Equity = Expectations (Part 2)
I’m trying not to be the critic opining from the outside because the critic always loses in the end. As Teddy Roosevelt says:
"It is not the critic who counts; not the man who points out how the strong man stumbles, or where the doer of deeds could have done them better. The credit belongs to the man who is actually in the arena, whose face is marred by dust and sweat and blood; who strives valiantly; who errs, who comes short again and again, because there is no effort without error and shortcoming; but who does actually strive to do the deeds; who knows great enthusiasms, the great devotions; who spends himself in a worthy cause; who at the best knows in the end the triumph of high achievement, and who at the worst, if he fails, at least fails while daring greatly, so that his place shall never be with those cold and timid souls who neither know victory nor defeat."
Founders and entrepreneurs will fail, learn, fail again and learn (and hopefully succeed) at last. How they capitalize their business is just one area that they can learn from experiences. I’m sure if and when I start a business, I’ll make a ton of mistakes. It’s inevitable. All I’m here to do is share what I’m observing and see if I can find the holes, or better yet the opportunities. I’m taking the learn-out-loud approach and welcome dissenters to put me in my place.
In Equity = Expectations (Part 1) we covered why entrepreneurs of all kind often try to solve problems in real estate and why they’re often drawn to venture capital as a way of funding their startup costs. Venture capital is plentiful right now, highly in vogue, comes with credibility and industry cache and occassionally comes with value-add services hiring help and introductions to potential customers. As more money has flooded into the space though, we’re finding that the value-add services are getting eroded and the pure transactional desires for the next deal and hunting for value has superseded portfolio support. This is a whole other issue that we can talk about regarding incentives and why the most ambitious and hungry hard workers tend to sit on the deal side and spend less time on the value-add (or asset management side). Also, as more technology and new entrants flood the real estate market, the noise barometer starts to get really loud and messy for the incumbents. I can’t tell you how many real estate companies have just thrown up their hands and said, “I need someone to tell me what to buy and what to do, it’s too much stuff to sift through.” This is the way of the world right now, everything is just moving so fast and expectations are higher than ever, leading to a lot of people feeling helpless to the change. Queue the mental health pundits. Anyhow, I digress…
We know that venture capital is a proven model of rocket fuel for businesses that can scale. What we’re finding however is that traditional operating models are seeking venture funding as a way to grow when there’s already buckets of capital available that’s best suited to the asset they’re looking to grow. While venture is primed to fund a technology asset (a piece of software that has defensibility and IP) a hard asset business that has line of site to stable cash flow and has liquidity, i.e. a single family rental home in Phoenix or a built-out office space for creatives is likely best suited for a mix of a warehouse lender + some equity (pref or otherwise) and likely a smarter way to scale up to buy/build assets. This still requires equity of course but who should step up?
As new companies that fit firmly in the “tech-enabled” bucket arrive to the early stage equity capitalization question, they need a few things besides just money. They need guidance and they need patience. These challenger businesses need to be able to hire people that can think long term, they need time to build relationships and they need time to build credibility. These things in real estate often take a lot longer than a 7-10 year typical lifecycle and certainly more than a 4 year vesting schedule. A great example of this is was when my friend approached me about building a ghost kitchen operator. She wasn’t planning on building the tech, she wasn’t planning on buying the assets but she had great relationships with food delivery companies and knew how to design a ghost kitchen with empathy towards the chefs in mind. That was her defensibility. She knew she could leverage best in class order-bundling and kitchen facilities management technology, she knew she could sign a lease or find a landlord willing to do a hybrid lease structure and most importantly, she was fresh-faced to the industry with more energy than anyone else who she was competing with and could hire talented and passionate people around her. In a sense, she was nimble, inspiring and hungry. I had faith she could hire talent and build a big business…but it would take TIME as this was a four-walled operating business. She could go to the VCs like many had before her and raise big money for her OpCo but then she would be forced to find a way to leverage each dollar in an unrealistic way - often spending it on drywall and HVAC systems - not the right use of equity. Instead she opted for friends and family and hoped that she could climb her way to maturity until more established debt capital would come in behind the effort and fund future operations. Therein lies the opportunity, the bundled capital offering: the first money in + early lending relationships + with takeout partners behind them.
So if I was spinning up this new GP fund how would I play it and how would I structure it? Well, I would want exposure to the following segments for the following reasons from fresh thinkers who are not well-entrenched in how the asset class has always looked.
-Reimagined senior care - I don’t want my parents living in the same type of place that their parents lived in at the end of their active lives. I want a founding team that leads with empathy but has the bravado to tell my 68 year old mother that her best years are ahead of her. This could come in the form of a tech-enhanced new-age senior care manager who can take equity positions in certain deals on a one-off-basis. This could also be a full-stack owner/operator like a group like Cantina.
-Affordable yet aspirational farmsteads and cottages - We all want that Instagram glamor shot that makes us look rustic but really we have full wifi and top notch amenities. Think Discovery Land meets Soho House but priced like a Marriott. This could look like Wilder Ways that brings the best of the outdoors experiences together with inspiring spaces.
-Urban loft style short-term rentals - Some people are averse to hotels and like the idea of living more like a local. STR helps you get that vibe and usually prices to a point beneath luxury hotel but above commodity hotel. I would back a sponsor that uses STR as the launchpad to get smart on consumer desires and then learns the hotelier management model and brings a fresh face to it - laden with technology. This group would start with managing units on behalf of real estate owners but would have to learn to eventually grow up into an owner/operator themselves. There are a number of these groups already.
-Flexible and creative office - Even existing co-working is starting to feel like an older, commoditized product type. I’m thinking Codi meets Industrious in that high ceiling, old brick factory in Brooklyn. I don’t like the thematic approaches to coworking (only for creatives or only for women). I like the all-inclusive style but in a space that inspires. This lends itself to smaller format and might be harder to scale but could be the conduit to help bungalow owners go through the change-of-use process and eventually create inspiring places to work (from homes).
-Last mile 3PL Fulfillment - These are the companies that are going to master-lease warehouse space, chop it up, enhance the fulfillment process using automation and technology and appeal to ecommerce and traditional customers of smaller footprint warehouse space.
-Ghost Kitchen Operations - They don’t need to create their own tech but they need to understand consumer desires in a certain radius. That’s the secret sauce to success and ensuring that the value-add services to faceless restaurants are compelling enough for a restaurant to want to shed their own standalone operations.
-Life Science Co-Lab Space - These are the operators that understand what the life science companies want, the spaces they need, and have the design / execution chops to build inspiring spaces for bio-innovators.
There are a bunch more real estate service and real estate ownership models that I’d want to help launch and that’s where this GP fund would look really promising. You could structure it with a private equity partner as the sole LP and a strong list of debt / banking relationships that you could bring in to fund various working capital / cap ex needs. The first $2mm-$4mm check is the seed money. It’s the money to pay and build the founding team, enough money to cobble together the existing technology solutions to white label it for the OpCo (without building fully from scratch) and finally it would be the capital needed for the first set of transactions. Over time, these operators would grow, mature and evolve their business models. While many would start out with management / leasing structures to grow and capture demand, the desire would be to grow them up and spin them out into challengers to the existing owner/operators - buying the real estate and owning even more of the residual value like a traditional REIT.
This is once again where I need someone smarter than me to tell me where I’m wrong or what I’m not thinking about, but I know this can be done.
Perhaps it’s called SEIT Capital and it means from seed to REIT. The idea is that you can use the first set of opco equity to grow an operating model that’s psuedo asset light and help evolve and shape shift it into an owner operator that is primed and ready to become a REIT using the same firm’s capital up and down the capital stack. We know this takes decades. We know there are different risk tolerances at each point in the journey. SEIT capital can be the navigating captain from start to finish.
Anyhow, it’s only a matter of time before we see REITs that are focused on the in-between asset classes as mentioned above. So if you want to build a company now that arbitrages real estate (you know what I mean if you’re doing it) or have an angle that you think can build a huge reinvented effort of one of the real estate asset classes - it’s time to make it happen. The right equity partner is coming soon!