Originally published on EQUITYMULTIPLE
This is a great time to be a startup – technology has helped reduce startup costs, a microeconomy has developed to service small company needs and, perhaps most important, venture capital has made rapid scalability possible. A recent Andreessen Horowitz study on US tech funding found that, despite fears of a looming tech bubble, the growth in post recession funding has followed a more sensible approach: on the one hand, early round funding, where only a small amount of capital is at risk, has increased dramatically in breadth; on the other hand, VC funding of “unicorns” (companies valued at over $1 billion) has also increased dramatically. It is this latter group that has more than a few analysts questioning whether such lofty valuations are warranted over the long (or even medium) run. Perhaps the most polarizing recent valuation has been that of WeWork, the three-year-old office space provider that’s set out to revolutionize commercial leasing by offering flexibility, Millenial-friendly amenities, and curated spaces that are geared toward collaboration, all without owning any actual real estate.
At $10 billion, WeWork is valued at more than almost every publicly-traded company that owns tangible, honest-to-goodness office buildings in the US. What’s more, this translates to nearly $3,000 per square foot of office space WeWork has leased, or roughly 400% more than the value of any comparable office space in New York or San Francisco.
While WeWork has undeniably created a feeling and an offering that’s easy to buy into, many on the real estate side find the gaudy valuation to be completely insane. For an industry that's used to valuing hard assets based on relatively consistent multiples of NOI, the sheer amount of growth speculation priced into WeWork’s valuation is difficult to reconcile. The main knock on WeWork’s model is fairly straightforward: they are operating on 10+ year fixed leases with landlords (the actual owners of their 3.6 million of leased office space), while short-term leasing to individuals and startups that are much more immediately responsive to fluctuating economic conditions. What happens when, five years into a ten year lease, job creation and consumer confidence slow, demand dries up, and tenants either close up shop or spurn the mood lighting and keg taps of their WeWork space for the thrift of a coffee shop or home office? Or, best case scenario, the skeptics say, the torrid office rental market persists past the expiration of WeWork’s current long-term leases, and landlords finally seize on the opportunity to jack rents and eat WeWork’s lunch.
While WeWork’s valuation may seem farfetched, these criticisms ignore a few legitimate and entrenched advantages that WeWork does have:
They have some real margin to play with: while margins vary by location, one recent study estimated WeWork’s lowest margins – in San Francisco’s South Financial District – at nearly 40%, while on the high end, gross margin reaches almost 70%. In other words, they have some cushion, and by the time the bulk of their leases expire, they will have the geographic diversification to double down where hearty margins remain, and stand toe to toe with opportunistic landlords when negotiating at the threshold of profitability.
They have resources: the lofty valuation seems based in part on the perception that WeWork is a visionary disruptor, and will make prescient moves to maintain its market dominance going forward (this should be familiar to anyone who has followed Wall Street’s ongoing infatuation with Amazon.com (AMZN) ). Right or wrong, WeWork has a sizeable war chest at its disposal, and could pivot dramatically in response to market conditions. Namely, there may come a day when WeWork surveys a landscape of depressed prices and starts actually buying up property.
They do, in fact, provide value: the presumption that current WeWork tenants will immediately bolt for a coffee shop at the first sign of a downturn unfairly discredits the essence of WeWork’s value proposition. Maybe people actually prefer the curated experience of WeWork tenancy to the constant drone of a coffee grinder and inconsistent wireless, and to the lonely monotony of a home office. They have also layered on real benefits to small companies, including an internal social network that facilitates service sharing and networking, access to discounted services like healthcare, accounting and legal and flexible conferences spaces for client meetings. WeWork has created a narrative and a brand that customers have bought into, and it seems unlikely that space leased through WeWork would be the first line item a small business slashes during leaner times. After all, WeWork came to prominence during a down economy, and had no trouble with occupancy then (albeit with a much smaller leasing footprint).
WeWork's Impending Future as the Status Quo
Having worked in a WeWork myself, I can attest to the value they provide. Sure, the spaces are cramped and (per square foot) expensive, but they also provide the type of flexibility that startups need (what other landlord can accommodate a tenant growing from two to six to 14 people in a matter of months?). The tenant base is also far more diverse than its critics are willing to admit – while I met tons of hard-coding tech savants, I was also neighbors with a broad cross section of the modern economy ranging from accountants to fashion designers and brand name dotcoms. Personally, I didn’t take much advantage of the widely-discussed free beer or programs like WeWork “summer camp” but, especially after years in a 1000 attorney law-firm, I found the energy of the environment ideally suited to tackling new challenges.
It will be interesting to see what happens when WeWork stops being the alternative upstart and becomes part of the status quo (which seems all but guaranteed given their rapidly expanding footprint). Part of WeWork’s allure is as a steward of the lean, fun startup ethos that so many of its tenants espouse. This is easy enough at the present moment, with margins sky-high, the economy humming, and investor optimism through the roof. There’s an old adage in the tech startup world, though: when the snack supply starts to wear thin, get your resume ready. If and when landlords or the economy put the squeeze on WeWork, or WeWork itself becomes the landlord, the amenities may be less plentiful, rents may rise, or, quite simply, WeWork’s brand credibility may dry up.
The problems on the horizon for WeWork are easy to spot – declining margins on the rent arbitrage they rely on, increased competition both from a host of direct competitors and indirect competitors like Liquidspace and the perils of adapting into a mature company. Clear obstacles provide good companies with time to plan and adapt and, so far, WeWork has proved to be up to that challenge. Regardless of what plays out, they have clearly tapped into a real shift in the way people work, which, despite what prognosticators may warn, is not going to suddenly reverse course.
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