April 01, 2003
Appeared in real estate SOUTHERN CALIFORNIA
Get ready for the battle between Biotech Beach and Biotech Bay. Or the showdown between Pharm Country and GeneTown.
Though they sound like sports franchises or attractions at a futuristic theme park, all are whiz-bang marketing monikers for regional concentrations of life science companies. The tightly clustered firms helped insulate such areas as San Diego, San Francisco, Boston and Washington, D.C. from the dot-com collapse and subsequent real estate fallout of three years ago. Demand has dipped, lease rates have softened and harder times have finally arrived for biotechs, but most observers still forecast a double-digit annual increase in demand and a healthy long-term outlook for lab space.
Real estate firms have embraced the trend by forming specialized divisions catering to the burgeoning biomedical niche. The new specialists prefer the more general description of “life sciences,” which include pharmaceuticals, biotechnology, chemical engineering and other disciplines.
The Southland’s “Biotech Beach” — San Diego County — is home to more than 400 companies, occupying 10 million sf. Four main submarkets contain some three-quarters of the lab space: University Towne Center, Sorrento Mesa, Sorrento Valley and what local dealmakers call “ground zero” because of its proximity to UC San Diego and its major research institutes — Torrey Pines Road in La Jolla.
“Biotech Bay”-- the San Francisco Bay Area — is the nation’s leader, with about 713 companies employing more than 80,000 workers, according to the California Healthcare Institute’s 2002 report on the state’s biomedical and R&D industries. “Pharm Country” stretches the analogy to include four states: New York, Pennsylvania, New Jersey and Connecticut. “Genetown” takes in five other New England states — Maine, Massachusetts, New Hampshire, Rhode Island and Vermont.
“We have seen dramatic growth in the San Diego market,” says Ann Banning-Wright, senior vice president with Syska Hennessy Group, a Los Angeles firm that designs and builds labs for biotechnology companies. San Diego and other West Coast clusters may be more effective collaborators through the sharing of ideas and technologies than their East Coast cousins, she notes. “One major Fortune 500 pharmaceutical company reported that they have 10 times the discoveries coming out of their West Coast facility than their East Coast facility,” Banning-Wright says. “The Southern California market is definitely on the upswing. Companies are upgrading and expanding at an ever-increasing rate.”
Global pharmaceutical companies are investing heavily in San Diego biotechnology, medical device and diagnostics companies, as well as their own R&D through joint ventures, strategic alliances, contract research, licensing and royalty agreements, she says.
San Diego’s life sciences industry has grown primarily in concentric rings around La Jolla, “ground zero” to the life sciences community, according to Brian Mulvaney, senior vice president and biotech specialist with Voit Commercial Brokerage. The core area includes Torrey Pines, home to some half-dozen academic institutions and research foundations, headed by UC San Diego. Other landmark centers include the Salk Institute, Scripps Clinic and Research Foundation, the Sidney Kimmel Cancer Center, the Burnham Institute and Novartis Institute for Functional Genomics.
Over the past three decades, the Torrey Pines core has poured over into surrounding office/R&D markets, Mulvaney says. Although Carlsbad, Oceanside and the Interstate 15 corridor boast strong life sciences markets, more than 260 companies occupying about 7.5 million sf are clustered in just a few square miles surrounding La Jolla. The vacancy rate for life science space remains less than 10%, half the rate for standard office space. With new biotech space hitting the market over the next 12 to 18 months, Mulvaney predicts demand will lag supply slightly, causing a softening of lease rates. Wet lab, chemistry and other biotechnology space now leases for between $2.33 and $3.58 per sf. Operating expenses and utilities, spurred by spiking energy costs, can add up to $1.60 per sf to these rates, Mulvaney estimates. Leases typically run between five and 15 years and include healthy doses of tenant improvement or retrofit dollars, he adds.
“Biotech clearly drove the office market in 2002,” adds Mark Wayne, a senior vice president with Burnham Real Estate in San Diego. “In 2003, however, a decline in the amount of venture capital in the biotech sector will likely cause some companies to scale back and others to vacate. This could cause the overall net absorption in 2003 to fall short of that achieved in 2002.”
One reason for the long-term bullishness of Mulvaney and his colleagues is sustained growth. Unlike its dot-com and telecom cousins, bioscience employment is expected to increase by more than 30,000 jobs over the next two to three years in the county. Biotech already accounts for nearly 20% of San Diego County technology jobs and will increase for the next decade, he adds. “With the increase of biotechnology approvals for drugs, therapeutics and other market sectors, the growth of this industry is still in its infant stage,” he says. “It’s estimated that investment in biotechnology and the life sciences areas in general have increased four?fold over the last few years.”
But despite the sector’s fundamental strengths, life sciences firms have foundered along with the rest of the soft economy for the last year or more. Although temporary, a glut of excess space has left nearly 800,000 sf vacant in San Diego, causing rates to edge downward. Absorption of lab space fell to a low of about 325,000 sf in 2002. With new inventory coming to market, demand may not pick up significantly for 12 to 18 months.
“ Last year, the big story was ‘biotech is keeping us afloat,’ but that’s fallen by the wayside,” Mulvaney says. “It may take some time for this down cycle to end and rents to stabilize. But San Diego is a strong life sciences region, and new companies will grow to fill much of the current supply.” The National Institutes of Health and “big pharma” — the world’s largest pharmaceutical giants — have invested nearly $50 billion in R&D over the last few years, according to Burland East, managing principal for Silver Portal Capital, a La Jolla-based private real estate investment bank specializing in raising institutional equity capital.
Major cutting-edge research institutions such as Scripps and Salk partner with smaller biotech companies in an intensely collaborative environment, fueled by annual increases in research spending of 13-14%, East says. Such partnerships frequently result in sudden and explosive growth — and the need for larger quarters. “Every time they grow, they have a demand for space,” he says. “Unlike a company like Merrill Lynch, where real estate space isn’t mission-critical, lab companies can’t just move around.”
The firms prefer the security of long-term leases because of their sophisticated and costly building requirements. Such necessities include one-pass HVAC to remove contaminated air, chemical benchs, reinforced flooring and robust high-amp electrical systems.
In a recent 10-year deal valued at $20 million, biotech firm Advanced Tissue Sciences/Dermagraft re-upped the lease on its 85,000-sf headquarters on Torrey Pines Road in La Jolla. The company saved money by getting an early jump on lease talks with its landlord, Alexandria Real Estate Equities Inc., the first REIT specializing in lab space.
“Because biotech firms face high relocation costs, some landlords have used this advantage to package expensive and often redundant payment terms for lease renewals on their properties,” says David Y. Cantwell, Studley managing director, who represented Advanced Tissue Sciences--now owned by Smith & Nephew--along with Scott Granger, associate director in the Orange County office.
Rather than wait for its lease to expire, Smith & Nephew started renegotiations early enough to take advantage of current market conditions favoring tenants. Advanced Tissue Sciences retained Cantwell in 1999 to develop a strategy to address costs to move the company’s medical machinery, as well as exorbitant shutdown costs and U.S. Food and Drug Administration regulatory expenses. Talks with the landlord began in third-quarter 2000, with a deal finally sealed in November 2002. Cantwell hopes the deal sets a precedent for biotech lease negotiations. “When a landlord realizes their costs associated with losing a tenant, terms can be achieved that save medical firms millions of dollars in long-term real estate expenses,” Cantwell says.
In designing facilities, Banning-Wright notes that adaptability is crucial to success in the biotech industry. Manufacturing processes and infrastructure must accommodate all changes quickly, including what a company will need today and what it will need in 10 years, she says. Flexibility for future expansion and new technology tops the list of features that laboratory designers must incorporate into life sciences buildings, she says. Lab spaces must accommodate a variety of specialized research and support, along with administrative and staff offices and conference rooms.
Reliable water and power supply, security, air handling and circulation systems are one thing, but another key factor is including enough amenities to attract and retain high-powered scientists and researchers. “True collaboration between the owner, users, engineers, architects and contractors — right from the start — ensures a high-quality facility that is constructed on time and on budget, without sacrificing a lab’s function, quality, reliability or safety,” she says. Putting lab renovations on a fast-track construction schedule means a design/build approach is an advantage to the owner. HVAC is so critical, however, that tenants turn to a hybrid design/build approach, where HVAC is given special detailing. Whether it is a new facility or renovations to an existing facility, a concise time schedule and a holistic project concept are key.
In Southern California, the companies cluster in San Diego, with a few in outlying areas such as Watson Pharmaceuticals in Corona, Guidant Corp. in Temecula and Amgen in Thousand Oaks. Industry professionals are historically clustered around their alma maters, East maintains. The actual users of the space – chemists, biologists, molecular geneticists, pharmacologists, DNA researchers, and physicians – want to share academic knowledge.
“It’s a weird business because it’s so highly concentrated,” he continues, noting that biotech principals typically on the faculty of major universities and publish deep research as part of collaborative teams of public- and private-sector researchers.
Replicating investor interest
Lab space is emerging as a hotbed of interest after years of being misunderstood and overlooked by institutional investors, East says. The cash-on-cost returns and internal rates of return on life sciences real estate are about 200-300 basis points higher than for standard suburban office over a typical five-year hold, he contends. With clusters in the nation’s costliest markets, the supply of new life sciences real estate is restricted, with about only a dozen active developers in the United States handling the mainly build-to-suit projects—though some speculative building does occur in established life sciences markets with very low vacancies.
Demand is being driven by the need for drug-based therapies and basic research in the battle against the major diseases. Pharmaceutical and R&D spending, both in the aggregate and as a percentage of sales, are growing. “We believe that overall demand for life sciences space is growing at 5% to 10% per year,” East says. The close vicinity to the academic centers feeds the industry with a highly educated workforce and provides great potential for collaboration and spin-offs. South San Francisco bioscience companies responding to a California Healthcare Institute industry survey predicted their capitalized real estate needs from 2001 to 2003 would reach $436 million, nearly double the $250 million they spent from 1998 to 2000.
San Jose is hoping to form its own biotech cluster in the shadow of South San Francisco, home to the largest concentration of life-science companies in the nation. the city's Redevelopment Agency will spend $6.5 million allocated in July to convert an existing building shell in the Edenvale area owned by Mission West Properties into a 33,750-sf bioscience incubator to launch start-up companies, says Ru Weerakoon, the agency's director of industrial development.
"One of the things that struck us was that there were no biotech incubators on the West Coast," she says. "Biotech eluded San Jose for many years, but we've got academic institutions of our own like Santa Clara University, UC Santa Cruz and San Jose State University."
With 26 biotech companies compared with several hundred in South San Francisco, Weerakoon admits that San JOse might be a mere satellite to the biotech cluster of companies to the north. "But we're going to market this and we see it as a real opportunity," she says. "Bioscience companies are looking for alliance with nontraditional sectors such as semiconductor and information technology firms and this creates separate and distinct opportunities for San Jose."
Most lab space developed now is of the generic variety, allowing landlords and owners to lease to a wider variety of users. East believes the sector harbors only modest risk for investors, posed mostly by vacancies resulting from biotech business failures. The industry tenant base includes big pharma and all the entities they fund, biotech, not-for-profit research institutes and academia. Biotech firms are at the greatest risk of failure, spurring landlords to require letters of credit and security deposits.
Meanwhile, a couple of high-profile projects are moving forward in San Diego County. Locally based IDEC Pharmaceuticals Corp. has broken ground on its five-building headquarters project on a 42-acre site in the University Town Center area. The first phase will involve the construction of two lab buildings, two office facilities and a "commons" building comprised of a cafeteria, fitness center and conference rooms totaling 352,000 sf. At build-out, Phase I of the IDEC complex is expected to accommodate 1,000 employees with the first group expected to move here in the summer of 2004.
Other biotech developers are moving up the coast in search of land. In mid-March, Carltas Development Co. received approval to build the first biotech project in the city of Encinitas, a master-planned park on 10 acres within Paul Ecke Ranch. Plans call for 125,000 sf of office, research and laboratory space in three buildings, with the potential to expand. The Paul Ecke Ranch Science Center was originally approved for agricultural/biotech uses. In December, Carltas received an extension on its major use permit for the site, and the project is available for biotechnology uses with an agricultural affiliation. Construction could begin as soon as summer. In addition to being the first biotech project in Encinitas, “it will also be the first biotech campus in San Diego County that includes access to one million sf of greenhouses,” according to John White, president of Carltas. Most companies needing to grow plants for their R&D processes must utilize off-site greenhouses.
Paul Ecke Ranch Science Center initially will include two two-story buildings, each with 50,000 sf, and a one-story 25,000-sf building. The campus will accommodate a variety of companies from both a size and use standpoint, says Brent Jacobs and Steve Bollert, both senior vice presidents with Burnham Life Sciences Group. “The only new biotech construction underway today in San Diego County is build-to-suit or build-to-own,” Jacob says. With just 8% vacancy in existing biotech inventory, the center can offer small- to large-sized biotech firms room to grow, he notes.