2023-06-16 17:49:22 ET
Summary
- I upgrade Alexandria Real Estate Equities from "hold" to "buy" due to strong like-for-like performance, favorable financing, and an improving balance sheet.
- Alexandria's Q1 2023 results showed the highest quarterly rental rate growth in the company's history at 48.3% and a strong same-store quarterly NOI growth at 9%.
- Alexandria's balance sheet remains resilient, with a debt ratio of around 36% compared to the sector average of 61%, and the company is able to leverage its investment grade rating to capture favorable financing terms.
- All of the expressed concerns by an activist investor lack substantial basis and go against both the Q1 2023 facts and financial prospects.
On April 16, 2023, I issued an article on Alexandria Real Estate Equities, Inc. ( ARE ) arguing that ARE is fairly valued and that, as a result, the upside potential is limited.
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My thesis has held true. The market has gone up by ~6.7%, while the share price of ARE has slightly decreased. On a total return basis, the spread lands at 521 basis points.
Also, since the publication of the article, ARE circulated its Q1 2023 figures , which revealed strong performance and embodied many signs of favorable financial prospects.
These stellar results were not sufficient to meaningfully impact the share price because of the relatively rich valuations.
Now, against the backdrop of a negative spread in performance and several indications of robust results going forward, ARE deserves to being upgraded from "hold" to "buy."
Below I will share three key reasons why, in my opinion, a buy rating is justified for ARE.
1. Strong like-for-like performance
Q1 2023 confirmed that the ARE portfolio is resistant to the prevailing headwinds in both the office and capital markets space. The fact that ARE managed to deliver the highest quarterly rental rate growth of 48.3% in the company's history is a clear proof of that.
Moreover, the growth stemmed from notable leasing activity, with leasing volume aggregating 1.2 million RSF. This figure exceeded the 1.1 million RSF average in quarterly leasing for the 5-year period prior to 2021.
All this contributed to a strong same-store quarterly NOI growth at 9% (cash basis). A part of the NOI increase was explained by the annual rent escalator clauses, which typically materialize in Q1 results.
In the remaining quarters, leasing activity will be somewhat more moderate, providing less upside potential for ARE to negotiate positive leasing spreads. However, already starting from 2024 there will be a significant amount of leases expiring that should offer an opportunity to continue delivering on the NOI growth.
All in all, the aforementioned dynamics serve as a clear testament to the resiliency of ARE's cash flow generation.
2. Fresh and favorable financing
Ending 2022 and also as of Q1, 2023 ARE carried a well-laddered structure of debt maturities with no refinancing needs until 2025.
Currently, ARE holds ~$5.3 billion in liquidity, which means that the scheduled maturities post-2025 can be easily refinanced without having to introduce unfavorable financing mechanisms.
During Q1, 2023, ARE managed to opportunistically tap into the financing markets to fund its annual CapEx spend. I was cautious with ARE's ability to source favorable financing due to overall pessimism towards the office segment and general tightness in the lending markets. In other words, ARE was and to some extent still is exposed to the risk of being subject to aggressive cost of financing (due to its financing strategy, which partially hinges on issuances of incremental debt), but the negotiated deals provide comfort.
In February 2023, ARE issued $1.0 billion of unsecured senior notes payable at an interest rate of 4.95% and a maturity of 21.2 years.
While the cost of financing is higher than the current weighted average interest rate level at ARE's books, the difference is insignificant (4.95% vs 3.64%). At the same time, they attracted $1.0 billion, which covers the bulk of ARE's near-term CapEx need, is stretched across 21+ years that, in turn, relaxes the pressure of FFO generation.
The key takeaway from this development is that ARE clearly is able to leverage its investment grade rating and large-cap status to capture financing at favorable terms even in the turbulent times like these. As a result, ARE is not so exposed to surging WACC and significantly growing interest expense that ultimately protects the underlying cash flow generation.
3. Improving balance sheet
Q1 2023, resulted in a slightly more debt-saturated balance sheet , which is mostly explained by the aforementioned $1.0 billion of incremental debt proceeds. The net debt and preferred stock to adjusted EBITDA ratio increased from 5.1x in Q4 2022 to 5.3x in Q1 2023. However, the actual coverage levels (fixed-charge coverage ratio) remained strong at 5.0x and did not change, confirming an improved cash generation.
These metrics indicate continued resiliency both on the absolute and relative terms. For instance, ARE carries a debt ratio of ~36%, while the sector average level stands at 61%.
Alexandria Real Estate
Going forward until year-end 2023, ARE has set a target to maintain the balance sheet at a healthy level, with even lower debt portion (relative to EBITDA) than it currently has.
This means that ARE will continue to possess an opportunistic balance sheet with a sufficient protection from any forthcoming meltdowns in the overall office stock. This will be especially critical once 2025+ debt maturities start to kick in and force ARE to participate more actively in the financing markets.
There is an elevated probability that the financing conditions will deteriorate even further, but the fortress balance sheet of ARE is and should continue to be strong enough to survive without falling at a mercy of "value destructive" cost of financing.
The bottom line and counter argumentation to Activist Investor Jonathan Litt, Land and Buildings Founder and CIO
Looking at the valuation multiples across the office real estate investment trust ("REIT") space, ARE seems to be overpriced, i.e., P/FFO of 13.5x for ARE compared to the sector average of 7.6x. In fact, ARE is the most expensive REIT in terms of the P/FFO multiple in the overall office REIT segment.
So, with regard to the valuation issue, I agree with the comments by Jonathan Litt on CNBC that ARE is richly valued compared to its peers.
However, ARE has truly robust fundamentals and one of the strongest balance sheets among its peers. Plus, as described above, ARE does not suffer with the accessibility nor the pricing of the financing, which is the total opposite for other common office players. The fortress balance sheet coupled with a continued like-for-like NOI growth, in my opinion, justifies the current price of ARE.
Another concern expressed by Jonathan was the falling occupancy rate, given the massive decline in cellphone data activity in ARE's buildings.
However, the recent quarters show no signs of deteriorating occupancy rates. In fact, the occupancy of ARE's operating portfolios has remained strong at 93.6% despite the notable lease renewal activities. Going forward until year-end 2023, ARE projects a slightly improving level of occupancy at 94.6 - 95.6%. Furthermore, in the context of a record-breaking quarter in which ARE delivered rental growth of 48.3% on the expiring leases, the argument of considerably increasing vacancy rates does not seem to hold.
Lastly, Jonathan pinpointed to the increased risk for ARE of not accessing financing.
Again, as described above, the real-life facts observed in Q1 2023, indicate no signals of worsening financing conditions for ARE. The fact that ARE managed to obtain financing at only 100 basis points above its weighted average level and on a 20+ year tenure, confirms ARE's attractiveness in the eyes of lenders.
In my humble opinion, Alexandria Real Estate Equities, Inc. stock is a buy at these levels.
For further details see:
Alexandria Real Estate: Upgrading Rating To Buy, I Disagree With Jonathan Litt