How the Market is Valuing Flex Office Space Post WeWork’s Failed IPO

The enthusiasm of lenders and investors for office buildings with space leased to flex-office providers cooled in recent months due to WeWork’s failed initial public offering, but ongoing demand for flexible office space has the market working towards a new normal.

That’s CBRE’s finding in its new report about flex-office valuations amid the market’s uncertainty in this space. New leasing by flex operators slowed in the fourth quarter, and transaction activity for office buildings with flex components is likely to slow this year. Still, CBRE says flexible office space is alive, well and changing the relationship between occupiers and landlords.

GlobeSt.com spoke with Julie Whelan, CBRE’s Americas senior director of research and author of much of the company’s research on the flex sector, for an exclusive Q&A about CBRE’s latest findings.

How have capital markets regarded flexible office space since the Wework revaluation?

The WeWork retrenchment and the flex sector’s subsequent slowdown didn’t start until the fall, so there wasn’t much effect on 2019 numbers. In last year’s transactions, buildings with a moderate amount of flex space – say, 30 percent or less of their total square footage – saw minimal differences in value in comparison to similar properties without flex space.

Specifically, we found that 71 percent of buildings with flex space that sold last year did so at cap rates within 50 basis points of their non-flex peer set. (Capitalization rates are a measure of a building’s value from dividing its annual income by its sale price).

This year, however, we’re finding that the capital markets are more cautious on buildings with more than 15 percent of their space dedicated to flex. That should loosen up over time as flex space further establishes itself as a permanent, integral part of the office market.

Are there situations in which lenders and prospective landlords don’t have as much caution about certain office buildings with flex space that are on the market, or perhaps some scenarios that they even like?

We see the sweet spot at that 15%-or-less ratio. That amount of flex space is small enough to allow a building’s strong local-market fundamentals and overall tenant mix to prevail over any perceived challenges with the presence of flex.

That ratio is common today anyway. At the end of last year, slightly more than half of buildings with flex space in the U.S. and Canada had less than 15% of their square footage dedicated to it.

There are still investors who are willing to take big bets on buildings with higher ratios of flex space. But, institutional investors favor buildings with small amounts of flex space versus those with larger portions. In the first quarter, they and REITs accounted for the vast majority of acquisitions of buildings with flex space of 20% or less.

What if a building’s flex operator simply fails – or breaks its lease?

In this rapidly rising rent environment, there is a high likelihood the landlord can re-lease the space at higher rates under traditional models.

CBRE’s analysis found that slightly less than half of leases signed by flex operators started prior to 2017. Rents have risen a lot since then, including a gain of 5.2% last year. If landlords are forced to look for new occupiers for that space, they might ultimately come out better financially.

If the building was profitable, and the operator failed for another reason, the landlord might even explore taking over the flex operation.

It seems there is a lot of discussion between landlords and operators around management agreements over traditional leases. CBRE’s new report highlights this ‘asset light’ approach as preferable for landlords. Why focus on that?

I think there is realization that there are flaws in a traditional lease model. Many flex operators are taking steps towards an asset-light, management-for-a-fee model. It allows the landlord more control over the design and operations of the space and direct influence over the membership mix. It also, most importantly, provides the landlord a higher net operating income, once stabilized.

Lenders and investors are now discovering how to value the asset-light model because we’re early in the process. With time and experience, this model will likely lead to a new way to value real estate with a flexible office component.