Why real estate needs agility to survive

EQ Office workplace optionality — photo credit: Chris Orzer
“Nothing in life is to be feared; it is only to be understood,” — Marie Curie

Agility is an organizational strategy most commonly used for rapidly changing business environments. Organizational agility is the ability to thrive in ambiguous environments, being able to adapt, have flexibility and drive balance over the long term. McKinsey & Company surveyed 2,500 business leaders about business agility and found that seventy-five (75%) percent have organizational agility as a top-priority; all needing to work in agile ways (this is a 50% percent increase from what companies currently do). Given the constant tension of technological change, agile, flexible ways of working are driving a secular shift in the office market that will not slow anytime soon.

“Agile, flexible ways of working are driving a secular shift in the office market that will not slow anytime soon.”

Real estate is a legacy industry that changes at glacial speed; and glaciers are melting faster today. Capital intensive industries like real estate (e.g. auto manufacturing, telecom, railways, airlines) have a lot of money tied up in facilities and infrastructure. These industries also have longer product development cycles that make change hard, slow and perceptively risky for every incumbent. This higher operating leverage (i.e. more fixed costs to variable costs) makes real estate and other capital intensive industries more vulnerable to economic slowdowns compared to digital, scalable businesses because we (real estate owners) still have high fixed costs (often leveraged) to pay, even when a local market taps the brakes or under a broader economic recession.

When faced with disruption, many incumbent leaders cling to legacy. Fear drives people to pursue what takes the least amount of energy to understand and particularly what’s worked before. And leaders who comprehend the bigger cultural trends and how technology is shifting demand, are most likely to see disruption as a positive force for change — not rejecting market adjustments but leading their companies into new business areas that increase financial performance.

Value Added Resellers (VARs) are disrupting commercial real estate. In other industries like hardware technology, VARs traditionally build a business model around solving limitations, or pain points that are created when big incumbents focus on larger customer segments. These resellers commonly provide a more hands-on approach to client service creating value above and beyond the original equipment supplied by the manufacturer (also known as “OEM”). VARs are commonly closer to the customer and thus better at seeing and reacting to changes emerging in demand (oh, and they can misrepresent the equipment too — but that’s another article).

The office market is now a dynamic two-sided marketplace, yet owners have largely ignored the side that occupies the product, the tenant. Office owners (i.e. big incumbents) attend to the larger customer segment, the capital markets that buy, sell and finance real estate assets. Today’s office VARs (e.g. Regus, WeWork, Knotel, Industrious) focus their business models on servicing occupier needs by buying bulk lease terms of 10–15 years to then repackage the offering into smaller, monthly or yearly chunks adding software (i.e. culture) and services to create a differentiated workplace experience. These office operators gain premium pricing for selling repackaged work place experiences, particularly when the product is move in ready, simple to transact and represents a modern way of working. These products are attractive to agile organizations and allow organizations of all size to scale real estate like never before while also transferring lease risks to those more capable of managing it — owners and operators. This is not a nascent industry and it’s growth curve is steepening as more office owners are offering alternatives to long term leases amid declining customer retention rates. The increasing costs for new customers acquisitions are driving landlords to find alternative, customer-centered solutions; more flexible office products.

The flexible office market dominates commercial real estate headlines even though it represents just 2% of total US office absorption for last few years. Growth by some operators, particularly WeWork appears paranormal particularly to any office owner running a capital intensive business. WeWork has nearly doubled its supply of leased space every year since its founding in 2010, controlling over 15 million square feet in the US by the end of 2018. And should WeWork double its supply in 2019 (namely to prove out a $47 billion valuation), this supply of flex office may not satisfy the need for agile space (i.e. inventory ≤4% of total US office market). Why? The demand for agile work environments and flexible lease structures is driving most small and medium sized organizations to contemplate alternative office products at lease expiration.

Platform value is seemingly, seriously emerging in WeWork’s position. The chart below was created using data from FactSet and Amazon filings to make a point about another company that survived on little profits and a big vision, Amazon. Amazon created a remarkable UX interface opening up the retail marketplace and expanded its reach being absolutely customer obsessed. Eventually Amazon found a gold mine in its AWS cloud business to drive a level of profitability that would allow the company to fund its growth; continue to subsidize shipping, develop other businesses, own the online digital marketplace and soon, much more.

WeWork is seemingly creating a similar case for delaying profitability, increasing customer acquisition costs (e.g. targeted digital ads, higher agent fees, reduced pricing, etc.) to capture market share while also migrating to other business models, analogous to Amazon. As the company migrates to larger customer segments (i.e. enterprise), its current VAR model maybe challenged. However, given the depth and strength WeWork has with its customer base and its ability to aggressively sell and rapidly deliver space, there is a business model here or two. As the flex market continues to mature, the company will need to (1) evolve and create a differentiated UX that satisfies the service level modern customers expect, so as to attract and retain them; (2) find a deeper, complementary relationship with the supply side (big incumbents — owners and financiers) to continue to grow its inventory; and (3) Uncover its AWS cloud cash machine to continue funding a capital heavy business model —including discipline, to reach an unstoppable future! Some argue that landlord’s improvement dollars, which operators receive after committing to pay rent under a long term lease — are funding the flex operating models — why #2 is important (yes, another article worth writing).

As agile demand grows, there are 3 things every incumbent must know.

  1. New channel partners will grow asset value —Traditional channel partners sell the base product with or for you, traditionally the commercial broker. These channels are widening and deepening to include digital platforms and flex operators. The addition of these channel partners is also driving differentiated products that increase absorption since these partners have customer centered sales and service models. Therefore owners are best served not excluding other operators in lease agreements.
  2. Flex operator exclusives are choke-holds to value. Most office owners traditionally allow operators to have an exclusive right to provide the co-working or flex product within the building or across an entire property. As the growth and diversity of flex products unfold, restrictions placed on the owner are quickly inhibiting access to a growing customer base; these are quickly reducing options for owners, constraining current and future value.
  3. Marketplace is the Holy Grail of commercial real estate. Who controls the distribution, the searching, the finding, transacting will own the real estate marketplace. Is it possible? Maybe, but the market is very fragmented. For now, there is no clear leader as to who will own the marketplace (i.e. be the Uber, Airbnb, Expedia for commercial real estate). Owners will want to support (receive and provide data to) a multitude of digital platforms versus supporting just one single player. The play book for the winner(s) require a killer customer UX with frictionless clarity around the product and its pricing.

A lot to chew on in those three points. In summary, forward thinking leaders that are driven by understanding over fear will shape our industry, the rest?… shaped by it. I’m reminded of the Hemingway quote from the novel The Sun Also Rises…

“How did you go Bankrupt?” — “Two ways… gradually, then suddenly.”