The other day I was pitched by a group who wanted my thoughts on their startup business idea.

The pitch was in essence “Regus for retail”, which meant that they wanted to rent an existing retail space in an urban core, and then create stalls for different startup retailers. A multi-tenant variant of pop up retailing.

They felt that they could get disgustingly high rents on a per square foot, shorter-term, flexible basis the same way Regus and the other executive suites players get hundreds of dollars per foot a year for their serviced offices.

The first thing that popped into my head when hearing the pitch was “flea market”, and how flea market merchants were all essentially startup businesses, and how flea markets take place on real estate that is essentially worthless.

The next thing was the inevitable clashing in a closed-air urban retail space of the selling activities of the various retailers: auditory clashing (the startup $10 smoothie vendor blending furiously over the classical music merchant), the olfactory clashing of the dude sizzling bacon for his righteous paninis, the visual clashing of the vendor with a cheap vinyl banner vs.the higher-level presentation of their adjacent tenants.

The critical concept that was lost on these entrepreneurs was that retail is a external-facing activity, vs. office use being internal-facing, and generally quiet and insulated.

The complexity of the mini-leases and the constant re-marketing of the unoccupied spaces, all for a staccato rent stream, probably isn’t worth it. No lender would want to take a risk like this, and no urban core building owner would want a revolving-door circus like that on their ground floor, at least not over the long term.

While I am all for improvement and innovation in the real estate business, often times things are the way they are for good reason.

Thoughts?

Selling skills.

Anyone can change a revenue growth rate assumption in Excel from 2% to 3%. A monkey could do that, too.

But while you can’t teach a monkey to sell, you can teach a business school student to, but business schools see it as beneath them to do so, and they don’t provide any formal training in it.

Well, this is really unfortunate. Can any business survive or thrive without strong sales? Not so much.

Yet the current state of affairs is that tens of thousands of newly minted MBAs and Masters graduates come out of school each June, and most have zero understanding of or appreciation for how to pitch a product or service to a sales prospect. They don’t know how to think about or structure a sales pitch, in writing or verbally, and if you put them on the phone with a prospect, it would be an absolute disaster. This lack of training is honestly doing the students and the businesses where they land a huge disservice.

All schools conferring any business-oriented degree absolutely need to require all their students make cold-calls for a full week, 8 hours a day, so the students learn what it takes to make a sale, so they have respect for the sales function and sales professionals, and so they think critically before changing that revenue growth rate assumption so casually and quickly.

Thoughts?

If entrepreneurs create most of the jobs, then we need to create more entrepreneurs. Most will fail, but we need to encourage as many as we can to try, to the fullest extent we can.

What have been and continue to be the barriers to entrepreneurship? Can we fix them?

Lack of education. Educational content, especially about business and entrepreneurship and fundraising, has been unleashed online. I don’t accept this as an excuse any more.

Lack of mentorship. Why hasn’t there been an Entrepreneur Mentorship project put online yet by the Obama administration? Not everyone lives in a major city with tons of potential mentors. Let’s get this up and running, and let’s get the successful business founders (still working, and retired) enrolled and actively participating. 15 minutes a week online with 1 mentee for 4 months. It could be up and running in a week. Get it done, please!

Lack of startup capital and marketing capital. I accept this less as an excuse because of Kickstarter and its various online brethren, but it is always a big issue. That said, capital chases good opportunities, so if you have something worth investing in (from the eyes of the investor, not from your vantage point) and you are willing to give a pound of flesh, then you should be able to get some capital.

Lack of personal savings for personal cash flow. This is a real issue. Kickstarter et. al. fundraising campaigns need to include budgeted funds for living expenses, not just product development costs. If you’re going to ask for money, ask for the money you need to go the distance to quit your job so you can focus on your venture, and so someone else can fill your job.

What incentives can be better provided to aspiring entrepreneurs who end up creating new jobs?

Universities can provide loan forgiveness. I’m probably the last person to have heard the expression, but due to the size of its endowment, someone described Harvard to me the other day as a “hedge fund with an educational non-profit arm.”

If you graduate from a school with educational loans, and you bust your butt and take on risk and make investment and end up creating lasting jobs, you should be rewarded by being relieved of at least some of your educational debt. You’re helping society, and you’re helping the economy, as a representative of that school. It’s phenomenal PR for them. Your school should reward you.  It’s the best fundraising action they could ever take, instead of pelting you with fundraising mailers and calls and emails that you routinely dodge.

The government can provide tax breaks.  If your company creates lasting jobs, your company should be rewarded with tax breaks for every job that you create.

I’m not a policy person, but there has got to be a way to structure this and sell it in Congress.

Thoughts?

People often ask me about the “clawback” provision in real estate private equity funds (Note: this is not the same thing as the “catch-up” mechanism, which you can read about here). Here is a plain English explanation of what it is, what it does, and how it works.

Contextual background.  A real estate private equity fund is an investment vehicle that first gets a large pool of investment capital commitments, and then goes out and identifies multiple transactions in which to invest that commingled capital.

The general financial compensation structure of real estate private equity funds is for the General Partner (aka the GP, or Sponsor), who raised the fund and whose members serve as the Fund Manager, to be compensated (above and beyond the return of their invested capital) through:

Copyright (c) 2013 by Real Estate Financial Modeling, LLC. Reproduction permitted with proper attribution.

1. An ongoing Management Fee [ F ] (e.g., 1.00% of assets under management) for the service they perform as fiduciary in screening and selecting suitable investments consistent with the risk profile communicated in the fundraising marketing materials, and for the function of managing those assets. This is paid to the Fund Manager up until the point at which all investor capital has been returned (which is typically upon the liquidation of all assets at the end of the fund). Other fees may also be negotiated such as Acquisition and Disposition fees.

2. A Preferred Return, or “Pref” [ J ] (e.g., an 8.00% annual return), which is typically calculated on a compounded basis on all of the GP’s unreturned invested capital and all of the GP’s earned but unpaid (Preferred Return) interest, and which is paid (the act of payment is called a “distribution”) when cash flows are available to do so, either monthly, quarterly, semi-annually or annually, as dictated by the fund documents. If the Preferred Return is not paid out at a designated distribution milestone, then it will accrue, or accumulate, on a cumulative basis. The Preferred Return is often paid to both the General Partner and the Limited Partners. If it is paid to only one of the two parties, it will be paid only to the Limited Partners.

3. A Carried Interest, or Promote [ N ], which is a way to financially incentivize and reward the GP in a disproportionately large manner relative to their cash investment in the fund for exceeding the level of performance of the Preferred Return. In other words,  the promote is paid (distributed) for all dollar returns achieved above and beyond the distribution of the dollar amounts purposed towards the Preferred Return. A typical promote amount on these incremental cash flows is the payment of available dollars up to the point where the GP has been paid in total 20% of the fund’s profits.

So, to be clear, excluding any Management Fees, the General Partner’s total share of cumulative fund profits is typically capped at a nominal percentage.

Here’s where the clawback potentially comes into play.

In the beginnings of the private equity fund business, the Fund Manager only received distributions of their Promote after the Limited Partners had received all of their invested capital back, which would likely not be until the end of the life of the fund (funds are typically 7-10 years in length). Thus, any Promote Payments that were made after the fund was liquidated could be precisely allocated at that point in time to not exceed the maximum share of fund-level profits for which the General Partners were eligible.

Over time, and due to the frenzy in the real estate market in the late 1990s and early 2000s during which time the markets were awash in equity capital, strong fund Sponsors with proven high-performance track records (such as Blackstone) successfully negotiated earlier (“front-loaded”) distributions of their Promote, so they could be rewarded sooner for big wins that happen earlier in the life of the fund.

The clawback came about to protect the fund’s Limited Partners for the possibility of the fund not achieving its targeted Preferred Return levels when measured as of the end of the fund due to weak performance and/or losses on transactions that came later in the life of the fund.

Clawback mechanics. The clawback, should it need to be triggered, works in the following way: as of the end of the fund’s life, at which point all investments have been liquidated, the Limited Partners have the right to “claw back” what, at that point in time, can then be calculated and classified as “excess” distributions made to the General Partners up to the point at which the General Partnership’s share of cumulative net fund profits no longer exceeds the nominal ceiling amount to which they were limited.

This can be really rough for the General Partners, who have likely spent those promote distributions years ago! GPs need to be very careful about what they agree to with Limited Partners, as while GPs might be able to extend the fund’s life somewhat to try to ride out a bad market, the Limited Partners will not let the GP extend the fund’s life indefinitely.

The other day I came across a fascinating 3-part series of papers from 2001 on the Working Papers page of the Zell-Lurie Center for Real Estate website: The Impact of New Information Technologies on the Commercial Brokerage Industry, by Joseph Gyourko and Asuka Nakahara (papers #376-378). The research was sponsored by SIOR (Society of Industrial and Office Realtors).

Part I of the research sizes the annual commissions for the U.S. office and industrial brokerage market at around $12 billion, ~75% of which belongs to leasing (as opposed to investment sales). In Part II of the research, the authors step through the 25 most likely candidates, many of which were startups, to impact the leasing and investment sales brokerage functions. The paper was published in February 2001, about a year after the NASDAQ peaked, so it’s an interesting time capsule in that regard.

Many of the companies reviewed no longer exist at their year 2001 URLs, either due to acquisition or due to having gone out of business. Some are still running at their 2001 URLs, and a few have even preserved their year 2001 user interfaces! Here are the companies:

I will write on Part III of their research separately.

It’s that time of year again, so I will share my thoughts on how new graduates can DEMONSTRATE their passion for working in the real estate business.

First off, future real estate executives, please understand the following three things, which are harsh but true:

1. Emailing someone your resume does not demonstrate passion for real estate, it simply signals that you want a source of income

2. Most executives don’t have time or interest in reading past paragraph one of a cover letter, unless paragraph one is dynamite

3. Cover letters that state how passionate you are about real estate are a dime a dozen

So how do you demonstrate your passion in a way that is more likely to get an employer’s attention? Here are a few ideas:

1. Author a bite-size sub-market study (e.g., condominium supply and demand in the DUMBO neighborhood of Brooklyn) that is relevant to that employer, and attach it to your email. You can get data from news articles, brokerage reports, municipal site plan filings and building permit issuances, and by walking the neighborhood and reading signage and talking to the neighbors of construction sites. Make a map that shows all of the currently selling and currently planned supply. Provide a ONE-paragraph Executive Summary of the study within the body of your email, estimating how many months of supply there are currently and give average pricing, and say “full report attached”.

2. Run a financial analysis that is relevant to that employer and attach the Excel file. If you don’t have your own model that you have built (which demonstrates passion), then as a fallback use one of ours.  Provide a ONE-paragraph Executive Summary of the opportunity within the body of your email, telling them at what purchase price and income levels the transaction starts to look attractive, and say “full analysis attached”.

3. Author a blog post about an issue in real estate that is interesting to you, and send them the link to that post (if it’s good enough, I’ll post it, or maybe Joe Stampone will)

4. Start your own blog (WordPress, Tumblr, both free) on real estate and send them the link to the blog

…Notice how every item above starts with an action verb, meaning you will be TAKING ACTION. Employers like employees who take action on their own accord. They don’t have time to babysit, and they want to have the peace of mind that even if they haven’t checked in with you recently, you’re likely kicking some butt on something of value to them vs. sitting around, texting with your friends, waiting to be told what to do.

If you’re still reading, you’re one of the truly motivated ones, and you have probably concluded that doing ALL of the above will further distinguish you from the less motivated.

Good luck. Remember, you need to SHOW, not tell. Talk is cheap.

Here are definitions of two sometimes misunderstood adjustment line items between Gross Potential Rent and Effective Gross Income for apartment/multi-family properties:

Loss to Lease:  a charge taken against Gross Potential Rent (GPR) for leases signed on apartment units after their initial lease-up term has expired to simulate when the leases are either renewed, or a new tenant moves in (in either case, leased), at a rent below the then-Gross Potential Rent. Loss To Lease is calculated by applying an assumed loss % to the GPR. The resulting dollar value is deducted from the GPR.

Example: your apartment, currently leased at $1,000/month, is coming up for renewal in 3 months, and the landlord sends you a letter with the new rent of $1,125/month for the new lease term if you renew. After considering it, you decide not to renew and notify them as such. A month later, the landlord emails you saying that they would be willing to renew your lease at your current rent of $1,000/month. You accept.

Assuming that the $1,125 is what the market would otherwise bear for your apartment unit when the current lease term ends, the $125.00 difference between your current rent and their $1,125 rent offer is the monthly Loss to Lease, which would be incurred by the landlord as of the commencement of the new lease term.

Downtime: a charge taken against GPR associated with gaps in income due to non-contiguous apartment lease terms. The gap in rental income will stem, at a minimum, from time needed to turn the unit over (cleaning, minor repairs, painting), and could additionally include time spent re-marketing the unit. The two variables for calculating Downtime are: 1) number of months of Downtime assumed (this can be less than one month, represented as a decimal such as 0.25), and 2) assumed % probability of lease renewal.

The formula for Downtime is: # of months down/12 * (1 – renewal probability %) * GPR.

The resulting dollar value is deducted from the GPR.

Know these to be defined differently? Please share below.

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There is a lot of excited discussion and digital ink spilled about the notion of “disruptive innovation” related to technology in the business media, at conferences, at venture capital conference room tables, and in business schools all around the world.  And there is the misconception that disruptive innovation applies to the real estate business simply because real estate is a business that is being touched more and more by technology.  

Please hear me loud and clear when I say the following: disruptive innovation does not exist or apply as far as the real estate business is concerned, and it will not in the future, either. Not even in the case of Airbnb (explained below). Real estate product and its consumption are fundamentally different from non-real estate product and its consumption, and at this point in history, real estate markets are no longer likely to be disrupted.

We define a disruptive innovation as a change to an existing market, and the associated business model change, that creates a new market altogether, which ultimately and unexpectedly overtakes the existing market.

The impetus for the business model change may or may not be a new or improved technology, but we stress that it is the new/altered business model enabled by the change that creates the disruptive impact to the existing market, not the impetus that makes the impact, whether the impetus is a technology or not (Source).  A clear example of a disruptive innovation is how the technology-enabled ability to inexpensively mass-produce cars disrupted the market for horse-drawn and train-based people transportation, eventually consuming it.

We define business model, at its most basic, as “a statement of how a firm will make money and sustain its profit stream over time.” In more detail, we define business model as ‘‘the totality of how a company selects its customers, defines and differentiates it offerings, defines the tasks it will perform itself and those it will outsource, configures its resources, goes to market, creates utility for customers and captures profits” (Source).

Source: MIT

So, on to real estate and why disruptive innovation does not apply.

Here are the premises of our argument:

1. A physical real estate property has financial value only to the extent that there is an income stream, whether one-time or recurring, that currently comes from and/or can come in the future from the property (let’s leave environmental/conservation land trusts out of the discussion because they are not part of the market), where that income stream is tied to the ability of a property end user to occupy and use that property for one or more uses for a period of time
2. Service providers within the real estate business exist and derive their value only in that most real estate can and in fact does generate an income stream
3. Nothing that has happened in real estate in the modern era has caused an existing real estate market to be overtaken by a new market (the definition of the impact of a disruptive innovation), and nothing will in the future

Let’s dig into the details first by looking at the past. Here are the major changes in the real estate market in the modern era:

1. Property ownership: fragmented → more consolidated (creation and proliferation of REITs, increase in pension fund real estate allocation %s)
2. Market information: scarce and asymmetric → less so due to broker research and paid databases and barter databases
3. Market liquidity: highly illiquid → less so due to birth and growth of REITs, private equity funds, MBS and CMBS
4. Property environmental impact: who knows and who cares → we know now and we care more
5. Urban parking ratios: minimums → maximums
6. Urban population % total population: growing
7. Information management / financial analysis: by hand (and gut) → by software (and gut)
8. Developer community engagement: reactive → proactive
9. Sources of equity: the 1% → the 1% and the 99% (REITs, crowdfunding)
10. Office worker location, on the margin: in the office → out of the office

Not a single one of these changes (some of which were and are technology-assisted) involved the overtaking of an existing market by a new market.

Disruptor or facilitator?

We need to understand the important difference between the application of technology to certain aspects of real estate, and how that application has simply facilitated the existing real estate business model further or extended and monetized it, versus the changing of the nature of how real estate properties derive their value, which is the utility of the space for one or more end uses, and the nature of the financial transactions that manifest the value as an income stream.

People talk over cocktails, coffee, golf and weekend bbq’s about how Airbnb is “disrupting” the hotel industry, and it drives me nuts because they are conflating media hype with reality, and just using a buzzword without cautious regard for what they are saying.  Are Marriott, Hyatt, Wyndham, Best Western, Choice, Ritz-Carlton, Hilton, Starwood, Joie de Vivre and the rest of the gang buying or contracting with owners of hundreds of thousands of individual apartments and single family houses in tens of thousands of cities in over a hundred and ninety countries so they can market and rent these physically disparate properties out over the web through inconsistent (sometimes scary) photography and text descriptions, send room service to them, host large-scale meetings and banquets at them, and clean and maintain them daily? (Or are they abandoning these operating elements of their business?) Are they severing their ties to their current multi-unit properties? If they were doing any of these, THAT would be a legitimate disruption of the hotel market: the changing of the business model for providing the utility of the product.  But that has not happened, and it will not happen because the economics do not scale and it is a logistical non-starter.

What Airbnb essentially did was layer a software-based reservations platform over the existing “stay at a friend’s or relative’s place while they are out of town” market (which took and received payment in goodwill/friendship capital), and they monetized it.  They found and served an existing market niche: people who typically stay at hotels but would be open to staying at a friend or relative’s empty place if they could, if at a minimum it provides the same utility as the hotel room, and the cons of doing so (including the resulting imbalance in goodwill/friendship capital) don’t outweigh the pros.  They simply connected your friends and your relatives to other people, and other people’s friends and relatives to you. Every one of the properties on Airbnb is that of someone’s friend or relative.

Airbnb serves up completely heterogeneous product.

Good for Airbnb! It was brilliant and they deserve recognition, and they are raking it in. But let’s be clear that they did NOT consume the existing hotel market, nor will they. AND, let’s be clear that they are not a hotel operating company. On the margin, through their reservations platform, they are competing with the existing hotel market. But the transaction’s nature remains the same: you give me a place to stay and I’ll pay you something reasonable given supply and demand for that perishable room-night.

Airbnb’s model of heterogenous product with no standards, with heterogenous pricing with no standards, will absolutely not consume the hotel business or even come close.  The mature hotel business format exists as it does today, and will continue to grow as it has for good reason: when you leave home, you want to know what to expect, even if it’s not the Ritz.

Operators know a thing or two about delivering standard experiences.

Professional hotel operators can consistently set and meet expectations better than any individual renting out their condo on a part-time or full-time basis ever could. And frankly, if one of these condo owners becomes so good at it, and they want to scale their operation to tens of thousands of room-nights or more per year, they will see the rationale and value, financial and otherwise, in owning physically contiguous, relatively homogeneous product, and they will buy or build a hotel.

Disagree? Please tell me why below.

Have something to add? Let’s hear it below!

OK, now let’s inspect the present and speculate about the future.

AngelList (self-designated) Commercial RE market companies, sorted by followers, 5/23/13.

Airbnb and its copycats are old news. They’ve been around since 2008.  On AngelList, as of 5/23/13, there were 154 startup companies that identify themselves as being in Commercial Real Estate, and 729 that identify themselves as being in Real Estate (primarily residential). There is some cross-listing overlap, so let’s say that there are 800 in total. Almost all of the companies are online operations, and they generally fall into the following categories:

1. Marketplace for the sale and/or lease of residential, lodging and/or commercial real estate, including:

• Short time-increment rental of residential units, retail space, meeting space or desks/offices, or what I like to call the “Vacancy Whac-A-Mole” model (best of breed: ? — it didn’t work in office space for Loosecubes, but others insist it will work for them, and some have found investors willing to place a bet)
• Residential, lodging and commercial property and space listings (best of breed other than Airbnb: 42 Floors, TheSquareFoot, SpaceList, LavaMap)

2. A service to support/enhance the marketing for those who list properties in marketplaces (best of breed: Floored, View the Space)

3. Investment capital aggregators/equity crowdfunders (best of breed: Fundrise)

4. Market data aggregators (best of breed: CompStak)

5. Asset management and financial analytics platforms/tool providers (best of breed: ?)

If you think about it, all of these companies are really just variations on the theme of the function they address. And I don’t say that to take anything away from the entrepreneurs behind them. (I actually love seeing all of these companies develop and love to see new companies succeed.) That’s what entrepreneurs do in 99.9% of cases: tweak something that is existing just enough so that they have an incremental unfair advantage in acquiring and retaining customers, even if that advantage can eventually be replicated by others.

These companies are facilitating the existing market for real estate transactions, not disrupting it. Let’s step through them:

1. If one or more of the short time-increment companies fluorishes, they will fluorish on the margins of the existing commercial space rental markets, where long-term space rental is the norm because predictability of future cash flows over multiple years is valued much more highly by property owners than intermittent, unpredictable space rental cash flows that require a constant screening of potential tenants and constant signing of leases for a given space

2. If one or more of the (non-lodging) property and space listings sites fluorishes, they will fluorish in the context of the existing space listings services, taking some share of the existing market

3. If one or more of the marketing support services fluorishes, they will coexist in the service part of the business with existing players only to the extent that their customers’ properties continue to have financial value associated with them (they certainly are not potential direct disruptors of the real estate business itself)

4. If one or more of the investment capital aggregators fluorishes, they will coexist in the massive global capital markets with other real estate equity providers

5. If one or more of the data aggregators fluorishes, they will coexist in the data aggregation part of the business, and the same goes for asset management and financial analysis platform providers (these are also certainly not potential direct disruptors of the real estate business itself)

Real estate is fundamentally different than transportation, telecommunications, technology hardware, steel manufacturing and photography, which are the textbook examples of markets that are impacted by disruptive innovation.  At the end of the day, in real estate, there is a space fixed in place, an allowable use of the space, and the types of uses of those spaces and business models for extracting cash flow streams from those spaces are not going to change. No matter how well any of these real estate startup companies or their successors do, they are not going to consume their respective markets by having created new markets. They might eat some or all of the lunch of their competitors, but that is a market entrant dynamic, not a new business model-driven market altogether.

The other day I moderated a panel on innovation in real estate for an audience of around 100 Georgetown University masters in real estate students. The audience had an average age of around 30 years old, so they could all be considered Generation Y/Millennials from a demographic perspective.

I posed the following question to the audience: Who aspires to be the head of a highly-profitable, 5,000-person company?

Nobody raised their hand.

Then I asked: Who aspires to be the head of an insanely-profitable, 20-person company?

Almost everybody raised their hand.

While this was not a representative sample, and typically real estate development organizations in particular are lean operations, I still think we have a serious problem here, which is that it seems that the notion of entrepreneurial success and fulfillment is shifting dramatically from what it used to be: founding or rising to run a company that is a massive job creator/employer.

Millennials are known to dislike authority, bureaucracy, layers of management and top-down control. So it makes sense that they would not aspire to lord over a massive organization that embodied those very things. But this means that when they are thinking about starting their own businesses, they are likely thinking about leveraging technology to the maximum and keeping the employee headcount as low as possible.

This is a major problem for the health of our job market, first and foremost, because most of these 100 students will not end up being entrepreneurs (and thus not directly be job creators). For the small percentage that end up succeeding in starting a business that becomes an employer, they are likely targeting a smaller operation that is aligned with their personal values, and with the assistance of software, is highly compact.

Does anyone else worry about how this could impact job creation? It was pointed out to me that unfortunately there are two major variables at play given the way I asked the question (which I cannot go back and change), the level of profitability and the company size, which could conflate one another. Thoughts? Sound off below.