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Alexandria CEO: New Lab Space Entrants No Threat to Moat

Jason Ren

Jason Ren: Hello, I am Jason Ren, a REIT analyst with Morningstar. Joining me today is Philip Martin, a REIT strategist with Morningstar, and chairman and CEO of Alexandria Real Estate Equities, Joel Marcus. Wonderful to have you.

Joel Marcus: Wonderful to be here. Thank you.

Ren: Alexandria is developing lab space in Asia for its partners. In a recent investors conference call, you remarked that the "research" research and development is in the United States, but some of the "process" research and development is moving out to Asia. One of my questions is how do you see research R&D eventually moving toward Asia, and how much of this is a threat or an opportunity to your operations?

Marcus: Thanks, Jason. So, a couple of preliminaries. First of all, on Asian operations, we have a small operation in China. We're still proving our model there. We do have a more expanded operation. We actually operate directly through partners in both India and China. So we have a pretty good-sized team on the ground in India. We are focused on primarily build-to-suit developments for European and North American companies involved in the broad life-sciences industry over there, primarily in Bangalore and Hyderabad, India.

When it comes to what I said on the call regarding U.S. or North American and European countries, first and foremost, they are focused on building big presences in India, in particular, to take advantage of that market. So you've got sales and marketing, you've got development. You have some, as I call it, process R&D and also clinical trial and data management work.

I think when you distinguish between novel, innovative research versus more traditional process-oriented research, I think it seems pretty clear that a novel inventive research will stay primarily in the U.S. and Europe. One reason is because of patent protections. The second reason is because of the main universities generating and institutes generating that kind of research, and the great minds really across the globe are still coming to the U.S. in rather large numbers.

So we see it concentrated here, and I think that will propel and help our business years into the future. But I think the opportunities lie in the big markets in India and other places where our clients want to take advantage.

Ren: Closer to home, we have been lately seeing health-care REITs such as Health Care REIT and HCP move into the lab space arena, and also lab space s sometimes thought of as a specialized office. So I just wanted to get view on the health-care REITs and maybe perhaps even other office REITs kind of moving in on your niche and how you might want to think about defending your economic moat and how your land holdings might play into that?

Marcus: I think that's a great question. So when we saw Slough sell its U.S. life-sciences portfolio back in 2007, and I believe HCP paid a pretty top-of-the-market price, about $2.9 billion, we valued that portfolio at about $2 billion. We looked at it, but ultimately we felt that it was concentrated really in two markets, one is South San Francisco and second was San Diego outside. A little bit in Torrey Pines, Calif., but in number of locations we were already pretty concentrated and had pretty dominant positions in those markets. So we decided early on, and I think after the first round, not to pursue it both on valuation and in location.

But I think HCP for them made a smart move. I think it was certainly they hit the market at a top price, but I think ultimately that may be good for them. It allowed them to diversify into another segment. It really doesn’t affect us in the sense that we already have positions in those markets. I think South San Francisco has turned out not to be such a great submarket. We've really redeployed our focus into Mission Bay, Calif., where we have exclusive control over all commercial land, and that’s a 1% vacancy market. So we have chosen to refocus our efforts there. Then in San Diego, there is quite a bit of competition across the board.

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Ultimately, it depends on location, quality of facilities, and quality of service, and there I think because we're a specialist, we operate on the ground directly. I think we've got a huge competitive advantage against any of the health-care REITs that do more macro kind of segment-oriented allocations to segments. I think it's hard to compete in that sense.

I think if you transition to the land bank, if we look at Cambridge, Mass., for example, our main competitor in Cambridge and our main partner is MIT actually. Forest City has a big presence there but really not in the Kendall Square area. They are really in the University Park area.

HCN is one of their partners there. They came in as a double passive investor, both in the entity and how they have restrictive rights. We almost never go up against Forest City in bidding against or competing against them as far as leases. I know of almost no cases in the past 10 years, which is kind of interesting.

So I think for the health-care REITs, the diversification, I think, is welcome for us because we have a pretty good-sized land bank. We have some in Mission Bay and New York where we are exclusive in both of those locations. We have no competitors inside those specific submarkets. In Cambridge, where we have a number of competitors, primarily MIT, we have the dominant land-bank position. So I think that ensures our future growth.

Also, somebody coming into those markets can't just go buy assets or land because primarily we own them, or MIT, or a major institution owns them. And they would not be sellers at really any cap rate. So I think it's hard to penetrate. So people who come into those markets are probably destined to be in secondary or suburban locations.

Philip Martin: How are the tenants dealing with the new entrants into the space? I know you've touched upon this a little bit, but this is a very specialized sector, a very specialized space. Do the tenants feel that they have more choices? Or is it still a wait-and-see for the health-care REITs and the HCPs? You're a proven commodity in this business. Is there still a wait-and-see approach by the tenants? Or do you see this really as not a serious threat longer term?

Marcus: Yeah. I think you break it down into two kind of points, Philip, and that’s a great question. I think when it comes to the operation on the ground operation, we have a huge competitive advantage because we have fully integrated teams in each of the markets, oftentimes with scientific talent that's associated with that.

We've won a number of lease opportunities in Cambridge that were very competitive on the basis that our people were the best-in-class. The facilities teams have come and told us that your guys understand our specific, scientific, and technical needs. Anybody can kind of lease space. But this is pretty different because it's high-cost relatively compared with higher-cost space, and it's also mission-critical space.

I think where we see it more competitive is when the brokers now enter the scene and they set up a kind of a little bit of a bidding war. They aren't looking at qualitative issues. They are looking at just pricing issues. So in places like a Cambridge or South San Francisco, brokers will set up, and you can go to HCP or you can go to some of the local guys and discuss the bid-ask and so forth. So there you see it a little bit more competitive. But in the actual operations, I think we have a huge competitive advantage in mission-critical space, which is very important. And on a technical side, we also have an advantage because of our engineering and scientific staff.

Martin: It's important to note that your business model is specifically focused on lab space, biotech, and pharmaceutical purposes, whereas many of the new entrants have a more diversified approach. I think that has to weigh into the minds of the tenants and their decision, maybe not the brokers yet, but certainly the tenants.

Marcus: The smarter brokers ultimately will counsel people if you go to the space. Time-after-time, we've won big deals in Cambridge in the brokerage community because they have told their clients, "This is a price, but this is the quality that you'll be getting both mission-critical facility and the operational side." And also our ability to save at the operating-expenses level too makes a big difference. But, yes, a lot of times some of the other entrants outsource those functions to property management firms, even brokerage firms and they really can't compete at an operational level because they are just real estate people. They are not scientific or technical people, but you are exactly right.

Ren: Keeping with the theme of tenants, one of the ways that to us it seems like Alexandria has differentiated itself is that eight of its top 20 tenants have a narrow-moat or wide-moat ratings and then another six or so are top-flight research institutions.

Health-care reform is on everyone's mind, and the key goal of health-care reform is to bend the cost-of-growth curve downward to below inflation. Also, recently there was some talk about how larger tenants might be able to exact better lease terms. So what's your outlook on underwriting to larger tenants, who are trying to achieve an above-inflation growth rate when maybe the entire health-care space's cost of growth is bending lower?

Marcus: So it's a pretty important and multifaceted question. First of all, kind of at the basic level, we have a team of six life-science experts, who spent much of their career on the technical side as well as the financial and business side, and they really enable us to both underwrite and evaluate tenants, both ones we target and ones we currently have.

We've done I think a very, very good job. Unique. It would almost be like having the two of you as part of our real estate underwriting team. It's a unique skill set that we have. So that enables us to avoid major risk that's on companies that may not make it or situations where we want to keep diversified both as to specific tenants, names in particular, and also sectors.

So if you go from that base, which distinguishes us from probably any other REIT out there, as we look at the health-care landscape today, we see Asia is a big growth market as we were just talking about. The U.S. and Europe will continue to be growth markets at a slower rate of growth than they used to be. I think the volume of patients that will be exposed to the bio and pharmaceutical products will increase over time just because of the way the governments are bringing more people into the system. Pricing pressures and reimbursement pressures will continue.

I think premium breakthrough novel products, which either detect, prevent, and diagnose major diseases and head them off will get good pricing. Compounds that have unique abilities to retard growth of disease or the onset of disease, let alone even manage and ultimately cure disease, I think will get premium pricing. We are involved with a company right now for example that has the most advanced cancer stem-cell product, that's a small molecule aimed at inhibiting cancer at its stem cell level, without radiation or chemotherapy. It's been in Phase 1 and 2, and the Food and Drug Administration has put it on a fast-track.

It's basically been effective against a broad range set of cancer tumors, which is pretty unique, without virtually any side effects among quite a number of patients, the dominant number of patients. And the few side effects there are seem to be like minor nausea and so forth. So compared with the traditional brutal chemotherapy radiation in combination with the pretty toxic chemical compounds, this might be one of the waves of the future.

So we continue to believe that although with the health-care pie, 10% or less is really attributable to cost to pharma and bio products, which is kind of a minor part, it's the only segment of the entire health-care pie that has the chance to truly manage, minimize, and, over time, hopefully contain health-care costs. So we're pretty bullish.

I think the critical question for us or America is: Will the government and will private industry continue to invest in novel R&D and develop these breakthrough products and services? So we need the government's support for the National Institutes of Health, that's important. And we need the industry, which has a run rate of about $60 billion-$70 billion of R&D today to continue to reinvest in this space, and they reinvest based on the ability to protect novel products either through data protection or through patent protection. The NIH budget is running at about $30 billion, and we hope that the government will preserve at least that run rate.