Feature Story: Expert advice – Be patient and proactive

GlobeSt panel remains upbeat about the prospects for LSRE

By Murray W. Wolf

As we all know, we’re in a period of economic uncertainty that is resulting in a slowdown of life sciences real estate (LSRE) transactions, financing, development and leasing activity. So what’s a LSRE professional to do?

A panel of industry experts that was assembled last week at the GlobeSt Healthcare 2022 conference had some thoughts on that. During the event, held Dec. 6-7 at the Andaz Scottsdale Resort & Bungalows in Scottsdale, Ariz., they expressed continued long-term confidence in the LSRE sector, and they counseled patience, flexibility and a proactive approach to addressing tenant concerns.

The panel featured four experienced executives from four firms boasting significant LSRE experience:
■ Prescriptive Capital, a Denver-based private equity (PE) real estate investment firm specializing in medical office, life sciences, and active adult and senior housing, and whose principals have more than $20 billion of transactions in the alternative real estate sector.
■ Transwestern, based in Houston, a privately held real estate firm with a dedicated, full-service healthcare real estate team providing agency leasing, tenant advisory, capital markets, asset services and research to owners of commercial real estate (CRE).
■ Harrison Street Capital LLC, a Chicago-based PE management firm specializing in “non-traditional” real estate – including student, senior and build-to-rent housing, as well as medical office, self-storage, data centers and life sciences – with a total of $53 billion in assets under management (AUM) across all product types; and
■ CBRE Group Inc. (NYSE: CBRE), based in Dallas, the world’s largest CRE services and investment firm (based on 2021 revenue), with more than 105,000 employees serving clients in more than 100 countries. CBRE provides real estate investors with advisory, acquisition, debt and structured finance, valuation, property management, leasing, and disposition services “for the full spectrum of life sciences facilities.”

The panel discussion, titled “The Booming Life Sciences: Will it Continue to be a Strong Player?” included:
■ Chris Bodnar, CEO of Prescriptive Capital;
■ Peter Conte, senior vice president (SVP) and national director, Laboratory and Life Sciences for Transwestern;
■ Tom Errath, managing director, head of research for Harrison Street; and
■ Zack Holderman, SVP with the CBRE U.S. Healthcare and Life Sciences Capital Markets group.

The moderator was Masi Azizi, content leader and head of production at ALM Media LLC, the parent company of GlobeSt.

As of last week, at the time of the panel discussion, the U.S. Federal Reserve had already raised the Federal Funds Rate six times since March 7, increasing the Effective Fed Funds Rate (EFFR) from 0.08 percent to 3.83 percent. And the Fed raised the Fed Funds Rate a seventh time this Wednesday (Dec. 14) by another 50 bps, or 0.5 percent, to about 4.3 percent – the highest level in 15 years.

Intended to combat inflation, this tightening of U.S. monetary policy has had broad repercussions for the life sciences industry and LSRE. Those effects are generally well known, so we won’t recap them in detail, but some of them have included: reduced PE investment in life sciences; layoffs and sub-leasing of existing space by life sciences companies; a freeze or pullback in LSRE lending; and the slowing of LSRE investment, development and leasing.

With that as a backdrop, Mr. Azizi asked the panelists for their take on the LSRE debt markets.

What’s happening with debt?

Mr. Holderman of CBRE noted that real estate portfolio managers “may still group medical office and life science in the ‘office’ portfolio. But they’re looking at the suburban office or urban office portfolio and saying, ‘We need to balance. We need to place capital.’ So, from a lender’s perspective, it’s still in favor.”

The difference, Mr. Holderman continued, is that major banks are not lending right now, although the debt funds are still active.

“Unfortunately, the cost of capital has gone up alongside everything else,” he said. As a result, if you are a developer who was planning to do an LSRE conversion or new development, “you may be thinking twice about moving forward with the project, which is going to stifle some of the future supply.”

Mr. Bodnar of Prescriptive Capital noted, “We looked at a project where we would be the LP (limited partner) capital for a new life sciences development of about 500,000 square feet. The development partner that we were working with went to … 40 different lenders, and it only came back with one term sheet and it was from a debt fund 500 (bps) over SOFR.” The Secured Overnight Financing Rate (SOFR) is a broad measure of the cost of borrowing cash overnight collateralized by Treasury securities.

“And so when you look at that type of pricing,” Mr. Bodnar continued, “yeah, you go look back and say, ‘I don’t know if this makes sense right now.’”

One solution, he said, is “trying to make the project smaller to attract a different type of lender.” But in life sciences, he continued, the projects tend to be larger, “and so the lenders out there that want to take that risk on that size of projects are the debt folks. If you can … split it up into smaller chunks, you might be able to get a better outcome on the debt side.”

Mr. Holderman agreed, noting that “your 80,000, 100,000 square foot life science deal … could be a very, very sizeable loan.”

He added that shorter-term loans might still be available, but interest rates are higher than in the past, and the parties need to consider where the economy will be in two or three years.

“There will be solutions,” he said. “It’s just going to be painful.”

Mr. Conte of Transwestern said he is starting to see some other sources of funding, which is part of the reason some projects are being developed in secondary or tertiary market locations “rather than the Main and Main of whatever the hub is.”

He continued, “And we’ve seen a resurgence in owner-users who are willing to bet on themselves and they can borrow money at the same rate and find an equity partner that can ride alongside them – and wants to because they’ve got six drugs in Phase 3 trials and three are looking promising.”

Creative deal structures

Asked about creative deal structures, Mr. Holderman replied, “So you think about creativity and in the life science space, we will have to be creative in 2023 for sure. Business plans are taking longer, tenant activity’s slowing. It’s going to just naturally elongate things beyond cap durations and maturities.

“So I think the solution will be finding the right liquid partner who’s going to stretch a little bit on leverage based on where they detached previously, but … I don’t foresee a huge shift. Maybe in the equity side of the business, there’ll be some … potential recap opportunities. I think some folks will certainly cull their portfolio, particularly the aggregators.

“I think there’s a lot of folks who have raised a lot of money who may have stretched on a tertiary submarket within a primary, and I think we’ll see some of that shake loose at more reasonable cap rates than what we’ve seen.”

How is LSRE different?

Asked about the difference between LSRE, medical office buildings (MOBs) and other CRE product types, Mr. Conte replied, “I don’t mean this in a disparaging way, but it’s training some of the capital markets to understand the differences between life science and healthcare and MOB … or biomanufacturing facilities, which is different than … R&D facilities.

“And as the general marketplace gets more educated for these things – yet there can be nuanced differences – there can be creative solutions to some of these problems.”

Mr. Conte continued, “We’re not all the way there yet,” adding that only two of the top 10 pre-pandemic funding sources are still actively in the market.

“That means there’s a whole new crop of groups with money and capability and drive to get something done,” he said. “Portfolio allocations, whatever you’re trying to chase, you’ve got to figure out. ‘Okay, how do we do it? How we do it more efficiently, how do we do it better, and how do we educate ourselves so that we’re creating maximum flexibility?’” He said landlords need that flexibility because they often find themselves signing 15-plus-year leases with options for life sciences tenants that “haven’t even made dollar one yet on their revenue projections.”

He added that facilities need to pivot quickly, if necessary. But understanding the life sciences industry takes time.

“It’s not a quick education,” he pointed out. “It’s an incredibly nuanced technical one.”

Mr. Holderman agreed, saying that the recent “boom” in LSRE was “10 years in the making.” It helps that LSRE data is becoming more readily available, he added, but, “You can’t just pull up a white paper and become smart on the market. If you want to invest in multifamily in Kansas City, you could probably find four or five white papers and know what absorption is and concessions, and you’re probably dancing. You can’t do that with our product type, especially in the more nuanced emerging markets.

“The loan size is the biggest deal. I mean, the smallest life science deal that I’ve worked on, I think it’s $50 million. And that’s not a regional bank or local bank deal… It’s too big for them.”

Mr. Errath of Harrison Street added, “And I think the difference that we’re seeing (is that) nobody in this room would probably do a spec medical office building, but (with) life science buildings, that’s how you have to play.

That’s one reason investors and lenders must be so much more cautious, he said.

“We find ourselves tearing apart these companies,” he said. “‘What do you do? What kind of science? Where do you fit in the market?’ All of that kind of stuff.” He said the underwriting process is almost “more venture capital than real estate.”

Mr. Errath added, “We started a little bit early, so we’ve seen a lot and we’ve been educated. We’ve even started looking at some of these biomanufacturers, GMP (Good Manufacturing Process) facilities, which is a whole other thing altogether.”

A period of growth

Asked what it will take to revive growth, Mr. Bodnar countered, “I think we are in a period of growth right now.” He said the past two years of white-hot LSRE activity were “an anomaly” and it is good the market has cooled a bit.

“I think this is a very healthy part of the cycle that we’re going through right now – that it’s actually making it easier for venture capitalists and even real estate owners,” he said. “I think Tom’s right that on the life sciences side as a real estate owner you’re almost acting like a venture capitalist as well. It’s healthy to see…

“I think there was a lot of exuberance in the market and this is a healthy time, but I still think we’re actively growing,” he said, noting that National Institutes of Health (NIH) funding continues to increase. He added, “We’re seeing more and more companies coming from outside of the United States, to the United States, to do the manufacturing, but also to potentially relocate their headquarters.”

“I think that Chris is absolutely right,” Mr. Holderman said. “We’ve seen a period of tremendous growth both from the tenant side” as well as the real estate side. For example, he noted that Longfellow Real Estate Partners LLC “raised $2 billion in their second fund and there’s a ton of liquidity in the equity side that is generally aligned with those who really know what they’re doing.

“There’s a handful – you know there’s not many, as many as we all would like – of qualified developers and owners and operators of life science product. But they’re pretty flush with cash.

“Now that only goes so far. So I think the transactions may occur based on the capital markets side from, again, folks looking at their portfolio. It’s been an aggregation play for a lot of folks. There are a few merchant builders out there that are a little shorter in duration, but I think that portfolio management will prevail and there’ll be deals in the Greater Boston area that may not be so centrally located or within the envelope that Alexandria (Real Estate Equities) wants.

“And so they may spin it out at a reasonable number. You can talk about what reasonable is in today’s market, but there will be opportunities to collect real estate where you might otherwise have been boxed out by a pretty frothy equity pursuit, investor pursuit period.”

Mr. Conte noted that the life sciences industry is poised to grow even more rapidly.

“If we’re talking about all the funding that’s going on at the very low end of that barbell, again, all the start-up groups, none of those have come out of their incubation period yet. We haven’t seen any of that hit the marketplace,” he said. So rather than divvying up slices of a static life sciences pie, “the whole pie is just expanding more rapidly going forward than it ever has previously.”

Mr. Errath added, “To zoom out even further, I think the only thing that really addresses the U.S. healthcare crisis in terms of cost is the life sciences. I mean, that’s the only solution that I can see, because I don’t think we’re changing our behaviors anytime soon to solve chronic diseases like kidney, cancer, heart disease which account for 80 to 90 percent of annual healthcare spending…

“And I don’t really see that stopping and especially not with an aging population that’s going to be even more in the next 15 to 20 years. So that to me provides a lot of the fundamental investment thesis for why we do this.”

Noting that studies have shown that almost no other investment delivers a higher average return than life sciences, Mr. Conte said, “The money’s not going to stop flowing that direction, right?”

“The NIH funding is what separates our sector from a lot of other sectors, too,” Mr. Bodnar pointed out. “I don’t see that funding going away, either.”

Mr. Errath agreed, saying, “I think the NIH gives the United States this unique competitive advantage, because a lot of these other countries are just getting started with it” and don’t have a start-up culture. “They do a little bit, but there isn’t an organized way to get funding and that’s really where all this starts.”

What do you look for?

Asked what to look for in emerging markets, Mr. Errath said, “I’m sure everybody’s going to say the same thing. So we’re looking for educational institutions, health systems, people who have scientists or need for scientists … and certainly an educated populace.

“But I think more and more … as we think past the three primary clusters of San Francisco, San Diego, Boston, quality of life matters,” he said, adding that there are now a lot of different geographic markets that can support life sciences businesses.

“And oh, by the way, some of these other places are cheaper to live, too, which comes into people’s calculus at least in terms of where they want to work,” he said.

Mr. Holderman, who is based in the San Diego area, said “I used to wrongly say that San Diego will never lose folks to Houston or Philly because it’s, you know, colocation and it’s a gravitational pull – and we were all wrong. At least I was wrong. It’s happening.”

He added, “Obviously, you can’t perform science successfully in a living room. You have to go in the office.” But he said companies with multiple locations are “able to have the quality of life decisions and still perform science and become profitable.”

Mr. Bodnar said that, in addition to talent coming out of universities, an attractive LSRE market needs the right infrastructure in the form of incubator space – better yet if the cities provide incentives.

Where are the opportunities?

Next, the panelists were asked to talk about specific geographic areas that are particularly attractive for LSRE.

Mr. Bodnar chose Dallas.

“So for Dallas, we’ve been looking at a lot of opportunities there,” he said. “I think Dallas from a lab-to-talent pool ratio probably is the lowest in the country – the lowest amount of lab space versus the amount of talent coming out.” He noted that the University of Texas (UT) Southwestern Medical Center at Dallas in one of the nation’s top research universities, and the Dallas LSRE market can be compared to where San Diego was 10 to 15 years ago.

“Dallas has a lower cost of living and about half the lab cost of coastal markets, too,” he added. “So you’re not just looking at where people live and making it more affordable for the talent pool to be there to raise a family, quality of life, but as a company, too, you’re looking at the infrastructure as well, and what that cost is to run your business. So that’s my Shark Tank pitch for Dallas.”

Mr. Errath chose to focus on the Boulder, Colo., market.

“So we made an investment in a development in Boulder to be done yet,” he began, referring to the $74.5 million acquisition of Lafayette Corporate Campus Portfolio in the Boulder area in August. Harrison Street and its joint venture (JV) partner, Chicago-based Sterling Bay, plan to convert the 23-acre, five-building, 293,394 square foot office park for life sciences use.

“But what attracted us to Boulder and Colorado was a lot of things that I talked about before,” he said. “It’s a place where people really want to want to go. And clearly it’s nascent from a life science industry perspective.”

Mr. Errath added that Colorado offers an attractive lifestyle for young people and it is an area with numerous hospitals, universities, and other life sciences and technology companies. He said the JV partners are hoping to be “place-makers” with the Lafayette project, creating an environment that will attract new companies as well as divisions of existing firms.

“We’ll see how that story plays out over the next several years,” he said. “But that is our pitch for the Boulder-Denver area.”

Mr. Holderman, who chose to focus on the Houston area, began, “I think we would all agree that we’re not picking one over the other. I think they’re all very viable markets for all the same reasons.”

But he said, “I look for a lot of the fundamentals that I see in San Diego, and I chose Houston.” He said it’s not necessarily an “emerging” market because it already has a considerable concentration of life sciences companies. But it has all the characteristics life sciences employers and employees look for with a cost of living that is half that of the San Francisco Bay Area.

“So Houston’s big on our radar,” he said. “I love Dallas. I’ve done some work in Denver/Boulder Tech. I think they’re all great markets.”

Mr. Conte said he chose to focus on the Bay Area. He cited a statistic saying that “52 cents of every dollar that’s spent in life sciences has been either in Boston or California.” With that level of investment, he said, those markets are still very attractive “despite California’s best efforts to not allow development and progress.” He said the Bay Area’s established infrastructure, innovative culture and ample funding make it a very attractive LSRE market, and he doesn’t see that changing.

In fact, he said, “I see it growing even better going forward.”

Mr. Holderman noted that in addition to the more established Bay Area life sciences markets of South San Francisco and the East Bay, there are emerging markets farther south in places like San Carlos, San Mateo, Burlingame and Emeryville.

Mr. Conte agreed, noting that those and other cities have made adjustments to make themselves more welcoming to life sciences users.

Mr. Errath added, “We have seven or eight buildings in Hayward and our people tell us that group in the Hayward area … couldn’t be more cooperative,” whereas established markets like South San Francisco don’t need to put in quite so much effort.

Asked about onshoring, the panelists agreed they are seeing more interest on the part of U.S. life sciences firms in keeping or returning manufacturing facilities in and to the United States. Some European and Asian companies are also looking into setting up U.S. manufacturing operations due to instability in their home markets – concerns such the war in the Ukraine, as well as China’s draconian COVID-19 lockdowns and its potential aggression toward Taiwan.

“Exactly,” Mr. Conte said. “If you’re if you’re a company that’s been doing nothing but providing some base level of a protein, or a reagent or assembling, and you’re out of China, well, there’s a high probability there’s been some disruption to that supply chain.”

Advice for LSRE professionals

Mr. Azizi closed by asking the panelists what advice they might give the audience.

“Be patient,” Mr. Errath said. “I think what’s interesting is we’re all thinking about how the capital markets effectively seized up. But … the fundamentals of this industry are still pretty compelling. There might be a slight pause, but this is certainly not going away and I think it’s still quite early in its development…

“There’s a lot that can continue to happen and I think it will in the next five to 10 years to despite what we’re seeing right now.”

“Agreed,” Mr. Conte said. He added that the most successful life sciences products and services of the coming years most likely don’t exist yet.

“It’s something that probably is still in just some white paper coming out of a university right now,” he said, “and the only way to address that need, which is effectively impossible to predict, is to build the most flexible, capable, fundamental buildings close to the centers of those institutions and where those labor pools are… It takes a little bit of boldness in this current climate to do that.”

“I echo what you both just said,” Mr. Holderman added. “We’ve lived it before. You have to have stamina, you have to stay focused on the basics, obviously.” He also recommended proactively addressing some of the immediate concerns of the tenant base, pointing to CBRE’s recent $110 million acquisition of Full Spectrum Group, a provider of technical support services for high-end laboratory systems in the United States. By providing lab maintenance and repair services, the company frees up scientists to do what they do best.

Mr. Bodnar said the best advice he can offer is “definitely is, ‘Be patient.’ And you know, don’t get paralysis based on what’s happening in the market if you are a big believer in the sector.

“I’ve had a number of questions by investors and just people I know as to, ‘Is life sciences a fad? (Is it like) the tech bubble of the early 2000s?’ And I say, ‘Absolutely not…’ We’re still really early” in the life cycle of the industry.

“What we will be talking about in just two years will be completely different,” Mr. Bodnar concluded. “But the fact is that life sciences cannot be a fad because of all the different industries across our economy, and what our GDP is dependent on is all fundamentally tied back to technology and innovation, which happens a lot on the life sciences side.” ❏