Puzzles & Roadmaps
“Since when did employee engagement in our tenant companies become our business?” The Chief Strategy Officer of one of Singapore’s largest REITs posed the question in the middle of a tense session about how they were looking to reposition their office portfolio. They wanted to ‘activate’ some of their offices buildings in such a way to be more attractive to young knowledge workers. They were looking at building a coworking brand. They feared that their portfolio was becoming stale.
Our answer was tentative, but in retrospect probably a decent one. “Well, the stickier your spaces and the more engaged are those who work in them, the more likely you will be able to retain them as tenants.” To which our client replied with a question, “So it is less of a B2B thing, and more of a B2B2C thing?”
That was a breakthrough for them, and a revelation for us. As a workplace strategy and ‘coworking’ consultancy, our clients are real estate developers, asset owners, brokers, and entrepreneurs whose curiosity is peaked by the coworking/shared workspace phenomenon. On the one hand there is the cool factor, given coworking’s idealistic roots in the Bay Area startup scene. Even the most traditional real estate professional seems to be attracted to coworking. On the other hand there are the economic factors affecting the entire office market. Where is demand heading? Will younger knowledge workers want the same product as their parents? Should we have coworking in our portfolio? If so, how much, and how fast? Can we make more money via the coworking leasing model (vs. the traditional model)? How do we underwrite projects that have such an uncertain future? How do we manage risk going forward? If we don’t do something (the classic innovator’s dilemma), will our products remain relevant in the coming decade?
Over the past four years we have built our business on answering these questions and helping asset owners ‘get into’ coworking. Prior to that, we were coworking space owners/operators, going back to the beginning of the industry. This article is a pause, or a moment of taking stock, in an industry experiencing hypergrowth. Coworking is indeed a part of the real estate industry, despite what some people might claim. Though elsewhere we discuss how it is more than just this. However, the extent to which coworking is impacting the real estate industry more broadly has as much to do with the power of culture, and how that shapes demand, than is generally appreciated. In this respect, Culture (big C Culture, not little c ‘corporate culture’) is the silent driver behind coworking’s success and the real estate industry’s incorporation of it as a new (and disruptive) leasing model.
Work and the Sharing Economy
Like Airbnb, Uber, and Lyft before them, coworking businesses such as WeWork demonstrate that some people (nearly two million at last count) are comfortable conducting their work in shared spaces with employees from other companies and industries. This reflects a generational comfort with sharing all sorts of things- houses and apartments, cars and car rides, tools, labor, etc. The overarching values that define the sharing economy are important here- collaboration, autonomy, community, flexibility, protean careers, reputation. Taken altogether, these values sit behind social transportation, social travel, and now the social workplace (i.e. coworking/shared workspaces).
With respect to the social workplace, we would be mistaken to assume that coworking is purely the domain of freelancers and startups. To the contrary, the industry’s off-the-charts growth over the past two years is being driven by the adoption of coworking by large firms and their employees. For example, in 2010 85% of members of coworking spaces were freelancers and employees of startups. Fast forward to 2017, and only 39% of coworking members were from the freelancer/startup demographic.
The knock-on effect of the corporate adoption of coworking is significant, and is currently altering the office leasing industry. Most of the coworking story is told through numbers, as the real estate industry is a ‘per sq ft industry.’ However, without the scale and scope of changing demand- which is in part an expression of the generational values of the sharing economy- it is highly unlikely that asset owners, investors, underwriters, and developers would have let coworking ‘in the door’ as a credible and viable leasing model across the office market landscape.
The aha! moment in the evolution of the industry occurs when large firms realize that, because of new technologies and anytime/anywhere work, they simply don’t need as much real estate on their books as they once did. Modular, flexible leasing accomplishes two things simultaneously. First, it can significantly reduce company’s real estate spending. Secondly, the kinds of workspaces offered in coworking spaces are more aligned (than their own offices) with the aesthetic and social values of their younger employees. This naturally puts pressure on the corporate real estate industry, which sees demand for its traditional product shrinking. All parties are now animated.
Space and Capital As Commodities
It is often said that prostitution is the oldest industry in the world. Perhaps this is true, but if so then the real estate industry is a close second. Collecting rent has been a part of the human repertoire since the domestication of plants and animals in the Near East some 10,000 years ago. Real estate’s centrality in most of the economies in the world is based in this history. It is, arguably, the backbone industry on which most economies sit.
Because of this, the industry is understandably ‘set in its ways.’ Conventional practices around lending and underwriting, leasing, credit, risk management, etc., are highly conservative for good reasons. So many people build wealth through real estate of various sorts that whole economies would be put at risk, as we have recently seen (2008), if rules are loosened too much.
When coworking came along in 2005, several years before the Great Recession of 2008, it was up against a CRE industry that was disinterested if not downright dismissive. The very idea that multiple sub-tenants would be contributing towards the lease requirements was a non-starter. How many will there be? Who will they be? Who do they work for? How credit worthy are they all? And, what is this thing called coworking anyway?
Anecdotal evidence among coworking operators in the early years of the industry (2006-2010) confirms this industry reaction. For many people it was difficult-to-impossible to get an asset owner to lease space to a coworking business. As for borrowing money from a traditional bank, this was absolutely out of the question. It was not until 2008-2009, when the full effect of the recession was spreading across the country, that building owners watched as more and more of their buildings became vacant. They faced an interesting dilemma: Either they could stick with their traditional terms of a 5-10 year lease for a single, credit worthy single tenant and receive $0 per month, or they could ‘experiment’ with coworking and sign a lease with a young entrepreneur for a year or two at a reduced rent rate and earn something.
Many of these early coworking businesses failed, which confirmed the fears of many in the real estate industry. However, many others thrived and in doing so encouraged others to start their own businesses. As unemployment climbed steadily between 2008 and 2011 to as high as 9.1%, millions of knowledge workers in the US and Europe gravitated to coworking spaces for both social and economic opportunities. The combination of looser leasing requirements with rising unemployment created a perfect storm for the growth of the industry.
WeWork, the industry leader, was founded in 2010, and by early 2018 has over 300 locations in 61 cities around the world and a valuation of $35B. WeWork is the sharing economy unicorn that most people still don’t know about. Largely because of WeWork’s success, but also because of the successful growth of other brands such as Knotel, Industrious, Convene, Work Bar, Tech Space, among others, money is pouring into the industry worldwide. It is estimated that in China alone there are around 3,000 coworking spaces, though getting an accurate count has proven difficult. The largest coworking space to ever come online, interestingly, is GoWork in Gurgaon, India. Being built in two phases, GoWork will be nearly 1M sq ft when completed. Other ambitious projects are being built in China as well, which underscores that coworking is no longer simply an American freelancer phenomenon.
Abundance of Space
The rapid growth in the number of coworking spaces, and thus the overall number of workstations (or ‘hotdesks’) for rent, simply added to a significant glut of office space, both in the US and internationally. When you take note of the standard space utilization rates of corporate offices in the US, which hover between 40%-50%, you have a picture of abundance/poorly managed space. Business such as Liquid Space, which is a marketplace for office buildings and coworking spaces to sell short term work and meeting spaces for people looking for flexible solutions, was born of this very abundance. Some have dubbed Liquid Space the Airbnb of office space. Similar types of platform marketplaces have sprung up around the world to broker the availability of excess office space.
This excess is driven in part by the traditional leasing norms favored by asset owners and brokers. For decades, tenant companies leased around 300 sq ft per person, which is significantly more than most people need. Over the past five-seven years, given the pressure being placed on brokers by the shared workspace industry, this number is coming down significantly. Allocating 150-200 sq ft per person is not uncommon today.
In WeWork locations, for example, single workstations are around 40 sq ft per person, with the total allocated per person (including common spaces), now being down between 65-90 sq ft per person. For traditional asset owners and brokers, this is truly disruptive. What has become quite clear is that in the traditional model tenant companies are being leased much more space than they either need or could possibly ever utilize at meaningful rates. This is the core industry-wide realization that has set the industry in motion.
Abundance of Capital
As Clayton Christensen and Derek van Bever have argued quite persuasively in an HBR article, both large firms and investment shops are awash in capital. Indeed, there is more cash on the books in corporate America than ever before. This is both good and bad. As they argue in “The Capitalist’s Dilemma,” Christensen and van Bever outline the process whereby firms hoard cash and recycle that cash via share buybacks and increased dividends as a way to manage institutional shareholder demands and expectations. An ideology of scarcity leads to the hoarding, despite the record levels of cash already on hand. That is, there is not a scarcity of capital, but rather an abundance. The result is that firms are not investing in their own businesses (or in their employees), but are rather engaged in what they call ratio management- IRR, RONA, EPS, etc. As long as these ratios are well managed, analysts reward firms with glowing reports and further investment. According to Christensen and an Bever, this is not a desirable state of affairs.
On the other hand, though,, the abundance of capital has turned out to quite fortuitous for the fate of the coworking industry. Many billions of dollars have been invested in the industry thus far, with WeWork receiving the lionshare of that. In a single round in 2017 WeWork received a $4.4B investment from Softbank. Smaller industry players also routinely receive rounds of funding in the range from $40M to $100M. In this respect, the abundance of cash is being acknowledged concurrent with the recognition that the global office market is at a once-a-generation inflection point of opportunity. Investors of all sorts- technology and real estate- are pouring in.
Space as Service
While coworking continues to be a feel good story in the popular media, its real impact in the office leasing industry can be seen in the numbers. According to recent research by JLL, coworking and flexible space (combined) has been growing at a rate of 23% since 2010, and it “has emerged as the primary growth driver within the office market.” As of Q2 2017, “expansion from this sector claimed more than a quarter (29.4%) of the total US office absorption over the past 24 months (18.1 million sq ft).” By Q4 2017 over 51M sq ft of real estate was being lease as coworking/executive suites/flexible workspace.
Fifty one million sq ft of executive suites/shared/coworking office space is still less than 5% of the over 1B sq ft of office space in the US. “Given industry shifts, flexible workspace and shared amenity spaces are projected to encompass approximately 30% of the office market by 2030.” This means that over 300M sq ft of office space will be leased as flexible office space (including coworking spaces) by 2030. Using standard industry projections, this suggests that by 2030 the coworking/shared workspace industry will be a 36B/yr industry.
Asset owners and investors are drawn to the numbers. Because of the decreasing footprint per workstation, combined with the premium charged for both the flexibility and social atmosphere that are part of most coworking memberships, operators can generate significantly more per sq ft via a coworking operation than the asset owner can through a straight lease to a traditional tenant. For example, in a 30,000 sq ft space, an efficient operator can generate $115-$130/ sq ft, while they might pay $45/sq ft to lease the space. The rent arbitrage in between these two numbers gets everyone’s attention. Generating these returns is not necessarily easy, but as the industry matures and operational best practices become more commonly known, it is likely that more asset owners will want to convert some portion of their office portfolio to this higher risk/higher yield leasing model.
The Power of Culture
Peter Drucker is generally credited with coining the phrase, “culture eats strategy for breakfast.” Countless CEOs and consultants have repeated it over the years, which is now a kind of maxim. We all know that even the best laid plans can be scuppered by a disconnected or switched off team that is not rowing in the same direction to execute company strategy. Rarely, though, do we think about the relationship between culture and the real estate industry. After all, real estate is a commodity that (theoretically) is in scarce supply, and the laws of supply and demand are supposed to apply. While this remains the case for the most part, a new ‘wild card’ has entered the picture to skew demand in disruptive ways.
Whether as freelancers or as employees of large firms, young knowledge workers today simply use products differently than previous generations. They experiment, prototype, graze, and move on. From our work with dozens of companies and hundreds of company employees, it is clear that for many young employees today the idea of working at a fixed workstation every day of the week is no longer very attractive. While their Baby Boomer counterparts do want to nest in their offices with pictures of their family and pets, for Gen Y and Gen Z this is anathema to a dynamic, social career that is fluid, collaborative, and autonomous. That is, the core values that young knowledge workers bring to work are simply different than those of previous generations. Coworking, in the independent workplace sector, and activity based working (ABW), in the corporate context, are elaborate accommodations of these shifting generational values.
The industry shifting impact that coworking is having on the office market, I suggest, is being driven by the shifting cultural demands for new ways of working. Such values differences are sometimes subtle, and it is always difficult to “prove” their influence. However, to the extent that the real estate industry- one of the oldest and most staid industries in the world- is now accommodating these value differences, is a testament to the power of culture.
The values-challenge posed by the sharing economy also present enormous opportunities to asset owners and their large-company tenants. Large property managers such as JLL, CBRE, Colliers, Cushman and Wakefield, and Avison Young have been actively researching coworking and the sharing economy’s impact on their portfolio properties, and many asset owners are already engaged in converting some part of their portfolio to shared and amenity spaces that cater to the social and cultural needs of younger knowledge workers. Following cultural demand, but also drawn to attractive rent arbitrage numbers, portfolio diversification in the direction of coworking is underway.
On the corporate side of the equation, there is significant movement too. Many large firms have embraced the coworking movement and have employees working from various spaces around the world: GE, Silicon Valley Bank, Salesforce, Dell, Unilever, Google, Microsoft, Samsung, Uber, Amazon, KPMG, Lyft, HSBC, Merck, The Guardian, Accenture, Marriott Airbnb, etc.
From a consultancy perspective, the corporate embrace of coworking is one of the most interesting. Our work with coworking ventures around the world allows us to see, first hand, places where thousands of employees from hundreds of companies work on their own work in shared spaces. What might Drucker say about these places?
The Social Building
WeWork, the industry leader, already sees itself in the ‘culture business.’ In their new ‘onsite solutions’ division, where they propose to manage company campuses for them, part of the value proposition is that those employees will be able to have a WeWork experience while doing their company’s work. With its sharing economy credo leading the way- “we build spaces and communities that help people make a life, not just a living”- WeWork is well on its way to eating both culture and real estate. The company’s recent contract with IBM, wherein they will manage the entire IBM campus at 88 University Place in Manhattan, is the first well documented case of campus/culture outsourcing in the industry.
It is unlikely that there will be a mass exodus of company employees to coworking spaces or a mass conversion of traditional offices to coworking-like arrangements anytime soon. However, it is clear that in a variety of ways the cultural forces behind coworking and the sharing economy are having an impact on the real estate industry (and their corporate tenants). Economists typically view culture as an ‘externality’ that only needs to be accounted for when the laws of supply and demand are out of sync. Today the cultural values of the sharing economy might be an ‘externality’ within the broader scope of the economy. Over the next decade or so, as Millennials become the largest generation at work, with Gen Z close behind them, the ‘externality’ of culture very well might eat other segments of the economy as well.
A quick return to that client conversation back in Singapore. Over the course of nearly six months of working together, the CEO and his team were finally able to distill what it is they are trying to achieve in their portfolio. We want to ‘activate our buildings,’ they said. ‘We want our buildings to be social places where young people want to work.’ And finally, in a most poetic turn of phrase, they put it this way: ‘The buildings are the hardware. We are already good at hardware. What we need is the software that brings the buildings to life.’
This article was originally posted on LinkedIn by OpenWork Agency Partner, Drew Jones, PhD.