Can the co-working revolution in office real estate survive a market downturn?

New Delhi, November 13, 2018: Vulnerability comes from long-term obligation to landlords while revenue-driving subleases are short-term.

The largest occupier of office space in Manhattan is not a bank or a law firm. Instead, it’s a real estate company that makes flexible office space available to commercial tenants, one cubicle at a time.

In September, WeWork Cos., a provider of co-working office space, left JP Morgan Chase and Co. behind to become Manhattan’s largest tenant. The company rents 5.3 million square feet of space in Manhattan alone. It already attained the same status earlier in London, where it opened in 2014.

Co-working companies rent office space from other institutional landlords, upgrade the space to meet the needs of startups and others active in the sharing economy, and then sublease the space at a premium to short-term renters.

A distinguishing feature of the co-working business model is the flexibility in the tenancy duration and the amount of space tenants can rent. Essentially, they may rent as little space as a desk for increments of time that can even be less than a day.

Yet this flexibility comes at a premium rate, in which the monthly rent for a desk (depending on the location) could be as high as $500. Yet, if one needs only a cubicle in a high-end office location, a co-working space will prove a lot cheaper than renting an office.

The co-working spaces offer other amenities, such as Wi-Fi, lounges, coffee bars, and, in some instances, beer on tap. The turnkey rental spaces have thus become a rapidly growing segment of office real estate since the economy started to grow after the Great Recession. JLL, a real estate services firm, reported that the co-working and flex space inventory in the U.S. has grown from 12 million square feet in 2010 to 59 million sq. ft. in 2018 according to the reports published in business.financialpost.com.

Some have likened the co-working companies to Airbnb. However, the two business models are inherently different. Airbnb is true to the fundamentals of sharing economy, in which peer-to-peer commerce is enabled via a technology-based marketplace. Unlike co-working firms, Airbnb does not acquire rental space. Instead, it facilitates peers to sublease their excess space for short-term rentals.

The co-working business model involves signing long-term leases from landlords and subleasing the space in smaller chunks for short-term leases. For some real estate experts, the long-term obligations of the co-working firms add to their vulnerability because their revenue-driving subleasing contracts are of shorter duration.

The mismatch between the long-term obligations and short-term revenues has made some question the US$20 billion valuation of WeWork. Those include Elaine Moore and Eric Platt, who wondered in a Financial Times article whether the company was worth a valuation of between 10 to 20 times the expected sales.

By comparison, IWG (formerly Regus) is the largest operator in the co-working space and is active in Toronto and Vancouver. The firm has reported profits suggesting a sustainable business model. Yet, IWG “has an equity value below $4 billion.”

The future economic outlook appears less favourable. As interest rates rise and volatility returns to the markets, business leaders have started to wonder about the next recession. The resilience of new business models that have not weathered a recession is of great interest to many. How will the co-working firms manage their expensive obligations if the demand for short-term rental space were to decline or disappear?

The recent influx of massive cash into co-working firms by large investment funds would suggest that the investors believe the co-working model is robust to recessions and economic downturns. The recent expansion of such firms in the London’s office market, which is suffering from the unwelcome consequences of Brexit, suggests that such firms experience growth when commercial rents decline and coveted office space becomes vacant. Cushman & Wakefield estimate that co-working spaces will represent as much as 10 per cent of the office inventory in the future.

The co-working space has been growing rapidly in Canada’s large urban labour markets of Toronto, Montreal and Vancouver. Backed by investors, co-working firms have acquired existing space and signed on to large under-construction space that will become available in two to three years’ time.

A lot could change in two to three years. Will the demand for office space in the next few years be as robust as it has been over the past 10? The answer to this riddle holds the key to the long-term sustainability of the co-working business model.