Fed's Rosengren flags risks to economy in WeWork-style model

(Reuters) - The rise in co-working spaces, like those offered by WeWork, may be a source of financial instability that could make the next U.S. recession worse by sparking a run on commercial real estate, Boston Federal Reserve Bank President Eric Rosengren said on Friday.

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While commercial real estate valuations and lending standards have been a persistent worry for Rosengren, it is the first time he, or any Fed policymaker, has publicly focused specifically on risks from the rise of such flexible workspaces to the overall U.S. economy.

“I am concerned that commercial real estate losses will be larger in the next downturn because of this growing feature of the real estate market, which could ultimately make runs and vacancies more likely due to this new leasing model,” Rosengren said in a speech at a credit markets conference at New York University’s Stern School of Business. He did not mention WeWork or any other company by name.

Rosengren also explained why he dissented against the central bank’s decision earlier this week to lower borrowing costs for a second time this year.

Office-space-sharing companies often use special purpose entities to lease space, in order to shield themselves in case of bankruptcy, he said. “The basic model provides you the opportunity to, in effect, not be required to pay your lease off,” he said. “Eventually if there are enough vacancies in that building it means that banks are going to take losses.”

That puts more potential stress on the property owners themselves in case of a downturn. But shared office space often pays higher rent than other types of commercial offices, making it an attractive option for property owners trying to squeeze more yield out of their assets in a low-interest-rate environment, Rosengren said.

“It will not be until a recession that this evolving model will be truly tested,” he said.

WeWork’s swelling lease obligations, and the potential risk to revenues if tenants vacate during a downturn, have been one of several issues that have soured investors against the company’s planned initial public offering.

WeWork owner The We Company this week postponed its initial public offering after weak demand for its shares forced it to dramatically discount the expected IPO value to between $10 billion and $12 billion, down from the $47 billion valuation it achieved in January.

“The fact that the shared office model relies on small-company tenants with short-term leases, combined with the potential lack of recourse for the property owner, is potentially problematic in a recession,” Rosengren said.

WeWork declined to comment on Rosengren’s remarks.

Flexible workspace operators have been one of largest drivers of leasing growth in major U.S. cities, led by Manhattan and San Francisco.

Brokerage CBRE Group CBRE.N said last week that it expects the U.S. market for flexible work spaces to generate significant growth over the next decade, with its baseline forecast calling for the service to expand to about 13% of U.S. office space by 2030. Brokerage Jones Lang LaSalle Inc JLL.N has estimated it could account for 30% by then.

“It’s important to think about the potential for runs on commercial real estate stemming from a situation where short-term leases might not be renewed in recession, and long-term leases are no longer economically viable,” Rosengren said.

Reporting by Ann Saphir; additional reporting by Herbert Lash and Jonnelle Marte in New York; editing by Chizu Nomiyama and Leslie Adler