AppFolio: Moat, Retention, & Moving Upmarket

Disclaimer: This interview is for informational purposes only and should not be relied upon as a basis for investment decisions. In Practise is an independent publisher and all opinions expressed by guests are solely their own opinions and do not reflect the opinion of In Practise.

Looking back in hindsight, why do you think AppFolio has won a part of this market in the SMB sub-1,000 units or 500 units section?

When we entered the market it was due to the lack of suitable solutions for people in that segment. At that time, Yardi and RealPage were the main players, but they were primarily servicing the enterprise market. There was no good solution for the smaller players. When we entered the market, most people were still using outdated versions of Yardi. Some were even using the DOS version as late as 2011. There was no real competition in the market, which allowed us to capture a significant share. It's a very sticky market with low churn, so as we captured the market, people didn't leave. This allowed us to take a dominant position in the SMB market. Even as AppFolio moved upmarket, they maintained their presence in the SMB sector, growing their customer base.

How did Yardi or RealPage react? RealPage bought Buildium and Yardi launched Breeze. When did this happen and why didn't they do it sooner?

Both of these were responses, that's correct. Buildium was starting to get some traction. When RealPage bought Buildium, it was a blessing in disguise. RealPage's strategy of cutting expenses led to customers leaving Buildium, even though they initially liked the product. These customers then moved to AppFolio due to dissatisfaction with how RealPage was operating. Yardi, with Breeze, encountered the innovator's dilemma. It's difficult for an enterprise-level company to successfully launch a downmarket product. Their resources and spending are always better suited for landing the next enterprise customer. They struggled to gain real traction. They did get some customers, but it wasn't from people leaving AppFolio for Breeze. They were just picking up some of the greenfield market. If I were to estimate the market share gains each year, I'd say it's about 90% AppFolio and 10% Yardi.

Are you referring to the sub-1,000 units market?

Yes, that's a fair statement.

So, in your opinion, Buildium isn't gaining any market share?

They're only losing market share.

What did Buildium do well before RealPage bought them that was gaining traction?

They operated similarly to AppFolio, in many ways. They also aimed to be an all-in-one solution. Their strategy was sound, but where they fell short, and we succeeded, was in our decision to delve deeper into the stack and add on services such as payments and screening. They chose to do this through partnerships.

This meant that while we had around 100 million in revenue, they only had about 12 million. This was because they were conducting these services through partnerships rather than doing it themselves and capturing the revenue. This made it difficult for them to keep up as they were limited in their earnings.

You could spend more on research and development and marketing?

Exactly. 

Why can't another solution displace AppFolio for those with sub-1,000 units in five years, for example?

There are two main reasons. Firstly, it's a highly regulated market, which took us a long time to build up. There were areas of the country we couldn't sell into until we developed specific features for them. This could be anything from being able to do interest payments on security deposits to complying with tax regulations in Arizona.

It took years to build out these features. I appreciate highly regulated industries because they create a natural barrier if you do it well. However, this makes it difficult for a challenger. AppFolio had to raise over $80 million to get to where they are now. If a new start-up raised $100 million tomorrow, had a strong roadmap, and AppFolio took their eye off the ball, then yes, there could be a competitor in five years. But I haven't seen anyone raising that kind of money or entering the market. It's very expensive to build out.

How could you build a cheaper solution than AppFolio?

It would be difficult due to the nuances of the market. It's highly regulated, so you can't miss a few key features and expect customers to sign up because it's slightly cheaper.

How difficult was it for these old managers to abide by the regulations who were using QuickBooks and Excel before you onboarded them?  

They were doing it manually, and often they were not compliant and were getting audited. Over the last 10 years, regulations and audits have increased. Now they have auditors coming into their offices, something they never had to deal with historically. Landlord-tenant laws have become more onerous over the last 15 years. It's now quite difficult to operate without having software. That's why, even at AppFolio, we weren't winning deals off QuickBooks and Excel anymore. We were winning Buildium customers and the like. People are now switching off of those other products.

How many greenfield accounts or units do you think are below 1,000 today?

I believe many are using some form of software, whether it's legacy Buildium, legacy Yardi, or currently AppFolio. A significant portion of the market is already cornered. Our growth strategy was to dominate that segment and capture as much of the annual Total Addressable Market (TAM) as possible. Once we reached close to that limit, we moved into an adjacent space. This was our playbook for going into multifamily and larger accounts. We've repeated this strategy as we start to hit TAM limits within those niche segments.

What was the TAM limit for the sub-1,000 segment?  

We would assess the number of units in the market and then calculate the available TAM each year. We did this through switching studies and found that on average, 10% of the market would switch each year. So if the total market of residential was 50 million units, then five million are likely switching software this year.

10% of all residential units are switching? 

It equates to a purchase decision every 10 years, which results in a good lifetime value. However, when they did switch to AppFolio, the churn rate was below 3%. This implies a 20-year lifetime value. We were seeing 10% in the market as a whole, but within our own base, they rarely left once they joined.

Of the 7.3 million units they currently have, what percentage do you think are those of sub-1,000 units?  

On a logo basis, it's probably around 90%. On a unit basis, it's obviously outside, because of the outlier units.

So it could be roughly 50-50 or something like 60-40 on a unit basis?

Yes.

If I gave you $50 million today, how would you go about displacing AppFolio?

I would focus on the areas of the market that aren't using AppFolio and try to capture those. Attempting to displace someone off of AppFolio would be incredibly time-consuming and expensive. For example, RealPage acquired Propertyware before Buildium. Propertyware was a disaster for them, barely held together. I spoke to the General Manager of that business after he left RealPage. He mentioned a week-long outage where customers couldn't log into their property. Despite this, and an NPS score of negative 80, the churn rate for his business that year was still below 3%. It seems that even if customers hate the product, they don't leave.

It's too hard to switch. The process is so ingrained that switching becomes painful. Over the next 10 years, we've pretty much won all the Propertyware clients because I don't think they have anyone on Propertyware anymore. However, it took a long time, years in fact. So it's less about money and more about time. If they're making mistakes and you're building a great product, you can win over time, but it's a long-term game.

What exactly is RealPage doing?

They're following the Thoma Bravo playbook. They're doing what they do best, which is cutting a lot of operational costs. They're cross-selling their products to their existing customer base to increase revenue. That's how they've positioned their sales team. It's an expansion sales team, not a land.

Do you know how many units PropertyWar had when it was acquired and how they differentiated versus AppFolio back in the day?

I believe they had close to a million units when they were acquired. Over time, that number has dwindled to almost nothing.

How did their product compare?

To AppFolio's at the time? Back then, it was comparable because AppFolio was still emerging. Propertyware was on the market before AppFolio. So, yes, it was a legitimate competitor even before Buildium was on the market.

If PropertyWare had a negative NPS yet still kept customers, why didn't RealPage just reduce the prices? Or how did they fail to retain them?

Over time, if there are outages or significant bugs, people will eventually leave, especially if you're really messing up. And that's essentially what they were doing. We see the same thing happening with Buildium now where support is non-existent. They're charging for every little extra service. If you call in for support, you have to pay a fee. So, customers are getting frustrated. They're not going to all leave in one year, but over the course of the next five to six years, they'll continue to leave. They've been leaving since the acquisition and will continue to do so.

How could Yardi not retain their customers in the early days of Appfolio scaling?  

We typically got Yardi customers from their legacy products. These were products that weren't even supported anymore. I wouldn't say AppFolio is winning a lot of Yardi Breeze customers. In fact, I think Yardi Breeze is actually gaining customers as well. I believe they're the only other product other than AppFolio that's acquiring new market share. However, especially in the sub-thousand category, it's like 90% AppFolio, 10% Yardi. But they are capturing some market.

Why couldn’t they convert Yardi legacy customers to Breeze?

Breeze was launched about four or five years ago. They didn't launch it sooner because of their growth trajectory. I don't think they considered AppFolio as a serious competitor for a long time. Most of Yardi's significant growth is international and commercial. They're selling to skyscrapers, with their biggest new growth offices in the Middle East. That's where they're making substantial profits, and it's an excellent strategy for them. I believe it's a smart strategy.

Are you referring to Breeze in relation to the legacy products?

No, I'm referring to their international and commercial expansion. It's all greenfield. They spent a lot of time trying to build Breeze out.

Were they taking the legacy product internationally, or were they taking Breeze?  

They're probably taking both now. But Breeze was initially a reaction to a specific need.

A US residential, cloud-based need?

Yes, they were trying to make it user-friendly, but it takes a considerable amount of time to build such products.

Do you have any idea about the market penetration when they're selling in the Middle East and other foreign markets? How much of it is legacy versus Breeze today? I'm thinking about the future. If AppFolio wants to expand to the Middle East or globally, is that market already saturated if they're selling Breeze in the Middle East?

I don't think so. Most of the overseas market is commercial. I wouldn't say Yardi has a significant residential foothold internationally. Many markets operate very differently in residential aspects than the US. Yardi's primary focus has been commercial internationally. So, yes, if AppFolio wants to get into commercial and go international, they'll have to contend with Yardi's dominance. It's going to be a challenge to displace them because they have such a dominant position. The residential sector is tricky because many international markets are not that large. There was a time when I considered expanding into Australia and the UK, but the residential markets there were about the size of one state in the US. The investment required to enter those markets was substantial. You need to have a presence, you need to have people in the market. There's still so much untapped potential in the US. That's why you haven't seen AppFolio go international yet. There's a lot of room for growth in the US. A better market entry strategy for them internationally might be to acquire a company that already operates residential software in the market.

I believe there are about four million units in the UK, roughly rented, for instance.

I think there are about seven million units just in Arizona. So, you're building a market entry strategy for this whole market, but it's like saying, "let's do Arizona."

But does Arizona have different regulations than, say, Texas? 

Yes, they are, but it's not the same scale as trying to enter the UK market where you have to know there are nuances by state, but it's significantly different.

What are the differences in the UK in terms of regulations from your understanding?  

The leasing process and how it works is different in the UK. The way people lease apartments, how taxes work, and the currency are all different. You need to be able to handle currency exchange. The way people report to their investors on properties is also different. There are many nuances. In the US, it operates pretty much the same, except for local regulations.

Which other international markets could the product be best deployed into? You mentioned Australia. Are there any other markets?

Canada. Canada has the most similarities. RealPage doesn't do much overseas. Actually, Yardi does.

That's because the regulatory environment is less different than coming to the UK from the US?

Yes, RealPage isn't in a position to make R&D investments to build out functionality for new markets. That's just not where they are. On the other hand, Yardi is privately held and they are a provider.

You mentioned Breeze, so let's compare Yardi Breeze and AppFolio. How do you think the two products are differentiated today, if at all?

Yardi Breeze and AppFolio are different in that AppFolio is more robust. It's an all-in-one platform with more solutions and features than Breeze. Breeze is newer to the market, so it doesn't have as much functionality. However, Breeze is backed by a company that's knowledgeable about the space. When you call support, they know what they're talking about. That's something that Breeze has going for them, but so does AppFolio. It's not just a fly-by-night startup trying to break into the space.

But as you said, because these products are so sticky, once you get a customer and you have a somewhat similar product, it's very rare that someone might switch from Breeze to AppFolio.

I don't see people switching from Breeze to AppFolio as much because Breeze is doing a good job. It's hard enough to get people to switch off a platform if they're doing a bad job. Even if Breeze isn't doing as good a job as AppFolio, but they're doing pretty well, they're not going to switch off that. I think AppFolio's focus is getting everyone other than Breeze customers to come onto their platform.

When you were building out the product for the value-added services, what was the biggest challenge in increasing the penetration rate of those services, such as insurance, payments, and screening?

The beauty of our businesses is that they practically sell themselves. We have a tenant portal where we showcase our offerings. With around eight million tenants logging in daily, they can easily see our products. For instance, while paying rent, a tenant can see the option to buy renters insurance for $20 a month. It's a simple online sign-up process.

Additionally, there's a trend in the property management space where property managers are starting to require residents to have renters insurance. They can either bring their own policy and show proof, or buy a policy through our portal. This movement coincided with the launch of our product, which had eight million potential customers viewing it, leading to a rapid uptake.

The biggest challenge was setting up and structuring the app, similar to what AppFolio has done. We go deep into the stack. We became a payment processor, a credit reporting agency, and an insurance company, with a subsidiary for each. We issue the policies and take the risk. We have reinsurance. The advantage is that if there aren't many claims, we share in the profits.

What was the attachment rate of the insurance?

It's one of the fastest-growing businesses. I think it was only about 20% penetrated when I left.

Why is it low?

It's relatively new to the market. It was only a couple of years old, and most people would buy it when they moved in. So, if you're an existing tenant, you usually have to wait for the natural turnover of units. During Covid, not many people were moving, but now it's picking back up.

What percentage of the insurance product is renters versus landlord insurance? 

At this point, it's mostly renters insurance. The landlord insurance is an offering where if the landlord wants to be covered, rather than having the renters cover their items.

Can you explain the philosophy of going deep and becoming an insurance carrier? Why not be an agent and just take a lead generation fee?

The benefits are twofold. Firstly, we can capture more of the gross margin dollars by capturing the full revenue and reducing the expense over time. Secondly, and more importantly, it improves the user experience. With a partnership, users would have to click a link in the tenant portal, be redirected to a different site, and re-enter all their information. We already have all that information. With just two clicks, we can issue a policy.

Is it really that quick? Just two clicks and it's done?

Essentially, yes. We already have all your information, including your Social Security number and rental payment history. This allows us to make quick decisions. All this information is already in our system.

How long did it take to set up the insurance?

We had it up and running in about six months. We had to enlist the help of outside counsel and evaluate different reinsurance companies.

And no one else does this, correct? Yardi or RealPage aren't carriers?

Correct, RealPage doesn't. I believe Yardi recently set one up as well. They likely saw our success and decided to follow suit.

How does the screening process work?  

We used the same deep-stack approach. The penetration for this is much higher, with over 80% of customers using the screening service.

Is that all customers or just SMBs that have 80% penetration?

All customers, including enterprise. It's a commodity, so there was no loyalty to their current provider. Being able to run a credit report on a tenant with one click in the app, and having it tied into your approval workflow is crucial, especially from a compliance perspective. They can set up decision criteria for what makes a good tenant. When the leasing agent runs a credit report, they don't see the output, which is better. It reduces risk. They just get a thumbs up or thumbs down. This ensures consistency across their entire portfolio, reducing the risk of discrimination.

If I'm a manager, I can specify the types of tenants I want, submit that, and then how deep are you in the stack? How does the reporting actually work on your end?

We can provide a comprehensive report to the company manager or anyone else in the company who has permission to view full reports. This report will include everything from a traditional credit report, such as every line of credit you've opened, as you would see in credit reports. However, the leasing agent at the front line will only see a simple approval or disapproval. The criteria set by the property management firm can vary. Each firm has different criteria. Some may require credit scores above 600, while others may require scores above 700. This can be customized as they also check criminal history.

Is it like a usage fee or a per-check fee?

Yes, it's $15 per check, or $20 per check.

As you mentioned, it's a commodity. So, I assume Yardi and RealPage have something similar?

They do, but they are not credit reporting agencies. They operate through partnerships.

How does one become a credit reporting agency?

It involves a lot of compliance work. You need to have compliance staff on board, and a consumer relations team that can handle disputes over credit reports. There's a lot of nuance to it. It's governed by industry laws, such as the Fair Credit Reporting Act.

How did you decide to become a payment processor instead of partnering with one?

It was mainly for the gross margin, dollar capture. If you go with a payment processor, they usually give you a one-time referral fee. But with our model, we collect a percentage of what's paid every month. It made a lot of sense. However, there's also a lot of compliance work involved in this. You have to manage chargebacks when people dispute, manage the underwriting process, and comply with anti-money laundering rules and customer login rules.

I assume the penetration of that is similar to screening, given it's a commodity?

It might be even higher, possibly around 90%.

I saw a post about the ACH charges that AppFolio recently launched. They're charging $2.50 for an ACH, or if the landlord pays a fee, they don't have to pay it. What are your thoughts on this?

It makes a lot of sense to start charging. We discussed this for years. When we initially offered free ACH, it was a strategy to differentiate ourselves and attract more customers. At that time, most people were paying through this method, and we were trying to encourage people to stop using checks. Offering it for free motivated people to stop using paper checks.

Fast forward to today, no one uses paper checks anymore. Most property managers don't accept them. Electronic payments have become the standard, and many people prefer debit or credit over ACH. Additionally, we've spent 10 years adding new features and value to the product. It would be difficult to find a customer who would say they only signed up for AppFolio because of the free ACH. Given all this, it made sense to start charging. We do pay a small fee to process ACH transactions.

But it's just a few cents to process a transaction, right?

Yes, it's just pennies.

That's practically pure profit.

Exactly, it's pure margin. It's free. It might upset some people, but it's not going to drive anyone away.

Why do you think they've decided to do this now? Is it a sign of the company's maturity?

Yes, I believe it is. We have a new CEO whose goal is operational excellence. This involves scrutinizing both revenue and expenses. Some might think we're struggling with revenue and need to grab it. But we're not. It's free revenue. Who wouldn't take that?

Are there other opportunities to do something like this in the stack? What else was discussed?

I'm not sure if there are many obvious ones, but I do think there's more opportunity to raise the price of the core product.

You still think it's cheap?

Yes, it's cheaper than Yardi.

$1.40 for a minimum of 50 units?

Yes.

What do you think it should be?  

I think in this day and age, you could start to push $2. They probably won't raise it that much immediately, but gradually over a few years. It's a fair price for what you're getting. We have value-added services that we charge more for than the core subscription, which includes the most features. It's a full accounting suite.

Can you provide some context on when AppFolio first discussed moving upmarket, say above 1,000 units?

Indeed, we've been discussing the right timing for this. I'd say we began to push in earnest around 2016 or 2017. We managed to incrementally increase our capacity, shifting our focus from 1,000-unit customers to 5,000, then from 5,000 to 10,000, and eventually to 20,000. Now, we're probably looking at 50,000 units. Whether we'll continue to expand beyond that, I'm not sure it's wise. There are only so many companies with over 50,000 units. They're already using Yardi Voyager, their flagship product. The cost of trying to displace those, compared to the potential gains, probably isn't worth it. They might be better off expanding into the commercial market or internationally if they ever reach that TAM limit. But there's still a lot to capture, even below 50,000 units. So, that's the direction they're likely heading in.

What was the product strategy to target enterprise managers? 

The main strategy involved adding more configurability and some customization to the product. We also needed to update many aspects for scale. For instance, in a smaller company, you could display all your properties on one page, but a larger company required pagination. User experience work also became crucial. Search functionality became more important because finding something in a list when you have 50,000 units is challenging.

What was the biggest challenge for the product?

The biggest challenge, as always, was change management. Customers might have been used to doing things a certain way, and our software platform was built for a more modern approach. So, part of the onboarding process involved getting them comfortable with changing some of their processes. This is always the biggest challenge with every ERP solution.

In seems as if there was a shift in AppFolio's strategy and philosophy. It seems the management moved from being more closed to more open with AppFolio Stack. Could you provide some context on why and how this happened?

We always had partnerships. However, we operated them as white-label services. For instance, we offered collection services through a partner, but we didn't advertise that. It was called AppFolio Collections. So, the perception was of a closed system. But in reality, we had about 30 partners behind the scenes, like the insurance company I mentioned. We always had these integrations and partnerships behind the scenes. One thing that became increasingly important to people was access to their data and the ability to integrate with new services that come on the market. Stack was our response to that, opening up with the goal that if any of them gained traction, we could always acquire them. When we were smaller, this wasn't much of an option. Now it is. So, it was less risky to open up at this point, and there was much more upside than downside to doing it.

That's where I was heading. How do you view the risk of opening up and implementing AppFolio Stack? 

I believe it's not that risky because we're not specifically opening up point solutions. We're very diligent about not opening up to direct competitors or creating a stack for payments. We already have a payments product. There are certain things that we kind of draw a line around, saying we wouldn't open up to those types of businesses. But for the others, it makes a lot of sense.

Could you tell me what the top point solutions that customers typically demand are?

The ones that come up are pretty much the ones that are on the list of Stack partners now, like some CRM solutions, maintenance solutions, and so on. We've been listening to the customer as we added the partners to the Stack platform.

So you basically polled them, identified the most common ones, the best ones, and added those as partners. Do you think they could be potential M&A targets in the long run if they fit?

Absolutely.

And which property types were the most difficult to add to the platform, like short-term rentals, affordable housing? I've seen them build out that. How was that challenging and why?

Those were like investments. They weren't huge ones to get into those spaces because they weren't that different. Like student housing, affordable housing. There were some nuances that had to be built out, but not a huge dramatic amount. The ones that are going to be most difficult are commercial properties. Commercial is a whole different beast. It almost would double the TAM. So it's a huge opportunity for the business, but it also requires a significant effort to get into.

Why is it so different?

Everything's different. You don't operate on a unit basis. You operate on square footage. There are nuances between retail, office, and industrial, where you market and lease. How you do leasing is through a broker, it's not through your own leasing agent. You market on different marketplaces in that sense.

And what's Yardi's product like there for commercial?

It's the best in the market.

How would you enter that market?

We would probably go after the SMB first. Because I think their product is more enterprise-focused.

One block, one building?

Yes, strip malls, small commercial spaces.

Why didn't they do that?

It's not as profitable for them. You have to imagine the direct sales team, they can go and sell one large skyscraper.

Why didn't AppFolio do that?

Well, Yardi was entrenched in that market. We saw this need in the SMB. So that's where we went. We built out a direct sales team and they were going door to door in Tucson, Arizona.

Even when you started investment management, couldn't you have started commercial instead?  

Yes, we did have a lot of commercial customers in investment management. Investment management is a separate entity built to sit on top of any property management platform you already have, such as RealPage. Many of our clients were hotels, commercial entities, large residential, and multifamily properties. Most of the investment management's customers were not fully property management customers yet.

What was the rationale behind starting the investment management business instead of a commercial business, given that the commercial sector seems much larger?

The commercial business was actually a heavier lift than the investment management business. The investment management business required a lot of work to get to market, but it was still less work than commercial investment management. The focus was to build out a new vertical over time. Financial services investment management was supposed to focus on general private equity with the first foothold being real estate private equity. However, the long-term plan was to include general private equity, venture capitalists, hedge funds, and so on.

What is the investment management TAM?

The opportunity for real estate investment management was probably around 200 million in revenue. If you expanded to all general private equity, it would be over a billion. It's a huge space, but within real estate only, it narrows to a couple of hundred million, which is still a great business line to have.

Do you think that's still an opportunity now or has it fizzled out?

No, it's still a huge opportunity. However, I believe they've narrowed their focus to just real estate since I left. I don't think they're pursuing the larger market. They seem content staying within the real estate ecosystem. That said, it's a huge win too, even within real estate. You get these large real estate operators on board, and when they choose a property management software or hire a third-party property manager, they ensure they use AppFolio. So there's the influence.

Was the annual cost around seven and a half thousand for that investment management? Is that how much it is?

No, the investment management product's entry point is actually higher. I think it's around nine thousand at the lowest price point, but there are customers paying over 100,000 a year.

So, how big is that business today, roughly?

Since I've left? It's probably in the mid-twenties in Annual Recurring Revenue (ARR), I'm sure.

Right, so around 5% of the business. Just to return to the differences in the corporate sector, how and why was the reporting so different? You built a product for SMBs with certain reporting requirements. Can you explain the difference in the UI requirements and the reporting between SMBs and enterprises, and why they're different? For example, we often hear from Yardi that their accounting functionality is superior. Can you explain why?

Some of it is just legacy. They've always used it for their marketing and it's stuck in people's minds. However, there's not actually a significant difference. In fact, we've compared our accounting with theirs and it does everything similarly. The reporting aspect becomes more complex as you grow because you have more owners who want to analyze things differently, or you want to present the rent roll in a different view and add some additional columns. So there's more customization around reporting requirements at the high end. That's true. At the high end, they often have an internal data or reporting team. Therefore, the need to have an API that allows you to extract your data and put it into their own database for reporting is more important. That's where Stack came in, with that API. The plus product has the API access built in.

What about revenue management?

Revenue management becomes important. The larger you get, the more valuable it is. For instance, when you manage 100 units, increasing rents by 5% isn't much, but when you have 10,000 units, a 5% increase in rent is significant.

How does AppFolio approach that? Is it always going to be a point solution for that type of business, that type of product? Or do you think AppFolio can actually handle it? I guess you need certain data and scale in the data across units to optimize pricing. How do you think about that?

They built the revenue management product into the Plus product of AppFolio. So it's part of the Plus product. It uses all that data across anonymized aggregated data to provide the revenue management insights that are needed.

How does that compare to Yardi, for example, or RealPage’s rev management tool?

It's pretty on par with Yardi's. RealPage acquired a company that was quite advanced in that process. So I'd say RealPage's might be slightly better still. Although I'm not sure how much AppFolio has invested in the last year. If they have, then they might have caught up.

What's the biggest challenge with revenue management in your mind, for AppFolio?

Adoption. Even among the big players, not everyone has bought into it yet.

You mean on AppFolio's or anywhere?

Just in the market adoption. Not everyone is using revenue management, even at the high end. My hypothesis is that in 10 years, when you go to look at the rent price on a building, it'll be like airline prices, fluctuating by the minute, based on demand and so on. But there's still some hesitation in the market around that. It's just the natural adoption curve for that.

What's the biggest challenge for AppFolio to onboard large managers today?

I think it's the same change management process changes, that sort of stuff. It's the usual stuff. I don't think there's anything specific that's been a challenge.

How can they acquire more customers? Let's say they're penetrating the SMBs more and winning some over from Buildium, as you mentioned. They're increasing their prices and have a great business in the SMB space. They're also targeting the enterprise sector. How can they win customers from Yardi, Entrata, and RealPage, especially when these companies probably have a similar churn rate and are also great businesses? 

The onboarding process is quite easy for us because we've made it customer-friendly. It's definitely harder to acquire enterprise customers. It's challenging to acquire customers in the enterprise sector. I was referring more to the onboarding process. The acquisition of enterprise customers is difficult and can take multiple years due to longer sales cycles. They're obviously bigger customers, but acquiring them is more of a slog.

How do you think this will play out for AppFolio?

I believe that, in the long term, both Yardi and AppFolio will continue to be successful. The market is big enough for multiple players. In my mind, it's not a winner-takes-all scenario.

How do you view the risk of AppFolio spending too much on sales and marketing to win these customers? As you mentioned, despite RealPage having a negative 88 NPS, you still can't acquire them immediately.

The counterargument is that the lifetime value of these customers is so high that you can afford to spend quite a bit on acquisition and still be in a good position because they're unlikely to leave. AppFolio is very sophisticated in how they look at customer acquisition costs and LTV to CAC ratios. They're constantly tuning this.

I've noticed that their sales and marketing expenses have started to creep up per unit because they're acquiring larger units and it takes longer to convert them. But you don't know if they will ever convert them, especially if RealPage and Yardi improve their offerings.

You have to consider the sales and marketing costs in relation to new unit acquisition and mix. If they're successful in acquiring larger customers, I would expect the cost of acquisition to increase as they target larger customers. That's expected.

But you still don't know if they're going to convert them.

Correct.

Given the long sales cycle, which may increase, what do you think is the biggest risk?  

There is always a risk. However, the sales cycles have generally been less than a year. That's the good news because you can see the results within a year. For the largest deals, it does push close to a year. The new CEO has a strong background in enterprise sales. He is well-versed in this area. If it's not converting, he won't continue to invest unnecessarily.

In your opinion, what is the biggest risk for AppFolio moving upmarket? What would concern you?

I would say patience is key. As I mentioned, it takes time to convert clients. If you're looking for a quick win in moving upmarket, it's not going to happen. It's a more competitive space. That's probably the biggest risk. However, I believe that AppFolio has a superior product and in the long term, a better product will prevail.

The churn rate was 3%. Was that across the board?  

That's across the board. I believe it's even less in the enterprise. Most of the churn is SMB.

How did enterprise adoption of valued services, like screening and payments, compare to SMBs? Was the penetration rate the same or different?

It's pretty consistent across the board.

And insurance?

It's pretty much the same there, across the board.

What about the maintenance center?

The maintenance center is perhaps a little more popular in the enterprise than the SMB.

Why?

They preferred to outsource it to avoid staffing it themselves.

A couple of final questions. Perhaps we can discuss the investment management side separately at another time. Given that AppFolio is clearly moving upmarket, if you were Shane, what would be your main focus on the product side to win these accounts?

Specifically, I would focus on continued configuration, adding customization where possible. But overall, I think the product is in a good position to win upmarket. The main challenge is the time and energy required to focus on that market.

There's nothing major missing in the product portfolio?

No, nothing major. Just minor adjustments that might be required for specific customers.

What do you think is a long-term margin for this business? 

Well, the margin is always going to be lower due to the depth of the stack. That's the trade-off. You get more gross margin dollars, but from the outside looking in, the gross margin appears lower. I think they could achieve 70%, which would be remarkable.

And the EBIT margin.

They aim to achieve the rule of 40. If they can maintain their growth above 30%, that would result in a 10% EBITDA margin. That would be ideal. I don't believe they're striving for an 80 on the rule of 40 or anything of that sort. They want to reinvest, but they also want to maintain that threshold.

But why would the margin be lower for screening? Isn’t screening for example pure margin. It's $15, with little variable costs? The insurance business obviously has a different margin, but it seems to be decent as well because it's a good product. Shouldn't these products have a net margin of around 20% to 30%?

It depends. Payments is the largest business within the company. For credit cards, we might charge 3%, but the interchange fee for rewards cards might be around 2.5%. So it's not exactly a lower margin business. Screening does have some costs associated with it, but it still has a higher margin.

So, the payments business might have a gross margin of around 30% to 40%, or even payments.

That's probably the one that lowers the overall blended margin.

Are you still a shareholder?

Yes, I still am. As you can tell, I am bullish on the space. I really like it. I was there for 14 years too, so I got to experience quite a bit of growth with the company.

What would make you sell though?  

Depending on who they bring in, I have a lot of confidence in Shane. If he left tomorrow, I would be concerned because I believe that with the right leadership, this company can do amazing things. If you have the wrong leadership, it could slowly decline. Nothing bad would happen overnight, but it could slowly become like RealPage, just slow.

Exactly.

A slow motion decline.

But is there anything that would make you worry? For example, the payment issue that tenants on Reddit are complaining about. Obviously, you're not too concerned about that, but is there anything that would make you think they're losing their way or their philosophy, or if their pricing changed significantly?

I don't think so. The business is quite resilient in that regard. I think the biggest other risks would be cybersecurity related, like if someone hacked it and stole money from tenants, although there is insurance. But theoretically, that could be a risk for many businesses. They invest a lot in their security, at AppFolio, and are very secure, but that's always a macro risk to the business.

Your long-term expectation is more like 10% to 15% EBITDA margins, rather than 30% to 40%, which is typical of some B2B SaaS companies. Do you think they're aiming a bit lower because of the payments?

Yes, I believe so. I wouldn't expect them to push it over 15%, because if they can maintain at least a 25% growth, and 15% EBITDA, that's rule 40. That's good enough for them. They're investing in growing their business.

What if they're only growing at 10%?

If they were only growing at 10%, there would be a strong push to try and reach 30%. That's what everyone wants, right?

Whether you can achieve it or not is a different question.

That's correct. I think they're on the right track. I believe they'll get there. But yes, it's true.