Exploring the Property Value Implications of Flexible Space
Innovative business models, changing technologies, and shifting consumer needs in recent years have contributed to the growing phenomenon of flexible office space. Recent research from CBRE shows that this niche market is spreading across larger enterprises, and attracting bigger investment interest.
In its report, “The Property Value Implications of Flexible Space,” CBRE compiled extensive data on flex space leases in both Class A and B buildings across several American cities, and the results are clear — investors are looking for opportunities to explore this market, and the data supports investment.
In the study, CBRE identified 31 sales over the past five years where third-party flexible space operators made up at least 10% of the total tenant mix at the time of sale. Using these case studies, they examined how factors like building class and capitalization rates, diversity and investment of tenants, and market fluctuations might affect a flex space lease for investors, landlords, and users. Data rich and extensive, the study is worth a read, but you’ll find our main takeaways below.
Historically, flexible operators have leased space in both large, amenity-rich office buildings and in smaller buildings in need of upgrades. Among the flex transactions, 52% of properties were classified as Class A and 48% as Class B. The study notes that variations in building class means broader appeal to a variety of users, and enables rapid growth. CBRE also points out that the flex transactions in this analysis performed favorably compared to national averages for high quality central business district (CBD) offices.
The study also notes that when flex space tenancy is present, cap rates decrease, then plateau, and eventually increase. For example, over the past five years, 81% of flex transactions had lower cap rates than the national average for a Class A CBD building. Of course, this result is largely because flex space tenants are concentrated in high growth markets with strong investment activity, where cap rates are lower. However, the study shows evidence that the inclusion of flex transactions is a potential boon to the value of the building, particularly Class B buildings, based on the tenants themselves, and the improvements/build out they make upon move-in. The increase in overall value rises, particularly in lower classified flex buildings, causing them to perform as Class A assets.
Using the Capital Hill property in Denver as an example, the study demonstrates how a Class B building with a coworking tenant was a positive strategic move. The tenant’s business originated in Denver, and provided a niche offering for the tech companies in that city. Investors were satisfied by the strong interest in creative office space. The company now operates out of several U.S. cities, and the property itself has a 6.6% cap rate, the highest of any flex transaction.
Higher cap rates seem to correlate directly with a higher threshold of flexible space transactions, but overall, the class of building, location, and improvements made on move-in all play a large role in property value increase, and demonstrate confidence in flex space transactions as a positive force in property value.
Know your market, know your tenant
Real estate fundamentals won’t change — good location, access, and strong businesses will always be crucial to the success of an investment. However, tenant investment in the space means a potentially higher price per square footage, and overall increased value. Flex space operators typically invest heavily in build-out, according to CBRE, and the study shows the price per square foot performance of each flex transaction compared to its peer transactions: 43% had a higher price PSF, 33% were on par with their peer set, and a mere 23% had a lower price PSF.
These numbers reflect the quality of tenants, and engaging with flex space operators who have a diverse population, a quality product, and strong investment in the space lessens the risk. Understanding tenants’ need for flexibility will enhance future opportunity as more and more companies look to flex space strategies for office space solutions. Inclusion of flex space in a portfolio also has the potential to diversify a building’s income stream.
Of course there are doubters, and the risk of exposure to flex tenants not prepared to satisfy long term lease agreements is still there. But CBRE confidently confirms the trends driving these new office requirements are unquestionable, and unlikely to change. Growth in this segment won’t be deterred even if there are small dips in demand, and the study goes on to remark that a downturn could even benefit this niche.
Clarity, change and confidence
With the market changing, and demands veering more and more toward flexible options, landlords and investors should look toward flex space opportunities. Although this sector is new, and not without risk, the results are promising — businesses are becoming increasingly innovative, and so are their needs. Read the full study for all the data, but the conclusion is clear: Flexible space is an opportunity to expand and diversify.