Demand for Space-as-a-Service is strong. But building a sustainable business around it is harder than it looks.

In Part 1 of this series we looked at how the changing nature of work, the changing nature of business, the increasing complexity of office space, and the digitization of offline data are driving demand for SpaaS.

In the following parts, we will look at some of the strategic challenges involved in catering to this growing demand. First, economies of scale and marginal costs.

Too Big to Scale

Real estate companies are essentially a collection of individual projects, particularly in the office and residential sector. Each project is seen as a standalone venture, often with different partners and its own return expectations. Owning many assets creates economies of scale at the portfolio management layer, but barely impacts the economics of each individual assets.

Put another way: For a real estate company, the cost of serving a new customer remains almost constant — it is a function of the cost of acquiring or developing more space. In short, real estate is generally a business with high marginal costs.

Aspiring to Zero

Technology, on the other hand, is a business that entails high upfront investment — in R&D, product development, experimentation — but once the product is ready, the cost of serving more and more customers diminishes dramatically over time. Technology businesses tend to have low marginal costs.

Good technology companies don’t just create products with low marginal costs. They create products that create such products: They generate and analyze data and employ management methods that allow them to constantly identify new customer needs, test possible solutions, and commercialize the ones that show promise.

WeWork aspires towards low marginal costs. It makes upfront investment in proprietary technology for site selection, design, fit out, energy management, customer acquisition, customer service, online payments, and more. The company also de-emphasizes the role of physical space in pricing its offering, allowing it to serve more customers per sqft than a traditional landlord.

That said, the cost of real estate ownership or leasing is still a major component of WeWork’s marginal costs, but less so than at a traditional real estate company. And arguably, WeWork’s marginal costs will only continue to decline. Hence its valuation — which we can discuss some other time. WeWork may or may not succeed, but the important thing to note is what it aspires to become, and how different that is from a traditional landlord.

Who Moved my Space?

Meanwhile, when a traditional landlord examines WeWork’s business, it doesn’t seem to make any sense: Why spend (“lose”) all this money upfront when you can simply lease out a building and make money without doing anything special? Similarly, the owner of a corner store can ask: Why does Amazon invest in developing face recognition, cashier-less checkout systems, and delivery drones when I can simply stick to what I’m doing and make money?

We already know the answer to the second question. The answer to the first one is not clear, but things are unlikely to stay as they are.

And the funny thing is: The store owner is right! Unless he plans to operate 10,000 stores, the investment is not worth it. At the same time, the economics of retail might soon mean that unless he can operate 50,000 stores, he’ll not be able to stay in business.

Likewise with other real estate assets: The rise of Space-as-a-Service will likely herald an era of unprecedented consolidation of office and residential ownership. In Part 3 of this series, we will look at the role of other strategic concepts, including Economies of Unscale, Aggregation and Unbundling, Modularity and Integration, Network Effects, and Symbolic Value. At the end of this series, we will look at what landlords can do, and what might happen if they do nothing.

Part 3

In Part 1 and Part 2 of this series, we looked at what is driving demand for Space as a Service and the role of Economies of Scale and Marginal Costs. In this part, we will look at other strategic concepts that new entrants should be aware of — including Economies of Unscale, Unbundling, Network Effects, and Symbolic Value.

Please bear with me while we get all the theoretical stuff out of the way. It’s a necessary step on the way to a practical plan.

Economies of Unscale

We’ve already covered economies of scale and the risk of being too small. Now, let’s discuss the risk of being too large. As Kevin Maney and Hemant Taneja point out at the MIT Sloan Review, technology enables “small, unscaled companies” to “pursue niche markets and successfully challenge large companies that are weighed down by decades of investment in scale”.

Simply put, being big usually means being committed to a certain corporate and capital structure, as well as having lots of habits and instincts that work great in the world as it is, but may trip you up once things start to change.

Market changes create opportunities for new entrants and disruptors. But identifying an opportunity is not enough: Historically, competing in the commercial real estate market was restricted to relatively large players who had proprietary market data, relationships with lenders, a rolodex full of tenants and experts, and the know-how required to developed and manage a building.

These days, market information is easily available online; relationships with service providers are commoditized by online marketplaces; new sources of capital are available to those who cannot access traditional funding; and development can be outsourced for a fee. Further, venture capital is available for those who wish to take on large and inefficient industries. This allowed Wework to build an international real estate franchise “overnight” by focusing on underserved customers.

The threat of unscaled competitors is not limited to narrow niches or unwanted demographics. Speed enables small new competitors to cater to the changing preferences of mainstream tenants. And indeed, Wework is no longer focused on freelancers and small business. And other emerging operators like KnotelBreatherConvene, and The Office Group now provide on-demand work and meeting spaces to increasingly large tenants, one building at a time.

The best real estate executives know how to take moderate risks in order to turn a project into a stable asset that generates predictable income. This measured approach works well in “peace time”, but when dramatic changes are required to simply remain relevant — striving for safety might lead to ruin.

Bundling and Unbundling

People used to buy whole albums in order to listen to a single song. Tech-driven changes to the cost of production, compression, marketing, payments processing, and distribution made it possible to unbundle the music album and sell individual songs. Then, technology facilitated the emergence of new business models that allow “free” access to thousands of songs at a time.

The long lease is the music album of real estate. It is held together by high development, marketing, distribution, transaction, and switching costs. The dynamics that changed the music industry are coming to real estate. Their impact on how things work will be more modest, but their aggregate financial impact will be immense.

Technology enables lower construction costs, targeted marketing, higher density (which frees up more space), higher usage (sharing with less downtime), faster transactions with fewer middlemen and standardized legal procedures, and it even makes it easier and cheaper for tenants to reach physical locations that were previously difficult to access. And, just like in other industries, technology facilitates the emergence of business models that subsidize traditional rents with new sources of revenue.

Being a real estate company in the 21st Century means cobbling together the components that bring value to target customers and shedding the pieces that don’t. In WeWork’s case, that meant giving tenants less space per employee, more common areas, beer on tap, the ability to socialize with other tenants, discounted pricing on affiliated brands and services, and on-demand access to a global network of meeting and work spaces.

Note that the process of unbundling and bundling often leads to outcomes that don’t make sense when viewed from a traditional real estate perspective: Wework gives customers less space for their buck, so its easy to conclude that its business model is not sustainable, or even fraudulent. But looking only at space misses other types of value that customer receive and are willing to pay for. And if you don’t have a clear idea of what your customers are willing to pay for, you’re not in good shape.

Network Effects

The value of traditional real estate portfolios grows incrementally. You add a $10 asset to a $100 portfolio, and the portfolio’s value is now $110. The value of a “network” of office buildings is equal to the combined value of each individual building. A tenant in building X does not receive any added value from the fact that the landlord acquired building Z — the rent and the product (a single space on a standard lease) remain unchanged.

Compare this to a network of shared cars: Each additional car increases the availability of service and reduces wait times for all customers. Each additional customer increases the opportunity to share rides and reduce costs, which incrementally increases the usage rate of all cars. This means that every single car or customer that is added to the network has a positive impact on the usage of all other cars and the value derived by all other customers. They don’t simply add their own value to the network, the multiply it.

Now consider Wework. The company’s tenants have access to a global network of shared spaces. Individual members can share, socialize, pool their buying power, buy from, or sell to each of the other 200,000 people on Wework’s network. This means that, to a certain extent, every additional location and every additional member has a positive impact on the usage of all other spaces and the value derived by all other customers.

This, in turn, means that opening your first standalone coworking location — no matter how big, beautiful, or well-located — will not be as valuable as a location that Wework adds to its network. It also means that opening multiple locations is not enough — you must have a value proposition that emphasizes and makes use of the value of the whole network.

Symbolic Value

This article is already running longer than planned, so we’ll make this part short. An product or offering can have functional value (what the “thing” does), experiential value (what it feels like to use the “thing”), and symbolic value (what using the “thing” says about me).

Traditional offices provide functional and some experiential value to their end users — a safe and clean space to work, with fresh air served at a comfortable temperature, and access to clean bathrooms. But office buildings don’t usually offer symbolic value. I might be proud of working at the Empire State, Burj Khalifa, Flatiron, The Shard, Mori Tower, or a handful of other buildings. But even in those cases the building doesn’t provide an indication of my values, my social affiliation, or my attitude. It doesn’t say much about me.

Working at a Wework building does say something about me. I don’t have a clear idea of what that “something” is , but it is clear that (some) employees find it valuable. The symbolic value of a brand can impact the actual value of a building. This is already the case with hotels and shopping centers, and is increasingly the case with office buildings.

The Downside of Upside

The market for Space-as-a-Service is huge. As venture capitalist Marc Andreessen points out, “in a great market — a market with lots of real potential customers — the market pullsproduct out of the startup.”

Even if the team is not great, even if the product is not great, the “customers are knocking down your door to get the product” and the main challenge is how to “respond to all the emails from people who want to buy”. Arguably, this is what is currently happening in the market for flexible space: the size of the market is constrained by the availability of adequate supply.

But landlords are at a disadvantage here. Ironically, they cannot meet demand because they already have a product. But the product they have — traditional office space, discovered via a broker, delivered mostly empty, on a long-term lease — is not the product that the market wants. It is often easier to build the right business from scratch than to change an existing business.

So what can landlords do? And what happens if they do nothing? We’ll cover this and more in Part 4 of this series. Subscribe to make sure you don’t miss it. It’s free.

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Dror Poleg advises the world’s largest real estate companies, funds, and institutional investors on innovation and long-term economic and technological trends. Click here to learn more.