The five Rs that shape flexible workspace joint ventures

There are key factors that lawyers should consider when drafting joint ventures between landlords and flexible workspace operators, writes Douglas Green. The flexible workspace market (FWM) has delivered very strong growth in recent years. In 2017/18, more than 21% of all commercial office leases in London (2.5m sq ft) went to flexible workspace operators. There are now around 5,400 flexible workspaces across the UK – of which 1,400 are in London. When this trend first emerged, landlords and building owners would typically grant a flexible workspace operator a straightforward lease for an agreed term. However, as landlords have gained a greater appreciation of the commercial advantages that can be generated from flexible workspaces, and operators have seen the benefits of working more closely with landlords, joint venture (JV) agreements between the two parties have become more common. They allow for a fairer allocation of the profits generated as well as a range of other benefits for both parties. Over the past year, GKRE has held a series of meetings with law firms, whose partners are keen to better understand joint venture agreements, their key features and how they differ from traditional leases. Our approach to joint venture agreements focuses on what we call the five Rs: Revenue Returns Responsibilities Rewards Relationship Revenue In traditional lease agreements, any discussions around revenues are much more straightforward. Typically, the quantum is the key focus. Agents usually take the lead in any rent negotiations, rather than the lawyers involved on the deal. However, in JV agreements, where profits are usually shared, this area requires greater legal focus. Lawyers need to have an understanding of profit and loss and core elements of the revenue need to be worked out and negotiated between the property owner and the flexible workspace provider, such as workstation income, meeting room income, any other ancillary income and how they are to be treated. Also, if revenue expectations are not met, which can be the case, then there needs to be an understanding between the two parties as to what provisions should be inserted in the JV agreement to address this. However, precipitate action should not be taken, as it is important to ensure sufficient time is given – typically a few years – for the operation to flourish. Returns Previously, operators enjoyed taking a priority return on their costs and fees. Today these are being re-balanced and the waterfall of payments looks very different, with both operators and property owners’ costs being more aligned. In the classic waterfall of payments, operating costs come before property costs. In some JV management agreements, fees have now slipped down the priority scale, while in others no fees are paid to the operators and the basis for the management agreement is a pure profit-share split. Currently we are involved in negotiations where the waterfall of payments changes over time to reflect the risk of the initial fill-up period. Responsibilities A key area for JV agreements is the division of responsibilities between the property owner and the flexible workspace operator. The operator clearly has responsibility for areas such as: running the marketing, attracting tenants, generating income from the operation, etc. However, there are a number of grey areas that need to be addressed in a JV agreement. The negotiations around the ongoing repairs, maintenance and dilapidations often consume significant time and energy. In most cases, the operator inherits brand new/fully refurbished space to an agreed specification. The ongoing repair and maintenance, while being the responsibility of the operator to facilitate, will most likely be recoverable through the profit and loss of the operation and, by definition, will be the owner’s/JV’s responsibility. Dilapidations at the end of the term is also a moot point, as consideration must be given to providing vacant possession and removal of fixtures/fittings depending on who owns them and making good damage caused by their removal. However, overall, the dilapidation provisions are significantly different to that of a lease and it is imperative that these are covered in the drafting of the agreement as they are often not considered in the heads of terms. Rewards This is a critical area of JV agreements. Both parties will have very different priorities on what rewards they want under the agreement. The operator will typically want a fee, either fixed or a percentage of gross turnover, for running the flexible workspace offer and will also want to share in the upside if performance surpasses the market notional rent. The property owner will want the operational and property costs covered and will be looking to recover capital deployed. In addition, building owners may have different reasons to enter into an arrangement and it might not be just for returns, instead they may be considering the longer-term aspirations they have for their assets. For some, the focus could be on the direct return from a JV agreement, for others, a flexible workspace in the asset may feed into a longer-term strategy of driving value in the whole building. Relationship How the JV agreement governs the relationship between the property owner and the flexible workspace operator – and also the operator’s tenants – is an important area. If a property owner signs a traditional lease agreement with a flexible workspace provider, the property owner typically has no relationship with the operator’s tenants. If operators leave a building they can take their tenants with them, as it is with the operator that the tenant signs an agreement. Under a JV agreement, the relationship with a flexible operator’s tenants can be negotiated. If a property owner is keen to have a direct relationship with such tenants, legally the operator must act as the “agent” on the owner’s behalf. This has become standard procedure and forms one of the main benefits of a JV management agreement, as it offers the benefit of the ownership and incubation of the tenants by the property owners. Drafting a JV agreement that covers the different perspectives of both property owner and flexible workspace operator is the challenge that lawyers face and one they need to master as these agreements are only likely to become more popular. The better understanding lawyers have of the broader flexible workspace sector, the more they will be able to draft agreements that satisfy both parties and also play a key role in the further growth of the market. Remainder While we believe the “five Rs” cover the main areas of JV agreements, there are, of course, other ancillary areas that need to be addressed. For example, the agreement should ensure a mechanism is put in place to separate all funds controlled by the property owner from those funds controlled by the operator. Another aspect to consider is the need to have controls over unbudgeted expenditure and ensuring the property owner has access to all pertinent business information upon any termination of the arrangements. There may also be a clause within the JV management agreement that set restrictions on trade both for the property owner and the operator. This will be likely to restrict both parties from creating another local joint venture management agreement in competition. Douglas Green is a director at GKRE