Good day, and welcome to the Q1 2019 Kilroy Realty Corporation Earnings Conference Call. All participants will be in a listen only mode. Please note, today's event is being recorded. I would now like to turn the conference over to Tyler Rose, Executive Vice President and Chief Financial Officer. Please go ahead, sir.
Good morning, everyone. Thank you for joining us. On the call with me today are John Kilroy and Jeff Hawken as well as other senior members of our management team who are available for Q and A. 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 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 8 days both by phone and over the Internet. Our earnings release and supplemental package have been filed on a Form 8 ks with the SEC and both are also available on our website. John will start the call with an update on our market conditions and a review of the Q1. Jeff will review operational highlights. I'll finish with financial highlights and a review of our updated 2019 earnings guidance that was published yesterday in our earnings release.
Then we'll be happy to
take your questions. John? Thank you, Tyler. Hello, everyone. Thank you for joining us today.
I'll begin this morning with a review of our market conditions, which continue to drive strong leasing activity. Then I will summarize our Q1 results and finish with an update on our development projects. Real estate fundamentals remain strong across our West Coast markets. New supply is extremely limited and there are few land sites suitable for near term development. Demand remains solid up and down the West Coast and we are seeing more diversified demand.
It's not just technology and media, it's far more broad based. These strong conditions have driven double digit rent growth on a net basis across our key urban markets. Among the biggest gains, South Lake Union rents are up more than 25% year over year. San Francisco rents are up 15%, Vacancy rates are now below 6% in our urban markets and hitting record lows in some areas. Bellevue is at 2.9%, San Francisco is at 4.4% and South San Francisco is about 2.5%.
And with very few large blocks of space available in our key markets, we expect the upward pressure on rents to continue. In fact, we are currently experiencing record high rents in most of our markets. Other indicators that we monitor, including job postings and VC funding remain healthy. Seattle and the San Francisco Bay Area continue to create new jobs at the fastest rate in the nation led by big technology. In San Diego, job postings ticked up approximately 15% over the prior quarter.
Capital raising also remained strong year over year driven by steady VC funding and a dramatically stronger IPO market. We also see support for continued regional strength in the robust levels of investment the key industries are making in their future. Global research and development spending across technology and life science approached $675,000,000,000 in 2018. This level of spending is driving rapid innovation and the continued penetration of technology into the core operations of nearly all businesses. The entertainment and media industries alone are expected to generate globally more than $2,000,000,000,000 in revenues this year content accelerates growth across the sector and we expect this to continue.
We now have Disney and Fox and others to come expanding into content streaming. We think this will translate into significant increased demand for space. The unique characteristics of our West Coast markets continue to attract significant investor interest. We are seeing diverse capital sources, including sovereigns, private equity, large institutional funds and major family offices, exploring purchases or joint ventures here. There is particularly strong demand for high quality well located assets with low CapEx requirements.
Large investors seem to be shifting their preference towards high quality state of the art newer assets as investors have achieved strong returns from the West Coast investments, the region should continue to attract more capital in all forms, creating a virtuous cycle of investment and growth. And we feel we are particularly well positioned given the young age of our modern portfolio. Now let's move on to Q1 results. We delivered another strong performance. We signed new and renewing leases on just over feet of space in our stabilized and development portfolio with cash rents that were up 34% and GAAP rents that were up 50% from prior levels.
Our stabilized portfolio is now 96% leased. We estimate that rents across our portfolio are approximately 20% below market, which as we mentioned last quarter is the largest rent differential in company history. We debuted our One Paseo mixed use development project in Del Mar with a community opening of the retail space that is now over 90% leased and over a third occupied. With this strong momentum, we made further progress on leasing the office component, which is now more than 75% committed. We commenced construction on 2 life science development projects, Phase 1 of Kilroy Oyster Point, a 630,000 Square Foot Project in South San Francisco and our 9,455 Town Center Drive building, a 160,000 square foot project in the University Town Center Submarket of San Diego.
And last month, we were awarded the EPA's Energy Star Partner of the Year for the 6th year in a row as well as the EPA's highest honor, sustained excellence. This underscores our continued commitment and sustainability and our leadership position as a global leader among all publicly traded real estate companies. In just 5 weeks, subsequent to quarter end, we signed an additional 520,000 square feet of new leasing and renewing leases with cash rents that were up 13% and GAAP rents that were up 34%. This activity included a 154,000 square foot 10 year renewal with Lucille Packard in the San Francisco Bay Area. In addition, 3 of the leases were expansion leases, one with 23andme at Oyster Point Tech Center and the other 2 were in San Diego.
Across these three transactions, tenants roughly doubled their existing square footage. With 23andme expansion, we are now 100% leased at our Oyster Point Tech Center. This brings our total year to date leasing to over 750,000 square feet. Turning to developments, we are making good progress on all of our current projects. In Hollywood, all components of our mixed use project are scheduled for completion.
Next year, both the office and the retail space are fully leased. In Seattle at 333 Dexter, we continue to have meaningful leasing discussions and remain confident that we will be substantially leased before it's delivered later this year. And in Del Mar office space, our One Paseo project is now 76% leased or committed and marketing is underway for the residential units that will begin delivering towards the 3rd and 4th quarter. Upon stabilization, these projects will generate an estimated cash NOI of approximately $90,000,000 70% from office and 30% from residential retail. This is in addition to the projected stabilized NOI of $75,000,000 from the 3 projects we have in the tenant improvement phase, including the Exchange 100 Hooper and 1 Paseo Retail.
Given our confidence in leasing of 333 Dexter and against the backdrop of strong market fundamentals and growth in the biotechnology and healthcare industries, we moved ahead with 2 new projects in the Q1. At Kilroy Oyster Point, we commenced construction on Phase 1 of our 40 Acre Life Science Campus situated on the Waterfront of South San Francisco. This phase encompasses 630,000 square feet of lab and office space in 3 buildings and has a total incremental investment of approximately $450,000,000 We expect to deliver the project in the second half of twenty twenty one. Kilroy Oyster Point commands an extremely attractive location in one of the nation's largest and most endemic life science clusters. Near term demand in the area exceeds 2,000,000 square feet.
Vacancy hovers at 2.5% and existing supply is extremely limited. We are in discussions with a handful of tenants for Phase 1. And in March, we commenced construction on a 160,000 square foot property in San Diego at 9,455 Town Center in the UTC submarket, our expected incremental investment in the project is approximately $95,000,000 with a scheduled delivery date of mid-twenty 20. The project is situated in the heart of University Town Center in close proximity to the new San Diego trolley service and the University of California, San Diego. It is a key employment center for a range of technology and life science companies.
Demand for the life science and UTC market submarket is very strong with a vacancy rate of approximately 5% and limited new supply. Office fundamentals are similar evidenced by a vacancy rate of under 4%. While we forecast this building to be occupied by a life science company, we've designed a flexible project that also appeals to office users. As you recall, we took a similar approach to the exchange in San Francisco, creating the opportunity to make the best decision at the appropriate time. Lastly, with regards to the Flower Mart, we expect our Prop M allocation sometime this summer.
It's too soon to tell when the 4 CEQA challenges will be resolved, but we continue to see significant interest from a variety of large users in what is arguably one of the most sought after commercial submarkets in the country. To fund our development, we remain committed to capital recycling. This year, we are targeting $150,000,000 to $350,000,000 of dispositions. We are currently in the market with 2 assets with a total value of approximately 150,000,000 dollars To wrap up, let me reiterate our focus on 3 key 2019 objectives that we communicated on our February call. 1st, our development pipeline.
During the quarter, we continued to make meaningful progress on leasing our development projects, including 333 Dexter and 1 Paseo and started 2 new projects, Kilroy Oyster Point Phase 1 and our Town Center Drive building. We continue to believe that development is the best way to create shareholder value at this point in the cycle and our focus is to ensure that our current projects deliver on time, on budget and they achieve superior returns. We expect to make meaningful leasing progress in our development projects before year end. 2nd, maximizing value in our stabilized portfolio. This includes leasing up our vacancies, driving rents where possible and proactively addressing expirations.
And 3rd, maintaining a strong and flexible balance sheet. This includes keeping our metrics conservative and having access to multiple forms of capital. That completes my remarks. Now I'll turn the call over to Jeff for more detail on operations.
Jeff? Thanks, John. Hello, everyone. Since John has given you a good picture of conditions in our markets, and I know most of you follow market statistics, I will focus my comments on updating you on lease expirations and the mark to market rental rates across our portfolio. I'll begin with an update on lease expirations.
We've made a lot of progress on our remaining 2019 expirations. We now have leased approximately 65 percent or 549,000 square feet of the 856,000 square feet of 2019 expirations. That leaves a little over 300,000 square feet or approximately 2.5% of the core portfolio remaining this year. None of the leases exceed 25,000 square feet and they are spread across our 4 regions. In total, we estimate that our 2019 lease expirations are approximately 24% below market.
As we discussed last quarter, we had 2 lease expirations in 2020 that exceeded 100,000 square feet, 1 in Northern California and 1 in Southern California. 2 weeks ago, we signed a renewal on the Northern California property. In Southern California, we now expect the tenant to vacate upon lease expiration in the Q4 of 2020. We have begun marketing of the space and plan to make good progress over roughly 18 months before expiration. Average rents in our stabilized portfolio continue to provide upside opportunity.
On a portfolio wide basis, our estimated average in place rents are approximately 20% below market. As John noted, the gap has never been larger in our history as a public company. By region, our in place rents for San Francisco are approximately 31% below market, Seattle is 14% below market, San Diego is 8% below market and Los Angeles is about 12% below market. Now Tyler will cover our financial results in more detail. Tyler?
Thanks, Jeff.
FFO was $0.95 per share in the Q1, which includes a positive $0.03 related to the improved credit quality of a tenant for which the company took a reserve in 2018. Same store NOI grew 3.2% on a GAAP basis in the Q1. On a cash basis, it declined 4.2%. As we previously commented, the decline was largely driven by last quarter's San Diego expirations as well as downtime from the Amazon lease in Seattle and downtime related to the cruise and drop box leases in San Francisco. At the end of the Q1, our stabilized portfolio was 92 0.5% occupied and 96.2 percent leased.
Moving to the balance sheet, in February, we repaid a $74,000,000 mortgage note at par that was due in June 2019. In March April, we sold approximately 1,200,000 shares structured as 12 month forward agreements under our ATM program at a weighted average price of $75.92 To date, we have not settled on these nor the 5,000,000 forward shares sold last August. At this time, we expect to settle the 5,000,000 shares in July. We currently have $465,000,000 available on our credit facility, which is expandable by $600,000,000 under an accordion feature. Our debt to market cap at quarter end was approximately 24% and our debt to EBITDA was approximately 5.7 times pro form a for the equity raises.
Now let's discuss our updated guidance for 2019 provided in yesterday's earnings release. 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 current guidance reflects information and market intelligence as we know it today, Any significant shifts in the economy, our market to tenant demand, construction costs and new supply going forward could have a meaningful impact on our results in ways not currently reflected in our analysis. Projected revenue recognition dates are subject to several factors that we can't control, including the timing of tenant occupancies. With those caveats, our updated assumptions for 2019 are as follows.
Our targeted dispositions for 2019 remain in the range of $150,000,000 to $350,000,000 With the commencement of construction at Oyster Point and UTC, we anticipate remaining 2019 development spending of $400,000,000 to $500,000,000 We expect to commence revenue recognition on our Dropbox lease at the Exchange in 3 phases: the first phase in the 3rd quarter, the second phase at year end and the third phase in 2020. Our forecast for year end office occupancy is between 94% 95%. We expect 3% to 4% growth in GAAP same store NOI for the full year and flat results on a cash basis with the negative impact largely incurred in the first half of the year. The impact of expensing internal leasing costs and third party legal fees associated with the change in lease accounting remains in the $0.08 to $0.10 range for the year. $0.02 of this was incurred in the Q1.
Taking all these assumptions into account, our updated 2019 earnings guidance is 3 point 6 4 $4 to $3.78 per share with a midpoint of $3.71 per share. We are effectively increasing the midpoint of our range by $0.03 from last quarter, driven by the reversal of the bad debt provision for the improved tenant credit quality. That's the latest news from KRC. Now, we'll be happy to take your questions. Operator?
Thank you. We will now begin the question and answer session. Today's first question comes from Nick Yulico of Scotiabank. Please go ahead.
Great. Thank you. I just had a couple
of questions here. First on Oyster Point, can you just talk a little bit more about the demand you're seeing in the market, whether market rents you think have hit close to $6 net per month? And then on the cost for the project, is there anything in the first phase that's impacted by, let's say, a higher amenity offering for tenants, which drove up the cost per square foot for the first phase?
Hey, Nick. This is Tracy Murphy. I'll try to take them in the order you gave them. So demand continues to be very strong in that market as everywhere in the Bay Area and across all of our markets, but it's just beyond about 2,000,000 feet specific to South San Francisco. And rents, to answer your question, haven't quite reached 72 dollars annually, but they have been squarely sort of in the $65 or mid-sixty sort of range from a Class A perspective.
And then total costs, I think John covered that in his comments, but the incremental spend on Phase 1 is roughly $450,000,000 call it $950,000,000 all in for Phase 1. And on the amenities, we will have a pretty robust amenities package consistent with expectations for a Class A project, And there will be a redundancy across phases, but we've been thoughtful to plan that sort of holistically before we committed to dollars for amenities on Phase 1.
I. Okay.
That's helpful. Thank you, Tracy. John, I just want to just turn to San Francisco and the Central SoMa Plan litigation, which is underway. I mean, is your intention there still to wait for that to get resolved before you thought about starting Flower Mart, even assuming if you got propM allocation?
Well, I think we could start substructure and so forth, but I think we'll take a look at that, Nick. I'm open minded, but I want to understand what the consequences could be given this particular litigation, which is more about blocking views, not by us, but others to some existing condo owners, those and then one neighborhood group. I think 1 of the 4 is going to be solved here pretty soon. So we're pretty open minded, but I'm optimistic that these things get resolved and put a full distance to court based upon the history in this city and based upon the history we've had elsewhere. But we're not the final arbiter of what happens, but we'll keep open minded.
I guess just one follow-up, John, is do you think that we could see more announcements that came on leasing for projects in that area where there's already been obviously one major lease that was done while this litigation was going on? Do you think there's a chance that other tenants could take leases ahead of this being resolved because
Yes, I think there's a likelihood that there's going to be a really big one. That's all I'm going to say.
Okay. Thank you very much.
And our next question today comes from Craig Mailman of KeyBanc Capital Markets. Please go ahead.
Hey, guys. Tyler, I just wanted to follow-up on the bad debt expense. I think 2Q of 'eighteen, you guys, I think it was $0.05 net, maybe $0.07 gross. Is there any more bad debt related to the tenant that you reversed that could come in through the balance of the year or is this it you guys think?
Yes. No, there is a couple of pennies left of that reserve. So that could come over time to the extent we have a different view on the tenant. Okay.
And they're current on rent and everything, right?
Yes.
Okay. And then just kind of bigger picture thoughts here. You guys did additional forward equity here at a discount to NAV. You guys did the forward deal last year at a discount to NAV, but the sales market is still pretty robust and Park Tower went at a pretty nice cap rate here. I mean thoughts on accelerating dispositions above your guidance versus incremental equity offerings where the stock price today?
Yes. This is John. We look at all those things, more to come.
Okay. So would you be willing to take more dilution on equity versus the sales? I guess just high big picture, I know you guys have nice yields that you're getting under development. I mean, does the math continue to work to take the discount and then make it up over time? Or are there better alternatives to that initial dilution?
Tyler, you want to add anything?
Yes. I mean, I think we do look at both alternatives in terms of funding and given that we had started Kilroy Oyster Point 9,455, we thought it was the right thing from a balance sheet perspective to use the ATM a bit more to help fund 2020. But you're right, we look at both dispositions and equity and evaluate how best to fund our growth. But in either event, what we're building and the returns we're getting are very accretive in either event. So, that's where we stand on that.
Okay. And then just on the forward ATM, when do you think the takedown of that roughly $100,000,000
is? Probably 2020. We have flexibility and we can take it down in pieces or over time. As I said in my remarks, probably July for the forward we did last year and probably 2020 for the forward we just did.
All right, great. Thank you.
And our next question today comes from Manny Korchman of Citi. Please go ahead.
Hey, everyone.
Tracy, Oyster Point, as you guys build that, do you think that leasing will come sooner and be more built to suit in nature or later something like Dexter where you have confidence that you'll lease, but it'll be closer to delivery and so you're building more of a generic spec project?
I would think of it more in the latter, Manny. I mean, the market is really healthy and conversations continue to be healthy despite how early it is, but it's historically not really been a pre leasing market. But we are pretty excited about our position in that market. And as John likes to say, more to come.
And then maybe John specifically on 333 Dexter, I guess we keep asking the same question. It's why isn't it leased in such a hot market? Is there anything specific that's holding things up or is it just a matter of the tenant hasn't signed yet?
No comment.
Thanks, everyone.
And our next question today comes from John Kim of BMO Capital Markets. Please go ahead.
Thank you. At KOP, are you committed to have a life science tenant in that asset? Or is there flexibility for an office user as there is at UTC?
Hey, John, this is Tracy. I mean, we if you remember back to Xchange, we have a life science warm up committed on Phase 1. So we think it's likely Phase 1 will go, life science, but it does have the flexibility to accommodate either. So I don't know if that gives you any clarity, but there's a lot of flexibility with the way we've designed it, intentionally.
Is there a strong preference to have it life science just given the market or is there greater demand or terminal value if it's an office tenant?
This is John. John, we're kind of agnostic in one sense because we're looking for what's best for value creation. On the other hand, we have multiple phases and it makes sense for the latter phases are likely to be life science to make the first phase life science. We've had many inquiries from the tech community, non life science tech and then we have, as Tracy has had a handful of significant deals that are pure life science. I think Phase 1 is likely to be life science.
We could explore other opportunities and we will. We want to keep our options open, but we are in the unique position of having one of the few really well located entitled sites for lots of square footage for 2,500,000 square feet, 2,700,000 square feet, whatever it turns out to be there in the four phases. So more to come as we build the final phases. I think we're going to do very well in Phase 1 with a number of life science companies that we are working with.
Okay. And then John, just another question on Flower Mart. There are local reports that the planning department will recommend 1,400,000 square feet to be allocated to your development, which is a little bit less than you have in Phase 1. Would you feel comfortable moving forward if you didn't the full allocation of the Phase 1 part of the farmer?
I don't really want to get into that, John, because there's a lot of negotiations going on between the city and the various developers and so forth. And I don't think it's prudent to answer that at this time.
Understood. Thank you.
And our next question today comes from Dave Rodgers of Baird. Please go ahead.
Yes. John, I wanted to follow-up on the asset sales. You did a good job in your comments talking about the demand for the highest quality assets and the net leased buildings. What are you comfortable taking to market? You said you've got a couple in the market now, whether these would be more non core or are you going to sell some of the better assets in the portfolio?
How do you think about that today?
Yes. I well, remember to the issue of funding, just generally because dispositions typically are a source of funding for our either acquisition or development as the case may be. There is as you know, there is debt, there is equity, there is joint venturing either of recapping existing assets or development joint venturing and of course there is dispositions. And we've tried to make it clear over the years that we look at all four of those things in sort of harmony and what is the best for us at any particular time. Specific to the range, we've given a range of 150 to 300 or 450 was 350, excuse me, too many numbers in my head today.
And we are very confident on the $150,000,000 We are assessing a couple of other projects. There is one that we thought we would sell, but when we take when we really drill down into it, we think there is big up side given where rents have gone and where demand is and we think there is probably 25%, 30%, maybe as much as 50% more value if we do some lease things in that one particular asset. So I can't give you specifics at this point, but we are not going to sell I don't see us selling any particularly strong core assets at this point other than one of the ones that's in the current $150,000,000 So we got a long year ahead of us. We have a lot of initiatives and we're I'm agnostic to tell you the truth, although when I see the rent increases that we're getting for an example here in San Francisco, deals that we did just a couple of years ago or a year and a half ago, now we're at rents that might be a third under today's market in a market that's likely to escalate by another 20%, 30%, 40% over the next few years.
So those obviously wouldn't be great candidates. So it's the acceleration in the market rents and demand for space is making our calculation as to what assets to select to dispose of a little bit more difficult.
I appreciate all that added color. Maybe shifting to 1 Paseo, the office leasing activity that you've done there, any more color that you can give on that and then the demand for the remainder of the space that you have under construction there?
Sorry, was that 1 Paseo?
Yes, sorry.
Yes, okay. You want to cover that, Rob?
Sure, Dave. This is Rob Parat. As we said on our last earnings call, the leasing activity we've had on the office space, particularly at One Paseo is unprecedented. And I think what we're seeing in San Diego in general is similar to the trends we're seeing in our other coastal markets on the West Coast, which is that along with fire category tenants, you've got technology tenants, life science tenants that are creating pressure in the market for the best in class office space. So when you look at what One Paseo delivers to a modern tenant in terms of floor heights, light and air, that sort of thing, that's what's driving the market.
Commodity space as it always does kind of lags the market. And we think I think what's unique also about One Paseo particularly is that it is mixed use. So you've got the residential, which is it's all going to add be additive. You've got residential, you've got this great retail where we're 96% committed now with many of the shops open and it's just creating a synergistic effect between the three components. So we're really excited about the activity we have.
We're excited about the types of tenants we're talking to. And I think it bodes well for this whole Del Mar submarket in terms of just future rent growth and absorption.
Great. Thanks. Last question for me, Jeff. The 4Q 'twenty expiration, sizing on that and how much work the building might need to re tenant?
So the one tenant that's going to be vacated in the Q4 2020, it's about 135,000 square feet And we got 18 months, so we're pretty excited about the activity. And Rob and his team are actively involved in looking at for new tenants.
Okay. Thank you, everyone.
And our next question today comes from Aaron Wolf of Stifel. Please go ahead.
Hi, I'm sorry.
Great. Thank you. John Guinee here. I guess, Tracy, two quick questions. What's your fully loaded price per square foot to develop Oyster Point and UTC?
And how much more is that than generic office product?
Okay, let's take that. So the first one on carry Oyster Point, I think we kind of touched on that. The incremental spend is roughly $450,000,000 but per square foot, we're approximately $950,000,000 a foot, which is a little bit shy of where market is on a competitive basis just based on our favorable land basis. So we're in a good spot from an all in cost basis on Kilroy Oyster Point. And then I'm going to rely on Michelle for the total cost of $9,455,000 I think we quoted $95,000,000 on an incremental basis.
Right. And then the price per foot is about $7.75 That's all in. Yes. So slightly different. You can see the difference of land basis and just construction costs, but they're both very favorable in terms of, the competitive set that they will play in, so to speak, as we lease up.
And then your question on just the incremental difference between office and life science, I don't know that we've said, but it's pretty modest. Some structural things that we do, but as you know about Kilroy, we do a lot of big floor plays, more rigid floor to accommodate tech and density. So for us, it's really modest.
Okay. And then Tyler, I think at your Investor Day last June in New York City, you gave soft guidance of an ability to hit maybe $1.10 or $1.20 a square foot a share in FFO by year end 2020. Do you still feel good about that number?
Yes. Taking all the other changes that have occurred like the lease accounting change and dispositions and staying leverage neutral and all that, we still feel we're in that ballpark, yes.
Great. Thank you.
And today's final questions come from Jason Green at Evercore. Please go ahead.
Just a question on dispositions. Given disposition guidance was unchanged from a modeling perspective, can you help us understand the expected cadence of dispositions through the year?
Roughly Q3 for those.
Got it. Thank you.
Thank you. This concludes our question and answer session. I'd like to turn the conference back over to Tyler Rose for any closing remarks.
Thank you for joining us today. We appreciate your interest in KRC. Goodbye.
Thank you, sir. Today's conference has now concluded and we thank you all for attending today's