It's not just tech companies that can trace their roots back to a garage. According to co-founder Joel Marcus, Alexandria Real Estate Equities (NYSE:ARE) -- a real estate investment trust specializing in life sciences laboratory and office space -- got its start in a garage, too. Since its founding in 1994, Alexandria Real Estate has grown into an $18 billion commercial real estate Goliath with $1.1 billion in annual revenue. Can this company's success continue? I recently spoke with Marcus to learn more about the company and its opportunities.

The business behind biotech

Initially, Alexandria's business model was to acquire single assets and transform them into lab and office space, but beginning in 2004, the company changed its approach to creating concentrated life sciences campuses, or biopharma clusters.

A person's hands arrange cut out construction paper into an upward trending arrow.

Image source: Getty Images.

Its urban clustering strategy is based on the belief that clustering similar businesses together boosts productivity, operating efficiency, and innovation, a concept promoted by Harvard economist Michael Porter. 

Porter literally wrote the book on competition (the title of one of his books is On Competition), and in a 1998 Harvard Business Review article, "Clusters and the New Economics of Competition," he wrote that the most successful businesses are typically found within close proximity of one another, or in clusters, despite technological advances allowing companies to operate anywhere.

The clustering approach has been a smart strategy that's paid off for Alexandria, especially in communities like Cambridge, Massachusetts, where Alexandria's 6.4 million square feet of life sciences space leverages Boston's reputation as a hotbed of medical innovation. Clusters in San Diego, San Francisco, Seattle, and New York have also contributed to the company's success.

Alexandria's also used the clustering approach to successfully attract tenants from the technology sector. It developed Google's first campus and today, it generates about 11% of its revenue from technology companies, including Amazon, Microsoft, and Google.

It turns out that Alexandria Real Estate's also a pretty savvy equity investor. Past successes, including investments in Google (it still owns shares) and Juno Therapeutics, have turned it into a valuable source of venture capital. Today, its investments have a market value of $724 million and a cost basis of only $511.2 million.

What's behind its growth?

When asked about the company's growth potential, Marcus is quick to point out that while there are about 10,000 known diseases, medicines are only available to treat about 5% of them. That staggering statistic suggests there's still a tremendous long-term opportunity to lease lab and office space to researchers who are investigating and developing new therapies.

In the short term, Marcus cites five key reasons why this industry is attractive:

  • Growing funding from the National Institutes for Health (NIH).
  • An increasingly friendly Food and Drug Administration (FDA).
  • More research spending thanks to philanthropy.
  • Record investments in biopharma by venture capital.
  • Robust spending on research and development (R&D) by commercial-stage biopharma companies.

In Washington's latest budget, the NIH secured a 9% increase in spending to $37 billion, and since the it's one of the biggest sources of research grant money in America, this bigger budget offers tailwinds to demand for Alexandria's real estate.

It also doesn't hurt that the FDA is actively seeking ways to accelerate its review and approval of new drugs, particularly for rare diseases. If the FDA adopts policies that streamline the time it takes from discovery to commercialization, it would encourage private investment and philanthropy across biopharma that supports demand, too.

That's already happening. Over the past couple years, private donors have become a much bigger source of R&D funding. According to Marcus, medical research philanthropy is north of $33 billion, a record high. Similarly, venture capitalists plowed $6.7 billion into life sciences during Q1 2018, which was also a record.

Scientists collaborating together at a workbench in a lab.

Image source: Getty Images.

Capitalizing on demand

Alexandria's occupancy rate is nearly 97%. That suggests plenty of opportunity to generate growth at its existing properties and via newly built properties.

The company builds into its leases 3% annual rent increases, and thanks to industry tailwinds, many of its tenants are expanding their footprint into adjacent spaces. Alexandria's also benefiting from tenants' increased interest in renewing leases now to lock in current rates for more space.

In Q1 2018, the company says internal growth at its existing properties accounted for 20% of the company's 17.8% year-over-year jump in net operating income. For the full year, guidance is for same-property net income growth of 3.5%. 

Development and redevelopment, however, is the biggest driver of Alexandria's improved operating performance. It accounted for nearly 70% of the 17.8% improvement last quarter, and with 2.3 million square feet of new space in its pipeline that's already 81% leased, it should continue to be a big contributor to Alexandria's success. 

What could go wrong?

The things supporting demand for Alexandria's properties right now could also be what pose the biggest threats to it in the future.

A strong economy and a willing stock market are fueling increases in venture capital and philanthropy, so an economic slowdown or biotech bear market could put the kibosh on those drivers of demand.

The FDA's willingness to push the gas pedal on drug approvals may not continue forever, either. In the past, the FDA's had periods where it's been slow to approve new medicines and it's conceivable that could happen again if any unforeseen safety concerns pop up from drugs that have recently gotten a green light. 

Furthermore, while NIH funding has been pretty stable in the past, it's not immune to the threat of budget cuts if the federal budget needs paring because of runaway debt or declining tax revenue.

Investor takeaway

It's anyone's guess how long the current bull market in life sciences will last, but the long-term trends supporting drug development make Alexandria Real Estate an intriguing investment idea.

The global population is getting increasingly older and longer-living, and worldwide, spending on prescription drugs is increasing at a roughly 6.5% compounded annual pace. By 2022, global spending on medicines is expected to reach an eye-popping $1.06 trillion.

The potential to capture a slice of an increasingly larger pie isn't the only thing driving medical innovation, though. Advances in technology are also emboldening researchers to take on increasingly more complex challenges. For example, new systems that sequence genes more quickly, accurately, and cheaply are accelerating the development of precision medicines that tinker with DNA and RNA, opening up incredible opportunities to tackle historically tough-to-treat indications, including late-stage cancer and genetic disorders

Granted, investors can invest directly in biopharma companies investigating next-generation medicines, but historically, about 90% of clinical drug trials fail, and that makes biotech investing inherently risky. 

Perhaps investing in Marcus and his team at Alexandria Real Estate Equities is a better way to profit from the biotech boom. After all, this REIT's been profiting from increased biopharma R&D activity for more than 20 years.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.