In recent months, many short term operators and coliving companies have been forced to close their doors or declare bankruptcy. While the Covid-19 pandemic is certainly a culprit in these sudden closures, there’s another factor that pre-dates the coronavirus: the master lease.
Master leases vs. management agreements
Master leases have historically been the go-to model for owner and operator agreements among coliving companies, Common included. While we stopped signing master leases in 2018, pre-Covid they were still the most popular agreement with prop tech operators from coworking to short term rentals to retail.
In a master lease agreement, an operator signs a long-term — in some cases over a decade long — lease for a building or a set of units, and then rents them out to tenants at a higher cost. The operator keeps the extra revenue generated from leasing out the units and the owner sees returns on their property whether it’s occupied or not. While this might seem like an easy deal — guaranteed cash for the owner and a straightforward agreement for the operator — during times of economic uncertainty, master lease agreements leave both parties stuck.
Master leases aren’t the only agreements that can exist between operators and owners. Management agreements, in which the owner pays the operator a management fee for marketing, leasing, and operating their property, are the norm across multifamily housing. These agreements are proven to be stronger and less risky during times of economic uncertainty, and more successful for both parties during economic booms.
In the context of coliving, management agreements make more sense for buildings consisting of both coliving and regular apartments. While added amenities like furnishings, household essentials, and cleaning services create a clear premium on rents in coliving assets, it’s difficult to create those premiums for a standard studio or 1-bedroom unit. As coliving shifts from a niche, standalone asset class into a unit type operated alongside more traditional models, management agreements make it easier for operators like Common to bring our signature brand and style of people-first property management to an entire building.
Staying ahead of the curve: the history of management agreements at Common
When Common opened our first coliving building in 2015, master leases were the dominant structure in the coliving industry. Our homes were small brownstones in major urban areas, and we were a new business operating a new model that owners weren’t yet familiar with or ready to trust. With master lease agreements, owners were confident they’d get a check every month regardless of what happened at the building. The risk seemed low, and no one could have predicted what would happen to the economy half a decade later.
However, as Common and the market for coliving grew, it became clear that master lease agreements weren’t the strongest model, for both us and our partners.
The first issue was that lenders viewed master leases skeptically. Despite the fact that Common’s buildings were occupied by creditworthy tenants on 12 month leases, the master lease agreement essentially blocked the bank’s ability to take these tenants’ credit into account when assessing a partner’s loan. They were only able to see that the landlord had rented out their properties to a company who, at the time, had a short credit history. Consequently, landlords saw higher interest rates on their buildings.
Additionally, while we benefited from offering convenient services and amenities for which we could charge renters, owners were cut out of coliving’s financial upside. We began exploring partnerships with owners who were interested in making new models like coliving and microunits a fundamental part of their business plan — an approach that doesn’t work under management leases.
We decided that if lenders were penalizing our partners, and partners had a lower incentive to incorporate coliving into their models, we needed a new approach. Soon, we began signing management agreements over master leases and by 2018, we stopped signing master leases altogether. Today, over 90% of our signed units are operated under a management agreement.
Does Covid-19 mark the end of master leases?
The pandemic has put the flaws of master leases on full display, driving operators and owners alike from the model. However, despite the win-win that management agreements provide owners and operators, they come with their own set of challenges and responsibilities.
The first and central challenge: owners have to believe in the fundamental thesis of what’s happening in the building. With a master lease, the owner only has to believe that the operator will be around to pay rent. With a management agreement, the owner has to have full confidence that the operator will manage the building well and cost-effectively because their profit and income is dependent on not just the survival of the operator, but their abilities.
Operators who are also transitioning to management agreements from master leases need to become great at reporting. Partners will want to know how they’re spending the management fee, if their marketing strategies are effective, or if they’re getting the most rent they could on a particular unit. To manage these relationships, they need to have strong client management and excellent communication; in the past year Common has built a team of portfolio managers to work directly with building owners, alongside a team of accountants to manage the financials of each property.
Beyond the pandemic
Covid-19 has pointed out obvious flaws in the master lease model; operators are unable to generate a premium on the pre-Covid rents that were in place when they signed their lease with the building’s owner. Luckily, Common made the switch to management agreements before the pandemic, and we’ve spent the past year both seeing the fortuitous results of this switch, and learning how to successfully work with partners under management agreements even during an economic downturn.
We predict that the management agreement model will only continue in popularity and success, but operators who are looking to switch must be prepared for the additional undertakings that come with them.