Schroders Capital on why an operator’s mindset is key

This article is sponsored by Schroders Capital

The increasingly operational nature of real estate and the drive to environmental sustainability means asset managers need a pro-active approach to ensure buildings continue to meet the needs of their occupants. Providing these solutions requires a hospitality mindset that will be critical to reduce risk and add value in the current environment, argues James MacNamara, head of operating real estate at Schroders Capital.

How has the nature of value-add asset management changed over recent years?

Value-add asset management typically refers to the work done by an asset manager to reduce the risk profile of an asset and thus increase its value. Whether they are done for long-term investors or buy/fix/sell investors, these asset improvement strategies can be used in conjunction with liability restructuring and trading strategies.

In the past, this may have meant signing long-term leases to tenants with strong covenants. The asset manager would use their knowledge of local market demand to find suitable tenants who would lease the space, perhaps even with minimal fit-out.

Today’s asset manager knows that signing a long-term lease is not sufficient to reduce leasing risk. This is because the way buildings support the needs of their occupiers is rapidly changing, and asset managers need to adapt the building and the way it is operated, long before the expiry of the lease. Today’s asset manager needs to understand the tenant’s business model and ensure the building contributes to the success of their business. This may be related to operating the building efficiently to achieve sustainability goals, providing concierge-like services or ensuring the building contributes to the well-being of its occupiers.

Why should asset managers become more closely involved with the tenants?

Asset managers who understand how the building contributes to the business model of their tenants are better able to adapt the building to the needs of the occupiers, to find mutually beneficial gains and ultimately to add value to the real estate.

The way people occupy buildings is changing as a result of changes in technology, demographics, travel habits and, of course, sustainability concerns. As a result of these changes there are offices built only within the last decade that no longer meet the needs of their users.

To be able to contribute to the success of the business within the building requires asset managers to adopt a customer-centric, services-led approach. Tenants are seeking to share the risk of change with landlords through shorter leases, sharing of operating costs and even rents linked to the success of the business. At a minimum, asset managers need to ensure the building is operated efficiently and the functional needs of its occupiers are met.

Increasingly, asset managers are also expected to provide additional services such as shared meeting spaces, food and beverage offerings, leisure and well-being activities.

When such services are designed and operated well, they can be an important factor in a user’s overall experience of their environment and shift their focus from functional needs to emotional needs. Tenants may even see these services as contributing to their ability to attract talent, improve productivity and create a sense of community.

Does the asset management industry have the skills needed to meet sustainability challenges?

It would be great if the sustainability challenge was a well-defined engineering issue that could be addressed solely through executing capital expenditure projects. However, providing solutions to the environmental challenge is much more than this. Asset managers need to demonstrate, and report on, a wide range of issues at the asset level, at the fund level and on the asset manager’s own practices.

Case study

The Cloud, Amsterdam: Conversion of a 22,600-square-foot vacant building into a multi-tenanted, energy-efficient building with extensive amenities.

The team acquired a vacant office, designed for single-tenant use, that was not able to attract new tenants, and they repositioned it into a high-quality, flexible office that was able to attract TMT tenants. Central to the design was the conversion of the previously underutilized courtyard into an enclosed atrium where shared amenities could be provided. This area became a hub of activity with meeting rooms, restaurant facilities providing locally sourced food and a business center, staffed by ex-hospitality professionals, to provide concierge services and organize intra-company social and well-being events.

Energy efficiency was improved and operating costs reduced through the use of sun-reflecting glass façades, dynamic heat and cold storage, occupancy sensors linked to the HVAC, lighting systems and solar panels.

Reducing operational carbon requires multiple bespoke changes to the building itself and to how it is operated. These changes may be individually small and time-consuming to implement but collectively can have a large impact. Beyond physical changes, occupiers may require training to ensure an efficient building is operated efficiently. Assessing the impact of these changes requires extensive data collection, and interpreting this data in the context of how the building is being used at various times can be complex. This data-led process is important as investors and regulators want to know how efficiently the building is actually operating and increasingly no longer rely on a rating of its potential efficiency.

Those who oversee both the real estate and the business within it, such as hotel or student accommodation owner-operators, are well positioned to track a wide range of variables from the business and from the real estate. These managers are already very focused on using their data advantage to test the impact of various initiatives and training programs and to develop dynamic building management systems. The benefits of this optimization are both to reduce operational carbon and to improve the financial performance.

Asset managers are also reviewing their own processes to ensure they practice what they preach. Large teams of specialists are being hired to address processes around engineering, sustainability research, procurement, IT solutions, dedicated legal and HR resources, etc. Sustainability needs to be part of the culture with the processes embedded into every step of the investment, asset management and fund-reporting chain. The industry is certainly focused on the challenge and going in the right direction.

How will these value-add asset management skills translate into improved returns?

The current macro environment, with rising interest rates, stubborn inflation and the retrenchment of banks, may lead to some forced sellers of real estate.
In situations with multiple stakeholders where execution is complex and price is not the primary focus, this could certainly result in attractive investment opportunities.

“Reducing operational carbon requires multiple bespoke changes to the building itself and to how it is operated”

However, such situations are not common, and for the majority of situations where execution is more straightforward, the forced seller is still likely to find several buyers and thus achieve a fair value for the asset. Clearly fair values today will reflect all the known challenges ahead – including the availability of financing, inflation, supply chain disruption, sustainability requirements – and investors will want to see an attractive yield on basis rather than mostly relying on a capital value increase for their returns.

Outperforming in this vintage – ie achieving higher returns than the minimum return appropriate for the risk implicit in the business plan – is more likely to come from having a differentiated approach to asset management than from an unexpected improvement in the macro environment. Managers with a hospitality mindset to meet the operational requirements of the occupiers and to address the sustainability challenges will have a significant competitive advantage in this market.

How can real estate investors price assets when transaction volumes are low and there is so much uncertainty?

Pricing risk and return in illiquid markets is something all real estate investors should be comfortable with. The future is always uncertain even if at times it is thought to be more predictable.

There has been significant consolidation in the real estate industry and many real estate investment managers are now part of very large, global, multi-sector asset managers who are active across many markets and in regular dialogue with their institutional clients.

Pricing risk and return across so many markets provides insights on relative value and allows managers to adjust their minimum required returns for any asset, also in relation to opportunities in asset classes. Global investment committees ensure risk and return is priced consistently across asset classes and strategies, whether debt or equity, public or private markets, direct or indirect investments. Local and specialist teams provide additional insights and nuance.

Whilst this allows buyers to offer a price for an asset, it may not be at a level where a seller will transact. Low transaction volumes suggest there is a bid/ask gap, not that there aren’t plenty of buyers. At such times, sale comparables are useful but they are not necessary or even sufficient to price an asset.