Bruno Lobo • Managing Partner S+A Capital
A structural shift in real estate
A structural shift is currently underway in the real estate industry as institutional investors increase their portfolio allocations to the living sector.
The sector encompasses the full life cycle of rental accommodation – student housing, coliving, residential ‘built-to-rent’ (or multifamily), affordable housing, independent/retirement community & assisted living/care home.
The living sector has grown in the past decade from 14% of global capital flows in 2010 to 25% in 2020 and is expected to account for one-third of global direct real estate investment by 20301.
The built-to-rent subsector was the largest contributor to the growth of the living sector with a record $485 billion of investment globally in 2021, 30% higher than offices, the second-highest sector2.
The growth and institutionalization of the living sector have been driven by its ability to deliver stable income streams with the least volatile total return profile of any major real estate asset class and the second-highest average annual return in the last decade3.
The attractive risk-return profile and low volatility of performance capitalize on consumer demand for specialized living formats with age-specific amenities and customer service allowing for convenience, flexibility, and community building.
Changing consumer demand is driven by broader, long-term trends such as demographic shifts and technological innovations that, combined with decreasing housing affordability and increased mobility, are transforming working practices and lifestyles and leading to the ‘hotelization’ of residential real estate.
The pandemic has accelerated these trends and highlighted the sector’s relative resilience with robust rent collection statistics and flexibility to adjust lease structures and services to a granular and diverse occupier base.
As a result, 85% of institutional investors expected to increase or maintain their allocation to the living sector over the next ten years4.
However, the current inventory stock within the living sector is insufficient and inadequate to meet investors requirements and evolving consumer demand.
Given the lack of adequate supply, investment opportunities in the living sector will be driven by the development of new purpose-built projects with innovative products and tenure structures.
As construction pipelines accelerate and expand to new geographies, opportunities to gain exposure to the sector will increase.
The fundamental challenge for investors, developers, operators and consultants is to create viable living environments in target locations that best meet changing consumer preferences and deliver attractive risk-adjusted returns.
Opportunities & Challenges
Investing in ground-up development within the living sector presents unique challenges given the emerging business model, evolving characteristics of buildings and services, consolidating operating structures, uncertain regulatory framework, and immature capital markets.
As yielding assets, purpose-built projects within the living sector can generate rent premiums per square meter over existing stock.
They also offer opportunities to diversify revenue streams by expanding service offerings and monetizing common areas and amenities from residents and non-residents.
Flexible layouts and contract terms enable adjustments to changing market circumstances and evolving preferences throughout the building’s life cycle.
Capital structures are also flexible as investors can calibrate their exposure to the operational component of the projects through leasing or management contracts with the operators.
The sector also allows for risk diversification given the differences between subsectors, the granularity of the occupier base, and the drivers of operational margins.
The main challenges include increasing construction costs and schedules, uncertainty regarding the municipal permitting process, lack of sites at adequate land basis, and access to competitive forms of financing given the forecasted rise in interest rates.
In addition, each subsector has a specific and complex operational component that requires specialization and dedicated on-site management. There is a lack of operational expertise and specialized management companies/operators.
On the other hand, the sheer volume of capital seeking exposure to the living sector will lead to a decrease in target returns and the need for institutional investors to take on more development and operational risk.
The expected increase in institutional investment in the living sector will drive changes in the sector while accelerating long-term structural trends, including:
- Emphasis on operational component and customer service
- Integration and digitization of services
- Use of short-term let to fill-in voids and attract customers
- Flexible unit typologies and adaptable common areas
- Wellness lifestyle real estate & communities
- Greater proximity between operator and residents
- Merging of living subcategories into new evolutionary categories
- Incorporation of mixed uses and activities that attract non-resident customers
- Enhancement and integration of indoor and outdoor public spaces
- Focus on sustainability and biodiversity of buildings
- Progressive segmentation of the capital structure
- Larger-scale projects integrating various living subsectors
- Lower-densities projects in secondary locations
Building exposure to the living sector
Investments in the living sector require a thematic vision with a specific strategy for each asset and location that capitalize on the complementary aspects of each subsector and specificities of each project 5.
Vertically integrated development structures are required to create value throughout the project lifecycle from origination, conceptualization, financing, construction, and operation.
The drivers of demand and location requirements for each subsector require quantitative consumer specialized market research as there is often a lack of market data and the absence of benchmarks.
Site selection requires an understanding of real estate market dynamics and city planning strategies to source opportunities at appropriate land basis outside of urban centers in expanding areas with good accessibility and urban infrastructure that allow for the creation of new destinations within the city.
Local regulatory frameworks are also often absent or inadequate to the requirements of projects, requiring specialized expertise in planning, building, and rental legislation to obtain planning approvals.
Preliminary design studies must be advanced enough to allow for preliminary cost and revenue estimates that can support feasibility studies and explore the interest of operators and banks in financing the projects.
However, it is essential that the preliminary design is flexible enough to adapt to the specific business model of operators and end investors who typically already have predefined business models with established operational programs and requirements.
Therefore, it is necessary to work with architects and other consultants who have specialized knowledge of the sector and its business model, and a sense of the operational requirements and different needs of the target residents of each subcategory.
The rise in inflation and construction costs present a significant challenge that requires exploring new materials and innovative construction solutions that enable standardization and modularization of projects, address flexibility and environmental sustainability requirements, improve building biodiversity, and optimize their maintenance costs.
To mitigate potential cost increases and schedule overruns, designers, general contractors, and sub-contractors need to work together with ownership from the early stages of projects to jointly propose cost-effective solutions and value-engineer design proposals. Collaboration in the ‘front-end’ stages of a project helps maximize value and reduces financial and program risk.
To obtain bank financing, the risk factors associated with construction costs and leasing must be mitigated, which requires formalizing project costs and revenues and funding the predevelopment phases of the development with alternative sources of capital.
The complexity of operations and the evolution of resident preferences require specialized operators with on-site management teams able to curate activities that enable the creation of communities during the asset’s life cycle to increase the retention rate and attract new residents.
Creating communities requires spaces and experiences that encourage interaction among residents, which requires more than simply increasing the number of amenities. It is necessary to creatively balance the private and common areas of the projects to be adaptable, versatile, and change function throughout the life cycle of the residents 6.
The living sector has an attractive risk-return profile, with resilient returns and low volatility. Gaining exposure to this sector requires investing in ground-up development. Successful living developments require a vertically integrated structure capable of creating value and maintaining flexibility throughout the entire project life cycle to design and build communities that put wellbeing at the center of living and create new destinations in the city.
1 JLL. 2021. Growth opportunities in the Living sectors. (https://www.us.jll.com/en/trends-and-insights/research/growth-opportunities-in-living)
2 CBRE. 2022. Una Nueva Living. (https://elinmobiliariomesames.com/vivienda/una-nueva-vida-living/)
3 Savills. 2022. Multifamily attracts record global investment. (https://www.savills.com/impacts/market-trends/multifamily-attracts-record-global-investment.html)
4 Investec. 2021. Future of Living II. (https://www.investec.com/en_gb/focus/future-living-ii/future-living-ii-key-findings.html)
5 Heitman. 2017. Revisiting the Living Sectors. (https://www.heitman.com/news/revisiting-the-living-sectors/)
6 Hines. 2021. Living for the Future. (https://s3.us-east-1.amazonaws.com/hines-assets/documents/Living-for-the-Future-web_2021-11-09-171131.pdf)