VNQ - 4% Yield 34% Below NAV And Down 42% We're Buying Alexandria Real Estate

2023-03-27 16:45:56 ET

Summary

• Fundamentals remain strong. Fear appears to be elevated. There are legitimate macro risks, but they're smaller for ARE than for many other stocks.
• We came across quite a few viable explanations for the dip. They can have a big bearing on market sentiment, but not on fundamentals. Great REIT at a low price.
• Through 3/22/2023, the plunge in ARE correlates extremely well with the plunge in office REITs. Office real estate is bad. Biotech labs are good. Fresh 52-week low.

Alexandria Real Estate ( ARE ) flew to the top of our list for an updated report as the share price plunged. We’ve been looking for two things:

1. Good reasons
2. Viable explanations

The difference is that a “good reason” involves some kind of damage to the fundamentals . Something that negatively impacts future cash flows by a material amount. A viable explanation is more likely to focus on factors that would impact sentiment without impacting fundamentals.

Good Reasons

None so far. I’ve been looking for them, but I haven’t found anything that I believe will drive a greater than 1% change in ARE’s revenue.

I have found a factor that may cause a reduction of 0.08% in revenue. The impact to FFO would be larger than 0.08%, but FFO margins are high (greater than 50% of revenue). Consequently, the impact to FFO should be less than 0.20% and it is temporary.

Following the collapse of SVB (Silicon Valley Bank), ARE filed a form 8-K on their exposure .

Here are the key parts:

Let’s take a bear-case scenario and say that life science valuations fall by 50%. That’s a pretty absurd bear-case scenario. The unrealized change in the value of the investments would be less than $5. In the bear-case scenario, a small number of biotech companies fail. ARE would need to replace a few tenants. In that bear-case scenario, maybe it puts a little pressure on leasing spreads for a year or two. Since all the depositors got 100% of their deposits covered, failures in the sector as a result of SVB should be pretty small.

Still, the reduction in fair value for those investments may be the largest factor. $5 seems like too much. But somewhere between $1.00 and $3.00 seems reasonable. That’s about a 10% to 30% drop in the fair value of those assets. They already recorded a reduction in 2022, which isn’t particularly surprising given the general direction of equity markets.

Viable Explanations

These explanations should be pretty simple. Consequently, they don’t take long to spell out. When something is trading on emotion, it should be easy to describe the fear. As a rule of thumb, if you can’t sum it up in a few very short sentences, it isn’t a good explanation for emotion. Explanations are all about emotions.

Here are the explanations I’ve come across that don’t impact fundamentals much but would explain the hit to ARE’s share price:

1. Biotech borrowed from SVB. No one wants biotech at the moment. The Biotech landlord is bad.
2. Biotech was in San Francisco. People leave San Francisco to work from home. A landlord with exposure to big cities like San Francisco is bad.
3. ARE is classified as an office REIT or a healthcare REIT (depending on the source). Office REITs are garbage because of rising vacancy, plunging rental rates, and cratering margins. Sell all office REITs.
4. Interest rates increased last year. Now FFO per share is going to be awful! REITs are bad.
5. Issuing shares is going to dilute shareholders.

We’re going to review some of those ideas in greater detail. This is the public release, so it's going to be shorter. There's also an extended subscriber version of our research on ARE and another subscriber article on ARE (subscriber paywalls) we never sent public.

Biotech Exposure

The vast majority of those tenants should be fine. A few companies failing will happen every year. That's expected when you have around 1,000 tenants:

I don’t see a big increase in tenant failures as a direct result of the issue with SVB. The value of ARE’s investments should be down, but we’re probably talking about $1.00 to $3.00 per share. How much did ARE’s price drop? From about $170 in early February to $117 today? That’s about $53. Notice that $53 is much more than $1 to $3.

San Francisco and Work from Home

Both are scary things, right? SVB collapsed there, so maybe everything there will collapse. Bad logic. San Francisco is the second largest market for ARE:

That’s fine. Biotech employees are not the ones leaving to work from home.

Office REITs Are Garbage

You can do “office work” from home. That’s a major reason that vacancy rates are ripping higher for office properties. That’s part of the reason we’ve said for years that we have zero interest in owning office real estate. Office REITs are like mall REITs a few years ago. Someone will make money trading those shares, but we’re not buying REITs with bad real estate.

The reason we like ARE is because “office work” and “lab work” are dramatically different. It’s not so easy to do “lab work” from home. ARE doesn’t have the same exposure to work from home as office REITs. Repurposing office space isn’t cheap and biotech clients have different requirements for the property. Maybe a few office properties can be repurposed efficiently?

In theory, maybe that creates a modest increase in supply a few years from now.

If anyone has the expertise to repurpose a building into a lab, it would be ARE. They're very active in developing properties. Office REITs have more expertise in office real estate (but apparently not enough to see this coming), and not so much expertise in labs.

Joel Marcus referenced the conversion from office to labs during the Q4 2022 earnings call:

ARE acquired an office building previously. That office building was already on their list of buildings to redevelop. It was chosen specifically because it was one of the few office buildings that had the structure necessary to make it viable for conversion. So if anyone is converting office buildings into lab space, ARE would be the best candidate to do it.

Short-Term Office REIT Correlation

Since early February 2023 (and arguably going back to early January 2023), ARE has been trading in tight correlation with a group of office REITs:

ARE is the navy blue line with circles. There are three REITs we classified as office REITs that are not moving with the bundle:

The outperforming REITs were:

• OFC and DEA

The plunging REIT was:

• SLG

The REITs moving together are:

• BXP, CUZ, DEI, HIW, KRC, and ARE (which is NOT an office REIT)

Note: The chart is as of 03/22/2023.

In early trading on 03/23/2023 (when the full piece was finished for members), office REITs were down slightly. They proceeded to get utterly demolished going into the later part of the day. Ironically, for this one day, ARE is not joining them. The movements so far today are:

• ( BXP ) down 4.18%
• ( CUZ ) down 5.26%
• ( DEI ) down 5.22%
• ( HIW ) down 4.65%
• ( KRC ) down 4.4%
• ARE down 0.60%
• ( VNQ ) down .07% (big REIT ETF)
• ( KBWY ) down 1.64% (sucker yield REIT ETF)

Most REIT subsectors are down today except for cell tower and data center. Due to the large size of those REITs, they are cushioning the dip for VNQ.

Short-Term Healthcare REIT Correlation

Some sources will label ARE as a healthcare REIT. They don’t fit that category either. Drastically different fundamentals. Further, ARE has basically zero correlation with healthcare REITs:

There's very minimal correlation between most of these REITs. NHI and OHI are correlated together. WELL and VTR are correlated together. MPW has been a dumpster fire. ARE is unrelated to this sector.

Short-Term Random Correlation

To demonstrate that ARE’s correlation with five office REITs lately is not random, I’ve selected two REIT ETFs and 10 other large REITs across different sectors. If the correlation is simply “REITs down,” then at least one of these lines should correlate as well as office REITs.

ARE did not correlate with any of those lines over the last few months particularly well. You can see a few bumps and dips in the sector, but no tight correlations. The only REITs with high correlation were the office REITs. That reinforces my view that the current plunge is all about dumping office REITs. ARE was simply caught in the fire because they are often classified as an office REIT.

Long-Term Office REIT Correlation

While Alexandria had a very strong office REIT correlation in Q1 2023, it has pretty much none for longer periods.

Going back to the start of 2016, the only REITs to deliver a material positive return (DEA is barely positive) here are OFC and ARE. From the way the lines cross, it's obvious those two REITs have no correlation. How about that call to reject investing in office REITs years ago on the premise they were not viable investments? That turned out well.

I can’t say what’s going on with OFC. It isn’t one of the REITs we cover. However, most of the sector got destroyed. That makes sense to me given the weak fundamentals in that sector. However, those weak fundamentals do not apply to ARE.

Valuation

At the time of preparing this for public release, ARE trades at $119.96. That puts shares at a .66 price-to-NAV ratio using a consensus estimate of $182.58. It also has shares trading 41.8% below their highest close of the last 52 weeks, which was April 6, 2022.

Using AFFO, shares trade at 16.74x forward consensus AFFO projections of $7.16. That means their 4% dividend yield is easily covered with a 68% payout ratio on AFFO.

Note: This is not some significantly inflated garbage AFFO, as we've highlighted for some other REITs.

Using FFO, shares trade at 13.37x consensus forward estimates of $8.97.

Conclusion

There does not appear to be a strong bearish argument against ARE based on fundamentals. The fundamentals for ARE look excellent. They have a unique asset class that cannot be replaced with work-from-home, an outstanding balance sheet with long maturities and over 99% fixed-rate debt, and significant leasing spreads driving growth in revenue, same-property NOI, and FFO (and AFFO) per share.

If anyone is equipped to turn office real estate into lab space, it's ARE. They have the right expertise and have already been putting it to use. The abundance of office real estate with plunging values may create a few more of those opportunities. While ARE has historically been able to fund development using new stock and debt, they also generate a significant amount of that cash flow from dispositions. If dispositions fall, they could reduce development (which reduces the future supply of lab space).

From a valuation perspective, ARE looks very cheap. They are trading near the lowest multiples seen in the last decade. Further, they reached those multiples by plunging in extremely strong correlation with major office REITs. Office real estate fundamentals are terrible but ARE is not an office REIT. They're a biotech REIT that got lumped in with office REITs and dumped accordingly.

Increased position

After publishing this for subscribers, we doubled our position in ARE.

We initiated our first position in June:

Then we doubled it a few days ago:

I think I prefer Schwab's older trade confirmation style better, but it still works.

Rating

Strong Buy on ARE. Shares are under $120, which is an excellent deal.

For further details see: