WeWork landlords in America are likely to learn: In a down market, they’re all going to be partners, voluntarily or otherwise.
By John E. McNellis, Principal at McNellis Partners, for The Registry:
With major announcements almost daily, WeWork is stealing so many headlines it’s annoying the president. The latest is its name-change to WeCompany, the old name being simply too restrictive for a company bent on global domination. Among its new divisions are WeLive, WeGrow and even WeBank is on the horizon.
Its other big news was related to SoftBank’s decision to pull back on the $16 billion dollar equity commitment to the company, reducing it to a mere $2 billion. Whether this was a belated reevaluation of the wee company’s prospects or a reflection of SoftBank’s own issues (its stock has declined 28 percent in value since October) is a matter of debate.
Lost among these headlines are a couple interesting notes about the company. First, the bonds it issued last spring with interest at 7.87% are now yielding 10.4%. Whatever SoftBank’s reason for re-trading its commitment, the bond market has consigned the company’s paper to the junk pile.
More interesting than its bond status, however, is what WeWork is doing today in Asia. Its pivot there might prove the company’s future, if not its salvation. WeWork has announced a series of joint ventures with major Chinese developers—most recently, Gemdale Properties, the giant state-owned real estate company—where, rather than simply leasing space from these developers (and taking 100% of the upside and assuming 100% of the risk), it is signing “participating leases” with them.
The details are sketchy, but the idea is simple: The building owner puts up the money for the tenant improvements, lowers WeWork’s base rent and then shares in the subleasing profits. In other words, WeWork is swapping profits for downside protection, not a bad idea in a rising market and a brilliant one in a falling market. And, according to WeWork, office rents are falling in all but two of its global markets.
Why would the Chinese do this? They’re smart guys. Why not insist upon the traditional landlord/tenant approach and force the tenant to take all of the risk?
One, they need WeWork far more than it needs them, since the company can go anywhere. The Chinese companies may be top-notch at “borrowing” technology and knocking off brands, but they suck at cool. And WeWork is cool; it has dazzlingly pulled off its brand. If co-working were just a matter of Beats, beanbag chairs and free beer, every frat in America would be banking money.
The other reason, back to them being smart guys, is that they must understand what WeWork landlords in America are likely to learn: In a down market, they’re all going to be partners, voluntarily or otherwise. Self-described big wave surfer Neumann has already announced he will ride the market down by rewriting the company’s unprofitable leases, lowering rents to profitability or abandoning the buildings.
The clever Chinese know that WeWork neither signs nor guarantees its own leases. Rather, for each lease it signs, it creates a single purpose entity (SPE) with limited capitalization; i.e. its leases carry almost no financial exposure to the parent company. This means that if a landlord refuses to sign a lease amendment giving away, say, 80% of her rent, Neumann can toss that particular SPE into bankruptcy and paddle off in search of the next big set. If we were on Gemdale’s board of directors, we might conclude that taking half of the upside isn’t such a bad move, since we’re going to be stuck with the losses anyway.
If WeWork truly wants to shelter itself from the coming winter storm — maybe not, they produce the biggest waves — the next step in its evolution from risk taker to guaranteed profitability could be the hotel model. Successful hotel companies create a strong brand and then, to over-simplify matters a bit, either sell franchises (the Motel 6 approach) or sign no-risk management contracts with owners of swanky hotel buildings (the Four Seasons approach).
Four Seasons and its competitors are paid a minimum fee regardless of the occupancy rate or gross income they produce for their owners. And they are paid big fees if all goes well. It isn’t impossible to lose money in the hotel management business, but it’s harder than in many other endeavors.
WeWork could do the same thing, it could become the Four Seasons of office buildings. It has the brand, it fills a need that it helped create and, as far as we can tell, its niche — short-term, micro-size office rentals in traditional long-term, big-space locations — is here to stay.
The point of this essay is not to bury WeWork, but to praise it for rationally pivoting its business in the face of economic climate change to minimize risk. Something we all might consider. By John E. McNellis, for The Registry.
Commercial real estate developer shares his insights on how to prepare for it. Read… Winter is Coming to Commercial Real Estate
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