Hey there, 👋!

In today’s email, we’re switching it up! We’re going to talk about office buildings as an asset class.

• WeWork’s bankruptcies

• Office to residential conversion

• Any opportunities in office buildings?

WeWork Bankruptcy

Office buildings have gotten a lot of attention since the rise of COVID. Many people have been predicting “the death of office”.

Hell, even WeWork (Coworking company) might be going bankrupt. Once worth $47b, it went public with a share price of $13 in 2019. Now, as of August 12, 2023, the share price is $0.13 (13 cents!) – according to Reuters.

That would be alarming, but WeWork was once valued with the multiple of a tech startup, not the multiple of a more traditional coworking space.

Coworking as a business is not a new concept. There are several players in the space, namely Regus and Industrious being them.

The issue is with the landlords that WeWork inked sublease deals with. They started out in the great recession leasing buildings from C class building owners.

This turned out to be a great deal for both parties – landlords got a paying tenant without doing much tenant improvements (TI) and WeWork got to be able to make money by arbitraging individuals paying for desk space and the lease rate with the landlord.

However, the economy picked up and WeWork picked up as well. WeWork became “the pretty girl at the school dance” and a lot of corporate landlords wanted a piece of the action.

Corporate landlords were infatuated with Adam Neumann’s charisma and were often bending over backwards to get them in their space.

Some of the most prominent landlords (Tishman Speyer, RXR, Boston Properties, and Rudin Management) in NYC have deals inked with WeWork. WeWork also started to buy some buildings themselves, as well as Adam Neumann and leasing it back to WeWork.

What does the possible bankruptcy of WeWork mean for landlords?

It could be catastrophic. But first, there are 2 different types of bankruptcy: Chapter 7 and Chapter 11.

Chapter 11

WeWork might declare chapter 11 bankruptcy. This is the type of bankruptcy which allows restructuring of entities. This means they might be able to renegotiate debt, back rent, and tenant improvements they were on the hook for.

This could mean that the landlords could get pennies on the dollar of backrent, which could affect valuations of the buildings that hosted WeWork. This goes back to the valuation of NOI.

NOI will drop, assuming WeWork is able to negotiate 50-70% on the dollar to pay back in rent. Divide that over a 5-6.5% cap rate (assuming for Tier 1 city CBD office building) and the value demise could be catestrophic and force LL’s into significant trouble.

Chapter 7

What about Chapter 7? Chapter 7 bankruptcy is also known as forced liquidation. The enterprise value of WeWork wouldn’t be too great.

WeWork predominantly doesn’t have any physical assets, unless it owns the buildings in the same entity. More commonly, if WeWork owns the building, it is held into a “prop co” and leases the building to the operating company “op co”.

Most of WeWork’s buildings are leased, not owned by the company. This means that most of the enterprise value is held by the credit WeWork has as a business.

Remember, their model is they lease space from businesses, add fancy amenities, and sublease that space in smaller quantities. There is no “alpha” in their model, aside from the WeWork name.

If WeWork files for Chapter 7, landlords would force the company into liquidation. Leases aren’t worth that much so the actual dollar amount creditors would fetch is pennies on the dollar.

What does this mean?

This isn’t a good look for WeWork. A lot of office landlords fell in love with Adam Neumann’s charm and are going to get screwed for it. Shareholder value for corporate landlords might fall (public REITs are huge corporate landlords) and individuals might get screwed.

This could also mean that one of WeWork’s competitors might be able to acquire WeWork for pennies on the dollar and expand their marketshare.

Office To Residential Conversion

Office to residential conversion has been the talk of the town, especially after the press is talking about the demise to office. Many landlords are giving the keys back to the bank while others are losing money, month over month.

There’s an obvious glut of affordable housing in the United States. There are also many Class B & C office buildings that are lying vacant. The obvious solution is “why not turn it into housing”.

That is great in theory, but there are a few drawbacks…

1. It is expensive

2. Zoning changes

3. Current tenants may pose a problem

To convert an office building is extremely expensive. Most offices have multiple elevator shafts, hallway bathrooms, and only exterior windows.

The “floorplates” are also designed in such a way where a single floor may be up to 15,000 square feet and leased to one corporate tenant. To reconfigure it to residential apartments would be quite expensive.

Let’s take a 15k square foot floorplate. In order to convert to residential, you would need to fill up some of the elevator shafts, add HVAC, replumb the building to have individual pipes for showers, sinks, and drains, and add interior windows to make it up to code.

If a building is a historical landmark, it would involve keeping the exterior facade of the building while renovating the interior. It would simply be too expensive.

The costs involved in converting a building to residential are not worth it and it would be more cost effective to demolish it and purpose build a large residential tower.

In addition, the tenants might face weird anomalies that are exclusive to conversions – windowless bedrooms, funky layouts, and very commercial locations.

Another issue with conversions is zoning. Most of the commercial office buildings in central business districts or “CBDs” are zoned commercial and not residential.

To have a residential building in a commercial area would mean the city has adapted the zoning or made an exception.

Historically, cities in liberal states (CA/NY) have been vehemently against upzoning to allow more dense housing. NIMBYs or (Not in my backyard) have pillaged local city councils to maintain sparse residential zoning to prop up high housing prices.

This means changing local policies, convincing NIMBYs to change zoning, and incentivizing developers with grants/tax abatements.

If local government becomes adept at upzoning, then office to residential conversions have a legal and financial foot to stand on.

Tenant Problems?

Another problem people may not think about is existing tenants in mostly vacant buildings.

Remember, landlords and tenants may pay TI or tenant improvements to customize a space exactly to their liking. The average lease of a commercial office tenant is around 5 years and many leases include options to extend the lease.

A problem may arise when there are existing tenants with an office building when a new owner buys it with the intent to convert it to residential.

Some tenant leases offer “first right of refusal”, giving tenants the first right to refuse any deal proposed. This can often cause problems if a landlord wants to do something other than the traditional use of an office building.

Additionally, some tenants may expect buyouts for the rest of their lease, incurring significant unexpected expenses for the landlord. There is a possibility the tenant may also refuse to vacate the space.

Possible workarounds?

It is possible to do residential conversions from older office buildings, there just need to be some fixes made.

There have to be tax breaks or concessions from the city/state/federal government to make the deals pencil. Stuff like tax abatements where there are low/no property taxes could be a solution. Grants for developers could also be a solution as well.

Addressing the housing shortage is key and office to residential conversions are a great solution if the numbers pencil and upzoning is allocated by city council.

‘With traditional construction financing being 9%+, it would mean the cash-on-cash return has to be at least 11%. Most sponsors/developers want to see a 200 basis point (BPS) spread between the cost of financing/capital and the yield.

Until concessions can be made, it is simply not worthwhile to do so.

Some notable cities that have done resi conversions are Cleveland, Los Angeles, and Washington DC.

Opportunities in Office Buildings

Does this mean office is a dying asset class?

In some ways, yes. Office is a dying asset class. The rise of remote work has killed a lot of poorly lit office buildings filled with soulless cubicles.

Office isn’t a very popular asset class right now and keys are being handed back to the bank from underwater landlords. This could pose as a great opportunity for a family office or REIT or private investment firm to pounce on well located assets for a significant discount.

The Wells Fargo Building (550 California Street) in San Francisco was once valued at $300mm in 2019. Wells Fargo bought it for $108mm in 2010 during the Great Recession. Most recently, it sold to an undisclosed buyer for between $42.6-46mm, a $60mm loss.

The office tower was once a trophy asset in a class A location in a Tier 1 city (arguably). $40mm is an absolute steal and this may set a precedent for the next few years for buyers with deep pockets.

I hope you’ve enjoyed this edition of the newsletter. It gives me immense pleasure to write it.

If there is any topic you want me to write about, please feel free to email back.

I do check my email quite often and would love to chat real estate if you’re interested.

Happy investing!

Cheers,

Mo