Earnings Call Transcript - ARE Q3 2018

Operator, Operator

Good day, and welcome to Alexandria Real Estate Equities' Third Quarter 2018 Conference Call and Webcast. All participants will be in listen-only mode. After today’s presentation there will be an opportunity to ask questions. Please note, this event is being recorded. I would now like to turn the conference over to Ms. Paula Schwartz with Investor Relations. Ms. Schwartz, please go ahead.

Paula Schwartz, Investor Relations

Thank you, and good afternoon, everyone. This conference call contains forward-looking statements within the meaning of the federal securities laws. The Company's actual results might differ materially from those projected in the forward-looking statements. Additional information concerning factors that could cause actual results to differ materially from those in the forward-looking statements is contained in the Company's periodic reports filed with the Securities and Exchange Commission. And now I'd like to turn the call over to Joel Marcus, Executive Chairman and Founder. Please go ahead, Joel.

Joel Marcus, Executive Chairman and Founder

Thank you, Paula, and welcome everybody to the third quarter call for Alexandria. And with me today are Steve Richardson, Peter Moglia, Dean Shigenaga, and Dan Ryan. The third quarter was an outstanding quarter by almost every financial and operating metric, particularly core operating metrics that were really stellar and Dean will talk more about that. My congratulations to our entire Alexandria family for each person’s day-to-day operational excellence, which is what really makes it all happen. And also congratulations to the world-class accounting and finance team on their hard work, resulting in our recent credit upgrade from Moody's, which is something very important. Moody’s focuses on tenant quality, and at Alexandria, it's one of our strongest characteristics. From the earnings release, 52% of our annual rental revenue is from investment-grade or large-cap public companies. We are very proud that 79%, almost 80%, of that revenue is from Class A assets in AAA locations, and about 60% of that is focused in Cambridge and San Francisco. The average lease term is about 8.6 years and 12.3 years for our top 20 tenants. This shows a very strong core tenant base. In terms of the industry, venture funding in life science continued at a very strong pace, over $7 billion in the third quarter, marking the fourth consecutive quarter with over $5 billion invested. This is a record-breaking trend driven by an increase in deal size and well-established venture firms raising larger funds at a faster pace. Also, we had our 47th new drug approved on October 24 this year, and the FDA has surpassed last year's 46th drug approval count and could be on pace to beat the all-time record of 53 set in 1996. Additionally, strong bipartisan support resulted in legislation enacted to increase National Institute of Health overall funding by $2 billion to approximately $39.1 billion. We are very fortunate about that, as it is a critical competitive advantage for the United States in biomedical research. There was also strong legislation passed to address the opioid crisis, which has resulted in over 64,000 deaths last year, more than those who died in the entire Vietnam War. All of us in the industry, particularly ourselves, are focused on specific things we can do to advance this project forward. Biotech IPO activity has been the strongest since 2014, approaching 50 IPOs, raising almost $5 billion during the first nine months. While the NASDAQ biotech index has faced some breadth of volatility recently, we have seen a flight to value and big-cap safety. Now, I will turn it over to Steve to comment on several operational aspects, then to Peter, and then back.

Stephen Richardson, Co-Chief Executive Officer

Great. Thank you, Joel. Steve Richardson here. This afternoon I'll highlight the continued strong demand for Alexandria’s highly differentiated Class A science and technology campuses and the country's leading innovation clusters. Building on what Joel mentioned about the life science capital markets, we had 17 IPOs this quarter as part of an overall strong demand context, driving stellar leasing and financial results with increases this quarter of 16.9% in cash and 35.4% in GAAP, the highest in 10 years. Diving into Alexandria’s cluster markets, Alexandria has been a first mover in each of these markets and has a dominant position with the highest quality campuses immediately proximate to the country’s leading life science research institutions. The Cambridge market remains extremely strong with a vacancy rate of 0.9%, and demand has spiked from 2.2 million square feet last quarter to 2.8 million square feet this quarter with fiber requirements exceeding 200,000 square feet. The San Francisco region has an overall vacancy rate of just 3.0%, with no availability in Mission Bay. Demand remains strong at 2.5 million square feet working up to the typical trend where life science companies are competing with tech companies for space and talent, especially with 17 tech requirements exceeding 100,000 square feet just in San Francisco alone, totaling direct tech demand of 7.2 million square feet down to Palo Alto. San Diego's core, UTC, and the Torrey Pines submarkets are also performing strongly with direct vacancy of just 5.3% and steady demand nearing 900,000 square feet. Moving North, Seattle’s life science cluster in South Lake Union remains tight with just 1.6% vacancy and lab demand at 400,000 square feet. Research Triangle Park is also a bright spot with AgTech and life science demand totaling 275,000 square feet. Lastly, Maryland is bouncing back with over 500,000 square feet of demand and a 4.6% vacancy rate. With continued constrained supply and healthy demand, market rents are holding strong. We are seeing pricing pressure across our markets with Cambridge now at $80 plus triple net, New York City in the mid-80s triple net, San Francisco mid to high-60s triple net, San Diego exceeding $50 triple net, Seattle similarly mid to high-50s triple net, and Maryland and RTP north of $30 triple net. One key takeaway here is that 68% of the renewals and releases year-to-date are from early renewals. This trend of urgency in the market is helping Alexandria’s teams to work collaboratively with its industry-leading tenant roster and continue to drive meaningful rental rate growth. With that, I'll hand it off to Peter.

Peter Moglia, Co-Chief Executive Officer and Co-Chief Investment Officer

Thank you, Steve. I'll spend the next few minutes updating you on our near-term pipeline, touch on cap rates, and address construction costs, as they remain a topic of interest. In 2018, we have deliveries of 217,000 square feet in service and another 489,000 square feet with a cost to complete of $76 million expected to be delivered by the end of the year. The total of 706,000 square feet is close to stabilization with 96% leased or under negotiation, expected to stabilize at a 7% cash yield. Great leasing progress was made this quarter at our five Laboratory Drive project in RTP, which is now 51% leased, with another 47% under negotiation. Remarkably, this project started only 15 months ago and was not expected to stabilize until 2019. The 399 Binney building in Cambridge, which will be delivered by year-end, has all but the retail space under negotiation with a number of high-quality, venture capital-backed companies looking to anchor several Alexandria projects in coming years. This 174,000 square foot development in the heart of Kendall Square is projected to stabilize at a 6.7% cash yield. The 9625 Towne Centre Drive project in the University Town Center submarket of San Diego is on target to be delivered to investment-grade tenant Takeda in the fourth quarter at a 7% stabilized cash yield. The 1.1 million square feet to be delivered in 2019 with a cost to complete of $319 million is already 85% leased with another 6% under negotiation. Major leasing progress was made at the 1818 Fairview, now renamed 188 East Blaine Street, which rose from 24% leased or under negotiation in the second quarter to 62% buoyed by leases from high-quality life science companies and institutions seeking a presence in Alexandria’s Eastlake neighborhood, headquartered at Lake Union. The initial stabilized cash yield is projected at 6.7% in a market where institutional assets have been trading in the low to mid-4s. Seattle's life science ecosystem is rich with high-quality institutions, such as the Fred Hutchinson Cancer Research Center, the Infectious Disease Research Institute, and the University of Washington. There has been historical slowness in the pace of commercialization from these institutions, but our deep relationships in ecosystem building are beginning to yield results, as evidenced by the previously mentioned success at 188 East Blaine and at 400 Dexter, completed last year. We are confident that we will continue to capitalize on our long-term investment in this market dating back to 1996, which is why we recently added 701 Dexter to our asset base, allowing us to develop up to 217,000 square feet of life science or tech space in South Lake Union, close to the University of Washington Medical School and the Gates Foundation. Now, regarding cap rates, there is always speculation regarding them whenever the 10-year treasury rises. Earlier in May, we saw the 10-year break the 3% barrier for the first time in 4.5 years, and while it toggled above and below that market has averaged around 3% since then, we have not seen any contraction in cap rates for lab product traded during this time. On the contrary, Alexandria sold our interest in Longwood Center in Boston for a 4.7% cap rate to our partner at the end of the quarter. With multiple Harvard-affiliated research hospitals, the Longwood medical area is inferior to Cambridge, so a mid-4 cap rate illustrates the appeal of life science assets to institutional buyers. Similarly, the sale of the LINX project, 490 Arsenal in Watertown also indicates status quo or if not cap rate contraction, as initial pricing guidance for this suburban location was mid-6% cap rate but traded at a 5.4% cap rate in September. Lastly, I want to provide an update on construction costs. In the first quarter, we noted that our 2018 and 2019 deliveries were insulated from the effects of tariffs due to our GMP contracts in place. Only scope changes involving steel or aluminum could expose us and while we don't anticipate scope changes, we have adequate contingency in place. Our report in the first quarter stated that re-pricing projects, including effects of tariffs would yield an increase in total project costs of approximately 1%. After further review, we’ve updated the estimate to 1.3%, incorporating this impact into all future escalation assumptions for new projects. A larger threat to our development cost structure is labor shortages caused by recent recessions that removed a number of skilled workers from the market. Workers are beginning to come back, though shortages can affect our costs and schedules if not proactively managed. We have been doing just that, leveraging our deep relationships in all markets to always have our contractors in place and employing processes such as bringing them early into the planning process to ensure our labor and costs are covered in our underwriting. With that, I'll pass it to Dean.

Dean Shigenaga, Co-President and Chief Financial Officer

Thanks, Peter. Dean Shigenaga here. Good afternoon, everyone. I'll briefly cover six topics: our solid third quarter results, continued strong internal growth, our balance sheet and improving credit metrics, non-real estate investments, sustainability, and our updated guidance for 2018. Kicking off with the results, as we enter the fourth quarter of 2018, it's useful to look back over the past year and reflect on the strength and consistency of our execution. The third quarter also reflects strong execution, with total revenues for the nine months of 2018 annualized at $1.3 billion, up 19% over the same period in 2017. Cash NOI for the third quarter annualized was $867 million, up $162 million or 23% over cash NOI for the third quarter of 2017. We reported FFO per share diluted as adjusted at $1.66, up 9.9% over the third quarter of 2017. We also reported continued and strong internal growth reflecting the robust fundamentals in our real estate and life science industry and our unique business strategy. Occupancy remains strong, up 20 basis points to 97.3% as of Q3 and up 50 basis points since the end of 2017. San Diego occupancy of 94.2% reveals temporary vacancy due to anticipated lease expiration of 44,000 rentable square feet related to Campus Point Court acquired in the fourth quarter of 2017. We are currently reviewing various renovation options for this space. In New York City, our occupancy was 97.2%, reflecting temporary vacancy as we transitioned 29,000 square feet to multiple tenants, with 77% of this leased or under negotiation today. Rental rate growth remains exceptionally strong. Over the past four years, our rental rate growth on annual leasing activity has ranged between 20% to 28% on a GAAP basis and 10% to 15% on a cash basis. For the third quarter, rental rate growth was 35.4%, representing the highest in the past decade and 16.9% on a cash basis, reflective of the unique rental dynamics in our submarkets today. Early lease renewals represented almost 70% of lease renewals and releasing space for the first three months of 2018, continuing to drive growth in rental rates and cash flows. We are well-positioned with 2019 contractual lease expirations representing only 5.4% of annual rental revenue, 25% of which is already leased. Our same-property NOI growth for the third quarter was very strong, up 3.4%, and 8.9% on a cash basis, in line with our full-year 2018 guidance. Our team has successfully accomplished several strategic goals this quarter and continues to strengthen our balance sheet and credit profile. Due to the strength in the private real estate market, we remain focused on the strategic and disciplined execution of important real estate dispositions, including the sale of Longwood generating about $70 million in proceeds, net of debt repayment, and a 4.7% cap rate. We are also advancing a partial sale of our JV interest in a high-value core property in Cambridge, expecting a lower cap rate than our previous sale at 4.5%. Over the past four years, including the in-process partial interest sale, we anticipate completing $1.5 billion in dispositions, averaging a highly attractive cost of capital in the 4% cap rate range. We raised about $196 million under our ATM program at a sale price of $127.66 per share during the quarter. As Joel mentioned, we received an upgrade in our corporate credit rating from Moody's to Baa1/Stable, highlighting our diversified portfolio with consistently high occupancy and high-quality tenants. Importantly, S&P has a positive outlook on our BBB flat rating as we work toward further improvements in our credit profile. We extended a critical source of liquidity by increasing commitments under our line of credit to $2.2 billion and improving pricing by 17.5 basis points to LIBOR plus 82.5 basis points. We also extended maturity under our $350 million unsecured term loan to 2024 and reduced pricing by 20 basis points to LIBOR plus 90. We repaid two LIBOR-based loans, aggregating $350 million, reducing unhedged variable-rate debt to 6% of total assets. We remain committed to improving our credit metrics annually, targeting annualized net debt to adjusted EBITDA closer to five times for 2019 and 2020. As a footnote, the new accounting rules required us to recognize significant unrealized gains resulting in unusually high net income for the third quarter, which we exclude from adjusted FFO per share. It's key to recognize that about $25.8 million in realized gains for the first nine months primarily stem from liquidity events rather than management decisions to sell securities. We expect about $35 million in realized gains for the full year, higher than previous years, indicative of the quality of innovation in the life science industry. I'd like to thank our AVP of Sustainability & High-Performance Buildings, Ari Frankel, and our entire team for our GRESB Green Star designation and the number one ranking in GRESB’s health and wellbeing module. We continue to strive for a positive impact on health, safety, and wellbeing across our stakeholders. We also remain focused on our Environment Impact Reduction Goals for 2025, recently highlighted in our inaugural corporate responsibility report. Our updated guidance for net income attributable to common stockholders on a diluted basis ranges from $4.34 to $4.36, reflecting unrealized gains on non-real estate investments of $117.2 million and a realized gain from the sale of Longwood at about $35.7 million. We reaffirmed the midpoint of our range for 2018 guidance for FFO per share, diluted as adjusted to $6.60, showcasing a strong execution year with a projected 9.6% growth over 2017. As a reminder, we will hold our Annual Investor Day on Wednesday, November 28, at the Alexandria Center for Life Science in New York City, where we will provide detailed guidance and assumptions for 2019. We appreciate your continued interest in Alexandria and thank you in advance for waiting until Investor Day for detailed guidance. Let me turn it back to Joel.

Joel Marcus, Executive Chairman and Founder

If we could go to Q&A operator.

Operator, Operator

We will now begin the question-and-answer session. The first question today comes from Manny Korchman with Citi. Please go ahead.

Emmanuel Korchman, Analyst

Hey, everyone. Just I don't remember that Dean or Joel mentioned this, but the JV in Cambridge, can you give us some details as to what that building is or more specific geography and also just your thoughts behind the new JV at this point?

Joel Marcus, Executive Chairman and Founder

Yes, I think the answer to that is no. We'll do it when we complete the transaction. I think Dean can talk about the capital raising. We've always tried to think about multiple sources, and so this is one key source that we're growing up on at this point.

Dean Shigenaga, Co-President and Chief Financial Officer

Yes, Manny, I would reiterate what Joel said. Over the last four years, about $1.5 billion in real estate dispositions, heavily weighted to high-value, low cap rate assets, have given us an attractive cost to fund projects that provide about a 7% cash yield, so pretty consistent execution here.

Emmanuel Korchman, Analyst

And then maybe you could give us updated thoughts on the New York market specifically in Long Island City with your entrance into that market and where you see yourselves building a larger cluster there, if this was a one-off opportunity.

Joel Marcus, Executive Chairman and Founder

Well, I think if you look at our press release of October 18, we tried to give a picture of our strategy in New York City, which is continuing to expand the campus at the Alexandria Center by the North Tower, looking at upsizing that a bit. Our acquisition of one of the Pfizer buildings on East 42nd and the acquisition in Long Island City fit well with that. There is a ferry from Long Island City right to the East Side Medical Corridor. I would view these as part of the same overall East Side Medical Corridor effort. While I view New York in a positive fashion, it's fundamentally different than other markets. It doesn’t have an established waiting line of tenants, and it’s earlier stage efforts. Each market is vastly different, and you cannot treat them alike.

Emmanuel Korchman, Analyst

And one quick one for Dean. I appreciate that you'll be giving full 2019 guidance at the Investor Day, but just regarding the impact from lease accounting, it'll impact your numbers. Do you have early estimates on that you could share?

Dean Shigenaga, Co-President and Chief Financial Officer

Yes, Manny, I'd say there are two things that have popped up for most REITs. The first is the initial indirect leasing cost that under the new rules will need to be expensed, which we anticipate to be quite insignificant for Alexandria, around 1% of FFO per share. The second consideration is certain ground leases which will be put on balance sheet. We have roughly a $200 million gross up due to that, but really from a P&L perspective, there is no significant impact from the new lease rules.

Emmanuel Korchman, Analyst

Thanks, everyone.

Sheila McGrath, Analyst

Yes. The gap in cash leasing spreads was significant this quarter. I was wondering if that was across the board or if one lease in a specific market was driving that?

Peter Moglia, Co-Chief Executive Officer and Co-Chief Investment Officer

Yes, Sheila, I’d say we had good strength across our markets, which is consistent with what we observed over the year, the full nine months as well as prior years. We've always had really good strength on contractual expirations, and early renewals have been a pleasant surprise to cash flow growth.

Sheila McGrath, Analyst

I think Peter mentioned that much of the leasing this year was early renewals. Can you provide more details about that? Do you expect this trend to continue?

Peter Moglia, Co-Chief Executive Officer and Co-Chief Investment Officer

Fortunately, real estate fundamentals and life science industry fundamentals are strong, so we're operating in a solid environment. Our expirations are modest year-to-year, but we've observed tenants being very proactive about securing space, renewing sometimes three-plus years prior to expiration. We're trying to be balanced, as there is potential upside in rental rate growth, so we are being patient while taking some off the table.

Sheila McGrath, Analyst

Last question on investment gains. Unrealized investment gains for the quarter were significant. Was that driven by an IPO or depreciation of existing holdings?

Peter Moglia, Co-Chief Executive Officer and Co-Chief Investment Officer

The unrealized gains were across a broad set of investments, reflecting the appreciation of our quality portfolio.

Joel Marcus, Executive Chairman and Founder

There has certainly been a strong IPO market this year reflected in that. Dean mentioned that for 2019, the lease expirations total approximately 1.3 million square feet with annual rental revenue about $41 million. Of that, 25% is pre-leased, and 12% is in negotiation, showcasing how people are proactively planning for 2019.

Dean Shigenaga, Co-President and Chief Financial Officer

To expand on the investments, I’d say the gains were roughly spread across private and public investments, illustrating good appreciation across the portfolio.

Richard Anderson, Analyst

Thanks. Good afternoon. When discussing early lease renewal activity, how would you compare the rollup in current year negotiations versus what you're doing for tenants approaching you early? Is it similar or something less or more?

Dean Shigenaga, Co-President and Chief Financial Officer

Rich, it’s Dean here. It’s actually a mix of everything as you would expect. The early renewals with large benefits to cash flows are very specific to the lease. We have a handful of those occurring each year for the last four to five years. However, we’re still securing strong mark-to-markets on average across the markets, featuring a blend of normal healthy mark-to-markets and larger early results.

Richard Anderson, Analyst

What do you define as normal?

Joel Marcus, Executive Chairman and Founder

By normal, I'd say it's right down the fairway of our guidance, around 10% on a cash basis.

Richard Anderson, Analyst

Okay. Looking ahead, I know you're not giving guidance, but the mark-to-market number has been a key part of this story for a while. As you look ahead, which markets are expected to show disproportionate exploration activity? Do you see this type of growth continuing, or is there a shelf life to this trend?

Joel Marcus, Executive Chairman and Founder

If you look at Page 24 of the supplemental materials, the 2019 lease expirations are well-distributed across Greater Boston, San Francisco, San Diego, Seattle, and some in Maryland, so there’s no burdensome concentration in one location. The annual rental revenues for those leases are comparatively low.

Richard Anderson, Analyst

Thank you.

Dean Shigenaga, Co-President and Chief Financial Officer

What Richard, I don’t have that in front of me. Let’s think about giving the market an update at Investor Day on that.

Jamie Feldman, Analyst

Thank you. At the outset of the call, you mentioned a strong VC funding market and strong biotech IPO market. With recent capital market volatility, how do we think about your business in a market where those two factors aren't as strong? What informs your decisions moving forward based on that?

Joel Marcus, Executive Chairman and Founder

As I mentioned in my opening comments, 52% of our annual rental revenue comes from investment-grade or large-cap public companies, which is where the capital has currently been flowing. We feel pretty good about that. It wouldn’t be favorable if venture funding dried up, or if the IPO market closed down. Still, even if conditions worsen in 2019, the amount of venture capital available for investment should remain strong, estimated at north of $2 billion, which will likely fund those entities. A decrease in valuations could turn out to be advantageous for investors in private markets by making investments more attractive, but I do not anticipate a significant change in the landscape over the coming year or so.

Dean Shigenaga, Co-President and Chief Financial Officer

If you think back to pre-2013, the biotech IPO window was pretty much closed for about a decade, yet they were still functioning well with liquidity events.

Joel Marcus, Executive Chairman and Founder

Yes, and as Dean mentioned, biopharma is currently experiencing a large percentage of topline revenue sourced from products originating outside of pharma, which indicates ongoing capital investment in the biotech industry.

Jamie Feldman, Analyst

Thank you.

Joel Marcus, Executive Chairman and Founder

Thank you very much, everybody, and we'll look forward to talking to you on the fourth quarter and year-end call. Take care.

Operator, Operator

This concludes our question-and-answer session. I would like to turn the conference back over to Joel Marcus for any closing remarks.

Joel Marcus, Executive Chairman and Founder

Thank you very much, everybody, and we'll look forward to talking to you on the fourth quarter and year-end call. Take care.

Operator, Operator

This conference is now concluded. Thank you for attending today's presentation. You may now disconnect.