How much are flex office assets worth now?

As workforces return, flexible office space is also making a post-lockdown recovery.

Occupancy levels for the sector stood at 41 percent in Europe and 40 percent globally as of July, according to a report from Workthere, the flexible office business of real estate advisor Savills. Meanwhile, contract occupancy – the percentage of total desks that were occupied by paying members – was expected to reach 68 percent in Europe and 64 percent globally by the end of August, the report stated.

The uptick in demand is expected to continue amid the covid-19 crisis. “Signing a monthly or a six-month contract that fully integrates all the services, that’s going to be probably even more relevant going forward,” notes Stéphane Theuriau, head of BC Partners Real Estate, the property arm of the London-based alternative investment firm. “Since we’re going to be in a world of uncertainty for at least a couple of years, taking a flexible solution, even if it’s more expensive, is probably going to be the right way to go.”

Office assets with a space-as-a-service component are currently valued less favorably than the traditional trophy office properties that are 100 percent leased to long-term blue-chip tenants. Emma Swinnerton, EMEA head of flexible leasing solutions at Chicago-based property services firm Cushman & Wakefield, says: “You’re unlikely to get the same covenant out of a flex workspace operator than you would out of a FTSE 100 corporate, for example, so comparatively, it’s seen as being riskier.” She explains that a co-working operator frequently sets up an individual special-purpose vehicle for each flex location it runs and consequently can walk away from the SPV without any impact on the wider business.

“There’s more volatility in that income stream, and there’s more risk associated with that as well,” adds Richard Kalvoda, head of the advisory practice at commercial real estate services and software company Altus Group. Similar to the hotel sector, “with space-as-a-service, it could go up or down tomorrow; whereas the traditional office space [is] pretty consistent.”

“Traditional valuers are going to be more sensitive to the classic model and probably discount the space-as-a-service model,” says Theuriau. However, he anticipates the industry’s attitudes toward flex assets will begin to shift.

Theuriau notes that many property firms have become more cautious about owning a large building leased to a single tenant, which puts a landlord at risk of having a vacant asset for an extended period. He believes that such a property will increasingly be viewed as riskier than an asset with multiple users on leases of varying maturities and with a space-as-a-service component: “That solution is going to look more resilient to long-term investors than your single-tenant, single asset, which was the model for your best deals historically.

“I have a feeling the valuation industry and the professionals are going to try to go for a more diversified cashflow base – and if that comes with shorter-term revenues, but a lot of diversification, they’re probably going to be okay with it. I don’t think there are going to be a lot of discounts versus your traditional lease model.”

Kalvoda agrees that, in the longer term, properties without a flex component will be valued less. “I think the trend definitely will go towards more space-as-a-service,” he says. “If that’s where the trend is going and that’s where the demand is, landlords need to future-proof their portfolio, because now there might be a premium. But at some point, there could be a discount if you don’t incorporate some form of that in your building.”

He likens space-as-a-service to LEED or other sustainability certification programs for buildings: “It used to be there might be a slight premium. Now there could be a discount because it’s expected and demanded by the market.”

From leases to partnerships

The pandemic is not only accelerating a shift in how flex assets are perceived in the market, but also in the relationship between landlords and flexible workspace operators. Swinnerton estimates 60 to 80 percent of operators are currently on traditional leases with landlords. However, she expects covid will trigger a shift from leases to management contracts, profit-sharing partnerships or landlords delivering in-house offerings.

“It’s sharing of risk with the owner, fundamentally,” explains Swinnerton, whose firm has its own white-label flexible workspace service known as Indego. “What you see at the moment is the sector is somewhat challenged and the operators who are finding it harder are those actually on a fixed-lease arrangement because they’ve got a fixed-cost base. They’re getting asked for concessions by their end customers in terms of terminations or rent reductions or holidays. There’s only so far they can go without going into the red, and then what happens is they are unable to pay rent to their landlord.”

Theuriau concurs: “If you think about it, when you lease an asset to WeWork on a 10- or 15-year lease, you’ve effectively lost control of your asset, because you’ve lost control of the final client, because the final client is actually going to WeWork.”

By contrast, if a landlord and operator are in a profit-share or management agreement, both parties are sharing in the performance of the flex space, whether it be the upside or downside. “It’s a fairly new model for the office space,” says Swinnerton. “But if you look at the hospitality industry, this is the model that hotels have been operating on for a long period.”

Theuriau observes that, similar to a hotel owner, an office landlord can negotiate more favorable terms with a management contract than with a lease. “If you have a Four Seasons with a service contract, you’re probably going to be better off than if you have a lease with Four Seasons long-term,” he says. “With Four Seasons having a lot of leverage because of the quality of the brand, the lease has been negotiated more favorably to Four Seasons than a profit-sharing service contract.”

He adds that in addition to being able to negotiate better terms, a service contract provides the office building owner with much more flexibility: “I can get rid of the operator if I’m not happy with the performance, because I think most of those companies have no credit.”

New valuation methodologies

This shift away from leases towards partnership structures will necessitate a different way of valuing flex assets, according to Swinnerton. However, to date, “there hasn’t been a defined methodology for how you value that,” she says, noting that the UK’s Royal Institution of Chartered Surveyors – a standard bearer for property valuations in Europe – has yet to provide specific guidance on this topic.

In response, Cushman & Wakefield released Tuesday a white paper outlining its own valuation methodology for flexible offices that are owned and operated by the same party or operated by a third-party being paid a management fee. The methodology would adopt a hybrid approach that would take into account both the trading performance of the asset as well as the capitalization of two income streams – the net operating income equal to the market rent if the space was on a traditional lease; and the NOI greater than the market rent and attributable to the space-as-a-service operation.

“We wanted to drive some momentum in this area, so that all parties can have some confidence about the approach you take to valuing flexible workspace,” Swinnerton says.

Kalvoda says that when the landlord has a lease or partnership with a third-party flex space operator, and it represents less than 20 percent of the building’s cashflow, there is no major difference in pricing compared with a traditional office building. However, if that percentage exceeds 20 percent, or if the landlord provides the space-as-a-service directly, then the valuation pricing parameters may change due to the added risk or income volatility compared with a traditional office building.

“As space-as-a-service becomes more in demand and you see more of your building being allocated to that, and directly to the landlord, I think you’ll see more of that become split out, because that becomes a big part of the cashflow then,” Kalvoda says.

What results are two separate income streams with two separate types of investors: a lower-risk, lower-return investor that is seeking a stable cashflow from the traditionally leased component and a higher-risk, higher-return investor comfortable with potentially more volatile cashflow from the space-as-a-service component.

Theuriau does not have any hard-and-fast rules about whether he would value the flex component differently than the traditional office component of a building. “It depends on who the operator is and the quality of offering,” he explains. “If I feel the operator is weak and it’s overpriced, and it’s not sustainable, then I’ll price it differently. On the other hand, if I feel that operator is bringing a competitive advantage to my asset, and it’s priced right, I may value it even more. It’s very much on a case-by-case basis.”

Theuriau would adopt three different methodologies to value an asset with a space-as-a-service component: a comparison between a property’s current cashflows and its projected cashflows if the flex component were to be re-leased under a standard lease; a discounted cashflow based on the amount of capital expenditures needed for a lease renewal; and assessment of the performance and growth potential of the service component. The final valuation for the asset would be a combination of all three values using the discounted cashflow approach.

“We definitely need a clear consensus around methodology,” says Swinnerton. “That will drive further confidence in this part of the business, particularly from the investment and banking communities. There will always be certain assets that you might need to look at in a different way for specific reasons, but I think in general, there should be a consensus.”

Does brand matter?

The importance of the operator’s brand on a building’s valuation is up for debate. Swinnerton maintains that most office occupiers will not place heavy emphasis on branding. “If you’re a normal business on the street, very few people will know who the different flex workspace operators are at all,” she says. “All they’re concerned about is, ‘I need an office for this many people, it needs to be in this location and I want to pay this much money.’ Obviously each of them will have different merits, in terms of the design and the amenities that are offered and the feel of the place. But customers are not making their decision based on how the space is branded.”

Kalvoda, however, believes that the branding of the space-as-a-service provider will have a generally positive impact on valuation and will become more valuable as flex space becomes more popular. He notes that Altus Group itself is a flex-space occupier in some of its locations around the world: “We’d like something standard, we’d like to have a known experience. If we’re renting in five different cities across the world, it’s much easier to deal with one operator, knowing there’s consistency of delivery in what the services are. That’s the consistency you see with hotels, where you generally tend to one brand, or even one hotel within a brand, because you know the experience you’re going to get.”