Dependable income generation is one of the factors that has helped draw institutional investors to commercial real estate in recent decades, on both the equity and credit sides. Financial institutions have long coveted 25-year tenancy agreements with blue-chip occupiers and have tended to judge credit quality on the covenant of a high-quality corporate tenant, as well as the underlying asset value.
However, the pandemic has revealed how exposed commercial landlords and investors are to societal changes driven by digitisation and the environmental, social and governance agenda. It has also left many facing the financial fallout from the pandemic, with some £6 billion (€7 billion) of unpaid rent built up during the pandemic in the UK, according to a May article in the Financial Times. How the industry works out the current arrears situation will be one of the most interesting case studies in real estate history.
Therefore, if anything has shattered the already diminishing illusion of blue-chip tenant covenants being a barometer of credit quality, the pandemic has. So, where will institutional capital go to seek safe haven returns and steady yields?
For many, the answer is likely to be operational residential assets. Historically, so-called ‘beds’ sectors have seen a smaller proportion of institutional investment because they lacked scale and investment-grade platforms to invest in. But that is changing. Capital has been diverted from sectors such as retail and offices into residential and student housing, which continue to offer strong and somewhat safer returns.
Purpose-built student accommodation is the biggest and most mature of the operational residential opportunity sets, representing 11.6 percent of total investment volume market share across the UK in 2020, ahead of multifamily (9.6 percent) and hospitality (3 percent), according to Cushman & Wakefield.
The UK build-to-rent market, including co-living as a sub-sector, is also on a strong growth trajectory with 36,000 homes under construction and a future pipeline currently standing at 94,700. Savills data shows £1.2 billion was invested into UK BTR during Q1 2021, the highest first quarter on record. The UK’s retirement housing sector is also primed for expansion, with Savills estimating in 2019 that, at full maturity, the sector could be worth £244 billion. Credible operating platforms have emerged, with experienced management teams, lean digitised operating models, and compelling branding.
Lenders and investors are beginning to appreciate the underlying demographic drivers which are making these sectors so attractive. The growing number of full-time students means PBSA will continue to prove a robust category, while an ageing population with vast stores of housing wealth has led to ever-increasing demand for retirement housing. The significant costs associated with buying a new home, and the more transient nature of work, means that people are renting for longer.
Significantly, BTR and retirement housing, including later living, remain relatively nascent sectors, meaning there is significant room for institutional capital to increase its role in financing new development, and operational assets. Such sectors have significant lifestyle benefits for occupiers, giving rise to the phenomena of ‘living as a service’, with flexibility, convenience, communal amenities and digitised services at the core, all underpinned by forward-thinking design and specification.
Sustainability is an important incentive that will accelerate the inflow of institutional capital into these operational assets. Most private equity sponsors, banks and non-bank lenders want to invest in assets that perform well against ESG metrics. This is both for risk management reasons – such as reducing the ‘stranded asset risk’ of obsolescence as regulations and occupier expectations change – and out of wider corporate commitments and reporting obligations on sustainability.
Operational residential providers are perfectly placed to integrate ESG standards into their offerings. New developments can be designed with sustainability standards in mind to increase energy efficiency and reduce carbon emissions. Operational residential units are perfect for modern methods of construction – reducing their environmental impact, minimising disruption to the local community, and expediting delivery. The sharing and access to social capital made possible by urban co-living assets encourages reduced consumption. The community aspect of these types of properties facilitates inclusivity, as well as being perfectly poised to facilitate the hybrid live/work/study social change that will no doubt be a lasting legacy of the pandemic.
A combination of societal changes accelerated by the pandemic, the appeal of safe-haven income-generating assets, the opportunity to invest in well-performing markets at an earlier stage of their maturity, and strong sustainability credentials will continue to fuel further inflows of institutional capital into residential operational assets in the post-pandemic world.
Randeesh Sandhu is co-founder of Précis Capital Partners, a development financing platform focused on the UK residential market, which launched in March 2021 with the backing of private equity firm TowerBrook Capital Partners