Underwriting flexibility

“In the future, all space will be flexible, eventually we will outlive the idea of leases.” That is the prediction of Edward Shenderovich, co-founder of flexible office provider Knotel. He is one of my favorite people to interview. One reason is that, unlike most people who are just waiting for their turn to talk, he always pauses before he gives an answer, thinking through his response and contemplating how best to say it. He also always gives me thoughtful, grave statements, ones that feel a bit like Russian poetry—which makes a lot of sense because he is both Russian and a poet. Little did I know it at the time but, a few weeks after our conversation, I would find out that Knotel was filing for bankruptcy.

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Edward gave no notice that his company was in trouble, although he must have known it at the time. In general, he was very bullish on his company’s mission, to become one of the main players in the growing flexible office market. Edward, like many, saw the pandemic as a catalyst for demand for flexible office space. “The ten-year office lease is not sustainable in today’s business environment. Most businesses don’t even know what their headcount will be in two years, let alone ten,” he said.

But even with the long-term future of the sector looking bright, the temporary hurdle of the pandemic was too great for the company to jump, it seems. Most offices have been closed for over a year now and flexible office spaces, with their short-term leases and shared amenity spaces, took a huge hit on revenue. Flex space providers partake in what is called lease arbitrage, they lease space long term from landlords and then repackage it as short-term rentals. Knotel had pioneered a business model that created a profit-sharing arrangement with landlords, hoping that, unlike its largest competitor WeWork, it would be able to partner with the owners of the buildings, sharing both the risks and the rewards.

But even Knotel’s partnership model was not able to sustain the company through such a prolonged office shutdown. The company’s assets are being purchased by global brokerage and property manager The Newmark Group which will try its hand at the balancing act between long-term liabilities and short-term assets.

Just like WeWork had done for co-working, Knotel proved to the world that flexible offices were valuable. But, how valuable is subject to a huge skew depending on who you ask. WeWork went from being worth $49 billion at the end of 2019 to under $3 billion in May. Knotel went from a $1.6 billion dollar enterprise to having their assets bought in a bankruptcy proceeding for a reported $70 million.

This huge fluctuation in value reinforces that we don’t yet have a great handle on how to value flexible offices. I’m not just talking about valuations to venture investors here, I’m talking about the nuts and bolts calculation of a building’s worth. While we have been underwriting office buildings since the industrial revolution, there has yet to be a consensus on how to value flexible office space. The main reason is that, unlike traditional office leases, flexible lease contracts don’t fit into the way we value buildings. I wanted to find out why.

Borrowed time

In the investment community’s eyes, commercial buildings are more akin to a bond than a stock. The predictable returns and easily calculable net present values of a traditional building with ten year leases in place make it easily comparable to other annuities rather than speculative equities. When it comes to annuities, the main factor in the valuation calculation is risk. For commercial real estate, that often comes down to the length of the current leases and the strength of the tenant.

This is, of course, a simplification. Rent from even the most stable commercial tenants is not a guarantee (as we have seen) and leases can be broken (as we will likely see much more of). But, month-to-month rental arrangements, as is the case with many flexible offices, certainly have less switching costs than long-term leases. The worry is that when things get bad, it is all too easy for flexible office tenants to cut ties. This concern turned out to be valid as companies like WeWork and Knotel saw their membership plummet shortly after the lockdowns went into effect.

The extra risk of untethered tenants certainly has its effect on value. But, just focusing on the risk of flexible leases is like only looking at one side of an equation. The market is calling for flexible leases. Flexible lease operators have proven that they can extract higher margins from clients and are able to increase an office’s density. More people paying more money equals more revenue. So why was the investment community so focused on the risks and not on the potential of flexible space?

I thought back on my conversation with Edward and remembered one important thing that he said, “The reason real estate is not flexible, the reason we have ten year leases, is because of financing. Financiers don’t know how to underwrite flexible space so there is a mismatch in the needs of the market to the needs of financiers.”

So my next stop was with a loan expert to try to see if this was the case. Stuart Gelb is the President of commercial real estate finance consultancy The Liquidity Source. He has seen a lot of financing get done and always seems to have a million different workarounds to try to get loans signed. When I asked him how he would go about structuring a loan for a flexible office, he shook his head. “Banks like to lend on guaranteed cash flow and you don’t have that with flexible offices,” he said. “There are no teeth in flexible leases so even if you were able to rent the space at a premium, lenders would likely offset that with a really high estimated vacancy calculation.”

I posed a hypothetical situation to Stuart that I would later pose to everyone else I would end up talking to on the topic: if you have two identical buildings, one has ten stories each rented to ten high-quality tenants with ten year leases and the other is ten stories with nine high-quality tenants with ten year leases and one story of flexible office, which one is worth more?

Stuart said that the second hypothetical building, the one with the flex floor, would qualify for a smaller loan, making it a less valuable building. The lenders wouldn’t consider the income generated from the flex floor in the rent roll calculation. Instead, it would land in “other income,” much like leasing an event space would. He did have a workaround, as I knew he would. He said that a large property firm could hold the master lease, essentially leasing to itself and assuming the liability should the lease payments be defaulted on. This trick would only work for large firms, though, since smaller landlords would not have the size needed to be considered a “Class A” tenant.

Continuity conundrum

It isn’t just about the size of the operating firm that determines the riskiness of a flexible office arrangement. According to Pauline Hale, the capabilities of the owner and the specifics of the local office market are also important. Pauline is a senior manager at The Altus Group, whose ARGUS valuation software is the industry standard for commercial property valuation. She has been advising clients about the nuances of building valuation for decades and she speaks with a pragmatic sensibility that is likely born both of her extensive professional experience and her personal passion for dog shows. “The question is,” she said, “if the operator goes under, what can be done with the tenants in place and/or how long would it take for the landlord to rent the space back out?” This has to do with how close the landlords are to the day-to-day operations of flexible space, and will they be able to quickly assume the management of the flexible operation. “Will they need to do an extensive buildout to lease it back out to traditional tenants? It isn’t just the chance of potential vacancy but the length and cost of it as well,” Pauline continued.

Pauline also has concerns that flexible space could actually cannibalize what could be larger leases; “You also have to factor in opportunity costs,” she said. “I think flexible office space makes sense if you have a hot market and can charge more for it or if you are able to activate a less desirable space like a ground floor or an awkward floorplan. But you have to have some concern as to whether some businesses will take this less risky option that might have otherwise committed to a longer lease.”

Again I find that most of the conversation from experts is around its weaknesses but I still wanted to get some education about its benefits. So, I booked a call with Karl Thompson, Project Manager at CREModels, a company that builds underwriting tools. To my surprise, we were joined by Karl’s entire team, who proceeded to argue over the finer points of flexible valuation in a logical, deliberate way that only teams with a lot of experience arguing are able to pull off.

“These leases have no teeth so they would certainly be seen as much riskier by an underwriter,” one would say.

“Sure but couldn’t you argue that with more tenants that increased chance would be spread out between different occupiers, adding some diversification and actually lowering risk,” another would rebut. It felt good for someone else to be the devil’s advocate for once.

“No, because when downturns happen, it usually happens for the entire local market.”

They went on like this for a while. Finally, Karl hit on the attribute that I wanted to explore further; “Some of these flexible offerings that have partnership agreements with landlords can be looked at like a percentage rent, which might be viewed as an upside—especially if the market grows.”

This was the first time I had heard someone talk about a building’s value similar to how we think about the value of companies. Stocks have a speculative component to them, it is often less about what a company is making today and more about what their future potential might be. Buildings, for whatever reason, don’t benefit from that same financial philosophy.

Market forces

So what would it take to give buildings the ability to benefit from the very likely growth in the demand for flexible office space? One idea was posed to me by Lucas Rotter, co-founder of Valcre, an appraisal software provider: “Flexible office is a new asset type so we might need to look at it as its own market and it warrants its own methodology, similar to hotels,” he said. “But for that to happen we would need to see someone aggregate comps for flex office in every market.”

This might not sound like a big ask but it is. Commercial real estate has always struggled with finding data on comparable properties. Sales prices can be easily found in public registries but lease terms, the very things that building value is pegged to, is private. There have been a number of companies that have been able to compile traditional lease terms into usable data (CoStar does this with an army of researchers; CompStak does it by crowdsourcing from brokers) but no one has done the same for flexible space.

Even if you were going to put together a comprehensive data set of comparables for flex space, there are a number of important considerations and limitations of the data. “To understand the premium on short-term, flexible office leases we would need to understand the flex market versus the ‘regular’ market,” said L.D. Salmanson, co-founder of the real estate analytics platform Cherre. L.D. is my go-to when I want to understand commercial property valuation. He helps some of the biggest firms in real estate harness data and, like anyone that actually spends time trying to solve complicated problems, he knows all too well of the deadly details of data. “First, we would have to carve out any co-working data from the set, since that is a different offering with different costs than flexible suites. Then, we would have to understand the net effective rent for flex office space which means taking into consideration the average vacancy and build-out costs.”

Balancing act

With the rise of flexible office space and the unrelenting advancement of technology, a comprehensive data set for flexible workspace is very likely, but probably a long way off. In the meantime, landlords who are considering adding flexible space to their portfolio will have to figure out ways to understand the risks and rewards of this new office product. The focus so far has been on the downside: the lending limitations, the higher risk of vacancy, the opacity of the market, and the heightened operational demands. But this ignores the counterbalancing upside of having flexible space in the building. If you look at flexible space as an amenity, you have to wonder how much more companies would pay for a traditional lease if they know they can easily grow into more space without more commitment. The extrinsic value, that is the value to the market, flexibility isn’t factored into a valuation methodology that primarily focuses on intrinsic characteristics.

To many, Knotel’s demise was more evidence of the unreliable nature of short-term leases, an example of how when times got bad the space arbitrage model imploded. But I wanted to understand what exactly were the factors that led to Knotel’s downfall. So, I reached back out to Ed. First, he told me that, “I still believe that the market opportunity we identified and executed on was the right one.” As for what caused the bankruptcy he said, “at the time we spoke, Knotel had several financing offers, which were contingent on Newmark being a team player. They were not.”

Instead, Newmark bought the company’s debts and drove the business into bankruptcy, later buying the assets through a bankruptcy fire sale. So, it turns out that Knotel’s struggles had more to do with corporate gamesmanship than lack of product/market fit. It also drives home the point that the future is uncertain, now more than ever. And in an uncertain world flexibility is valuable, even if not in the eyes of the property industry. As logical as the property valuation process tries to be, it lends itself to lots of guessing. You might be able to know how much a building’s income streams add up to, but other factors like disasters, inflation, and regulation are less predictable

Everyone I talked to for this piece had rather strong opinions about the viability of leasing short-term office space. But, as Jesse Livermore, considered to be the pioneer of day trading famously said, “Markets are never wrong, only opinions are.” Markets usually find a way to right themselves but it takes time. If Class A tenants embrace flexible space as a long-term office solution, as many speculate they will, then underwriters will find consistent ways to value that income. If the demand is not there then owners and investors will find the highest and best use of that square footage. That’s just the way the marketplace works. In the interim, the volatility of a new market will lead to some firms failing while others use that to their advantage. [Propmodo]