have been wrong many times in the past where I thought people were crazy paying for the kinds of assets they were buying, the amount they were paying, and found out that they bought really good deals. We tend to be a little bit more conservative.

So I don't know that we are going to see anywhere near the level of deals that we have seen over the last three years this year. But we're only halfway through the year.

We are just very disciplined and we are very mindful of the balance sheet. And we think this is a time where you can -- I am one of the older guys, I guess, in probably the office space. And I have seen many times in my career where people said -- hey, everybody else's buying, we got to buy too. That is a recipe for disaster.

So I don't think we have our foot on the gas. I think we are just very disciplined.

We are very opportunistic. If there is a wrinkle in the market that allows us to buy something that we really like and fits all our criteria, then you will see us buy.

Okay. Sounds like you've got the right approach. Thanks.

George Auerbach, ISI Group.

Great. Thanks, guys. John, any update on One Paseo, your plans there and the potential build-to-suit in San Diego?

Well, One Paseo I am cautiously optimistic. There has been a big harangue down in San Diego resulting from the new mayor and he has kind of kicked over the hornets' nest and there's people that are trying to throw him out and whatnot. And that has delayed things a little bit, but I am optimistic that that is going to get sorted.

And assuming it does, then we will proceed with that project, again subject to all the macro things. But we have very strong leasing interest on all the food groups there.

What was the second part besides One Paseo? Pardon me.

The potential build-to-suit in San Diego.

The big one? I really can't comment much more. They are a big company. They have been focusing on some other needs they have outside of San Diego and according to their broker, and more to come. We think we are very well positioned if they move forward, and that is our hope.

All right, thanks. Tyler, just on the occupancy guidance, the year-end target for the high 92% range. Just to clarify, that is on the current portfolio or that includes the effect of the acquisitions and the dispositions?

Well, it includes the overall portfolio. So yes, the dispositions are not included in that number. Sorry.

Okay. Any color on the narrowing of the leased-to-occupied spread this quarter? Was that just some leases that may have been targeted for the second quarter that got pushed out? Or -- it just seemed like being 93% leased by quarter end stepped back a bit from last quarter.

No, I think we are basically on track. We are a little bit ahead of where we were last quarter on occupancy, right?

And you are commenting on the lease percentage came down a few basis points; but our overall occupancy number for the year is the same. I think for the third quarter we are expecting sort of the mid-91% occupancy.

But that lease percentage, hopefully we can drive that higher. But at some point, you get to the 94%, 95% lease percentage you can't -- you're not going to get much higher than that. So I don't think there is anything driving that particularly.

Okay, thank you.

Brendan Maiorana, Wells Fargo.

Thanks and good morning out there. John, or Eli, is there any more color that you guys can provide on the planned acquisition in San Diego? I heard your comments, but I think you guys have been pretty clear that you are going to be measured in terms of acquisitions, given where pricing is.

So what made this one attractive from a return perspective, where it seems like a lot of deals in the market have pretty low near-term returns?

Well, let's just say that the property, without getting too specific, is -- they're outstanding buildings leased to outstanding tenants. It has a development component, and we are very comfortable with the range of yields we're going to get on that, which gooses the overall project return substantially.

It also happens to be adjacent to another major property that we own, and it has some benefits that are specific to us with regard to that larger asset that we think gives it extra strategic meaning to us.

I don't really want to go much further because I am not supposed to disclose what the asset is until it is closed, because of a confi. So we are getting -- if you think about San Diego, we are selling nonstrategic assets that are a little bit on the fringe, at least in our view, a couple of exceptions there. And we are going to reinvest from time to time in San Diego when we see an opportunity to get a terrific asset at a great price or a good price where we think we can move the yields up substantially, that has extra strategic meaning for us.

So we're not looking at buying in bulk in San Diego. But whether it is San Diego or San Francisco or Seattle or Los Angeles, Hollywood, etc., we're going to be opportunistic about buying those things that we think we can drive shareholder value -- or where we can drive shareholder value. And that is what we think this opportunity is in San Diego.

And, John, on the dealmaking side of that because it has a development piece and it was a core on the other side, it didn't quite fit neatly into anybody's box. So the competition was less, and we think the value that we were able to buy there was very, very solid compared to something that was all of one thing or all of another thing.

So that was an opportunity for us to step in. And obviously we got kind of the best treatment too, from our credibility in the market there. So those are the kind of deals we like to make when we're going to make a deal.

Sure. Yes, that's helpful. Then on the disposition side, in Seattle I know you guys have a new portfolio there. But there is a large portfolio deal with Spear Street this quarter. Does pricing in Seattle make you think maybe a little bit more about potentially monetizing some of your assets there, given what pricing seems to have done in Seattle over the past few quarters?

Well, you know, I recall when -- a couple years ago when we started to invest in Seattle and there were some folks that thought we maybe had paid up too much or whatever, turns out we made very good buys. And we are now seeing some real inferior assets trade at much higher cost per square foot or at much lower cap rates.

We think there is still more room to go in the assets that we have there. So we might sell an asset or two that is smaller, but we are pretty pleased with the buys.

We bought some outstanding assets that we have been able to move the rents up on. We think we're going to be able to move more rents up.

We have quite a bit of leasing activity and renewal activity going on in those assets right now. Eli, do you want to comment any further on that?

No, I just think -- yes, that deal that was done up there more than validates the assets that we bought, the prices we paid, the focus on the investment world, on the value of that market, and the fundamentals that people see coming -- currently existing and further coming in that market.

Okay, great. Thank you.

Michael Knott, Green Street Advisors.

Hey, guys. Tyler, just curious on the borrowing front where you think you will be able to borrow today, both secured and unsecured, and maybe how much that has changed in the last couple months.

Yes, well, 10 year is, what, at 2.50%, 2.55%? I haven't looked today what it is. So I'd say roughly we're 4.50%-ish, probably on a 10-year deal on an unsecured basis.

We haven't been that active in the secured market recently, but it is probably a little tighter than that I would guess. That market is pretty -- remains tighter than the unsecured market but is less flexible. So I don't know if that is 4%, but I am sort of guessing at that.

I think it is for 10, 4.20% from what I have heard.

4.10% maybe.

Then on the -- you know how that has changed? We did our 10-year deal in January at 3.90%. So it is up 60 basis points from there. Obviously in between now and then, the market -- the Treasury went down, and now it is back up.

So the hottest time we probably were in the 3.70% range and then we did the deal at 3.90% and now it is probably 4.50%-ish.

Okay. When you look ahead to 2014, your lease roll is pretty manageable, about 9% of revenue, I think. Is there anything in there that stands out as something that you are particularly focused on?

This is Jeff. Yes, if you look at our 2014, we've got about 10% of the square footage rolling. We have already renewed the Microsoft at Westlake Terry in Seattle.

We have got two transactions that are 100,000 square feet or more that we are going to get back in the first quarter. But we have already got great activity on those two assets. So other than that it is a pretty smooth roll next year.

Okay. Then just given all the acquisition activity that Kilroy has undertaken in the past years, I just wanted to check in on the Menlo Park acquisition. Curious; it looks like it is still under 85% leased. Just curious how that one is coming relative to your underwriting.

Yes, this is John. I would say that has been a disappointment for us based upon our initial underwriting, although we are seeing some activity. We recently changed the brokerage group.

It is an area that we are very focused on, and frankly I have been very personally unhappy, and I have let some people here know that I am very unhappy. So hopefully we are going to -- I would like to make me and you and all our investors happier on that asset.

That is a very important asset for us to improve upon. We may end up selling that asset.

Thanks for the candid color on that. Then last question for me would be -- I assume that Orange County office is not in the disposition plans if the upper end of your range is $300 million and if you sold -- it sounds like San Diego alone could be a little more than that. So just curious where Orange County sits today.

Yes, I'm going to ask Eli to comment on that, but just a quick one here. As we did mention, we have got more than $300 million in the market right now. And as we did mention, the number, the $150 million to $300 million -- we started the year with $150 million in guidance; we said it could be $150 million to $300 million or more depending upon what our acquisition and development funding requirements are.

Well, we are not in the market on the Michelson building. We are on the market or will be in the market on a couple of the little buildings there that are nonstrategic to us. And, Eli, can you give any more color on that?

Yes, that is exactly right. We are working very actively on every non-Michelson asset in Orange County and have some LOIs on some and are marketing others, and expect to probably deal with the smaller assets over the next 6 to 12 months at the latest. Michelson we don't have on the market; we think that continues to hold plenty of solid value. And if and when we need to, want to pull the trigger for some reason on that, we expect it to be there.

Okay, so it would make sense to continue holding just one building in this market here?

Well, you know, it's easy for us to manage it between -- with our activities in South LA County as well as North San Diego County, and we have people on the ground at the building and so forth. I am never -- I have never been enamored with -- you have heard me all say this before, but probably before you were even in the real estate side of the business, Michael, when we went public 17 years ago, I always said Orange County office is something you've got to be careful to have exactly the right product and you've got to be a timer because of that big beast called the airline company.

So I don't see us being big acquirers there. We will be opportunistic, for sure, if there is a great buy. I don't see any great buys right now.

But from a management standpoint, it is not a problem for us. If it was in Portland or something and we had one asset -- and I am not going to Portland -- but that would be a different thing. But we have the talent and the quality of talent for that building.

Understood. Thanks.

John Stifel (sic), Stifel.

John Guinee here. Sorry about that. Eli, what you guys have done over the last few years is buy and sell from all quadrants, some of your better product with longer-term leases as well as some of your nonstrategic. Just an educational question.

If you have a single-tenant building, decent credit, let's say it's 100,000, 200,000 square feet, $30 net, on a cap rate basis where does it trade if you have got versus a 15-year lease versus 10-year lease versus a 5-year lease? To give people a sense for where the breakpoint is in cap rates relative to lease term.

Yes, well, I will try to do that with -- these will be general; I will give you order of magnitude. But falling below 10 you fall off very quickly, it is more like a cliff then it is a continuum.

Between 10 and 15 it is really more of a slope. So I would say the difference between 10 and 15 is somewhere in 100. The difference between five and 10, that same five years is 250 or 200 just in rough order of magnitudes.

Now that can all be -- there are so many things that confound that. If the 5-year lease is under market and somebody really likes it they could of course pay way up for that and pay more than the long-term leases if they think they can do it. It is also depending on where those prices in those leases end up with respect to replacement costs. If you have a 15-year under-market lease that results in a price that is well below replacement costs, you might see somebody paying a 4 cap for that where the general market -- if that price were at replacement cost, maybe that is a 5 cap.

So there is lots of -- it also depends on how strategically located the product is. So if it is something in a great area and you know you are going to release it and all of that kind of stuff, then -- there is just many moving pieces around that.

But there is a nice slope between 10 and 15, and a quick drop-off less than 10 is the general phenomenon that happens with those, if you hold everything else equal in terms of the different moving pieces that I just described. And there are other moving pieces that I didn't describe.

So taking that to the next level, if you just signed a new 15-year lease, the interest in selling it -- there is obviously a lot of issues -- but the interest in selling it is minor from 15 down to 10 years on the term, and then it becomes significant, particularly if the income buyers are very, very active.

I wouldn't say minor between 15 and 10. It can be quite notable. I think 15 and 10 is -- 15 is much better, but it's -- everything else being equal, the 5 years between 5 and 10 or from debt going down from 10 to 5 hurt you a lot more than 15 to 10.

Got you. Thank you very much.

It is just really hard to talk theoretically here.

Yes, I got it. All right, thanks.

Vincent Chao, Deutsche Bank.

Hey, guys. Most of my questions here have been answered, but just curious on the spread there between -- or the drop-off under 10 years. I guess if people are underwriting rent growth, wouldn't they be inclined to want a little bit more exposure to the earlier lease rolls?

Yes, the risk buyers are, absolutely. The core buyers, the guys who buy -- there is a different buyer pool for a long-term net lease and somebody who is trying to buy some risk,. Obviously, it is more the private equity for the latter, and for the former it is core or very conservative set of buyers who are going to put very modest leverage on it, fixed leverage.

The 5-year thing that has some upside, they are going to put floating-rate leverage on that. They're going to lever it at a higher number. They are going to seek different returns, but they are going to be -- it is going to be very -- there is going to be a lot more assumptions that the 5-year lease term buyer who thinks there is a lot of upside is going to have to put in that to achieve the kind of returns that they ultimately want to receive.

That is why there is no way to really -- you just have to go through this from 16 different ways between replacement costs, rents, location, value, how much demand there is for the product, under market, over market, all of those kinds of things to get it exactly right.

If you look at three years ago when people -- when debt was not as attractive as it has been recently and when the market has been constipated because of the Great Recession, people were more focused on core assets and that method of valuation. Now what we are seeing is with increases in rental rate, with markets that have improved significantly with regard to vacancy, and with increased momentum of tenants in the market and so forth, the value guys are out there in full force.

So to the questions that John Guinee was asking, that is more of a core kind of evaluation. But you are quite right that sometimes -- and I know in our own case -- sometimes when we look at deals we say there is no value we really can add to that thing; we can't be competitive. Whereas if there is roll when you think the market rents are going to continue to increase and the tenant demand is going to go up, there is great value in that profile.

So you are quite right. That is the other side of the equation that you are bringing up.

Yes, and the last thing I will add to the whole thing is the longer the in-place lease term is, the more willing people are to pay a price that looks to be above replacement cost, for two reasons. One is because the effect of the residual price on the overall return is pushed out in time, so it is less effective.

And number two is they expect replacement cost to increase over time. So the more time they have to compensate for those two factors, the easier it makes them to pay up for a good -- a big price per foot on those long-term lease deals.

Okay, think you. That is very helpful. Just one last question, just a final question on the disposition guidance increase. How much of that really was -- obviously you have the acquisition that you now are hoping to close here in the fourth quarter. How much of it was just to pay for that versus maybe just the general conditions in San Diego and some of the buyers you mentioned that are still in the market looking for assets?

Yes, when we gave guidance at the beginning of the year $150 million because we knew we were -- but we said at the time it could be substantially more. Now we said it's going to be $150 million to $300 million; it could be substantially more.

We didn't increase our guidance there because we are buying this asset. I think we have been pretty consistent that we are going to sell into the market.

We have obviously increased our development activity, and we have always said that we want to maintain a very solid balance sheet. So the short answer is we didn't increase it in order to pay for the acquisition in San Diego. If we had more stuff that we would like to buy, we would probably have more stuff that we would like to sell, though.

Okay. Thanks, guys.

Dave Rodgers, Robert W. Baird.

John, at the beginning of your comments I think you mentioned a 400,000-something square feet of LOIs. Can you requote that number for me as well as the new and renewal breakdown?

Jeff, I am in San Francisco so I don't have the same papers in front of me that Jeff does. Do you want to go through that, Jeff?

Sure. Of the 400,000 square feet of LOIs, new is 39% and renewal is 61%.

Any hopefuls for 2013, or is it going to be all 2014 starts from the new perspective?

Say again, Dave.

I guess when you look at the new percentage of that, of the new leases that you are working on there, any hopefulness that those will get into 2013? Or are those going to be '14 deals in terms of (multiple speakers)?

Yes, I think the 400,000 feet was at the end of June, and we have already made progress converting some of those since the end of June. So our guess -- it is hard to know exactly -- there may be 100,000 feet of that or a little bit more might be hitting this year versus next year.

Oh, yes. That's helpful. That is what I was asking. Thank you.

And then, Tyler, I guess when you talk to the rating agencies, if you were to sit down with them today and you looked at two different components, I guess, of income that is coming in the future -- one, the difference in the lease versus occupied percentage today; and then two, the development NOI projected over the next couple of years what percentage of credit for that NOI are you getting?

Is there a direct formula? Do you have good clarity of how much that is counting for you today as you look to deploy more money and manage those leverage metrics?

Yes, that is a really good question because we have that conversation with the rating agencies all the time. It is a struggle, to be honest, because on the development front we have a lot of EBITDA coming down the road here. The first delivery is this year, then LinkedIn is next year, and salesforce and Synopsys are in '15.

So there is no formula that they have that says that we are going to give you 50% credit, or 75% credit. Obviously, all those buildings are fully preleased; so from our perspective they should be giving us 100% credit. But they are really not.

They basically have told us more of it needs to come online before they are going to give us full credit. But again, there is no magic number.

I think on the lease versus occupied I think they are more willing to give you the credit because you have a contractual lease and it is just more certain. Their view of development always is it's more risky. Even if it is preleased, maybe it is the construction risk or whatever.

But it is an ongoing conversation, an ongoing battle to be honest, to get them to understand the value of our development pipeline.

Okay, great. Thank you.

There are no further questions in the queue at this time. I would now like to turn the call over to Tyler Rose for closing remarks.

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

Thank you for your participation in today's conference. This concludes the presentation. You may now disconnect. Have a great day.