Downtown landlords are warming to the idea of co-working space

Like many office landlords, Tony Lindsay has had doubts about the co-working craze.

Watching as WeWork and its shared office provider peers signed a barrage of big, long-term leases and subleased that space to companies that could rent it by the month, the principal of Chicago-based developer North Wells Capital sat on the sidelines—even losing out on some tenants that chose co-working over his firm's River North properties.

"We were saying the other shoe is going to drop at some point," if an economic downturn suddenly stripped co-working firms of their revenue, "and I don't want to be stuck holding the bag," Lindsay says.

Now, nearly a year into a COVID-19 crisis that has devastated some of the shared office sector's biggest players and stung countless landlords, North Wells just inked one of its first new office tenants since the pandemic began in Chicago startup Workbox—a co-working provider.

Not that his opinion on co-working companies has changed much with the industry's fast-growing players taking it on the chin. Giants WeWork—one of the biggest users of office space in downtown Chicago—and Regus have been shuttering locations nationwide while much of the workforce operates remotely. New York-based co-working firm Knotel, valued at more than $1 billion in 2019, filed for Chapter 11 bankruptcy in January.

"Jumping into the realm of co-working is something we didn't take lightly," says Lindsay, whose deal with Workbox included more than 15,000 square feet at 306 W. Erie St. "But the reality is we identified having co-working in our portfolio as being really advantageous to respond to the market in almost any way possible."

Rising vacancy and the foggy future of office demand are pushing landlords to embrace shared workspace providers in ways they were reluctant to do before, industry experts say. With companies lost on how much office space they'll need in a post-pandemic world, demand for workspace that can be leased on flexible, short-term deals is expected to soar as tenants dip their toes back into the office market pool.

Many landlords are preparing for that by turning to co-working specialists for help. But the model is changing: Instead of inking traditional leases, more landlords are signing co-working providers as consultants or management partners, forging revenue-sharing deals to manage their flexible office space. As opposed to a co-working company paying rent, for example, it would get a fee for managing the space and split profits from shared office leases with the property's owner—akin to the hotel world, where investors own properties but hire major brands like Marriott or Hyatt to manage them.

Workbox will pay some rent but also share some of the profits from tenants it brings in above a certain threshold, Lindsay says, calling it "the symbiotic relationship that we were looking for."

It's not a new formula—New York-based Industrious, which recently signed on to manage a full floor of co-working space at Willis Tower, has signed such management agreements for several years and is trying to convert its legacy leases into landlord partnerships. But it's now becoming a more popular strategy as landlords stare down the most competitive environment in recent memory, says Michael Kloppenburg, a senior consultant in the flexible office practice at brokerage Avison Young who works with landlords on implementing shared office strategies.

"We're seeing some experimentation going on" from landlords that resisted co-working before but are now gravitating toward deals "whereby they control the space but they outsource management expertise to someone that's got a history of doing it," he says.

Some landlords have a bad taste in their mouth after their co-working operator tenants got crushed by the pandemic, leaving their buildings with heavily divided space that would be expensive to repurpose into something other than shared offices. More than 10 percent of the roughly 5,800 pre-pandemic co-working locations nationwide have gone dark from issues like lease defaults or bankruptcies, according to an estimate from Chicago-based shared office provider Novel Coworking.

But even those whose co-working tenants collapsed recognize tenants will crave lease flexibility coming out of the pandemic. Skokie-based Next Realty recently signed brokerage Stream Realty Partners to take over leasing of an 80,000-square-foot office that co-working brand Spaces abandoned in January at 620 N. LaSalle Drive. Stream will install its own flexible office brand, Rapid, in part of the space.

"The optionality for a company that is in flux about its office demands (makes) this an ideal solution," Next Realty President and Chief Operating Officer Marc Blum says. "I think this concept is here to stay. It will supplement your traditional office space, and I believe there will be demand for a very long time."

Stream's brokerage rivals are also diving deeper into co-working space management to meet landlords' needs. CBRE recently paid $200 million for a 35 percent stake in Industrious and will integrate its own co-working brand into the company's operations. Regus parent IWG also bought a majority stake in the Wing, a female-focused shared office provider. Commercial real estate firm Newmark is acquiring Knotel's assets.

Yet some landlords are still hesitant to add co-working to their buildings for the same reason they were before the pandemic: Their investors—and more importantly, lenders—still see co-working space as a big risk. Many have a hard time understanding the return on investment for co-working space that may have highly volatile occupancy, a metric they usually rely on to justify putting new capital into a building, says Mara Hauser, founder and CEO of suburban shared office provider 25N Coworking.

"There are still hurdles there," says Hauser, who estimates her work consulting landlords on their flexible workspace strategy has doubled since the start of the pandemic.

She foresees investor and lender sentiment on co-working changing over time with so many companies demanding shorter lease terms after the pandemic. But it remains a tough sell for now.

They're going to a lender saying 'we want $130 to $150 per (square) foot to build out the space, but we have no idea how we're going to get that money back,' " Hauser says. "It's an amenity space . . . so you're talking to lenders about value and revenue generation that will occur from an amenity space. In the past, amenity spaces didn't bring in revenue."

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