March 28, 2023

Capturing the Operational Upside in Real Estate Investing

Success in operational real estate requires an ability to manage partnerships and risks that may not be familiar to traditional real estate investors.

As noted in a previous article, real estate investors are increasingly turning to operational assets because they can generate higher returns compared to traditional real estate investments. But investing in operational real estate (ORE) is more complex, and success depends on the ability to ensure the smooth operations of the investment, as well as the ability to assess and manage associated risks. In this article, we highlight some factors that are usually beyond the scope of traditional real estate investing but are important to success in ORE.

ORE investors not only have to assess the value of real estate assets but also the value of operating businesses that rely on the underlying assets. This involves evaluating the potential revenues, costs, and profits of the operating business. To do that effectively, investors must understand the nuances of different business models and subsectors, which can be subject to complex seasonal or business cycle dynamics, changing consumer preferences, or other factors.

ORE is management intensive by nature, and most institutional investors do not have the expertise or staff to manage ORE investments on their own. As a result, many enter into partnerships with third-party operating and management teams to handle the day-to-day business of their investments. Investors must be able to assess whether a potential partner can deliver stable cashflows over the lifetime of an investment. The ability to pick the right partners — and negotiate agreements that effectively identify and allocate responsibilities and liabilities — is critical to success.

ORE investments often involve purchasing an existing company and owning the assets required to operate a business. That may include acquiring employees, intellectual property, and material business contracts. The buyer could inherit all known and unknown liabilities of the target, including operating liabilities related to employment and pensions, litigation, regulatory breaches, and taxes. This creates additional transaction risks that necessitate broader legal, tax, accounting, and commercial due diligence.

To give a sense of the complexity, we highlight some important considerations in six areas:

  • Employment. Investors may have to assess employee contracts and transfer regulations, considering factors such as minimum pay regulations, pensions, holiday pay, and bonuses and incentive schemes. If the acquisition will be merged into an existing business, investors may need to consider redundancy processes and costs.
  • Intellectual property. Investors will have to consider whether acquiring an existing business gives them rights to the operating brand. Other questions include: Are brand names, logos, and other IP assets appropriately protected? Is IP owned by the business or by the third-party operator or a franchisor? Do any of the activities of the business infringe on the IP of a third party?
  • Data protection. It may be unclear who owns certain types of data. Does the ORE investor or the operator/manager own the customer lists and contact details of the ORE business? Who is liable if data has not been appropriately gathered or protected?
  • Regulatory restrictions. Some real estate investors might not be allowed to invest in operating businesses (e.g., due to restrictions in their fund documentation or statutory laws). This applies to German pension funds that are subject to the so-called “real estate quota.” Investors should analyze each proposed transaction to identify regulatory issues that may affect the deal. In some cases, acquisitions can be structured to comply with regulations (e.g., through carve-outs that put operational activities in sidecar investment vehicles).
  • Management incentives. The interests of the management team should be aligned with the interests of investors, whether through a management equity participation plan or some other long-term incentive plan.
  • Taxes. Income generated by ORE businesses may be taxed differently than standard rental income. Investors should consider tax structures (with input from relevant professionals) at the outset of each ORE deal.

The heightened need for robust due diligence, and the likely preference for larger partners that may be more financially stable than smaller players, may mean that ORE investors will tend to prefer portfolio deals or deals involving large, single assets over smaller investments. Regardless of deal size, those who understand the success factors will be best positioned to capture the full potential of their ORE investments.