Space as a Service – A Wakeup Call for Landlords

This is Part 4 of a multipart series, please see past posts for context – Parts 12, and 3.

A revolution or a fad?

WeWork has announced a confidential filing to go public, a long-awaited move that will open up more transparency into one of the most interesting real estate business plays seen this decade. The core business of WeWork and its competitors is offering Space as a Service (or SaaS). They do not purport to lease space by the traditional fixed-address, long-term contractual method common in commercial real estate. Instead they offer shorter-term flexibly defined contracts that have more in common with hotel stays and gym memberships than property leases. They bundle services, furniture, and even offer access to a community ecosystem. This represents a very different way to provide office space than historically done. Thus, the question many in the real estate industry ask, is this a revolution or a fad?

SaaS is a Business Model

At the core of the co-working industry is a business model, one that I and others have dubbed “Space as a Service”. If hotels are the short-term format of apartments, then co-working might as well be the hospitality equivalent for office space. Users/tenants get a place to work (may or may not have a private, dedicated office) that includes common space and shared amenities. Many of the “tenants” simply have memberships that allow for limited access or simply the right to set up a laptop at a common bench or other coffee shop like feature. Thus, the revenue and business models are much more complex than in traditional office leasing. First, it maybe impossible (or irrelevant) to think in terms of occupancy as a key performance indicator; much like a modern fitness gym, memberships are sold on the basis of underutilization and optionality. Second, tenants are getting an all-inclusive deal that includes coffee (and even draft beer at times), wifi, and other creature comforts. Third, they gain access to a system and a network. Finally, they are tailoring offerings to solo-entrepreneurs and Fortune 100 corporate users; further, they are servicing both out of the same locations. As such, I see SaaS to be a revolutionary business model that fits the desires of a broad array of tenants/users. In this regard, I do see SaaS as sustaining and potentially long-run disruptive to traditional leasing of commercial properties.

Collaborative Office Spaces Might be a Fad

It’s critical to distinguish the SaaS business model from the current look and feel of many co-working spaces as well as the many buildouts by tenants who create so-called “collaborative” offices. These include spaces with few to zero private offices or cubicles and instead offer wide-open workbenches and an overall flow and design that looks more like a Starbucks than traditional office space. Research is finding that such collaborative spaces may actually reduce productivity and are not appropriate for many industries and work functions; as such, many office users are already scaling back its implementation in many cases. While the final verdict on collaborative office designs is still pending, it is not really the deciding factor if SaaS and its many offerors, including WeWork, will be successful for the long-term. It’s the confounding of these two ideas, SaaS and co-working, that confuse some real estate professionals trying to understand the success and viability of firms like WeWork.

Is Co-Working and/or SaaS Scalable?

CBRE tracks nearly 4 billion square feet of net rentable office space in the United States, an asset that can be found in practically all cities across the country as so many institutions require it for daily operations. It is hard to estimate how much space is currently configured for co-working and/or offered via a SaaS business model; but a report by Emergent Research estimates that by 2019 there would be at least 3.1 million workers in co-working spaces. Using the reported 50 square feet per employee that many offerors like WeWork claim to be the standard, then there must be at least 155 million square feet of co-working space globally. Thus, for all it’s press coverage, co-working is still just a small part of the overall office market. WeWork is now the largest office tenant in New York City, but it has yet to establish anywhere near that significant presence in the many varied, smaller markets across the US. With constraints like parking ratios, there are doubts if the dense co-working model will work outside of the mass-transit serviced metros like NYC, Chicago, and the like. Thus, co-working has limitations due to physics, but the SaaS model can potentially work anywhere and everywhere.

Why Office Landlords Should Seriously Consider SaaS Business Models

The Great Recession shook a lot of industries’ profitability leading to the rapid need for cost savings. Collaborative spaces that lower the square footage per employee were one of many such maneuvers popular this decade. Further, many small and large firms found that short term leases allow for better flexibility and business scalability; hence, WeWork and its competitors made their niche. Firms may reverse their mindsets that collaborative spaces are productive spaces, but the desire for shorter-term, flexible space solutions is likely to persist. Recent changes in the accounting methods of leases as liabilities will exacerbate this trend. In sum, business users of office space want and need SaaS; so far, they are willing to pay for it. Thus, the core reason office landlords should seriously consider SaaS business models is that their tenants will demand it and will go where they can get it.

Advantages of SaaS Business Models for Landlords

The main advantage is the ability to significantly increase the revenue per square foot by the addition of short-term price premia and the ancillary revenue from embedded services (like wifi, furniture, and common elements). The trade-off is more variable revenues period by period; essentially, the office proforma will look more like a hotel proforma. On net, this will make an office property more profitable by margin, at least during periods of economic expansion. Another side benefit is the reduction of costly tenant turnover which can entail massive capital expenditures in the form of tenant buildouts/improvements and leasing commissions. SaaS tenants tend to take space as it is as part of the trade-off of the short-term leases structure and overall flexibility. Thus, on net, it is plausible that many properties will actually be more valuable under a SaaS business model; however, this will not be universal, some will be worse off.

SaaS Business Models and Economic Downturns

An area of hot debate is how well the various co-working operators will perform in an economic downturn. They are generally leasing long-term from traditional landlords at one price and releasing short-term to users for higher prices that include embedded services. Thus, the co-working space operators could experience a drastic decline in revenues during recessions and be at risk of defaulting on the underlying lease. While this logic is true, it may be short-sighted. While some co-working tenants are likely to cancel or non-renew leases, new tenants may be found from firms ditching traditional space. Such is what occurred in the last downturn, where sub-leases became popular with firms looking for short-term discounts. In reality, the SaaS business model will bring similar risk and profitability profiles that the hotel and tourism industry has always enjoyed to the office market. With intelligent management, adequate cash reserves, and some intestinal fortitude SaaS operated office buildings should survive just fine.

Conclusion

WeWork and co-working in general cannot and should not be ignored by owners of office buildings. Just ask the taxi cab industry if they wish they had reacted to the arrival of Uber and Lyft earlier. While I do not think the office leasing industry is at anywhere the same risk as cabs were to ride hailing apps, there is peril in not giving customers what they want when someone else is willing to do so. Many tenants will want short-term leases and flexible space options with embedded services, they will pay premiums for such offerings. Thus, it’s better to join the party and profit than let the competition have all the fun!

6 Comments on “Space as a Service – A Wakeup Call for Landlords

  1. Pingback: Co-Living is the New Co-Working | Joshua Harris, PhD

  2. Pingback: Dual-DINK Demographics – Two Sides of the Demand Equation | Joshua Harris, PhD

  3. Pingback: Democratization of Global Travel – It’s a Small World After All | Joshua Harris, PhD

  4. Pingback: Infrastructure – The New Dimension in Real Estate Market Analysis | Joshua Harris, PhD

  5. Pingback: Regulatory Drag – The Hidden Hand Restraining Growth | Joshua Harris, PhD

  6. Pingback: Labor Force Misalignment – A Unique Economic Factor | Joshua Harris, PhD

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

%d bloggers like this: