Apple generates more profit from the App Store than all of Manhattan's landlords generate from rent. It also offers some important lessons about why some tenants will stop paying.

Why should anyone pay rent? We already know technology makes people less dependent on location. But technology is also doing something else: It makes it easier for tenants to band together and force landlords to change — or to go bankrupt. Covid-19 is forcing tenants to reconsider things they've always taken for granted. Two economic theories and a few stories from the online world offer a hint of where we're headed. Let's explore.

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App Store 101

Have you ever used an app? Of course you did. On the iPhone, the only way to install an app is by downloading it from Apple's App Store. On computers and Android phones, it's possible to install software from different sources — from a CD or flash drive, from the web, or from 3rd-party app markets. The iPhone has only one app store, the one owned by Apple.

The App Store is a big business in itself. In 2019, it generated about $50 billion in gross sales — revenue from app sales and in-app purchases. Most of that money didn't go to Apple, it went to tens of thousands of companies and individuals who built apps. For example, when a user pays $1 to install Angry Birds (a popular game), 70% of that dollar goes to Rovio Entertainment, the company that developed the game. The remaining 30% goess to Apple itself.

30% of $50 billion is a lot of money, especially when Apple is simply taking a cut from revenue generated by people who worked hard to build apps that customers want to use. How does Apple justify this cut? It puts in a lot of effort to ensure every single app on its App Store adheres to a "high standard for privacy, security, and content".

Each of the 2 million apps on the App Store underwent a review and approval process to make sure it is up to par. Apple's team reviews 100,000 submissions every week — including new apps and updates of existing apps. This level of quality allows the iPhone to attract the world's most affluent and highest-spending customers.

The analogy to real estate is obvious: Apple provides smaller companies with exposure to high-quality traffic in a safe and reputable location. Even the 30% cut is quite comparable to real estate. People who rent an apartment in large cities give about 30-50% of their salary to their landlords. Companies that rent office space pay about 5-15% of their total revenue in rent. Retailers pay around 10% of their turnover in rent. The numbers vary between markets and sectors, but you get the idea.  

To continue this analogy, Apple's total revenue from the App Store in 2019 is equal to about half of all the office rent paid in Manhattan during the same year*. The operating margins in a good software business are much higher than the operating margins in a good real estate business, so we can assume that Apple generates more profit from the App Store than all of Manhattan's landlords generate from rent^.

But not everyone wants to pay.

The App Store Rebellion

84% of iPhone apps are free. Apple takes a cut only from apps that actually cost money or from apps that sell other digital products. For example, some gaming apps are free, but users can purchase "weapons" or virtual accessories within the app. Some utility apps are free, but users can purchase premium features or pay to remove ads. Apple takes a cut out of such payments.

Some companies prevent their customers from buying things on their app in order to avoid Apple's "rent". Amazon's iPhone app does not sell Kindle books or other digital media because these would be subject to a Apple's commission. The apps for Spotify and Netflix don't allow customers to sign up and pay for their services; they only allow customers who already have a subscription to log in. In order to avoid Apple's "rent", a Netflix or Spotify subscription has to be bought elsewhere — on a computer, in a mobile web browser, or over the phone.

Some cases are even trickier. Earlier this week, a software company called Basecamp launched a new email service called Hey. The service costs $99 a year, and users can pay for it on Hey's web site. To avoid Apple's "rent", Hey's iPhone app does not allow users to pay for the service; they must do so online before (or after) they install the app.

The Hey app was initially approved by Apple and published on the App Store. But when Basecamp tried to publish an updated version of the app (to fix some bugs), Apple refused to approve it and threatened to remove even the older version from the store. The stated reason for this refusal was the fact that Hey did not allow its users to purchase an email subscription within the app. Apple did not like the fact that Hey sells a digital service but avoids paying a 30% cut.

Here, too, there is a clear real estate analogy. Hey's behavior is similar to a retailer that moves into a shopping mall where rent is charged as a percentage of sales. The retailer uses the store to allow people to pick up goods that were bought and paid for online. As a result, the retailer uses the store, but the landlord does not get paid because the sales were technically not completed inside the store.

The analogy is not meant to justify Apple's behavior in this case. In particular, Apple seems to have a double standard when it comes to subscription apps: As mentioned above, the iPhone apps for Netflix and Spotify are allowed on the App Store even though they do not offer in-app subscription purchases and do not pay 30% to Apple for every subscription. But Basecamp, the company behind the Hey app, is not as famous or popular as Netflix or Spotify. And that's why its response to Apple is so interesting.

Basecamp is a private company. It never raised venture capital or went through a well-publicized IPO. Most people have never heard of it. Still, it is a big business and its two founders have a lot of followers on Twitter. Once Apple refused to approve their new app, these two founders started complaining about it on Twitter. They accused Apple of acting like a "mafioso", subjecting them to a "shakedown", and engaging in "exploitative" practices.

Thousands of people liked and shared those tweets. What started on social media soon found its way to mainstream media. Dozens of publications picked up the story, including the New York Times, Washington Post, and CNBC. Influential technology analysts such as Ben Thompson and John Gruber also piled in. Everyone was criticizing Apple.

The dispute is threatening to eclipse Apple's annual event for software developers, scheduled for next week. Analysts are predicting that Apple will formally update its App Store policy to allow apps like Hey to operate freely, without sharing a cut of their sales with Apple. Even if that does not happen, it is clear that Hey managed to mobilize a large group of consumers and media organizations in order to avoid Apple's fees.

Putting our real estate goggles back on, the backlash against Apple doesn't make sense. No one forced Hey to publish an iPhone app. Apple spent a lot of money building and maintaining a popular, reputable, and safe space for its customers: Why shouldn't it be allowed to charge "rent" from anyone who wants to use that "space" to sell their wares?

To answer this question, we need to dive more deeply into the idea of rent.

Money for Nothing

As I mention in my book, Karl Marx and Adam Smith didn't agree on much, but they both agreed that "rent" was a result of a landlord's monopolistic power and not a result of any particular effort to provide value. As Smith wrote in The Wealth of Nations, landlords' "revenue costs them neither labour nor care, but comes to them, as it were, of its own accord, and independent of any plan or project". Marx later quoted Smith in his own writings.

Both Smith and Marx derived their unfavorable view of rent mostly from the pre-industrial world — where land was owned mostly by aristocrats that collected revenue without doing anything to improve the experience of their tenants. But the term "rent" is also used by more modern economists to describe an unhealthy relationship between businesses and society.

In 1974, the economist Anne O. Krueger introduced‡ the term "rent-seeking" to describe activities that seek to "increase one's share of existing wealth without creating new wealth". In one example, Krueger looked at professional licensing as a way for existing businesses (say, barbers or dentists) to limit the number of competitors in their industry. As a result, those who are already licensed can eat a bigger piece of the pie — but they are not increasing the pie.

Customers in industries that are plagued with rent-seeking behavior often end up paying high prices and having limited choice and not-so-great service. Of course, in many cases, licensing is an important way to set higher standards for an industry and keep customers happy and safe. "Rent-seeking" refers to activities that aim to extract a personal benefit without increasing the welfare of customerds and society at large.

Which brings us back to the App Store. The essential argument against Apple is that it is engaging in rent-seeking behavior by enforcing a "licensing" program that only approves apps that share their revenue with Apple. But is it fair to say that Apple is only looking to extract wealth created by others?

It's not fair. Apple's App Store enabled the creation of tens of thousands of new companies and it allows billions of people to trade with each other safely and peacefully. If that's the case, why isn't it obvious that Apple should be allowed to take a cut out of the economic activity it helped generate?

To answer this question, we need to dive into an even older economic theory.

What you see is what you pay

In 1850, the french economist Frederic Bastiat published a pamphlet titled What is Seen and What is Not Seen. The pamphlet introduced the theory that people tend to overemphasize the cost (or value) of things that are clearly visible and underestimate or ignore the cost of things that are not visible.

Bastiat argued that every obvious economic or political action has consequences that play out over time. While the action is obvious, its origins and consequences are often harder to discern and harder to associate with the original action. This explains why many actions have unintended consequences (for example: rent control is a seemingly positive action to make housing more affordable, but it often leads to housing shortages and even higher rent).

Bastiat's "seen and not seen" also applies in reverse — when a series of positive actions that are unseen are followed by a single action that is very visible and perceived as negative. This is the case of Apple's App Store: the company spent years and plenty of resources to create an environment that allows other businesses to prosper. But once it's time to collect a share of the value it generated, Apple may seem like it is charging people for nothing.

Based on the most concrete and most visible evidence, it is easy to construe Apple's behavior as rent-seeking. This is particularly true when the conversation is conducted on social media, where no one has patience to dive into the details and everything is summed into a simple visual or sound bite. And in such an environment, even traditional publications are incentivized to adopt a more simplistic tone and amplify the voice of online mobs.

(This phenomenon has implications well beyond technology and real estate. It enables and empowers the rise of populist individuals and political movements. But that's not what we're here to discuss.)

Bastiat's theory explains why the world's largest company, which owns one of the world's most loved brands (Apple), is struggling to justify the value of one of its greatest creations. The cost (30%) is much more visible and concrete than the value provided by the App Store. Ironically, the fact that the App Store works so well makes it almost invisible. We take it for granted because it doesn't force us to stop and think about how risky and cumbersome it would have been to buy, sell, verify, and download software without it.

The App Store is so popular and successful, that people take it for granted. Before we wrap this up and return to traditional landlords, Bastiat has one more idea to share with us.

The Road Not Taken

In his Pamphlet, Bastiat includes a little parable to explain the difference between the seen and unseen. He tells the the story of a shopkeeper whose son accidentally broke a window. The shopkeeper pays six francs to repair the damage. The glazier who fixed the window then takes the money and spends it on other services that provide business to even more people.

Looking at this story, it is easy to conclude that breaking the window did not cause any damage to society. The money that the shopkeeper spent on repairing it ended up flowing into the economy and benefitting many other people.  

Not so fast, says Bastiat. This conclusion is only focused on the actions we can see. What the story doesn't tell us is what didn't happen: If the child would not have broken the window, the shopkeeper would still have six francs. And he would still end up spending those six francs on something else (chocolate, for example). The money would have flowed into the economy and the shopkeeper would still have an intact window (and some chocolate!). In other words, society at large would have been wealthier.

Economists are still arguing about the parable of the broken window and its implications. But the parable introduces one valuable concept that all economists agree on: opportunity cost.

Simply put, opportunity cost describes the value you miss out on when you choose one option over another. In the example above, the opportunity cost of spending six francs on a new window is that the same six francs cannot be spent on a piece of chocolate. Money (or time) that you spend on one thing, is money that you cannot spend on another thing.

Every action we take has an opportunity cost. But because these costs are often invisible, we tend not to think about them. As a result, we often end up spending too much of our time and money in sub-optimal fashion. Once in a blue moon, if we're lucky, external events force us to reconsider our choices.

Which brings us back to landlords.

The Virus and the Cure

Traditional landlords enjoy one clear advantage over Apple: they offer a physical space, a tangible product that anyone can see and appreciate. It is easy to argue that the App Store should be free and "unsee" all of Apple's efforts to keep it safe; it is much harder to argue that an office space should be free because the space is so visible and clear.

But this does not mean that landlords are safe. Paying rent may be justifiable, but rent still has an opportunity cost. The money companies (or residents) spend on real estate could be spent on many other things. Luckily, most companies take their office for granted, they see rent as a simple fact of life. They never stop and think about all the other things they could have done with their money.

Covid-19 forced everyone to stop and think. Previously, companies had 100% of their employees at the office and contemplated how many of them can be allowed to work remotely. Now, companies are starting with 100% of employees working remotely and are contemplating how many of them should be at the office at all, how often, and for what purpose.

This change in perspective will have dramatic consequences. Once you see your opportunity costs clearly, it is impossible to unsee them. Many companies will never go back to the old arrangements. And landlords will be at a disadvantage vis-a-vis tenants who wish to renegotiate existing leases and traditional arrangements.

Most companies will continue to use office space. But landlords will have to justify their rent. They would need to make visible and concrete efforts to show customers that they care about them and understand their needs. They would have to adapt their offering to the way people work and not expect people to adapt their work to their office building. This is not just a matter of marketing or messaging; it's a matter of complete structural change in what it means to be a landlord (for details and a practical roadmap, see this book).

Ironically, Apple is much more of a monopoly than the people who own the world's most valuable land and buildings. And even its own customers are revolting and forcing it to change its ways. Despite the backlash against it, Apple will continue to extract billions in profits from its App Store — because ultimately, the App Store enables and empowers millions of people to build incredible businesses and make the most of their talents.

"Enable and empower millions of people to build incredible businesses and make the most of their talents." Office, retail, and even residential landlords should aspire to do the same. Those who won't, won't survive the backlash.

Notes:
*  $15 billion App Store revenue vs. $30 billion in rent, my rough estimate. Manhattan has about 400 million sqft of office space, times about $75 per sqft / year in rent.
^ Real estate owners make most of their money when they sell or refinance a building, not from direct profit on rent.

‡ The idea of rent-seeking was based on previous work by Gordon Tullock.
Photo credit: The Battle of Yavin, Star Wars