Lenders need to re-evaluate their valuation approach in order to maximise flexible workplace opportunities.
Flexible workspaces have seen a renaissance over the past ten years. Out have gone the forlorn pot plants and deliberately featureless surroundings, increasingly being supplanted by modern bright co-working facilities targeted at a new generation of entrepreneur. Once a home for anonymous companies to operate in relative privacy, statement-making shared facilities such as yoga classes, networking groups, business mentoring and in-house barista coffee shops are now all part of the attraction.
This reworked concept of a ‘space-as-a-service’ has clearly found a market. The impact has been most pronounced in the capital, where the stock of flexible working space has nearly doubled in five years. As the adoption of the IFRS 16 lease accounting standard takes effect, large corporations are also finding the creative entrepreneurial environment fostered in flexible workspaces better suited to their strategic and operational objectives, as well as reducing on-balance sheet liabilities.
For flexible office operators, the business model is also proving a winner. In our experience, many are operating at near-100 percent occupancy, and the churn at the best sites can be as often as low as 15 percent. Though capital investment may be higher, the most fashionable locations can command a significant premium in the market and value-add services can further underpin the bottom line. Indeed, profit margins in the prime Central London spots can be upwards of 80 percent.
Whilst this seems to be a win-win for all involved, the explosion in flexible workspace supply is testing some lenders’ traditional approaches to valuing developments.
For decades, commercial office valuation methodologies have been based on lessee-occupiers signing up to long leases (typically 10 years or more), usually punctured with an occasional break clause and a periodic (and often upward-only) rent review. With a tenant effectively locked-in, the mechanism to value the development is relatively straightforward.
Flexible workspaces injects a significant degree of uncertainty into the mix. Whilst the operator may sign up to a conventional long-term commercial lease agreement, their own revenue is highly contingent on their ability to sublet that space to others at a significant markup on cost. The operators’ recent track record may indicate strong occupancy, low churn and decent margins, but the longevity of the new-generation flexible workspace is yet to be proven, and short-term contracts can be easily terminated in an economic downturn. Given the strict covenant requirements lenders specify as part of traditional development funding, such an occupier can cause significant valuation hurdles to appear.
The result has been some lenders have refused funding on developments where the proposed occupier includes a flexible workplace provider, despite the clear growth trajectory of the sector and the potentially strong returns that can be generated.
Profitable and sustainable lending opportunities are potentially being squandered due to traditional valuation methodologies that are no longer fit-for-purpose.
Lenders and valuers already have a ready-made alternative approach that could be easily adopted. In many respects, the flexible office business model is not dissimilar to that of a hotel – the end user may or may not stay for very long, but overall the buildings’ occupancy level will ensure sufficient income to cover the rent. Here, valuers use other data sources, such as historic performance, future projections, and a reasonable assumption of profitability to come up with the fair maintainable level of trade (FMT).
There is little reason to think why the approach taken to value hotel developments can’t be adopted for other uses. Income-based valuations of commercial office space may be in their relative infancy, however forward-thinking lenders are already taking this pragmatic approach when making valuation and funding decisions.
At KPMG’s Restructuring practice, we have a dedicated team that can support lenders understand the challenges of flexible workspace and how to overcome issues around. In particular, the assessment and accuracy of the level of fair maintainable trade is critical and we can review historic accounts and the company’s forecast to identify areas of risk.
Our Real estate valuations team also have extensive experience in valuing serviced office properties and operators. With our strong track record undertaking business and hotel valuations, we are comfortable assessing forecast risk and articulating its impact on value. We can also support investors and developers in tackling some of these challenges.
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