Here’s How The Market Is Valuing Flex Space Amid Covid

Market perception of flex office space has dramatically improved this year, after the pandemic forced a rout that saw a retreat from the sector.

A new report from JLL on the state of flex space globally notes that while investors have typically employed a more cautious approach to flex space, the share prices of publicly traded flex operators like IWG have climbed since the pandemic’s early days. (KKR and TIGA’s majority stake in TEC is one such example.) And the sector’s supply-demand drivers are pointing to even further growth post-COVID.

Historically, flex tenancies have created cap rate premiums relative to comparable assets in more traditional segments of the economy when comprising a large share of rentable building area, according to JLL. And in past down cycles, operators have turned to bankruptcy protection, further driving investors away from the asset type.

JLL data states that when the flex share of an asset’s total rentable building area hits 19% or greater, those assets generally underperformed their peers when it came to pricing. But “capital sources have become more accepting of flex tenancies under certain circumstances, such as when spaces are committed to large enterprise customers or are backed by strong lease covenants including letters of credit and/or corporate guarantees, are well-capitalized and have a strong record of rental payment,” the report notes.

As office occupiers have begun to reevaluate their space needs in the wake of COVID, demand for flex space has surged. But the challenge for landlords, according to JLL,  is “how to deliver flexibility when lease duration and long-term committed cash flows have historically driven asset values, liquidity and the availability and cost of financing.”

 “Underwriters have generally developed a consensus around valuing traditional leases with SPVs (the historical norm for third-party controlled flexible spaces), but the new era of management agreements has made financial modeling more complex,” the report notes. “Management agreements replace a SPV with licenses or service contracts, which alter the traditional landlord-tenant deal structure. The lack of data points and limited track record of license-based income therefore requires a “leap of faith” on behalf of lenders and landlords. Given these unknowns, the preference of the investor community has generally been to keep the allocation of flexible space in an asset limited to help mitigate risk.”

Conversion clauses can also be used to minimize risk, permitting landlords to change deal structures into a traditional lease when they want to exit the investment. But while popular, such clauses can create tension in negotiations and drive tenants away.

In the future, JLL predicts investors will underwrite flex deals as they do other variable-revenue cash flows like percentage-rent retail leases – and “accept that the future of office investing will involve more volatility in net operating income.

“As the market moves toward management agreements, the investment market will need to become comfortable with assessing the potential revenue streams that can be generated from a particular building, location and operator. Investors will also be seeking greater returns as compensation for the operational risk,” the report concludes.