Putting the Tech Back in Proptech

While VCs have flocked to proptech in recent years, we think few have segmented the category correctly.

By the Lightspeed Fintech Team

Venture capitalists often act in packs. One of the challenges with proptech investing is much of the capital can be focused on the asset — i.e. the property and not the tech. While the market in 2022/2023 has undoubtedly changed, in 2021 VC’s pumped $32B into proptech companies. Companies like Divvy Homes hauled in $300M+ to support a rent to own home ownership model. In the same year, Pacasco took in over $200M+ to enable individuals to partially own second homes.

There’s a good reason why VCs have poured so much money into proptech: real estate is a phenomenal investment asset. During our last major economic downturn, most real estate performed demonstrably better than an investment in public market equities. According to the National Council of Real Estate Investment Fiduciaries (NCREIF), the average annualized rate of return for real estate properties in the US between 2000 and 2010 was 8.6%. If you invested a dollar in private real estate in 2000 it would be worth $2.28 by the end of 2010. Compared to a dollar invested in the S&P 500 index it would be worth $0.87 in the same period. Even though this is a highly selective 10 year window, the comparison shows how real estate can perform in an equity market downturn.

The average annualized rate of return for real estate properties in the US between 2000 and 2010 was 8.6%.

We’ve all heard the tag lines before: real estate is recession proof. Real estate is the largest store of consumers’ wealth. Real estate is how individuals create and pass along generational wealth. We generally agree with these statements, but we think the recent macroeconomic shock should adjust the way VCs look at Proptech. We define proptech as the use of technology (mainly software, hardware, and data analytics) to improve various aspects of real estate, such as the accessibility of the asset class, property management, sales, leasing, and development.

Market Shocks

To state the obvious, mortgage rates have increased to the highest levels in over two decades. This has created a downward spiral on the volume of real estate transactions and subsequent housing prices. Yet, it’s not just inflation that’s shocking the market.

There are more institutions taking ownership of real estate than ever before. Last year, 24% of residential real estate was purchased by PE Funds, REITS, iBuyers, and similar ventures — up from 15% in 2021. This kind of capital influx drastically changes the nature of a market. Institutional buyers have different motivations,rationale, and investment horizon compared to an individual consumer or even a small landlord. Institutions pay in cash, often overpay, move fast, and view the risk/reward trade-off in a different way than a newly married couple expecting their first child.

These shocks means that just blindly investing in the asset becomes harder to produce an outsized economic return (especially as the cost of capital goes up and holding periods increase). And VCs have reacted: Venture funding into proptech declined 38% in 2022. Like most economic decisions, the opportunity cost to pump hundreds of millions of dollars into a long term, slowly appreciating asset makes returning a fund in a 7–10 year cycle difficult.

Even in this quickly changing macro environment, we believe there is still plenty of room for value accretion. Investors seeking to generate alpha here will be increasingly focused on the tech behind proptechs in 2023 and beyond. While VC’s have flocked to proptech in recent years, we think few have segmented the category correctly. We’ve segmented proptech into three categories and defined what “tech” opportunities exist in each segment.

Category 1: Asset Heavy Proptech Businesses

This category is what we often think of when we talk about proptech. These are tech businesses that develop, own (or indirectly own) the assets of real estate. In many cases, companies are set up with an Operating Company (OpCo) & Property Company (Prop Co) relationship where VCs invest in the OpCo and the Prop Co raises fund vehicles for the purpose of owning real estate assets directly. Examples of companies in this space are below.

What is the tech?

The tech often focuses on how the proptech company finds and selects investment assets, or how the asset can be fractionalized for more consumer benefit. All “asset heavy” proptechs aren’t created equal. Some look like REITs and some add incredible value to a consumer by fundamentally changing the nature of what it means to own real estate.

Category 2: Proptech Enabling Tools

This category looks like what many VCs love: software. Because real estate is such a large asset class there are a plethora of stakeholders. The army of developers, builders, brokers, financers, servicers who all touch some part of the real estate value chain use varying degrees of software. Businesses that enable this market are often high gross margin businesses, displacing generic legacy solutions or manual workflows (think data tools, workflow tools, or communication tools). Examples of companies in this space are below.

What is the tech?

The innovation here often comes from translating manual, slow processes to something automated and more efficient (potentially enhanced with AI or ML). Additionally, marketplaces that disintermediate a value chain like Houzz or Wreno make it easier for consumers or businesses to find quality services that previously took months.

Category 3: Proptech Financial Products

Category three is defined by the financial tools that sit on top of or behind a real estate transaction. Often these companies build financial tools or products that enable the real estate asset. The obvious example is companies that enable mortgages, escrow accounts, or better forms of payment for real estate. This category also serves the broader capital markets, commercial owners, or consumers engaging with the bespoke purchase of real estate (ie securitizations). These businesses often look like fintech businesses. Things like transaction volume and AUM matter here. Some of these proptechs might touch the asset, but often do so in a less capital intensive way.

What is the tech?

While the product innovation can look like similar automated, intelligent workflows, they often include a level of financial engineering or some type of pricing, risk or underwriting model that traditional incumbents don’t offer. The value of these businesses often comes from a data advantage, or the structuring of a financial product to better service the needs of a real estate customer.

What Excites Us in Proptech:

We think the next wave of proptech companies will focus on generational technology development rather than just the asset class. This doesn’t mean VCs will stop investing in asset proptech businesses, it will just mean that the core unit economics of real estate must withstand macro shocks and show promises to lead into other software or platform revenue streams.

To sum it up: the next generation of leaders in this category will put the “tech” back into proptech. These companies will have some form of unique advantage in either customer acquisition, analytics and insights, or distribution, all driven by their technology over everything else. We strongly believe in this market cycle, the asset value alone is not enough to lead to venture style returns.

At Lightspeed, we are actively spending time working with founders in proptech and supporting the next wave of proptech innovation. If you’re building here let us know: Email Connor Love and Sam Eisler on the Fintech team, or find them on Twitter at @ConnorLoveCA and @seisler1.