Not very long ago, it was pretty clear what real estate was: the homes, hotels, offices, shops and industrial parks that housed people and industry. For institutional investors in the asset class, life was even simpler, as they likely eschewed grubby industrial and warehousing space, or even housing in markets where owner occupation was high.
Nowadays, an institutional investor in real estate might have in its portfolio co-living and co-working properties, student and senior housing, affordable housing, medical offices, healthcare, life sciences laboratories, data centers, TV studios and self-storage facilities. New niche sectors are emerging all the time, gradually broadening the definition of what real estate is.
Meghan Burke, a managing director in the real estate client solutions group at Macquarie Asset Management, outlines the drivers behind this expansion: “There have been technological and demographic changes, as well as changes in approaches to sustainability, that have driven change in real estate. Many of these mega-trends were also accelerated by the pandemic.”
Eric Wurtzebach, head of Americas real estate at Macquarie, adds: “What has also changed is investors’ willingness to understand niche asset classes and increase allocations to those sectors. So, simultaneously we have had technological and demographic changes that created new asset classes and increased the willingness of real estate investors to embrace them.
“Institutional investors and the broader real estate market have become far more sophisticated and focused on fundamental underlying trends. There is also more readily available data, and it is used to better assess the trends that are driving demand and risk-adjusted returns, for example.”
New sectors responding to new and growing demand, such as data centers, have been drivers of investment. But compressed yields for traditional real estate sectors – CBRE data shows US office cap rates compressed nearly 300 basis points between 2010 and 2020 – have also pushed investors to seek new avenues to boost risk-adjusted returns.
Carole Guérin, managing director and head of Americas at Canadian pension fund PSP Investments, says: “We have invested in a number of niche or alternative real estate sectors, such as life sciences and content production studios, where there are strong drivers, such as the growth of streaming services. We have also, on occasion, invested outside traditional sectors in order to access more attractive yields.”
For real estate investors in niche sectors, the question of scale is an interesting one. In some areas – data centers for example – the rapid growth of the sector and the requirement to partner with an operator means there is a potential opportunity to build scale. However, many niches, such as self-storage, can be tough to scale up in smaller markets. In comparison, an office building in a gateway city can easily account for more than $100 million of equity.
“Scale is a problem for some real estate niches because it can be hard to build a business or a portfolio to a level where it is material to an institutional investor,” says Doug Cain, head of unlisted property at Future Fund, Australia’s sovereign wealth fund.
A niche operation
Perhaps the major difference between core and niche real estate sectors is the operational element. One of the characteristics of many niches, such as co-working, healthcare or self-storage, is the requirement for daily operations. This is not unique to niche real estate, as hospitality is also heavily operational; however, it is a notable factor in investing in almost all newer sectors.
“We have… on occasion, invested outside traditional sectors in order to access more attractive yields”
Carole Guérin, PSP Investments
“That operational intensity is an added consideration, but at the same time that also tends to bring longer, stickier clients, and you’re able to often have higher rent values,” explains Burke. “Frequently, these operationally intensive asset classes can generate a higher and more stable return profile.”
Wurtzebach says: “Another key operational element, which is increasingly applicable to core real estate sectors, is a focus on the end user. Especially in this post-pandemic world, office landlords need to provide the amenities – collaborative learning spaces, outdoor space, lounges, gyms – which the end users, the office workers, demand.”
The operational element might make some institutions think differently about assets and where they might sit. Should data centers be real estate or infrastructure? Should a mixed property company or operating company investment be in real estate or private equity?
However, Future Fund’s Cain says: “Some niche sectors have a considerable non-real-estate operating element, but if an investment is sound with an appropriate risk-adjusted return, institutions will find somewhere for it to sit. Working across asset classes is an art that we’re always trying to improve.”
There are also potential additional risks associated with sectors where real estate investors will be involved with, or even invested in, the operator. Neverthless, there is the prospect of unlocking additional value, either from investment in the operator or by gaining access to real estate opportunities through the operator.
PSP’s Guérin says: “We don’t necessarily seek out an increased operational requirement, although that operational element can be necessary to give you an edge in certain sectors. However, the investment’s return needs to compensate for that additional risk.”
This makes investors in niche sectors particularly focused on structures, alignment of interest, and control. “Real estate with an intensive operational side requires more from managers,” says Cain, “and so your managers and relationships are important, as well as having the right ownership structures, which should provide flexibility.”
Guérin adds: “We prefer the joint-venture model, as it provides alignment with partners and still gives us a degree of control. When we are entering new markets, for example as we expand in Asia-Pacific, we may invest in funds to gain us expertise, especially when there will be opportunities to co-invest alongside the fund.”
The demands of operationally intense real estate mean that operating partner selection is crucial, says Wurtzebach. “It really comes down to operating partner selection – finding a sophisticated, knowledgeable partner that can handle operational complexities. In many of these niches, there are very few good, trusted operating partners.”
When is niche not niche?
As mainstream real estate sectors become more operational, there is something of a blurring of the line between niche and core.
“I think that trend is going to continue,” says Burke. “Of course, you can look at some of these niche sectors as ultimately subsectors of some of the more traditional core sectors. So, is life science and medical office a niche or a specialist part of the office sector? To an extent, it doesn’t matter, because investors and managers will continue to seek specialist real estate, however it is described, in search of the best risk-adjusted returns.”
Data centers, cold storage and self-storage are popular niche sectors at present, but where does the future lie? “Sectors driven by long-term secular and structural trends, such as the aging population, lack of affordability in the residential sector and growing data usage, should succeed, so we probably spend more of our time thinking about global mega-trends and then drill down into the cities and the sectors in our region to identify opportunities,” says Wurtzebach.
Burke suggests that the US market has been an early adopter of niche sectors in several instances. “It’s a combination of investors willing to go outside of the traditional areas, managers more able to think outside of the box, and being less constrained in regulatory terms.”
Guérin says: “We look to have the right allocation across sectors in our portfolio over the long term, but those big food groups, the traditional real estate sectors, are still needed at the heart of the portfolio to balance the portfolio’s risk.”
Dealing with data demand
As new data centers are added all over the world, more real estate investors are rushing into the space.
BlueWeave Consulting & Research predicts the value of the global data center market will grow by more than 10 percent each year between 2021 and 2028, from $206.2 billion to $404.9 billion.
“Virtually everything we do in our daily lives and in our business lives goes through a data center in one way, shape or form,” says Erin Ledger Beaupre, senior managing director at Macquarie. “And emerging technologies such as AI, driverless cars and 5G networks involve massive amounts of data. So, as we become more digitized as an economy, even though we are getting more efficient in how we use that data, we require more data center capacity.”
The operation of data centers is a specialized business due to the need to secure significant amounts of power and provide a specialist fit-out. Many real estate managers have either paired with an operator or formed their own platform.
“On the real estate side, one way to access the sector is to partner with an operator and have access to their customer relationships and scale, but not necessarily own a piece of that larger operating platform,” explains Ledger Beaupre.
“As in many niche asset classes, it has been the larger investors moving first,” she continues. “We have seen those investors moving into this space for five or 10 years, but now smaller institutions are entering the sector. There have been a variety of structures offered but there is still not a huge suite of opportunities.”
A recent and growing concern for investors in the sector has been sustainability, due to its huge power consumption. “Three years ago, I was not having this conversation, but now that’s one of the first conversations we have with investors,” says Ledger Beaupre. “They are looking to work with their managers and operators to find solutions.”