Next Gen Real Estate: Yesterday’s Real Estate vs. Tomorrow’s
Authors: Daniel Fetner, Ryan Freedman & Adam Donahue
This is the second post in Alpaca’s ongoing Next Gen Real Estate Series. Missed the previous post? Read it here.
Unpacking Yesterday’s Real Estate
When most investors hear the term “Real Estate,” a few adjectives generally come to mind:
- Tangible asset class
- Uncorrelated
- Stable
- Cash-flowing
- Tax efficient
It’s a term we naturally associate with imagery of city sky-scrapers, garden-style apartments, the retail store down the street, or perhaps the data center that’s recently been built near your home in the suburbs.
But today there’s so much more to Real Estate than these traditional adjectives and associations. What about electric vehicle charging stations, glamping destinations, co-warehousing or tech-enabled single family rental platforms?
From here a key question emerges: can the Real Estate of tomorrow — enhanced by technology — provide the same benefits as yesterday’s Real Estate, but with more attractive pricing and increased alpha?
Before we get to the answer, let’s quickly review how capital has historically flowed through the sector.
Over the last several decades, low interest rate environments and high equity valuations have caused many investors to increase their exposure to alternative investments, with Real Estate being one of the most favorable paths towards achieving diversification. Throughout this historical pattern, we’ve seen allocators cycle through a number of different sub asset classes within Real Estate in order to achieve the most compelling risk-adjusted returns.
Framing the Real Estate Investing “Game”
Simply put, the ultimate goal is to find assets that are either mispriced or mismanaged, thus providing an attractive entry point, and then conservatively underwrite asset appreciation (usually due to a combination of macro tailwinds and fundamental improvements that can take place).
In many instances, one can look back and observe capital flowing from one asset class to another in order to achieve these attractive entry points, and appreciation potential. Seemingly we’ve seen the emergence of new investment products that, at one time, were not investable quickly become mainstream and institutionalized.
The pattern has typically looked something like this:
The Capital Allocation Cycle
- Low interest rates and high equity market valuations lead investors to seek exposure to alternative investments, in this case, real estate
- “Early adopters,” primarily family offices and HNW’s discover a new niche asset class within Real Estate (think student housing, cold storage, data centers)
- These early adopters work to find opportunities, and begin to deploy capital as pricing is more attractive vs. traditional Real Estate opportunities (think office, multi-family, hotels) due to capital dislocation
- Institutional investors (pensions, endowments, hedge funds, private equity), begin to notice the emergence of the “niche” opportunity and flood the sector with capital
- Investors typically enjoy multiple years, and often decades of asset appreciation and favorable exits
- Overtime, cap-rates compress due to supply & demand from capital inflows
- The cycle repeats and and investors begin searching for the next undiscovered asset class
Understanding Niche Asset Classes — We’ve Seen This Movie Before
Today it’s hard to imagine that an asset class as well known as Student Housing was once considered a “speciality” and “esoteric” investment. Yet if you rewind to the mid ‘90’s, you’ll observe two powerful trends that surfaced:
- First, university enrollments increased faster than their on-campus housing supply. RREEF and the National Center for Education Statistics have estimated that dorm capacity fell from 32.2% of total enrollment in 1990 to 24.8% in 2004.
- Second, the new residents (echo boomers) were very attached to their parents and more responsible and environmentally conscientious than their predecessors.
Several years later, endowments, pension funds and other institutional investors began to notice the opportunity to invest in student housing as a way to diversify their existing portfolio, which at the time, primarily consisted of the four main “food groups” of real estate (multi-family, retail, office, industrial). Why add this new asset class? A few reasons include:
- Low correlation with other assets in their portfolio
- Attractive yield
- Recession resistance
- Higher entry cap-rates
Prominent domestic investors — including Blackstone, AXA, CALSTRS, Harvard Endowment, AIG, and Liberty Mutual — have all been involved in student housing, as have international investors such as Canada Pension Plan, Government of Singapore Investment Corp and Abu Dhabi Investment Authority.
This same pattern in which we’ve outlined for student housing can be directionally applied to solar, cold storage, data centers, and senior housing, among others. There are obvious questions that follow:
- What is the next asset class to emerge?
- How do I know when I’ve found it?
As we consider these questions, we generally look for a few things that we’ll outline below.
How to Spot a Niche Asset Class
- Capital Dislocation: are the primary sources of capital small esoteric investors, such as family offices and HNW’s?
- Attractive Entry Points: when you compare the entry cap-rate to the closest adjacent asset class, is there a much wider spread (i.e. Glamping vs. Hotels)?
- Operational Inefficiencies: is there some sort of innovation taking place? Is there a new technology or solution that is causing the asset to operate more efficiently?
- Early Proof of Traction: while we like to be early to achieve maximum upside, it’s also good to know that there is at least some level of social proof amongst our peers. Perhaps the size of deals are not large enough for institutional investors yet, but they are at least sharpening their pencils and paying attention.
The Inflection Point for PropCo
While the term “PropTech” has been around for some time now, we believe we are at a critical inflection point within the sector. We’ve witnessed a quantum of institutional capital deployed across OpCo deals (venture backed, tech oriented portion of a real estate company); the primary source of capital has predominantly come from venture funds and traditional asset managers.
For examples of the “Tomorrow’s Real Estate” framework, see our previous blog post here.
While investing in traditional OpCo structures continues to be an innovative approach to achieving PropTech exposure (we do this through our VC funds), we are now seeing more and more founders bifurcate their capital structure to offer investment vehicles for both PropCo and OpCo. Here is the value-add for both companies and investors as we see it:
Benefits of PropCo Structure for Both Parties
Companies: By dividing their capital structure into two buckets, founders can continue using “traditional venture dollars” for OpCo items such as human capital, software, partnerships and marketing. In order to fund the expansion of their Real Estate portfolio, they can tap traditional real asset allocators for the PropCo portion, as it’s likely inefficient (and dilutive) to use venture capital dollars to acquire real estate. By taking this approach, startups are able to match appropriate cost of capital with the appropriate structure.
Investors: This structure allows investors to achieve many of the common benefits of real estate investments, but with more attractive entry points, increased efficiency through OpCo, and potential warrant exposure to generate alpha.
While Tomorrow’s Real Estate takes many different forms, the common theme across these niche asset classes is the ability for PropCo and OpCo to work in unison to achieve great efficiency and unlock value which is not possible through traditional real estate investments.
Stay Tuned
To learn more about the inner-connectivity and synergies the PropCo structure offers, we will examine the PropCo “FlyWheel” in an upcoming post.
Please Reach Out!
If you’re an entrepreneur considering a PropCo-OpCo structure or an institution exploring the PropCo space, please reach out to Daniel@alpaca.vc and Ryan@alpaca.vc. We’d love to speak with you.
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