WeWork’s Massive Pivot
Evidently $18 Billion in Leases Was Just Too Much…
Just eight months after my article criticizing the coworking giant for not investing in real estate ran, the coworking giant is making a massive investment in ground-up development on Rainey Street in Austin, Texas. We covered the news in a CultureMap article titled, National coworking giant reportedly purchasing acres of Rainey Street real estate.
Back in April I argued that WeWork’s reliance on leasing instead of acquisition was their “achilles heel”. WeWork raised their first seed round almost three years after Uber was founded and more than a few people suggested that WeWork was the Uber of coworking. Uber’s claim to fame is that they’re the largest car company that doesn’t own a single car. Similarly WeWork has become the largest office real estate company that doesn’t own the buildings they license to their clients — ironically, I think this fact will turnout to be their achilles heel. What is good for Uber isn’t necessarily good for WeWork — and I predict it could cost the company and investors billions of dollars. If you’ve never heard of WeWork you obviously haven’t be paying attention to the decade old coworking trend described as,
“…a style of work that involves a shared workplace, often an office, and independent activity. Unlike in a typical office, those coworking are usually not employed by the same organization. Typically, it is attractive to work-at-home professionals, independent contractors, independent scientists or people who travel frequently who end up working in relative isolation.”
WeWork’s business model is very simple — rent space in great buildings, build the space out for office use, and then license offices and/or desks to various sized companies in various industries. Today the company has over 234 locations across the globe and they excel at creating amazing office environments for their customers. WeWork recently raised more than $4 billion after a string of smaller (but still very big) funding rounds. Earlier this week the company sold more than $700 million in junk bonds — B rated with a typical default rate of 31.24% carrying a higher than usual interest rate of 7.875%. According to their disclosures and news reportsWeWork has:
- Leased more than 14 million square feet to date
- Lease lengths between 10 and 20 years (some have termination options)
- Lease obligations of over $18 billion (not counting escalations)
- A current occupancy rate of 81% (breakeven was predicted at 60%)
- A cost structure where they license their space for half of what it costs
- Lost almost $200 million last year
While these bullet points might concern you they didn’t seem to concern the junk bond traders — demand was so great WeWork increased their junk bond offering from $500 million to $700 million. The funny thing is that I don’t really think the bullet points are a big deal either. Their real issue is that they are improving the value of property owned by others (i.e. their landlords) at the expense of their investors. This should be a huge red flag for everyone but the landlords.
The fact that Uber doesn’t own a fleet of cars is a primary driver of their growth. Uber leverages your time and your car to deliver their service. The moment you purchase a car it begins to depreciate and in a sense Uber allows their drivers to extract value from their cars by accelerating the depreciation.WeWork, on the other hand, pays the landlord rent for the privilege of improving the landlord’s property. Real estate, unlike a Ford Focus, tends to increase in value year-over-year. Uber is avoiding buying cars because cars are a HORRIBLE investment. But why is WeWork avoiding buying real estate?Historically real estate has been a good investment. They have easy access to BOTH equity and debt. Wouldn’t it be smart to own the real estate instead of simply leasing it?
Before I go further with my criticism I think I should explain that I made this EXACT same mistake when I was building my first startup — LayerOne. The concept of neutral colocation was popularized by companies like mine in the 1990s. Basically we would rent around 10,000 square feet in a highly connected building (i.e. with access to multiple fiber optic networks), build it out with raised floors, high capacity HVAC systems, generators, battery backups, and cable infrastructure, and then license cabinets and cages to internet and telecom companies. Our typical facility might cost us $10 million to buildout and our rent averaged around $65 thousand a month. We had facilities in Dallas, Miami, Chicago, and St. Louis with smaller outposts in LA and New York — we also had signed a BUNCH of leases all over the country that we had yet to buildout.
One day we were visited by an investment company out of Palo Alto who was considering making an investment. We explained our business model and the value of being in the right place (i.e. the highly connected buildings). The interesting thing about the “right” buildings is that they were almost all completely full — we had secured some of the last available spaces in the very best buildings from coast-to-coast. I explained that this was a HUGE advantage and a reason they should invest. These guys turned out to be a LOT smarter than we were. They took the list of our leases and began buying the buildings we had identified as “key” — it turns out we could have easily done the same thing. For the cost of the datacenter we built in each building we could have purchased the ENTIRE building leveraging our equity with readily available debt. We eventually sold our data centers to Equinix and they’re doing well — but the guys who bought the buildings are absolutely killing it.
Fortunately, for WeWork, as Americans shift more and more of their retail purchasing online the demand for retail space is declining. Don’t get me wrong, brick and mortar retail isn’t going anywhere but the United States has dedicated between four and ten times as much space to retail as their European and Asian counterparts. The shift to experiential shopping is perfectly timed to take advantage of the shift of talent people and high-paying jobs back to city centers. Richard Florida of CityLab explains,
“Big companies like Google or Amazon can afford to build their own new facilities. But smaller companies and gig-economy workers need flexible coworking spaces that companies such as WeWork provide, and they need affordable living spaces as well. Both of these can be built in the shell of former retail spaces.”
Ironically, WeWork is very much aware of this trend and in a departure from their typical leasing strategy, WeWork bought the iconic Lord & Taylor building on Fifth Avenue in Manhattan last year. The company will lease about a quarter of the building back to Lord & Taylor and use most of the remaining space for their global headquarters. The big question is whether or not WeWork will recognize the opportunity for ALL of their locations.
Large retail real estate companies like Simon and GGP have a LONG history of selling (not leasing) large boxes attached to their malls to big box retailers like Lord & Taylor. WeWork should exploit this fact along with the tectonic shift in brick and mortar retailing to future proof their business and lock in upside for their shareholders by purchasing their facilities instead of leasing them. If the company had pursued a strategy ofbuying instead of leasing they might have a $100 billion valuation instead of a $20 billion valuation.
When the Dot Com bubble burst the physical spaces that housed the internet faced tremendous financial pressure. They had signed very expensive longterm leases during the meteoric rise of the internet. During the downturn, intransigent landlords refused to restructure their leases and one by one data center providers filed chapter 11 and walked away from their facilities — investors lost billions while landlords suddenly had billions of dollars worth of facilities. Between 1999–2003 there was a HUGE transfer of wealth from technology investors to real estate investors. WeWork, given their current model, is almost certainly going to experience the same sort of transfer if the U.S. economy falters and the demand for office space slows.
Money is cheap. Prime real estate is in oversupply. Demand for WeWork-type spaces is in huge demand. It is time for WeWork to take advantage of the world we’re living in and starting buying the buildings they occupy before it is too late. Coworking is here to stay and the only question left to answer is who will own it. With their play in Austin, WeWork is answering that question — they’re going to own their future. Kudos…