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The rise of flexible space in Asia Pacific has been meteoric. JLL research indicates major operators grew their footprint at an annualized rate of 35% over the 2014-2017 period and that pace of growth has carried over into 2018 (Figure 1).
Figure 1: Flexible space stock*
Source: JLL Research
A number of factors have driven the growth of this industry, and the co-working segment in particular, including the flexible terms offered to members, the plug and play ease of setting up, the sense of community and ready access to social and professional networks.
Initially co-working appealed to startups who found it more affordable than opening a traditional office.
But increasingly large corporates have started including co-working in their real estate strategy. And to accommodate corporates, operators have increased the size of their centres – our latest research indicates the average flexible space lease grew nearly 40% in 2016 (Figure 2). That momentum has slowed somewhat but centres have continued to grow.
Figure 2: Average flexible space lease*
Source: JLL Research
Catering to corporates with larger centres enables operators to stabilize their rental income (providing much needed comfort to landlords and investors), but it also means heavier rent obligations and larger expenditure on fit out. As a result operators have been chasing additional funding from investors and exploring alternative business models.
Alternatives to standard leasing
To date the most popular flexible space model has been rent arbitrage.
Essentially, operators charge higher rents per unit basis to their members than the rent they pay to landlords. To achieve this, operators typically have seat densities much higher than a traditional office. However, as more operators have entered the market, competition has intensified and arbitrage margins have come under pressure.
Base or turnover rent, a popular retail lease structure, is one alternative. Tenants pay either a fixed base rent or a percentage of sales, whichever is greater. Such a model provides lower fixed rents than market but aligns the upside when centres perform well.
The management contract, popular in the hotel industry, is another alternative. Here, the operator charges a percentage of total revenues and/or gross operating profit for branding and operating the premises and typically there is no lease obligation for the operator. As with hotels the primary upside and downside is with the owner of the property who is dependent on the operator to keep occupancy and profitability high. Operators have limited obligations compared to other models and yet they are still incentivised to maximize profitability.
While these alternatives offer operators a means to better withstand a market downturn, they will have a direct impact on how investors view the cash flows from a commercial asset.
Going forward, the ability of the operator to demonstrate profitability above and beyond a traditional rental model will determine whether alternative models…