The New Office Behemoth

May 2019 | Scotsman Guide
Lee Roberts

One of the most significant trends of the current commercial real estate cycle has been the rise of behemoth coworking companies. These global companies that provide shared workspace have transformed the way that office buildings are occupied and leased. In many U.S. cities, coworking landlords are driving the market and anchoring the most important new office developments.

Commercial mortgage brokers are advised to pay attention to this trend. The rapid rise of these companies in the U.S. market has bolstered office fundamentals, asset sales prices and commercial loan financing volume during this recovery. The questions are, will it last, and what will become of coworking companies and the office properties they occupy when the next recession hits?

Raising questions about the long-term future of coworking is a surefire way to start a debate among commercial real estate professionals. Many see coworking companies as classic disrupters, pointing to the significant improvements in flexibility and efficiency that coworking can provide.

Manhattan-based WeWork, which was founded in 2010 and will soon have offices in more than 30 U.S. cities, is the most visible coworking provider. The company is the largest tenant of office space in Manhattan, controlling 5.3 million square feet of space in the borough as of this past August, according to Cushman & Wakefield. WeWork’s major competitors, Luxembourg-based IWG (formerly Regus) and Sydney, Australia-based Servcorp also have large footprints in the U.S. office market.

Large amounts of coworking space have become available in major markets at an astonishing rate. These companies also have the backing of deep-pocketed investors. One of the major players in global finance, Tokyo- based conglomerate SoftBank Corp., for example, has invested billions of dollars in WeWork through a vision fund founded by SoftBank’s founder, Masayoshi Sun. “Detractors view the coworking companies, and WeWork in particular, as akin to the dot-coms that emerged during the technology bubble in the late 1990s.”

The next dot-com? Not everyone sees a bright future for these companies, however. Detractors view the coworking companies, and WeWork in particular, as akin to the dot-coms that emerged during the technology bubble in the late 1990s.

During the dot-com surge, the underlying technology may have seemed exciting and disruptive, but profits were elusive. WeWork reported losses, for example, of $1.2 billion in the first nine months of 2018, although its sales also increased during this period to $1.5 billion, according to the Financial Times. Critics of WeWork’s approach cite a certain arrogance reminiscent of that dot-com era: Anyone who questions its business model or valuation is branded as a Luddite, hopelessly unable to grasp the new reality.

Those with longer memories may recall that Regus — a pioneer in coworking and temporary office space — went public in 2000, only to file for bankruptcy in the U.S. in 2003. Although there are exceptions to this rule, many lenders will not allow more than 20 percent to 30 percent of a building to be leased to coworking tenants. On the landlord side, coworking tenants are sometimes asked for letters of credit or large security deposits.

Investors in these companies have shown more caution of late. SoftBank, for example, slashed its latest planned investment in WeWork from an originally planned $16 billion to $2 billion, the Financial Times reported this past January. This still leaves WeWork with a remarkable imputed capitalization of about $47 billion. By comparison, that’s about twice the $23.1 billion market cap reported this past March by Yahoo Finance for Boston Properties, which owns about 48 million square feet of office space — much of it Class A space in U.S. gateway markets — and has several other properties under construction or development.

WeWork has some compelling arguments to make in its defense. First, its sheer scale as a tenant gives it a certain market dominance. A WeWork lease brands a building as not only a Class A building, but also as fashionable and hip. Skeptics may say that WeWork’s customers will go back to their kitchen tables during a downturn. WeWork can respond to that claim by noting that more than 30 percent of its tenants work for companies with 1,000 or more employees. According to Entrepreneur, WeWork runs an entire building in New York for IBM, as well as Airbnb’s office in Berlin and Amazon’s office in Boston. This suggests that coworking is not a fad, but an important part of how the structure of the office market is changing.

There are two key dangers for the coworking brands. The first, and most obvious, is that they are leasing space on long-term leases and then re-leasing it on a short-term basis. WeWork’s tenants, whether they are Amazon or a one-person startup, use coworking space for flexibility. Flexibility to grow, to be sure, but also to shrink.

It doesn’t seem logical for so many large companies to seek short-term coworking space, rather than traditional leases, if not for the ability to rapidly adjust their space needs downward, if necessary. The best that can said about the outlook for coworking companies is that their performance in a broad-based downturn is still unknown.

The second danger to the coworking outlook might be more fundamental: If one agrees that coworking is here to stay as a permanent component of the office market, what particular competitive advantage do the big companies, such as WeWork, have? Most markets already have spawned local competitors and, in many cases, these companies predate the entry of the larger players. They are often in more transitional locations and frequently can undercut prices. In many new projects, developers assume a certain percentage of coworking space, but are indifferent about the provider. In some cases, the property owner believes that they can do coworking leases themselves, either directly or through a third-party property manager.

WeWork and other big global players in the coworking space say they are playing a different game than their smaller competitors. The local providers tend to serve startups and nonprofits, whereas WeWork or one of the other large global companies can meet the needs of corporate users that may be expanding simultaneously across a dozen cities. One should not forget, however, that the corporate users have alternatives to the WeWork model. A Fortune 500 company also can lease space directly with a big office real estate investment trust, such as Boston Properties, which owns their office buildings and is constructing more.

WeWork also may face other large competitors in the coworking arena. Real estate services companies, such as JLL, CBRE and Cushman & Wakefield, will likely be the next to aggressively enter the coworking space. They are best positioned to compete against the coworking providers for large corporate tenants. They already have the tenant relationships, know the demand, and have the best feel for supply. CBRE already has dipped a toe in the water with a new subsidiary called Hana.

So far, these large, decentralized organizations have moved slowly. But if coworking remains an important trend regardless of the economic cycle — as many think it will — the traditional players in the office market aren’t likely to stay on the sidelines for long. Coworking may evolve much like online brokerages did. The initial disrupters — E-Trade, TD Ameritrade and others — were expected to drive out the established players with a better, cheaper, more flexible model. Yet, the legacy stockbrokers like Morgan Stanley and Charles Schwab Corp. are still around and thriving.

Online brokerages were an important and exciting new advancement, but the innovations didn’t have to be provided by the upstarts. The established players absorbed the new technology and kept moving, making the end users the ultimate beneficiaries. Commercial mortgage brokers and investors should consider that the office market of the future will feature coworking as an integral component, and today’s disrupters will deserve credit for making it happen. They just might not be the long-term survivors.

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Lee Roberts

Managing Partner

Lee co-founded SharpVue and leads its real estate investment effort. He has spent his 25+ year career in real estate investment and finance and has been involved in the sector in several contexts, including private equity, investment banking and commercial banking. Immediately prior to SharpVue, he served as budget director for the State of North Carolina, a role in which, among other initiatives, he led an effort to rationalize the state’s real estate portfolio.

Before his time in public service, Mr. Roberts was most recently Managing Director of Piedmont Community Bank Holdings, a private equity-backed bank investment platform in Raleigh. He was earlier a Partner at Cherokee Investment Partners, a real estate private equity fund in Raleigh, and he spent nine years with Morgan Stanley in London and New York, focused on real estate investment banking.

Education: Georgetown, JD; Duke, BA

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