REIT says it has adapted since the LSRE bull run ended in 2021
By Murray W. Wolf
In July, Alexandria completed an extension of its ground lease at Technology Square, adjacent to MIT in Cambridge, Mass. (Photo courtesy of Alexandria Real Estate Equities)
PASADENA, Calif. – Alexandria Real Estate Equities Inc. (ARE) reported a mixed bag of second quarter (Q2) 2024 financial results Monday, July 22, exceeding Wall Street expectations regarding some metrics but falling short in others. But the Pasadena-based real estate investment trust (REIT) continues to deliver healthy operating results in the areas of leasing, asset management and development.
During the pure-play life sciences real estate (LSRE) REIT’s Q2 earnings conference call with securities analysts, which was held Tuesday, July 23, Alexandria Executive Chairman and Founder Joel S. Marcus said the firm delivered “another very solid … quarter” despite “the continuing uncertainty of the backdrop, as soaring U.S. debt and government spending problems continue pretty much unabated.
“And, in thinking about our daily efforts, we all think about the Navy SEAL credo: ‘The only easy day was yesterday.’”
Mr. Marcus added, “Our goal is much like it was – but very different, given the facts, of course – after the 2008-2009 Great Financial Crisis (GFC) and the bear market aftermath: to position ourselves to come out of this sector bear market with the acumen and business strategy really to enable our life science industry and tenant growth, much as we led the long, historical bull market (from) 2014 to 2021 with record-breaking earnings growth for our sector.”
First, the financials
Alexandria’s Q2 results exceeded financial analysts’ consensus expectations in the key REIT measure of funds from operations (FFO), racking up an FFO of $405.5 million, or $2.36 per share. That exceeded the average estimate of six analysts surveyed by Zacks Investment Research of an FFO of $2.34 per share.
On the other hand, Alexandria reported Q2 revenues of $766.7 million, which fell 1.23 percent short of the Zacks Consensus Estimate of $776.3 million. However, that represented a year-over-year (YOY) increase of 7.4 percent. Rental revenues were $755.16 million compared to the $764.41 million average estimate, representing a YOY increase of 7.2 percent.
Alexandria’s Q2 earnings per share (EPS) were $2.36, a positive surprise of 0.85 percent, and far exceeded the EPS of $0.51 the firm reported during the same quarter of 2023. Net EPS (diluted) was $0.25 versus the average estimate of $0.87.
As for its stock price, when the financial markets closed this past Friday, July 26, Alexandria shares were selling for $116.10, down from a 52-week high of $135.45 on Dec. 14, 2023. That represented a decline of 14.4 percent, although the REIT’s share price is up 2.3 percent year-to-date (YTD). Like most REITs, the stock also boasts an above-average annual dividend yield of 4.37 percent,
In a recent survey of 12 analysts, one rated Alexandria stock a “strong buy,” six said it was a “buy” and five advised that investors “hold.”
Real estate performance
Of course, no REIT should be evaluated purely on the basis of its financial performance; the operating results of its real estate assets – which drive the bottom line – tend to be far more revealing.
Additionally, as far and away the nation’s largest owner of LSRE, Alexandria’s operating results are more closely watched than most other companies in the sector. As of June 30, 2024, Alexandria owned 42.1 million square feet of operating properties and 5.3 million square feet of properties under construction, plus one committed near-term project expected to start construction in the next two years.
So, for readers of BREI, Alexandria’s operating metrics not only explain its financial results, they are also a strong indication of the state of the LSRE sector as a whole.
And the state of the market generally isn’t good – a “bear market,” as Mr. Marcus mentioned earlier.
However, despite the life sciences industry slowdown, the overall occupancy rate for Alexandria’s properties is 94.6 percent. The REIT leased more than 1.1 million square feet during Q2 and about 2.3 million square feet during the first half (H1) of 2024. It was also able to pass along an overall rental rate increase of 7.4 percent (3.7 percent on a cash basis) during Q2 and 26.2 percent (15 percent on cash) during H1.
Alexandria executives primarily attribute the firm’s “strong” revenue growth to its focus on what it calls its “mega campuses,” which it describes as properties located in “the world’s best clusters,” including Greater Boston, the San Francisco Bay Area, San Diego and others – “strategic locations where the key building blocks for innovation thrive.”
Mr. Marcus said during the earnings call that the mega campus model, focused on high barrier-to-entry markets, gave it “first-mover advantage in the top life science clusters” and continues to provide an ongoing competitive advantage. These “collaborative” life sciences mega campuses account for 74 percent of the firm’s annual rental revenue (ARR), he said, and the company aims to increase that to more than 90 percent “in the near future.” By contrast, he says other developers in less favorable locations are facing challenges.
In addition to its “high-quality locations,” Alexandria says its “strong brand, experience and operational excellence” contribute to its ability to maintain comparatively high rates of occupancy and tenant retention.
As noted above, Alexandria’s Q2 leasing was robust, including both development and redevelopment projects. Ninety-two percent of the space it delivered during Q2 was in mega campuses. The tenant base is “diverse and high-quality,” the firm says, with 53 percent of ARR coming from investment-grade or large-cap companies, including Eli Lilly and Company (NYSE: LLY) and Moderna Inc. (Nasdaq: MRNA).
Mr. Marcus added that 96 percent of the firm’s leases include contractual rental rate increases, which “ gives us great future protection.”
Alexandria’s development and redevelopment pipeline totals 5.4 million square feet, with 61 percent leased or under negotiation. Those projects are expected to deliver about $480 million in incremental annual net operating income (NOI) during the next few years, the firm says.
The company has “significant” upcoming deliveries, with 2024 and 2025 projects already 87 percent leased.
“Over the next few months,” Mr. Marcus said, “we are laser-focused on leasing the remaining 1 million, approximately, square feet rolling this year and getting a strong jump on the significant 2025 rollovers. Also, over the next few months, we are laser-focused on our ‘24 and ‘25 deliveries and continue to increase our leasing on those well beyond the current 87 percent to drive NOI (net operating income) growth.”
Meanwhile, Alexandria continues its “asset recycling program… actively pursuing a value-harvesting strategy, with $884 million in completed and pending asset sales.” The firm says this strategy supports its focus on high-quality assets and the culling of non-core properties.
Despite “a challenging macro environment,” Alexandria executives say they are optimistic about the firm’s position thanks to their strategic focus on “high-quality assets and strong tenant relationships.” After the LSRE building boom in recent years, they say they anticipate reduced new supply after 2024, which could benefit the firm’s existing properties.
Life sciences industry strength
“The life science industry… is the crown jewel and the cherished industry of our country and truly the world’s leader in innovation in the discovery of new medicines,” Mr. Marcus said, concluding his opening comments. “We have built this one-of-a-kind company to be at the vanguard of this cherished life science industry as it recovers from the aftermath of the COVID rocket ship.”
What makes the life sciences industry so attractive? Hallie Kuhn, Senior VP of Science and Technology and Capital Markets, explained.
“First, the $5 trillion, secularly growing life science industry continues to command robust levels of capital from diverse funding sources,” she said, “and second, life science innovation is advancing at a historic pace, yielding new medicines that extend and save lives.”
Ms. Kuhn went on to extoll the industry’s virtues, citing its high levels of research funding, mostly positive regulatory environment, and the recent approvals of numerous new drugs and therapies. She also noted that Alexandria’s tenant base includes many of the companies behind these innovations.
“Coming full circle,” she said, “the life science industry continues to demonstrate sustained strength, energized by this incredible pace of innovation and reinforced by diverse sources of funding.”
LSRE is benefitting from ‘pent-up demand’
CEO and Chief Investment Officer Peter M. Moglia then drilled down into the real estate metrics.
“A respected economist recently made the case that pent-up demand from the pandemic has continued to be a key source of inflation,” Mr. Moglia said, “which is one of the reasons the raising of short-term rates has been ineffective, and that sectors of the economy with pent-up demand will continue powering the economy going forward in 2024 regardless of rates or who wins the election.
“Healthcare was one of the sectors mentioned. Patients returning to doctors’ offices and hospitals are releasing pent-up demand for therapies and medicines, which should send a strong signal to the industry to grow. We look forward to enabling that growth…”
During a question-and-answer (Q&A) session later during the earnings call, Mr. Moglia noted, “Alexandria delivered 284,982 square feet, 100 percent leased, with 92 percent of the space contained in mega campuses located in our high-barrier-to-entry sub-markets… Development and redevelopment leasing of approximately 341,000 square feet was more than three times the volume of last quarter, led by strong credit tenant leasing.”
He added, “The ability to execute on our development and redevelopment pipeline when others are clearly struggling is mainly attributed to our strong brand built on operational excellence and the attractiveness of our mega campus platform, which houses 69 percent of our current pipeline. Projects to be delivered in 2024 and 2025 are 87 percent leased, and projects expected to stabilize in 2026 and beyond are 40 percent leased or under negotiation because of our continuing strong execution during the quarter.”
Mr. Moglia continued, “Transitioning to leasing and supply, the leasing market is in a flight to quality. Failed projects are often in tertiary markets and operated by inexperienced entities with little to no know-how or capital to fund tenant improvements. The majority of fully vacant buildings in our markets are recently delivered buildings from these entities, who majorly underestimated the skill sets needed to be successful in life science real estate and pick sites as if they were investing in office.
“High-quality locations in the core areas of innovation and high-quality sponsorship matters. Many of these new entrants are learning that the hard way.”
He added, “Although the search rings of the tenant bases have expanded with the delivery of new supply, the strike rings have tightened as quality tenants, leery of inexperienced and undercapitalized developers, choose the trusted brand. We leased 1,114,001 square feet during the second quarter, highlighted by the strong leasing in a development and redevelopment pipeline…
“On competitive supply, 2024 is going to be the peak year for new deliveries and then it will begin to dissipate in 2025 to about half of what we will deliver in 2024. We are likely to see little-to-no new deliveries from pretenders after 2025, unless projects currently under construction are delayed.”
With respect to Alexandria’s “asset recycling program,” Mr. Moglia said, “Our value harvesting transactions will be heavily weighted towards the third and fourth quarters, but significant progress continues to be made. During the quarter, we closed on the $60 million, non-income producing asset in New York and increased our pending transactions subject to letters of intent or purchase-and-sale agreement negotiations by approximately $549 million, to a total of $806.7 million. This, combined with our $77.2 million in closed sales and $27 million of forward equity sales agreements expected to be settled in 2024, brings our pending and closed transactions to $884 million, approximately 59 percent of the midpoint of guidance for dispositions, partial-interest sales and equity.”
Mr. Moglia later noted, “Good quality assets are still in demand. I don’t want to spoil any thunder for next quarter, but we do have a couple of things that are going that are pretty good.”
He added, “Interest in our non-core asset sales remains consistent and we believe the anticipated rate cuts and thawing of the financial markets will bring more buyers and have a positive effect on values. The lack of financing available to investors has been the driver of the widely reported lack of capital markets activity in the broad market. Capital flows have a major impact on valuations and commercial real estate debt has trended downward as a percentage of GDP (gross domestic product) for the last two years prior to the first quarter of ‘24.
“However, this appears to be reversing as new CMBS issuance for the first half of 2024 is up nearly threefold from the same period last year, which should provide positive momentum for our current and future efforts.”
Later, during the earnings call, Marc E. Binda, chief financial officer (CFO) and treasurer, noted, “We may also consider reducing the size of our future pipeline through asset recycling in the current pipeline and into our mega campuses.
“(In) July ’24, we completed the sale of our vacant, non-laboratory building located in Manhattan for $60 million. This building was designated as held for sale in 4Q ‘23 and was sold following the lease expiration for the full building in July of ‘24.
“The aggregate total of completed and pending dispositions under negotiation, plus a small amount of equity we raised on the ATM (an at-the-market stock sales program) aggregates (to) $912 million, or 59 percent of the midpoint of our guidance of $1.55 billion. While the macro environment remains challenging, we are reasonably optimistic that we can execute on our disposition plan in 2024 at values representing a reasonable cost of capital.”
‘Leasing volume was strong’
Earlier during the call, Mr. Binda recapped the financial results and provided more color on Alexandria’s Q2 and H1 leasing performance.
“Leasing volume was strong for the quarter and the first half of 2024 at 1.1 million and 2.3 million square feet, respectively,” he said. “The second quarter is up 27 percent over the average of the back half of 2023 and is consistent with our historical quarterly average for the period from 2013 to 2020.
“We continue to benefit from our tremendous scale, high-quality tenant roster and brand loyalty, with 79 percent of our leasing activity over the last 12 months coming from our existing deep well of approximately 800 tenant relationships, including the 127,000 square foot development lease that was executed this quarter with a multinational pharma company at our mega campus development in Sorrento Mesa.
“The rental rate increases for the first half of ‘24 were strong at 26.2 percent and 15 percent on a cash basis, and our outlook for rental rate growth for the full year ‘24 remains solid at 11 percent to 19 percent, and 5 percent to 13 percent on a cash basis. Rental rate growth for lease renewals and re-leasing of space for the quarter was 7.4 percent and 3.7 percent on a cash basis…
“Looking ahead to the first quarter of 2025,” Mr. Binda continued, “we highlighted a few key lease expirations aggregating 600,000 square feet with $37 million of annual rental revenue that are expected to have 12 months to 24 months of downtime on a weighted average basis, with more than half of that coming from a lease expiration with Moderna at Tech Square (in Cambridge, Mass.) which, as a reminder, recently expanded into 462,000 square feet at (Alexandria’s) recently completed 325 Binney project.
“These spaces may require some time to re-lease and/or reposition the assets, and are likely to remain as operating assets,” Mr. Binda said.
Mr. Marcus later interjected, “Moderna has essentially or is moving out of that space in Tech Square 200 and moving to their new R&D (research and development) and headquarters at 325 Binney. So, they leave behind laboratory assets in that space or spaces, and our plan is to release those generally as a multi-tenant situation.
“So, it’s not really any change. We clearly knew for a long period of time that Moderna was leaving, and this is just part of their growth and something we’ve done time and time again.”
Development and redevelopment strategy
Mr. Binda continued, “Turning next to external growth, during the quarter, we continued to execute on our development and redevelopment strategy by delivering 284,982 square feet from the pipeline, which will generate $16 million of incremental annual net operating income.
“We also expect to see significant future growth in incremental annual net operating income on a cash basis of $80 million from executed leases as the initial free rent from recent deliveries burns off over the next seven months on a weighted average basis…
“We have 5.4 million of rentable square feet of development and redevelopment projects that are 61 percent leased or negotiating, and those projects are expected to generate $480 million of incremental annual net operating income over the next four years, including $187 million over the next six quarters.”
Later, during the Q&A session, one of the securities analysts, Michael Griffin of Citigroup Inc. (NYSE: C), noted, “I noticed that the 651 Gateway (office conversion) project (in South San Francisco) was pushed to ‘26. Is this just a function of maybe more tepid demand in South San Francisco, and at what point would you have to stop capitalizing costs on this project and start having it flow into the income statement?”
“Yes, that’s exactly correct,” Mr. Moglia replied. “Of all the markets… South San Francisco certainly… has one of the most outsized supply issues.
“Remember, too, this is an old building that we inherited in a joint venture. So, the time and effort to get this redeveloped is just what it is. The good news is we have several transactions going on that weren’t alive last quarter. So, I think that’s good news.”
Tech Square in Cambridge, Mass.
Mr. Binda then provided details regarding a recent transaction involving Alexandria Technology Square, or Tech Square, the firm’s seven-building, 1.2 million square foot life sciences complex in Cambridge, on about 10.4 acres immediately adjacent to the campus of the Massachusetts Institute of Technology (MIT). The REIT, which bought the complex 18 years ago for $600 million, leases the underlying land from the university.
“In July, we completed an extension of our ground lease at Tech Square,” Mr. Binda said. “This will require a prepayment of rent of two $135 million amounts in 4Q ‘24 and 1Q ‘25 and will be amortized into non-recoverable ground rent expense starting in 3Q ‘24 through 2088 on a straight-line basis…
“A few key items to note. First, we view this asset, Tech Square, as a generational asset located adjacent to MIT in Cambridge at the center of Main and Main, with several important relationships located on the campus. Second, since we acquired this mega campus in 2006, NOI has nearly quadrupled over our ownership period. And third, even with the expected prepayment of rent, we believe this adjusts to a very attractive annual ground rent cost relative to market over the next 65 years. And ultimately, we believe that this extension enhances the long-term value of the campus. For all these reasons, we are very pleased with the outcome.”
He added, “We remain disciplined with our strategy for long-term funding of our business and recycling capital from dispositions and partial interest sales to minimize the issuance of common stock. Our disposition strategy is heavily weighted towards outright dispositions of assets not integral to our mega campus strategy, allowing us to enhance the quality of our asset base.
What’s ahead for the LSRE business?
Asked about the future of the LSRE sector, Mr. Marcus replied, “I think you have to remember that we’ve seen the internet bubble crash in 2000, the GFC in 2008-2009, and then kind of the blow-up of the rocket ship of COVID as it kind of came down to earth, and each one is kind of different.
“I think this time, we don’t have financial institution problems, we don’t have lots of companies that had kind of fake business plans failing, like back in 2000, not so much biotech, but certainly in the dot-com bubble era. I think this time, we’ve never seen supply in our particular niche. Supply has always been there, but it’s never been oversupplied, in a sense.
“And so when you combine that oversupply with more muted demand coming off just rocket ship demand of 2021 – I mean, our leasing quadrupled during some of those quarters and years, which you just know can’t be sustained…
“How that translates into is the big question everybody wants answered, but there’s no algorithm to do it. How that translates into a more consistent and robust demand. And I think that’s what we’re all kind of working through. And every cycle is just different.
“And so we’re very optimistic about the future. Obviously, we wouldn’t be in this business if we weren’t. But we know that we have to make adjustments to our assets, our capital plan and make sure that we have we’re best positioning the company to help our 800 tenants grow and attract a whole lot more.
“And we think by selling more of the non-core assets, slimming down the future pipeline a bit and doubling down on the mega campus is the right strategy til the market really turns. And I think whether the election, whether it’s the executive branch or each of the houses, helps reinforce a more robust economic environment…”
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