As frozen debt markets and economic worries stifle commercial real estate investment activity, developers are beginning to decode the secrets of the maturing $90 billion biotech industry, where research space can generate returns reaching 12% or more. That marks a big shift in thinking from the last decade, when few developers dared to wager on the risky industry, fearing that failed laboratory tenants would stick them with empty and largely unrentable buildings.
To be sure, risks remain ingrained. Despite the sector's growth, most of the 1,500 U.S. biotech firms don't make money. Biotech startups face many challenges to their survival, including the difficulty of raising capital to finance clinical trials, meeting benchmarks in a timely fashion and enduring high failure rates on drug tests. It can take 12 years for an idea to end up on the shelf as a bona fide product.
Add to that the fact that lab buildings can cost as much as $500 a sq. ft. to develop — roughly four times the capital it takes to develop a conventional office building. Much of the extra cost goes into reinforced concrete floors, roofs with heavy load capacities, heavy-duty HVAC systems, and upgraded electrical, gas and plumbing infrastructure, among other essentials required in labs.
Lease structures vary by market. Developers may erect shell space and then provide $75 to $150 a sq. ft. for tenant improvements. Or they may build in some of the improvements and require tenants to pay for additional upgrades. Increasingly, developers are delivering turnkey buildings to tenants. Typically, landlords try to secure long-term, triple-net leases from more mature companies. Young companies, however, frequently must furnish letters of credit for the first six months or more of rent.
The risk of tearing out expensive improvements and converting labs to conventional office space still makes many developers queasy, but some investors have learned that if one biotech tenant flunks out, the industry can supply another.
“Twenty years ago this was a new industry and people were concerned about how expensive buildings were,” recalls Frank Wuest, president of Forest City Science + Technology Group in Cambridge, Mass., a division of Cleveland-based developer Forest City Enterprises. Forest City owns and manages 2 million sq. ft. of research and development space in five U.S. markets.
“Now the biotechnology industry has a track record, and there is evidence that there is demand for this space as it turns over,” Wuest adds. “So there's a history of less risk.”
That's particularly true in and around the most recognized biotech clusters in Boston, San Diego, San Francisco, and Baltimore that leverage a critical mass of intellectual capital, highly educated workers and formidable research institutions. In Cambridge, for example, average asking rents have climbed 15% to nearly $60 a sq. ft. since early 2006, reports the Boston office of real estate brokerage Jones Lang LaSalle.
Other markets such as Seattle, New York, Philadelphia and North Carolina's Research Triangle also have successfully pushed to build biotech clusters. Over the past several months, pharmaceutical companies have stepped up efforts to buy or partner with biotech companies to beef up their flagging drug pipelines.
Successful lab space developers, meanwhile, are generating annual returns of 8% to 12% from the properties, experts say. That's down from returns in the high teens five to 10 years ago. The bottom line: The biotech industry isn't going to vanish amid healthcare spending that is expected to hit 19.5% of GDP in 2017, up from about 16% today.
“As the lab space market has matured, you've seen the product go from one or two stories to three to five stories or more with more sophisticated systems,” Wuest says. “And you've also seen more mature companies in the market.”
Part of the reduced risk to developing research space, longtime developers argue, centers on the fact that they're serving the broader life sciences industry. While the sector encompasses conventional biotech firms — those that are trying to modify cellular activity to prevent diabetes or halt the aging process at 25 years — it also includes pharmaceutical companies, diagnostic laboratories, government and university institutions, and bioinformatics, the analysis of biological information using computers and statistical techniques.
What's more, bioenergy companies trying to craft enzymes that can turn waste into fuel are leasing research and development space.
“We're way beyond serving just the biotech industry,” says Joel Marcus, CEO of Pasadena, Calif.-based Alexandria Real Estate Equities. The real estate investment trust (REIT) is the largest landlord of life sciences properties with a portfolio of some 13.3 million sq. ft. of primarily lab space in nine U.S. markets, China and Canada. Some of Alexandria's biggest tenants include the U.S. government, GlaxoSmithKline and Novartis AG.
Mixed-use anchor
Other developers are beefing up their life sciences portfolios, too. On downtown Baltimore's east side, Forest City and local civic and business leaders have teamed up to create a biotech business park adjacent to the Johns Hopkins Medical Institutions that will anchor a broader $1.8 billion neighborhood revitalization. All told, it will include research space, conventional offices, retail and residential units across 88 acres when completed in 2017.
In early April, Forest City opened a $211 million, 278,000 sq. ft. research and development building, the first of five planned biotech buildings in the project. So far the company has leased some 45% of the space to four tenants, including mid-stage biotech firms BioMarker Strategies and Cangen Biotechnologies and two major research organizations, the Howard Hughes Medical Institute and the Johns Hopkins School of Medicine Institute for Basic Biomedical Sciences.
Forest City developed a similar mixed-use project over 20 years on 27 blighted acres adjacent to the Massachusetts Institute of Technology in Cambridge. The development, started in 1985, includes 1.3 million sq. ft. of research space, 530 residential units and 250,000 sq. ft. of hotel, retail and restaurant space. Forest City also has 8 million sq. ft. of biotech space in various stages of planning and development nationwide.
One challenge facing biotech developers, Wuest says, is to create projects that cater to biotech companies of various sizes and stages of scientific advancement as well as research institutions.
While mature, creditworthy tenants give landlords security, successful startups can provide developers with organic growth. Case in point: Alkermes, which developed Vivitrol to help control alcohol dependence, initially began working out of a Forest City conference room in 1987 while the developer built out Alkermes' 3,000 sq. ft. of lab space. Fifteen years later, Alkermes set up its headquarters in Forest City's 145,275 sq. ft. research and office building at 88 Sydney St. in Cambridge near MIT.
Funding doldrums
Interest in biotech development is rising despite the credit market turmoil, which has temporarily stalled sales activity across all property sectors, including lab buildings. But ripples from the credit upheaval also have sent biotech financing spiraling downward.
Venture capital funding of biotechs plummeted 40% in the first quarter over the first quarter of 2007, to $837 million, reports Burrill & Co., a San Francisco life sciences venture capitalist, merchant banker and media group. Meanwhile, only one biotech company had completed an initial public offering (IPO) as of mid-May this year, raising $6 million. In the first quarter of 2007, six biotech firms raised $527 million.
“The fluctuations in venture capital and the stock markets continue to torment early-stage startups,” says David Clem, managing partner for Hanover, N.H.-based Lyme Properties. A division of Lyme Timber Co., the lab developer sold to San Diego-based BioMed Realty Trust its entire 2.4 million sq. ft. portfolio of labs, projects under construction and land for $1.5 billion between 2005 and 2007 in three separate transactions.
“These are very capital intensive businesses that take a long time before they're even close to having something that looks like it's going to be a product,” adds Clem, who says Lyme is again looking for life sciences development opportunities.
White pharma knight
But Clem and other experts maintain that the biotech industry remains on a solid growth path despite the falloff in funding. In fact, pharmaceutical companies are increasingly targeting biotech companies for acquisitions and partnerships to secure future products.
Most recently, for example, British drug behemoth GlaxoSmithKline announced it would pay $720 million for Sirtis Pharmaceuticals, a biotech firm based in Cambridge that specializes in drugs to combat age-related diseases such as diabetes, Parkinson's and Alzheimer's. Not only are such deals providing biotech firms with critical drug trial and research financing, but they're also giving early investors in the target companies a chance to cash out and reinvest their capital in other early-stage companies.
“Biotechnology will continue to be a driver of innovation,” says Marcus of Alexandria. “It will continue to provide big pharma with the wherewithal to fill their pipelines, and that's what's going on right now.”
That activity and general biotech expansion continue to fuel construction. Brokerages have yet to track research space nationally, but developers in New York, Philadelphia, Seattle, Boston and other major biotech markets are developing large projects totaling 6 million sq. ft. of pre-leased and speculative space.
In Cambridge, for example, BioMed Realty recently completed what Lyme Properties started — a 417,000 sq. ft. building at 301 Binney St., which is roughly 25% leased. BioMed Realty, a REIT that owns some 9 million sq. ft. of life sciences space in 12 U.S. markets, partnered with Prudential Real Estate Investors to acquire that project in addition to a 185,000 sq. ft. existing property and land for $510 million in 2007. That was BioMed's third and final acquisition from Lyme Properties — the only one in which Prudential was involved.
This quarter the REIT is scheduled to complete the 18-story, 703,000 sq. ft. Center for Life Science Boston in the Longwood Medical area near Cambridge, which is 80% leased. BioMed Realty acquired that project from Lyme in 2006 for $473 million, and is investing an additional $700 million. The REIT also has started building a $245 million spec 280,000 sq. ft. lab building in Cambridge. Alexandria Real Estate also announced in May that it planned to build a $1 billion, six-building lab complex in Cambridge over the next 10 years.
Spin-off scientists
The decision of some pharmaceutical companies to acquire, rather than develop, new drugs is generating activity at a far lower level of the biotech food chain. Researchers and scientists are leaving the drug companies and launching their own startups, says Chad Urie, a senior vice president in the San Diego office of Boston-based Colliers International, who brokers life sciences space.
Those individuals are securing venture capital backing and ultimately aim to sell their endeavors to a pharmaceutical firm or larger biotech player in the future. But the fledgling companies currently only need between 7,000 sq. ft. and 20,000 sq. ft., which in many cases isn't readily available in San Diego. So developers are creating smaller lab spaces out of large blocks for the startups.
Nexus Properties in La Jolla, Calif. is developing a 59,000 sq. ft. speculative building to house the small tenants near University City in San Diego's University Towne Centre, known as UTC. It has a biotech vacancy of 6.6%, according to Colliers in San Diego.
Urie predicts that the cost of the building — roughly $310 a sq. ft. when including tenant improvements — will put upward pressure on the current triple-net rent rate of $37.60 a sq. ft. in the UTC market. Across San Diego, rental rates for lab space have climbed 10% to 15% over the last six months.
“We've seen a big change in what life sciences demand looks like in Southern California, and frankly on the West Coast,” Urie says. “The landlords that will be successful are implementing the strategy to create multi-tenant buildings.”
Experts predict the venture capital and IPO markets will eventually reopen for biotech just as the debt markets will someday loosen for real estate. They further anticipate that biotech still has huge growth ahead, given the fact that the industry is only some 30 years old.
How big is the potential? The top 10 biotech companies on the Nasdaq Biotechnology Index generated aggregate revenues of nearly $40 billion in 2007.
That's respectable, but small potatoes compared with pharma behemoths like Pfizer Inc., says Michael Lynch, who now leads general contractor DPR Construction's national biopharmaceutical core market group in Redwood City, Calif. Pfizer Inc. reported revenues of over $48 billion last year.
“The biopharm industry is just an infant when compared with the big old pill-making industry that we've known for decades,” Lynch says. “But it's growing infinitely faster.”
Joe Gose is a Kansas City-based writer.
Suburbia snags Cambridge biotech firms
Three high-profile life sciences companies that left Cambridge, Mass., for the suburbs over the last several months have sent a shudder through one of the premier biotech clusters in the United States. Altus Pharmaceuticals and ImmunoGen have moved to Waltham while Shire Human Genetic Therapies in February announced it would relocate to the former Raytheon Co. headquarters in Lexington.
All told, the companies will occupy some 450,000 sq. ft. along Route 128, a growing research corridor of about 2.3 million sq. ft. due west of Cambridge and Boston.
“Anytime you have that kind of leasing activity in a market that size, it's big news,” says Mark Winters, a managing partner for Cushman & Wakefield's global life sciences practice in Boston. “Clearly the Route 128 market is maturing as a life sciences market.”
Concerns are mounting that Cambridge's high costs and a lack of large, contiguous spaces initiated the retreat, and some local brokers foresee a continued exodus. Boston area property experts concede that Cambridge is indeed pricey — rents in Waltham and Lexington are about 30% to 40% less than those in Cambridge, where new lab space fetches around $70 in triple-net rents, according to Richards Barry Joyce & Partners, a commercial real estate brokerage in Boston.
Cambridge lacks large blocks of space, too, even though vacancy in the market has climbed to 13% this spring from 7% last fall, according to Richards Barry. Developers recently completed 594,000 sq. ft. of lab development in the market, and an additional 980,000 sq. ft. is under construction in Cambridge and nearby Boston. About 730,000 sq. ft. of that space is already leased, however.
ImmunoGen sought to consolidate three locations into one and had found a possible solution in Cambridge, says Daniel Junius, ImmunoGen's CFO. But by moving to the suburbs, it's saving about 33% in occupancy costs, he adds.
Still, other considerations came into play. The company wanted to operate in a newer facility, for example, and ultimately too few competitive blocks of 88,000 sq. ft. existed in Cambridge.
“You don't make a move from Cambridge to the suburbs lightly because it can be disruptive to employees,” says Junius. “But the overall quality of the facility is very high, and comparable costs for these facilities in Cambridge would have been prohibitive.”
The moves also reflect the needs of employees, many of whom live in the suburbs and endure a long commute into Cambridge. “Workers for some of the more mature companies here live in the suburbs and are worried about getting their kids to the bus,” says Robert Richards, president of Richards Barry.
Life sciences experts are hardly panicking over the fate of Cambridge, which contains about 17 million sq. ft. of office and lab space.
A recent study of Boston office and lab tenants dating back to 1999 shows that companies which used at least 50,000 sq. ft. accounted for 4.5 million sq. ft. Cambridge absorbed 45% of the space needs even though the market only represents about 9% of the total Boston area office and laboratory inventory, according to Cushman & Wakefield.
“Cambridge continues to be the demand engine,” Winter says, “and the market off which everybody else drafts.”
— Joe Gose