The untapped potential in operational real estate

An operational strategy could unlock return premiums for investors across the risk spectrum, according to a report by law firm Macfarlanes.

Operational real estate markets in the UK could reach £760 billion ($967 billion; €885 billion) in size, according to a report published today by London-based law firm Macfarlanes, in conjunction with Montfort Communications, and seen by PERE.

The report defines operational real estate as an asset where income and values are linked to the performance of an underlying operator. Typically associated with operationally intensive asset types such as hotels, and more recently in emerging alternative sectors such as student accommodation and senior living, the report argues operational structures can be applied to traditional and emerging sectors alike to unlock potential returns for investors.

“The alternative sectors often grab the headlines, but a lot of the issues and considerations around operational real estate are increasingly creeping into the traditional sectors, where we’re seeing clients using operational concepts to try and revitalize assets,” Nicole Mitchell, head of real estate strategy and policy at Macfarlanes, tells PERE. “For example, could a specialist operator revitalize a shopping center with a more experiential approach to shopping, or can an enhanced service provision with a focus on wellbeing lure workers back to offices?”

Nicole Mitchell and Robert Porter
Macfarlanes’ Nicole Mitchell and Robert Porter have observed return premiums of 20-30 percent in operational real estate assets

Mitchell says the growth of operational real estate markets in the UK represents a natural next step in the evolution of real estate, as asset owners are increasingly practicing an active management approach to drive up returns. Where operational real estate investments are typically in the wheelhouse of the value-add or opportunistic investor, however, Mitchell is seeing appetite for operational strategies moving down the risk curve to core investors.

“Investors really need to focus on driving the income component of the return, with capital values being as challenged as they are. Operational real estate gives you the tools to do that,” she says.

Fund manager Hines, which has been investing in operational real estate for several years, set up its own operating company in 2017, Aparto, which manages 17 operational student housing assets across the UK, Ireland, Italy and Spain. According to Simone Pozzato, managing director and fund manager for the Hines European Core Fund, residential tenants are looking for a greater level of service than ever before.

“What this means is that the speed of change and increased level of services needed offer an opportunity to landlords who are willing to provide a set of services, together with the assets they are leasing,” says Pozzato. “Investors, on the other hand, find the higher income return attractive versus the traditional real estate model.”

Robert Porter, senior consultant at Macfarlanes, says he has seen premiums of 20-30 percent on returns for assets where the operational business was structured together with the real estate.

In today’s economic climate, where returns are being squeezed by interest rate rises, higher costs and declining capital values, managers are having to work harder to provide their investors with required returns. This could drive greater interest in operational models, says Porter, because of the intrinsic cashflow benefits derived from managing the operations as well as the real estate.

“In traditional structures you can have a nice long lease, but if the covenant goes, what do you do then? Operational real estate is attractive not just from the point of view of increasing the income, but also in potentially increasing the sustainability of that income,” he says.

The risk factor

That said, Pozzato says investors are taking a more cautious approach to exploring operational real estate opportunities in the current market context, considering whether the additional risks are adequately compensated and priced into the assets. “However, we’ve observed during the last 12 months that sectors like PBSA have proved to be very resilient.”

Indeed, being closer to the operational brand using the real estate requires a level of reputational risk that many investors are uncomfortable with, explains Mitchell, because with operational assets, the quality and performance of the operator also have to be considered.

While the level of exposure to an operating brand and its employees may vary, the different risks involved in operational real estate investments can be addressed with the right governance in place, she adds. Methods include operator due diligence, incentivizing operating partners, and monitoring them on an ongoing basis. Macfarlanes’ report details the specific risk considerations of each structure associated with operational real estate models.

The different risk profile and more complex due diligence required means some of the larger, institutional core managers may need to change their thinking to play in this space, adds Mitchell.

Pozzato says having an in-house operational team helps Hines to deliver on an operational level and provide higher income returns for investors without conflict of interest. “It is a huge advantage to have proprietary operational performance data when assessing and underwriting new asset level opportunities.

“Operationally, the margins for OPRE are very different to the traditional real estate models, and small increases in costs can impact margins and diminish returns for investors. Furthermore, the value of the asset and its operational integrity become enmeshed, and it’s not always possible to sell them together as a package deal, so exit strategies need to be carefully thought through at the beginning of the investment.”