WeWork’s Potential Bankruptcy: What Will Be The Effect On Office Vacancy Rates?

• WeWork’s potential demise won’t be much of a problem for its clients, as they will be taken on by the new owners. 
• It is a problem for the company’s landlords, who will be faced with the choice of negotiating to accept a lower rent and write-off of arrears or losing an occupier in a very weak market. 
• This raises questions for U.S. real estate as well as U.S. commercial banks.  

“In the second quarter of the year, average vacancy rates hit 31.6 percent in San Francisco, up from 10 per cent in late 2020, according to data from CBRE.” This quote from the Financial Times on Monday raises a number of interesting questions about San Francisco, U.S. real estate, U.S. commercial banks and the effect of WeWork’s potential bankruptcy (as discussed in my article last week).  

San Francisco’s very high vacancy rate is perhaps an outlier to a certain extent as it has increased almost 20% since before Covid (Q4 2019), compared to between 10% and 14% for other major U.S. markets such as New York. Nevertheless, an overall average office vacancy rate of around 19% for major U.S. markets may presage big problems ahead for landlords and for their lenders. 

It is in this context that WeWork’s demise may prove to be important. Its present difficulties were not caused by a flaw in the business model, as Fortune magazine erroneously suggested a couple of months ago. Nor would its demise be much of a problem for its clients, almost all of whom will be taken on by the new owners (of the company post restructuring), but it is a problem for the company’s landlords who will be faced with the choice of negotiating to accept a lower rent and write-off of arrears or losing an occupier in a very weak market. 

Some locations may be good enough to make the loss of WeWork manageable in the sense that the building can be re-let to another occupier. But, many will not be, and landlords will have to bite the bullet and take the write-offs or face having an empty building.  In a percentage of cases, the losses from these write-offs will cause landlords to default on their bank loans — either because of cash flow issues, having lost that rental income, or because they breach loan covenants such as the interest coverage ratio required in the loan terms. 

What impact might those defaults have on U.S. banks? While the overall level of Non-Performing Loans (NPLs) in the U.S. banking system remains low, the volume of distress is clearly on the rise in commercial real estate lending. In the first half of 2023, the delinquency rate rose from 2.75% to 4%.  MSCI Real Assets reported $64 billion of distressed CRE loans at the end of Q1 2023, with another $155 billion said to be “in the pipeline.” 

Driving both the high vacancy rate and the consequent rise in distressed CRE debt is the reluctance of American workers to return to pre-Covid patterns of working. Organizations just need less space if employees are working remotely some, or all, of the time. Local factors can also play a part, with San Francisco’s homelessness and drug abuse problems contributing to office workers’ reluctance to return to work in some downtown districts. 

The hollowing out of CRE through remote working is not yet a global phenomenon. Office markets in European and Asian cities — excluding China, which has its own issues — are seeing more “normal” vacancy rates of around 9%, and healthier take-up of new or vacant second-hand space. This may be explained by the relative success of employers in persuading their staff to resume normal working and the greater difficulty for occupiers in terminating leases early in Europe compared to the U.S.  

The investment world has little confidence that this relatively favorable position will continue, however, judging by the share prices of London listed REITs, down 30% over the last six months. No doubt WeWork’s travails are one cause for pessimism, given that it was feted by the Financial Times in 2018 as the largest occupier of office space in London with double the footprint of Google, but another is the enduring expectation of a recession later this year or early 2024.  

The level of share prices on the stock market is said to be a leading indicator, so vacancy rates may start to rise if investors are correct. Who knows, perhaps Europeans will discover the joys of working from their relatively cramped homes and copy their U.S. cousins? In anticipation, real estate companies are being more cautious about new projects, and are bringing less space to market in both the U.S. and elsewhere.  

One CRE sector that continues to grow pretty much everywhere is coworking. WeWork’s demise will not have been caused by a lack of demand for its flexible space product — well-run centers around the globe are experiencing occupancy rates in the 90s today, well above break-even levels.  

Smaller operators and larger ones alike are looking to expand their portfolios. The early worries about leasing long and renting short have, pace Fortune, disappeared decades ago, and it seems that, although employees quite like remote working at least some of the time, not everyone likes working from home or is able to do so. A fully equipped and fully serviced office near where they live fits the bill nicely. 

One question remains unanswered, at least for finance and investment professionals like myself, and that is: can larger coworking companies ever realize, in practice, the economies of scale that this business should offer in theory? The track record is not good, with WeWork’s failure today following on from HQ Global Workplaces’ collapse twenty odd years ago. Only IWG has managed to stay the course, and its performance has been no more than lacklustre for its shareholders.