Coworking Closures Adding Stress To D.C.'s Struggling Office Market
Just two years ago, coworking was the fastest-growing sector in the D.C. office market, with providers like WeWork leasing large blocks of space and serving as a primary demand driver for the otherwise-stagnant market.
That dynamic has now flipped. Flexible workspace providers have given back hundreds of thousands of square feet of space during the pandemic, further weakening a D.C. office market in desperate need of new growth sectors.
"Coworking was really the only sector that was new and was driving positive growth for the city up until this year," JLL Senior Research Director Michael Hartnett said. "None of these sectors that are D.C.'s homegrown sectors are in growth mode outside of a bit of tech. Coworking was really the only sector that was in growth mode this cycle, or at least the largest."
WeWork in October closed three of its oldest D.C. coworking spaces in Chinatown, Shaw and the U Street corridor. Last month, it announced the impending closures of four additional, newer spaces in Chinatown, Dupont Circle, the H Street Corridor and Crystal City. The latest round of closures is scheduled to take place Friday.
Homegrown coworking operator MakeOffices folded last month, but pledged to try to find other coworking operators to take over its nine spaces in the region in Rosslyn, Reston, Tysons, Bethesda, Dupont Circle, K Street, Glover Park and at The Wharf.
In the six months ending Jan. 31, the overall occupancy of D.C.-area flexible office space providers declined by 879K SF, roughly 18% of their previous footprint, according to CBRE data, which included the WeWork and MakeOffices reductions.
"We're not done with some of this contraction," CBRE Senior Director of Research Ian Anderson said. "It's going to get worse before it gets better."
The closures create pressure for the owners of these spaces, who now must either find other coworking operators to take over the spaces or put them back on the market to search for direct leases.
It is not an easy time to find new tenants, with D.C.'s office market last year recording negative absorption of 1.4M SF, according to CBRE, which pegged the District's year-end vacancy rate at a record-high 15.9%.
'Bearing The Brunt Of Their Mistakes'
The pandemic has exacerbated the problems facing the coworking market, but it was not the initial cause of much of the distress.
WeWork had already begun looking to restructure its portfolio following a rapid expansion and failed IPO in 2019. The company signed eight D.C.-area leases totaling over 550K SF in the 12 months leading up to August 2019.
"WeWork, even before the pandemic, we all realized that their business model of expanding as rapidly as possible in some of the most expensive buildings in the city was unsustainable pre-pandemic," Savills Corporate Managing Director Jon Glass said. "Now they are recorrecting a lot of the mistakes that they made in the past, and it's these landlords that took a flyer on them that are bearing the brunt of their mistakes."
A WeWork spokesperson said the company has no plans to close additional D.C. locations. WeWork declined to disclose the terms of its exits from the leases for the seven spaces it is closing, but the spokesperson did shed light on how it aims to fill its existing spaces.
The coworking provider previously had in-house sales people performing most of its marketing for prospective members, but it has now retained brokerage firms across the U.S. to help it find new members. In D.C., it retained Cushman & Wakefield to help fill its still-operating spaces, the spokesperson confirmed.
WeWork is using these broker partnerships to better position itself as a landlord that provides tenants with a variety of workspace offerings, a spokesperson said.
While WeWork faced its own challenges before 2020, the pandemic severely damaged the sector that is focused on shared workspace and short-term leases.
"The model was built on short-term flexibility, and when people aren't in the office for the long-term, they're going to cancel short-term commitments, because that's an easy line item to cut," Glass said.
MakeOffices Chief Operating Officer Josh White told Bisnow last month that the company was forced to close because it experienced an increase in terminations from companies facing financial difficulties.
"The challenging economic environment was certainly felt by our membership, which resulted in increased terminations and reductions in revenue that made ongoing operations challenging," White said.
IWG, which operates around 50 D.C.-area flexible workspaces through its Regus and Spaces brands, filed for Chapter 11 bankruptcy protection on dozens of spaces across the country last year, including at least two D.C.-area locations in Chevy Chase and Rosslyn, the Washington Business Journal reported.
IWG North America CEO Wayne Berger told Bisnow the bankruptcy filings will impact roughly 4% to 5% of its real estate portfolio around the world, though he declined to provide details on spaces in the D.C. area or elsewhere.
"We have been working with our landlord partners over the last year to help find ways to move forward, especially with some of those later-opening locations that haven't had a chance to gain traction yet," he said. "Our intent is to continue to keep all of our locations open and continue to move forward, but where we have situations if we're not able to reach amenable partnerships with our landlords, sometimes we do have to take that decision to move forward with a closure."
Industrious President Justin Stewart, whose company has been a rare example of a growing coworking provider during the coronavirus pandemic, said its occupancy hit a low point during the summer and has increased since then.
"The pandemic happened, you saw a dip in occupancy, and then around August it started to go up, and around October we started to see real big jumps in our portfolio," Stewart said. "Now in February, we're starting to see more people coming back than ever before."
The company's business model of management agreements that share revenue with the building owners has allowed it to stay asset-light and attracted the attention of CBRE, which paid $200M for a 35% stake in Industrious this week. Industrious Director of Real Estate Peri Demestihas attributed the closures from other providers to their long-term lease model rather than a lack of demand for coworking.
"The closures had more to do with a business model that doesn't make sense," Demestihas said. "When you go out and sign extremely expensive leases, it gets really difficult as soon as things get a little tough. That's a really tough business model to run."
The Yard co-founder and Head of Real Estate Richard Beyda, whose firm operates one D.C. space on Capitol Hill, said its occupancy has been around 70%. The coworking provider retained Colliers to help it find larger users to fill its space, but it has no plans to close the space, Beyda said. On the contrary, it is looking to add more.
"We didn't gorge on real estate like some of our competitors did the last three or four years," Beyda said. "We didn't jump all over spaces like some of the guys out there."
The Unwanted Spaces
The WeWork and MakeOffices closures are leaving over a dozen blocks of built-out coworking space without an operator. Many will remain coworking space under different management, while others could come back to the leasing market as vacant space.
Two of the nine MakeOffices spaces have already been accounted for. JLL said last month it is taking over the management of the company's flagship location at The Wharf and will operate it under new branding. Maryland-based Launch Workplaces reached a deal to take over the former MakeOffices space in Glover Park, the Washington Business Journal reported earlier this month.
Industrious is in talks to take over multiple closed coworking spaces in the D.C. area with its management agreement model, Demestihas said, but he declined to disclose which ones.
"We have been reached out to about a lot of these locations," he said. "We're working really closely with landlords on a handful of them, but we're going to be strategic. We're not just going to take everything and anything that comes to us. It has to fit our brand, our operation model."
Beyda said The Yard is "actively in negotiations," to take over space from competitors that are closing down in D.C. He said it is negotiating a hybrid model that would be structured as a management deal for the short term and convert to a traditional lease after 12 or 24 months.
"The spaces are already built out, so we can come in with not that much capital improvement from the landlord and run it while the market stabilizes," he said. "This way the landlord can get some income and not have to write a big check for new TI or free rent."
Anderson said he thinks a majority of the spaces will stay as flexible office under new management.
"There are going to be other operators swooping in," he said. "There could be demand from owners who want to take advantage of this space and maybe set up their own flexible office space, but a lot of this space that has gone empty will be reinvented under new ownership or a new provider."
Landlords may prefer to sign long-term leases that make their assets more stable in the eyes of investors, but finding those leases to replace closing coworking spaces appears difficult in today's market.
With large tenants still few and far between, Glass said keeping the spaces as flexible office is likely the only viable option for many of the landlords at the moment.
"How are you going to lease these big chunks at a time?" Glass said. "There's just not that many big tenants like that looking for this kind of space to take it all down themselves at once. They're going to have to work with their teams to model how long would the space have to sit to re-lease it to one user."
Douglas Development and JBG Smith, which each own multiple buildings where WeWork announced closures, both declined to comment on their plans for the spaces. Insight Property Group, which owns the H Street location where WeWork closed, also declined to comment.
JBG Smith's two leases with WeWork totaled 163K SF, making it the REIT's seventh-largest tenant as of Dec. 31, according to its most recent earnings report. The report didn't address the WeWork closures, which were announced after the quarter ended, but CEO Matt Kelly discussed coworking generally in his quarterly investor letter.
Kelly said the REIT has agreed to lease modifications with "virtually all at-risk co-working tenants," and it has changed its accounting method for the leases. He said it has written off all accounts receivable and straight-line rent receivables of the "struggling operators," and has converted them to a cash basis of accounting.
"While coworking tenants are a small component of our overall office portfolio and comprise only 3.5% of annualized rent, they face serious headwinds in the current environment," Kelly wrote in the letter.
What It Means For The Office Market
The contraction of the coworking sector comes at a bad time for the D.C. office market, and it is only adding to the large amount of vacancy that landlords are working to address.
"The net impact is an increase in vacancy on the direct side," Hartnett said. "It leaves more exposure in the market right now when it comes to available space, when it comes to vacancy."
Anderson said he thinks coworking will rebound over the long term, but it will have to go through more pain to get there.
"For the short term, it's going to obviously add some stress, there's going to be some more closings, it's going to be a bit of an upheaval," Anderson said. "But this is not some of the same structural issues you have for example with retail. We just need to go through a bit of a phase here."
While the closures have led to a net decrease in occupancy from the coworking sector over the last six months, there have still been some operators expanding, especially in the suburbs.
Industrious reached a deal to open a 43K SF space at Pike & Rose in North Bethesda. The operator has signed at least six other D.C.-area deals in the last three years.
"We did the obvious, we did Bethesda, the Arlington corridor and Alexandria, but I think there's plenty of opportunities outside that," Demestihas said. "You talk to landlords and they're big believers in Northern Virginia, and going even further out could really be an incredible opportunity for us."
As part of CBRE's investment in Industrious, Hana, CBRE's fledgling flexible office arm, will be merged into Industrious as part of the deal. Hana opened a 39K SF flexible workspace location in National Landing last month, its first location on the East Coast.
Office Evolution, which operates suburban flexible workspace locations that average around 9K SF, opened a new space in Fairfax in November, and it has spaces in Tysons and Herndon. The company, which uses a franchise model with local operators, plans to continue expanding in the suburbs, Office Evolution founder and CEO Mark Hemmeter said.
"The combination of small locations, suburban and locally owned is very different than a huge WeWork, corporately owned in Downtown D.C.," Hemmeter said. "That's why we've survived through this."
Anderson said the suburban coworking market is much better positioned than the downtown market, as it hasn't been as heavily supplied and its demand has remained more stable.
"The suburbs are going to have a much smoother ride as we move forward here, not only in terms of less contraction, but in terms of possibly more growth," Anderson said.
But for the owners of the spaces that closed, whether they sign management agreements with flexible workspace operators or put spaces on the market for direct lease, they still need to find tenant demand for hundreds of thousands of square feet of office space that coworking providers have abandoned.
Jarvis Commercial Real Estate principal Ernie Jarvis, a D.C. office broker, said he thinks the pandemic has changed the way employers think about office space, and he doesn't think they will rush back to densely packed, shared workspaces even after their employees are vaccinated.
"I think coworking space is not dead, but you'll need the jaws of life to revive it," Jarvis said. "On the heels of COVID, it's still in the back of everybody's mind. Even post-vaccine, social distancing is important, so the pendulum will swing that way for a while and that will affect coworking areas. People like WeWork will have to reinvent themselves."
The majority of the pain in the coworking sector has been felt downtown, Berger said, because that is where the sector had expanded the most, and because downtown buildings that require mass transit and elevator rides have remained quiet during COVID.
“If you look at markets like D.C., such a large percentage of absorption rates in the downtown cores have been under coworking operators and flex space providers," Berger said. "What you’re seeing now is a rationalization, because of the impact that’s taken place with COVID that’s going to have a natural imbalance on downtown, because that’s where the balance of investment went beforehand.”