15 August 2019
The flexible workspace sector has quickly become a major driving force behind activity in the commercial office market. Over the last five years, it has experienced fast-paced growth, with stock take up now reaching 521 million sq ft globally across 35,000 flexible workspace centres. Today the flexible workspace sector has reached a size that it now attracts interest from large property owners, alternative property investors as well as traditional income seeking funds.
Yet despite this the sector lacks a coherent, market accepted, valuation guidance method. Although a number of competing models have been put forward and RICS has a working group considering the issue, a market accepted valuation remains elusive. If it can be agreed then it could see significantly greater fund flows as larger institutional investors target flexible offices, which could then see the sector emerge as a separate asset class and spur another period of strong growth.
Current valuation models are not fit for purpose
The lack of a recognised valuation or guidance model has disrupted numerous deals across the country for many operators and investors because current valuation approaches are not consistent and are ultimately unsuitable for flexible workspace. This has led some surveyors and property valuers to use a model that is normally applied to public houses or in most cases, just traditional property methods. The former valuation method firstly tries to establish whether the building is run by a Reasonably Efficient Operator (REO). Such a valuation model requires the surveyor to estimate the trading potential of the building, rather than the actual level of trade under the existing ownership, and it excludes personal goodwill. As part of the process the surveyor is required to estimate the Fair Maintainable Turnover (FMT) and Fair Maintainable Operating profit (FMO) of flexible workspace and then apply a discount to its EBITDA.
A double discounted method of this nature ignores the trading history of the flexible workspace in favour of a conservative estimate of trading potential, disregarding many years of hard work and evidence of profitability, which ultimately punishes the vendor. Approaches such as this do not, in my opinion adequately reflect the true value of the workspace. Ultimately, the lack of clear valuation model causes friction between investors and operators, and operators and valuers, affecting many deals across the sector.
Different approaches to flexible workspace are confusing
Surveyors have in the past been quick to assess flexible workspaces as a risk, making assumptions of occupancy rates and profitability that fall well below traditional office valuations. This leads them to underestimate the profitability associated with flexible workspaces.
Several valuation models have been put forward to address this situation. One well-known formula across the sector is the Fuchs Formula, conceived by Giles Fuchs, CEO of flexible office operator Office Space in Town. This valuation model splits the annual income generated by a flexible workspace centre into two or more tranches, applying a market yield to the first tranche up to ERV and then discounted yields applied to the outstanding income based on its contracted or variable nature.
There is an alternative way to achieve similar result as this formula, which GKRE believes can and does adequately calculate growth and assess risk. This approach would apply a discounted yield to the total EBITDA produced by the centre. A valuation model of this nature can result in roughly the same valuation figure as that put forward by the Fuchs Formula, while removing complexities that might dilute or delay a valuation.
As with any valuation, further considerations should be given to location, sustainability, profitability, efficiency and operational skills associated with the business at hand. Once all of these have been considered, together with the usual property due diligence, there is little to suggest the operation will deviate from its ability to generate consistent returns. These will often exceed the market rent and as such should be valued accordingly.
Market agreed valuation could attract significant institutional investment
As the flexible workspace market has continued to grow, it has caught the eye of significant investors. US private equity fund Blackstone bought the Office Group valuing it at over £500m in 2017, while last year another US private equity house Carlyle completed three acquisitions and said it would commit £150m on the launch of its own flexible offer, Uncommon. Towards the end of last year, Asian family office Celvam Management acquired London Executive Offices for £475m. FTSE 250-listed RDI REIT also bought a controlling stake in a property portfolio owned by Office Space in Town (OSiT). Apart from RDI all these groups are alternative investors, with short and medium-term time horizons with regard to seeking an exit.
However, if a market-wide valuation for flexible offices was agreed, there would be potential for flexible offices to emulate other property sectors such as
WeWork continues to grow
hotels and student accommodation, and be recognised formerly as a separate asset. The sector would likely attract large, long-term institutional investors, such as pension funds and insurance companies and see them view flexible offices as a core part of their investment portfolios. Such a hugely positive scenario will hopefully spur RICS and sector valuation expertise to agree a market valuation sooner rather than later, for the benefit of all involved in the flexible office sector.