The concept of modern, amenitized co-working space caught fire in the mid-2010s and has been part of the office ecosystem ever since. After the pandemic supercharged remote and hybrid work trends, co-working and flex space became even more popular, especially with large corporate occupiers, who saw carving out space for co-working as a smart component of their overall office strategy. But one of the issues with co-working space has always been the question of how it’s valued within the context of an office building. After co-working giant WeWork went from being valued at $49 billion in 2019 to less than $1 billion as of early this year, plus other companies like Knotel struggling, it’s leading to more questions about just how valuable this kind of space is. Co-working space is sold with month-to-month contracts rather than 5 to 10-year leases that are common in traditional office arrangements, so the methods typically used to value traditional office space can’t easily be applied to co-working space. But now, flexible office space continues to be popular and seems to be an amenity that has helped some buildings keep their vacancies low. That means that the real estate industry, and the lenders that service them, are becoming more savvy in the way they underwrite these spaces.
When valuing space in a traditional office building that doesn’t have co-working tenants, underwriters will look at a few key things: the current leases that exist, the cash flow they bring, the creditworthiness of a tenant, and the size of the lease relative to the building’s size. For co-working and flex space, it gets a little muddier. Tim Kuhn is Director at Altus Group. He has an extensive valuation background with stints at Blackrock and JP Morgan before joining Altus. Kuhn said co-working is largely viewed just like any other office tenant in a lot of respects, but there are some special considerations. “If a large portion of the building is heavily co-working, it may present more risk, therefore may require more return or higher discount and exit rate assumptions by an appraiser,” said Kuhn. But one of the main differences between co-working tenants and traditional tenants is the agreements between the landlord and the co-working operator. Kuhn said these days, co-working tenants are a conundrum for landlords, especially as co-working and flex operators have been increasingly moving toward management or revenue-sharing agreements.
In these kinds of agreements, a co-working operator will often seek a lower rent initially while offering in return some kind of profit-sharing to the landlord from revenue generated from the co-working or flex space. Agreements like these make it much more viable for co-working tenants to succeed, and it’s something the embattled WeWork has been targeting since at least last fall as part of its ongoing goal of profitability. However, it does make it more difficult for landlords. “Often co-working tenants are not offering any type of credit on a lease, so there’s no corporate guarantee, and that matters to valuation, and it matters to landlords,” said Kuhn. “So there’s not really anyone to chase down if there’s a default, no guarantee of the rent, and the profit-sharing is speculative.” Generally, unless there’s a good history of the tenant producing revenue sharing, it’s likely not given much weight in a valuation. Instead, more emphasis is put on contractual rent.
Some valuation teams are trying new approaches with co-working and flex tenants that involve projecting future cash flows and discounting them back to their present value. Jacob Bates is the Head of Americas, Flex by JLL. Before JLL, Bates was the CEO of the flex space company CommonGrounds Workplace, which had 20 locations around the U.S. Bates and his team has found success lately in estimating the value of an investment using its expected future cash flows (also known as Discounted Cash Flow) in what he calls “forward-valuing” management and revenue agreements. Over the last couple of years, it wasn’t uncommon for valuation teams to take a more backward-looking view on flex space, in an approach typical for multifamily, hospitality, and retail properties, where teams look at 2 to 3 years of operating and revenue history, create a link of that and then apply a cap rate, according to Bates. In forward valuing, everyone involved—valuation teams, appraisers, and lenders—agree to a forward-looking strategy that looks at a 10-year projection and applies a cap rate. “It makes everyone comfortable around forward-valuing it like a lease,” Bates said. “This is a new trend, something that we’ve been pushing toward for years, and we think it’s going to change how the industry looks at valuing buildings going forward.” However, there is not a ton of data available to understand market fluctuations in the co-working industry like the kind that exists in the hospitality industry.
There’s no question that co-working and flex spaces can be harder to value and are often looked at as riskier, but there are instances where these kinds of spaces can end up being more favorable than traditional office space. In places where co-working and flex space are in strong demand from office workers, landlords can feel more confident in choosing these kinds of tenants. “Office workers of today are very demanding,” Kuhn said. “They drive more than ever what landlords do with office space.” Co-working operators may not have been the most desirable tenant in the past and may even be the last tenant of choice now, but a lot of office owners would rather have a building occupied than manage through vacancy. After all, occupancy trumps vacancy. And while mortgage lenders have historically viewed co-working operators as more of a risky investment, banks also want to avoid having to foreclose on a property, so they may be more agreeable to a co-working tenant than no tenant at all.
After the pandemic emptied out offices and led to more remote work, flex space and co-working space were viewed even more favorably than before as a good–and perhaps temporary–option for companies while they waited to see what would happen with the virus. But it turned out to be more than just temporary for a lot of companies. The methods in valuing this space, which had been uncertain, have evolved as flex space and co-working space have become more common and accepted. That’s good news for the industry since it looks like the concept has a lot of staying power and will likely be a permanent part of the new office ecosystem that has become more diversified. Major brokerage firms and landlords have launched flex space divisions in order to get a piece of the market share, all while more upstart companies are coming into the space. That will help set a precedent for underwriting and valuing this kind of space. Co-working may have started as a temporary solution for startups looking to eventually land in a traditional office building on a traditional lease, but it now looks to be a more permanent strategy for companies of all kinds in the long term. And as advances in technology continue to grow and better support virtual collaboration, it underscores how much value flex space provides to the office market.
