A team is the single most important point of success or failure for a project. Team culture and leadership have a great influence on productivity, and team communication is essential for effective and sustainable product delivery. Co-located teams have a better chance to create great team culture and leadership, than teams that do not communicate face-to-face. Interacting in-person helps build trust and respect, common vision and shared responsibility faster and more deeply.
Having a fully co-located team requires an open-space environment, set hours to maximize face time, and sometimes even lunches together, so that the team spends the most time in face-to-face interactions. In the pursuit of co-location other valuable things get dropped. Better specialists are not willing to work the exact hours, or are not available in a set location. Introverts suffer from too many hours in the open-space environment. And, because all communication is face-to-face, the team never has to develop the skills to communicate in any other way.
However, while co-location brings a significant benefit, it also comes with a cost. Getting every member of the team in the same room at the same time for the duration of the project often requires a change. Sometimes that cost is trivial. For example, if team members are scattered around the organizations' campus for historical reasons. Co-locating a team like that is as simple as designating a team room, arranging furniture in an open pattern, and moving the team members over. Chances are, the organization is better off getting the team co-located, and reaping the benefits of improved team dynamics. But there are plenty of situations where co-location is very expensive - or even impossible. For example, a project team must include a specialist who resides in another city or country, or a key person on the team has to work from home some days. Co-location may not be an option, but the team can still deliver.
It is harder to build Agile culture of trust, open communication and shared responsibility in a distributed team, but it can be done. Communication is a skill, one that teams can develop, if there is the will, training, and positive reinforcement. Remote teams can get very good at communicating using different channels. Regular (or even occasional) travel to get the team together allows to build strong relationships, that last long after everybody went back to their original, possibly far away, locations.
There are many distributed teams that do great work, are Agile, deliver value, and enjoy great team culture. Co-location is one way to achieve these goals, but it is not the only way.