Operational real estate deserves recognition as a standalone asset class, according to new research. No longer an alternative or subset, it should be seen as a valid way for investors to capture greater real estate value.
The research, carried out for the Investment Property Forum, reviews a number of issues the growing niche faces, around metrics and reporting, descriptions and risk assessment; and comes up with a series of best practice recommendations for taking the discipline forward.
In studying operational real estate, the researchers, from Didobi Limited, in partnership with Heriot Watt University and Nottingham Trent University, also draw substantially on the hotel sector in providing examples of current practice. But they point out that OpRE is now of growing interest across a much broader range of property types.
“Operational real estate is no longer just the preserve of alternative property types and is a rapidly growing source of income in offices and, especially, retail,” said Bill Page, head of real estate markets research at Legal & General Investment Management Real Assets, who chaired the steering group overseeing the research. “The importance of understanding and measuring the unique attributes of risk is therefore paramount and this research adds transparency to what is, for many, still an opaque part of real estate investing.”
“It’s not necessarily about the physical aspects, it’s about the link between the investor and the activity that is carried out by the operator or tenant in that building. And that has a very big impact on how one goes about assessing the risk and returns associated with that.”
OpRE provides useful diversification opportunities for investors, and promises higher returns than traditional real estate. Against that, the key perceived risks are economic, business risk and cashflow volatility.
Matthew Hopkinson, a director and co-founder of Didobi, said operational businesses added another layer of investment risk: “Having the right skillsets, approach and data in order to appraise and manage this risk will determine the level of returns achieved by investors.”
The report has laid out an IPF definition of operational real estate thus: “A real estate investment where the return is directly and deliberately linked to the revenues and profits of the business conducted on or from the premises.”
Stephen Ryan, an experienced fund manager who is on the Didobi team, and one of the contributors to the IPF report, told Hotel Analyst: “I know that institutional investors can have a particular mindset. The report aims to change that, and we think we’ve moved things along – we hope it opens the door.”
One of the complexities of OpRE is working out how to assess and quantify risk. The report notes that there is no standard approach across the real estate sector, and investors use a range of methods. This typically will look to assess economic and business risks, and the likely variability of operational earnings, costs and revenues.
Ryan said the report team sought to find ways of measuring operational real estate risk and performance that would give comfort to more traditional mainstream investors. They opted for tools from the equity and bond markets, to help quantify risk, for example.
Space as a service is one area Ryan believes investors will move into, a view echoing the optimistic tone of a newly slimmed-down WeWork, and IWG, which operates Regus and has declared the post-pandemic landscape its greatest opportunity in 31 years.
Ryan said he knows that at least one corporate sponsor of the IPF report is reviewing the repercussions of its learnings. “They’ve gained more courage and insight” as a result – and will be more likely to shift more quickly into OpRE investment.
Ryan said hotels are likely to be the gateway for many investors interested in moving towards direct operational real estate investment. “Everyone has been to a hotel – not everyone has used self-storage.” He also noted that the hotel sector has strong metrics – from credit and bond ratings, to individual hotel group results – which can provide the level of information institutional investors often require.
In the hotel sector, there has already been a noticeable growth in mainstream investors seeking to participate in operational real estate. In 2018, investor Schroder purchased hotel management specialist Algonquin, in a move that was widely seen as a move to improve returns by taking a direct operational stake. At the time, Schroders Global Head of Real Estate Duncan Owen commented: “We want to open up a sector that is undermanaged to pension funds and other institutional investors who are able to identify the opportunities. We just liked the performance of the sector, its hands-on nature, its management – we will both be operating and managing.”
In 2020, the group launched an operating hotel fund, targeting a spend of up to EUR800m on 10-15 European hotels, with the aim of earning strong returns by not just refurbishment, but operational improvement too.
The hotel sector is also seeing its hospitality skillset being appreciated by a wide range of operational real estate businesses. In reporting on niches from private rental to senior living, Hotel Analyst has spoken to former hotel management staff who have been poached, as operators appreciate the need for softer skills to help drive customer satisfaction.
HA Perspective [by Chris Bown]: Watch out, there’s more investors about. The IPF report sets out to shine a light on the opportunities of operational real estate, but also lays out the challenges. It’s a whole different world from owning an office block with a long lease to provide the income – but the returns are commensurately better. Just ask Schroders, Invesco or some of the other buyers and holders of hotels.
Working towards clear comparables and metrics is the big challenge for ORE investors. The report sets out some ideas, but there will surely be many more discussions, before it becomes possible to easily benchmark investments. However, that is unlikely to restrict the growth in interest from all types of investors. And Ryan tipped defined contribution pension schemes as the next new kids on the block, as they take a greater interest in relatively less liquid and more chunky investments.
Additional comment [by Andrew Sangster]: Traditional real estate used to be fairly simple: in commercial it was offices, retail and industrial; and then you added residential. Everything else fell into the exotic “alternatives” box.
Hotels have, for the past decade or so, increasingly made it into the traditional camp too. Even if the exotic agreements – anything other than a fixed lease – terrified the most traditional of the traditionalists.
The problem with OpRE is that it shakes up the whole traditionalist worldview. Out goes concepts of tenant and landlord and fixed contracts to be replaced with significantly more complex ways of assessing and quantifying the risk of making an investment in a property.
Discounted cash flow analysis has been around a long time but there are different ways to skin the DCF cat. Internal Rate of Return is gradually being eased out of the picture by the preferred Net Present Value, says the IPF. The three key parts are the modelling of cash flows, the calculation of the discount rate and setting of a holding period.
With OpRE, investors like the diversification it offers and the (potentially) higher returns. But the challenges are developing the in-house expertise to exploit opportunities and learning how to work with third-party operators.
RE investors understand how to assess location, one of the two key drivers of returns, but getting to grips on measuring an operator’s skill, the other key driver, has required a whole new tool kit.
Getting it right, brings rewards. This week, Capital and Counties Properties, the REIT that owns a big slice of London’s Covent Garden, reported that it has kept its vacancy rate at just 3.5%, the same level as it was before the pandemic.
During 2020, some 65 new agreements were struck, about half of which were pop-ups or “animations” that help drive footfall to the area. These leases are short-term and turnover-based, allowing the REIT to keep a grip on how the overall estate develops.
But don’t think that these leases are uncommercial. Critical has been the flexibility in capturing revenue so, for example, for retailers, an element of click and collect sales is incorporated.
It helps that CEO Ian Hawkesworth was in Hong Kong during the 2003 SARS epidemic. He anticipated a brutal impact and that is what hit Capco – a 26% decline in like-for-like values. Hardest hit is retail, down 34%, and then f&b, down 30%. Offices were less marked, down 13%, and residential was off just 7%.
The way back is going to be long given that 40% of the footfall in Covent Garden has historically been long haul or regional European visitors. A quick spring back for domestic UK demand is anticipated, however, and can already be seen in forward restaurant bookings.
Hawkesworth is modest about what drives success at the REIT: GDP growth, inflation and “a little bit about how well you brand your estate”. As well as getting to grips with multichannel retail, Capco has also pushed what it calls “animation”. These experiential concepts include new brands like Kick Game, a shop that is a secondary market for sports shoes (it’s not for you unless you’re familiar with Yeezy and Supreme).
Hospitality, f&b, is an integral part of this too. Pedestrianisation that has enabled more al fresco dining has helped drive trade. And in turn this enhances the office and residential offers in the area.
The synergies between the different elements of RE have helped create a whole that is greater than the sum of its parts would be if each were taken in isolation. Critical to delivering this holistic success is fully grasping the role of operational real estate.