With office occupation rates on the slide and the life sciences industry’s demand for lab space on the rise, the repurposing of existing offices into medical laboratories has become an important new asset class, writes Liz Chen, a lab planner at HGA Life Science + Advanced Technology Group’s San Diego Office. Chen highlights some of the specificities of office-converted labs versus purpose-built facilities, prospective market headwinds to watch out for, and what a fruitful value creation strategy – leveraging the expertise of architecture and design teams – should look like in any office-lab conversion project.
The COVID-19 pandemic structurally changed the life science ecosystem and demand-supply equation in the value chain. In the midst of the pandemic, the industry faced unprecedented challenges in fighting against highly contagious diseases, fast-tracking lifesaving vaccines, and seeking beds and medical resources to rescue lives. In particular: repurposing existing offices into new labs for scientific use has gained unprecedented traction and office-lab conversion has incrementally become a new asset class.
Statistics show that the U.S. office vacancy rate, as of July 2023, climbed 17.1 percent reaching 180 basis points over the past 12 months. Commercial rent growth continued to fall systematically and in some of the priciest cities: Manhattan was down 2.8 percent YOY and Bay Area was down 5.57 percent YOY.[1] Meanwhile, lab scientists and clinical technicians were unable to perform life science research through Zoom. The growth of life science jobs (in Figure 1.) compounded by the intrinsic growth of R&D, translated into a solid demand for high-quality life science real estate (e.g., (AI-enabled) lab, biomanufacturing facility, vivarium, cleanroom, etc.). Projections show that life science real estate will grow 30-50 percent in the next decade – an equivalent of 45-65 million square foot (SF) of newborn demand over the current 131 million SF inventory stock.[2]
Made with Visme Infographic Maker
Source: Avison Young[3]
With such a robust tailwind, the article deciphers the distinctive advantages of office-lab conversion to become corporate value creation drivers and break down potential headwind factors that may slow down the current virtuous condition. Meanwhile, the article identifies value creation techniques (i.e., α) beyond corporate strategy that would further drive shareholder values to ensure the golden goose (e.g., life science real estate) lays golden eggs (scientific breakthrough, drug development, and therapeutics commercialization).
1. Life Science Real Estate: Ground-up Purpose Built Lab vs. Office-converted Lab
Office-converted labs stand for labs creatively repurposed from office buildings or corporate campuses, while purpose-built labs refer to labs constructed based on ground-up greenfield development. The office-converted labs have a series of advantages over the ground-up labs in terms of construction speed, cost-effectiveness, earning potential, etc.
Made with Visme Infographic Maker
Construction speed. Both ground-up labs and converted labs follow a standard design-(bid)-build process from planning, design, and construction. Lab conversion often has a faster turnaround time: around 12-18 months to bring the defined functionality to operation. In contrast, ground-up labs in general take around 18-36 months, sometimes even longer. The difference results from the fact that the building has already existed which by default would encounter fewer design and construction activities.
Cost-effectiveness. Lab conversion typically saves 50 percent or more of the construction cost since site utilities, architecture and structure, and mechanical, equipment, and plumbing (MEP) systems have already been installed unless a mandatory upgrade is necessary. Take the top three life science clusters in the U.S.: Boston/Cambridge, the Bay Area, and San Diego. Statistics show that the construction cost of converted labs in these three regions ranges from $300/SF to $600/SF compared with $675/SF to $1,200/SF for ground-ups.[4]
Cluster. In life science clusters (e.g., science parks), site selection and access to the talent pool are two interrelated factors in the nuance of our business. Biotech, Medtech, and pharmaceutical companies have access to a pool of talents from renowned universities and institutions; scientific researchers benefit from close collaboration. From the corporate strategy and (real estate) investment perspectives, it is sensible to convert an existing office located within the cluster rather than hunt for buildable land for a ground-up lab.
Rent earning. In the last five years, life science real estate has enjoyed a hefty rent growth. Asking rents increased an average of 53 percent in the top 10 U.S. life science clusters, compared with 20 percent in commercial real estate. Rent increase on lab reached 95, 86, and 82 percent respectively in the Bay Area, Chicago, and Raleigh regions. In practice, the lab provides 1.5 – 2.5x of rent versus commercial office; meanwhile, rent premium for a new lab is 20 – 40 percent higher than the current average of asking rent.[5]
Tenant retention. Compared to commercial offices, cash flow in life science real estate offers greater stability. In addition to higher long-term net operating income growth and cap rate, the asset in certain cases has lower ongoing capital expenditure.[6] In addition, life science real estate has a higher retention rate and longer lease term due to the onsite nature of R&D endeavours, meaning that labs did not encounter the same work-from-home effect as commercial real estate.
2. Prospective Headwinds
While closely watching out for potential cost escalation, delay, and earning potential, it is imperative to keep managing and monitoring the changing headwind and market sentiment. Major adversary factors are:
Outsized supply and demand elasticity. A short-term surge of new lab construction plays a meaningful role in harvesting our ecosystem but with a balance. A risk of oversupply in both office-converted labs and ground-ups may lead to excessive demand, triggering an undesirable rent downfall when an imbalance occurs.
Market transparency. Office-lab conversion becomes a new asset class; In hindsight, insufficient data around conversion feasibility and constructability compounded by unanticipated cost escalation, rising interest rates on the cost of borrowing, and the risk-averse lending market, collectively hampers the investment willingness. In reality, a handful of building owners nonchalantly hold the existing commercial real estate even longer despite the ultra-low occupancy/ emptiness and still do not believe that commercial offices are the golden gooses rather than seeking an adaptive (re)use.[7]
Upgrade complexity and conversion cost. Life science real estate typically involves highly specialized lab planning and intricate facility programming to support daily clinical research and drug experimentation. A sudden power glitch may wipe out months or years of scientific endeavours, resulting in a disastrous delay in drug development and therapeutics commercialization. Despite the significant savings on cost and schedule, lab configuration often requires a series of upgrades (e.g., standby power generator) and enhancements (sound attenuation and CMU walls) to the existing office building.
3. Value creation strategy in office-lab conversion
Asset transformation and repurposing require a series of technical research beyond standard investment research and strategic execution. This section showcases how the lab planning and architecture design team, with their esoteric expertise, assist pharma executives in creating state-of-the-art labs to further drive long-term shareholder value.
Architectural Value Creation. To materially realize the office-lab conversion, a humble beginning starts with a close examination of the constructability and feasibility analysis to delineate three major value creation categories: site utilities (SU), architecture and structure (AS), and mechanical, electrical, and plumbing (MEP) systems with corresponding transformative details. The process of constructability analysis involves not only identifying transformation opportunities and conversion feasibility but also mapping out a series of value creation strategies for a specific life science real estate asset. The analysis formulates a foresight between the existing building condition and the proposed upgrade to inform the executives whether a ground-up or converted lab creates the most value. For example, a site improvement master plan reveals a thorough analysis of geographical conditions, stormwater management, road infrastructure, and corresponding purposeful upgrades to facilitate a smooth circulation of people, goods and supplies, and vehicles.[8]
Design excellence and managerial craftsmanship. Office-lab transformation relies on the design team to provide lab programming advice and execute client-specific design blended with lean six sigma and best practices, identify opportunities for design construction upgrades through creative lenses, instrumentally perform change management, and support dispute/claims resolution. The team exhibits a user-centric (tenant-centric) mindset through definitive actions; meanwhile, performs managerial functionality to facilitate processes and deliverables among parties.
Practitioner-centric design thinking. The design team, besides a mastery of design and managerial expertise, demonstrates design thinking with a fusion of investment discipline. It is relatively common to see that boondoggle and glitz and glamour projects snuck in at the expense of the R&D budget to cover the ongoing maintenance of outlandish pieces which eventually translates into long-term liability on corporate balance sheets. The beauty of office-lab conversion is a process of re-imagination to fulfil craftsmanship transformation but with a calculated discipline.
Overall, the article invites the C-suite and board of directors to pay attention to three critical aspects: meritorious advantages of office-converted lab over ground-up, navigation of changing headwind, and recommendations for value creation strategy through sophisticated design partners. Labs are where scientific discoveries are born and the future of medicine is trialled and developed. Meanwhile, we should weigh on upside potential and downside protection in various scenarios to ensure that the golden goose (life science real estate) laid golden eggs (scientific breakthrough, drug development, and therapeutics commercialization) to drive long-term shareholder value and make the world a better place.
References
[1] Jozsa E. U.S. Office Sales Total $14.8B Halfway Through 2023. CommercialEdge. Published July 19, 2023. https://www.commercialedge.com/blog/national-office-report/#:~:text=The%20national%20U.S.%20office%20vacancy
[2] HinesView. Hines Perspectives: Life sciences.; 2021:8. https://s3.us-east-1.amazonaws.com/hines-assets/documents/Life-Sciences-Thought-Paper.pdf
[3] Avison Young. Despite slowing in the first half of the year, select Life Science job postings remain above pre-COVID levels. Published July 19, 2023. https://www.avisonyoung.us/w/despite-slowing-in-the-first-half-of-the-year-select-life-science-job-postings-remain-above-pre-covid-levels-1
[4] CBRE. Despite the Cost, Construction of Life sciences Properties Brings Strong Returns. CBRE. Published April 21, 2022. Accessed August 8, 2023. https://www.cbre.com/insights/briefs/despite-the-cost-construction-of-life-sciences-properties-brings-strong-returns#:~:text=Although%20a%20costly%20proposition%2C%20investors,by%2044%25%20overall%20last%20year
[5] Berthelette L, DeNight L, Kruczlnicki M. The Conversion Conversation: Factors Driving Office-to-lab Repositioning in Key Life sciences Markets. Newmark. Accessed August 9, 2023. https://www.nmrk.com/insights/real-insights/the-conversion-conversation-factors-driving-office-to-lab-repositioning-in-key-life-science-markets
[6] LaSalle Investment Management. Global Life sciences Real Estate Opportunities.; 2022. Accessed August 9, 2023. https://www.lasalle.com/wp-content/uploads/2022/12/life_sciences_insight_report_isa_2022.pdf
[7] Office Adaptive Reuse Task Force. Office Adaptive Reuse Study.; 2023: 23. Accessed August 9, 2023. https://www.nyc.gov/assets/planning/download/pdf/plans-studies/office-reuse-task-force/office-adaptive-reuse-study.pdf
[8] National Institutes of Health. Design Requirements Manual.; 2016: 199. Accessed August 9, 2023. https://orf.od.nih.gov/TechnicalResources/Documents/DRM/DRM1.503262020.pdf
