In the US, the flexible workspace market has been firmly established for years, and profit share leases and management agreements are common. The recent proliferation and popularity of flexible space providers in the UK, led by US operators, has prompted UK landlords to reassess their approach. Is there now a real alternative to fixed rent lease arrangements in this market in the UK, to allow owners to capitalise on this trend and maximise returns?
Management agreements (widely used in the hotel industry) are becoming increasingly prevalent in the UK flexible workspace market. It is an agency contract where the property owner hires a flexible workspace operator to manage the owner’s flexible workspace business, as agent for the owner, in return for the operator receiving a fee – the operator takes no property interest in the building.
This model suits those owners with a higher risk/return strategy or those who want more control over this business. The business effectively stays with the owner, so the returns are potentially higher when the space is profitable but there is also a greater risk of lower returns when it is not. The owner will be responsible for the initial capital expenditure and the running costs associated with the business. In return, the operator will run the business for the owner under the operator’s own brand. Whilst the operator is paid a base fee for doing so, it is usual for further incentive fees to be offered to the operator to incentivise better performance.
We have seen well-known landlords recently start to operate flexible spaces themselves. Certainly in the past, providers have collapsed when downturns left them with costly lease liabilities but little demand for space. The ownership model avoids this problem and some landlords have been keen to set up their own flexible space brands to capitalise on this. However, these landlords are competing against operators who are well established in the market. And not all owners will have the insight into how to operate these businesses effectively: flexible space is much more operationally intensive than traditional offices, so it as much an issue of capacity as it is expertise. Appointing an operator with a well-established brand will allow the owner to tap into an up and running, well recognised platform and the benefits this brings. The owner will also retain various ownership benefits such as cash flows, depreciation deductions and tax benefits etc by appointing an operator to manage the business.
Whilst the hotel investment market has matured in recent years, with increasing numbers of institutional investors acquiring hotels operated under hotel management agreements, the office market is much more used to more traditional property arrangements. Management agreements can present a number of downsides to an owner, as the owner has limited operational control (although this can be addressed in management agreement). The owner is also liable for all expenses (operational, fixed and fees to the operator), so the start-up costs can be high. The owner suffers higher downside risks (which are shifted to the operator in the case of a lease). However, this can be limited by the owner being offered a minimum guaranteed return. Typically in the hotel industry, premature termination of a management agreement might result in very high termination expenses - it will be interesting to see if flexible space operators in the UK follow suit.
An alternative and more traditional property route would be a profit sharing lease, where profits are divided between the landlord and tenant. This type of lease is widely adopted in the retail and leisure sectors, albeit a landlord will usually require a rent that is below market to ensure that at least part of the landlord’s income stream is maintained if the business is not profitable. It enables the landlord to capitalise on the tenant’s success, something which a standard fixed rent lease will not do. Profit-sharing leases can also include a termination right, so a landlord can terminate a lease if the tenant is performing badly, thus allowing the landlord to re-let the property.
The office market is changing and the traditional attitudes towards risk are changing with it. Tenants are moving away from traditional longer lease structures in favour of more flexible space arrangements so their landlords are also re-considering their attitude to risk in this market, with management agreements and profit sharing leases offering a new dynamic.