- March 1, 2018: Vol. 30, Number 3

Co-working: Investors are taking note of the shared-office-space trend

by Reg Clodfelter

After the familiar “ding,” the elevator doors of 201 Spear St. in San Francisco open to the lipstick-red lobby of one of WeWork Cos.’ four floors in the building. Like clockwork, the dulcet tones of the latest Drake single resound from the co-working space, where a conga line of contractors is parading across the elevator lobby before the doors close again. The doors reopen eight floors later to the white tiles and fluorescent lights — reminiscent of a school cafeteria — that comprise every other floor in the building, and your correspondent steps into another drab day of office work in San Francisco.

This sight is all too common in office buildings across the United States as co-working companies, led by WeWork, have grown to meet the changing demands of the modern labor market. Nowhere is it more evident than in gateway markets. In New York City, WeWork alone leases more than 1 percent of the city’s office space across 44 locations, according to Green Street Advisors. While the industry’s share of total office space is still small on a relative basis, its rapid growth is forcing investors to take notice.

“I would bet that all of the investment managers in this room have some shared office space in their portfolio — I know that we do,” said Bill Maher, director of North America investment strategy at LaSalle Investment Management, while discussing co-working trends at the VIP Americas conference in Dana Point, Calif., in January.

In its 2016 report Shared workspaces: The market perspective, JLL pegged the co-working industry at only 0.7 percent of the total U.S. office market. It has grown since then to between 1 percent and 2 percent of the market, according to Jamie Russo, executive director of Global Workspace Association, a trade association for shared-workspace operators.

Co-working has shown up on institutional investors’ radar, but not everyone is sold on leasing to the industry, with many wondering if it is a passing fad, or if eventually they will have to get on board.

A working arrangement

When you look at the trends underpinning the growth of co-working spaces, the numbers are staggering. Freelancers currently make up 34 percent of the U.S. workforce, a number that is projected to grow to 43 percent by 2020, according to Intuit, the owner of TurboTax — and office portfolios will need to keep pace. By 2030, JLL predicts 30 percent of corporate real estate portfolios will be dedicated to co-working or flexible space solutions.

The rise of the gig economy and companies’ changing employment needs are not the only trends fueling this shift toward a contractor-driven economy.

“Newer generations of employees have increased that revolving door,” says Adam Stoltz, managing director of workplace experience and strategy with Transwestern. “We certainly see employees that are more willing to make a move to find something that is more flexible and more fulfilling than past workforce generations.”

Co-working companies have stepped in to fulfill the square-footage needs of this growing segment of the workforce, and they have often made quite the premium to do so. According to the JLL report, shared offices cost about $139 per square foot, a 181 percent premium over the average class A CBD rental rate of $49.59 per square foot. When looking at average rental rates overall, that premium jumps to 331 percent, according to National Real Estate Investor.

Numbers like that will catch any investor’s eye, and they have made some institutional investors consider the prospect of opening their own co-working spaces. But sources for this story were resolute in warning against this path, citing the extensive management and curating efforts needed to operate a successful co-working space, let alone the marketing required to fill such a space with hundreds of independent contractors.

Outside of management issues, institutional investors have other hurdles to clear to open their own co-working spaces.

“If you’re an institutional investor, you need to consider the potential impact of UBTI,” says Eric Smith, executive vice president at L&B Realty Advisors. Institutional and tax-exempt investors are all too aware of the dangers posed by activities that generate unrelated business taxable income, and the services offered in co-working spaces could certainly qualify.

The alternative, and the route many institutional investors have investigated, is leasing space to WeWork or another of the major players in the industry. But that comes with its own issues to be considered, specifically when working with the industry’s biggest icon.

“WeWork is out of the ordinary relative to other office tenants and other co-working operators,” LaSalle’s Maher added during a panel session on real estate demand and technology trends at the VIP Americas conference. He explained most of WeWork’s leases are special-purpose entities that have no additional credit, so the startup’s $20 billion valuation, which may sound appealing to investors, is not going to be used to support the landlord if there is a downturn in the office market, because the firm is not offering any of those assets as credit. He went on to contrast that arrangement with Regus, a publicly traded competitor that will give landlords balance sheet credit.

Last, investors should consider the viability of these co-working companies as they move out of their venture capital–fueled growth phase. “The big question I have is, what’s the source of rents 12 years from now, revenues? That’s what really counts for landlords,” adds L&B Realty’s Smith. Many of these companies are steeped in venture capital that is, in part, keeping them afloat. According to self-reported figures, only 40 percent of all co-working spaces are profitable, though that percentage has risen for four years running, as stated in the 2017 Global Co-working Survey from Deskmag.

Reservations aside, office owners clearly are renting space to WeWork and other co-working operators at a healthy clip, suggesting the benefits at least appear to outweigh the challenges. These spaces can bring an “it” factor that differentiates a building from others in the market. They also can create a pipeline in which small companies that start in a co-working space suddenly take off and move to a larger space in the building they are already familiar with, an outcome sources for this story characterized as typical. Finally, they can be a resource for other tenants that, for whatever reason, are experiencing rapid, temporary head-count growth — an arrangement that is increasingly common in today’s high-speed economy.

Threading the needle

Though the perception is these spaces usually are stocked with a wide variety of professionals, this is not necessarily the case. Nearly 50 percent of membership in U.S. co-working spaces is composed of small businesses, and another 12 percent is mobile corporate users; only 20 percent of membership are “solopreneurs” and freelancers, according to the 2017 Industry Survey by the Global Workspace Association.

“One of the things that’s really transformed how organizations occupy new space is the speed of change and the unpredictability of where their business is going to be in two to three — let alone five — years,” explains Transwestern’s Stoltz.

The truth is, modern businesses are experiencing unprecedented rates of head-count change, especially when considering their proclivity to use independent contractors to handle specific projects and campaigns. These businesses often rely on co-working spaces or similar arrangements to handle temporary growth, and having one in a building can be a great resource for that building’s tenants.

One way many owners are threading the needle between providing these spaces for their tenants while avoiding UBTI issues is to build a “tech lounge” or something similar into a building’s amenity deck. These spaces do not offer the same services as a typical co-working space, but they often echo the aesthetic, providing businesses in the building square footage to offload temporary employees or to give permanent employees a private space on the same premises.

With national occupancy rates for office assets typically at about 85 percent, using one floor to offer tenants a “tech lounge” as part of the amenity deck can go a long way toward differentiating an office building from its competition — and keeping occupancy higher over time. Spaces like these are becoming increasingly common, such as Blackstone’s Assemblyon2 on the second floor of 100 Summer St. in Boston. Although these spaces can negate many of the downsides that can crop up when leasing to a co-working company, they do not necessarily mimic the benefits, either.

“I’d rather lease the space to WeWork [than offer a tech lounge] because WeWork brings the value of scale and a coolness factor; it brings an intangible energy that is really tough for me to value,” says Smith. “But WeWork can’t be in every building.”

Work cut out

Although important questions for the co-working industry remain, such as how well it will survive the next offic- market downturn, the underlying metrics remain quite positive (and one should keep in mind the current rise in co-working was driven in part by the effects of the most recent downturn).

“Co-working is the first iteration of an answer to the pent-up marketplace demand for more flexibility, shorter terms, access to better workspace design and no personal guarantees on a lease,” says Russo, with the Global Workspace Association. “This is what the real estate consumer wants, and it’s not going anywhere.”

The numbers continually back up this assertion. But, whether they are leasing to WeWork or Regus, opening up a tech lounge, or trying to manage a co-working space on their own, office owners need to walk into the arrangement with eyes wide open.

“The first thing I’d ask someone looking to get into shared workspace is: ‘What’s your model? What’s your intention?’ Because certainly not all co-working experiences are created equal,” says Stoltz. “There is a tremendous opportunity here if you are thinking about how to differentiate your building from another — but it has to be done right.”

If owners are able to do it right, whatever the route, then they too can start each morning wishing they had exited the elevator at the bright-red lobby and jumped in the conga line.

Reg Clodfelter is a freelance writer based in Berkeley, Calif.

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