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WeWork building

A Return To Basics: Real Estate Operations Aren’t “Physical Social Networks”

How did the real estate sector’s most famous proptech, WeWork, fail?

By Noel Neo

November 10, 2020- Venture Capital’s (VC) search for the next unicorn surprisingly led them to the staid world of property management. At its height, WeWork was valued at $47 billion. This staggering value was perhaps predicated on the perceived scalability of its business model, based on the assumption that using VC funds to quickly accumulate a vast global footprint, either bought or leased at competitive prices, would eventually translate to an extensive volume of paying clients. It is not an uncommon model. Technology start-ups often employ revenue models that build scale in the first few years of their business by offering free or low-fee services and converting these early stage users to paying customers later to rake in profits.

WeWork’s previous rich valuation could also be due to investors and the media drawing similarities with unicorns like Airbnb, which has just filed for an IPO in November and is valued at $30 billion.

Whatever the justification, the money did flow to poster-boy WeWork, where the then CEO , Adam Neumann, convinced investors they were buying into a “physical social network” replete with community managers at each of WeWork’s locations. And the flow of funds did not stop at WeWork as a slew of co-working, co-living and hospitality operator startups also benefitted from the euphoria of the shared economy .

Photo by Eloise Ambursley on Unsplash

The cost of real estate

But real estate operations based on a long-term lease and underwritten by short-term subleases is quite a different proposition from the likes of Facebook and Amazon, where revenue growth can far outpace costs beyond a certain threshold and thereby generate super normal profits.

For tech firms providing an online service, costs are relatively fixed – a team of programmers running an app on a server; so even if it’s not profitable at a million clients, it could breakeven at 10 million clients and be massively profitable at a billion clients. With such economics, a case could be made for backing firms that burn cash for market share in hopes of an outside chance of a massive future payoff.

Real estate operations, on the other hand, do not have the same operating leverage. Real estate has unit specific costs – i.e., each property comes with its rental cost and requires manpower to operate the buildings. If an operator is underwriting projects at a loss for one property, it will simply lose more money as it scales up. There is no magic number of projects or clients that turns a loss into a profit.

The bursting of the VC real estate as a “physical social network” bubble occurred when WeWork filed for its IPO in August of 2019 with a US$47 billion valuation. Then the Theranos fraud and Uber’s failure to live up to its hype were fresh in the minds of investors, analysts and journalists. And so they were less predisposed to allow another ‘visionary founder’ pull the wool over their eyes.

Beyond the clear lack of ability to turn a profit (instead losses were growing alongside revenue), the public disclosures revealed a ton of self-dealing, conflicts of interest and governance issues. Cheap VC money with an associated lack of accountability from not needing to turn a profit was a terrible combination in hindsight

Co-working’s profitability

Just over a month from WeWork’s Securities and Exchange Commission (SEC) filing, WeWork’s valuation had plunged more than 70% and Neumann was ousted as CEO. The workspace company is now valued at about $2.9 billion, according to Softbank’s earnings report for the year ended March 31.

That’s not to say real estate operations is an untenable business model. Indeed IWG PLC has the same business model as WeWork – to lease office space long-term and sublease short-term; yet IWG is profitable and listed on the London stock exchange with a market capitalisation of GBP2.73 billion (US$3.59 billion).

What went wrong at WeWork was its model of paying over market and below breakeven for growth due to its ability to raise cheap VC investment – but therein lies the chicken-and-egg, for without that growth, WeWork would not have been able to raise VC monies!

This is a lesson WeWork’s backers seem to have taken to heart. After ousting Neumann, they brought in Sandeep of Brookfield, a battle hardened veteran from the real estate industry. One of Mathrani’s first acts was to downsize – selling off entire segments of the business and axing many of the community managers that had helped position WeWork as a “physical social network”.

The jury is out on whether WeWork and similar lease and sublease startups that overpaid for their properties pre-Covid will be able to survive the current storm, but what is clear is the epoch of VCs funding the sector on the basis of a “physical social network” is behind us.

Operators that wish to survive and thrive in today’s landscape will need to get used to getting elbow grease in to ensure each property they sign is profitable as a standalone project. The speed of scaling will not be as fast as in the go-go VC days, but it can still be a very solid business if properly executed.

About the author:

Noel Neo, CFO of K Hotel Group

Noel Neo (CFA) is CFO of K Hotel Group – Singapore’s leading lease and sublease hospitality operator backed by veterans from the real estate industry, including some of Asia Pacific’s most renowned REIT investors. He was previously in private equity real estate with Pacific Star Group, Pacific Star Development and APREA.

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