In the past 10 years, the commercial office segment has seen the flexible office trend emerge as a major factor in both tenant demand and value creation for assets. While they did not invent the services office concept, WeWork and others took the concept to its logical extreme, raising too much capital without a clear path to profitability. While WeWork’s recent ‘reset’ are a check on their business model, they have demonstrated beyond a shadow of a doubt the seemingly insatiable demand for more flexible terms for leasing an office.
More and more occupiers - and not just tech startups - just don’t want to sign a traditional long term lease. More on why a little further down.
Even though the coworking wave has occupied a significant mindshare in CRE, it actually commands a relatively small marketshare. As illustrated below, space leased and operated as coworking space represents less than 2% of the nearly 4 billion square feet of office space in the U.S. This is not nearly enough supply to meet the large and growing demand for shorter and more flexible office leases.
Companies that value agility in their use of their real estate lease assets - and these are not just startups but major F500 companies like Microsoft and Bank of America - are happy to pay a premium above long-term lease rates. While this may be surprising, it makes sense in light of recent shifts in how our economy works.
Much of our modern economy has shifted towards an asset-lite approach to owning things. In the consumer realm, this is driving factor behind well-documented trends towards lower rates of, for example, car and home ownership (sometimes this is called the ‘sharing economy’).
But the same is true in business - business prefer to reduce the total long-term assets they hold on their balance sheets, because the return on those assets is often low and there are better things those companies can do with their cash than owning millions of dollars for 5 or 10 years of office leases or, for that matter, hundreds of servers and switches in a data center. This is the driving force behind the growth of cloud computing, and it also explains the exploding demand for shorter-term office leasing.
Econ 101 tell us that here there is excessive unmet demand willing to pay premium prices, sellers will create supply to meet it. And that supply is hiding in plain site - it is the approximately 25% of commercial office space that landlords deliver in smaller (less than full floor) footprints, usually 25,000 square feet or less.
The only thing it takes to unlock this supply is for landlords to agree to offer some of their smaller footprint spaces on shorter terms - 1 to 3 years - than they usually agree to. Once a few roadblocks are removed around the leasing process, the supply floodgates start to open up.
Roadblock #1. Occupier awareness.
Most potential tenants simply do not know that short-term leases are available and think that a glass box in a coworking space is their only option. Even when landlords offer such leases, potential occupiers have no idea these options are out there. The main reason for this is that landlords do not market directly to businesses, they use leasing agents to market and promote their spaces. And when companies bring up the topic of shorter term or flexible leases, most tenant brokers respond with ‘no way you’ll find that’ or ‘let’s see if we can find you a sublease’. Remember that tenant brokers earn commissions on the total value of a lease so shorter-terms translates to ‘lower commissions’ to them. No wonder occupiers have no idea flex leasing is an option.
But landlords are overcoming this obstacle by partnering with firms that know how to get the word out to occupiers in the modern world. Most of these are digital native companies that are experts at using internet demand generation platforms and approaches to reach business of all sizes and shapes with targeted messaging. Some of these partners - like Swivel! - also equip their landlord partners with digital tools to educate tenant brokers that they’re open and ready for flex leasing, on terms that will save tenant brokers massive amounts of time while still paying their traditional brokers fees.
Roadblock #2. Higher landlord leasing costs: tenant improvement and vacancy losses.
This roadblock is a little more technical and it involves the arcane world of landlord economics. Basically, landlords care about net operating income (NOI), which can be simplified to the rental income of a property minus operating and transaction expenses and vacancy losses.
As the thinking goes, when measured over a 10 year period, 2 five year leases are likely to represent a lower loss due to vacancy between leases when compared to, for example, 5 two year leases. But if the landlord using a modern leasing platform like Swivel, this does not need to be the case. First, because these shorter-term spaces are always being marketed there is a ready pipeline of tenants to lease the space right away. Second, smart landlords build out their spaces as ‘spec suites’ that avoid the major construction overhaul between tenants associated with longer term leases, and in today’s tight construction market this can save 6-9 months vacancy loss.
In addition to saving time between leases, agile leasing also saves costs the landlord has to pay to sign a lease, by lowering their tenant allowance (TI) expenses. TI are dollars the landlord gives to the tenant to at least partially offset their design and build out (construction) costs. They are used as a sales incentive and considered just a cost of doing business. TI allowance rates vary with market conditions but it is not unusual for a landlord to pay out $300,000-$500,000 or more up-front for a 15,000 sq. ft. five year lease.
When done right, shorter-term flex spaces do not require any physical re-construction between tenants, or if they do it is limited. This allows landlords to lower their TI costs for new tenants dramatically, usually closer to $150,000 or even less for the same space.
Once occupier demand is unlocked and costs are controlled, the door is open for innovative property owners to offer agile options for some share of their properties. Once they do, the benefits are game-changing, including:
- Premium rent rates for their agile leases, often 30% or more above their base long-term lease rates,
- A more dynamic and flexible rent roll, that includes swing space options for larger occupiers looking to lease or expand,
- Increased property values, due to the dramatically higher NOI from their agile leased square footage.
Swivel has created an interactive Swivel’s Agile Leasing Calculator to allow owners, operators and leasing teams to see how these trends play out in an actual property.
Both owners and occupiers benefit from agile office leasing. Owners from higher NOIs and asset values, and tenants from increased use of their own precious capital. At Swivel we can’t wait to see what the next 10 years will look like.