The Performance of Business Centres Over a Complete Business Cycle (Including a review of prior research)

This research document has been produced by Business Centre Capital Company Limited (“B3C”),

B3C does not offer investment advice or make recommendations regarding investments.

Under no circumstances is the information contained in the document to be used as or considered to be an offer to sell, or a solicitation of an offer to buy, any security. Where information has been obtained from outside sources, it is believed to be reliable but not represented to be accurate or complete.

Authors: Mr Jonathan Price and Mr T. Spicer

Foreword

This report was originally conceived of as an attempt to understand how the business centre industry has performed over a complete business and real estate cycle and consequently covered a period of ten years. It was inevitably a historical survey and did not attempt to address the issue of what lay ahead, or how the industry would look in the 21st century.

A lot has happened since the report was written and since the last data was collected at the end of 2001. This foreword summarises those post balance sheet events, briefly reviews the situation of the industry in autumn 2002 and looks forward to 2003.

1999 and 2000 were years of plenty for the OBC industry. Boosted by the insatiable demand for space from dot.com companies, OBC operators were able to charge licensees up to five times the basic market price of the space with average multiples of three to three and a half times. By the end of 2000 the dot.com bubble was deflating rapidly and the telecoms companies were entering a period of decline. In the US, things started going flat about August 2000 and November marked the edge of the precipice for the downturn.

The effects of these changes were being felt by the end of the first quarter of 2001 in the UK and USA in those centres with a large percentage of TMT (technology, media and telecoms) clients. In continental Europe, Germany and France in particular did not feel the slide until much later in 2001 and were in a state of denial. Asia remained buoyed up by the continued growth in the Pacific region.

At approximately the same time, the US economy went into recession, and US multinational companies (MNCs) began implementing cost cutting measures including the closure of satellite offices overseas. The first of what proved to be several low points came in mid 2001 with the confluence of the three factors mentioned leading to a substantial drop in occupancy in those centres with the relevant clients types, principally the luxury operators. Those affected responded to the loss of business in the classic manner, by reducing their pricing. By the end of the third quarter complaints could be heard of a ‘price war’ being waged by the three big operators, Regus, HQ and MWB Business Exchange.

The impact of the three negative factors was felt differently by different classes of OBC and it is important when reviewing this period to distinguish between them. As already noted the business centres most affected were the well-known luxury operators, Regus, HQ Global Workplaces and MWB Business Exchange, all of which had significant numbers of clients among the affected categories. In the US, HQ was particularly affected, as Regus was really just opening their space and in many cases, never even got the clients in the first place. By the time the centres were operating, the market had already evaporated.

The mid market operators, offering buildings and services which are roughly equivalent to 3* hotels suffered much less as their client base has traditionally been more heavily weighted to small and medium sized enterprises (SMEs) and local companies than to multi-nationals or new economy businesses. Likewise, the budget sector and managed workspace operators, the 2* and 1* equivalents, were relatively unaffected. SMEs as a group can be fairly said to be more ‘value’ oriented than MNCs and are comfortable in 3* locations around transportation centres and in the suburbs. Regus/MWB/HQ have fewer locations in these areas and are mostly to be found in the central business districts (CBD).

Location also played an important role in relation to occupancy trends. Centres in recognised high tech or telecoms locations suffered proportionately much worse than similar centres elsewhere. Hence in 2001-2002, the following locations were not good places to be: Silicon Valley (still only about 55% occupied), the Thames Valley and in Asia, Singapore and Bangalore. The West End of London was hit badly in 2001, but occupancy recovered in 2002 owing to the attractiveness of the location to businesses of all types. The rates that are being charged do not however approach those that were possible in 1999-2000 and care must be taken when using physical occupancy as the measurement. Experienced operators tend to base their assessments on ‘economic occupancy’, a measure of revenue based on full physical occupancy at the full or ‘rack’ rate. So, a centre that was 100% full physically at a 50% discounted rate would only count as 50% economic occupancy.

The second low point for occupancy occurred following the events of 11th September in New York, which served to accelerate the withdrawal of US companies from overseas and other non-core offices. The tentative recovery that had been seen in some locations in the third quarter of 2001 was stifled by the tide of reaction to the attacks. We see the low point in North America as from November 2001 to Feb 2002.

The demand for space weakened further in the first half of 2002 in response to a general softening of the real estate market in the US and elsewhere. OBCs were being forced to compete with tenants in traditional buildings seeking to sub-lease surplus space. In addition, Regus’ attempt to develop its virtual client business with its ‘Net Space’ product appeared to confuse many of the larger OBC tenants and they wanted Net Space pricing for traditional OBC space.

During the second half of 2001 and 2002 the price war among the luxury providers that had been started in mid 2001 intensified, and in some locations, it was clear that space was being ‘dumped’ i.e. sold at rates below cost, in order to generate some cash-flow for the operators. Many independent operators believed that the big operators were seeking to use predatory pricing in an effort to drive small players out of the market. If true, this tactic backfired on the larger players, as the smaller operators were generally better managed and had lower operating costs than their large competitors.

Alongside the general fall in rates being charged, a change of emphasis could be seen, particularly in the approach of Regus to the market. Attempts were made to move away from Regus as the operator toward a franchise arrangement in which Regus would offer brand franchises to independent operators. The OBC industry is very familiar with the franchise business model as this was used extensively by HQ and its predecessors in the period 1980 to 2000. Regus’s attempt to re-launch its growth using a franchise model was however almost completely unsuccessful, as the independent operators were sceptical about the value of the brand and considered the terms offered to be unattractive.

Regus was more successful in its attempts to find demand for longer term contracts among major corporates, principally by reducing its price in exchange for the long term contract. Several deals were announced in 2001 and 2002 with companies such as Nokia and Compaq. If one looks closely at the terms of these deals it can be seen that they tend to offer great flexibility to the customer at a relatively low cost. One must therefore wonder about the long term viability of this approach.

The third and final low point for occupancy occurred in mid 2002, but was not as widespread as the previous low points. At that time average physical occupancy of luxury centres was probably no higher than 50%, whereas mid price and budget centres reported 60% and 70%+ respectively. In the third quarter of 2002 the situation has clearly improved and OBC operators around the world report increases of 10% or more. The averages conceal wide variations, and it should be noted that there are centres in many locations which are experiencing occupancy rates of 80%+ or 90%+ and are effectively full.

Despite having been in existence for more than 30 years, the OBC industry structure is very immature, with a proliferation of small operators without economies of scale. As an attempt to remedy this disadvantage, a number of associations and networks exist to create economies of scale through collective organisation. The best example is the Alliance Business Center Network, which brings together over 300 locations around the world, united by a common branding and Internet presence. These networks offer such advantages as group procurement systems for essential supplies and services and in the future are planned to include Internet delivered reservations and accounting systems.

Nevertheless, we expect 2002-2003 to see significant consolidation as OBC operators backed by major investors move to aggregate centres at low multiples, taking advantage of the market conditions to negotiate an attractive in cost. Our view is that the consolidation will be regional and led by ‘local or super local’ operators who know the market and can take advantage of opportunist situations to grow. Most of this growth will come from ‘closings’ and takeovers of centres that were previously operated by the larger operators. It is important to understand that while Regus and HQ are the ‘largest’ operators, with the exception of the UK, they very rarely dominate any local or even regional market; in North America and continental Europe this is usually done by a local operator. (See Appendix 1)

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