CRE FinanCE W Rld

Sharing the Experience — As Co-
Working Grows, the Office Isn’t
Necessarily an Office Anymore
Steve Jellinek
Vice President Research,
Structured Finance
Morningstar
Credit Ratings
Edward Dittmer, CFA
Vice President CMBS
Morningstar
Credit Ratings
Lea Overby
Managing Director
of Research,
Structured Finance
Morningstar
Credit Ratings
F
ueled by structural changes in the workforce and
mainstream companies looking for more flexible expansion
options, co-working — another facet of the sharing
economy — will play a more significant role in commercial
real estate, posing challenges to underwriting and valuation
standards for the commercial mortgage-backed securities market.
While loans with exposure to co-working account for a small portion
of the CMBS universe, office loans with exposure to co-working
spaces could become a significant part of the CMBS universe
as this business evolves.
Since co-working’s inception with executive suite giant Regus
PLC, the number of co-working spaces climbed to about 7,800
globally, a 36% rise between 2014 and 2015, according to a
survey conducted by Deskmag, a co-working magazine. Even with
this rapid growth, these companies lease roughly 1 million square
feet backing just 1.1% of the $139.32 billion in outstanding CMBS
office loans, as of November 2016. That’s a small portion of the
849.9 million square feet of leasable office space that secures
these loans. Nevertheless, co-working, which typically involves
individual members or member businesses paying a fee to share
office space, is spreading quickly, evolving with pioneering rental
models and innovative service offerings.
That’s not to say that co-working will expand unabated. We believe
growth will come in fits and starts, as factors such as unpredictable
revenue streams, lack of long-term commitments, and economic
uncertainty will play a role. Additionally, fixed costs can be high
because co-working providers usually rent their space upfront
and must build out the space and amenities before they can lease
space to tenants. Furthermore, volatility may be high because of
the lack of barriers to entry and a fragmented customer base, with
niche players coming and going to serve everyone from healthcare
technology to writers and designers.
To protect investors from increased cash flow volatility, underwriting
and valuation standards must evolve. In this regard, identifying
organic demand is critical. A building with a co-working company
as a tenant may have strong leased occupancy, but that may not
paint an accurate picture of how much that space is being used. To
gauge demand, Morningstar Credit Ratings, LLC looks at the property’s
historical occupancy and occupancy within the collateral’s
market. If these rates are lower, then we would assume for underwriting
purposes that less space may be used than what current
leased occupancy rates would otherwise suggest. Likewise, we
may temper our occupancy expectations in areas showing signs of
a bubble, where demand is outpacing supply and rents are rising.
Shared Workspaces Offer Flexibility
A typical co-working space is a site where independent professionals,
freelancers, and even corporations — anyone with workplace
flexibility and mobility — can come to work on a shared floor. The
co-working sponsor leases space from the primary landlord and
then subleases to individuals or corporations by desk, private office,
or suite. The operator provides flexible terms, various amenities,
and building programs to create a strong sense of collaboration
and synergy.
Co-working spaces have been largely occupied by independent
workers seeking a cost-effective place to work outside the home,
but corporate occupiers are showing increased interest in shared
workplaces. Although millennials, which we define as those born
between 1980 and 2000, are major influencers of office design
and will most likely factor into how companies address co-working,
they are not solely behind this trend. According to CBRE Group,
Inc., 63% of workers using these spaces are between the ages of
31 and 50, and less than 25% are millennials.
Largest Players
While there are numerous co-working companies, most are too
small to be among the five largest tenants at a property backing
a CMBS loan. However, we found six co-working companies, the
largest of which is Luxembourg-based Regus, that are one of the
five largest tenants for CMBS collateral. Although not a traditional
co-working company, Regus is gradually expanding into co-working.
For 2015, the company reported more than 2,700 locations
worldwide and more than 46 million square feet of office space,
which it subleases through a business model similar to co-working;
however, most of it is traditional office space. In 2016, Regus
expanded on its co-working format, called Spaces, in the U.S.
Regus leases more than 545,000 square feet in 27 properties
securing $867.8 million in U.S. CMBS loans, but tenant risk is low,
as it has more than 20% of the gross leasable area at just one
property, which backs a $5.7 million loan. The workspace provider,
which reported a healthy pretax profit of £84.3 million for the first
half of 2016, up from £79.1 million for the first half of 2015, has seen
revenue increase at an average of 15.3% per year from 2011-15.
WeWork, which opened its first location in 2010 in New York City,
operates 128 co-working locations in 39 cities and 12 countries
with plans to expand into India, according to its website. The
company has become one of New York City’s largest occupiers
of commercial real estate, with roughly 2.8 million square feet as
of January 2016, according to Newmark Grubb Knight Frank, a
meteoric increase from 42,000 square feet in 2010.
A publication of CRE Finance World Winter 2017
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