Life Sciences: Lots of underwriting, but not much buying

Yet IMN panel says there are still pockets of opportunity for investors

By Murray W. Wolf

NEW YORK – The life sciences real estate (LSRE) market continues to be characterized by good long-term fundamentals and strong investor demand, but also increased selectivity on the part of both tenants and investors, at least in the short term. As part of that, there has been a “flight to quality” and a “reversion to the core,” tenants and investors are more interested in top-quality facilities in the most desirable locations.

Meanwhile, although investors aren’t seeing many distressed assets yet, that could change as millions of additional square feet deliver during the next 12 to 24 months. And the flood of new entrants to the LSRE market has dried up because it’s become more difficult to obtain financing without a proven track record.

Those were some of the key takeaways from a panel discussion during the IMN (Information Management Network) LSRE Forum, held June 28 in New York. The session was titled, “Investing in Real Estate for Life Sciences.” It was moderated by Christian Dalzell, founder and managing director, Dalzell Capital Partners LLC.

The panelists were:
■ Michael Borchetta, director, transactions, Harrison Street Real Estate Capital LLC;
■ Marci Loeber, managing principal and chief investment officer (CIO), Griffith Properties LLC; and
■ Tim Olivos, managing director and portfolio manager, Ventas Inc. (NYSE: VTR).

Due to the volume of information the panelists shared, BREI is splitting our report into two parts.

This week, we take a look at what the panelists had to say about the LSRE investment market in general, their approach to underwriting, how they’re sourcing deals, where they’re finding opportunities, why tenants are being more selective, and how all of that is affecting leasing and asset values.

Next week, BREI will share the panelists’ insights into distressed properties, changing lab-to-office ratios, emerging geographic markets, the impact of AI (artificial intelligence) and other scientific breakthroughs, the persistence of the bid-ask gap, and more.

The dollars are still flowing into life sciences

During the introductions of the panelists, Ms. Loeber of Boston-based Griffith Properties explained, “We’re a women-owned firm based out of Boston. And we’re owner, operator and developer of life science, both R&D (research and development) and manufacturing, industrial and, believe it or not, office, which is a four-letter word these days. And we focus in Boston, the Philadelphia area and Washington DC.”

Mr. Borchetta said, “I’m a director on the transactions team here at Harrison Street within the life science space. We have about 8 million square feet of exposure in the U.S., and have also made a big push into Europe as well. We are one of the largest owners there. My role is to identify new acquisition opportunities and development opportunities in the space.”

Mr. Olivos of Chicago-based Ventas said, “We’re a diversified Healthcare REIT” (real estate investment trust), with a market capitalization of “about $30 billion dollars. I’m an investment officer covering medical office and life science properties, and our life science portfolio is about a little over 11 million square feet, all across the country.”

Mr. Dalzell of Westport, Conn.-based Dalzell Capital Partners began, “Everything that’s going on in the in the life science market seems to suggest that the investment into the sector has been rather intense despite the slight drop in funding. The amount of money that is going into trials that is being funded by the NIH (National Institutes of Health) that’s being funded by private and public entities both here and abroad has been rather staggering and, as a result, we’ve seen the amount of life science assets under construction increase from about 40 million (square feet) to almost 70-some million today.

“What are you buying these days?’

“Given that … rather … volatile but altogether positive backdrop, since there are so many strong fundamentals propelling the industry, Marci, what are you buying these days?”

“Well, we’re underwriting a lot – not to say buying,” Ms. Loeber replied. She continued, “There are a lot of opportunities out there,” but “a lot of them are broken deals … because, obviously, during COVID, doing life science became the flavor of the day… There were a lot of people that got into life science and they’ve tripped up. So, we’ve seen a fair amount of opportunities from that perspective, where ownership … didn’t execute on their business plan, financing markets or such.

“So we’re looking at a lot of deals,” she said. “None of them, quite frankly, work; the numbers are upside down, and the expectations that the sellers want, don’t seem to work”

Mr. Borchetta of Harrison Street said, “I’d say on the flipside what’s been really encouraging is … for stabilized product, especially in core markets, you continue to see this tremendous amount of demand from the capital market-side groups.”

Many of the recent deals have been recapitalizations of LSRE assets rather than outright sales. He noted that a number of firms, particularly Alexandria Real Estate Equities Inc. (NYSE: ARE), the LSRE market’s largest U.S. property owner, have brought recaps to the market. He noted that the capitalization rates (a measure of first-year returns) for many of those deals were in the 4 percent range, which is less than the recent average of about 5 percent. (Cap rate compression, without a relative increase in rental income, is normally inversely related to asset pricing. In other words, falling cap rates tend to go hand-in-hand with rising asset sale prices.)

“Now, most of those have a mark-to-market story,” he continued, referring to the process of adjusting asset values to reflect current market conditions. “But you know, when you trace across asset classes and you see a four-handle (4 percent cap rate) for a very solid product, I think that’s an encouraging sign of what people are getting to.

“But to echo what Marci’s saying on the value-add side and the development side – it’s becoming increasingly challenging to get deals done. The debt side of the equation … is becoming much less supportive of those types of business plans.”

Mr. Olivos of Ventas added, “I think they both covered it well. There are just not as many core deals right now. Beyond Alexandria recapping, there are a lot of long-term owners in the space who don’t feel the pressure to sell on the core side.

“So we’re seeing some of those broken deals. We’re seeing some potential development opportunities where the debt doesn’t quite get there. And there might be a need for a preferred or mezz (mezzanine financing) piece, but it’s definitely not like what it was 12 months ago.”

‘How do you source new transactions?’

Noting that the panelists’ comments about market conditions were “hard to hear,” Mr. Dalzell asked, “How do you source new transactions then? Are you accessing relationships? Are you scavenging the bin or…?”

Ms. Loeber said her firm’s approach to sourcing deals hasn’t changed “just because there is disruption on the demand side and the financing side… It’s still the old-fashioned, ‘It’s a relationship business.’ So that piece of it in this market hasn’t changed. You have to certainly work harder to find deals, but how you get them hasn’t changed.”

Mr. Borchetta said, “Yeah, I think what’s fun is to try to find some of these, whether it’s different sub-strategies, or submarkets within some of these broader markets…” he noted that both Ventas and Harrison Street “have always focused on some of these more secondary markets that are eds- and meds-focused,” referring to markets anchored by strong research universities and academic medical centers, “places like Durham, Boulder, Chicago, Houston.

“Those types of markets are continuing to see demand, and they’ve always been much more influenced by the NIH funding than necessarily venture capital (VC),” he continued. “The NIH funding has hit about $50 billion… About a decade ago, that was at $30 billion and change. So you’ve seen a tremendous amount of funding go into just as much these core markets as secondary markets. In many cases, those (secondary) markets haven’t seen nearly the same supply wave that you’re seeing in markets like Boston, South San Francisco and San Diego.”

“I think Michael’s exactly right,” Mr. Olivos said. “We’ve got a university-based life science strategy. So we’re typically partnering with universities. They are about half of our tenancy across our portfolio. So there are opportunities outside of some of those top markets that have a lot more supply coming on where you can find opportunities, and that’s probably where we’re more focused right now.”

Mr. Dalzell asked if some of the larger research universities, such as the University of Pennsylvania and Drexel University, with their own lab space, are becoming more of a competitor rather than a partner.

“We view them as a partner,” Mr. Olivos of Ventas replied. “I mean, Philadelphia is probably our prime example of our biggest success story. We’re in University City there, right in between Penn and Drexel and CHOP (Children’s Hospital of Philadelphia). And they’re great partners, and they’re helping drive the success of Philadelphia, and that market is increasing. So I think they’re a really important part of just continuing to build that ecosystem where Philadelphia is just on the rise.”

Mr. Borchetta agreed. Harrison Street has a project delivering in New Haven, Conn., in partnership with Yale University, and Yale absolutely exemplifies “the word partner,” he said.

“They’ve helped us procure additional tenants. That building will be delivered nearly 100 percent full by the time we’re open.” He said leaders in college towns view it as mission-critical “to keep the talent there and to allow these towns to grow and benefit from all the research and science that they’re doing. So we’re really bullish on that.”

Pockets of opportunity

Given current market conditions, Mr. Dalzell asked if there is “an opportunity to focus on perhaps something different? … Have you guys looked at different broadening asset classes or sub-classes?”

Mr. Borchetta of Harrison Street noted that although most people are referring to traditional wet lab R&D space when they’re talking about LSRE, the space is broader.

“A lot of the space that I think we’re going to see the preponderance of demand over the next 12 to 24 months looks very different than a mid-rise Cambridge (Mass.) product that’s eight to 10 stories,” he said. “I think the GMP (Good Manufacturing Practice) space … is interesting, and combine that with onshoring and some of the science progressing to a point where it’s actually commercialized. I think that’s a pretty interesting segment.

“And I think if you start to look at broadening to places like med device and diagnostics, which are more dry lab in nature, I think the life science Industry is very broad and you’re going to see some of these sub-specialties and sub-sectors start to outperform, maybe,” the traditional wet lab R&D space most investors have focused on.

“So just to add to that,” Ms. Loeber said, “I think certainly on the GMP side, those buildings that were targeted because they’re single-story – they have a lot of adaptability to other uses; the dry lab or the clean energy uses,” which are currently in high demand in Massachusetts.

Mr. Dalzell asked if in the current “flight-to-quality” environment, “with so many new assets coming online, newly renovated, newly-built … are you seeing the distress coming from, let’s say, the less sophisticated trying to develop something that might be beyond their reach? Or is it just a missed time calculation on the capitalization? Or…?”

“Well I think right now you certainly have the reversion to core within certain (geographic) markets,” Ms. Loeber replied. “Everyone wants to be close” to core markets like East Cambridge, “and tenants had to migrate out of that area because there weren’t options. And now people have options to stick to East Cambridge.

“So … certainly in Boston, you’re seeing East Cambridge, the Seaport and Watertown emerge as sort of the core markets, and those are the top choices for tenants. So if you’re not in those (markets), and then in the suburbs, Waltham and Lexington. So the tenants have the luxury to choose, where six, nine, 12 months ago, 24 months ago they didn’t have those kinds of options, and the geographic spread was by necessity, not by choice.”

Tenants have more options

Tenants are also assuming that the asset quality will be at a high level, Ms. Loeber continued.

“And you now have those options, obviously, given the amount of new supply that’s come online and the quality of the conversions,” she said. “But people don’t have to go out to new construction and more distant suburban markets like Framingham, Mass., “where a year ago, they might have had no choice” depending on what was available at the time.

“Now, tenants have more options… People didn’t have that kind of luxury when the market was hot, and you had to go out, tour and the next day you had to send out RFPs (requests for proposals). And now they’re going through a much more normalized process, which you saw during pre-COVID.”

Mr. Dalzell asked if newer LSRE assets coming online are creating disruptions by adding supply in existing markets where the panelists’ firms own properties.

“I think Marci was exactly right,” Mr. Olivos said. “There’s just more optionality for the tenants now.

“Before, in a lot of these markets, there just wasn’t space available. So if you had space coming online, you had a line out the door. You also had tenants with tons of funding, almost taking more space than they even needed at the time that they would grow into, just because they wanted to lock that up for themselves in the future.

“Now, they’re probably a little more cost-conscious, only taking what they need, and there’s a lower requirement,” he said. “There are more options and they can pick the best ones for themselves. So there’s more competition in those big markets.”

Having said that, Mr. Borchetta noted that Harrison Street recently renewed a lease for space in its Osborne Triangle at MIT project in Cambridge at “pretty much a record (rental rate) for us, well, into the hundreds (of dollars per square foot), despite this … glut of supply and headlines.”

As a result, he said, landlords continue to enjoy leasing success with the “right building, right submarket, right fit-out for what the tenants want. Those are in high demand, and continuing to see, especially on the renewal activity, very strong rents…”

Mr. Dalzell asked the panelists about building flexibility and construction costs. Ms. Loeber said developers are building more flexible buildings, but without any decrease in construction costs. “I think that is a ways away,” she said.

Mr. Borchetta said, “The reality is, especially for existing owners, the inflation costs are real.” He added that there have also been supply chain issues for years for components including chillers and generators, and now they are also having trouble getting switch gear.

“So you really haven’t seen this even leveling off for pricing yet.”

But that is a favorable situation for current assets, he said.

“There’s a lot of embedded value in the existing properties that were delivered either during COVID or pre-COVID-19,” he said. “And there’s a real mark-to-market story … the reason why you’re seeing people price existing assets into the 4 percents is because they’re very confident with the mark-to-market story and below-replacement-cost-basis, just given where costs have gone.”

Mr. Olivos followed up, “Yeah, like Michael said, those few core deals that are coming online probably have as much competition as there was 12 months ago, just because people do have money that they want to put into the right assets. So when there is a good opportunity, there’s still a lot of competition.”