Firms Seen Raising Risk of High Office Vacancy, Greater Defaults in Any Recession
The president of the Boston Federal Reserve Bank is warning that coworking creates a new type of financial risk to the commercial real estate market in major urban office markets.
Boston Federal Reserve Bank President Eric Rosengren said Friday the coworking business model of leasing direct space long-term and then subleasing that space on short-term leases exposes coworking companies to a higher risk of failing to make enough income to cover their rent. That problem is compounded by the common practice of some coworking firms that sign leases using limited liability companies that protect the parent company from any repercussions resulting from prematurely leaving a lease such as a bankruptcy, he said.
"The fact that the shared office model relies on small-company tenants with short-term leases, combined with the potential lack of recourse for the property owner, is potentially problematic in a recession," he said in prepared remarks at an event in New York. "This also raises the issue of whether bank loans to property owners in cities with major penetration by coworking models could experience a higher incidence of default and greater loss-given-defaults than we have seen historically."
The statement comes just two days after the Federal Reserve dropped interest rates by a quarter-percentage point, in a move that officials said is aimed at keeping U.S. economic figures steady in the face of trade wars and global political uncertainty. The cut is the second since July, and Rosengren has publicly criticized both, arguing the move is unnecessary in a "robust economy" with a low unemployment rate.
"I will also point out that evolving market models, along with low interest rates, are creating a new type of potential financial stability risk in commercial real estate," he said. "One such market model is the development of co-working spaces in many major urban office markets."
The warning follows weeks of high-profile scrutiny of WeWork, one of the world's largest coworking firms, as it sought to go public. The New York City-based company is postponing its initial public offering after investors and analysts expressed concern about its business model and billions of dollars in losses disclosed ahead of the public share sale.
Coworking has taken off across the country and grown an average of at least 26% each year since 2010, according to brokerage CBRE Group's 2019 flexible workspace report. More than 70 million square feet of U.S. office space is now dedicated to flexible use, compared to 9.5 million in 2010, according to CBRE. WeWork accounts for 33% of all U.S. flexible workspace.
Rosengren's concern comes after some critics, including veteran real estate executive Sam Zell, have said coworking is a fad that could suffer during an economic downturn.
Some lenders have said they assign a lower value to an office building that has a significant amount of space taken by shared office space providers given their leasing model. The short-term leases that shared office space providers offer mean in an economic downturn tenants could simply move to lower-priced real estate elsewhere, according to some lenders and analysts. WeWork has commissioned a study that says some buildings have been valued more highly because of WeWork's presence.
While coworking space accounts for just under 2% of the overall U.S. office market, CBRE predicts the percentage of coworking space in that market could grow to 6.6% by 2030 in a recession and up to 22% under the most aggressive scenarios by 2030. The city with the highest percentage of coworking space making up its overall market is San Francisco at 4%, which is still below the 6% in global cities such as London and Shanghai.
Rosengren said the rush toward coworking may be further fueled by low capitalization rates, the projected rate of return on a property, in the nation's most expensive cities "as low rates potentially lead to a reach for yield."
He added that "the owner of the building may be willing to take on this added risk because shared office space often pays higher rent, which is particularly attractive in a low-interest-rate environment," he said.
As a result, he said, coworking has the "potential for a run on commercial real estate as revenues decline" should small tenants decide not to renew leases. "This segment of the economy is likely to be particularly susceptible to an economic downturn, potentially resulting in office vacancies rising more quickly than they have historically," he said. That, combined with property owners' "reaching-for-yield behavior," may spur them to sign more deals with coworking firms.
"It will not be until a recession that this evolving model will be truly tested," he said.
CoStar reporter Marissa Luck contributed to this story.