Could WeWork bring down Manhattan’s commercial real estate market?

Everyone loves WeWork, right? They have well-designed spaces in the best neighborhoods in cities. They’re a sort of physical manifestation of our entrepreneurial desires. Seriously, a bunch of good looking, plaid-shirted people drinking artisanal coffee and building wireframes of apps and whiteboarding video marketing spots? That’s just… cool.

So cool, that the Wall Street Journal just reported this week that WeWork now occupies more office space than anybody in Manhattan, just passing JPMorgan Chase. You know, the biggest bank in the country, with $2.5 trillion with a T in assets.

It’s really a testament to how much people love WeWork.

But its also sort of a problem. Or at least could easily become a problem.

The article noted,

WeWork is one of the biggest and fastest-growing of the “flex space” office providers, a group that also includes Knotel Inc., Industrious Office and IWG PLC. These companies rent office space from building owners, then sublease it for as short as a month or up to three years. They offer tenants greater flexibility than do traditional landlords, which typically lock in renters for a decade or longer.

In finance, this would be called a duration mismatch. If you’re managing a pension portfolio, and the average person in your plan is 20 years from retirement, you’d want all the assets in your plan to have a duration of 20 years – that is, to make sure any changes in the value of the liability (how much you must pay pensioners) are offset by changes in the value of that pile of assets (how much you’re investing now to pay them in the future). And note, it isn’t exactly linked to “years” in practice, but for simplification sake, we’ll run with it. This gets mathy because the change in the value of a 1-year Treasury note acts differently than the change for a 30-year Treasury bond when interest rates move.

All this is to say that this duration mismatch makes WeWork’s strategy incredibly risky. If they enter into a 30-year lease on some commercial real estate space, and sub-lease it for 6-months, 1-year, or 3-years to companies, they are banking that they’ll be able to replace those tenants with other tenants who can pay the same amount in a few years.

But what happens in an economic downturn? There will be less demand for that real estate space, so WeWork will either have trouble filling its space, or will cut prices to draw in customers. But at the same time, they have the same lease payment to make for their own lease on the space.

Anyone who has lost a job or has taken a pay cut when they have a mortgage knows how stressful this is. And when there’s a much bigger recession things can get ugly. Just think back to 2008 and 2009, when the entire US housing market fell into tatters because of an economic downturn.

That’s sort of the kind risk WeWork poses to the New York commercial real estate market. What if an economic slowdown puts pressure on smaller companies and entrepreneurs to cut costs? What then happens to all that commercial real estate space WeWork is leasing in New York? What kind of effect could that have on the bigger real estate market in the US?

JPMorgan is able to withstand a recession. They have a ton of money, and can raise capital quite easily. WeWork, on the other hand, is a private company that relies on private equity funding, but has also tapped into the bond markets for financing.

The results have been less than stellar. The WSJ wrote a story right after the first bond issue in April titled, WeWork Bonds Fall As Debt Investors Question Startup Stories. The bonds have recovered since then, but are still trading below par.

And oh yeah, the economy is humming along right now. WeWork’s story might get a lot more interesting when things get choppy.

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