Why would you buy an investment property with a serviced office occupier as your sole tenant? The traditional answer would have been: “because it’s cheap” or “because it’s the only thing available” but does this still hold true, or are there some things that make a serviced office occupied building more attractive to investors? If so what has changed?
Here is the disaster scenario that everyone talked about in the dark years of 2008/9, and at the bottom of the previous cycle:
A landlord is approached by their tenant, a serviced office provider, claiming they will go bust if the rent is not reduced. The landlord is not phased, because the tenant’s parent company has guaranteed the lease, so there is no reason to reduce the rent. “Oh, but, hadn’t you heard? The parent company guarantor has been wound up”, says the tenant to the landlord’s horror. Sure enough, the landlord discovers that the guarantor has changed its name to ‘Fly-by-night Ltd’ and gone bust. A new umbrella company with a similar name to the original guarantor now holds the assets which include the Special Purpose Vehicle (SPV) tenant, but it has no obligation to guarantee the lease. Disaster.
So 10 years on what has changed? Not a great deal to prevent this from happening. However the conversation has moved on in quite an interesting way. Many of the big serviced office deals agreed in the last five years have been guaranteed by no more than a bank guarantee of 12 months’ rent. On a 15-year lease that seems light, but it is better than a guarantee you cannot rely on at all, and there does seem to be more optimism about the long-term viability of SPV tenants. Profits of three times rent for three years, which is traditionally required, is a high hurdle for a serviced office to achieve, so why have investors been willing to ignore this long-standing test?
People believe in the product that underpins the occupancy: co-working, collaboration, the creative environment and community.
These have attracted occupiers to the new model of serviced offices and fortuitously they have been particularly appealing to the youthful TMT sector which is full of small companies expanding too fast for conventional leases to be relevant. The combination has been explosive but is it sustainable? So far, the model has evolved to attract larger and different requirements just when demand had begun to look satisfied. This is a strong trend.
It’s not just about backing a trend though. For one thing, the bank offering the guarantee will be your ally in putting pressure on the tenant to remain solvent. For another, SPV tenants are not always building specific but can be city specific. So, if two neighbouring serviced offices are operated by the same provider, that provider can’t close one in order to save the other, this has not been the case in previous cycles. However, if the sector consolidates through acquisition, operators will be able to prune out poor performers from the combined portfolio, particularly in densely occupied clusters.
Another interesting possibility is that the new breed of serviced offices is actually more profitable than the old model, so they are less likely to go bust. Some have identified an income stream in addition to rent. There has been a lot of speculation about what these could be, including data and special services such as faster internet and corporate deals which offer HR support and healthcare packages.
The rapid growth of the serviced office scene in the last few years has resulted in an untested rental structure and should be an important consideration before investing in this sector. Many of the initial rent-free periods enjoyed by serviced office operators are still running and it is said that one of the largest of these operators has only just begun to pay any rent in London. The covenant of serviced office operators has always been hard to evaluate and although the proposition has changed, it is still not a vanilla offering.
Serviced offices have many benefits and we have learned a lot about the sector whilst working with operators; letting space to them and trading the buildings they occupy. For many, the sector still offers a wealth of opportunity and it is maturing. However, if you want to get beneath the skin of the sector, we have some interesting insights to share.