Schroders= What real estate mgr need to learn from the hospitality sector post Covid

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The days when real estate landlords and tenants only communicated via a bank account are over. All real estate investing ultimately involves “joint ownership” of the operational risk of the businesses occupying the buildings, on top of the operations within the buildings.

Business has become more unpredictable, even without Covid-19 in the mix. The interruption of business and disruption of rent collection during the pandemic has exploded the myth that landlords are insulated from the fortunes - or misfortunes - of their tenants. Environmental awareness and responsibility increase the demands for efficient use of resources, particularly in the built environment.

As a result, intimate knowledge of occupiers’ business models, their success drivers, as well as their intended use of the buildings has become fundamental to investing in real estate. Operational skills and a “hospitality” mind-set have become crucial to managing and driving sustainable income and value creation.

An era of rapid change

The average age of companies in the S&P 500 index’s top 10 has more than halved since 2000, from 85 years to 35 years. This change is partially due to technological advances, the disruption of legacy businesses and shifts in consumer preferences. The average vacancy rate in European shopping centres doubled between 2015-2020. The amount of serviced office and co-working space tripled. European sales of electric vehicles have risen fourfold. Even food retailers are increasingly morphing into warehouses run by robots and software.

Given the fixed location and nature of real estate assets, the real estate market suffers particularly from these rapidly changing customer demand trends. E-commerce is severely impacting retail and logistics demand. Changing working habits require flexible working concepts. Changing health considerations are affecting user-density. New and demanding ESG regulation is impacting building development, operation and reporting requirements.

The hospitality mind-set

This new paradigm requires a completely different, hospitality-driven skill set from real estate owners and managers. Hotels have operated in this type of adaptive manner for years. Hotel owners know most “lease” contracts are only valid for the day. Room rates are set according to location, the nature of the occupant and purpose of their stay. Some rooms are used for meetings only.

Under such a model, each asset arguably needs to be managed as a business, rather than being perceived as a collection of lease contracts. This means optimising the building and services to cater to the tenant’s business model and sustainability objectives. The next step is to then find the best economic/contract model that works for both tenant and landlord. The model could and should be different for each tenant or tenant group, and dependent on the location of the building and its intended use.

A recent McKinsey study predicts that, as a result of new working preferences, the office sector may see total office demand shrink by 20-30%. Whether this forecast comes true remains to be seen. However, what is already clear is that there are many new ways of working under consideration. As result, the “standard office layout” is likely to change into many different layouts for distinct user categories. New offices could be a centrally located or high-end “client and brand” head quarters. They may be fully serviced and flexible community culture centres, or even a “15 minute city office”, i.e. decentralised satellites that can cater to integrated home and team meetings. Tenant agreements are expected to become more fluid and be driven by use – for example, individual rooms, long stay, conference centre or a monthly flex arrangements.

Demand for physical retail space has already shrunk by 15-20% across Europe, so this part of the market is a step ahead in this evolution. All new forms of contract coming out of the current lockdown situation should cater to the online/offline business models that successful retailers will have to implement, and thus be tailored to the specific use of the asset.

Is a property used more for branding, for distribution or rather for actual sales?
Will real estate be able to consider footfall as a key performance indicator and thus a basis for the terms of a contract?
Are shop locations mainly used for branding presence rather than actual sales?

Logistics space - although strongly in demand today - caters to various different industries and third party logistics and is subject to similar trends.

In short, real estate investors that work in direct partnership with their occupiers, with a hospitality driven mind set, are more likely to address emerging trends proactively. A more reciprocal arrangement can insert flexibility into space design, form of contract and user experience. As a result we would expect superior performance, both financially and in terms of ESG objectives.

What the new landlord-tenant relationship means in practice

So what are the key areas of required cooperation, and what will ultimately be the winning and sustainable model governing this relationship? Traditionally, the relationship between landlord and tenant has been viewed as a zero-sum game, with a winner and a loser.

How do you build a mutually beneficial partnership between building owners, occupiers and the environment, in a win-win situation? At the centre of this new form of cooperation is transparency and willingness to share.

Sharing of business critical information

In every negotiation stakeholders strive for their own optimal outcome, which is often believed to be to the detriment of the counterparty. However, as parties are driven by different motives and considerations, often both parties can benefit through transparently sharing objectives. If the asset owner better understands the crucial drivers of the tenant’s business success and receives timely information, it can tailor services, discounts and optimise contract terms along the life of the relationship. This contributes to both the tenant’s business survival and future development.

Sharing of operational data and costs

At a more granular level, increased sharing of data on the actual building’s use is equally important. Usage data can facilitate improvements in the building experience. It can ensure optimal use of space, minimise the use of scarce resources like electricity and water, minimise waste and cut carbon emissions.

The built environment accounts for 40% of global CO2 emissions. Some of this is a result of the use of building materials (embodied CO2), but a substantial part is due to operational use: cooling, heating and lighting. Both stakeholders should be willing to share the cost of improving the embodied carbon footprint at the original development, or making the building more energy efficient in operations. Using better insulation and alternative energy sources, such as solar panels, can reap benefits for both parties. Not only are emissions reduced, but utility costs are lowered.

Finding ways to consistently measure resource consumption in assets with multiple tenants without breaching privacy is also a key challenge. A range of technology solutions and mobile apps have been developed that control building access, provide directions to available desks and meeting rooms and allow people to control temperature and lighting.

These apps work in combination with sensors and controls built into locks, heating & ventilating equipment and lighting in a real-world example of “the internet of things”. Research suggests that staff who can control their heating and ventilation are happier and more productive. Detailed data on energy consumption can help building managers optimise heating and cooling and prevent waste, help focus the cleaning staff on hot spots and detect faults in equipment before they become serious. This leads to more reliable buildings, lower utility and service charges and ultimately prevents early obsolescence.

Rethinking the contractual relationship

Landlords and tenants should think more flexibly about the tenure, format and economics of a lease. This flexibility should not be limited to just the term of the lease or the adaptability of the space. As discussed earlier, the best economic model between landlord and tenant takes into account the true purpose of the asset.

As a result of the market shake up caused by Covid-19, landlords and tenants now have a second chance to optimise their relationship. Asset owners, slow to respond to new trends, lost ground to flexible office providers and other “asset-light service providers” who positioned themselves as middle men, ultimately at a higher cost to tenants. This ground can now be made up.

Turning over a new lease

The real estate market is rapidly changing and landlords need to adopt a full hospitality-led approach to asset and property management. Every asset must be managed as a business in itself to ensure longer-term income, value creation, limit carbon emissions and waste and prevent obsolescence. This will require more specialist real estate resource to drive operational performance, closer management of supply chains and investment in new technologies. Operational partnerships with the tenants are crucial to ensure environmentally-friendly and sustainable outcomes.

The real estate industry needs to follow the example of the operationally-savvy hotels segment. All stakeholders, including asset owners, tenants, employees and the environment can be serviced in the best way. The short-term costs of this proactive approach have to be shared by both landlord and tenant, but will be more than outweighed by the long-term sustainable benefits for all.

An era of rapid change

The hospitality mind-set

What the new landlord-tenant relationship means in practice

Sharing of business critical information

Sharing of operational data and costs

Rethinking the contractual relationship

Turning over a new lease

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