Concrete Analysis

Institutional funds eyeing co-working boom

The appeal of co-working spaces has moved beyond start-ups and small business to attract multinational companies

PUBLISHED : Tuesday, 19 September, 2017, 8:31am
UPDATED : Wednesday, 20 September, 2017, 9:11am

The popularity of co-working spaces is no longer limited to start-ups and small businesses. The sector is becoming increasingly attractive to multinational companies seeking to build flexibility in their real estate portfolios. Confidence in the growing sector has rippled into the investment market, prompting institutional funds to incorporate co-working space real estate into their investment models to justify acquisitions of office buildings in Hong Kong.

Generally speaking, co-working spaces can be grouped into three major categories. Each type appeals to a wide variety of tenants. One of the models targets young, local freelancers and artists. An example exists in a revitalised industrial building in Kwun Tong, which is now playing host to an array of workshops set up by local musicians, artists and independent entrepreneurs.

Another type of co-working space mainly caters to start-up companies and can be found in grade B buildings. Co-working environments are ideal for start-ups not only for the flexibility of the lease terms but because they inspire collaboration and creativity. Thanks to shared facilities, interactions are made more frequent: a manager from an interior design company could brainstorm ideas with a software engineer sitting at the next table.

The third major tenant of co-working spaces are multinational companies, including international banks and insurance companies, which are seeking flexible office solutions. Tenants of traditional offices are generally required to commit to a two-year minimum leasing period and may be subject to hefty renovation costs. By adopting a co-working space, multinational companies are able to cope with the volatile economic environment more efficiently.

CBRE data shows that co-working space operators, including serviced offices which have co-working elements, currently occupy 960,000 square feet of office space in Hong Kong. Since these operators have secured 222,000 sq ft of new office supply in the first half of 2017, the total footprint of the co-working sector will increase to more than 1.18 million sq ft by the end of 2017, or a 70 per cent jump year on year, assuming all new spaces will be opened on schedule. The supply will continue to grow as demand is unlikely to abate in the near future.

The demand has inevitably improved investor sentiment in Hong Kong’s real estate market, despite the fact that valuations of office buildings in Hong Kong have recently soared so high that yields dropped to a critical level. For example, a grade B building in Sheung Wan was priced at HK$20,000 per sq ft, with an average rent of HK$35 per sq ft, resulting in a 2 per cent yield. The relatively low investment return for office buildings across Hong Kong had dampened institutional funds’ real estate investment sentiment and temporarily paralysed office transactions.

However, the grade B office building investment market has now outperformed the overall market. In the first half, overall office transaction slipped 12.6 per cent year on year to HK$20.2 billion. Meanwhile, en bloc and whole floor transactions of Grade B office buildings surged 45 per cent year on year to HK$8.7 billion, according to CBRE Research. The increased activity can be linked to the uptick in interest from institutional investors in renovating grade B offices for co-working operators.

Although the initial yield is not attractive, institutional funds can secure rental increments by strategically structuring leasing contracts with co-working operators. As an incentive to entice co-working operators, landlords can offer to foot renovation fees for tenants at the beginning. In return, co-working operators could be asked to commit to a five to 10-year lease and promise to repay the renovation fee in increments over the leasing period while accepting annual rental increases. This offers the investor security while waiting for the opportune time to dispose of the asset.

Riding on the coattails of co-working space operators, the Hong Kong real estate market will likely witness a steady flow of demand for grade B office buildings for the foreseeable future. As long as institutional investors can secure a co-working operator, the opportunities to profit will be strong.

Stanley Wong is executive director of capital markets at CBRE Hong Kong