Will the serviced office sector weather the COVID-19 storm?

Flexibility and ease of entry and exit are key attractors for occupiers of serviced office space (alongside the quality of space and services offered), but these very features that appeal to occupiers also make the sector particularly vulnerable during a downturn as businesses can quickly reduce their property footprint.

Serviced office letting agreements will typically be a year or less in duration and can often be terminated with just 2 - 3 months’ notice, depending upon the length of the agreement. In contrast, larger businesses occupying conventional, non-serviced space will usually have signed leases for a period of between 3 and 5 years, often without the ability to terminate the lease beforehand.

The flexibility conferred on occupiers through a serviced office letting agreement will put the occupier in a strong bargaining position to re-negotiate the terms of their occupancy, including seeking a rent reduction in order to stay in business. However, this is not the case across the board, and our experience suggests that the extent to which this happens will vary according to the specific market and nature of occupiers within a building.

The serviced office sector’s bias towards smaller firms also adds to its vulnerability, as this market segment tends to be more vulnerable during a downturn. Typical serviced office agreements will be for fewer than 10 desks, and even in central London typical serviced office lettings tend to be sub-20 desks.

The technology sector has seen particularly strong expansion in the UK in recent years, and smaller technology firms have been a key driver of demand for serviced offices. However, many of these firms have been backed by venture capital funding and have yet to make a profit. In these changed economic times, it remains to be seen whether this source of funding will continue or whether some investors may simply cut their losses and sit on their hands until economic conditions become more benign.

It is therefore possible that a sizable number of unprofitable fledgling technology firms may disappear, while others may simply terminate their serviced office letting agreements to cut costs and work from home until economic conditions improve.
Those serviced office operators with a more diverse portfolio of occupiers, across different size bands and business sectors, are therefore likely to weather the current economic storm more effectively.

The current serviced office business model relies on much higher densities than are the norm in traditional office space, in order to achieve profitability with relatively low margins. This model clearly runs counter to the new environment of social/professional distancing, where employers and employees will be more conscious of seating proximity and will demand lower occupancy densities in the interests of keeping the workforce safe. It is also possible that the Government could introduce guidelines on social distancing in the workplace (advisory or mandatory) for the duration of the epidemic.

Many occupiers of conventional office space were placing an increasing emphasis on employee wellness before the COVID-19 crisis, for example by providing more circulation space with the right environment for creativity, collaboration and staff wellness. This is increasingly being seen as a positive for staff recruitment, productivity and retention, as well as meeting a range of ESG and efficiency criteria. Even without the Covid-19 crisis, the serviced office sector would probably have had to adapt its offer, based on a reduced occupancy density to meet the emerging operational demands of occupiers.

We think that these issues will become even more important post-crisis, resulting in a much longer-term shift in occupational standards. Whilst this will impact occupational density standards across all office space, it will be a particular concern for the serviced office sector.

Occupiers of serviced office space have committed themselves to high rents, which reflect the all-inclusive nature of the letting package (and which will account for the capital expenditure incurred by the serviced office provider associated with fitting the space out and providing furniture etc). If, as seems very likely given the ensuing economy downturn, service office occupiers use the option of relocating as a way of negotiating a rent reduction, the providers of serviced office space will have no option but to reduce their operating costs to maintain an acceptable return – and that means, in turn, re-negotiating their rent with their landlord.

The move to lower occupancy densities, and the downward pressure on rents exerted by occupiers, means that many landlords will probably have to restructure the tenancies that they have granted to serviced office operators. The alternative is to take the risk that the operator could cease trading or, in the case of the larger national and international players, close down the single purpose companies that many have used to take the leases.

A landlord faced with a serviced office tenant who has ceasing trading has two main options. Firstly, damage limitation, to retain as many of the existing end users as possible and continue running the serviced office directly. Secondly, if this is not a viable proposition, the landlord will have to invest a not inconsiderable sum in stripping out the serviced office provider’s fitting out works – the configuration of which is unlikely to suit most occupiers of conventional office space – and re-offer the space on a conventional, non-serviced, basis.

Whilst the crisis will undoubtedly have an adverse impact on some landlords, it also presents them with a potential opportunity to enter the serviced office sector (as indeed some were already doing prior to the crisis). This is not necessarily an easy transition for all landlords to achieve and would require the right skills and a clear strategy. However, there could be plenty of business platforms available for landlords to purchase, plus people with the necessary expertise who may now be looking for employment.

We will not know the full economic impact of COVID-19 for some time. In the light of the significantly downgraded and uncertain economic outlook, businesses may increasingly seek short-term space solutions as lease breaks or expiries approach, rather than committing to longer leases.

Some larger corporate occupiers will doubtless be looking to restructure their businesses. Some may decide to use serviced office space as part of a “wait and see” / consolidation strategy, before committing to signing up to longer-term, conventional office space on a 5-10 year lease.

The COVID-19 crisis is creating some delays in the completion of new office developments, precipitated by the restrictions in the movement of people and disruption in the building materials supply chain. Although these delays may only be for a few months, this is likely to be sufficient to affect some occupiers who have already entered into pre-completion letting agreements. Whilst some may be able to rely on working from home during this period, and some may wish to extend the leases on their existing premises to tide them over, others may need to consider alternative temporary accommodation if the option of extending their existing tenancy is not possible. In this situation, serviced offices would be the obvious solution.

The serviced office sector may therefore see a short-term boost to demand over the next three to six months from those occupiers who are unable to extend their leases and who simply need short-term “breathing space”.

It is important to differentiate between the short-term effects of the current crisis and the longer-term direction of the office market.

The COVID-19 crisis is likely to drive a more rapid and permanent shift towards working at home, accelerating a trend that was already emerging, as a greater number of employees become more accustomed, and embrace the “WFH” concept, and as more employers see that productivity and staff wellbeing can often be enhanced.

The counterpoint is, of course, that working from home is not conducive to activities such as team working, sharing ideas and meeting face-to-face, as well as for forging a corporate identity and creating a sense of belonging and unified purpose to an organisation. These important aspects of working in an office will have been lost during the crisis. Some business functions will still need to be carried out in an office environment including, for example, the trading of commodities and financial instruments.

Occupiers will increasingly challenge the assumptions that they have made about what they wish to use their office space for.

Although the short-term outlook for the serviced office sector is likely to be very challenging, we think the longer-term prospects look brighter. Many small businesses like the hassle-free, plug in and go, ready fitted out accommodation model, which negates the need to tie up working capital in an expensive office fit out, added to which serviced office agreements do not attract stamp duty.

Further, the recent introduction of new accounting standard IFRS16 means that real estate liabilities have to be capitalised and declared on company balance sheets. Serviced offices, with their shorter lease structure, are therefore a very effective way of circumventing this issue.

The serviced office sector has grown with immense speed over the last three to four years in particular. WeWork is the highest profile operator and has expanded aggressively. However, a range of operators of all sizes and with different offerings have also entered the market. In addition, some traditional landlords have developed their own serviced office offerings to compete.

Given the rate of expansion and the range of operating models, a degree of consolidation was always likely at some point. The COVID-19 crisis looks set to be the trigger for this, and will likely make the correction quicker and steeper than it might otherwise have been.

WeWork is of course very much the focus of attention and was already experiencing high-profile funding and revenue issues prior to the COVID-19 pandemic. The firm leases or owns in excess of 3.5 million sq ft across central London alone, and is the largest single occupier of office space in the capital after the UK government. It now seems almost inevitable that the business will need to be restructured and rationalised, although the brand name remains very popular and is likely to continue but, most probably, under different management.

WeWork is not the only potential casualty of this crisis, and many of its competitors will almost certainly be attempting to obtain rent reductions, rent holidays and rent-free periods from their landlords. Where this is not possible it is very likely that individual business centres will go into administration where they are not viable. Many of the less well funded small-medium sized providers are particularly vulnerable.

The serviced office sector clearly faces significant structural issues, which are likely to take a year or two to work themselves through before the sector gets back on its feet.

Most of the UK’s key city centre office markets have been suffering from a shortage of grade A supply over a number of years. Added to this, the rapid growth of the serviced office sector has crowded out corporate occupiers from the grade A space that has come forward, further reducing choice.

London has been the epicentre of the serviced office revolution, and the sector now accounts for around 5-7% of the overall Greater London market. Central London has seen the biggest “crowding out” effect. An extreme example is 2 South Bank Place, which has been the only new space to come on stream in the Waterloo area for almost a decade - a submarket starved of grade A stock. WeWork took the building in its entirety on a pre-letting agreement, denying a range of other occupiers the opportunity to locate to high quality, non-serviced office space in the area.

With the restructuring of the serviced office sector, some space will inevitably come back onto the market, predominantly in relatively new or recently refitted buildings. This increase in quality availability should benefit occupiers looking for space on conventional leases – providing them with greater choice and, therefore, a better bargaining position.

With the likely retrenchment of the serviced office sector, grade A vacancy will increase. Despite this, the wider lack of quality supply should give landlords a degree of comfort that there are opportunities to find new tenants (albeit not from the serviced sector), should a serviced office operator vacate.

* IPF (February 2020), Property Ownership in a Flexible World

In the short term, COVID-19 means that demand for serviced offices will inevitably fall and vacancy levels will rise as occupiers exercise break options and move to cheaper space or adopt a working from home policy to reduce operating costs. Some occupiers will cease trading altogether, and the technology sector, with its reliance on venture capital funding, could potentially be particularly vulnerable. There is a partial offset to this, as some businesses seek serviced office space as a stop-gap accommodation solution given the current uncertainty.

Ironically, one of the key drivers of demand for serviced office space – short term lease flexibility – could be the undoing of some serviced office operators, as those smaller occupiers, so key for demand, leave them the most exposed to potential loss of rental income. Those operators with a diverse portfolio of occupiers are most likely to weather the storm.

In the short term there will almost certainly be a restructuring of the sector, reflecting previous over-expansion. Many serviced office providers will wish to renegotiate leases with their landlords to maintain margins and to compensate for loss of revenue in the face of lower densities and fewer customers.

However, in the longer term, office occupiers will continue to demand lease flexibility in an increasingly uncertain world. The rapid expansion of the serviced office sector has given occupiers an increased choice of flexible space models and high-quality services. This is a permanent change and corporates will continue to demand this, and indeed increase their demand for it.

However, the serviced office sector will need to adapt and embrace the changing needs of corporate occupiers. We are likely to witness the rise of a new generation of serviced offices, based on a lower occupational density.

The serviced office concept will undoubtedly remain a key feature of the market, although the rate of growth and model of delivery may well be very different going forward.