March 8, 2019
The U.S. office REIT sector has benefitted from a fundamental and generational shift in office demand trends that’s ushered in an era in which co-working providers have stepped in to fill a void in key global office markets. Fitch Ratings warns the rapid growth of firms such as WeWork could raise tenant credit risk, and artificially boost rents in select office markets.
Though there have been benefits for tenants, especially smaller ones, and landlords, Fitch says, the shared office space business model entails an asset/liability duration mismatch that favors flexible customer commitments over long-term customer contracts that help offset the high capital intensity of office assets.
The growing exposure to speculative-grade co-working space chains, may increase tenant credit risk, points out Fitch. This will inevitably make evaluating REIT tenant concentration and credit and retention risk an even more important factor in credit analysis. That’s because long-term leases are a key positive office sector attribute that helps balance high capex and leasing costs. Fitch says, the co-working model with smaller, less established tech and new media startups, is expect in aggregate to underperform established peers during a downturn.
Fitch believes WeWork would be able to sustain a downturn and remain committed to satisfy its long-term lease obligations. Yet, it says, “We view the traditional landlord/lessee model where a REIT landlord leases space to co-working providers under a long-term agreement, providing lease incentives based on prevailing market conditions and practices, as more credit friendly. A fee-based management model whereby the landlord bears the capital investment and cash flow risk in exchange for greater potential upside are less credit friendly.”
Fitch says it’s CMBS group takes a cautious approach to analyzing properties where WeWork is a key tenant. Analysis by the firm concludes, “This includes ensuring rents are at, or below, market levels, and that the space is fungible to facilitate backfilling the space with new tenants, if necessary. If WeWork is the property’s single tenant, a dark value analysis that assumes an immediate lease default and certain assumptions for downtime between leases, carrying costs, re-tenanting/releasing costs, developer’s profit, etc. is performed, to ensure the dark value covers the high implied investment-grade proceeds for the loan.”
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