Navigating the evolving leasing landscape

One of the key emerging trends in real estate in recent years has been the growing prominence of the increase in operational real estate across the sector.

By Penelope Rance

4 minute read time

Operational real estate refers to property assets where value is driven by the underlying business operations they support. While traditionally associated with alternative asset classes such as hotels and healthcare, the sector has developed more widely to include serviced offices, Purpose Built Student Accommodation, self-storage, outlet retail, last mile logistics, and Build To Rent (BTR) housing (both multi-family and single family).

There has also been an increase in its use within the more traditional sectors of office, retail and industrial. Due to structural changes and economic challenges faced in these sectors with landlords forced to be more creative to maintain occupancy levels in the face of weaker demand.

Changes in the leasing landscape are not new to landlords or lenders who have successfully transitioned from the traditional 25 year lease model to much shorter terms, now typically ranging from 3 to 5 years. However, the continued rise of operational real estate will require investors and lenders to further evolve their approaches as income becomes increasingly linked to business performance rather than fixed rent.

What’s driving growth in operational real estate?

Operational real estate now forms part of many balanced real estate investment portfolios. Peter McClay, Senior Director, Real Estate Finance at RBS International outlines “The increase has emerged for several reasons including investors seeking exposure to new and emerging sectors – it's often the only way to access these sectors.

Another attraction is the potential for landlords to be aligned with the performance of the asset and the ability for income to grow in line with operational revenues which can lead to higher returns.”

BTR is an example that has seen significant growth over recent years given the supply / demand imbalance in the residential market. “BTR lends itself to operational real estate where long term income streams should be fairly predictable because of the granularity and relationship with earnings growth” Peter adds.

Traditional and modern leasing structures

While there has been an increase in the prevalence of operational real estate, it still represents a relatively small portion of the overall investment market which remains dominated by the traditional rental model. However, it's important to note that the lease lengths have reduced significantly over the past 20 years.

As leasing models continue to adapt in response to market dynamics and evolving occupier demands, it is helpful to understand the different approaches currently in use:

Traditional lease model – fixed rent for a predetermined period. Subject to 5 yearly rent reviews if applicable. These arrangements offer stable income with minimal operational involvement from the landlord.

Base and turnover rent – combines a lower base rent with a variable element based on business performance. Potentially a tenant may pay more rent (than a traditional lease model) in a good year but less in a weaker year. The challenge for lenders is how much reliance to place on the turnover element, which is often assessed based on a tenant’s historical trading performance.

Operational real estate – rent payable is determined by the operational success of a business. It carries more risk than traditional property investments in the form of cashflow volatility. The risk migrates from credit risk on an underlying tenant (the reliance on the operator to meet their contractual lease obligations) to a business sector risk in relation to the performance of the business within the property.

Peter highlights “Investors and lenders have become more comfortable with the various lease types, subject to the asset history and or operator. However most prefer to have a balanced portfolio rather than one with 100% operational real estate."

Why are landlords and investors seeking operational real estate exposure?

Peter observes “Having spoken to several Institutional Fund Managers, many enjoy the close working partnership and alignment of success between landlord and occupiers leading to a strengthening of relationships. There is greater transparency surrounding the operational side of businesses. Any issues can be identified earlier and with intervention can lead to more positive outcomes.”

A further benefit is the ability to implement environmental improvements more regularly. As operators benefit from increased operational efficiencies, landlords see improved income as a result.

Traditional five yearly rent reviews could be contentious and slow to reflect market changes, whereas operational real estate often uses annual rental cycles which provides an opportunity for landlords to benefit from any rental growth more regularly.

Due to weakening occupational demand in the retail and office sectors, many landlords have become ‘accidental’ operational real estate investors. In an effort to retain and attract tenants, they are increasingly offering flexible leasing arrangements that support a diverse mix of tenants – allowing newer businesses to ‘incubate’ with little or no risk, while creating the potential for more established, long-term occupiers to emerge.

Challenges for Lenders

As with previous shifts – such as the decline of long term leases – lenders must adapt to take account of the increase in operational real estate.

Traditionally, real estate financing focused on all aspects of the property, both the occupational and investment aspect of the asset. This included analysis of underlying leases and the covenant strength of tenants. The certainty of income made it easier for lenders to underwrite the risk and provide financing.

With operational real estate, lenders must also fully analyse the underlying business including income projections and the operational costs involved within a business.

Peter comments “In many lending institutions there were separate teams to look at distinct sectors such as hotels or healthcare with traditional real estate dealt with by a separate team. Lenders will need to spend more time analysing the operational risk, which may not only require input from other credit teams but will also involve an upskilling of those lenders who have only focused on traditional real estate historically.”

An evolving approach

As the leasing landscape evolves, lenders are adapting their lending practices and risk assessment strategies, innovating in response to emerging operational risks and varied leasing arrangements.

Appetite for risk will, of course, vary. There remain lenders and borrowers who retain a preference for long-term income streams and lack an appetite for the additional risk posed by shorter-term leases or variable income. Others, however, are embracing the evolution. “We acknowledge the increased risk but believe that strong lender/borrower relationships and appropriately structured facilities for good assets in the right locations go a long way in mitigating it,” concludes Peter.

Please contact your relationship director if you would like to discuss any of the topics raised here.

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Navigating the evolving leasing landscape

By Penelope Rance

4 minute read time

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