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Kilroy Realty Corp. (NYSE:KRC)

Q4 2012 Earnings Conference Call

January 31, 2013; 01:00 p.m. ET

Executives

John Kilroy - President & Chief Executive Officer

Tyler Rose - Executive Vice President & Chief Financial Officer

Jeff Hawken - Chief Operating Officer

Eli Khouri - Chief Investment Officer

David Simon - Executive Vice President in Los Angeles

Heidi Roth - Chief Accounting Officer

Michelle Ngo - Treasurer

Analysts

Craig Mailman - KeyBanc Capital Markets

Josh Attie - Citigroup

John Guinee - Stifel Nicolaus

Brendan Maiorana - Wells Fargo

Michael Knott - Green Street Advisors

George Auerbach - ISI Group

Operator

Good day ladies and gentlemen and welcome to the fourth quarter 2012, Kilroy Realty Corporation earnings conference call. My name is Essania and I’ll be your operator for today. At this time all participants are in a listen-only mode. Later we will conduct a question-and-answer session. (Operator Instructions).

I would now like to turn the conference over to your host for today, Tyler Rose, Executive Vice President and Chief Financial Officer. Please proceed.

Tyler Rose

Good morning everyone. Thank you for joining us. On the call with me today are John Kilroy, our CEO; Jeff Hawken, our COO; Eli Khouri, our CIO; David Simon, our EVP in Los Angeles; Heidi Roth, our CAO; and Michelle Ngo, our Treasurer.

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 our statement regarding the forward-looking information in this call and in the supplemental.

This call is being telecast live on our website and will be available for replay for the next seven days, both by phone and over the Internet. Our press release and supplemental package have been filed on a Form 8-K with the SEC, and both are also available on our website.

John will start the call with an overview of the quarter. Jeff will review the conditions in our key markets, and I’ll finish up with financial highlights and initial earnings guidance for 2013. Then we’ll be happy to take your questions. John?

John Kilroy

Thanks Tyler. Hello everyone and thank you for joining us today. The fourth quarter capped an immensely productive and successful year for KRC. We entered 2012 a significantly larger and more diverse enterprise with a bigger geographic footprint, a deeper talent bench, a broader operating platform, a stronger financial position and a sharper strategic focus on the West Coast’s most promising growth markets for commercial real estate.

Throughout the year we leveraged our strengths to improve the quality and diversity of our office portfolio, continued our leading role in the development of a new generation of office space, built our visibility and credibility among potential tenants, maintained our momentum in leasing and capitalized on market conditions to monetize the value of non-strategic assets in our portfolio. Overall, we are very pleased with our ability to execute against all of these goals.

During 2012, we acquired $674 million of office buildings and seven transactions totaling 1.8 million square feet. We continued to establish KRC as a premier landlord in the best performing sub-markets of greater Seattle, added to our extensive Bay Area portfolio and significantly enlarged our platform of Los Angeles media and entertainment-oriented properties. Our projected stabilized cap rate for these acquisitions is in the mid-6% range.

We also added six development projects to our pipeline last year that upon completion will have a projected total investment of $1.2 billion and will significantly contribute to FFO growth.

Our decision to establish a development program in Northern California proved especially well timed. Five of our six new projects are located in the Bay Area, and four of them are fully pre-leased and under construction. In addition, we secured the rights to develop an additional $125 million Bay Area office project located in Redwood City. Overall, we project average cash yields in the low to mid 7% range for our pipeline.

We delivered another record year in leasing, topping 2011 results and producing the best performance in our company’s history. Across 2012 we signed new or renewing leases on more than 2.3 million square feet of office space, including 1.3 million square feet in the fourth quarter alone.

Our consistent leasing performance over the past three years has driven up our occupancy by 1,000 basis points. At the end of 2012 our stabilized portfolio was 92.8% occupied and 94.3% leased.

On the disposition front, we completed the sale of our entire industrial portfolio in the fourth quarter at a cap rate in the mid-5% range. For the year we sold 46 buildings in four transactions, generating gross proceeds of $500 million. Our success in disposing of non-strategic assets at full value prices has played a meaningful role in our ability to fund acquisitions and more recently development while maintaining the strength of our balance sheet.

Throughout 2012 we deepened commercial and community relationships in our key markets, strengthened our reputation as an innovator in commercial office space and added significant new names to our roster of top-quality tenants.

Salesforce.com, LinkedIn, Synopsys, Adobe, TD Ameritrade, Concur Technologies, Lucile Packard Stanford Hospital, all joined our roster of significant tenants last year. In San Francisco alone, a banner year of tech leasing for the city with more than 4.5 million square feet of tech leasing activity, KRC executed nearly one-fifth of those transactions.

We ended the year with a more valuable portfolio that is increasingly diversified across the best real estate markets on the West Coast and is meeting tenant needs in terms of densification and collaboration.

San Francisco, now among the world’s top-performing real estate markets in greater Seattle, a smaller but equally powerful magnet for the region’s fastest growing companies, represent close to half of our total NOI on a pro forma basis.

In San Francisco, specifically the SoMa district and the Mission Street corridor, rents for higher quality space continued to escalate and on a triple net basis have almost doubled since 2009. And in Seattle where the demographics are among the nation’s best, wage growth was the highest in the nation in 2012 at almost 5%.

Further, with an in-house dedicated sustainability team, we’ve built one of the largest LEED portfolios of any public REIT, with 30% of our portfolio LEED certified and half of our portfolio Energy Star certified. With the completion of our in-process developments, including 350 Mission Street, which will be the first ground-up LEED Platinum office project in San Francisco, almost half of our portfolio will be LEED certified, a very important criteria for both our company and for our tenants.

On the management front, I believe we’ve assembled the best commercial real estate team operating on the West Coast today and conscientiously established a leading presence in some of the most high growth, best performing and innovation driven markets in the country. It’s exciting and satisfying to see our carefully planned strategies succeed. We are focused on our commitment and intend to execute with energy and precision.

With that in mind, let me review our most recent highlights. It was a strong quarter for leasing. We signed leases on 1.3 million square feet of office space at average cash rents, 8% higher than the prior rents. We also have 430,000 square feet of in-place LOI’s and average cash rents approximately 15% higher than prior rents.

A market worth highlighting is San Diego, where we executed almost 300,000 square feet of leases in the fourth quarter. 80% of those were new leases, taking our San Diego lease percentage to 93%, up from 90% last quarter. The San Diego office market continues to improve with 13 consecutive quarters of positive absorption. Both vacancy rates and the unemployment rate continue to decline. We are encouraged by what we are seeing in our San Diego sub-markets and expect further improvement this year.

In San Francisco, we continue to see strong leasing activity at our 410,000 square foot, 360 Third Street redevelopment project. We signed three leases during the quarter totaling approximately 150,000 square feet and increased our lease percentage to 75% from 9% just a year ago when we acquired the building. We now have a diverse group of tenants that includes Comcast, SquareTrade, sports network Pac-12, advertising powerhouse AKQA, RealPage, and NBC.

The largest lease we executed in the fourth quarter, which was also the largest lease executed in San Francisco for all of 2012, was with Salesforce.com. As most of you know, in October we acquired the land and rights to develop a 27-story office tower at 350 Mission Street in the heart of San Francisco’s Mission Street corridor.

This is a very high visibility project for a number of reasons; its main and name location, its access to transportation, its cutting edge design with a digital wall and highly sought after side core configuration, and its first for the city of San Francisco, ground-up, LEED Platinum certification.

From the moment our ownership was announced, we had strong interest from several high profile tenants. Just eight weeks after acquiring the land, we signed a long-term lease with Salesforce for 100% of the property.

The project is currently under construction and we expect to deliver the building in phases during 2015. While we currently have the rights to build a 27-story tower, we anticipate adding an additional three stories, which Salesforce has committed to take and is permitted under current zoning. The project total investment for a 30-story tower is approximately $280 million.

We also closed on two other significant pre-lease development projects in the fourth quarter. First, we acquired a fully entitled 12-acre land site in the Silicon Valley sub-market of Sunnyvale, where we have commenced construction on a new 587,000 square foot headquarters campus for LinkedIn under a 12-year lease.

The new state of the art, $315 million corporate campus will feature three mid-rise Class A office buildings and a parking structure, all designed and pre-certified to meet LEED Silver requirements. The $13 billion global networking company is expected to take delivery of the project in the second half of 2014.

Sunnyvale is a highly sought after location with many significant tenants, including Apple, Yahoo, AMD and now LinkedIn. The development site is located along two major arteries bisecting Sunnyvale and just 1 mile via shuttle from CalTrain, providing both high visibility in the prominent Silicon Valley sub-market and convenient access to multiple forms of transportation, including the Central Expressway.

I think this is a pretty good example of how our development experience, Bay Area relationships and financial wherewithal allowed us to successfully secure a 100% pre-leased project, to a credit tenant that will generate very accretive returns for our shareholders.

As part of the overall LinkedIn campus, we also acquired an adjacent 76,000 square foot building for approximately $29 million. The building is currently 100% occupied by LinkedIn with seven years remaining on the lease.

The second development project is 331 Fairchild, an 88,000 square foot build to suit project in Mountain View, a sub-market of Silicon Valley. We are building an office headquarters building for Audience, Inc., a global provider of advanced voice and audio processors for mobile devices, on a 10-year lease. We estimate our total investment cost for the project will be about $45 million. We are under construction and completion is scheduled for later this year.

We are also making good progress on two in-process development projects. At our Columbia Square site in Hollywood, we are completing plans for the restoration of the 100,000 square feet of existing historic buildings and continuing to refine the design and square footage of the remaining office, retail and residential phases. The project has expanded somewhat and we currently estimate the project total cost to be slightly over $350 million.

And we anticipate receiving entitlements for 333 Brannan Street, our 170,000-square-foot, $85 million, state of the art brick and timber design project in SoMa within the year. This continues to be one of the most sought after and highest rent locations in all of San Francisco.

To recap our development activity, we have four projects under construction in the San Francisco Bay Area. They represent a total investment of over $800 million and all 100% pre-leased. Our two in-process development projects are currently in the design phase and are projected to have an aggregate estimated investment of over $400 million.

Given that the average cash yields on our projects are in the low to mid 7% range, which includes about $100 million of apartments at Columbia Square and market acquisition cap rates are 5% or lower, we believe we are creating very meaningful value for our shareholders. While cap rates can vary, the difference between current cap rates and forecasted initial yields would equate to more than $500 million of value creation.

On the acquisition front, we have completed $2.2 billion of transactions since March 2010, with our most recent acquisition in Seattle’s Lake Union district occurring earlier this month. Westlake Terry is a two building, 320,000 square foot core Class A office complex located in the very strong South Lake Union sub-market that has a current vacancy rate of just 4%.

We paid approximately $170 million for the property, including the assumption of $84 million in secured debt. The in-place cap rate is approximately 6.8%. Built in 2007 with LEED Gold certification, the project is located in the heart of South Lake Union, occupies a full city block, and is ideally located on one of Seattle’s main mass transit arterials, as well as directly adjacent to the South Lake Union transit line.

It is fully leased to a diverse tenant base that includes Group Health Cooperative’s headquarters; the other major tenant is Microsoft. The purchase price is roughly 20% below replacement cost and well below other recent trades in the area. This is another acquisition that I believe highlights the strength of our franchise in uncovering attractive investment opportunities.

To sum up, we are laser focused on the successful execution of our many activities; execution of our substantial development and redevelopment pipelines in the best West Coast markets, execution of taking our value add opportunities to core properties, continued execution of our leasing program, and execution of our asset disposition program. In addition, we believe we are well positioned to find more high quality value creating opportunities through our West Coast franchise.

KRC’s core real estate markets continue to experience economic improvement, positive year-over-year job creation and growing demand for high quality workspace. We see technology playing a bigger role in our everyday lives and have observed that technology is impacting all industries, retail, healthcare, education and entertainment among many others. We have positioned ourselves to continue to serve these dynamic growing industries.

According to a recent report on venture capital funding, investment levels are solid, but moderate and sustainable versus the prior cycle. During the latest quarter, California and Washington accounted for 55% of the nation’s VC dollars. This should bode well for our markets. With the continued growth of the technology sector, we are also seeing significant demand from non-tech tenants.

Our intent as a company is to continue to have a diverse portfolio. We’ve built organizational strength and capacity from Seattle to San Diego to take full advantage of attractive opportunities as they emerge; we’ve successfully executed across a larger operating platform and created value through development, redevelopment and our disposition program; and I’m confident we will continue to add new projects to the current mix, while acting with financial discipline and maintaining our focus on long-term value creation.

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

Jeff Hawken

Thanks John. Hello everyone. We continue to see improvement across all of our West Coast real estate markets. San Francisco is clearly in a performance class by itself, as it is now ranked among the top markets in the world. Seattle also remains very strong and Southern California has seen slower, but steady improvement.

Let’s take a closer look at our key markets, starting with San Diego, which in addition to experiencing ongoing positive absorption, has also had modest job growth and unemployment rate dropped to 8.1% from 9.3% a year ago.

The county added a net 20,300 jobs over the past 12 months. Given the limited new supply picture, we believe San Diego is poised for continued growth, driven by strong biotech, healthcare and telecom concentration.

As John mentioned, we made meaningful progress on leasing up our San Diego portfolio. We executed approximately 240,000 square feet of new leases in the fourth quarter, increasing our percentage leased to 93% in this region.

Moving to Orange County, our portfolio there now totals about 500,000 square feet of office space, following the sale of our industrial portfolio. Similar to San Diego, the unemployment rate dropped to 6.8% from 8.0% a year ago, and net absorption has been positive for three consecutive quarters. We are now 92% leased in this region.

The Greater LA area has shown signs of improvement as well, with the unemployment rate dropping from 10.2% from 12.0% a year ago. Entertainment employment was up 4% in 2012, almost back to pre-recession levels. It’s the view of the leading tech expert that Los Angeles companies are just beginning to see the benefits of the integration of technology into media and entertainment.

We expect our growing media and entertainment platform and the completion of our Columbia Square project to serve this expanding industry. We are 95% leased in LA. San Francisco continued to outperform in the fourth quarter with all time high leasing volumes driven by the continued growth of intellectual capital industries. The region’s unemployment rate dropped to 6.2% from 7.6% a year ago.

In the Silicon Valley sub-markets of Mountain View, Sunnyvale, Menlo Park where our projects are located, the fundamentals remain very strong with continued positive rent growth. We are 96% leased in the Bay Area.

Looking at Seattle, this market continues to have strong demographics and solid real estate fundamentals, particularly in our primary markets of Bellevue and Greater Lake Union. Bellevue is ranked by CNN as the fourth best place to live in the U.S., with more than 60% of its population above the age of 25 having a bachelor’s degree or higher. The median age of a worker in Bellevue is now just 34, down from 57 in the year 2000.

EBay just relocated from suburban Bellevue to CBD Bellevue to accommodate its workforce’s need for an amenity rich environment, abundant living choices and excellent transportation options. South Lake Union shares the same market strengths and now has a vacancy rate of just 4%. The Seattle unemployment rate is at 6.2% versus 7.8% a year ago. We are 96% leased in our Seattle properties.

Across our entire portfolio, we estimate that our rent levels are at the current market rates. Our remaining 2013 lease expirations total a modest 850,000 square feet, and we have signed LOI’s on approximately 20% of this space. We estimate that for these expirations our rent levels are approximately 5% below market.

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

Tyler Rose

Thanks Jeff. FFO was $0.63 per share in the fourth quarter and $2.25 for the year. This includes $0.015 of acquisition related expenses, as well as $0.01 of one-time income related to a tenant default payment. In addition while DirecTV’s cash rent commenced in December, we didn’t recognize any NOI on a GAAP basis since they didn’t take out occupancy on most of the space. That impacted our fourth quarter results by about $0.005 versus our prior forecast.

We ended the year with stabilized occupancy at 92.8%; that’s up from 90.1% at the year-end 2011 and 91.1% at the end of the third quarter. We are now 94.3% leased. Excluding one-time cash payments in both 2011 and 2012 related to the same tenant default I just mentioned, same store NOI in the fourth quarter would’ve been up 4.8% on a cash basis and down 0.8% on a GAAP basis.

As John noted, we just purchased the Westlake Terry project in South Lake Union for $170 million. As part of the transaction, we assumed $84 million of secured debt that has an interest rate of 6.05% and matures in 2019.

Turning to financial transactions, we amended our $500 million unsecured credit facility during the fourth quarter, in an agreement that reduced our borrowing costs and extended the maturity to April 2017. The facility now bears the interest of LIBOR plus 1.45% and includes a 30 basis point facility fee. During the quarter we raised approximately $10 million under our ATM program.

Earlier this month, we issued $300 million of 10-year senior unsecured notes at a rate of 3.8%. Given the strength of our markets, our improving fundamentals and our pre-leased development pipeline, we received strong support from the credit markets.

In terms of our balance sheet, we ended the year with a bit of an anomaly. We had a significant cash balance, as well as outstandings on our credit line. This was related to increased restricted cash as a result of 10/31 transactions.

These transactions have now been closed out and with the bond offering and proceeds from the industrial sale, we paid off our line of credit, paid off a maturing $84 million mortgage and funded the Westlake Terry acquisition. We now have full availability on our bank line and approximately $150 million of unrestricted cash to help fund our development program. We have no other debt maturities until late 2014.

Now, let’s discuss our initial guidance for 2013. To begin, let me remind you that we continue to 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 information and market intelligence as we know it today. Any significant shifts in the economy or our markets going forward could have a meaningful impact on our results in ways not currently reflected in our analysis.

With those caveats, our assumptions for 2013 are as follows: We do not include any incremental acquisitions or acquisition related expenses in our forecasted numbers, although we have included Westlake Terry and its related costs. For reference, we have been averaging about $0.06 of acquisition related expenses a year over the past three years.

We estimate 2013 development spending on our under construction development and redevelopment projects and Columbia Square to be approximately $350 million. That excludes any spending on Redwood Tower since the timing is uncertain.

Capital recycling remains an important component of our strategy and capital source. While 2012 included two larger portfolio transactions, we expect 2013 to include more one-off transactions. Our current guidance includes $150 million of dispositions, although this could change significantly depending on market conditions and other potential growth opportunities.

We project same-store cash NOI growth to be approximately 3.5%. We expect operating margins to remain in the 70% range for the year. We have included $0.03 or so of dilution from higher projected bad debt expense and the impact of a higher stock price on our exchangeable notes, and we estimate that DirecTV is in occupancy for half of the first quarter in terms of revenue recognition.

Finally in terms of occupancy, we expect to end the year at roughly 93%. While we were doing well in terms of backfilling our expirations as demonstrated by our 94% leased rate, there will be downtime before some of the new leases take effect, particularly in Del Mar and Bellevue. Given that, you will see a decline in occupancy over the next couple quarters of about 300 basis points to the 90% range before the new tenants move in. Again, these projections are subject to potential future acquisitions and dispositions.

Taking all that into consideration, including our recent bond deal, we are providing initial 2013 FFO guidance of $2.43 to $2.63 per share.

That’s the latest news from KRC. Now we’ll be happy to take your questions. Operator?

Question-and-Answer Session

Operator

(Operator Instructions). And the first question comes from the line of Craig Mailman from KeyBanc Capital Markets. Please proceed.

Craig Mailman - KeyBanc Capital Markets

Hey guys. You’ve obviously had really good execution here on leasing of the development pipeline and sourcing investments, and you obviously have a few other projects that you are going to look to start here in 2013.

Just curious from kind of a big picture perspective, how interested you guys are in keeping sort of the pedal to the floor here in doing aggressive sourcing, either when you built the suits or land sites or moving outside of Northern California and maybe LA to some other markets where you have parcels, or are you guys getting a little bit more hesitant here and maybe going to take a little bit more cautious stance as you deploy capital or look to deploy capital going forward?

John Kilroy

That’s a lot of questions. This is John. That’s a lot of questions all in one, so I’m going to try to be succinct. If you look at the history of this company, from the time we went public in 1997, we have bought when it made sense, we have sold when it made sense, we have developed when it made sense, and nothing has changed our philosophy. If anything, we are more focused on that than ever.

With regard to what we are seeing, is as long as we can stay within these very strong locations that we want to be in, and acquire assets that have the physicality that will serve them and us for the long term, meaning that they will respond to today’s tenants and future tenants in a positive way, and that we can make money for our shareholders, then we’ll be buyers or developers, subject again to the way we look at the macro world, our balance sheet, all of that sort of stuff.

We are very, very sober about the way we go about this and we’re opportunistic. We are not going to go out on the risk continuum geographically or building billions of dollars worth of spec projects or go off into tertiary areas.

Craig Mailman - KeyBanc Capital Markets

And you guys are still seeing a pretty good mix of projects and you haven’t really lowered your return hurdles to maybe keep the momentum?

John Kilroy

No.

Craig Mailman - KeyBanc Capital Markets

Okay, then just a quick one. San Diego sounds like things are going well there and just hearing the comments on the 430,000 square feet of LOI, it sounds like if you back out the LOI’s on the expiration table, maybe 108,000 square feet of new lease in that LOI pool. Just curious, how much of that may be in San Diego versus some of your other markets?

Jeff Hawken

You’re asking how much of our LOI’s are in San Diego?

Craig Mailman - KeyBanc Capital Markets

Yes. I’m just trying to get a breakout. Is that about right? There’s about 180,000 square feet of new lease in that LOI versus kind of the rest of it as renewals you guys are working on?

Jeff Hawken

Yes, well I mean I can give you the LOI breakout of the 430,000 square feet. About 250,000 square feet of it is in San Diego. 130,000 of it is in LA, so the bulk of it is in LA and San Diego.

Craig Mailman - KeyBanc Capital Markets

Perfect. Great, thanks guys.

Operator

Your next question comes from the line of Josh Attie from Citigroup. Please proceed.

Josh Attie - Citigroup

Thanks. Tyler, can you walk us through the move outs that you talked about that would reduce occupancy by 300 basis points? Can you tell us which buildings they are in and if new leases have been signed yet to back fill them in the back half of the year?

Jeff Hawken

Yes, this is Jeff. The two primary markets is Del Mar as Tyler said and San Diego. So Kilroy Center Del Mar, we have a tenant that’s going to be vacating. We’ve already re-leased about 80% of that building. So over the next couple of quarters we’ll see, as we retrofit the building for TI’s, that tenant will then move in.

And then the other one is up in Bellevue, Seattle, where we have a large tenant that will be moving-in in the third quarter. So again, we’ve got an earlier termination with the existing tenants to make the space available. It’s about a 122,000 square foot lease that we’ll occupy in the third quarter.

Josh Attie - Citigroup

Okay, thanks. And can you talk about the kind of sources and uses and the funding of development spend? It sounds like it will be $350 million for this year. You obviously have room on the line to do it, but I guess when you think about this year and also the next couple of years, how do you anticipate funding most of the development spend?

Tyler Rose

Yes, as I said, we have $150 million of cash today and in our guidance we have $150 million of disposition, so that’s $300 million. So for this year we’re pretty well funded, if you assume that, and we don’t assume any equity in these numbers, but we have availability under our ATM program to reissue equity and we have availability under the line. So assuming nothing else changes, we are in good shape for this year.

Next year, with the projects we have underway we’re $250 million to another $300 million roughly of spending. My guess is we’ll do more dispositions and depending on the markets, we may continue to issue debt or access the ATM market. I mean obviously next year is a different, we’ll have to see how it goes, but the big picture is we’re going to continue to raise capital through dispositions for a big part of that.

Josh Attie - Citigroup

And are there any potential tax issues with the disposition slated for this year?

Eli Khouri

No. This is Eli. We’ve been able to do 10/31 exchanges on 100% of all the dispositions that we’ve done and we’ll be able to do that going forward, so there aren’t any tax-related issues to it.

Josh Attie - Citigroup

Even if you use some of the money to fund development?

Eli Khouri

The way money moves around on the balance sheet and the way that we temporarily fund acquisitions, it’s too complicated to explain on this call, but the answer is there’s no implication to the question you asked. There are no tax implications, even though the proceeds will ultimately be able to fund in a fundable base of development.

Josh Attie - Citigroup

Okay thanks, and just my last question, it looks like you took a vacant building out of Sorrento Mesa and put it into redevelopment to increase the density. Can you just tell us a little bit about the timing and the potential cost of that project?

John Kilroy

Yes, this is John. That’s a 45,000 square foot concrete tilt up building at a killer location. We’ve got two hospitals that are under construction, one Scripps, one UCSB. They are both billion dollar modifications to their existing hospitals, billion dollar plus each.

They’re moving some of the MOB uses off campus, so we have everybody that wants to lease, major companies want to lease our site, which would be sort of a 150,000 square foot to 200,000 square foot MOB. As you know we’ve been very successful with MOB’s down in San Diego. We’ve essentially turn keyed them when we’ve sold them, haven’t we, Eli?

Eli Khouri

Yes.

John Kilroy

So we have been spending the last year plus with the city to get them – the way it works is you go through these preliminary conversations and hearings and what not, to determine whether they will green-light you to go through the entitlement program to receive the MOB designation. We’ve gone through that, so now we are not going to lease the building. We are going to go ahead and get the MOB processed through. Once we do that, we’ll scrape the building, build the MOB and I think we’ll have a tenant day one.

And the total cost is going to be, depending upon the size let’s call it $70 million plus, depending in terms of our cost for what will be a – it will be $50 million to $70 million or something like that, depending upon whether it’s 150,000 square feet or whether it’s 200,000 square feet.

Josh Attie - Citigroup

Okay. Thanks very much.

John Kilroy

Welcome.

Operator

The next question comes from the line of John Guinee from Stifel Nicolaus. Please proceed.

John Guinee - Stifel Nicolaus

Great, thank you. First John, a quick question. Did you ever think 10 years ago you’ll be using the phrase, highly desirable side core configuration again?

John Kilroy

Yes, it’s interesting, but I think the thing John, and I know you have a development background, I really think that there’s such an extraordinary thing that’s been going on and because of our development activities over the years we saw it very early, but I think what’s happening right now is you’re going to see a lot of buildings obsoleted throughout the country. That they are just not going to be able to handle the densification and the layouts and so forth and of course the side core is such a powerful thing for these kinds of companies, and yes, I hear you. I laugh about it a little bit.

John Guinee - Stifel Nicolaus

Okay. Second, real quick, is DirecTV, $35 a square foot, is that a net or a gross number, annualized base revenue? Do you know Tyler? I’m just looking at page 20.

Tyler Rose

It’s a gross lease.

John Guinee - Stifel Nicolaus

Gross lease, okay, got you. Then going back to you John, when I look at your development cost per square foot, they all seem incredibly good, i.e., low, with the exception of LinkedIn in Sunnyvale, where you’re in the land for about $180 a square and in the entire facility for about $533. How did the number get that high or am I just way off base there?

Tyler Rose

I’m not sure that’s exactly the numbers. I don’t have them committed to memory.

Eli Khouri

Yes, those numbers are pretty close. I think in an event like that what you are looking at is that because the lease was already in place, the acquisition price of the land is obviously going to be higher than if you had owned it or had a basis in the land for many years going back. But our total basis in that is going to be well below a commensurate acquisition for a long-term lease. So there is a median point there that maybe John, I don’t know…

Tyler Rose

Yes, well I think the other thing John is we bought all the architecture plans that were all completed, all the entitlements, permits, all that kind of stuff. So that number has a combination of what the land and entitlements go for today, as well as all the architectural stuff and engineering stuff.

John Guinee - Stifel Nicolaus

Okay, and then the last question is San Diego land position on page 25, it’s about the same list as five or six years ago. Any chance to monetize any of that land in the next couple of years?

Jeff Hawken

Yes, I think there is. I mean we’re working. I think we go before the planning commission on One Paseo, which is the lion’s share, not the lion’s share, but the biggest piece of that, which is the mixed use project which we’re making a lot of progress on.

We’re going to continue to have to fight for a while, but I think it gets resolved and so I think that will potentially get underway I would say next year. I don’t think it’s realistic that it’s going to – I mean it could get underway this year, we’ll see. And we have done substantial pre-leasing there of the retail. Everybody wants the apartments and the office building. I’m confident the two office buildings that we’ll have substantial pre-leasing there based upon our negotiations underway.

On the other sites, lot eight in Sorrento Mesa, we’re under preliminary design right now, and lot two in Sorrento Gateway, we’re negotiating with a tenant we have for that building. And then the other two big ones after One Paseo are the Santa Fe Summit. We actually have somebody we’re dealing with.

So we’re seeing the signs that what’s happened is there’s just so little Class A space available, and while the markets have improved in San Diego from a county standpoint, they’ve particularly strengthened in Sorrento Mesa and in the Del Mar 56 corridor, which is where we have our land parcel.

So I don’t want to say absolutely, but my sense is we are going to move a couple of pieces of land, probably lot two and lot eight into development within the next 12 months.

John Guinee - Stifel Nicolaus

Thank you very much.

Jeff Hawken

And to kind of think about that in return, it’s sort of in that early 7% total project return, but it’s sort of incremental returns in the high 8’s.

John Guinee - Stifel Nicolaus

Okay, and then Tyler, are you capitalizing interest on any of these projects?

Tyler Rose

No. Well, on One Paseo yes, but none of the other San Diego projects.

John Guinee - Stifel Nicolaus

Got you. All right, thank you.

Tyler Rose

Your welcome.

Operator

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

Brendan Maiorana - Wells Fargo

Thanks. Good morning out there. I think you guys mentioned that rents, at least on the 20% of LOI’s were at 5%, in places 5% below market. Is that a good number as we look out for all of 2013 and look out a little bit beyond that? And then related to that, Tyler I think you mentioned same store NOI growth was 3.5%. I just wanted to confirm that as well.

Tyler Rose

Yes. I did say 3.5% and I think on the rents what Jeff said was our overall portfolio was effectively flat. What he said was for 2013 expirations we are 5% below market, and then over the next couple of years, obviously it’s sort of hard to predict, but at the moment we’re sort of saying we’re in the 2% to 3% range under market for the next several years. So the good news is for the expirations sort of through 2016 we are under market.

Brendan Maiorana - Wells Fargo

Okay, that’s helpful. And then this question is probably for John or Eli. As you’ve kind of stated in the prepared remarks John, you guys aren’t buying stabilized assets, at least not much anymore, although you did buy Westlake Terry and you’d look to deploy capital where it’s appropriate and sell where it’s appropriate.

It sounds like even though it’s not in the guidance that you’ll do an additional acquisition or maybe additional development projects, it sounds like you’re hopeful that you could get some of those done. $150 million of sales is a reasonable number for ‘13, but I’d imagine that your non-core assets are probably larger than that target, and if you’re able to invest more, do you think that you sell more and is 2013 a good time to sell stabilized assets?

John Kilroy

Yes, 2013 is a great time to sell stabilized assets, and I was at an East Dale presentation, Eli and I were and David yesterday and of course they are saying cap rates are going lower and lower based upon spreads, we’ll see what happens. But the likelihood of doing greater than $150 million is directly tied to – that’s a placeholder.

We’ve said we’re going to do more if it makes sense to do more. So what would make sense to do more is a combination of where you redeploy the capital and so forth. We’re going to balance our expenditures and our dispositions as well as we possibly can. It doesn’t always happen perfectly, because it’s two different activities and in the case of dispositions this year Eli, most of that stuff is one-off, right?

Eli Khouri

In the year coming up, yes, a lot more portfolio activity in part of the year, yes.

John Kilroy

Yes. So, I think we are going to be pretty busy on all fronts. But with regard to your comment about traditional development or different acquisitions, if we can find the things that we feel comfortable in acquiring and taking to a higher value and getting the kind of appropriate returns and measuring it against risk and all, everything from our bond rating to our relationship with our banks and our shareholders and all the rest, then in other words I can say, as long as we can see it doing good deals, we are going to do them, if all things else being equal.

I have to tell you that having been in this business for 40 years and seeing the clowns that we have running our country on both sides and everything else going around the world, I have a healthy dose of conservativism financially.

Brendan Maiorana - Wells Fargo

Sure. No, that’s helpful, and then I would imagine that once you sell, dispose of versus what you invest in that there will be a move up in terms of quality as you get this done over the past couple of years. As we just think about where you’re likely to sell assets versus the development in value add investments, do you think from a cap rate perspective, initial stabilized yield perspective, your yield on new investments is higher than the exit cap rates that you sell at?

Eli Khouri

Well, if you look back at the last couple of years, it’s been exactly that. I mean I think we’ve been selling in the mid 5’s and buying in something closer to the mid 6’s and what we ended up buying, there’s a lot more running room in those assets, there’s a lot of growth, they are higher quality assets, they’re more strategic to us, better physical quality.

So we think we’ve made a great trade in all of the things that we’ve done to date on our disposition program, and we think we’ll be able to continue to replicate something along those lines. I mean that’s the opportunity that we are ultimately pursuing in the business that we’re doing. So that’s our objective to continue to be able to do that.

Brendan Maiorana - Wells Fargo

Sure. Okay, thank you.

Operator

Your next question comes from the line of Michael Knott from Green Street Advisors. Please proceed.

Michael Knott - Green Street Advisors

Hey guys. I was actually just going to ask on maybe any color you can provide on the profile of what you’re likely to sell in 2013, and is maybe the Orange County office on the docket?

John Kilroy

We’ve talked about this before. I don’t see any strategic reason to be in Orange County with what we’ve got. Do we dabble in something in the future? Maybe. But yes, I’d say those are probably logical.

And then we’re looking at some things that are more on the periphery in San Diego that are very good assets, but we think it’s time to re-deploy that, some of those dollars into other activities. And then Eli, what else have we got? Without getting real specific, some of the stuff on the 101 core that we have, we’re going to look at that.

So basically, if you think of what might be, if you sort of look at what might be in the – I don’t want to use it core in the sense of a city or a core product, but if you think of what might be more at the nucleus and then as you radiate out from that, some of those things are likely to be high priorities.

Eli Khouri

Yes. I mean we have a couple of deals that are already in the marketing process. We have another handful of deals right behind those that are as John described, that are about to enter or are approaching the beginning of entering the marketing process, assuming some of those things that we are checking out before fully launching continue to check out.

Michael Knott - Green Street Advisors

Okay, thanks. And then curious on geographically where you expect to grow from here. John, I know you talked about before eventually wanting to have, I think you said 50/50 Southern California and other. But just curious what you sort of think about, say West LA right now and do you feel like that market is obviously it’s trailed the Bay Area. Do you feel like that that market is a place to make some bets? Is it maybe like Bay Area 2010?

John Kilroy

Yes. I like West LA for sure. One of the thing that’s very curious to me though is, we all know the history behind West LA. It’s got some good schools and what not, it’s close to what people live in the ocean. Most of us in this room that live in LA, live fairly close to where we’re sitting here in West LA, so I like it.

The things about a lot of the buildings that are in some of the areas you’re mentioning is the physicality of them. I don’t think is really that great for the long term. So you start to look at where people might go, where you place your bet and then what the cost is.

For an example, we know that there’s a project that we’ve passed on twice before down Olympic Boulevard that’s supposedly coming to the market. Well, the light rail system has totally screwed the parking, excuse the language, but it’s totally taken away the parking on that project and so we look at that and say, that’s a limit. You could buy it; it’s in West LA. It’s decent physically, except for the parking has been really slammed. So that’s an example of a building we wouldn’t buy. But yes, we look at everything.

David, you probably could speak with a greater degree towards LA, so…

David Simon

Yes. Michael, we’re constantly going through the market. Santa Monica is really strong as you know. We’ve been down in Playa Vista looking around there, the west side. So all of those markets to try to find what John described as kind of the value add opportunity where we can put our muscle into it and really create value is where we are going to continue to look, and I suspect we’ll be able to pick off an asset or two as we look downfield for this year.

John Kilroy

And then of course there’s the bigger things, which is without mentioning the name, but somebody that owns a lot of assets in the north and south and so forth, and obviously when those things come up, it would be foolish for anybody to think that we are not going to take a good, hard look. So we’ve got our eyes ultimately on some things there as well.

Michael Knott - Green Street Advisors

Okay, thanks. And then on the leasing, I think you’re a little over 94% leased today. What’s sort of your thought over the next couple of years in terms of where you think that could go; a couple more points above that maybe?

John Kilroy

Yes, I think so. I think in the Bay Area we certainly can get there; I think Seattle as well; LA. I think there’s going to be some transformations in west LA, frankly, just going back to that for a second, because we’re dealing with quite a few people in west LA that are really taking a very hard look at our Columbia Square property, and the characteristics of their thinking is basically that it’s harder and harder to get to West LA.

More and more people, as you hire more and more people, they live somewhere else and the affordability in West LA is pretty tough. So I’m not forecasting that West LA won’t do well. I think it will do very well, but I think there are some other areas where some of the entertainment people will go. We like that Hollywood play that we’ve got.

In terms of the whole occupancy thing, it’s hard to tell. I think for a long time, for an example in San Diego, for years we operated at 100%; that’s a little unrealistic. So is it 95%, is it 96%, is it 97%, and then for how long does it stay there, who knows? But yes, I think it moves up, because there is very little product under way. But again, I’m talking about our portfolio, not necessarily the market, because within each market there is so much in the way of product that is deficient.

Michael Knott - Green Street Advisors

Right. Okay, thanks.

John Kilroy

You’re welcome.

Operator

(Operator Instructions). And your next question comes from the line of George Auerbach from ISI Group. Please proceed.

George Auerbach - ISI Group

Thanks. Hey guy. John, I guess how do you think about what inning we are in the development cycle, and how do you think about with your investments and land positions, positioning the company for where you think we are in the cycle?

John Kilroy

Well, it depends on each market for sure George. Your development in Seattle at this point doesn’t make sense in my mind, but it will get there at some point. Development in San Francisco, you’ve got to be very careful that you’re building the right product in the right area and what you want.

I mean, if you get too far field, you can find stuff that you can renovate, but you get more on the fringe and you get sort of, I don’t want to mention the name of some of the companies, but some of the companies that might be the ones that blow up. If you’re down in the core, you’ve got to be careful that you have the right kind of cores and floor plates and all that sort of stuff, and the right kind of cost structure.

So we’ve got our eyes on some things in the Bay Area that we think will materialize. Some of them are this cycle, which we like, because you have visibility. Some of them are next cycle and we’ve got to be very careful there to make sure that you don’t over invest and that you can withstand in your land cost or whatever some extraordinary circumstances that can happen from a timing standpoint.

In regards to the innings, I think we are fairly early in the inning, but I think that the game has changed for the players, and while we are seeing the talk that, hey, there’s some mezzanine money or this kind of money for local developers, the reality is development today, most things are fairly big; they are $100 million, $200 million, $300 million.

For a private guy, I mean there are certainly some private guys that can do this and Don brings the biggest of all, he can do what he wants is think about it, you’ve got to do personal guarantees, you need to raise equity. If you can get construction financing, even if you have a tenant, you need to raise 40% or 30% equity. That equity has an extraordinary cost.

So I think there’s a governor on the supply side if you will, based upon financing costs and whatnot, and I think that’s when we have a pretty good game plan, because we have development of something that we’ve historically done. We have a cheaper cost of capital than the private guys do and we give more certainties to the client. So I’m enthusiastic about further opportunities.

I can’t say, and I would be foolish to say that we’re going to do $800 million a year. I mean putting aside balance sheet and all the rest, last year, face it, we got there and sort of hit it perfectly, and I think just like what we bought in San Francisco, we bought sort of perfectly, we played the value-add perfectly or pretty well. We played the development thing, I think about as good as anybody could play it.

I see more coming based upon the discussions we’re having with tenants that need to be in the right kind of facilities, and I cannot emphasize it, I’ve probably said this twice in a different way on this call, but if you do not have the ingredients that these folks need, these companies need to attract and retain their employees, then you do not have an asset that you want to own for the long term.

And most of the assets in Silicon Valley meet more of that characteristic than they do the highly receptive, this-is-what-we-want kind of asset. So I think there’s going to be more opportunities. I can’t tell you how much.

George Auerbach - ISI Group

Okay, that’s helpful. And I guess just one more on the funding side. I guess given your sort of lack of confidence in the politicians and the development spend that you sort of know is coming this year and next year, I guess how do you think about accelerating the sales program or maybe being a bit more active on the ATM? Is kind of the biggest pushback on that just not wanting to incur the dilution too far in advance of the development?

Tyler Rose

It’s a good question, because we think about that a lot and we are not shy about incurring some dilution if it makes sense from a business perspective. It’s a long-term game, right? So we are thinking about exactly those things, and as I mentioned, we’ve got the cash effectively, assuming we complete our disposition to fund this year, but we are mindful, if not, of the world out there and being pre-funded, and that’s why we like our position right now with $150 million of cash, and we will continue to think about that.

John Kilroy

But I mean if you just look at the pattern that we’ve gone on, if you think about a couple things here, we did the bond yield. Well, that was dilutive, right, because we had $150 million in the bank, so you could figure out the dilution on that for a quarter.

We also had dilution like this Direct TV deal. While the rent started in December, first they didn’t occupy. They’re only going to occupy in the middle of this quarter. So we had a $0.005 or thereabout of last year’s dilution, we probably have $0.015. That’s in our numbers, about $0.015.

So things don’t go perfectly. They don’t go perfectly in funding and all the rest, so there will be times you have a little dilution here or there. But to take a look at the history of this company, we are going to be on the conservative side of the curve.

George Auerbach - ISI Group

That’s helpful. Thank you.

John Kilroy

You’re welcome.

Operator

Ladies and gentlemen, I will now turn the call over to Tyler Rose for closing remarks.

Tyler Rose

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

Operator

Thank you very much. This concludes today’s conference. Thank you for your participation. You may now disconnect. Have a great day.

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