Kilroy 4Q15 Earnings Call Notes

Kilroy Realty’s (KRC) CEO John Kilroy on Q4 2015 Results

West Coast market fundamentals continue to outperform

“While we recognize that there are macro factors creating uncertainties about the capital markets and future business conditions, West Coast market fundamentals for office space continue to outperform. We see strong demand and limited supply for the type of work environments that our tenant base requires. Rental rates and net absorption continue to increase, while vacancy rates continue to decrease year-over-year in the innovation driven markets of San Francisco, Seattle, Los Angeles, and the submarkets of Del Mar in San Diego.”

VC funding still well above healthy levels of 2011-2013

“While Bay Area VC funding in the fourth quarter was down from the highs of 2014 and early 2015, it is still well above the healthy levels of 2011, 2012, and 2013, which was a period of considerably higher vacancy rates. And already in the first quarter, brokers are advising that there are currently 750,000 square feet of new leases in process in the San Francisco market.”

Demand continues to look strong

“”based on our discussions with global heads of real estate, executives of companies in our markets and the brokerage community, demand continues to look strong against the backdrop of low vacancy rates, low availability of contiguous blocks of desirable space, constrained supply and increasing rental rates.”

There are big name companies in San Francisco, Seattle, San Diego and Hollywood that are looking to bring their people together in new space

“There are some additions, which I can’t obviously talk about which companies they are. But we are seeing some pretty strong demand for two to four years out, that’s been going on for the last year or two. These are companies that are pretty much household names, big balance sheet that are looking at how they modernize. Just like Viacom did down in Hollywood, where they brought all their divisions together and they — in some cases, they expanded various divisions, and in some cases divisions were reduced in size. But overall, they want to get their people together. The same thing is happening at San Francisco, Seattle, San Diego and Hollywood.”

There are big tech companies looking at space under construction right now that’s going to be eye popping

“There is a couple of major tech companies that are looking at some of the space that’s under construction right now, for major requirements; whether they move on that this year or not, I can’t really tell you, Brendan. But I can tell you that, amongst the — within the comments that Rob Paratte made and I made to Jamie a moment ago about future requirements, there are some big plays that are going on right now, that I think are going to be eye popping. If they go forward, they are going to be eye popping for San Francisco, they are going to be eye popping for Seattle.”

People are moving to where labor wants to live and play

“I think you are going to see a continuation of the trend that we have seen over the last four years, which is folks migrating to where the labor wants to live and play, you have to get two better areas than the city of San Francisco and Seattle.”

There are some properties that are not necessarily the best that are trading at pretty high numbers

“Well, I haven’t seen anything that’s a deterioration. What we have seen is some products that frankly, I would surprise, that the values they traded for, whether it was in San Francisco or LA. Some of the stuff, in my view, was not what I’d call core — kind of core locations, but not necessarily core, that traded at really healthy values in my opinion, based upon assumptions of — I think the markets, assuming that they are going to continue to be rental rates, we underwrite everything, we bought very little last year, we bought nothing, other than a couple of land sites. So I’d say that, some of the products that are coming on-stream are great. Some of the products that are coming on-stream are kind of — Mike and Rob, help me, or I’d say kind of not first cabin, not necessarily best location, and yet they are trading at pretty high numbers. We have seen a few projects that have come onstream, and I got to be careful, because we probably got confidentiality agreements on a couple of these things. We have seen a couple of things where the pricing was so over the moon for the outset or the location that they had to backup and ask for a different bid or lower bid. But those are properties, that in my mind — its like — somebody says they are going to sell you a Volkswagen Bug for $80,000, you are probably not going to get a lot of bids. So there is some of that.”

Haven’t seen any pullback from foreign investors

“We haven’t seen anything. Obviously, we don’t — there’s probably some better sources on that with East Hill and HFF and CBRE and what not. But we haven’t seen any pullback. To the contrary, we are seeing a number of foreign governments that are wanting to be in the cities that we are in.”

We are probably going to get projects off, but the macro does concern us. We are becoming a little more conservatively biased

“What we are seeing on the ground, and the demand we are seeing for a couple of years out would suggest that we are probably going to get some of those projects off next year. But I think, this is the time. I mean, everybody knows — who has ever heard me speak, knows that I concern about the macro, things that are going on in the world. We are not — I mean, we are definitely subject to all that stuff. So yeah, we are going to be conservative and make sure that we get a lot of pre-leasing done across the portfolio and make sure that we like the — what we are seeing in the tea leaves. And then we will make a decision. But I’d say, the bias has become more conservative towards development — spec development, given the factors that we are conforming with around the world.”

Overview of cap rates in markets:

“cap rates in San Francisco today, for quality space in the high threes or low fours and IRRs are in their high fives. In Silicon Valley, its sort of the same thing, maybe IRR is five to six. In Seattle, its cap rates of 4% to 5%, and kind of a 6% range IRRs. In LA, its anywhere from the high threes to the low to mid fours and cap rates, and low to mid to high, depending on the product, 6% IRRs. In San Diego and into Del Mar, its sort of in the 5% range on cap rates, and IRR is sort of the 6% to 7% range.”

We know VCs who got involved in companies that went from $4B to $10B to $6B

“I don’t think we have enough input on that. We haven’t seen it. We spend a lot of time — I personally spend a lot of time. I know Rob does too spend a lot of time with the VCs, the angel investors and others that are involved, that aren’t always VCs, that are family offices or others that are involved in a lot of these companies and a lot of those folks — what we are getting is yes, you’re going to see what value reductions, there are some people that have been burnt, where the company went from $4 billion to $10 billion, $6 billion or whatever it might be. Feel bad for those investors. If they are a tenants of ours, if they were okay, if we were okay at $4 billion, we are certainly okay at $6 billion and we did underwrite $10 billion.”

Some companies will fail and deserve to fail

“I feel like right now, people are being very — the VCs and so forth, they are spending a lot of their money on third and fourth stage, as opposed to first stage, and that’s not all bad. Some companies will fail and deserve to fail, let’s just be honest about this. The nature of technology is that, it rapidly evolves or even increase the revolution, and sometimes that obsoletes some other things.”