The Sky is Falling… But There Are Still Plenty of Reasons to Remain Optimistic
It’s funny how quickly things can change. I took some time over the past weekend to read through some of the articles that I published last year. The topics that I covered varied from article to article, but the underlying theme was consistent. It was high times in the PropTech industry. Record amounts of funding were being deployed throughout the Real Estate ecosystem. Valuations were sky high, yet somehow they kept going up. Companies were going public (often through SPACs) at valuations that seemed detached from reality, but since the pace only continued to accelerate, I started to believe that this new reality was here to stay for the long term. Mortgage rates remained near historic lows, homes were selling over asking price within days, commercial landlords were investing heavily in tech to lure people back to the office. ESG initiatives finally started to get the proper attention and resources that it deserved. Interesting and innovative new technology solutions and business models were being launched, and the world was finally giving PropTech the respect and attention that we as an industry had been craving. The wind was at our backs, and life was good. And then everything stopped.
PropTech is a very broad term and there are many different segments that make up the Real Estate industry. These segments include Residential, Office, Multifamily, Industrial, Retail, Hotels, Student Housing, Assisted Living, Self Storage, Life Science, Hospitals, and more. Within each segment of the industry, there are dozens of different categories of services that PropTech solutions address. Just a few examples of these different categories include Property Management, Security, ESG, Leasing, Tenant/Resident Experience, Communications, Financing, Disposition, Flex/Co-working, Parking, Network Infrastructure, and the list goes on. In addition to all of the existing categories and business models in the real estate industry, the past decade has introduced us to new technology powered offerings and services such as iBuying, Co-Living, Fractional Ownership, and Hybrid Work.
As is the case with most industries, innovation in PropTech has been primarily driven by nimble startups which are unencumbered by legacy hardware, corporate bureaucracy, and a need to satisfy public markets by focusing all their energy on short term quarterly results. As these startups began to gain traction and win business from more mature players in the space, legacy companies fought back in 1 of 2 ways. In certain instances they developed and deployed their own version of a similar offering that the startup pioneered, and other times they acquired the startup outright (some companies did both). There were certain instances where newer models were so disruptive (offering much better results at a fraction of the cost) that cloning the model would have been detrimental to the long term health of a legacy company because they would simply cannibalize their existing customer base by moving them from high cost / high margin solutions, to low cost / low margin solutions.
Startups are designed to not turn a profit in their early days, and their primary focus has been on top line revenue growth. Revenue growth was the key metric that investors were focused on. Monetary policy during the past few years led to cheap, easily accessible funds, so as long as a company’s revenue continued to grow at breakneck speeds, finding investors to infuse fresh capital was rarely an issue. Some of these companies were starting to see improvements in unit economics as they charted their path to profitability. Other companies viewed unit economics as an afterthought. Their plan was to continue to scale revenue anyway possible, often heavily subsidizing deals with their war chest of capital. As long as new funding continued to flow, startups assumed that there would always be a way to cash out (either through an IPO or an acquisition). Once the exit occurred, the holes in their model would become someone else’s problem, and that someone else was often retail investors. The list of PropTech companies that went public in the past few years that are now trading at pennies on the dollar are far greater than the list of PropTech companies that have grown their market cap post-IPO. It was only a matter of time before investors woke up and realized that many of these money losing companies were never going to work, and that time has now come.
The fallout from the economic changes was swift. Many of these early stage companies were years away from profitability, and their burn rate was only sustainable if they had another round closing. At the same time, reality began to sink in for the entire technology sector, and valuations went into free fall. To compound the problem, interest rates shot up, and the market started to cool down. The companies and business models that had poor unit economics took the biggest hit. Some closed down immediately, and others cut headcount down to the bone which simply bought them a little more time before their inevitable extinction. In some cases, the legacy companies that had created their own offerings that mirrored the models of these startups, shut those divisions down and pivoted back to their original model. One example of this, where billions of dollars were lost between the startups that pioneered the offering and the legacy companies that adopted it is iBuying.
iBuying was a radically different model for selling your home. The US residential real estate brokerage industry generates roughly $80B of gross commissions annually, and because the low-tech brokerage model has remained relatively unchanged for decades, entrepreneurs identified this sector as ripe for disruption. The first major player to make a name for themselves in the iBuying space was Opendoor which launched in 2014. Other new players started to emerge, and eventually the legacy industry heavyweights started to get in on the action. More and more money flooded into this category, and the share of homes sold through iBuyers started to accelerate. But then something surprising happened. Zillow, which had achieved a market cap north of $40B a few months earlier, abruptly announced that they were ceasing operation of their iBuyer division and they were laying off 25% of their team. They blamed their issues on a faulty underwriting model. Zillow went from an admired leader to the butt of the jokes overnight, and the industry players were convinced that this issue was with Zillow’s execution instead of a fundamental flaw in the business model. However, It didn’t take much longer before everyone started to realize this model in its current form was never going to work. It turns out that Zillow was actually the smart one because they realized the issues first.
The fall out is continuing to take place, and the losses are astronomical. Opendoor, which had raised $1.9B from VCs and went public in December 2020 (hitting a market cap of $19.6B), reported a nearly $1B loss in Q3 of 2022. This was followed by a massive layoff along with the ousting of their Co-Founder/CEO. Their market cap is now approx $1.5B. The second largest startup in the space, Offerpad, raised a total of $335M before going public in September 2021. They too have gone through deep rounds or layoffs and their stock has lost 78% of its value. Opendoor and Offerpad were the 2 leading iBuyer startups, but many other companies raised hundreds of millions of dollars with a similar model, and many of them are now on life support. The legacy companies that rolled out their own iBuyer divisions include Anywhere (formerly Realogy), Keller Williams, Redfin, and Zillow. Every one of these companies have ceased operation of their iBuyer division after experiencing massive losses. Glenn Kelman, CEO of industry giant Redfin recently said, “I probably should have closed the iBuying business earlier. It shouldn’t have taken a housing market correction to realize how capital-intensive and risky that was.”
In fairness, some PropTech companies that launched over the past few years are thriving, and different segments of the business have been performing better than others. It may sound counterintuitive, but often it was the companies that raised significantly less funds (they only raised what they needed to execute their plan) that are in better shape than the companies that raised massive sums at outrageous valuations. I too was caught up in the hype, foolishly believing that capital would continue to flow as freely as it had been. Hindsight is always 20/20, and looking back with some distance, the signs were there all along. There was one announcement in particular that made me realize that something was terribly wrong.
It was January of 2021 when the announcement was made. LATCH, the developer of an integrated Smart Apartment Platform (they manufactured Hardware and Software) announced that they were going public via a SPAC. I was very aware of LATCH at the time. They were a direct competitor of mine at Kastle. I must admit that they had a very compelling offering. They leveraged an Apple-esque design for their smart locks (even the boxes that they arrived in were beautiful). To power their smart locks, they developed an End-to-End software platform promising to deliver style, functionality, security, and convenience to the hottest segment of the real estate industry: Multifamily. Having worked as an executive in the same industry, I knew how technically complicated and nuanced access control, visitor management, and package delivery could be, but I would be lying if I said that I wasn’t impressed. Even though LATCH was still in its infancy, they were quickly becoming the talk of the town. But my level of admiration for their company instantly turned to skepticism when they published their S-1 leading up to their SPAC. It was the section below, detailed in an article published around that time, that captured the essence of my skepticism.
“Over the course of 2020, Latch earned $167 million in booked revenue (aka revenue from contracts to be fulfilled in the next 24 months). Their net revenue in 2020 was estimated at $18 million as of January, and the company projected net revenue to grow to $600 million in 2024”.
I am not an expert when it comes to breaking down company financials, and when I first read this quickly I mistakenly thought that they were claiming that their revenue was $167M and they were forecasting it to get to $600M by 2024. Based on my knowledge of this industry, I knew that there was no way that they generated that much revenue in 2020. I re-read it again and quickly realized my error. The $167M was not actual revenue that they collected. It included contracted revenue for projects that were planning to install over the next 24 months. A sweet spot for LATCH was new construction, and many of the Multifamily assets that they were selling into had not even broken ground. Accounting rules only allow companies to recognize revenue on the percentage of work that is completed – for example: if a project hadn’t broken ground, the revenue that they can recognize was $0. The actual recognized revenue from 2020 was $18M.
$18M in revenue is still impressive for a company as young as LATCH, but the red lights started flashing when I read that they were seeking (and achieved) a post-IPO market cap of $1.56 Billion. You read that correctly. This 5-year old company, which had never turned a profit and had lost $56M on $18M of Gross Revenue, was going public at $1.56B. LATCH went public on June 7, 2020, with a price per share of $10.80. Over the next few months, the stock price increased by 40% peaking at $16.79 on February 1, 2021. I couldn’t wrap my head around these numbers, and even though I was nearly certain that something was off, I started to question my own judgment. Eventually cracks started to appear in the broader technology sector, and the fairytale story quickly turned into a nightmare.
Fast forward to today and things look very different for LATCH. Their stock is trading at $0.87 (it had hit an all time low of $0.52), and their market cap is $126M. They laid off the majority of their team, including their Co-Founder/CEO. To be fully transparent, there was more to the story than just challenging market conditions, including reports and allegations of massive financial irregularities . But even without those financial reporting issues, my belief is that they still would have eventually ended up in the same mess that they are in today.
This is also a cautionary tale for building owners and managers who were early adopters. LATCH manufactures proprietary hardware (wireless resident locks, intercoms, and access readers) which only runs on LATCH’s proprietary software. If LATCH was to go out of business, their hardware would become useless, and the cost to rip and replace, coupled with the disruption to the building’s operation and security of the residents, would create a massive headache for multifamily building owners and managers.
One can make the argument that companies fail all of the time (even in strong markets), and that this is exactly how the free market is designed to work. Granted the LATCH story is an extreme example of dysfunction, but it represents what is playing out across many companies in the PropTech industry. The amount of capital that was invested in PropTech companies over the past 2 years is estimated to be north of $50B. There were some amazing companies that were funded during this time, and there were some not so amazing companies as well, but the one thing that they have in common is that they raised money at valuations which were not based on reality.
Startups that hit valuations of $1B+ are referred to as unicorns because an accomplishment of this magnitude is such a rare feat. But during the past few years, the amount of capital in the system was so plentiful and easily accessible, that new unicorns were being crowned all of the time. When something that should be such a rare occurrence starts to become the norm, odds are high that a bubble is forming.
The PropTech industry is facing headwinds that seemed unthinkable only 6 months ago, but I am still very bullish on its future. One reason why many of these startups were able to raise so much money is because real estate has operated in the dark ages from a technology standpoint. Technology advancements in real estate lagged far behind other large industries, and it was primed for disruption. Many companies started to make real progress in modernizing the industry, but much more work is needed. Investors have experienced massive losses recently, but I would argue that there has never been a better time for investors that have dry powder. Many of the companies that launched over the past few years have extremely compelling offerings, and new companies are still being launched to tackle the massive challenges that still exist today. In addition to creating efficiencies, many startups are mission focused on issues that affect everyone including climate change, employee health & well-being, and diversity & inclusion. Investors that have capital to invest in startups are now able to do so at valuations that are logical, and the companies that are still standing are typically the ones that have proven out their business model and demonstrated a path to profitability. One of the most exciting recent announcements that should instill confidence in the broader market is that leading PropTech investor Fifth Wall recently closed on the largest ever PropTech specific funds, which totaled over $1B.
Reading this article may give you the impression that I am all doom and gloom, but the truth is that I am more bullish on the future of PropTech than I have ever been. The funding environment for startups has become significantly more challenging, and there is much more scrutiny and due diligence that investors are conducting before they cut a check. But, that is how a healthy market should work, and there will always be funding for the most promising companies. Capital had become too easy to raise, and many companies were able to do so with business models that were not sustainable and were never going to turn a profit. The shakeout which we are currently experiencing is painful, but it is also necessary. The best companies will still receive funding, investors will be able to deploy money at rational valuations, and the real estate industry will continue to benefit from innovation and disruptive models. There is still more pain to be felt, but the future of PropTech remains bright and flush with opportunities.
The entire real estate industry is still in need of modernization, and winners will start to emerge in many of the different segments. There are certain categories where I believe we will see the most action and success coming from the start up community. If I were to place bets on where we will see the most innovation over the next 12 months, here is where I would invest my money:
ESG – Real Estate drives approximately 40% of global emissions, and occupiers, investors, and the public are demanding action from owners of real estate. We are so early in this important journey, and success affects everyone on this planet. Failure to improve in this area is not an option.
Construction – The construction process is expensive, time consuming, and filled with regulatory hurdles and inefficiencies. Innovative companies have started to make headway, but there is so much more work to be done. Even a small percentage of improvement on construction costs can save billions of dollars annually. Additionally, Office to Resi conversions are a hot topic. As the office market cools and affordable housing remains scarce, the gating factor is often the construction costs that are associated with a conversion.
EV Infrastructure – Electric cars are growing in popularity, but mass adoption of these vehicles requires the proper infrastructure in order to support them.
Flex/Co-Working – I anticipate the move from traditional leases to flexible solutions will continue to skyrocket. There are some amazing players in this space, but as the industry continues to grow, more solutions are needed to provide a frictionless experience for companies of all sizes. Additionally, more solutions are needed to allow landlords to offer flex options directly to occupiers without the need for a middleman.
AI – There are so many inefficiencies in the real estate industry, and I believe that AI can solve many of them. Real estate is a people business, and although technology will never replace people, AI can streamline so many manual tasks that currently take way more time and resources then they should.
SFR – The SFR market is exploding in popularity, and many of the largest real estate companies and institutional investors are deploying massive amounts of capital into this space. As interest rates remain high, and the economy continues to soften, I anticipate that renters will continue to take market share from homeowners. This segment is in need of a full suite of solutions for everything from acquiring these assets, property/asset management, renovations, leasing, and disposition.
Appraisals – Buying/Selling a home is one of the most frustrating processes that people encounter. All efforts to disrupt the brokerage model have so far failed, and even though someone will eventually figure it out, there are plenty of opportunities to streamline the current process. The biggest bottleneck in the home buying journey is the appraisal process, and solving for this is imperative if we want to modernize this industry.