‘Evolved’ REITs Manage Coworking’s Risks, Rewards

Having WeWork and other shared office space providers on the tenant roster is becoming the norm for office property owners. The variable is how landlords structure these arrangements, according to Stephen Boyd of Fitch Ratings.
Stephen Boyd

Coworking arrangements are growing in popularity across America―and it’s been a trend REITs have embraced.  Leveraging the fundamental and generational shifts affecting the way employees work, coworking arrangements have established a long-term foothold in the global office markets―creating new opportunities for U.S. office REITS. But this rapid growth trend brings with it tenant and rent risk that needs to be managed.

Shared office space providers aggregate and diversify risks associated with smaller, less established tenants.  They also benefit asset values through the high level of investment in space buildouts often required.  However, this business model also brings with it an asset/liability duration mismatch that favors flexible customer commitments, which leave REITs without the ability to offset the high capital intensity of office assets.

U.S. equity REITs and other commercial real estate-related companies have gone public with the benefits and risks associated with contracting space to coworking tenants.  Boston Properties and SL Green Realty find coworking is a critical net absorber of space. Empire State Realty Trust says coworking disrupts the relationships between tenants, landlords and brokers with outsized risk from weak equity-dependent business models.

U.S. office REITs have traditionally relied upon investment-grade industrial and financial corporate tenants, enabling them to effectively manage rental income risk. Growing exposure to speculative-grade coworking space chains, such as WeWork, may increase tenant credit risk. This will inevitably make evaluating REIT tenant concentration and credit and retention risk an even more important factor in credit analysis.

Traditional Leases or Fee-Based Agreements?

Long-term leases are a key positive office sector attribute that help balance high capex and leasing costs. WeWork caters to smaller, less established tech and new media startups, which are expected to underperform established peers during a downturn. Notwithstanding limited structural lease security, WeWork’s ability to curtail growth investments in a downturn to improve its financial flexibility and reputational risk will sustain its willingness to satisfy its long-term lease obligations.

The traditional landlord/lessee model, where a REIT landlord leases space to coworking providers under a long-term agreement, providing lease incentives based on prevailing market conditions and practices, is more credit friendly. A fee-based management model whereby the landlord bears the capital investment and cash flow risk in exchange for greater potential upside is less so.

Despite the risks, coworking arrangements look here to stay. REITs that are in a position to execute on this trend should do so managing the risks with the rewards.  Evolution is critical to success in any business, and those who can evolve smartly stand to benefit the most.

Stephen Boyd is the Senior Director in Fitch Ratings’ Corporates group. His primary areas of expertise are real estate, lodging and leisure companies.