Ken Riggs; CFA; Vice Chair RERC, a SitusAMC Company
Michael Franco, CFA; Chief Executive Officer, SitusAMC
WeWork is back in the news and again not for good reason – though for almost a year its news has rarely, if ever, been good. Following its spectacular public downfall in mid-2019, including a massively overvalued IPO attempt, complicated financing structure and eccentric CEO behavior, the company was still above water at the end of 4Q 2019, with 739 locations across 140 cities and more than 662,000 total memberships. With a $3 billion bailout from SoftBank and a new real estate-savvy CEO, there appeared to be light at the end of the tunnel for WeWork as it headed into 2020.
That light turned out to be an oncoming train for the entire coworking market in the form of the coronavirus (“COVID-19”). As COVID-19 became a global pandemic, most businesses directed their “non-essential” employees to stay home or work remotely, governments enforced lockdowns in some countries and many U.S. states enacted shelter-in-place or similar social distancing regulations. These measures left WeWork spaces, and most traditional office spaces, virtually empty. Amid investor skepticism of the coworking business model in a post-COVID-19 world and ongoing investigations by the Justice Department, the SEC and the New York and California attorneys general, WeWorks’s guardian angel, SoftBank, announced that it would not follow through on its prior tender offer to purchase stock from other shareholders. That was a big blow to former CEO Adam Neumann, who would have collected $970 million from the deal. On May 4, 2020, Neumann and a special committee of WeWork’s board sued SoftBank for reneging.
If WeWork’s image was not tarnished enough, its members across the world have come out against the company’s aggressive rent collection tactics during the pandemic. According to members (as published in multiple media outlets), WeWork has refused to shut down its locations, allowing it to collect membership fees even while some governments forced companies to allow their employees to work from home. Members have stated that WeWork charged a 10% late fee for missed payments and took money out of their accounts while in the process of negotiating rent deferrals. The Wall Street Journal recently reported that WeWork itself missed rent payments on some properties in April. Reportedly, WeWork paid its April rent for most of its perceived key locations that it views as critical to its long-term business strategy; however, its CEO, Sandeep Mathrani, admitted that WeWork did not pay rent in approximately 20% of its locations in April and May and had collected only 70% of rent from its tenants in April.
Given these recent events, it makes sense to revisit coworking in general and, more specifically, the impact of WeWork on the larger commercial real estate market.
IS COWORKING DEAD?
COVID-19 may become the largest threat to the coworking office business yet as it strikes the existential question about whether the concept of coworking can survive in a world of social distancing. Negative press coverage on the broader “sharing economy” is just about everywhere you can imagine and large “sharing economy” players such as Uber, Lyft, Airbnb, etc. have all seen significant decreases in their stock prices, laid off significant number of employees, and/or have raised capital to insulate themselves from near-term liquidity pressures.
In The We Company’s S1, it listed the trends propelling WeWork’s growth as (a) Urbanization, (b) Globalization, (c) Independent Workforces, (d) Flexible Solutions, (e) Workplace Culture, and (f) the Sharing Economy. Of these trends, how many are still working today?
As people are confined to their homes and as working from home becomes more accessible and accepted, many believe that the urbanization trend may shift again in favor of suburban living in the coming years. Globalization, once a hallmark of the world economy, faced headwinds during 2019, but we have seen in certain industries an outright reversal in globalization trends due to COVID-19, with many nations considering moving key industries back onshore. Independent workforces, which benefited from a tight labor market that made finding resources to hire internally more costly and difficult, may face headwinds from companies looking to redeploy existing employees to support activities that were once outsourced. While flexibility and culture should always be a benefit, quite a few legs of the coworking stool seem to have been removed.
Despite these facts, it’s important to differentiate between short-term and long-term trends. After all, the office sector has always embraced change. Many people may not remember this, but the open-office concept has been around since the 1960s. Any fan of the TV show “Mad Men” will remember the large bank of side-by-side desks with private offices reserved for only the top executives. Open-office popularity peaked in the 1970s and gave way to the large private offices of the 1980s, only to be reborn. Like fashion, in office design and preference what’s old can always be new again. Therefore, whereas short-term trends may be negative, long-term coworking’s future does not have to be so dour.
THE COWORKING ENVIRONMENT
It is important to remember that WeWork is not the only show in town. Regus has over 3,000 locations in almost 900 cities. IWG PLC, which owns Regus, also owns 10 other coworking brands. Some of the top CRE firms, including Tishman Speyer, Hines and CBRE, have launched coworking environments. Cushman & Wakefield launched a coworking service called INDEGO in the U.K. in February 2020. These firms all realized the value and potential of flexible workspaces and coworking in launching their own brands.
In our opinion, flexible workspaces and coworking is generally appealing and will continue to be a long-term trend. In 2019, $5 billion worth of office sales had a flexible component, according to CBRE. Just prior to COVID-19, CBRE predicted that coworking would account for 13% of all office space by 2030, up from under 2% in 2019.Technological advances and the ever-changing space needs of companies will continue to make flexibility a highly sought after amenity. Even if COVID-19 significantly impaired coworking, does going from a 13% prediction by 2030 to 0% make sense? After all, even within WeWork approximately 40% of its memberships were “enterprise” or corporate lease clients.
FUTURE DEMAND GENERATORS
There are several reasons that the COVID-19 crisis might help flexible office space demand. If we do experience a V-shaped recovery, businesses will presumably want flexibility as their workforces quickly expand. Alternatively, if the economy is slow to recover, companies might place a premium on spaces that require short-term commitments, even if those commitments are associated with higher rents. While the psychological impact of the current economic shock will remain in the back of people’s minds in the medium and long term, we must also realize that conditions can change rapidly and the offices themselves can be re-designed to maximize marketability to virus-conscious clientele.
Somewhat ironically, the potential increase in companies allowing employees to work from home permanently or semi-permanently may increase coworking demand from individuals. People are social creatures who will still want to interact with others and go to a dedicated space – but free from distractions that can exist at home. Additionally, not all homes are conducive to working. While the prognosticators are sitting in their home offices writing death warrants for the coworking industry, many working people are hunched over a coffee or dining room table. In fact, we may see new companies that specifically cater to the individual work-from-home customer base. Just think of the success that Starbucks had in providing a communal space to freelance authors.
CAN WEWORK PULL THROUGH A RECESSIONARY PERIOD?
Prior to COVID-19, RERC outlined some of the risks with the coworking model. Coworking firms sign long-term leases with office landlords and then sublease space short-term to companies through a membership fee system, some even on a month-to-month basis. This means that companies like WeWork will have to contend with high fixed costs, but revenues can ebb and flow. RERC argued that both small and large members present an additional layer of risk to the coworking business model in the event of an economic downturn. Small companies and individual entrepreneurs would be the most likely to fail – and the first to leave – during a recession, but large tenants often occupy a greater amount of space, resulting in huge vacancies should they leave.
There is nothing like a global crisis to test these theories.
WEWORK IMPORTANCE TO THE OFFICE MARKET
For office property owners, the location, property quality and local economic environment are paramount to the property’s performance. The market carefully distinguishes between stabilized well-positioned properties and non-stabilized properties facing NOI volatility and uncertainty. The bifurcation that we were already seeing in retail pre-COVID will become apparent in most property types and markets in a COVID or post-COVID world. Properties that have WeWork and other coworking firms as tenants are no exception.
If WeWork were to renegotiate existing leases or if it went through a financial restructuring or dissolution, it is important to realize the impact it may have on the U.S. office market. To understand that impact, it makes sense to start with the overall size of the “flexible-office-space” or “coworking” market relative to the total office market and to understand the reach of WeWork within certain submarkets.
According to CBRE research, flexible-office-space comprises only about 2.0% of the total office inventory; however, it is generally highly concentrated in the top-10 markets where market share for coworking is higher. In only 15 U.S. markets was flexible-office-space more than 1 million square feet of inventory. Of coworking space under lease, it is estimated that WeWork represents approximately 30-35% of the total after rapidly expanding throughout 2018 and 2019.
U.S. markets with the most WeWork exposure include New York (WeWork is Manhattan’s largest tenant), San Francisco, Chicago, Los Angeles and Washington, D.C. However, even within these markets, by WeWork’s own metrics shown in Exhibit I below, they represent a small share of the overall potential market. Furthermore, the broader market supply risk is the net vacancy rate of WeWork at any point in time, particularly if the landlord decides to adopt the localized business model. Therefore, while these markets would bear the brunt of any WeWork-related issues, any distress created would be localized to specific buildings with an over-indexed exposure and other buildings that would compete with those buildings for tenants. The good news is that many of these buildings and their capital providers have already started reassessing their exposure, where possible, so if pain does come it would no longer be a surprise.
SOFTBANK TO THE RESCUE?
The SoftBank of today is not like the one of old. As such, it may not be the backstop it once was for WeWork. After having invested approximately $10.25 billion in WeWork from its own balance and through the Vision Fund, the value of those investments today has been substantially written down to a combined carrying value of approximately $2.4 billion as of March 31, 2020 ($6 billion invested from its balance sheet with a current value of $1.47 billion and $4.25 billion invested from the Vision Fund with a current value of $938 million). Additionally, several other significant SoftBank investments (Uber, OneWeb, Oyo, etc.) made with its own balance sheet and the Vision Fund have also floundered.
This declining financial position, which has led to a 21.5% decline in SoftBank Group Corp’s stock price from late July 2019 through May 18, 2020, has had a dramatic impact in the way that SoftBank can think about an additional investment into WeWork. After all, the SoftBank of today (i) is taking on activist investor Elliott Management, which has aggregated a $3 billion investment stake and is pushing for an increase in independent directors and financial controls and (ii) has committed to a 4.5 trillion yen plan ($41 billion+) plan over the next year to sell assets (including its stakes in Alibaba and T-Mobile) in order to pay down debt and repurchase its own shares in an effort to increase shareholder value.
Where SoftBank has been an investor of last resort for the company historically, it may not be able to play that role moving forward. These facts, coupled with investor sentiment from other current shareholders (T. Rowe Price stated in its annual report that “… we are ready to declare this a terrible investment”) may mean that if fresh equity is needed, it may not be able to be raised without a significant restructuring of the company’s existing capital stack and financial commitments.
WeWork and its coworking brethren are not facing anything that other industries are not. The challenges stemming from COVID-19 are the same for airlines, restaurants, salons, etc. These industries will have to implement sanitization and social distancing measures, at least until a vaccine is found and the trust of being next to other people is restored. Coworking companies, just like other firms, will find that those that were just barely making ends meet prior to the crisis will fail and those that were performing well financially will weather the storm. Where WeWork ends up will be a function of the duration of the dislocations caused by COVID-19 and, potentially, its ability to raise additional capital and renegotiate existing commitments.
No matter what the outcome is for WeWork, the U.S. office market will survive. Like in other downturns, additional space will become available and it will take time to absorb new inventory in certain markets. It is always darkest before the dawn, and despite the current negative coverage, we believe that the sharing economy, and flexible-office-space, may be soon saying that that “the reports of [their] death are greatly exaggerated.”