Why Co-Working Spaces Will Be The Canary In CRE’s Coal Mine

In the past decade, the rise of the gig economy has inspired the truly meteoric growth of the co-working industry. Case in point, WeWork last month surpassed Google’s parent company Alphabet as the nation’s largest leaser of new office space and has only continued to grow since then. Today, Boston hosts at least 35 different co-working locations, WeWork among them, and if you stop by on any given weekday, it’s safe to say that you’ll find yourself with plenty of company.

While modern co-working is often associated with “hip” millennials, big companies worldwide have invested in office-sharing options for their traveling or remote staff since the late 80s. For young companies or sole proprietorships, co-working represents huge benefits, ranging from decreased overhead to shorter leases. But it also presents a looming question – what happens if the co-working bubble bursts?

How the Dot-Com Crash Halted Co-Working

In my previous life in the private equity sector, investing in co-working spaces prior to the Dot-Com crash was pitched as recession-proof. It was thought that members would stay even when the economy recedes because costs and membership commitments were lower than traditional office spaces.

If hindsight is 20/20, then office-sharing giant Regus should be a bellwether for the industry. They too had dreams of rapid expansion and a “recession-proof” business model, but instead faced bankruptcy, as large companies shut down “outposts” in co-working spaces, small businesses closed, and entrepreneurs returned to desk jobs.

What is particularly concerning about this is that 15 years ago, co-working represented a niche. Today, co-working spaces occupy Class A locations and attract a wide array of users. Co-working operators like WeWork are offering additional amenities (including gyms, spas and even education!), while businesses with no industry expertise are now expanding into the sector (Lifetime Centers).

There are two key factors that must not be overlooked when thinking about the future of coworking:

1. It’s a fixed-cost business, just like traditional real estate. Whether you have one person working on-site or 50, rent, electricity, insurance and janitorial costs remain mostly constant. This issue is compounded by adding high fixed-cost amenities like gyms. Thus, when the bubble bursts, costs stay flat, but revenue drops off.
2. In a down economy, small businesses and freelancers are often hit the hardest and change course first, leaving co-working companies on the hook for empty offices.

While some spaces have hedged their bets against a downturn by entering into lease-sharing agreements with corporate giants, operating dual function spaces—think office by day, bar by night—or even investing in wave pool makers, the next bubble burst will greatly impact the co-working market, and by extension, the entire CRE industry.

Effects of a Burst on CRE

I should begin by noting that the gig economy, in all of its forms, is something we’ve never really seen before, and it’s, therefore, hard to say exactly how it will alter the landscape when the next economic bubble bursts – and it will inevitably burst. That said, any way you slice it, there’s no escaping the fact that when the economy takes a hit, the ripple effect from co-working spaces will come crashing into CRE markets. And, because none of the latest co-working giants like WeWork have yet had to experience an economic downturn, there’s no way to know how well the various safeguards, like profit sharing and attempts to diversify, will perform.

For the sake of argument, let’s play it out a bit. Let’s say that in the next downturn, Dell decides to bring its army of employees at WeWork back into the home office. Meanwhile, entrepreneurs start hunting for a steady job, and freelancers—the heart of the gig economy— spruce up the home office. In each case, the flexibility of the co-working model is exactly what makes it one of the easiest and quickest costs to cut (the proverbial “low-hanging fruit”).

Because of the rapid drop off, Co-working Company A suddenly can’t pay its rent, so it negotiates with the owner to reduce its leased footprint. The owner accepts rather than losing the lease entirely but then has to lower rent as an enticement to lease out the newly vacant space.

Other co-working operators—along with traditional tenants—face similar headwinds. Rent declines spread from individual buildings to blocks, to neighborhoods and ultimately entire cities. And unlike the first time the co-working bubble burst, the ripple effect on the entire CRE market will be much larger, faster and sharper this time around because co-working operators now represent such a larger piece of the CRE pie.

I would love to say that today’s co-working companies have recognized and accounted for the weaknesses and shortcomings of office-sharing giants past. After all, these are largely new companies operating in an entirely new business landscape. That said, WeWork just recently announced a new relationship with Microsoft, whereby the software giant’s 300 NYC employees will now have access to WeWork’s co-working space. I look at that deal, and I can’t help but wonder what Microsoft will do the next time profits are sagging and the company needs to make a few quick cost cuts.

All of this said, I personally don’t foresee an imminent risk of this happening in the next few years. Even if it does, there’s a chance that the economy can muddle along. Interest rates are low, there’s a lot of liquidity and the Fed is supportive of growth—all things that tend toward a more optimistic outlook. That said, the bubble will burst. Experts may not agree completely on when or how, but there’s little question that it will happen. And when it does, co-working spaces will inevitably be the canary in CRE’s coal mine.

Brian R. Iammartino, CFA is Co-Founder and Managing Partner of btcRE LLC, a boutique commercial real estate investment and development firm. In this role, Brian leads the firm’s day-to-day operations, drawing upon his extensive expertise in commercial real estate investing and consulting. He also has a strong background in general finance, complex investment structuring, urban public policy, and community engagement.

Brian Iammartino

Officio, Newbury Street Boston MA

Plug Coworking, Cambridge MA