Operational real estate is gathering steam in the UK, and projected to grow to a market size of £760 billion ($967 billion; €885 billion), according to a report by law firm Macfarlanes in conjunction with Montfort Communications. Investors are increasingly comfortable exploring an OPRE model, as reported by PERE last week, with risk appetite for the strategy expanding from value-add investors to core investors, and from emerging sectors to more traditional asset types.

However, the additional risks that arise when the income and value of a real estate asset is linked to an operating brand can be a sticking point for the lending community. As Macfarlanes’ report states, OPRE investments typically also have more occupiers and shorter leases than traditional real estate, making them inherently more risky and more complex than a property leased to an investment-grade tenant.

“If it’s an evolution in practices for managers, it also is for lenders,” says Nicole Mitchell, head of real estate strategy and policy at the London-based law firm. “You could say there’s a larger amount of work from a lender perspective, because you’ve got to look at both the real estate fundamentals but also the resilience and performance of the operator and their business plan.”

Manager Moorfield Group invests in traditional and alternative real estate in the UK out of its closed-end value-add fund series. Operational real estate is a key part of its opportunity set, having been active in student accommodation since the late 1990s, investing in build-to-rent for the past decade, and more recently investing in emerging sectors such as self-storage, single-family rental housing and student houses in multiple occupation (HMOs).

According to Charles Ferguson-Davie, chief investment officer at the London-based firm, some lenders are more comfortable with OPRE sectors than others. “But, in our experience, there are different examples of each type of lender in most sectors.”

He says Moorfield borrows from high-street banks, debt funds and insurance companies, and has noticed growth in the number of debt funds in the market over recent years.

“Higher funding costs have changed the value of assets and how much debt can safely be secured, and more operational real estate may carry some additional risks that might feature in reducing lender appetite compared with other assets that might have longer contractual income or less risk,” explains Ferguson-Davie. He believes the current risk-off environment also has a hand in this.

With OPRE, an asset owner is also more exposed to operational costs than with a conventional lease, where the tenant carries the risk from changes in operating costs. When economic conditions are volatile, operational real estate can benefit from inflation linkage and growing income, says Ferguson-Davie. However, operational costs such as energy and wages are also higher, and “uncertainty about these cost pressures is having a greater bearing on lending appetite at the moment.”

Worth the risk

However, many believe there is enough reward for a lender to compensate for the additional evaluation OPRE requires. “That extra work can be worthwhile, however, as lenders are getting a bigger margin compared with straight real estate,” says Macfarlanes senior consultant Robert Porter, who advises private equity real estate firms and other property clients on transactions that include equity financings.

Ferguson-Davie agrees: “If these risks are factored into the pricing and result in higher yields on cost, the cashflow cover for debt service can be greater in operational real estate depending on the sector.”

He says Moorfield has seen higher yields in nursing homes, self-storage and student HMOs.

“I’ve done deals with senior and mezzanine on operational real estate and they do work, they can be fitted together, but there’s a bit of learning on the way as to what changes there are from traditional deals,” Porter adds.

A lot of the characteristics of a typical real estate deal will have to adapt when an OPRE model is involved, according to Mitchell. These include the level of freedom required to run the operational business, given “lenders can’t have the same stranglehold on cash as in a conventional real estate deal.”

Porter agrees: “You can’t keep coming back to the bank for consent for daily management issues; you’ve got to put in processes whereby it can run smoothly. You have to try to keep that balance between daily flexibility and the banks retaining their secure position.”

A key consideration for accessing financing for OPRE deals is transparency, the report concludes. Occupiers and owners will need to provide clear and accurate information to lenders on the nature of the cashflows that will service the debt, including operational costs and potential income.

As for the lenders, despite the challenges and additional layers of complexity involved in OPRE, Mitchell says “it’s where a lot of the action is at the moment, so lenders are simply having to get their heads around it.”