One of the most eye-popping corporate and real estate stories over the last few months has been the logic-defying rise and now dramatic fall of WeWork. After a meteoric ascent as a disrupter of how office space is used, this co-working company or “space-as-a-service” business is now facing the realities of operating under the spotlight. Its recently pulled IPO drew deeper examination of both its financial model and corporate governance, and neither was very pretty. From a valuation perspective the drop has been significant, from a last private round at $47 billion to $20 billion to SoftBank’s reported bailout at $8 billion. To put these values in context, the largest shared office provider in the world, IWG plc, known by its largest business line, Regus, has 20% more square footage than WeWork, 50% more gross revenue, real earnings, a 9.9 trailing P/E multiple and a market cap of only $3.5 billion. How do sophisticated investors get so caught up in the hype?
To be fair WeWork has been the leader in exploring new ways to use office space and accommodate today’s more flexible, tech savvy workers. The question is how disruptive are they? The answer may be, not very, or not enough that they can’t be copied. In addition to WeWork a host of other co-working providers have emerged, including Industrious, Impact Hub, Spaces, Knotel, and Make Office among others. At the same time major owners and operators of office real estate across the country such as, Hines, Boston Properties, CBRE, Tishman Speyer and others are developing their own plans to accommodate the co-working end user. Furthermore, that end user has evolved. In addition to the start-up with a few employees, the Fortune 1000 who have some need for flexible space are increasingly using co-working options. The major office providers across the country have recognized this shift and want to maintain their direct relationships with those corporate users by offering them more flexibility. As a result, they are creating their own flexible office offerings, utilizing the best ideas for buildouts and services that the coworking companies offer. In effect, they are becoming direct competitors.
For WeWork to justify its reduced valuation or maybe just to survive, the company will need to continue to grow at an aggressive pace while facing the headwinds of increased competition and a potential late cycle slowdown.
Speaking of a slowdown, office sales volume in the region is down by 20% YOY. This is predominately due to fewer large transactions in DC, which reflects a pullback of international capital, particularly from Asia. For example, Japanese investor Unizo is marketing its remaining five building DC portfolio, which it purchased in 2016 and 2017 for a total of $785 million. It is hard to tell whether the lower volume is due to political concerns or the rising vacancy rate in DC which we have written about previously. Despite these headwinds, it should be noted that DC office prices continue to hold up. This is somewhat surprising given capital flows and leasing challenges in DC. In Northern Virginia the dynamic is different. Robust tech leasing and the “Amazon effect” have created more interest in the close-in submarkets. At the same time institutional investors are still wary of the suburban office asset class. For those buyers that are active in suburban office space, the quality of building tenants and the average lease term in the building are the deciding factors in attracting investor capital. High re-tenanting costs make office buildings a trading asset class and not long-term hold candidates. The investment strategy is buy, create sustained cash flow and sell into an institutional market hungry for yield.
The volume of apartment sales remains steady across the region as renters continue to absorb the large supply of units being delivered, and in most submarkets, rents are rising. Modest rent growth and lower interest rates are pushing values up. Apartments have become a low risk, steady return asset class for the institutional buyer.
The industrial market is on fire due to low vacancies and rising rents. We recently bid on a complex industrial redevelopment opportunity where there were 22 offers! With little supply in the pipeline and the continued demand from ecommerce users as well as traditional warehouse tenants serving the close-in markets, industrial will continue to be a favored asset class.
Our investment strategy has always been predicated on the premise that each asset class has a unique market. That is proving to be the case in this climate. The cyclical differences between asset classes remind us that the dynamics of getting into and out of real estate asset classes require both a nimble and disciplined investment approach.