How operational real estate is reshaping investment strategies
As part of our spotlight on ‘Navigating structural shifts’, INREV spoke with Mike Bessell, Chair of the INREV Operational Real Estate Committee, about the advent of more operational approaches to investing in European real estate and INREV’s work to help investors make the most of this evolution.
Mike sees a major driver of the growing interest in operational real estate (OpRE) to be the burgeoning attraction of newer niche sectors, many of which are sub-groups of the four traditional sectors (residential, office, industrial, and retail), but have a stronger operational element. ‘A typical example is student housing within the broader residential sector,’ he explains. ‘This is more operational in nature because, depending on the nature of the lease structure, the owner can relet each room, which individually accounts for a very small share of the total space, on an annual basis or even more often. Such exposures are attractive as the returns they provide significant diversification benefits against the traditional sectors, thus appealing to investors as they look to improve their risk return profile within the real estate space.’
Another factor that has supported the growth in operational exposure is the evolution of asset allocation techniques among investors. ‘A growing number of large institutions are moving away from a strategic asset allocation framework towards a total portfolio approach. The institution may no longer have a set percentage allocation to real estate, which the real estate team then looks to spread across diverse categories. Instead, each individual investment plays its own part in the portfolio, meaning that its expected risk-return characteristics are judged in their own right.’
Thinking specifically about the return component of this calculation leads on to another key reason for the growing popularity of the operational approach, namely the potential to find value and enhanced performance by harnessing the profitability of the asset operator. This is reflected by INREV’s definition of operational real estate as ‘an investment in a real estate asset structured so as to create a strong correlation between returns to the asset owner and the underlying operational performance of the operator or occupant.’ (Global Definitions Database)
Operational relationships cover the spectrum from wholly external operation to completely internal operation within the investor’s own organisation.
Mike explains that investors are looking for the upside returns that can be accessed by aligning with some of these operational elements. ‘Take the example of hotels. Investors can access this through a hybrid structure, where an operator pays a minimum guaranteed rent, but on top of that the investor receives a profit or revenue share that gives exposure to the upside of the performance of the hotel. This kind of investment is adding to returns as well as providing risk diversification, by increasing exposure to the operation of the building and the quality of the operator.’
However, he stresses that the ‘operational’ term can cover a wide range of leasing relationships, depending on the specific property type, as well as the investor’s return objectives. ‘This is not a binary issue,’ he continues. ‘Operational relationships cover the spectrum from wholly external operation to completely internal operation within the investor’s own organisation. The INREV OpRE committee has started to grapple with this diversity of relationships, because it has implications for best practice in terms of reporting, transparency, risk management and valuation. Investors need to understand the range of structures and how they work in order to assess what they can expect from each one.’
Mike describes the three different models of operational intensity that INREV has identified as follows: ‘The cleanest and easiest to convey is with a third-party operator, a completely standalone operational entity, though with some alignment with their profitability via a sharing arrangement. In the second type, the investment manager owns the operator and uses them to run assets across a fund or number of funds. And then there is the third type, where the individual fund or mandate owns the investment in the operator rather than the investment manager. In this last case, the operational upside is most clearly aligned with the return to the capital source.’
Operational assets are becoming an important part of mainstream investors’ portfolios.
The INREV OpRE committee has gone on to develop good practice recommendations for each of these models, which in turn are feeding into the latest update of the INREV Guidelines, currently in the consultation phase. ‘This reflects the fact that operational assets are becoming an important part of mainstream investors’ portfolios. Each of the three structures has its own advantages and challenges, so our aim has been to help investors understand how they work in practice rather than promote one approach over another. Then investors can reach their own conclusions about which will work best for them, depending on their investment strategy and regulatory domicile, for example.’
Another key issue that the committee has been addressing is valuation. ‘An important focus has been providing guidance on determining the value of the building on a standalone basis versus the incremental value that is contributed by the operational element,’ says Mike. ‘Valuing the operational part requires somewhat different cash-flow modelling to traditional real estate, but most of the larger international valuation firms now have specialised teams for this. Understanding how much the operational interest is contributing to the overall performance of the asset is clearly a necessity when analysing what has been gained by making this kind of investment.’
Mike is confident that the recent enthusiasm for OpRE will build further momentum. ‘I strongly expect that operational approaches will make even greater inroads within the more mainstream real estate sectors. The market’s more granular way of thinking will allow operational influences to permeate even more widely, combined with the structural shift towards a total portfolio approach that I mentioned. All of this is playing into the hands of this trend.’
Interested in learning more? Explore our Operational Real Estate theme page for all resources on this topic, or subscribe to our current spotlight on ‘Navigating structural shifts’ for updates delivered directly to your inbox.
