How have institutional investment strategies evolved?
Pre-crisis investment strategies were driven by cyclical pricing movements of the three sectors comprising over 90% of the existing real estate universe, office, retail and industrial.
During the GFC, it became evident that strategies based upon cyclical pricing resulted in pro-cyclicality
During the GFC, it became evident that strategies based upon cyclical pricing resulted in pro-cyclicality. Post-crisis, institutional investors reviewed their strategies, shifting to long-term fundamentals driving the economy and society. Rather than responding to change, investors anticipate it and evaluate its impact on the demand for, and use of, real estate. Cyclical pricing became a second stage consideration, followed by tactical considerations in respect of timing and changing opportunities.
Aligning strategies with long-term underlying mega-trends has enabled investors to identify new opportunities in both existing sectors, as well as exploring emerging sectors such as senior living, healthcare, student accommodation and science parks. A defining characteristic of these opportunities is that indirectly operational risk exposure is greater (Table 1). Managing this risk has implications for investment mode and/ or required asset management expertise.
What is operational risk exposure?
Operational risk is considered a component of income risk embedded in covenant strength . Traditionally, investors were less concerned with understanding the operational aspects of the business as the occupier is substitutable. Moreover, the market rent is not only determined by one business or sector but also depends on the location and building quality.
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Operational risk is considered a component of income risk embedded in covenant strength
In contrast, many of the new real estate opportunities depend on the operational success of their underlying occupiers. For example, investments in senior housing and nursing homes are often accessed through joint venture between a real estate investor/ fund and an operator in essentially and OpCo/PropCo arrangement. Real estate investors have increased exposure to the business of their operational partner both as a specific entity and to the sub-sector itself. Although this is reflected in relative pricing it requires investors and fund managers to understand and monitor operational aspects of the underlying business to mitigate risks.
The degree of increased exposure to operational risk varies across types of opportunity and also with the structure of investments . To protect investments, active asset management requires a more operational approach either directly, or through operational partners. For example, social and technological change is transforming retail to a sector focused on delivering experience and a sense of place, community and belonging. The investor’s role has evolved from passive to active and as the continuum extends, some investors are moving from active to operational, either directly or indirectly through the appointment of both service and technology partners.
The degree of increased exposure to operational risk varies across types of opportunity and also with the structure of investments
What are the implications for real estate investment?
Investors increasingly consider the operational business of occupiers underlying real estate investments. Investing directly with a self-selected operator and/ or in a joint venture arrangement is preferred for several reasons.
First, the operating occupier is considered fundamental to investment outcomes and investors prefer to undertake their due diligence on selected operator(s) and on-going monitoring/ management of the relationship. Second, within some sectors the investment opportunity is more extensive, encouraging direct relationships between operators and real estate partners to generate scale benefits. Thirdly, within some sectors operators are seeking real estate solutions that offer them security and certainty over a long-term horizon, matching long-term investors objectives.
Other large investors prefer to invest in these sectors through funds, benefiting from their specialist expertise. Given the legal requirements and risk structure of these sectors differ across markets, it is not practical or cost efficient to develop it internally. Instead, they focus on their due diligence and selection of managers and co-investors with comparable objectives.
Access to necessary expertise and resources is even more true for investors seeking exposure to niche sectors but lacking the scale of capital required to develop well-diversified portfolios. This makes non-listed funds an essential route to real estate investments for a wide range of investors.
Operation real estate is just one of the subjects touched upon in the Coming of Age: the rebirth and renewal of the non-listed real estate industry. Operational real estate risk will be the focus of the next INREV research paper, expected to be launched in September. If you would like to find out more about this new research or participate in the project contact research@inrev.org. Watch this space for further insights.