To transform the world’s largest asset class, entrepreneurs must rely on a new combination of capital.
Last week, we explored Neumann’s Vortex, the cycle of fast growth, negative cashflow, and venture injections that threatened to bury WeWork and other companies that are de-facto operators of physical space. We saw how Adam Neumann’s reliance on Softbank forced WeWork to grow at an unreasonable pace and spend money on unnecessary projects and acquisitions in order to appear more tech-like. Neumann enjoyed Softbank’s the all-you-can-eat buffet, but then realized he’s not able to leave.
This week, we will consider other ways for WeWork to fund its expansion, with lessons that are relevant for entrepreneurs and investors in office, multifamily, hospitality, and industrial real estate. As we try to find an alternative to Hotel Masayoshi, let us check in on more traditional hotels.
Bellhops and Bellwethers
The hotel industry offers a few hints about WeWork’s future. My new book includes a deep dive into hospitality operating models and their relevance to office, multifamily, and beyond. For the purpose of this short article, here are a few key points.
The world’s largest hotel group, Marriott International, owns or leases a fraction of the buildings it operates. Most of these buildings fly the flag of Marriott’s multiple brands under a franchise or management agreement. Many of the buildings Marriott “occupies” are owned by lodging REITs such as Host Hotels & Resorts. These REITs specialize in developing and owning buildings, and leave it to Marriott to specialize in service, product design, service, loyalty programs, and distribution.
Several other large hotel groups are structured along similar lines. Many hotels also include a third-party manager that handles the non-customer-facing aspects of managing the asset . Their role of such manager is akin to the one property management companies play in other types of buildings.
The world’s largest hotel franchises do own some buildings. These are often trophy assets that these companies must own in order to guarantee access to flagship locations that are important to their brand(s). In other cases, the buildings they own are vestiges from old portfolios that will likely be sold once the time is right. Which brings us to another important point: Companies such as Marriott and Hilton used to own many more of their buildings. They managed to gradually shed them off.
The Hotel Parlay
Hotel companies were able to secure franchise agreements only after they built reputable brands and developed the marketing muscle to generate bookings — an ability that traditional landlords lacked. Brands and distribution became particularly important once customers started moving around in cars as opposed to trains and canal ships. Owning a hotel building next to a train station or a dock was originally a natural monopoly. But with cars, customers could stop and spend the night wherever they wanted. How do you convince a customer to pull over? A recognizable brand goes a long way. A national sales team that can generate advance booking also helps.
The co-evolution of hotels, motels, cars, and telephones is detailed in my book. Hotels managed to leverage their brands to transition from asset heavy, fully integrated models towards lighter models. These new models allowed them to offload real estate costs to other entities that were more comfortable owning buildings, signing leases, and handling construction costs. Not surprisingly, there are plenty of investors who wish to own a hotel building and do not wish to own any shares in a hotel brand — just like there are many people who prefer to park all their net worth in a house rather than buy shares in Starbucks or Walmart.
These days, hotels secure inventory in five main ways:
- They sign franchise agreements with building owners — often, a REIT or private fund that specializes in hotel ownership.
- They sign management agreements with the same.
- They sign leases, usually rolling the costs of most interior construction and even some furniture to the owner of the building. Sometimes, these leases main include a way for the building owner to share some of the hotel’s profits.
- They participate in “Sandwich Leasing” deals, in which a third party signs a master lease with the building owner and then signs a management agreement with a hotel brand. In this way, the landlord and its lenders enjoy the certainty of a traditional lease, the hotel brand can avoid making uncomfortable commitments, and the third party gets to share the upside of the hotel like a landlord without actually buying a building.
- They acquire the buildings themselves, often with other private equity partners, and with plenty of traditional real estate financing provided by banks.
It took over 100 years for hotels to figure out how to balance the risk of owning an asset and the risk of owning a branded business. And hotels are being forced to rethink their operating models in face of competition from Online Travel Agents, home-sharing companies, and digitally native operators such as Sonder and Lyric who can offer building owners hotel-like revenue without the hassle of partnering with a traditional brand. But that’s a different story. Let’s get back to our original question.
How can WeWork finance its inventory?
Let’s start with what WeWork shouldn’t do. WeWork should not use venture capital to finance long leases or building acquisitions. I repeat, WeWork should not use venture capital to finance long leases or building acquisitions. The only reason to use such expensive capital for this purpose is on order to prove a concept. WeWork’s concept has been proven. Scaling it has to rely on a different set of solutions.
OK. So what can WeWork do instead?
- Sign leases. Yes, leases. But it should get the money to do so from investors who are looking for a reasonable return, but are not looking for venture-type growth or venture-level returns.
- Get sandwiched: Find investors who are comfortable with signing leases directly with landlords and then bring in WeWork as a manager who shares the revenue. Who would be crazy to sign such a lease? You’ll be surprised. Coliving companies such as Medici, Starcity, and Common are already securing similar deals. They find investors who are willing to finance master leases, building acquisitions, and even development projects that these brands can then operate for many years. These can be small investors who buy/lease a single building or larger investors who invest in specialized real estate funds that are set up for this purpose. To be clear, these investors are real estate investors, not venture capital investors.
- Get more of its enterprise customers to sign leases directly with landlords, and then step in to specify the design and handle the operation. (WeWork is already doing this; it should do more and, especially, it should do less of other things it’s been doing).
- Continue to try to secure management and franchise deals with traditional landlords, but wait patiently until the industry is mature enough for this model to become standard. A way to expedite this is to behave responsibly and prove to landlords and lenders that WeWork’s business is viable.
All this might sound great, but isn’t it a bit too late? WeWork is already trapped. How can it get out?
Exit through the Front Door
The only way out of the Masayoshi Hotel is with Softbank’s help. WeWork is already “stuck” with the billions it raised from its existing investor. Ironically, in order to grow WeWork to its full potential, Softbank will have to refrain from pushing the office company towards startup-like growth and performative investment in tech.
WeWork is already doing many things right. It just needs to keep doing them, more slowly, with a simple story that shows landlords and lenders that buildings perform better with a WeWork in them. Some of this is just a matter of time — with every passing day, demand for space-as-a-service is growing and owners are coming to terms with the fact that the old way of leasing space is obsolete. Luckily, many landlords are greedy, and if they see that WeWork is consistently making money using their assets, they’ll want a piece of it and offer the company management deals or revenue-sharing arrangements instead of asking it to sign leases.
Ultimately, the capital stack for coworking and coliving companies will be a combination of venture capital (to finance actual tech and product development), real estate equity, real estate debt, and traditional bank financing for business expenses associated with opening a new location. The exact combination is a work in progress and will anyway differ by company and by deal. I don’t have all the answers, but I promise I’ll keep thinking about it. Subscribe to make sure you don’t miss a beat.