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What does the rise of flex space mean for investors?

The following excerpt is from the recently released ‘Disruption or Distraction’ flex space office report. You can download the full report here.  

As flex space gets more mainstream, lenders and investors are becoming more accepting of moderate exposure to the flexible office segment and its diversification benefits, as part of a well-diversified tenant roster. Nevertheless, the growing – and evolving – flex space market will disrupt conventional development and investment models.

It will be harder to underwrite development or investment decisions, based on current and forecast pricing and supply levels.

As flex take-up moves to 30%, and stock competes with ‘conventional’ office space for large requirements, it gets harder to get a clear view on ‘real take-up’. Space listed as let can still, in reality, be on the market. While some larger corporate deals will be well documented, the plethora of smaller, short-term deals are almost impossible to track, meaning that real vacancy rates and supply levels become more opaque. Vacancy rates calculated according to conventional methods could be prone to underestimation. The rents paid by end users, and the incentive packages, are also opaque. Meanwhile, valuations may move towards a cashflow model. However, given that the scale of the sector is unprecedented, values could see different trajectories to the mainstream market at various points in the cycle.

It will be harder to make longer-term market predictions.

Historically the relationship between (net effective) rents and supply has informed views on future market movements. As the flexible segment grows, it will take away some of this transparency. Also, rental levels, supply and vacancy levels in flex space could potentially move very quickly, given the short-term nature of commitments. Even if it were possible to accurately gauge fundamentals, the situation could change rapidly within months. This could be problematic during a sharp boom or a downturn. It will also be more difficult for investors to understand potential competition when deciding whether to move ahead with deals or projects.

Lease lengths are likely to continue to decline.

 The shift will be most evident in traditionally “long-lease” markets such as the UK and in the sub-500 sq m sector. However, this needs to be set against other trends in the office sector, which suggest there will be greater investment in branding, experience and technology in HQ locations, which will require long-term commitments. In reality, the market will provide more choice, from fully flexible to longer term solutions, to suit a broad set of changing wants and needs.

Yields should be largely unaffected.

Limited exposure to flexible space has not had a noticeable impact on yields. Indeed, investors may benefit from diversification and the operator’s ability to energise communal spaces. Lack of tenant track record and

underlying tenancy risk, however, typically increases an asset’s perceived income risk profile. Buildings in which flexible space represents over 50 percent of Rentable Building Area have so far traded at a discount. Recent deals on the continent have shown a decreasing yield differential, although the current cycle and the absence of quality investment product must be taken into account.

There will be more competition and a profusion of new models, with new participants moving into the space.

More investors and developers will consider flex space models, collaborating with existing operators and looking at M&A. At the same time, some of the new wave of operators are already beginning to invest directly in real estate, looking to control assets wholesale or sometimes in joint ventures with funds or other sources of capital.

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