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No Mercy No Malice

We (might) Work

April 2, 2021

Real estate is an awesome gig.

For starters, the supply of fertile land (urban centers) is finite, but the source of demand keeps growing (more people/capital moving to cities). On top of that, we’ve granted real estate development such favorable tax treatment that it is nearly immune from taxation. Even Donald Trump, arguably the worst business person in U.S. history, made money in real estate development, despite the serial failure of the underlying business. As one tax law expert put it, the real estate industry “thinks of the tax code as a basket of goodies to feast on rather than a financial obligation of doing business.” Imagine buying stock and being able to depreciate it as it increased in value.

Thanks to ever-growing demand and favorable tax treatment, real estate once minted more billionaires than tech. In 2019, 223 people on the Forbes billionaire list owed their wealth to real estate, compared to 214 from tech.

Then … Covid.

The third great conveyance of the modern economy (the first two being globalization and digitization) is in full swing: Dispersion, the process of value leapfrogging traditional points of distribution. Three sectors stand to register the greatest reallocation of stakeholder value (i.e., shit-kicking): healthcare, commercial real estate, and education as consumers leapfrog hospitals, HQ, and campuses.

Dispersion is enabled by both globalization and digitization. High-bandwidth communications link billions of people, and robust mobile devices render that network continuous. Now, blockchain technology is enabling the network to store value (bitcoin) and act on it (ethereum). This will bring further disruption to industries low on IQ and heavy on EQ, such as insurance/asset management/central banking (wrapping my head around this is my biggest challenge for 2021).

The point is, the pandemic has accelerated all of these trends. A year-plus of forced acceptance of remote services in every sector has carved permanent change into our behavior. And, few sectors have seen a more radical transformation than office work.

Valuation

Any discussion of valuation must be set against the backdrop of a firm’s valuation. Gannett Co., Inc. faces structural challenges, but at a $2.5 billion enterprise value (0.7x revenue), Gannett is undervalued. Tesla is a great product and company, but at $637 billion (20x revenue), it is overvalued (send in the clowns/trolls). Disclosure: I am a shareholder in Gannett and consistently wrong re Tesla.

Anyway, the office real estate in the U.S. alone is a $2.5 trillion asset class, and it is going to leak the GDP of Switzerland to residential over the next decade. However, it’s not as easy as going short all office firms and long all residential. The fire that will rage within the office sector will raise seeds of dormancy — and create unexpected winners. One pyrophile plant that emerges from the fire may be WeWork. I’m especially proud of that last sentence.

Why We (might) Work

The wholesale abandonment of office space has been among the most striking fallouts of the pandemic, and it will have profound effects on the way we live and work, long after the virus has been tamed. In New York, new office space is coming on the market 59 percent leased, down from 74 percent pre-Covid. San Francisco went from its lowest-ever office vacancy rate to its highest in the same year, and office rents are set to decline by 15 percent. The worst may be yet to come. Analysts predict that commercial vacancy rates will rise from 17.1 percent in 2020 to 19.4 percent in 2021, besting the previous high of 17.6 percent in 2010. And, as $430 billion in commercial and multifamily real estate debt matures in 2021, lenders will be forced to reconcile the effect of the pandemic on their investments.

These changes will endure. Twitter, Facebook, and Slack have all announced the move to a predominantly remote workforce. Pinterest recently paid $90 million to terminate its HQ lease in San Francisco. REI sold its new headquarters before even moving in, and CVS plans to cut 30 percent of its office space. At my New York-based education startup, Section4, we asked employees if they wanted to come back to work after the pandemic; overwhelmingly, they wanted to stay home. We paid $1 million to terminate our SoHo office lease. After decades of promise, the telecommuting revolution is here.

Back in 2017, I predicted WeWork, then worth $16 billion, would lose 75 percent of its value and become the “poster child of unicorn mania.” Two and a half years later, that prediction was wrong, very wrong — WeWork was preparing to go public on the heels of a $1 billion investment from Softbank that valued the company at $47 billion.

But it just didn’t pencil out. After deploying my unique domain expertise (math) I concluded: “Any equity analyst who endorses this stock above a $10 billion valuation is lying, stupid, or both.”

The ensuing meltdown was cinematic — literally. Tonight, WeWork gets its closeup, in a documentary on Hulu, The Making and Breaking of a $47 Billion Unicorn. I’m in it. I have not seen it, but it is a w e s o m e.

(BTW, the production company wanted me to come to a studio in New Jersey for filming. I told them I had a two hour window and that they needed to come to my place in SoHo or find another angry professor to make terse comments. They shuttled a dozen people to my place and set up a studio in my kids room, next to the climbing wall. At that moment, I realized that people tolerating you being an asshole doesn’t make you …  any less of an asshole.)

Anyway, that wasn’t the end of the story of We. Despite losing $60 million per week of Softbank’s money in 2020, WeWork didn’t go out of business. Instead, to the board’s credit, the company fired the Jesus of reclaimed wood and smoked glass, Adam Neumann, and brought in an experienced manager. Sandeep Mathrani shed 100 of the company’s worst performing properties along with the self-dealing arrangements foisted on the company by Neumann, and laid off 8,000 employees. A crisis is a terrible thing to waste, and if WeWork turns the corner to profitability in Q4 of this year, as it has promised investors, it will be the case study in fire intensity and germination.

The new WeWork is a stronger company than the 2017 model. It’s still not worth $50 billion, but it might be worth $9B (or more). The new WeWork will benefit from the massive investments in space and brand equity (i.e., global awareness); additionally, people underestimate the difficulty of scaling “vibe,” where WeWork has a proven talent.

Most companies aren’t going 100 percent remote. But when we return to the office, we will want less space that is more flexible, and more appealing to the premier asset of any firm: its ability to attract skilled, young human capital. Pre-corona, Section4 had a long term lease on 8,000 feet at $70 per square foot. Post-corona, it will probably be closer to 2,000 at $100, and on a year-to-year lease. Further out, I could see us opening offices in Miami or Austin, where great talent is migrating.

Imagine: a commercial real estate play, with properties around the world, configured as flexible office space, rentable by the hour, the day, or the month, with great community spaces, aspirational design, and strong tech. In sum, We might Work.

Pass the Pipe (Here We Go … Again)

However, Softbank has not run out of real estate opium quite yet. Now it is trying to pass the pipe to Compass investors, hoping the markets enter into consensual hallucination that a rollup of residential real estate brokerages is (wait for it) a tech company. Yesterday, Compass went public at a valuation of approximately 3x revenue. Realogy, the closest competitor, trades at 0.29x revenue. From the Compass site:

Compass is building the first modern real estate platform, pairing the industry’s top talent with technology to make the search and sell experience intelligent and seamless.

The firm even describes itself as “a tech company reinventing the space,” despite the fact that itspent 78 percent of expenses on commissions to brokers, instead of technology or algorithms. This makes sense as Compass is … a real estate brokerage.

Just before the IPO, the underwriters cut the pricing range and halved the number of shares offered.  Despite a massive haircut in supply, the first day pop was an anemic 12 percent. I’ve worked at an investment bank taking companies public, founded companies that have gone public, and been on boards of companies going public. Dramatically reduced supply (shares) at a lower price, coupled with Goldman’s unparalleled institutional base of buyers, and Compass barely got out. In sum, the corners of this trade are beginning to collapse and could lead to a broken IPO within days. WeWork may be rising from the ashes as Compass begins to smolder.

Life is so rich,

P.S. The Section4 Sprinter community is growing. These sprinters are professionals from a variety of companies (think: top tech, consulting, mid-size firms, etc.), roles (entrepreneurs getting their hustle of the group to seasoned managers looking to level up), and countries (50+ represented).  They are getting access to top business school professors, actionable frameworks, and a community of learners they can discuss topics with.  The next sprint, Product Strategy, is taught by my esteemed colleague Adam Alter — learn more here.

P.P.S. On this week’s Prof G Pod, Marty Chavez, a senior advisor to Sixth Street Partners and the former CIO and CFO of Goldman Sachs, shares his ideas around regulating big tech like big banks and discusses the trends playing out in the digital ecosystem — including the digital asset space and fintech. You can find this episode on Apple Podcasts, Spotify, or wherever you listen.

28 comments

  1. AndreeaN says:

    Watched this last night, and need some of your relatable wisdom. For the life of me, I cannot grasp the part where Masa-san is described as–paraphrasing–believing that in 30 years, our world will be ruled by AI, so he’s putting all his chips there. Can you (Prof. SG only, please and thank you!) share WHY this is a good thing? Why in the F are we willing to give away our very humanity?!?

  2. Peter Winter says:

    Didn’t Packy just write a big piece on WeWork like this?

  3. Andy says:

    Scott,

    Thank you so so much for a post that was not political – mostly. You are thought provoking and I enjoy the weekly read, but not politics being jammed down my throat from clearly a singular point of view – which is your right! (also mine to skip the read)

    Per this post, how about getting away from the coasts a bit…. The fact that NYC and San Francisco are seeing a mass exudes is nothing new. Top 3 to 4 growing cities out of the top 10 for the past decade have been in TX, clearly because of the taxes and business friendly atmosphere. You yourself stated you might move your offices to Austin or Miami – weird how the political and business atmospheres are similar in those states vs. NYC and San Francisco…. Joe did it just to severely cut his payday on his recent contract. The income tax savings alone paid for a few houses… People in TX are hoping/praying that the mass migration from within the USA, people realize why they are leaving their homes – don’t bring broken policies with you… I would love to see your analysis from multiple of your posts go further inland than the coasts. Much real-estate in cities is in high demand through the pandemic, just not the two cities you sight. Also, there are many companies that can have workers work remotely, but many that cannot. I would also like to see the analysis of what companies and what job descriptions will potentially stay remote, all jobs does not make sense and lacks depth of analysis. All the best.

  4. Calcey Technologies says:

    Great read as always, Prof! Office space will have a demand but companies will probably be more dispersed geographically without limiting themselves to one big skyscraper. Up in NYC, Upflex is a company that has the potential to benefit massively from this change, as they make it super easy for companies to set up hub-and-spoke offices. (And WeWork is one of their partners too!)
    They are doing something quite interesting, do check it out here: https://bit.ly/2PrMSHX

  5. J.R. says:

    I was interested in your article but you discredited yourself by saying Donald Trump was the worst business man in history which is an extreme exaggeration given he is a Billionaire. Regardless of your viewpoint on his politics his business success is undeniable.

  6. Iz says:

    What r your thoughts on new Knotel owner post ch 11 picking up former wework/selina executives ? Makes no sense

  7. Mickey says:

    I appreciate companies that are trying to do what they can to pull us out of this mess. All negativity does is build negativity.

  8. Glenn says:

    Scott. I’ve spent my entire career in the valuation of commercial real estate and found your comments insightful and on point. I look forward to reading more of your thought on CRE.

  9. Petros G. Sideris says:

    Hey.

    Give Marty my regards. I’ve never talked to him but whilst in Goldman he was my role model.

  10. Prof J Morris says:

    Scott,
    My first read and i enjoyed it. Thanks.

    Prof J Morris
    REIT Professor
    Masters of Real Estate Program
    Georgetown University
    Washington DC

  11. Rob says:

    Hi Scott, loved the podcast with Raoul Pal; need more interpretation. I am 72 and an advanced case of the dying brain.

  12. Melissa Terzis says:

    I’m a huge fan of yours. Also, I’ve been saying this about Compass for years: https://wolfstreet.com/2016/10/03/app-maker-unicorn-compass-real-estate-tries-to-disrupt-residential-real-estate/

  13. Vj says:

    2 years ago I experienced WeWork for a year, my employer a small company of 6 people couldn’t get an affordable leases in the DC market. Those were prepandemic days and I saw a churn of customers at WeWork, else my experience was largely positive. The concept of a hot desk was good and many freelancers preferred it and WeWork did create a community.

    The pandemic allowed me to finally shake off the hour long DC commute and I can’t imagine the prospect of being stuck on the roads daily or even a couple of days a week.

    I hear lots of colleagues with my current employer reluctant to commute .. anyone who had a decent working space at home is reluctant to change the status quo of the last year

  14. William says:

    Accenture (ACN) went largely virtual 15 years ago, shedding tons of office space, going to ‘hoteling’ for in office work. That was when their stock was ~$35ish. now ~$275:ish. Hmmm?

  15. John says:

    I noticed last summer that Compass is starting to become property managers to some NYC apartment buildings that would be considered slumlord types. They need to keep the revenue growth going and looks like they will go off brand to do that.

  16. john patrick foley says:

    Scott:
    You are optimistic about your forcast the fall in prices and occupancy for commercial real estate. Retail storefronts in big cities (look around you in NYC) probably exceed that estimate already.

    However the more interesting cost problem (which you have not addressed, at least yet) is managing the remote workers effectively. A 23 year old acquaintance with little specific tech education (international relations) after a year or two making stupid big money at SalesForce got hired away for even crazier money because she performed and continued to do so remotely… I suspect we have not seen the tip of the iceberg and productivity losses from poor management of mid level performers as nothing in my experience of the past year has changed my observation that businesses can usually only manage the top performers remotely, e.g. they didn’t need to be managed in the first place.

    I think you are right about a lot of businesses choosing to stay mostly remote, and outside of specialty consultancies with hand picked top performers (e.g. Section4) i think there will be chaos brewing in the next 18 to 24 months.

  17. Patrick says:

    Oh Scott,
    You’ve been so trendy…setting up shop in the fabulous Soho. Back in the day when I set up shop there, my building was almost empty of 100 years of light manufacturing facilities and linoleum-covered office floors. Maybe it’s happening again! Hope this time they leave the Herman-Miller furniture behind. NYU MBA ’67

  18. Christopher A Trapani says:

    Compass: They reserved a shit-ton of shares/options for agents and executives (as revealed in their S-8). Their proclaimed pay out of 78% of commissions to their sales agents is suspect as well, it’s effectively much higher. They pay thousands of dollars in bonus and recurring marketing payments directly to agents which I doubt they are fully accounting for. What seems to be going on is the luring of agents to exchange their commission income for the purchase of evermore Compass options; that’s the way the firm is trying to make up the difference in its unfavorable split share (of commission income with their agents) but comes at the expense of a great deal of dilution and for the agents longer-term, particularly if this stock does not substantially increase. Regardless, the very fact we are talking about Compass’ share of agent produced, brokerage commissions as their source of revenue affirms the fact that this is a bricks and mortar (and heavily invested in 100’s of offices in the most expensive markets across the US- $600M in lease obligations if I am not mistaken), residential real estate firm, not an easily and cheaply scalable tech company.

  19. Morgan Myrmo says:

    Scott- would be cool to note the WeWork entered into a merger agreement with BOWX, a SPAC, to go public with a valuation around $9 billion.

    • Danny Noonan says:

      Compass has 0 tech. 0. If they try to get a bigger piece of the agents commissions the agents will all leave!

  20. Doug Orr says:

    Scott isn’t using his grumpy cynicism superpower. The idea that (a) companies will do what workers want or that (b) remote work (office space at home, can’t get cheaper) is going to make more profitable businesses, neither pass the smell test.

    Covid work at home was done with a gun to the corporate head. Remote work, I assert, is less productive, unless you natively use git as your most important tool…which most people don’t. Zoom calls suck a lot a a little less than a lot.

    Most likely, remote work will be the next gig work. Workers will compete nationally for their no benefits jobs (and the “privilege” of working from leafy, low cost Ohio). Office work, where intense networking leads to productive breakthroughs, will now become the privilege reserved for high ambition top performers.

    Companies still save lots on real estate and things generally get worse for workers. Capitalism, baby!

    • Brian says:

      You are right. I work for a big bank, remote work-from-home contact center agent productivity down by 30%+, and that’s just a start.

  21. Loren Guzik says:

    I’d like to take the other side of the trade. We’ve already seen Google send people back to the office. Chicago has started to see office space tours again. Granted we won’t be back full throttle. What we’re not talking about is that office space is “Too Big To Fail”. The job losses and real estate taxes consequences of huge office vacancies will send municipal budgets into a permanent tail spin. Pension funds will get crushed, family offices will get crushed, banks will get crushed. The domino effect would be catastrophic. How are restaurants, dry cleaners going to survive? Or do we permanently give them checks because we decided to work from home? What are the social issues? The Dog says we buy with our brain, our heart or our groin. The office and post office gatherings are where romantic relationships and life long friends are created. What is that substitute? Zoom?

  22. Cole Inman says:

    “At my New York-based education startup, Section4, we asked employees if they wanted to come back to work after the pandemic; overwhelmingly, they wanted to stay home”
    Interested to hear the combination of your two thoughts: cities aren’t going anywhere (agree) and young people want to be in the office (personal preference, more choice is better. Some don’t want to howl in the money storm.). You’ve said you have mostly young people at Section4, and it seems clear they want to be in the city, just not the office.

    “29% of workers would quit if not allowed to work from home” This one is dear to my heart because I’ve done it. As you always say “the team with the best players wins” The best players certainly are in that 29%. What could the upside to saying no to remote ever be? It’s saddening just how much white male ego shines through in firms that say a big “hell no” to remote (Netflix, banks, ect.)

    BTW, typo in 6th paragraph, Ethereum instead of Etherium.
    Keep bringing the heat Prof!

  23. Dave Jenkins says:

    The WeWork model is just inherently broken. Od warehouses could be free as in beer for WeWork to swoop in and make hip, and the model still won’t be profitable. Even moreso now as customer demand drops (permanently).

    As you point out, real estate works because of asset appreciation– WeWork doesn’t participate in that appreciation, and as such, is losing out on the money.

  24. Ametorist says:

    Please invite Dror Poleg in your podcast, author of Rethinking Real Estate. Substack / more info here you won’t regret it! https://www.drorpoleg.com/ Huge fan keep it up.

  25. Steve says:

    Thank you for this broad view of the dispersion play explaining all those little bits. Flawless.