For an outsider looking at WeWork at the start of 2019, it would have seemed that the firm was only getting more and more successful. But, since filing for its famously failed IPO in August 2019 it has cut its valuation down from $47 billion to $5 billion and laid off 2,400 employees, including its co-founder and CEO, Adam Neumann.
The fact of the matter is that the WeWork business model of lease arbitrage, a “middle man” strategy used by so many real estate and hospitality operators, is in today’s market, so fraught with risk from the outset. Tech is fundamentally disrupting this space by empowering asset owners to flexibly tap into the same upside directly, cutting out the need for “middle men” and radically streamlining the value chain.
Lease or rental arbitrage is the practice of a tenant renting a property on a long-term basis (master lease), then subletting it on either a short or long-term basis for a profit. This is exactly what WeWork does when it rents buildings long-term, and then sublets either desks or entire offices. Whilst it can undoubtedly be a lucrative business model during good times, it is entirely reliant upon favorable market forces to ensure that there’s sufficient margin to play with (i.e. low cost of master lease vs. strong demand to sublet at a significantly higher price point). Assuming these favorable dynamics do exist, critically the arbitrage then needs to be serviced by a cost-efficient operation in order to turn a profit for the operator. In WeWork’s case, despite reporting profits in the early days of the company, it was reported to be losing $219,000 hourly in July 2019. In 2018 as a whole, the firm lost $1.9 billion.
Why do I question the future viability of this business model? When a company enters into a long-term lease, it incurs a long-term liability that is enforced by the terms of the tenancy agreement. The arbitrage business model typically assumes that this liability is serviced through profitable ongoing operations.
Profitable arbitrage, however, is dependant upon a favourable relationship between long and short-term rental prices throughout the period of the master lease. Given the disruptive impact of technology, such as marketplaces upon the global real estate, there is strong evidence to suggest that this will simply not be the case going forward.
The Airbnb paradigm
Take the residential sector, for example. Prices for short-term rentals have historically been buoyant with guests generally willing to pay a premium for the flexibility and convenience of short-term holiday renting. Airbnb’s disruption of this market, however, has now made it so easy and convenient for guests to book accommodation online that it has tapped into a huge well of pent up global demand. In turn, this has resulted in swathes of hosts seeking to tap into this demand directly and bringing their inventory coming onto Airbnb’s platform, increasing competition to win occupancy and driving nightly rates down, very much to the benefit of guests. Whilst very specific pockets of value and opportunity will prevail for hosts, at a macro level the delta between long-term and short-term rental prices is most definitely narrowing. Short-term renting in the residential sector has never been easier to access, however it is a less profitable opportunity today than it has been historically.
This same dynamic is now to be expected within commercial real estate as technology innovators respond to “the WeWork effect” and work to streamline traditional office brokerage. These platforms will enable corporate tenants to book office space more easily and at increasingly competitive prices, whilst empowering asset owners to monetise their properties more flexibly and in new ways.
It stands to reason therefore that, alongside a natural backlash resulting from WeWork’s recent unravelling, investor appetite to back similar lease arbitrage plays, across both commercial or residential sectors, will now wane. Consequently, many growth companies in this space will be forced to substantively adapt their investment-fuelled business models to focus on more immediate and sustainable profitability.
Technology is an enabler, not a middleman
Airbnb has been described by cynics of the tech industry as “a rare [example of a] profitable unicorn”. As it now prepares for IPO in 2020, we might ask ourselves how it can possibly justify a valuation of $35+ billion, and how can other proptech platforms take inspiration from Airbnb’s meteoric rise?
The answer is that Airbnb’s technology platform is in many respects powering the future direction that both the real estate and hospitality industries are now taking. As a product it enables hosts to understand what nightly rates they can likely achieve through the platform, and it provides them with the tools needed to tap into its marketplace on their own terms. It is a true example of “an enabling technology platform” which allows property owners to efficiently monetise their assets and directly benefit from any upside. At the same time it allows consumers to benefit from a competitive marketplace.
As Airbnb matures and confidence in its platform grows, institutional landlords and asset managers are now seeking to diversify their traditional long-term rental strategies in order to tap directly into higher-yielding short and medium-term rental demand without the need for an intermediary broker or managed service provider. To go back to the WeWork analogy, it enables a given commercial landlord to tap into the WeWork opportunity, without the need for WeWork itself – fundamentally streamlining the existing value chain. The result is tangible value creation; more money in the pocket of the landlord, and a better value proposition for the end consumer.
WeWork’s story is a stark reminder of the gritty reality of the lease arbitrage (or “middle man”) model: it may seem profitable today, but it is in fact susceptible to volatile and unpredictable market forces, and at best offers thin long-term margins. As a consequence, smart investors are now flocking to back enabling property technology platforms with valuable “hard” IP that streamlines value chains, and allows landlords to capitalize by tapping into more of the value generated by their assets directly. WeWork’s inflated $47bn valuation was, by contrast, only ever attributable to its perceived brand equity and market ambitions, rather than the inherent value of its actual business and technology.