ARE - Alexandria Real Estate: Life Sciences Demand Suggests Growth Potential

2023-11-27 20:07:55 ET

Summary

• Alexandria Real Estate is a leading life sciences-focused REIT with a portfolio of research labs in major US life sciences centers.
• The company has been negatively impacted by the overall decline in commercial REITs, but the demand for life sciences properties remains strong.
• Falling interest rates could benefit Alexandria by reducing borrowing costs, increasing property values, and making REITs more attractive compared to government bonds.
• Life Sciences demand remains high and suggests a positive outlook for Alexandria.

Introduction

Alexandria Real Estate Equities ( ARE ) is a leading life sciences-focused REIT that owns research labs across major life-sciences centers in the US. Despite solid fundamental growth and demand for labs outstripping supply, the shares have plunged over 50% since 2021, with the share price currently down 28% year to date. Despite this drop, I believe the negative sentiment surrounding the company is overstated, with the life sciences industry continuing to grow, underpinning demand for lab space which makes up the majority of Alexandria Real Estate’s portfolio. With solid earnings and growth prospects, let me explain further why I believe Alexandria Real Estate is a buy.

Company Overview

Founded in 1994 , Alexandria Real Estate is a real estate investment trust focused on the submarket of life sciences real estate. It aims to develop, own, and operate commercial buildings, laboratories, and campuses leased to tenants in the life sciences category. These properties are in AAA innovation locations including Boston, San Francisco, San Diego, New York, and others. They have over 1000 tenants ranging from large pharma companies such as Bristol Myers Squibb ( BMY ) and Eli Lilly ( LLY ) to smaller companies and startups. With over 430 specialized properties with 74.9 million gross leasable area, the company ranks as one of the largest life science property owners in the world.

Industry Overview

Since the pandemic many commercial REITs have taken a double hit; impacted by rising interest rates and a shift to working from home. Unlike most other commercial REITs, life sciences are not easily replaceable with remote work, meaning many life sciences properties have been insulated from this trend and have not seen occupancy rates impacted. In fact, demand for life sciences properties has only increased since the pandemic. With the global biotech market set to grow by 12.8% CAGR from 2023 to 2030, demand for life sciences real estate looks only set to grow. This, combined with a shortage of lab space, means the outlook looks bright for companies operating in the provision of life sciences real estate.

So, what is driving all this demand for lab space and growth in the life sciences industry? Over 90% of known diseases have no available treatments, suggesting there is an unmet medical need and hence there is a tremendous opportunity for growth in innovation and hence the life sciences industry. This has resulted in many new treatments and advancements in new technologies in the past few years such as the use of mRNA in COVID-19 vaccines to the growing market of cell and gene medicines. As these new techniques have been developed, their possible applications in tackling some of the diseases with no treatments have grown. This has the potential to vastly increase the number of new medicines over the coming years, all of which must be developed in a life sciences laboratory, hence strongly supporting the demand for lab space.

For life sciences companies to operate and rent lab space they need funding. In the Q3 Earnings Call for Alexandria, it was stated that an estimated $400 billion will be deployed to support the life science industry this year, exceeding the 10-year average of $360 billion. Notably, this funding is from a mix of sources; venture capital, R&D budgets, government, and philanthropy. This diverse array of funding sources helps underpin the secular growth in the industry and additional demand for Alexandria’s lab space.

Interest Rates

Operating in an asset-heavy business like real estate means interest rates have a big impact across the business, from borrowing to property valuation. Since the Fed began making rises in interest rates, Alexandria’s share price has fallen. However, we may now be approaching a moment of change as the Fed’s focus starts to shift from raising interest rates to making rate cuts in 2024. US interest rates appear to have peaked and market sentiment indicates that rates may begin to fall in the latter half of 2024.

Falling interest rates are a massive positive to Alexandria with three main impacts.

Firstly, lower interest rates mean lower borrowing costs which will allow Alexandria to fund new acquisitions and development projects, expanding their revenue-generating potential. Reduced rates will also improve their balance sheet by reducing interest costs allowing capital to be allocated for more productive investments and enhancing overall financial flexibility.

Secondly, falling interest rates leads to increased property values as lower interest rates result in lower borrowing cost for purchasers and real estate investors, resulting in them being able to afford more for the same money so prices rise. Given Alexandria’s main asset is its properties, a rise in property prices will result in a rise in net asset values that should positively impact the share price.

Finally, lower interest rates can enhance the attractiveness of REITs compared to government bonds, primarily through the impact on dividend yields. REITs often distribute a significant portion of their income as dividends to shareholders. When rates are low, the yields on government bonds may also be low. In this environment, the comparatively higher dividend yields offered by REITs become more appealing to income-seeking investors. As interest rates fall, the yields on REITs such as Alexandria, will be more attractive compared to now lower-yielding, lower-risk assets such as government bonds.

Q3 Results

In the third quarter of 2023, Alexandria Real Estate showcased robust financial performance, with Funds from Operations (FFO) exceeding expectations. The reported FFO of $2.26 per share surpassed estimates by $0.02. However, the revenue figure stood at $713.8 million, falling slightly short of expectations by $14.67 million.

The final financial year 2023 FFO per share is expected to be in the range of $8.97 to $8.99. In response to the positive Q3 results, the company adjusted its 2023 guidance, boosting the lower end of its adjusted FFO per share range.

Occupancy of properties it owns remained high with occupancy in North America slightly increasing to 93.7% from 93.6% in the previous quarter.

Alexandria's same-property net operating income exhibited steady growth, rising by 3.1% year-on-year in Q3, with same property NOI rising 3.7% year-on-year. The quarter's leasing activity, though slightly lower than Q2, showed continued momentum in Alexandria's real estate portfolio. Remarkably, 80% of the leasing activity in the last twelve months originated from Alexandria's client base, comprising over 800 tenants, indicating a strong existing client relationship. This showcases Alexandria’s resilience and how life science properties are continuing to outperform the wider commercial property market.

Valuation

To value Alexandra Real Estate, I use a Dividend Discount Model, where, in theory, the fair value of the share is the sum of all future dividend payments discounted back to the present day. To estimate dividends in future years we take the average dividend growth of the previous four years, which results in an estimated annual dividend growth rate of 5.6% for forecast years and in perpetuity.

A discount rate of 10% is used as this is the minimum required rate of return I expect when making an investment into an individual company.

Running the numbers gives a target price of $119.76, a 13.9% upside from the current share price. As explained above, it is important to note that if US treasuries fall in yield, a lower discount rate may be more appropriate. Using a discount rate of 8% would give a target price of $219.56.

Risks

When I consider an investment in Alexandria Real Estate, there are two main risks I believe are the most important to consider.

Firstly, a life sciences industry downturn. One problem with focusing on a single industry is that you are fully exposed to a downturn in that industry. Following higher interest rates and a pullback in R&D spending, venture capital life sciences funding fell from a high of $50 billion in 2021 to $35 billion in 2022. If funding continues to fall, this will result in reduction in demand for lab space putting pressure on rental and occupancy rates as supply exceeds demand. It could also result in a rise in default rates among Alexandria’s tenants. Despite this, Alexandria Real Estate is partially protected by the diverse tenant base it has, with over a thousand tenants. Among these tenants, large-cap tenants such as Eli Lilly make up 49% of total annual revenue.

Secondly, there is competition and oversupply in Alexandria’s key operating markets. With many markets facing large-scale growth in supply both from Alexandria and its competitors, there is a risk that this will result in higher competition for tenants that forces rent down to attract and retain tenants. Alexandria aims to reduce this risk through its cluster location model, and operating high-quality assets that attract tenants which provide high barriers to entry for new landlords and high barriers of exit for tenants.

Conclusion

In conclusion, despite a disappointing few years for Alexandria, the outlook looks much brighter, with demand remaining strong and interest rates looking like they may have peaked with sentiment suggesting they could fall in the latter half of 2024. Throughout this period, Alexandria has continued to grow funds from operations and attract new tenants. With this in mind, I am comfortable assigning Alexandria a tentative buy rating at this stage, with a long-term view.

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