The Long View: How mortgage banks created the co-working lease

Andrew Ross Sorkin, author of the book “Too Big To Fail,” recently wrote an opinion piece in the New York Times arguing that WeWork might be just that: too big to fail. In September, the co-working giant became Manhattan’s biggest office tenant with 5.3 million square feet. The company now has such clout in the market, Sorkin argued, that landlords couldn’t afford to kick it out over unpaid rent in the event of a serious market downturn lest they want to be left with empty buildings. Instead, they’d be forced to lower WeWork’s rent.

You can agree or disagree with Sorkin’s claim that WeWork is unsinkable (I disagree), but he’s right about one thing: those 15-years leases with fixed rents that WeWork signed all over the city won’t be worth much if the office market tanks.

WeWork makes its money through short-term contracts with office users, meaning its income can go up and down with the whims of the market. But the rent it pays landlords is fixed. This so-called asset-liability mismatch at the root of the co-working industry is well known, and as the odds of a market downturn increase a growing number of industry insiders see it as a problem.

“We feel the lease-based nature of this industry is unnecessarily risky,” said Jamie Hodari, CEO of co-working company Industrious. “It produces bad incentives.”

Industrious is among a handful of co-working companies trying to switch from leases to management agreements, where operators get a percentage of revenues and profits, the landlord pockets the rest, and no rent is paid. But so far, leases still dominate the industry as a whole. The vast majority of WeWork’s New York locations are leases. At Knotel, which claims to be big on management agreements, they still just accounted for 13 percent of its locations in the third quarter of 2018.

It’s a strange situation: most people seem to agree that long-term leases are a bad model for the co-working industry, and yet they continue to be the norm. One big reason: mortgage lenders.

Because long-term leases seemingly promise a stable source of income for landlords, banks generally consider them less risky and reward them with lower mortgage rates. Talk to co-working (and co-living) operators, and they often point to lenders as a main reason for why they opt to sign lease after lease. A major Midtown South office landlord recently told me that he would love to copy WeWork and lease out small, furnished offices under short-term deals, but his lenders won’t let him.

“Long-term leases provide – in general – more stable and predictable cash flow,” said George Doerre, a vice president at M&T Bank. “Whatever benefit may come from exposure to the higher revenues from co-working may be undone by the need for greater cushion and downside sensitization due to the more volatile income stream,” he added, referring to the need to put money aside in good times to cover debt payments during a downturn.

By insisting on 15- or 20-year leases with a fixed rent, banks are, in theory, minimizing the risk of a loan default, because borrowers have a stable income they can use to pay interest. But that security is often an illusion. Co-working companies can only pay rent for as long as they find enough customers, and any corporate guarantees they sign are worthless if they run out of money and shut down. This means the landlord still shoulders much of the risk, but they get little of the reward. In good times their rental income is still fixed, and the co-working operator can profit handsomely.

This means office landlords face a choice: cheaper mortgage rates, or a profit-sharing arrangement that compensates them for the business risk they shoulder.

Decades ago, hotel owners faced a similar choice. The rise of global brands like Hilton and Marriott meant the industry split between companies that own hotels and companies that operate them. In France and Germany, where most hotels ended up in the hands of risk-averse institutions like insurers, long-term leases came to dominate, said Lauro Ferroni, JLL’s global head of hotel research.

But in the U.S. and in most other parts of the world, management agreements became the norm. Sharing profits and revenues meant property owners saw their income rise in boom times, while avoiding the risk that an operator could default on their lease during a market downturn in a notoriously fickle business. Hotel brands, meanwhile, managed to avoid the liabilities of long-term leases. “If you’re the operator, it’s really a favorable structure,” Ferroni said of management agreements.

In return, hotel owners accepted slightly higher mortgage costs. According to research firm Trepp, the average interest rate for hotel commercial mortgage backed securities issued between 2014 and 2018 was 4.93 percent, compared to 4.65 percent for office buildings (on top of that, the average loan-to-value ratio for hotel CMBS was slightly lower than for office CMBS).

Eventually, office landlords may come to accept the same tradeoff.

WeWork, for example, has started branching out from traditional leases.

“As we continue our growth, we are offering a range of options – including joint ventures, profit sharing deals and management agreements – that allow landlords to share in the upside we generate,” WeWork’s chief real estate development officer Granit Gjonbalaj said in a statement. “This has already proven to be a successful strategy and represents a win/win for WeWork and the landlords we partner with.”

Industrious’ Hodari said he has noticed a change in landlords’ willingness to move away from leases. Until 2017, most of his company’s new locations were leased. But this year, he noticed that landlords are increasingly open to management agreements, which now account for the vast majority of its new spaces.

“The industry’s perception has shifted really quickly,” he said.