ARE - Alexandria Real Estate: A Booming Office REIT That The Market Is Mispricing

2023-12-13 00:51:56 ET

Summary

• Buying beaten-down stocks whose underlying businesses are healthy can be a rewarding investing strategy.
• Alexandra Real Estate is the crème de la crème of mission-critical life sciences office real estate, which is more durable than typical office real estate.
• The company maintains a BBB+ credit rating from S&P on a positive outlook.
• ARE appears to be trading at a substantial discount to fair value.
• If the company can deliver growth as expected and return to its mean valuation, it could 3x the S&P through 2025 and 2x it over the next 10 years.

Readers who have followed me for a while know that I am at least partially oriented toward value investing. That is because I believe there is significant money that can be made by buying quality businesses while they are out of favor. That's due to both a higher starting dividend yield and the potential for valuation multiple expansion when starting from a lower valuation multiple.

As most readers are probably aware, the COVID-19 pandemic led to an unbelievable surge in remote work. For many white-collar workers, there isn't an absolute need to work on-site at a job anymore.

This explains why from 2019 to 2023, a recent Gallup analysis of the U.S. workforce shared the following findings:

In 2019, 60% of remote-capable employees spent their week working fully on-site , whereas that figure has fallen to just 20% in 2023. In contrast, only 8% worked exclusively remotely in 2019, compared with the 29% of remote-capable employees who are fully remote today. At the same time, hybrid work has increased significantly, en route to becoming the most prevalent work arrangement in most offices.

This means that approximately 40% of remote-capable employees have shifted from working entirely on-site to either a hybrid or exclusively remote work arrangement.

Even with the hybrid work arrangement comprising about half of remote-capable employees per Gallup, the demand for office real estate isn't what it was pre-COVID. Thus, it's no wonder office REITs have been punished lately.

I am an example of this trend toward exclusively remote work in action as I'm currently writing this article from my home office.

But do you know what I or nobody else can do from their own home? Develop treatments that can improve the quality of life for challenging health conditions, such as cancer, heart disease, and diabetes. This is what makes the selloff of the life sciences real estate pioneer, Alexandria Real Estate ( ARE ), so puzzling.

Down 19% so far in 2023, I will further elaborate on why ARE isn't your typical office REIT. This is why I believe the market's misunderstanding of the business could offer an interesting buying opportunity here.

ARE's 4.3% dividend yield is slightly more than the 4.2% yield of the 10-year U.S. treasury (as of December 12, 2023). This also comes with the potential for mid- single-digit annual dividend growth moving forward. That's because ARE's 67% payout ratio is comfortably below the 90% that rating agencies prefer from REITs.

If this wasn't enough, the company's 36% debt-to-capital ratio is considerably less than the 60% debt-to-capital ratio that rating agencies like to see from REITs. That is why S&P awards ARE a BBB+ credit rating on a positive outlook. According to Dividend Kings, this implies the risk of the latter going bankrupt by 2053 is just 5%.

Thanks to ARE's well-covered dividend and vigorous balance sheet, Dividend Kings estimates the risk of a dividend cut in the next recession at a modest 0.5%. Even if a severe recession were to occur, the probability of a dividend reduction would be just 1.05%.

Strong fundamentals aside, ARE is also an enticing value. Dividend Kings' historical valuation metrics such as dividend yield show the stock to be worth $186 a share. Relative to the current $117 share price (as of December 12, 2023), ARE is trading at a 37% discount to fair value.

Assuming the company reverts to fair value and matches growth expectations, here is what total returns could look like in the next 10 years:

• 4.3% yield + 5.3% FactSet Research annual growth consensus + a 4.7% annual valuation multiple boost = 14.3% annual total return potential or a 281% 10-year cumulative total return versus the 9% annual total return potential of the S&P 500 ( SP500 ) or a 137% 10-year cumulative total return

Alexandria Has Secular Trends And Portfolio Quality On Its Side

Unlike the office real estate space overall which has struggled in recent years, ARE has thrived. These struggles have a lot to do with the fact that most office properties aren't differentiated. That means there are more players (and more competition) within the office real estate market for tenants, which weighs on occupancy and rent growth.

The contrary to its office REIT counterparts, ARE's 419 properties spanning 41.5 million rentable square feet as of September 30 are niche. Leveraging over 800 relationships with tenants like Bristol-Myers Squibb ( BMY ) and Eli Lilly ( LLY ), ARE constructs properties that are fit to the needs of these tenants. These properties are mostly developed in high-demand clusters, such as the San Francisco Bay Area, Boston, Maryland, and the Research Triangle in North Carolina.

Here are a few of the things that I like about both the life sciences real estate industry and ARE:

1. The work performed by the life sciences industry is sustained through leasing properties such as the ones owned by ARE.
2. Due to the $2 trillion-plus spent on R&D since 2018, the demand for these properties is also consistently growing.
3. This sustained a healthy 93.7% occupancy rate as of September 30 for ARE.
4. Finally, the vast majority of ARE's leases (96%) have annual rent escalations of around 3%. This factor alone pushes FFO per share steadily higher.

Relating to my second point, ARE is doing everything in its power to help meet the rising demand for life sciences real estate. According to CEO Peter Moglia's opening remarks during the Q3 earnings call , the company has delivered nearly 1.3 million rentable square feet to the market across 10 projects year to date. Looking out over the next several years, REIT also has 33.6 million square feet of projects that are currently in development. Combined with gradual rent growth, that is why FactSet Research thinks that ARE's FFO per share can grow by 5.3% annually long term.

Additionally, the company also has the financial resources to continue developing projects to grow aside from organic growth. This is made possible by an investment-grade balance sheet. ARE also notes that its BBB+ credit rating ranks it in the top 10% of all publicly traded U.S. REITs.

Even more encouraging, the company has no debt maturities prior to 2025 and $5.9 billion in liquidity. These elements arguably position ARE as a financial fortress (unless otherwise linked, all details in this subhead are sourced from the ARE overview page and ARE Q3 2023 Investor Presentation ).

Moderate Dividend Growth Can Be Maintained

Earlier this month, ARE upped its quarterly dividend per share by 2.4% to $1.27. Along with the 2.5% dividend increase in June, the company's quarterly dividend per share is 5% higher than it was this time last year.

Similar dividend growth should be poised to continue. This is because the analyst consensus is that ARE will generate $8.98 in FFO per share in 2023. Compared to the $4.90 in dividends per share that have been paid this year, that works out to a viable 54.6% payout ratio.

Risks To Consider

ARE operates as the leading player in the life sciences real estate industry. However, the company still has risks.

As of September 30, 32.4% of ARE's total annual rent revenue was derived from its top 20 tenants (page 60 of 151 of ARE's most recent 10-Q filing ). If any of these major tenants were to encounter financial difficulties, ARE may not be able to collect its rent on certain properties. This could temporarily weigh on financial results as the company would have to work to find new tenants for affected properties.

Another risk to ARE is the concentration of its properties in select geographies. If natural disasters or similarly devastating events were to occur in any of the company's major markets, its operating results could be negatively impacted.

If interest rates remain elevated for longer than anticipated, ARE's stock performance could trail the market. This is because, in higher rate environments, competition from options like high-yield savings accounts and U.S. treasury bonds make REITs less attractive to more conservative market participants.

Summary: An Ultra SWAN With Compelling Total Return Potential

ARE's fundamentals earn it the distinction of being a 13/13 ultra SWAN per Dividend Kings' quality rating. Sealing the deal for my buy rating of the stock is its valuation.

Shares of ARE are trading at a 13.4 P/FFO valuation multiple right now. For context, that's well below the historical P/FFO valuation multiple of 17.7. If the company returns to this multiple and grows as expected, it could generate 56% cumulative total returns through 2025. That's much better than the 16% cumulative total returns that the SPDR S&P 500 ETF Trust ( SPY ) is projected to deliver over that time.

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