UPDATED, April 25, 2019, 1.07 p.m.: In January, Adam Neumann went on CNBC to quiet concerns that his company, WeWork, was in trouble. News had just broken that SoftBank Group, WeWork’s primary investor, had walked back a $16 billion deal, and Neumann, with celebrity pal Ashton Kutcher in tow, wanted to reassure the world that demand for his office-space-as-a-service company was still high. In fact, he said, it was increasing.
“In Q4 of 2018 we’ve seen a big drop in the market, WeWork has never grown faster,” Neumann said. “We would use the opportunity of a downturn to grow faster.”
Flexible office leasing has long been part of the office market, and has gone through more than one boom-and-slump cycle. But co-working – the modern, jazzed-up, socially conscious avatar of flexible office leasing that WeWork pioneered and dominates – is yet to be tested by a downturn. If one were to come to pass, WeWork’s model would face its first existential test.
WeWork’s latest financials show that 2018 revenue about doubled year-over-year to $1.82 billion. However, net losses in that same period more than doubled, to $1.93 billion, and the company’s marketing spend almost tripled – a sign of its urgency to grow its customer base as occupancy rates and average revenue per member take a hit.
Detractors have challenged WeWork’s $42 billion valuation – that number makes it the second most valuable startup in the U.S. – and point to far more modest valuations of similar publicly traded companies. For example, IWG, which provides office space through its Spaces and Regus brands, and has almost 100,000 more work stations than WeWork, is worth just $3 billion.
“We have benefited from a lack of people understanding our business, and we have had no challenges raising capital and equity from the largest, most sophisticated investors in the world,” Michael Gross, WeWork’s vice chairman, said in an interview.
While the company’s risk of defaulting on its lease obligations seems low, it remains reliant on “the strength of its balance sheet and deep-pocketed investors,” according to a recent report by CB Insights, which analyzes high-growth private companies.
If WeWork’s access to cash dries up, however, it may find itself lacking a shield against any upcoming downturn, and high-cost growth may no longer be an option. SoftBank’s January decision to slash a planned $16 billion commitment to the company came a month after investors in the Japanese firm’s Vision Fund expressed reservations about WeWork and after SoftBank’s mobile-services division had a lukewarm public offering.
WeWork says it now has $2.2 billion in cash and $4.4 billion in cash commitments to fund its current growth rate for up to five years, regardless of the economic climate.
“The company definitely maintains a healthy multiple of liquidity to help it fund its future capital investments growth,” said Kevin McNeil of Fitch Ratings. “That is a consideration of their bargaining power in a potential downturn.”
To emphasize its international focus, the company last week tapped senior executive, Eugene Miropolski, to be its London-based chief operating officer, and it now says that blue-chip enterprise clients now make up a third of its memberships. In other words, it’s no longer the company for the little guy: WeWork, now rebranded as the We Company, is a global institution.
“There’s two schools of thought: whether we see an increase in demand for office space in a downturn…[or] the opposite,” said Dom Harding, who runs Workthere Americas, a flexible-office space advisor that’s a subsidiary of Savills. “But we just haven’t seen it before. We haven’t been through a downturn when there has been this much adoption of flexible office space out there.”
Slowdown on the horizon
In less than a decade, WeWork has grown from a single storefront in Soho to more than 400,000 members occupying 425 locations in 100 cities worldwide. It is currently the largest private office tenant in New York, London and Washington D.C, and has evolved from providing desks to freelancers and freshly-minted startups to entire buildings for Fortune 500 firms.
Some of its key individual markets continue to boom, but a macro look at the U.S. and European markets show that commercial leasing rates slowed toward the end of last year — signalling a drop in demand for office space.
Manhattan, which is WeWork’s largest territory at over 5.3 million square feet, reported a record 32 million square feet of leasing activity last year. That figure was buoyed by flexible office firms, which made up 18 percent of leases, a huge jump from 4 percent the previous year, according to CBRE. In the first quarter of 2019, however, commercial leasing dipped 2 percent below its five-year quarterly average.
The same was true of London, another city where WeWork was the largest tenant last year. Despite uncertainty over Brexit, the capital of the United Kingdom registered record leasing volume, driven by flexible office deals. But leasing volume was down 17 percent year-over-year in the fourth quarter of 2018.
Across the U.S., leasing volume dropped 7 percent to 74.7 million square feet in the fourth quarter, according to Cushman & Wakefield, while in Europe there was a 14 percent decline. The Asia Pacific region, where WeWork expects major growth, was up 21 percent during the same period, according to JLL.
WeWork has acknowledged that demand for office space has dropped. In January, it told Fast Company that all but two of its markets reported declining commercial rent prices. But the company has emphasized its expansion in Europe and Asia as a way to soften its U.S. exposure.
As office rents and leasing volumes decline, so have two other key indicators. WeWork’s occupancy rates dropped to 80 percent in the fourth quarter, down from 84 percent the previous quarter. And the average annual revenue per member has dropped 13 percent from 2016 to $6,360, according to the Wall Street Journal.
WeWork said these declines can be attributed to its expansion into submarkets, where rents are lower, and the fact that most of its locations take up to 18 months to reach full occupancy and mature.
“In good times, bad times, maybe your occupancy might swing,” said Gross, WeWork’s vice chairman. “But at the end of the day, we are talking about half a million desks.”
Lessons from the past
WeWork has the benefit of being able to hit the history books. Shortly after the 9/11 attacks, the demand for office space dropped nationwide. Regus, the office leasing firm that managed spaces for giant corporations, was rocked by this new reality.
“The music stopped,” said John Arenas, who was then-president and general manager of Regus Americas. The firm, which had 3 million square feet across the U.S., had signed the majority of its leases at the top of the market in 1999, a year before its IPO. Falling demand left the company saddled with long-term commitments it could no longer afford.
Regus filed for bankruptcy in 2003, and Arenas set about rebuilding the company’s U.S. business. It began signing flexible leases that included revenue-sharing arrangements with landlords, so that if the market declined, so did the company’s burden. The new leases it was signing as the market reset in 2004 were at far cheaper rates than what Regus paid in 1999. The firm also developed secondary and tertiary markets rather than fixating solely on large urban centers, which were more sensitive to price fluctuation.
By the time Lehman Brothers imploded in September 2008, Regus had enough armor to withstand the real-estate crash. In fact, it emerged profitable, and in the following two years made $300 million in profit off of just $1.2 billion revenue. Its office occupancy rate, which had hovered at 86 percent, dipped only 7 percent before rebounding to 89 percent in 2011.
When comparing Regus’ position then to WeWork’s now, Arenas, who is today chief executive of Serendipity Labs, a flexible-office leasing franchise, points to the fact that 90 percent of leases held by Regus in 2008 were mature, or held for longer than 18 months. He also noted that Regus was publicly-traded and governed by institutional investors, adding that it had a “certain discipline around the business.” (This month, Regus announced plans to introduce franchising, in a bid to fend off the threat of WeWork’s rapid expansion.)
By comparison, WeWork expects to have just 234 of its locations mature by October 2019, or closer to 40 percent of its total spaces. At Neumann’s behest, the company has made some curious investments that align closely with his personal interests; bets well outside the realm of WeWork’s core products that have perturbed some institutional investors.
WeWork’s rapid expansion, moreover, has come during a U.S. bull market. That strategy, Arenas said, “feels good on the way up, it feels terrible on the way down.”
“If you hit a recession while you’re in that mode and don’t have mature locations, not just with occupancy but profitability, with term and tenure, then it becomes risky,” he added.
WeWork is framing a potential downturn as a business opportunity. The company has said that it would be there to catch Fortune 500 companies looking to downsize, those that need quick, flexible office space, in any market, rather than locking in a rigid long-term lease directly with a landlord.
“We are talking about a global shift in how people are going to consume commercial real estate, we feel very clear that we are not going to reverse that trend,” Gross said. “WeWork happens to be the biggest player in the space.”
But many spaces WeWork secures with enterprise firms consists of satellite or ancillary offices, according to Tatiana Kleiman, an S&P Global Ratings analyst who covers WeWork. “In a downturn they could more easily cut a contract with WeWork than with its landlord leases,” she said.
WeWork’s competitors have echoed its sentiment that demand for third-party office space will in fact increase during a decline in the market. Knotel, which has pitched itself as WeWork’s archrival and provides space free of branding, says that all of its of its 200-plus locations are used by enterprise clients.
“The existing business is profitable,” said Amol Sarva, Knotel’s founder and chief executive. “If the world were to change overnight, it would be a question of how much we want to grow.”
Industrious, which has 60 locations in the U.S., has secured revenue-sharing agreements with landlords for what it says will offset the risk of defaulting on leases. Jamie Hodari, Industrious’ co-founder and chief executive, said that customers have indicated that they would double down on “their consumption of workplace-as-a-service in a recession.”
WeWork says that its business model has already been tested in some markets that have experienced economic decline, including China and Argentina, and that demand from customers has grown for its office space in these regions.
“I think our occupancy there was low 80s, high 70s, before the economy started tanking and now we’re high 90s,” Neumann said of Argentina in January. “And I think we’ve seen similar movement in China.”
There are however, some indications that WeWork is attempting to increase discipline around its business. This month, Reuters reported that the company had walked away from negotiations to secure five office spaces in Hong Kong this year, after its regional officers failed to get budget approval. In a statement, the company disputed this account, and said that it had already sourced “100 percent of real estate needs needs for the year.”
And at the start of April, the firm told brokers that it would enforce a standard 5 percent commission fee, and 3 percent for renewals, rather than the wildly fluctuating commissions brokers previously enjoyed.
“Now they are spending less money, because they have less money,” said Knotel’s Sarva. “Peak WeWork is behind us.”
Correction: The story was updated to clarify that Manhattan’s Q1 2019 leasing volumes dipped 2 percent below its five-year quarterly average. It has also been updated to attribute the United States commercial leasing volume figures for 2018 Q4 to a Cushman & Wakefield report. The story also clarifies that WorkThere, the employer of Dom Harding, is a flexible office space advisor, not a provider.