The COVID-19 pandemic has disrupted many things but the appetite for investing in operational real estate in the UK is not one of them. In this article, we examine the ways in which investors can engage with managers/operators to make the most of this opportunity.
Despite the impacts of the global pandemic, or perhaps because of it, we anticipate the demand for operational real estate will continue to accelerate. We are already seeing that, in a post-COVID-19 world, people are going to be demanding more from their property, whether that be individuals looking at new ways of living and working (remotely), businesses looking for greater flexibility and services from their properties to encourage employees to come back to work and needing to provide best in class working environments to retain staff, hotels looking to flex their space by offering rooms as temporary offices or combinations of various different users. All these demands are driving fundamental changes to occupier/guest/user expectations of services delivered as part of their property/accommodation requirements and the ways in which they are provided. All types of users are starting to view property occupation as buying a service rather than simply acquiring a space in a building. In addition, hotels and holiday parks serving the domestic tourist market buoyed by continued restrictions on international travel are seeing a surge in bookings and rates and therefore in returns, making them ripe for investment and acquisition.
All this growth presents more opportunities for the significant number of investors clamouring to access the operational real estate space. One of the drivers for this demand is that operational real estate is seen as offering higher returns than many traditional real estate investments. One of the reasons for that being that the operational nature of the business carries greater risk and the operational model comes with higher owner operating costs than the traditional model of holding and leasing property. An analysis of the breadth and quality of services gives potential occupiers greater scope to compare and contrast different offerings than simply comparing bricks and mortar which creates a further risk factor — if you don’t get your offering right then you won’t attract and retain the occupiers willing to pay the level of rents and fees needed to generate the expected returns. For many real estate investors, especially those transitioning from traditional real estate investments into operational real estate, one of the key factors to success is partnering with the right manager and appointing them on the right terms. Many institutional investors do not have the in-house capability (in terms of staff numbers or expertise) to be able to design, deliver and manage these sites day to day. Most therefore rely on third party managers and, as the hotel sector has known for some time, that choice can make or break your investment.
Not all managers are created equal. Alongside the growth in investors looking for operational real estate opportunities, the market has seen a similar growth in companies holding themselves out as managers and/or operating partners — everyone wants in on the game. New entrants to the manager market do not always have the expertise needed to deliver success. Many manager start-ups are founded around one key individual (or a small group) with experience in the relevant sector but there is still a need to be cautious, especially if the manager entity is in growth mode taking on multiple new sites — how thinly is that experience going to be spread? Radius restrictions, non-compete clauses and key-person provisions can all help here. Which is not to say that established managers are always a safe bet, especially in a fast moving market place. Just because a manager has a great track record of managing one particular asset class does not mean they are necessarily going to be able to successfully make the transition to managing other assets or mixed-use schemes. Established managers generally have established operating processes, can they flex those quickly enough to match the demand of the rapidly changing operational real estate sector?
Once an investor has identified the right manager to partner with they are generally well served by bringing in that manager sooner rather than later. A good manager will help with sourcing sites and do the heavy lifting on diligencing operational matters when acquiring an existing business. The manager’s input into design and development for a new build or the refurbishment of an existing building can ensure that the physical operational aspects work as efficiently as possible, saving the investor operational costs. Trying to save fees by delaying appointment of the manager is often a false economy.
Having identified the right manager and decided to bring them in early, the next questions are “what is the right way to contract with them?” and “How do you incentivize them through that contract to make your investment succeed?”
From an investor perspective, trying to follow the traditional property investment model and leasing the space to the operator may initially seem favourable. That is largely how the serviced office sector still operates with the provider taking a traditional fixed rent lease and therefore taking on the operational risk (although some providers in that space are now disrupting that model with turnover/profit share rents becoming more common and hybrid models differentiating between the core office space and other facilities that might be shared by other users of the building). However, even if the investor takes some risk by including a profit share rent and perhaps making a substantial contribution to fit-out/set-up costs and future capital expenditure, there is some insulation provided by the lease model. Inevitably that means the potential returns are lower — retaining the traditional leasing model means retaining traditional leasing economics.
In contrast to serviced office providers, the majority of hotel managers long ago transitioned to the ‘asset light’ model; few now hold property directly (whether on a freehold or leasehold basis) and this now seems to be the preferred model for most operational real estate managers, it seems unlikely that many operators would want to take on the risk of property ownership. A version of the hotel management agreement model is generally now found across the board. Under this arrangement the manager takes a much smaller risk than when taking a lease, though in return takes a smaller share of the income/profit. The low operator risk under the management agreement model does not however equate to no risk. Managers paid by reference to a percentage of income or profit have seen their fee income decimated by the COVID-19 pandemic, especially in the hospitality and leisure sectors where 2020 income all but disappeared, other sectors have also been hard hit. Will the pandemic cause operators to reconsider even that low level of risk and seek a fixed fee or minimum base fee?
One compromise between the serviced office and hotel extremes is the joint venture model. Requiring the operator to put ‘skin in the game’ alongside taking a management agreement is increasingly seen as important to demonstrate their commitment to the project. The amount of ‘skin’ is often very small, maybe as low as 2% of initial equity and in some instances is not even paid but loaned by the investor partner or offset against initial fees. In some senses such a joint venture may be more symbolic than a genuine risk share arrangement however, it does commit the manager more meaningfully to the project and can be used to structure more creative financial incentives.
From an investor perspective it is important your manager is properly incentivized to maximise income from your business. Incentive fees that ratchet up as profit increases, perhaps after delivery of an owner priority return, are a very common arrangement. A joint venture arrangement allows more creativity through promote structures that often reflect the performance of a portfolio rather than an individual asset and allow analysis of metrics other than income and profit such as IRRs. However, the COVID-19 pandemic has clearly evidenced that even the best structured business supported by the best operational manager can fail to meet budgeted performance targets. How then do you keep your manager motivated to improve your operational real estate business once it becomes clear that profit hurdles or promote thresholds won’t be met? As noted above, a re-assessment of basic fee structures may be one consequence of recent events. Ensuring managers have a guaranteed minimum level of income (and therefore something to lose if they are not hitting their non-financial KPIs) may provide that incentive. That of course places an even greater level of risk on the investor who has to fund those basic fees through periods of reduced income; this in turn brings incentive fees into the spot light — the manager cannot expect as larger share of the upside of good performance if it is not bearing the risk of poor performance.
Whilst financial provisions in the management agreements and joint venture documents are fundamentally important, the elements governing delivery of services should not be overlooked. Particularly over the next few years as the ‘new normal’ takes hold, flexibility and adaptability will be key. Property and operational real estate is in a period of flux — what seems like the right approach to service delivery now may look out of place in a relatively short period of time. Having a manager and a management agreement that can quickly adapt will be important. Both investors and operators will want control over the product and how it is delivered. For example, we have seen over the last year hotels adapt their operations to offer other accommodation such as temporary office facilities — who makes that call, the owner or the manager? Can either party force it upon the other? What if there is a need to fund substantial capital expenditure as a result? How does that impact fee calculations, especially in the short term whilst the new offering is being implemented? It is not unusual to have management fees escalate over an initial period as the business stabilizes but what happens if you are re-positioning under an existing management agreement? Ultimately there is only so much crystal ball gazing that can be done and only so much flexibility that can be built into management agreements and at some point both parties may need to come back to the negotiating table. That is perhaps an easier discussion if your operator is also your JV partner.
As the operational real estate market continues its rapid growth the relationship between investors and operators/managers will be key to delivering success. Such growth presents win/win opportunities for both parties, but only if you get your relationship right.