Flex Frontier: Coworking’s Next Big Markets

The openings underscore a major trend in coworking: Not its expansion into markets beyond the San Francisco-New York fulcrum that many operators such as WeWork rode to prominence — that’s been going on for a couple of years now at least — but rather coworking and flexible office space’s potential in these secondary markets. Because WeWork is hardly alone in looking beyond its coastal origins.

A CBRE (CBRE) analysis released in May and covering 30 markets nationwide found that half have more than 1 million square feet of flexible-office inventory. The rest? The sky’s the limit, according to the analysis, which read, “Many U.S. markets have not even scratched the surface of this sector, including high office-using employment growth markets like Nashville, Austin and Charlotte.” 

As they do scratch the surface, analysts say that these secondary and tertiary markets could end up illuminating much more about the future of coworking than the next WeWork or Regus lease in the Bay Area or Manhattan. They’ve already proven the sector’s past and present appeal. 

“I think the bottom line is that the concept is not going away,” Bethany Schneider, director of research at Newmark (NMRK) Knight Frank, said. “It’s really changed the landscape in a way that’s not going to be undone at this point.”

A network and density

In fall 2018, a business catering company called ezCater leased 100,000 square feet on four floors at 40 Water Street in downtown Boston following a fundraising round that netted $100 million toward expansion. 

Only months before, WeWork announced plans to take that space from developer Related Beal and operate it as the company’s largest Boston outpost. Enter ezCater, which had room for up to 750 employees at 40 Water. The company’s chief executive reportedly said they liked the more flexible terms WeWork could offer compared with conventional landlords. (WeWork declined to comment for this article.) 

The Boston deal highlighted what’s going to become a more common trend in coworking, analysts and operators say. Gone are the days when coworking operators catered almost exclusively to freelancers and small start-ups. Now they’re looking to accommodate much larger, more established companies seeking flexible terms either for themselves or for incubator space that might foster a little bit more of an entrepreneurial spirit than a corporate HQ would. 

Coworking operators Industrious and Galvanize have several Fortune 500 partners each, and firms with more than 1,000 employees constituted between 25 and 30 percent of WeWork’s business as of the start of 2018, according to research from NKF. 

The watershed deal for this whole trend was probably in 2017, when IBM took all of the approximately 70,000 square feet that WeWork operates in Manhattan’s 88 University Place. But companies like Amazon, HSBC and Microsoft (MSFT) have also signed on to different coworking deals. 

The trend is driving coworking operators to move into those secondary cities in anticipation of larger companies pursuing more coworking space beyond the big gateway markets.

“As they move from primarily servicing entrepreneurs and freelancers [as they did] 10 years ago to a lot of focus on enterprise, they need to be able to provide that network for those enterprise clients who are national or global in nature,” said David Smith, Cushman & Wakefield (CWK)’s Americas head of occupier research. “So, there’s not a need to be everywhere, but a need to be in more places. That’s part of the strategy.”

As for where coworking operators are opening in these cities, that’s a function of population density and the demand it can create, according to NKF’s Schneider. 

“That’s why a lot of these coworking companies that have opened in these kinds of secondary and tertiary markets are doing so in the CBDs of those markets,” Schneider said, referring to central business districts. “You need to have the customer base there.”

Nashville and Charlotte are good examples of attractive customer bases for coworking and flex-office operators, analysts say. Charlotte is the nation’s No. 2 financial services hub, behind Manhattan, as lenders including Bank of America call the city home. Nashville has a diverse economy in terms of employers, with a particularly robust health care sector and sizable outposts for Dell and Amazon. Both cities’ populations are growing, and each has a distinct downtown. 

“They have all the major players there that we would typically find in a New York or a San Francisco,” Julie Whelan, head of occupier research for the Americas at CBRE, said of Nashville in particular, where coworking accounts for 1.79 percent of the office market inventory (in Charlotte, it’s 1.57 percent). “To me, that really says a lot about how operators are looking at that particular market in terms of current growth and the ability to proceed there.”

At the same time, coworking and flex-office providers still look at fundamentals in these markets, regardless of the larger companies’ plans.  

“The market’s available inventory, vacancy rates, employment growth and business environment, and presence of existing customers and owners” — that was how Eugene Lee, chief investment officer for Knotel, answered a question over email about what metrics the rapidly expanding flex-office operator looks for in new markets. Knotel announced plans to expand into Boston, Washington D.C. and Toronto in the coming months (their current U.S. locations are in San Francisco, Los Angeles and New York). (Disclosure: Commercial Observer’s publisher and chairman, Joseph Meyer, is an investor in Knotel.)

Knotel founder Amol Sarva told CO in November 2018 that the company aims to be bigger than WeWork “in the next 15 months.”

Beyond growth

Ten markets — Manhattan, Los Angeles, Washington, Chicago, Boston, San Francisco, Dallas-Ft. Worth, Seattle, Denver and Atlanta — accounted for more than 70 percent of the nation’s coworking and flex-office space inventory as of May 1, according to CBRE. The firm’s research also showed that the 10 biggest markets accounted for nearly two-thirds of flex-office leasing in the first quarter of 2019. 

But, individually, such space — and the leasing driving it — accounted for more than 3 percent of total inventory in only two markets: Manhattan and San Francisco. In the others, it was around 2 percent or much less — 0.75 percent in Washington, D.C., for instance. So even the larger markets have potential for growth, never mind the nation overall.

“With nearly 4 billion square feet of traditional office space in the 54 major metros tracked by CBRE, continued growth of flexible space is inevitable even under conservative estimates,” the CBRE report said.

This growth potential has spawned a veritable parlor game in commercial real estate concerning the fate of coworking as it expands beyond its original gateway markets to the likes of Charlotte and Nashville. At the end of 2018, NKF released a white paper with five scenarios for the next few years of coworking. (Scenario No. 1: “Coworking growth accelerates rapidly, reaching 20 percent of inventory by 2023.”)

All of these analyses have tried to see around the corner, not only at coworking’s expansion, but at how it will weather an inevitable economic downturn. Two schools of thought have emerged, both of which coworking’s spread into secondary and tertiary cities accentuates.

One is that nothing can stop it. Coworking will gradually grow toward that 20 percent benchmark over the next few years, as NKF predicts, or beyond. A recession might even help the growth along, according to Darin Harris, North America chief executive for Regus, which is one of the two largest coworking operators, along with WeWork. 

He said that companies buffeted by the uncertainty of a downturn would be more apt to seek the flexibility inherent in coworking leases. Plus, he said, the evolution of coworking works in the sector’s favor, come what may. “It’s not just entrepreneurial clients who have one or two locations, or one or two desks,” Harris said. “Each [Regus] location has a very diverse range of clients, from small to large corporations.”

What’s more, coworking has become popular among conventional landlords. More than one in 10 coworking locations worldwide were a joint venture between a landlord and a coworking operator as of August 2018, according to Cushman & Wakefield, and that share has only likely grown.

Also, the number or landlords launching their own coworking ventures (or at least spaces) is expected to grow too. That’s because coworking spaces can save landlords money long term.

“[T]raditional leases can be tighter since organizations don’t need to allow for as much expansion space that is not utilized or is underutilized for the first several years of the lease term,” Cushman & Wakefield’s report from August 2018 said. “Coworking allows for the rest of the portfolio to be right-sized.”

That helps explain investors’ comfort level with coworking’s growth. The same Cushman & Wakefield report estimated that investors were fine with up to 30 percent of a building or asset being allocated to a coworking provider with relatively strong credit. “Anything above that may currently be viewed adversely,” the report stated. “However, we expect that the range of comfort will increase over time as investors and lenders have more experience trading assets with significant coworking occupancy.” Beyond that, they might sweat the effects, but few buildings in the U.S. have breached that 30 percent threshold.

Finally, coworking’s growth is bound up in a looming consolidation wave — whether or not there is a recession. This consolidation will likely be manifested most clearly in the secondary and tertiary cities as the likes of WeWork and Regus fan out and start to clash as they court larger clients looking for these spaces. 

“The smaller, niche players will have a harder and harder time competing as this trend continues to grow,” NKF’s Schneider said. “I think, especially in the smaller markets, it will be really tough for these kind of mom-and-pop, one-off coworking concepts to compete when someone like WeWork comes in.”

There are no major consolidation deals in the works, but the scaling up — and out — of bigger operators probably makes some mergers and acquisitions inevitable, analysts say. A downturn could hasten those as less-well-capitalized operators struggle; and the growth out of that in the smaller markets could end up as the real tell for coworking’s future. 

“Now, what’s the saturation point for those markets?” CBRE’s Whelan said. “We don’t know.”

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Co-Everything

How coworking’s growth is spurring changes beyond office space

After noting (at length) the meteoric rise and looming potential of coworking office space, a CBRE report from earlier this year concluded on this note: “The flexible leasing trend is not limited to offices … There is potential for diversification of coworking across niche players, asset types and geographic submarkets.”

In other words, it need not just be coworking operators leasing office space to individuals or companies. As CBRE noted, the approach, in all its flexibility, built-in services and communality, could come to include everything from medical labs to industrial facilities to retail. 

And it might increasingly arrive in front of clients in different ways than before. 

Take what Regus announced in mid-July. The company — one of the two largest coworking and flex-office providers globally, along with WeWork — launched a franchising program. 

Under the new program, franchisees would have to have a minimum net worth of $1 million and a minimum of $350,000 in liquid assets per probable location and would have to be willing to open a minimum of five locations no smaller than 10,000 square feet over a two- to three-year period, with initial investments of $650,000 to $1.7 million per location — with a $50,000 initial franchise fee.