The hotelization of real estate: a capital light management agreement business model

June '21

Problem

There is a fundamental mismatch between co-working companies (ex: WeWork) signing long-term leases as they combine short-term assets with long-term liabilities.

The short-term assets are variable, unpredictable leases from the co-working customers.
The long-term liabilities are long-term fixed leases that the co-working companies are signing with landlords.

In good times, the co-working companies earn the upside of renting out space to tenants at a higher cost than their lease, and the landlords earn guaranteed rent payments well above their mortgage obligation.

However, during times of economic uncertainty, these master lease agreements leave both parties stuck.

Solution

Leases are not the only agreements that can exist between operators (tenants) and landlords.

Management agreements, in which the landlord pays the operator a management fee for activating and operating the property, have been successfully used in hotels, multifamily housing, co-living (Common), co-working and event spaces (Industrious, Convene, Hana), retail spaces (Neyborly), and the storage locker business (LuxorOne).

The management agreement is a different business model that has proven to be less risky during economic uncertainty and more prosperous during economic booms. Best of all, it creates better alignment between all parties involved: landlord + operator + users.

Why Now

The trend of providing flexible, on-demand space is accelerating rapidly, and it is clear that these users' demands are here to stay.

As traditional long-term leases won't always work with co-living/co-working/co-wellness business models, we believe that management agreements will soon make their way to all real estate asset classes.

Management agreements solve the gap between what landlords want and what end-users want. Management agreement operators activate space and earn operating income for landlords while providing flexible and low-risk space to end-users.

Additionally, the rise of creators is increasing entrepreneur levels across the world. This model helps individual creators utilize beautiful and functional spaces that would otherwise only be accessible to large companies.

It is up to companies, like Maverick Community, to convince landlords that these arrangements are better and more sustainable for all parties. I suspect that retail, office, and flex vacancies caused by a combination of e-commerce and Covid-19 will help to encourage landlords to fill their empty spaces via management agreements.

How it works

Funding + Buildout + Design

The landlord creates an SVP (Special Purpose Vehicle) and funds this business with enough money to build out the space and furnish it. If the landlord pays for the buildout and the equipment/furniture then the percentage split is much more favorable to the landlord.

Sometimes the landlord can avoid an expensive build-out if the management company inherits a ready-made space (ex: a gym operator inheriting a former gym space).
Additionally, sometimes the management company pays for the equipment/furnishings needed to run the business (ex: gym operator paying for the fitness equipment and getting a loan to finance the purchase).

If the management company pays for the buildout and the furnishings then they will usually have an agreement in place that allows them to recoup their investment from the landlord if the landlord backs out of the deal early.

The management company works together with the landlord to design and furnish the space.

Fees + Term

The management company and the landlord agree on a management/overhead fee and percentage revenue and/or profit split. The typical term is ~5-years, and there is usually an out for the landlord if specific KPIs are not hit.

There can be waterfall arrangements so that once the operator hits market rent, then the percentage split for the management company increases.

Operation + Payments

The end users/clients of the space (ex: fitness trainers) pay their rent to the SPV created by the landlord. Likewise, the SPV pays the employees managing the space (managers, cleaners).
The management company manages the SPV bank account and maintains fully transparent books with the landlord.

Pros and Cons for the landlord and the management company

Management Company Pros:

Avoid the fragility of signing a long-term lease. A long-term lease offers you upside when the business is doing well, but you can quickly go out of business amidst volatility (ex: Covid-19).
Ability to expand more quickly and open more locations. Customers will no longer put up with traveling 30+ minutes to the office or to the gym, which puts pressure on businesses to have multiple locations.
Alignment with the landlord and end-users (customers).

Management Company Cons

Less income

Ex: Industrious makes 15-20% less on their management agreement locations versus leased locations.

Landlord Pros

More control and less risk. The management company works for the landlord and shares all operating numbers with the landlord. This creates more significant alignment and less risk for all parties involved: landlord x management company x end-users.
Greater earning potential. Leases cap the earning potential for landlords, but management agreements allow landlords to enjoy the upside of the revenue and the property value.

Ex: Industrious management agreements earn landlords ~30% more versus their leased locations.

More flexibility and less risk in times of economic uncertainty. Ex: landlord being left out on the hook for WeWork properties that abandoned their leases.
Fewer vacancies. Opening up to the management agreement model allows more businesses and individual creators to fill open space, especially space that is typically less desirable. Ex: LuxorOne used the strategy of telling landlords to give them their most undesirable space that no one else wants.

Landlord Cons

Variable, less predictable income tied to revenue versus fixed income from a lease. The landlord shares in the downside risk if a tenant is not doing well.

Traditional lenders say it is harder to underwrite a loan based on flexible, variable income streams but lenders also have a hard time underwriting loans for co-working/co-living leased tenants.

Higher up-front build-out costs.

Management Agreement Challenges

You must gain the trust of a landlord before they agree to a management agreement. The landlord has to believe in the business model.

The business model most likely needs to be proven before a company can transition from a leasee to a management company.

You have to spend a lot of time reporting and being transparent to the landlord. The landlord must understand the actual costs of the management fee and be confident that they are getting the maximum rent possible out of their spaces. You must have excellent communication and relationships with your landlord partners.
So far, these management arrangements work primarily in medium to bigger office buildings where only a few tenants have management agreements (Ex: Industrious takes up 20% of a large office building. It is worth noting that Industrious inside malls have been most the successful locations (versus in office buildings). People want to go to sites surrounded by other goods and services!).

The question is... can management agreements also work in smaller retail spaces where there are only a few tenants?

It likely depends on the size and sophistication of the landlord.
It also likely depends on the management company finding unique spaces typically hard for landlords to lease (especially in the beginning phases of a company).

Why Maverick Community is excited about the potential of management agreements

Management agreements would allow us to scale and expand more quickly using the least amount of capital. Additionally, the more locations we have, the more entrepreneurs that we can create. We believe that there is a real network effect to our business as the more locations we have, the more successful our creators can be. For example, it is difficult for a single instructor or even a single brand to find enough customers to fill multiple classes per day every day of the week out of a single location. However, numerous studio sites give our creators the ability to market to more people in different neighborhoods.
We believe landlords will be more open to our management agreements because fitness and wellness tenants benefit their entire building or center. We will bring more people to shop, eat, and buy products and serve as an amenity to other co-tenants.
Management agreements give us another angle with a different category of investors. Venture capital is usually not interested in real estate businesses because they take a lot of money to scale. Investments in real estate companies typically go towards build-out and lease securitization. Management agreements allow for investments to scale the workforce, the brand, and grow locations.
Our physical locations do not need to be on the hottest corner of main street because it is the instructors that will be marketing themselves online and driving people to our sites. This is very similar to the strategy of DVNBs (Digitally Native Vertical Brands), ex: e-commerce first companies like Bonobos, who are not leasing property in the highest traffic, most expensive areas because it is their online traffic and social media marketing that drives customers wherever they open up shop. With this in mind, we can apply the same LuxorOne strategy described above, where we can gain leverage over landlords by taking their most undesirable spaces. We win by taking spaces that no one else wants, and this can be directly from landlords or sub-leases with other businesses with too much space.
Long-term, we could to combine the management agreement strategy with the strategy of buying locations. While purchasing property puts you on the hook for a mortgage payment, similar to a lease payment, you gain the upside of increasing the real estate you occupy. We would focus our purchasing in the lower income and up and coming neighborhoods where the increase in value would be a direct result of Maverick's success.

Partnership with Co-Working and Co-Living Management Companies

We can initially explore this model by partnering with co-working and co-living management companies that have already convinced landlords that this is the business model of the future. A great example of a successful partnership that I hope to replicate is what Convene did with For Five Coffee.

Shout out to Farooq Malik, Caleb Parker, Joe Merullo, Ilana Ettinger, Britt Zaffir, and Chris Moreno for exploring this idea with me and to Jamie Hodari of Industrious for explaining the management agreement concept as a guest on the Fifth Wall and Everything CoWorking podcasts. Also, to Dave Cairns who puts out great content on LinkedIn (see example here).

Go back to Maverick Community June 2021 update