The Changing Face of the 10-Year Commercial Lease

To hear investors and landlords alike, it appears that the ten year commercial lease is done with–the latest victim of our disruptive digital age. Today, the argument goes, the ten year commercial lease has been killed by recent trends in the marketplace–specifically by startups and tech companies seeking shorter, more transient lease terms.

But that’s far from the truth. In fact, ten-year leases are alive and well, and show no sign of going away in the foreseeable future. What has changed, however, are tenant demographics and demands, which affect real estate markets all the same.

Let’s take a look at some trends, underlying causes, and see if we can draw any conclusions about possible avenues of profit for today’s commercial real estate market.

The decline of FIRE tenants… 

From my previous entry, readers no doubt know that London and New York are two of the key gateway markets in which my firm, GreenOak Real Estate, operates and invests.

Though both cities are very clearly tech hubs, this reputation actually isn’t all that well-known to the general public–especially in comparison to their established reputations as strongholds of finance, insurance, and real estate (FIRE) companies. Yet despite what you may think, since 2014, the market share of FIRE tenants is declining, at least in relation to tech, advertising, media, and IT (TAMI) sectors. The facts bear this out: London’s tech scene is thriving, while New York’s own startup sector is affectionately known as Silicon Alley, a moniker from the dot-com boom of the early 2000s.

All this is to say that London and New York are good benchmarks for how startups interact with the existing real estate scene. True, neither city is quite as saturated as California’s Bay Area, but all the same, can give us important clues as to how tech entrepreneurship can affect long-term real estate trends.

…and the rise of coworking spaces

The most obvious evidence of the rise of TAMI tenants is the rapid spread of coworking spaces. Airy, open-plan offices that blur the line between office and private home, coworking spaces combine plush couches, standing desks, and touches like foosball tables or even nap pods to help boost productivity. They’re also much preferred by startups, due to the lower, per-tenant costs and increased opportunities for interaction (which lead to better networking and improved innovation).

And coworking spaces are on the rise: by 2017, there were an estimated 13,800 coworking spaces worldwide, a twofold increase from 2014, when there were 5,800 such spaces. Further, nearly 1 million people are projected to cowork, with the vast majority of coworking spaces (81%) expecting both more income and more members.

But here’s the thing: as Will Silverman pointed out in our PrivCap talk from last year, there’s a disconnect in the marketplace: even if tenants, specifically startup founders, expressed interest in shorter lease terms, they still have to win over lenders, who also have a say in the property. Specifically, the concern is that there would be a lack of sufficient financing, and thus, a correction in property values–and a loss of revenue.

Essentially, even if the desire and demand is there, the funding isn’t. And Will is correct: ironically, those who are best-positioned (financially) to work with a free-hand are generational owners–who are also the least able to afford it. They don’t have lenders and shareholders pushing them in certain directions, but neither do they have the requisite funding to make the necessary changes to their properties and give Millennial startup workers what they want.

But the better question is not whether such landlords want to take the coworking market for themselves. It’s whether they would even be able to do so in the first place.

Can landlords dethrone coworking spaces?

Certainly all this talk about killing ten year leases overlooks one crucial option: cutting out the middleman, in this case, coworking providers.

Think about it: these coworking providers rent space on a large scale, often from large, well-established commercial property firms. They then refit and renovate the space, building in countless amenities, services, and comforts–anything and everything that Millennial workers may desire, from outdoor terraces with barbecues to ping-pong tables. Afterwards, they seek out startups and rent space to them, with a number of options for desks, private offices, and the like.

But here’s where their business model turns a profit: coworking providers, unlike their tenants, have stellar credit. The vast majority of the startup founders who lease coworking space likely have either terrible credit (perhaps from past business failures) or nonexistent credit (simply because they haven’t had the time yet to establish themselves and their brand). On their own, the tenants of coworking spaces would be unlikely to qualify for a lease, particularly at some of the most desirable, metropolitan locations.

From this, we can understand two points:

  • First, coworking spaces want stability in the form of a long-term lease; this way, they have a space tied down, and aren’t required to continually sink money into expensive renovation, remodeling, or relocation costs.
  • Second, coworking providers take the lion’s share of the profit. True, they also take most of the risk as well: after all, they are the ones losing money if one of their tenants defaults on a lease or falls behind on payment. But given the rates for offices and upcharges for “additional features” (essentials such as extra desks, conference rooms, and even telephones), it’s clear that coworking spaces stand to gain far more than they lose.

But the discussion of a coworking space’s business model raises two important questions: Can landlords even replace them? Should they even try to do so?

If anything, disintermediating coworking providers will not be easy for existing landlords. As many real estate investors and management firms have realized, the key to the success of coworking lies in fostering a vibrant, active, and most of all, engaged, community. For tenants, a day at the office doesn’t mean boredom and drab repetition–a key cause of rampant workplace disengagement, estimated to be around 51%. And don’t forget workplace loneliness–an important corollary of our society’s wider struggles with loneliness.

And yet, in our increasingly tech-centric world, the most stable tenants are precisely these coworking providers. Needless to say, this puts commercial real estate companies in a bind: do they then release these profitable tenants and, in a bid to increase revenue, copy their business model? Or do they just continue the relationship, relying on the stable, long-term leases that coworking spaces undoubtedly sign?

However you look at it, commercial real estate won’t be the same, especially given the disproportionate influence of coworking (and its many benefits) on more conventional workplaces throughout the country. Only time will tell what path real estate investors, lenders, and management companies will take.

By | 2017-06-19T15:34:24+00:00 May 1st, 2017|Real Estate|0 Comments

About the Author:

Sonny Kalsi is an accomplished real estate investor with more than 20 years of experience that spans a range of areas, including: investment management, real estate financing and hedge funds. Since 2010, Sonny Kalsi has worked as a partner-owner of GreenOak Real Estate, the independent real estate merchant banking platform where he is also a founder. Sonny's professional career also includes almost two decades of experience at Morgan Stanley, where he served as Managing Director and Global Head of Real Estate Investing in parts of Asia and in New York City. In an effort to share this wealth of knowledge and experience, Sonny Kalsi teaches at Columbia University as an adjunct professor in the university's Real Estate Development program. Connect with Sonny on Twitter at @SonnyKalsi_

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