Wait, Don’t Sign That Lease! (The Coworking Bubble, Risk, and Opportunity)

(This article mostly applies to those in markets heavily saturated with coworking activity and high density commercial real estate.)

I had a very interesting conversation last night with a highly successful coworking operator who owns several locations on the east coast. Our conversation echoed some of the thoughts I’ve had about leasing spaces, especially in certain market climates. During our conversation, reality came crashing down like a ton of bricks.

Let’s start by taking a lay of the land.

We are in a very interesting era for coworking. There are successful brands on the tips of everybody’s tongues, the most talked about being WeWork. There are many small, regional networks that have gained a lot of traction over the years: Grind, Workbar, Coworkrs and NextSpace to name a few. There are serviced office centers (business centers) jumping in on the coworking model. There are real estate firms studying coworking, poised to drop huge amounts of money on the industry. And lastly, there are countless (really, countless) indie coworking initiatives being conceived of all around the world, month after month. Add to this the explosion of startups and coworking initiatives going on in Asia, and one may be left to wonder: are we experiencing a coworking bubble?

Well, that’s complicated. There are several things to ponder here.

First, is there a bubble?

This depends on what you mean by bubble.

Is the market going to crash because startups, real estate, and coworking spaces are, in many cases, overvalued and overpriced in many hot markets? No, I doubt it. Nothing like the subprime mortgage induced crash of 2007-2008.

However, there will certainly be corrections in some markets. From my personal observation the San Francisco Bay Area market is the most ripe for a large correction in the next two or three years. Some people in our industry are telling me New York City is going to see one as well, possibly a lot sooner, though NYC hasn’t seen prices rise nearly as much as San Francisco (who’s asking price for office rent has doubled in just one year).

For San Francisco, the situation is largely tied to the tech and startup industries. There’s a lot of debate about what will happen to the startup industry in San Francisco and throughout the United States. I’m not going to speculate too much, but there’s a lot of startup duplication, a lot of useless garbage being built, and the rents have largely inflated because of the influx of venture capital in the last 3 to 4 years. That capital is slowing down and drying up as investors become more cautious, imploring their portfolio companies to get to profitability as quickly as possible.

Furthermore, landlords in San Francisco aren’t even paying for tenant improvements anymore because these startups will pay for very expensive, funky, startup-y buildouts with their own cash (well, their investors’ cash). Property owners are in a major position of power right now and they don’t need to give deals to anybody. So they don’t.

The Risk

Real estate markets are always cyclical, and when a market is as heavily influenced by a select few factors (as is the case in San Francisco), the foundation of the market is wobbly.

The trouble can occur in two ways: the mass exodus of tenants due to the inability to pay rent or loss of market opportunity (this is what happened to Detroit), or hyper expansion (the overdevelopment of new property due to the perceived market opportunity), both of which result in too much supply.

What does this mean for you?

Well, it largely depends on your market, but the general feeling from many humble coworking and serviced office operators in some major markets is: wait.

What happens when you sign a ten year lease and the market corrects during that lease? As a coworking space, you’re particularly vulnerable, because your product is directly tied to the real estate market. All you’re doing is essentially subleasing space at or around market rate, plus a little extra for the shared amenities you provide. In major markets, there’s just not enough differentiation between most spaces, hence they become commodities.

If you’re in a lease at the time of a major correction (more than 15%), you’ll be forced to drop your prices in order to stay competitive. Whereas most indie coworking spaces are barely making any money at all, this could put your brand under water. Even if you have a killer community, many simply won’t want to justify the cost difference if they can go to a reasonably similar competitor for 15%+ less, especially if they are startups with investors breathing down their necks.

What has the commercial real estate market been doing over the last several years in your region? If it’s been going up, up, up, and as a result several new buildings are finishing construction and coming on the market, take caution. As soon as there’s an oversupply for too long, the prices will drop.

So What Should You Do?

Well, if you’re in the boat of “I just signed a ten year lease,” your options are fairly limited.

First, you should certainly have each location set up under a different legal entity, so if worse comes to worse you can bankrupt that entity without destroying your entire business. I’m no lawyer, but create as much separation with funds and entities as possible. That’s what my lawyer friends tell me.

Have a solid relationship with your landlord because in the end, you’ll be at their mercy should you need to renegotiate your lease agreement. And if you’re in this boat, you’ll have to renegotiate to stay in business.

Have good relationships with your competition. There’s an opportunity to stay in the game if you get acquired. Read more on this in the next section.

If you haven’t signed yet, take a good and long look at your market’s trends for the last few years. Look at the market as a whole. Is there renewed economic interest in your downtown? Is the supply and demand of residential and commercial real estate in relative equilibrium? Is demand increasing for both? Is residential inventory keeping up with the inventory of commercial? How long are offices sitting on the market before being leased? If it’s a long time and prices are going up it could be sign of a coming correction.

Don’t fool yourself, you’re as much in the real estate business as a real estate broker, investor, or property owner. School yourself of you’ll get schooled.

The Massive Opportunity

Probably the most interesting part of my conversation with my colleague was about the coming opportunity.

In major markets where there are large corrections, coworking spaces will go out of business. There are so many spaces operating at, or barely above, breakeven. This will result in many communities being completely destroyed.

But there’s hope.

For groups or individuals who have cash reserves, a market correction is like being a kid in a candy store. And the store is having and “everything must go” sale. These brands and individuals will be poised to purchase or partner with distressed spaces and get very favorable terms.

My colleague explained to me how she expects small network brands (some listed in the beginning of this article) to gobble up locations when the market correction happens. I would also add to that real estate holdings companies and real estate investors.

My recommendation: be a gobbler, not one that gets gobbled. Don’t sign that lease, save, then buy that on-sale candy.

So What Am I Doing?

I had been planning to start a new space in the next year. However, I’ve decided I’m waiting. Unless a really good deal comes along, I’ll stay in the role of the backseat driver for the time being.

This good deal could present itself in the form of a down market or when these major markets correct. Time will tell. But, when the opportunity comes in any interesting market, I’ll be ready to pounce.

Will you?