Description

Alexandria Real Estate Equities (Ticker: ARE)

Price: $38.60

Target Price: $21.00

Estimates ($ millions, except per share)

                                                2009E       2010E         2011E

NOI                                              323         314          299

EBITDA                                         286         275          260

FFO/share                                  $4.43      $3.58        $3.03

*Adjusted for non-recurring items

Summary and Conclusions:

Alexandria Real Estate Equities (ARE) is the largest landlord of life science real estate in the US.  As of March 31, 2009 the company owned 11.1 million square feet of laboratory and life science office space.  A majority of its portfolio is centered around four different geographic regions: Eastern Massachusetts (28% of total square feet), Suburban Washington DC/Maryland (22%), San Diego (14%) and San Francisco Bay (13%). 

Alexandria primarily leases laboratory and office space to life science companies.   Tenants include large pharmaceutical companies, small biotechnology companies and non-profit research organizations.  Lab facilities are highly customized real estate properties with very significant building specifications.  For example, typical attributes of these properties include specialized HVAC systems that pull 100% of air from outside (versus 20% in typical office space), temperature chillers, minimum ceiling heights of 14 to 17 feet, reinforced floors and 15-20 watts per square foot electricity (versus 2.5 watts per square foot in typical office space).  These modifications make the cost of developing lab properties extremely expensive at $300 to $500 per square foot.  Annual rental rates average $30 per sq foot.

We believe Alexandria is an excellent short opportunity due to increasing pressure on the funding of its tenant base, deteriorating fundamentals, significant operating leverage and financial leverage and our expectation for future equity dilution driven by a continued recapitalization of the company's balance sheet.  We expect a continuation of occupancy and rent declines driven by life science tenants' lack of access to capital and consolidation amongst large pharmaceutical and biotech tenants.  Our price target of $21 is arrived at by using an 8% capitalization rate on 2010 Net Operating Income of $314 million.  This price target translates into a dividend yield of 6.6% and EV/EBITDA multiple of 14.2x.

Investment Thesis

Highly volatile tenant base.  After a record year for venture capital and biotech financing in 2007, venture capital funding declined 8% in 2008.  Our checks indicate venture funding has materially worsened over the last 6-12 months.  According to VentureSource, venture firms raised just $2.4 billion in the first quarter of 2009, down 64% from a year earlier.  The National Venture Capital Association estimates biotech venture capital funding fell 46% in the first quarter of 2009.  In addition, the capital markets remain nearly closed for life science entities that aren't self-sustaining in nature.  We estimate 55% of ARE's annualized rents come from biotech or medical technology tenants.  Out of those tenants, we estimate 75% to be considered "at-risk" tenants.  These are companies that have no predictably recurring revenue stream and are burning cash.  We expect an increase in vacancy rates over the next 12 to 24 months as cash levels continue to decline at these companies.  While the company advertises as tenants such successful biotech companies as Genetech, Amgen, Gilead, Celgene, Genzyme and Biogen, none of these companies fall within Alexandria's top 20 tenants. We estimate that these successful biotech companies combine for less than 6% of total annual rents. 

Weakening markets in Alexandria's major geographic regions.  Our channel checks indicate certain major life science-heavy regions in the US are seeing a significant weakening of fundamentals.  The San Diego and San Francisco markets are particularly weak due to large concentrations of failing small biotech companies and consolidation of large pharma companies looking to rationalize office space (Pfizer/Wyeth, Merck/Schering-Plough).  The first signs of the fundamental weakness began to show up in Alexandria's fourth quarter  2008 and continued into the first quarter of 2009.  As seen in the chart below, San Francisco, Boston, San Diego and Washington make up 77% of Alexandria's total square footage.  The combination of these four regions has seen 180 basis points of occupancy declines and -2.4% rent declines since the peak in the third quarter of 2008.

Occupancy declines accelerating.  Since the company reported peak occupancy of 95.6% in the third quarter of 2008, combined occupancy has declined over 130 basis points through the first quarter to 2009.  As seen in the chart above, ARE's top 4 regions have seen occupancy rates fall 180 basis points since 3Q08.  We believe this is a direct result of the weak economy, its tenant base running out of cash, declining funding levels for its "at-risk" tenant base and consolidation among large pharma companies (Pfizer/Wyeth, Merck/Schering-Plough).  As an anecdote, Pfizer recently backed out of a lease with ARE for a 158,000 sq foot building in Mission Bay area in San Francisco.  The building cost ARE $55 million or $350 per sq ft to complete and will go unoccupied for the foreseeable future.  We expect this trend to continue and forecast a total of 300 basis points of occupancy decline through 2010 from the peak in 3Q08.  During the last cycle from 2001 to 2003, peak to trough occupancy fell 510 basis points from 99.0% to 93.9%. 

Rent declines are expected to follow occupancy declines.  As one would expect, rent declines are a direct result of occupancy declines as landlords cut rents in order to keep tenants in the space.  Average rent per square foot was down -0.8% year over year and -2.2% sequentially in the first quarter 2009 to $30.61 per square foot.  Since the third quarter of 2008, rent prices have declined -2.4% for ARE's top 4 geographies.  These are the first pricing declines we have seen during the current cycle.  We expect this trend to continue and estimate average rent per sq ft will decline -3% in 2009, -3% in 2010, -5% in 2011 as higher priced rents come up for renewal (see lease expiration table below). 

Significant lease expirations through 2012.  As noted above, we expect the industry will experience occupancy and pricing pressure which will be a key driver of weaker financial results for the next 2 to 3 years.  This environment will be particularly painful for Alexandria as 35% of total square footage is up for renewal over the next three years.  Twenty-one percent of the expiring leases come from the San Francisco area, a geographic area that has seen a significant deterioration in fundamentals in the recent quarters.  In San Francisco, occupancy was down 170 basis points and rents were down 8% sequentially in the first quarter 2009.  Our checks indicate that vacancies have risen in the South San Francisco/Mission Bay area from 5%-7% to 9%-11% recently.  In addition, we have heard of a tremendous amount of subleased space that has yet to come on the market.  This space is being subleased from 60-70% off the listed price. 

Highly leveraged balance sheet leverage/Potential refinancing problems.  We believe ARE will effectively need to recapitalize its balance sheet over the next couple years as a significant amount of unsecured debt matures and the company's cost of debt increases from its current effective interest rate of 5%.  As discussed later in this memo, we believe the company's cost of refinancing will increase to 7.0%-8.0% in the future.  As of 3/31/09, the company's net debt/2009E EBITDA stood at 10.0x.  We view this level of leverage as unsustainable given the volatility of the underlying business.  As seen below, the company has significant maturities of debt coming due over the next 4 years.  While we believe the company has ample liquidity to get through 2010, we expect the company to begin to address its looming 2011 and 2012 maturities over the next 12-18 months through dilutive equity issuance or higher cost debt refinancing.

Permanent equity value impairment as company deleverages over the next 3 years.  We believe the company will pursue a multi-strategy approach to recapitalizing the company through a combination of equity issuance, secured debt financing (60% of asset base is unencumbered) and debt paydown using cash flow from operations.  We believe that any avenue the company decides to take leads to further equity dilution and will negatively affect the stock price.  As a current example, BioMed Realty (Ticker: BMR), a direct competitor to Alexandria, completed a $350 million financing for its prized Center for Life Science in Boston on June 29, 2009.  This property was a brand new, state of the art facility and the occupancy rate was greater than 90%.  The interest rate on this 5 year loan was 7.75%.  These refinancing rates are consistent with rates that Alexandria's management are seeing in the market. By comparison, Alexandria's current effective interest rate is 5.0%.  If Alexandria were to refinance all of its unsecured debt at this rate, FFO would be diluted 22% from 2009 FFO estimates. 

Expensive valuation provides downside protection for our short.  Alexandria trades at an expensive valuation on an absolute basis and relative to the REIT universe.  This should provide a good amount of downside protection for our short position.

***REIT universe is based on Citigroup's 2009 estimates, *ARE multiples on $35 stock price

Valuation scenario analysis presents attractive risk reward. We believe shorting Alexandria presents a compelling risk reward at the current price of $32.50 per share.  We get to our price target of $21/share by placing an 8% cap rate on 2010 NOI.  Additionally, we expect further NOI declines in 2011 due to a large amount of high rent square footage up for renewal during the year.  The current upside/downside ratio in being short the stock is over 3:1 in our opinion.  In addition, paying the annual $1.40/share dividend (4% yield) is not expensive compared to other REITs which have dividend yields in the high single digits.

Risks To Investment Thesis

• Funding for tenant base may be stronger than expected.  If the capital markets open up and venture funding comes back before many VC backed companies run out of cash, then tenants will not be forced to terminate leases and results could be better than expected.
• Fundamentals are stronger than we expect.  While we have started to see fundamentals breakdown in the last two quarters, they may not decline as much as we are expecting.   We are expecting NOI to decline -1% in 2009, -7% in 2010 and -5% in 2011.
• Development/Redevelopment pipeline could yield stronger results.  While we assume a yield on the development pipeline in our NOI estimates, we have tempered our results since more than 50% of the pipeline is not yet leased.  We are skeptical of the company's ability to fully lease these ground-up development properties and its practice of artificially inflating the occupancy rates by moving properties into redevelopment on the balance sheet.  We believe 5-6% of the company's square footage is moved in redevelopment annually as the properties are vacated which has the effect of artificially inflating occupancy rates and Funds From Operations.  The company is able to capitalize interest expense while the property is classified as redevelopment on its balance sheet as opposed to expensing interest through the P&L. 
• Capital markets may allow the company to refinance current balance sheet at attractive rates.  While ARE has already been rejected from participating in the government's TALF program due to the government's opinion that its business is too volatile, it might be able to participate in future programs or receive equally favorable terms on its debt refinancing.
• Government funding for research is a wild card.  The government has pledged $10.4 billion in funding for the National Institutes of Health and $3 billion for the National Science Foundation.  It is unclear if or how much this funding will benefit pre-venture capital research. 
• FDA approval of a few blockbuster drugs could renew enthusiasm for biotech.  If the FDA approves a few blockbuster drugs over the next couple years we could see a renewed interest in biotech investing and an inflow of capital to the industry.  However, with the current administration in Washington, it appears that any new health plan will pressure the profitability of drug companies. 

Highly leveraged balance sheet leverage/Potential refinancing problems.  We believe ARE will effectively need to recapitalize its balance sheet over the next couple years as a significant amount of unsecured debt matures and the company's cost of debt increases from its current effective interest rate of 5%.  As discussed later in this memo, we believe the company's cost of refinancing will increase to 7.0%-8.0% in the future.  As of 3/31/09, the company's net debt/2009E EBITDA stood at 10.0x.  We view this level of leverage as unsustainable given the volatility of the underlying business.  As seen below, the company has significant maturities of debt coming due over the next 4 years.  While we believe the company has ample liquidity to get through 2010, we expect the company to begin to address its looming 2011 and 2012 maturities over the next 12-18 months through dilutive equity issuance or higher cost debt refinancing.  Highly leveraged balance sheet leverage/Potential refinancing problems.  We believe ARE will effectively need to recapitalize its balance sheet over the next couple years as a significant amount of unsecured debt matures and the company's cost of debt increases from its current effective interest rate of 5%.  As discussed later in this memo, we believe the company's cost of refinancing will increase to 7.0%-8.0% in the future.  As of 3/31/09, the company's net debt/2009E EBITDA stood at 10.0x.  We view this level of leverage as unsustainable given the volatility of the underlying business.  As seen below, the company has significant maturities of debt coming due over the next 4 years.  While we believe the company has ample liquidity to get through 2010, we expect the company to begin to address its looming 2011 and 2012 maturities over the next 12-18 months through dilutive equity issuance or higher cost debt refinancing. 

Catalyst

Rent rolls, tenant bankruptcies, and balance sheet refis at higher interest levels will lead to NOI and FFO erosion.