The process of underwriting tenants may involve a number of important – and sometimes competing – considerations at the best of times. In propsci space, this is further complicated by the specific requirements of early stage and/or fast-growing life science companies, which can create a unique and challenging set of factors for a landlord to consider. This is especially true for owners and developers that are new entrants to this rapidly-growing sub-sector of the real estate industry. Pressures of a global pandemic only serve to increase the importance of properly and thoughtfully subscribing tenants prior to entering into new leases.
In this latest article in our Envisioning the New Normal: Real Estate + Life Sciences series, we explore some of the key considerations for the landlord to underwrite new life science tenants and give some thought to the different approaches we’ve seen in the U.S. and UK markets.
UNDERSTANDING THE SCIENCE (WHERE POSSIBLE)
When assessing a potential life sciences company as a tenant, it is important to try and understand the viability of its business / financial model and, where possible, to assess the value of its science. In the U.S., some of the most sophisticated and established life science owners , developers and operators either employ specialist consultants or have in-house capabilities to assess the science-related information provided to them by prospective life science tenants. This enables them to better understand the background of life science tenants and to seek to weed out – by assessing the strength or otherwise of their science – those whom they consider may not have a sustainable business plan.
Knowledge gained from this exercise may also give landlords the opportunity to capitalize on gains to be made in early life sciences investment by sitting alongside venture capital investors. Similarly, there are also some examples of landlords which are part of venture firms that look to form relationships with tenants so that they can participate in future financing rounds of such tenants. While this has an obvious advantage in terms of access to opportunities for future investment, the key aim for landlords in understanding the science behind prospective life sciences tenants is to prevent a company with doubtful prospects of success from signing on to a very expensive lease.
Despite some notable examples of landlords who are able to exercise due diligence and evaluate science in a meaningful way, the vast majority of real estate firms and investors recognize that they will not be able to understand science in any meaningful way and are not currently trying to do so. That said, many are aware that even a basic understanding of the science of prospective tenants will benefit landlords, and we therefore expect this capability to become an increasingly common trend among those real estate firms that focus on the growing propsci market.
UNDERSTANDING THE SOURCE OF CAPITAL
Companies in the life sciences sector require significant cash to fund their activities. Most early stage, and many later stage, life sciences companies are likely to be totally reliant on external financing. Typically, they will be heavily loss-making and a number of years away from the point where they will generate any revenue from their operations. Life sciences companies are typically only funded for the next stage or two of their development activities, and so their cash runway is often only 12-18 months, at which point they will need to seek a further cash injection from their current investors or raise capital from new investors.
Any cash that life sciences companies have will be carefully budgeted and allocated for the clinical development of their drugs or devices. With this in mind, landlords will need to take careful due diligence to enable them to understand how the prospective tenant is financed: is it backed by the venture? Does he get his capital from a foreign parent? Does it rely entirely on the strength of its science or its reputation for its pipeline of fundraising? Or is it financed in a different way? The source of capital and the security or availability of future financial support may make a significant difference from the financial underwriting and risk perspective.
The analysis of the landlord can be made simpler if one or more major venture companies are involved in supporting the life sciences company. Such venture firms are constantly developing a pipeline of new portfolio companies and, in the event that one of their portfolio companies fails, some landlords are comforted by the fact that another company is likely to fill the vacancy in the same portfolio without too much disruption or renegotiation of the relevant lease.
If a life sciences company relies on foreign capital, there may be concerns about the enforcement and collection of guarantees from foreign parent companies. This can lead to complicated legal negotiations to ensure that someone of value is able to meet these obligations and that such obligations can be enforced in a meaningful and cost-effective manner.
If the ability of a life sciences company to raise funds is in doubt, this can lead to a very different discussion with landlords on the terms of rent amounts / structure, security deposits and tenant improvement packages, and so landlords should be prepared to show flexibility and imagination when approaching these discussions.
Despite the availability of capital, life science companies operate in a world where their development program could simply fail at any time. If this happens and the company does not have a back-up or alternative program, the investor capital will be withdrawn in most cases and the company will simply be wound up.
PROTECTING LANDLORDS FROM FUTURE DIFFICULTIES
Security deposits from life science companies are generally large (compared to other sub-sectors of the real estate industry) and in the form of letters of credit/bank guarantees. It is not abnormal to design creative burndown structures for 12 + month security deposits which are based not just on time but also on growth milestones. Examples of burndown milestones include: I future fundraising events, such as raising an agreed level of follow-on financing by a certain date; and (ii) the achievement of certain clinical or commercial milestones in the drug development (although accurately defining those milestones can often be a difficult drafting exercise where input from specialist life sciences lawyers is essential).
Landlords should also bear in mind that most life science companies will run out of money only a few years (or even sooner) into a 7–10 + year lease term , making security deposits and future sources of capital essential. While parent guarantees from venture firms are generally unheard of, to the extent that another source of capital is available, landlords should seek upper-tier guarantees wherever possible.
Life sciences companies often have very specific requirements for the space they occupy and may require the landlord to make these specific requirements easier. Life sciences companies may have complex requirements for the fit-out of their space. Some will need a customized, fully operational laboratory and, given the innovative nature of their work, will often require a very high specification in terms of the safety of their premises. Other tenants will have specific requirements in terms of utilities and construction services and the need to store, use and/or dispose of hazardous materials. Tenants will also want to ensure that there is room for them to expand as their development program and headcount increases.
A key consideration of the landlord when reviewing large tenant improvement packages is to ensure that the design of the space will be of use to second-generation tenants. As noted above, life science companies may run out of funding prior to the termination of their lease and therefore a space that can be easily reused will be leased again more quickly and will require less investment in terms of future specification.
In view of the above, landlords are becoming much more involved in the planning, review and approval of design changes. We are aware of specific examples where tenants with out-of-market requirements, such as very large perennials or customized laboratory equipment, can only use a certain percentage of their owner’s capex allowances to make such modifications and must meet the minimum standard for the rest of their laboratory space. This allows landlords to facilitate their tenant ‘s requirements, while minimizing expenditure on bespoke fit-out items (where the return on such items is uncertain) and ensuring that their property will remain attractive to a range of future tenants.
PREVIEW PART 5
The next article in the Envisioning the New Normal: Real Estate + Life Sciences series will explore the impact of technology on the growth of the life sciences industry. This new spotlight on life sciences companies comes amid a historic surge in investment in biotech, pharmaceutical and medical device start-ups focused on the search for innovative approaches to, among other things, health issues facing an aging population. Life sciences companies old and new, as well as owners and operators of the life sciences lab and office space, are accelerating the use of existing and new technologies in order to keep pace with research , development and production.