Real estate’s “SOS”: how to future-proof a major asset class

Owners and managers must focus on sustainability, operational excellence and finding new solutions (SOS) in management and investment, to keep pace with changing market dynamics.

03-13-2023
Multi-use office

Authors

Sophie Van Oosterom
Global Head of Real Estate

The passive ownership model of treating property simply as a space from which to generate contractual long term rental income returns is fast becoming a thing of the past. Forward-thinking investors today are adopting active ownership approaches to all real estate sectors.

Recognising the impact of the rapidly changing market environment on different regions, markets, asset classes and - above all - tenant demand is crucial. Only from there, can investment and management strategies be tailored accordingly.

Critically, there is a need for a client-centric, business-led approach that seeks to understand what role assets can play accommodating prevalent trends in society or business. The way assets are managed can contribute to the wellbeing and business models of their occupants. This needs to be understood and actioned to ensure long term sustainable income and value from these assets for owners.

This client-centric, business-led approach is also necessary to access the best investment strategies for a given trend. The chosen structure of the real estate investment, whether direct or indirect, via loans, or in the listed market, should depend on relative value, governance preference, opportunity and access to best operators.

Owners and managers should focus on three key areas both at asset and portfolio level, as well as to investing and management: sustainability, operational excellence and solutions that allow flexible contractual formats and investment structures.

We call it today’s real estate SOS.

Sustainability and operational excellence at asset level

Sustainability and operational excellence are often quoted separately, but in practice heavily interlinked at asset level. By its physical nature, real estate affords investors the ability to adapt and reposition assets for the modern world, to ensure they can be operated efficiently. This means running the assets to minimise use of scarce resources (like water and electricity), waste and carbon emissions, while contributing positively to business models of tenants and well-being of the ultimate occupiers.

This approach may require additional services, more intense management on the ground and/or additional capital expenditure to transition the assets to become more energy efficient. However, only when these elements are integrated, can the long-term relevance of the assets be secured for occupiers and can occupiers’ business models thrive (and thus their ability to pay rent). The consequence is long-term sustainable income and financial returns for owners over the hold period.

Solutions that are virtuous (rather than zero-sum) for tenants and owners

Providing different solutions to tenants and investors, aligning the assets operations and income ultimately with the success of the occupier’s business, makes all real estate investments operational in nature. Herein also lies the upside.

Many real estate investors and traditional bankers have been wary of the inclusion of more flexible, operationally aligned income clauses in contracts. This income is perceived to be more risky than income from bond-type, long-term lease contracts. However, in the current environment the owner already “owns the down-side risk” of a tenant’s business model not working well. A proactive, operational, hospitality-like approach - allowing for flexible terms to optimise income - should be seen as enabling a virtuous circle.

The benefits of running each asset as an efficient business by itself are obvious. Selecting and supporting tenants with more flexible solutions allows them to survive more volatile market conditions and changing societal demands. It helps tenants deal with higher (energy) costs, higher interest rates and increasing (sustainability) regulations. A partnership approach will likely optimise long-term sustainable income and value for both parties as bankruptcies, vacancy and obsolescence are prevented.

Understanding and managing real estate asset in a sustainable, operationally excellent, solutions model is a first step to creating a future-proof portfolio. It should be capable of delivering real performance through periods of economic volatility and market disruption.

The approach can also be applied to selecting investments and for portfolio construction. The same themes apply: align investments with sustainable trends and focus on operational excellence in the execution partner. A solutions approach can then be applied to find the best risk/return weighted, relative value investment strategies, that leverage the trends identified.

Sustainable trends at portfolio level selection

We currently consider four long-term trends that have a significant long term influence on the demand for real estate around the world in similar ways:

  • The interface for work has shifted, consolidating income and value in those buildings which address specific needs and evolving tenant preferences.

  • Shifting individual preferences, including lifestyle and consumption choices, have been accelerated by the pandemic, deepening disparities in demand between and within impacted sectors.

  • Rapidly changing demographic profiles are rebalancing the accommodation markets, with systemic undersupply in certain segments

  • Higher industry and regulatory standards demand a holistic investment approach to create positive environment and social impact to ensure circularity and prevent obsolescence

Aligning investment strategies to benefit from these trends ensures a market tailwind. It is easier to swim with the tide than against it, as the saying goes. Subsequently, selecting the best opportunities within these strategies requires careful assessment of which market segments offer best relative value. This must account for dynamics in each market, using a consistent risk/return framework to benchmark opportunities against.

For example, the theme of individualism is tightly interwoven with the continued growth of e-commerce. A logical real estate strategy benefitting from this trend would be investing in logistic warehouses. Many investors over the past years have done so, which has resulted in significant value increases. There has been some almost indiscriminate valuing of expected growth, to some extend beyond long-term fundamentals. The closest alternative investment strategies, involving investment in assets that facilitate assembly in the “last mile” or provide out-of-town convenience, are exposed to the same durable theme. However, these opportunities have been relatively overlooked and could provide better risk adjusted value.

Our proprietary relative value framework consistently compares risk and returns in various market segments against the benchmark-required Sustainable returns. It helps to spot outsized return opportunities.

Operational excellence in investments means finding the best partner able to execute on the specific investment strategy. The right partner needs to understand (local) supply and demand dynamics and be operationally embedded to service the assets. Knowhow on how long-term trends can be converted in a specific market, and how the performance of the investment can be best aligned with the occupiers business successes is key.

Lastly, when aiming for investment outperformance, different structured solutions should be considered to best cater to governance preferences, duration of the perceived investment opportunity, liquidity needs and market timing fitting the investment strategy.

For example, investments seeking to benefit from a short-term supply/demand disruption or a “fix/sell”, are typically better governed directly or in a short term, closed end structure. On the other hand, investments seeking to benefit from long-term structural trends are best accessed with low cost longer-term capital structures or partnerships. In addition, relative and risk adjusted value embedded in the explicit price of the various structures (think “potential overshooting” of long-term fundamentals in the listed market), are vital considerations.

Direct investments in assets can be combined with investments in open-ended funds, closed ended partnerships, listed funds or real estate loans. Ultimately, all investment structures provide access and exposure to income and value from real estate, that can benefit from the same underlying trends. Optimising and mixing various investment structures opens up the entire universe of real estate investment market, and allows for optimal access to operational excellence.

Philosophical discipline, flexible execution

As with all investment, success is not verified until it can be replicated. The SOS framework is designed to underpin every investment and our approach to asset management, in order to sustainably outperform our clients’ investments objectives over the short-, middle- and long-term. The approach is designed with a hospitality mindset. It is designed to be flexible, agile in operations and to ensure long-term partnerships with our stakeholders, including investors, tenants, society and the environment.

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The views and opinions contained herein are those of Schroders’ investment teams and/or Economics Group, and do not necessarily represent Schroder Investment Management North America Inc.’s house views. These views are subject to change. This information is intended to be for information purposes only and it is not intended as promotional material in any respect.

Authors

Sophie Van Oosterom
Global Head of Real Estate

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