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What Have We Learned From Clockwise

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What Have We Learned From Clockwise

At Castleforge we foster an environment that encourages continued learning and development of each member of staff. Examples include skill-specific educational courses that team members are welcomed to take, our internal library filled with books (albeit many of which are still in pristine – i.e., unread – condition) or our Monday meetings where everybody on the team contributes something they learned during the week before. In this spirit, we thought we would take the next couple of pages to review what we’ve learned in our experiences so far with our Clockwise serviced office product.

We began our journey into the serviced office market back in late 2012 with a paper that outlined the business plan for what five years later would eventually evolve into Clockwise. We argued that a refreshed and better designed Regus was what numerous companies were looking for in order to provide flexibility as well as quality accommodation, and that moreover, they were going to be focused on the then-secondary London locations like Southwark, Clerkenwell and Shoreditch (we actually still have a copy of this paper to prove that we aren’t making it up!).

We did finally have the opportunity in 2017 to carry out the main idea of our original business plan by converting a section of the empty office space in Savoy Centre, Glasgow into a serviced office product. And it worked. Within 15 months of opening in May 2017, we were over 90% occupied on the private office space and over three times subscribed on the “club” membership which provides hot desking in the common lounge area. All this in the 1970s brutalist building that had once been voted one of the ugliest buildings in Glasgow but that is now experiencing a rapidly improving market perception.

The business plan worked so successfully that while we originally only fitted out approximately 30% of the office building as a Clockwise trial, we are now converting the majority of the office tower to Clockwise serviced offices. Upon full stabilization to an average 90% occupancy level, we are a net EBITDA per square foot on Clockwise that is typically 76% above market rents versus an overall cost basis to achieve this that is only 23% higher than “traditional” fit outs.

We have recently opened our second Clockwise location in Belfast and will open our third location in Liverpool in Q1 2019, which both comprise a combination of Clockwise serviced office and traditional space to lease on longer terms. While we monitor performance on the operational assets, we are entering design stages for our fourth and fifth locations in Bristol and London, adjusting our deployment of Clockwise accordingly. Through focusing on Clockwise we have made a number of observations that we would not have seen without this experience, and we felt it would be valuable to share some of these with you.

Flexibility vs. Convenience

We are not alone in discovering that, given the choice, tenants typically prefer more flexibility around office size and more convenience of having a pre-fitted office space. What is a little less intuitive is that different sized occupiers value each of these two benefits to varying degrees.

Our experience has shown us that most smaller and medium-sized enterprises, especially in UK regional cities, are not tech and software businesses that grow from two to 200 employees overnight. Many have the same number of employees that they did a few years ago, and even if they are growing, it is not at an exponential pace. Thus, the flexibility of being able to scale up and down on space is helpful but not essential. However, we learned that many of these tenants immensely value the convenience of serviced office space that is already fitted out. These tenants are not equipped to become temporary real estate experts by finding and negotiating with a contractor and architect to fit out their office space. Moreover, few have tens of thousands in cash lying around to easily pay the upfront costs to fit out an office, especially considering that this space may become obsolete faster than anticipated if the tenant undercooks their internal growth estimates.

One example from Savoy is a 15-person recruitment business that took space in a Clockwise unit. Initially, they asked for a small discount of 5-10% in return for signing up to a two- or three-year term rather than the standard month-to-month contract that we offer. Instead, we offered them space in our other building at 58 Waterloo Street nearby on a three-year lease. The occupational cost of this would have been ~£45,000 versus ~£55,000 per year in Clockwise, a 20% saving for the tenant, while the initial rent free provided by us would have covered their fit out cost, keeping the overall capital cost the same over the three years in a demonstrably “better” building in a core CBD location. This sounds like a superior deal, but they still chose to take Clockwise at Savoy at the full rack rate, citing two reasons: first, their lack of desire to pay upfront the £50,000 or more for a security deposit and fit out cost and second, avoiding the need to find someone internally who would take the time to work with an architect and contractor to design and fit out the office as nicely as we had done for one of the 15-desk units at Clockwise.

Turn Key Solutions

It may therefore not come as a surprise that due to our experience with Clockwise, we’ve updated the way we think about how we lease smaller floorplates (below ~5,000 square feet). Rather than provide a white box for tenants to take on traditional leases where they themselves have to fit out their space, we have begun to also offer a fit out option on the smaller floorplates to a turnkey stage (meeting rooms, furniture, desks, toilets and all) where a tenant can sign the lease and begin working the very next day.

The turnkey solution is certainly beginning to pay dividends. A typical “white box” lease we had completed at 58 Waterloo Street was at £25 per square foot over half a floor with 18 months of rent abatements on a 60-month lease, equating to a net effective rent of approximately £18 per square foot. Compare this to our latest discussion on a turnkey half floor in the same building at £27 per square foot with virtually no rent abatements on a three-year lease, so still about £27 per square foot net effective, resulting in a 50%+ gain on net effective rent. Marginal fit out costs and exit yields must be considered in the round as well, but we have calculated that the increase in net effective rent more than compensated for either of these increases. Equally importantly, the velocity of leasing was materially improved as a result of the Cat B turnkey fitout as the switching costs for potential tenants to come into Waterloo Street were significantly lowered.

We expect to continue the strategy of providing a turnkey solution, and we are finding that we’re not the only ones. We note that the likes of Great Portland Estates and Derwent London, who often deal with smaller floorplate occupiers and who have had a more difficult time recently as those smaller occupiers have used serviced office as a substitute to traditional leases, are themselves fitting out the space to a turnkey finish so as to win back tenants from the likes of WeWork and The Office Group.

Larger Corporations

On the other hand, many large corporations do have real estate experts in house and do have a significant amount of balance sheet cash on hand, so still do take “traditional” leases. However, these businesses are all looking for ways to improve their operating margins, and they realise that what they spend annually on real estate is one of the most inefficiently utilised items in their income statements. We note that recently, Ernst & Young (“E&Y”) announced that they are looking to increase the proportion of flexible offices in their estate from 10% to 30% in the UK and Ireland. E&Y has already gone from zero flexible office space to 10% of their portfolio in the past two years alone, but understands that in order to be agile and efficient with the use of space they will need to triple the amount of flexibility they currently have.

Again, back at Savoy we’ve recently signed a 25-desk lease at Clockwise on a month-to-month basis with a major blue chip corporation. They told us that while they do have space already around the area, this was for a specific project team. While this would make this year’s cost for the project team higher, they would be able to quickly eliminate costs associated with the team should that project ever be cut. As landlords, this ability to provide both “traditional” leases and flexible space in the same building has served us very well, and sure enough this same tenant’s interest was piqued, and they are seeing what
traditional leases over certain floors would look like. This combination is occurring elsewhere in our portfolio. At our Liverpool asset we have also experienced blue chip tenants approaching us on a 5-10 year lease basis because the building also provides overflow space for them through Clockwise that can eventually be converted into an additional lease if required. Even if we charge a higher rent per square foot, this is still a more cost-effective option for the larger tenant versus taking on a longer-term lease for more space than required, just in case they need more in the future. As a landlord we also possess more negotiating leverage given that we are reducing the number of vacant floors available in buildings where we deploy Clockwise, creating some scarcity of space for these larger tenants.

Clockwise Outside the UK

Since the referendum vote in mid-2016, we have maintained an analysis of the dynamics of supply and demand in select European cities, since we believed that some could one day become competitors for the universe of UK tenants who need to remain within the EU. When doing like-for-like comparisons of serviced office product, one of the most interesting things we have found was that while serviced office as a product is far less developed and sophisticated on much of the continent when compared to UK regional cities, the serviced office desk rates are often higher than they are in UK regional cities. Furthermore, we noticed that acquisition office values per square meter in many cities on the continent are not too far apart from what they are in UK regional markets.

Further, while competition amongst serviced office providers is lower than in the UK regions, and desk rates are sometimes higher than in the UK regions, the cost basis for construction is pretty similar. This implies that achievable yields on cost are higher in certain markets in continental Europe. When you factor in that borrowing margins and the bank risk-free rate are both lower, the degree of positive leverage for serviced offices on the continent begins to look much superior to that achievable in the UK regional markets. We have been monitoring select markets where we think we can create a competitive advantage, though we are being judicious with our resources in doing so.

Even considering these advantages, we are careful about where and how we use Clockwise to ensure each new location is designed and managed to achieve its full potential. We also keep in mind that Clockwise is not “one fits all” solution, and so we are careful to select the type of buildings and locations that best suit this offering while also limiting liquidity risk on exit. However, we believe this tool enables us to create complementary portfolios in key markets where we can maximise our operational advantages and maintain a defensible portfolio mix of tenants.

21st February 2019

Market Commentary