WeWork and Other Shared-Office Providers Aiming to Reinvent How Office Leasing Works

 

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“A man cannot be comfortable without his own approval.” Mark Twain

 

By Randyl Drummer  March 24, 2016

Potential Benefits — and Risks — Seen as Corporate America Warms to Co-Working Concepts

One overlooked story of the tech- and energy-fueled recovery and expansion in U.S. office markets is the rising role of WeWork and other shared office providers, which have emerged as the largest single companies occupying newly leased office space.

 

New York City-based WeWork, the co-working startup firm which recently made headlines when its latest round of fundraising implied a valuation of $16 billion, is the tenant in 70 direct office leases totaling 4.63 million square feet, according to CoStar data. In New York City, where WeWork was founded in 2010, the company has signed 20 leases totaling more than 2.1 million square feet.

WeWork edges out Google parent company Alphabet, Inc. as the nation’s largest lessee of new space over the last two years, with 3.55 million square feet of new leases signed in the U.S. since the beginning of 2014, according to a survey of CoStar data for nearly 37,000 office leasing transactions for spaces greater than 5,000 square feet. Regus, a WeWork rival specializing in more traditional shared workspace, ranks a distant third behind Google with just over 2 million square feet.

WeWork co-founder Miguel McKelvey said last year he expected the firm to expand to 1,000 locations in coming years. The company has received over $1 billion in investment from Fidelity and T. Rowe Price Group and other investment banks. Major investors in WeWork also include Boston Properties Chairman Mort Zuckerman.

This month, WeWork recruited Cushman & Wakefield tech and media leasing broker Sean Black who arranged several deals in New York City for WeWork. Black was brought in to oversee new co-working locations on the East Coast as an executive vice president for WeWork, his former client, according to Crain’s.

The strong office leasing activity by WeWork and its competitors have helped fill the leasing gap in New York City and other big markets where financial firms pulled back in the wake of the Great Recession.

“It’s hard to measure exactly how much office space is being allocated to shared spaces and incubators rather than to direct leases,” said Andrew Davidson, managing director of MB Real Estate in Chicago, where WeWork and other co-working providers took more than 300,000 square feet in the CBD and signed the market’s three largest leases in 2015, with nearly 200,000 square feet leased in the first two months of this year. “Some say it eats away a little bit at what would be leased on a conventional basis, but at the same time, it’s a huge aggregator and magnet for companies and talent.”
Large Companies Find Synergy, Cost Saving
Similar to traditional shared workspace providers, the appeal is the flexibility they afford solo entrepreneurs, freelancers and temporary workers, as well as larger companies looking to enter new geographic markets without committing to a long-term lease or the expense of building out space. Co-working is becoming more of a disruptive force in well-established office leasing markets, similar to other sectors of the sharing economy such as Airbnb in the lodging sector.

“As companies become accustomed to such flexible real estate options, the existing leasing process will be seen in a new light,” MB Real Estate’s Davidson said. “Building owners may have to adapt to new tenant expectations in order to remain competitive.”

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Tech has been a major contributor to office leasing and job growth so far this cycle, so it’s not surprising that a disruptive technology like WeWork has emerged front and center, says Aaron Jodka, manager of U.S. market research for CoStar Group.

“While the life cycle of a typical WeWork member remains in question, tenants find value in the co-working space and smaller firms are likely to take their own office space as they grow and receive their own funding,” Jodka said.

One unknown potential impact is related to WeWork’s recent eye-popping valuation, which is helping to fuel its rapid expansion. There is some concern over the potential fallout should co-working startups and other venture capital-funded businesses encounter a sharp correction in the tech sector and sharing economy. The more office space WeWork and similar firms lease the more potential risk it creates for their landlords.

“Boston Properties can always sell a building to raise capital. But what would WeWork do if they start trending downward?” asked Paul Leonard, senior real estate economist for CoStar.

Leonard argues that WeWork’s thousands of memberships agreements, which amount to month-to-month subleases, result in operating fundamentals that are more like hotels with their measurements of average daily room rates rather than the office sector, where three- to 10-year leases are the norm.

“On a per-square-foot basis, WeWork is obviously charging a premium, making it extremely profitable in good times,” Leonard said. “But it has yet to be tested during a recession. We know hotels don’t do well during recessions. Since their leases are ultra-short, they’ll be the canary in the coal mine/”

Some observers have pointed to the past performance of Regus, the original re-lessor of office space and now a WeWork competitor, which nearly collapsed during the dot-com implosion 15 years ago and again during the Great Recession.

However, having a long-term lease to WeWork is no riskier than leasing to other startups or tech companies, and any closed branches would likely become sublease space rather than a direct vacancy on the books of the building owner, Jodka said.

Also, WeWork was founded in the aftermath of the last recession, just as advances in technology and changing corporate attitudes towards employees and contractors working remotely led to a groundswell of independent workers. Assuming that trends in shared office use continue, “there’s no reason to think their membership won’t hold up through the next downturn as well,” adds J.J. Sollazzo, real estate economist and senior New York market analyst for CoStar Portfolio Strategy.

Larger companies taking space at WeWork tend to be those more comfortable with technology. For instance, Microsoft Ventures, the software giant’s venture capital arm, maintains space at WeWork in Seattle for its workers, which also provides it a way to support startup companies in its portfolio and scout out possible investment opportunities.

A new report from CBRE Group, Inc. also suggests that cost savings may be a big motivater for large companies utilizing shared workplaces, as well as their appeal they hold for millennial workers in New York City, San Francisco, Los Angeles, Boston and other pricey gateway markets where office rents have spiked. A CBRE survey of large corporate occupiers found that more than 40% of respondents are using or actively considering shared workplaces, with a rapidly growing segment specifically eyeing co-working platforms such as WeWork, Grind and NeueHouse.

CBRE found that communal workspaces can save companies more than 15% in the first year of a 10-employee office requirement in Washington, D.C., compared with a traditional short-term lease of “plug and play” space. The average annual cost for the requirement in a co-working building is between $52,000 and $84,000, compared with $72,000 and $92,000 for a three-year conventional lease of 1,400 to 1,900 square feet, according to CBRE.

Beyond the per-square-foot cost savings, shared space may qualify as a business expense for tax purposes, rather than a lease liability on company balance sheets — a potentially important consideration as businesses adopt new accounting standards requiring lessees to capitalize leases in financial statements. Shared space also allows occupiers to occupy and exit space more quickly and reduce first-year costs for office fit outs, amenities and furnishings.
Co-Working Model Elicits Both Skepticism, Confidence
Because WeWork leased many of its inital locations shortly after the recession ended, it was able to sign its initial leases “at very tenant-friendly rates,” Sollazzo said. The company has a reputation for driving hard bargains with landlords, but increasing asking rents in the office market could squeeze the company’s margins in some markets when the economy slows down, he added.

For now at least, while tenants are available to backfill space if a WeWork client moves out as the economy continues to grow, “the next downturn will tell a lot about its resilience,” Jodka said.

Fitch Ratings said it is skeptical of WeWork’s business model and would probably become concerned if the company grew to comprise a meaningful percentage of a landlord’s annual base rents, Fitch Managing Director and REIT analyst Steven Marks said in commentary earlier this month. The ratings firm noted that, at the implied $16 billion valuation, WeWork is comparable in size to Vornado Realty Trust and Boston Properties, Inc., two of the largest and most established U.S. office REITs.

Some office owners argue that WeWork attracts a different pool of tenants, ones that may noty ordinarily work in those locations without the share-office structure. For Fitch, the shared workplace provider appeals to smaller start-up tech companies with weaker credit.

“WeWork’s business model carries higher risk than an office owner, as it is responsible for fitting out space and paying fixed rents, regardless of its own underlying occupancy,” Marks said, and echoed concerns that an economic downturn or a decline in startup funding could have on the shared-office firms’ customer base.

Several large office REITs are signing leases and forming development partnerships with WeWork, including Vornado Realty, which opened shared office space last month as part of a strategy to induce tech employees to live and work in the Crystal City neighborhood of Arlington, VA.

In partnership with Vornado, WeWork is expanding beyond shared offices inot residential. This spring, the two firms will open the first micro-apartments under WeWork’s new residential brand, WeLive, said Mitchell Schear, president of Vornado’s Washington D.C. division.

In New York’s Brooklyn Navy Yard, WeWork will occupy one-third of a 220,000-square-foot building at Dock 72, a project co-developed by Boston Properties and Rudin Management.

Not all building owners view the booming shared-office market the same. Empire State Realty Trust Inc. Chairman and CEO Anthony Malkin said during a presentation at last summer’s REITWeek meeting in New York that he’s skeptical of operations that employ free-lance and part-time employees.

“When these companies grow up, they will want a real building and a real landlord. They’ll need to get to meetings,” Malkin said.

Reflecting this traditional viewpoint, Malkin said Empire State Realty maintains a strong credit profile because “we lease to the right tenant and the right businesses.”

Editor’s Note: This is the second of a two-part CoStar series on shifting trends in the office workplace and CRE leasing markets.Last week:Talent Trumps Cheap Rent as Office Tenants Deploy ‘Smarter’ Workplac

 

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