Discover how the WeWork bankruptcy will impact commercial real estate, the 3 reasons why they failed, and the 4 lessons every commercial real estate investor can learn from their collapse.
WeWork Business Model
WeWork, one of the nation's largest co-working spaces recently filed bankruptcy. For those of you who are unfamiliar with WeWork, it is a co-working start up that provides flexible office spaces. Their business model is simple; they lease entire office buildings (or several floors of an office building) and then they re-rent or sublease smaller sections so that the total rental income is higher than the underlying lease payment they are making. Their customers can choose from private office space, co-working spaces, meeting rooms or simply a dedicated desk. This approach became seemingly very successful and after a few years of exponential growth, the company was valued at $47 billion. At it’s peak, the stock was worth $520 a share. Today, the stock is priced at $1.25. Which begs the question, how did WeWork go bankrupt?
3 Reasons Why WeWork Went Bankrupt
1. WeWork Grew Too Fast
They acquired too many properties too quickly. It would be like if you buy a house that you can afford, but now you want to buy more homes even though you can’t afford it. So you borrow money from someone else to buy two other homes. Now you have three homes and three mortgages to pay. How long can you do that? And that was their problem, they were overleveraged and it was not sustainable.
2. Poor Due Diligence
As a startup company, WeWork did a poor job of due diligence. They failed to bring in real estate professionals with the expertise to evaluate each deal and because of that, they didn’t adequately assess the risks in their deals. A thorough assessment is comprised of physical due diligence, financial due diligence, and legal due diligence. I have a training on the importance of due diligence called 6 Tips on Due Diligence for Commercial Real Estate that will help you know exactly what the risks are and avoid the pitfalls WeWork fell into.
- Physical Due Diligence: WeWork did a good job on the physical due diligence, building inspections and market research (I've toured their facilities and they're beautiful). So they did a good job of acquiring properties or leasing properties in great locations and making them look appealing. However, where they failed is in financial due diligence.
- Financial Due Diligence: The problem with the companies financial review was that their financial projections were too aggressive, and they overpaid on their leases. This is why we always encourage investors to be conservative in their income and expense projections.
3. COVID-19 Pandemic
During the pandemic, workers shifted to remote working and that trend has continued. Companies no longer need office space because now people can work from home. With less income coming in, WeWork couldn’t pay their lease payments, meaning owners couldn’t pay their mortgage and bills. Again, we teach our protege students that not only do you need to be conservative in your projections, but you also need to be prepared for contingencies and stress test your net operating income.
All three of these factors played a key role in the collapse of a $47 billion business.
3 Impacts of WeWork Collapse on Commercial Real Estate
1. Increase Office Vacancy
My direct market for investing is the San Francisco Bay area, where WeWork has one of their headquarters. I've been familiar with WeWork from day one and paid close attention to how they impact the market. The office vacancy in the Bay area is already 30%, so with WeWorks bankruptcy it will only get worse. Nationally, office vacancy is at 20% and again, with WeWorks failure that number is likely to climb.
2. Rent Decreases
As office vacancy increases and more space becomes available, rents will drop. In fact, they are already dropping.
Loan Default and Sell-Off
3. As rents drop, rental income will decrease, and landlords will begin to default on their loans. Also, as rental income drops, their property values will decrease, and landlords will be forced to sell at low prices. Again, we can see this trend already with office buildings. Case in point, a building in my city that was valued at $220 million in 2021, just sold for $70 million cash. All this points to a massive disruption to the market. And anytime you have a massive disruption in an industry like commercial real estate, it equals opportunities. In a few weeks, I'm going to give you what I believe will be next years opportunities, so keep an eye out for my 2024 predictions.
4 Lessons to Learn from WeWork Bankruptcy
Why does WeWork’s failure matter to you? You can learn from their mistakes and these lessons will make you a better commercial real estate investor. They did not adhere to basic commercial real estate principles, which meant they they couldn’t weather market instability. Here are 4 lessons you can learn from their failure:
Lesson #1: Vet Your Tenants
You should always vet or qualify the tenants. In the case of WeWork, if you owned an office building and were considering leasing to WeWork, and you looked at their profit and loss statements, at their balance sheets, and how much cash equity they had, you would not rent to them regardless of how much they were willing to pay you. Now, obviously many landlords did and they did not vet WeWork correctly.
Lesson #2: Invest for Cash Flow
WeWork was overly optimistic on their cash flow projections, and they spent lavishly. The founder of the company took his focus off the cash flow and foolishly spent investor money on wild parties, airplanes and all the trappings of wealth. The lesson you can learn from this is to always invest for cash flow because commercial estate is a cash flow business. This is one of the basic principles of commercial real estate that we teach our Protégé Program students.
Lesson #3: Maintain Cash Reserves
Having cash reserves for unexpected expenses or economic downturns is one of the ways to safeguard your commercial real estate from disaster. In fact, it's a guiding principle in our Protege Program as part of asset management. One of our proteges Chris does a great job of emphasizing the importance of cash reserves in building his $12 million portfolio. You can watch his interview with me about it here: How to Invest in RV Storage. The truth is, real estate is seasonal. It has highs and lows and it’s during those lows, those rainy seasons that you need a rainy day fund to keep everything afloat. WeWork didn't follow this basic principle and instead relied on investor money to keep them in business.
Lesson #4: Always be the Landlord
Case in point: the founder of WeWork bought the buildings and leased them to WeWork. It was unethical and he shouldn’t have done that, but he did. And not only did he get the cash flow from leasing his buildings, but later on when everything began to collapsed, he sold his buildings for millions of dollars. Again, it was unethical, but it proves this point that you need to be the landlord, whether it's multifamily, self storage, mobile home parks, or warehouses. And then as the landlord, vet your tenant, always invest for cashflow, and have plenty of cash reserves. Follow these four commercial real estate principles, and you will have assets that are both profitable and sustainable.
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