Can Office Business Centers Lead Us Out of the Real Estate Glut?
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In August 2003, Pacific Business Centers (PBC) opened a new Office Business Center (OBC) in a Class A building in San Mateo, California. Much can be learned from this experience, for landlords and real estate investors alike.
OBCs are the 21st century equivalent of executive suites, where flexible office space users have access to private offices, conference rooms, state-of-the-art network connectivity, and back-room office infrastructure under short term renewable leases.
A real estate success in one of the worst Bay Area submarkets
The opening of this brand new San Mateo center by PBC took place at the heart of one of the most depressed office real estate sub-markets in the San Francisco Bay Area where vacancy approached 30%, not to mention considerable corporate shadow space.
The landlord saw the benefits of attracting PBC to develop a low risk, counter-cyclical, operation that would also work as an incubator of space for the rest of the development. The premise was that tenants would occupy larger chunks of space elsewhere in the building when they had outgrown their OBC offices.
The PBC San Mateo center opened with 45 private offices, including two large mini-suites, in 14,000 SF of space in its first phase. The center can accommodate over 110 workstations. Tenants share a lobby, reception area, copying room, conference rooms, T-1 line, a Cyber Café and other back-office amenities. Also offered are reception services, answering and screening services, and on-site admin and desktop support staff. This particular center also provides server co-location services and managed application services in a 700 square foot data center. The data center is equipped with 24 hour HVAC, redundant power, UPS, multiple T-1 access, and on-site IT & networking staff.
Fast ramp up
Leasing the space just one office at a time… the center is already 63% occupied only six months after opening, beating the original projections by a wide margin.
Full occupancy is in sight more than one year ahead of the conservative business plan. Revenues exceed projections by over 80%. How would that all be possible in a depressed market?
Part of the answer stems from the somewhat counter-cyclical nature of OBC use. The demand from traditional OBC users, such as lawyers, CPAs, financial advisors and other professional firms may go down a bit but never really goes away in a down cycle.
In fact, in recession years OBCs can see an up-tick in demand from independent consultants. Many provide services that were outsourced by large corporations as part of a downsizing effort. The consultants might be laid-off executives themselves. Small corporate branch offices will also often regroup in an OBC as a way to cut down on overhead and to better deal with the uncertainty of the corporate business model.
Diversified tenants, low transaction costs
The broad cross-section of industries and activities that make up the tenancy of an OBC provides a natural hedge against vacancy risk. Because an OBC in essence "retails" office space to small users on a short term, high velocity, basis there is little dependency on large tenants.
This, coupled with a high price-elasticity, makes it possible for an experienced operator to manage a center to full occupancy, irrespective of the real estate cycle. Transaction costs associated with re-marketing and re-letting vacant space are minimal. Which landlord would not like to do away with down re-letting time, free rent, brokerage fees, and expensive TIs?
Riding the real estate cycles
In an up market, the short term nature of OBC leases provides a convenient way to consistently reset rent income at market. Churn is good. In effect, the OBC provides investors and participating landlords the ability to ride the estate market cycles without locking themselves at or near the bottom.
An OBC provides clear economic benefits to its tenants, in the form of a shared infrastructure and value added services. In effect, tenants only pay a small portion of the conference room, reception area, T-1 line, copying room & telecom equipment, and they "pay per use" for other services without the associated overhead. Because of this, a well run OBC should generate a meaningful premium over market rates after paying for its own operating expenses.
A participating lease can be the right vehicle to make this happen. Under a participating lease, the landlord receives a fixed percentage of rent charged to the OBC sub-tenants. The percentage is set at a level which provides the landlord a meaningful premium over market rent, while providing the proper financial incentives to the OBC operator to ensure alignment in objectives and interest. The landlord retains most of the real estate risk and rewards while the OBC operator retains most of the operational risks and rewards.
Are OBC operators a good credit risk?
In essence an OBC operator "buys" space wholesale from the landlord, in the form of a long term lease and "retails" it in small chunks, 100 to 250 SF for the most part.
Under a traditional lease, the best collateral provided to the landlord by the OBC operator is the operation itself. In a down real estate market, OBC rental rates may go down but value-added service revenues tend to remain stable, while the demand for OBC flexible office space does not go away. A constant rent income flow from sub-tenants is the best collateral a landlord could wish for. Certainly a lot better than the "credit grade" quality once offered by the Enrons and Parmalats of the world! With an OBC the main assets are the sub-tenants. These are assets that stay in the premises and can't easily be funneled away to exotic places.
Under a participating lease, there is no real possibility of default. Lease agreements can actually be designed such that below certain performance levels the landlord can recapture the space for other use. The short term nature of OBC service agreements with its sub-tenants is what makes it all possible.
What makes a good OBC operator?
There are distinct differences across three main categories of players worth highlighting: single-center operators, regional players, and global players.
Single-center operators are typically not a good choice for centers in class A or class B buildings. As in any service business a professional approach with consistent Quality Of Service standards is critical. "Mom & Pop" operations tend to also struggle keeping up with technology, a very important and constantly changing feature in the connectivity services offered by OBCs.
Whereas bankruptcies are relatively rare with OBC operators, a couple of global, operators did run into financial troubles, specifically Regus and HQ. This was due to exponential growth at the peak of the last real estate cycle and an acquisition appetite their stomach could not handle. What's interesting is that very few of their "non-performing" centers disappeared from the OBC supply chain. In most cases, healthy regional players are picking up the pieces and quickly re-opening former Regus and HQ centers under a different name and management … to the landlord's relief. Both Regus and HQ suffered from corporate bulimia but their assets are generally healthy and both companies are expected to come back strong in a couple of years.
The most critical success factor in this low margin, service-oriented, OBC business is local economies of scale, bar none! This, coupled with operational and local marketing expertise, is the recipe for success. This is why regional operators are typically the healthiest and most successful players in the OBC industry.
Pacific Business Center (PBC) is a case study example of such a successful regional OBC operator. It operates five centers in the San Francisco Bay Area, enabling an optimal deployment of its workforce and marketing resources across the local portfolio with operational agility. PBC is also affiliated with the ALLIANCE Business Centers NETWORK with close to 450 locations worldwide. The Alliance Network is not only the largest OBC network of independent OBC operators in the world, soon with more locations than Regus and HQ combined, but its membership is healthy and growing.
This balance between global reach and local focus is the best recipe to maximize Quality of Service and customer satisfaction. This, in turn, enables PBC to run profitable operations and fulfill expectations from its customers, investors, and landlord-partners alike.
(*) Laurent Dhollande is the CEO of FlexAlliance, an advisory firm that assists Fortune 100 companies on the provisioning and management of distributed flexible office space. FlexAlliance also assists landlords in getting their supply of office space ready for a forthcoming explosive growth in demand for flexible office space. Mr. Dhollande firmly believes in the concept of a utility model for office space and is an active investor in Pacific Business Center, a California operator of Office Business Centers. Mr. Dhollande is a frequent speaker at professional real estate conferences. He can be reached at firstname.lastname@example.org.
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