Kilroy Realty Corp (KRC) 2015 Q3 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the Q3 2015 Kilroy Realty Corp Earnings Conference Call. My name is Caroline and I'm your Event Manager for today. At this time, all participants are on listen-only mode. We will conduct a question-and-answer session towards the end of the conference. (Operator Instructions) As a reminder, the call is recorded for replay purposes.

And now, I'd like to turn the call over to Tyler Rose, Executive Vice President and Chief Financial Officer. Please go ahead sir.

Good morning, everyone, and thank you for joining us. On the call with me today are John Kilroy, Jeff Hawken, David Simon, Heidi Roth, Mike Sanford, Rob Paratte and Michelle Ngo. 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 packages have been filed on a Form 8-K with the SEC and both are also available on our new website. John will start the call with a review of the third quarter; Jeff will discuss conditions in our key markets; I'll finish up with financial highlights and a review of our updated 2015 earnings guidance that we provided in yesterday's release.

Then, we'll be happy to take your questions. John?

Thank you, Tyler. Hello everyone and thank you for joining us today. Let me start by addressing the recent articles and questions related to the strength of the tech sector generally and the San Francisco market specifically. While we are always on the lookout for signs that the real estate market is changing, for both the good and the bad, we currently see nothing on the ground in our discussions with tenants and business leaders or in specific real estate statistics that suggests that the cycle has turned.

UCLA Anderson and The Economist are forecasting two more years of expansion. Revenue producing technology companies continue to grow and benefit from the proliferation of the internet and mobile devices and West Coast real estate markets continue to build strong momentum, with fundamentals improving in all of our submarkets including San Francisco.

Quarter-over-quarter, we saw demand increase for large blocks of space due to supply stayed limited and rental rates continue to rise. Sublease space fill in San Francisco and Silicon Valley had a 10-year high in absorption. In our discussions with Executives of large technology companies about their internal studies on head count, they note that San Francisco and Seattle remains the top markets in the US for attracting talent. We see this in recent reports on tech job openings, which remain robust.

San Francisco reported over 3,500 tech jobs to fill; Seattle reported almost 3,000 and Los Angeles reported more than 2,200 tech job openings. We also saw Google, Microsoft, Apple, Amazon and others recently report stronger than expected earnings. We don't want to sound Pollyannaish, we acknowledge that it's a risk to current economy and we are mindful of the importance of venture capital funding to the tech industry, particularly with the start-ups.

We just aren't seeing deterioration in the fundamentals. In fact, the level of demand both in Silicon Valley and San Francisco has never been stronger, as evidenced by the data. San Francisco has had 1.5 million square feet of net absorption so far this year, with another 500,000 square feet projected for the fourth quarter. There are currently 26 San Francisco requirements of over 100,000 square feet, up from 15, last quarter and only two spaces of that size are available.

Silicon Valley has already had one of its strongest absorption years with projections for a very strong fourth quarter and we're seeing demand increase in all of our markets. In San Francisco, demand increased from 7.8 million square feet in the second quarter to 9.2 million square feet in the third quarter, an 18% increased. In Silicon Valley, demand increased to 9.4 million square feet from 8.2 million square feet in the second quarter, a 15% increase.

Seattle increased about 25% to 30% third over second quarter. With a strong market conditions, we made solid progress during the quarter. We wrote newer renewing leases on 385,000 square feet of space in our stabilized portfolio, putting us just over 1 million square feet year-to-date. We are now 95.6% occupied and 97.2% leased. Rents in our third quarter leases were up 39% on a cash basis and 53% on a GAAP basis.

We also have approximately 400,000 square feet of letters of intent outstanding in our core portfolio. On an adjusted basis, we produced a year-over-year increase in cash same-store NOI of 5.4%. We delivered 100,000 square feet of office space to NeueHouse at our Columbia Square mixed-use project in Hollywood. We completed the acquisition of 100 Hooper Street, the last fully entitled shovel-ready development site in San Francisco for $78 million. We effectively settled all remaining outstanding issues with our surrounding neighbors regarding the development of our One Paseo mixed-use project in Del Mar and are moving ahead on entitlement and design.

We completed the sale of six non-strategic properties in San Diego for gross proceeds of $163 million. We completed the sale of $250 million of equity to help fund our current development program and we issued $400 million of 10-year bonds to replace maturing debt, and maintaining the strength of our balance sheet. We also continued to make progress on our development program. In addition to delivering the historic office space at Columbia Square last quarter to NeueHouse, we completed and delivered the first building at our Crossing/900 projects earlier this month. We expect to complete and deliver the second building in early November. The two building 339,000 square foot office property located in downtown Redwood City in the heart of Silicon Valley is fully leased to Box.

We commenced construction, just two months ago, on our Exchange at 16th project, our 700,000 square foot development project in Mission Bay. We are in negotiations and have significant interest from a variety of tenant prospects both tech and non-tech. Of the roughly 2 million square feet plus of interest for this facility, approximately 60% is non-tech. And I might add that the demand numbers I gave you on San Francisco don't reflect a shadow pipeline where we've signed NDAs with several people that represent millions of square feet beyond that nine-point-some-odd-million square feet of current demand. So we think things are shaping up very nicely for the Exchange.

So we anticipate and we're confident that The Exchange will be substantially leased well before completion of construction, which is not scheduled until the third quarter of 2017. And earlier this month, cash rent commenced on Phase 1 at our 350 Mission Street project, The 450,000 square foot SOMA office tower is fully leased to Salesforce. Tyler will discuss revenue recognition later in the call.

With regard to our near-term development pipeline, our four projects remained extremely well positioned for potential starts next year. First is, 100 Hooper Street. As we have previously discussed, we can start construction at any time, but we'll likely wait until we have executed a significant portion of the leasing on The Exchange or on Hooper itself before we break ground. Since acquiring the site three months ago, we are in early stage discussions with a handful of both tech and non-tech prospects, any one of which could take substantial space in or a majority of the project.

Second is One Paseo in Del Mar, our mixed-use development project that will bring much needed contemporary office, residential and retail space to the very affluent neighborhood of Del Mar. We made significant strides this year with our neighbors and community groups to settle all the issues and let's move forward on the approval process and we anticipate being able to start construction mid next year of one or more phases depending on market conditions.

Finally, the near-term pipeline includes the Academy in Hollywood and 333 Dexter in South Lake Union, both projects located in strong and vibrant markets. We expect to have final approvals on both projects by the end of the second quarter. Taken as a whole, these four projects represent a near-term development pipeline with a preliminary estimated investment of approximately $1.5 billion.

Looking further out, we continue to make progress on expanding and designing a world-class destination at the Flower Mart in San Francisco. We recently completed the acquisition of a 0.5 acre site to add to our development plans, Subject to final entitlements and market conditions, we expect to commence construction in approximately two years and estimate the total investment to be slightly over $1 billion, including land.

In total, our overall development pipeline acquired at a very attractive basis provides a tremendous opportunity to create value over the next several years. Each project is distinctly situated in highly desirable sub-markets that provide the infrastructure we seek, including public transportation, retail, residential and entertainment amenities, as well as communities that embrace historical or iconic elements.

Turning to dispositions, through the end of the third quarter, we completed the sale of 10 buildings encompassing more than 1 million square feet of space in a land site in Orange County for total gross proceeds of $335 million. That puts us at the high-end of our projected dispositions for the year. But with investors showing strong ongoing interest in acquiring commercial real estate and the continued disconnect between public and private valuations, we continue to look at additional opportunities to sell non-strategic assets and recycle the capital into higher value creating opportunities.

We are currently working on another relatively large disposition transaction that will likely close in the first quarter and expect to have more details to share on this front on our next call. More broadly, as I said earlier, the fundamentals across our markets remain strong. We believe the markets we operate in are uniquely attractive to growing companies given their access to talent, public transportation and cultural and lifestyle benefits that appeal to a generational force.

We are taking nothing for granted and are [sober] with regard to the cyclicality of our business. We've operated in West Coast markets for more than 65 years through multiple cycles. And our track record as a public company shows that we develop when it makes sense, we acquire when it makes sense and we just manage our core portfolio when that makes the most sense. We will continue to operate with this investment strategy. On the operational front, we remain focused on our top priorities of leasing, capturing in better rent growth, on-time and on-budget construction, and financial strength.

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

Thanks, John. Hello, everyone. Economic conditions across all of our markets remained strong. California continues to add jobs at a robust rate and forecasters now project the state's job and GDP growth will consistently outpace the US through at least 2017. A similar story is unfolding in the Greater Seattle area, where unemployment has now hit an eight-year low and job-creation continues at a rapid clip.

Let's take a look at the real estate fundamentals in each of our markets, starting with San Francisco. San Francisco Bay Area continues to outperform most other US markets with strong demand and a limited supply of large blocks of commercial space. Sublease space declined in the quarter to 1.2 million square feet or 1.6% of the market, down from 1.6 million square feet in June or 2.1% of the market. Class A direct vacancy remains effectively at 0% in the SOMA district and 8.4% in the South Financial district.

Silicon Valley had a very strong third quarter with over 1.6 million square feet of absorption. Tech expansion has driven Class A vacancy rates in the region, excluding San Jose down to 3.6%, the lowest in almost a decade. We are currently 98.6% leased in the Bay Area and our in-place rents for the region are approximately 32% below market. In greater Seattle, strong demand has pushed asking rents to their highest level in almost a decade. In our primary Seattle submarkets of Bellevue and South Lake Union, Class A direct vacancy rates are now at both 5.6%. In Downtown Bellevue, Salesforce recently announced it would double its workforce and triple the amount of its leased office space.

Our Seattle portfolio is currently 97.4% leased and our in-place rents are approximately 10% below market. In our San Diego markets, steady business expansion coupled with limited amounts of new commercial office space continue to drive rental rates higher. There have been 11 new Class A leasing transactions greater than 20,000 square feet in 2015, after only three in 2014. In our Del Mar and Sorrento Mesa submarkets, Class A direct vacancy rates are now 9.4% and 5.8% respectively.

Our San Diego portfolio is currently 97.4% leased. Our San Diego in place rents are approximately 7% above market. We are seeing strong rent growth in Los Angeles, particularly in markets attractive to creative services, entertainment like Santa Monica, West LA, Beverly Hills and Hollywood. In West LA, the Class A direct vacancy rate is 11.6% and in Hollywood it is 5.1%.

Across our Los Angeles portfolio, we are now 95.4% leased. Our in-place rents here are approximately 16% below market. Looking at our overall portfolio, we now estimate that our rents are roughly 15% below market. Remaining 2015 expirations total approximately 276,000 square feet with 200,000 square feet now expected to be vacated. This includes Qualcomm's recent announcement they would not be renewing their 68,000 square feet with us in Sorrento Mesa. That's an update on our markets. Now Tyler will cover our financial results in more detail. Tyler?

Thanks, Jeff. FFO was $0.77 a share in the third quarter. We ended the quarter with stabilized occupancy at 95.6%, down from 96.7% at the end of the second quarter. As we previewed on earlier calls, our occupancy dipped in the third quarter due to lease rollovers in several of our markets. Most of this space has now been re-leased.

Same store NOI was up 5.4% on a cash basis and 3.6% on a GAAP basis in the third quarter, after adjusting for 2014 lease termination fee. We were active in the capital markets during the quarter. In July, we completed the registered direct placement of just under 3.8 million common shares for proceeds of approximately $250 million and in September, we sold $400 million of 10-year senior unsecured notes in a public offering at an annual interest rate of 4.375%.

The funds from these transactions were used to fund the $78 million acquisition of Hooper Street and the repayment of two maturing mortgages totaling $90 million. We will also pay off $325 million of maturing bonds next week and use the remaining proceeds to fund development spending. Taking all these transactions into account, we will have a $100 million of unrestricted cash after the payoff of the bond and full availability on our $600 million bank line, which is expandable to $900 million

Now let's discuss updated guidance for 2015. To begin, let me remind you that we approach our near-term performance forecasting with a high degree of caution. Given all the uncertainties in today's economy, our internal forecasting guidance reflect the information and market intelligence as we know it today and each and every shift in the economy, our market tenant demand, construction cost and new office supply going forward could have a meaningful impact on results in a way that's not currently reflected in our analysis. Projected revenue recognition days for new developments are subject to several factors that we can't control, including the timing of tenant occupancy.

With those caveats, our assumptions for the remainder of 2015 are as follows. As always, we don't forecast any potential acquisitions or acquisition-related expenses. We anticipate remaining 2015 development spending on our seven projects under construction to be approximately $150 million. On the development delivery front, as John mentioned, we delivered the first building at Crossing/900 in Redwood City in October and we expect to deliver the second building in November.

While we had anticipated that we would recognize revenue on our 350 Mission Street property in the fourth quarter, given tenant delays in completing TI work, we now anticipate revenue recognition to commence in phases starting in January with stabilization expected in the second quarter. The change of timing has no impact on cash rents as Salesforce began paying rent on about 20% of the building earlier this month.

Our core portfolio assumptions are follows. Given our continued strong same-store performance, we are increasing our projected 2015 GAAP same-store NOI growth to a range of 3.5% to 4% on an adjusted basis. We are lowering our projected year-end occupancy to approximately 94% driven by Qualcomm's decision not to renew 68,000 square feet in Sorrento Mesa.

We expect occupancy to be back up to approximately 95% by the end of the first quarter and we now project 2015 FAD payout ratio of approximately 70%. To sum up, last quarter, we provided 2015 FFO per share guidance of $3.30 to $3.40, increasing our mid-point $0.03 to $3.35. This quarter, given the stronger project revenues of roughly $0.04, partially offset by delayed revenue recognition totaling $0.015 of 350 Mission, we are again, increasing the midpoint of our 2015 FFO guidance by $0.03 to $3.38 per share and tightening our range to $3.36 to $3.40 per share. That's the latest news from KRC.

Now, we will be happy to take your questions. Operator?

(Operator Instructions) John Kim, BMO Capital Markets.

Thank you. Good morning. It looks like you have an additional $945 million of funding remaining on your current and near-term development pipeline spread out over a few years. Will the expected asset sale proceeds next year be enough to fund your commitments next year on a leverage-neutral basis?

Well, it depends on how much we sell of course, but let me - I'll give you a range. We sold $400 million on round numbers this year. We already have about two-thirds of that in the bag for early next year and I think we'll increase that substantially. It could be the number of multiples of that. So I think we're going to do just fine on our funding.

This is Tyler. On the comment on leverage neutral, as you know, our leverage is very low, debt to market cap is in the mid 20s; debt-to-total assets it's probably 30-odd; debt-to-EBITDA is now down to -- at the end of the year into the low mid-sixes. So we have that capacity as well.

John, on the large disposition that you referenced, can you provide any commentary on what market it's in and whether not it's a developed asset or an asset you acquired?

I choose not to do that. We have a confidentiality agreement with these people that doesn't really allow us to talk about it. So I've got to honor that. But we signed purchases and sale agreement, they're just completing their due diligence and I'm very comfortable with the transaction.

Okay and on the tenant improvement costs. It looks like they were above where they were last year. Is this a function of more San Diego space expiring this year and are you surprised by the stickiness of tenant incentive?

Yes I don't think there is anything that's really driving that. I think it's just a function of what properties got for leasing and what the market is and the tenant requirements. So there is nothing really a trend or anything that's sort of, year-over-year that's driving that other than the specific tenant improvements of any given building.

So, the rental levels are increasing, you're getting higher releasing spreads, but the TI is still pretty high.

Yes, I think, generally speaking again it's based on each particular space, but again, you're seeing really good spreads on the rents and I think tenant improvements concessions are certainly down in terms of free rent pretty much across our markets. So it's really just a function of tenant improvements.

Okay, and then my final question is on NeueHouse and if you can provide any commentary on how they are operating as far as their own occupancies and if you have any appetite to expand with them in other markets.

I could take that. So they are open and operating in Hollywood and they have a very deliberate pace on how the membership works there. Hitting or meeting their expectations and coming in and they had a huge lineup of potential membership prior to even openings. So the space is great. They're off and running to a great start in our Hollywood project.

In terms of the other part of expanding into the other markets, they'd like to expand with us in other markets and we're going to look at each of those individually, see what makes sense.

Got it, thank you.

Craig Mailman, KeyBanc.

John, your comments were helpful and your views on San Francisco here, but I'm just curious, as you guys look to lease up Exchange at 16th and get interest on the 100 Hooper, is your underwriting of tenant credit changing at all or are you guys trying to maybe fill it up with more non-tech type tenants [this go] around?

Well, again, we have a bunch of NDAs on that property with just about every tenant we deal with now the substance requires you to sign an NDA. So we can't really disclose who they are, but the tenants that we're working with and there are several of them. Of the 1.2 million square feet to 1.3 million square feet that's non-tech, all of those transactions are very, very long lease-terms with extremely high credit. And it is our goal to make those transactions. And I think we will. I'm very comfortable we're going to make -- we can't make all of them because we don't have enough square footage. But I will say this, non-tech tenants take a lot longer than tech tenants to get deals done with.

I guess, but the way you are looking at tech credit these days, are you guys scrutinizing it more or less than six to 12 months ago.

I think we're very thorough in scrutinizing tech credit six months ago and a year ago and two years ago. If you look at some of the tech tenants that were smaller, we had massive letters of credit. And we had great comfort that the buildings, because the buildings were designed by us for unknown tenants as supposed to design specifically for a singular tenants. So we felt very comfortable that we had assets that would perform well.

There was a pickup with the tenant and we had tremendous credit support. So our underwriting, I think, has been very thorough throughout this cycle. We have not done deals with some of the tenants that we thought didn't have great credit, where we had the opportunity and we will continue to show a lot of scrutiny with regard to our financial review of our customers, whether they are tech or non-tech.

That's helpful. Then, I guess as you guys walk the space these days, particularly on the tech-side, what does the utilization look like?

They're just packed in. I mean, Rob, you want to comment, I mean you meet with all of our tech tenants and all of our tech prospects as well as non-tech on a regular basis?

Sure. Good morning, everybody. We do meet as John said, on a regular basis with all of our tenants as well as prospects and these are well established national and multinational companies and they have very deep real estate teams that do nothing but study headcount, and as John said earlier at The Exchange, with a couple of the tenants we're talking to, it's not going to be a quick decision, just the snap of a finger to take 0.5 million square feet as an example.

So I think caution has actually been exercised by these companies from 2012 on. It's not a new phenomenon. In terms of them acting in a more pragmatic and slow method and I do feel that they are busting at the scenes with all the planning and all the staff they put in, they've been undershooting the space needs they have. So in the example here in San Francisco that are well known, there are lot of companies that signed leases in June that are now looking for more space.

And one other point I'd like to make is that we're talking to several companies that are having needs that are 2016 needs, that they are literally I would say scrambling to try and fill now space needs. Once they get those buttoned down, those needs, they have new needs rolling into 2017 and 2018 that are significant.

And then just lastly, could you guys just run through your mark-to-market expectations by market?

I think I can do that. So Jeff went through that in his comments I think, we're 15% under market as a portfolio, San Francisco is 32%-plus under marketed, Washington is about 10% under market, LA about 16% under market; San Diego is about 7% over market.

Vance Edelson, Morgan Stanley.

Great, thanks. So, John, you did a great job addressing the tech question upfront. One of the more positive things we're hearing is that if VCs are less active, it's only because other investors are nudging them out with hedge funds and others now, trying to invest earlier before the IPO. For example, which would be a good thing for leasing demand if funding sources are growing more and diverse.

Have you heard anything about how some of your newer early stage tenants are getting funded these days? Do you still primarily here about VC money backing them or are there any signs that it's getting more diverse?

Well, I'm certainly not an expert on that and I will say this, we have tenants in our buildings like Capital One, which look exactly like a tech company that took two floors at 201, 3rd Street and there in San Francisco, looking like tech companies because they're funding tech companies. So you have the banks in it in a big way now and you have the VCs obviously in it in a big way historically and then you have some of the big tech entrepreneurs that are the household names that have made billions, that are funding other tech companies and going around the VCs. They are, in essence, being their own VC I suppose. So the funding sources seem to be increasing.

And I just want to point out something here because frankly, I'm a little frustrated with some of the articles that have been written by some of the people that are probably on this telephone call. I understand that we've had five years of terrific growth in San Francisco and Silicon Valley and four years or so in Seattle with the tech-sector. But there are other sectors that are growing tremendously. I wish I could tell you what I know, but I can't find one sector because we have NDAs (inaudible).

But I think that what we're seeing here is, it seems like there is some hiccups when Twitter said they're going to not proceed with 100,000 foot lease and lay-off 300 people or something or Zynga, a year ago when they have had their problems and it's a bad business model, I suppose for them. These are the natural hiccups that we're going to see. But if everybody and every single tech company have to be doing terrific for people to write positive articles, then by definition, you can't always have a positive article.

The reality is, I have never seen a market nor have the brokers that I talk to or the people I work with here that have long time been in San Francisco and Silicon Valley, never seen markets stronger than they are today; never seen demand greater than they are today; never seen a supply imbalance greater than it is today, on the positive side, meaning lack of supply.

There are two major things that are going on. There is a revolution in technology, if this was the Industrial Revolution, it'd 1900. Think about the disruption that's going on, I think Marc Andreessen, the famous VC investor said it very well several months ago, new technologies are devouring entire industries. It's happening at all different levels, Cyber Security, Medicine and Technology, which is in its infancy, Technology and Media, Active wear and wearable's, Fin-Tech meaning financial tech, which is in part to your issue about financing is that major financial institutions, banks and so forth are buying these start-up financial to entrepreneurs that are in the technology side, because they can't develop this creativity themselves.

That is exploding, in automobiles, driverless cars and in movies, in entertainment, in energy; almost every industry is transformed or will be by technology and we are in the early stages of it. And with that, we are going to have some volatility. I think the way I would characterize it is, we're going to have tremendous growth over the next several years and for many decades, but it will be punctuated at times with some volatility because we're not going to see every company or start-ups go to the moon. And you can tell that I'm frustrated, most of you know me for a long time, I have never seen such a disconnect with what's being written by some and what's going on the ground. And I care more about what's going on in the ground

And then just shifting gears for Tyler, the G&A line dipped a noticeable amount, anything unusual there? Or is that a decent run rate going forward?

Most of that's related to our deferred compensation mark-to-market, so $1 million of that is showing up as a reduction in other income. So it doesn't have any impact on the bottom line of FFO. So G&A is down but the other income is down by roughly $1 million of that and it is a little bit of other things in G&A that was -- the G&A was down, but most of that is related to the deferred comp.

And then last one from me, back to some of John's comments earlier, you alluded to the private demand remaining strong. Can you give us any more color on foreign capital flows and the interest in your properties? Would you say it's getting any more or less active with foreign capital looking for a home and is there any movement in cap rates worth mentioning?

I think to the first part of the question, I have never had more people come into this office that are foreign sources of capital as I have in the last six months, never. Not in the rest of my life up until that time. Everybody wants to be in these markets and then if you take a look at the couple of deals that were just done, the most recent transactions of substance were the Twitter buildings, which went for roughly $970 a square foot and the Airbnb building, which we for about the same.

And I think if you apply those cap rates and those IRR projections to our buildings -- to most of our buildings which were rented at higher rents, you would have value substantially in excess of that. There is a wall of money trying to buy both foreigners and others in this city and elsewhere. And again, I've never seen it to this magnitude.

Manny Coachman, Citi.

Good morning. This is Michael Bilerman. John, maybe just teeing off of that and you talked about this disconnect between public and private market values and I'm just curious where your view is, with your stock where it is today relative to the private market value of your portfolio?

Well, if you were to apply market values to -- you're not going to have the same cap rate applied to things in San Diego, if you are to things in San Francisco, Silicon Valley. I think, LA is demonstrating very low cap rates. There is just the dearth of product that's available down there. I'm actually frankly surprised with some of the valuations in LA given where the market is on rental rates and so forth. But yeah, I think the value is substantially higher than the market is valuing the Company today, but I am very confident that we will demonstrate some tremendous leasing here on some of the properties that we just started construction on, at blockbuster rates with blockbuster companies.

And then, how do you balance and I recognize it is a balance, but raising equity at [66] if your belief is that the value of your assets is that dramatically above that selling equity in your Company, arguably at a big discount and taking that dilution, obviously you're using it to fund accretive development. But just walk us through the thought process of doing that, when you're so confident in the asset values and selling assets?

Well, you're talking about the $250 million we did earlier this year?

Yes

Yes, I mean just take a look at it. We're building to roughly 8% -- going at plus or minus 8% going in ROCs. So I think that the use of the proceeds speaks for itself.

And I also appreciate all your commentary regarding San Francisco. Outside of research analysts reports that you're talking about, where else do you hear, I mean it have to be emanating from somewhere, I don't agree (multiple speaker)?

Well, Michael look what's going on, the hedges play the techs and then the play the companies, the real estate companies that are public that do business with the techs. We all know what's going on. Hedge fund industry is out of control in my view. It ought to be regulated, I'm not a big regulation guy but I'm talking about primarily about some of the analyst reports, which I don't think had been very thoughtful. I won't name names.

As long as it is not ours, do you have any -- I mean you think about the affordability from a rental perspective residential side in San Francisco, clearly that's getting a lot of airtime in terms of people living [what's going on] at Oakland, right and Uber going over there and trying to attract employees. I mean, does it give you any concern at all in terms of the price of entry to attract talent and that talent being pushed out of San Francisco and that potentially affecting the residential market, affecting the office market.

You know there are things called roads and ferries and BART and Caltrain and that's how people get to work. The lion's share of people that work at San Francisco don't live in San Francisco and the transportation and housing is a regional issue in just about every city in the world, certainly here in the Bay Area. You can't deliver enough houses in San Francisco over the next 10 years to satisfy the number of people that wanted to live here. It's always going to be expensive to live here.

But what you're seeing is a tremendous number of apartments being built in the city. You're seeing a tremendous number of apartments being built in Oakland. You're seeing them being built in other another areas and people will commute via the transportation systems. That's why we've been such an advocate over the last six years of projects that are near public transportation. These cities don't want cars. They want you to use public transportation and it's sort of a chicken and egg.

You have to have public outcries that we need better public transportation in order to get people to pay for the bonds and so forth that finances it. Here in San Francisco, they're talking about additional -- they've been acting on it. They got trans-bay terminal under construction; they've got the Central SoMa Subway that will connect BART and Caltrain that will start construction here shortly; they're talking about more BART tubes. Transportation always lags, but housing is generally going to be at the end of those transportation terminals. The city of San Francisco does not have the land area to build everything it needs to build.

Yes and last quick one. Are you changing your underwriting at all in terms of underwriting tech-tenants or other tenants either upfront deposit or any prepaid rent, has anything changed in your calculus as you are renting space?

Well, I answered this question to somebody earlier in this call. We've always been try scrutinize -- show a lot of scrutiny and a lot of due diligence and we go through amazing amount of due diligence in underwriting with their CFOs and if there is venture capitals with them and we get huge letters of credit and we make sure that we have rents that are no higher than market and that we have product that is not specific to any one tenant. So I'm not going to say that we're harder on people than we were before, because we've always been pretty hard on tenants.

Brendan Maiorana, Wells Fargo Securities.

Thanks, good morning out there. Question, I guess, probably for John or Mike Sanford. So, I always felt like in the San Francisco market there was some risk that some of the early stage tech companies, the funding model slows down a little bit, maybe they don't grow as aggressively, but the opportunity for the city in terms of a tenancy seem like it was from the large tech companies that are in the Valley that don't have a big presence in the city. Are you seeing much migration of those tenants into San Francisco that are looking around more now than maybe they have been there in the past?

Yes, hi it's Mike Sanford. Good morning. We definitely have been seeing migration from the Valley into San Francisco. It's all of the things that John and others have been talking about for years. Folks want to be in the city, especially the millennial workers live here in an urban environment. But I think what's really compelling about the statistics is not only is San Francisco extremely strong, this is the fifth year in a row of over 1 million square foot of absorption. It's not a one hit wonder; it's been consistent year-over-year.

But I think what adds to that is the fact that the Valley is also extremely strong. 1.6 million square feet of absorption in this quarter, which is more than San Francisco for the entire year. The vacancy rates down there, as you heard earlier in the call, excluding San Jose, under 4%. All of the key markets we're in are near 0% to 1% vacancy from a Class A standpoint.

And what you're seeing is a classic demand and supply imbalance. You heard us talk about the stats, how many tenants looking for over 100,000 square feet, how little supply there is. But those numbers are only sort of part of the story. There is actually more demand than that's being reported, as John discussed. We know tenants that are in the markets that aren't on those lists.

On the flip side, there is actually a less supply. So a lot of the tenants that are absorbing this space are mostly going to Class A space and leaving space that is practically functionally obsolete for today's users. So the numbers are even better than what we're seeing in the statistics and that strength in both sectors of the Bay Area is the foundation for growth for the future.

And Mike, maybe just, as you are looking at rent growth on a forward basis maybe over the next year or so, kind of what do you think -- what are kind of the best expectations of forward rent growth and how does that compare to maybe where it's been over the past year or two?

Well just before Mike does that, I want to make it real clear that our underwriting on The Exchange, our underwriting on 100 Hooper, our underwriting on the future Flower Mart has all been done at rates lower than what is currently in the market today. We are very conservative in our underwriting. Lots of contingencies, lots of expectation and generally we've been way over estimating what cost increases might be and so forth, but Mike go ahead.

Yes, so historically we've been seeing double digit rent growth both in the Valley and San Francisco and if you look at what we've seen year-to-date, you're on pace for over 10%, again that 10% to 15% range in both markets.

As John said, we're more conservative as we project out and looking at rent growth when we underwrite. But I think the other important point to note is even though rents now are roughly at where they were during the 2000-cycle there is so much more density in the spaces today, right. John talked about this for years and so from a cost per employee perspective, rents are actually down. And I think that's an important characteristic to remember when you see rental rates on a per square foot basis today. There has been sort of a paradigm shift in how people are using space and they're using it more densely and we're providing the building the service in exiting and the like and the elevator so and so forth to support that density.

Okay. That's great. And then just last one maybe for Jeff or Tyler. So you guys mentioned that year-end occupancy down to 94% because of Qualcomm. I think it was 94.5% last quarter. Where were some of the -- given that you are around 95.5% now, where were some of the other tenants that were expected to roll to drive occupancy down by year-end given that your lease rate is substantially higher than that?

Yes, well from the second to third quarter, the rollover there was split fairly evenly, about a third in San Francisco, third in Seattle and third in LA approximately. From third to fourth quarter, most of it is in San Diego. I think there is a 160,000 feet and a 130,000 feet of that's in San Diego and 30,000 feet of its in Seattle.

Nick Yulico, UBS.

Thanks. Just going back to the exchange development, can you talk some more about why you guys went with the optionality of doing I think 50-50 office, life science for the project and going back to over a million tenants that were non-tech that you said that are looking at Exchange, are life science tenants considered non tech?

We're not talking any life science tenants right now. I mean we've had discussions but that's not in my calculus of square footage that we talked about. With regard to our decision, what we did is we wanted to make sure we had the height floor to floor and that we had the structural capacity to handle a broad range of tenants, whether it's life science or whether it's something else.

And so we made that decision to incorporate that into the building. We thought that was a good long-term investment because we always look and we're building buildings at locations that are irreplaceable that are world class design and that are LEED platinum and the best in class and we look at these as assets that we get on for the next 100 years. They are certainly going to perform well whether we own or if somebody else for hundreds of years, not for 20 years. So we are a lot different than the merchant builder that simply looks at how do you build it? Kind of get away with it as cheaply as you can, lease it and flip it. We're the absolute opposite.

Okay, so at the end of the day, I mean, do you envision half of that project being life science or is it (multiple speakers).

No, I said no.

Okay. And then I think Ross had a follow up question.

Hey John, Can you talk a little bit about One Paseo, let's get out San Fran and go south. You got a $178 million in there. I went back in your supplemental from 2011. You had a $120 million into the project four years ago. So I guess the question is having, watched $58 million go in over the last four years. Reasonably speaking, what should we all be expecting for a return given the pretty serious carry cost there?

Yes we're forecasting in the high six percentile or high 6s and we may do better than that. That's [on stabilized] ROC unlevered and remember, about half of that is apartments.

And is that on kind of current rent? Are you making any assumptions that market rents are going to keep going up by the time you deliver?

I believe it's on current rents. David?

Yes, the office is on current rents. The retail product that we'll be developing will be pretty unique down there. So we feel pretty good about the attractiveness of that and a lot of interest in that and the apartments are on current market rents.

And at this point in time, are you going to do the whole thing on your own or are you going to JV any of it?

We haven't decided.

David Rodgers, Robert W. Baird.

Yes, morning guys. Jeff, first question for you or maybe Tyler but with regard to the 160 basis point, I think, differential between lease and occupied, any meaningful kind of chunks of new leasing that we should expect to kind of come in through those numbers and kind of timing on that, if you can give us that?

Well, as I mention I think, we expect most of that re-leasing will come in by the fourth quarter but most of it is in the first quarter, so by the end of the first quarter we're projecting to be back in 95% and some of that's in San Francisco (inaudible) and one third in Seattle.

Okay, that makes sense. And then, with regard to the kind of tenant reimbursements in the quarter, they seem to be a little bit lower off this quarter. Is there anything unusual or unique in that that we should be thinking about?

No, I think it will revert back in the fourth quarter. There were some basic resets, some [camp abatements] prior year refunds that came through in the third quarter that caused reimbursements to be a little bit lower but also expenses were a little bit lower. So if anything - our numbers were at $0.77, it would have been even better than that if it wasn't for some of those factors. But we'll be back to normal. We project to be back to normal next quarter.

Okay. And then, John maybe a question for you on 350 Mission, I think you said that the move in was a little bit slower there. Was that just a build out issue and I guess just on a broader question, are you still seeing a pretty good take up of space as you are completing either tenant space through developments, re-development or just through second-gen leasing. There is a pace at which tenants are kind of filling that space up and I guess should we make any co-relation from the 350 Mission slowdown?

No, 350 Mission is because they changed who was going to occupy the building. You now have the senior management at -- the Chairman and President and all that stuff taking the top three floors and they've hired a different architect than the one they were using before and have slowed it down.

Jamie Feldman, Bank of America Merrill Lynch.

Great, thank you. Can we focus on 333 Dexter for a moment and just talk about progress on the project and then maybe the leasing pipeline?

Well in terms of the progress, we've gone through the initial steps for the City and submitting and so forth and we're on line to receive approval. I believe it's right around the end of the first quarter of next year or early the second quarter. So we are confident, they love our design and in terms of re-leasing and so forth, Rob, you want to handle that?

Sure. As with any ground up development that we do, we have a pretty robust pre-leasing and marketing program that we've started already. We will have and you guys will probably see them in different presentations, upgraded videos and that type of thing that we're doing overtime, anticipating a second quarter construction start. And in terms of marketing, I would say the thing that's really most interesting about it is the level of interest that we're getting from companies outside of the Seattle market in the project and it's also been very well received just in terms of design and some other attributes which I don't want to get into giving our secrets away, but we have local interest as well as outside of Seattle interest in the project already.

We just hired the broker last month.

Okay. And do you think it will be more of life science or office and what do you think about the relative returns of both?

I think it's going to be all office and I think it's going to be somewhere in the neighborhood of what we've been achieving down here in San Francisco which is in that sort of high 7% to low 8% initial ROC.

Okay. And then did you give an update on The Heights at Del Mar in terms of leasing progress?

No, we didn't. David, you want to do that or Rob.

Sure. We're really pleased. We're virtually closed in now at the property. It's unbelievable in terms of the landscaping and amenities that we've finished there. We have active discussions with about 200,000 feet of tenants, some are -- a couple of them actually are looking at the whole building and the rest are multi-tenant and we expect to have some success to announce there soon. But again, Del Mar is the best submarket in that San Diego County area and I think it's an amenity driven market and what we're providing is just leagues above what I think you find in UTC and some of the more dense urban parts of San Diego.

Okay, so assuming you get leasing done, I assume it comes online not leased or not occupied, like when do you think it will actually --

Yes, our pro forma was that it would lease up -- it's not really a pre-leased market there. So our pro forma has always been that it would lease up in the year after the Shell is complete and the Shell is going to be complete, I think it's early in the first quarter.

Okay. And then finally, the demand pipeline for exchange, do you think it will be more single tenant or a multi-tenant?

Well that's interesting because again I wish I could share with you, but I can't share with you because we're tied up in non-disclosure agreements. But we have multiple major organizations that want either substantial portions like half or so or all of it. And any one of which we would be delighted to have as our tenants and you would be delighted to see us have as our tenant. And we are talking about long, long, long term leases.

And some of the color we're getting from the market is that those kind of tenants don't like to share and want their own branding. Can you get that in that building?

I'm not going to comment on that. I'm very comfortable whether we go multi tenant. Look at this way, Jamie, we could fill that building up with 100,000 square foot tenants, we could have done it already, but the ones that we are talking to, the credit profile is so terrific that it becomes an incredible bond.

Jed Reagan, Green Street Advisors.

Hey good morning guys. Do you have a pipeline of new acquisition and developments projects out there that you're actually chasing? Do you still feel like there is attractive opportunities out there today or do you feel like you've got enough on your plate at the moment.

Well on the development side, at the fringe little pieces that are next to existing development parcels or whatever are always [venturous] to us. We look at everything. In terms of acquiring existing buildings it's going to be something that we can fix and create additional value just buying at today's cap rates isn't particularly exciting to us.

Okay. And just on Southern California, couple of quick ones. What are your thoughts on Orange County as a Kilroy market these days? Now the area is showing a lot of good job and rent growth and you've got just the one building down there. So just curious how you are thinking about that these days?

We look at everything. We haven't found anything that we like, that we felt was appropriately priced for what our metrics would want to be, but we look at everything.

So that's a market you could see yourself being in longer term?

Possibly.

Okay. And then I guess related to that there has been some press on downtown San Diego catching some momentum and just wondering if you are getting more constructive in that area and maybe do a little more there overtime and then how about thoughts on downtown LA at this point?

Downtown LA we look at -- we hear a lot of hype, but when we go through the numbers its trading tenants. That doesn't mean there won't' be the occasional building that does a terrific job because it's unique or whatever. But look at a lot of stuff, we haven't seen anything that we would want to act on in term of San Diego, it's true, Downtown and some of the areas has gained some momentum and we're looking at things but again we are looking at it, we haven't had anything that we've come close to pulling the trigger on.

And to your earlier question about what are we looking at in terms of acquisitions or what is our appetite for acquisitions or development? We do have a couple of major development things that we're talking about. And again, we have NDAs with major companies in connection with what would be basically buildings that we would build for them that would be buildings, Kilroy type buildings and those could be very substantive, but nothing to report at this point.

Across a range of markets or focused on one market?

Let's call it the Bay area and the Greater Seattle market. And then of course within our development things, we're having very good discussions, early discussions on the academy which we should have entitled in the first or second quarter of next year. We have somebody that's interested in all of the office space there, which I think David, the office breakdown of that project is about 270,000, 280,000 square feet, isn't that correct?

Yes. That's correct.

So, again it's early stages Jed, but it's encouraging because that market has become a market of great demand and the rents and so forth have gone way up and we're just really pleased that we got in there earlier than most.

And do you feel like the depth there and sort of breadth of that could be to sustain another million plus, 2 million square feet of new development over the next three to five years?

Well, it about 6 million square feet of demand in the Greater Hollywood market and Rob, it's something like 20%, 25% of that is growth, meaning new demand for the market. And with the type of tenants that we're seeing and talking with, they want to have the environment that has vibrancy, the Kilroy kind of project which is in that market, it's the restaurants and the outdoor areas and the rooftop decks and all that sort of stuff because that's very appealing to the kinds of consolidations that these companies are endeavoring to make.

Yes, I think it's not a huge market, but it's a great market and the operating cost in that market are vastly lower than downtown LA on a per square foot basis, vastly lower.

Steve Sakwa, Evercore ISI.

Thanks. Most of my questions have been asked. But John, I guess I had two. So on the east side of Seattle we just came back from there and there is definitely a couple of new projects that are going up, totals maybe 1.5 million feet and you've also got Expedia that's going to moving to a different campus more in Seattle are how are you just thinking about the Bellevue market longer-term?

Well, longer term I think it's great, because this is really an area that has all the amenities in shopping and different price ranges and so forth of for-rent housing and condominiums and improving transportation systems and so forth, so longer term very bullish.

What we saw is when this stuff started, we were looking at some of the development sites there and we didn't ultimately pull the trigger. Other have pulled the trigger on a couple of them as you know, Trammell Crow is underway with -- what is it, 400,000 or 500,000 feet; Salesforce has taken a 100,000 fleet there; and there are going to be some buildings coming on stream. The good news for us is that we saw that coming and we did the long term lease that take us through, what is it, with Concur. I mean the key Bank building is solid for many, many years. The other buildings, the Skyline building that we have out there, where Expedia leases up roughly 100,000 feet from just.

That we think is an opportunity. We have another tenants that's in there that needs expansion. Hopefully, we'll able to put something together, but then we have a lot of interest in that building. We have rents in that building that are way below current market and way below what the others are going to need in there to be build building. So if it gets to a point where there are -- is a period where there is less demand than there is space coming on stream, I think we're in a very good defensive position with the way we have improved that building and with what our rental structure is there. It could be that we don't get the growth if that were the case in our rents, but our rents are way under market on those leases.

Okay. And then just I guess kind of coming back to I guess another part of Seattle, I guess what's your appetite to acquire more land either in South Lake Union or other parts of Seattle at this point?

Well, we look at everything. We're very focused on 333 Dexter. We think we've got a terrific design and terrific flow plans, as Rob mentioned, we have had quite a few people from the Bay Area and elsewhere take a look -- either real estate departments looking at what. Let me just go backwards. With most of the companies and you can kind of figure out who they are, whether they are tenants or gone tenants of ours. We are regularly in discussions with regard to what their requirements are. Where they see their headcounts going up and so forth in our markets, telling them what we are doing, sharing with them what kind of buildings, what kind of space we are going to have coming on stream at what time. Getting input from them with regard to anything they like to see differently. So we are very good exchange of ideas with these tenants and that's why we know that there are some that really like what we're doing at 333 Dexter.

In terms of the local market there, most everything that's been started gets leased pretty quickly. We made our beat there. I don't see us buying another big site there unless we had a tenant at least for the near term. But I'm very bullish on that area. I think it is an area that is very, very similar to the SoMa area here in San Francisco. It's has the same vibe and has all the amenities, all the price points at housing. It's just a fabulous area. And the fact is that a lot of people don't want to be in high rises. They want to be in lower rise. Those are two 12 story buildings.

You got the new transportation or the big berths that dig there, that back in operation. So I think we're going to transportationally advantaged with 333 Dexter versus our competition. It's just got all the stuff that we look for in a terrific site, so we're focused on it.

Manny Coachman, Citi.

Hey, John, it's Michael Bilerman again. I just want to come back to sort of the market overall and totally like your comment, not trying to be pollyannaish about the situation and that you're relying on the data everything you're seeing on the ground. Everything you're seeing from the tenants, but we know no one rings a bell when it's over. So what are the things that investors should be focused on? What are you focused on to understand that turn when thing start to slow before it gets picked up in the data, right. So what are things that we need to be mindful of, clearly it's not the analyst reports of the hedge funds, so what are the things that we should be mindful of?

Well, I'm not trying to pick on the analyst, I think there has been some -- my sense is that everybody wants to try to be the one that calls for change in the market and we're not seeing that in the data. We're not seeing it in the data with regard to what's being leased, we're not seeing it with regard to concessions, we're not seeing it with regard to demand. And by the way demand is far greater than the 9 million square feet that is the broker show in the third quarter report because I can tell you we're dealing with a bunch that are not -- there is a couple of million square feet out there that's not even reflected in those numbers. But there is a whole bunch of things and you know them as well as I do. You write on markets all the time.

If all of a sudden we see massive amounts of sub-lease space come out. If all of a sudden we see demand really diminish, I mean, those are going to be pretty strong indicators. But what we're seeing is the exact opposite of that. And I think any of you have to come to see us at (inaudible) that are on these calls or whatever over the years, know that we have always tried to be very conservative with regard to our underwriting and not get over our skies.

I will admit and to Ross' point earlier, we are lot longer in One Paseo than I ever wanted to be or dreamt that I would be, but we got down there in [the buzz], saw that crazy mirror that got fired and we couldn't foreseen that. But I think if all of a sudden we start seeing people saying they don't want to be in San Francisco, they don't want to grow in San Francisco then that is going to suggest that the market is going to become much more regular than the strong growth that we've seen.

But I think it was Morgan Stanley that recently came out with a paper, maybe I'm wrong. And it talked about San Francisco and it talked about residential and it talked about office and it said, at half the growth that we've been experiencing, it would still be an extremely robust market, at least I'm paraphrasing them. I think that we will see, at some point, the market moderate, but that doesn't mean that the lights are going to turn out. It just means that it's going to become more normal. One of the things that I'm very encourage by and I wasn't in this market although Mike Sanford was and Rob Paratte were amongst the other people that worked with us up here is that it is a lot different that the dot com area.

Nobody was talking about profitability in the dot com era. They were talking about growth and how much money and value their company was going to be worth. What we're seeing now is amazing numbers with regard to profitability. But innovation is not going to stop, and all the things I mentioned earlier is that there are more -- many of the discussions we're having with major tech companies are new initiatives they have, that's why you've got to sign an NDA because they have a new group to do something that nobody has ever thought before.

So that's why I love this market is because we will see ups and downs, we're not going to see everything go to the moon. We're not going to see every start-up survive, we're not going to see every unicorn just instantly become more billions and billions and increasingly more and more billions every six months, but we are going to see an amazing amount of growth from tech sector and you've got embedded here the talent base and the universities and it's where these people want to be. We started out on our comments that tech companies want to be -- their two first choices are the Bay Area and Seattle.

As you think about, your comments about doing these larger building leases, long duration, high credit versus filling up building with 100,000 square foot tenants, which arguably and probably have weaker credit, is that more so from your belief and you said, I think you mentioned the bond. Do you view yourself as then selling an interest at net assets or selling that asset outright to capture that value in that credit lease, because arguably holding on, there is the value creation you are going to create immediately but then obviously little growth thereafter, how should we think about the strategy that you are going about in doing that versus taking arguably little bit shorter duration, smaller leases and filling it up sooner?

It's a very good leasing question and you could figure out the answer, but I'm not at liberty to comment on. I'm in the midst of a whole bunch of negotiations. I'm not going to model them up. But you've got a very good sense.

Thank you. That's the end of the Q&A ladies and gentlemen. I'd now like to turn the call back over to Tyler Rose for closing remarks.

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

Thank you, Tyler. Ladies and gentlemen that concludes you call. You may now disconnect. Have a good day.