Magical Thinking And Unicorns: The Irrationality Of Thriving In A Recession

Published on September 26, 2019 - By Cecilia Amador de San José

• Following the former WeWork CEO’s decision to step down, it’s clear that Adam Neumann’s mission to raise the world’s consciousness hasn’t yet reached its fairytale ending.
• This comes amid growing evidence that a recession is coming as soon as next year. How will this affect the supply-and-demand dynamics of the flexible office market?
• While some workspace operators will see demand during a downturn, others will experience the opposite, and profit will be harder to sustain in a market with declining rents.

Adam Neumann’s magical thinking to raise the world’s consciousness has amounted to nothing more than the hallucination of a unicorn. The former WeWork CEO ‘stepped down’ this week — that’s according to the official announcement, but most people know the reality is much closer to being pushed out by investors. 

A recent Bloomberg article revealed that Mr. Neumann sent a memo to WeWork staff saying that too much of the focus has been placed on him. He also wrote that:

“The spotlight on us (mostly negative) has never been greater than at this moment, and with this visibility we have an opportunity to expand our global business to more people than ever before.”

Talking about expansion as other company executives and investors consider slowing down expansion and cutting costs is just another clear indicator of Mr. Neumann’s idealistic magical thinking. But he’s not the only one with that type of thinking within the flexible workspace industry. 

The Next Recession

A significant amount of news headlines are telling people to brace for the next recession, which is coming as soon as next year. A Duke University/CFO Global Business Outlook found that 48.1% of chief financial officers in the United States are predicting the American economy will be in recession by the middle of next year. 

Other research points to quite the opposite scenario, arguing that the private sector is doing well, the average American is doing better, average indebtedness is at a historic low, and Americans’ disposable incomes are also growing. 

Regardless of which side you take, the fact remains that economic cycles can’t last forever and a recession is bound to hit — if not next year, a few years later. 

The Flexible Workspace Industry’s Magical Thinking

Talk of a potential economic downturn have permeated every corner of the flexible workspace industry, with experts trying to predict what will happen once the cycle turns. Most reports and expert opinions believe that the flexible workspace industry will survive a recession, arguing that the flexible model in the real estate industry is here to stay. 

In CBRE’s words, “a recession will affect the supply-and-demand dynamics of the flexible office market just as much as it will the traditional office market.” While it will likely dampen demand for flexible space and the number of providers is likely to shrink, the industry as a whole is expected to survive.”

It’s a pretty sound judgement. But there’s more to it than just long-term survival. 

Here’s where the magical thinking kicks in. 

In a recent interview with Fortune, Amol Sarva, CEO of Knotel, stated that: 

“We’re going to see a tidal wave of demand when [economic] trouble comes. There’s a lot of evidence that a flexible platform is going to be a far more efficient way of consuming office space.”

It’s not too far away from what WeWork included in its S-1, that “in a downturn, [WeWork] expect[s] that businesses will search for more flexible and lower cost alternatives.”

Hate to break it to you, but that’s not exactly how things are likely to go down. 

While some flexible workspace operators will see some demand during a downturn, most operators will experience the opposite, and profit will be harder to sustain in a market with declining rents. 

While eventually demand will increase for some operators, this is not something that will happen instantaneously due to long term lease obligations. The exodus, however, will happen almost immediately due to month to month agreements. 

Quick side note here: this is not to say the industry won’t survive. It will, but not everyone will be on the winning side. 

There will be winners and losers in a downturn, and demand for flexible workspace is likely to dampen. Freelancers, startups, and entrepreneurs will need to cut costs, and most of them will go back to working from home or a coffee shop (two coffees a day are much cheaper than a coworking membership, throw in a sandwich and the statement holds true). 

“The fact that the shared office model relies on small-company tenants with short-term leases, combined with the potential lack of recourse for the property owner, is potentially problematic in a recession.”
– Eric Rosengren, Boston Federal Reserve Bank President, speaking to Reuters.

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Corporate members will also need to cut costs; some will close branch offices, reduce their staff, and call people back into their headquarters (no matter how long or painful of a drive it may be for employees) or let them stay at home. It makes no sense for companies to keep paying for flexible space (which comes at a premium), when they have lease obligations of their own and cash is tight. Once these lease obligations are fulfilled, they are likely to lean towards flexible space solutions. 

“Products along these lines (flexible workspace models) are heavily funded by a few larger corporate tenants seeking shorter office leases. If these companies decide to suddenly depart or ask tough budgeting questions during a recession, their evacuations could cause sudden pain for less prepared coworking ventures.”
– Flip Howard, WORKSUITES CEO, speaking to Bisnow

Not everyone will leave their flexible workspace, but not everyone will stay. It’s quite possible that most members will want to renegotiate their membership price, asking operators to bring the price down. So not only will flexible workspace operators have to make up for lost members, but they will also suffer from what they can charge for memberships. 

But the problem is, if a flexible workspace operator signed a lease or purchased inventory during an up cycle at peak price and they have to pay for the space on an escalating basis, then bringing prices down during a recession is simply not an option; they’ll either have to fold or renegotiate their terms.

Winners and Losers: Diversification Is Key

Larger operators will have leverage to renegotiate. Smaller players likely won’t. It’s the latter — and those that took on property in an up cycle — that will likely disappear in a recession as their centers change ownership models or simply close down due to not being able to keep up with rent and payments. 

To be on the winning side, operators need to have a diversified portfolio. Diversified in terms of geographic location and when they took on their property. 

Larger operators, especially those that have been around for a long time, have likely signed leases when  the market was low, mid, and high. This places them in an advantageous position because they can re-price their memberships without risking reaching negative numbers. 

This will place extra pressure on smaller operators as members might simply choose to leave their center for a cheaper one.  People might not leave the industry, but they might change centers. 

If an operator signed a lease in a down cycle when prices were low, then their rent is lower than those who signed a lease in a mid or up cycle. If they have a variety of locations, then even if one location is not making a profit, another one will. Meaning that they are more likely to remain on the positive side of the balance sheet even during an economic downturn. 

Geographic location is also important. Flexible workspace operators with presence in different markets, ideally different countries, are also in an advantageous position — this is especially the case if the recession isn’t totally global. These operators might lose money in some markets, but will continue  to generate a profit in other markets. 

Landlords: the Key to Survival

While a recession will be a challenging time for flexible workspace operators, the good news is that “the real estate industry’s structural shift to delivering more flexibility to tenants is here to stay.”

Small operators that do not have a diversified portfolio in terms of geographic location or when they took on space could benefit greatly from working closely together with landlords to correct the pricing dynamic. 

We’re already seeing a shift in landlord sentiment towards flexible workspace operators; many property owners are entering into shared models with flexible workspace operators where both landlord and operator share the risks and rewards of a coworking space.  

The willingness of landlords to share the risks and rewards will, to a large extent, determine the fate of the majority of flexible workspace operators in a recession. 

Magical and hopeful thinking that demand will increase immediately after the economy turns won’t do the flexible workspace industry any good. Rather, flexible workspace operators need to be aware of the challenges that lie ahead, and start to actively think about how they can possibly overcome them and prevent the exodus of existing members. 

Instead of waiting for the recession to hit, start working with your landlord now. After all, operators won’t be doing any good to their community if they close their doors. Demand will eventually increase, but this will be preceded by a decrease in demand.