The national office market is mired in its worst slump in a decade as Corporate America continues to shed workers. More than 500,000 jobs were eliminated between February and April. The unemployment rate now registers 6%. Predictably, double-digit vacancies and declining rents in the office sector have led to a big drop in leasing activity and limited development opportunities.

But there is a niche in the office market where vacancies are a fraction of the national rate, rents are way above average, and prospects for growth actually exist. It is the specialized (and regionally concentrated) business of supplying space to the biotech and life sciences industry.

Biotechnology is a complex and capital-intensive industry that, unlike much of the U.S. economy, continues to grow. Spending on research and development by seven of the large big-cap pharmaceutical companies is expected to total $24 billion this year and $25.6 billion in 2004, according to J.P. Morgan's pharmaceutical company research team. Spending by the big pharmas has increased an average of 12% per year since 1995. What's more, publicly traded biotech companies spent about $11.9 billion on research & development in 2002, according to J.P. Morgan, which estimates an annualized growth rate of 18% since 1995. Projections call for similar growth over the next few years.

While the office market has been burdened by excess sublease space, most real estate built for biotech is of the build-to-suit variety, so vacancies are often sharply lower and rental rates are typically 20% or more higher. More importantly, for developers who venture into this niche the investment returns on biotech space can be several hundred basis points higher than for conventional office space.

This is also a high-tech niche that has a firm foundation. Unlike the dot-comers, which routinely leased two to three times as much space as they needed to accommodate future growth that never materialized, biotech tenants tend to be far more conservative and lease only 20% to 30% more space than actually needed, say real estate experts. They also typically enter into leases that extend 10 years or longer.

The impact of biotechnology on some local economies and commercial real estate markets has been dramatic. In metropolitan San Diego, about 10 million sq. ft. — or 16% of the market's total office inventory of 63 million sq. ft. — is classified as biotech space, according to Malcolm O'Donnell, managing director with CarrAmerica Realty. “Biotech in San Diego is like a heart, pumping capital and jobs into the marketplace,” says O'Donnell. The portfolio of the Washington, D.C.-based real estate investment trust includes 500,000 sq. ft. of research space in San Diego and another 300,000 sq. ft. in Seattle.

Most real estate assets customized for the biotechnology sector are located in research clusters that are in close proximity to major government agencies that fund research. The dominant repositories of biotech are New England, with 239 resident firms, and the San Francisco Bay area, with 213 companies, followed by San Diego (110 companies) and the Mid-Atlantic (105), according to accounting firm Ernst & Young. But virtually dozens of additional cities, ranging from Atlanta to St. Louis to Chicago, have biotech ambitions.

Assessing the Fundamentals

How much demand is there for real estate product built for biotech tenants? Cambridge, Mass., the epicenter of biotech space on the East Coast, offers a clue. David Clem, managing partner of Lyme Properties LLC in Cambridge, one of the leading developers of wet-lab space in the Boston area, says that over the past 10 years the Cambridge market absorbed an average of 400,000 to 500,000 sq. ft. of biotech space annually. Clem believes that in certain underserved markets, such as greater Philadelphia, Baltimore and New York, similar demand exists.

“Biotech is not a silver bullet, it's not a panacea to solve the woes of the office market,” emphasizes O'Donnell of CarrAmerica. “It's a sector that is complex and capital intensive, but there are opportunities if you are sophisticated and you have enough experience to understand the inherent risks.” Those risks include development costs that can run twice as high as conventional office space and the possibility that some start-up companies heavily dependent on federal funding may not survive. Biotech firms can take as long as 12 years to bring a product to market.

In metro Seattle — where former Microsoft executive Paul Allen and his development company Vulcan Inc. plan to build about 2 million sq. ft. of biotech space over the next several years in south Lake Union — the vacancy rate for biotech space registers 5% compared with nearly 16% for the overall office market, according to Colliers International.

The south Lake Union biotech campus under development by Vulcan is located within a few miles of the Fred Hutchinson Cancer Research Center and the University of Washington. Ada Healey, vice president of development for Vulcan Inc., describes the market as “underserved.”

Meanwhile, in metro Boston, CRESA Partners reports that the vacancy rate for existing biotech space registered 9% at the end of the first quarter compared with a whopping 28% for the office sector. That figure includes sublease and shadow space.

The biotech sector has been relatively insulated from the extreme downward pressure on rents that's weighed heavily on the office market. Net rents for research lab space are currently running $50 to $60 per sq. ft. in Boston and Cambridge compared with $20 to $25 for Class-A office space, according to Nancy Kelley, senior vice president and director of life sciences at Spaulding & Slye Colliers, a real estate services provider based in Boston.

The prospects of a higher return on investment and portfolio diversification have attracted seasoned developers such as CarrAmerica and Forest City Enterprises. “Although it can be more expensive to build these projects, they are not inherently risky as long as you are in the right locations,” explains Peter Calkins, senior vice president of development and planning for Forest City Commercial Group. “As a general rule, biotech companies tend to be relatively stable in their site selection. Once they've made a significant investment in the real estate, they don't pick up and move.”

Forest City is in the final stages of a 20-year development on a 27-acre site adjacent to the Massachusetts Institute of Technology in Cambridge, Mass. When it's complete in 2005, University Park will comprise 2.3 million sq. ft., including 10 research and office buildings, four residential complexes, and 250,000 sq. ft. of hotel, restaurant and retail space. Millennium Pharmaceuticals, which already had a strong presence at University Park, last year took occupancy of 35 Landsdowne Street, a 202,000 sq. ft. building that includes a state-of-the-art research laboratory and auditorium. Millennium now leases 750,000 sq. ft. at University Park.

The project has performed well financially for Forest City, a publicly traded REIT. The company's unleveraged returns on the biotech buildings are well above 10% — in the low to mid-teens, according to Calkins. Those unleveraged returns are similar to what Forest City might receive on standard office product during more traditional times, but these days are hardly normal. “In today's environment, I don't believe anyone would attempt to develop standard office product. We certainly wouldn't.”

Biotech companies comprise approximately 4.7% of Forest City's commercial portfolio of retail, office and R&D facilities. Calkins says that the company hasn't established a percentage target for growth in this niche. “We simply recognize that this is a market sector where we have expertise and we expect to be opportunistic.”

Biotech space makes up only about 3% of CarrAmerica's portfolio, but the returns are generally superior. The expected unleveraged internal rate of return for biotech developments is, at a minimum, 1.5% to 2% higher than ordinary office projects, according to O'Donnell. Among its holdings is the La Jolla Spectrum Technology Park in LaJolla, Calif., a 157,000 sq. ft. office/biotech project completed in 2000. Syngenta and The Scripps Research Institute are the tenants.

O'Donnell sees the potential to double the portfolio in the next three to four years. “We see opportunities to grow in core regions like San Diego, Seattle and the I-270 corridor in Washington, D.C. But biotech, on a relative basis, will remain a small piece of our 24 million sq. ft. overall office portfolio.”

Among the companies that specialize in providing lab space to tenants is Alexandria Real Estate Equities, a publicly traded REIT based in Pasadena, Calif., which has a portfolio of 89 office properties totaling 5.7 million sq. ft. The REIT's biggest stake is in Washington/Baltimore where it owns 1.7 million sq. ft. that is 98% leased.

Alexandria has become proficient at acquiring properties developed by others that have dependable tenancies and revenue streams, and then maintaining occupancy via remodeling and improvements. J.P. Morgan Securities analysts predict that Alexandria's growth in funds from operations (FFO) over the next few years could exceed the office sector average by as much as 8%. In April, the company raised its quarterly cash dividend to 53 cents a share, a 6% increase in its quarterly dividend.

There are other signs biotech is thriving. At Spaulding & Slye, life science clients accounted for 7% of the company's total revenues in 2001, according to Kelley. By 2002, that figure rose to 12%, and this year it will surpass 20%. Spaulding & Slye now has more than 70 clients in the life sciences field, including MIT, the National Institutes of Health and Johns Hopkins University.

Early Pioneer

In Cambridge, Lyme Properties recently completed work on two buildings totaling 600,000 sq. ft. at its latest project in Kendall Square for Genzyme and Vertex. Adjacent to MIT, Kendall Square has a colorful history. In the 1960s, it was envisioned as the future headquarters of the space agency NASA before the government chose Houston instead.

In the 1970s, the City of Cambridge, through its redevelopment authority, initiated new zoning and planning measures to reposition the area for high-tech development. In the 1980s, One Kendall Square, a 10-acre site featuring a complex of 13 structures — some of them dating to 1887 — began to take on biotech tenants. In the past 15 years, the biotech roster has expanded to include Genzyme Corp., Biogen, Amgen and Vertex Pharmaceuticals along with two dozen other biotech firms.

“Private-sector life science development around Boston really started at One Kendall Square,” says Clem of Lyme Properties, who developed his first lab space in 1984 on that site. “Some of the old industrial buildings at One Kendall Square had attributes like heavier floor loads and high floor-to-ceiling heights that lent themselves to gut rehabs and conversions to biotech research space.”

Another 185,000 sq. ft. biotech building at 320 Bent Street developed by Lyme Properties and near its Kendall Square site nearby has landed Microbia Inc., which is developing antifungal therapeutics, as its lead tenant.

Clem says that the cap rates used by underwriters on his Kendall Square projects range from 9% to 12%, depending on the relative strength of the tenant rosters. Publicly traded tenants with actual products or drugs in the pipeline are viewed more favorably than start-up biotech companies.

“The Kendall Square address and the concentration of biotech companies in the area contribute to more favorable rates since the location has been proven over the past 20 years,” says Clem.

What Are the Risks?

Wet-lab space requires unique ventilation and plumbing systems as well as industrial-like floor load capacity, resulting in construction costs that can easily run two to four times what an ordinary office building costs, say experts.

The biotech sector also isn't immune to dramatic shifts: The market cap of all U.S. biotech companies was $353.5 million at year-end 2000, according to Ernst & Young. By the end of 2002, the market cap had fallen to $225.9 million.

The decline in valuations has led to rising vacancies. In metro San Diego, for example, the biotech vacancy rate has crept up to 5%, much higher than the historical average of 1%. “Still, biotech was the last sector to be rocked by the recession, and expectations generally remain high,” wrote Christopher Crooks, a principal with CRESA Partners, in an April report on the state of biotech in metro Boston. He predicts more consolidation of biotech firms in the near term.

The Next Frontier

The keystone biotech centers in the U.S. — places like Torrey Pines Road outside San Diego and East Cambridge and the Technology Centre of New Jersey in North Brunswick — have virtually reached saturation in some cases. There is little land or lab space available in these places, prized by biotech firms for proximity to major universities and research centers.

What is available has grown expensive. For example, Novo Nordisk A/S, a company working on insulin delivery systems for diabetes, erected a facility in Clayton, N.C., more than an hour's drive from the Research Triangle in Raleigh/Durham, to get space at a good price.

“In the future, I'd bet that companies will be migrating to places like Boulder, Colo., where land is more readily available,” according to Patrick Kelly of the Biotechnology Industry Organization in Washington, D.C., a trade association. “Clusters of research aren't absolute,” says Kelly. “Companies will find they can sustain themselves away from clusters.”

Editor Matt Valley contributed to this report.

BIOTECH HOT SPOTS
(MEMBERS OF THE BIOTECHNOLOGY RESEARCH ASSOCIATION)

Seattle/Tacoma

19 members
3% membership

San Francisco

114 members
16% membership

Los Angeles

24 members
4% membership

San Diego

61 members
9% membership

Raleigh/Durham

35 members
5% membership

Washington/Baltimore

61 members
9% membership

NY/NJ

106 members
15% membership

Boston

101 members
14% membership

Philadelphia

42 members
6% membership

Chicago

21 members
3% membership

Note: Percentages listed do not add up to 100%. The remaining 16% of the total membership base is scattered throughout the country.

Source: Biotechnology Industry Association