Thursday, May 3, 2018

Will WeWork Work?

WeWork, the darling startup that has helped landlords fill empty and spec office spaces across the U.S., is getting dinged this week.

On Monday, WeWork closed on a bond issuance that raised $702 million and increased the company's cash-on-hand to $3 billion. But the high price of the debt, which carries a 7.875 percent interest rate, and facts surrounding the capital raised are causing some in the financial market to question WeWork's business model.

Office owners are closely monitoring WeWork's financial health as co-working grows in importance to the commercial real estate industry. More than 28 million square feet of office space will be occupied by co-working companies by year-end 2018, up from 24.9 million square feet as of Dec. 31, 2017, according to CoStar Portfolio Strategy. The co-working industry has quintupled in size over the past 10 years.

Analysts are quick to point out that WeWork's lease obligations total $18 billion, including $3.8 billion over the next four years and confirmed by a copy of the prospectus obtained by CoStar News. That means its lease payments due through 2022 are higher than the $3 billion WeWork has in cash right now.

Several analysts questioned WeWork’s use in the prospectus of “community-adjusted EBITDA (earnings before interest, taxes, depreciation and amortization).” In WeWork’s case, community-adjusted EBITDA removes growth costs including those for office space, sales and marketing from a property’s earnings.

WeWork's bond offering is concerning on several levels, says Conor Sen, a portfolio manager at New River Investments, a Los Angeles-based registered investment advisor (RIA). "First, the financials they released showed a tremendous amount of cash-burn, and inventing metrics like 'community-based EBITDA' is usually a bad sign," said Sen, who also is a columnist for Bloomberg View. "Second, the pricing of the bond, close to 8 percent, implies an indicative credit rating deep into junk territory, far lower than what the rating agencies gave it.

"And third, from a broader-market standpoint, when cash-burning companies like Netflix and WeWork are issuing debt, it can be a sign of froth more generally."

Sen said the fact WeWork bonds issued at $100 and closed for $97 is "very weak for such a recent offering."

For its part, WeWork said Monday that its bond offering is a success and points out that it had to increase the initial planned offering of $500 million by more than 40 percent, due to demand. With the capital raise, WeWork is in its strongest-ever financial position and now has $3 billion cash-on-hand, the company tells CoStar News. WeWork said it plans to use the net proceeds for general purposes as it pursues "disciplined and focused global expansion." Currently, international markets account for two-thirds of WeWork's growth.

In a note to clients, Eastdil Secured says concerns about the bond offering are being blown out of proportion by the press. "What we have here is a failure to communicate," Eastdil Secured writes in a nod to the prison warden in the 1967 movie Cool Hand Luke. "[The media] focused on the $18 billion of future rent commitments. While that number is correct, as we all know WeWork's guarantee structure is capped and burns down. Their actual guaranteed rent liability is a tiny fraction of what the headlines showed."

And while co-working has grabbed national and local headlines for the past couple of years, it's a small player in the U.S. office market - for now.

Of the 24.9 million square feet currently occupied by co-working operators, WeWork accounts for 10.1 million square feet. Regus' International Workplace Group (IWG) is the largest with 14 million square feet. Combined, IWG and WeWork account for 71 percent of all co-working space, according to CoStar.

WeWork's model centers on the company committing to long-term leases on large chunks of office space at market rents. While WeWork's landlords throw in tenant improvement allowances, they do not cover the overall build-out costs. WeWork then subleases spaces for a healthy premium while also charging for some conference room use, copies and other expenses.

The model is profitable when the economy is growing and corporations expand and entrepreneurs start new companies that want flexibility and lack the "credit-worthiness" needed to commit to long-term leases. WeWork has been focusing more on attracting larger corporate clients, such as French auto and motorcycle maker Groupe PSA. The company chose Atlanta for its North American headquarters and is setting up shop at WeWork’s location at 1372 Peachtree St. in Midtown, developed by Lincoln Property Co. Southeast.

While any financial distress at WeWork will worry individual landlords, real estate watchers say co-working would not single-handedly imperil the current strong national office market. In fact, co-working remains only a small segment of office occupiers. Even in its largest market - New York City - WeWork, IWG and other co-working operators represent less than 1 percent of the market with more than 7 million square feet, according to CoStar Portfolio Research.

In no other market does WeWork and its competitors occupy more than 0.4 percent of the market's office inventory, according to CoStar.

In Atlanta, where WeWork has committed to two sites in Buckhead and two in Midtown, typically of about 50,000 square feet, at least one owner is not worried about the viability of WeWork's model. When asked whether North American Properties has any concerns about reports of WeWork's debt offering and financial obligations might have in its lease at Colony Square in Midtown, NAP Managing Partner Mark Toro said, "We do not."

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