Let's assume Investing Stoics is becoming a growing startup; There is so much to do that I can not handle it alone. I decide to hire ten employees to help with content creation and operations. Now, I am scouting for an area to set up our office and am hit with multiple problems. What if my business continues growing, and the company requires a hundred employees? Should I get a bigger office? What if bad days are ahead, and I have to fire everyone else? Now, what's the point of having an office? Even if I find the right office size, I have yet to raise any funding, so how do I spend lakhs of rupees(or even crores) to set up the whole place? Do I focus on how the interior or the business itself should look?
It's just a lot of hassle. With the rising trend of startups, big businesses preferring to work in a managed office(I will explain this later), and the rising growth of commercial real estate, co-working businesses are at the cusp of a multi-decadal theme, which could potentially create immense wealth for shareholders. This blog analyzes the listed companies and covers the sector comprehensively. So, let's begin.
What is a co-working/flex space?
Co-working space is a fully furnished office space that is leased by a co-working company. The company splits the area into parts and lends it out to freelancers, startups, small businesses, big businesses, etc.
As the founder of Investing Stoics, I can personally buy a daily, monthly, or yearly pass to work in these dynamic coworking spaces. As my business grows, I have the flexibility to purchase more passes or seats to accommodate my expanding team. Now that we've grasped the basic concept, let's delve into the various business models, the reasons behind the success of co-working spaces, and the trends shaping this industry.
Business model
There are multiple types of business model these operators work in. Lets look at them in depth.
Co-working model: The co-working businesses will lease a commercial space and provide the interiors and amenities. Different people can book a daily, weekly, monthly, or yearly space and come and work. This can be for individuals or for teams.
Managed offices: This is the key to success. When a big corporate takes up the entire space from the operator, and the operator puts up the upfront capex and designs the interior to the needs of the corporate. Managed offices have a few key advantages. This ensures 100% occupancy, it ensures that the place is filled from the first day and the most important thing is that the leases are minimum 3-5 years long which help prevent asset-liability mismatch(what led to WeWork getting bankrupt).
Virtual offices: A lot of small businesses need an office for GST registration. What Operators do is, they allot a seat to these businesses so that they can register a GST number under the co-working space address and also receive benefits such as call forwarding, admin, etc. This is a very lucrative business as operators charge double or triple the average price, and it all flows down to the profits.
Within this, you also need to understand the rental agreement with landloard as that too is a key business strategy
SL or Straight lease model: Under the SL model, developers or space owners lease space to flexible workspace operators on traditional leases wherein typical market terms and conditions are applicable, including a fixed monthly rental, common area maintenance charges, security deposit, minimum lock-in period, lease tenure and escalations. The operator entirely bears the capital expenditure for fitting out the property. The SL model is India's most prevalent arrangement between a space owner and a flex workspace operator. In this model, you incur high capex and are susceptible to asset-liability mismatch but make very high profits when the times are good.
MA or Managed aggregation model: Under the MA model, the landlords may incur capital expenditure to help set up the office space and, in return, become a partner in the revenue made. Such contracts have minimum rental payment or profit sharing, whichever is higher. In this way, you reduce asset-liability mismatch by lowering the rental costs and capex but forgo a chunk of your profit when the times are good. In this model, you boost ROCE against a trade-off of margins.
Whats driving the sector?
1.Rise of startups
In 2010, startups occupied 2% of office occupancy in India. However, in 2021 the number rose to 10%. Startups leasing offices have grown at a staggering 38% CAGR in the past decade. Due to the nature of startups being unpredictable in terms of growth and, it is generally not a smart idea to overly commit to buying an office at an early stage and spending heavily. Co-working spaces allow these startups to increase their seat count from 5 to a 100 and also back to 5 when the times go bad. With co-working space, startups do not have to do upfront Capex and can instead pay for space on a monthly basis.
2. A change in corporate trend
If we were to start a co-working office, we would expect that most of our clients would be startups and freelancers. That's actually wrong! Covid marked a shift in the culture of corporate working. People want flexible working where they spend half of their days working from home and the other half collaborating with their colleagues and workng on projects. Instead of buying and furnishing a big office, corporates approach Operators who set up the office and spend for the infrastructure with their specific requirements and lease it to them on a multi year tenure.
3. Huge TAM
India's grade A commercial real estate is close to 810mn sqft as of FY23. Out of this, co-working space constitutes only 61 mn sqft. Avendus, a financial firm in India, believes the Flexwork space will outpace the industry and grow at 15% for the next five years. From a value perspective, the industry will grow at a CAGR of 21% for the next five years. It could be valued at 9 billion dollars!
Moreover, the industry is becoming consolidated, with the big players capturing most of the seats( almost 60-70% of the seats are under the top 10 players) and growing even faster. Imagine the growth ahead for the ones who end up leading the industry. It's enormous!
4. It just works!
The only way a new industry can survive is if it actually adds value to the sytem. The first thing I looked for when I was studying this sector was its advantage over a traditional lease and I have come to realise, it has a lot of benefits for all the parties involved and that is why this industry is here to stay.
Credits: Avendus Capital private limited
Look how simple the operations become with a co-working operator involved! Lets look at the indepth advantages now!
Advantages for the Landlord
Elimination of vacancy risk: A single Operator will lease the whole floor at times and the leases will be 5-9 years long. This eliminates the worry of loss of income and helps fill the estate faster.
Increases brand value and visibility: A heavily occupied co-working space attracts audiences and fills the commerical estate. This increases the brand value and visibility of that building and helps fetch a premium for the same leases.
Professional incentive: Operators need landlords as much as landlords need them. This creates positive incentives which leads to timely payment, better ethics and longitivtiy in tenure.
Higher profits: A lot of co working operators offer profit sharing model, where landlords are guaranteed a minimum rent but also profit sharing if the operators fill the area up. This allows higher income generation for the landlord.
Advantages for the Co-working Operator
Strong unit economics and returns: If done right, the business can be very lucrative and can generate ROCE of over 30%!
Very high Scalability: These businesses are underpenetrated and have a lot of growth ahead. Most listed businesses are guiding for 100%+ growth.
Asset light: These operators do not own the land and hence Operate on an asset light model. This allows faster growth at a lower required capital.
India as an Outlier: One of the biggest advantages is the rise of corporates using co working spaces in India. These offices are called managed offices(I will explain all business models below) which ensure 100% capacity utilisation from day one and very long lock in period.
Optionalities: Operators can expand into food and beverages, networking events, backward integrate into land and furniture etc. the optionalities to expand in this value chain are multifolds.
Advantages for the client
Cost effective: A study by Aventus showed that co working is 20-22% cheaper compared to having their own office.
Flexible: You can book however many seats you want for however many days you want. The flexibility you get from co working spaces is unmatched.
Capex to Opex: Businesses need not spend money upfront and transform their cost structure to an opex one. This way, the cash flows stay rich and they do not have to heavily commit to any asset.
No hassles: Admin work, cleaning, security, repairs, furniture, Pantries, tea/coffee etc is all fulfilled by operators. Businesses need to worry about nothing except their work. This allows startups to no stray away from their core operations.
Key variables to track
Let's understand the metrics which will make or break your industry and then anaylse some of the listed businesses. There are a lot of things to understand and we will go through each of them.
Seats: Seats mean the number of people the operator can accomodate. If an area has 100 seats, that means that area can accommodate that many people at any given time.
Average tenant tenure: You know why WeWork failed? because they failed at this. It is extremely necessary that one looks at the average tenure of the clients. A short rental lease would mean that the contracts will end soon and they will be out of clients while they still have to pay the landlords. This leads to asset liabilty mismatch and ultimately a cash flow crunch. The higher the tenant tenure, the better.
Occupancy rate: Out of a 100% of your seats, how many seats are you able to fill? its basically capacity utilisation. In this metric however, a key thing to note is the time taken for a new property to reach 85%+ utilisation. The faster it is, the higher the overall margins and the higher the demand scenario in that area is.
Seats under development: This is basically capacity expansion. A higher seat guidance means the company sees strong growth ahead.
Square feet: Kind of similar to seats, it helps you grasp the area the business has under management(AUM) and the area its developing.
Micro market: Tier 1 cities rules the sector. Most of the supply and demand is focused in thse cities and these are the ones which are seeing a boom in rising office spaces. Out of all, Bangalore has the highest supply and has 40% of the total leased seats. Below you can look at the supply distributed and the average price per seat. The average price will wary quite a bit from area to area.
Business model being used: Most businesses operate in all three models discussed above. However, it is important to understand the contribution of each models. Managed offices provide good returns and are the safest. You also need to understand if the business operates under the SL model or MA model.
Client concentration: Most of the clients belong to the ITES space( about 40%). You must have seen the news of TCS, Infosys etc froze hiring and some even reduced headcounts. With AI rising and western economy under stress there is a chance that IT sector might not need so many employees and hence might need incremental office space. Thus, a good co-working business will not be concentrated in a single sector or even worse, a single company.
Risks
Commodity industry: You can't really differentiate yourself much, so as the industry evolves, the companies might become pure competition and that can kill your hopes of high returns.There are two ways in which you can create a competitive edge. One, is to increase Value added services. By providing features such as conference rooms, audio visual rooms, better food and beverages, interior etc you can command higher prices and create a brand. Another way is cost optimisation. The best way to optimise costs is to become a part of the value chain and cut costs as much as possible. This will provide stability and higher margins.
Concentration risk: Avoid Concentration in geography, sector and company. Any downturn on these and there will be severe operating deleverage in the business. When the times are good, they will be really good but when the times turn bad, it will be worse.
Rising competition: Capitalism can not allow businesses to have return ratios in excess of 30%! And most of these businesses are operating at such great returns. Supply is coming in and so are new players, one must be aware of when there are chances of oversupply.
Asset liability mismatch: Leasing spaces from landlord 5+ years while having clients for a few weeks is an asset liability mismatch. This is an example of asset liability mismatch. If you do not find clients consistently, you end up paying the lease and earn nothing in return.
Unit economics: This is very important. One must need to know the cost breakdown. The biggest costs will be rent but according to Neeraj Marathe who is an investor in an unlisted co-working business , it should not exceed more than 45-48% of revenue. Otherwise, it is not sustainable. A few other things to take note of is capex per seat(lower the better), sqft per seat, and tracking miscellaneous expenses. These expenses can be repairs and such stuff and will comeback to haunt the ones which were stingy during the Initial capex.
Business analysis
disc: nothing here is a buy or sell recommendation.
I will be discussing two businesses that interest me and have given high growth guidance.
EFC ltd
Disc:Invested
Entreprenuial facility centre was established in 2012 and currently has 40,000 seats. It has an AUM(area under management) of 1.9 mn sqft. It has a presence in 7 cities. It has various verticals of businesses. It generated a revenue of 419 crores and a PAT of 63 crores in FY24.The biggest vertical being co working and managed offices, followed by interior fit outs and a newly set up business of furniture manufacturing.
Operational numbers
Seats: 40,000
Seats under development: 41,139
Average tenure: 2 years
Average landlord contracts tenure: 5-8 years
Average rent per seat: 6250 rupees
Capex cost per sqft: 1250 rupees
Average sqft per seat: 35 sqft
Capacity utilisation: 92.5%
Analysis
I will try to include the main elements of the business that interest me and i think are vital to the business. However, I would really suggest that you analyse the business independently as well.
Backward integration
A key element to understand is how its trying to control the value chain. EFC has set up a business for furniture production which will not only sell external entities, but also provide the needed furniture for their main operations. This way, they can increase their margins and also generate a lot of revenue. the factory being set up has the potential of generating 300-400 crores of revenue.
Moreover, they have set up two new subsidaries which are focused on AIF and REIT. These businesses will act as real estate investment funds by taking funds from public and investing in land which will be leased to their co working operations. Hence, they eliminate the threat of landlords and provide better yields for shareholders and investors. It is still at an early stage but its a very big optionality.
Growth
Apart from the growth by furniture. EFC aims to increase its seating capacity to 92,000 in FY26 That gives a CAGR of 51%! Thats quite a lot. Moreover, the management has said they can increase this to 75% and are guiding for a revenue growth of 100%+. Moreover, the management has said that the current PAT margins of 14% can be between 15-20% in the future as other businesses pick up. So there is a lot of growth ahead. However, there are two problems that arise with this. First is that the cash flows are negative(almost). However, that I personally believe that is fine because most money will be invested back to fuel such growth. Another issue which I do not like is fund raising. This too is needed for growth but it leads to equity dilution and you may not end up benefiting at all.
Risks
Most of the risks that apply to the industry apply to EFC as well. Althugh they have eliminated a lot of risks such as geography concentration, asset liability mismatch, and low occupancy: they do have a high concentration in clients and sector. Top 10 clients contribute 50% of revenue and anyone not renewing their lease can lead to problems.
Valuations need to be studied independently, a 45 PE might seem high at first but I use the PEG ratio and hence find it reasonable.
Kontor space
Kontor space was incorporated in 2018 and is primarily present in MMR. Their core business involves acquiring and leasing properties in Mumbai and regions nearby, and leasing them out to small/medium enterprises and individuals. The business had sales worth 11 crores and PAT of 1.95 crores.
Before we begin, the business coms under SME and has a market cap of 67 crores. Hence, you must be careful with your investment decision.
Operational numbers
Seats: 2400
Seats capex: 5000 seats by FY25 and 10,000 by FY26
Average tenure: 5 years
Average landlord contracts tenure: NA
Rent per seat: 15,000-25,000 rupees
Capex cost per sqft: 3000-4000 rupees
Average sqft per seat: NA
Capacity utilisation: 90%+
Analysis
Growth
One of the biggest reasons to make this business worth studying is its growth guidance. they are guiding a 4x growth in seats in 2 years! They have been successful in finding anchor clients(managed offices but can also take 50% of your whole area) for most of their offices. This allows profitability to stay at a good level. Moreover, they are only present in Mumbai but are expanding to Pune as well. Another vital thing, there are minimal chances of asset liability mismatch because of such a high average tenure.
Risks
Brace yourselves, because there are multiple risks with the business. One of the risks is concentration. They are concentrated in Mumbai and a single client contributes to 10% of their revenue. They have not provided exact breakups but anchor clients are a signifcsnt chunk of their revenue and due to being a small business, they are yet to succesfully diversify from a few big clients. However, that should happen with time. My problems are mainly with the corporate governance. They have a vehicle loan worth 60L which is for personal usage. Another thing is that they need cash and might raise funding to expand but still have given out a loan. There are chances of corporate governance issues and hence one must be careful.
Compared to EFC, the business is cheaper on a PE basis or an EV/EBITDA basis and is significantly cheaper on a PEG basis.
AWFIS space solutions
AWFIS was incorporated in 2014. Awfis Space Solutions provides desk needs to customised office spaces for startups, small and medium enterprises as well as for large corporates and multi-national corporations. Awfis is the biggest listed business in this industry by a significant margin and has a total seats of 110,000 and 5.6Mn Sqft AUM. It is also involved in interior designing and fittings and provides facility management. It reported revenues worth 849 crores and a PAT of -18 crores.
Operational numbers
Seats: 1,10,000 seats
Seats capex: 40,000 by FY25
Average tenure: 2.5 years
Average landlord contracts tenure: NA
Rent per seat: 6000-18,000 rupees
Capex cost per sqft: 1700-1800 rupees
Average sqft per seat: NA
Capacity utilisation: 71%
Analysis
MA model
66% of their business vomes from the MA model.Which means that it is on profit sharing basis with the landlord. Due to this, the margins of Awfis are significantly lower than EFC but their ROCE touched 43% this year! Another thing to note is that it is the only one out of the three which is cash rich. A problem does arise that it is not profitable but here the case is that the earnings are eaten away by Depreciation.
Growth
The business is expected to grow at 30%+ with a bullish bias towards margin. they can expand by 1-2%. Compared to its competetiors, the growth guidance is quite low however in absolute terms its still good. The big base prevents it from growing at such high rates.
Risks
So I believe this is a very strong business in terms of risk mitigation. It is not dependent on any geography,revenue of top 5 clients is only 13%, its the least cyclical of all because of its MA model. Moreover, a key risk that I did not mention was over reliance on brokers. It is best to find clients on your own and AWFIS gets 60% of its clients by itself. We can not analyse this with competitors because they haven't disclosed this number.
The valuations with respect to its EBITDA is good. However, I would bet on growth more than anything else but that is an independent decision.
These are the businesses that interested me, I will attach the work of Avendus who have worked on a number of private entities such as WeWork and Smartworks but also of the listed entity AWFIS.
With a strucutral shift in the commerical real estate, we might be witnessing a mega trend in the making. It will be interesting to see how this story turns out. Let me know what were your key learnings and definitely message me if you guys have any doubts.
P.S: Subscribe if you enjoyed the content!
Credits:
Marathe, Neeraj. “Factors Driving ‘co-Working’ Spaces.” YouTube, 28 Mar. 2024, www.youtube.com/watch?v=-xJlmIdUYEg. Accessed 27 June 2024.
Bajaj, Dhruv. “Co-Working Office Spaces- the next Big Mega-Trend | Smart Sync Services #investing #stockmarket.” YouTube, 4 May 2024, www.youtube.com/watch?v=HKORPnHVTAY&t=100s. Accessed 27 June 2024.
Manhar, et al. “EFC - Entrepreneurial Facilitation Centre.” ValuePickr Forum, 11 June 2024, forum.valuepickr.com/t/efc-entrepreneurial-facilitation-centre/146688. Accessed 27 June 2024.
Ashar_Mann, et al. “Kontor Space Limited.” ValuePickr Forum, 10 June 2024, forum.valuepickr.com/t/kontor-space-limited/146611. Accessed 27 June 2024.
DRHP,Concalls, Annual reports of EFC(I), Awfis space solutions and Kontor space limited.
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