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Factors to Consider in Commercial Shared Economy Leasing

By Imran Naeemullah

The underlying theory behind the shared economy is not an original concept. Even in biblical times, proprietors opened their homes to travelers for food and lodging in exchange for payment or barter.

The diversity of co-working providers points to one likely trend in co-working: consolidation.

The diversity of co-working providers points to one likely trend in co-working: consolidation.

(credit: iStockphoto.com)

The shared economy of today, however, expands beyond the traditional notion of sharing products and services. In modern terms, the “shared economy” refers to “an economy system in which assets or services are shared between private individuals, either for free or for a fee, typically by means of the internet.” Alessio Di Amato, Uber and the Sharing Economy, 2 Italian L.J. 177, 184 (2016). The premise of the shared economy is that parties, through an online shared marketplace, collaborative platform, or peer-to-peer application, share value from an underutilized skill or asset.

The shared economy encompasses a variety of economic models: (i) the collaborative economy/collaborative consumption model (CCMs), (ii) the peer-to-peer economy (P2P), (iii) freelancing/gig economy, (iv) crowdfunding/crowdsourcing, and (v) co-working/co-branding. Derek Miller, The Balance Small Business, The Sharing Economy and How It Is Changing Industries (June 25, 2019), https://bit.ly/2O8GzFx. The shared economy has affected various industries and sectors, such as transportation, consumer goods, real estate, and professional and personal services, forcing industry leaders to take notice.

According to a survey conducted by the Pew Research Center, 72 percent of American adults have used at least one of 11 different shared and on-demand services, around one-in-five Americans have used four or more of these services, and seven percent have used six or more. Aaron Smith, Pew Research Center, Shared, Collaborative and On Demand: The New Digital Economy (May 19, 2016), https://pewrsr.ch/2O85aKv. Although nearly everyone with an internet connection can participate in the shared economy, one segment of the population dominates usage: millennials, who are reported to drive most of the growth in the shared economy. Robert Williams, Mobile Marketer, Forrester: Millennials Boost Growth of Sharing Economy (Jan. 30, 2018), https://bit.ly/37rwzif. In addition to this age cohort, college graduates with relatively high household incomes living in urban or suburban centers are much more likely to participate in the shared economy, compared to those with a high school degree and earnings of less than six figures annually. Shared, Collaborative and On Demand: The New Digital Economy, supra. According to a report published by AIG and Marsh, the typical worker in the shared economy is “30-49 years old, holds a four-year college degree, and has a full-time W-2 job” and will out-earn the median US wage worker by nearly $15,000 per year. AIG, Insuring the Sharing Economy 4, 7, (2017) https://bit.ly/37q30O7.

The shared economy is estimated to grow from $14 billion in 2014 to $335 billion by 2025. Niam Yaraghi and Shamika Ravi, Brookings, The Current and Future State of the Sharing Economy (Dec. 29, 2016), https://brook.gs/2OuyZEa. A portion of that growth estimate is based upon projections for growth by two household names, Uber and Airbnb. Id. Positive growth projections are also attributable to the growth of co-working in the commercial real estate sector. Accordingly, the shared economy has had a significant impact on the real estate industry and will likely continue to grow.

This article highlights the shifts being made toward the shared economy in commercial real estate, discusses the concept of co-working, examines characteristics of co-working, reviews some of the advantages and disadvantages of co-working, and evaluates the legal issues underpinning co-working arrangements.

The Commercial Shared Economy Landscape

At its core, co-working is the subletting of office space. In this respect, co-working arrangements have existed for many years, namely in the form of executive office suites offered by brands such as Regus. These spaces are essentially office “shells” in which basic business services, such as printers and copiers, are available for use by the members occupying the space. The members’ use of the space, however, is as an essentially anonymous (and perhaps temporary) office setup, a waystation between the home office and a traditional office.

Two other arrangements constitute co-working. The first is the “pure co-working” model, perhaps most closely identified with co-working giant WeWork. The growth of co-working in recent years is attributable largely to the pure co-working model. Pure co-working builds on the executive office suites model by layering in additional services and amenities and, crucially, collaboration and socialization between the various occupants of the space. WeWork, for instance, offers amenities such as high-end coffee, draft kombucha, fruit-water dispensers, and spaces for events such as yoga classes and wine tastings. Gideon Lewis-Kraus, The Rise of the WeWorking Class, N.Y. Times Magazine, Feb. 21, 2019, https://nyti.ms/2KEslKo. These amenities serve to provide the foundation of what resembles a traditional office, one in which the “real product [is] ‘office culture’ as a service.” Id. In other words, firms such as WeWork not only offer a space in which the worker has the flexibility of not being tied to a long-term lease, but also balance what might otherwise be a sense of rootlessness with a robust offering of corporate-type events that provide a feeling of belonging.

The second emerging model of co-working is referred to as “flexible office space,” in which “a single tenant hires a company to house and manage its office needs, including finding and customizing space, and then operating and managing that space.” Newmark Knight Frank, The Future of Coworking and Flexible Office Space: Five Potential Paths 5 (Dec. 2018), https://bit.ly/35xXHKX. Firms such as Convene and Knotel are the dominant players in this type of co-working arrangement. Id. WeWork also appears to be making inroads in this arena, with blue chip companies such as IBM housing employees in an entire building operated by WeWork. The Rise of the WeWorking Class, supra.

Perhaps unsurprisingly, given the rapid growth of the co-working industry, there are numerous other companies entering the market. They vary in size and some focus on particular niches or cities. Examples include firms such as Alley, District Cowork, MakeOffices, Industrious Office, Techspace, Serendipity Labs, Greendesk, SoMeCentral, Spaces, and Impact Hub. New York City is home to the largest co-working industry, though co-working is rapidly emerging in cities of all sizes across the country. As of 2018, one study indicates that co-working arrangements occupy 1.4 percent of office inventory in 24 large metropolitan areas. The Future of Coworking and Flexible Office Space: Five Potential Paths, supra.

Co-Working Characteristics

The diversity of co-working providers points to one likely trend in co-working: consolidation. With WeWork having established itself as the 800-pound gorilla of the field, and other established players such as Regus expanding into pure co-working arrangements, it seems almost inevitable that at least some industry consolidation will occur.

As of November 2019, WeWork (more specifically, its parent company, We Co.) had recently suffered a failed initial public offering. Further, WeWork was the subject of ongoing negative media coverage regarding its finances and business model. As one newspaper reported, the company’s “frenetic growth” has the potential to “weigh it down for years and hamper the attempts to remake WeWork.” Peter Eavis, ‘It’s Definitely Pretty Empty’: Why Saving WeWork Will Be Hard, N.Y. Times, Oct. 24, 2019, https://nyti.ms/37q3OT9.

It is difficult to predict what trajectory WeWork will take over the next several months. However, at least one encouraging sign is the willingness of a major WeWork backer, Japan’s SoftBank, to help facilitate WeWork’s turnaround. SoftBank’s CEO described his firm’s most recent investment in WeWork as an opportunity to allow WeWork’s capital investments to pay off, predicting that WeWork will earn $1 billion in annual profits within a few years by focusing on its core office product. Shelly Banjo and Gearoid Reidy, How SoftBank Says It’ll Fix WeWork and Turn It Profitable, L.A. Times, Nov. 6, 2019, https://lat.ms/2KHzauB). This much is likely: absent a major shift in the marketplace, it seems probable that WeWork—and the co-working model in general—will continue to grow in popularity even if the pace of that growth is slower than it has been in the last few years.

There are also various other trends taking shape in co-working. One is the emergence of the use of a management agreement in place of a lease. Under a management agreement, “operators get a percentage of revenues and profits, the landlord pockets the rest, and no rent is paid.” Konrad Putzier, The Long View: How Mortgage Banks Created the Co-Working Lease, The Real Deal (Jan. 4,2019), https://bit.ly/2XzSuzj. This “allows the office owners to retain control of the space and capture a share of the profits, while allowing the co-working operator to market and manage the space without the risk of committing to a long-term lease.” The Future of Coworking and Flexible Office Space: Five Potential Paths, supra, at 3.

The popularity of management agreements varies by operator. For example, the CEO of Industrious stated that 75 percent of his company’s new projects in 2018 used management agreements but only 25 percent used leases. Herbert Lash, U.S. Landlords Copy Hotel Model to Cut Risk as Coworking Surges, Reuters, Oct. 19, 2018, https://reut.rs/2qqqBxE. Knotel, which reportedly favors using management contracts, only had management agreements in place at 13 percent of its properties as of late 2018. The Long View: How Mortgage Banks Created the Co-Working Lease, supra. For its part, WeWork is apparently increasing its own use of management contracts instead of its focus to date on leases. Natalie Wong, Ellen Huet, and Jack Sidders, WeWork Keeps Pushing. Now Landlords and Rivals Are Pushing Back, Wash. Post, Dec. 19, 2018, https://wapo.st/333x6na.

Although there are various ways to structure management agreements, a common feature is substantial upfront capital improvement incentives offered by the landlord to the tenant. The landlord benefits from catalyzing future revenues and profits under the management agreement if the co-working operation is successful. The main benefit to co-working operators, besides decreasing the risks posed by long-term lease commitments, is receiving greater financial incentives from the landlord than would typically be offered in a tenant improvement allowance.

From a practical perspective, with the economic give-and-take involved in such arrangements, as well as the general risks associated with joint venture relationships, some of the most heavily-negotiated provisions in a management agreement will concern financial matters. For instance, the landlord may seek more detailed reporting from the tenant than would otherwise be expected in a commercial lease. Such reports could include items such as membership statistics (analogous to occupancy levels), the percentage of revenues derived from month-to-month membership agreements versus longer-term arrangements (such as with corporate users who take much larger spaces), and major expense drivers (such as amenities). For its part, the tenant will likely want to negotiate the flexibility to operate its business without excessive landlord interference and to implement changes in its business model as market conditions dictate.

Another trend in co-working is to lease out underutilized property, such as vacant retail, as co-working space. The Future of Coworking and Flexible Office Space: Five Potential Paths, supra, at 3, 12. Another trend is for existing landowners, including large companies such as Tishman Speyer, to operate their own co-working spaces within their current properties. Id. at 5. Among other things, this offers the benefit of being able to obtain rent for spaces that are not currently rented out under long-term leases.

The typical “co-worker” is likely seen as a young entrepreneur operating in the technology industry. Although this stereotype undoubtedly holds true in many cases, the growth of co-working demonstrates that a much broader spectrum of co-workers exists. For instance, where companies such as IBM have elected to house teams of workers in co-working spaces, those companies are simply substituting the co-working space for a traditional office space. Other co-working arrangements are targeting specific types of workers, such as, in the case of WashREIT, offering co-working space that is “a combination of coworking space and speculative office suites aimed at federal contractors who need shorter-term office space that is available immediately.” Id. Another audience for co-working arrangements is remote workers who, despite not being housed in their company’s offices, prefer some degree of office interaction.

The typical co-working space also varies widely. Although the stereotypical “seat on a couch” is certainly available, more formal arrangements such as dedicated offices also exist. In this respect, co-working operators seek to appeal to a wide customer base. As in the case of federal contractors noted above, co-working space affords the flexibility of finding office space immediately without having to commit to that particular space for the long-term.

Pros and Cons of Co-Working

The advantages of co-working are fairly obvious from the above discussion. In addition to offering a sense of social cohesion and flexible office arrangements, co-working spaces provide efficiencies such as sharing in the cost of the myriad office amenities that are otherwise impractical or unattainable for a single worker renting his or her own space. Co-working also allows for part-time workers to secure space without having to commit to a lease. The same is true for remote workers. For instance, someone who works remotely may want to work from home two or three days a week but enjoy the benefits of an office the rest of the week.

There are, of course, drawbacks to the co-working model. One is the lack of privacy. That is true of any virtually any office, but the lack of privacy is arguably exaggerated in a co-working space because that prying “co-worker” is not, in fact, an actual co-worker. Those who choose to work in a co-working setting may need to take additional measures to ensure confidentiality of their work, particularly those working with sensitive data, such as certified public accountants and attorneys.

Another drawback is the relative inability to control the duration of one’s working arrangements. For instance, in a typical long-term office lease, the tenant may not have an option to extend the lease, but it likely has at least a reasonable expectation that the landlord will (absent changed circumstances) be willing to negotiate a new lease at the end of the then-current term. The same may not be true of co-working, because the co-worker is effectively a licensee dependent on the willingness of the property owner to continue to offer office space.

Other drawbacks include unsettled law and potentially increased liability. For instance, in a traditional lease, if one party breaches its obligations, the other party has ample precedent in leasing law to draw upon in evaluating its options for recourse. The same is not necessarily true when an individual “co-worker” has a dispute over the services provided by the co-working operator. Other concerns include issues such as premises liability: who is responsible if, for instance, someone slips and falls in a co-working office? Other issues include the aforementioned privacy risk. The flexibility of a co-working space could lead to an increased risk of breaching client data—the measures one must take, such as securing computer workstations, are arguably even more important in a co-working space than a traditional office.

Leasing and Legal Issues

Because co-working itself is not a new legal concept, and generally involves sophisticated parties engaged in a commercial transaction, the legal issues related to co-working are more closely related to contract negotiations than challenges or changes in law. Of the different types of arrangements that fall within the co-working genre, “pure co-working” is the arrangement most commonly associated with challenging traditional leasing arrangements.

Though there are a variety of matters subject to negotiations under a lease, the most contested items related to co-working involve access and security, assignment and subletting, amenities, and compliance with laws.

A key benefit offered by most co-working spaces is 24/7 member access. Most commercial office buildings are commonly outfitted with security systems such that access is permitted by key cards instead of physical keys. However, depending on the location and layout of the building and the location of the co-working space, providing on-site security personnel may be required. The charges and duties related to such security personnel is a hotly negotiated item under a lease. One aspect of that negotiation deals with whether the landlord will pass on additional charges for overtime for providing security to the space after normal business hours for the building. Of course, in buildings where all tenants are permitted 24/7 access, this matter is of less concern.

Most commercial leases have provisions that limit or prohibit an assignment or transfer of the lease, or sublease or occupancy of space by any party other tenant, without the landlord’s express consent. Because co-working operators provide their members with flexible options to access the space, it would be nearly impossible to obtain landlord consent for each member. Accordingly, tenants that operate co-working spaces will negotiate a carve-out so that members accessing their space do not require landlord consent.

A distinct characteristic of co-working space (aside from its open layout) is its amenity-rich environment. Upscale design, modern finishes, snack bars, standing desks, game rooms, yoga, dog parks, childcare, and wellness rooms are just a few examples of offerings found in many urban spaces. All of these upgrades from the traditional office environment are expensive but are an important part of differentiating the space from that of competitors. Accordingly, tenants are pushing more for a significant allowance for tenant improvements from landlords. Landlords looking to repurpose or update their space or simply interested in exploring the trend of co-working are willing to meet the tenant’s needs for more of an upfront allowance (although much of the money will be recaptured through rent). Even with a landlord’s contribution, tenants take care to negotiate their surrender obligations under the lease so that many items remain the personal property of tenant and can be removed from the space after expiration of the lease.

Before a tenant’s occupancy of its leased space, a certificate of occupancy or “CO” must be issued by a local government agency. A certificate of occupancy generally indicates the subject property has passed inspections and is cleared for occupancy, but some COs also contain restrictions on the use of space and number of persons who may inhabit the space during any one period of time. Although co-working generally falls under the category of “general office use,” there is a concern that using the space for “co-working” itself does not meet the traditional general office use requirements. Also, because the occupancy of the space can fluctuate on a daily basis, landlords do not want to be responsible for potential violations to the CO that co-working could bring. Accordingly, under a lease that allows for co-working, landlords push for the tenants to be responsible for the CO. In addition, landlords will also shift the burden of complying with all applicable laws onto the tenant. If a local ordinance passes that would prohibit or significantly limit co-working within a building, a landlord will still want to hold the tenant liable for all amounts due under the lease.

Conclusion

As the co-working industry evolves, it is conceivable that other issues may arise and that the most hotly contested provisions in agreements between property owners and co-working operators will change. Local market conditions and practices may also influence the negotiations between a property owner and a co-working operator. Nonetheless, the issues discussed in this article are those that are likely to arise during negotiations and, if not, they should be considered.

By Imran Naeemullah

Imran Naeemullah is a commercial real estate and finance lawyer in Honolulu, Hawaii, and is vice-chair of the Section’s ground leasing committee.

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