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Operate to accumulate: a case for re-evaluating real estate operating risk

Hotels, student accommodation and build to rent are becoming assets of choice for real estate finance deals, care homes are attracting a number of different finance investors, whilst the once mighty retail sector suffers and the office market grapples with Brexit uncertainty.

Hotels, student accommodation and build to rent are becoming assets of choice for real estate finance deals, care homes are attracting a number of different finance investors, whilst the once mighty retail sector suffers and the office market grapples with Brexit uncertainty. Phil Abbott real estate finance partner at Fieldfisher, considers whether a re-assessment of how we look at retail and offices in line with changing asset usage could rebalance the market.

In a polarised market for income-generating real estate, asset classification is becoming an increasingly problematic issue.

At two recent industry events, the Urban Land Institute (ULI) UK Conference and the CREFC Europe Spring Conference, the topic of re-evaluating traditional non-operating assets (such as retail and office space) as operating assets for the purpose of financing transactions featured on the agenda.

In his post-conference blog, ULI Capital Markets Chair John Forbes stated:

“[An] aspect that was a consensus view across the panel is that the nature of property is moving to a point where real estate investors need to take much more operating risk."

“Wherever you are in the capital stack, you need to have much greater understanding of the operational risk."

“The increased exposure to operational risk opens up new opportunities for some, as some long-standing market participants, such as traditional lenders find this more challenging.”

Operating assets, such as hotels and care homes, which rely on the trading provided in or through them to generate income, are valued on an "income basis" - the value reflecting the trading potential of the property concerned - and where lenders will likely set financial covenants on a both a loan to value and an EBITDA to leverage basis.

In contrast, generic property such as retail and office, which can be occupied by a range of different business types, has been valued on the basis of a "market" approach – and where lenders have traditionally employed, in addition to the loan to value test, an interest cover test based on net rental income (projected or historic) to finance costs.

The newest arrival in this area is built to rent (BTR) (also known as private rented sector, or PRS) accommodation – residential property that is constructed solely for renting from corporate landlords, often institutional investors, rather than sale.

The shift in deal activity towards operating assets has largely been at the expense of formerly prized retail and office space, which were once the two main planks of real estate investment.

The argument that retail and office should, in an increasing number of cases, be analysed as operating assets, given the rapidly changing ways in which these types of buildings are being used, is still nascent, but rapidly growing stronger.

Re-thinking retail

In the retail sector, the collapse of many big high street names has left millions of square feet vacant in what was once considered “prime” real estate – particularly on our once famous provincial "High Streets".

Of those established retailers who continue to trade, these companies are no longer signing up to 10+ year leases.

Retailers realise they have to be more nimble and be prepared to pull out of bricks and mortar shop space in favour of a warehouse-based online model, if warranted by their customers' shopping habits.

In some cases, usually those where relatively small units have become available, this exodus has led to an influx of “pop-up” retailers and leisure outlets – craft beer and vegan food shops being among some of the most ubiquitous examples – on short leases.

There has also been a radical and rapid rethink in the way these retail units are run, with much more focus on the customer’s “experience” and emphasis on interaction with knowledgeable staff about brands and products – as opposed to the self-guided retail model.

Large out-of-town shopping centres, where much of the retail malaise has been felt, are likewise being distinguished by the experience they offer shoppers.

Outlets which continue to attract high footfall are the centres with extra attractions alongside shops, such as trampoline parks, restaurants, cinemas and performance spaces, marking them out as “destination” shopping venues.

The off-beat office

The rise of a flexible working culture, combined with much better business tech in the UK, and increasingly shorter tenancies required by growing start-ups in particular, has also changed the use case for office space.

An obvious example of the response to this trend is the new breed of co-working spaces, with bars and pizza delivery points at their heart, but even traditional office blocks are making their space more malleable and attractive to tenants in a way that resembles an operating facility.

On-site or co-located services such as bars and canteens, roof gardens, showering facilities, bike stores and gyms are becoming common features in offices – add-ons which tenants would not put in themselves, but which they expect to be provided by landlords.

As companies are increasingly only prepared to sign shorter leases, there is pressure on landlords to keep refreshing and updating the offer to attract new occupants.

The clear message is that businesses are not looking for more space, but better space – this requires investment.

Implications for real estate financing

As retail and office landlords can no longer rely on security of tenure or the availability of tenants to take vacant space on traditional terms, there is understandable curiosity among real estate owners to adjust some of the terms on which properties are analysed and valued.

Suggestions put forwards at the ULI and CREFC conferences were that both office and retail need to be thought of as “live” assets, in a similar way to hotels, rather than static spaces.

From a legal perspective, this shift will be significant for how real estate is valued for how financiers structure deals and in particular how financial covenants are set.

The traditional loan to value test, which gives the lender some security if the value of the property falls that it can sell and get its money back following default, as well as provide cover for refinancing risk, will (subject to comments below) remain valid for most assets.

However, an interest cover test may not be so relevant, given the instability of income generation from real estate assets – operating or otherwise.

Alternative tests, such as debt yield - the net operating income of the relevant asset divided by the total debt  x 100 are considered by some as a better alternative - but it remains to be seen what the industry will adopt.

Perhaps most significantly for the real estate sector, it has been suggested that valuers will need to adjust their valuation methodology to reflect the way an asset is likely to be used and what income it is expected to generate.  So the loan to value test mentioned above is largely contingent on what RICS decide to do (if anything) regarding valuation methodology per asset class.  For the latest asset class, BTR, RICS have produced more sophisticated valuation methodology taking into account operating asset features – see link here.
Clearly, for those heavily exposed to the struggling end of retail real estate sector, it is in their interest to turn the market around with a new approach to valuations and financing.

Anecdotally, there seems to be palpable resistance – some active, some passive – to the suggestion of re-analysing traditional real estate as operating assets.

To some extent, there is a lethargy and ambivalence to change which affects many large industries dominated by a handful of big players.

On the other hand, valuers may be concerned about their liability for existing valuations for properties and what the ramifications will be if the assessment criteria are overhauled – noting the market practice has remained static for many years as regards traditional asset classes.

Perhaps the biggest change is a cultural one. In the absence of any legislation to force the industry to embrace new ways of thinking, any shift will have to come from within the industry.

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