The Impact of WeWork on Property Value
July 10, 2019
The Impact of WeWork on Property Value
Over the past decade, co-working based tenants have grown into powerful players in nearly all major US office markets as well as several foreign markets. The industry leader by several metrics is WeWork, which currently occupies space in 38 countries and 32 major markets across the U.S. In recent years, WeWork has ramped up its expansion efforts and currently manages approximately 10.0 million square feet of office space worldwide. As co-working models continue to grow in prominence on a national basis, ownership groups are seeing co-working tenants comprise larger portions of their rent rolls. This shift has raised red flags among investors about the stability and the sustainability of the co-working business model, particularly since there are signs that the current economic expansion may be winding down.
The primary area of concern is co-working’s dependency on short-term rental agreements to produce long-term cash flow. As stated in CBInsights’ recently published article, How does WeWork Make Money, “the mismatch between the long-term leases with landlords and the short-term rental agreements with tenants,” poses a major risk to the company’s financial stability. This risk profile is elevated considering that 88 percent of the company’s revenue was comprised of memberships in 2018 and a majority of these memberships consist of freelancers and solo entrepreneurs, who are less able to withstand an economic downturn. Furthermore, WeWork has sacrificed near-term profitability in favor of an aggressive expansion model that prioritizes securing market share and brand ubiquity. As such, the company’s primary cost centers of rental commitments, renovation, and customer acquisition and retention are currently outpacing revenue by a significant margin.
In addition to prevailing concerns regarding the business model’s sustainability, other secondary concerns have been raised by leasing brokers and property management groups. Michael Lirtzman of Sterling Bay in Chicago noted that co-working tenants like WeWork can be “hard users” on the building. Depending on the tenant’s industry, the typical space per worker of an office building is between 175 and 200 feet. Due to WeWork’s specialized buildouts and per-desk leasing structure, the company has managed to reduce this ratio to 100 feet per worker. And while this ratio is, of course, important to WeWork’s bottom line, it can cause accelerated wear and tear on common areas of the building and create elevator congestion. Additionally, landlords and leasing brokers have voiced concerns about leasing space to a competitor within their own building as WeWork is able to offer tenants more flexible lease terms than a direct lease with ownership can typically provide.
WeWork has garnered the greatest attention among co-working tenants in recent years due to its large-scale expansion into nearly all of the major office markets in the U.S. Despite the rapid growth of WeWork, the company has found ways to mitigate its perceived financial concerns. It has taken successful strides toward attracting more established tenants with better income and credit characteristics.Through the company’s recently deployed Enterprise offering, WeWork has begun to attract high quality tenants such as Facebook and Microsoft. This new offering adapts the business model to meet the needs of larger organizations through large suite or entire floor leasing, custom buildouts, and access to the company’s growing database. In exchange, WeWork is able to sign these higher quality tenants to longer leases, which has decreased the risk profile of the company’s tenant base and increased the company’s average in-place lease term from between seven and eight months in 2017 to 20 months in 2018. Furthermore, leasing brokers in major markets indicate that WeWork’s Enterprise offering is becoming increasingly attractive to these types of tenants. Greg Inglin of Colliers International in Seattle noted that he is aware of a nationally recognized tenant with high credit that is in discussions to lease 300,000 square feet from WeWork in downtown Seattle. Additionally, Facebook recently leased a total 450,000 square feet from WeWork at two office buildings in Mountain View, California. Nate Jones of Eastdil Secured in San Jose added that he expects this trend to continue as it affords major companies like Facebook flexibility when entering a new market.
WeWork has found ways to strengthen its tenant base and quiet some concerns about the sustainability of the company’s long term financial health, and this has enabled leasing brokers and ownership groups to leverage WeWork’s aggressive expansion initiative. Part of the reason that WeWork has been able to expand into a significant portion of the country’s major office markets in such a short period of time is its willingness to sign leases at above-market rents. The company is able to take on higher rents due to its ability to re-lease space at a significant premium created by higher space efficiency and shorter lease terms. In turn, leasing brokers have capitalized on this upside in income potential. Jones of Eastdil Secured noted that leasing teams have been using WeWork’s willingness to lease large spaces at high rents to lease-up the remaining 15 to 20 percent of vacant space at an office building in order to quickly stabilize the property. This is a particularly useful strategy prior to marketing a building for sale. Additionally, leasing brokers like Nick Garrett of LDG Commercial in San Diego have noticed that having a co-working tenant like WeWork in the building can improve leasing activity as an amenity for prospective tenants who want the ability to expand quickly.
However, there does seem to be a breakpoint on how much is too much space for a co-working tenant to occupy on a rent roll before the aforementioned financial risks outweigh the benefits. Lirtzman of Sterling Bay contends that most investors become concerned when a co-working tenant occupies more than 20 to 25 percent of a rent roll. Jones of Eastdil Secured provided a slightly more bullish range, estimating that a co-working tenant can likely occupy between 25 and 35 percent of a building prior to its tenancy having a negative impact on value. He supported this more bullish projection by stating that a co-working company like WeWork typically leases space at Class A buildings in strong locations. As such, the remainder of the rent roll is often leased to a strong tenant base, which largely offsets the inherent financial risk. Sales such as The Triangle in Denver in May 2017, appear to support his more bullish projection when it comes to higher quality co-working tenants like WeWork. The listing broker on the sale, Jenny Knowlton of CBRE, indicated that WeWork occupied approximately 30 percent of the building and that the tenancy did not materially impact the buyer pool. Lastly, in January 2019, CBRE published a report titled The Property Value Implications of Flexible Space. The report found that compared to peer transactions, differences in overall capitalization rates were minimal so long as the co-working tenant occupied less than 40 percent of the building. Of the sales with less than 40 percent co-working space, 67 percent had similar overall capitalization rates, 27 percent had higher overall capitalization rates, and 7 percent had lower overall capitalization rates.
While the exact impact of a co-working tenant like WeWork is difficult to quantify from a valuation standpoint, market evidence indicates that leasing a majority of a building’s space to one such tenant is detrimental to the overall value of the asset. Inglin of Colliers International referenced the recent sale of 501 Eastlake in the Lake Union neighborhood of Seattle, which was fully leased to WeWork when it traded in August 2018. While he did not disclose the actual cap rate, he stated that the building traded 50 basis points higher than it would have had it been leased to a standard collection of tenants. Additionally, Lirtzman of Sterling Bay noted that he is aware of two cases in Chicago in which ownership groups are hesitant to bring properties to market due to a significant portion of the rent roll being leased to co-working tenants. Based on this sentiment, each broker interviewed noted that ownership groups have begun placing caps on the percentage of a rent roll that they are willing to lease to a co-working tenant.
Moving forward, investors will continue to closely track the trends surrounding co-working tenants, particularly WeWork given its robust market share. Considering the fact that the WeWork business model has never been tested by a downturn, ownership groups will continue to exercise caution in leasing to co-working tenants or acquiring buildings with too much co-working exposure. However, co-working’s increasing popularity as a convenient solution for both landlords and tenants means that, whatever the economic impact on property value, this form of occupancy is now a permanent part of the landscape.