By Connell McGill,
CEO and Co-Founder, Enertiv
It’s clear to anyone paying attention that co-working is a force to be reckoned with.
In just the last four years, WeWork’s membership has surged over 3,000 percent to more than 250,000 users served at 14 million square feet of office space. Meanwhile, competitor Knotel recently raised $400 million to keep pace with their own incredible rate of growth.
Most traditional landlords recognize that they can no longer ignore the transformation underway in the office sector.
While some have decided to compete directly, many have opted to partner with service providers. The flexibility, convenience, and multitude of amenities make co-working an attractive option to tenants, especially millennials who are making up more and more of the workforce.
Ironically, despite the attractive work environment, WeWork’s expertise in squeezing more tenants into the same floor area means the average tenant gets 15–20 percent less space per worker than those in a traditional long-term lease.
At the end of economic cycles, real estate executives keep a close eye on elevated supply growth from new construction. However, some worry that co-working is changing the underlying fundamentals of commercial real estate in a way that is been largely overlooked.
Danny Ismail from Green Street Advisors points out that “the bottom line is that densification creates a meaningful drag on office fundamentals that isn’t visible in traditional inventory growth statistics — and that means it can be overlooked by commercial real estate executives. In effect, markets need more employment growth to compensate for the increased utilization.”
In addition to this “shadow supply” changing the fundamentals of employment-driven demand for office space, the sustainability of short-term leases through a downturn is causing wariness among some investors.
A study by Scope Ratings and Scope Risk Solutions analyzed the effects that WeWork is having as one of the world’s most important tenants, and how it may perform in the late stage of the economic cycle. It points out that landlords should be wary of “a preponderance of short- to mid-term contracts with a material risk of subtenants leaseholds expiring, and the danger of contract mismatches given subleases of varying durations.”
How this transformation will ultimately play out remains to be seen. However, these factors are already being priced into asset values
A study from Eastdil Secured suggested “leasing to WeWork has little to no cap rate impact for the landlord, provided WeWork leases less than 25 percent of the total building. When WeWork leases 50 to 100 percent of the building, a cap rate premium of 50 to 75 basis points or more is common if WeWork does not offer a parent guarantee, as it often does not.”
Drawn by higher per square foot leases, some landlords are trying to offer their own solutions. However, the same Eastdil Secured study notes “significant scale, know-how and brand awareness would be required to operate [a co-working service] profitably, and providers like WeWork are already miles ahead on all of the above.”
With the combined forces of densification, short-term leases, and potentially higher cap rates threatening real estate fundamentals, how can owner-operators continue to drive profitability?
Conventional wisdom has maintained that the focus must be on increasing occupancy rates through improved marketing and amenities, and by deploying technology to reduce friction throughout the leasing process.
This is not wrong. Tenancy is the life blood of a healthy asset and continuous execution is required to fill leases in competitive markets. However, intense competition also tends to create an “arms race” for similar marketing techniques and amenities that produces diminishing returns and higher costs over time.
A complementary option is to implement a significant cost cutting program targeted at the largest and most controllable operating expenses, as well as limiting CapEx outflow.
On first appearance, this may not look like a valuable alternative for an asset manager. For a standard office portfolio, a two percent decrease in occupancy is offset by a 10 percent decrease in the two largest controllable operating expense categories, maintenance and utilities.
But the opportunity is there. Recent estimates by the Department of Energy put waste related to maintenance and repairs at 22 percent. The Environmental Protection Agency (EPA) has estimated that buildings waste 30 percent of the energy they consume.
Given the amount of waste in building operations, achieving double digits reductions in those expense categories may be easier than going head on against macro trends with the same tactics as everyone else.
In addition, although reserves for capital expenditures are not included in the textbook definition of net operating income (NOI), in practice many analysts do include reserves in the calculation. Better operational strategies not only reduce the direct costs associated with running a property, extending equipment’s useful life means that CapEx outflow is controlled.
Luckily for those who have thus far treated building operations as a necessary evil largely to be ignored, solutions built to streamline processes and identify savings have advanced significantly in the past few years.
IoT sensors can now capture real-time performance data from every piece of critical equipment in a building for an investment of around two cents per square foot.
The headwinds facing the industry are only going to get stronger as the coworking footprint increases. Optimizing the expense side of the balance sheet can serve as a powerful hedge against the changes to traditional fundamentals.