Benjamin Dyett proclaimed on a webinar hosted by the League of Extraordinary Coworking Spaces (LEXC) last April that, as an owner of Grind Spaces a coworking space brand, he will never sign another traditional commercial lease. A year later, both sides of the market are finally much more interested in creative lease structures and operating models. There are landlords, developers, and REITS that want flexible, shared workspaces in their buildings enough to get flexible themselves.
What are some of the non-traditional lease structure deals that are getting done?
- Landlord/operator joint venture
- Landlord as owner, operator as manager
- Landlord as brand licensee
Landlord/Operator Joint Venture
In this approach, the Landlord takes ownership in the location. If there are multiple locations, each might be set up as a separate LLC and the landlord takes an interest in the space located on his/her property. The agreement is structured to give the landlord upside in exchange for reducing the risk for the operator.
A successful coworking or a more traditional serviced office space is charging more per square foot than the landlord. This is the basic premise of the model. The operator leases space, divides up the space to be used by individuals or teams, adds services, design, community, amenities that are appealing to flexible workspace users and, assuming they optimize revenue via memberships to the space and virtual office services, and manage their overhead well, make a profit.
The landlord has not historically undertaken this effort himself because it is an entirely different business than owning and managing buildings. However, once a landlord understands what you’re up to, he might think that he can do this on his own, but that is not typically a successful outcome, especially the rising expectations that the average workspace consumer now has about their options.
There are challenges to the shared workspace model that typically require an operator that wants more than 1-2 locations to take on external investment. Build-outs, furniture purchases, etc. are not usually funded by cash flow quickly enough to grow the business at the operator’s desired speed. The other use of cash flow at startup is paying rent out of a cash reserve until the space has enough membership revenue to hit the break-even point. While some spaces are successful with aggressive pre-sales, it can be challenging in some markets/locations. So in this first example of a non-traditional approach, the operator gives the landlord equity in the business in exchange for the landlord’s participation in build out costs and a rent schedule that aligns with revenue timing.
There are many ways to shape a joint venture and much of it will depend on operator and landlord preferences and financial circumstances. The primary factors to be negotiated include:
- Who will finance the build out?
- If landlord-financed, will the business pay the landlord back for the build-out over time?
- Will the operator sign a lease? If so, what will the rent commitment be?
- Will there be a management fee paid to the operator?
- Who will finance the furniture?
- What gets paid before profit flows to each party?
Benefits to Each Party:
The operator can open a shared workspace at a greatly reduced up-front cost and lower risk. In some cases, the operator might not even be on the lease, contributing to lower long- term risk. The landlord can participate in this new sector of the shared economy. He/she can understand at a deeper level what people want out of the workspace of the future. She can generate more revenue per square foot than from a traditional tenant. She can be a part of creating a business that has a significant impact and relationship with the surrounding community. He can make a larger building more attractive by having a flex workspace as part of the mix. He may benefit from businesses outgrowing the flex space and moving into their own space in his building.
Reduced risk for the operator, higher upside for the landlord.
The operator gives up ownership and upside, there’s still risk for both parties that the business fails or under-performs. Incentives must be carefully aligned to ensure that both parties are taking actions that result in profit.
When this Works Best:
An important note here is that the numbers generally don’t work for this approach for smaller spaces. An operation must be scaled to at least 10,000 square feet (and in most cases, more) in order to produce enough profit to share with the landlord and make a stake in your business more attractive to him than having a traditional, high credit tenant. It also works better for a shared space operator with multiple locations so that they’re already sharing overhead such as website costs vs. having one P&L support all overhead. And it works best for a space that has a strong percentage of private offices in the mix. The market is seeing that generally, private office spaces still sell faster and more consistently than open desk seating in most markets.
It also works best when a landlord has a personal reason for wanting to get involved in coworking. He “gets it.” He gets the shared economy, he gets that workspace is being consumerized, he gets that he needs to start thinking differently about his portfolio in order to stay competitive.
Landlord as Owner/Operator as Manager
The asset owner owns the space but signs an operating agreement with an experienced coworking space operator.
Financial Structure: The asset owner pays the mortgage, does not collect rent from the operator, pays the operator a monthly fee for running the space from an operational and community management standpoint. Either party may own the brand. See the next option for brand licensing for more on that topic.
Benefits to Each Party:
The asset owner can integrate flexible workspace into its portfolio without taking on a role outside of their core competency which includes designing, operating and building community. The operator with a proven track record in activating work hubs can do their thing without the up front investment required to start a space.
Ideally, each party is doing the part of the business that they are best at without the risk of messing up the other aspects of the business.
Many asset owners want coworking spaces in their portfolios but REITs for example, can’t have service income on their balance sheets so getting active in the market is challenging. For operators, no risk = no upside. So this setup may be better suited for really strong COO’s vs. entrepreneurs. Generally this model also comes with a low commitment from the asset owner to the operator. The asset manager may decide that running the business looks easy and decide to drop the operator under a 60 day notice clause. This likely turns out badly for both parties.
Note: The risk to this model is that the asset manager may not know how to identify the right location for a work hub. The operator might be better at location identification but if not invested in the risk side of the business, may let the asset manager make a suboptimal location decision because it gets them a space to run regardless. One could argue that if the operator is aligned with the location and confident in the business model (which is what the asset manager wants), then the operator should be willing to fundraise and sign the lease. This is the dilemma that will most likely result in more joint ventures (outlined above) getting done than this version.
When this Works Best:
When an asset owner “gets” that they are best at real estate and not best at activating a contemporary workspace. When the operator’s focus is purely on leveraging her skills of designing and running a successful shared workspace without the up-front financial investment and long-term upside.
Landlord as Brand Licensee
The asset owner runs the whole shebang but licenses the brand and likely the technology that the operator is running to manage marketing and memberships.
The asset owner pays the operator a monthly licensing fee for use of their brand. The asset owner also likely hires the brand owner to design the space for a fee in order to ensure brand consistency for the members.
Benefits to Each Party:
The asset owner can have complete control over the business while leveraging a brand that has a proven track record for drawing and retaining members.
The incentive conflicts outlined above are greatly reduced. The asset owner has full control over the business, takes all the risk and upside. The brand owner gets greater brand distribution/presence and the upside of a monthly licensing fee.
It’s unlikely that the asset owner has experience operating a shared workspace and might totally screw it up and dilute the brand which is bad for both parties.
When this Works Best:
This situation likely works best when there’s a long-standing relationship and a lot of transparency for both parties before engaging in this arrangement.
What other arrangements do you see surfacing in the shared workspace model? What other pros/cons are there to each of the models above?