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Coworking is Snatching Up Office Space, But Is More Disruption on the Horizon?

Coworking space has led all other office user types in absorption so far this year. Pictured is 1701 Rhode Island Ave., a seven-story office building in Washington, D.C. that is fully leased to coworking space provider WeWork. The property recently sold for $119 million to an affiliate of EXAN Capital.

CARLSBAD, CALIF. — The office investment market is back on track and buoyed by significant sources of capital for deal making, following some political and economic uncertainty over the past year, according to the June 2019 Office Investor Sentiment Report by Real Capital Markets (RCM).

Among the key takeaways is that a majority of investors (87 percent) who participated in the survey view coworking as a moderate to high risk to investment values, with 37 percent of that group noting that the market could already be saturated. Overall, investors are looking more closely at the investment value of coworking space, given its rapid expansion and potential exposure to any market downturn.

The report also notes that investors remain confident in the office market in general, especially given economic conditions and population growth.

“Conventional wisdom and years of experience tell us that we may be long in the [economic] cycle,” says Tina Lichens, COO of Carlsbad, Calif.-based RCM. “At the same time, there is a broad sense of optimism, albeit somewhat cautious, that with the level of capital poised for investment, there are still allocations to be met and transactions to be completed.”

Coworking risks, opportunities

Coworking space has led all other office user types in absorption so far this year, snatching up more than 5.4 million square feet between January and June, according to JLL. Some investors are questioning whether this market segment is nearing a saturation point. According to RCM, the top three ways coworking is impacting the market include pushing vacancies down, creating an incubator mindset and paving the way for more dramatic disruption to office leasing.

Paul Noland, vice president of acquisitions for L&B Realty Advisors LLP, says that coworking is disrupting the traditional office leasing model. It is less expensive and less labor-intensive than standard leasing.

Expecting consistency

Investors interviewed and surveyed by RCM suggest that the U.S. office investment market is back on track, following a slowdown at the end of 2018 that lingered into early 2019. Political and economic forces — the government shutdown, uncertainty about interest rates and the real threat of tariffs and trade war escalation — raised questions, generated considerable uncertainty and slowed activity.

However, at the mid-point of 2019, property owners, investors and brokers expressed confidence in the health of the market, given the strength of the economy, continued job growth and population expansion in many markets.

Suburban office resurgence

RCM survey participants believe that the greatest opportunities in today’s office market lie in value-add suburban properties (39 percent of respondents), along with well-located properties in emerging markets (37 percent). Markets with good fundamentals, including population and job growth, as well as a highly trained labor force, are making the grade with investors. Examples include Charlotte, Chicago, Kansas City, Minneapolis, Phoenix and St. Louis.

On the other end of the spectrum, the three property categories seen as less attractive, or having the least opportunity, include: stabilized, well-located downtown buildings; trophy properties; and stabilized, well-located suburban properties. These findings reflect the perceived lateness in this investment cycle and investors’ continued focus on growth, value and yield, according to RCM.

Operational challenges impact value

In spite of its relative strength and consistency, the office sector is not without its share of challenges. In rank order, the biggest challenges named by respondents are the cost of tenant improvement allowances (63.7 percent); the ongoing trend of tenants leasing less space (53.6 percent); and the cost of converting underperforming assets (42 percent).

Tenant improvements present a great underwriting challenge. Universally, tenant improvement costs are increasing considerably faster than rents. Increases in tenant improvement costs make underwriting problematic, especially in markets with lower rents. While there can be greater disparity in rental rates from primary to secondary and tertiary markets, tenant improvement costs, from materials to labor, are consistent regardless of geography.

“We’ve reached a very interesting time in this current investment cycle,” says Steve Shanahan, executive managing director of RCM. “This is an investment cycle that despite its challenges, has been extended by robust levels of capital available for investment, coupled with putting many lessons that have been learned from past cycles into practice.”

Kevin Shannon, co-head of U.S. capital markets for Newmark Knight Frank, reinforces the optimism for a certain level of consistency in the markets. “While there are potential issues like the level of corporate debt and a tariff war with China to contend with, right now there are mostly green lights in our path.”

In May, RCM surveyed its database of office owners and investors in order to compile the sentiment report, which can be accessed in full here.

— Kristin Hiller

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