This beaten-down sector could be a bright spot in commercial real estate

Published Tue, Jun 6 20233:13 PM EDTUpdated Tue, Jun 6 20235:00 PM EDT

As the market reassesses the value of office properties, investors have been steering clear of many commercial real estate stocks. But there are some healthier spots that could be worth a second look. Greg Kuhl, a portfolio manager at Janus Henderson, said he likes the outlook for Alexandria Real Estate Equities , a pure-play owner of life sciences centers. Even though its stock has been under pressure, Kuhl expects the accelerating pace of health care innovation to stoke demand for laboratory space in years to come. According to Kuhl, the U.S. Food and Drug Administration has been working to speed up the drug approval process, and this has helped drive research and development investment. "We are told that 2023 is on track to be equal to, or maybe the best year ever, in terms of new medicines being approved," Kuhl said, "so that's a positive from the innovation perspective and the speed of innovation." An aging population also will have more medical needs, which will need to be served, he said. The market dynamics Alexandria Real Estate Equities enjoys very high occupancy levels of about 95%, and Kuhl anticipates many of the leases in its portfolio are priced about 20% below market rates. That will provide the company with upside potential as leases mature and renew. The dynamic also provides investors with some cushion should market rental rates come down a bit, Kuhl said, adding there haven't been any signs of that being the case yet. ARE YTD mountain Alexandria recently hit a 52-week low of $110.64. Still, there is a risk rents could be under pressure as new supply comes online in the industry. Strong demand over the last five to seven years inspired developers to build new centers, he said. Some are being built from the ground up, but others were traditional office spaces being converted into life sciences centers. Kuhl said the conversions usually aren't as desirable as spaces first developed as labs. "There are some characteristics that are hard to replicate for a real R & D life science user that you can't really do in a conversion," he said. Research facilities typically require a lot of specialized equipment, including ventilation systems and electric, and floors often are built to carry heavier loads, he explained. "But once they are up and running, the ongoing maintenance expense and the expense of re-tenanting, we think, is lower than traditional office," he said, which makes for a much more profitable business. Typically, when office tenants move out of a building, landlords are asked to reconfigure the space to suit the needs of the new tenant. "That happens every time an office turns over," he said. But lab space is a little different, he continued, saying it's "much more fungible" and the specialized needs tend to be handled by the tenants. While Alexandria Real Estate Equities has been an active developer, many of its projects already have tenants in place, according to Kuhl. Biotech funding cliff In recent research notes, Mizuho analyst Vikram Malhotra said the stocks of both Alexandria Real Estate Equities and its competitor Healthpeak have been hurt by concerns biotech companies, especially those that went public in 2020 and 2021, will be hitting a funding cliff in the coming months, which will lead to companies either going bankrupt or needing to be acquired. Either outcome could knock the demand for lab space and prove difficult for landlords. In April, Mizuho did an analysis of both companies' tenant rosters to see what kind of cash runway the companies have. Following that work, Malhotra set buy ratings on both stocks, saying any credit risks in the space are "manageable." PEAK YTD mountain Healthpeak share are trading near the lower end of its 52-week range. According to his research, about 84% of Alexandria Real Estate Equities' square footage is leased by public health care companies that have more than eight quarters of funding in hand, while 3% is leased to those that have less than four quarters of funds. For Healthpeak, 72% of its square footage is leased to tenants that are public health care companies with more than eight quarters of funding and only 6% of its space is leased to ones with less than four quarters of funds, he said. Malhotra said he sees lab REITs as a "lower-beta way to play the volatile Life Sciences environment." His $145 price target on Alexandria Real Estate Equities implies 25% upside from Monday's close. However, the average analyst price target is even higher, $164, according to FactSet. Alexandria Real Estate Equities' shares are down 19% so far this year, underperforming both the iShares Biotechnology ETF (IBB) and the S & P 500 , which have lost 1.7% and gained about 12% year to date, respectively. As for Healthpeak, Malhotra has a $25 price target, which is 22% above where the stock closed Monday. Healthpeak's shares are down about 16% year to date. Other stocks with exposure to the sector include Ventas , Boston Properties and Kilroy Realty . But each of these companies are more broadly diversified and have exposure to other types of commercial real estate. Kilroy, for example, had been focused on properties in the tech hubs, but it now has a growing life sciences portfolio. As for Kuhl, in the short term, he said it will be difficult for Alexandria Real Estate Equities to find a catalyst to move its stock. However, over time, he expects the story to be proven out. "We do think on a longer-term basis, this is deeply discounted, but it's going to take time to prove to the market," he said.