In the search for stable and consistent long-term income, institutional investors and their appointed asset managers are becoming increasingly nimble at adjusting sector allocations to adapt to changing market conditions, Richard Cooper, Partner, writes in IREI (Institutional Real Estate Inc.).
Two property types have already become established safe havens for institutional investors. Industrial and logistics schemes, especially those with high ESG accreditations and positioned close to transport corridors, have benefitted with several institutional investors now forming joint ventures with established industrial developers. In addition, retail parks, which performed strongly during and immediately after the COVID-19 crisis, are now in demand, with many institutional investors divesting from traditional shopping centres into this sub-sector.
A somewhat less discussed area — which has seen a flood of institutional investment — is the living sector. One method to enter into this market is well established, wherein institutional investors wholesale purchase a large section of existing properties from a residential developer and then contract an operator to manage the portfolio on their behalf. KKR, Blackstone, and M&G Real Estate have all made significant forays using this model in the North American market, while Lloyds Banking Group’s Citra Living’s purchase of 600 homes from Barratt Homes in 2023 indicates single-family rental will become a high-growth element of the UK residential market.
On paper, this arrangement works smoothly for both parties. The addition of investor financing for the scheme significantly de-risks delivery for a residential developer, who previously would be expected to generate bridge financing themselves. For investors, using the in-house expertise of established residential developers or housebuilders allows them to avoid creating or acquiring their own residential delivery teams, while benefitting from the experience and economies of scale that housebuilders enjoy through large contractors and suppliers.
Many institutional investors, cautious about securing maximum long-term income, are now opting to involve themselves during the design and delivery stage, rather than purchasing post-completion.
A new model
This has led to the creation of a new partnership model of delivery. This model relies upon delivery partnership between an established residential developer or volume housebuilder and an institutional funder, either in a forward-funding or forward-purchase structure.
Within this model, an established developer leads on delivery, but with continuous oversight from the institutional investor. Upon project completion, the institutional investor takes final control of the scheme, normally appointing an operator to manage the new asset or portfolio. Though single-family rental is a growing sector that uses this model, institutional investors have been more rapidly entering the build-to-rent (BTR), later living, co-living, and purpose-built student accommodation (PBSA) subsectors.
As a consequence, the role of a development monitoring surveyor is becoming increasingly crucial in order to ensure alignment between the two different parties within partnership.
Reach beyond today’s requirements
Though both parties are often established developers or asset managers, potential misalignment often arises on both sides of the partnership, as investors try to align their accepted institutional standards, which are in place across all other asset classes and embodied in their systems and governance, with the procedures and processes traditionally used by housebuilders and volume developers.
These institutional standards are driven, in large part, by a different risk management approach, and insurance conditions, but also the source of their funding. Large pension funds and insurance companies often have a membership or market reporting requirements that steer them to adhere to much higher standards than are required by statute. In practice, this means they often require developers to deliver schemes based on the requirements that will be in place 10 years from now, rather than what is acceptable today.
For some residential developers and housebuilders, the normal model of plot-by-plot sales, and the reliance on the traditional residential market, has disincentivised them to go beyond what is required by statute. Upon the sale and completion of a unit within a larger scheme, day-to-day operation is largely out of a developer’s hands, and therefore, in the absence of any data indicating that consumers will pay a premium for a higher-standard unit, there is little apparent benefit from surpassing the legal standard.
The residential developer’s model has created well-established and easily replicated procedures to produce standardised residential units, which are highly liquid on the traditional market.
Institutional investors are often simply unable to supply capital, or financing, to projects where there is such a mismatch in both delivery and operational standards. Without external capital, these schemes will not be delivered. As such, residential developers have begun to raise their own bar to meet investor requirements with the unpalatable result of sometimes reducing unit sizes or numbers, or broadly increasing costs.
No longer a simple policing role
The role of a development monitoring surveyor is to highlight at an early stage where these differences may exist, assess the risk associated with these issues, and assist in navigating a path to reach a balanced conclusion, which respects a developer’s traditional approach but also tries to accommodate a funder’s requirements.
Gone are the days of a monitoring surveyor simply policing the process. Often this requires creating a hierarchy of issues within a scheme’s delivery. There may be the odd red-line issue, where strict alignment is mission critical, but for most issues a more solutions- driven approach may be required. Throughout a project’s delivery, a development monitor needs to understand that if a commercial scenario does not stack up, the chance of delivering a correct standard product is reduced.
Areas of potential misalignment exist across all aspects of a scheme’s delivery. One of the biggest areas of recent rapid change is fire safety, something that all institutions treat as a clear-cut issue. For example, following the enactment of the United Kingdom’s Building Safety Act (BSA) in 2022 and the subsequent creation of the Building Safety Regulator (BSR), institutional investors are now opting for much higher standards than are required by the BSA — cautious that future governments may enact more stringent requirements later on.
At a delivery stage, this could mean following the procedures required for a high-risk building for those under 18 metres (60 feet), or even for those assets not covered by the BSA (notably hotels), which may come into scope in the future and therefore have an impact on future disposal. During the design stage, this has led to consideration of second staircases below the statutory 18-metre (60-foot) minimum height, or a requirement for more stringent fire suppression systems in smaller schemes.
The procurement structure of residential developers also creates challenges, with many residential developers having tried-and-tested procurement systems that often do not involve a main contractor or traditional employer’s agent, which funds have always relied upon for issuing warranties to underpin any risk. Many residential developers use a form of management contracting, and in those situations, careful consideration of the funding agreement is needed to ensure that the overall risk profile and reliance package is acceptable.
Where do ESG considerations fit in?
From a sustainability perspective, longer-term investment decisions need to be underpinned by confidence in a product’s future liquidity, with statutory compliance inherently behind the curve in this regard when addressing rapidly evolving ESG considerations.
Rather than relying on pure statutory requirements, institutional investors now use forward-looking performance targets which take into consideration the latest climate risk forecasts from dedicated ESG consultants. These forecasts now include issues such as overheating, flood risk and more extreme weather events. Factoring in potential mitigation for identifiable future risks builds in resilience without necessarily affecting day-one costs, but this is predicated on a flexible approach to building design from housebuilder partners.
Similarly, in the race to net-zero carbon, energy strategies excluding gas and focusing on heat pump technology and renewables are the key to securing long-term asset performance, combining occupier demand for lower fuel bills with robust environmental credentials.
Missing these opportunities at the build stage risks significant future cost and disruption to address through retrofit.
Proactive alignment
Institutional investors are also looking for greater collaboration between housebuilders and dedicated landscaping teams.
The UK government’s introduction of a 10 percent biodiversity net gain requirement through planning legislation is a big step forward, addressing decades of decline. However this is still only applied to large developments. Meanwhile, institutional investors often mandate minimum gains of 20 percent-plus across all developments through the imaginative use of green walls and roofs, planting that thrives in tight urban environments, and small public pocket-parks, benefiting both residents and local communities.
In order to ensure this alignment continues through design and delivery, the monitoring team now needs to provide a much more proactive and solutions-based service — guiding decision making at each key moment, with an extensive knowledge of each party’s established procedures.
As this market grows, we expect the role and scope of development monitoring to expand and progress.
