The topic of flexible workspace valuation has been of interest to investors, asset owners, operators and debt providers alike, as the effects of COVID-19 have amplified the need for a clear and consistent approach to valuation, as the sector comes under scrutiny. Currently, there is a lack of hard data, evidence, and certainty regarding what form of agreement would best fit assets and operators, as well as drive value.
In late 2019, the RICS produced a paper entitled “Valuation of flexible workspace,” which most in the sector assumed would signpost the methodology and create a standard for the sector. While there is no formal methodology detailed by RICS, the paper warned of the pitfalls of valuations and advised caution to those without any experience in the sector.
The ‘art’ of valuation is to seek to replicate the market and reflect the approach a potential investor would adopt when formulating their offer for an asset. Therefore, valuation in this sector should be no different; just as an investor would not look at an asset making strong returns and offer based on the vacant possession value, neither should real estate professionals.
The most common questions we receive from our investor clients relate to the types of agreements in the market and how they impact their valuations, particularly when seeking debt. No conversation on the topic of agreements between asset owner and operator is ever the same. It is true that flexible workspace assets are generally operated using one of four delivery models, but outside of a lease it’s rare that we see the exact same deal structure more than once.
We have found that the ‘science’ of valuation is to reach a consensus between the investors, operators and debt providers in any deal. This is the case in each of the four main bases of value.
THE VANILLA LEASE
The covenant and surety offered by the tenant (operator) is the main factor that will impact valuation. There is generally evidence available; however, we would also factor in the variable nature of that tenant’s base of income, i.e. its members and what the strength of their covenant might be.
The EBITDA of a well-run asset can be comfortably above 200% of the Market Rent of the asset on a vanilla lease basis. While there is limited evidence in the market, in early 2020 the sentiment was that there would be a high volume of M&A activity.
Assets that are owner operated could fundamentally be sold to an alternative operator as a going concern, or to an investor with a view to either self-delivery (which is rare) or inserting the same or an alternative operator on a management agreement.
The Market Rent element of EBITDA is generally ‘safe’ for a good quality asset that has reached operational maturity. It is the sustainability and future growth potential of the top slice element (the EBITDA over and above the Market Rent) that dictates the yield that should be applied to this element.
These agreements are becoming more popular. They generally involve a certain level of base rent (let’s assume 50% of the Market Rent), with a percentage of turnover/EBITDA element on top. They are considered to provide security to the freeholder on the basis that half of the Market Rent is guaranteed.
This creates another layer to the top-slice method and, again, the yields adopted should reflect the historic trading levels or the trading potential of the asset. A good understanding of how these assets operate is key to determining the appropriate yields, as well as the quality of the asset itself.
These operational agreements offer the least security of income to the freeholder; however, they also offer the greatest potential returns of the non-self-delivered options. Again, valuing these agreements must be done with regard to the sustainability of the income.
The main issue from a valuation perspective is the real lack of evidence in the market. Where deals have taken place, there has been limited visibility over the actual trading figures, and therefore the returns for the investor.
There is an argument that suggests, from an operational perspective, that management agreements are in fact favourable to a vanilla lease given that some flexible workspace operators have a history of terminating leases prior to natural expiry where the market has moved. This leaves an operational gap that would be less likely to happen under a management agreement.
Finally, some investors see value in having asset management opportunities from having a management agreement rather than a lease.
There is an element of uncertainty regarding valuation during the period prior to the maturity of the operation for assets on both a Hybrid Lease and Management Agreement. We have found that the concern of many investors is that over this period any valuation for debt purposes will not truly reflect the future potential of the agreement.
In the hospitality sector, the Fair Maintainable Trading (FMT) level is typically adopted. Only with a detailed understanding of the operator’s projections and what a FMT can reasonably look like for that particular asset and location can one reflect the attributes of the agreement in place. This is an agreement that could result in strong returns for the investor, and therefore must be more valuable to an asset owner than having vacant possession.
Another issue surrounds the capex contribution. The investment must be reflected in the valuation; however, this makes it even more important to demonstrate the future benefit to the asset owner. This can only be the case if the buildout is transferrable and another operator could trade successfully from the premises. Without the ability to assess the trading potential, the impact of the capex on the valuation would make these agreements unviable unless the assets reach maturity on day one, which is unrealistic.
When a hybrid lease or management agreement is in place, an investor is unlikely to view this as held with vacant possession, so why should a valuer? At the same time, an investor is not going to assume that these agreements alone are going to be more valuable (without proof of trading levels) than a vanilla lease. Where the flexible workspace element of an asset is only one part of a multi-let asset, an investor may well see the additional benefits to the rest of the building – this benefit is likely to materialise through a shortening of assumed letting/re-letting periods as well as tenant retention. While any valuer would not be able to quantify this benefit, it provides further weight to the argument that a more positive approach (rather than Vacant Possession) should be adopted.
This again is where the valuer must reflect the approach of an investor. It is then the duty of the valuer to demonstrate this to the debt provider in their report, thereby completing the triangle.
The challenge presented to valuers by the emergence of such a diverse range of deal structures and assets is still significant; however, understanding how mature flexible workspace assets operate and generate income is vital to analysing them as an investment. The Colliers Flex Office Rating System enables us to plot the underlying asset quality and helps determine the potential sustainability of the existing or projected cash flows. While there is limited direct evidence available in the market, it is then up to the valuer to utilise their experience to ensure their adopted approach is one that would be reflected by a purchaser in the market and considers the risk and returns that are achievable. This is a fundamental principle that is frequently forgotten.
To discover more about flexible workspace and the latest trends, read our Outlook Report.