REIT Industry Balances Love/Hate Relationship With Office Coworking Providers
Shared Office Space Companies Can Boost Tenant Risk Even as They Fill Buildings
MARK HESCHMEYER (via CoStar)
Empire State Building owner Tony Malkin said landlords will regret the day they leased to office coworking tenants. Photo: CCO Public Domain
The surge in shared office providers is raising tenant credit risk and artificially boosting rents in certain markets, even as these coworking companies provide a key service to help fill buildings, industry analysts say.
This dual phenomenon is marked by both strong advantages and disadvantages as the use of coworking increases, analysts at bond rating agencies DBRS and Fitch Ratings point out. And it’s also sparking a love/hate relationship among office landlords, according to comments from executives.
Coworking makes a lot of sense for office real estate investment trusts because tenants in those spaces migrate to being direct tenants, said Brian Harris, chief executive of mortgage REIT lender Ladder Capital Corp. Even so, Harris added, “as far as a lender, [I’m] always cautious when you see space in a headline being leased by a company that is new and oftentimes not making money. That always concerns me a little bit.”
Fitch analysts note that on the plus side, the high level of investment by coworking companies in space buildouts can boost REIT asset values. And long-term leases are a key positive office attribute that helps balance high capital expenditures and leasing costs. At the same time, the traditional landlord and lessee model where a REIT landlord leases space to coworking providers under a long-term agreement can be viewed as credit friendly.
On the down side, the shared office space model entails an asset and liability duration mismatch that favors shorter-term leases over long-term leases. However, longer leases help landlords offset the high capital costs of office assets.
Growing exposure to speculative-grade coworking space chains such as WeWork may increase tenant credit risk, Fitch noted. Coworking caters to smaller, less established technology and new media startups, which Fitch expects in aggregate will underperform established peers during a downturn. And a fee-based coworking management model where the landlord bears the capital investment and cash flow risk in exchange for greater potential upside can be viewed as less credit friendly.
There seems to be some consensus over coworking tenants on the credit side. Fitch’s commercial mortgage-backed securities group expresses a cautious approach to analyzing properties where WeWork is a key tenant. This includes ensuring rents are at, or below, market levels and that the space is interchangeable enough to facilitate filling the space with new tenants, if necessary.
At the same time, “owners also have noticed less demand for direct leases to smaller tenants,” DBRS analysts noted in a report. “This change in demand could lead to the need to reconfigure floor plates to accommodate more mid-sized and large tenants. Also, WeWork, for example, has raised expectations for what office space should look like and what amenities are available. After the WeWork experience, tenants now seeking their own space will likely demand higher tenant improvement allowances to meet these expectations.”
This love/hate relationship between the office real estate investment trust executives is playing out in quarterly earnings conference calls this year. On one end of the spectrum are executives for REITs including Boston Properties and SL Green Realty who view coworking as an important filler of space.
Sharing that view is Ted Klinck, executive vice president of office REIT Highwoods Properties Inc., “We’ve been fortunate to capture demand from several companies that have outgrown their coworking space. So it has been advantageous to have them in our buildings. I think we’ve got examples in probably all of our markets, where companies have come to us after they’ve outgrown their space.”
On the other end are opinions like this from Tony Malkin, chairman and chief executive of Empire State Realty Trust: “I have been very clear for years and the world now recognizes that these companies seek to disrupt the relationships amongst tenants, landlords and brokers with outsized risk from weak equity dependent business models. I maintain that landlords, investors and lenders will regret the day they decrease the probability of their future cash flows with the leases they have made with these tenants.”
Coworking office providers such as WeWork, Spaces and Knotel combine functional space with trendy design and hospitality elements designed to appeal to both small startups and large established tenants. And it’s still growing and changing as new entrants join the field.
Bob Sulentic, president and chief executive of CBRE Group, told analysts that coworking now makes up 1 percent to 2 percent of the global base of multi-tenant space today. CBRE expects it to keep growing to 3 percent; others are betting that could grow to 5 percent to 10 percent, he said.