Kilroy Realty Corp (KRC) 2013 Q3 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the Q3 2013 Kilroy Realty Corp earnings conference call. My name is Jasmine, and I will be your operator for today. 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 conference 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. Please 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.

At the outset, I need to say that some of the information that 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 supplementals. This call is being telecast live on our website and will be available for replay for the next 7 days both by phone and over the Internet. Our press release and supplemental package have been filed on a Form 8-K with the SEC and both are also available on our website.

John will start the call with an overview of the quarter. Jeff will review conditions in our key markets. 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. We had another great quarter with quality execution across all fronts including leasing, capital recycling, acquisitions, re-development, development, and our balance sheet. We are poised to launch the next set of development projects to expand our portfolio and fuel our growth. Let me start with leasing where we continue to generate excellent results.

We are on pace with last year's record leasing year and signed new or renewing leases on 510,000 square feet at rental rates that were 7% higher on a cash basis, and 21% higher on a GAAP basis. In addition, we have another 639,000 square feet of in place letters of intent. This solid leasing performance continued to boost our occupancy as we ended the quarter with our stabilized portfolio 92.2% occupied and 93.7% leased. We were successful in extracting a $0.05 per share cash payment from a former tenant driving our FFO to $0.69 for the quarter.

We made significant progress in our capital recycling program during the quarter. We negotiated dispositions on 17 non-strategic properties and three separate transactions, and we will recycle the proceeds into higher value acquisition development opportunities. The first of the three transactions, the sale of an older mostly vacant 60,000 square foot property in Orange County closed earlier this month, generating proceeds of approximately $10 million. We anticipate the remaining two transactions for 13 properties all located in San Diego will close by year end.

In acquisitions, we completed our purchase of The Heights in the Del Mar, a transaction we announced last quarter. The class A office campus is located in one of San Diego's strongest sub-markets and is adjacent to our One Paseo development project. The Del Mar market continues to outperform with rental rates for the top tier class A properties, excluding parking rent, now at $42 per square foot per annum on a triple net basis. The Heights includes two existing buildings that are 100% leased and a land site entitled for a future development that currently is anticipated to be under construction by mid 2014. The purchase price for both components was approximately $126 million.

On the re-development front, we're making terrific progress on our renovations at Sunset Media Center in Hollywood, Skyline Tower in Bellevue, and 360 Third Street in San Francisco. In the third quarter, we completed the total renovation of 360 Third Street which includes the largest roof deck in San Francisco. We have successfully converted the 40 year old, former call center building into a top quality, top performing office project which has is now LEED Gold Certified and 96% committed. We expect to achieve similar results at Sunset Media and Skyline Tower when the renovations on these two projects are completed early next year.

And in development, we remain on time and on budget with our five under construction projects encompassing 1.5 million square feet and totaling $860 million. At the beginning of the fourth quarter, we completed and delivered the first of these five projects. The completed project is an 88,000 square foot office property located in Mountain View, a sub-market of Silicon Valley. The tenant, voice and audio mobile technology specialist audience, took occupancy of the property and began paying rent on October 1.

We have also been busy preparing the next set of development projects in our near-term growth pipeline. In the fourth quarter, we expect to break ground on three additional development projects, the new office component at Columbia Square, a new office project named Crossing/900 in Redwood City, and our modern brick and timber style office building at 333 Brannan Street in San Francisco's SoMa district. Phase II of our Columbia Square project, which is located in the heart of a rapidly-transforming Hollywood market, will include two new LEED Gold office buildings totaling 350,000 square feet and a 200 unit residential tower along with subterranean parking.

We are well under way with Phase I the renovation of the historical office buildings and retail and just started construction on the parking structure for Phase II. Leasing discussions for the office and retail space are proceeding well, and we are seeing significant interests from several prominent entertainment users for spaces ranging from 50,000 square feet to 300,000 square feet. We remain on target to start the residential portion of the project late in 2014 and upon completion of all phases, the Columbia Square project represents a total estimated investment of approximately $385 million.

Crossing/900 is our about to commence office development in downtown Redwood City immediately adjacent to the Caltrain station, the major public transportation system connecting Silicon Valley with San Francisco. The two office buildings will be LEED Gold, total approximately 300,000 square feet and have a total estimated investment of approximately $180 million.

Redwood City is experiencing a strong renaissance among both businesses and residents interested in locating or expanding on the San Francisco peninsula. It has a very attractive location on the Bay, close proximity to the airports, to two major freeways, and of course the rail station next door. It is an established urban [vibe] and an amenity rich town center and a variety of housing options. These are all the things that we look for in our new development projects. We're making very good progress on the leasing front. There are about 15 major users requiring 100,000 square feet or greater that are interested in this project.

Our 333 Brannan Street project in the SoMa sub-market of San Francisco provides the appeal of a contemporary work space enclosed in a 19th century brick and timber design LEED Platinum building located in the heart of the city's thriving technology district. We have all the titlements and plans now in place to begin construction on the building which has a total estimated investment of approximately $95 million. Pre-leasing at 333 Brannan is also going well and we are in the early discussions, trading paper with a number of users. Commencement of construction will occur later this quarter.

All three of these projects share some important fundamentals that give us the confidence to move forward with their construction. They are all well located in economically vibrant markets that have strong, long-term potential, decreasing vacancy rates, rising rental rates, a diversity of housing, and excellent transportation options. Each project will be state-of-the-market products that is ideally positioned to capitalize on the growing demand for collaborative and sustainable office space and each project is designed for densities from seven to eight people per 1000 per square foot -- excuse me, per 1000 square feet or greater. And given our attractive cost basis, they are all projected to generate strong returns.

In summary, we continue to renovate, re-develop and renew our portfolio to meet the needs of the modern tenant. We remain focused on the best locations in some of the best markets in the country. We are delivering the type of product that is in high demand. We are constantly improving the overall quality of our portfolio. And we remain leader in the industry in owning and developing LEED and Energy Star Certified buildings.

As I said at the outset, we had a great quarter with quality execution across all fronts. We are benefiting from a strong West Coast platform and experienced team which gives us a competitive advantage as we continue to run our business and make decisions that we believe will generate strong earnings growth and build long-term shareholder value. With that, I will turn the call over to Jeff for a review of our markets. Jeff.

Thanks, John. Hello, everyone. I'm happy to report that all of our key markets continue to exhibit economic growth and improving commercial real estate fundamentals. Across California, most coastal markets continue to see unemployment trending down and job growth trending up. Since the state's jobs market bottomed out in February 2010, California has added over 825,000 net new jobs, including 224,000 in the last 12 months. And in the state of Washington, Greater Seattle's strong demographics continue to create jobs with the second largest year-over-year drop in unemployment among the country's top markets.

Let's take a market by market look. The Bay Area is ahead of the national economy evidenced by job growth and leading edge productivity, and has established itself as the center of technology and information. The region led the nation in tech job growth over the past 5 years with more than a 50% growth rate. San Francisco had an amazing third quarter with both absorption and demand moving closer to peak 2012 levels. While the pace of the last couple of years of megatransactions has taken a breather, we're starting to see demand for the 100,000 square foot transactions increase over the last few quarters. The city continues to have the lowest vacancy rate in the country. We are currently 94% leased in the Bay Area.

Seattle remains a close second in overall performance. Seattle was recently ranked as the sixth strongest overall economy in the country by the US Chamber of Commerce and our primary Seattle sub-markets of Bellevue and Lake Union, class A vacancy rates declined to 2.6% and 3.9% respectively and rents have continued to increase. In Bellevue, there are currently only two available blocks of space greater than 50,000 square feet or so and they are both an older, less attractive product. This has driven class A, CBD rents to its highest level since 2008. Bellevue is benefiting from the continued immigration of companies from the suburbs into the CBD. Tenants that have major operations at Bellevue include Microsoft, Expedia, eBay, Concur, Oracle, and Cisco. We are currently 96% leased in our Seattle properties.

In the third quarter, San Diego experienced its 16th consecutive quarter of positive net absorption, including some large tenant move-outs in the downtown sub-market. More broadly, San Diego, which has the third largest GDP in California, continues to benefit from a unique set of characteristics, a highly attractive place to live and work, a well educated work force, and minimal new office supply. Total office use in employment in San Diego is predicted to grow more than 3% per year over the next 5 years. Our stabilized San Diego portfolio is 93% leased.

Los Angeles remains mixed with overall vacancy for the region still in the high teens. However, markets with a higher concentration of technology, education, and health care companies, including West LA and Hollywood, are experiencing rent increases. At our Sunset Media Center property in Hollywood we are now achieving rents 20% higher than our original pro forma and once our renovations are complete, we expect rent levels to increase further. Across our Los Angeles portfolio, we are now 94% leased.

Company wide, as John mentioned, we continue to make significant progress on the leasing side, including our 2014 and 2015 expirations. Last quarter we renewed more than 280,000 square feet of space with Delta Dental and Microsoft, and we have a 200,000 square foot LOI with another existing tenant for a 2015 expiration. Assuming we complete this transaction, since the beginning of the year we will have reduced our 2015 expirations by approximately 400 basis points from 18% to 14%.

Looking at 2014 lease expirations, we have 1.1 million square feet or 10% of our portfolio expiring with only four leases greater than 50,000 square feet. Two of those expirations are in San Diego in the first quarter. Across our entire stabilized portfolio, we estimate that current rent levels are now slightly below market rates. As a point of reference, early last year we estimated that we were 6% above market. That's an update on our markets and now 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 third quarter which included the $0.05 cash payment related to a prior tenant default. The net $0.64 included $0.01 of acquisition-related expenses, about $0.01 from the equity offering and $0.01 from lease termination fees. So, if you add back these adjustments, our core FFO would have been $0.65 per share, up $0.02 from our internal forecast.

You will note that in our financials we have classified the 14 properties that we are in the process of selling or have sold as held for sale properties as of the end of the third quarter. Excluding the held for sale properties, we ended the third quarter with stabilized occupancy at 92.2%. Including the held for sale properties, our occupancy would have been 91.5%. Our stabilized portfolio is now 93.7% leased.

Same-store NOI in the third quarter increased 1.8% on a cash basis and 1.1% on a GAAP basis. This does not include the $0.05 per share cash payment we received from the prior tenant in the third quarter as this property is included in discontinued ops. It does include legal expenses related to the one-time payment received in the second quarter. Stripping out those legal costs, third quarter same-store NOI on a cash basis would have been up 2.7%.

CapEx was higher in the third quarter primarily due to increased costs for early lease renewals that Jeff mentioned and one significant tenant improvement allowance on the lease executed in 2011. We raised equity capital during the third quarter completing a public offering of approximately 6.2 million shares of common stock at $50 per share for net proceeds of $296 million and our ATM program generated just over $11 million. With regard to capital recycling, we sold a [$15] million LA property in the second quarter and, as John mentioned, we just completed the sale of a $10 million Orange County property. As we mentioned, we are working to complete the sale of the 13 San Diego properties by the end of the year.

Overall, we have full availability on our bank line, approximately $100 million of unrestricted cash, and no debt maturities until late 2014. For the remainder of 2013, we estimate development spending to total approximately $125 million. Our current projection for 2014 development spending, assuming the four under construction properties and the three fourth-quarter starts, totals about $375 million.

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 of the uncertainties in today's economy. Our internal forecasting and guidance reflects information and market intelligence as we know it today. Any significant shifts in the economy, our market, tenant demand, construction costs, and new office supply 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 said last quarter that we would be in the high 92% range. Given all of the ins and outs and the disposition, we now think we will be approaching 93%. We are assuming no additional acquisitions or dispositions. Last quarter, our FFO guidance was a range of $2.53 to $2.63 per share. Taking into consideration the $0.05 payment, $0.03 of dilution from the equity offering over the third and fourth quarters, and the $0.02 improvement in core results, we're increasing our guidance range from $2.60 per share to $2.64 per share.

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

(Operator Instructions)

Your first question comes from the line of Josh Attie from Citi.

So, you're moving forward with Columbia Square, Crossing/900, and 333 Brannan the fourth quarter, and then Del Mar early next year. There's no leasing done at these properties yet, but you did note a pretty active pipeline in your prepared remarks. When we open up supplementals three or six months from now, should we expect the pipeline to be highly pre-leased or do you see yourself taking more risk on this round of projects?

Well, we certainly hope it is going to be highly pre-leased based on the discussions we're having in all of these areas. We have multiple tenants interested in significant space at rents that are at or in some cases significantly above those we have pro forma'd, so we feel pretty good based on the demand that we are seeing and the negotiations that we are having.

Is pre-leasing a requirement for some of these starts in your mind in the fourth quarter?

I've made it clear with regard to the projects that we have mentioned here that we have felt very comfortable for the last couple of quarters that we would start them without pre-leasing, although we think we will have significant leasing during the next several quarters.

And then on Columbia Square, I know you had talked about bringing in a capital partner for the residential piece previously. Is that still your intention?

Well, what we said is we will bring in an operating partner, whether it's a capital partner or not, that -- I don't think we have signaled that, but we do have somebody that we're close to concluding negotiations with. We thought we were going to do it with somebody else. We ended up making what we feel is a better transaction with a better operator that should be announcing I would think in the next quarter conference call.

Okay. Thank you.

And your next question comes from the line of Jamie Feldman from Bank of America.

I was hoping we could dig a little deeper just in terms of the amount of demand in San Francisco, LA, and San Diego. I guess starting with San Francisco, you had mentioned 100,000 square foot and larger tenants seem to be picking up even more. Can you talk about that? And then LA, kind of exactly which sub markets are you talking about where things are better? And then just San Diego in general.

Sure. Starting with San Francisco, I was talking with one of the top brokers in the market earlier today and his view of things is pretty much what we see. And basically what it was is that the leasing in the first half of 2013 didn't look as robust compared to the banner year that we saw last year. On the other hand, what we're seeing is that demand and lease activity has really picked up in the third quarter and his view and I know the view of other brokers and we're seeing this in our own properties is that demand seems to be up substantially now in the fourth quarter. That's what we saw last year as well.

So, the way to think about this is that there are a couple of large blocks of space that I think will get leased within the next 6 to 9 months. And I think what you will see in San Francisco sometime within the next year, maybe 8 months out, is a significant additional spike in rents. We are seeing rents over the course of the last 12 months go from an -- and now this is an average across all buildings -- an average around $50 to around $56 today and people are getting close to asking rents. Obviously some buildings get much better, some buildings don't do as well. If you are a 15,000 square foot user or a 10,000 square foot user and you're looking for commodity space, you can find it in 30 or so different locations within the city. A lot of that is over in the northern financial district. If you are looking for technology, open collaborative space, most of that wants to be over south of Market and people are having a hard time finding that.

In the case of our 333 Brannan, we have multiple requests for those that want to lease that building. It is roughly 170,000 feet in its entirety or substantially and some people that want to lease it, and then have options on the other buildings that we have in the area to accommodate future growth. So, I think what we're seeing now is we signaled over the last several quarters that we were seeing a lot in this sort of 35,000 to 70,000-foot range. We're now seeing quite a few in the 100,000 square foot plus range in addition to the smaller tenants.

It's not a have and have not. Obviously, the north side of Mission has done considerably better as the market has improved, but if you're on the south side of Market, and I said Mission before, but the south side of Market, particularly in the south financial district, and you have space that lends itself more to the larger floor plate requirements of the technology crowd, you have something that is in very high demand. So, I think we're going to see continued very strong leasing based upon everything we're seeing in a renewal and some of the bigger requirements.

The other thing that I would point out that has happened in San Francisco over the course of the last 10 years, and of course we have been here for 4 so we are kind of newcomers, but this has been highly spoken about by many people who watch the transformation of San Francisco, is it truly has become a 24/7 city. The amount of people living in San Francisco now versus 10 years ago or 5 years ago has substantially increased. There has been thousands of residential units that have been finished and leased. There are thousands more under construction that are spoken for. There's thousands more to come. You're seeing the gentrification of Potrero Hill, Noe Valley, these different communities where historically weren't known as real bedroom communities and now are. You're seeing the retail and all of the other amenities and of course the public transportation that goes along with it. So, there really is a remarkable shift and transformation that has gone on in the city and we're very proud to be a part of it.

Moving down south, Silicon Valley --

If I can interrupt for a second though, can you talk a little bit about the risk of supply?

Okay. Well, yes, there is supply coming on stream and some of that has been talked about for a while, but just bear with me for a second, Jamie.

In terms of San Francisco, right now you have Foundry Square 3 which is 285,000 square feet. We understand that that building is somewhere in the neighborhood of 80% leased now or greater based upon what the brokers are saying. You have 535 Mission which is 290,000 square feet which is next to our 101st building on Mission Street which Boston Properties is doing. I don't know what their leasing status is. That is a building that has smaller floors. You have 50 Hawthorne which has 53,000 square feet. That's a Boston Properties building and they can speak to that more clearly than I, but I'm sure it will do very well.

You have 333 Brannan which is 170,000 square feet that will come on and -- those buildings that I just mentioned, by the way, Foundry Square 3, 535 Mission, and 50 Hawthorne all come on stream either early or late 2014. In 2015 you have 333 Brannan which is 170,000 feet. You have 222 Second Street which is Tishman Speyer and JPMorgan 450,000 feet which is a, I think, 27 story building. You have 270 Brannan which is 200,000 square foot building and you have 345 Brannan which is currently in an appeals period so I don't know when that gets done, but that's about 100,000 feet.

And then looking at 2015, assuming this project proceeds as quickly as possible to completion, you have 181 Fremont, which is a combination condo, tower, and office building on the lower levels, has about 400,000 square feet of office. And then in 2017, plus or minus, you have the Transbay Tower and you could talk about some properties about that and get a much better view as to what is happening there. And then you have the buildings that get renovated or whatever that would add to the supply.

And of these buildings, I think the ones -- we've had an opportunity to do several of these things. The buildings we really like are the -- Foundry's done, 333 Brannan. The other buildings on Brannan I think are going to do extremely well because that is really where people want to be the most and if you look at the rent on triple net basis, other than high floor, high view of the bay from the financial district, the Brannan buildings I would say get almost the highest rent per square foot on a triple net basis because they're getting $60 plus rents with a $12 operating cost. So, I don't see supply as being a worry. I think are going to be some buildings within the supply group that are not as appealing to the area where you see the strongest demand, but that remains to be seen.

Moving to Silicon Valley, there is about 3.4 million square feet under construction. If you exclude the corporate campuses that are being built by Apple and Facebook and Google and so forth, of that 67% is pre-leased and is based upon what we're hearing, I think a good deal more of that will be leased before it is delivered. And then moving down to LA, you asked what markets we like the most. Obviously, we like the west side and we like Hollywood. Our Long Beach property, we are not going to build any more there I don't think, but we like that location. It has served both counties very well. Sort of ambivalent of the rest of LA and never been a big fan of downtown.

In terms of San Diego, I really like what is happening in the Sorrento Mesa market and in the Del Mar market. In Sorrento Mesa, bear with me for a second, in the class A you have a vacancy of 7.2%. You have asking rents that are in the sort of low 30s triple net. I think if you did a new building there, you would command a significant premium to the rents I just mentioned. There is a once -- excuse me, there is about one space of 25,000 to 26,000 square feet that is available in terms of blocks of larger space, so I like that market a lot and there is very strong demand.

In terms of also in San Diego in Del Mar, like what's going on there. Rents are now in the $42 triple net range plus parking. I think those are going to grow. That is the top tier class A. The vacancy rate is single digit if you look at top tier class A, if you look at all class A which is anything over a four-story building no matter when it was built, it is about 11% or 12%. We think that market is going to do very well based upon discussions we are having in that area.

And then not to short Bellevue, Washington, and Lake Union. Lake Union has got a number of buildings that are underway or planned, most of which are pre-leased, we're not building anything there. We don't have anything under construction nor do we own a development site in Washington at this point, but we really like what is happening in Bellevue. Rents are -- the high point before was about $35, $36 triple net plus about $6 for parking on top of that. The market hasn't reached that but I think based upon the deals we're doing now, we are about $33 triple that plus the parking.

There are only two buildings that have 50,000 square feet in them. They are both older, 1970s style buildings. You're seeing a big increase in the number of people that want to move into Bellevue and Lake Union from the suburbs. That continues to be the trend we see throughout all of our markets and there again you have a vibrant downtown 24/7 living, amenities, et cetera. So, that's kind of what's going on in our markets. Long answer.

Great. Thanks. Appreciate it.

You're welcome.

And your next question comes from the line of David Toti from Cantor Fitzgerald.

Two quick questions. The first, you have spoken quite a bit, John, about market strength and we have seen it first hand touring some of your markets recently, but it seems like the tenant improvement numbers continue to tick up and I know those are kind of lumpy. But are you seeing a commensurate improvement in sort of tenanting costs that is going along with some of the sort of pricing power in the market strength or is that really going to lag into next year in your opinion?

Well, it bounces around. One thing that we typically do, frankly, sometimes we get criticized for it, but we tend to do longer leases than shorter leases. So you end up with a little bit more TI allowance, but it's lumpy. Tyler, you've got the math. I mean it was up this quarter over last quarter. A lot of that just deals with the nature of the transactions. It is kind of all over the loft, but I think any time you see an improvement in market demand, particularly when you get down into under 10% vacancy, that generally you have to give less TI and you get better rents and you have all of the other terms and so that's the trend I think we are going to see. It's just lumpy.

We might see some strengthening in the beginning part of next year, more of a 2014 event?

Yes, again, it depend on the assets and the markets. I mean as Jeff mentioned all of our markets are seeing pretty good fundamentals. Some are infinitely better than others. I mean it's hard to compare San Francisco and west LA or San Francisco and San Diego, but I do think we will see a trend, but there will be the occasional lump here and there. That's just the nature of our business.

Okay. And then I just have one very left-field question. Have you guys considered partnering with BXP on the Transbay project?

No, we didn't consider it before BXP, we haven't considered it -- we haven't been asked.

All right. Just curious. Thanks for the details.

You're welcome.

Your next question comes from the line of Gabe Hilmoe from UBS.

Maybe a quick question for Jeff. In terms of the 2014 lease roll and I guess the million square feet expiring, are there any known move-outs expected that we should be thinking about?

Yes, as I mentioned in my remarks, we've got two in the first quarter in San Diego, they're both 130,000 and another building is 120,000. One of those we have actually re-leased and we've got activity on the second. Then we have got a 60,000 square foot building in the third quarter in San Diego that's likely to move out, although we don't know for sure. So, out of the four leases or 50,000 square feet, I dealt with three, the other one is in LA and we are in the process of renewing that one.

Okay. And then, John, just a quick one for you. Just on the comments regarding Seattle and the occupancy and rent trends there, where does that market need to get to where you become more comfortable expanding in a bigger way there?

Well, I would love to see us grow for the right assets. I mean we are -- I don't want to say a slave, but we are very, very focused on what I call my circles and squares. If it's not in a zone we want to be in, we're not going to do it. If it's not a building with the physicality that we can develop or buy that really fits the modern tenant, we're not going to do it. And then of course it's a question of whether we can make money and so forth.

With regard to the two markets that we like up there, South Lake Union, we bought there and we're not developing anything there unless we find something that is unique. I think we have missed most likely the South Lake Union build development in this current cycle because there are too many people ahead of us. Things could change. We could end up partnering with somebody. We're not having any discussions to that. So, I mean who knows.

In Bellevue, it's -- we bought the buildings that we thought were really good. We passed on the other ones that came up. There are some more that are going to transact. They are older 70s or 80s style buildings that don't fit our square, don't fit our physicality. They are well located. I just don't get real comfortable with that. From a development standpoint, there are a couple of sites that can be developed in Bellevue, there's a handful of them. Some are far better than others and the rents are not far off from where ultimately it could justify construction.

We're looking at those kinds of things as we do in each and every market. I'm not signaling anything, but I think we're at the point where we have moved pretty quickly in this cycle in my view up and down the coast where it went from you could acquire at a big discount to replacement costs, great assets, or assets that you could value add to great asset in core markets, core product. That's gone other than at the margin.

And the value-add stuff in the great areas there is still some of that, you got to work harder and we think we're a sharp shooter and we managed to pull in some of that. And of course development is an area that we have that is a particular core strength of the Company and it's one of the reasons you see us talking about it because I don't like to develop empty buildings, I like developing leased buildings, I like developing when have you multiple tenants who are interested in space, seriously interested at rates that make sense, and I think we will see some of that in the greater Bellevue Washington area and that's likely where we would grow first. Having said that, watch, something will come in tomorrow that Eli will bring in that makes sense that is an existing acquisition, but I say that a little kiddingly. I just think acquisitions are really tough right now.

Thank you.

You're welcome.

Your next question comes from the line of Craig Mailman from KeyBanc Capital Markets.

Just curious on the San Diego sale, are you guys willing to give a contract price on that or maybe just ballpark how far above book?

No, we're not going to discuss purchase price at this point. As John said, we're hoping to close by the end of the year and we typically don't discuss the purchase price until we close the transactions and we had put the carrying value on to our balance sheet for the held for sale but that really has no relation to the purchase price, so you can't really use that number.

I guess maybe another way, are you guys going to blow through the high end of $300 million disposition guidance for the year?

We are feeling comfortable with where we're at.

Okay.

That is as far as we are going to go until the people have gone hard to close in December, but one thing that we've learned and I may put my foot in my mouth too many times on these calls talking about deals, and everybody reads our transcripts, whether it's our competitors that are private or public or tenants or brokers and sometimes it works against us in negotiations, so we have to be a little bit more cautious.

That is fair. And just curious moving to San Francisco. You guys were early, have kind of benefited from that, and you're still developing there. Just curious what your thoughts are on potentially taking some chips off the table there to redeploy into the developments rather than sell assets on the markets or hit the equity market again?

We're always looking. We got a building or two that we're looking at, nothing that I want to signal at this time. Most of the buildings are multi-tenant. There is still a lot of upside we think to manage the roll overs or the renewals in those assets, but we're obviously -- we're not married to any asset. I love all of our buildings and sometimes I love it when somebody else buys them at a great price.

Great. Thank you.

And your next question comes from the line of Vance Edelson from Morgan Stanley.

Hi, thanks for taking the questions. First, on the penny of acquisition-related expense, we haven't seen that called out since I think the fourth quarter of last year when you were very active acquiring, in fact we had a couple of quarters or maybe just one that had acquisitions but no special mention of the expenses. So, is the $0.01 this quarter largely in line with what you'd expect for one acquisition or for any reason were the expenses higher this time?

There was no particular reason to call it out from -- whether it was higher or lower. I mean we had the one acquisition during the quarter which was the main -- we look at several acquisitions and there are some costs with dead deals as well that we have to put into that account, but most of it related to the Heights in Del Mar.

Okay. Great. And then on the future development pipeline in San Diego, it's still largely TBD on the start date. How does this fit with your big picture views on San Diego? You've obviously provided some pretty favorable commentary for a quarter or two in a row now. So, in your mind when might it make sense to proceed with some of the projects?

I can see starting what we call Lot 8 which is in Sorrento Mesa, it's about a $75 million, 180,000 square foot office building. I could see the potential of starting that sometime in the not too distant future based upon visible demand and the paucity of space that is available in class A. I could see starting the building that we -- that I mentioned in my comments that is -- it is roughly somewhere around 80,000 feet plus or minus, it is part of the Heights in Del Mar. We're having discussions with people on that building right now. The numbers make a lot of sense.

And then we have some negotiations going on that we've mentioned before in connection with Santa Fe Summit with a major user and most of you know who it is and I'm not going to verify that it is who you think it is or not just because I don't want to go there. But we have a potential transaction that is very early, too early to handicap but we are having discussions for somebody that would take all of Santa Fe Summit plus some property that we would acquire next door, and that could be a very large transaction, very large.

Okay. Very helpful. Thank you.

And your next question comes from the line of Michael Knott from Green Street Advisors.

Everything sounds mostly positive but I'm curious on, it looks like you're getting a nice occupancy pop from selling the San Diego assets, but it sounds like the full year or -- excuse me, the year end occupancy guidance is not really changing that materially. Just curious if you hadn't done this sale, would your guidance be coming down a little bit in terms of that specific occupancy figure or am I just not processing that right?

A little bit. It would have come down -- again, within a range, we're talking 50 basis points, but it would have come down potentially a little bit. In our original forecast, which had included the disposition properties, we had assumed some leasing in that portfolio. So, that would have helped the numbers, but we think we will do a little bit better than we had done before.

Okay. And then just looking at the light roll for 2014 and then also in 2016, is this going to be the part of the cycle where we start to see exceptionally high occupancy rates for your portfolio like we've seen in the past, just because of the roll is going to be -- you have mitigated some of that?

That is the plan.

Okay. And then rents expiring next year, a little bit below your portfolio average, and it sounds like the portfolio average is below market. Is that even more true of next year's expiries?

Yes, for '14 our current projections are roughly $0.04 -- 4%, 5%, sorry, under market.

And then any color on One Paseo? It sounds like the homeowners there and the local groups are still somewhat against your project.

I think there is always a loud minority that are against everything. We feel that the project is far better positioned now than it was earlier in the year when we had this disgusting mayor down there that had his hand out everywhere, including in places he got thrown out of office for. I guess that is the best way I can say it, but we've had very constructive meetings with the planning department and so forth and we're optimistic that we are going to see approval next year, and if we do, we think we have just an absolute home run project.

Okay. Thank you.

You're welcome.

Your next question comes from the line of Brendan Maiorana from Wells Fargo Securities.

I just wanted to get a little more detail, I think you guys had mentioned 639,000 square feet of leases under LOI. Can you just kind of give a break out of what is maybe new leasing versus renewal and sort of what that implies for occupancy? And maybe, John, as you said does that sort of portend that you could reach those very high occupancy numbers next year given the level of leases under LOI?

Tyler, you or Jeff want to deal with new versus renewal?

Sure, this is Jeff. On the 639,000 of LOIs, 51% is new and 49% of that number is renewal.

Okay. Thanks. And if I look at the spread between the leased and the occupied rate, it is 150 basis points today. How do you think that is, is that a good mid cycle number for KRC or do you think that you can kind of narrow that spread such as the occupancy moves up even if the lease rate doesn't as we look out over the next several quarters?

Really, it is hard to predict that spread because if you do one large lease it can move that number substantially. I think the 93-7 lease, once you get to sort of 94, 95, you're at frictional vacancy, so I don't think your lease percentage is going to go much above that, but it is hard to handicap that spread.

Okay. Fair enough. And then, Tyler, I think we talked a little bit about this last quarter but it seems like the expense, the operating expenses have been higher this year. And maybe there are just some anomalous things that have happened in the quarters, but is that something that we should expect the OpEx to start to normalize and flat line as we go out over the next few quarters or do you think that there's still just pressure on operating expenses and the increases are likely as we go forward?

Well, some of those operating expense increases are related to the legal fees that we've incurred as part of the one-time gain we got in the second quarter, as I mentioned. So, that shouldn't continue to hit the numbers on a normalized basis. So we also had utility, insurance, and tax increases, and some of that we get recovered on, so I wouldn't expect the same level of increases because we, over time, are going to work through those legal issues and we won't have those legal expenses.

So as we kind of -- I mean is this year just seem like it has been where you guys have been hit a little bit? As we go out next year, if you're able to get revenue increases comparable to what you've shown, your same-store numbers probably likely move higher?

Yes, I think so. Again, we haven't given guidance for 2014 yet and we will do that on the next quarter's call but our margins average in the 70% range and that should continue. At this point, we think we should see more improvement next year, but we will provide more details on that on the next call.

Sure. Fair enough. Thanks.

And your next question comes from the line of John Guinee from Stifel.

Great. Okay. Thank you. In anticipation of NAREIT in a few weeks, probably Eli but maybe also David Simon wants to chip in, can you talk about what's on the market for sale and what kind of pricing you are expecting in the big deals that are floating around in each of your markets?

This is Eli. Look, in terms of just specifically, we had talked a long time about Q4 being an increase in what's available and we have actually seen that. Right now, I would say that in the market, there are two really super core assets. One is Century Plaza down in Century City that Dave can talk about if we needed to get into the details, and up here 101 Second Street which I think each of those, at least parts of that, particularly the good building down in Century City, the best building, are really core and it's attracting very, very international attention. And then more broadly we have seen a whole smattering of I would call second to your core, if you will, here in San Francisco, in Silicon Valley.

So it has come to pass that there have been more offerings, and I think that the core pricing is going to be as strong as we've seen it in terms of price per square foot and in terms of cap rates. The debt markets are functioning really well and the depth of equity capital is really strong. As John said, it is very, very tough out there. I don't think that means we are blanked out of the market. There are -- have always been seams that we can mine, whether it's a relationship, whether it's a broken process, whether it's a real high value add, whether it's a sharp shot or whatever it might be or kind of a year-end type situation, so we may still find them, but it is extremely, extremely competitive. It hasn't relented at all and would say it has firmed up since the last call and continually over time.

Before David gets in there, this is John, and there are some pretty good recent examples. There's a building that was formally the Twitter headquarters that it's pretty well located, it's not too far from our 360 Third, it's not as prominent a street and so forth, that building's address is what?

795 Folsom.

795 Folsom. That building went for $600 a square foot and it is kind of in the condition that it's a little bit better on the inside and it's pretty well leased, 80% or so, but it's a building that's kind of in the condition that 360 Third was when we first bought it with not as good bones and that is pretty strong pricing. That deal requires that sort of everything go right and that the credit of the tenant stays solid, and you're able to make deals in sort of the mid 60s, isn't it Eli, in order to scrabble out a 6% return or so in due course.

So, there are buildings like that that are traded very dearly for what they are. And then as Eli pointed out, there is some of the real uber core stuff that every sovereign and most major insurance companies or whatever would love to own that are going to trade at cap rates that are probably in the 4s and at high prices per square foot and we're seeing it all. What we've really seen a lot is money that has flowed also to suburban markets. We've taken advantage of that in San Diego just because they're trying to find better yields.

Thanks.

I had a couple of --

Go ahead, David.

No, I was just going to add a couple more, John, on the west side. Lantana was a big sale, high 600s a foot. To Eli's comment on Century City, an older building traded -- the Commonwealth -- north of 600 a foot. As Eli said, Century Park, the towers are going to be uber core and going to be really thin yield, and the price per foots are going to be potentially record setting in there. So, the quality stuff and the core stuff is really trading extraordinarily rich pricing right now.

Where are these numbers relative to replacement costs, John?

Well, it depends. Until some of this stuff transacts, I think the stuff that the pricing we've heard rumors about with regard to what this big asset that several million square feet in Century City goes for, if it goes for what it is rumored to be, that will be above replacement cost a fair bit. In San Francisco, I don't know what 201 Second is going to go for. And so replacement costs I think has gone up substantially in most of these markets simply because with the development, with construction going on, there are a lot of hospitals, a lot of apartments, there are some office buildings, et cetera, commodity pricing has increased. Steel has gone up, concrete has gone up, et cetera, labor is certainly not coming down. So, where things are with replacement costs, I can't -- until we see some of these things transact, I don't know.

I can say some of the buildings that have transacted that have been older buildings that have good floor plates and so forth have transacted way above what they originally cost. Some of these things you couldn't get approved today. Like our 360 Third building which we're now 96% committed, you could never get that building approved in that area of the city because they want tall little skinny buildings with tiny little floor plates. So, kind of wandering around in my answer, but we're seeing some transactions that are certainly going above replacement costs. I think replacement costs we're going to see go up substantially over the next few years, guys.

Great. And just David Simon, just to confirm, the Commonwealth deal with the private guys not the public REIT I think, right?

Yes.

Okay. Thanks.

And your next question comes from the line of Vincent Chao from Deutsche Bank.

Just wanted to go back to the 1Q expiries that you know about. One of them sounds like you've already addressed and one there is activity on, but just curious how much downtime, if any, that you expect on those?

The one that we re-leased, the lease expires end of February and commencement date is, I believe it's August of next year, so that is the timing for that one. The other one again we have activity but we haven't landed a deal yet.

Got you. Okay. And then just going back to your comment, John, about the material costs going up and labor costs going up, I'm just curious how much inflation you've seen in development costs and construction costs overall maybe on a year-over-year basis here recently?

I can answer that to the best of my ability but I don't have Justin Smart, some of our guys here who deal with that every day and every market could give you an answer. So, with that proviso, we've seen not everything go up and not in every market. Southern California is still fairly, is holding fairly good compared to San Francisco which has definitely escalated. Seattle has held for the past 8 months pretty steady, but let us talk about that in our next call or call us, call Tyler and we will get you better data there. I just don't want to speculate. I just don't have it in my head and I don't want to put my foot in my mouth.

No, that's fair. I will do that. And --

I am Irish, so I have done that enough.

Okay. Just going back to the markets, I mean you gave a tremendous amount of color on supply, demand in each of your markets. Just curious if you could maybe boil that down a little bit and as we think about, or as you think about, market rents for next year, how do you see those trending in LA, San Francisco, Seattle, San Diego?

Well, rents have gone up. If we take San Diego, we have seen some pretty significant increases in rents over the past couple of years in Sorrento Mesa and Del Mar to the point where we're feeling pretty comfortable that with the visible demand we see, we are going to be able to get very good rents. That's not even throughout San Diego by any stretch of the imagination. It still is -- I kind of break it down this way, okay? Let me just step back.

We, through our dispositions over the course of the last two years with what we have in the pipeline to sell now and the 500 million we sold last year, we basically transformed the Company increasingly towards CBD, more urban-type space or what I will call sort of super suburban. And by super suburban I'm talking about spaces where there's clusters where people want to be that has very similar characteristics to the urban areas and the technology areas where people want to be, transportation, et cetera. And the rents that you see in those markets are escalating at far greater rates than they are in, call it, typical suburbia, and it is because those are the places where people find that they can attract and retain the most important ingredient they have in their industries which is their people. And people costs represents roughly 80% of most people's cost structure in these technological companies and real estate represents sort of 5%.

So, if you can pay a little bit more for your real estate, but attract better people and retain them, it is tremendous leverage. So, those are where you are going to see the highest increases in rent and those are going to be markets that we are very focused in, and like Lake Union, like Bellevue, like Hollywood. Hollywood, we have seen 20% increase in rents over the last year or so and I think we are going to see substantially more for truly class A space. Most of what is called class A in that market is not class A, it is junk.

On the West Side, I think you are going to see increases in rent, I'm unwilling to project what it is going to be because everybody talks about $3 rents or $10 rents and obviously $10 rents are not going to go up as fast as $3 rents for similar products. In San Francisco, I would be -- we have seen rent increases, average rents from the early 50s to the mid 56s over the course of the last year. I think you will see a significant spike somewhere in the next year, and whether that spike is $5 a foot or $10 a foot, I don't know. It is not going to be for the commodity space, it just won't be until that space gets consumed. Directionally, I think we are going to see some pretty good spikes based on the demand and based on the supply characteristics.

In Redwood City, to give you an idea, the deals that we are negotiating down there all are in the $50 plus triple net plus parking rents per square foot, all of them, and sometimes well north of that. And that is up over -- the rents in comparable projects a year ago were in sort of the $36, $38 triple net range. So, it kind of gives you directionally, I know I'm jumping around, I can't get real specific about any particular market at any given point in time because it changes so dramatically and it's -- what we're seeing though is a continued trend of people moving out of suburbia, into these super suburban or CBD-type environments for all the reasons that you have heard me mention over the past five years and I don't see that changing. So, that should be good for rents.

Sounds like it. Okay, Thanks, guys.

You're welcome.

And your final question comes from George Auerbach from ISI Group.

Thanks. John, I know you're reluctant to talk about transactions before they close, but just on the developments it sounds like you have a lot of activity. What do you think the odds are that you have a significant pre-lease at one or more of the three new build to suits -- I'm sorry, one of the new three starts by this time, by your next conference call next year?

You mean by the fourth quarter conference call?

Yes.

I think we should have something based upon what we're doing now, but I don't want to jinx it, George. Unfortunately, I don't get to make the decision when the other people sign and one thing I have learned with, particularly the entertainment companies, they are slower than molasses because they have so many different constituents that they have to bring together. And in the case of some of the people we're dealing with there, these are major consolidations, so you're talking about multiple groups and all of the kittens have to be heard, make I'm mixing metaphors, but everybody has to sort of buy into these things and that is a process.

With some of the tech companies that we're dealing with and some of the other legal firms, et cetera, up in the Bay Area, I can tell you that most of these people have occupancy requirements that suggest they need to make a decision very soon. So, that is why I think we will be able to announce something. On the other hand, I don't want to get pinned down. I'm -- one thing that I do like, and David Simon points this out to me regularly as do some of our other people, is that while we've been negotiating with some of these folks, the markets are continued to improve with regard to where rents are and where availabilities are. So, I like that trend, but ultimately as I always tell our people, we are not -- I'm not into running around between the 20s. I'm into scoring and scoring is ultimately you got to put the tenant -- you got to get into the end zone with the tenant and I think we are doing a very good job making substantial progress on almost all fronts. So, that's a long way of saying I hope so.

No, that is good color. And lastly, Tyler, just in terms of funding for the development spend, you have $200 million of cash plus the sale proceeds coming hopefully in December. Given the $500 million or so of development spend you laid out, is it fair to say that the capital raising is excluding any new starts or acquisitions pretty much behind you?

Well, based on the numbers you just laid out, we have $100 million of cash, not $200 million of cash but, as you say, we have a fair amount of capital right now, so a near term financing, whether it is debt or equity, it doesn't seem necessary, although interest rates are pretty attractive right now. They have declined 50 basis points over the last month or so and so would we do a bond offering right now? Probably not, but we need to think for the future as well and you don't know on an acquisition front if we find something. So, I can't say that we are not going to do more financing. From just what you laid out, if there were no new acquisitions, no other development starts, yes, we have capital.

Great, thank you.

And there are no remaining questions at this time. I would like to hand the call back over to Mr. Tyler Rose for any closing remarks.

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

Ladies and gentlemen, that concludes today's conference. Thank you for your participation. You may now disconnect. You all have a great day.