Commentary It's Questionable If Wework Will Recover from Its Coronavirus Infection

Commentary It's Questionable if WeWork Will Recover from its Coronavirus Infection

DBRS Morningstar WeWork to Suffer in 2020 June 4, 2020 With WeWork no longer the darling of Wall Street, investors have to contend with how the coworking

company will perform in a recessionary environment. The Coronavirus Disease (COVID-19) pandemic has Contents caused the company to close many facilities, which are not generating any revenue, or significantly 1 WeWork to Suffer in 2020 2 Overwhelming Number of Long-Term curtail its operations. As part of its overaggressive expansion, WeWork took on lengthy leases in more Leases That Landlords Won't Want to than 520 locations, mainly with venture capital (VC) funding, including from its zealous patron, SoftBank Renegotiate Group Corp. (SoftBank). While traditional tenants typically secure 10-year leases, WeWork’s leases 2 Disruptions to the Office Sector Challenging WeWork in 2020 averaged 15 years. Part of the reason was to justify the expensive build-out costs that the company 4 Small Exposure, Large Footprint in CMBS asked landlords to fund upfront. Furthermore, the company’s future leasing liabilities drastically 4 A Closer Look at the Future of Coworking outweigh its revenue commitments. As indicated in its S-1 filing during the failed IPO push, WeWork Operators 5 The Bottom Line owed $47.2 billion in rent to landlords, while its committed revenue backlog, which represents noncancelable future generating revenue, totaled only $4.0 billion as of June 30, 2019.

Olivia Mandell Analyst The coronavirus’ effect on the economy will take time to truly understand; however, DBRS Morningstar North American CMBS expects WeWork to struggle with potential disruptions to the office space in the aftermath of the + 1 847 471-5353 [email protected] pandemic. In 2020, the U.S. economy can anticipate lower levels of economic activity, persistently high unemployment, and an increase in vacancy for commercial real estate. The “new normal” of white-collar Steven Jellinek professionals working from home could also dent WeWork’s prospects in the coming years. Small and Vice President North American CMBS medium-size businesses, which represent 57% of WeWork’s members per the S-1 filing, may be most +1 312 244-7908 affected by economic turmoil. Moreover, effective office rent could decline significantly, posing [email protected] problems to WeWork and other coworking operators, whose membership rates depend on prevailing

Edward Dittmer, CFA market rent. WeWork’s ability to successfully emerge from the coronavirus pandemic will hinge on its Senior Vice President ability to pare down its lease liabilities, either by renegotiating rents or selectively terminating leases. North American CMBS

+1 212 806-3285 [email protected] In an interview with CNBC, WeWork Chief Executive Officer Sandeep Mathrani projects a positive outlook for the company in 2020, anticipating that the coronavirus will trigger an increased demand for Erin Stafford Managing Director its space. WeWork maintains that, as employers are eager to bring employees back to the office, North American CMBS enterprises will need more rather than less square footage to facilitate social distancing among +1 312 332-3291 employees. By this logic, WeWork, with its spacious flexible floor plans, could present an attractive [email protected] opportunity for companies that are seeking short-term leases for additional space at additional locations. Although, it is unlikely that any increase in demand will overcome its deficit in rent to landlords.

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Overwhelming Number of Long-Term Leases That Landlords Won’t Want to Renegotiate Page 2 of 7 WeWork’s leases are lengthy and binding. As outlined in the company’s S-1 filing, its average lease term

Page 2 of 7 in the United States is 15 years. These leasing obligations are fixed payments and are not tied to how much space it uses. The filing also noted that its leases do not contain early termination clauses, with Page 2 of 7 few exceptions, and the company remains legally obligated to pay them in the future.

Page 2 of 7 In contrast, WeWork’s primary source of revenue—its memberships, accounting for 83% of income for the first half of 2019—are short term and flexible. While its average U.S. lease term is 15 years, memberships only average 15 months, per its S-1 filing. Moreover, Forbes reported that 28% of its members have month-to-month leases; they may cancel at any time for any reason, with one month’s notice. With high fixed costs, and an uncertain revenue stream, WeWork is susceptible to incurring operating deficits, especially in an environment in which it struggles to meet sufficient occupancy levels.

Finally, WeWork tends to occupy a large proportion of any property it occupies. In our previous commentary titled Coworking Doesn’t Pose a Contagion Threat to the Office Real Estate Industry, but There Are Risks to Landlords, we analyzed 22 commercial mortgage-backed securities (CMBS) loans backed by office properties that include WeWork as a tenant. In eight of these properties, WeWork occupied more than 75% of the building. Only three properties had WeWork accounting for less than 25% of the building. If WeWork were to vacate or reduce its rent or square footage, the landlord’s revenue would take a significant hit.

Given all of the above, we expect landlords to be hesitant to allow WeWork to terminate or negotiate leases. If the company were to vacate a building, the landlord may have to undergo additional build-out costs to prepare the space for another tenant. Even in traditionally strong markets like New York City or San Francisco, replacing tenants at favorable rates may be hard as a result of the disruption from the coronavirus. In 2020, we expect office vacancies to reach historic highs. Reis, Inc. (Reis) offers a baseline forecast, with office vacancies spiking to an unprecedented 19.4% by the end of 2020 nationwide. Moreover, Reis projects a 10.5% decrease in effective office rent across the U.S. in its base-case scenario for 2020. Even if a landlord were able to secure a tenant, it will most likely be at a lower rate than WeWork’s. This would leave landlords with a structural decline in future revenue. Therefore, landlords may take a chance on WeWork remaining solvent as an option.

Disruptions to the Office Sector Challenging WeWork in 2020 In 2020, we expect less demand for all flexible office providers, including WeWork, considering the increase in unemployment and decline in economic activity. The pandemic has had a severe impact on the labor market. The Bureau of Labor Statistics reported 23.1 million unemployed Americans as of April. U.S. GDP contracted 5.0% (quarter over quarter, seasonally adjusted annual rate) in Q1 2020, the largest decrease since Q4 2008, when GDP decreased by 8.4%. In a moderate scenario, DBRS Morningstar assumes that U.S. GDP will decline by 5.0% for 2020 as a whole and that the unemployment rate will average 10%. For more information, please read Global Macroeconomic Scenarios: June Update, published June 1, 2020. Based on the S-1 filing, WeWork’s primary revenue driver is small and medium- size businesses, which tend feel the worst effects of recessionary economic turmoil. We expect this

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year’s poor financial conditions to drive individuals and businesses to cancel memberships either to cut Page 3 of 7 costs or as a result of reduced headcount.

Page 3 of 7 Until there is a vaccine or treatment plan, we expect individuals to continue working from home, further Page 3 of 7 hurting demand for WeWork memberships. Large technology companies, such as Google and Facebook,

Page 3 of 7 Inc., have all announced that employees can work from home until the end of 2020. Twitter, Inc. also announced that its employees may work from home indefinitely. Enterprises in other sectors may also keep a significant portion of their non-client-facing workforce at home during this period. Until the country is able to implement a long-term solution to the pandemic, businesses may adopt a conservative approach to re-entering their employees in the office to reduce the risk of new outbreaks and to maintain positive employee relations.

For the foreseeable future, companies are unlikely incur the cost of securing additional square footage at more locations to decrease workplace density. Businesses are already locked into long-term leases that are virtually vacant. Rather than acquire an additional lease at WeWork or another coworking operator, enterprises will most likely operate pre-existing leased space at below capacity for essential employees who must go to the office.

In addition, market rates for effective office rent could significantly decline because of an increase in office vacancies and a lack of new demand, which could impair WeWork’s ability to derive revenue. Office rent declines may be most severe in dense urban centers. According to Reis’ base-case scenario, effective rents in 2020 would decrease by 10.5% on a national scale. For markets such as New York, Reis estimates the market rate for effective office rent will drop by 20.3%. Other major hubs, such as San Francisco; San Jose, California; Orange County, California; and Boston, will also experience steep declines in office rent (Exhibit 1).

Exhibit 1 Projected 2020 Changes: Effective Rents and Employment

MSA 2020 Effective Rent Change (Forecast) 2020 Employment Change (Forecast)

New York -20.3% -3.01% San Francisco -17.0% -3.80% San Jose -16.2% -3.52% Orange County -14.0% -3.24% Boston -12.6% -2.81% Source: Reis, Inc.

Decreasing market rent is problematic for WeWork given that its membership rates reflect the prevailing market rent. Because there is little demand for office space, WeWork’s membership rates may slip, which would decrease its revenue per member. Moreover, if WeWork subleases its space to another office tenant, it will most likely be unable to charge its subtenant a sufficient rent to cover its own leasing obligations.

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Small Exposure, Large Footprint in CMBS Page 4 of 7 Although CMBS exposure to WeWork is low at $3.87 billion, or 0.7 % of the total CMBS universe, the

Page 4 of 7 relatively small number of loans with WeWork as a tenant may face heightened risk because they are concentrated in cities heavily affected by the coronavirus. For instance, 38.6% of the loans with WeWork Page 4 of 7 are in the greater New York City area, the current center of the outbreak (Exhibit 2). Moreover, of the 17

Page 4 of 7 exposed New York City office buildings backing CMBS, only five have WeWork occupying less than 25% of the total square footage. In fact, the company accounts for more than 50% in eight of the 17 properties. Therefore, while consolidation in the coworking industry isn’t a threat to the overall market, it may have an outsize effect on individual properties if companies try to reduce their space in a particular building.

Exhibit 2 Top Five Markets With CMBS Exposure to WeWork

City State Trust Balance ($) % of Portfolio

Greater New York City Area New York 1,495,096,282.38 38.60 Greater Los Angeles Area California 619,100,000.00 16.00 Washington District of Columbia 617,712,236.41 16.00 Denver Colorado 277,100,000.00 7.20 Greater Seattle Area Washington 221,000,000.00 5.70 Other Various 642,478,855.42 17.00 Total n/a 3,872,487,374.21 100.00 Source: DBRS Viewpoint

A Closer Look at the Future of Coworking Operators Regardless of WeWork’s future, our long-term outlook is that the coworking concept is here to stay. However, WeWork’s IPO failure and how other operators perform during the recessionary environment will cause coworking to look much different in the aftermath. Even before the coronavirus started, investors’ sentiment soured. In Q3 2019, growth in flexible office leasing commitments decreased sharply from its peak in Q4 2018, per CBRE Group, Inc. (CBRE). For the past four quarters ended Q1 2020, new leasing commitments for flexible office space decreased significantly, at 32.1% year over year (Exhibit 3). CBRE attributes this decrease to WeWork shifting its focus to achieving profitability from aggressive growth after the failed IPO. In fact, WeWork did not add to its overall lease burden in Q1 2020, the first time since its establishment. However, it is not the only coworking operator to face such challenges. Others have reduced new leasing commitments. In Q4 2019, the largest contributors of new leasing commitments were Spaces, WeWork, Industrial, and Knotel. Except for Spaces, all of them leased significantly less space than over the past year.

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Exhibit 3 Flexible Office Commitments Page 5 of 7

Renewal New Four-Quarter Average Page 5 of 7 6 Page 5 of 7 5

Page 5 of 7 4

quare Feet quare

S 3 illion M 2

2.2 3.8 4.9 3.7 3.7 4.1 1.1 1.0 0 Q2 2018 Q3 2018 Q4 2018 Q1 2019 Q2 2019 Q3 2019 Q4 2019 Q1 2020 Source: CBRE Research, Q1 2020.

As coworking operators have largely pulled back on new leasing commitments, VC firms have become less willing to invest in flexible office space. In a review conducted by Pitchbook, analysts found that when considering the entire financial year of 2019, the dollar value of VC investment for coworking space was high, largely because of SoftBank’s planned bailout of WeWork. However, during the entire year, there were actually fewer VC closings across all coworking operators since its peak in 2018. Moreover, since WeWork’s failed IPO in September, not a single round of VC funding has closed for any coworking firm, per Pitchbook.

Freelancers and enterprises of all sizes may have an appetite for coworking after there is a treatment or vaccination plan for the virus; however, the leading operators of the future may look different than their traditional peers. Coworking operators may forgo the traditional model, characterized by long-term lease commitments, and opt for a partnership/revenue-sharing model. In the traditional model, the coworking company leases space from the landlord for a longer term to account for the amortized build-out cost and then subleases space to its members at an elevated rate. In a partnership/revenue-sharing model, coworking operators and landlords share the build-out costs, and the coworking operator manages the space on behalf of the landlord for a percentage fee of the total revenue. According to CBRE, landlords such as Hines and RXR Realty have pioneered such agreements, and we expect more to follow suit.

The Bottom Line In navigating the effects of the coronavirus pandemic, we believe that WeWork will face severe difficulties if it can’t reduce its portfolio of long-term leases. We expect disruptions in the office sector stemming from increased unemployment, further contraction in GDP, and increasing numbers of professionals working from home. As a result of reduced economic activity and health concerns, WeWork members may cancel their already short-term commitments. To stem the tide of potential cancellations, the company may lower its membership fees, further weakening its revenue base. Subleasing space won’t likely cover the rent that WeWork committed to. The company may struggle to pay its leases in the future.

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The threat level to the world of CMBS is minimal. WeWork represents a small fraction of the total CMBS Page 6 of 7 market. Rather, individual landlords would see the effects of potential weak market conditions and

Page 6 of 7 WeWork’s inability to make payments. Given the proportionately large footprint WeWork typically occupies in properties, landlords would be severely compromised if WeWork were to fail to pay its rent. Page 6 of 7 If WeWork fails to survive its coronavirus infection, landlords might be the collateral damage.

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