Is coliving a good real estate investment?

To be completely honest, the global real estate industry has not yet settled on a definitive answer to this question and it will be years (or even decades) before we reach a general consensus. In the meantime, however, I’m here to convince you that coliving is an excellent real estate investment and real estate investors would be wise to get onboard the coliving train before it’s too late.

So what makes me so confident about coliving? For the record the opinions presented in this article aren’t meant to be professional investment advice, but over the past few years I’ve had the opportunity to learn about the coliving industry in a variety of ways that I believe when put all together have given me a unique perspective.

Last summer I spent the three months of my MBA internship visiting 30+ coliving locations across Asia and North America and interviewing hundreds of coliving professionals at those various locations. After graduating this past spring, I joined the executive team at Co-Liv, a global nonprofit working to empower the coliving movement, and was hired at Nomos Group, a real estate investment and advisory firm specializing in financing the coliving sector. I’ve also had the chance to work closely with Six Peak Capital, one of the first private equity real estate firms specialising in coliving with over 20 coliving properties in their portfolio today.

After experiencing coliving first-hand and getting ‘behind the scenes’ in the financial models, I’m even more confident in coliving’s ability to provide superior social AND financial outcomes for all involved. Many people are still unaware about the basic coliving investment thesis and with this in mind I hope to explain it at a very high level below. We’ll then review what I believe are the biggest financial challenges and best opportunities for coliving over the next decade.

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The thesis

Financially, the coliving investment thesis is quite simple. When compared to traditional residential real estate, the coliving playbook will increase Net Operating Income (NOI) by:

1. Increasing revenues through a combination of densification and the provision of a more social living experience for renters,

2. While marginally increasing the development costs or a denser building and the operational costs for a convenient, community-driven living product.

Obviously this is easier said than done, and the real secret to any investment thesis is how those returns are planned to be achieved.

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Increase Revenues

The coliving business model can increase revenues in a variety of ways, but the most important revenue driver for the biggest coliving players is densification. While not all coliving buildings are designed the same way, most coliving floor plans utilise 4-6 bedroom units that lead to much higher revenues per square foot when compared to traditional apartment buildings with 2-3 bedroom units. In many cases coliving densification simultaneously translates to lower chunk rents for each tenant, but up to a 50% increase in total revenues for the property.

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Marginally Increase Costs

The coliving playbook relies on larger upfront development costs (more bedrooms, more bathrooms, etc.) and higher operating costs to provide the convenient, community-driven living experience. However, as long as these costs can be efficiently managed during the development process and in the operation of the building, the increase in revenues should far outweigh the additional costs incurred.

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Increased NOI of 20-30%

Offering a higher density and higher quality living product while effectively managing costs can allow for a 20-30% increase in NOI (calculated as total rents minus operating expenses). In turn this leads to higher annual returns for investors as well as a potential uplift in property value assuming buyers value those cash flows in a similar way to traditional apartments.

So, the coliving playbook does increase development and operating costs when compared to traditional living solutions. Building more rooms, hosting more community events, and providing more thoughtful amenities comes at a higher cost. If executed correctly, however, the revenue uplift from densification will far outweigh these increased costs and lead to higher cash flows.

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Patient capital will be rewarded

The above is an extremely simplified way of explaining how coliving can potentially provide real estate investors with outsized returns in the short term, but the long-term value of coliving assets is a bit more complicated. Due to the capital intensive nature of real estate investing, many institutional investors are understandably very risk-averse and therefore wary of new innovative residential models such as coliving. This typically translates to lower valuations for a new real estate asset class until there are adequate amounts of performance data and sales to provide “comps” in a given sector.

So in the short term, real estate investors can be content with receiving a higher yield from coliving properties when compared to traditional apartment assets. In the longer term, however, investors will of course be concerned with the valuation of coliving properties upon sale. Put into industry parlance the question is: at what cap rates (total NOI divided by sale price) will coliving assets trade? Since there haven’t been sufficient major coliving asset exits we can’t be sure what future cap rates will be.

If coliving follows in the path of student housing (as many in the industry believe it will), however, we can assume that cap rates will eventually converge with traditional multi-family levels once more coliving performance data is available and the model is better understood. In other words, once the coliving market has years of data showing its relatively higher performance and the industry has some major sales to set benchmarks on how to value a coliving asset, institutional investors will start to view coliving as a more proven, and thus less risky investment. Once the coliving investment thesis is further proven out in the form of higher rents and NOIs, coliving investors can also hope to capture higher total returns in the long-term as coliving assets are valued more similarly to traditional residential assets.

What this means for investors is that if you’re hoping to invest in a real estate asset for a hold period of five years or less, coliving may still suffer from a lack of transaction data depending on what market you’re in. However, I believe patient capital - capital willing to invest in and hold a coliving asset for a ten year period or longer - will be handsomely rewarded with higher annual returns in the short term AND higher returns in the long-term as coliving cap rates potentially converge with those of traditional residential real estate assets.

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Challenges

Above we outlined one of the main financial challenges for coliving as an asset class: the uncertainty around valuation metrics. This challenge of uncertainty will inevitably be overcome in the next ten years as more data is collected on coliving performance and coliving assets start to transact. In addition to the financial challenges for coliving, I’d like to also highlight two other challenges for coliving as an asset class, namely market saturation and government regulation.

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Market Saturation

Around the world coliving companies are seeing excellent occupancy rates. There are a multitude of inputs which help to explain these higher occupancy rates (including the simple provision of a better living product), but undeniably one of the biggest drivers is the current mismatch between supply and demand driving the sector. While Cushman & Wakefield’s latest US report on coliving estimated that there are over 50,000 coliving beds in the pipeline, there are only around 8,000 beds currently in operation. Coliving operators can’t open properties fast enough as they don’t have nearly enough beds to take advantage of current demand. Common, the largest coliving operator in the US, has reported an average of over 20,000 inquiries per month across their 2,500 bed portfolio, while Starcity reported that they received 2,400 inquiries across their 500 bed portfolio in June of this year, even in the middle of a pandemic.

Although we don’t know when the supply will match the demand for coliving, market equilibrium will inevitably occur at some point in the future. If I had to guess, I would say that we are nowhere near reaching that equilibrium level, but it nonetheless will be a challenge for the industry when that moment does arrive, just as it has in certain student housing submarkets. Once supply catches up, the almost unthinkably high occupancy rates enjoyed by some coliving operators will fall, exerting downward pressure on rents, thereby decreasing investor returns.

At that point, coliving becomes just like any other real estate sector; dependent on the specifics of the market, sub-market, asset price, financing and efficiency of operations to generate returns; ultimately meaning the market becomes competitive and efficient. The most savvy and rigorous investors will generate excess returns vs. the market (by finding above average investment opportunities), while those with less acumen will suffer. An important factor will be working with a coliving operator that can efficiently manage costs while providing a top quality product.

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Government Regulation

Even the slow pace of change in the real estate industry can’t compete with the notoriously glacial pace of change in government regulation. In cities around the world most housing laws were put in place with the right intentions to respond to the specific urban living conditions at the time they were written. As decades pass and lifestyles change, however, city dwellers demand new uses from their urban environments than they did at the time those (now archaic) housing laws were passed.

As an innovative living model utilising different floor plans and a more hands on operating approach, coliving oftentimes faces regulatory challenges in efficiently executing its business model. For example in Chicago, building 4-6 bedroom coliving units can be a bit more difficult due to a law pertaining to door locks. If in-unit bedroom doors have a certain kind of lock they are legally considered their own apartment which can increase tax rates and parking space requirements to a level where a coliving model becomes economically untenable.

Oftentimes the default response of city governments to innovative real estate models is to maintain the status quo and resist change. While coliving may face short term challenges from unfavorable government regulations, I believe the lifestyle trends that underpin the foundation of the coliving movement - for example housing affordability, increased urbanisation and increased median age of first marriage - will require governments to react in more positive ways to update their regulatory frameworks to provide for various forms of coliving.

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Opportunities

We’ll wrap up our discussion on a high note by providing a brief description of some of the biggest opportunities for coliving investment over the next decade. Above we mentioned the immediate opportunity of higher annual cash flows for investors driven by the coliving model’s NOI uplift. Below we’ll highlight two additional opportunities for coliving investors which are conversions from other distressed real estate classes and the improvement of the coliving experience over time.

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Hospitality/Office/Retail Conversions

It’s no secret that hotels, office spaces and retail have had an extremely tough year as these asset classes are not designed to perform well during a pandemic. I’ve been on dozens of real estate calls over the course of 2020 and it’s rare that a call ends without somebody mentioning the opportunity for coliving investors to convert distressed assets into a coliving building.

At the surface level this makes sense - typically hotels, office space, and malls are located in high traffic,desirable locations that would also work for residential uses. In practice, however, there has yet to be any large-scale success for coliving conversions and at the time of this writing there haven’t been many distressed sales resulting in coliving conversions in these asset classes yet. The market seems to be waiting to see how things shake out post pandemic and what level of demand the ‘new normal’ will bring. At a high level I’m bullish on this ‘conversion’ opportunity, but it remains to be seen whether this will actually provide a sizable opportunity for coliving to expand its reach in desirable urban locations.

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Coliving Experience Improvement

Not to say that current coliving operators aren’t offering a quality living product, but we are only at the tip of the iceberg as far as the potential evolution of the coliving experience. It seems like every week there is a new communal living concept popping up across the world as innovators and entrepreneurs create new residential models that better fit the realities of the twenty-first century resident. As with any innovation, the early going is more of a shotgun approach and the best ideas and business models will percolate to the top over time.

People often ask: who is the Apple of the coliving industry? Who has cracked the code on a scalable, community-centered coliving business model that can develop a cult-like brand following and achieve peak profitability? The answer to that question in my view, is that the coliving industry doesn’t yet have an Apple quality brand or product and I’d say we’re pretty far from it. For overall industry growth this is excellent news as the market will test the various business models, the best operators will eventually outcompete the rest and the industry will likely see acquisitions (such as Starcity’s acquisition of Ollie earlier this month) and consolidation.

After experimenting with different spatial design models, identifying operational best practices and generally improving the coliving business model, coliving will develop consensus return benchmarks (e.g. expected IRR, yield on cost, etc.) and over time become a stable institutional real estate investment sector.

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Conclusion

While the pandemic has definitely constituted a vigorous and unprecedented test to the coliving model, I believe in the long-term these tough times during coliving’s infancy will help to create a leaner, more efficient industry model that will yield even better risk-adjusted financial returns for investors. The coliving operators that survive the challenges caused by the pandemic will emerge with stronger and more financially sound business models that rely on fundamentals rather than the magical valuation methodologies of the venture capital world to generate value for both their residents and their investors.

I’m also bullish that the coliving industry will be able to successfully navigate the challenges of the next decade while taking advantage of the opportunities caused by an uncertain economic environment to contribute to the best version of coliving evolving iteratively through competition. Hopefully this article has provided an insider’s perspective into the basic coliving investment thesis and helped to explain why real estate investors around the world are starting to hop on the coliving train.