Over the past few years, PropTech has experienced an explosion of space-as-a-service startups. These businesses are optimizing real estate assets and re-inventing how employers manage their offices, employees travel and people rent their living space. Rent and other real estate related costs, such as, FF&E, facilities management, etc are dramatically increasing and by spreading expenses across multiple tenants, space-as-a-service startups reduce costs for tenants and increase cashflow for property owners. The players serving as a conduit for this fundamental paradigm shift, such as, WeWork, Stay Alfred, Bungalow and Hubhaus stand to capitalize from generating meaningful new efficiencies.
Space-as-a-service startups can leverage three business models: 1) master lease, 2) development and 3) an “OpCo” & “PropCo” hybrid, whereby companies own (PropCo) and operate (OpCo) the real estate assets. The master lease model enables startups to grow much faster than vertically integrated developers. Speed to market is a major advantage in a competitive space, allowing first-movers to capture the best inventory as well as the attention of users and venture investors, who have been attracted to the master lease model because of its more capital efficient approach. Although margins tend to be lower for master lease companies, the growth profile aligns itself well with the types of returns venture investors expect. As a result, and for the purposes of this blog post, we will focus on the master lease model.
How do venture investors value space-as-a-service startups? Although there isn’t a direct, pure-play public comparable set, these startups most closely resemble publicly traded REITs and REITs are typically valued off of the funds from operations (otherwise known as EBITDA excluding the gains on sale of property) directly linked to the underlying real estate assets they own. However, these new startups are not yet profitable so valuing them off of FFO multiples is not meaningful. Having said that, these startups are growing revenue incredibly fast, sometimes by as much as >4x y/y which is significantly more than the typical single digit y/y growth publicly traded REITs are experiencing. As a result, today, space-as-a-service startups are heavily reliant upon a balance of revenue multiples and velocity (in addition to market size, margin expansion, etc). However, these startups have very different margin profiles from publicly traded REITs, given startups typically leverage the master lease model for growth while REITs typically leverage the ownership model for cashflow. This begs the questions, what is the cost structure of a space-as-a-service startup? What are the top quartile benchmark margin metrics and will they be able to support long term, sustainable publicly traded companies in the future?
Given the nascent stage of the space-as-a-service industry, startups tend to calculate margins differently and, thus, there are no generally accepted industry wide benchmark metrics. In an attempt to try to put a framework around acceptable cost structures, we find it helpful to normalize margins to compare apples-to-apples.
Gross margin is typically calculated by subtracting the master lease from gross revenue (rent revenue + other ancillary revenue). Some companies include specific variable cost line items, such as, utilities, cleaning, equipment, support, etc in their cost of cost of sales. For the sake of clarity, rather than including variable costs in the gross margin calculation, it could make sense to exclude all variable costs from gross margin and subtract all variable costs from gross margin to calculate contribution margin, which represents the total profit available to pay for fixed expenses. Although contribution margin is not a generally accepted accounting principle, it is widely used by many investors to better understand margin expansion and breakeven points.
The industry is still in the early stages of development but from our experience, the best performing master lease space-as-a-service companies generate >30% gross margin and >15% contribution margin.
Publicly traded REITs typically operate at ~50% EBITDA margins (using EBITDA as a proxy for FFO) which implies a lot of ground to make up for startups. Having said that, some startups will eventually cross the chasm from master leasing to owning by leveraging the hybrid business model including an “Op Co” to finance operations and “Prop Co” to finance real asset acquisitions. This hybrid business model could help drive EBITDA margin expansion closer to ~50%. Only time will tell if startups will be able to make this jump, but if I was a betting man, I would wager the best team, with the best product, leveraging the hybrid business model focusing on the right asset class and at the right time (ie in a market dip), will be able to do it.