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16 May 2024

Investment Models for Operational Real Estate Assets

Investors typically select an integrated, third-party, or franchise model, depending on their objectives and factors related to their particular market and sector.

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Investing in Operational Real Estate

Our series of article explores opportunities for investors to create value through operational real estate.

The growth of operational real estate (OpRE) is one of the most significant recent trends in global real estate markets. OpRE is relevant to a wide range of real estate asset classes and subsectors, and an increasing number of diverse investors are attracted to the strategy.

Compared with traditional real estate investment strategies, OpRE has historically been considered higher risk because the investments are more complex and often opportunistic, but a key driver for investors is the potential for higher returns on invested capital because the investor assumes more of the operational risk.

Success depends on selecting the right investment model for OpRE assets, given investors' objectives and sector dynamics. Some models simply link lease rates to operational performance, and investors have virtually no role in running the operations of the underlying real estate asset. Other models enable comprehensive management of the operations. Most lie somewhere between these two poles, with investors taking some role in operations, whether directly or through a third-party specialist operator.

Below we review the investment models that private equity real estate investors typically use for their OpRE investments. We also highlight some key drivers and determinants that affect which model investors select, and we provide some guidance on which models are used most often by sector.

OPERATING MODELS

In the following sections, we show typical configurations for integrated, third-party, and franchise models, with some variation in each.

Integrated Model Trade and Real Estate Combined in a Single Vehicle
Opco and Propco Split into Separate Vehicles

Third party operated model leasing
Third party operated model external operator

Franchise model within an integrated operational real estate business
Franchise model with a third party operator

Drivers and Determinants

Nascent vs mature sector

The latter typically means more operators so less need to tie the operator to the investment, i.e., pointing to a third-party operated model vs an integrated model.

Scale of the investors holding/strategy

Less scale implies less sense in internalising the operating components; an external manager model may be more cost effective.

Structural Inhibitors

Investors such as REITs or UK pension funds are limited in receiving non-property (i.e., trading) income and investors such as German regulated investors are subject to regulatory constraints on assuming operational risk; this will drive such investors more towards a third-party operated model.

Investor risk/reward profile

Spectrum from lease (lower risk, lower reward) to third-party operator (medium risk, medium reward) all the way to an integrated model (higher risk, higher reward).

Operational and capital expenditure

Where a significant operational and capital expenditure is required, the operator will require a greater degree of permanence, pointing to integrated or lease structure vs external management model.

Exit strategy/investor profile

Whether investment is held on balance sheet or via an open-ended fund, termed JV or closed ended fund. Investor ownership time horizon will inform investment model (e.g., to preserve operational continuity).

Valuation Impact

Differing valuation methodologies and brand/IP value will drive the choice between a scaled integrated model or franchise approach.

Tax Efficiencies
Certain tax considerations may drive the choice of model e.g., an opco/propco split may deliver VAT and wider tax benefits, but where the trade is more valuable than the real estate, combining both in a single vehicle may yield tax savings, particularly on exit. 

By Sector: Typical Operating Models

The importance of the drivers and determinants vary by sector. We highlight the factors that matter most for each sector below – and we identify which models tend to work best in each sector as a result.

Sector Drivers and Determinants Typical Operating Model
Healthcare (including hospitals and behavioural health facilities etc.) Highly regulated sector requiring specialised operational expertise and investment in special capital equipment. Integrated model or third-party operated model (leasing to a specialist operator).
Purpose built student accommodation (PBSA)
  • Sector characterised by heavy undersupply of stock so a focus on development/opportunistic investments in key university cities/towns.
  • Increased focus on brand building and “hotelisation“ (and potential value upside in doing so).
  • Capital intensive as the real estate is “purpose built” but a relatively mature sector with good availability of experienced operators.
 Integrated model or third-party operated model (appointment of an external manager).
Data Centres
  • Nascent sector servicing the growing demand for space for IT infrastructure in the digital age.
  • Capital intensive with high barriers to entry.
  • Requires specialised operational expertise and investment in special capital equipment.
 Integrated model or third-party operated model (leasing to a specialist operator).
Hospitality and leisure (including hotels, holiday parks and members clubs)
  • Management intensive with a range of revenue streams from ancillary offerings (e.g., food and beverage, events hosting etc.).
  • Mature market with heavy focus on branding.
 Franchise model (alongside either a third-party Operated Model (appointment of an external manager) or an integrated model (typically with an opco/propco split)).
Co-living
  • Nascent sector driven by the surge in demand from young professionals in large cities for quality and affordable housing.
  • Capital intensive (due to the need for ground up development) and (like PBSA) a focus on / potential benefit in brand building.
 Integrated model.
Build-to-rent (BTR)
  • A mature market in countries like the U.S. and Germany but a relatively nascent market in the UK.
  • Addresses the problem of housing demand continuing to outstrip supply.
  • Capital and management intensive.

Integrated model or third-party operated model (appointment of an external manager).
Self-storage
  • Rapidly maturing market catering for users who hire the self-storage units on a short-term basis. Sector characterised by a high turnover of users (similar to hotels).
  • Management intensive and (like PBSA and co-living) a focus on / potential benefit in brand building.
 Integrated model, third-party operated model (leasing to a specialist operator) or franchise model.
Co-working
  • Nascent sector driven by the surge in demand from small businesses and startups for flexible office space on more flexible rental terms than conventional leased office.
  • Management intensive and (like PBSA and co-living) a focus on / potential benefit in brand building.
 Integrated model or third-party operated model (leasing to a specialist operator).
Life sciences
  • Nascent market servicing the growing number of life sciences startups driven by the global boom in spending on pharmaceutical R&D in the wake of the Covid-19 pandemic.
  • Capital and management intensive with a requirement for some specialised operational expertise and investment in capital equipment.
 Integrated model.
Senior Living
  • Nascent market in the UK (more mature in other countries) driven by shifting demographics in the UKand Western Europe coupled with chronic shortage in purpose-built retirement housing.
  • Capital and management intensive with a requirement for some specialised operational expertise and investment in capital equipment.
 Integrated model third-party operated model (leasing to a specialist operator).

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