Five things to factor into life sciences underwriting

The US life sciences sector is multiplying rapidly, both in the amount of venture capital raised to fund research and innovation and the number of institutional lenders and investors that are chasing acquisition and development opportunities in core and up-and-coming markets.

Here are five things lenders should consider when looking at opportunities in this no longer-so-niche asset class:

Transaction volume is rising steadily

Investment in life sciences properties reached $70 billion in 2020, an increase from $36 billion in 2018, according to a mid-year report from Cushman & Wakefield. Although year-end 2021 volumes were not yet available when Real Estate Capital USA went to press, Cushman was projecting the potential for investment volume to top $90 billion.

“The amount of demand for lab space at present is at an unprecedented level,” Charlie Rose, a managing director and portfolio manager who oversees the credit business at Invesco Real Estate, tells Real Estate Capital USA.

Venture capital funding booms

Venture capital funding for life sciences companies, the primary tenants of life science assets, crossed the $10 billion mark in 2014 and has been rising steadily since that time, according to a third quarter Newmark report.

In the first half of 2021, volumes reached $26.7 billion, a record level that surpassed the $33.1 billion seen in 2020.

Additionally, there were 59 initial public offerings for biotech companies in the first half of 2021. “Increased levels of activity in the public markets will continue to validate future venture capital funding and encourage investors to gain exposure to smaller, private life science companies with high growth and IPO potential,” the report stated.

Increased federal funding helps power the sector

According to the Department of Health and Human Services, budget appropriations for research sponsored by the National Health Institute, the Food and Drug Administration and the Center for Disease Control have all been on the rise since 2019.

During that period, the DHHS saw its budget rise from $1.2 trillion in 2019 to $1.4 trillion in 2021. The FDA saw its budget go up from $2.8 billion to $3.6 billion during that period, while the CDC saw its budget rise from $7.7 billion in 2019 to $8.2 billion in 2021. Finally, the NIH budget outlays increased from $34.9 billion in 2019 to $39.8 billion in 2021.

“[The increases in demand we are seeing are] being driven by a number of factors including strong funding inflows from the NIH, as well as venture capital and an acceleration in the pace of innovation in the bioscience space, in part as a result of the global pandemic,” Rose says.

Traditional locations are drawing in institutional capital

While the life sciences sector is expanding across the country, the majority of capital continues to flow toward the most mature markets. These markets – Boston’s Cambridge submarket, San Francisco and San Diego – have a total of 16.6 million square feet of space under construction or renovation and another 54.5 million that has been proposed, according to a December report from Newmark.

“Historically, you’ve had three markets which have stood far ahead of the rest of the country in terms of life science activity: Cambridge, the San Francisco Peninsula and San Diego,” Rose says. “I do believe there is opportunity within secondary markets, particularly on the equity side where pricing may be less efficient. As a lender focused on downside protection, we are largely avoiding those markets.”

Office to lab conversions rising

There’s a growing trend of office-to-life science conversions, with Invesco’s Rose noting the firm had originated about $1 billion across 10 loans to fund these transactions in recent years.

“On the credit side, we have focused on the office to lab conversion strategy,” Rose says. “We believe there is less execution risk on lower-density office to lab conversion deals than there is on higher-density office conversion deals.”

Invesco focuses on business plans that can be executed in a relatively short time horizon, a factor Rose believes allows the firm to have better clarity and insight into the supply picture. “We’re largely avoiding business plans where you have to wait several years to vacate existing offices,” he adds.

The firm’s lending activity in 2021 included a five-year, floating-rate acquisition loan to an unnamed buyer of the 322,318-square-foot Crossroads Research Center in Union City, California, where the buyer intends to execute a conversion strategy.

What’s next?

The expectation is that transaction activity, investment, pricing and lending in the life sciences market will continue to grow in 2022. Newmark reported pricing for life science and R&D assets averaged $585 per square foot in 2021, a 50 percent rise over the same period in 2020. Limited supply of high-quality space – particularly in Cambridge, San Francisco, and San Diego – will help bolster this phenomenon.

One related factor that could also affect life sciences is the rise in US healthcare spending, which the Centers for Medicare & Medicaid Services estimated grew 9.7 percent in 2020 to $4.1 trillion or $12,530 per person. The institute’s National Health Expenditure Accounts, which aims to estimate total healthcare spending across the country found health spending accounted for 19.7 percent of the nation’s gross domestic product.

Invesco’s Rose believes the outlook is strong for the sector. “The opportunity in the amount of demand from tenants has never been higher before and the amount of opportunity from a real estate investor’s perspective has never been greater before,” he says.