Fueled by the dangerous accelerant of “Other People’s Money”, WeWork expanded rapidly across the country and worldwide. At the beginning of the year, the company was “valued” at $47 Billion making it the most valuable startup in the country. Reality eventually caught-up with WeWork after it shelved its IPO in September, forced out its CEO, reportedly lost $1.25 Billion in 3rd Quarter, and, according to a recent article in Business Insider, laid-off about 20% of its workforce.
In major cities like Chicago and New York, WeWork became one of the largest office tenants. In Chicago, WeWork established themselves as the second largest tenant with just under 1M sf; that said, WeWork represents less than one percent of the Chicago CBD office market. To maintain market share, other co-working companies continued to expand albeit at a relatively slower pace. Landlords gladly leased space to these co-working companies to fill vacancies at typically above-market rates.
As a result, while not apparent in our strong economy with unemployment at a 50+ year low, it is my opinion that co-working supply has far outpaced demand. In a recent Wall Street Journal article, Boston Fed President, Eric Rosengren, recently warned of the risks of co-working to the commercial real estate market, (See: Boston Fed President Warns of Co-Working Risks to Property Market). It will become apparent once we have an economic slowdown in the US, as many co-working users will “return to the mother ship” (for the large corporate users who used co-working for satellite offices) or will work virtually. As Warren Buffet famously said: “Only when the tide goes out do you discover who is swimming naked.”
The co-Working business model is simple: long-term lease of office space, build and furnish and then sublet for a premium to multiple subtenants (actually licensees). In a September 4, 2019 interview with CNBC, real estate billionaire Sam Zell , in reference to WeWork’s planned IPO said: “Every single company in this space has gone broke.” Sounding prescient, he went on to say: “Every other time in history when they create that, results are predictable. Why is this any different?”
Co-Working, however, is a sector that is here to stay, as I wrote about last December in my post: Is Co-Working the Right Choice for Your Business? Office Space Alternatives for Tenants Today , for 3 reasons: (1) Service, transforming office space from a product to a service; (2) Flexibility, given today’s fast changing business and product cycles; and (3) Community, fostered by sometimes complimentary businesses. Of course, tenants pay a premium for this arrangement which is analogous to staying at a hotel for an extended period instead of renting an apartment.
While investors in co-working companies face exposure to losses, many landlords are actually on the front lines when co-working goes south. That is due to some overly eager landlords agreeing to leases with co-working companies that leave them with little recourse in the event of a lease default.
Many co-working leases are not with the co-working company, but with a shell company (special-purpose entity “SPE”) that is created for each co-working location. This structure is much like how building owners create SPE’s for each building to isolate liabilities. Under this structure when a co-working site is no longer profitable or is in default, the co-working company can simply pull the plug and the co-working SPE is the entity that remains liable to the landlord, not the parent co-working company. This could be an issue for tenants in buildings where landlords lease a significant portion of a building to a co-working company. If the co-working company goes under, it could lead to a cash flow interruption for the building owner and possibly a default under its mortgage.
Looking ahead, I think we’re going to see landlords (and their lenders) be more conservative in underwriting leases with co-working companies. To stave off the impact of the “WeWorks” of the world, some landlords have created their own co-working ventures, as was reported in the Wall Street Journal (See: WeWork’s Latest Threat: Old-School Landlords Trying to Copy WeWork). Landlord, Hines Interests, recently launched its version called “Hines Squared”, with building owners such as Boston Properties and Tishman Speyer following suit. Time will tell if they will succeed in this sector.