This article is sponsored by Schroders Capital
The term ‘operational real estate’ refers to properties where the investor’s returns are primarily generated from the profits of the business conducted on the premises. Historically this definition was used for real estate such as pubs, care homes and cinemas.
However, as more investors see the benefits of having more control over the day-to-day operations in and around the real estate, the concept can and should be applied to almost all real estate.
James MacNamara, head of operational real estate strategies for Schroders Capital, the private assets arm of Schroders managing more than €20 billion of real estate, tells PERE how the model works and explains its increasing appeal.
How is operational real estate different from traditional real estate?
In traditional real estate, such as office or residential properties, the tenant’s ability to pay the rent is not overly reliant on their use of the real estate itself. Indeed, there are situations where a strong, creditworthy tenant may be willing to pay a rent higher than what the business conducted in the property alone can sustain – for branding or logistical reasons, or to control market share.
In most cases when assessing the value of a building, the investor is looking at the covenant strength of the tenant and the ability to relet the space when that tenant vacates.
In operational real estate, the investor should instead look at the underlying business conducted on the premises and think through how the asset can facilitate the tenant’s business to ultimately optimize income from those businesses in a sustainable way.
As such, the investor needs to undertake a more comprehensive underwriting and analysis of the operations of the building.
In today’s changing environment, where tenants think through different ways to live, work and play as a result of new market circumstances or changed preferences, property that was previously considered traditional real estate has become operational real estate.
How do you implement ESG goals in operational real estate?
In assets where we have more direct control or influence over the operations, whether we own and operate them ourselves or work closely with the manager, there’s a greater ability to really get under the skin of ESG.
For environmental goals, like many real estate investors, we have committed to achieving net-zero greenhouse gas emissions by 2050. Most landlords have already implemented energy conservation measures, such as LED lighting, optimizing building management systems and upgrading HVAC systems. For further gains, landlords and tenants will need to work together closely to share data on utilities usage – including electricity, gas, water and wastewater – and find ways to invest in long-term building improvements, such as solar panels and efficient glazing, while sharing the savings.
Looking beyond energy and waste considerations, having greater influence over the day-to-day operations can help drive the social aspects of an ESG policy. For example, our ESG agenda for hotels covers issues such as human rights, equality and pay policies, working conditions for employees, staff awareness training on sustainability issues, and guest engagement on sustainability and ethical marketing. Our ESG agenda also covers supply chain considerations, such as responsible procurement policies, plastic reduction targets, recycling targets, targets for local sourcing of supplies, and promotion of local heritage and culture.
Social benefits also drive good returns. We attract customers who are looking for companies who prioritize social issues and see evidence of this; we have higher rates of staff attraction and retention, and we improve our suppliers.
How has today’s changing environment affected landlord-tenant relationships?
The relationship between the landlord and tenant is no longer just regulated by the leased contract, but ultimately by how well the business of the tenant can thrive in the property. This new relationship, when managed properly by the landlord, can be beneficial for both tenant and landlord.
Landlords can provide more flexible lease terms to attract additional tenants including fitting out the space for the tenant and allowing tenants to release under-utilized space for alternative users. Landlords can invest in energy-saving measures that reduce tenants’ utility costs. Landlords can provide additional services, such as food and beverage, concierge services or shared meeting facilities. Landlords can upgrade common areas, basement space and outdoor areas to create a more appealing environment for tenants.
What lessons can we learn from the hotel sector?
Hotel landlords have various ways to manage their hotels, each of which has a different level of influence over the operations within the property. Some hotel landlords may prefer to lease the hotel to a third-party tenant who pays a fixed or variable rent. Other hotel landlords may sign a management contract with a third-party manager who operates the business on a simple fee basis for the landlord, with the landlord earning the remainder of the income. Other hotel landlords choose to operate the business themselves, giving them the greatest level of influence over suppliers, staff, interaction with local communities, choice of brands and marketing channels.
Schroders Capital manages 55 hotels across nine European countries with an in-house specialist hotel team of 40 professionals. For many of these hotels, we’re responsible for the day-to-day operations – ie, we’re both landlord and tenant. One of the benefits of being in this position is that we have greater flexibility to adapt the property in order to maximize returns from the business within the property.
For example, we’ve found opportunities to convert hotel rooftops into trendy food and beverage locations, convert basement space into private cinemas and use hotel common areas for co-working spaces that leverage other services, such as internet connections and food and beverage services.
Of course, operating hotels is not just about making the physical space more efficient. It’s also about providing an experience and connecting on an emotional level with the guests using interior design, staff, taste, branding, marketing, associations with musicians and artists, etc. Creating and providing these experiences requires a hospitality mindset that complements purely looking at the physical real estate.
Increasingly across all real estate, users are basing their decision to use that space not just on tangible factors such as location and lease terms, but also on less tangible factors such as being around a like-minded community, being able to enjoy additional services and ensuring the building is managed with similar environmental and social values to their own. These less tangible factors are well understood in the hospitality sector.