Along with the opportunities created for the office market, however, there are challenges. Despite the surge in popularity and demand, coworking has upended familiar financial assumptions and paradigms for landlords, lenders and property appraisers. Because these office models rely on short-term, flexible rental agreements, coworking operators appear riskier to appraisers than traditional tenants.
Coworking entails extra investment in office design and higher operating costs. And finally, commercial mortgage lenders, underwriters and brokers must grapple with the time mismatch between long-term mortgages and the short-term rental agreements of the end users — a situation which risks a liquidity squeeze. But before considering the financial challenges of coworking, it’s important to understand why flexible office space is more than a passing trend.
Brave new world
The growing popularity of coworking reflects how the world of work has been remade in the age of high tech. Employees want amenities, inspiring design and networking opportunities that coworking operators specialize in. Individuals and startups have the flexibility to rent desk space on a monthly basis. And corporate members can easily scale their space needs up or down according to fast-changing business conditions.
There’s ample evidence of the rise in coworking space. As of midyear 2018, there was an estimated 47.8 million square feet of coworking space in the 87 markets tracked by Cushman & Wakefield. Although half of this space was located in six major gateway cities in the U.S., coworking also was gaining ground in a growing number of other cities, including Seattle, San Diego and Denver. Coworking office space is expected to comprise as much as 10% of the office supply in some urban markets, according to Cushman & Wakefield’s analysis.
The overwhelming majority of real estate executives said they plan to implement flexible workplace strategies for offices within three years, according to CBRE’s 2018 Americas Occupier Survey Report. CBRE also called flexible office solutions a defining trend of this office-market cycle.
The growing adoption of flexible offices, however, has challenged the comfortable financial conditions enjoyed by property owners. For decades, landlords have been accustomed to getting highly leveraged loans from banks at low interest rates. Once landlords found a dependable tenant to sign a long-term lease, the lender could be assured that the property would earn a stable return over the loan term.
Shorter lease terms, however, potentially alter the financial fundamentals of office buildings by pushing up capitalization rates — a valuation metric that expresses, among other things, the risk associated with a given property. Not only are short-term rentals perceived as jeopardizing to cash flow, the operating costs associated with flexible office-space leases are often higher than those for traditional office tenants. Coworking companies, especially local independent operators, are considered riskier tenants.
Because these changes require a different underwriting and credit-risk analysis, some lenders and landlords have had difficulty accepting coworking. They would prefer the same long-term, low-risk models they’ve become accustomed to — a situation that could make financing an office property with a coworking component potentially more expensive and challenging.
It would be a mistake, however, to make a blanket assumption that coworking always has a negative impact on property values and risk metrics. The actual impact appears more nuanced.
Last year’s Cushman & Wakefield study, for example, analyzed the sales of 17 properties with coworking tenants. The cap rates for these assets were lower than or comparable to traditionally leased offices when 40% or less of the building’s space was allocated to coworking. This suggests that, in some sales, investors paid a premium for a building with coworking tenants if less than one third of it was dedicated to short-term shared office space. As the proportion of the coworking space increased, however, investors started to demand a discount on the purchase price. Cushman & Wakefield concluded that the market is comfortable when 15% to 30% of the building is leased to a coworking provider with good credit.
Coworking also offers some upside that suggests when it is added to the asset’s mix, it could actually increase the value of the property. Coworking enables flexible terms and the efficiency of common meeting rooms and areas. Landlords often offer extra amenities that can be shared among diverse tenants. As a result, the owners are able to command higher income per square foot while reducing overall occupancy costs to the end users. Coworking office operators give buildings extra agility to absorb spillover demand from traditional tenants that are expanding. All of this will likely result in a net positive on the overall building valuation. By partnering with the right operators, landlords can potentially generate a higher return on investment compared to a traditional lease model.
Lenders and appraisers are learning to recognize these upsides, and some are embracing new valuation and risk models to account for the coworking phenomenon. According to a June 2019 survey from law firm Ropes & Gray, some 81% of respondents believe that properties with coworking tenants are valued using different measures than those with traditionally leased office space.
One of the commonly mentioned concerns about coworking spaces is that an economic downturn poses a major risk: tenants with short-term agreements are liable to leave in large numbers. But the same Ropes & Gray survey found that 61% of lenders believe coworking operators are actually better positioned than their traditional-office counterparts to weather a recession.
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After years of profiting from a cushy financing model, property owners and lenders are learning to venture beyond their comfort zone, identify the financial subtleties of coworking and figure out how to underwrite the advantages. They realize that if they don’t adjust to these new realities, they will be left behind and ultimately compromise the financial performance of the building.