Five Traps for Real Estate Tech Entrepreneurs
Selling into real estate owners? Here's what not to do
For better or worse, real estate is gaining a reputation as a tough industry for tech innovation. While perhaps warranted, many of the proptech startup failures I witness can be boiled down to a handful of mistakes. And I see those mistakes getting made over and over again; it’s rare I meet an real estate tech entrepreneur who isn’t making at least one.
Today’s letter will go through each of those mistakes with examples as well as illustrations of what entrepreneurs can do instead to build their businesses while avoiding these mistakes.
Mistake #1: Repeatedly Hit a Stabilized Asset’s NOI
VCs love recurring revenue software businesses. Margins are high, revenue is predictable, and vertical software offers plenty of inspiring success stories. And since buildings last a long time and don’t change very much, real estate seems like a great fit for the recurring revenue SaaS model.
Unfortunately, the fundamentals of real estate finance don’t agree, and many entrepreneurs have failed in their attempts to sell a product that is an expense line on an individual building’s P&L, even if that product comes with the promise of future savings or increased revenue.
In the real estate world, NOI is everything; stabilized buildings are valued on a multiple of NOI. So the cost of a software product isn’t just a monthly fee, it’s the impact of that monthly fee on the building’s asset value given current valuation multiples. Suddenly, the cost of a $50 per month software product sold into a stabilized multifamily asset trading at a 5 cap is $12,000. ([$50 * 12] / 0.05
While many software products promise higher revenue or lower expenses, owners don’t always get credit for those benefits in the sale or refinancing process. For example, buyers will often apply their own revenue and cost assumptions to a potential purchase, adding back in costs based on their own operating model—but are unlikely to look line-by-line at individual software expenses, meaning that the seller gets dinged for a SaaS product’s cost but doesn’t get credit for its benefits.
Software with benefits that are very difficult to tease out of the noise—higher tenant renewal rates, for instance—are in a particularly tough situation. But the same goes for products that promise improved results in categories that aren’t currently a problem, such as tenant marketing in supply-constrained coastal markets.
What to do instead: In general, developers are far more willing to spend money during an asset’s design and construction and lease-up periods if they believe it’ll enhance the asset’s ultimate value. Vendors can be much more successful selling high-ticket one-time purchases during that time than attempting to harvest recurring revenue in perpetuity from stabilized assets. For startups, this also means cash comes sooner, reducing the need for outside capital.
And relying on one-time sales on a per-project basis doesn’t mean that each purchase needs to be sold in again; most developers have a regular flow of new projects and will be happy repeat customers of a good product.
Mistake #2: Build for the Tech-Savvy REITs
Logos like Avalon Bay, Equity Residential, Starwood, and Prologis are great to have in your product marketing. For many vendors and real estate entrepreneurs, landing a big name like one of the major REITs seems a big step along the path to industry adoption and success.
But unlike in other industries, the biggest real estate names are (counterintuitively) often early adopters and can be the easiest to land. There are a few reasons for this: One, the largest real estate companies often have executives focused on technology and innovation; they’re a presence at major conferences like CRETech and Blueprint and may be partnered with proptech-focused investors like RET or Fifth Wall to gain outside insights on the newest technology products and innovations. Two, they have established processes for evaluating and piloting new technology at a handful of properties before rolling it out more broadly. And finally, most REITs self-manage, removing the annoyance of rolling out a new technology through a third-party management company.
But for multifamily, the large, tech-savvy operators are unrepresentative of the bulk of units, which are largely owned by "middle-market" owners with 2,000 to 20,000 units across a handful of MSAs. These "middle-market" owners generally do not have anyone with an "innovation" focus in-house, often use third-party managers, and don’t have an established process for evaluating or piloting new technology. And while they may participate in NMHC, ICSC, or ULI, they’re probably not attending a real estate technology conference, so getting exposure to these operators is challenging.
While other segments like office and industrial are somewhat less fragmented, the largest and most sophisticated owner-operators can still offer entrepreneurs a false positive by testing out a new technology early on. And worse, an entrepreneur may end up tailoring his or her product, features, and marketing for the savviest users, making it more difficult to penetrate the larger market.
What to do instead: Real estate tech entrepreneurs should do the hard work to get in front of middle-market owners early on. This may involve building a regional salesforce earlier than they’d like, but having product feedback come from less-sophisticated owners is essential to building a product that can gain broad adoption across the real estate market.
Mistake #3: Don’t Consider the Lender’s View
In the early days of pitching Common—a coliving operator—to developers, one particular piece of feedback from a LA multifamily developer stuck with me: "I don’t build what the tenant wants. I build what the bank wants."
This view isn’t an outlier; rather, it’s largely representative and not changing any time soon, particularly in the current rate environment with lenders increasingly fearful and cautious. For a new concept or technology, making an asset harder to lend against is a death sentence. Much of a developer’s time, effort, and relationships are spent cultivating lender relationships and securing both construction and permanent financing. Anything that jeopardizes that effort—even in exchange for higher NOI—will be a tough sell.
This was likely the greatest mistake coliving companies—including Common—made. Even with 12 month tenant leases, lenders saw large units with unfamiliar floor plans as a serious risk and struggled to underwrite a "fallback" or "day two" scenario that didn’t put debt service payments at risk. Eventually, we solved the problem by mixing coliving units with more traditional floor plans, avoiding more esoteric layouts, and working with developers to better explain the product. But it was a long journey, and any product that requires owners to have a complicated conversation with their lenders is going to have an uphill climb.
What to do instead: If you can avoid doing anything that a lender is going to see as new or different, avoid it. Whenever possible, lenders want to "check the box" and move on. Understand how lenders operate and what you can do to allow them to check that box.
If you’re going to do something new and different, think about how you’re going to solve the debt problem from Day 1. Too many innovative operators focus on LP equity alone without addressing the debt component, which will inevitably become an issue as savvy prospective LPs dig in.
Entrepreneurs who aren’t building products that don’t fit neatly into lenders’ buckets may need to bring their own debt, raising special-purpose capital from firms like Saluda Grade or Rialto. This debt won’t be cheap, but it is willing to take some risk and will allow a concept to be proven out.
Mistake #4: Complicate a Property Manager’s Life
While owners may be enthusiastic, many useful real estate products die on a property manager’s cluttered desk. While large ownership groups like REITs may have established processes and dedicated staff to support the rollout of new technology, smaller operators do not. The people implementing a new technology—both at the executive and property level—also have lots of other jobs and things on their plate, and it’s easy for the new tool to fall to the wayside.
In my experience, technology succeeds or fails on the basis of whether or not a property manager believes it will improve his or her life. This is a subjective metric because the reality is—well, subjective. When a property manager gets a call about a new technology from their regional lead or their client’s asset manager, do they say "Oh, this sounds interesting" or "Ugh, not this again"? Property managers, after all, are primarily judged by their assets’ performance: occupancy, rent growth, renewal rate, and—most importantly—NOI. It is highly unlikely a property manager would get fired for not fastidiously overseeing the implementation of a new tech tool, and they know it.
The most notable proptech success stories have made property managers’ jobs easier. Revenue management, for example, simplifies a property manager’s job by taking the task of monitoring price changes at nearby properties and adjusting rents off their plate.
What to do instead: Technology vendors need to think not just about how their pitch lands with owners, but how frontline property managers will hear it. Property managers tend to be operationally-minded, so having answers to key operational questions-up front is critical. For example:
Who will be responsible for implementing the new tool?
What kind of training will be available? Is the training also available asynchronously for building staff who may not be on-site that day?
Who maintains it? Who do I call when it breaks?
Ideally, technology vendors should avoid requiring property managers to have a relationship with yet another specialized technician; a property manager’s experience will be far better if an associate property manager or on-site maintenance technician can diagnose and fix the most common issues that arise.
Mistake #5: Don’t Think Incrementally
Real estate is an incremental business; it’s an industry of compounding effects stretched over many years, decades, and generations. Veterans of multiple real estate cycles are trained to think this way and understand the long game of building value over an extended period of time.
Note that "think incrementally" in this case doesn’t mean "make marginal improvements." Rather, it’s about taking a more systematic, stepwise approach to gaining adoption or success, thinking through each step of a plan and how A leads to B and B leads to C.
This is the "put title on the chain" problem. About two years ago, every other real estate tech entrepreneur was starting a company to move real estate title onto a decentralized ledger. This is one of those concepts that might make sense and be an improvement on the status quo if it were to be the case today, but there’s no obvious way to get from our current situation (records stashed in county courthouses nationwide) to that hypothetical future. There’s no clear path to incrementally approach the problem.
When industry veterans say that real estate "is a relationship business," they’re talking about another version of this quandary. Relationships are built incrementally over years, and most real estate buyers prefer to work with pre-existing relationships. There’s no obvious way to shortcut that process.
What to do instead: Make sure your product and capitalization strategy are aligned with the realities of your business. On the product side, the user experience should "work" even at an early stage when adoption is limited. This is obviously easier for some businesses (e.g., software) than others (marketplaces). But having a good experience for the first and tenth customers as well as the thousandth is essential for succeeding when selling into owners.
Finding the right capitalization is also key. Venture dollars aren’t a good match for the slow-and-steady, relationship-based approach that defines many good real estate-related businesses. We wrote a bit about some venture alternatives in an earlier Thesis Driven letter.
Real estate needs innovation and new approaches. But those new concepts need to meet real estate owners, developers, and lenders where they are and not ask businesses built over generations to do too much too quickly. Avoiding the mistakes outlined above will put a new concept in a better position to succeed and drive change over time.
—Brad Hargreaves
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