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Life sciences: There will be a ‘hiccup,’ but LSRE prospects remain strong

Over the long haul, this industry will continue to grow, IMN conference panelists agree

By John B. Mugford

The “Acquisitions” panel included (from left to right): Murray W. Wolf of BREI, Adam Weinbaum of Alvarez & Marsal, Lynn LaChapelle of JLL, Erik Tellefson of Capital One Healthcare and Irwin Boris of Heritage Capital Management. (Photo courtesy of IMN.)

Any question about whether the life sciences real estate (LSRE) sector is in a bit of a bubble right now was put to rest during a panel session at the recent IMN (Information Management Network) Life Sciences Real Estate Forum, held July 28-29 in San Diego.

“We believe very much that there is a probability … that assets that we would buy today could be worth less in six, nine, 12 months from now,” said Adam Weinbaum, managing director of Alvarez & Marsal Capital Real Estate LLC, the private family office of New York-based Alvarez Marsal Inc., a financial services company and consulting group with 65 offices around the world.

In the long term, however, the firm remains confident about the asset class, Mr. Weinbaum noted, adding, “We believe in (the LSRE space) and cycles and the way things work. We do believe that today if you buy something there’s a likelihood that it’s going to be worth less in the short term, and no one wants to catch a falling knife. So, for us, we’ve had to really implement a level of conservatism in our underwriting, which quite frankly makes you non-competitive in a number of deals.”

He went on to say that he does not expect the firm to make another LSRE acquisition for the remainder of 2022, even though that could change if the market changes and/or an unexpected opportunity arises.

“But right now feels like a really precarious time,” he added, “and we’re okay taking the next four to six months off, sitting back and waiting and seeing what happens. And I know there’s another number of colleagues in other companies that are taking this similar approach.”

Mr. Weinbaum was one of four panelists during a session titled, “Acquisitions, Due Diligence & Disposition Strategies.” The discussion was moderated by Murray W. Wolf, publisher of Minneapolis-based Healthcare Real Estate Insights (HREI) and the newly launched Biosciences Real Estate Insights (BREI).

The other panelists comprised:
■ Irwin Boris, senior VP of acquisitions with Heritage Capital Management;
■ Lynn LaChapelle, a managing director based in San Diego with JLL Capital Markets, part of Chicago-based Jones Lang LaSalle Inc. (NYSE: JLL); and
■ Erik Tellefson, managing director of Capital One Healthcare, part of McLean, Va.-based Capital One Financial Corp. (NYSE: COF).

Ms. LaChapelle of JLL noted that many buyers are taking the same approach pointed out by Mr. Weinbaum, adding that they will make purchases that are “strategic” to their portfolios, or when an LSRE facility houses a small smart-up firm, perhaps a “biolab” company, they believe will experience growth.

“So, number one is being strategic,” she said. “Secondary is caution. People are very cautious right now in underwriting.
We’ve even seen, though we’ve had tremendous amount of market rent growth, that people are starting to dampen the market rent growth back to 3 percent.

“We’re also starting to see tenant improvement (TI) dollars, instead of the $225 a square foot number we used to see, we’re starting to see them grow to $250, maybe even $275, if they have to. With that, though, we’re seeing concessions being reduced. And then, of course, we have to carry that because most of our transactions have been ground up development deals.”

Mr. Wolf opened the discussion by providing data indicating how much the LSRE sector has grown in recent years, especially since the onset of the COVID-19 pandemic, which he noted “accelerated the growth of many life sciences companies during the past two years … and propelled VC (venture capital) funding to a record in the neighborhood of $40 billion or so depending on whose stats you want to use.”

As a result of such growth of the life sciences sectors and demand for space, construction of new facilities, including the conversion of other property types, has accelerated and sales of existing facilities reached $18.4 billion in 2021, an all-time record representing “an amazing, almost 64 percent increase year over year, according to Newmark.”

He added that pricing for “Class A” life sciences facilities in the country’s major life sciences clusters “surpassed $1,000 per square foot in some cases in 2021, with pricing approaching $2,000 a square foot for best-in-class assets, but many secondary and tertiary markets, as we’ve seen, have also enjoyed a lot of significant activity in the past couple of years.”

“Some of the biggest beneficiaries in this area were properties in the largest life sciences clusters as we’ve talked about, namely Cambridge Boston, South San Francisco, and of course, right here in the San Diego area, in the Sorrento Mesa submarket.”

However, with certain aspects of the economy showing and creating headwinds for many industries, Mr. Wolf said “the picture” heading into the second half of 2022 “is clouded a little bit. We’re facing record inflation, rising interest rates (and) … bearish financial markets. VC capital funding for life sciences is still at historically high levels, but it has cooled a bit.”

Mr. Wolf added that “on the real estate side, all of the 2021 life sciences development, including a fair amount of spec building and construction beyond the established clusters has, not surprisingly, contributed to higher inventories, lower occupancy rates and reduced asking rents, not precipitously, but you definitely were feeling it.

“Some of you have even begun to talk about the possibility of a life sciences real estate bubble.”

Is there a bubble?

“I would say that this market … had been white hot for a number of years, and I don’t think we’re white hot anymore,” said Mr. Weinbaum of Alvarez & Marsal.

However, while he still considers LSRE to be a “hot market,” he added that the sector is going through its first full cycle in which “fully stabilized assets” are being put up for sale.

“It’s still a hot market and the story is still very much playing out, as we can look at, for example, adaptive reuse,” he said. “We’re starting to see projects that are going through a full life cycle that are coming out to market and being sold, whether they’re in San Francisco, Boston or here in San Diego. That’s not something that we haven’t really seen before because, generally, the owners of life sciences properties have been long-term holders.

“So, we haven’t seen this cycle of fully stabilized assets being brought to market, and we need to understand who’s buying those assets.”

The LSRE sector, he added, is “very much … here to stay as (a number of) the institutions have, you know, designated life sciences as an asset class that must be a part of their portfolio. How they’re rebalancing their portfolios, and what percentage (LSRE) is going to be in it, that I don’t know.”

Another question moving forward, he said, is whether buyers will start “paying market cap rates. Are they going to use the same fundamentals that we’ve been using in real estate all these years, or are they going to start choking at the prices per square foot.

“We just don’t know, but that is something that’s very much playing out right now. I know there’s a bunch of transactions in San Francisco in the Bay Area that are happening. There are some transactions here in San Diego… It’s an exciting thing to see.”

Making sure to mitigate risk

Before Mr. Wolf posed to the panelists the question of whether the LSRE sector is in a bubble, he compared the space to healthcare real estate (HRE), which, like any other real estate sector, goes through good times and not-so-good times, even though many HRE professionals often refer to it as being recession-resistant.

“In the healthcare real estate world, we often say, ‘People are always going to get sick.’ There’s always going to be a demand,” he said, “and through multiple recessions, healthcare real estate has proven to be, if not totally recession-proof then certainly recession-resistant, and it does seem like we might currently be on the brink of a recession.”

So, he asked the panelists, “Are you at all concerned about life sciences? Is this business here to stay? How do you think we’re going to get through this the next couple of years?”

Mr. Boris of Heritage Capital Management, which, during the past four to five years, has “had a fairly large component of healthcare and life sciences” assets, said the success of life sciences properties is dependent on “your tenant mix or, you know, how well funded those tenants are… You do have to worry about tenants being acquired and consolidated, and then, what do you do with the space they vacate?”

He provided some insight into what Heritage does to protect itself from tenants vacating the firm’s space.

He noted that there is risk for LSRE facility owners who, perhaps, own “a life sciences campus across the street from some old R&D (property) that (contains) flex (space), and the rent differential is perhaps 40, 50 percent less (across the street), and the tenant has to save rent and you’re willing to put the money in to sort of meet them halfway and they end up moving across the street anyway.

“I always have to assume that that’s going to happen (and prepare for it), because I like to know how I can sleep at night. I’ve got a mortgage.”

When Mr. Wolf asked whether, as a result of such concerns, Heritage is “tweaking its tenant mix,” Mr. Boris responded: “We are. We like a mix of … life sciences and some traditional flex users. We have a half-a-million square foot campus in Indianapolis across from the university hospital there. And so, we have some compounding pharmacies and some other R&D space, with some medical groups. And mixed in there, some traditional stuff.

“So, I’m not worried about (that property),” he continued, adding that the firm includes “relocation clauses in everybody’s leases. So as these tenants expand and contract, I can move them around, because if you have a grant, you can’t move your address necessarily or your insurance billing, as it’s a grandfathered address. So, I have to be able to allow you to expand and contract for grant purposes or for insurance purposes.

“It’s why we like a lot of flexibility.”

Where are rents going?

The panelists indicated that for a number of years tenants of LSRE facilities have been paying, for the most part, below-market rents, especially in certain markets.

Mr. Tellefson of Capital One, which he said has been averaging about $1 billion annually in LSRE financings in recent years, noted that “one of the interesting dynamics (in the LSRE sector) has been the (below) market rents. (For example), particularly up the street here in the Sorrento Mesa (submarket of San Diego) a lease six months ago was way below market; it’s still way below market today – like, significantly.

“And, you know, Murray as you pointed out, with the rising interest rates and some of the equities on life science companies, it will be interesting to see if that dynamic (stays the same), or which direction it goes. So that’s a positive for a lender. You know, I feel like the folks that signed the lease probably wish they’d waited a little bit, but you know it’s good for us to have it. We like below-market leases anyway.”

Mr. Boris of Heritage Capital added that “rents are always going to come and go and I hate long-term leases because you know, the more I can move the rents up and down the better I feel about the market.”

Heritage looks to acquire facilities with short weighted average lease terms (WALTs), he noted, as most LSRE leases are for longer terms with “pretty flat rent escalations.”

Ms. LaChapelle said JLL keeps a close eye on average rents for office, life sciences, and industrial and flex facilities.

“Over the past in San Diego, specifically, we’ve seen 20-plus percent rent growth between 2020 and 2021 and close to a 30 percent rent growth between 2021 and 2022,” she said. “Overall, on a national basis, life sciences rents are up 14 percent year over year with Boston, really the One Kendall Square area of Cambridge, getting close to $120, $130 triple net. The Bay Area is closer to $80 a square foot triple net, and San Diego is just right behind between in the $72 to $80 plus triple net.”

Rising rents, she said, has led to increased development of “purpose-built life sciences campuses instead of … repositioning. As rents have risen in the past four years, we’ve seen that purpose-built life science projects are being developed primarily in Boston, San Francisco and here in San Diego as well.”

The rise of purpose-built facilities

Ms. LaChapelle noted that when rents in LSRE facilities were in the $48 to $60 per square foot (PSF) range a few years ago, there “really weren’t a lot of purpose-built life sciences projects.”

The sector’s largest landlords, such as Pasadena, Calif.-based Alexandria Real Estate Equities (NYSE: ARE), Denver-based Healthpeak Properties Inc. (NYSE: PEAK), and San Diego-based Biomed Realty, which is part of New York-based Blackstone (NYSE: BX), “were the leaders of the (purpose-built) movement because they have the lowest cost of capital. And there was a tremendous amount of demand for that kind of space.”

Many of the purpose-built projects, she noted, have entailed converting other types of properties, such as industrial/flex, office and R&D parks, into LSRE facilities.

“Buildings that could be converted were really in high demand because it was all about speed-to-market,” Ms. LaChapelle explained. “As those products have been converted, tenants have moved out and we’ve seen that purpose-built campuses are really starting to come on online. It’s interesting, as about 50 percent of the Sorrento Mesa market is being converted right now to life science product, which is really remarkable.

“Our overall vacancy rate (in the Sorento Mesa market) is less than 1 percent, and in the wave of development that’s occurring, 90 percent of it is preleased through 2024. So, while I know everybody’s concerned about … the lack of tenant demand, but honestly, a lot of those companies that raised money in 2021 are really hunkered down and holding onto capital. And what we’re seeing is that there is going to be a second wave of deployment of capital once the bid-ask spread in warrants and stock prices kind of between the VC (venture capital) funding and those emerging growth companies start to capitulate in 2023.

“We do think that demand for space (in the local market is) probably going to be not quite as high as our 4.8 million square feet that we had last year, but that it will be closer to 3 million, or 3.5 million square feet.”

Still bullish on LSRE

Even though the market could be facing some headwinds and a bit of a bubble, the panelists, as noted earlier, remain upbeat regarding the space and the life sciences industry itself over the long run.

Mr. Tellefson is certainly one the bulls.

“We are still bullish on healthcare assets in general and life sciences in particular,” he said. “The interesting thing, though, is that probably since 2007 this is the first time that deals are being sized by debt cover as opposed to a percentage of cost. So that, that makes it interesting, right?

“That really affects the kind of cognitive dissonance between buyer and seller. Because to Lynn’s point, you can only put X amount of debt on it because it just won’t cover any more, particularly with how expensive hedges are, as they are often required these days as the interest rate management gets expensive. And then, when interest rates go up, spreads go up. So, the cost of borrowing in general is getting higher, ergo you get a lower loan and therefore, theoretically perhaps, you’ve bid a little less.

“So, we’ll see if all that math plays out,” Mr. Tellefson added, “but you know, for now we’re very happy to lend on them.”

Capital One, he noted, is focused on financing stabilized LSRE facilities in the stronger geographic markets, or places where there are compelling cases for such facilities.

“We’re looking at Boston, San Francisco, Raleigh-Durham (N.C.) and San Diego for the most part,” he said. “And then we also really like places and facilities where there is a tie-in with universities … which gives us a typically solid anchor tenant, which is usually the R&D and usually has a connection with a university whose credit is backfilled by folks that work with the university. We like those types of geographies, even though we not necessarily opposed to other types of geographies that make sense for other reasons as well.”

Capital One also wants to be sure that if a facility fails as an LSRE project, it can be converted to some other use.

Going back to Mr. Wolf’s point that there will always be a need for healthcare, and for that matter, R&D and the production of drugs to treat and perhaps cure certain diseases, Ms. LaChapelle said that a the “population continues to age, cell and gene therapies will continue to scale, and … making sure that we can ensure that our country can have adequate supplies (of such drugs) is super important.

“Because of this, I think (LSRE) is going to continue to grow. And, you know, as far as funding goes, there will always be funding for good science. Big pharma is sitting on over $170 billion of dry powder for M&A activity. So, if the VC funding companies don’t put their money out at any certain time, pharma is there to step in.”

Mr. Weinbaum added that “over the last 10 years or 15 years, our lives and technology have been focused on our phones, the internet, our connectivity, solar power, electric cars, etc.

“I very much believe that the next 10, 15 or 20 years are going to be focused on technology for us, for our bodies, our lives, our health, and that’s what we’re seeing,” he said.

“COVID has only accelerated that, and my hope is that the younger generation has seen this and they will be energized by this and will want to go into this industry, producing more and more engineers, chemists and scientists that want to cure disease, cure illness, make all of our lives better.

“So, I very much believe that the life sciences industry and the real estate part of it are here to stay. Do I think there’s, is there going to be a hiccup? I think without question, but over the long haul, this industry will continue to grow.”

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