Shares of Alexandria Real Estate Equities, Inc. (NYSE:ARE) hit the 52-week low list, even as the company sold off some of its properties in an attempt to sharpen the strategy and obtain proceeds to bolster the balance sheet.
Perhaps it is somewhat surprising to some ARE investors to see shares perform so bad, as the focus of the company, on life science markets, seems to be sound from a fundamental point of view with apparently still solid demand from end users.
Strong end markets, low leverage, fixed debt and pre-let developments look favorable, but investors fear the impact of the current environment, likely fearing lower occupancy rates and/or falling rents going forward.
The Company
Alexandria has a mission to create and grow life science ecosystems and clusters which accelerate innovation in advancing human health and improve nutrition. Since its IPO in 1997, Alexandria Real Estate Equities has delivered nearly 1,500% returns until March of this year, marking a strong performance on the back of this positioning and strong execution.
Strong growth has furthermore been driven by strong rental growth, a strong tenant base (even as it includes biotechnology companies and start-ups) as Alexandria has taken on a fixed and long-dated debt at very reasonable rates. The company has massive investments in recognized hubs like Boston, Cambridge and San Diego, among others.
2022 – As Base
Looking at the 2022 results, as released earlier this year, we see the company operating with a roughly $35 billion balance sheet, which contains about $30 billion in investments in real estate. The firm is relatively conservatively financed, operating with nearly $23 billion in equity.
Total revenues, mostly comprised of rental revenues, rose from $2.1 billion in 2021 to nearly $2.6 billion last year. The company posted GAAP earnings of half a billion dollars, but earnings do not really tell much with real estate companies, mostly because this comes after a billion dollar depreciation charge. Moreover, the company incurred some investment losses and real estate gains as well. Funds from operations (“FFO”), which adjust for some of these items, rose to $1.36 billion, for earnings equal to $8.42 per share.
Shedding some color on the other characteristics from the portfolio: the company has reported 95% occupancy rates, had lease contracts with a weighted leverage lease term of just over 7 years, as the company leased out over 8 million square feet in 2022. Other than the lower relative ratios, the company has average maturity of debt of around 13 years, with 99% of debt being of fixed nature, all looking quite solid.
For 2023, the company guided for continued growth, seeing adjusted funds from operations improve to a midpoint of $8.96 per share. After the release of the results, the company raised a combined billion in 2035 and 2053 notes, as I was pleased to see that the company could raise the latter maturities at a 5.15% rate.
Solid Start To 2023
In April, Alexandria posted a 14% increase in first quarter income to $700 million, due to the strong rental rates. Funds from operations advanced to $374 million, improving fourteen cents to $2.19 per share. That said, occupancy rates fell a bit below 94%. GAAP earnings only came in at $75 million, with results hurt by a $45 million investment loss. Amidst continued growth in the portfolio, equity was stable at $22.6 billion, although the total balance sheet increased to nearly $37 billion amidst growth in the (development) portfolio.
With 170 million shares outstanding and now trading at $110, the market value of $18.7 billion trails the book value by about $4 billion. This more or less suggests that the market believes that the book value of the properties is inflated by around 10% here. That said, based on potential income, the properties are only valued at around 13 times gross rental income here, which either tells that the market believes that this multiple should be lower, occupancy rates might fall a great deal, or rents will come down. Nonetheless, despite these fears, the company hiked the dividend by 2.5% early in June to $1.24 per share (that is on a quarterly basis).
In June the company sold some assets. The company has sold a group of five dated laboratories in a $365 million deal, for a weighted-average cap rate of 5.2% Based on the lower and historical valuations, the company recorded a $187 million gain in connection with the deal. This places the company on track to sell over one and a half billion dollars in properties this year, badly needed as the company has nearly 7 million square feet of projects, representing over $600 million in rental value.
This means that these divestments are really aimed to limit the growth in the investment portfolio, although I am pleased to see that the company has pre-leased a great deal of new developments, has secured a lot of long-term debt which furthermore is fixed as well, all while the balance sheet is quite solid.
Despite this observation, shares of Alexandria have fallen to $110 here. To put this move into perspective, these were similar levels at which shares traded pre-financial crisis, as shares fell to the $30s in 2009.
Through 2016, the shares had recovered to the $100 mark again as shares rose to the $200 mark in the summer of 2021, with shares peaking in the $220s later that year. Inflationary trends and higher interest rates hurt shares during 2022, and while shares still traded at $160s in February, shares have now fallen towards the $110 mark.
While a current 4.5% dividend yield is compelling, the reality is that investors have not seen many capital gains here. Note that the business, unlike the shares, has seen huge growth. In fact, (rental) revenues only broke the half a billion mark in 2014, now having five-folded, although the share count more than doubled over this period of time. Amidst all these trends, the balance sheet expanded from $8 billion to $37 billion.
What Now?
It is clear that investors are fearful that current revenue growth is not sustainable, fearing lower occupancy rates and lower rental rates over time as laboratories and offices might not be immune to the fact that workers have not returned to the office.
This makes the debate about the current prospects for this type of real estate interesting and some kind of battleground. This comes amidst lower traffic, an economic slowdown and in the medium to long term the rise of AI to replace workers. Often regarded as mission-critical, that statement might be applicable in the case of laboratories, although the portfolio includes some offices as well.
While some short reports have surfaced, this feels a bit late as shares are cut in half from the highs already, while debt is long in terms of duration and leverage ratios appear to be very modest.
Amidst all these developments, I am taking a wait-and-see approach on Alexandria Real Estate Equities, Inc. Based on the positioning, I am very attracted to the business in the long haul, but for now I fear the impact of lower occupancy rates, in combination with relative higher property expenses (due to the nature of the real estate, the ecosystem and quality requirements). Given this, while rents are sky-high in relation to other types of real estate, and historical standards after years of strong rental growth, Alexandria Real Estate Equities, Inc. stock will be an interesting battleground.
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