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WeWork’s Gamble On Growth

Even for a startup, the gap between expectations and reality is enormous at WeWork. The company has emerged as an early leader in renting out co-working spaces, and for this investors have lined up to buy in at a valuation of $10 billion, making it one of the world’s most valuable venture-backed private companies.

But an analysis of its financial projections, contained in an investor presentation from late last year obtained by The Information, shows that WeWork is forecasting big growth in profits and members even as it is pushing off significant expenses into future years. That could make its profit projections tough to meet.

The Takeaway
WeWork has pursued strategies to push off expenses into the future, betting they will be offset by dramatic growth in membership and sales per member, according to financial data obtained by The Information. WeWork could grow to a size on par with the largest commercial landlords–or struggle to stay ahead of fixed costs.

Whether or not WeWork succeeds long term could shed light on how much the philosophies and business approaches commonly associated with tech startups can affect deeply established businesses such as real estate–and whether or not venture-like returns can be expected outside of traditional tech. Indeed, the company’s success will come down in part to convincing customers that it’s selling more than just space, and getting an increasing amount of revenue from each member despite rising competition.

The investor presentation, sent as part of a fundraising round late last year, showed that WeWork is projecting operating profit of $942 million by 2018 on revenue of $2.9 billion, a huge increase from the $4.2 million in operating profit it was expecting for 2014 on $75 million in revenue.

Such profit growth would put WeWork on a par with other big commercial landlords. Boston Properties, the largest office real estate company, reported operating income of $802 million last year. A person familiar with WeWork’s current financial information said the short term revenue projections remain “in the zone” but declined to comment further.

To reduce near-term costs, the documents show, WeWork aims to negotiate large concessions from landlords such as free initial rent in return for longer lease commitments–discounts that WeWork does not spread out over the length of the lease in its financial projections, as standard accounting guidelines usually call for, boosting near-term profits in the eyes of investors.

The company is also banking on landlords agreeing to cover most of its remodeling costs at buildings it leases. To persuade landlords, WeWork said it would share some of its profits with them.

To meet its revenue projections, WeWork is predicting a huge increase in the people who sign up for workspace, to 260,000 in 2018 from 16,000 last year. It also plans to launch a residential leasing business, WeLive, which is projected to contribute nearly a fifth of total revenues by 2018.

WeWork may well succeed: It has a combination of scale and cachet lacking at competitors such as Regus, NextSpace and Industrious, lots of capital, negotiating leverage and a large potential pool of customers. But if it doesn’t, profits could vanish–an unwelcome proposition for a company with leases locked in well into the 2030s.

The Numbers

WeWork launched in 2010 and has grown quickly, to 20 locations last year and 50 now, mostly in the U.S., although there are some in Britain, Israel and the Netherlands. Its main business is subletting desk space or offices to people either working independently or for small firms, including many startups. WeWork executives have said that membership has perks beyond a desk, including a sense of community and collaboration with other members.

A blend of real estate and tech investors have provided financing, including Menlo Park venture capital firm Benchmark Capital and Boston Properties Chairman Mort Zuckerman. WeWork has also received hundreds of millions of dollars from mutual funds managed by Fidelity, T. Rowe Price and others.

The company also makes money by providing phone lines and copying to members, as well as selling health insurance and gym memberships on behalf of providers of those services. These revenues made up only 6 percent of total revenue last year but are projected to grow in future years, investor presentations show.

To secure space and guard against rising rents in the future, WeWork has been locking in leases longer than most commercial tenants. Sixteen out of 19 WeWork leases in New York reviewed by Compstak, a real estate data company, were at least 15 years. Brokers say that’s longer than usual.

The approach has helped it to obtain free rent periods. When companies lease a space, they sometimes receive free rent for the first few months as part of negotiations. In general, the longer the lease, the longer the free rent period, along with other concessions such as construction cost sharing.

WeWork launched in 2010 and has grown quickly, to 20 locations last year and 50 now, mostly in the U.S., although there are some in Britain, Israel and the Netherlands

Public filings by commercial mortgage lenders show, for example, that WeWork signed a 20-year lease in New York’s financial district and received more than a year of free rent. Since so many of WeWork’s leases are new, this has helped allay near-term costs, thanks to its policy of accounting for the free rent immediately.

But it means WeWork’s rental costs are only temporarily low and will rise sharply in future years. WeWork’s cash rent expense per available desk was projected to more than double between 2014 and 2018, from $1,009 per desk annually to $2,244.

Then there are the costs of construction. WeWork remodels buildings it leases to suit its needs and it can cost the equivalent of years of rent to improve a property up front. As is common in real estate, WeWork expects landlords will pitch in to help cover remodeling costs. What is less common, though, is that WeWork built its projections assuming landlords will begin to cover a majority of these costs at most locations.

As an inducement, WeWork will offer a share of revenues or profits. WeWork’s financial projections said it would give up 9 percent of annual revenues in such deals; the investor presentation suggested the impact on profits could be even greater. A person familiar with the company said that profit-sharing deals were expected at only a minority of locations, however, and that landlords would cover more costs because they would be persuaded that WeWork’s tenancy would increase property values.

Convincing landlords to share profits in exchange for covering more of the costs could prove difficult, however. “We tried to do that with all our landlords and they all said no,” said Jeremy Neuner, co-founder of NextSpace, a competing provider of co-working spaces. “It’s very tenuous and very dependent on how the business does.”

WeWork will have to deal with increases in other expenses, including building operating expenses.

And yet margins are projected to improve. That’s because WeWork expects growth in both membership and per member revenue.

Meanwhile, as revenues rise, corporate and marketing costs would also drop drastically in comparison, improving margins. Such costs would drop from 34 percent of revenues last year to 14 percent next year, the investor presentation shows.

Potential Risks 

If revenues don’t rise astronomically–if demand slumps, or occupancy levels drop, the story could be different. If occupancy rates and average revenue per member simply stay at 2014 levels, for example, the company could struggle.

Another pitfall could be a drop in office rents. While WeWork’s long term leases protect it if rents rise, some brokers believe the market is at a peak. “If the market tanks, then what they’ll need to charge the tenant to keep swimming will be higher than someone going out into market and leasing their own office space,” said Jeff Nissani, a broker at Marcus & Millichap.

WeWork’s leasing practices have evolved since its beginnings. Its first lease, in New York’s SoHo district, was 5 years with a 5-year option to extend. Rent was low–about $37 a square foot, compared with $45 per square foot average projected this year. But it apparently did not obtain some of the same concessions such as free rent that future locations did, and has below-average profitability, according to investor slides. Last year, WeWork did not exercise its option on the location in time, causing its landlord to declare a default and seek a $500,000 penalty; the matter is now the subject of a lawsuit. WeWork has stated in court filings that the default proceedings could result in its eviction from its original flagship location.