Alexandria Real Estate: Cheap But Still Up, Remains a Buy (NYSE:ARE)

In June 2023, I revised my bear thesis and went active Alexandria Real Estate Equities, Inc. (NYSE:ARE) because of dirt cheap valuations and strong cash flows with no signs of deterioration. The talk since by The bears were that the ARE should suffer from the structural decline of office properties, facing slow and painful increases in vacancy rates. While this has been true and applicable to many, if not most, office REITs, in ARE’s case the combination of pure play focus on life science/lab clients and trophy-like properties were clear mitigators of this risk. Even if ARE were to experience some top-line pressure, it would still be fine given the balance sheet multiple and robust single-digit P/FFO.

In the chart below we can see how since the publication of my initial bull thesis ARE performed somewhat in line with the overall REIT market. However, since July, there has been a notable divergence between the ARE and the index, leading to negative alpha.

It appears that the ARE has not responded so well to the improved interest rate outlook. Let’s now look at the recent quarterly (Q2) earnings results to understand if the bull thesis is still attractive.

Revision of the thesis

Before dissecting the Q2 2024 earnings data, it’s worth noting that ARE continues to trade at a low P/FFO multiple of 9.5x. In fact, since I aired my bullish investing case on ARE, the multiple has improved as earnings have risen and the share price has remained almost flat (the return we see in the chart above is mainly driven by the dividend component ). ).

Looking at Q2, 2024 earnings, the most important metric that measures underlying cash generation — FFO per share — is clearly on the rise. Compared to Q2, 2023, FFO per share increased 5.4% or $2.36, resulting in an FFO payout ratio of 55% (on an annualized basis). Management also reiterated the midpoint of full-year 2024 guidance for FFO per share of $9.47 – representing a 5.6% increase from full-year 2023 earnings.

One of the key drivers behind the increase in FFO per share was the improvement in same-store NOI, which increased 3.9% on a cash basis. Some of the growth was achieved through built-in rental escalators, but much of it came from positive leasing momentum. For example, total rent/rental growth for S1, 2024 was 15% on a cash basis. Rent increases resulting from launch activity were also solid at 3.7%.

So already here we can conclude that the core business is growing even despite single digit multiples and struggling office sector.

What we need to consider in addition to positive organic growth is incremental earnings growth from organic development activity. For ARE which is able to reinvest ~45% of its FFO generation back into the business and obtain cheap debt due to its strong investment credit rating, the project’s CapEx (and returns) is significant and can really move the needle.

For example, ~285,000 square feet of new space IS being delivered this quarter that was 100% leased (92% of the space was associated with mega campuses). The remainder of the projects that ARE expects to bring online in the remainder of 2024 and 2025 are already 87% leased, with NOI expected to stabilize beginning in early 2026. Identified or projected incremental NOI resulting from new business development is $480 million, which in the context of Q2, 2024 annualized NOI of ~$1.9 billion is massive.

Speaking of this growth, commentary on the recent earnings call from Joel S. Marcus – Executive Chairman and Founder – provides some nice insight into ARE’s strategic points:

So thinking about our competitive advantages and what we choose to really emphasize. I think most importantly, our first-mover advantage in the leading life science groups, we continue to refine and refocus our footprint, and you see that through our actions quarterly. Our high-quality assets, aggregated into desirable and well-appointed megacampuses, we continue this monumental effort truly driven to and through our re-development and development efforts in each of our massive megacampuses and our attempt to reduce and hopefully the strategy of mega campus pipeline success, future pipeline and obviously the sale of most of our non-core assets over time. This will be critical to our ongoing business plan.

While the current share of rental/rental income from megacampuses is already 74% of total top generation, ARE’s goal is to increase this to 90% over the next two years, primarily through organic CapEx activity. This should further de-risk ARE’s business and introduce even greater barriers to competitors making a comparable property offer.

Finally, and perhaps most importantly, I do not see any negative impact on the capital structure from the aforementioned investment activity. There are two reasons. First, ARE is in the process of divesting its non-core assets, which in Q2, 2024 have already generated over $60 million of fresh liquidity. Given the current LOIs that are in place, the total expected proceeds from secondary asset monetization are estimated to generate $807 million. Second, the current balance sheet shape remains in robust shape with a strong investment grade credit rating and a well-scaled debt maturity profile with a weighted average term to maturity of 13 years. Third, the new projects themselves will generate incremental EBITDA, which in turn will help keep the capital structure (ie, net debt to EBITDA) in balance.

The bottom line

From the above analysis we can definitely conclude that ARE business is strong showing clear patterns of continuous and stable growth. All core performance metrics are clearly green (eg FFO growth, same-store NOI growth, leasing spreads, flat occupancy, etc.). In addition, the current growth agenda is set to de-risk the business and generate additional cash flows.

One of the main reasons why, in my opinion, ARE has not responded so well to the positive beta factor in the growth REIT index lately is its debt maturity profile. The key driver that has pushed the overall REIT space higher recently has been the improved interest rate outlook, where cheaper debt financing would greatly benefit many REITs that currently face high financial risks as their balance sheets and debt structures their are clearly not as robust as in the case of ARE. Namely, the fact that SOFR drops a little has no material impact on ARE, hence the immaterial reaction of the stock.

The key risk for ARE is rising vacancy rates. However, given the aforementioned fundamentals and underlying performance metric dynamics, combined with new growth projects coming online that can be financed in a sustainable manner (ie, conservative FFO payouts and asset divestitures non-core), this risk, which would ultimately lead to a decrease in FFO, seems unlikely.

I maintain my bullish stance on Alexandria Real Estate Equities.