Flex Office Spaces: Balancing Freedom and Structure With Drew Cunningham, Real Finds Podcast #35 Transcript
Gordon Lamphere: Thanks for checking out the Real Finds Podcast. On the podcast today, we have Drew Cunningham. Drew is CEO of The Dilweg Companies, a real estate investment firm focused on the Southeast. On the podcast, we talk about short-term and flex work, the future of flex office, how to manage and really get into the weeds of flex office, and implementing flex strategies in a traditional office portfolio. If you’re an office investor or looking at changing up your portfolio, this is a must-listen episode. Drew, thank you so much for hopping on the podcast today.
Drew Cunningham: Thank you. Thanks for having me.
Gordon Lamphere: Why real estate? What got you into the business?
Drew Cunningham: Not a very complicated answer. I went to Villanova University’s business school, and when I graduated I needed a job, like everybody else. I had an opportunity with a townhome developer in New York, it sounded really interesting, so I went for it. That’s what started me.
Is Office Dead?
Gordon Lamphere: You’ve worked for some of the biggest names in the business and some pretty large REITs. The “office is dead” narrative is everywhere. What are you seeing from your perspective?
Drew Cunningham: There is some of that. We’ve had a pretty big behavioral change since COVID. Flexible work environments have been around a long time; I had my own company for a while and was pretty flexible with my employees. But the work-from-home scenario is new over the last few years, and I do think it’s here to stay. It’s had a fairly significant negative impact on current space users, who have contracted their footprints, and on demand. So it’s not great. Does that mean office is dead? No. There’s a lot of space on the market to absorb, but as the economy recovers and companies grow, not all that growth is going to be in people’s living rooms and dens. Office is far from dead. It’s just going to take a while to get back to a healthy vacancy rate.
What Flex Office Actually Means
Gordon Lamphere: What is flex office? The word flex is thrown around so often in real estate.
Drew Cunningham: Great question, and I ask it frequently. When people talk about flex, the first thing I say is, let’s get straight with each other. A long time ago, I was at a public company buying flex properties in Florida, and that was single-story commercial space with some component of office and some component of warehouse or distribution, and depending on where the wall between those uses fell, that was flex. You could flex to more office or more distribution. That’s not what people are talking about today. What people mean now is better described as flexible-term space. That’s a completely different animal: regular office space where the terms are flexible for the tenant. They don’t have to sign a five, seven, or ten-year deal. It could be six, nine, twelve, or eighteen months, kind of like how WeWork used enterprise space.
Gordon Lamphere: What’s driving the demand, and what’s holding it back?
Drew Cunningham: Let’s start with how it evolved, because it’s relatively new. I’ve been a landlord for over thirty-five years, and with the exception of coworking, which is a type of flexible space we can set aside for a moment, I was not very interested in flexible space as a landlord. Flexible-term space isn’t really a value adder. The way we create value in commercial real estate, office in particular, is by creating rent rolls with a lot of credit and a lot of WALT, weighted average lease term. Flexible space decreases your WALT. So when people value your building, if you have a lot of flex space, or even just very short WALT, they’ll apply a much higher cap rate, which means less value. I’m not sure we have clarity on an answer to that yet, and it’s a big concern for me as tenants continue to want flex space. It’s great for cash flow, but not so great for value creation when you cap it. It’s new enough that we haven’t figured it out. Is there a time down the road when some portion of office buildings act like hotels, where tenants come in on very short terms, and there are enough of them that rollover is continual and downtime is small, so you can apply a lower cap rate and it’s not a value inhibitor? That’s possible, but we’re not there yet. From the landlord’s perspective, it’s a challenge. From the tenant’s perspective, I totally get it. Flexibility and optionality are always great for tenants. Put yourself in their shoes and it makes complete sense.
Cash Flow Versus Value
Gordon Lamphere: As an operator of about two million square feet of office in Chicagoland, give or take, what we’ve seen consistently is that our small flexible spaces have been great at reducing vacancy, bringing people into the building, and acting as incubator or semi-incubator spaces. But they take a lot of effort, and with today’s build-out costs, they’re often not that profitable, or profitable at all. Are you seeing flex office as a semi-incubator, or as a profitable avenue?
Drew Cunningham: It can definitely act like that, and I’d agree. We’re seeing the same things, which is why there’s friction between owners and users right now. On your cost comment: on a seven-year lease in a good submarket, you might spend $75 a foot in TI today to get a tenant into their suite. For flexible-term space to work, it has to be super attractive. Spec suites were, and still are, a great thing to have. In the beginning, people built spec suites like regular tenant space, then added bells and whistles, and most recently I’ve seen landlords spending $125 a foot to make them almost extravagant so they lease quickly. That’s great for cash flow: space that might have sat vacant until you built it for a longer-term tenant is now leased and collecting money. But I come back to this: if it’s not term, and you go to sell the building, how is that space capped? Say a building is fifty percent flexible-term and fifty percent normal office, and it’s a hundred percent leased. Before interest rates and all that, a buyer might apply a seven and a half cap to the fifty percent with seven years of WALT. But if you’ve done a bunch of one-year, eighteen-month, or two-year deals with ten tenants on the other fifty percent, what cap rate applies to those? There’s really no WALT, and your build cost was super high. To me, that’s a problem.
Now, my viewpoint comes from being historically a value-add buyer and owner of office. Our typical hold is three to five years, so what I described doesn’t work great for that owner. Where it may work well is for REITs, for example, where cash flow is important and they’ll hold the real estate for a very long time. They’re less concerned about the exit cap rate, because they’ll work through peaks and valleys and sell at a strategic time. For them, cash flow is great. So I think there’s a place for everybody, but it depends on who the owner is and who the users are.
Gordon Lamphere: From what you’re seeing in the Southeast and the Sun Belt, which saw less decline from COVID, is the national vacancy rate the primary driver of the rise of flex space, with landlords more willing to bend over backwards for tenants, or is it a change in demand?
Drew Cunningham: There’s a lot there. It doesn’t matter if you’re an A, B, or C owner, public or private, a long-term holder or a short-term flipper: our enemy is vacancy. That’s a fact. Real estate owners attack that problem. Office owners are a competitive, smart group of people, and they’ll consider anything if it leads to space being leased. The question is whether leasing the space that way is a good thing, and that’s where the friction comes in. I’m a big fan of spec suites, because the term is typically three to five years, at least in our experience. We don’t really do one- or two-year spec suite deals. Shorter term creates a problem depending on what kind of owner you are. But people will do it because if it leases space and solves a problem, maybe that’s good. Sometimes, depending on the pressures you’re under, you solve the short-term problem and worry about the long-term repercussions later.
How Much of a Building to Dedicate to Flex
Gordon Lamphere: You’ve been successful in the Southeast at developing solid leasing and flex strategies. What’s your ideal strategy for flex space that works for a five-year hold?
Drew Cunningham: In the assets we own and going forward, there’s a portion of a building we’d like to dedicate to some kind of flexibility. Real estate is very local, so it varies from city to city and submarket to submarket. We’ve moved in this direction and been successful, and we’ll continue. We’ve dedicated floors to spec suites, and that’s worked. For actual flexible-term space, I don’t know if it’s ten or fifteen percent of the building. I get uncomfortable if it’s more than that, for the reasons we discussed. But that’s the kind of owner we are. Different owners will develop their own tailor-made strategy with some portion dedicated to it.
Gordon Lamphere: On flex terms, we’ve been hesitant to go below six months. The costs add up, and amortizing them over six months just doesn’t work. Six to twelve months is our bread and butter, where folks want to stay a little longer, and even if the lease doesn’t work out, you don’t lose money. Is that your bread and butter, or are you looking at one- or two-month leases?
Drew Cunningham: Not one or two months. For me, short term is a year plus. I don’t think we’d do anything under a year. A year to two years is what I think of as flexible-term space. One thing we haven’t talked about is that there’s a rent premium with flexible term, which helps offset things, and it’s interesting what that premium can be. We had WeWork as a tenant, they defaulted, and we inherited some of their tenants and got a good look at the rent they were paying for eighteen-month and two-year space. I’ll be honest, I was shocked at the premium. WeWork delivered services that justified it, and we wouldn’t deliver those same services, so maybe we get less of a premium. But to be concrete: in a building where our rent was $32, there were WeWork tenants paying in the low fifties. That’s massive. There are a variety of reasons for that, and some are things we just can’t do.
Amenities: Know Your Audience
Gordon Lamphere: We’ve worked with landlords on the fine line between services tenants demand and are willing to pay for, versus luxuries that don’t add substantial value or improve leasing. What have you found tenants actually demand versus what’s extravagant?
Drew Cunningham: I love this conversation, because in commercial real estate there’s always an issue du jour, and it may last years. Even in lease negotiations, every tenant focuses on some hot-button clause for a year, and a year later it’s a different clause. Amenities are an issue du jour that’s lasted a lot longer than a day. We’ve focused on it because office owners are competitive and will do whatever it takes to win tenants. Years ago it was having a fitness center. Then fitness and being green. Then fitness, recycling, green, LEED, energy efficient. The list keeps growing, and they’re all good things. Since COVID, it’s battling work from home: the tenant’s problem is also the landlord’s problem, because the tenant needs to attract employees and needs attractive space to put them in. So what amenities do tenants want? I’ve spent a fair amount of time on this. There’s no one size fits all, and it’s very divergent from A to C.
We are not a midtown, downtown, high-rise, trophy, best-in-class owner. We’re a B to A-minus suburban owner with some urban property, a value-add company. We find things that are broken, do a big capex spend to make them pretty and fix the problems, then increase the rent and lease them. So having the right amenities is very important to us. We surveyed our tenants about a year ago, because we wanted to make them sticky and thought the right amenities would help retention and attract new tenants. I was pretty shocked. I expected: we want hub space, social space, state-of-the-art fitness, meeting rooms with all the AV equipment, specially cleaned air, yoga on the lawn, we want it all. That’s not what we heard. For our tenant class, B to B-plus, the answer was clear: we want a very well managed property. We’re in the South, so we want it cold in the summer. Clean, cold, cheap space. Very few said, I want a fitness room or meeting space. Now, if you surveyed the super-high-end trophy space with super credit, you’d get a very different answer: fitness, meeting space, green initiatives, all incredibly important. So the answer on services and amenities is: know your audience and cater to it.
Gordon Lamphere: I couldn’t agree more, and we’ll link to another episode where we talked about surveys. Surveying your tenants is one of the most important things you can do. We found similar things in our market, though it’s different from the South. People wanted great parking, covered or close, because Chicago winters are brutal. For any investor or broker trying to lease their properties: survey your tenants, and follow good methods, not just a random SurveyMonkey. On what actually leases and is effective long term: how does somebody take that short-term tenant and create value with a long-term tenant? Or are we still working that out? We’ve had some success building on startups, but we’re still creating a long-term solution to reconfigure perceptions of office. How do you make the jump from the one-year tenant to five years in premium A-minus space?
Drew Cunningham: Again, there’s probably no one answer. You made the comment earlier about shorter-term tenants acting like incubators. That’s true, and we’ve had many examples. That’s a plus. And even leasing short term, cash flow is good. But I don’t mean to over-harp on this: it really depends on who you are as an investor and owner. If you’re a shorter-term holder, flexible term is tough to wrangle with. If you’re a longer-term holder, it’s more sensible.
Gordon Lamphere: What’s the biggest barrier for flex space valuation in the short term? A lot of people on a five-year plan are worried about it.
Drew Cunningham: It’s new. Anything new and immature, people don’t know how to value or treat, because they don’t know how it behaves. It’ll take time. If you had an eighty-thousand-square-foot building that was all short-term flexible leases, you’d probably have a very high cap rate applied, because people wouldn’t have confidence in dependable occupancy. Will portions of office one day evolve into a hotel-like scenario, where a six-month term isn’t abnormal? Possibly. We may end up there. But before buyers apply reasonable cap rates, it’ll have to prove itself. Cap rates are all about dependability, and right now it’s undependable. Time will fix that. If the concept evolves and becomes dependable, it’ll be treated differently in valuations.
Training Staff for Short-Term Leases
Gordon Lamphere: We live in a world of known unknowns. One thing we’ve struggled with, and gotten effective at, is creating long-term procedures for this changing reality. Training on-site staff to deal with six- or twelve-month leases is hard, because it’s constant renewals, almost more like residential than traditional five- and ten-year office leases. What are you seeing in training property managers and staff, given your portfolio size?
Drew Cunningham: It’s a different mindset, and it starts with the leasing team. You have to change the way they think and market, being open to shorter term. Then yes, it’s more burdensome on property management: move-ins, move-outs, rollover. Sometimes tenants are unkind to the space, even in twelve months, so on the way out you’re making repairs or spending more TI on a space over and over. When people do flexible-term space well, like spec suites, it’s an expensive build, because you want very attractive space. If you’re doing it right, you’re spending a lot up front to make it last, and then a little every time somebody rolls out. Occasionally, even on an eighteen-month term, a tenant asks you to move a couple of walls, and you have a decision to make. A few walls isn’t a big deal. More than that drives your cost up, and we don’t love that.
Gordon Lamphere: It’s a totally different mindset. For investors looking at reevaluating their buildings and adding flexible space, what strategies should they adopt besides training staff?
Drew Cunningham: Here’s what I wouldn’t do: jump in with both feet and turn a third of your building into flexible-term space. Your market might not even want it. Like anything in investment, do your homework. Make sure market support is there. Spend a lot of time with the tenant rep community. We make a ton of effort with tenant reps on leasing in general. Those folks know their clients and their needs, and they’re happy to communicate with landlords. Talk to them a lot before deciding. Then remain fairly conservative. Stick your toe in the pool, in a small way, and if it works, grow it. Just because you build out short-term space doesn’t mean it leases. We’ve had a floor or half a floor here and there that we built, invested in, and marketed, and it took a long time to lease. We eventually did, but our expectations were higher than the results in those examples.
Gordon Lamphere: We started with ten spaces in our portfolio, and now it’s maybe ten or fifteen percent of the total. So dip your toe in the water. Don’t do a cannonball, because you’re going to learn so much.
The Final Four
Gordon Lamphere: We like to do the Final Four, where we learn more about you and your philosophy on life, real estate, and business. First, one of my favorites: ten years from now, what will have changed most about the real estate world?
Drew Cunningham: You can see it coming now. Technology is a huge factor. Think about where we were ten years ago versus today. Simple things like VTS, which a lot of people use, give you insight on your phone into your total leasing pipeline at every building you own in a detailed, sophisticated way. It’s been around a bit more than ten years. All the energy management and building technology we have today that we didn’t have not long ago just gets better and better. Buildings become more energy efficient, better for the environment, lower carbon footprint. The sophistication of real estate as an industry will keep increasing. That’s one. The other is use, and not just office. The world is changing rapidly in how people approach all real estate: inline retail, malls, hotels. There’s a short-term rental industry popping up and maturing right in front of us, apartment-like units you rent for a couple of nights or a few weeks on hotel-like stays. That’s really flexible-term apartments. All of those things will continue to evolve and mature over the next ten years.
Gordon Lamphere: One guest said real estate is going to evolve into much more of a consumer good than it’s been, and based on our flex space discussion, I think we’re headed there. Now let’s go back in time. Drew, if you could give yourself a one-minute spiel of advice at the start of your career, what would it be?
Drew Cunningham: I talk to a lot of young people graduating college who want to get into real estate. I have three sons, so their friends ping me about a career in real estate. The number one thing I tell them, which I wasn’t focused on when I started, is that it’s a cyclical business. You have to be prepared for the ups and downs, and not everybody is built for that. Some people prefer to be steady, with less fluctuation. If you want a career in real estate, you have to understand its peaks and valleys and know how to navigate them. When things are going well, sock money away and be smart, because eventually bad things happen and you’ll have lean years. It ebbs and flows. That’s my best advice. I don’t think young people focus on that, and I wish I’d been more aware of it myself.
Gordon Lamphere: I wish more young brokers took that mentality. As fourth generation, I’ve seen ups and downs since childhood. During COVID, a huge portion of my portfolio is industrial, but there was still a period of about three months when almost nothing happened, because everyone was so scared. Three months, no deals, no commission, zero dollars. Brokers who started in the Goldilocks period from 2020 to 2023 made so much money, and now they think the good times will keep rolling. That’s probably not the case. There are plenty of investment, office, and other brokers about to really struggle, and I hope they saved a nest egg, because the next eighteen to thirty-six months could be rough.
Drew Cunningham: Imagine you graduated college and got into brokerage in 2010. You’ve had a nice run. You’ve never seen bad. But bad happens. I’ve got third-party leasing providers, the Cushmans, the JLLs, the CBs, some of whom haven’t done a deal in a year or two. It’s really hard, and these are very successful people who’ve done extremely well, made lots of money, and are great people. This is tough on them. You need to understand that and be smart when you’re winning.
Gordon Lamphere: I can be a bit of a sap on this podcast, but if you have a friend in brokerage going through a hard time, reach out and call them. I know enough people who are really struggling right now, and sometimes a call can save a life. On a happier note, let’s switch to books. What’s a book that’s changed your life, that someone interested in business, real estate, or just life should read?
Drew Cunningham: I hope this isn’t too corny. I work very hard, so I like to shut off with trashy books, lousy TV, or sports. That’s how I shut my brain off. But one book I thought was fantastic is Lone Survivor. I wouldn’t call it trashy at all. It’s a book you read for pure mental relief and excitement, an incredible story about Navy SEALs that became a movie, and probably one of my favorite books ever, just for pleasure. On the business side, I’m a big fan of Ray Dalio. His book on the changing world order is, I think, his most recent. I’m from Long Island, and Ray is on Long Island. Obviously a super successful guy. It’s a super interesting book about the evolution of people, societies, and debt, and how they peak and crash. It’s very apropos for today, with all the debt issues and geopolitical problems we have. It’s a heavy read, but he highlights the important parts in the book, which makes it an interesting read.
Gordon Lamphere: I’ve got to check that out. He sounds like a true business manager, highlighting the important parts. And Marcus Luttrell and Lone Survivor, phenomenal book. I read it the summer before law school. Now the most important question. We bring on folks like you because you’re in the arena and know what’s going on, and you have unique insight into who we should bring on next. Who’s the next guest?
Drew Cunningham: Commercial real estate, and the office business I know best, is made up of a lot of great people. It’s one of the great attractions of the industry: people are great, they like to have fun, and it’s a social business. So it’s hard to pick, but there’s one voice right now that seems to be in front of the pack, and that’s Scott Rechler at RXR, another Long Island guy, as it happens. Everything I hear from Scott is right on. He’s the kind of guy who doesn’t mind hitting you between the eyes with reality, even if it’s unpopular, which I appreciate. He’s vocal about what’s happening: the impact of debt, interest rates, rising cap rates, tenants’ use of office, repurposing buildings. A very smart, successful guy, and I like his clarity and approach. If you could get Scott on, that would be a good land.
Gordon Lamphere: I’d love to reach out. One final question: if somebody wants to reach out to you, what’s the best way?
Drew Cunningham: Email is probably best: [email protected], D-I-L-W-E-G.
Gordon Lamphere: Drew, thank you so much for hopping on the podcast today, and we’ll have to have you on in the future.
Drew Cunningham: Thank you, Gordon. I appreciate it. It was fun.
Gordon Lamphere: Thanks again to Drew. If you enjoyed the podcast, please give us a like, a follow, and a subscription. All your interactions truly matter and help us get guests like Drew. You can find us on YouTube, Spotify, or wherever you get your podcasts. I’m Gordon Lamphere with the Real Finds Podcast. Thank you for listening.
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