On Friday, Boston Federal Reserve Bank President Eric Rosengren delivered a speech in which he pointed out a threat from co-working business models that few people had even considered (including myself).
Rosengren dropped a bomb by saying business models similar to WeWork’s could threaten the overall economy. He mentioned several elements of the co-working business model that haven’t really been discussed.
WeWork Is a Dangerous Cog in a Big Machine
The major flaw in the WeWork business model has been a topic of much concern and was significant enough to help torpedo the company’s IPO plans.
In normal commercial real estate transactions, a property owner takes out a mortgage and then signs a long-term lease with primary tenants. That tenant pays rent, over many years, that is in excess of the property owner’s mortgage payment.
If the tenant is unable to pay, the property owner usually has some kind of a lien or other recourse that he can collect on from the tenant. In the meantime, he may also be able to lease out the property to another tenant. Of course, in a recession, that would be very difficult.
In the WeWork model, a property owner will sign a long-term lease with WeWork or some other co-working parent company.
However, rather than sign a traditional long-term lease, the primary tenant structures itself as a “special purpose entity,” or SPE, which are known as being “bankruptcy remote.” That is, they can just walk away from their lease and the property owner has no recourse.
The property owner gets higher rents out of an SPE than they will a regular tenant because of that higher risk.
WeWork, or the SPE, then subleases the space into much smaller units.
They will rent co-working stations by the hour, day, week, or month. Those spaces may simply be a seat at a desk or community table, they may be small private offices, or they may be large conference rooms.
WeWork or the SPE will do an expensive and luxurious build-out in order to attract these sub-tenants. The revenue generated from these subtenants is theoretically more than enough to cover the long-term lease obligations that the primary tenant has to the property owner.
That’s all well and good until we hit a recession.
How a Recession Kills WeWork and Everyone Else
There is a legitimate fear that sub-tenant demand will dry up and do so rather quickly. After all, they don’t have long-term leases to worry about. They’re renting in the extreme short term. So that revenue vanishes.
Now, the primary tenant such as WeWork might normally have to make good on their long term lease commitment. But as an SPE, it no longer has to continue paying its long-term lease obligations to the property owner.
An SPE such as WeWork could just walk away from its obligation.
That, in turn, could cause the property owner to default on their mortgage. As a result, commercial real estate defaults start adding up. That has the potential to create a chain reaction and ripple through the entire American economy. We already saw what happened during the mortgage crisis, but this could be equivalent or worse.
As it happens, WeWork is less likely to do this because CEO Adam Neumann is himself landlord for a number of properties that WeWork signs long-term leases with.
That’s not the case with all of the other co-working businesses.
Thank the Federal Reserve
Rosengren also pointed out part of the reason this situation even exists is because the Fed has been too accommodative with monetary policy. By keeping interest rates so low for so long, it has enticed commercial real estate speculators to scoop up money on the cheap in order to fund their property purchases.
Indeed, Rosengren actually voted against the most recent cut in the federal rate.
That does beg the question to a certain extent because one wonders how the economy would even have improved as it has without such low interest rates.
Regardless, his comments do show that there may be hidden risks to the gig economy, or the short-term rental economy, that have not been considered.
Unseen Risks of the Gig Economy
We’ve already seen how rideshare technology companies, like Uber and Lyft, have devastated the taxi industry. Thanks to a combination of rideshare companies’ flouting of regulations, and municipalities not pressing their case, Uber and Lyft have invaded every major city. As a result, taxi drivers have seen their lives destroyed because the value of their taxi medallions has imploded.
With Uber and Lyft increasingly subject to regulatory authority, such as the recently signed bill in California that would reclassify drivers from independent contractors to employees, that could result in higher costs for rideshare companies. That would result in them requiring higher commissions from drivers, which would lower driver income.
Many of these drivers may have taken out auto loans in order to have a vehicle in which to use for a rideshare job.
As the chart below shows, auto loan delinquencies are now approaching the same levels as they were in the mortgage crisis. The aggregate dollar amount of delinquent loans has also skyrocketed.
That could lead to a huge default chain reaction in the auto loan market.
There may also be a hidden second mortgage crisis brewing.
Thanks to Airbnb and similar companies, there may be countless speculators who bought up properties with the intent to turn them into short-term rentals that would pay the mortgage.
That’s simply a residential version of the commercial mortgage problem just discussed.
Again, in a recession, short-term rentals may dry up and those property owners may default on their mortgages.
So as wonderful as these new disruptive economies may seem at first, it appears that society may have made a bit of a monkey’s paw deal that will come back to bite it.