Real Estate as a Service: What Developers/Owners Need to Know

Michael Kloppenburg of Avison Young’s flexible office solutions practice has in-depth experience working on a variety of large coworking projects as leasing manager. Here, he offers his take on the real-estate-as-a-service market today and where it might be going in the future. (See related article.)

Development: What distinguishes real estate as a service from other types of amenitization?

Michael Kloppenburg

Michael Kloppenburg: The need for active management. Thoughtful, hands-on management is required to provide an actual service to tenants and guests, rather than simply providing space. Service is the operative word.

Development: What is the value proposition for the landlord of real estate as a service?

Kloppenburg: Meeting the undeniable market demand for flexibility and managed office services, which in turn makes your assets more competitive and drives increased rents, tenant retention, and ultimately building values. By offering workplaces for businesses to expand and contract, the choice to leave the building becomes more difficult. Allowing a business to flex and adapt provides the agility required in today’s economy. Tenant engagement within the building ecosystem is enhanced through technology; the overall experience improves and becomes more meaningful for tenants.

To most efficiently capture revenue, the infrastructure must be owned and managed by the landlord, or there must be a partnership agreement with a space operator where these new revenue streams are shared. The question is what are your core competencies, and can you effectively deliver the services on your own, or is partnering a better option?

Development: What has been the lender/investor response to real estate as a service?

Kloppenburg: In our experience, lenders and investors appear to remain comfortable with conventional lease arrangements for flexible space operations. Given recent events [the failed WeWork IPO], I suspect there will be additional scrutiny placed on those basic leasing economic fundamentals when analyzing a new potential flexible space lease. Risk management remains important.

Where we have seen consistent resistance from capital markets is with alternative partnership arrangements wherein the space and the improvements are not secured by a traditional lease instrument, such as management contracts or participation leases. The capital required to build out and furnish a coworking space is substantial, so detailed financial projections and a sound business plan must be part of the owner’s approach to pitch his or her lender.

Development: In what ways are building owners getting involved with coworking operators?

Kloppenburg: Aside from traditional lease agreements, coworking operators are partnering with owners through management or operating agreements and participation leases. These are becoming more common. Although the concepts are still being socialized with institutional owners and lenders, a lot of progress has been made with these concepts in the past 12 months.

Development: How do you think coworking/flex space impacts property valuations, occupancies or tenant retention?

Kloppenburg: The capital markets will have opinions on the value of buildings with large exposures to coworking spaces, but I believe it should be viewed based on the lease structure and the rents derived from the operating business. Leases should be valued based on the operator’s performance history and the ability to honor its rent obligations. Partnerships require a more nuanced explanation to establish trust and understanding, but if structured properly, value can be derived through additional revenue streams to the owner and a premium over market rents. A stable, serviced operation is a value-add to the building.

Intermediate options such as thoughtfully designed, pre-built spec suites lease quicker and reduce tenant improvement costs over the long term, which we believe also increases value. We continue to see tenants demand speed to occupancy, term flexibility, and a finished product that removes the stress and challenges of building out their own spaces. Tenants are more frequently relying on third parties to deliver their spaces, allowing them to focus on their core businesses. Landlords that are making these options possible are positioned to capitalize on evolving tenant demands and preferences.

As acceptance of these types of space products grows, we expect markets to become more comfortable with shorter leases and coworking in general to properly adjust building values.

Development: What effects would an economic downturn have on the real-estate-as-a-service business model?

Kloppenburg: I believe in tough times, businesses will flock to flexibility rather than engage in capital-intensive long-term commitments.

Similar to the spirit of retail leasing to manage market fluctuations, if the coworking operator and owner are aligned in their business objectives, together they can absorb the effects of a downturn. Landlords can also lean on these spaces to provide creative solutions to avoid tenant defaults.

Development: What types of companies are seeking flexible leasing arrangements? What types of companies are drawn to traditional leases?

Kloppenburg: We see businesses of all types and sizes embracing flexibility. Every major Fortune 1000 enterprise business is applying some level of flexibility to their portfolio. This is not necessarily a new concept, but you are now able to match your company culture more closely with an operator’s — WeWork or Regus environments are not for everyone. With some varieties, such as Knotel’s model, and owner-built and managed spec suites, the ability to customize private space is also offered.

Development: What does the growth of real estate as a service mean for the traditional lease?

Kloppenburg: The traditional lease is and will remain a mainstay as the majority of the office marketplace. As of Q2 2019, the market penetration for flexible office was around 2% in the U.S. CBRE published a report outlining three scenarios for growth of the flexible sector. Low, medium and high ranged from approximately 6.5% of the market to 22% of the market by 2030. JLL previously predicted a shift of up to 30% flexible space out of the total office inventory. A driving factor depends on large enterprises converting portions of their portfolios to flexible arrangements.

Development: What type of impact will the recent events surrounding WeWork have on landlords?

Kloppenburg: Skepticism and scrutiny from landlords will be strong moving forward, and more landlords will likely attempt to meet the market through partnerships where they have more control of the assets or by doing it themselves. The extent of the impact for landlords will be determined by how they choose to participate with flex in their own portfolios, either through traditional leasing and partnering with shared space operators or building in-house capabilities to provide these products to their tenants.

Development: What can those with WeWork exposure do?

Kloppenburg: They are probably considering how they would manage that space if WeWork defaulted. I see that as an opportunity for other operators to take over those spaces and reuse a lot of the existing infrastructure. Tenants may question WeWork more, which presents an opportunity for the company’s competitors. Personally, I believe WeWork has received the funding necessary to continue its operations, restructure internally, slow its growth and emerge in six to 12 months with a revived message.

Development: Is this business model the future of office? What do you think offices will be like in 10 years?

Kloppenburg: It is absolutely a meaningful component of the future office. Leases are getting shorter and will continue trending in that direction as tenants demand more flexibility. I also see the market shifting to delivering finished products and managed services to tenants, thereby removing the complexities of building, designing and furnishing space for occupiers. The relationships between tenants and landlords will be in greater alignment, and technological enhancements will continue to drive operational efficiencies within the built environment. That will positively impact productivity and value.