Life Sciences: ‘Increasing demand’ and ‘vast opportunities’

Alexandria executives conveyed upbeat messages during their Q3 earnings call

By Murray W. Wolf

PASADENA, Calif. – Despite “a de facto recession,” a “self-inflicted inflationary and high interest rate environment” and “too much stupid supply,” particularly in the South San Francisco market, the nation’s largest owner of life sciences real estate (LSRE) says concerns about the sector are overblown.

Executives of Alexandria Real Estate Equities Inc. (NYSE: ARE) conveyed upbeat messages last Tuesday (Oct. 24) during the firm’s third quarter (Q3) 2023 earnings conference call with securities analysts.

As BREI reported last week, Pasadena, Calif.-based Alexandria, the nation’s largest owner of LSRE, beat consensus estimates for its funds from operations (FFO) in Q3, as it has for each of the past four quarters. However, the life sciences-focused real estate investment trust (REIT) missed the consensus estimate for revenues, took a $90.8 million impairment as it scrapped plans for a lab conversion project in the Greater Boston market, and has seen its stock price plunge about 29 percent year to date (as of yesterday, Nov. 3) versus the S&P 500’s gain of nearly 14 percent.

Yet executives of the only publicly traded, pure-play life sciences REIT remain staunchly optimistic about the life sciences industry and the company’s future.

A market ‘filled with skeptics’

Alexandria executives rarely speak to the news media, so their comments during their quarterly earnings calls provide a rare glimpse into the firm’s mindset and strategy. So let’s take a closer look at what they shared with the securities analysts last week, starting with comments from Alexandria Executive Chairman and Founder Joel Marcus.

“We know this is a tough, ‘show me’ market filled with many skeptics,” Mr. Marcus said. “Many of those skeptics (are) doubting the health of the life science industry despite clear facts to the contrary – overblowing the impact of the elevated levels of new construction, no matter the quality, location and/or sponsor or operations. And we know of numerous operating debacles causing substantial damage to tenants by so-called other operators…”

He noted that a leading indicator of the health of the $5 trillion life sciences industry – and a demand driver for LSRE – is the volume of U.S. Food and Drug Administration (FDA) approvals. He pointed out that there have been 45 drug approvals so far this year, “and it could surpass the all-time high of 59 in 2018.” He also noted that biotech, with about three-fourths of those approvals from 2015 to 2021, “continues to be the mainstay of innovation.”

Mr. Marcus continued, “Third quarter leasing of approximately 870,000 rentable square feet was very solid and especially with a weighted average lease term (WALT) of an amazing 13 years and very strong leasing spreads, almost 20 percent on the cash basis and almost 29 percent a GAAP basis while leasing costs were decreasing.”

He added, “We are in a de facto recession and in a self-inflicted inflationary and high interest rate environment. So that is driving caution. But the life science industry is unequivocally healthy, thriving and the key to improved healthcare outcomes, which are desperately needed for all of us.”

Demand despite a downturn

Hallie Kuhn, senior VP of science and technology and capital markets, went on to spotlight the strengths of the life sciences market.

“First, massive unmet medical need, with over 90 percent of known diseases having no available treatments, drives the life science industry, providing a tremendous opportunity for innovation, new company formation and life science industry growth,” she told the earnings call listeners. “This opportunity set does not change at the whims of the market. It is non-cyclical and non-discretionary.

“Second, tenant growth and demand are event- and milestone-driven. Important milestones include new biological discoveries, successful advancement of experimental therapies into the clinic, and ultimately the demonstration of the safety and efficacy of new medicines. Expansion of new therapeutic modalities such as cell, gene and RNA medicines; better diagnostic tools to accurately identify and diagnose patients; and increasingly efficient and predictive clinical trial designs have the potential to increase the number of new medicines over the coming years.

“Third, multifaceted and differentiated funding sources ensure that life science companies founded on impactful and differentiated technologies with experienced management teams continue to thrive. Altogether, we estimate over $400 billion will be deployed to support life science companies in 2023 across venture funding, biopharma R&D (research and development), philanthropy, government, grants and public equity financings.”

Ms. Kuhn noted that funding this year has already exceeded the previous 10-year average of $360 billion.

“Together, the massive unmet medical need, event-driven growth, and robust and diverse funding sources result in secular growth of the life science industry that drive additional demand for Alexandria lab space, even amid an economic downturn.”

Ms. Kuhn also touched on the potential impact of artificial intelligence (AI) and machine learning (ML) tools. Contrary to speculation by some, she said, AI will not “negate the need for lab space. In many cases, AI-focused life science companies require significant lab footprints to generate the immense biological and chemical datasets needed to effectively train AI ML models.

“To this end, the acceleration of AI may, in fact, increase the need for laboratory footprints, and we already see this manifesting as an exciting emerging segment of demand,” she said.

“Now, moving to the health of our diverse life science tenant base. While some analysts and investors have a misconception that small and mid-cap biotech (companies) are a proxy for the entire life science industry and its growth, the reality is broader and far more complex.”

Ms. Kuhn said large multinational pharma firms, which account for 18 percent of Alexandria’s accounting rate of return (ARR), are “leveraging healthy balance sheets to double down on R&D and in licensing… Biopharma also has an estimated $500 million in M&A firepower to continue to bring external innovation into their portfolios… The specific impact of M&A events needs to be looked at on a case-by-case basis, but it’s broadly positive.”

Public biotech companies, which account for about 24 percent of Alexandria’s ARR, are also generally doing well, she said.

“For our pre-commercial companies, the public market for small and mid-cap biotechs certainly remains challenging. However, companies that meet expected milestones have executed significant follow-on financings and stock prices have responded positively,” she said.

Investment is strengthening

Life science venture capital (VC) investment is on track to reach an estimated $27 billion this year, Ms. Kuhn said, exceeding pre-COVID-19 pandemic levels.

“Further, while a frequent assumption is that many financings are being propped up by current insiders, the data highlights that this is just not true,” she said. She pointed to a “detailed analysis” by Oppenheimer & Co. Inc., a brokerage and investment bank, of year-to-date Series A and B financings, which she said found that nearly 80 percent were led or co-led by outside investors, “speaking to a healthy appetite from investors to fund new deals.”

Ms. Kuhn continued, “Our new lease with Altos Labs on our One Alexandria Square mega campus in San Diego is one example of a stellar private company, having raised a historic $3 billion to deploy towards self-reprogramming to treat diseases associated with aging.”

She added, “Last, life science products, services and devices, which represent 22 percent of our ARR, continue to be the workhorse of the industry, providing the hardware and software, so to speak, that fuel experiments in the lab.

“There are challenges that exist post-COVID as some companies ramped up products and services, either directly or indirectly driven by COVID-19 and are now resetting strategic priorities. But novel areas of science and successful products are emerging and generating new forms of demand, such as the new obesity drugs…”

In light of current market conditions, Ms. Kuhn said, “Companies are highly conscious of every dollar spent. They do not have the luxury of risking their science on unreliable lab space or in locations where they can’t recruit the right talent.

“We continue to see increasing demand for companies looking … for just-in-time availability of high-quality lab space in amenitized campuses in the best locations with the infrastructure and operations that ensure their mission-critical work is supported 24/7 and that there is a path for future growth needs.”

Ms. Kuhn concluded, “So, as we traverse challenging times, remember that the resilience of this industry is rooted in a truly vast opportunity for new discoveries that will improve the lives of everyone on this call today – the most impactful of which are yet to come.”

‘Golden age of biology’

Next up during the earnings call was Peter Moglia, Alexandria’s CEO and co-chief investment officer.

“On our fourth quarter 2022 call, I spoke about our optimism for the future of the life science industry, referencing that we are in the early innings of the golden age of biology,” he began, “and I pointed out that we’ve only had the blueprint of the human genome for 20 years. And in that time, we’ve developed more new modalities to attack disease than in the previous 100.

“On Friday, Oct. 13, buried on the third page of Section A in the Wall Street Journal, another scientific revelation was reported – one that scientists likened to The Human Genome Project and that could yield similar results in neuroscience.

“An international team of scientists unveiled the most comprehensive map of the human brain ever completed – a map that the article stated will set a critical foundation for the understanding and eventually treating brain-related diseases, such as Alzheimer’s, epilepsy, schizophrenia, autism and depression. As I watched as my own mother decline daily due to Alzheimer’s and experienced the enormous emotional, monetary and time burden it inflicts on our family, I have a full appreciation of what this map may do for mankind.

“It’s yet another example of how important the life science industry is improving our lives and how it’s only going to grow in influence. And that, ladies and gentlemen, is why this $5 trillion secular growth industry is poised to drive our business for decades to come.”

Development is on the rise

Mr. Moglia then offered detailed comments about Alexandria’s development pipeline, leasing supply and sales.

“In the third quarter, we delivered 450,134 square feet and seven projects into our high barrier-to-entry submarkets, bringing total deliveries year-to-date to 1,290,721 square feet covering 10 projects,” he said. The space was 100 percent leased.

He noted that the initial weighted average stabilized yield for the 10 projects is 6.5 percent, with individual yields ranging from mid-5 percent to 9.5 percent.

“One of those developments in the mid-fives is located in Cambridge (Mass.) and is 99 percent leased, and the other is in our Shady Grove mega campus (in Maryland) and successfully leased 23 percent of its space in the third quarter,” he said.

“The Cambridge asset is in a prime location and its yield reflects the cost to acquire it, which was justified, because we had commitments to fill 100 percent of it before closing, making it a build-to-suit core investment that expanded our ACKS (Alexandria Cambridge Kendall Square) mega campus. The Maryland asset’s yield has been driven down by complex site conditions, but it has been very well received by the market and we are bullish on its long-term performance as part of our Shady Grove mega campus.”

Mr. Moglia added, “Development and redevelopment, leasing activity at approximately 205,000 square feet was higher quarter-over-quarter for the second quarter in a row, which we are pleased to see in an environment where tight financing markets have focused tenant demand on turnkey space.” He noted that Alexandria also signed LOIs (letters of intent) covering nearly 230,000 square feet of space in its pipeline.

Alexandria expects 808,095 square feet of space, currently 99 percent pre-leased, to be placed into service next quarter, and 1.8 million square feet, 96 percent pre-leased, next year, according to the firm’s Q3 supplemental information.

The demand curve is ‘a barbell’

Turning to leasing, Mr. Moglia said, “During the quarter, we executed a lease termination with a tenant at our 10935 and 10945 Alexandria Way mega campus development in Torrey Pines, and leased approximately 89 percent of the space to a stronger credit tenant,” he said. “This is a win for Alexandria as we were able to substitute a higher credit tenant into the new development, increase the term for that space by three years and receive higher rents.

“We did increase the TI (tenant improvement) allowance for the new tenant, but the incremental rent we are receiving yields at 14 percent return over that incremental TI allowance – all in all a great outcome.”

Mr. Moglia said, “We are executing and winning nearly every high-quality leasing opportunity when we have available product, a testament to the daily operational excellence demanded and required by our mission-critical tenants. We leased 867,582 square feet in the third quarter of ‘23, with Maryland significantly supporting the leasing activity led by San Diego and Greater Boston.”

He noted that the leasing activity “has come from a broad base of our regions,” and Alexandria’s quarterly and year-to-date leasing volumes “are consistent with our pre-COVID levels.”

Rents are also on the rise, he said, and the year-to-date weighted average lease term is 11 years. Alexandria’s average tenant rent collections from Q1 2021 through Q3 2023 were 99.8 percent, according to the firm’s Q3 supplemental information.

“And last quarter,” he said, “we reported that we were seeing demand increase, especially in our Greater Boston, San Francisco and San Diego markets. We see demand holding steady today and believe it will trend upward, but are fully aware that the volatile geopolitical environment we are in can create the uncertainty that sometimes slows decision making.”

Mr. Moglia said the demand curve can best be described as a “barbell,” with requirements of 5,000 to 30,000 square feet from emerging-stage companies at one end of the spectrum and requirements of 100,000 square feet or more from large pharma and biotech firms at the other.

“Alexandria is well positioned to capture this demand because many of these opportunities are coming from existing relationships,” he said, “which typically account for a significant amount of our leasing. Over the past year, 80 percent of our leasing has been generated from existing tenants.”

He noted that “unleased competitive supply remaining to be delivered” is declining in most markets as developers “are beginning to act rationally,” reducing the estimated square footage to be delivered.

Some lab space might end up as office

Later in the earnings conference call, during the closing question and answer (Q&A) session, analyst Joshua Dennerlein of Bank of America (NYSE: BAC) asked how the additional space coming online might affect rental rates and TI allowances.

Mr. Marcus replied that Alexandria’s “mega campus platform and our reliability and brand … gives confidence to tenants that they’re going to be well taken care of. And so there is a premium to that that will help us overcome the competitive supply dynamic when it comes to that.”

When asked about specific markets, he added, “I would say it’s also important to distinguish (between markets). We think in Cambridge the impact would be far less than South San Francisco. South San Francisco … just adds too much stupid supply. The good news is a lot of that supply is in an area that people don’t want to be in.”

Mr. Moglia later added, “It does appear that developers are finally understanding that the (South San Francisco) market has plenty of supply underway, and … there’s not more needed on a speculative basis. And so that’s good news for the coming years.”

Mr. Marcus added, “And remember… this isn’t the first time we’ve hit hard times as a company. We’ve been around for close to 30 years, and we’ve worked with our tenant base during all of these times. And the goodwill that accumulates and how we’re able to help them is why 80 percent of our leasing comes from these existing tenants.”

Mr. Moglia also noted that much of the space included in the estimated development pipeline might not turn out to be lab space.

“You’ll notice the big increase in vacancy in San Francisco of buildings essentially that delivered and they delivered in shell condition,” he said. “I took a deep dive with the team as like, ‘Guys, what does this product look like?’ And a lot of it is just buildings that are basically waiting to see whether they should be office or lab.

“They were built with an ability to be lab and so we’re counting them in our supply numbers. But they could very well go office because nobody is super committed… A lot of these projects are agnostic about whether or not they’re going to be office or lab, especially in the larger markets. But we are counting on them on our competitive supply because they could be. But they may very well not be, and they very well may fail if they don’t have financing to provide TIs.”

More asset sales ahead

Regarding Alexandria’s ongoing series of asset sales, Mr. Moglia said, “We continue to be fortunate that there is a considerable demand for Alexandria’s assets and life science assets broadly.” The firm has sold nearly half of the assets it plans to sell, he said.

“Our overall strategy for the full year of 2023 has been to execute on a combination of partial interest sales and sales in whole of non-core workhorse assets. These sales will provide the capital needed to recycle our high-quality development/redevelopment mega campus pipeline, which will widen our moat by expanding our highly differentiated mega campuses…

“We only closed on one asset (sale) this quarter we can report on, but to give some color on dispositions that are pending, they are all non-core, solid workhorse assets.

“Obviously, it’s a challenging interest rate environment and economic volatility has reduced overall transactional activity, but demand for our assets has remained resilient. As mentioned, we are on track to meet our goals.”

In September, Mr. Moglia continued, Alexandria closed on the previously announced sale to Boston Children’s Hospital of a vertical ownership unit comprising about 268,000 rentable square feet, or about 44 percent of Alexandria’s 660,034 square foot 421 Park Drive purpose-built, ground-up life science development in the Fenway submarket of Greater Boston.

Marc Binda, Alexandria’s new chief financial officer and treasurer, then walked listeners through the company’s financials.

‘The macroeconomic environment has changed’

As for that impairment charge mentioned previously, Alexandria said in its Q3 earnings news release, “In October 2023, we recognized a real estate impairment charge of approximately $90.8 million to reduce the carrying amounts of two non-laboratory properties located in our Greater Boston market to their current fair values, less costs to sell.

“We initially acquired these industrial and self-storage properties with an intention to entitle the site as a life science campus, demolish the properties upon expiration of the existing in-place leases and ultimately develop life science properties.

“Since our acquisition, the macroeconomic environment has changed. Upon our reevaluation of the project’s financial outlook and its alignment with our mega campus strategy, we decided not to proceed with this project. The impairment charge was recognized upon meeting the criteria for classification as held for sale. We expect to complete the sale of these properties in 4Q ‘23.”

For more information about Alexandria’s Q3 results, please click below.

News Release: Alexandria Real Estate Equities, Inc. Reports: 3Q23 and YTD 3Q23 Net Income per Share – Diluted of $0.13 and $1.08, respectively