The incredible growth of co-working companies is changing the way many people work. With Vancouver and Toronto each having over 1.7 million square feet of co-working office space, it seems this trend is here to stay.
Flexible working spaces saw a surge in demand with the 2008 crisis, as companies like WeWork were able to negotiate attractive leases in gateway cities that were having trouble filling their vacancies amidst the global financial turmoil. This, coupled with the ongoing shift in work culture and the need for many companies to have flexible leasing options during hard financial times saw co-working firms experience tremendous growth.
Yet what started off as a service to small entrepreneurs and budding startups looking for flexible options has been attracting long-term corporate leases from Fortune 500 companies as well. As it turns out, it is not only small, nimble businesses that require an option other than five-year-minimum office leases. Increasingly, large firms are seeking co-working spaces as temporary solutions to their office needs before finding a longer-term location, as well as for testing a new market and having satellite offices for remote workers.
WeWork is on pace to hit $3.3 billion in revenue this year, with 40 per cent of that coming from large companies, including Amazon, Microsoft and Salesforce. In Vancouver, we see that exemplified with Deloitte Canada becoming the sole tenant of Spaces’ five-storey site on Granville while it waits for a new location to be ready by 2020. Similarly, Amazon is currently leasing 53,000 square feet from WeWork before settling in its future Dunsmuir Street location.
Despite the explosive growth of the industry, there are still concerns regarding co-working companies and their impact on real estate assets.
Most notably, $12 billion in private capital and eight years later, WeWork has still not turned a profit and is struggling to push through with its plans for an initial public offering.
Ironically, the reason co-working is so attractive is also its biggest challenge: lease flexibility.
Most terms that co-working firms have with the landlord are traditional office leases upwards of three years long, but their tenants are on flexible monthly, weekly and even daily terms. This begs the question: what happens in a recession when small firms struggle financially and large corporations downsize?
The concern is that the short-term, low-commitment tenants would downsize or outright leave their office locations due to financial constraints. To an asset manager overseeing office buildings, this adds uncertainty and doubt to the reliability of a co-working company as a tenant.
Value of commitment
This in turn brings out another question: how to assess value on a building with a co-working tenant?
Just as an office building with a long-term government lease would be priced differently if it was sold vacant, an investment property’s value may also be skewed with co-working firms as tenants. How do you measure and underwrite occupancy, capitalization ratesand expectations around tenant improvements?
Real estate services firm Cushman & Wakefield released a report last year that showed buildings sold with at least 40 per cent designated for co-working space between 2016 and 2018 typically traded at cap rates 50 to 100 basis points higher than similar properties sold within that time frame.
Cap rates reflect risk
The reason for higher cap rates boils down to risk and occupancy.
Buildings leased to co-working spaces may look full on the rent roll, but they may not necessarily be fully occupied. Additionally, landlords have to consider the potential for high costs associated with reconfiguring the co-working space back to a more conventional office should the co-working tenant terminate its lease.
With these concerns in mind, there are also benefits to the landlord for renting out to co-working companies. In addition to filling vacancies, co-working spaces also serve as incubators for smaller tenants that may grow to become long-term tenants at the landlord’s other locations. A growing number of property owners are also partnering with these companies to gain some of the benefits of the co-working leases while also shouldering some of the risk of the short-term commitments.
Flexible leases, office amenities, low-cost setup and a thriving business community: what’s not to like about being a tenant in a co-working space? As for the landlord, balancing the need to fill vacancies and achieving a reliable, profitable mix of tenants remains fundamental.
Ultimately, this trend is here to stay and more companies continue to show up with interesting concepts for co-working spaces, but an economic downturn could expose co-working challenges.
Marc Goffaux is the director of research at Hawkeye Wealth, a Vancouver-based investment firm specialized in private real estate opportunities in Canada and the U.S. He can be reached through hawkeyewealth.com