Cleo Folkes Kaushik Shah
Life is rarely simple, and often perplexing. Office property, like most other forms of property, is continually going through a transformation of what is needed by whom and how. Tenants, demanding changes to suit their needs, are in the driving seat and many landlords try to catch up with the demand.
Real Estate investment is more and more following an operational model rather than a bond-like investment delivering ‘fixed income’. Investors increasingly look for higher or diversified returns in an over-crowded market. They seek alternatives to offering longer leases in a world where traditional office, retail and industrial/logistics units have seen leases shorten dramatically since the 1980s.
This need for a stable income, a steady cash flow, low volatility and security of income is turned on its head by the new co-working & serviced office trend. Co-working has taken the office markets by storm in cities like New York and London: landlords are willing to let to them or partner with them, and for now tenants are keen to take space. Tenants are not tied in, so they are happy.
Co-working and serviced office space operators make money from operating margins and business mix: buy-in space in bulk and let to multiple tenant types at a steep mark-up. They offer space, convenience, a ‘community’, a service. The ‘members’ are willing to pay a substantially higher rent providing them short-term commitment and flexibility. They are packed into a room, with high membership rates like in a gym: probably they won’t all turn up at the same time. Each ‘member’ is given little space, and emphasis is placed on communal areas, events and apps to create a community and feed entrepreneurship and dynamism.
But how about the landlords and investors? What do they make of the ‘WeWork revolution’? Are they able to turn things round in their favour? Do they jump on the bandwagon, should they offer co-working space themselves? What’s the same, and what is different from standard office leasing? What should landlords consider? In this first article we look at the bigger, cyclical picture. In two follow-up articles we will look more at the operational realities, challenges and opportunities.
Back to the big picture and business cycles. The problem is how to see these operators from a landlord’s point of view. The co-working and serviced office operators take long leases, and in turn mop up demand from occupiers demanding flexible leases on short-term commitments. It is what keeps average lease lengths from shortening further for investor landlords. It halts downward pressure on rents, and some argue that is has extended the property cycle. The other factor is user-growth in the technology sector (for example, fintech-blockchain) and the advent of the gig-economy, having an impact on how space is utilised. A co-working type offering meets the requirements of that new type of enterprise. So, that’s perfect then, right?
Is it? There are various points where we feel unease with these co-working/serviced office providers. The serviced offices phenomenon is not new. Regus, now ‘updated’ into IWG, is bigger and much older than WeWork and the co-working phenomenon. Regus and other providers who have been through boom and bust cycles know how difficult it is to have long-term commitments and short-term income, both clearly not aligned. The short-term tenants scale back their presence or evaporate by going bust or having to change their business model.
Co-working operators flooding the market are attracted to WeWork’s valuation and brand recognition. As economic cycles turn, innovation slows, and supply outstrips demand, we fully expect these operators to struggle to deliver performance, given their high operational leverage.
The older, more mature providers like IWG are actually making a profit. WeWork is grossly ‘negative cash flow’ given its expansion phase aiming for scale and market share. WeWork is riding largely on the rent-free periods. What if there is a perfect storm of an economic bust, declining tenant demand and income, and rent-frees have come to an end, plus money needs to be spend on updating the furniture, fixtures & fittings?
WeWork has insulated itself by having rental guarantees provided by subsidiary companies – and I hear they replace even those with lesser guarantors once the rent-free periods have come to an end. Is that good news for a landlord? We doubt it.
So how does a valuer see this tenant? We hear that that having a small amount of co-working space added to an office building boosts value as it increases that building’s dynamism and helps attract other, bigger, steady tenants. But when the amount of flexible office space is over say 20% of space, it takes value off a building because of the above problems.
Landlords and Investors are faced with a world wherein some things don’t change much, like the location, build quality and sustainability of a building, whilst other things undergo rapid, cultural and structural change. Co-working operators are turning office landlords’ worlds on their head. Business cases are studied. Cash Flows and covenant strength are double checked. Heads are scratched. And wishful thinking continues.
Authors: Cleo Folkes and Kaushik Shah, who provides the course Deeper Understanding of RE Cash Flows, a course that looks into the many forms and functions of cash flows within the property industry and how they fit into the decision making process. Real life is complex, and this course provides rare insight and an overview.