Coworking Is Killing Off Dilapidations, So Who Should Foot The Bill?

The explosion of serviced offices is transforming all elements of the UK real estate industry. There’s surely not a single landlord left who isn’t aware of the march of WeWork and its contemporaries, alongside tenants’ desire for more flexible lease terms.

Although the breadth of the serviced office and coworking offering is good news for tenants, it is creating a confusing playing field for landlords. There are now so many ways to let space, either on a short-term or long-term basis, that leases can grow complex. One area of real estate that shouldn’t be overlooked is dilapidations, where the market’s impact isn’t necessarily falling in a landlord’s favour.

Traditionally, landlords could expect a healthy dilapidations payment at the end of the lease to cover the cost of restoring the property. The situation is getting less cut and dried as landlords lease space to serviced office operators, or even offer plug-and-play space themselves. If they don’t prepare now, they could be considerably out of pocket once the tenants have left the building.

The Vanishing Dilapidation Payments

Serviced office or coworking leases are typically all inclusive, which means that dilapidations effectively don’t exist. Instead, the rent might be slightly higher to compensate the landlord for the deterioration of the building, or there will be a set exit fee per square foot set at the beginning of the term. So far, so good, although it might not work out this way.

“There are several risks for landlords in this situation,” Hollis partner Ashley Winter said. “Firstly, have they recouped enough? If the tenant significantly alters the place, what’s their recourse? They need clauses to protect themselves. If the coworking bubble bursts, for example, they can’t rely on the tenant to pay to change the building into what comes into fashion next.”

Landlords take on an added risk if they choose to fit out a space themselves. Ten years ago, it was rare for a landlord to fit out space; instead, space was left blank for the tenant to make their own decisions. Today, landlords are increasingly considering leasing a building or perhaps a couple of floors on a plug-and-play basis, ready for the tenant to step in the door. This might include creating meeting rooms or breakout areas such as a kitchen.

The trouble is, how can the landlord guarantee that the next tenant will want the same kitchen or meeting room layout? Though the rent will be higher, redesigning and fitting a space for a tenant can be a significant cost.  

A second risk for landlords is whether they have been proactive enough about saving the additional rent to cover the cost of repurposing the space at the end of the tenancy.

“Is the landlord ring fencing that money or making hay while the sun shines?” Winter asked. “It’s possible that a landlord’s finance model will leave them short at the end of the term when faced with a refurbishment bill.”

Not Only Offices

It’s not only office landlords that need to consider dilapidations within a flexible lease. The coworking phenomenon has spread to other areas of the real estate market.

“We have seen a rise in retail and industrial property owners offering flexible lease terms,” Winter said. “For example, industrial operators have started to offer small units on flexible terms so the company can take more space as they grow. It’s written into the contract that if they take more space in the same facility, they won’t be pursued for dilapidation costs.”

In this situation, the landlord is banking on benefitting from a growing tenant. However, someone will still have to pay to refurbish the space for the next tenant.

The best way to counteract dilapidations risks is take early precautions, Winter said.

“If landlords make sure they have someone to assess what likely dilapidations might occur, for example on a three-year term, then they can recuperate enough for that,” he said. “They then need to make sure that money is saved.”

When fitting out a plug-and-play space for a tenant, staying as neutral as possible is the best solution. For example, a landlord could fit dividing walls to create meeting rooms to provide some flexibility and future-proof the space.

Traditional leases are becoming a rare breed, as the nature of taking space has evolved, a situation that is only set to increase. To avoid a sudden financial shock, a landlord needs to think ahead. The only certainty, however, is that serviced offices are set to continue to grow.

This feature was produced by Bisnow Branded Content in collaboration with Hollis. Bisnow news staff was not involved in the production of this content.