23 June 2020

Serviced offices after coronavirus: does co-working work for your HQ?


Tom Hughes
Senior associate | UK

It is no secret that there have been a number of high-profile casualties within the serviced office industry. Office providers of all sizes have struggled with almost impossible trading conditions and the response from the providers has been a well-documented request for rent concessions from landlords across their portfolios and a heavy reliance on additional borrowing.

Depending on what you read, the future of the office as a concept is either about to fall off a cliff forever to be consigned to the annals of history, or is destined to return to normal seemingly overnight. The reality of course will be somewhere in the middle – but it is going to be informed by the experiences of businesses for whom ‘lockdown’ has been an unprecedented experiment in wholesale home working. Our offices will not vanish – indeed their importance might even increase as a result of the surge in remote working – but what we do in them, and how and when we access them is going to change. These changes will be hugely significant, and will prompt business to reassess their occupational space needs in ways they haven’t done before.

So, is the serviced office industry going to boom?

Again, it depends to whom you talk to. The providers undoubtedly say ‘yes’ and have gambled big on uptake being strong coming out of the epidemic, using the lure of greater returns to reach new deals with their landlords that allow them to share more widely in the providers’ profits in return for leniency on rents during the tough times. The providers all point to the 2008 economic crash and the surge in uptake of serviced office space that followed. But whilst the inevitable recession will come, the coronavirus experience has been very different and the future looks much less clear.

In the short term, the co-working model with its ever increasing densities is dead. Social distancing in the workplace means occupancy levels are likely to return to just 25-30% across offices in general. In the co-working sector where densities have been at their highest, this could be lower still. There will still be demand driven by businesses who simply have nowhere to go, but what this will look like is deeply uncertain as the trade-off for lower density of occupation must inevitably lead to price increases.

The interesting questions is whether there will be demand from new businesses – businesses that had not previously considered serviced offices as an option for their office needs – who might be tempted by the prospects of flexibility and the ability to cap ‘the bottom line’ in terms of real estate costs for the duration of the contract.

Wherever an occupier lies on this spectrum (new joiner, or committed enthusiast), the following trends are likely to come into play:

HQ agreements

The providers want longer-term stable revenue from occupiers who are willing to take one, two or even more, whole floors on an exclusive basis. Similarly, in the aftermath of the epidemic, occupiers might be shy to commit to new leases with institutionally acceptable terms of say 10 – 15 years. This convergence in the market could see a spike in demand for these so called ‘HQ agreements’ and might tempt a class of less traditional occupiers into the serviced office market.

But is it that simple? Can you trade-in your old lease for an HQ agreement and carry on as normal?

The short answer is ‘no’. Despite the convergence in demand, HQ agreements are fraught with complexities. The contracts themselves tend to have the look and feel of a typical serviced office contract and will often incorporate standard ‘non-negotiable’ terms and conditions. Whilst these standard terms might be sufficient for taking 6 desks on a rolling monthly contract, they are unlikely to be suitable for larger agreements which relate to office space for hundreds of employees and which may run into many millions in terms of fees payable over the duration of the contract.

Occupiers looking to move away from traditional inflexible leasehold occupation in favour of a more flexible HQ agreement are likely to be sorely disappointed. Forget rolling contractual break clauses and the ability to add or remove space as required. HQ agreements usually contain a fixed commitment for a minimum period of between 1-3 years. Whilst incentives and teaser rates might be on offer initially, the basis of the commitment is likely to be just as static as a lease – and in some respects perhaps even more so, because HQ agreements will generally have no equivalent assignment or subletting provisions.

The underlying basis for occupation under a serviced office agreement is contractual. The contract represents a licence to occupy the specific workspace subject to certain conditions but the key requirement must always be that that occupation is non-exclusive. Generally, conceptually for an occupier, an HQ agreement is a lease by other means where the business is shielded from the inconvenience and cost fluctuations of having to fit-out and operate their own office. What occupiers don’t anticipate is that their provider will almost certainly have a contractual right to re-locate them, or that they won’t be entitled to exclude other users from the office.

The position becomes murkier still when considering whether a contract granted for a number of floors to a single occupier is capable of being a licence at all, or whether in the eyes of a court in substance the arrangement would be regarded as a lease. The distinction here being important for, amongst other reasons, deciding whether stamp duty land tax is applicable.

Occupiers who want to consider taking significant space under a serviced office contract for the first time, should do so being aware of the pros, and well as the traps, pitfalls and limitations of the model.

Design led response

The post-coronavirus landscape will involve a design led response to these new ways of working. The old maxims and ‘one size fits all approach’, where office space requirement for a business could be relatively easily calculated simply by reference to headcount, have now gone. Remote, agile and activity based working mean deciding on a business’s physical office space requirement is a much more bespoke task – and whilst design led solutions might seem to neatly fit with the ethos of co-working and serviced office space, in reality there are question marks around just how many providers are set up to deal with occupier demand for truly bespoke office design solutions. This is much more than scatter cushions and a choice of matching dralon; office design has been slowly undergoing a revolution and its importance is peaking like never before. Will the providers be able to cope with the vision and new demands of their occupiers?

Feasibility

When the extent of the office space requirement is eventually known (following some engagement with the design team), sensible discussions can ensue about the cost-benefit analysis for an occupier of taking responsibility for that space directly via a lease, versus paying a serviced office provider to do that for them. It was a generally held rule of thumb that, from a pure economic analysis, the break-even point for the length of a serviced office contract beyond which it would no longer make financial sense to take fully serviced space, was in the region 2.5 – 4 years. Beyond this, the premium paid to the provider was not thought to be justifiable in pure financial terms, because overall the costs of taking responsibility for the space directly (when spread over the duration of the contract or lease) would be lower. We will have to wait and see whether this maxim still applies. It is going to be impacted in the short term by a surge in availability of ‘fitted out’ office space available on a short or medium term leasehold basis as larger occupiers are predicted to look to offload surplus space to lower overheads. But in the longer term, with more staff working from home, the role of the office might even be elevated, making it an even more important expression of the business and its culture. As a result, some predict rising levels of investment per square foot as overall office space requirements reduce.

What is unusual about where we are now is that, in order to consider financial feasibility properly, occupiers need to start with the design process in order to work out the budget – rather than the budget dictating the design process.

Risk

Significant upfront payments from occupiers required for fitting out large serviced office spaces – the type that are the subject of HQ agreements – have been the norm in the serviced office market. Providers often fund the preparation and fit out of their occupier’s space with forward payments received directly from the occupier. As public questioning of the business models of many large providers grows, so too might the reluctance to continue to part with such large upfront unsecured payments. These feelings might be compounded by the knowledge that many providers will be running leaner margins as a result of the deals done with landlords that see them participating in a greater share in the profits when times are good. Put simply, the market may not tolerate this level of insolvency risk going forward.

In the short term, occupiers and providers will need to negotiate their way through this on a case-by-case basis, but with no obvious solution afoot it is hard to predict what the standard practice will become in the long term.

Conclusion

The serviced office industry is clearly here to stay. However, the future success of the industry would seem to turn on the extent of the medium to long term changes in attitudes towards office space which have been accelerated as a result of the coronavirus epidemic – and in particular whether the serviced office model can adapt to the increasingly design led solutions to issues facing businesses and the way they use their offices.

Tom Hughes Senior associate | London

Category: Article