In 2017, venture investors deployed over $5 billion in real estate technology, more than 150 times the $33 million invested in 2010. Once a sector seemingly ignored by the venture industry, real estate tech has come front and center, notably producing two of the three most valuable startups in the United States, WeWork and Airbnb.
Driving this investment explosion is the evolution of real estate tech from its initial phase of software and marketplaces complementing the incumbents to a new era where tech enabled players are going head to head against the sector’s largest incumbents (hotels, commercial landlords, brokerages) and consuming massive amounts of investor capital as they scale. As challengers mature into leading players, we believe we are entering a third phase in the evolution of real estate technology. The businesses that define the emerging third phase of real estate technology are likely to look more like the earliest technology businesses in the space – more complementary than competitive to incumbents and deriving their value proposition by utilizing new technological capabilities. This phase likely will include companies that leverage sensors and virtual reality to create smarter spaces, machine learning to standardize and draw insights from industry data and platforms to more efficiently manage transaction services as well as to design, manage and outfit physical spaces.
Given that U.S. real estate is a $35 trillion asset class, and represents a multi-faceted market generating over $1 trillion in revenue annually, according to IBISWorld Industry Reports, the strong interest in companies built to serve, arbitrage or compete with the incumbents is not surprising. Nevertheless, up until a few years ago there were only a handful of significant U.S. real estate tech success stories.
Venture investors are a thoughtful and forward-looking group, so why did it take so long for the real estate exuberance to set in? In part, despite the industry’s size, there was seemingly a general wariness of the structural issues that make it challenging:
- Traditionally, the incumbents have made for terrible customers
- Real estate agents and brokerages (the key intermediaries) have not historically made large investments in technology and, in some cases, were opposed to adoption out of a concern that tech driven transparency could lead to their diminished relevance
- Landlords and developers see their primary focus as acquisition and/or asset management and have been reticent to make significant investments
- Traditionally, the incumbents have made for terrible customers
- The data is very messy
- Real-time data relied on sub-scale self-service info entry on non-standardized technical platforms
- Property listing data was often not updated with closing data
- Some agents believed that maintaining proprietary listing information was advantageous
- Creating meaningful client value and competitive barriers through tech in a space that is defined by a “real” and physical experience is difficult
- Market demand is not “stable”- most real estate markets go through cycles that heavily impact businesses serving the industry
Real Estate 1.0: The Complementary Phase
Despite the previously mentioned obstacles, real estate tech was not absent from the prior tech booms. The VC sweet spots of software & data and marketplace companies helped fuel the success of real estate tech “1.0” in the late 1990s. For example, commercial real estate data powerhouse CoStar went public in 1998 and HomeStore (now Move.com), the residential real estate industry’s marketplace, listed the following year. Moreover, in the mid-2000s, data management business, Altus Group, which makes the industry leading asset management software Argus, went public along with commercial marketplace LoopNet. With this activity, the seeds were planted for the big winners of the post 2008 residential market growth: Zillow and Trulia, traditional tech marketplaces for the home purchase sector.
Real Estate 2.0: The Challenger Phase
The second wave of real estate tech, “2.0,” has matured over the last six years, giving rise to two new categories, tech enabled services and space arbitrage. Space arbitrage businesses seek to create customer value by offering existing physical spaces either for a different use than the owner intended or for a shorter duration than previously possible. Although AirBnB fits the model of a traditional two-sided marketplace, its core value proposition is more about introducing a new way for people to use (and consume) space rather than about ease of search for traditional “real estate or hotel” inventory (like the 1.0 marketplaces). WeWork is the clearest example of a space arbitrage business, though it is increasingly seeking to offer a diversified set of tech enabled services. The 2.0 wave hit a milestone in July 2017 with the successful IPO of Redfin, a tech-enabled real estate brokerage. This was the first true real estate tech-enabled services company to go public and did so at a valuation multiple comparable to pure technology comps. The majority of the 2.0 success stories have been businesses which found opportunities to improve on the offerings of incumbents and grow at their expense. These companies generally included a technology component though also involved significant people-delivered or space-related services to monetize.
So this begs the question: what changed to enable real estate tech 2.0? Several factors, including:
- More than half a decade of increasing real estate values gave startups macro tailwinds on transaction volume, investor ebullience, and propensity for landlords and brokers to invest in their businesses
- Industry incumbents recognized that they did not want to become the “Blockbusters” of a potential “Netflix” future in real estate and that an embrace of tech likely would be important to maintain relevancy
- The success of Uber, a business which monetizes its technology through the work of hundreds of thousands of contractors, demonstrated the huge potential value of operationally intensive businesses powered by technology
One important difference between most of the tech 2.0 versus 1.0 companies is that while rapid growth is possible in both, the capital required for expansion of tech enabled services and space arbitrage typically have a somewhat linear relationship with growth. This is because they often have to hire more people and/or secure more physical space to be able to grow revenues. WeWork (a 2.0 company) raised more capital in its Series C round of capital ($150 million) than Zillow, Trulia and LoopNet (1.0 companies) raised collectively from inception through to all three of their IPOs. Investors, and more importantly management teams of tech 2.0 companies must be cognizant of the capital needs of their businesses. Sustaining high growth rates on increasingly large revenue bases has and will continue to require differentially larger amounts of capital than the real estate tech successes of the first wave.
As technology continues to permeate every facet of business, the lines investors draw around what they will support will become increasingly blurred. Questions about how much real estate exposure a venture backed business can and/or should have is no different than VCs debating whether holding cryptocurriences makes them a hedge fund and should therefore be beyond the scope of investing in new fintech.
The growth of businesses in the tech enabled and space arbitrage categories demonstrates that technology need not be at the core of a Company for it to rapidly expand and develop into a category leader. It also makes it particularly challenging to delineate between traditional real estate and real estate technology. In the process of fundraising for Compass, David frequently was asked to explain how a service business could have a high multiple of revenue and be valued like a traditional technology company. My response was that valuations should reflect a Company’s long-term growth rate, profitability and defensibility, and if a business can deliver those things the value will reflect that. Technology is a means, not the end in delivering economic value.
Looking forward, the key questions we believe investors in real estate tech 2.0 should be considering are:
- Commissions and Fees: Will technology reduce friction costs in real estate or reallocate them (and who will be the winner in either scenario)?
- Sustainability of Space Arbitrage: Will the premium consumers and businesses place on space flexibility and the natural conservatism of many landlords solidify real estate intermediation as a sustainable market (or like businesses in fintech subsisting on historically low interest rates, face an existential risk if market conditions change rapidly)?
- Durability and Competitive Advantage: Which real estate service businesses have efficiencies of scale and growing competitive advantages that will allow them to beat incumbents and avoid the next wave of entrants?
The 2.0 companies are almost universally direct challengers to incumbents in the industry, whereas the 1.0 companies were complementary or at most mildly threatening to existing players. AirBnB (2.0), while creating some new demand, is taking share from hotels and hostels that had done little to innovate their core operating model; WeWork (2.0) is decimating traditional office management companies like Regus; and Redfin, Compass, OpenDoor (all 2.0) along with others are attacking the traditional real estate brokerages. The stasis of the incumbents created significant opportunities for new comers to quickly take share. Nevertheless, to survive and thrive, the 2.0 companies must stay laser-focused on how technology and the platforms they are investing heavily to build can create better operating cost structures than incumbents and barriers to entry to buttress themselves from the type of competitor attacks that they orchestrated.
There is still a ways to go; real estate tech 2.0 is still developing as quickly scaling “newish” entrants continue to fight to win share and new businesses emerge to tackle property management, commercial brokerage, real estate investor services and various other sub-segments. However, some of the companies that look highly successful today may not survive a significant recession intact if they have over-indexed on share gain at the expense of sustainable economics relative to their competitors.
Real Estate 3.0: The Synthesis Phase
Real estate 3.0, which is still in its nascent stages, may potentially look more like real estate 1.0 where the key ‘startups’ are complementary to incumbents and have technology more central to their offering. The themes of this phase will likely include:
- Internet of Things technology and spatial visualization: Home and commercial space sensors, automation and construction planning tools.
- Google’s purchase of Nest was a precursor to the increasing excitement and investment of consumers and businesses in technology to enhance their physical space, a trend from which companies like eero, Sonos and Ring have benefited. Even more impactful for the construction and development sectors will be the evolution in virtual reality and user intuitive spatial planning tools that could reshape how people make decisions about what they build and how they outfit the space.
- Real estate big data: Leveraging the recent gains in the accessibility of large information sets to make decisions on real estate investment and planning
- Entrants are now leveraging machine learning to build upon the early wins in data aggregation by companies like Zillow and CoStar and provide radically more standardized and sophisticated ways to analyze real estate data. HouseCanary, for example, has built a database that includes not only property level info across the country, but also home financing data and interior home characteristics.
- Platforms to manage services and purchasing: Resources that help people manage real estate transaction services and the needs of their physical space.
- Houzz illustrates how lucrative a segment this can become as its consumer home visualization tool, monetized by home services lead generation, has grown the company to a valuation of over $4 billion. WeWork, Zillow, Redfin along with their segment up-and-comers, have all invested heavily in building multi-service platforms, where clients would select home and office providers though their site, though none seem to have cracked the code to unlock the true value of the opportunity, leaving the opportunity for new startups.
Despite the increased activity, real estate tech companies as a percent of total sector value remains a small fraction of many other sectors such as financial services, healthcare, travel, etc. Over the next half decade, the 2.0 winners and up and comers are likely to start looking like incumbents and, more significantly, the positive externalities of tech companies investing in real estate infrastructure, data and visualization will help lay the groundwork for the sector’s continued growth and development. The success of the challengers has dramatically heightened the awareness of real estate owners and service providers to the importance of technology, albeit, in many cases, at the expense of the incumbents’ usefulness. The combination of this increased awareness and VC’s eagerness to continue to fund the space should lead to many successful 3.0 companies that can scale even faster than their predecessors.