These 2 REITs Are Still Great Buys After The Real Estate Rally

Co-produced by Austin Rogers.

Real estate is back!

After a long and painful bear market in real estate investment trusts (“REITs”) from 2022 to the first half of 2024, investors finally seem to be warming up to REITs again.

Over the last 6 months, the Vanguard Real Estate Index Fund ETF Shares (VNQ), a good proxy for REITs, recently overtook the S&P 500 (SPY) in total returns.

The big tech stocks that have driven up the major indices are seeing substantial selling pressure, while beleaguered and high-yielding REITs are enjoying significant inflows of investor capital.

After the strikingly rapid rally of the last month or so, many previously attractive REITs have become less appealing from a value standpoint. Yields have declined as income-seeking investors rush to lock in as high of yields as possible before interest rates and REIT yields decline further.

But there are still some very attractive opportunities in the REIT space. You just have to know where to look.

Below, we discuss two options to consider.

Alexandria Real Estate Equities (ARE)

ARE’s stock has dropped over 6% this year and is down nearly 50% from its peak level achieved a few years ago.

And yet, this REIT is the undisputed leader in US life science real estate. About 3/4ths of its portfolio are ultra-high-quality mega-campuses (i.e., research clusters) located adjacent to major research universities. In life science, “Alexandria” is synonymous with quality, and the company is typically pharmaceutical/biotech companies’ first stop when looking for R&D space.

ARE’s locations, building quality, and campus ecosystems effectively act as a competitive advantage against other standalone life science buildings that do not offer these traits.

Moreover, ARE’s financial management is also top-notch, as the BBB+ rated company maintains relatively low debt, a long-duration bond maturity ladder extending out 30 years, and a low payout ratio of about 55% of adjusted funds from operations, or AFFO.

Incredibly, about 1/3rd of ARE’s total debt matures in or after 2049, and yet the weighted average interest rate on ARE’s debt remains below 3.9%.

And in its recently released Q2 2024 results, ARE reaffirmed its AFFO per share guidance of $9.47 at the midpoint. So why is ARE’s stock performing so badly?

In a word: Supply.

Everything in economics is about supply and demand, and life science real estate is no different.

As a delayed response to the boom in life science R&D spending during and immediately after COVID-19, there has been a gargantuan amount of life science real estate space delivered to market over the last year or so. In fact, between Q2 2019 and Q2 2023, the life science construction pipeline (seen below) nearly quadrupled.

Over the last year, about 18 million square feet of life science space has been delivered to market, including 5 million square feet in Q2 2024 alone. A striking 4.6 million square feet of this space completed in Q2 2024 (over 90%) was delivered vacant and unleased.

At this point, however, the life science construction pipeline has shrunk significantly down to about 21 million square feet. By this time next year, it will have roughly halved again, assuming no major new groundbreakings or delays to existing projects.

This is what the market seems to be worried about. The strong organic growth ARE experienced during the 2010s through 2023 appears to be threatened by the magnitude of new competing supply entering the market — so goes the narrative, anyway.

Already, across all life science space in major R&D markets, vacancy rates range from 6% to 40%, with most in the 10-20% range.

With this much vacant space, landlords will naturally start to get desperate and accept lower rent or larger rent concessions to fill it. This puts downward pressure on all competing life science space.

For reference, here are ARE’s largest markets, with the top three (Boston, San Francisco, and San Diego) together accounting for 73% of total rent.

Fortunately, ARE has very little exposure to the highest vacancy markets (which also aren’t major life science markets) of Chicago and Houston, although it does have exposure to San Francisco.

But there are three pieces of good news investors must keep in mind.

First, life science is fundamentally different from traditional office space in that at least some work has to be done in the office, where the specialty equipment and biological samples are located.

That is why life science companies disproportionately favor in-office requirements.

Notice that 70% of life science companies require either full-time, mostly in-office, or at least half in-office work weeks, while none allow fully remote work or employee choice for number of days in office.

Second, keep in mind that due to aging populations around the world and longer lifespans, demand for pharmaceutical and biotech products is projected to grow rapidly in the coming years and decades. Thus, there will more than likely be ample demand to fill the vacant space over time.

In the past five years, both life science and especially biotech R&D employment has significantly outpaced total nonfarm employment.

This growth will likely continue over long periods as demand for drugs likewise grows.

Third, as discussed above, ARE’s properties do not represent the average life science building. They are superlative in location and quality, which means they generally absorb a disproportionate amount of net absorption/tenant demand.

Although it is currently a tenants’ market, allowing them to push for more rent concessions, it should also be noted that tenants are typically willing to pay above-average rent rates to be located in ARE’s R&D clusters.

These factors give us confidence that ARE will navigate the current oversupplied life science market with only a slowdown in growth before returning to its normal levels of growth once the supply is fully absorbed and the market normalizes.

BSR is a Sunbelt multifamily REIT that exclusively owns Class B apartments in suburban areas, most of which are in the “Texas Triangle” of Houston, Dallas/Fort Worth, and Austin.

Although Sunbelt markets are typically seeing the biggest increases in supply of apartments, they are also enjoying some of the highest job and population growth in the country.

So why, if BSR’s well-located and affordable apartment portfolio is so good, is BSR so significantly underperforming its Sunbelt multifamily peers of Camden Property Trust (CPT) and Mid-America Apartment Communities (MAA) this year?

We think by far the biggest reason for BSR’s underperformance is the fact that it primarily trades on the Toronto Stock Exchange (under ticker symbol HOM.U) and only secondarily over-the-counter in the US (under ticker symbol BSRTF).

This severely limits its investor appeal and reach, but we would stress that it does nothing to change the fundamental value of its portfolio.

The fact that trading shares of BSR is slightly harder for US investors does not mean the company itself is low-quality. Quite the opposite.

As proof of that, just take a look at BSR’s growth metrics over the last several years:

BSR has been generating best-in-class organic and bottom-line growth metrics, including this year as a massive wave of apartment supply hits Sunbelt markets.

How is BSR able to generate this kind of net operating income growth even without acquisitions or in-house developments?

In short, BSR’s Class B apartment communities sit in suburban areas, outside the urban cores that have seen the biggest leaps in rent rates over the last several years. BSR’s rent rates are far more affordable, which has two big implications.

1. BSR’s in-place rent rates are well below urban cores, even though those urban core areas have seen falling rent rates recently.
2. BSR’s in-place rent rates are also well below the asking rents for newly delivered apartment communities in their areas, making them the more affordable yet substantially similar option for renters.

Historically, Class B apartments have done decently well in all economic environments. They enjoy the benefits of workers getting jobs and achieving upward mobility during economic expansions, and they tend to be the kinds of units that higher-income renters trade down to during economic downturns.

Even as CPT and MAA have flat to slightly negative same-property NOI growth this year, BSR continues to put up positive rent and NOI growth because of this strategic and exclusive focus on Class B.

Additionally, BSR is growing its bottom line (AFFO per share) due to smart capital allocation.

Over the last few years, as BSR’s high cost of capital has disallowed profitable acquisitions, management have allocated available capital to deleveraging (steadily eliminating floating rate debt) and buying back stock.

Where is the money coming from for these buybacks?

As of Q1 2024, BSR is only paying out ~54% of its AFFO as dividends. That leaves a substantial stream of retained cash flow with which to tidy up the balance sheet and reduce shares.

One major explanation for why management have made such strong capital allocation decisions recently is the fact that insiders (especially the two founding families) own ~40% of the company and are therefore looking out for their interests as well.

At an AFFO multiple of 14.2x, BSR trades at a major discount to its closest peers. MAA currently trades at a ~19x AFFO multiple, while CPT’s AFFO multiple is a little over 20x. Even if BSR only achieved a 17x multiple, that would still imply ~20% upside to today’s price.

We think BSR amply deserves such a valuation.

On top of all of the above, we think BSR makes a highly likely buyout candidate if management is unable to narrow the valuation gap on their own. Plenty of potential buyers on the public and private side would likely be interested in acquiring BSR if the stock stays undervalued.

Bottom Line

We are pleased to see real estate enjoy some time in the sun again after such a long REIT bear market. But even after the brief rally REITs have enjoyed, there are still attractive buying opportunities available. You just have to know where to look and be willing to roll up your sleeves to do your due diligence.

ARE and BSR are two such opportunities that, we think, will perform very well in the future despite the particular maladies currently holding them back.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.