Recent sales data suggests that office buildings with less than 30% of their total square footage occupied by flexible space providers sustain little to no loss in value. Of the $5 billion worth of 2019 office sales with flex space components, 71% had a capitalization rate that was either 50 basis points above or below a baseline peer set (Figure 1). Micro-market real estate fundamentals appear to be the most important consideration for investors, regardless of the presence of flexible office space.

Figure 1: Cap Rate Spread vs. % of Flexible Office in Building

Figure 1

Source: CBRE Research, Real Capital Analytics, Q1 2020.

Shifting Sentiment


Investor sentiment has changed since WeWork’s failed initial public offering and associated revaluation in Q3 2019. Since that time, the capital markets have signaled less demand for both equity and debt on buildings with a material 15% or more of their total space occupied by flex operators. With time and experience, this demand should regain traction.

Factors driving this shift in sentiment include:

  1. “The WeWork Effect.” WeWork is the biggest concern in the marketplace because of its size relative to other operators. Because of WeWork’s restructuring, assets with material flexible operator tenancy are receiving increased scrutiny from investors.

Figure 2: Largest Flexible Office Operators

Figure 2

Note: IWG has over 20 MSF of leases; 16.8 MSF of that is within the geographic boundaries in which CBRE tracks flexible office space.
*Q4 2019 figures represent preliminary data, subject to final revision.
Source: CBRE Research, Q1 2020.

  1. The debt markets are limiting viable investors. Many lenders have reached the limit of their exposure to flexible office space. Investors bound by lender stipulations are finding it difficult to consider buildings with a material flexible office component.
  2. The underwriting associated with flexible office space leases is conservative. Most flexible space operators are deemed non-investment-grade tenants. The underwriting associated with their leases includes lengthy “go dark” scenarios. While this underwriting is creating a risk premium on the asset that it is not viable for the seller, flexible space operators with a strong operating history or parent company may be underwritten differently.

Despite some caution, there is capital markets activity for buildings with flexible office space. The adage of location, location, location is still particularly strong in cases where assets have flexible office components. Some scenarios that are more acceptable given current market sentiment include:

  1. Flexible office lease is for below market rent. Average office asking rent grew by 5.2% last year, the largest increase since 2016. Flexible space operators who signed leases earlier in the cycle likely have leases at below market rents. This scenario is more favorable to potential investors, especially value-add, who could re-tenant at higher market rates if necessary. With just under half of flexible space expansion occurring before 2017, many flex operator spaces represent below market opportunities in case of default.
  2. Flexible office space is under 15% of a prime office building’s total square footage. Buildings with strong micro-market fundamentals still seem to be favored despite a nominal amount of flexible office space. Investors continue to prefer newly constructed or renovated assets in hot submarkets with a high level of amenities and a strong tenant mix. In the event of default by a flexible office provider, the space could be easily re-tenanted in these submarkets. As of year-end 2019, 52% of all buildings with a flexible operator in the U.S. and Canada had less than 15% of flex office. Institutional investors, the largest real estate investment group, were the biggest buyers of properties with less than 20% flex space (Figure 3 & 4). Private investors remained the biggest buyers of buildings with more than 20% flexible office space.

Figure 3: Sales Volume by % of Flexible Office & Investor Type

Figure 3

Source: CBRE Research, Real Capital Analytics, Q1 2020.


Figure 4: Sales Composition by % of Flexible Office & Investor Type

Figure 4

Source: CBRE Research, Real Capital Analytics, Q1 2020.

  1. Flexible space lease is backed by strong covenants. Corporate guarantees by reputable parties, letters of credit and strong security deposits are all lease covenants that would give the investor pool more confidence in any office asset with a flex space component. Having a remedy for damages from a flexible space operator default creates a more favorable view of the asset.

Regaining Traction – An Asset-Light Approach


Although nearly 1 million sq. ft. of new flexible office space leases were signed in Q4 2019 (U.S. Flexible Office Figures Q4 2019), an “asset-light” approach seems to be the future of this space model. In an asset-light approach, a brand name operator manages the flex space offering on behalf of the landlord for a fee. This scenario changes the risk profile of the asset and most importantly provides a higher net operating income to the landlord. It also provides qualitative benefits to the landlord, such as more transparency in the metrics and control of the tenancy, as well as space design.

A partnership/revenue-share agreement between a landlord and flexible space provider is a step toward an asset-light approach. Figure 5 provides an example of the net operating income a partnership-based approach could provide to the landlord.

Figure 5: Partnership Model Illustration

Figure 5

Source: CBRE Research, Q1 2020.

 

This kind of value proposition likely will provide a more sustainable and successful flex space offering. It makes landlords and operators partners in attracting and retaining an occupier base that can grow within the owner’s building or broader footprint.

Ultimately, operators must provide transparent metrics. Consistent positive cash flow, profit margins, occupancy metrics and tenant mix are just a few data points that would go a long way in making investors comfortable with flex offerings.

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