By Douglas Green, Director GKRE
GKRE has been inundated with requests recently from property companies for advice on how to deliver joint venture agreements for flexible workspace in locations across the UK. Our experience of this type of transaction means we are well placed, and delighted, to do this but the question occurs to me, why now? And what are a property company’s options if they want to get involved in the flexible workspace market?
Why now? – the decline of the traditional lease
It has been well documented that the flexible workspace market is revolutionising the UK office market. A recent report by CBRE revealed that 92% of UK landlords believe the sector is on the brink of becoming mainstream. And, more than three-quarters of them are considering using flexible office space within their portfolios.
Every forecast expects this revolution to continue and, as a result, the impact on property owners is going to be profound.
Office leases are already getting shorter year by year. The demand for tenant flexibility and, more recently, the increase in tenant CVAs is eroding the security of rental income.
This is changing the way property owners view their properties. According to CBRE, global investors believe that up to 20% of coworking space in a building enhances its value.
My view is that the successful property owners of the future will be the ones who no longer think only of generating income from property in the traditional way, ie by granting leases.
What are a property owner’s options?
As I see it, there are a number of options open to property owners.
1. Grant a traditional lease to an operator
Flexible workspace operators took over 21% of central London office space in 2017, much of it in trophy buildings and mostly on traditional leasing terms. With the increased covenant strength of operators, this is now the vanilla option. Safe but with no upside.
WeWork is now the largest occupier of office space in central London behind the government. Bearing in mind this level of commitment, WeWork’s latest valuation (now $35bn according to some sources) should make the property world sit up and think. By selling its product as “space as a service”, WeWork is effectively using the premises let to it in such a way as to take value away from the property owner. This is why it is valued differently to a property company and why its valuation is so huge.
2. Run your own operation
One option for landlords is to throw themselves into the fray and take on the operators themselves. This means a head-on clash with flexible workspace operators who have had several years’ head start. It would be a steep learning curve for the vast majority of property owners.
This is the route The Crown Estate and British Land, among others, are going down. The plus side for landlords if they get it right is three-fold. First, they can generate income far in excess of ERV. Second, where flexible workspace forms part of a building, they can incubate occupiers as they grow from start-ups or SMEs to fully fledged tenants with a sense of loyalty to the owners. Third, they create a brand with a value in its own right.
That’s all very well in theory but how easily can property companies turn their hand to running flexible workspace businesses?
James Lock, Managing Director of Blackstone UK (which owns a majority stake in The Office Group), believes it might be a mistake: “There are a lot of firms potentially coming to the sector late who haven’t got the insight around how you operate and run these businesses. It’s about the bottom line, it’s about efficiency of management, it’s about practical management and people can get caught out,” he said.
3. Invest in an operator
Various funds and property companies including Blackstone, Moorgarth, RDI and Brockton have invested in operators or created their own operations. But this can involve a large investment as shown by recent deals such as Blackstone’s purchase of a majority stake in The Office Group that valued the business at £500m and RDI buying 80% of four flexible workspace offices from Office Space in Town for £161.7m.
4. Enter into a joint venture management agreement or profit share lease
I believe this is the best option for most property owners.
I’ve been in the sector long enough to remember when entering into a joint venture or management agreement with an operator was seen as a sign of desperation by a property owner. They usually took most of the risk and little of the upside.
This perception has undergone a radical change as we know first-hand from advising numerous parties on management agreements, including between EPIC and Orega in Glasgow and Halkin Management and Maybourne Group in relation to 41-43 Brook Street, Mayfair (pictured below).
In legal terms, a management agreement is a contract between a property owner and an operator, usually operated through a joint venture company. As such, it is important that property owners recognise that this is not a traditional property transaction.
In broad terms, under a management agreement, the property owner provides the property, is responsible for capital expenditure and covers the initial running costs of the operation until it becomes self-sufficient. In return, the operator runs the workspace, usually under its own brand for a fixed management fee. The profits are divided according to a detailed formula and this acts as a further incentive for operators to continue to drive revenue.
The upside for the landlord is similar to creating their own brand. However, they are sharing the risk with an established brand in the sector whilst also benefiting from the potential for a return often in excess of ERV, the ability to incubate occupiers in its own buildings, the opportunity to offer flexible workspace to existing tenants to grow into, and the creation of a ‘community’ within its building, making it more attractive to other tenants.
To landlords worried about a downturn leaving them underwater with operating expenses and unpaid capital expenditure, The Office Group’s Charlie Green offers some words of reassurance:
“Our revenue dropped 12% at the beginning of 2009, but by September it was back up to previous levels. Income does drop, but if you have the best buildings in the best locations you can adjust your pricing, still make a margin, manage your way through and ride out a downturn.”
All in all, I believe management agreements offer property owners who want to get involved in property’s most dynamic sector the best balance between risk, reward and responsibility.
If you are a property owner and would like to discuss in confidence how you can get involved in the flexible workspace market, please contact me now on 020 3427 5678 or email email@example.com