Flexible workspace is here to stay. The pandemic has accelerated corporate demand for amenity-rich flexible working environments to attract the best talent, as well as to get people back into the office. But what is the best way for property owners to enter the market or provide a flexible offering within a wider property estate?
Although WeWork’s recent struggles have perhaps led some commentators to question whether the flexible workspace sector can survive, the fundamental drivers behind that situation were over-expansion and a high fixed-rent business model. Overall, demand-side drivers continue to encourage growth, and not just in London. Companies that have always used flexible space continue to evolve their businesses and, increasingly, larger corporates are adjusting their property estates to improve efficiency and provide more appropriate facilities.
Flex options
Even before the pandemic, larger, more strategic, income-driven property owners were entering the flex sector, such as Myo, Storey and Studio – from Landsec, British Land and Tishman Speyer respectively. The pandemic pulled others in as a partly “defensive” move to replace exiting operators or to generate short-term income. The increasing demand from larger corporates for flexible options opened up opportunities for landlords to support conventional lettings by providing a flex space amenity.
With an ever-increasing range of operators and the conflicting demands of the occupancy market, property owners and their banks and investors, what is the best way to achieve this?
Of the large property owners, few are established to deal with the operational intensity that often comes with running a flex space. Even a more “managed” solution requires greater operational engagement than most are used to. Typically, only those with in-house operational capability and a clear strategic vision of how flex fits within an estate will attempt it. Most don’t have these dynamics and therefore will have to partner with an operator to meet their flex provision needs.
This means entering into a lease or a management agreement with an operator. Options range from traditional “rack-rented” leases through to more performance-based alternatives (eg retail-style turnover leases), while management agreements can be very much more bespoke to the dynamics of the operator, the landlord and the property itself.
Pros and cons
The clear benefits of a traditional lease are simplicity and clarity (of responsibilities at least, not necessarily legally) together with fixed rent and a structure that is well known and comparable. Whatever the covenant of the occupier, that lease will be capable of being valued. However, the operator takes on significant financial commitments which will account for two-thirds or more of its cost base, together with the investment required for fit-out and the substantial working capital required to pay rent and service charges in advance. The landlord offsets some of this by incentives, but makes that commitment in anticipation of future income and has no visibility of the underlying operation beyond confirmation of payment of service charges and rent.
Therefore, from a landlord perspective, real visibility of covenant is critical. Is the operator proposing a newly formed special purpose vehicle? Sometimes this is completely logical (and may even provide some visibility of performance to a landlord). However, is there a guarantee of sufficient value and substance, and where does that sit within the capital structure of the guarantor? Even with an established operator providing an existing trading company covenant, what is its financing structure? These are all areas to which landlords need to pay increasing attention, as highlighted by the WeWork situation. In addition to lack of visibility of the operation, does the tenant operator have an incentive to engage in a broader estate amenity strategy?
A management agreement with an operator provides a hybrid option. A professional operator deals with the operational and trading aspects of running a flex space while the landlord retains much greater visibility and oversight of the business. Such an agreement also provides the potential for landlords to achieve greater long-term income returns and, in larger buildings in particular, support lettings in other parts of the building. The management agreement can sometimes deal more easily than a lease with any special circumstances of a building.
That said, with usually no fixed-rent payment commitment and a requirement to fund fit-out, clearly the main financial risk lies with the landlord.
It is therefore key to find the right established partner and structure. Risk sharing on the part of the operator helps. When structured thoughtfully, the operator is incentivised to maximise income to the benefit of both parties and to work in real partnership with the owner. Sharing risk means that, in tougher times, there is a genuine partnership and much greater transparency over the operating dynamics.
Careful consideration
Demand is driving the need for broader provision of flexible workspace. The key thing for the property owner is to choose the model that best suits it, the building and local market conditions.
Leases offer a well-established market comparator which provide fixed, long-term returns, but can put financial strain on an operator in tougher trading environments, landlords have little or no visibility of underlying trading, and there may be little incentive for the operator to engage with the landlord strategically.
Management agreements are not for everyone, but do provide landlords with the appropriate investment parameters and strategic intent, as well as the ability to partner with an experienced operator and to share some risk on the project. They have the potential to deliver greater long-term income returns while allowing much greater oversight for the landlord of its asset and the underlying business.
Alan Pepper is chief executive of Orega
