Making it in Real Estate: Starting Out as a Developer [2 ed.] 9780874204575

Table of contents :
Front Cover
Title Page
Copyright
About the Author
Contents
Preface
Part 1: Making It in Real Estate
1. Quit Your Job?
2. Doing It on the Side
3. Playing Small Ball
4. Specialize or Die
5. Bromancing the Deal
6. Size Matters
7. Buying It Right
8. Desperately Chasing Yield
9. Liquid Assets
10. A Little Help from My Friends
11. Fickle Shades of Green
12. Autographing the Deal
13. The Politics of It All
14. Decked by City Hall?
15. Sell versus Hold
16. Lies, Damn Lies, and the IRR
17. Working without a Net Worth
18. Monogamy and Its Downside
19. Let Us Now Praise Famous Architects
20. General Contractor Relativity
21. Sex, Lies, and Off-Market Deals
22. Do As I Say
23. The Back of a Napkin
24. No Partners, No Problems
25. The “NTM”
26. Understating Your Net Worth
27. Leaseholds: Buy ’Em Where They Ain’t
28. Your Empire: Build It or Buy It?
29. The 1031 Exchange: Panacea or Placebo?
30. The Only Free Cheese Is in a Mouse Trap
31. Game of Phones
32. Winter Is Coming
33. Winter Is Here
34. There’s No Place Like Home
35. Investing in Accidental Assets
36. Retail’s Wholesale Risks
37. Environmental Contamination: Hazardous to Your Health?
38. A Sod Roof Too Far
39. Money
40. Abandon All Hope
Part 2: Making It in Life
41. How to Keep Friends and Influence No One
42. Commencement Address
43. Your Obituary
44. Seeing the Forest for the Trees
45. In Memoriam: James J. Curtis III
46. Postscript
Glossary: Real Estate Jargon Demystified

Citation preview

STARTING OUT AS A DEVELOPER Jo h n M c N e llis

Second Edition Expanded and Updated

About the Urban Land Institute

About the Author

The Urban Land Institute is a global, member-driven organization comprising

John McNellis is a principal with McNellis Partners, a commercial development

more than 45,000 real estate and urban development professionals dedicated

firm he cofounded in the mid-1980s in Northern California. After graduating from

to advancing the Institute’s mission of providing leadership in the responsible

the University of California, Berkeley, and the University of California Hastings

use of land and in creating and sustaining thriving communities worldwide.

College of the Law, McNellis began his career as a lawyer in 1976 in San Francisco.

ULI’s interdisciplinary membership represents all aspects of the industry, including developers, property owners, investors, architects, urban planners, public officials, real estate brokers, appraisers, attorneys, engineers, financiers, and academics. Established in 1936, the Institute has a presence in the Americas, Europe, and Asia Pacific regions, with members in 80 countries. The extraordinary impact that ULI makes on land use decision-making is based on its members sharing expertise on a variety of factors affecting the built environment, including urbanization, demographic and population changes, new economic drivers, technology advancements, and environmental concerns. Peer-to-peer learning is achieved through the knowledge shared by members at thousands of convenings each year that reinforce ULI’s position as a global authority on land use and real estate. In 2019 alone, more than 2,400 events were held in about 330 cities around the world.

More interested in business than in law, he started fixing up houses in his spare time and gradually worked his way to more complicated projects. At 28, he formed a partnership with an older client and began his career as a retail developer. Cobbling together the equity from friends and family, they built and opened their first shopping center in 1983, by which time McNellis was no longer practicing law—except on behalf of his own projects. Within a few years, he formed McNellis Partners with Beth Walter and Mike Powers. They continue to be partners more than 35 years later. Specializing in developing supermarket-anchored shopping centers in Northern California, the partnership has followed a strategy of developing about two projects a year and doing so with internal capital only, thus retaining 100 percent ownership of its developments. In recent years, the company has begun developing mixed-use projects and, in an effort to diversify, investing in small Silicon Valley office buildings and residential projects.

Drawing on the work of its members, the Institute recognizes and shares best practices in urban design and development for the benefit of communities around the globe. More information is available at uli.org. Follow ULI on Twitter, Facebook, LinkedIn, and Instagram.

©2020 Urban Land Institute 2001 L Street NW, Suite 200 Washington, DC 20036-4948 Published in the United States of America. All rights reserved. No part of this book may be reproduced in any form or by any means, electronic or mechanical, including photocopying and recording, or by any information storage and retrieval system, without written permission of the publisher.

ULI Project Staff Gwyneth Jones Coté President, Americas

James A. Mulligan Senior Editor/Manuscript Editor

Catherine Gahres Senior Vice President, Membership and Marketing

Brandon Weil Art Director

Trey Davis Vice President, Membership and Marketing

Craig Chapman Senior Director, Publishing Operations

Recommended bibliographic listing: McNellis, John. Making It in Real Estate: Starting Out as a Developer, 2nd ed. Washington, D.C.: Urban Land Institute, 2020. ISBN: 978-0-87420-457-5

ii

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About the Urban Land Institute

About the Author

The Urban Land Institute is a global, member-driven organization comprising

John McNellis is a principal with McNellis Partners, a commercial development

more than 45,000 real estate and urban development professionals dedicated

firm he cofounded in the mid-1980s in Northern California. After graduating from

to advancing the Institute’s mission of providing leadership in the responsible

the University of California, Berkeley, and the University of California Hastings

use of land and in creating and sustaining thriving communities worldwide.

College of the Law, McNellis began his career as a lawyer in 1976 in San Francisco.

ULI’s interdisciplinary membership represents all aspects of the industry, including developers, property owners, investors, architects, urban planners, public officials, real estate brokers, appraisers, attorneys, engineers, financiers, and academics. Established in 1936, the Institute has a presence in the Americas, Europe, and Asia Pacific regions, with members in 80 countries. The extraordinary impact that ULI makes on land use decision-making is based on its members sharing expertise on a variety of factors affecting the built environment, including urbanization, demographic and population changes, new economic drivers, technology advancements, and environmental concerns. Peer-to-peer learning is achieved through the knowledge shared by members at thousands of convenings each year that reinforce ULI’s position as a global authority on land use and real estate. In 2019 alone, more than 2,400 events were held in about 330 cities around the world.

More interested in business than in law, he started fixing up houses in his spare time and gradually worked his way to more complicated projects. At 28, he formed a partnership with an older client and began his career as a retail developer. Cobbling together the equity from friends and family, they built and opened their first shopping center in 1983, by which time McNellis was no longer practicing law—except on behalf of his own projects. Within a few years, he formed McNellis Partners with Beth Walter and Mike Powers. They continue to be partners more than 35 years later. Specializing in developing supermarket-anchored shopping centers in Northern California, the partnership has followed a strategy of developing about two projects a year and doing so with internal capital only, thus retaining 100 percent ownership of its developments. In recent years, the company has begun developing mixed-use projects and, in an effort to diversify, investing in small Silicon Valley office buildings and residential projects.

Drawing on the work of its members, the Institute recognizes and shares best practices in urban design and development for the benefit of communities around the globe. More information is available at uli.org. Follow ULI on Twitter, Facebook, LinkedIn, and Instagram.

©2020 Urban Land Institute 2001 L Street NW, Suite 200 Washington, DC 20036-4948 Published in the United States of America. All rights reserved. No part of this book may be reproduced in any form or by any means, electronic or mechanical, including photocopying and recording, or by any information storage and retrieval system, without written permission of the publisher.

ULI Project Staff Gwyneth Jones Coté President, Americas

James A. Mulligan Senior Editor/Manuscript Editor

Catherine Gahres Senior Vice President, Membership and Marketing

Brandon Weil Art Director

Trey Davis Vice President, Membership and Marketing

Craig Chapman Senior Director, Publishing Operations

Recommended bibliographic listing: McNellis, John. Making It in Real Estate: Starting Out as a Developer, 2nd ed. Washington, D.C.: Urban Land Institute, 2020. ISBN: 978-0-87420-457-5

ii

iii

Contents 1. Preface . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . vii Part 1: Making It in Real Estate 1. Quit Your Job? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 2. Doing It on the Side . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 3. Playing Small Ball . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 4. Specialize or Die . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12 5. Bromancing the Deal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15 6. Size Matters . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18 7. Buying It Right . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21 8. Desperately Chasing Yield . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24 9. Liquid Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27 10. A Little Help from My Friends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30 11. Fickle Shades of Green . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33 12. Autographing the Deal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36 13. The Politics of It All . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39 14. Decked by City Hall? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42 15. Sell versus Hold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45 16. Lies, Damn Lies, and the IRR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48 17. Working without a Net Worth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51 18. Monogamy and Its Downside . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54 19. Let Us Now Praise Famous Architects . . . . . . . . . . . . . . . . . . . . . . 57 20. General Contractor Relativity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60 21. Sex, Lies, and Off-Market Deals . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63 22. Do As I Say . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66 23. The Back of a Napkin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69 24. No Partners, No Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72 25. The “NTM” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 76 26. Understating Your Net Worth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79

Contents 1. Preface . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . vii Part 1: Making It in Real Estate 1. Quit Your Job? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 2. Doing It on the Side . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 3. Playing Small Ball . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 4. Specialize or Die . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12 5. Bromancing the Deal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15 6. Size Matters . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18 7. Buying It Right . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21 8. Desperately Chasing Yield . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24 9. Liquid Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27 10. A Little Help from My Friends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30 11. Fickle Shades of Green . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33 12. Autographing the Deal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36 13. The Politics of It All . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39 14. Decked by City Hall? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42 15. Sell versus Hold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45 16. Lies, Damn Lies, and the IRR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48 17. Working without a Net Worth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51 18. Monogamy and Its Downside . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54 19. Let Us Now Praise Famous Architects . . . . . . . . . . . . . . . . . . . . . . 57 20. General Contractor Relativity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60 21. Sex, Lies, and Off-Market Deals . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63 22. Do As I Say . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66 23. The Back of a Napkin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69 24. No Partners, No Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72 25. The “NTM” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 76 26. Understating Your Net Worth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79

27. Leaseholds: Buy ’Em Where They Ain’t . . . . . . . . . . . . . . . . . . . . . 82 28. Your Empire: Build It or Buy It? . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86 29. The 1031 Exchange: Panacea or Placebo? . . . . . . . . . . . . . . . . . . . . 89 30. The Only Free Cheese Is in a Mouse Trap . . . . . . . . . . . . . . . . . . . 92 31. Game of Phones . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95 32. Winter Is Coming . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98 33. Winter Is Here . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101 34. There’s No Place Like Home . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105 35. Investing in Accidental Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108

Preface

36. Retail’s Wholesale Risks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111 37. Environmental Contamination: Hazardous to Your Health? . . 119 38. A Sod Roof Too Far . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 124 39. Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 127 40. Abandon All Hope . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 131

Part 2: Making It in Life 41. How to Keep Friends and Influence No One . . . . . . . . . . . . . . . . 137 42. Commencement Address . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 140 43. Your Obituary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 145 44. Seeing the Forest for the Trees . . . . . . . . . . . . . . . . . . . . . . . . . . . . 148 45. In Memoriam: James J. Curtis III . . . . . . . . . . . . . . . . . . . . . . . . . . 151 46. Postscript . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 154 1. Glossary: Real Estate Jargon Demystified . . . . . . . . . . . . . . . . 157

I learned real estatethe same way I learned the facts of life. On the street. I learned development gradually—deal by deal—often acquiring experience just after I needed it. Had there been a practical book on development when I started out, I would have read it because we don’t always have to learn the hard way. On occasion, we can remember the advice of others and spare ourselves the first-degree burns of inexperience. That’s why I’ve written this book. As complex and risky as real estate development is—an encyclopedia rather than a primer would be required to cover all a developer should know— there are certain truths so obvious they can be book-learned. If they are not, lessons will be learned the expensive way, usually at the very moment the fledgling developer realizes she’s too far out over her ski tips. In this book, I ask you to consider whether you truly wish to leave the comfort and security of your salaried position and whether you—and your family—might not be better off if you were to pursue your desire to develop on the side. I have no statistics on this, but a career’s worth of observation and

vii

27. Leaseholds: Buy ’Em Where They Ain’t . . . . . . . . . . . . . . . . . . . . . 82 28. Your Empire: Build It or Buy It? . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86 29. The 1031 Exchange: Panacea or Placebo? . . . . . . . . . . . . . . . . . . . . 89 30. The Only Free Cheese Is in a Mouse Trap . . . . . . . . . . . . . . . . . . . 92 31. Game of Phones . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95 32. Winter Is Coming . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98 33. Winter Is Here . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101 34. There’s No Place Like Home . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105 35. Investing in Accidental Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108

Preface

36. Retail’s Wholesale Risks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111 37. Environmental Contamination: Hazardous to Your Health? . . 119 38. A Sod Roof Too Far . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 124 39. Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 127 40. Abandon All Hope . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 131

Part 2: Making It in Life 41. How to Keep Friends and Influence No One . . . . . . . . . . . . . . . . 137 42. Commencement Address . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 140 43. Your Obituary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 145 44. Seeing the Forest for the Trees . . . . . . . . . . . . . . . . . . . . . . . . . . . . 148 45. In Memoriam: James J. Curtis III . . . . . . . . . . . . . . . . . . . . . . . . . . 151 46. Postscript . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 154 1. Glossary: Real Estate Jargon Demystified . . . . . . . . . . . . . . . . 157

I learned real estatethe same way I learned the facts of life. On the street. I learned development gradually—deal by deal—often acquiring experience just after I needed it. Had there been a practical book on development when I started out, I would have read it because we don’t always have to learn the hard way. On occasion, we can remember the advice of others and spare ourselves the first-degree burns of inexperience. That’s why I’ve written this book. As complex and risky as real estate development is—an encyclopedia rather than a primer would be required to cover all a developer should know— there are certain truths so obvious they can be book-learned. If they are not, lessons will be learned the expensive way, usually at the very moment the fledgling developer realizes she’s too far out over her ski tips. In this book, I ask you to consider whether you truly wish to leave the comfort and security of your salaried position and whether you—and your family—might not be better off if you were to pursue your desire to develop on the side. I have no statistics on this, but a career’s worth of observation and

vii

anecdotal evidence have taught me that a considerable majority of developers might have been far better off, financially and emotionally, limiting their real estate pursuits to an avocation. The true developers among you will brush aside this advice as meant for others. And it is for you—the true developer—that I offer what I hope will be useful advice on everything from what you should buy to how you should focus your objectives, run your own firm, and deal with the players in our world—the bankers, partners, politicians, consultants, and brokers. If there is an overarching theme in these pages, it is simply this: the best way to survive, and thrive, is to manage every risk within your control. So many risks are beyond your control—interest rates, global tectonic shifts, the bankruptcies of your tenants, even the weather—that you will, like the rest of us, invariably lose money one day. Whether that loss proves a temporary setback or the end of your career may depend on how you have managed your other risks. If you have created firewalls by limiting your exposure to your lenders, partners, vendors, and service providers, you will survive. If, however, your first loss is the domino that causes your other risks to tumble, you may not. My desire, then, is to leave you holding the same admiration, caution, and healthy respect for real estate development that a zookeeper has for his lions. *** I wrote that preface in summer 2016. Much has happened in the past four years. The longest economic expansion in U.S. history was felled by a virus, and I realized that in the first edition I had not addressed surviving a recession. Also, astute readers have on occasion raised questions I hadn’t considered. I hope this edition—with its 20 new chapters—addresses these issues and others that have occurred to me as I continue to ponder life and the craft of developing real estate. September 2020

viii

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

Part 1:

Making It in Real Estate

anecdotal evidence have taught me that a considerable majority of developers might have been far better off, financially and emotionally, limiting their real estate pursuits to an avocation. The true developers among you will brush aside this advice as meant for others. And it is for you—the true developer—that I offer what I hope will be useful advice on everything from what you should buy to how you should focus your objectives, run your own firm, and deal with the players in our world—the bankers, partners, politicians, consultants, and brokers. If there is an overarching theme in these pages, it is simply this: the best way to survive, and thrive, is to manage every risk within your control. So many risks are beyond your control—interest rates, global tectonic shifts, the bankruptcies of your tenants, even the weather—that you will, like the rest of us, invariably lose money one day. Whether that loss proves a temporary setback or the end of your career may depend on how you have managed your other risks. If you have created firewalls by limiting your exposure to your lenders, partners, vendors, and service providers, you will survive. If, however, your first loss is the domino that causes your other risks to tumble, you may not. My desire, then, is to leave you holding the same admiration, caution, and healthy respect for real estate development that a zookeeper has for his lions. *** I wrote that preface in summer 2016. Much has happened in the past four years. The longest economic expansion in U.S. history was felled by a virus, and I realized that in the first edition I had not addressed surviving a recession. Also, astute readers have on occasion raised questions I hadn’t considered. I hope this edition—with its 20 new chapters—addresses these issues and others that have occurred to me as I continue to ponder life and the craft of developing real estate. September 2020

viii

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

Part 1:

Making It in Real Estate

1

Quit Your Job?

Over a beer, a young friend recountedhis progress with a retail development firm. I was surprised to hear how much he had learned and how much responsibility he already had. When he explained his lead role on a mixed-use project, I asked how profitable the development would be for the company. He guessed about $10 million. I asked if he had a profit share. Reluctantly, he explained that he had been promised a percentage in the deal but that his employer, a man of infinite wealth, had gone silent on the issue. With nothing in writing and the project’s final entitlements days away, he could only hope his boss would honor his word. Business has few certainties, but one is this: employees are seldom paid more than “go money.” That is, companies large and small, public and private, will pay enough to keep their key employees from going elsewhere. The publics blame their parsimony on their duty to their shareholders, and the privates blame their silent but surprisingly stingy partners. If your dissatisfaction is with the job itself—and not your income— you should quit. That is, if you can afford the cash flow hit. If you’re an entrepreneur at heart and the only decision you’re making at work is where to park in the morning, quit. If you can cobble together a year’s worth of living expenses and go into business and fail, what’s your downside? Merely

3

1

Quit Your Job?

Over a beer, a young friend recountedhis progress with a retail development firm. I was surprised to hear how much he had learned and how much responsibility he already had. When he explained his lead role on a mixed-use project, I asked how profitable the development would be for the company. He guessed about $10 million. I asked if he had a profit share. Reluctantly, he explained that he had been promised a percentage in the deal but that his employer, a man of infinite wealth, had gone silent on the issue. With nothing in writing and the project’s final entitlements days away, he could only hope his boss would honor his word. Business has few certainties, but one is this: employees are seldom paid more than “go money.” That is, companies large and small, public and private, will pay enough to keep their key employees from going elsewhere. The publics blame their parsimony on their duty to their shareholders, and the privates blame their silent but surprisingly stingy partners. If your dissatisfaction is with the job itself—and not your income— you should quit. That is, if you can afford the cash flow hit. If you’re an entrepreneur at heart and the only decision you’re making at work is where to park in the morning, quit. If you can cobble together a year’s worth of living expenses and go into business and fail, what’s your downside? Merely

3

the salary loss from your crappy job. And if you have to white-flag it back to

Personally, I switched from real estate law to development because it seemed

the corporate world, you will be more valuable because of your experience.

to me that developers have a lot more fun than lawyers do (I was right). My

Potential employers will know you are ambitious, that you have an owner’s

financial ambition at the time was to make as much as a developer as I would

perspective, and that—let’s face it—you’re unlikely to bolt again.

have as a lawyer.

It’s a different story if it’s all about the money. If you love your job and your hunger is only for wealth, then ask yourself if you’re really worth more

Turning Gordon Gekko’s aphorism on its head, greed is not good enough. Where does all this leave my young friend who loves his job and its

than go money. If you still think so, explain to your boss how valuable you are,

challenges but who will likely end up unhappy with his compensation? (By

ask for a big raise, and then listen hard to the reply. He’s your boss for a reason.

the way, if you can succeed at running your own business, you will always

He has more experience than you do, and it’s even theoretically possible that

be unhappy with your compensation.) If, like George, he thinks he can do it

he is smarter than you or better in business (these are two entirely different

better on his own or, like Merv, he wants to be his own boss, or if he simply

things: many of the smartest people I know are terrible at business). And if

wants to have more fun, then he should consider setting up shop.

your boss says your compensation is fair, he may be right. In my experience, those who start a business just to get rich almost never succeed. The ones who

But to paraphrase the teachings of Siddhartha, there is a “middle way” that we will explore in the next chapter.

make it are those who love what they’re doing and start their own companies only because they have no choice (no one will hire them), because they want to be their own boss, or because they think they can do it better on their own. They believe they will be more productive—and have more fun—if they can peel away the corporate bureaucracy, the weekly team conference calls, the Sisyphean reporting requirements, the multiple sign-offs needed for deals, and even the mandatory company socializing. I asked George Marcus, one of the most successful men in American real estate, what he thought about starting a company for the money. “Anyone dreaming of going into business just to get rich is fooling himself. You start a business because you have a passion to improve a business strategy or an industry.” George knows what he’s talking about. At 25, he started Marcus & Millichap and finally took it public in 2013 (the stock price has since doubled). He is also the founder and principal shareholder of another public company, Essex Property Trust, arguably the country’s best-performing real estate investment trust over the past 20 years. Mervin Morris, a giant in the retail industry and founder of the Mervyn’s department store chain, told me simply, “I went into business for myself because I wanted to be my own boss and make a comfortable living.”

4

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

QUIT YOUR JOB? 5

the salary loss from your crappy job. And if you have to white-flag it back to

Personally, I switched from real estate law to development because it seemed

the corporate world, you will be more valuable because of your experience.

to me that developers have a lot more fun than lawyers do (I was right). My

Potential employers will know you are ambitious, that you have an owner’s

financial ambition at the time was to make as much as a developer as I would

perspective, and that—let’s face it—you’re unlikely to bolt again.

have as a lawyer.

It’s a different story if it’s all about the money. If you love your job and your hunger is only for wealth, then ask yourself if you’re really worth more

Turning Gordon Gekko’s aphorism on its head, greed is not good enough. Where does all this leave my young friend who loves his job and its

than go money. If you still think so, explain to your boss how valuable you are,

challenges but who will likely end up unhappy with his compensation? (By

ask for a big raise, and then listen hard to the reply. He’s your boss for a reason.

the way, if you can succeed at running your own business, you will always

He has more experience than you do, and it’s even theoretically possible that

be unhappy with your compensation.) If, like George, he thinks he can do it

he is smarter than you or better in business (these are two entirely different

better on his own or, like Merv, he wants to be his own boss, or if he simply

things: many of the smartest people I know are terrible at business). And if

wants to have more fun, then he should consider setting up shop.

your boss says your compensation is fair, he may be right. In my experience, those who start a business just to get rich almost never succeed. The ones who

But to paraphrase the teachings of Siddhartha, there is a “middle way” that we will explore in the next chapter.

make it are those who love what they’re doing and start their own companies only because they have no choice (no one will hire them), because they want to be their own boss, or because they think they can do it better on their own. They believe they will be more productive—and have more fun—if they can peel away the corporate bureaucracy, the weekly team conference calls, the Sisyphean reporting requirements, the multiple sign-offs needed for deals, and even the mandatory company socializing. I asked George Marcus, one of the most successful men in American real estate, what he thought about starting a company for the money. “Anyone dreaming of going into business just to get rich is fooling himself. You start a business because you have a passion to improve a business strategy or an industry.” George knows what he’s talking about. At 25, he started Marcus & Millichap and finally took it public in 2013 (the stock price has since doubled). He is also the founder and principal shareholder of another public company, Essex Property Trust, arguably the country’s best-performing real estate investment trust over the past 20 years. Mervin Morris, a giant in the retail industry and founder of the Mervyn’s department store chain, told me simply, “I went into business for myself because I wanted to be my own boss and make a comfortable living.”

4

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

QUIT YOUR JOB? 5

2

Doing It on the Side

Are we in the wrong business?

On the “Best Jobs in America” lists, a career in real estate rates lower than carjacking. In fact, commercial real estate doesn’t rate at all on these ubiquitous lists. The closest we come is “real estate agent,” a distant #89 on U.S. News & World Report’s Top 100 Jobs list, lapped by such swell careers as “substance abuse counselor” (#36), “bill collector” (#57), and “exterminator” (#61). And at $80,000 a year, “real estate brokers” earn #159 among the Top 300 Highest Paying Jobs published by Myplan.com. That list’s top 20 paying jobs, by the way, are all physicians, starting with anesthesiologists at $233,000 and ending with general practitioners at $181,000. Should we be applying to med school, or is it possible these data don’t tell the whole story? Misreading data is a common failing—“Son, you got four F’s and a D. What’s that tell you?” the father asks. “That I’m spending too much time on one subject, Daddy?” To deduce that one should elect for a career in exterminating rather than real estate courtesy of U.S. News is likely such a mistake. What best-jobs data will never reveal is one of real estate’s greatest

What other part-time work or avocation is so lucrative? You could probably work part time as an exterminator or perhaps even as an anesthesiologist, but as long as you are working by the hour—as long as you’re working and your capital isn’t—you will always be working. If you love your day job but are unhappy with its compensation—the dilemma posed in chapter 1—you don’t have to quit. You just need to start a new hobby: give up fantasy football and spend your free time on a dilapidated house. If you take the long view—you should: real estate is the classic get-rich-slow business—you will do well. My late father-in-law was a bright man who came home from World War II devastated by his experiences as a combat medic in the South Pacific. Bill found solace in the bottle and was an alcoholic by his mid-30s— drinking a six-pack of beer and a bottle of vodka every day. Yet somehow he found the fortitude to quit drinking and start life over at 45. With no savings, no formal education beyond high school, and no marketable skills other than a talent for sales, Bill slowly amassed a small collection of San Francisco Bay area real estate—a couple of houses, a few promissory notes, a duplex or two, and a five-unit building—worth several million dollars at the time of his death 40 years later. More important, his real estate allowed him to retire in his late 60s with a secure income of $150,000 a year. How did he do it? One small building at a time. Bill made his living by day but his fortune by night, buying a property every year or two, fixing it up, sometimes selling it, sometimes keeping it. His properties were never pretty—they probably lost money at first—but 25 years later when it was time to retire, he had paid off their mortgages and his cash flow was as free and clear as a Sierra stream. And it’s really that simple. If you love your job or find the prospect of going out on your own—of working without a net—overwhelming, and yet you still want a future independent of a corporate pension, buy a neglected house in a quiet town and get started. If you can cobble together enough of a downpayment—

strengths—that one can amass a considerable fortune by doing it on the side.

perhaps with family and friends’ money (the topic of a later chapter)—so

6

DOING IT ON THE SIDE 7

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

2

Doing It on the Side

Are we in the wrong business?

On the “Best Jobs in America” lists, a career in real estate rates lower than carjacking. In fact, commercial real estate doesn’t rate at all on these ubiquitous lists. The closest we come is “real estate agent,” a distant #89 on U.S. News & World Report’s Top 100 Jobs list, lapped by such swell careers as “substance abuse counselor” (#36), “bill collector” (#57), and “exterminator” (#61). And at $80,000 a year, “real estate brokers” earn #159 among the Top 300 Highest Paying Jobs published by Myplan.com. That list’s top 20 paying jobs, by the way, are all physicians, starting with anesthesiologists at $233,000 and ending with general practitioners at $181,000. Should we be applying to med school, or is it possible these data don’t tell the whole story? Misreading data is a common failing—“Son, you got four F’s and a D. What’s that tell you?” the father asks. “That I’m spending too much time on one subject, Daddy?” To deduce that one should elect for a career in exterminating rather than real estate courtesy of U.S. News is likely such a mistake. What best-jobs data will never reveal is one of real estate’s greatest

What other part-time work or avocation is so lucrative? You could probably work part time as an exterminator or perhaps even as an anesthesiologist, but as long as you are working by the hour—as long as you’re working and your capital isn’t—you will always be working. If you love your day job but are unhappy with its compensation—the dilemma posed in chapter 1—you don’t have to quit. You just need to start a new hobby: give up fantasy football and spend your free time on a dilapidated house. If you take the long view—you should: real estate is the classic get-rich-slow business—you will do well. My late father-in-law was a bright man who came home from World War II devastated by his experiences as a combat medic in the South Pacific. Bill found solace in the bottle and was an alcoholic by his mid-30s— drinking a six-pack of beer and a bottle of vodka every day. Yet somehow he found the fortitude to quit drinking and start life over at 45. With no savings, no formal education beyond high school, and no marketable skills other than a talent for sales, Bill slowly amassed a small collection of San Francisco Bay area real estate—a couple of houses, a few promissory notes, a duplex or two, and a five-unit building—worth several million dollars at the time of his death 40 years later. More important, his real estate allowed him to retire in his late 60s with a secure income of $150,000 a year. How did he do it? One small building at a time. Bill made his living by day but his fortune by night, buying a property every year or two, fixing it up, sometimes selling it, sometimes keeping it. His properties were never pretty—they probably lost money at first—but 25 years later when it was time to retire, he had paid off their mortgages and his cash flow was as free and clear as a Sierra stream. And it’s really that simple. If you love your job or find the prospect of going out on your own—of working without a net—overwhelming, and yet you still want a future independent of a corporate pension, buy a neglected house in a quiet town and get started. If you can cobble together enough of a downpayment—

strengths—that one can amass a considerable fortune by doing it on the side.

perhaps with family and friends’ money (the topic of a later chapter)—so

6

DOING IT ON THE SIDE 7

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

that you at least break even after paying your expenses, you’re set. Even if

3

your rents never increase a cent, you will eventually pay off the mortgage and all that cash flow will be yours. If you can pull this off a few times, you can retire as comfortably as my father-in-law did.

Playing Small Ball

“I hit big or I miss big.I like to live as big as I can.” A winning formula for the greatest baseball player ever, but unless you’re determined to become real estate’s Babe Ruth, you might consider following in someone else’s spikes. Mortals make the Hall of Fame by hitting singles. The late Tony Gwynn was dearly remembered as a better person than a hitter, and he was the greatest hitter of his generation. Tony hit singles. Derek Jeter made the Hall hitting singles. And so can you. But this is where the baseball metaphor strikes out— players make the Hall of Fame batting .300. You won’t. Unless you’re making money on eight out of every 10 deals, you’ll enter a different hall, the one where you file Chapter 11. Don Kuemmeler, a founding partner of Pacific Coast Capital Partners, is more precise. Don says PCCP, a $6.5 billion real estate management firm, has to bat .850 on its equity deals and .990 on its debt placements to maintain its targeted profitability. How should you choose real estate investments? The same way you take a lion’s temperature—very carefully. Hitting those numbers isn’t easy— $6.5 billion firms are few and far between for a reason—because sooner or later, everyone loses money in real estate.

8

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

9

that you at least break even after paying your expenses, you’re set. Even if

3

your rents never increase a cent, you will eventually pay off the mortgage and all that cash flow will be yours. If you can pull this off a few times, you can retire as comfortably as my father-in-law did.

Playing Small Ball

“I hit big or I miss big.I like to live as big as I can.” A winning formula for the greatest baseball player ever, but unless you’re determined to become real estate’s Babe Ruth, you might consider following in someone else’s spikes. Mortals make the Hall of Fame by hitting singles. The late Tony Gwynn was dearly remembered as a better person than a hitter, and he was the greatest hitter of his generation. Tony hit singles. Derek Jeter made the Hall hitting singles. And so can you. But this is where the baseball metaphor strikes out— players make the Hall of Fame batting .300. You won’t. Unless you’re making money on eight out of every 10 deals, you’ll enter a different hall, the one where you file Chapter 11. Don Kuemmeler, a founding partner of Pacific Coast Capital Partners, is more precise. Don says PCCP, a $6.5 billion real estate management firm, has to bat .850 on its equity deals and .990 on its debt placements to maintain its targeted profitability. How should you choose real estate investments? The same way you take a lion’s temperature—very carefully. Hitting those numbers isn’t easy— $6.5 billion firms are few and far between for a reason—because sooner or later, everyone loses money in real estate.

8

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

9

If you bought anything in the 2004–2007 bubble, you lost big. But this

It’s hard to hit a home run paying all cash, but it’s also impossible to strike

is the point: if you didn’t have to sell, your losses were merely on paper. And

out, and since even the best in our business lose money, you might seriously

if you could afford to wait long enough, you actually turned a profit. If,

consider small ball. By the way, the Bambino himself agreed with this

however, you were forced to sell bubble-era acquisitions in 2009–2011, you

philosophy: “If I’d tried for them dinking singles, I could’ve batted around

lost, somewhere between a lot and everything. What three factors force one

.800.” And so can you.

to sell into a terrible market? Debt, debt, and debt. The other “D’s”—death, divorce, and disaster—are easier to ignore than a foreclosure notice nailed to

Finally, if you’re truly going out on your own, take this last bit of advice from the Babe to heart: “Never let the fear of striking out get in your way.”

your door. In baseball, the difference between a single and a home run is how hard you swing the bat; in real estate, it’s how much leverage you use. In a rising market, leverage turns singles into home runs. Let’s say you bought a $5 million property with a million dollars in equity and a $4 million loan and that two years later it’s worth $6 million. You would have achieved a 100 percent return on your million-dollar investment. Home run. If you had instead purchased the same property with no debt, your return would be 20 percent (a million-dollar profit on a $5 million cash investment). Single. Note that we’re simply measuring the return on your equity investment to determine your level of success. If, however, the property had lost 20 percent of its value, the leveraged buyer would be tapioca—the equity gone and the property too when the loan matures. On the other hand, the cash buyer has a 20 percent loss on paper, but nothing else changes. Assuming the drop in value is systemic (e.g., the Great Recession), the property’s cash flow remains the same: if you were making $300,000 a year when the property was worth $5 million, you’re still making $300,000 when it’s worth $4 million. Bob Hughes, one of the most original thinkers in our business, drawled in the depths of the recession, “John, my net worth’s gone down by half, but my cash flow’s the same.” And since net worth is meaningless (see chapter 17), since ultimately it’s all about cash flow, nothing changed for the talented Mr. Hughes. Nor will it for you if you are prudent with leverage.

10

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

PLAYING SMALL BALL 11

If you bought anything in the 2004–2007 bubble, you lost big. But this

It’s hard to hit a home run paying all cash, but it’s also impossible to strike

is the point: if you didn’t have to sell, your losses were merely on paper. And

out, and since even the best in our business lose money, you might seriously

if you could afford to wait long enough, you actually turned a profit. If,

consider small ball. By the way, the Bambino himself agreed with this

however, you were forced to sell bubble-era acquisitions in 2009–2011, you

philosophy: “If I’d tried for them dinking singles, I could’ve batted around

lost, somewhere between a lot and everything. What three factors force one

.800.” And so can you.

to sell into a terrible market? Debt, debt, and debt. The other “D’s”—death, divorce, and disaster—are easier to ignore than a foreclosure notice nailed to

Finally, if you’re truly going out on your own, take this last bit of advice from the Babe to heart: “Never let the fear of striking out get in your way.”

your door. In baseball, the difference between a single and a home run is how hard you swing the bat; in real estate, it’s how much leverage you use. In a rising market, leverage turns singles into home runs. Let’s say you bought a $5 million property with a million dollars in equity and a $4 million loan and that two years later it’s worth $6 million. You would have achieved a 100 percent return on your million-dollar investment. Home run. If you had instead purchased the same property with no debt, your return would be 20 percent (a million-dollar profit on a $5 million cash investment). Single. Note that we’re simply measuring the return on your equity investment to determine your level of success. If, however, the property had lost 20 percent of its value, the leveraged buyer would be tapioca—the equity gone and the property too when the loan matures. On the other hand, the cash buyer has a 20 percent loss on paper, but nothing else changes. Assuming the drop in value is systemic (e.g., the Great Recession), the property’s cash flow remains the same: if you were making $300,000 a year when the property was worth $5 million, you’re still making $300,000 when it’s worth $4 million. Bob Hughes, one of the most original thinkers in our business, drawled in the depths of the recession, “John, my net worth’s gone down by half, but my cash flow’s the same.” And since net worth is meaningless (see chapter 17), since ultimately it’s all about cash flow, nothing changed for the talented Mr. Hughes. Nor will it for you if you are prudent with leverage.

10

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

PLAYING SMALL BALL 11

4

Specialize or Die

A recent college graduate wrote,asking for advice. Mentioning how thrilled he was to be accepted into Marcus & Millichap’s training program, he wanted to know which area he should specialize in: land, apartments, or industrial. I told him it didn’t matter as long as he picked one and stuck with it. Yet to spend his first day in real estate, this fellow had already figured out a truth that eludes many: if you don’t specialize, your specialty will be failure. In small towns noted more for alfalfa than economic opportunities, a broker can be a grammar school teacher—that is, he can know just enough about a half dozen subjects to be one step ahead of his clients and sell anything that walks in the door, from ranches to diners to mobile homes. In a city of size, the competent broker is more of a high school teacher, sticking with one broad subject, selling, say, only industrial properties. And in major markets, top brokers are more akin to university professors, focusing on narrow niches within their specialty—an office leasing agent who represents only law firms. But which specialty matters little and which niche almost not at all because each product type will have its days in the sun over the years. What you do doesn’t matter that much, but where you do it is huge. To paraphrase

brilliant developer in Lancaster, California. My advice? If you’re stuck in my hometown or any other city with Lancaster’s dim prospects, move. Like every other clueless neophyte, we started out in apartments, but, as profitable as they are for many, they didn’t work for us. Richer in experience but little else, we decided we had no wish to own buildings where anyone slept. Waving farewell to our residential tenants, we shifted into the fast lane, the glamour world of suburban industrial. How tough could industrial be, we asked ourselves. Within months of buying our first pair of warehouses, we found out. We learned that when the biggest industrial developer in town owns both an ocean of free land and a construction company, he will build a new warehouse every month until the day he retires. And he won’t ever retire. And rents will never rise. Ten years later, we cracked the Dom Perignon when we managed to sell our warehouses for exactly what we paid for them. In short, rather than being apartment and industrial moguls, we might have more profitably spent our time as forest fire lookouts. But all was not lost. Somewhere during our 10 years in the industrial wilderness, we fell into a retail deal and developed a shopping center in Healdsburg, California. That project—we still own it—became the template for everything we’ve developed ever since, namely, neighborhood shopping centers in cities that fight development as if it were contagious. The degree to which we specialize is worth stressing. Within the high school subject of retail, our professor’s niche is this: our development projects are “necessity retail” (supermarkets, drugstores, and discount department stores); they range from 25,000 to 150,000 square feet; and they are located within a two-hour drive of San Francisco. Within that narrow range, we can often be competitive with larger, better-known developers, challenging their superior capital with local knowledge and an ability to act quickly. Our geographic limitation—that two-hour drive time—isn’t based purely on laziness. If a project is no more than two hours away, we can drive there, have the meeting with the city, get our hats handed to us, and still get back to

Warren Buffett, I’d rather be a mediocre developer in a brilliant city than a

the office to deal with other challenges.

12

SPECIALIZE OR DIE 13

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

4

Specialize or Die

A recent college graduate wrote,asking for advice. Mentioning how thrilled he was to be accepted into Marcus & Millichap’s training program, he wanted to know which area he should specialize in: land, apartments, or industrial. I told him it didn’t matter as long as he picked one and stuck with it. Yet to spend his first day in real estate, this fellow had already figured out a truth that eludes many: if you don’t specialize, your specialty will be failure. In small towns noted more for alfalfa than economic opportunities, a broker can be a grammar school teacher—that is, he can know just enough about a half dozen subjects to be one step ahead of his clients and sell anything that walks in the door, from ranches to diners to mobile homes. In a city of size, the competent broker is more of a high school teacher, sticking with one broad subject, selling, say, only industrial properties. And in major markets, top brokers are more akin to university professors, focusing on narrow niches within their specialty—an office leasing agent who represents only law firms. But which specialty matters little and which niche almost not at all because each product type will have its days in the sun over the years. What you do doesn’t matter that much, but where you do it is huge. To paraphrase

brilliant developer in Lancaster, California. My advice? If you’re stuck in my hometown or any other city with Lancaster’s dim prospects, move. Like every other clueless neophyte, we started out in apartments, but, as profitable as they are for many, they didn’t work for us. Richer in experience but little else, we decided we had no wish to own buildings where anyone slept. Waving farewell to our residential tenants, we shifted into the fast lane, the glamour world of suburban industrial. How tough could industrial be, we asked ourselves. Within months of buying our first pair of warehouses, we found out. We learned that when the biggest industrial developer in town owns both an ocean of free land and a construction company, he will build a new warehouse every month until the day he retires. And he won’t ever retire. And rents will never rise. Ten years later, we cracked the Dom Perignon when we managed to sell our warehouses for exactly what we paid for them. In short, rather than being apartment and industrial moguls, we might have more profitably spent our time as forest fire lookouts. But all was not lost. Somewhere during our 10 years in the industrial wilderness, we fell into a retail deal and developed a shopping center in Healdsburg, California. That project—we still own it—became the template for everything we’ve developed ever since, namely, neighborhood shopping centers in cities that fight development as if it were contagious. The degree to which we specialize is worth stressing. Within the high school subject of retail, our professor’s niche is this: our development projects are “necessity retail” (supermarkets, drugstores, and discount department stores); they range from 25,000 to 150,000 square feet; and they are located within a two-hour drive of San Francisco. Within that narrow range, we can often be competitive with larger, better-known developers, challenging their superior capital with local knowledge and an ability to act quickly. Our geographic limitation—that two-hour drive time—isn’t based purely on laziness. If a project is no more than two hours away, we can drive there, have the meeting with the city, get our hats handed to us, and still get back to

Warren Buffett, I’d rather be a mediocre developer in a brilliant city than a

the office to deal with other challenges.

12

SPECIALIZE OR DIE 13

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

By the way, specializing doesn’t mean that you shouldn’t move on once

5

the tin mine is played out. When it finally sputters, you need to pick a new specialty (and then stick with that) or a new area. If you become a developer and have any success at it, you will one day receive a call from a silver-tongued broker. She will be calling from a land far away, from Atlanta or Denver or perhaps Houston. She will flatter you with blandishments about your reputation and, when at last she deems you ready, she will describe a wonderful opportunity that somehow all of the local developers in her city have managed to overlook. Before responding to her siren call, ask yourself this: how likely is it that Atlanta or Denver or Houston

Bromancing the Deal

doesn’t have even one homegrown, totally connected developer who is at least as smart as you? And then thank the broker for the call and stay home.

“I always act as our brokerwhen we buy properties. That way I take the commission we save as my fee and it doesn’t cost my investors anything.” Except seeing good deals. In a dead heat with drunk-texting, this is among the worst mistakes a young principal can make. The problem with acting as your own broker is that it works beautifully on crap, thereby masking its insidious effect on good deals. If a broker had a listing on land in Chernobyl, she would gladly share her commission with you or even Charles Manson to get rid of it. And toss in a closing dinner. Good deals are another story. In hot markets, great deals are rare. They’re scarce even after the bubble bursts. And if the brokerage community knows you’re representing yourself, you will swiftly discover where the Mafia learned its code of silence. The listing broker may begrudgingly send you her sales package, but will she share what else she knows about the property? No. If, instead of insisting on half of the commission, you allow yourself to be represented by another broker, you create two potential sources of future deals instead of one agent certain you screwed her out of a full commission. Buy three deals in a year and, in scenario one, you have three brokers who won’t return your calls or, in scenario two, six who think you’re a stand-up guy.

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MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

15

By the way, specializing doesn’t mean that you shouldn’t move on once

5

the tin mine is played out. When it finally sputters, you need to pick a new specialty (and then stick with that) or a new area. If you become a developer and have any success at it, you will one day receive a call from a silver-tongued broker. She will be calling from a land far away, from Atlanta or Denver or perhaps Houston. She will flatter you with blandishments about your reputation and, when at last she deems you ready, she will describe a wonderful opportunity that somehow all of the local developers in her city have managed to overlook. Before responding to her siren call, ask yourself this: how likely is it that Atlanta or Denver or Houston

Bromancing the Deal

doesn’t have even one homegrown, totally connected developer who is at least as smart as you? And then thank the broker for the call and stay home.

“I always act as our brokerwhen we buy properties. That way I take the commission we save as my fee and it doesn’t cost my investors anything.” Except seeing good deals. In a dead heat with drunk-texting, this is among the worst mistakes a young principal can make. The problem with acting as your own broker is that it works beautifully on crap, thereby masking its insidious effect on good deals. If a broker had a listing on land in Chernobyl, she would gladly share her commission with you or even Charles Manson to get rid of it. And toss in a closing dinner. Good deals are another story. In hot markets, great deals are rare. They’re scarce even after the bubble bursts. And if the brokerage community knows you’re representing yourself, you will swiftly discover where the Mafia learned its code of silence. The listing broker may begrudgingly send you her sales package, but will she share what else she knows about the property? No. If, instead of insisting on half of the commission, you allow yourself to be represented by another broker, you create two potential sources of future deals instead of one agent certain you screwed her out of a full commission. Buy three deals in a year and, in scenario one, you have three brokers who won’t return your calls or, in scenario two, six who think you’re a stand-up guy.

14

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

15

For anyone meant for the business, this should be obvious. The next rung

Once you’ve selected the right broker and are treating her the way you

on this ladder is almost as evident: in a competitive situation, always pay the

would wish to be treated, remember this: disclose everything except your

listing broker the full commission. Even if this means paying your own broker

bottom line. While “You get in enough trouble being honest” is a great moral

on the side. It is unlikely Einstein really said, “The most powerful force in the

north star, one can suffer from being if not too honest, then at least too

universe is compound interest,” but if he were given to monetary ruminations,

forthcoming. Sharing too much information with your agent can be expensive.

he might have added, “It’s second only to the power of the financial incentive.”

If you were to let even Gandhi know your absolute bottom line when signing

In a hot market, the listing broker may present a half dozen offers to his

his listing agreement, you would likely receive a spate of offers within a

seller. If the offers are close, which is he going to tout? Those in which he nets

horseshoe-toss of that number, possibly depriving you of a higher price.

$50,000 or the one in which he pockets $100,000?

Trust your fellow man, but recognize the frailty of human nature.

On the other hand, money alone is not enough; it never is. Mirroring life itself, business is about relationships. In real estate, a bromance is your friendship with your broker (male or female), presumably platonic but deep nonetheless. Wise principals spend quality time with their favored brokers. Why? Because they are truly friends, and it doesn’t hurt when it comes to getting the “first call, last look” on deals. The advice then is simple: work on your relationships, become friends with your brokers, and treat them fairly. This is not to suggest, however, that you should accept any broker’s proposed commission schedule or listing agreement without first ascertaining the going rate. And then fighting a bit. Beyond treating agents with respect, choosing the right one matters because the best agents are as specialized as the best principals. The major houses with their vast marketing networks are superb at extracting a buyer’s last nickel, and thus brilliant if you’re a seller and not all that useful to buyers. The small shops tend to be where the best buy-side deals are ferreted out, usually a result of determination and local knowledge. In retail, the best buyers’ brokers are often not the investment sales guys but leasing agents. This is intuitive: retail is about tenants, about delivering the right tenant to the right location, and tenant reps know exactly where their clients want to open stores. Often enough, these agents encounter sites where the existing ownership is unwilling—or unable—to execute on development opportunities.

16

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

BROMANCING THE DEAL 17

For anyone meant for the business, this should be obvious. The next rung

Once you’ve selected the right broker and are treating her the way you

on this ladder is almost as evident: in a competitive situation, always pay the

would wish to be treated, remember this: disclose everything except your

listing broker the full commission. Even if this means paying your own broker

bottom line. While “You get in enough trouble being honest” is a great moral

on the side. It is unlikely Einstein really said, “The most powerful force in the

north star, one can suffer from being if not too honest, then at least too

universe is compound interest,” but if he were given to monetary ruminations,

forthcoming. Sharing too much information with your agent can be expensive.

he might have added, “It’s second only to the power of the financial incentive.”

If you were to let even Gandhi know your absolute bottom line when signing

In a hot market, the listing broker may present a half dozen offers to his

his listing agreement, you would likely receive a spate of offers within a

seller. If the offers are close, which is he going to tout? Those in which he nets

horseshoe-toss of that number, possibly depriving you of a higher price.

$50,000 or the one in which he pockets $100,000?

Trust your fellow man, but recognize the frailty of human nature.

On the other hand, money alone is not enough; it never is. Mirroring life itself, business is about relationships. In real estate, a bromance is your friendship with your broker (male or female), presumably platonic but deep nonetheless. Wise principals spend quality time with their favored brokers. Why? Because they are truly friends, and it doesn’t hurt when it comes to getting the “first call, last look” on deals. The advice then is simple: work on your relationships, become friends with your brokers, and treat them fairly. This is not to suggest, however, that you should accept any broker’s proposed commission schedule or listing agreement without first ascertaining the going rate. And then fighting a bit. Beyond treating agents with respect, choosing the right one matters because the best agents are as specialized as the best principals. The major houses with their vast marketing networks are superb at extracting a buyer’s last nickel, and thus brilliant if you’re a seller and not all that useful to buyers. The small shops tend to be where the best buy-side deals are ferreted out, usually a result of determination and local knowledge. In retail, the best buyers’ brokers are often not the investment sales guys but leasing agents. This is intuitive: retail is about tenants, about delivering the right tenant to the right location, and tenant reps know exactly where their clients want to open stores. Often enough, these agents encounter sites where the existing ownership is unwilling—or unable—to execute on development opportunities.

16

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

BROMANCING THE DEAL 17

6

Size Matters

In the opening sceneof Rosencrantz and Guildenstern Are Dead, Rosencrantz correctly calls heads 92 times in a row in a coin-tossing game. While such luck is theoretically possible, Stoppard’s play is considered absurdist for an excellent reason. Making money 92 times in a row in real estate is also theoretically possible, but, if anything, is even less likely—about the same as winning the lottery without buying a ticket. This is why size matters. Follow these numbers: decades ago—in year one of my real estate career—I bought a duplex in my tumbleweed hometown for $24,000 and made money. A year later, I purchased a four-plex for $60,000 and made money again. The next year we bought a four-plex in San Francisco for $350,000 and did well. The following year, we acquired a couple of industrial buildings for $1.2 million and broke even. Two years later, we developed a shopping center at a cost of $9 million and it turned out well. And finally—the next year—we bought a troubled shopping center for $15.5 million. In seven years then—over the course of just six purchases—our deal size increased 64,000 percent. Had we continued on that heady trajectory for

It didn’t turn out that way. The day we closed on the troubled center was its finest hour. We had purchased it with shockingly easy money, borrowing 102 percent of the price (we pulled out fees) from our savings and loan partner. Because this center was proof that there is no location so perfect it cannot be ruined through bad design, our grand plan was to raze 80 percent of its cornfield maze of buildings. In the end, however, we could do no more than throw a Band-Aid on the project’s terminal defects. Failing in its redevelopment, we rode that property all the way down—imagine Slim Pickens atop the nuclear warhead in Dr. Strangelove—until we lost it. It took us some years to recover from the loss. The episode was rich in lessons, but the one to focus on here was the deal’s leviathan size relative to our portfolio. If it’s axiomatic that sooner or later you will lose money in real estate—and it is—then our 64,000 percent increase in deal size was the equivalent of sitting down at a Vegas blackjack table and letting our winnings ride hand after hand after hand. If you’re going to lose money only 10 percent of the time—an optimistic assumption—then if your 10th deal is about the same size as the preceding nine, you will be scorched but not incinerated when it blows. Let’s say your niche is $1 million apartment houses that you fix up and sell for $1.3 million and that you stick with that formula. Do it successfully nine times in a row and you’ve banked $2.7 million. Then when you lose your 10th deal to the bank, your pride will be bruised more than your balance sheet. If, on the other hand, your 10th deal is 64,000 percent larger than your first, its loss could force you underwater and never let you up. Take this advice too literally, however, and the world is nothing but duplexes. Grow your deal size, but do it in moderation and manage your risk. By the way, big-picture risk management for developers only comes in a couple of basic colors: the classic tactic is to use other people’s money, take fees up front, and never sign recourse, while the long-term-investor approach is to avoid spec projects and invest enough equity to weather any storm.

another seven years, we would have been doing $10 billion projects and been the richest developers on the planet.

18

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

SIZE MAT TERS 19

6

Size Matters

In the opening sceneof Rosencrantz and Guildenstern Are Dead, Rosencrantz correctly calls heads 92 times in a row in a coin-tossing game. While such luck is theoretically possible, Stoppard’s play is considered absurdist for an excellent reason. Making money 92 times in a row in real estate is also theoretically possible, but, if anything, is even less likely—about the same as winning the lottery without buying a ticket. This is why size matters. Follow these numbers: decades ago—in year one of my real estate career—I bought a duplex in my tumbleweed hometown for $24,000 and made money. A year later, I purchased a four-plex for $60,000 and made money again. The next year we bought a four-plex in San Francisco for $350,000 and did well. The following year, we acquired a couple of industrial buildings for $1.2 million and broke even. Two years later, we developed a shopping center at a cost of $9 million and it turned out well. And finally—the next year—we bought a troubled shopping center for $15.5 million. In seven years then—over the course of just six purchases—our deal size increased 64,000 percent. Had we continued on that heady trajectory for

It didn’t turn out that way. The day we closed on the troubled center was its finest hour. We had purchased it with shockingly easy money, borrowing 102 percent of the price (we pulled out fees) from our savings and loan partner. Because this center was proof that there is no location so perfect it cannot be ruined through bad design, our grand plan was to raze 80 percent of its cornfield maze of buildings. In the end, however, we could do no more than throw a Band-Aid on the project’s terminal defects. Failing in its redevelopment, we rode that property all the way down—imagine Slim Pickens atop the nuclear warhead in Dr. Strangelove—until we lost it. It took us some years to recover from the loss. The episode was rich in lessons, but the one to focus on here was the deal’s leviathan size relative to our portfolio. If it’s axiomatic that sooner or later you will lose money in real estate—and it is—then our 64,000 percent increase in deal size was the equivalent of sitting down at a Vegas blackjack table and letting our winnings ride hand after hand after hand. If you’re going to lose money only 10 percent of the time—an optimistic assumption—then if your 10th deal is about the same size as the preceding nine, you will be scorched but not incinerated when it blows. Let’s say your niche is $1 million apartment houses that you fix up and sell for $1.3 million and that you stick with that formula. Do it successfully nine times in a row and you’ve banked $2.7 million. Then when you lose your 10th deal to the bank, your pride will be bruised more than your balance sheet. If, on the other hand, your 10th deal is 64,000 percent larger than your first, its loss could force you underwater and never let you up. Take this advice too literally, however, and the world is nothing but duplexes. Grow your deal size, but do it in moderation and manage your risk. By the way, big-picture risk management for developers only comes in a couple of basic colors: the classic tactic is to use other people’s money, take fees up front, and never sign recourse, while the long-term-investor approach is to avoid spec projects and invest enough equity to weather any storm.

another seven years, we would have been doing $10 billion projects and been the richest developers on the planet.

18

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

SIZE MAT TERS 19

Paraphrasing Goldilocks, just as deals can be too large, they also can

7

be too small. If you’re humming along doing $1 million apartment houses and someone offers you a $100,000 duplex to rebuild, don’t do it. Even if it’s a guaranteed layup. Why? Because with so little money involved, you will neither take it seriously nor pay enough attention. You will fail to sit on your architect and thus miss the extravagance of his design. Your contractor’s change orders will be so much smaller than those on your bigger projects that they will pile up unchallenged. And you won’t be calling your leasing agent

Buying It Right

every day to find out why the vacancy persists. In the end, you will bounce the ball off the rim. The trick then is to fight in your weight class. Find deals that fully engage you while, at the same time, allowing you to fight another day if they go bad. In business at least, size matters.

In Anna Karenina, Tolstoy begins:“All happy families are alike; each unhappy family is unhappy in its own way.” This is true of real estate as well: all happy deals are alike—they start with a motivated seller. Young developers often make the mistake of chasing unlisted properties, listening to brokers who are certain that, if the developer will only offer exactly the right price and terms, the reluctant property owner may consider a sale. You need a couple of these snipe hunts under your belt to learn that it’s easier making money flipping burgers than chasing complacent owners. An excellent question to ask whenever someone pitches you a deal is simply: “Why is she selling?” If the answer doesn’t involve a compelling need to sell (e.g., death, divorce, dissolution, or disaster), thank the broker for his call and go back to the sports page. The worst answer to this question is: “If she can get her price, the seller will consider it as long as she can find a trade property.” This means she will sell only if you pay her an astronomical price and she gets to steal her trade property. Let it go. Even motivated sellers can—until their time runs out—be unrealistic about their pricing expectations. If you know a seller must sell because of, say, estate taxes due, but he’s demanding $10 million for a great property worth $7

20

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

21

Paraphrasing Goldilocks, just as deals can be too large, they also can

7

be too small. If you’re humming along doing $1 million apartment houses and someone offers you a $100,000 duplex to rebuild, don’t do it. Even if it’s a guaranteed layup. Why? Because with so little money involved, you will neither take it seriously nor pay enough attention. You will fail to sit on your architect and thus miss the extravagance of his design. Your contractor’s change orders will be so much smaller than those on your bigger projects that they will pile up unchallenged. And you won’t be calling your leasing agent

Buying It Right

every day to find out why the vacancy persists. In the end, you will bounce the ball off the rim. The trick then is to fight in your weight class. Find deals that fully engage you while, at the same time, allowing you to fight another day if they go bad. In business at least, size matters.

In Anna Karenina, Tolstoy begins:“All happy families are alike; each unhappy family is unhappy in its own way.” This is true of real estate as well: all happy deals are alike—they start with a motivated seller. Young developers often make the mistake of chasing unlisted properties, listening to brokers who are certain that, if the developer will only offer exactly the right price and terms, the reluctant property owner may consider a sale. You need a couple of these snipe hunts under your belt to learn that it’s easier making money flipping burgers than chasing complacent owners. An excellent question to ask whenever someone pitches you a deal is simply: “Why is she selling?” If the answer doesn’t involve a compelling need to sell (e.g., death, divorce, dissolution, or disaster), thank the broker for his call and go back to the sports page. The worst answer to this question is: “If she can get her price, the seller will consider it as long as she can find a trade property.” This means she will sell only if you pay her an astronomical price and she gets to steal her trade property. Let it go. Even motivated sellers can—until their time runs out—be unrealistic about their pricing expectations. If you know a seller must sell because of, say, estate taxes due, but he’s demanding $10 million for a great property worth $7

20

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

21

million, you have a dilemma: do you tie the property up at his price and then

as many as four properties. Schedules and goals aside, it’s critical to have the

gently attempt to educate him about the property’s true value and renegotiate

discipline to sit it out when prices make no sense to you.

your deal, or do you let a competitor charge that particular hill, await his

The best deals sometimes come with the worst contracts. Loan servicers

demise, and come in as the second or even the third buyer once the seller has

who have foreclosed on choice properties often employ lawyers who delight

accepted reality? Both strategies entail risk: if you go in first, you’re likely to

in preparing wickedly one-sided agreements. My advice? If the price,

be the first messenger shot, but if you let someone else go first, he just may

contingencies, and closing date are right, don’t worry about the 50 pages of

succeed with his bait-and-switch strategy.

crap in the contract. Agree to buy the property as is, to indemnify the seller,

When confronted with an unrealistic seller, we usually advise his broker

to accept whatever ridiculous terms the seller insists on, but be exceptionally

that teaching market values to a seller is not our business and that we will wait

careful with your own due diligence. In particular, insist on a written

until he learns this from someone else. Thus, we lose deals.

agreement—an estoppel letter—signed by each tenant of the property that

Worse, though, is to win an overpriced deal. If you chase that $7 million

confirms all the terms of the tenant’s lease and the fact that neither tenant nor

deal for which the seller will only take $10 million and you fall in love with

landlord is in default. And never let a seller convince you to accept his estoppel

the property or become too invested in closing the deal and talk yourself into

in lieu of estoppels from the tenants. Why? Because if the seller’s substitute

meeting him halfway and paying $8.5 million, you will spend the next three

estoppel is wrong, and the tenant happens to have a valid offset against rent or

years of your life working for the seller. You handed him your future profits on

the right to terminate or the right to extend the lease for free, all you have is an

day one.

expensive lawsuit against a seller who already has your money.

If there isn’t a country and western song that sobs, “Don’t fall in love with

As an aside, if there’s any way a seller will meet you, do it; become his

nothin’ that can’t fall in love with you,” there should be. If you’re looking for

new best friend. Even if he’s tighter than a clam, you will learn something

love, at least fall for the numbers and not the property. One astute friend ties

merely by visiting him at his office. And if your closing is subject to anything

up properties sight unseen, not even visiting a property until he is in contract

remotely out of your control—entitlements or new leasing—then the more

at a price he loves. He doesn’t want a building’s ocean views or historic charm

contact you have with the seller, the more you keep him honestly apprised

to soften his yield requirements.

of what’s going on, the better your chances will be of getting the closing date

The best time to find a motivated and realistic seller is when no one else is

extensions you need to make the deal happen.

buying. “Buy when there’s blood in the streets” is the timeless adage. Had you

Finally, even if you’re going to lose $50,000 in due diligence costs, walk

done so in 2009, you would have made a fortune. Market timing is, however, a

away from deals that turn out to be wormholed. This is easy advice to give and

rare talent, and buying into disaster requires not only a cast-iron stomach and

hard to follow, but to succeed, you have to learn when to leave your ante on

a prophet’s certainty of the future, but also the ability to raise patient money

the table.

when few others can. It might be easier to buy and sell on an established pattern, say, two to three deals a year and then stick with it like a farmer with his annual plantings. By way of example, we have averaged about two new deals a year over the past 35 years, some years not buying anything, others

22

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

BUYING IT RIGHT 23

million, you have a dilemma: do you tie the property up at his price and then

as many as four properties. Schedules and goals aside, it’s critical to have the

gently attempt to educate him about the property’s true value and renegotiate

discipline to sit it out when prices make no sense to you.

your deal, or do you let a competitor charge that particular hill, await his

The best deals sometimes come with the worst contracts. Loan servicers

demise, and come in as the second or even the third buyer once the seller has

who have foreclosed on choice properties often employ lawyers who delight

accepted reality? Both strategies entail risk: if you go in first, you’re likely to

in preparing wickedly one-sided agreements. My advice? If the price,

be the first messenger shot, but if you let someone else go first, he just may

contingencies, and closing date are right, don’t worry about the 50 pages of

succeed with his bait-and-switch strategy.

crap in the contract. Agree to buy the property as is, to indemnify the seller,

When confronted with an unrealistic seller, we usually advise his broker

to accept whatever ridiculous terms the seller insists on, but be exceptionally

that teaching market values to a seller is not our business and that we will wait

careful with your own due diligence. In particular, insist on a written

until he learns this from someone else. Thus, we lose deals.

agreement—an estoppel letter—signed by each tenant of the property that

Worse, though, is to win an overpriced deal. If you chase that $7 million

confirms all the terms of the tenant’s lease and the fact that neither tenant nor

deal for which the seller will only take $10 million and you fall in love with

landlord is in default. And never let a seller convince you to accept his estoppel

the property or become too invested in closing the deal and talk yourself into

in lieu of estoppels from the tenants. Why? Because if the seller’s substitute

meeting him halfway and paying $8.5 million, you will spend the next three

estoppel is wrong, and the tenant happens to have a valid offset against rent or

years of your life working for the seller. You handed him your future profits on

the right to terminate or the right to extend the lease for free, all you have is an

day one.

expensive lawsuit against a seller who already has your money.

If there isn’t a country and western song that sobs, “Don’t fall in love with

As an aside, if there’s any way a seller will meet you, do it; become his

nothin’ that can’t fall in love with you,” there should be. If you’re looking for

new best friend. Even if he’s tighter than a clam, you will learn something

love, at least fall for the numbers and not the property. One astute friend ties

merely by visiting him at his office. And if your closing is subject to anything

up properties sight unseen, not even visiting a property until he is in contract

remotely out of your control—entitlements or new leasing—then the more

at a price he loves. He doesn’t want a building’s ocean views or historic charm

contact you have with the seller, the more you keep him honestly apprised

to soften his yield requirements.

of what’s going on, the better your chances will be of getting the closing date

The best time to find a motivated and realistic seller is when no one else is

extensions you need to make the deal happen.

buying. “Buy when there’s blood in the streets” is the timeless adage. Had you

Finally, even if you’re going to lose $50,000 in due diligence costs, walk

done so in 2009, you would have made a fortune. Market timing is, however, a

away from deals that turn out to be wormholed. This is easy advice to give and

rare talent, and buying into disaster requires not only a cast-iron stomach and

hard to follow, but to succeed, you have to learn when to leave your ante on

a prophet’s certainty of the future, but also the ability to raise patient money

the table.

when few others can. It might be easier to buy and sell on an established pattern, say, two to three deals a year and then stick with it like a farmer with his annual plantings. By way of example, we have averaged about two new deals a year over the past 35 years, some years not buying anything, others

22

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

BUYING IT RIGHT 23

8

Desperately Chasing Yield

To paraphrase a vulgar aphorism, self-delusions are like opinions— everybody has one. Some have many. Self-delusions are sometimes tragic: consider starving anorexics who consider themselves fat. Occasionally self-delusions are merely sad: picture aging athletes certain they are good for another season. And some are entertaining: despite being a perennial finalist for “America’s Worst Cook,” my dear mother prided herself on her culinary skills. Self-delusions in real estate are about as rare as fixed professional wrestling matches. It may be that only a nationwide self-delusion can explain today’s over-the-top pricing of “core” real estate. It also may be that the usual suspect—greed—is a major factor. As of summer 2016, prices for prime office buildings in the country’s most desirable cities (those with ocean views) are at an all-time high—more than 10 percent greater than their previous peak. This pricing is not limited to high-rises. Any well-located asset considered bulletproof as to vacancy and rental decline is on fire. First-class regional shopping malls are fetching the same stratospheric prices as freestanding

Properties deemed core by investors hardly need a broker to command a record price. As used in real estate, the term core has become so imprecise as to be almost without meaning. Sometimes it signifies that the building in question is located in one of America’s top-tier cities (New York City, San Francisco, Los Angeles, Boston, Chicago, and Washington, D.C.). Sometimes it means that the building is in a given city’s best neighborhood. Occasionally, it refers to the economic strength of the building’s tenants. And it can also merely suggest that the building in question matches the rest of the investor’s portfolio (another junkyard to an owner of junkyards would be a core asset). Brokers use it as shorthand to message interested buyers: “I guarantee this is a triple-A, no-risk, you’re-never-going-to-lose deal.” And therein lie both the sales pitch and the rub. The sales pitch is simple: “Mr. Clever Investor, because you’re getting 0.01 percent on your money in the bank and only 1.82 percent with U.S. Treasury bonds, you really should buy this trophy for a 4 percent return. This core asset is as safe as Treasuries, plus it’s a brilliant inflation hedge.” It may be true that you can’t cheat an honest man, but cheating a greedy one is a piece of cake, and few swing at this pitch unless they’re desperately chasing yield. The investor might, however, object to the pricing by pointing out that even the best real estate—say a Midtown Manhattan trophy building— historically sells for less than corporate Baa bonds, and that today that bond rate is 4.79 percent. The indefatigable broker concedes the poor initial return but swears the overall return on investment (the internal rate of return, or IRR) will be splendid if one holds the building ten years and sells it then for a whopping profit. (For more on the IRR, see the Glossary and chapter 16). In short, the broker is asking you to treat the property like a bond. If you do so—if you ignore a property’s fundamentals and simply focus on whether its purported income beats bond yields—you could have a serious problem one day. When interest rates rise—surely they will someday—bond

McDonald’s restaurants.

values plummet. If Treasury yields were to rise to 6 percent yield, then the core

24

DESPERATELY CHASING YIELD 25

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

assets you bought at a 4 percent return will now trade at, say, at an 8 percent

8

Desperately Chasing Yield

To paraphrase a vulgar aphorism, self-delusions are like opinions— everybody has one. Some have many. Self-delusions are sometimes tragic: consider starving anorexics who consider themselves fat. Occasionally self-delusions are merely sad: picture aging athletes certain they are good for another season. And some are entertaining: despite being a perennial finalist for “America’s Worst Cook,” my dear mother prided herself on her culinary skills. Self-delusions in real estate are about as rare as fixed professional wrestling matches. It may be that only a nationwide self-delusion can explain today’s over-the-top pricing of “core” real estate. It also may be that the usual suspect—greed—is a major factor. As of summer 2016, prices for prime office buildings in the country’s most desirable cities (those with ocean views) are at an all-time high—more than 10 percent greater than their previous peak. This pricing is not limited to high-rises. Any well-located asset considered bulletproof as to vacancy and rental decline is on fire. First-class regional shopping malls are fetching the same stratospheric prices as freestanding

Properties deemed core by investors hardly need a broker to command a record price. As used in real estate, the term core has become so imprecise as to be almost without meaning. Sometimes it signifies that the building in question is located in one of America’s top-tier cities (New York City, San Francisco, Los Angeles, Boston, Chicago, and Washington, D.C.). Sometimes it means that the building is in a given city’s best neighborhood. Occasionally, it refers to the economic strength of the building’s tenants. And it can also merely suggest that the building in question matches the rest of the investor’s portfolio (another junkyard to an owner of junkyards would be a core asset). Brokers use it as shorthand to message interested buyers: “I guarantee this is a triple-A, no-risk, you’re-never-going-to-lose deal.” And therein lie both the sales pitch and the rub. The sales pitch is simple: “Mr. Clever Investor, because you’re getting 0.01 percent on your money in the bank and only 1.82 percent with U.S. Treasury bonds, you really should buy this trophy for a 4 percent return. This core asset is as safe as Treasuries, plus it’s a brilliant inflation hedge.” It may be true that you can’t cheat an honest man, but cheating a greedy one is a piece of cake, and few swing at this pitch unless they’re desperately chasing yield. The investor might, however, object to the pricing by pointing out that even the best real estate—say a Midtown Manhattan trophy building— historically sells for less than corporate Baa bonds, and that today that bond rate is 4.79 percent. The indefatigable broker concedes the poor initial return but swears the overall return on investment (the internal rate of return, or IRR) will be splendid if one holds the building ten years and sells it then for a whopping profit. (For more on the IRR, see the Glossary and chapter 16). In short, the broker is asking you to treat the property like a bond. If you do so—if you ignore a property’s fundamentals and simply focus on whether its purported income beats bond yields—you could have a serious problem one day. When interest rates rise—surely they will someday—bond

McDonald’s restaurants.

values plummet. If Treasury yields were to rise to 6 percent yield, then the core

24

DESPERATELY CHASING YIELD 25

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

assets you bought at a 4 percent return will now trade at, say, at an 8 percent

return and thus be worth half what you paid. Treat real estate like a bond and

9

it will treat you like a bondholder. This is where the self-delusions come in. Anyone with the money to buy real estate must know that interest rates are unlikely to stay low over the long term. So a buyer must believe she can somehow outrace the avalanche of falling prices that will rumble right behind rising interest rates. Likely delusions can be: “We’ll get out of this deal before rates run up.” Or, “Even though the building is fully leased and we’re doing nothing to it, we’ll double rents as the leases turn over.” Or, “We’re buying this for the next generation.” Or, back to the IRR—the calculation that sank a thousand

Liquid Assets

ships—“Our fully leveraged IRR yield will be at least 8.5 percent no matter what happens to rates.” Better—or at least cheaper—to be self-deluded about one’s youthful looks or charm or killer jump shot.

I always wanted to make the front pageof the Wall Street Journal . . . until I did. The December 12, 2014, WSJ showed our Healdsburg, California, shopping center doing an excellent imitation of McCovey Cove during a Giants game, replete with canoers and kayakers. This picturesque scene, of course, made the happy-talk news on local television. I wish I could say we were delighted to add a bit of levity to the storm that battered Northern California. Lake McNellis was short-lived, and its damage was relatively minor. We were quite fortunate, for parking lots can fail beneath oceanic weight, landscaping can be washed away, shops ruined, inventory destroyed, and the drying process long and expensive. Even in drought-wracked California, rivers flood. And when a town is built on a riverbank, as Healdsburg is on the Russian River, all of the storm drains, culverts, and flood prevention measures one can muster are merely a lesson in futility—if not humility—when the almost perfect storm rolls in. We cannot prevent floods or earthquakes or fires, riots, terrorist attacks, or even little greasy kitchen fires that inevitably cause either more damage than one has insurance for or not enough to cover the deductible.

26

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

27

return and thus be worth half what you paid. Treat real estate like a bond and

9

it will treat you like a bondholder. This is where the self-delusions come in. Anyone with the money to buy real estate must know that interest rates are unlikely to stay low over the long term. So a buyer must believe she can somehow outrace the avalanche of falling prices that will rumble right behind rising interest rates. Likely delusions can be: “We’ll get out of this deal before rates run up.” Or, “Even though the building is fully leased and we’re doing nothing to it, we’ll double rents as the leases turn over.” Or, “We’re buying this for the next generation.” Or, back to the IRR—the calculation that sank a thousand

Liquid Assets

ships—“Our fully leveraged IRR yield will be at least 8.5 percent no matter what happens to rates.” Better—or at least cheaper—to be self-deluded about one’s youthful looks or charm or killer jump shot.

I always wanted to make the front pageof the Wall Street Journal . . . until I did. The December 12, 2014, WSJ showed our Healdsburg, California, shopping center doing an excellent imitation of McCovey Cove during a Giants game, replete with canoers and kayakers. This picturesque scene, of course, made the happy-talk news on local television. I wish I could say we were delighted to add a bit of levity to the storm that battered Northern California. Lake McNellis was short-lived, and its damage was relatively minor. We were quite fortunate, for parking lots can fail beneath oceanic weight, landscaping can be washed away, shops ruined, inventory destroyed, and the drying process long and expensive. Even in drought-wracked California, rivers flood. And when a town is built on a riverbank, as Healdsburg is on the Russian River, all of the storm drains, culverts, and flood prevention measures one can muster are merely a lesson in futility—if not humility—when the almost perfect storm rolls in. We cannot prevent floods or earthquakes or fires, riots, terrorist attacks, or even little greasy kitchen fires that inevitably cause either more damage than one has insurance for or not enough to cover the deductible.

26

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

27

In times of breathtaking prices for real estate, it may be appropriate to put

Yet even a building as safe as kindergarten loses value every year through

the flood question more broadly and ask if any building is truly as safe as so

what too many view as merely a tax benefit—depreciation. Rather than simply

many buyers would love to believe.

a happy paper loss on April 15, depreciation is real: buildings eventually wear

Yes, it’s possible to own a building or two for even a very long time

out. The Internal Revenue Service (IRS) has decreed that 39 and a half years

without suffering casualty losses. But a whole portfolio over an extended

is the standard useful life for buildings, and it allows a 2.5 percent deduction

career? That’s not statistically possible. Yet, if an owner is truly prudent

for depreciation every year. This also means—because the IRS has it about

in buying insurance, it will cover most of her direct losses arising from an

right—that your building is often cooked when your depreciation burns off.

accident. Indirect losses are another matter, however, and often as not go

Your children can either scrape your worn-out building and start fresh or go

uncompensated. As it happened, we had flood insurance for Healdsburg,

the more expensive route of gutting and rebuilding it.

but because we also had a five-figure deductible, we definitely paid for the pleasure of helping the WSJ sell newspapers. Let’s leave the world of cinematic losses that seldom occur and consider a

Either way, all you have left is your residual land value. If you have chosen your land carefully—on high ground yet within walking distance of big water (maybe a little farther than our shopping center)—your land appreciation should

more common way to watch values vanish: no-holds-barred competition. We

more than offset your building loss. If not, you might be reminded of the old

might call this “Houston roulette” because Houston’s laissez-faire approach

joke: How do you make a small fortune in real estate? Start with a large one.

to zoning is one of Texas’s lasting charms. Subject to a building permit alone, developers there are free to build anything they like, anywhere they like, anytime they want. But live by the dollar, die by it. Cities with minimal regulations and barriers for developers often end up in situations in which no project is safe from competition. If you build a 75-story high-rise and advertise the finest views, your ex-partner can build 100 stories tomorrow and tout even better views. You build a supermarket at the best intersection in town and overnight your competitor assembles three parcels across the street and throws up an even snazzier market. One of you dies. Where land is plentiful and approvals are easy to obtain, economic obsolescence—and breathtaking loss—requires no more than an idiot with a pot of money and a dream of a new building next to yours. The formula of doom is as simple as the Pythagorean theorem: developer + money + easy zoning = death-spiral overbuilding. This is exactly why smart money loves core properties. Because developers can somehow always come up with the money, the best defense is to own properties in the handful of coastal cities in which the zoning and approval process is akin to medieval torture.

28

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

LIQUID ASSETS 29

In times of breathtaking prices for real estate, it may be appropriate to put

Yet even a building as safe as kindergarten loses value every year through

the flood question more broadly and ask if any building is truly as safe as so

what too many view as merely a tax benefit—depreciation. Rather than simply

many buyers would love to believe.

a happy paper loss on April 15, depreciation is real: buildings eventually wear

Yes, it’s possible to own a building or two for even a very long time

out. The Internal Revenue Service (IRS) has decreed that 39 and a half years

without suffering casualty losses. But a whole portfolio over an extended

is the standard useful life for buildings, and it allows a 2.5 percent deduction

career? That’s not statistically possible. Yet, if an owner is truly prudent

for depreciation every year. This also means—because the IRS has it about

in buying insurance, it will cover most of her direct losses arising from an

right—that your building is often cooked when your depreciation burns off.

accident. Indirect losses are another matter, however, and often as not go

Your children can either scrape your worn-out building and start fresh or go

uncompensated. As it happened, we had flood insurance for Healdsburg,

the more expensive route of gutting and rebuilding it.

but because we also had a five-figure deductible, we definitely paid for the pleasure of helping the WSJ sell newspapers. Let’s leave the world of cinematic losses that seldom occur and consider a

Either way, all you have left is your residual land value. If you have chosen your land carefully—on high ground yet within walking distance of big water (maybe a little farther than our shopping center)—your land appreciation should

more common way to watch values vanish: no-holds-barred competition. We

more than offset your building loss. If not, you might be reminded of the old

might call this “Houston roulette” because Houston’s laissez-faire approach

joke: How do you make a small fortune in real estate? Start with a large one.

to zoning is one of Texas’s lasting charms. Subject to a building permit alone, developers there are free to build anything they like, anywhere they like, anytime they want. But live by the dollar, die by it. Cities with minimal regulations and barriers for developers often end up in situations in which no project is safe from competition. If you build a 75-story high-rise and advertise the finest views, your ex-partner can build 100 stories tomorrow and tout even better views. You build a supermarket at the best intersection in town and overnight your competitor assembles three parcels across the street and throws up an even snazzier market. One of you dies. Where land is plentiful and approvals are easy to obtain, economic obsolescence—and breathtaking loss—requires no more than an idiot with a pot of money and a dream of a new building next to yours. The formula of doom is as simple as the Pythagorean theorem: developer + money + easy zoning = death-spiral overbuilding. This is exactly why smart money loves core properties. Because developers can somehow always come up with the money, the best defense is to own properties in the handful of coastal cities in which the zoning and approval process is akin to medieval torture.

28

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

LIQUID ASSETS 29

10

A Little Help from My Friends

Lighthouse keepers can do it by themselves.Developers can’t. That said, new developers typically need to pull off at least their first deal on their own, playing every instrument in the orchestra: investment broker, leasing and mortgage broker, contractor, day laborer, property manager, janitor, lawyer, and even accountant. There is a benefit to this wearying exertion: just as a conductor must know how all his musicians should sound, you should have a good feel for what your service providers do, and trying it yourself is a quick way to get it. As a developer, you can stay small—doing fixer-uppers—and be a oneman band. That option would be a mistake for the ambitious. The moment you can afford to have someone else do it, your time will be too valuable to waste painting houses, chasing loan quotes, or keeping books. If you have the desire to tackle larger, more complicated projects, you will need help, particularly with the skills you lack. The question is, should your help come from consultants, employees, or partners? First, let’s put money back in the drawer. Financial partners are far too important to be lumped with any others in the development process. They—

To be prudent, your ascent from solo act to major development firm should entail an interim step of employing consultants and service providers on an hourly basis only. As long as you can rent any profession—legal, architectural, engineering, whatever—and still get first-rate work on the day you need it, you will be better off renting rather than buying. Initially, the math is simple: if you are spending $100,000 a year in legal fees and your lawyer is making $200,000 at her firm, it would be crazy to hire her. Less intuitively, even if your outside legal bills were to increase to $300,000 a year and you could hire her for $200,000, the flexibility you retain—you can cap a consultant like a rotten pipe—may be worth the extra $100,000. Employees are expensive. No one ever lays off a superfluous employee on the first day a big project is lost; months drag on before even the flintiest developer pulls the trigger. Renting rather than buying help is obvious. As obvious, but as often ignored, is the way to get the best service from your consultants. First and foremost: pay your bills on receipt. Second: treat your consultants with friendship, kindness, and respect. Make them feel like part of your team. Lunches, drinks, and handwritten thank-you notes work wonders with harried service providers. On the flip side, if you question his bill, if you tell your consultant he should have finished his task in 10 hours rather than the 20 he billed, you’re accusing him of, at best, incompetence. He will take this criticism as an affront to his integrity. Rather than continue to employ— and badger—a resentful consultant who’s going to bottom-pile your work, negotiate his bill if you must, pay him, and replace him. Don’t commute over burned bridges. The trick to getting the highest-quality output from consultants is this: hire the most experienced person you can afford who will actually do your work. Remember, you are always hiring an individual, not her company or firm. It does you no good to hire the fanciest firm in town if a junior associate is assigned your work. One way to adopt this precept is to hire well-seasoned

and their pros and cons—will be dealt with separately in an ensuing chapter.

sole practitioners.

30

A LIT TLE HELP FROM MY FRIENDS 31

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

10

A Little Help from My Friends

Lighthouse keepers can do it by themselves.Developers can’t. That said, new developers typically need to pull off at least their first deal on their own, playing every instrument in the orchestra: investment broker, leasing and mortgage broker, contractor, day laborer, property manager, janitor, lawyer, and even accountant. There is a benefit to this wearying exertion: just as a conductor must know how all his musicians should sound, you should have a good feel for what your service providers do, and trying it yourself is a quick way to get it. As a developer, you can stay small—doing fixer-uppers—and be a oneman band. That option would be a mistake for the ambitious. The moment you can afford to have someone else do it, your time will be too valuable to waste painting houses, chasing loan quotes, or keeping books. If you have the desire to tackle larger, more complicated projects, you will need help, particularly with the skills you lack. The question is, should your help come from consultants, employees, or partners? First, let’s put money back in the drawer. Financial partners are far too important to be lumped with any others in the development process. They—

To be prudent, your ascent from solo act to major development firm should entail an interim step of employing consultants and service providers on an hourly basis only. As long as you can rent any profession—legal, architectural, engineering, whatever—and still get first-rate work on the day you need it, you will be better off renting rather than buying. Initially, the math is simple: if you are spending $100,000 a year in legal fees and your lawyer is making $200,000 at her firm, it would be crazy to hire her. Less intuitively, even if your outside legal bills were to increase to $300,000 a year and you could hire her for $200,000, the flexibility you retain—you can cap a consultant like a rotten pipe—may be worth the extra $100,000. Employees are expensive. No one ever lays off a superfluous employee on the first day a big project is lost; months drag on before even the flintiest developer pulls the trigger. Renting rather than buying help is obvious. As obvious, but as often ignored, is the way to get the best service from your consultants. First and foremost: pay your bills on receipt. Second: treat your consultants with friendship, kindness, and respect. Make them feel like part of your team. Lunches, drinks, and handwritten thank-you notes work wonders with harried service providers. On the flip side, if you question his bill, if you tell your consultant he should have finished his task in 10 hours rather than the 20 he billed, you’re accusing him of, at best, incompetence. He will take this criticism as an affront to his integrity. Rather than continue to employ— and badger—a resentful consultant who’s going to bottom-pile your work, negotiate his bill if you must, pay him, and replace him. Don’t commute over burned bridges. The trick to getting the highest-quality output from consultants is this: hire the most experienced person you can afford who will actually do your work. Remember, you are always hiring an individual, not her company or firm. It does you no good to hire the fanciest firm in town if a junior associate is assigned your work. One way to adopt this precept is to hire well-seasoned

and their pros and cons—will be dealt with separately in an ensuing chapter.

sole practitioners.

30

A LIT TLE HELP FROM MY FRIENDS 31

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

Last point on consultants: think Noah’s ark. You need two of each of

11

them—two contractors, two architects, two engineers, two escrow officers, and so on. And they should know about one another. Why? Because, putting aside competition’s salutary effects on service and cost, you need a backup plan. Life trumps business and, sooner or later, your favorite consultant will be unavailable to you, perhaps at your deal’s most critical moment. You can outsource your entire orchestra for a good while, but one sunny day you will be sitting in a fancy office, working a deal, when the bemused seller will interrupt your pitch to ask, “Who’s this we?” If a single pilot can’t land the plane, and you achieved we only by throwing in your border collie, it’s

Fickle Shades of Green

time to bring in either partners or key employees. This can be a tough choice. While employees will cost you more than partners if you fail or have only middling success, they are cheap if you are truly successful. If you knock the ball out of the park and believe you could have done so without them, your partners will prove inordinately expensive. Moreover, the extra

“Friendship is constant in all other things save in the office and affairs of love.”

cost of partners may be misspent. Doling out a partnership interest doesn’t

Shakespeare had it right.And money is less constant than love. Even if

automatically buy you better or more loyal help. Employees are often as

your project is profitable, the money that loved you when you first put together

dedicated and capable as partners. But, properly viewed, life’s about the

your deal can grow distant, even hostile, over the course of the investment.

journey and not what’s left in your suitcase at your last stop. The trip is

And if things do go wrong, the principal advantage a partnership has over a

easier—and more enjoyable—with others helping shoulder your losses and

marriage—ironclad dissolution rights—can cause a developer a world of grief.

share in your victories. While we have all been through ill-suited partners,

In short, a dollar-denominated relationship is one of those wrong places to go

many of my successful friends have had career-long partners. Beth Walter,

looking for love.

Mike Powers, and I have been partners since the early ’80s. It’s your call.

Instead of love, seek understanding; seek money that listens. While capital is seldom a great listener—money talks—one type of capital available to real estate is harder of hearing than the other. Almost everyone starts with family and friends’ money (F&F). Also known as country club money, this is your preferred form of outside equity. You will get the best economic deal from your friends, you will have more control over your project, and, typically, you will be more difficult to dethrone should your deal sputter.

32

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

33

Last point on consultants: think Noah’s ark. You need two of each of

11

them—two contractors, two architects, two engineers, two escrow officers, and so on. And they should know about one another. Why? Because, putting aside competition’s salutary effects on service and cost, you need a backup plan. Life trumps business and, sooner or later, your favorite consultant will be unavailable to you, perhaps at your deal’s most critical moment. You can outsource your entire orchestra for a good while, but one sunny day you will be sitting in a fancy office, working a deal, when the bemused seller will interrupt your pitch to ask, “Who’s this we?” If a single pilot can’t land the plane, and you achieved we only by throwing in your border collie, it’s

Fickle Shades of Green

time to bring in either partners or key employees. This can be a tough choice. While employees will cost you more than partners if you fail or have only middling success, they are cheap if you are truly successful. If you knock the ball out of the park and believe you could have done so without them, your partners will prove inordinately expensive. Moreover, the extra

“Friendship is constant in all other things save in the office and affairs of love.”

cost of partners may be misspent. Doling out a partnership interest doesn’t

Shakespeare had it right.And money is less constant than love. Even if

automatically buy you better or more loyal help. Employees are often as

your project is profitable, the money that loved you when you first put together

dedicated and capable as partners. But, properly viewed, life’s about the

your deal can grow distant, even hostile, over the course of the investment.

journey and not what’s left in your suitcase at your last stop. The trip is

And if things do go wrong, the principal advantage a partnership has over a

easier—and more enjoyable—with others helping shoulder your losses and

marriage—ironclad dissolution rights—can cause a developer a world of grief.

share in your victories. While we have all been through ill-suited partners,

In short, a dollar-denominated relationship is one of those wrong places to go

many of my successful friends have had career-long partners. Beth Walter,

looking for love.

Mike Powers, and I have been partners since the early ’80s. It’s your call.

Instead of love, seek understanding; seek money that listens. While capital is seldom a great listener—money talks—one type of capital available to real estate is harder of hearing than the other. Almost everyone starts with family and friends’ money (F&F). Also known as country club money, this is your preferred form of outside equity. You will get the best economic deal from your friends, you will have more control over your project, and, typically, you will be more difficult to dethrone should your deal sputter.

32

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

33

The F&F profit-sharing formula hasn’t changed since the dawn of

asked by F&F investors, institutional money demands a compounded monthly

capitalism: from the project’s cash flow, the equity gets a preferred return

return as high as 15 to 20 percent before you share in any profits. Using an

a few percentage points higher than Treasury bills (say about 5 percentage

IRR approach, this formula adds the cash flow the equity receives each year to

points) and, once that’s paid, any remaining cash is split 50/50 between money

its share of sales proceeds and then calculates the rate of interest on the total

and developer. If the project entails less work, risk, or return than a ground-

thus paid. If that return fails to exceed the equity’s minimum required yield,

up development—such as a simple lease-up on an empty building—then the

you receive nothing. This, by the way, is a common result for developers in

split might be 80 to the equity, 20 to the developer. When the project is sold or

institutional joint ventures. You can do well with institutional money, but only

refinanced, the proceeds are first used to bring the preferred return current

if you can build, lease, and sell your project exactly on budget and on time.

and then to repay the equity in full. And then any remaining proceeds are

But a delay or a significant cost overrun may mean that your partner gets a 14

divided 50/50 (or 80/20 in the simpler deals).

percent return instead of the 15 percent it required and you get an expensive

Assuming you want outside partners (whether you should is covered in a later chapter), F&F is the way for you to start and what you should stick with

life lesson. And if things do go poorly with your project and you start begging for

as long as you can. F&F investors are, by definition, your friends and they—in

relief, your institutional partner’s attitude may remind you of Tommy Lee

the beginning at least—will listen to your explanations about why you missed

Jones in The Fugitive. Moments before he leaps into the abyss from atop an

your performance benchmarks. They may even be sympathetic. And because

enormous dam, a desperate Harrison Ford swears, “I’m innocent.” Ready to

they will neither be real estate professionals nor have the rights in your

gun him down, U.S. Marshall Tommy Lee replies, “I don’t care.”

partnership agreement that professionals would insist on, they will

Instead of love, look for money that listens. You want the best economic

likely have little choice but to ride out the bad times with you. Even if the

deal you can get from your money partner, but you also want someone with

love is gone. (If you want to go to heaven, never accept money from anyone

patience and understanding, someone who is content to be your partner even

unless you are certain he can readily afford the loss of his investment; far

when the fan gets clogged.

too many guys will raid their kids’ college funds for a risky venture just to act like hitters.) The chief drawback of F&F money is obvious: unless you picked your parents and college roommates on the basis of their balance sheets, this is at best a quarter tank of gas. You could be running on fumes about the time you need to fund your next big deal. In contrast, the other equity’s proven reserves are beyond measurement. Institutional money flows from multiple headwaters and—as long as you don’t need it—is always readily available. It costs more than F&F money and is basically deaf. Called hot money for good reason, it will burn a serious hole in your deal—if not you—if you fail to deliver on time. How? Through the unholy miracle of compound interest. Rather than the simple interest of, say, 5 percent

34

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

FICKLE SHADES OF GREEN 35

The F&F profit-sharing formula hasn’t changed since the dawn of

asked by F&F investors, institutional money demands a compounded monthly

capitalism: from the project’s cash flow, the equity gets a preferred return

return as high as 15 to 20 percent before you share in any profits. Using an

a few percentage points higher than Treasury bills (say about 5 percentage

IRR approach, this formula adds the cash flow the equity receives each year to

points) and, once that’s paid, any remaining cash is split 50/50 between money

its share of sales proceeds and then calculates the rate of interest on the total

and developer. If the project entails less work, risk, or return than a ground-

thus paid. If that return fails to exceed the equity’s minimum required yield,

up development—such as a simple lease-up on an empty building—then the

you receive nothing. This, by the way, is a common result for developers in

split might be 80 to the equity, 20 to the developer. When the project is sold or

institutional joint ventures. You can do well with institutional money, but only

refinanced, the proceeds are first used to bring the preferred return current

if you can build, lease, and sell your project exactly on budget and on time.

and then to repay the equity in full. And then any remaining proceeds are

But a delay or a significant cost overrun may mean that your partner gets a 14

divided 50/50 (or 80/20 in the simpler deals).

percent return instead of the 15 percent it required and you get an expensive

Assuming you want outside partners (whether you should is covered in a later chapter), F&F is the way for you to start and what you should stick with

life lesson. And if things do go poorly with your project and you start begging for

as long as you can. F&F investors are, by definition, your friends and they—in

relief, your institutional partner’s attitude may remind you of Tommy Lee

the beginning at least—will listen to your explanations about why you missed

Jones in The Fugitive. Moments before he leaps into the abyss from atop an

your performance benchmarks. They may even be sympathetic. And because

enormous dam, a desperate Harrison Ford swears, “I’m innocent.” Ready to

they will neither be real estate professionals nor have the rights in your

gun him down, U.S. Marshall Tommy Lee replies, “I don’t care.”

partnership agreement that professionals would insist on, they will

Instead of love, look for money that listens. You want the best economic

likely have little choice but to ride out the bad times with you. Even if the

deal you can get from your money partner, but you also want someone with

love is gone. (If you want to go to heaven, never accept money from anyone

patience and understanding, someone who is content to be your partner even

unless you are certain he can readily afford the loss of his investment; far

when the fan gets clogged.

too many guys will raid their kids’ college funds for a risky venture just to act like hitters.) The chief drawback of F&F money is obvious: unless you picked your parents and college roommates on the basis of their balance sheets, this is at best a quarter tank of gas. You could be running on fumes about the time you need to fund your next big deal. In contrast, the other equity’s proven reserves are beyond measurement. Institutional money flows from multiple headwaters and—as long as you don’t need it—is always readily available. It costs more than F&F money and is basically deaf. Called hot money for good reason, it will burn a serious hole in your deal—if not you—if you fail to deliver on time. How? Through the unholy miracle of compound interest. Rather than the simple interest of, say, 5 percent

34

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

FICKLE SHADES OF GREEN 35

12

Autographing the Deal

It seems we all lie.Depending on which lying study you choose to believe, we tell somewhere between a couple and a couple hundred lies a day. The lower number is found among monks who have taken a vow of silence while the higher number counts days attending conventions. Most of our lies are harmless enough, pumping ourselves up, making others feel better, beveling society’s hard edges. But if believed, one persistent lie—“I never sign personal guaranties”— can traumatize a young developer. If she overhears a group of aging developers swearing they haven’t signed a guaranty since 1999 and then complains to her banker of how unfairly she’s being treated, it will likely be unpleasant. And if she decides to shop bankers, she will be wasting everyone’s time. Oversimplifying matters slightly, two basic loans predominate in real estate: lower-risk permanent loans for stabilized assets (a 10-year loan on a fully leased office building) and higher-risk construction loans (an 18-month loan to build an apartment house). Although nonrecourse debt, permanent loans universally contain “carve-out” guaranties in which the borrower promises he will properly maintain the property and use the rent from the property to pay the mortgage,

lender—if he takes the rent to Vegas—he will be personally liable. Commonly known as the bad boy provisions, these are signed by everybody. And everyone signs guaranties whenever they’re doing construction. Everyone is signing autographs. The rich and sometimes the clever can avoid repayment guaranties—a guaranty that the construction loan itself will be repaid—but everyone inks a completion guaranty—a promise that all construction will be finished and paid for. Guaranteeing completion rather than repayment is lights-out better for a borrower. Why? Because as long as you finish the building, you can toss the keys on your lender’s desk if your anchor tenant goes bankrupt before your grand-opening party or you find yourself unable to repay the loan for any other sad reason (there are more than a few). The old developer may tell you he doesn’t sign bad-boy or completion guaranties either, but if you press him, he will admit some well-capitalized entity he owns or controls signs for him. The lender still gets the ink. And even when bank underwriting standards are melting like crayons on a desert dashboard, you will be guaranteeing everything but the outcome of the Super Bowl if you’re trying to finance your first couple of development deals. It’s impossible to argue with the advice you hear at every industry cocktail party—“Never guarantee nothing.” Yet guaranties can have a salutary effect. Like rock-climbing Yosemite’s Half Dome, they have a way of focusing one’s attention. If it is your personal net worth on the line, you will truly vet the deal, tweak the risks, and verify that approvals are in hand, construction costs fully quantified, the tenants as creditworthy as advertised, and so on. In short, knowing it’s your guaranty may make you climb down from a deal you shouldn’t have attempted in the first place. If having no personal liability makes you a little less careful—it does—and you do a regrettable deal, you may not be liable for the loan, but your partners will have lost their investment and you will have nothing to show for a couple of years’ worth of effort but a slammed reputation. “Can you skip the pontificating and tell me instead how I get around

taxes, expenses, and so on. If he intentionally wrongs the property or the

guaranties?” a reader might ask.

36

AUTOGRAPHING THE DEAL 37

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

12

Autographing the Deal

It seems we all lie.Depending on which lying study you choose to believe, we tell somewhere between a couple and a couple hundred lies a day. The lower number is found among monks who have taken a vow of silence while the higher number counts days attending conventions. Most of our lies are harmless enough, pumping ourselves up, making others feel better, beveling society’s hard edges. But if believed, one persistent lie—“I never sign personal guaranties”— can traumatize a young developer. If she overhears a group of aging developers swearing they haven’t signed a guaranty since 1999 and then complains to her banker of how unfairly she’s being treated, it will likely be unpleasant. And if she decides to shop bankers, she will be wasting everyone’s time. Oversimplifying matters slightly, two basic loans predominate in real estate: lower-risk permanent loans for stabilized assets (a 10-year loan on a fully leased office building) and higher-risk construction loans (an 18-month loan to build an apartment house). Although nonrecourse debt, permanent loans universally contain “carve-out” guaranties in which the borrower promises he will properly maintain the property and use the rent from the property to pay the mortgage,

lender—if he takes the rent to Vegas—he will be personally liable. Commonly known as the bad boy provisions, these are signed by everybody. And everyone signs guaranties whenever they’re doing construction. Everyone is signing autographs. The rich and sometimes the clever can avoid repayment guaranties—a guaranty that the construction loan itself will be repaid—but everyone inks a completion guaranty—a promise that all construction will be finished and paid for. Guaranteeing completion rather than repayment is lights-out better for a borrower. Why? Because as long as you finish the building, you can toss the keys on your lender’s desk if your anchor tenant goes bankrupt before your grand-opening party or you find yourself unable to repay the loan for any other sad reason (there are more than a few). The old developer may tell you he doesn’t sign bad-boy or completion guaranties either, but if you press him, he will admit some well-capitalized entity he owns or controls signs for him. The lender still gets the ink. And even when bank underwriting standards are melting like crayons on a desert dashboard, you will be guaranteeing everything but the outcome of the Super Bowl if you’re trying to finance your first couple of development deals. It’s impossible to argue with the advice you hear at every industry cocktail party—“Never guarantee nothing.” Yet guaranties can have a salutary effect. Like rock-climbing Yosemite’s Half Dome, they have a way of focusing one’s attention. If it is your personal net worth on the line, you will truly vet the deal, tweak the risks, and verify that approvals are in hand, construction costs fully quantified, the tenants as creditworthy as advertised, and so on. In short, knowing it’s your guaranty may make you climb down from a deal you shouldn’t have attempted in the first place. If having no personal liability makes you a little less careful—it does—and you do a regrettable deal, you may not be liable for the loan, but your partners will have lost their investment and you will have nothing to show for a couple of years’ worth of effort but a slammed reputation. “Can you skip the pontificating and tell me instead how I get around

taxes, expenses, and so on. If he intentionally wrongs the property or the

guaranties?” a reader might ask.

36

AUTOGRAPHING THE DEAL 37

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

You do what the old developers do. You get the bank to waive it by putting up more equity and accepting a higher interest rate on the loan. Or, if you want to keep your equity down, you skip the banks and go straight to the debt funds (Blackstone, Starwood, etc.) and pay a lot more interest. There’s a problem, however, with this approach for a young developer: a rich guy may not care too much if his lender demands more equity because his idle cash is earning 0.015 percent interest in the bank. On the other hand, you should really care because your idle cash is jingling in your pocket. You are using Other People’s Money (OPM) for your equity, all of which carries a much higher coupon rate than bank debt. The banks are in the 2 to 4 percent range; OPM costs anywhere from 5 to 12 percent—meaning that every dollar of OPM kicks your dented can of profit a little farther down the road. But you counter with the old saw that you would rather sleep well than eat well. Not bad as bromides go, but there’s a word for a developer with no money or risk in the deal: consultant. Your financial partners may not be theoretical physicists, but they usually have an intuitive feel for business. They know that if you are putting up nothing more than your time and your rapidly expiring purchase contract, they can hire you rather than partner with you. Take this home: there is no way to make real developer profits without taking at least some real developer risks. No risk, no reward. That said, you should try your best to limit risks: have tenants do their own improvements in exchange for a fixed contribution, outsource everything (nothing runs up a tab like employees), and never hire your college roommate as your general contractor. And, of course, listen to the old guys: guarantee as little as possible. Or better yet, choose your deals with infinite caution and then, like diving off the 10-meter board, your guaranty will only look scary.

13

The Politics of It All

Rents and occupancy rates are tumblingtoday in North Dakota because shale oil is mud in a $35-a-barrel world. Once it was the hottest real estate market in America; now a northerly is blowing across the prairies and landlords are scarcely better insulated than shale’s jobless roughnecks. This turnabout is not unique to the Dakotas. Properly viewed, the lords of real estate are always bit players, mere vendors to the stars who make economies twinkle. As long as a gold rush rampages, we do well renting tents and cabins. But, sooner or later, mines peter out. If real estate is no more resilient than its surrounding economy (it isn't) and if all economies eventually falter (they do), how does a prudent investor protect herself, particularly if she is buying into a bull market’s heat? The best way to protect yourself from the next correction requires a skill few possess—namely, the ability to call your shot, to time the market perfectly, and to sell at its peak. If you happen to have this rare talent, forget real estate and go straight to Wall Street. (By the way, a correction occurs when others get creamed, a crash when you do.) For less farsighted mortals, buying with all equity—using little or no debt—is a fair if timid strategy. It works well enough for the rich, but it is a poor option for someone starting out. If you can convince your investors

38

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

39

You do what the old developers do. You get the bank to waive it by putting up more equity and accepting a higher interest rate on the loan. Or, if you want to keep your equity down, you skip the banks and go straight to the debt funds (Blackstone, Starwood, etc.) and pay a lot more interest. There’s a problem, however, with this approach for a young developer: a rich guy may not care too much if his lender demands more equity because his idle cash is earning 0.015 percent interest in the bank. On the other hand, you should really care because your idle cash is jingling in your pocket. You are using Other People’s Money (OPM) for your equity, all of which carries a much higher coupon rate than bank debt. The banks are in the 2 to 4 percent range; OPM costs anywhere from 5 to 12 percent—meaning that every dollar of OPM kicks your dented can of profit a little farther down the road. But you counter with the old saw that you would rather sleep well than eat well. Not bad as bromides go, but there’s a word for a developer with no money or risk in the deal: consultant. Your financial partners may not be theoretical physicists, but they usually have an intuitive feel for business. They know that if you are putting up nothing more than your time and your rapidly expiring purchase contract, they can hire you rather than partner with you. Take this home: there is no way to make real developer profits without taking at least some real developer risks. No risk, no reward. That said, you should try your best to limit risks: have tenants do their own improvements in exchange for a fixed contribution, outsource everything (nothing runs up a tab like employees), and never hire your college roommate as your general contractor. And, of course, listen to the old guys: guarantee as little as possible. Or better yet, choose your deals with infinite caution and then, like diving off the 10-meter board, your guaranty will only look scary.

13

The Politics of It All

Rents and occupancy rates are tumblingtoday in North Dakota because shale oil is mud in a $35-a-barrel world. Once it was the hottest real estate market in America; now a northerly is blowing across the prairies and landlords are scarcely better insulated than shale’s jobless roughnecks. This turnabout is not unique to the Dakotas. Properly viewed, the lords of real estate are always bit players, mere vendors to the stars who make economies twinkle. As long as a gold rush rampages, we do well renting tents and cabins. But, sooner or later, mines peter out. If real estate is no more resilient than its surrounding economy (it isn't) and if all economies eventually falter (they do), how does a prudent investor protect herself, particularly if she is buying into a bull market’s heat? The best way to protect yourself from the next correction requires a skill few possess—namely, the ability to call your shot, to time the market perfectly, and to sell at its peak. If you happen to have this rare talent, forget real estate and go straight to Wall Street. (By the way, a correction occurs when others get creamed, a crash when you do.) For less farsighted mortals, buying with all equity—using little or no debt—is a fair if timid strategy. It works well enough for the rich, but it is a poor option for someone starting out. If you can convince your investors

38

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

39

to put up 100 percent of a purchase price, leaving you risk-free, they will

downstream condo profit to the pricing of every other apartment building on

convince you to give them 100 percent of the profits, leaving you profit-free.

the market once the play was public.

The second-best way to protect yourself against loss is to create so much

And that leads us to an excellent way of either creating lasting value or,

value that you will still be afloat when the tide bottoms out. Combined with

if you don’t get the votes, losing the sitting part of your anatomy: rezoning

a conservative level of debt (say 50 to 60 percent), this is also the best way to

property in first-class towns, where it’s a lot harder than skateboarding. Smart

make a lasting fortune. While it is sometimes true that value can be created

guys—particularly smart guys with plenty of money—will tell you to never buy

through a brilliant purchase, stealing property—despite what you may hear at

unzoned property. They will insist that you close only after you have your final

conferences—is hard. By and large, sellers tend to be smart enough and, when

city approvals. This great advice is easy to follow in down markets or fly-over

they are dumb, their stupidity more often lies in mulishly overvaluing their

cities, but if you’re going to develop in the best locations, sooner or later you

holdings than in wanting to give them away.

will be buying—or handing over so much option money you might as well be

Doing something—anything—to a property can create value. But the easier the makeover, or the more obvious it is, the less value you will create. If

buying—unzoned property. And praying for votes at city hall. We have arrived—at last—at politics. The next chapter will give you

you buy an empty building, paint it, re-landscape it, and lease it out, you may

a few hard-learned lessons in the art of rezoning in recalcitrant cities. But

have created lasting value or you may have simply caught the leasing market’s

before getting to those, it may be worth leaving you with something to

next wave. Unless the building’s vacancy was truly a result of inept ownership

ponder—namely, the politicians’ view of their relationship with developers.

(as your broker will swear) rather than of market conditions, your paint and

The legendary Jesse Unruh, czar of California’s Assembly in the 1960s, nailed

petunias may have left the property’s shortcomings unresolved. Consider

it when he opined, “If you can’t eat their food, drink their booze, take their

selling it.

money, and then vote against them, you’ve got no business being up here.”

If, instead, you demolish that building and build a new project in its place—or build fresh on an empty lot—you will have created lasting value, but the question will be for whom. If the property was already zoned to permit your new project or if it’s in a town where rezoning is easier than skateboarding, then chances are your dumb seller baked most of your eventual profit into his asking price. And, if you pay his price, you could end up spending a couple of years of your life having effectively worked for him, leaving you with a shiny new project worth about what it cost to build. Once in a great while you can do something to a property that no one else has thought of and hit it big. The first guy to tie up a major luxury apartment complex at apartment prices, convert it into condominiums, and then sell it off at condo prices made enough to retire the national debt. The second guy, not so much. Why? Because it took the dumb sellers five seconds to add the

40

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

THE POLITICS OF IT ALL 41

to put up 100 percent of a purchase price, leaving you risk-free, they will

downstream condo profit to the pricing of every other apartment building on

convince you to give them 100 percent of the profits, leaving you profit-free.

the market once the play was public.

The second-best way to protect yourself against loss is to create so much

And that leads us to an excellent way of either creating lasting value or,

value that you will still be afloat when the tide bottoms out. Combined with

if you don’t get the votes, losing the sitting part of your anatomy: rezoning

a conservative level of debt (say 50 to 60 percent), this is also the best way to

property in first-class towns, where it’s a lot harder than skateboarding. Smart

make a lasting fortune. While it is sometimes true that value can be created

guys—particularly smart guys with plenty of money—will tell you to never buy

through a brilliant purchase, stealing property—despite what you may hear at

unzoned property. They will insist that you close only after you have your final

conferences—is hard. By and large, sellers tend to be smart enough and, when

city approvals. This great advice is easy to follow in down markets or fly-over

they are dumb, their stupidity more often lies in mulishly overvaluing their

cities, but if you’re going to develop in the best locations, sooner or later you

holdings than in wanting to give them away.

will be buying—or handing over so much option money you might as well be

Doing something—anything—to a property can create value. But the easier the makeover, or the more obvious it is, the less value you will create. If

buying—unzoned property. And praying for votes at city hall. We have arrived—at last—at politics. The next chapter will give you

you buy an empty building, paint it, re-landscape it, and lease it out, you may

a few hard-learned lessons in the art of rezoning in recalcitrant cities. But

have created lasting value or you may have simply caught the leasing market’s

before getting to those, it may be worth leaving you with something to

next wave. Unless the building’s vacancy was truly a result of inept ownership

ponder—namely, the politicians’ view of their relationship with developers.

(as your broker will swear) rather than of market conditions, your paint and

The legendary Jesse Unruh, czar of California’s Assembly in the 1960s, nailed

petunias may have left the property’s shortcomings unresolved. Consider

it when he opined, “If you can’t eat their food, drink their booze, take their

selling it.

money, and then vote against them, you’ve got no business being up here.”

If, instead, you demolish that building and build a new project in its place—or build fresh on an empty lot—you will have created lasting value, but the question will be for whom. If the property was already zoned to permit your new project or if it’s in a town where rezoning is easier than skateboarding, then chances are your dumb seller baked most of your eventual profit into his asking price. And, if you pay his price, you could end up spending a couple of years of your life having effectively worked for him, leaving you with a shiny new project worth about what it cost to build. Once in a great while you can do something to a property that no one else has thought of and hit it big. The first guy to tie up a major luxury apartment complex at apartment prices, convert it into condominiums, and then sell it off at condo prices made enough to retire the national debt. The second guy, not so much. Why? Because it took the dumb sellers five seconds to add the

40

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

THE POLITICS OF IT ALL 41

14

Decked by City Hall?

Jesse Unruh’s admonishment is worth rememberingby anyone seeking property entitlements. Judging from your conversations with council members, you may march into city hall thinking you have the votes, but private promises can fade the moment a public hearing turns contentious. It’s not that politicians are necessarily duplicitous; it’s that they consider themselves protectors of the public good while deeming you—no matter your honesty—hopelessly self-interested. Owning this moral high ground, politicians can justify behavior toward developers that would raise eyebrows in Hell. And let’s face it, the angry neighbors are often right: your city doesn’t need another traffic-clogging monument to stucco. But even if your project would be the best thing to hit town since fluoridated water, it is still easy to lose. The trick is to help the politicians help you. Give them the ammunition— or more accurately, the cover—they need to vote for you. Here are a few suggestions: First, figure out who your opposition is and why they care. Meet with them. Compromise—reduce the project a little or throw in another public

look the planning director in the eye and tell him you’re tapped out. He will, of course, know you’re not, but will nevertheless appreciate your efforts. Second, figure out who runs the town. Cities where you want to develop tend to require three levels of approval—an architectural review committee, a planning commission, and city council. Dominated as they are by prima donna design professionals, architectural review committees are often annoying, but they seldom have real power. It does happen on occasion, however, that the second tier—the planning commission—is the true decisionmaker with a timid council reluctant to overrule it on appeal. More often, the city council controls major projects, and it is there your ultimate efforts must be directed. There are, however, cities where the mayor or even the city manager has inordinate influence over the process and must be individually persuaded of your project’s civic value. Meet with the decision-makers at the outset but advise them that you are going to honor the approval process, that before you even file your application you will meet with the neighborhood and the planning department to solicit suggestions and opinions. And do exactly that. Only then, after your first several meetings, do you formally file your development application. If you are young, personable, and not obviously wealthy, handle your city meetings yourself. If you are not, hire an entitlements professional to represent you. Definitely have someone else represent you if you see nothing amiss in the following anecdote: while campaigning in West Virginia, a wealthy politician once grandly proclaimed to a bar jam-packed with coal miners, “A beer for the house and a Courvoisier for me.” Try to meet individually with each of the board members—architectural, planning, and city council—before their public hearings. This is timeconsuming and sometimes painful, but it is the only way for any challenging project to be understood. If any representatives refuse to meet with you—they often do—then write them a letter outlining why your project should be approved. And remember that as part of the public record your letter will

benefit—and then meet with them again. Repeat this procedure until you can

be subject to scrutiny by your opposition. Keep it short, straightforward,

42

DECKED BY CIT Y HALL? 43

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

and factual.

14

Decked by City Hall?

Jesse Unruh’s admonishment is worth rememberingby anyone seeking property entitlements. Judging from your conversations with council members, you may march into city hall thinking you have the votes, but private promises can fade the moment a public hearing turns contentious. It’s not that politicians are necessarily duplicitous; it’s that they consider themselves protectors of the public good while deeming you—no matter your honesty—hopelessly self-interested. Owning this moral high ground, politicians can justify behavior toward developers that would raise eyebrows in Hell. And let’s face it, the angry neighbors are often right: your city doesn’t need another traffic-clogging monument to stucco. But even if your project would be the best thing to hit town since fluoridated water, it is still easy to lose. The trick is to help the politicians help you. Give them the ammunition— or more accurately, the cover—they need to vote for you. Here are a few suggestions: First, figure out who your opposition is and why they care. Meet with them. Compromise—reduce the project a little or throw in another public

look the planning director in the eye and tell him you’re tapped out. He will, of course, know you’re not, but will nevertheless appreciate your efforts. Second, figure out who runs the town. Cities where you want to develop tend to require three levels of approval—an architectural review committee, a planning commission, and city council. Dominated as they are by prima donna design professionals, architectural review committees are often annoying, but they seldom have real power. It does happen on occasion, however, that the second tier—the planning commission—is the true decisionmaker with a timid council reluctant to overrule it on appeal. More often, the city council controls major projects, and it is there your ultimate efforts must be directed. There are, however, cities where the mayor or even the city manager has inordinate influence over the process and must be individually persuaded of your project’s civic value. Meet with the decision-makers at the outset but advise them that you are going to honor the approval process, that before you even file your application you will meet with the neighborhood and the planning department to solicit suggestions and opinions. And do exactly that. Only then, after your first several meetings, do you formally file your development application. If you are young, personable, and not obviously wealthy, handle your city meetings yourself. If you are not, hire an entitlements professional to represent you. Definitely have someone else represent you if you see nothing amiss in the following anecdote: while campaigning in West Virginia, a wealthy politician once grandly proclaimed to a bar jam-packed with coal miners, “A beer for the house and a Courvoisier for me.” Try to meet individually with each of the board members—architectural, planning, and city council—before their public hearings. This is timeconsuming and sometimes painful, but it is the only way for any challenging project to be understood. If any representatives refuse to meet with you—they often do—then write them a letter outlining why your project should be approved. And remember that as part of the public record your letter will

benefit—and then meet with them again. Repeat this procedure until you can

be subject to scrutiny by your opposition. Keep it short, straightforward,

42

DECKED BY CIT Y HALL? 43

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

and factual.

Have a neighborhood outreach meeting before every public hearing, put your project in its best light, and hope like hell you can garner a few supporters. Getting a controversial project approved requires at least some disinterested public support—that is, backing from individuals who will gain nothing from its construction. The city council will discount—if not dismiss—support from the construction unions, your next-door neighbor whose property value will double, and the nonprofits you will enrich as part of your project’s public benefits. You need genuine support. Fortunately, even the greenest council member knows support is much harder to muster than opposition. This is why a handful of independent supporters can offset a room full of opponents. And if you do manage to recruit well-intentioned neighbors to speak on your behalf, remember them afterwards with a handwritten thank-you note or, better yet, chocolates or flowers. (What would you want in return for spending a whole evening at a public hearing on behalf of a stranger?) Leave your Rolex, Porsche, and, whenever possible, your lawyer at home when attending project meetings. Bringing a lawyer is a lot like hissing “Don’t you know who I am?” to a hostess when she tells you there’s a 45-minute wait for a table. It shows you’ve already lost. Never take a cellphone call—or check email or game scores—during any meeting, no matter how mind-numbingly protracted it becomes. There may come a point during the council meeting when the city clerk announces the next five neighborhood speakers in advance. And, since you’ve already had 10 public meetings, you know that each of them would rather see you crucified than your project approved. Even so, you must sit there and politely listen to their concerns. When you can no longer follow this last rule, it’s time to hang up your spurs. (I had to.) Finally, tell the truth and keep your word. You might as well admit your project’s drawbacks or civic costs because if it’s controversial enough, it will all come out anyway. And everyone remembers the promises you make in a public hearing. Keep them.

15

Sell versus Hold

Some decisions in life are easier than others.Deciding whether you want fries with that is a piece of cake. Deciding to tell a remorseful friend the truth about her new tattoo is harder. Among the hardest decisions in real estate is determining whether to keep or sell a finished project. Do you sell the disco while they’re still dancing or does it become a transgenerational asset? To answer this question, a new developer might consider taking a deep breath and first asking herself where she wants to be in 20 years. Does she want to be a media darling running a big company and doing the splashiest deals in town, or would she prefer to work on building her cash flow and net worth? While not by definition mutually exclusive, these two objectives often work out that way. You’re better off deciding the big picture question before you do your first deal because without a goal and a strategy to reach it, you may find yourself not only making poor tactical decisions, but also unable to make the right ones. In other words, unless you plan in advance, the sell/hold decision may prove a luxury you cannot afford. Oversimplifying the menu, development firms come in two basic flavors: merchant and investment builders—that is, those who sell everything upon completion and those who never sell. And, of course, countless firms hybridize these distinct businesses.

44

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

45

Have a neighborhood outreach meeting before every public hearing, put your project in its best light, and hope like hell you can garner a few supporters. Getting a controversial project approved requires at least some disinterested public support—that is, backing from individuals who will gain nothing from its construction. The city council will discount—if not dismiss—support from the construction unions, your next-door neighbor whose property value will double, and the nonprofits you will enrich as part of your project’s public benefits. You need genuine support. Fortunately, even the greenest council member knows support is much harder to muster than opposition. This is why a handful of independent supporters can offset a room full of opponents. And if you do manage to recruit well-intentioned neighbors to speak on your behalf, remember them afterwards with a handwritten thank-you note or, better yet, chocolates or flowers. (What would you want in return for spending a whole evening at a public hearing on behalf of a stranger?) Leave your Rolex, Porsche, and, whenever possible, your lawyer at home when attending project meetings. Bringing a lawyer is a lot like hissing “Don’t you know who I am?” to a hostess when she tells you there’s a 45-minute wait for a table. It shows you’ve already lost. Never take a cellphone call—or check email or game scores—during any meeting, no matter how mind-numbingly protracted it becomes. There may come a point during the council meeting when the city clerk announces the next five neighborhood speakers in advance. And, since you’ve already had 10 public meetings, you know that each of them would rather see you crucified than your project approved. Even so, you must sit there and politely listen to their concerns. When you can no longer follow this last rule, it’s time to hang up your spurs. (I had to.) Finally, tell the truth and keep your word. You might as well admit your project’s drawbacks or civic costs because if it’s controversial enough, it will all come out anyway. And everyone remembers the promises you make in a public hearing. Keep them.

15

Sell versus Hold

Some decisions in life are easier than others.Deciding whether you want fries with that is a piece of cake. Deciding to tell a remorseful friend the truth about her new tattoo is harder. Among the hardest decisions in real estate is determining whether to keep or sell a finished project. Do you sell the disco while they’re still dancing or does it become a transgenerational asset? To answer this question, a new developer might consider taking a deep breath and first asking herself where she wants to be in 20 years. Does she want to be a media darling running a big company and doing the splashiest deals in town, or would she prefer to work on building her cash flow and net worth? While not by definition mutually exclusive, these two objectives often work out that way. You’re better off deciding the big picture question before you do your first deal because without a goal and a strategy to reach it, you may find yourself not only making poor tactical decisions, but also unable to make the right ones. In other words, unless you plan in advance, the sell/hold decision may prove a luxury you cannot afford. Oversimplifying the menu, development firms come in two basic flavors: merchant and investment builders—that is, those who sell everything upon completion and those who never sell. And, of course, countless firms hybridize these distinct businesses.

44

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

45

The classic build-to-sell approach, merchant building has two principal

Simply put, unless your return on a project’s total cost is roughly 2 percent

advantages over its counterpart: the ability to do many more deals and to

higher (or more) than the cap rate at which you can sell the property, you will

profit much sooner. Merchants can do more deals because their required

be economically compelled to sell it. You will have no sell-versus-hold decision

returns on cost are lower than those of investors. They typically charge greater

to make.

fees for the acquisition and construction of their projects and sell them as

To bring this point home, it may be worth summarizing our firm’s

soon as they are finished. Merchants are about fees and sale proceeds now;

strategy: we’re more interested in having fewer, higher-quality properties with

merchants are about ordinary income. (In real estate, now is a relative term.

lower debt than we are in amassing a portfolio to pay overhead. And we never

Even the swiftest projects take at least two years before you can cash in and

intentionally develop a property with a merchant approach—that is, one for

more likely a minimum of three to five years from the moment you first see a

which the only exit strategy is a sale. Why? We think it’s too risky. Merchant

property to the day you sell.)

building works great in good times, but the moment the market slips—and

The stodgier strategy, investment building is the build-to-hold approach.

it will—that 100-basis-point spread can disappear overnight. While the

To keep a property long term, an investment builder needs a going-in return

investment builder isn’t impervious to loss in a down market—everyone loses

well in excess of the merchant’s. He charges his project little in the way of

money sooner or later—he’s on safer ground.

front-end fees. Investors are about cash flow later; investors are about capital

We try to develop to investor yield standards—that 200-point spread—

gains. Turning an old expression on its head, investors mortgage the present

but we still sell about two-thirds of the projects we develop. Why? In the

for the sake of the future.

beginning, we needed the money. We continue selling today for the simple

Merchants typically seek an overall return on cost of about 100 basis points—1 percent—greater than the cap rate at which they expect to sell the

reason that many properties are at their best on day one. When do we sell? We sell if our return on cost comes in too low (either

property. (The term cap rate, or capitalization rate, is explained at length

because of construction cost overruns or our failure to achieve anticipated

in the Glossary). Thus, if he anticipates a cap rate on sale of 6 percent, the

rents). We sell when the barriers to entry for our project’s future competitors

merchant will develop for a 7 percent return on total cost. As long as prices

are low or when we have concerns about either our tenants’ longevity or the

remain steady or rise, the merchant will profit handsomely on the sale, but—

quality of our location. And conversely, we keep our high-yielding properties

here’s the point—not so handsomely as to enable him to keep his project for

in competition-constrained environments.

the long term. To do so, he would have to leave too much equity, earning too little return, in the deal. In short, he is forced to sell. For a similar project, investors will require a return on cost 200 basis

If you want to run a big development firm, become a merchant builder. If you want the luxury of deciding which deals to keep and slowly building your cash flow, consider investment building. But if you go the investor route,

points—2 percent—greater than the expected sale cap rate, an 8 percent return on

choose the properties you keep carefully: many do have their finest hour at the

cost if cap rates are 6 percent. If you wish to be an investment builder, this higher

ribbon cutting.

requirement means two things: (1) because you will be competing with merchants with lower return thresholds, you will be less competitive and winning far fewer deals; but (2) you will be able to retain your projects for the long term.

46

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

SELL VERSUS HOLD 47

The classic build-to-sell approach, merchant building has two principal

Simply put, unless your return on a project’s total cost is roughly 2 percent

advantages over its counterpart: the ability to do many more deals and to

higher (or more) than the cap rate at which you can sell the property, you will

profit much sooner. Merchants can do more deals because their required

be economically compelled to sell it. You will have no sell-versus-hold decision

returns on cost are lower than those of investors. They typically charge greater

to make.

fees for the acquisition and construction of their projects and sell them as

To bring this point home, it may be worth summarizing our firm’s

soon as they are finished. Merchants are about fees and sale proceeds now;

strategy: we’re more interested in having fewer, higher-quality properties with

merchants are about ordinary income. (In real estate, now is a relative term.

lower debt than we are in amassing a portfolio to pay overhead. And we never

Even the swiftest projects take at least two years before you can cash in and

intentionally develop a property with a merchant approach—that is, one for

more likely a minimum of three to five years from the moment you first see a

which the only exit strategy is a sale. Why? We think it’s too risky. Merchant

property to the day you sell.)

building works great in good times, but the moment the market slips—and

The stodgier strategy, investment building is the build-to-hold approach.

it will—that 100-basis-point spread can disappear overnight. While the

To keep a property long term, an investment builder needs a going-in return

investment builder isn’t impervious to loss in a down market—everyone loses

well in excess of the merchant’s. He charges his project little in the way of

money sooner or later—he’s on safer ground.

front-end fees. Investors are about cash flow later; investors are about capital

We try to develop to investor yield standards—that 200-point spread—

gains. Turning an old expression on its head, investors mortgage the present

but we still sell about two-thirds of the projects we develop. Why? In the

for the sake of the future.

beginning, we needed the money. We continue selling today for the simple

Merchants typically seek an overall return on cost of about 100 basis points—1 percent—greater than the cap rate at which they expect to sell the

reason that many properties are at their best on day one. When do we sell? We sell if our return on cost comes in too low (either

property. (The term cap rate, or capitalization rate, is explained at length

because of construction cost overruns or our failure to achieve anticipated

in the Glossary). Thus, if he anticipates a cap rate on sale of 6 percent, the

rents). We sell when the barriers to entry for our project’s future competitors

merchant will develop for a 7 percent return on total cost. As long as prices

are low or when we have concerns about either our tenants’ longevity or the

remain steady or rise, the merchant will profit handsomely on the sale, but—

quality of our location. And conversely, we keep our high-yielding properties

here’s the point—not so handsomely as to enable him to keep his project for

in competition-constrained environments.

the long term. To do so, he would have to leave too much equity, earning too little return, in the deal. In short, he is forced to sell. For a similar project, investors will require a return on cost 200 basis

If you want to run a big development firm, become a merchant builder. If you want the luxury of deciding which deals to keep and slowly building your cash flow, consider investment building. But if you go the investor route,

points—2 percent—greater than the expected sale cap rate, an 8 percent return on

choose the properties you keep carefully: many do have their finest hour at the

cost if cap rates are 6 percent. If you wish to be an investment builder, this higher

ribbon cutting.

requirement means two things: (1) because you will be competing with merchants with lower return thresholds, you will be less competitive and winning far fewer deals; but (2) you will be able to retain your projects for the long term.

46

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

SELL VERSUS HOLD 47

16

Lies, Damn Lies, and the IRR

Outright fraud in sales packagesis about as rare as total amnesia. However negligently prepared the offerings may be, they seldom contain jaw-dropping lies. If one says a property’s current gross income is $1 million, it usually is. And simple offerings—say, a flyer pasted together by a residential broker selling a gas station—are seldom far off track. Why? Purported facts about the present are subject to verification, painful lawsuits spawn in the waters of outright deception, and the shallow-end players are careful. So, too, are the sophisticates swimming in real estate’s deep end, but they can achieve depths smaller fish can only dream of. Through the magic of the IRR, the big sharks claim the ability to foretell the future. And while lies about the present are subject to door-pounding process servers, gilt-edged projections about the future are not. An IRR calculation is simple in theory: one takes the projected annual cash flow an investor hopes to receive from a property for a given holding period—usually 10 years—and adds to it the property’s estimated sale value in the 10th year, and then uses the combined sum to calculate the total return on investment (or IRR) over that 10-year period. So, if a property pays 5 percent in annual cash flow over 10 years and then sells at the end of that 10th year for twice what the investor originally paid, the IRR would be not quite 11 percent.

It’s worth pointing out that if one assumes that rents and expenses remain constant during the 10-year period (this assumption will often prove wildly optimistic) and that the selling cap rate 10 years out will be the same as the buying cap rate today (more optimism), the IRR will be identical to the cap rate paid today. In other words, if you bought it at a 6 cap and received a 6 percent yield for the 10 years you owned it, then sold it for exactly what you paid for it, your IRR would be 6 percent, the same as your initial cap rate. The breathtaking fallacy behind every IRR analysis ever prepared is obvious: it assumes that one can predict highly complex and interrelated financial conditions—interest rates, capitalization rates, tenant demand, new competition, population growth, personal income shifts, and so on—10 years hence. A mere handful of people predicted the crash of 2008–2009, and they did so only a year or two in advance. In 2009, no one predicted that apartment prices would be soaring in 2011 or that A-quality commercial-building prices would equal their all-time highs. Predicting how real estate will price in 10 years is, simply put, impossible. It’s akin to accurately predicting rainfall totals in 2030. But knowing that they’d have as much luck picking the 2030 Super Bowl winner as in nailing long-range prices deters almost no one in real estate’s upper echelons. Glossy high-end sales brochures and investment committee reports routinely contain impressive Argus spreadsheets that magically produce the IRR the buyer or investment committee desires. The magic is easier than voodoo: you just keep raising the anticipated 10th-year sales price until the desired IRR is hit. Who is going to be around in 10 years to tell the analyst she was wrong? Commissions and careers will be made and remade and bonuses paid many times over before the truth will out. A buyer would have more fun—and get just as reliable information— consulting a fortune-teller. Alternative interpretations of the IRR acronym such as “inflated rate of return” or “I rationalize risk” should come to the mind of anyone confronted with reams of spreadsheets predicting rising rents, falling expenses, zero vacancy factors, and impressively low cap rates.

This plays a lot better in a prospectus than a measly 5 percent return. 48

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

49 LIES, DAMN LIES, AND THE IRR 49

16

Lies, Damn Lies, and the IRR

Outright fraud in sales packagesis about as rare as total amnesia. However negligently prepared the offerings may be, they seldom contain jaw-dropping lies. If one says a property’s current gross income is $1 million, it usually is. And simple offerings—say, a flyer pasted together by a residential broker selling a gas station—are seldom far off track. Why? Purported facts about the present are subject to verification, painful lawsuits spawn in the waters of outright deception, and the shallow-end players are careful. So, too, are the sophisticates swimming in real estate’s deep end, but they can achieve depths smaller fish can only dream of. Through the magic of the IRR, the big sharks claim the ability to foretell the future. And while lies about the present are subject to door-pounding process servers, gilt-edged projections about the future are not. An IRR calculation is simple in theory: one takes the projected annual cash flow an investor hopes to receive from a property for a given holding period—usually 10 years—and adds to it the property’s estimated sale value in the 10th year, and then uses the combined sum to calculate the total return on investment (or IRR) over that 10-year period. So, if a property pays 5 percent in annual cash flow over 10 years and then sells at the end of that 10th year for twice what the investor originally paid, the IRR would be not quite 11 percent.

It’s worth pointing out that if one assumes that rents and expenses remain constant during the 10-year period (this assumption will often prove wildly optimistic) and that the selling cap rate 10 years out will be the same as the buying cap rate today (more optimism), the IRR will be identical to the cap rate paid today. In other words, if you bought it at a 6 cap and received a 6 percent yield for the 10 years you owned it, then sold it for exactly what you paid for it, your IRR would be 6 percent, the same as your initial cap rate. The breathtaking fallacy behind every IRR analysis ever prepared is obvious: it assumes that one can predict highly complex and interrelated financial conditions—interest rates, capitalization rates, tenant demand, new competition, population growth, personal income shifts, and so on—10 years hence. A mere handful of people predicted the crash of 2008–2009, and they did so only a year or two in advance. In 2009, no one predicted that apartment prices would be soaring in 2011 or that A-quality commercial-building prices would equal their all-time highs. Predicting how real estate will price in 10 years is, simply put, impossible. It’s akin to accurately predicting rainfall totals in 2030. But knowing that they’d have as much luck picking the 2030 Super Bowl winner as in nailing long-range prices deters almost no one in real estate’s upper echelons. Glossy high-end sales brochures and investment committee reports routinely contain impressive Argus spreadsheets that magically produce the IRR the buyer or investment committee desires. The magic is easier than voodoo: you just keep raising the anticipated 10th-year sales price until the desired IRR is hit. Who is going to be around in 10 years to tell the analyst she was wrong? Commissions and careers will be made and remade and bonuses paid many times over before the truth will out. A buyer would have more fun—and get just as reliable information— consulting a fortune-teller. Alternative interpretations of the IRR acronym such as “inflated rate of return” or “I rationalize risk” should come to the mind of anyone confronted with reams of spreadsheets predicting rising rents, falling expenses, zero vacancy factors, and impressively low cap rates.

This plays a lot better in a prospectus than a measly 5 percent return. 48

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

49 LIES, DAMN LIES, AND THE IRR 49

That the old-school return on investment (ROI) calculation is a much

17

more precise measurement of financial performance means it’s of little value to large swaths of the real estate community. A proper ROI calculation ignores cap rates and future values and looks only at what a property’s net operating income will be upon completion of construction and full lease-up. Also, by assuming a property is held free and clear, the ROI deprives one of the funhouse-mirror distortions created by leverage. If one has a fair bit of preleasing and a construction contract in hand when solving for ROI, this calculation can be quite accurate. Thus, the ROI can be devastating for those selling the future as a far rosier place than today.

Working without a Net Worth

We all have our self-delusions. Having them about numbers and the future values of our acquisitions can be an expensive mistake.

Cash flow is real estate’s real value.

Franklin D. Roosevelt’s first vice president, John Nance “Cactus Jack” Garner, is remembered for having observed that the vice presidency wasn’t worth a bucket of warm spit. Except he didn’t say spit. The difference between the vice presidency and a financial statement is that the latter is occasionally worth a bucket full. As a young developer, I could never convince my bankers of the grandeur of my financial statements. A standard financial statement was then—as it is today—little more than a compilation of one’s net worth. As 99.4 percent of my net worth consisted of the “equity” I held in our various limited partnerships, my bankers were not nearly as impressed as they might have been. Holding my statement at arm’s length, my banker would patiently explain that while my 5 percent subordinate-to-everyone general-partnership interest may indeed be worth millions, her principal concern was debt repayment: where would my loan payments come from and what was my cash flow? Because my cash flow at the time was permanently dammed somewhere far upstream, I thought this line of questioning rather impertinent. But maybe she had a point.

50

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

51

That the old-school return on investment (ROI) calculation is a much

17

more precise measurement of financial performance means it’s of little value to large swaths of the real estate community. A proper ROI calculation ignores cap rates and future values and looks only at what a property’s net operating income will be upon completion of construction and full lease-up. Also, by assuming a property is held free and clear, the ROI deprives one of the funhouse-mirror distortions created by leverage. If one has a fair bit of preleasing and a construction contract in hand when solving for ROI, this calculation can be quite accurate. Thus, the ROI can be devastating for those selling the future as a far rosier place than today.

Working without a Net Worth

We all have our self-delusions. Having them about numbers and the future values of our acquisitions can be an expensive mistake.

Cash flow is real estate’s real value.

Franklin D. Roosevelt’s first vice president, John Nance “Cactus Jack” Garner, is remembered for having observed that the vice presidency wasn’t worth a bucket of warm spit. Except he didn’t say spit. The difference between the vice presidency and a financial statement is that the latter is occasionally worth a bucket full. As a young developer, I could never convince my bankers of the grandeur of my financial statements. A standard financial statement was then—as it is today—little more than a compilation of one’s net worth. As 99.4 percent of my net worth consisted of the “equity” I held in our various limited partnerships, my bankers were not nearly as impressed as they might have been. Holding my statement at arm’s length, my banker would patiently explain that while my 5 percent subordinate-to-everyone general-partnership interest may indeed be worth millions, her principal concern was debt repayment: where would my loan payments come from and what was my cash flow? Because my cash flow at the time was permanently dammed somewhere far upstream, I thought this line of questioning rather impertinent. But maybe she had a point.

50

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

51

Soberly viewed, a financial statement is more daydream than fact. If

And even assuming you chose curtain No. 1—the $10 million free and

someone claims he’s worth a wildly crazy amount—say a Silicon Valley

clear—that doesn’t say beans about your cash flow, my nagging banker’s

fortune of $300 million—that’s a lovely reverie, but the chances of that guy

original concern. Ten million dollars parked with Wells Fargo may be safe,

actually coming up with $300 million in cash are slim. First, instead of the

but it nets you nearly nothing at today’s interest rates. Ten million dollars

pipe-dream number he claims on his statement for the illiquid asset that

in gold or any growth stock is good for a nice round zero in annual income,

constitutes the vast bulk of his empire, he has to mark that asset down to

while $10 million in Treasury bonds has a pulse somewhere between zero

market, be it stock in a privately held company, timber, a coal mine, whatever.

and 3 percent, depending on term. And high-quality corporate bonds? A tad

Then, he has to sell it, pay federal and state taxes, and—if he’s married—divide

higher than Treasuries.

that sum by two. If he owns that $300 million in stock in a publicly traded company, that

So this is where real estate finally pays off, where maybe we’re not so dumb after all for having chosen this profession. (When I was quizzing my

means he’s the chief executive and can’t sell because his holdings are in stock

editor about numbers to illustrate this point, I asked her how much money

options or are contractually or de facto restricted. (The CEO can’t be seen

one needed to be really rich; she countered by asking whether we were talking

dumping his company’s stock.)

Silicon Valley rich or just real estate rich. Sighing, I dropped the question.)

While financial statements are generally more exaggerated than circus-

Anyway, an enviably solid real estate portfolio worth $10 million could easily

tent revivals, they are particularly worthless in real estate. Thanks to the

net $500,000 to $700,000 a year in stable, recurring cash flow, far better than

miracle of the 1031 tax-deferred exchange, if a real estate entrepreneur has

its obvious alternatives. My banker was right: it is all about cash flow.

been around long enough to be truly successful, his current properties—say

To paraphrase Mark Twain: When I was a young man of 30, my bankers

they show $10 million in equity—will likely trace their tax-basis origins back

were so ignorant I could hardly stand to have them around. But when I got to

over 30 years and involve a dozen 1031 exchanges.* This means his assets will

be 40, I was astonished by how much they had learned in 10 years.

have tremendous negative bases for tax purposes and likely carry a latent tax liability often surpassing the claimed equity. The only way for a real estate mogul to sell without triggering this tax—dying—has yet to be widely embraced. Putting real estate’s idiosyncrasies aside, financial statements are still problematic. Even if a financial statement were to accurately reflect the market value of assets and deduct the inchoate taxes, issues likely linger. How would you prefer your own personal $10 million net worth—assets of $10 million and liabilities of $0, or assets of $3.01 billion and liabilities of $3 billion? An overleveraged net worth can, back to Cactus Jack, bubble away like spit on a griddle.

* Internal Revenue Code Section 1031 is a provision allowing sellers of real estate to defer the taxes they would otherwise owe by exchanging their sale proceeds into other real estate of equal or greater value.

52

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

WORKING WITHOUT A NET WORTH 53

Soberly viewed, a financial statement is more daydream than fact. If

And even assuming you chose curtain No. 1—the $10 million free and

someone claims he’s worth a wildly crazy amount—say a Silicon Valley

clear—that doesn’t say beans about your cash flow, my nagging banker’s

fortune of $300 million—that’s a lovely reverie, but the chances of that guy

original concern. Ten million dollars parked with Wells Fargo may be safe,

actually coming up with $300 million in cash are slim. First, instead of the

but it nets you nearly nothing at today’s interest rates. Ten million dollars

pipe-dream number he claims on his statement for the illiquid asset that

in gold or any growth stock is good for a nice round zero in annual income,

constitutes the vast bulk of his empire, he has to mark that asset down to

while $10 million in Treasury bonds has a pulse somewhere between zero

market, be it stock in a privately held company, timber, a coal mine, whatever.

and 3 percent, depending on term. And high-quality corporate bonds? A tad

Then, he has to sell it, pay federal and state taxes, and—if he’s married—divide

higher than Treasuries.

that sum by two. If he owns that $300 million in stock in a publicly traded company, that

So this is where real estate finally pays off, where maybe we’re not so dumb after all for having chosen this profession. (When I was quizzing my

means he’s the chief executive and can’t sell because his holdings are in stock

editor about numbers to illustrate this point, I asked her how much money

options or are contractually or de facto restricted. (The CEO can’t be seen

one needed to be really rich; she countered by asking whether we were talking

dumping his company’s stock.)

Silicon Valley rich or just real estate rich. Sighing, I dropped the question.)

While financial statements are generally more exaggerated than circus-

Anyway, an enviably solid real estate portfolio worth $10 million could easily

tent revivals, they are particularly worthless in real estate. Thanks to the

net $500,000 to $700,000 a year in stable, recurring cash flow, far better than

miracle of the 1031 tax-deferred exchange, if a real estate entrepreneur has

its obvious alternatives. My banker was right: it is all about cash flow.

been around long enough to be truly successful, his current properties—say

To paraphrase Mark Twain: When I was a young man of 30, my bankers

they show $10 million in equity—will likely trace their tax-basis origins back

were so ignorant I could hardly stand to have them around. But when I got to

over 30 years and involve a dozen 1031 exchanges.* This means his assets will

be 40, I was astonished by how much they had learned in 10 years.

have tremendous negative bases for tax purposes and likely carry a latent tax liability often surpassing the claimed equity. The only way for a real estate mogul to sell without triggering this tax—dying—has yet to be widely embraced. Putting real estate’s idiosyncrasies aside, financial statements are still problematic. Even if a financial statement were to accurately reflect the market value of assets and deduct the inchoate taxes, issues likely linger. How would you prefer your own personal $10 million net worth—assets of $10 million and liabilities of $0, or assets of $3.01 billion and liabilities of $3 billion? An overleveraged net worth can, back to Cactus Jack, bubble away like spit on a griddle.

* Internal Revenue Code Section 1031 is a provision allowing sellers of real estate to defer the taxes they would otherwise owe by exchanging their sale proceeds into other real estate of equal or greater value.

52

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

WORKING WITHOUT A NET WORTH 53

18

Monogamy and Its Downside

Bankers like exclusivity,but developers should be less enamored. A picture of a smiling developer and a happy banker shaking hands could illustrate Wikipedia’s explanation of “symbiotic relationship.” Developers need to borrow and bankers need to lend, despite their occasional issues with regulators. We could almost end this chapter right there, but a few nuances in this often happy relationship are worth touching on. Unless the announcement of your birth appeared in the New York Times, you have to get started somewhere, and, for successful deals at least, a banker’s money is always the cheapest in town—far cheaper, no matter the interest rate, than giving away half the deal. Yes, rookie developers must part with nearly everything regardless. But with a bit of luck, they may over time be able to decide for themselves how much to rely on banks versus equity partners. Veteran developers usually argue in favor of partners, noting that you have to personally guarantee bank debt whereas you promise your equity partners nada (at least in the fine print). However, if you are going to feel a moral obligation—forget the partnership agreement’s absolution—to repay your investors, you’re better off guaranteeing bank debt: your ethical and legal obligations are identical and you get to keep all the profits. Also, personal guaranties have the side benefit of focusing your attention on the moment

54

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

at hand—in this case, your deal’s underwriting. Sooner or later we all lose money, but perhaps a bit less often when it is our own money. So, a banker is a successful developer’s best friend. But the first time you try to borrow more than a cup of sugar, your banker will want a committed, monogamous relationship. She will want all your business. She will shake hands and promise she will take care of all your needs; she will lend you every dollar you will ever need. And she will mean it. Your BFF with financial benefits. Here’s the problem: you can’t shake hands with a corporation. Despite the best intentions in the world, your banker is only as good as the last loan she committed to you. Although she may truly become a close friend over time, likely as not she will quit, retire, be fishing, or be in the hospital the week you absolutely need a loan commitment. Or, her bank will be merged out of existence (this has happened to us three times), be taken over by the feds, or simply stop making real estate loans. The solution? You need an open relationship with three bankers at three different banks. That way the lights are always on somewhere. Will this be without its own sturm und drang? Of course not—for the same reasons an open relationship has never worked for any couple since Adam and Eve: your bankers will hate it. But they will begrudgingly accept it once they understand and accept your legitimate need for a financial backup plan. Your role then is to nurture that understanding and acceptance. Bankers are sensitive souls. They don’t get out of their offices all that often; their joys are in the neat, the orderly, and the calm. Bankers are a lot like accountants, only with personality. They love nothing better than sipping herbal tea while poring over your spreadsheets, provided, of course, your numbers are handsomely positive. They savor reports showing solid leasing and construction progress; they embrace financial statements with even the merest hint of liquidity. While easily pleased, bankers are not perfect. They can react badly when startled. The casual mention of a second lien holder’s pending foreclosure— especially one known for months—can be cause for surprising rancor. They can be prickly about not having their calls returned or about receiving a

55 MONOGAMY AND ITS DOWNSIDE 55

18

Monogamy and Its Downside

Bankers like exclusivity,but developers should be less enamored. A picture of a smiling developer and a happy banker shaking hands could illustrate Wikipedia’s explanation of “symbiotic relationship.” Developers need to borrow and bankers need to lend, despite their occasional issues with regulators. We could almost end this chapter right there, but a few nuances in this often happy relationship are worth touching on. Unless the announcement of your birth appeared in the New York Times, you have to get started somewhere, and, for successful deals at least, a banker’s money is always the cheapest in town—far cheaper, no matter the interest rate, than giving away half the deal. Yes, rookie developers must part with nearly everything regardless. But with a bit of luck, they may over time be able to decide for themselves how much to rely on banks versus equity partners. Veteran developers usually argue in favor of partners, noting that you have to personally guarantee bank debt whereas you promise your equity partners nada (at least in the fine print). However, if you are going to feel a moral obligation—forget the partnership agreement’s absolution—to repay your investors, you’re better off guaranteeing bank debt: your ethical and legal obligations are identical and you get to keep all the profits. Also, personal guaranties have the side benefit of focusing your attention on the moment

54

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

at hand—in this case, your deal’s underwriting. Sooner or later we all lose money, but perhaps a bit less often when it is our own money. So, a banker is a successful developer’s best friend. But the first time you try to borrow more than a cup of sugar, your banker will want a committed, monogamous relationship. She will want all your business. She will shake hands and promise she will take care of all your needs; she will lend you every dollar you will ever need. And she will mean it. Your BFF with financial benefits. Here’s the problem: you can’t shake hands with a corporation. Despite the best intentions in the world, your banker is only as good as the last loan she committed to you. Although she may truly become a close friend over time, likely as not she will quit, retire, be fishing, or be in the hospital the week you absolutely need a loan commitment. Or, her bank will be merged out of existence (this has happened to us three times), be taken over by the feds, or simply stop making real estate loans. The solution? You need an open relationship with three bankers at three different banks. That way the lights are always on somewhere. Will this be without its own sturm und drang? Of course not—for the same reasons an open relationship has never worked for any couple since Adam and Eve: your bankers will hate it. But they will begrudgingly accept it once they understand and accept your legitimate need for a financial backup plan. Your role then is to nurture that understanding and acceptance. Bankers are sensitive souls. They don’t get out of their offices all that often; their joys are in the neat, the orderly, and the calm. Bankers are a lot like accountants, only with personality. They love nothing better than sipping herbal tea while poring over your spreadsheets, provided, of course, your numbers are handsomely positive. They savor reports showing solid leasing and construction progress; they embrace financial statements with even the merest hint of liquidity. While easily pleased, bankers are not perfect. They can react badly when startled. The casual mention of a second lien holder’s pending foreclosure— especially one known for months—can be cause for surprising rancor. They can be prickly about not having their calls returned or about receiving a

55 MONOGAMY AND ITS DOWNSIDE 55

developer’s reply at 6 p.m. on Christmas Eve. And bankers may be at their

19

least charming when confronted with bald-faced lies, displaying far less in the way of patience than, say, a mental health worker. Somewhere along the line, bankers lost their childlike joy in surprises. Bankers are aware of their senseless, pathological aversion to risk, but, knowing how unhip it is to be wimpy, they hate being reminded of it. They especially hate it when a developer tosses aside their concerns with a chuckling dismissal: “Toxics? No problem, bro. That town already glows in the dark; no one will ever notice our little spill.” The clever developer will make allowances for these personality quirks when maintaining her connection with her banker. But with a little care (under-promising is a time-honored strategy), your new best friend, your

Let Us Now Praise Famous Architects

banker, will be your pal forever, or at least until he retires, gets transferred, or goes fishing.

And let us remind not-so-famous developersto seek business counsel elsewhere. Without a commitment to architectural innovation and excellence, without wide recognition of our best and brightest designers, our world might easily resemble the outskirts of Moscow, that endless, post-apocalyptic forest of gray, pitted concrete. Also, let’s face it: architects are always the coolest guys in the room. Everybody likes them. They know the latest vacation spot (usually some islet in the Indian Ocean). They’ve got the hippest glasses and the best quote from the New York Review of Books; they’re well spoken. (City councils love them.) They’re urbane and witty, and they have that dash of the professorial that implies intellectual depth. All true, but architects should come with a printed caution—perhaps as simple as tobacco’s—“Warning: Architects Kill.” Or more elaborately: “Warning: A design professional is like a loaded .45—take lessons before employing.” On the one hand, the marriage of a skilled developer and a top-flight architect may prove wondrous, often producing glorious offspring: a building,

56

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

57

developer’s reply at 6 p.m. on Christmas Eve. And bankers may be at their

19

least charming when confronted with bald-faced lies, displaying far less in the way of patience than, say, a mental health worker. Somewhere along the line, bankers lost their childlike joy in surprises. Bankers are aware of their senseless, pathological aversion to risk, but, knowing how unhip it is to be wimpy, they hate being reminded of it. They especially hate it when a developer tosses aside their concerns with a chuckling dismissal: “Toxics? No problem, bro. That town already glows in the dark; no one will ever notice our little spill.” The clever developer will make allowances for these personality quirks when maintaining her connection with her banker. But with a little care (under-promising is a time-honored strategy), your new best friend, your

Let Us Now Praise Famous Architects

banker, will be your pal forever, or at least until he retires, gets transferred, or goes fishing.

And let us remind not-so-famous developersto seek business counsel elsewhere. Without a commitment to architectural innovation and excellence, without wide recognition of our best and brightest designers, our world might easily resemble the outskirts of Moscow, that endless, post-apocalyptic forest of gray, pitted concrete. Also, let’s face it: architects are always the coolest guys in the room. Everybody likes them. They know the latest vacation spot (usually some islet in the Indian Ocean). They’ve got the hippest glasses and the best quote from the New York Review of Books; they’re well spoken. (City councils love them.) They’re urbane and witty, and they have that dash of the professorial that implies intellectual depth. All true, but architects should come with a printed caution—perhaps as simple as tobacco’s—“Warning: Architects Kill.” Or more elaborately: “Warning: A design professional is like a loaded .45—take lessons before employing.” On the one hand, the marriage of a skilled developer and a top-flight architect may prove wondrous, often producing glorious offspring: a building,

56

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

57

an entire project, swiftly designed that not only fits well with its surroundings but also is embraced by its community and is profitable from the beginning. On the other hand, a neophyte developer or amateur owner—especially

Property owner about to acquire knowledge the hard way: “Thanks, man, but we’ve got it covered. We've asked around, and we’re hiring the best architect, the number-one engineer, blah, blah, blah—we are ready to roll.

one with an ego—will as likely as not get his project finished, but the chances

Just wanted to see if you guys would pay too much for this fabulous

of turning a profit any more quickly than the Great Pyramids are slim.

development opportunity.”

Why? Because, like other artists, an architect is ultimately in the business

OK, hotshot designers: do yourselves and your inexperienced client a big

of pleasing her clients, and if a developer insists that a shopping center look

favor. When you finish spinning out your ideas for the world’s coolest design,

like the Ponte Vecchio, the architect will design it thus, complete with a water

advise her to seek professional development expertise. She can either hire it for

feature that creates a moat around the center, guarding it from any would-be

a small fortune or lose a large one learning it on the job.

shoppers. Or if the developer made his first fortune in the nursery business and happens to be overly fond of landscaping, an architect will design and install a 10-foot, wrought-iron fence around his project, thereby protecting the petunias and everything else in the center from pesky visitors. These two clownish—but true—examples (both from the Central Valley of California) illustrate the point: if you don’t know what you’re doing, your architect won’t save you. We toured a failed mixed-use development with condominiums over ground-floor retail in Napa County that had a flaw so obviously fatal that both owner and architect should have seen it on their first visit to the dirt—it was virtually on top of a firehouse. Who would buy a home knowingly running a risk of 3:00 a.m. wake-up calls from careening fire trucks? Apparently, nobody. The condos didn’t sell, and the project went back to the lender. Yet the fault, dear Brutus, lies not in our starchitects, but in ourselves. We cannot rely on architects to tell us that second-floor retail never works. Or that shops facing 90 degrees away from their anchor tenant’s front door are in the commercial equivalent of purgatory, just maybe a bit more dead. And we must learn the hard way what happens when we jack up our buildable area by penciling in too many compact parking spots. Every year some cocky property owner comes to visit us, and the conversation goes like this: McPartners: “You might consider hiring an experienced developer: developing a successful shopping center only looks easier than tic-tac-toe.”

58

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

LET US NOW PRAISE FAMOUS ARCHITECTS 59

an entire project, swiftly designed that not only fits well with its surroundings but also is embraced by its community and is profitable from the beginning. On the other hand, a neophyte developer or amateur owner—especially

Property owner about to acquire knowledge the hard way: “Thanks, man, but we’ve got it covered. We've asked around, and we’re hiring the best architect, the number-one engineer, blah, blah, blah—we are ready to roll.

one with an ego—will as likely as not get his project finished, but the chances

Just wanted to see if you guys would pay too much for this fabulous

of turning a profit any more quickly than the Great Pyramids are slim.

development opportunity.”

Why? Because, like other artists, an architect is ultimately in the business

OK, hotshot designers: do yourselves and your inexperienced client a big

of pleasing her clients, and if a developer insists that a shopping center look

favor. When you finish spinning out your ideas for the world’s coolest design,

like the Ponte Vecchio, the architect will design it thus, complete with a water

advise her to seek professional development expertise. She can either hire it for

feature that creates a moat around the center, guarding it from any would-be

a small fortune or lose a large one learning it on the job.

shoppers. Or if the developer made his first fortune in the nursery business and happens to be overly fond of landscaping, an architect will design and install a 10-foot, wrought-iron fence around his project, thereby protecting the petunias and everything else in the center from pesky visitors. These two clownish—but true—examples (both from the Central Valley of California) illustrate the point: if you don’t know what you’re doing, your architect won’t save you. We toured a failed mixed-use development with condominiums over ground-floor retail in Napa County that had a flaw so obviously fatal that both owner and architect should have seen it on their first visit to the dirt—it was virtually on top of a firehouse. Who would buy a home knowingly running a risk of 3:00 a.m. wake-up calls from careening fire trucks? Apparently, nobody. The condos didn’t sell, and the project went back to the lender. Yet the fault, dear Brutus, lies not in our starchitects, but in ourselves. We cannot rely on architects to tell us that second-floor retail never works. Or that shops facing 90 degrees away from their anchor tenant’s front door are in the commercial equivalent of purgatory, just maybe a bit more dead. And we must learn the hard way what happens when we jack up our buildable area by penciling in too many compact parking spots. Every year some cocky property owner comes to visit us, and the conversation goes like this: McPartners: “You might consider hiring an experienced developer: developing a successful shopping center only looks easier than tic-tac-toe.”

58

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

LET US NOW PRAISE FAMOUS ARCHITECTS 59

20

General Contractor Relativity

of the recession you’re either laying off 70 percent of your staff (hard to do) or going broke. Over the years, we’ve made most of the mistakes—and lost money—most of the ways one can in development, but at least we never tried to build our own projects. We do, however, hire an independent consultant to act as our owner’s representative for our construction. But here’s the point: he’s paid by the hour, and should we ever cease building, we would have no ongoing financial obligation to him. Again, the more costs under your control, the less likely you’ll have to read Chapter 11 of the U.S. Bankruptcy Code. We prefer the second option: choosing a contractor the moment a deal seems real, very early in the entitlement phase, and sticking with him through the grand opening. Having a level-headed contractor on board early helps prevent your architect from designing a monument to herself. The contractor is the yin to the architect’s yang: he will explain that your architect’s vision for your new car wash will cost more than El Salvador’s annual budget, that curved lines in buildings are more expensive than right angles, that

We turn now to general contractors,the manly men who can sink

there can be such a thing as too much glass in a building. In short, the value

a 10-penny nail into a two-by-four with just two whacks, the guys who only

engineering—the reality check—a contractor provides your design early on

drive pickup trucks . . . and Ferraris. If you’re going to be a true developer—

can be invaluable, especially if you’re new to the game.

someone who builds from the ground up—you will need to work with

The downside to this approach is losing the ability to bid out the project.

contractors. Oversimplifying as usual: you can handle them three different

If this is a concern, you can still select your preferred contractor at the outset,

ways—bid out every project to, say, three contractors; work exclusively with

but agree that you will pay him a fair “walk away” fee if his isn’t the winning

one from a project’s outset; or act as your own contractor.

bid. This works.

Let’s start with the third option. It’s fair to say that once developers reach

By the way, if circumstances don’t require you to bid out a project (e.g., if

a certain size, the temptation to take construction in-house—to control the

your major tenant or bank doesn’t insist on it), you might think long and hard

entire construction process and keep the contractor’s fees and overhead—is

about whether you really need to do so. Most general contractors do almost no

often irresistible, especially among the fee-driven merchant builders. Ignoring

construction work in-house; the vast majority likely do none of it. All the real

the thousand ways a contractor can go broke, large developers are prone to ask

work is done by subcontractors. This means that once you agree with a general

themselves the wrong question—“How hard can it be?”—and jump into the

contractor on his fees and costs, he’s on your side of the ledger. If, instead of

construction business.

bidding out your project among general contractors, you select one but require

Developers that do everything in-house—from entitlements to

him to get at least three bids from each of the major subtrades—grading,

architecture to construction—are often successful in bull markets, but the

concrete, plumbing, electrical, and so on—you’ve accomplished the same

overhead required to support such organizations means that on the first day

result: the best price for your project.

60

61 GENERAL CONTRACTOR RELATIVIT Y 61

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

20

General Contractor Relativity

of the recession you’re either laying off 70 percent of your staff (hard to do) or going broke. Over the years, we’ve made most of the mistakes—and lost money—most of the ways one can in development, but at least we never tried to build our own projects. We do, however, hire an independent consultant to act as our owner’s representative for our construction. But here’s the point: he’s paid by the hour, and should we ever cease building, we would have no ongoing financial obligation to him. Again, the more costs under your control, the less likely you’ll have to read Chapter 11 of the U.S. Bankruptcy Code. We prefer the second option: choosing a contractor the moment a deal seems real, very early in the entitlement phase, and sticking with him through the grand opening. Having a level-headed contractor on board early helps prevent your architect from designing a monument to herself. The contractor is the yin to the architect’s yang: he will explain that your architect’s vision for your new car wash will cost more than El Salvador’s annual budget, that curved lines in buildings are more expensive than right angles, that

We turn now to general contractors,the manly men who can sink

there can be such a thing as too much glass in a building. In short, the value

a 10-penny nail into a two-by-four with just two whacks, the guys who only

engineering—the reality check—a contractor provides your design early on

drive pickup trucks . . . and Ferraris. If you’re going to be a true developer—

can be invaluable, especially if you’re new to the game.

someone who builds from the ground up—you will need to work with

The downside to this approach is losing the ability to bid out the project.

contractors. Oversimplifying as usual: you can handle them three different

If this is a concern, you can still select your preferred contractor at the outset,

ways—bid out every project to, say, three contractors; work exclusively with

but agree that you will pay him a fair “walk away” fee if his isn’t the winning

one from a project’s outset; or act as your own contractor.

bid. This works.

Let’s start with the third option. It’s fair to say that once developers reach

By the way, if circumstances don’t require you to bid out a project (e.g., if

a certain size, the temptation to take construction in-house—to control the

your major tenant or bank doesn’t insist on it), you might think long and hard

entire construction process and keep the contractor’s fees and overhead—is

about whether you really need to do so. Most general contractors do almost no

often irresistible, especially among the fee-driven merchant builders. Ignoring

construction work in-house; the vast majority likely do none of it. All the real

the thousand ways a contractor can go broke, large developers are prone to ask

work is done by subcontractors. This means that once you agree with a general

themselves the wrong question—“How hard can it be?”—and jump into the

contractor on his fees and costs, he’s on your side of the ledger. If, instead of

construction business.

bidding out your project among general contractors, you select one but require

Developers that do everything in-house—from entitlements to

him to get at least three bids from each of the major subtrades—grading,

architecture to construction—are often successful in bull markets, but the

concrete, plumbing, electrical, and so on—you’ve accomplished the same

overhead required to support such organizations means that on the first day

result: the best price for your project.

60

61 GENERAL CONTRACTOR RELATIVIT Y 61

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

If you do decide to bid out your project to multiple general contractors, be wary of outlier low bids. Given the often frantic, 11th-hour nature of the bidding process, honest contractors can make mistakes and dishonest ones will bid low intending to make it up in change orders (especially if they decide you’re an easy mark). If, say, three bids are within nickels of one another at $10 million while a fourth is $8 million, you will likely be buying yourself more than $2 million’s worth of trouble by accepting that low bid. Also, unless your bank or financial partner insists on it, you might consider waiving the requirement that your contractor provide a bond for your job. A bond is expensive and, if you ever do make a claim on it, you will learn that insurance companies pay off about as frequently as Vegas slot machines. Better to verify that your contractor is “bondable” and let it go at that. Finally, and for what it’s worth, we figured out long ago that a contract as thick as a cornerstone won’t help with a crooked or inept general contractor and that a handshake suffices 90 percent of the time with an honest, competent one; the contract simply reminds everyone of what they agreed to do. We stopped putting our projects out to bid nearly 20 years ago, relying instead on a couple of top-flight contractors with whom we do business nearly every year, making them part of our team. Our general contractors work with us from day one—before anyone knows whether a project will ever be built. They provide us with value engineering and cost estimating on one plan iteration after another, all without charge because they know that if the project proceeds, the work is theirs. This, we believe, is the right way to relate to general contractors.

21

Sex, Lies, and Off-Market Deals

Jesus spent 40 days in the desert,eating nothing and resisting the devil’s temptations. Along a similar, if less biblical parallel, the IRS allows you 45 days to wander the wilderness in search of a 1031 exchange, all the while battling brokers’ blandishments. We emerged from that commercial Sahara, and while we may not have encountered the devil himself—in real estate, one can never be sure—we were sorely tempted by properties not worth a windshield inspection. Like common wisdom, lies have a certain currency, but the more outrageous the lie, the shorter its longevity. “We’re from the government; we’re here to help” was so preposterous that it cannot have been uttered more than once before becoming a sad political joke. The more plausible falsehood, “It’s a reverse commute,” had a decent run some years back, and real estate’s perennial fabrication—“This property just needs a little hands-on management”—is seldom out of play. The Methuselah of business lies, the one that may endure forever, has been sung by nearly every guilty chief executive: “I had no idea my employees were robbing the company blind . . . on my behalf.” This absurdity coupled with the standard mea culpa—“I am guilty of trusting my team too much”— will no doubt persist until the last employee is thrown under the bus.

62

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

63

If you do decide to bid out your project to multiple general contractors, be wary of outlier low bids. Given the often frantic, 11th-hour nature of the bidding process, honest contractors can make mistakes and dishonest ones will bid low intending to make it up in change orders (especially if they decide you’re an easy mark). If, say, three bids are within nickels of one another at $10 million while a fourth is $8 million, you will likely be buying yourself more than $2 million’s worth of trouble by accepting that low bid. Also, unless your bank or financial partner insists on it, you might consider waiving the requirement that your contractor provide a bond for your job. A bond is expensive and, if you ever do make a claim on it, you will learn that insurance companies pay off about as frequently as Vegas slot machines. Better to verify that your contractor is “bondable” and let it go at that. Finally, and for what it’s worth, we figured out long ago that a contract as thick as a cornerstone won’t help with a crooked or inept general contractor and that a handshake suffices 90 percent of the time with an honest, competent one; the contract simply reminds everyone of what they agreed to do. We stopped putting our projects out to bid nearly 20 years ago, relying instead on a couple of top-flight contractors with whom we do business nearly every year, making them part of our team. Our general contractors work with us from day one—before anyone knows whether a project will ever be built. They provide us with value engineering and cost estimating on one plan iteration after another, all without charge because they know that if the project proceeds, the work is theirs. This, we believe, is the right way to relate to general contractors.

21

Sex, Lies, and Off-Market Deals

Jesus spent 40 days in the desert,eating nothing and resisting the devil’s temptations. Along a similar, if less biblical parallel, the IRS allows you 45 days to wander the wilderness in search of a 1031 exchange, all the while battling brokers’ blandishments. We emerged from that commercial Sahara, and while we may not have encountered the devil himself—in real estate, one can never be sure—we were sorely tempted by properties not worth a windshield inspection. Like common wisdom, lies have a certain currency, but the more outrageous the lie, the shorter its longevity. “We’re from the government; we’re here to help” was so preposterous that it cannot have been uttered more than once before becoming a sad political joke. The more plausible falsehood, “It’s a reverse commute,” had a decent run some years back, and real estate’s perennial fabrication—“This property just needs a little hands-on management”—is seldom out of play. The Methuselah of business lies, the one that may endure forever, has been sung by nearly every guilty chief executive: “I had no idea my employees were robbing the company blind . . . on my behalf.” This absurdity coupled with the standard mea culpa—“I am guilty of trusting my team too much”— will no doubt persist until the last employee is thrown under the bus.

62

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

63

Most lies, however, last only a bit longer than Christmas poinsettias no

Our time in the desert revealed another unpleasant—and frankly,

matter how much care they receive. Rapidly heading in that direction but still

puzzling—development in the brokerage world: the now nearly universal

au courant is the claim, “It’s an off-market deal.” During our six weeks in the

practice by the industry’s national powerhouses to “cooperate” with outside

desert, we heard that more times than we could count, even with our shoes

brokers in every way except the one that matters, the commission. When a

off. Apparently never in the history of real estate had so many sellers decided

listing agent from a national firm sends his marketing package to an interested

that the best way to market their property was to feign indifference to its sale.

outside broker, the following conversation ensues:

The appeal of the off-market pitch—at least to the ever-hopeful brokerage community—is that it is technically true. It is true that the off-market property isn’t publicly listed for sale. What is false is usually everything else, everything the optimistic broker wishes to imply from the seller’s refusal to

“What’s the split on the commission?” asks the outsider. “No split. We keep 100 percent of the commission, but you can put yourself in for whatever you think is reasonable on top of that.” This sounds great . . . for a moment. “Wait a second. That means that

sign a listing—namely, that the property’s apparent exclusivity is the buyer’s

if my client makes an offer that includes a 2 percent commission to me, the

VIP pass, the chance to snare a great deal, a pirate’s treasure map.

buyer has to pay 2 percent more than he would on a direct deal, correct?”

A true off-market property may indeed be a worthy prize, but brokers are seldom involved because principals deal directly with principals. Yes, it happens occasionally that an experienced owner who knows what an

“Exactly.” “So my buyer is always in the hole by 2 percent compared to any one of your clients?”

asset is worth will permit a broker with whom he has a longstanding

“Yep.”

relationship to quietly offer it to a buyer with whom the broker, in turn, has a

“Once he understands that, my client will never make an offer.”

similar relationship.

The small, independent buyer-oriented brokers are thus effectively shut

But that is not what one is seeing. Today’s off-market deals are neither principal-to-principal nor the result of mature broker-client relationships.

out of the best public deals and forced to scrounge for off-market dross.  The “we-keep-it-all” listing may be a four-bagger for the brokers, but

Rather, they are the progeny of brokers desperate for product cold-calling coy

why would any seller go along with it? Isn’t it possible the small broker had

sellers. The private offering thus obtained is a lot like a Times Square Rolex—a

the buyer with the hottest hand, the one that might have paid the most? How

waste of time.

could this arrangement ever benefit a seller? Why are even sophisticated

If compelled to pursue a private deal, one should bear in mind that the

sellers willing to accept a no-share listing?

phrase “off-market deal” is now shorthand—like “SWF” in a personals ad—for “Conniving seller seeks gullible buyer to pay 20 percent more than fair market value, pay all commissions, accept nothing as an underwriting package, and close as-is after seven days.” One might ask why any broker would bother chasing such a deal. Brokers are, by and large, at least as savvy as their clients and would surely understand the futility. Why would anyone live in Siberia? Same answer to both questions: they have no choice.

64

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

SEX, LIES, AND OFF-MARKET DEALS 65

Most lies, however, last only a bit longer than Christmas poinsettias no

Our time in the desert revealed another unpleasant—and frankly,

matter how much care they receive. Rapidly heading in that direction but still

puzzling—development in the brokerage world: the now nearly universal

au courant is the claim, “It’s an off-market deal.” During our six weeks in the

practice by the industry’s national powerhouses to “cooperate” with outside

desert, we heard that more times than we could count, even with our shoes

brokers in every way except the one that matters, the commission. When a

off. Apparently never in the history of real estate had so many sellers decided

listing agent from a national firm sends his marketing package to an interested

that the best way to market their property was to feign indifference to its sale.

outside broker, the following conversation ensues:

The appeal of the off-market pitch—at least to the ever-hopeful brokerage community—is that it is technically true. It is true that the off-market property isn’t publicly listed for sale. What is false is usually everything else, everything the optimistic broker wishes to imply from the seller’s refusal to

“What’s the split on the commission?” asks the outsider. “No split. We keep 100 percent of the commission, but you can put yourself in for whatever you think is reasonable on top of that.” This sounds great . . . for a moment. “Wait a second. That means that

sign a listing—namely, that the property’s apparent exclusivity is the buyer’s

if my client makes an offer that includes a 2 percent commission to me, the

VIP pass, the chance to snare a great deal, a pirate’s treasure map.

buyer has to pay 2 percent more than he would on a direct deal, correct?”

A true off-market property may indeed be a worthy prize, but brokers are seldom involved because principals deal directly with principals. Yes, it happens occasionally that an experienced owner who knows what an

“Exactly.” “So my buyer is always in the hole by 2 percent compared to any one of your clients?”

asset is worth will permit a broker with whom he has a longstanding

“Yep.”

relationship to quietly offer it to a buyer with whom the broker, in turn, has a

“Once he understands that, my client will never make an offer.”

similar relationship.

The small, independent buyer-oriented brokers are thus effectively shut

But that is not what one is seeing. Today’s off-market deals are neither principal-to-principal nor the result of mature broker-client relationships.

out of the best public deals and forced to scrounge for off-market dross.  The “we-keep-it-all” listing may be a four-bagger for the brokers, but

Rather, they are the progeny of brokers desperate for product cold-calling coy

why would any seller go along with it? Isn’t it possible the small broker had

sellers. The private offering thus obtained is a lot like a Times Square Rolex—a

the buyer with the hottest hand, the one that might have paid the most? How

waste of time.

could this arrangement ever benefit a seller? Why are even sophisticated

If compelled to pursue a private deal, one should bear in mind that the

sellers willing to accept a no-share listing?

phrase “off-market deal” is now shorthand—like “SWF” in a personals ad—for “Conniving seller seeks gullible buyer to pay 20 percent more than fair market value, pay all commissions, accept nothing as an underwriting package, and close as-is after seven days.” One might ask why any broker would bother chasing such a deal. Brokers are, by and large, at least as savvy as their clients and would surely understand the futility. Why would anyone live in Siberia? Same answer to both questions: they have no choice.

64

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

SEX, LIES, AND OFF-MARKET DEALS 65

22 Do As I Say

The previous chapter ended with questions:Why would a seller ever permit a listing broker to keep 100 percent of a sales commission? Why let a broker eliminate a whole class of potential buyers—those who would never consider a property unless it was presented by her trusted outside agent? Is it not possible that an outside buyer would pay the most for the property? Random research resulted in some explanations, if not altogether satisfactory answers. Starting with the big leagues—deals in excess of $100 million—the broker justification for keeping it all has a certain snob appeal: “There are only 200 buyers in the whole country who can do a $100 million deal, and 150 of them don’t have any money,” explained a managing partner at one of the nation’s top real estate investment banks, only half joking. “We personally know every player who can write the check. Adding an outside broker adds nothing but confusion.” But what about some unknown buyer—someone who just won the lottery or inherited $1 billion offshore? Someone controlled by a broker who will never present your deals if there’s nothing in it for him? “Never happens.” But it could.

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MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

Asked if he cared whether his brokers split their commissions with outsiders, a big-league institutional seller replied, “Nope.” Why not? “I’m not worried about finding buyers in a haystack: our listings get plenty of exposure.” Maybe that works in the Bigs. But what about in Double A ball, the $5 million to $20 million range? Just as there are only about a thousand billionaires in the entire world but more than 10 million individual millionaires, there are thousands of players in the minor leagues; no single firm can have meaningful contacts with even a plurality. But that doesn’t stop the nationals—hell, even the little brokers—from going for the whole commission. The surprise is that some sellers, even sophisticated ones, permit it. We encountered one such seller—a notoriously difficult real estate investment trust—in the $15 million sales range. According to the brokers, this seller had squeezed all the juice out of the commission in the first place—leaving nothing to share—and didn’t care about (more likely, never considered) the limiting effect that approach might have on the buyer pool. Maybe that nasty maneuver works; maybe the percent or two the seller saved by screwing its own brokers offset the lost opportunity of an outside buyer. Maybe. A very senior brokerage executive laughed at my question, as if it were about the right cookies to leave Santa on Christmas Eve. “No one ever cooperates. Most agents won’t even cooperate within their own firms: they hide their listings from everyone, even their own mothers. We at least force our brokers to cooperate within the company: an agent is fired if he doesn’t post his new listing on the company server within 24 hours. A seller always gets nationwide exposure with us.” We are all brokers of one stripe or another. We are all selling something to someone all of the time. Is ignoring the following math too much to expect of any of us? A $10 million deal sold directly with a 2.5 percent commission nets the broker $250,000. Flogging the same deal farther and wider and cooperating fully with an outside broker might—just might—bump the price

67 DO AS I SAY 67

22 Do As I Say

The previous chapter ended with questions:Why would a seller ever permit a listing broker to keep 100 percent of a sales commission? Why let a broker eliminate a whole class of potential buyers—those who would never consider a property unless it was presented by her trusted outside agent? Is it not possible that an outside buyer would pay the most for the property? Random research resulted in some explanations, if not altogether satisfactory answers. Starting with the big leagues—deals in excess of $100 million—the broker justification for keeping it all has a certain snob appeal: “There are only 200 buyers in the whole country who can do a $100 million deal, and 150 of them don’t have any money,” explained a managing partner at one of the nation’s top real estate investment banks, only half joking. “We personally know every player who can write the check. Adding an outside broker adds nothing but confusion.” But what about some unknown buyer—someone who just won the lottery or inherited $1 billion offshore? Someone controlled by a broker who will never present your deals if there’s nothing in it for him? “Never happens.” But it could.

66

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

Asked if he cared whether his brokers split their commissions with outsiders, a big-league institutional seller replied, “Nope.” Why not? “I’m not worried about finding buyers in a haystack: our listings get plenty of exposure.” Maybe that works in the Bigs. But what about in Double A ball, the $5 million to $20 million range? Just as there are only about a thousand billionaires in the entire world but more than 10 million individual millionaires, there are thousands of players in the minor leagues; no single firm can have meaningful contacts with even a plurality. But that doesn’t stop the nationals—hell, even the little brokers—from going for the whole commission. The surprise is that some sellers, even sophisticated ones, permit it. We encountered one such seller—a notoriously difficult real estate investment trust—in the $15 million sales range. According to the brokers, this seller had squeezed all the juice out of the commission in the first place—leaving nothing to share—and didn’t care about (more likely, never considered) the limiting effect that approach might have on the buyer pool. Maybe that nasty maneuver works; maybe the percent or two the seller saved by screwing its own brokers offset the lost opportunity of an outside buyer. Maybe. A very senior brokerage executive laughed at my question, as if it were about the right cookies to leave Santa on Christmas Eve. “No one ever cooperates. Most agents won’t even cooperate within their own firms: they hide their listings from everyone, even their own mothers. We at least force our brokers to cooperate within the company: an agent is fired if he doesn’t post his new listing on the company server within 24 hours. A seller always gets nationwide exposure with us.” We are all brokers of one stripe or another. We are all selling something to someone all of the time. Is ignoring the following math too much to expect of any of us? A $10 million deal sold directly with a 2.5 percent commission nets the broker $250,000. Flogging the same deal farther and wider and cooperating fully with an outside broker might—just might—bump the price

67 DO AS I SAY 67

to $10.1 million. This would net the seller an extra $97,500 but, after splitting

23

the commission, reduce the listing broker’s commission to $126,250. With that overwhelming financial incentive as backdrop, any knowledgeable owner should probably reject outright a broker seeking a listing who fails to ask for a keep-it-all clause. If the broker doesn’t have the sense to at least ask for it, how competent can he be? It’s the owner who needs to represent herself on this issue, who must understand the wide divergence of her interests and those of her broker. If you do find yourself thinking about the right cookies for Santa or wondering whether brokers, if left to their own devices, will battle to wrest the

The Back of a Napkin

last dollar for an owner to their own economic detriment, you might consider perusing the section on residential brokers in Freakonomics by Steven Levitt and Stephen Dubner. Their study of 100,000 residential brokers in the Chicago area proves statistically what we already know intuitively: brokers are best at representing themselves. I asked that senior-most brokerage executive if he, acting as a principal, would ever sign a listing agreement in which the broker had no obligation to cooperate. “Never.”

If you begin analyzing sales packages,you will soon encounter properties with numbers so flat, returns so anemic, and projections of future values so childishly optimistic that you may despair of ever finding a decent deal. Don’t. A great deal is rarely great on the first day it is offered to you; no one consciously gives anything away in business. Because great deals are made, not born, you must analyze many properties that make little sense at their asking prices. Why? Because things have a way of changing. If his property languishes long enough on the market, a frustrated seller may become reasonable. In that hope, you underwrite his nonsensical deal today. You decide that at his $10 million asking price, the seller should be institutionalized for delusional insanity, but that at $6 million, the property might work. And then you wait. And wait. More often than not, the seller will pull his property or someone will outbid you, but if you bait enough hooks, a fish will come along. Work listed properties, but ignore the asking prices and decide for yourself their actual values. Then follow their progress on the market, checking in with their brokers every few weeks for updates. You can, by the

68

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

69

to $10.1 million. This would net the seller an extra $97,500 but, after splitting

23

the commission, reduce the listing broker’s commission to $126,250. With that overwhelming financial incentive as backdrop, any knowledgeable owner should probably reject outright a broker seeking a listing who fails to ask for a keep-it-all clause. If the broker doesn’t have the sense to at least ask for it, how competent can he be? It’s the owner who needs to represent herself on this issue, who must understand the wide divergence of her interests and those of her broker. If you do find yourself thinking about the right cookies for Santa or wondering whether brokers, if left to their own devices, will battle to wrest the

The Back of a Napkin

last dollar for an owner to their own economic detriment, you might consider perusing the section on residential brokers in Freakonomics by Steven Levitt and Stephen Dubner. Their study of 100,000 residential brokers in the Chicago area proves statistically what we already know intuitively: brokers are best at representing themselves. I asked that senior-most brokerage executive if he, acting as a principal, would ever sign a listing agreement in which the broker had no obligation to cooperate. “Never.”

If you begin analyzing sales packages,you will soon encounter properties with numbers so flat, returns so anemic, and projections of future values so childishly optimistic that you may despair of ever finding a decent deal. Don’t. A great deal is rarely great on the first day it is offered to you; no one consciously gives anything away in business. Because great deals are made, not born, you must analyze many properties that make little sense at their asking prices. Why? Because things have a way of changing. If his property languishes long enough on the market, a frustrated seller may become reasonable. In that hope, you underwrite his nonsensical deal today. You decide that at his $10 million asking price, the seller should be institutionalized for delusional insanity, but that at $6 million, the property might work. And then you wait. And wait. More often than not, the seller will pull his property or someone will outbid you, but if you bait enough hooks, a fish will come along. Work listed properties, but ignore the asking prices and decide for yourself their actual values. Then follow their progress on the market, checking in with their brokers every few weeks for updates. You can, by the

68

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

69

way, minimize luck’s outsized role in hitting the seller at exactly the right moment by staying in close contact with his broker. If being diligent and dogged in the pursuit of deals is the yin, the yang is

Properly viewed, land value is what you are solving for with your pro forma. You could show a seller that all of the other variables in your equation—save one—are third-party, verifiable costs not subject to much

this: if a deal doesn’t work on the back of a napkin, it doesn’t work. If you can’t

negotiation. If you’re going to build a project on the farmer’s favorite corner,

make sense of those flat numbers and anemic returns with a simple calculator,

you know what your construction, financing, permit, and leasing costs will

you should move on. You need only middle-school arithmetic and a dash of

be, and you should know the rents you will achieve. The one variable subject

algebra to figure out whether a deal works. If you require a quant to get you

to negotiation is the return on investment you are seeking. If, after some back

there, if you need someone to start running net present values to justify the

and forth, the farmer ultimately concedes that your return should be fair (I

price you want to pay today, you’re cooked.

have yet to meet such a farmer), and, let’s say, 7 percent, then his land value

The trope “Figures don’t lie and liars don’t figure” is about half right, and the right half is about half-misleading. Liars do figure. It’s that most are spectacularly bad at it, only plotting a move or two in advance when 10

will follow automatically when you plug the other variables in your formula. Whether the farmer himself follows is another question. Coincidentally, this last point is a great advertisement for dealing with

are required. Yes, numbers are honest in their way—faithfully performing

smart, sophisticated sellers—and better yet, with developers themselves.

whatever mathematical gymnastics you wish—but they can, when

As tough as they may be—you will never steal a property from them—they

underpinned by negligent or fraudulent assumptions, tell the most convincing

understand math and the realities of real estate development, and they may

lies. Figures may not lie, but their assumptions do.

ultimately acquiesce to a fair deal. Farmers, trust fund babies, and school

Bad assumptions are myriad, but real estate has its perennial favorites:

boards do not have this understanding. Instead, they know an acre across town

a listed property’s rents will rise by, say, 5 percent a year in the future while

sold for $30 a square foot five years ago and they want $30 a square foot for their

its expenses remain fixed; a buyer will be able to terminate a below-market,

20 acres now.

long-term lease for nearly nothing; space that hasn’t been occupied since the

In sum, pursue deals hard, but keep them on a napkin.

French Revolution will rent within six months after closing; and, because of a property’s unique characteristics, it will outperform its overall market’s vacancy and rental rates. One false assumption seems at first blush not only benign but also reasonable—namely, that land has an intrinsic value. It doesn’t. This is worth remembering well: whether raw or improved, land has no innate value. Rather, it has a cost. Even with an empty field, you reap property taxes, liability insurance, and periodic fire prevention measures. Land’s only economic value is the income it receives after the costs required to produce that income are paid. If your development pro forma starts out with the seller’s value for his land, you may get there, but likely only by accident. As likely, your equation won’t work because that land value will drive your return through the floor.

70

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

THE BACK OF A NAPKIN 71 71

way, minimize luck’s outsized role in hitting the seller at exactly the right moment by staying in close contact with his broker. If being diligent and dogged in the pursuit of deals is the yin, the yang is

Properly viewed, land value is what you are solving for with your pro forma. You could show a seller that all of the other variables in your equation—save one—are third-party, verifiable costs not subject to much

this: if a deal doesn’t work on the back of a napkin, it doesn’t work. If you can’t

negotiation. If you’re going to build a project on the farmer’s favorite corner,

make sense of those flat numbers and anemic returns with a simple calculator,

you know what your construction, financing, permit, and leasing costs will

you should move on. You need only middle-school arithmetic and a dash of

be, and you should know the rents you will achieve. The one variable subject

algebra to figure out whether a deal works. If you require a quant to get you

to negotiation is the return on investment you are seeking. If, after some back

there, if you need someone to start running net present values to justify the

and forth, the farmer ultimately concedes that your return should be fair (I

price you want to pay today, you’re cooked.

have yet to meet such a farmer), and, let’s say, 7 percent, then his land value

The trope “Figures don’t lie and liars don’t figure” is about half right, and the right half is about half-misleading. Liars do figure. It’s that most are spectacularly bad at it, only plotting a move or two in advance when 10

will follow automatically when you plug the other variables in your formula. Whether the farmer himself follows is another question. Coincidentally, this last point is a great advertisement for dealing with

are required. Yes, numbers are honest in their way—faithfully performing

smart, sophisticated sellers—and better yet, with developers themselves.

whatever mathematical gymnastics you wish—but they can, when

As tough as they may be—you will never steal a property from them—they

underpinned by negligent or fraudulent assumptions, tell the most convincing

understand math and the realities of real estate development, and they may

lies. Figures may not lie, but their assumptions do.

ultimately acquiesce to a fair deal. Farmers, trust fund babies, and school

Bad assumptions are myriad, but real estate has its perennial favorites:

boards do not have this understanding. Instead, they know an acre across town

a listed property’s rents will rise by, say, 5 percent a year in the future while

sold for $30 a square foot five years ago and they want $30 a square foot for their

its expenses remain fixed; a buyer will be able to terminate a below-market,

20 acres now.

long-term lease for nearly nothing; space that hasn’t been occupied since the

In sum, pursue deals hard, but keep them on a napkin.

French Revolution will rent within six months after closing; and, because of a property’s unique characteristics, it will outperform its overall market’s vacancy and rental rates. One false assumption seems at first blush not only benign but also reasonable—namely, that land has an intrinsic value. It doesn’t. This is worth remembering well: whether raw or improved, land has no innate value. Rather, it has a cost. Even with an empty field, you reap property taxes, liability insurance, and periodic fire prevention measures. Land’s only economic value is the income it receives after the costs required to produce that income are paid. If your development pro forma starts out with the seller’s value for his land, you may get there, but likely only by accident. As likely, your equation won’t work because that land value will drive your return through the floor.

70

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

THE BACK OF A NAPKIN 71 71

24

for $400,000, a mere 4 percent of the total project cost. If the project tanks—

else’s money. As a novice, you have financial partners by necessity. Should you

quarterly reports and semiannual trips to New York or Cleveland to explain

No Partners, No Problems

In the beginning, we all need financial partners.The wealthy may use their families and the rest of us our friends, but we start with someone have them by choice later? Once you achieve a certain success, are you better off using your own money and doing fewer and smaller deals, or satisfying your edifice complex with ever-larger financial partners? It’s your call. Both approaches can succeed; both can fail. With few exceptions, the best developers in America have always had capital partners. And the arguments in favor of sticking with outside money are compelling. The first—you can do more and larger projects—needs no commentary. Deals are fun: the more, the merrier. The second is worth considering: having a financial partner is a great way to manage risk. If your partner invests 90 percent of the equity (the usual arrangement) into a partnership in which you have no personal liability, and that partnership’s outside borrowing is also nonrecourse, you can make real money while having very limited risk. Say you’re going to develop a project that costs $10 million and will be worth $13 million on completion, that it requires $4 million in equity, and that a bank will lend your partnership the remaining $6 million on

some do—your loss is only $400,000, but truth be told, you probably charged that much in development fees during construction. Even in a loser, you’re home free. And if it hits, if you sell the project for $13 million, and if you have the typical profit split with your money guy (about a net 30 percent after repayment of all capital and preferred returns), you make about a million. If you had $4 million in the bank, you could do this single project without a financial partner and retain the $3 million profit yourself, or you could theoretically do 10 projects with a financial partner, investing $400,000 in each, and net $10 million. This sounds so good one is reminded of the old joke about the Hollywood producer who went crazy and put his own money into a movie. Why would anyone ever self-fund? Because with no outside partners, you control your own destiny. You keep a property as long as you like or sell it overnight on a hunch. You avoid the fate of your partner’s money. Far more important, you avoid the risk of having someone you have never met wake up one morning and change your life by noon. Dressing in his hotel room, the pension fund chief who committed $2 billion to your financial partner hears on CNN that commercial real estate is starting to bubble. He decides on the spot to cut his exposure and tells his underlings to walk on their commitment. A few hours later, your good buddy—the vice president who until this moment acted like he ran the show— sheepishly announces that you need to either sell the project now or find a new money partner (that nonrecourse language you love in your partnership agreement works both ways: the money partner has no liability if he defaults). When you point out that the building is only 75 percent leased and you will both get creamed, your buddy says he understands. When you whimper that you’re going to lose three years’ worth of work and the chance to make millions, your former buddy hangs up. If you were to receive this call—we did—you might decide to revise your

a nonrecourse basis. Your partner puts up $3.6 million and you write a check

investment strategy. You might decide that in the future you will forgo the

72

73 NO PARTNERS, NO PROBLEMS 73

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

24

for $400,000, a mere 4 percent of the total project cost. If the project tanks—

else’s money. As a novice, you have financial partners by necessity. Should you

quarterly reports and semiannual trips to New York or Cleveland to explain

No Partners, No Problems

In the beginning, we all need financial partners.The wealthy may use their families and the rest of us our friends, but we start with someone have them by choice later? Once you achieve a certain success, are you better off using your own money and doing fewer and smaller deals, or satisfying your edifice complex with ever-larger financial partners? It’s your call. Both approaches can succeed; both can fail. With few exceptions, the best developers in America have always had capital partners. And the arguments in favor of sticking with outside money are compelling. The first—you can do more and larger projects—needs no commentary. Deals are fun: the more, the merrier. The second is worth considering: having a financial partner is a great way to manage risk. If your partner invests 90 percent of the equity (the usual arrangement) into a partnership in which you have no personal liability, and that partnership’s outside borrowing is also nonrecourse, you can make real money while having very limited risk. Say you’re going to develop a project that costs $10 million and will be worth $13 million on completion, that it requires $4 million in equity, and that a bank will lend your partnership the remaining $6 million on

some do—your loss is only $400,000, but truth be told, you probably charged that much in development fees during construction. Even in a loser, you’re home free. And if it hits, if you sell the project for $13 million, and if you have the typical profit split with your money guy (about a net 30 percent after repayment of all capital and preferred returns), you make about a million. If you had $4 million in the bank, you could do this single project without a financial partner and retain the $3 million profit yourself, or you could theoretically do 10 projects with a financial partner, investing $400,000 in each, and net $10 million. This sounds so good one is reminded of the old joke about the Hollywood producer who went crazy and put his own money into a movie. Why would anyone ever self-fund? Because with no outside partners, you control your own destiny. You keep a property as long as you like or sell it overnight on a hunch. You avoid the fate of your partner’s money. Far more important, you avoid the risk of having someone you have never met wake up one morning and change your life by noon. Dressing in his hotel room, the pension fund chief who committed $2 billion to your financial partner hears on CNN that commercial real estate is starting to bubble. He decides on the spot to cut his exposure and tells his underlings to walk on their commitment. A few hours later, your good buddy—the vice president who until this moment acted like he ran the show— sheepishly announces that you need to either sell the project now or find a new money partner (that nonrecourse language you love in your partnership agreement works both ways: the money partner has no liability if he defaults). When you point out that the building is only 75 percent leased and you will both get creamed, your buddy says he understands. When you whimper that you’re going to lose three years’ worth of work and the chance to make millions, your former buddy hangs up. If you were to receive this call—we did—you might decide to revise your

a nonrecourse basis. Your partner puts up $3.6 million and you write a check

investment strategy. You might decide that in the future you will forgo the

72

73 NO PARTNERS, NO PROBLEMS 73

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

glamour of owning a minuscule interest in a sleek high-rise and instead buy

the flaw in the assumption in the ramped-up production model just described:

a corner gas station on your own. You might decide that having a measure of

you cannot find 10 good deals as readily as one. Rather than diversifying your

control over your life outweighs the benefits of big-time financial partners.

risks, pushing deal quotas intensifies them.

No one from Cleveland will ever call you about your Arco. No one will insist you sell when it’s lunacy to do so or, conversely, refuse to consider a sale in the

A more accurate but less catchy title for this chapter might be “No Partners, More Control.”

hottest market ever. You don’t need a bad financial partner for problems to arise. You could have the best, kindest, most reasonable and intelligent money partner and still develop a serious conflict of interest. And it could be your fault. You and Mother Teresa could jointly decide on day one that you will hold your project for 10 years. Two years later, you could be desperate—your wife dumped you, your other project went bankrupt, whatever—and need to cash out. Mother sweetly explains that a deal is a deal and that she’s neither going to sell the project nor buy you out. She’s content, and you are screwed. Against this backdrop, our experience may be of some use. When we started out years ago, we had institutional money partners. Some were good, some bad—one was a downright scorpion—but they invariably, and understandably, did what was best for themselves. And if that meant crushing us like an empty can, they might have murmured the right things, but they still flattened us. We left the financial partner world in the early 1990s, moving from large deals in joint ventures to projects one-10th the size without money partners, using our own limited capital. That decision has worked out. Over time, we have averaged a couple of projects a year and, to generate capital for our next project, we have typically sold—or better yet, 1031 exchanged—two out of three completed properties. To our mild surprise, we found we had netted as much from these small, 100 percent–owned projects as we would have in splitting profits multiple ways in big-city joint ventures. And with fewer headaches. For what it’s worth, we have consistently found that the constraint—or bottleneck—in successful development is not the lack of capital but of highquality projects. Great deals are truly few and far between. And therein lies

74

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

NO PARTNERS, NO PROBLEMS 75

glamour of owning a minuscule interest in a sleek high-rise and instead buy

the flaw in the assumption in the ramped-up production model just described:

a corner gas station on your own. You might decide that having a measure of

you cannot find 10 good deals as readily as one. Rather than diversifying your

control over your life outweighs the benefits of big-time financial partners.

risks, pushing deal quotas intensifies them.

No one from Cleveland will ever call you about your Arco. No one will insist you sell when it’s lunacy to do so or, conversely, refuse to consider a sale in the

A more accurate but less catchy title for this chapter might be “No Partners, More Control.”

hottest market ever. You don’t need a bad financial partner for problems to arise. You could have the best, kindest, most reasonable and intelligent money partner and still develop a serious conflict of interest. And it could be your fault. You and Mother Teresa could jointly decide on day one that you will hold your project for 10 years. Two years later, you could be desperate—your wife dumped you, your other project went bankrupt, whatever—and need to cash out. Mother sweetly explains that a deal is a deal and that she’s neither going to sell the project nor buy you out. She’s content, and you are screwed. Against this backdrop, our experience may be of some use. When we started out years ago, we had institutional money partners. Some were good, some bad—one was a downright scorpion—but they invariably, and understandably, did what was best for themselves. And if that meant crushing us like an empty can, they might have murmured the right things, but they still flattened us. We left the financial partner world in the early 1990s, moving from large deals in joint ventures to projects one-10th the size without money partners, using our own limited capital. That decision has worked out. Over time, we have averaged a couple of projects a year and, to generate capital for our next project, we have typically sold—or better yet, 1031 exchanged—two out of three completed properties. To our mild surprise, we found we had netted as much from these small, 100 percent–owned projects as we would have in splitting profits multiple ways in big-city joint ventures. And with fewer headaches. For what it’s worth, we have consistently found that the constraint—or bottleneck—in successful development is not the lack of capital but of highquality projects. Great deals are truly few and far between. And therein lies

74

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

NO PARTNERS, NO PROBLEMS 75

25 The “NTM”

Properly constructed, primers shouldbe sequenced in terms of importance. The first chapter should contain the writer’s best advice; the next, his second best; and so on. Skewing this time-honored rule slightly, we arrive at this primer’s midpoint and my best advice—the “NTM.” Having read my dismissal of the IRR as little more than the bent cards of three-card monte and my questioning of the ROI’s utility when used as a long-range predictive tool, the close reader may express skepticism over my unqualified endorsement of the NTM. But here you have it: if you learn nothing else from this extended epistle, learn the NTM. The immutable laws that govern the universe are often breathtakingly elegant in their simplicity—consider Newton and Einstein—and it is thus with the first law of real estate. What is the NTM? Rather than a formula, it is the touchstone question you should ask yourself every time you consider a deal, take a job, or enter a partnership. If asked and answered, it will detour you away from countless financial culs-de-sac. What is it? Simply this: “the Net to Me.” Phrased as a question, this is the most powerful tool in your shed. If, for example, you plumb its depths before you accept a job, you could save yourself a world of regret. Assume

76

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

that potential employers offer you $150,000 a year in salary plus 10 percent of the profits in the projects they wish you to develop for them. They tell you their apartment communities cost $85 million to build and, when all goes reasonably well, sell for $100 million. The math is simple: 10 percent of $15 million is a small fortune, and you’re ecstatic. But moments before you sign the employment contract, you remember this chapter and how even the mightiest numbers are humbled when repeatedly divided by two. You recall the famous anecdote I mentioned about the billionaire founder of a national retail chain. This distinguished gentlemen had a penchant for young wives who refused to sign prenuptial agreements. You remember that by the time his fourth wife divorced him, his billion-dollar net worth had been sliced in half four times and was down to $60 million. Remembering all this, you ask, “But what’s the net to me?” You inquire how their projects are financed, insisting on knowing how much profit actually trickles all the way to the sea. You learn that these developers have an internal money partner who funds their overhead and predevelopment costs; in return, he receives 50 percent of the net profits. You discover that the company takes on an outside financial partner for each project once it’s entitled; with its preferential returns, the outside partner receives about 70 percent of the net profit. You take the $15 million profit you first envisioned and allocate 70 percent to the outside money and then half of the remainder to the inside guy. You calculate that, even if the sailing is smooth, your NTM will not be $1.5 million, but rather $225,000. You note that simply cutting the pie twice reduces your 10 percent slice to 1.5 percent. The modest silver lining (if you’re a developer at heart, you are always searching for silver linings) in having only 1.5 percent of a deal is that profits must implode before you feel it—a $1 million construction cost overrun will only sting you for $15,000. Like Einstein, the NTM recognizes time as the fourth dimension. In the example, you solved for space—your total compensation—but, fully applied, you also solve for time, your hourly rate. If someone told Bill Gates he merely needed to cross the street to pick up that $225,000 on the curb, he would probably do it in a flash, having an hourly rate approaching infinity.

THE "NTM" 77

25 The “NTM”

Properly constructed, primers shouldbe sequenced in terms of importance. The first chapter should contain the writer’s best advice; the next, his second best; and so on. Skewing this time-honored rule slightly, we arrive at this primer’s midpoint and my best advice—the “NTM.” Having read my dismissal of the IRR as little more than the bent cards of three-card monte and my questioning of the ROI’s utility when used as a long-range predictive tool, the close reader may express skepticism over my unqualified endorsement of the NTM. But here you have it: if you learn nothing else from this extended epistle, learn the NTM. The immutable laws that govern the universe are often breathtakingly elegant in their simplicity—consider Newton and Einstein—and it is thus with the first law of real estate. What is the NTM? Rather than a formula, it is the touchstone question you should ask yourself every time you consider a deal, take a job, or enter a partnership. If asked and answered, it will detour you away from countless financial culs-de-sac. What is it? Simply this: “the Net to Me.” Phrased as a question, this is the most powerful tool in your shed. If, for example, you plumb its depths before you accept a job, you could save yourself a world of regret. Assume

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that potential employers offer you $150,000 a year in salary plus 10 percent of the profits in the projects they wish you to develop for them. They tell you their apartment communities cost $85 million to build and, when all goes reasonably well, sell for $100 million. The math is simple: 10 percent of $15 million is a small fortune, and you’re ecstatic. But moments before you sign the employment contract, you remember this chapter and how even the mightiest numbers are humbled when repeatedly divided by two. You recall the famous anecdote I mentioned about the billionaire founder of a national retail chain. This distinguished gentlemen had a penchant for young wives who refused to sign prenuptial agreements. You remember that by the time his fourth wife divorced him, his billion-dollar net worth had been sliced in half four times and was down to $60 million. Remembering all this, you ask, “But what’s the net to me?” You inquire how their projects are financed, insisting on knowing how much profit actually trickles all the way to the sea. You learn that these developers have an internal money partner who funds their overhead and predevelopment costs; in return, he receives 50 percent of the net profits. You discover that the company takes on an outside financial partner for each project once it’s entitled; with its preferential returns, the outside partner receives about 70 percent of the net profit. You take the $15 million profit you first envisioned and allocate 70 percent to the outside money and then half of the remainder to the inside guy. You calculate that, even if the sailing is smooth, your NTM will not be $1.5 million, but rather $225,000. You note that simply cutting the pie twice reduces your 10 percent slice to 1.5 percent. The modest silver lining (if you’re a developer at heart, you are always searching for silver linings) in having only 1.5 percent of a deal is that profits must implode before you feel it—a $1 million construction cost overrun will only sting you for $15,000. Like Einstein, the NTM recognizes time as the fourth dimension. In the example, you solved for space—your total compensation—but, fully applied, you also solve for time, your hourly rate. If someone told Bill Gates he merely needed to cross the street to pick up that $225,000 on the curb, he would probably do it in a flash, having an hourly rate approaching infinity.

THE "NTM" 77

If, however, your prospective employer agreed that you could have the whole $1.5 million you first envisioned, but allowed as how it might take 20 years of cankerous neighborhood meetings (we had a project take that long), you might politely decline. After a score of public hearings lasting until midnight, your hourly rate would certainly feel far less than the minimum wage. Time is your most important dimension. In considering your NTM, solve for your hourly rate. How long is this going to take? How much of my life must I devote to this project? And in doing so, ponder the advice a sage contractor gave a homeowner about her proposed remodel: “It will cost twice as much and take three times as long as you initially believe.” If a job offer is appealing to you, if a deal makes sense to you, if a tough listing is yours for taking, go for it, but determine your NTM first. Know where your potential income caps out, have a feel for your hourly rate, and avoid the heartache and hard feelings that inevitably accompany unpleasant financial surprises.

26

Understating Your Net Worth

A salaried employee knows his NTM like his drive home from work: he sees it every two weeks on his pay stub. On the other hand, an entrepreneur,

If you’re in real estate,if you’re developing or simply investing in property,

someone who risks what little capital she has and a couple years of her life on

you’re in the business of borrowing money. And if you’re a serial borrower, you

a project, should know what she can earn if the deal works out. She should

have a chore to do every January: you must prepare your personal financial

be able to scribble on the back of a napkin what she stands to gain in one column and weigh it against another in which she lists what she’s giving up— her salary, her medical benefits, her job security, and time with her family. Without a realistic understanding of her upside, her decision to become a developer could prove so flawed that she regrets it ever after. Although this advice is self-evident, it’s worth underscoring. Why? Because we have heard too many times from friends and acquaintances about how their career-launching projects were in the end bitter disappointments. Disappointments that, in our view, could have been anticipated from miles off—the profit share was suspect from the beginning—and that might have been avoided altogether by a judicious application of the NTM. In sum, make sure the prize is worth the leap.

statement for your bankers. Unlike the reporting requirements for public companies, financial statements for individuals are simple—a balance sheet that lists all liabilities and assets, and deducts the one from the other, thereby producing a statement of net worth. Broadly stated, real estate liabilities are as objective as your body temperature; reporting them is easy, a matter of faithfully recording numbers. If you list the year-end balances on all your commercial and private loans, credit cards, taxes due, etc., you’re home free. Besides, you might as well be accurate and complete: loan balances are easy to verify by curious credit departments. Assets are another story. Valuing property is more subjective than judging a cake-baking contest. Think about it: appraisers use three different approaches to evaluate a commercial property—replacement cost, income capitalization, and comparable sales. While less voodoo than, say, oh, psychology or economics, appraising is still as much art as science. Frank appraisers will admit their

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79

If, however, your prospective employer agreed that you could have the whole $1.5 million you first envisioned, but allowed as how it might take 20 years of cankerous neighborhood meetings (we had a project take that long), you might politely decline. After a score of public hearings lasting until midnight, your hourly rate would certainly feel far less than the minimum wage. Time is your most important dimension. In considering your NTM, solve for your hourly rate. How long is this going to take? How much of my life must I devote to this project? And in doing so, ponder the advice a sage contractor gave a homeowner about her proposed remodel: “It will cost twice as much and take three times as long as you initially believe.” If a job offer is appealing to you, if a deal makes sense to you, if a tough listing is yours for taking, go for it, but determine your NTM first. Know where your potential income caps out, have a feel for your hourly rate, and avoid the heartache and hard feelings that inevitably accompany unpleasant financial surprises.

26

Understating Your Net Worth

A salaried employee knows his NTM like his drive home from work: he sees it every two weeks on his pay stub. On the other hand, an entrepreneur,

If you’re in real estate,if you’re developing or simply investing in property,

someone who risks what little capital she has and a couple years of her life on

you’re in the business of borrowing money. And if you’re a serial borrower, you

a project, should know what she can earn if the deal works out. She should

have a chore to do every January: you must prepare your personal financial

be able to scribble on the back of a napkin what she stands to gain in one column and weigh it against another in which she lists what she’s giving up— her salary, her medical benefits, her job security, and time with her family. Without a realistic understanding of her upside, her decision to become a developer could prove so flawed that she regrets it ever after. Although this advice is self-evident, it’s worth underscoring. Why? Because we have heard too many times from friends and acquaintances about how their career-launching projects were in the end bitter disappointments. Disappointments that, in our view, could have been anticipated from miles off—the profit share was suspect from the beginning—and that might have been avoided altogether by a judicious application of the NTM. In sum, make sure the prize is worth the leap.

statement for your bankers. Unlike the reporting requirements for public companies, financial statements for individuals are simple—a balance sheet that lists all liabilities and assets, and deducts the one from the other, thereby producing a statement of net worth. Broadly stated, real estate liabilities are as objective as your body temperature; reporting them is easy, a matter of faithfully recording numbers. If you list the year-end balances on all your commercial and private loans, credit cards, taxes due, etc., you’re home free. Besides, you might as well be accurate and complete: loan balances are easy to verify by curious credit departments. Assets are another story. Valuing property is more subjective than judging a cake-baking contest. Think about it: appraisers use three different approaches to evaluate a commercial property—replacement cost, income capitalization, and comparable sales. While less voodoo than, say, oh, psychology or economics, appraising is still as much art as science. Frank appraisers will admit their

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79

methodologies are wormholed with judgment calls. And because they’re

you posted a couple of years ago is now a mere $10 million—your hurting spouse

working for the lenders, these professionals have zero interest in overvaluing

won’t believe a word, and the already ugly process will only get worse. You will

your buildings. While they usually come up with a value that won’t kill the deal,

be faced with answering that age-old legal question, “Were you lying then or are

they seldom give you a penny more than you need. Properly viewed, there’s a

you lying now?” This has happened to two of my friends.

distinct upside to this: if you use your lender’s appraised value for your assets,

I asked a friend whose net worth starts with a “b” how he values his

neither your judgment nor honesty is likely to be questioned. In short, that

buildings on his financial statement. He said he lists his properties at their

third-party appraisal provides a safe harbor for your valuations.

depreciated book value, regardless of their current market value. This approach

One could posit that every investor in America is hell-bent on growing

means that if he bought an office building 30 years ago for, say, $1 million,

her net worth every year and that the easiest way to do this is to goose her

he reports it today on his financial statement at $500,000 to account for his

numbers a little bit (as opposed to developing a successful new project). As with

depreciation—even though the building’s fair market value may be $20 million.

the millions who subtract pounds and add inches to their dating-site profiles,

This is the financial statement equivalent of Jeff Bezos flying standby on JetBlue.

it’s tempting to push values. You can select a property value that can only be

While marveling at this approach’s jaw-dropping conservatism, I pointed out

achieved—like summiting Everest—at a brief moment in time; that may not be

that he could never figure out his net worth from such a statement. He replied,

outright fraud, but it’s still kind of dumb.

“If you know how rich you are, you’re not that rich.”

Why? Your bankers are smart. If they think you’re B.S.-ing them on simple reporting requirements, how much are they going to trust you when the tide goes out? What do we do with our financial statements? We carry our properties at the bank-appraised values until long after the original appraisals have become meaningless. And when we do eventually abandon outdated appraisals, we value our properties based on a capitalization rate worse (by about 100 to 125 basis points) than the market rate. That is, we undervalue our properties. (My longtime partner Mike Powers gets all the credit for this approach.) This fiscal conservatism has a couple of obvious benefits and one obscure one that hopefully you’ll never enjoy. First, nothing makes a banker feel cozier than a lowball valuation. Second, when the next recession arrives, you won’t have to whack your net worth by 10 to 20 percent, because you’ve already baked that nasty dip into your numbers. Finally, if there’s the slightest chance you might divorce someday, consider this: if you plant your financial statement atop Mount Everest, your spouse’s divorce lawyer will wave that statement in court and demand half. When you say, “Whoa”—the market crashed, the recession hit, that $25 million net worth

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UNDERSTATING YOUR NET WORTH 81

methodologies are wormholed with judgment calls. And because they’re

you posted a couple of years ago is now a mere $10 million—your hurting spouse

working for the lenders, these professionals have zero interest in overvaluing

won’t believe a word, and the already ugly process will only get worse. You will

your buildings. While they usually come up with a value that won’t kill the deal,

be faced with answering that age-old legal question, “Were you lying then or are

they seldom give you a penny more than you need. Properly viewed, there’s a

you lying now?” This has happened to two of my friends.

distinct upside to this: if you use your lender’s appraised value for your assets,

I asked a friend whose net worth starts with a “b” how he values his

neither your judgment nor honesty is likely to be questioned. In short, that

buildings on his financial statement. He said he lists his properties at their

third-party appraisal provides a safe harbor for your valuations.

depreciated book value, regardless of their current market value. This approach

One could posit that every investor in America is hell-bent on growing

means that if he bought an office building 30 years ago for, say, $1 million,

her net worth every year and that the easiest way to do this is to goose her

he reports it today on his financial statement at $500,000 to account for his

numbers a little bit (as opposed to developing a successful new project). As with

depreciation—even though the building’s fair market value may be $20 million.

the millions who subtract pounds and add inches to their dating-site profiles,

This is the financial statement equivalent of Jeff Bezos flying standby on JetBlue.

it’s tempting to push values. You can select a property value that can only be

While marveling at this approach’s jaw-dropping conservatism, I pointed out

achieved—like summiting Everest—at a brief moment in time; that may not be

that he could never figure out his net worth from such a statement. He replied,

outright fraud, but it’s still kind of dumb.

“If you know how rich you are, you’re not that rich.”

Why? Your bankers are smart. If they think you’re B.S.-ing them on simple reporting requirements, how much are they going to trust you when the tide goes out? What do we do with our financial statements? We carry our properties at the bank-appraised values until long after the original appraisals have become meaningless. And when we do eventually abandon outdated appraisals, we value our properties based on a capitalization rate worse (by about 100 to 125 basis points) than the market rate. That is, we undervalue our properties. (My longtime partner Mike Powers gets all the credit for this approach.) This fiscal conservatism has a couple of obvious benefits and one obscure one that hopefully you’ll never enjoy. First, nothing makes a banker feel cozier than a lowball valuation. Second, when the next recession arrives, you won’t have to whack your net worth by 10 to 20 percent, because you’ve already baked that nasty dip into your numbers. Finally, if there’s the slightest chance you might divorce someday, consider this: if you plant your financial statement atop Mount Everest, your spouse’s divorce lawyer will wave that statement in court and demand half. When you say, “Whoa”—the market crashed, the recession hit, that $25 million net worth

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UNDERSTATING YOUR NET WORTH 81

27

Leaseholds: Buy ’Em Where They Ain’t

In their heyday, New York hedge funds were famous for hiring physicists to analyze financial statements. They tasked their rocket scientists with combing through terabytes of data to find mispriced assets and risk anomalies— irregularities in pricing from which they could profit. This worked . . . a little. The problem was that, despite its occasional stampeding-herd blunders, Wall Street is really good with money. It’s efficient. Thus, finding underpriced assets was—and is—a challenge, even for the brightest of these ivory-tower quants. And once found, the mispriced golden seam usually played out overnight as everyone else jumped in on the action. Real estate is a different story. It’s more quaint than quant. Inefficiencies abound. In any given sale, one side knows far more about a property’s pluses or perils than the other. Inside information that would send you to Riker’s Island if you bought the stock can make you a legal fortune in real estate. If a CEO privately tells you his company is tanking, you’re redecorating your jail cell if you dump your shares of stock. But if you’re his landlord and sell his headquarters instead, you just saved yourself a fortune. For better or worse, a

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shrewd seller can throw an “as is” clause or two into his sales contract and hide a world of sins behind “buyer beware.” Even when a market anomaly is widely known in real estate, it can persist for generations. Hell, it can last forever. That brings us to leaseholds. If you own real estate outright, if you have title to the ground, you own it in fee simple. If, rather than own the ground, you lease it for any number of years (up to 999 years in London), you have a leasehold or ground lease. With a leasehold, you keep all the rent from the property’s tenants, but in turn pay rent to the underlying landowner and—here’s the rub—you give the property back to your landlord when your ground lease expires. She keeps any buildings or improvements you built on her land, and you walk away with nothing. Admittedly, this walk-away-with-nothing aspect to ground leases is not the happiest of endings. It feels like some nihilistic French movie where one desiccated smoker is left pondering everyone else’s ruin. This doomed finale means that almost everyone hates leaseholds; almost nobody buys them. From sophisticated institutional buyers to a rookie trying to snare her first duplex, very few people want a leasehold, even if it has 50 years of remaining term. This antipathy means that an asset will often sell more cheaply than it should if it’s a leasehold. In theory, a leasehold should trade for a return on investment—or capitalization rate—high enough to pay its buyer the same return a fee-simple buyer would receive plus a premium: namely, the amount necessary to repay the buyer his original investment over the leasehold’s remaining term. The reasoning behind this premium is straightforward: a leasehold is in essence an amortizing loan. And just as a lender must get her interest and principal repaid over the course of her loan, a leaseholder must be fully repaid his original investment before his personal French movie ends. On Wall Street, that leasehold premium would likely be calculated to the penny: the Street would pay the bargained-for return plus the necessary amortization and nothing more. On Main Street, real life is seldom so efficient. In fact, leaseholds typically trade for a return on investment about 2 percentage points higher than their fee-simple counterpart. And, on occasion, much higher.

LEASEHOLDS: BUY 'EM WHERE THEY AIN'T 83

27

Leaseholds: Buy ’Em Where They Ain’t

In their heyday, New York hedge funds were famous for hiring physicists to analyze financial statements. They tasked their rocket scientists with combing through terabytes of data to find mispriced assets and risk anomalies— irregularities in pricing from which they could profit. This worked . . . a little. The problem was that, despite its occasional stampeding-herd blunders, Wall Street is really good with money. It’s efficient. Thus, finding underpriced assets was—and is—a challenge, even for the brightest of these ivory-tower quants. And once found, the mispriced golden seam usually played out overnight as everyone else jumped in on the action. Real estate is a different story. It’s more quaint than quant. Inefficiencies abound. In any given sale, one side knows far more about a property’s pluses or perils than the other. Inside information that would send you to Riker’s Island if you bought the stock can make you a legal fortune in real estate. If a CEO privately tells you his company is tanking, you’re redecorating your jail cell if you dump your shares of stock. But if you’re his landlord and sell his headquarters instead, you just saved yourself a fortune. For better or worse, a

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MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

shrewd seller can throw an “as is” clause or two into his sales contract and hide a world of sins behind “buyer beware.” Even when a market anomaly is widely known in real estate, it can persist for generations. Hell, it can last forever. That brings us to leaseholds. If you own real estate outright, if you have title to the ground, you own it in fee simple. If, rather than own the ground, you lease it for any number of years (up to 999 years in London), you have a leasehold or ground lease. With a leasehold, you keep all the rent from the property’s tenants, but in turn pay rent to the underlying landowner and—here’s the rub—you give the property back to your landlord when your ground lease expires. She keeps any buildings or improvements you built on her land, and you walk away with nothing. Admittedly, this walk-away-with-nothing aspect to ground leases is not the happiest of endings. It feels like some nihilistic French movie where one desiccated smoker is left pondering everyone else’s ruin. This doomed finale means that almost everyone hates leaseholds; almost nobody buys them. From sophisticated institutional buyers to a rookie trying to snare her first duplex, very few people want a leasehold, even if it has 50 years of remaining term. This antipathy means that an asset will often sell more cheaply than it should if it’s a leasehold. In theory, a leasehold should trade for a return on investment—or capitalization rate—high enough to pay its buyer the same return a fee-simple buyer would receive plus a premium: namely, the amount necessary to repay the buyer his original investment over the leasehold’s remaining term. The reasoning behind this premium is straightforward: a leasehold is in essence an amortizing loan. And just as a lender must get her interest and principal repaid over the course of her loan, a leaseholder must be fully repaid his original investment before his personal French movie ends. On Wall Street, that leasehold premium would likely be calculated to the penny: the Street would pay the bargained-for return plus the necessary amortization and nothing more. On Main Street, real life is seldom so efficient. In fact, leaseholds typically trade for a return on investment about 2 percentage points higher than their fee-simple counterpart. And, on occasion, much higher.

LEASEHOLDS: BUY 'EM WHERE THEY AIN'T 83

Here’s a simplified example of what the 2 percent discount will do for your economics: A great office building with an annual income of $1 million would sell today for, say, $20 million—i.e., at a 5 percent capitalization rate. Put another way, you’d get a 5 percent annual return on your $20 million if you were to buy the building. To keep it simple, let’s assume you paid cash for the property, that

our investment. When you get your entire investment back in two years, do you really care if you only have 11 years left of pure profits? You shouldn’t. Of course, it’s more complicated than this, but the point is that by seeking investments others shun, you can do quite well. “Wee Willie” Keeler’s famous advice to baseball batters—“Hit ’em where they ain’t”—applies just as well to real estate. Buy ’em where they ain’t.

its income neither increases nor decreases over 50 years, and that it’s still worth the $20 million you paid (in inflation-adjusted dollars) 50 years from now. Take that same office building with the same $1 million income, but sell it subject to a 50-year ground lease—thus, at a 7 percent return—and its price drops to $14.3 million. If you treat the $14.3 million purchase price as a loan to be repaid and repay yourself on a fully amortizing basis over 30 years with interest at 5 percent, your annual payments would be $920,265. This means that not only would you be making a greater annual return than the fee-simple owner from day one—about 5.3 percent on your investment—but that you would have recouped your entire investment in the property by the end of the 30th year. All this while, the fee-simple owner still has his $20 million invested in the building. This in turn means that the annual $1 million cash flow in years 30 to 50 still represents a 5 percent return to the fee-simple owner, but an infinite return to you, the leaseholder, because you then have zero invested in the deal. Yes, the fee buyer (more accurately, her grandchildren) would still own the property at the end of the 50 years. But the leaseholder would have been free to reinvest his repaid $14.3 million decades earlier. And if you want to see how quickly a number can shrink, calculate the present value of $20 million paid 50 years from now. If you discount it at that same 5 percent rate of return, that far, far away $20 million is worth a mere $1,744,075 today. Finally, as alluded to earlier, the discount for leaseholds, particularly in the last 10 to 15 years of their terms, can be staggering. We bought a leasehold that had 13 years left to run. It was a small retail shop building that, with a minimum amount of re-leasing, produced an annual return of 50 percent on

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LEASEHOLDS: BUY 'EM WHERE THEY AIN'T 85

Here’s a simplified example of what the 2 percent discount will do for your economics: A great office building with an annual income of $1 million would sell today for, say, $20 million—i.e., at a 5 percent capitalization rate. Put another way, you’d get a 5 percent annual return on your $20 million if you were to buy the building. To keep it simple, let’s assume you paid cash for the property, that

our investment. When you get your entire investment back in two years, do you really care if you only have 11 years left of pure profits? You shouldn’t. Of course, it’s more complicated than this, but the point is that by seeking investments others shun, you can do quite well. “Wee Willie” Keeler’s famous advice to baseball batters—“Hit ’em where they ain’t”—applies just as well to real estate. Buy ’em where they ain’t.

its income neither increases nor decreases over 50 years, and that it’s still worth the $20 million you paid (in inflation-adjusted dollars) 50 years from now. Take that same office building with the same $1 million income, but sell it subject to a 50-year ground lease—thus, at a 7 percent return—and its price drops to $14.3 million. If you treat the $14.3 million purchase price as a loan to be repaid and repay yourself on a fully amortizing basis over 30 years with interest at 5 percent, your annual payments would be $920,265. This means that not only would you be making a greater annual return than the fee-simple owner from day one—about 5.3 percent on your investment—but that you would have recouped your entire investment in the property by the end of the 30th year. All this while, the fee-simple owner still has his $20 million invested in the building. This in turn means that the annual $1 million cash flow in years 30 to 50 still represents a 5 percent return to the fee-simple owner, but an infinite return to you, the leaseholder, because you then have zero invested in the deal. Yes, the fee buyer (more accurately, her grandchildren) would still own the property at the end of the 50 years. But the leaseholder would have been free to reinvest his repaid $14.3 million decades earlier. And if you want to see how quickly a number can shrink, calculate the present value of $20 million paid 50 years from now. If you discount it at that same 5 percent rate of return, that far, far away $20 million is worth a mere $1,744,075 today. Finally, as alluded to earlier, the discount for leaseholds, particularly in the last 10 to 15 years of their terms, can be staggering. We bought a leasehold that had 13 years left to run. It was a small retail shop building that, with a minimum amount of re-leasing, produced an annual return of 50 percent on

84

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

LEASEHOLDS: BUY 'EM WHERE THEY AIN'T 85

28

Your Empire: Build It or Buy It?

“What’s your strategy in allocating capital between buying finished projects and doing development deals? What percentage of each do you buy?”

not all the contributed capital was ultimately repaid. Forget about tax breaks, fees, or interest; just a bright-line test: was the equity returned? Using this criterion, we had five losers, four of which were development deals and one a leased office building. This means our failure rate for both approaches was identical: 7 percent of both our developments and our existing buildings were losers. It’s worth noting that all our failures had occurred by 2000, suggesting we became better at developing over time.* One conclusion from our improving fortunes might be this: the day you no longer have to do deals, the day your livelihood isn’t dependent on the fees from your next deal, is the day your batting average jumps a couple hundred points. Then I turned the analysis upside down and solved for our 10 best deals. Interestingly, our big winners were evenly divided between building new and buying finished. Because a development deal can require 100 times the effort of buying a leased project, you might infer that you should spend your time chasing existing buildings rather than running multiyear marathons getting dirt lots entitled, designed, built, and leased. But our experience has also been that finding great deals among

someone asked me at a ULI conference. Flustered, I had to admit that not only

existing buildings is an order of magnitude more difficult than finding solid

didn’t we have a strategy, we’d given it so little thought that I had no idea how

developments. Why? Because everyone wants a piece of cake. The easier an asset

many of each we’d done. I explained that we simply bought the deals we liked

is to underwrite, the fewer its risks—the higher its price. Of those 14 properties

as they came along. He seemed satisfied with that, but I was left wondering

we purchased, 10 were effectively off-market. They found us. They’d either

about my unexamined belief—and oft-stated tagline—that the only way to make

been listed so long the world had forgotten them, or they had challenges beyond

lasting money in real estate is to add value, to be a real developer.

the abilities of neophytes or the attention span of the bigger, volume-driven

The funny thing about unexamined beliefs (eating carrots improves your

players. And just as our losers came early in our career, these winners came late.

eyesight) is that they can crumble like Middle Kingdom papyrus upon the

Why? Because great deals usually start with a great purchase. And how do you

least scrutiny.

pull that off? You step up and close for cash with a very short escrow—a tactic

I checked our records. Since 1983, we’ve done about 70 deals. Fifty-six of those—80 percent—were development projects, either ground-ups or major renovations. And we bought 14 finished, fully leased properties.

beyond a beginner’s reach. In hindsight, our failure to strategically allocate our equity between building and buying cost us nothing and may have been a boon. If we’d stuck

Based on this tiny sampling, I tried to determine—for us at least—whether one tactic was better, whether one was safer or more profitable, which had more losers. For this purpose, I assumed that a loser was a project in which

* My partners would like me to point out that no “friends and family” investor ever lost a nickel with us. In the 1980s, it was institutional money; by the ’90s, we’d stopped using outside money, and the losses were ours alone. Nor has any lender ever gone after us.

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28

Your Empire: Build It or Buy It?

“What’s your strategy in allocating capital between buying finished projects and doing development deals? What percentage of each do you buy?”

not all the contributed capital was ultimately repaid. Forget about tax breaks, fees, or interest; just a bright-line test: was the equity returned? Using this criterion, we had five losers, four of which were development deals and one a leased office building. This means our failure rate for both approaches was identical: 7 percent of both our developments and our existing buildings were losers. It’s worth noting that all our failures had occurred by 2000, suggesting we became better at developing over time.* One conclusion from our improving fortunes might be this: the day you no longer have to do deals, the day your livelihood isn’t dependent on the fees from your next deal, is the day your batting average jumps a couple hundred points. Then I turned the analysis upside down and solved for our 10 best deals. Interestingly, our big winners were evenly divided between building new and buying finished. Because a development deal can require 100 times the effort of buying a leased project, you might infer that you should spend your time chasing existing buildings rather than running multiyear marathons getting dirt lots entitled, designed, built, and leased. But our experience has also been that finding great deals among

someone asked me at a ULI conference. Flustered, I had to admit that not only

existing buildings is an order of magnitude more difficult than finding solid

didn’t we have a strategy, we’d given it so little thought that I had no idea how

developments. Why? Because everyone wants a piece of cake. The easier an asset

many of each we’d done. I explained that we simply bought the deals we liked

is to underwrite, the fewer its risks—the higher its price. Of those 14 properties

as they came along. He seemed satisfied with that, but I was left wondering

we purchased, 10 were effectively off-market. They found us. They’d either

about my unexamined belief—and oft-stated tagline—that the only way to make

been listed so long the world had forgotten them, or they had challenges beyond

lasting money in real estate is to add value, to be a real developer.

the abilities of neophytes or the attention span of the bigger, volume-driven

The funny thing about unexamined beliefs (eating carrots improves your

players. And just as our losers came early in our career, these winners came late.

eyesight) is that they can crumble like Middle Kingdom papyrus upon the

Why? Because great deals usually start with a great purchase. And how do you

least scrutiny.

pull that off? You step up and close for cash with a very short escrow—a tactic

I checked our records. Since 1983, we’ve done about 70 deals. Fifty-six of those—80 percent—were development projects, either ground-ups or major renovations. And we bought 14 finished, fully leased properties.

beyond a beginner’s reach. In hindsight, our failure to strategically allocate our equity between building and buying cost us nothing and may have been a boon. If we’d stuck

Based on this tiny sampling, I tried to determine—for us at least—whether one tactic was better, whether one was safer or more profitable, which had more losers. For this purpose, I assumed that a loser was a project in which

* My partners would like me to point out that no “friends and family” investor ever lost a nickel with us. In the 1980s, it was institutional money; by the ’90s, we’d stopped using outside money, and the losses were ours alone. Nor has any lender ever gone after us.

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YOUR EMPIRE: BUILD IT OR BUY IT? 87

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

to an allocating strategy of, say, 50/50, we would have missed out on good deals. Jumping back and forth freely between the two tactics let us do rather well with both. To put a cork in this, veteran developers will tell you to build in good times (because you can’t find decently priced existing buildings) and buy in bad (when projects sell for less than replacement cost)—a pretty decent rule of thumb.

29

The 1031 Exchange: Panacea or Placebo?

Upon selling a supermarket, w  e deposited our proceeds into a 1031 exchange account. Call this maneuver the triumph of hope over experience because we have had precious little luck exchanging properties in recent years, pulling off just one trade from among a half dozen attempted. What happened with the failures? Simple: in each instance we decided we would rather pay the taxes than trade into properties that were—in our view—either overpriced or snake-bitten with risk. Why did we try again? Because we thought retail properties might have at last been fairly priced, that somewhere between gaudily priced trophy properties and power centers beset with “box risk” we might have found a decent deal—that is, an unleveraged 8 percent return without untoward risk. As it happened, we didn’t, and we were left pondering the pluses and minuses of the Internal Revenue Code Section 1031 exchange itself. The 1031 is unquestionably the greatest gift to the brokerage industry since the 6 percent residential commission. Absent the 1031, a large but unknowable percentage of owners would never sell, preferring to ride a property straight off a cliff rather than pay avoidable taxes. (About one-

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MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

89

to an allocating strategy of, say, 50/50, we would have missed out on good deals. Jumping back and forth freely between the two tactics let us do rather well with both. To put a cork in this, veteran developers will tell you to build in good times (because you can’t find decently priced existing buildings) and buy in bad (when projects sell for less than replacement cost)—a pretty decent rule of thumb.

29

The 1031 Exchange: Panacea or Placebo?

Upon selling a supermarket, w  e deposited our proceeds into a 1031 exchange account. Call this maneuver the triumph of hope over experience because we have had precious little luck exchanging properties in recent years, pulling off just one trade from among a half dozen attempted. What happened with the failures? Simple: in each instance we decided we would rather pay the taxes than trade into properties that were—in our view—either overpriced or snake-bitten with risk. Why did we try again? Because we thought retail properties might have at last been fairly priced, that somewhere between gaudily priced trophy properties and power centers beset with “box risk” we might have found a decent deal—that is, an unleveraged 8 percent return without untoward risk. As it happened, we didn’t, and we were left pondering the pluses and minuses of the Internal Revenue Code Section 1031 exchange itself. The 1031 is unquestionably the greatest gift to the brokerage industry since the 6 percent residential commission. Absent the 1031, a large but unknowable percentage of owners would never sell, preferring to ride a property straight off a cliff rather than pay avoidable taxes. (About one-

88

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

89

third of all 2017 California deals involved a 1031 exchange buyer.) Thanks

return of 5 percent is lights-out better than paying 33 percent in taxes (if

to the exchange’s profit-saving effect, America’s commercial deal volume is

you’re in California) and having your remainder earn zero.

significantly greater than in countries that tax real estate sales profits. As

If, on the other hand, you have a little more experience and could be

decent and good-hearted as Canadians surely are, they share our Yankee

comfortable investing in nothing more exotic than an indexed mutual

enthusiasm for tax avoidance. Thus, with no comparable tax-deferred

fund (one consisting of a broad basket of a stock exchange’s representative

exchange provision, Canadian deal flow per capita is about 85 percent of

companies), you might be doing yourself a disservice buying that drugstore.

ours. Yes, the 1031 is a great boon to American brokers, but is it that great of a

Even in tax-crushed California, the math is intriguing. Buy the drugstore

deal for principals?

and you’re neck deep in concrete: you have a 5 percent yield for the rest of your

It depends.

life and the hope that the property has residual value when the lease burns off.

It depends on how you invest in real estate. Successfully exchanging is

Pay your combined state and federal taxes of about 33 percent instead, and you

harder if you’re a developer rather than what is widely, if inaccurately, known

have total liquidity. You need only average 7.5 percent on your after-tax dollars

as a “passive investor.” Developers want wholesale properties that are laden

to equal your drugstore’s 5 percent.

with zoning, construction, and leasing risk—deals to which they can add real

This is not an idle comparison. Taken as a whole, the S&P 500 has

value. You can find wholesale deals in the 45-day designation period—high-

averaged somewhere between a 7.5 and 10 percent total return since 1928.

risk career projects—but relatively seldom can you solve or swallow half their

(Pundits vary in their estimates; the Federal Reserve’s own raw data suggest

risks within the 180-day closing limitation. By the way, a great way to go “one

a shade under 9 percent.) If this long-term trend were to continue, you would

and out” is to close on a deal with untamed risks.

be far better off paying your taxes, putting the balance into the market,

On the other hand, if you’re that passive investor, if your milieu is

and letting it grow rather than worry about leaky roofs and the chain store

finished, 100 percent–leased real estate, you can readily find such assets

demanding a 50 percent rent reduction the next time its lease extension

within the 45-day identification period, wring out or assume whatever risk

option arises.

the property entails, and have time enough to close within the overall 180-

And I will tell you from personal experience that your jaundiced banker

day period. Whether the deal will have a happy ending is another story: ask

is far more impressed with $10,000 in a Fidelity account—real money—than

longtime veterans about their worst deals and often as not they began with

with your claimed equity of $100,000 in an LLC.

a trade.

If you can stumble across a fair deal during the 45 days, the 1031 is

As important, the efficacy of the 1031 as a wealth builder (your ultimate

your best friend. But before you pull the trigger on a Walgreens in South

goal) depends on the breadth of your financial perspective, your perceived

Dakota, you might consider paying your taxes and expanding your

range of investment alternatives. If you’re starting out, if your portfolio

investment horizons.

consists of real estate and pocket change for pizza (basically my financial statement for many years), if every dime you have is either invested in property or sitting in a bank earning zero percent, the 1031 is as critical to your success as a booster rocket is to the space shuttle: it’s the only way to achieve liftoff. Even trading into a marginally located drugstore with a fixed

90

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

THE 1031 EXCHANGE: PANACEA OR PLACEBO? 91

third of all 2017 California deals involved a 1031 exchange buyer.) Thanks

return of 5 percent is lights-out better than paying 33 percent in taxes (if

to the exchange’s profit-saving effect, America’s commercial deal volume is

you’re in California) and having your remainder earn zero.

significantly greater than in countries that tax real estate sales profits. As

If, on the other hand, you have a little more experience and could be

decent and good-hearted as Canadians surely are, they share our Yankee

comfortable investing in nothing more exotic than an indexed mutual

enthusiasm for tax avoidance. Thus, with no comparable tax-deferred

fund (one consisting of a broad basket of a stock exchange’s representative

exchange provision, Canadian deal flow per capita is about 85 percent of

companies), you might be doing yourself a disservice buying that drugstore.

ours. Yes, the 1031 is a great boon to American brokers, but is it that great of a

Even in tax-crushed California, the math is intriguing. Buy the drugstore

deal for principals?

and you’re neck deep in concrete: you have a 5 percent yield for the rest of your

It depends.

life and the hope that the property has residual value when the lease burns off.

It depends on how you invest in real estate. Successfully exchanging is

Pay your combined state and federal taxes of about 33 percent instead, and you

harder if you’re a developer rather than what is widely, if inaccurately, known

have total liquidity. You need only average 7.5 percent on your after-tax dollars

as a “passive investor.” Developers want wholesale properties that are laden

to equal your drugstore’s 5 percent.

with zoning, construction, and leasing risk—deals to which they can add real

This is not an idle comparison. Taken as a whole, the S&P 500 has

value. You can find wholesale deals in the 45-day designation period—high-

averaged somewhere between a 7.5 and 10 percent total return since 1928.

risk career projects—but relatively seldom can you solve or swallow half their

(Pundits vary in their estimates; the Federal Reserve’s own raw data suggest

risks within the 180-day closing limitation. By the way, a great way to go “one

a shade under 9 percent.) If this long-term trend were to continue, you would

and out” is to close on a deal with untamed risks.

be far better off paying your taxes, putting the balance into the market,

On the other hand, if you’re that passive investor, if your milieu is

and letting it grow rather than worry about leaky roofs and the chain store

finished, 100 percent–leased real estate, you can readily find such assets

demanding a 50 percent rent reduction the next time its lease extension

within the 45-day identification period, wring out or assume whatever risk

option arises.

the property entails, and have time enough to close within the overall 180-

And I will tell you from personal experience that your jaundiced banker

day period. Whether the deal will have a happy ending is another story: ask

is far more impressed with $10,000 in a Fidelity account—real money—than

longtime veterans about their worst deals and often as not they began with

with your claimed equity of $100,000 in an LLC.

a trade.

If you can stumble across a fair deal during the 45 days, the 1031 is

As important, the efficacy of the 1031 as a wealth builder (your ultimate

your best friend. But before you pull the trigger on a Walgreens in South

goal) depends on the breadth of your financial perspective, your perceived

Dakota, you might consider paying your taxes and expanding your

range of investment alternatives. If you’re starting out, if your portfolio

investment horizons.

consists of real estate and pocket change for pizza (basically my financial statement for many years), if every dime you have is either invested in property or sitting in a bank earning zero percent, the 1031 is as critical to your success as a booster rocket is to the space shuttle: it’s the only way to achieve liftoff. Even trading into a marginally located drugstore with a fixed

90

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

THE 1031 EXCHANGE: PANACEA OR PLACEBO? 91

30

The Only Free Cheese Is in a Mouse Trap

I once had a phone conversation with a broker that went like this: “Hey, John, it’s Joe Smith. How you doing?” “Fine. What can I help you with?” “I’ve got a really interesting deal for you,” Joe says enthusiastically. “It just went on the market.”

“Gem Tree Partners,” answers the broker. “Their money guy doesn’t want to finance the redevelopment.” “Gem Tree? That’s John Reid’s company, right?” “Yes. His partner—” “Wait. The Parkwood Center in Townville?” I ask. “Yeah, that’s it,” the broker replies, optimistic. “I know that center. It’s at the corner of Caveat and Emptor?” “Yeah,” says the broker. “It’s an oversized Pay-More Market of about 65,000 feet that should be no more than 40,000, right?” “Yeah, you got it.” Optimism ticking down a beat. “And it has a 20,000-foot closed drugstore and a 30,000-foot R&M tucked into a corner with almost no visibility? And R&M is threatening to vacate unless the owner builds it a new 15,000-foot store on the hard corner at a ridiculously low rent?” “Well, yeah, I guess,” the broker answers, optimism gone. “It’s on about 25 acres,” I continue, on a roll. “The center is too big by at least 150,000 feet and it has zero tenant interest?” “You know this center pretty well, huh?” the broker replies. “And it’s cut off by better supermarkets a half mile in either direction on

“Hit me with it.”

Caveat. And because the town has no growth, there’s no residential or any

“It’s the Parkwood Center in Townville. We think it has a lot of upside. It’s

other redevelopment play. That Parkwood Center?”

got a couple of developable pads and—” That worn-out word “upside” catches my attention. “Why do we want to

“Yeah, that’s it,” the broker admits, dejected. “How do you know so much about it?” “Reid is a friend. We met over this deal and I told him to hand the keys

buy it?” “It’s got real upside,” the broker purrs. “You can reposition the

back to his lender.”

supermarket, move a couple of the junior anchors around, bring in a new

“Oh.” Total gloom.

major, get the shops to market rent, and you’ve got—”

“Joe?” I ask.

“Why is the seller selling?” I ask, interrupting his pitch.

“Yeah?”

“He’s having trouble with his financial partner. We really like this deal—”

“This is the worst deal you’ve ever pitched me. My advice to you: don’t sell

“Who’s the seller?” I interrupt again. Bad habit, but useful in time

it to anyone you ever want to talk to again.”

management.

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THE ONLY FREE CHEESE IS IN A MOUSE TRAP 93

30

The Only Free Cheese Is in a Mouse Trap

I once had a phone conversation with a broker that went like this: “Hey, John, it’s Joe Smith. How you doing?” “Fine. What can I help you with?” “I’ve got a really interesting deal for you,” Joe says enthusiastically. “It just went on the market.”

“Gem Tree Partners,” answers the broker. “Their money guy doesn’t want to finance the redevelopment.” “Gem Tree? That’s John Reid’s company, right?” “Yes. His partner—” “Wait. The Parkwood Center in Townville?” I ask. “Yeah, that’s it,” the broker replies, optimistic. “I know that center. It’s at the corner of Caveat and Emptor?” “Yeah,” says the broker. “It’s an oversized Pay-More Market of about 65,000 feet that should be no more than 40,000, right?” “Yeah, you got it.” Optimism ticking down a beat. “And it has a 20,000-foot closed drugstore and a 30,000-foot R&M tucked into a corner with almost no visibility? And R&M is threatening to vacate unless the owner builds it a new 15,000-foot store on the hard corner at a ridiculously low rent?” “Well, yeah, I guess,” the broker answers, optimism gone. “It’s on about 25 acres,” I continue, on a roll. “The center is too big by at least 150,000 feet and it has zero tenant interest?” “You know this center pretty well, huh?” the broker replies. “And it’s cut off by better supermarkets a half mile in either direction on

“Hit me with it.”

Caveat. And because the town has no growth, there’s no residential or any

“It’s the Parkwood Center in Townville. We think it has a lot of upside. It’s

other redevelopment play. That Parkwood Center?”

got a couple of developable pads and—” That worn-out word “upside” catches my attention. “Why do we want to

“Yeah, that’s it,” the broker admits, dejected. “How do you know so much about it?” “Reid is a friend. We met over this deal and I told him to hand the keys

buy it?” “It’s got real upside,” the broker purrs. “You can reposition the

back to his lender.”

supermarket, move a couple of the junior anchors around, bring in a new

“Oh.” Total gloom.

major, get the shops to market rent, and you’ve got—”

“Joe?” I ask.

“Why is the seller selling?” I ask, interrupting his pitch.

“Yeah?”

“He’s having trouble with his financial partner. We really like this deal—”

“This is the worst deal you’ve ever pitched me. My advice to you: don’t sell

“Who’s the seller?” I interrupt again. Bad habit, but useful in time

it to anyone you ever want to talk to again.”

management.

92

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

THE ONLY FREE CHEESE IS IN A MOUSE TRAP 93

I ended the conversation wondering whether he would take my comments

31

to heart—whether it would dissuade him from pitching this career-busting deal to others. I thought not. Joe had either learned almost nothing in his 20 years in the business or was a brokerage serial killer. Was his pitch gross negligence or fraud? On reflection, I decided it had to be the former, the offspring of his cupidity and surprising ignorance of retail redevelopment. Had Joe truly understood the center’s dismal prospects, he would have at least called someone a bit less

Game of Phones

experienced. I also decided his intent didn’t matter. Whether Joe was guilty of murder one or involuntary manslaughter, the result was the same: the buyer ultimately dies. What does this conversation tell you? If you’re a broker, it should tell you to choose your listings carefully because the only question on projects like Parkwood will be how much of your reputation you’ll lose by marketing it. If economic necessity requires you to take a Parkwood listing, do your best to figure out its potential downside and disclose that upfront. Joe could have maintained his credibility if his initial pitch included an accurate summary of Parkwood’s flaws. He could have capped those off by saying, “But remember there’s no such thing as bad real estate, only bad pricing. Maybe it works for you at some number.” The lesson for principals is obvious: the only free cheese is in a mouse trap. Learning to recognize the trap of easy upside without breaking any fingers is part of the tuition one must pay to become proficient in real estate. Start by always doing your own underwriting. And if you’re not experienced in underwriting a particular property type, find someone trustworthy who is, or skip the deal.

The International Council of Shopping Centers, better known as the ICSC, gathered in May 2019 for its annual meeting in Las Vegas. Retail’s leading trade organization, the ICSC counts as members the tenants, developers, contractors, and brokers who have built almost every shopping center in the country. Tens of thousands of them attended the Vegas meeting, swapping hopes, plans, dreams, and lies, congratulating one another just for showing up. The mood in Vegas was considerably more ebullient than that back at the players’ home offices, especially those of the owners of America’s retail. As the conference neared, Business Insider reported that retailers had already announced closures of 6,200 stores for 2019, more than for all of 2018. Against this loss, 2,264 new stores were slated to open, the majority of which—Dollar Tree, Dollar General, and Family Dollar—sell the cheapest of all merchandise. Any developer who told you then (or as this edition goes to print) that she isn’t having issues with at least some of her tenants is spinning facts faster than Disney’s teacup ride. In truth, a week rarely goes by without at least

94

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

95

I ended the conversation wondering whether he would take my comments

31

to heart—whether it would dissuade him from pitching this career-busting deal to others. I thought not. Joe had either learned almost nothing in his 20 years in the business or was a brokerage serial killer. Was his pitch gross negligence or fraud? On reflection, I decided it had to be the former, the offspring of his cupidity and surprising ignorance of retail redevelopment. Had Joe truly understood the center’s dismal prospects, he would have at least called someone a bit less

Game of Phones

experienced. I also decided his intent didn’t matter. Whether Joe was guilty of murder one or involuntary manslaughter, the result was the same: the buyer ultimately dies. What does this conversation tell you? If you’re a broker, it should tell you to choose your listings carefully because the only question on projects like Parkwood will be how much of your reputation you’ll lose by marketing it. If economic necessity requires you to take a Parkwood listing, do your best to figure out its potential downside and disclose that upfront. Joe could have maintained his credibility if his initial pitch included an accurate summary of Parkwood’s flaws. He could have capped those off by saying, “But remember there’s no such thing as bad real estate, only bad pricing. Maybe it works for you at some number.” The lesson for principals is obvious: the only free cheese is in a mouse trap. Learning to recognize the trap of easy upside without breaking any fingers is part of the tuition one must pay to become proficient in real estate. Start by always doing your own underwriting. And if you’re not experienced in underwriting a particular property type, find someone trustworthy who is, or skip the deal.

The International Council of Shopping Centers, better known as the ICSC, gathered in May 2019 for its annual meeting in Las Vegas. Retail’s leading trade organization, the ICSC counts as members the tenants, developers, contractors, and brokers who have built almost every shopping center in the country. Tens of thousands of them attended the Vegas meeting, swapping hopes, plans, dreams, and lies, congratulating one another just for showing up. The mood in Vegas was considerably more ebullient than that back at the players’ home offices, especially those of the owners of America’s retail. As the conference neared, Business Insider reported that retailers had already announced closures of 6,200 stores for 2019, more than for all of 2018. Against this loss, 2,264 new stores were slated to open, the majority of which—Dollar Tree, Dollar General, and Family Dollar—sell the cheapest of all merchandise. Any developer who told you then (or as this edition goes to print) that she isn’t having issues with at least some of her tenants is spinning facts faster than Disney’s teacup ride. In truth, a week rarely goes by without at least

94

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

95

one tenant calling us to ask for a rent reduction. Some of these requests are

challenging times to help retailers “rationalize rent.” These companies have

legitimate—the tenant is truly struggling—but some, perhaps many, spring

a simple yet distinctly unpleasant business model: they get paid only when

from a profitable retailer’s rapacity, a company seeking to take advantage of

and if they succeed in prying a rent reduction out of a landlord, getting a

weak landlords in the climate of fear engendered by the near-constant retail

commission (ranging from 5 to 12 percent) on the rent saved.

Armageddon headlines. The temptation to say “Bite me” to this importuning is nearly irresistible,

Think about this: a call from the retailer itself means that you’re dealing with a salaried employee in the real estate department, someone who

but—here’s the public service announcement—resist it. With little more than

presumably wants to continue doing business with you, someone who may

personal experience and anecdotal evidence as support, I would suggest that

even value your relationship with the company, someone whose livelihood is

tenants are bluffing at least half the time when they threaten a store closure if

not dependent on screwing you out of as much rent as possible. Dealing with

their demands are not met. But that means that sometimes they aren’t. In this

one of these boiler-room operations—imagine the sales floor in Glengarry

context, you might do well to recall that “Go ahead and shoot” are purportedly

Glen Ross—is different. This person will threaten you with store closures,

the last words most often uttered just before dying.

misrepresent sales and profitability, and cajole, pester, and badger you until

Rather than swear or slam the phone down, the prudent owner should

you cave in. If you get such a call, hang up—again without swearing—and

listen, remain calm, and then ask the retailer for evidence to back up its

call the retailer’s real estate department and insist that the only way you will

poverty claims. Specifically, you should request not only the store’s gross

consider any sort of lease restructuring is in conversations directly with the

sales for the preceding five years, but also a store-specific profit-and-loss

company itself.

statement (P&L). The retailer’s response will be that it never divulges P&Ls. Your rejoinder should be that you never grant hardship requests without proof of hardship. With minimal tussling, the retailer will give you the store’s sales history and, with a little effort, you should be able to determine on your own whether its sales warrant a rent break. Another way to do this is to call a competing retailer, someone who understands the tenant’s business, and ask him what he thinks of the poverty plea. If, at the end of the day, you satisfy yourself that your tenant is still making money, just say no. If you think its situation warrants a reduction, ask yourself what your plan B would be if the tenant bolted. If you have no obvious substitute tenant, make the deal. As my brother used to say about a different but analogous situation, “When there’s only one train in the station, you better get on it.” While the practice of renegotiating rent is older than selling Thanksgiving turkeys as loss leaders, there is a relatively new, ugly wrinkle to the game. A commission-based cottage industry has sprung up in these

96

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

GAME OF PHONES 97

one tenant calling us to ask for a rent reduction. Some of these requests are

challenging times to help retailers “rationalize rent.” These companies have

legitimate—the tenant is truly struggling—but some, perhaps many, spring

a simple yet distinctly unpleasant business model: they get paid only when

from a profitable retailer’s rapacity, a company seeking to take advantage of

and if they succeed in prying a rent reduction out of a landlord, getting a

weak landlords in the climate of fear engendered by the near-constant retail

commission (ranging from 5 to 12 percent) on the rent saved.

Armageddon headlines. The temptation to say “Bite me” to this importuning is nearly irresistible,

Think about this: a call from the retailer itself means that you’re dealing with a salaried employee in the real estate department, someone who

but—here’s the public service announcement—resist it. With little more than

presumably wants to continue doing business with you, someone who may

personal experience and anecdotal evidence as support, I would suggest that

even value your relationship with the company, someone whose livelihood is

tenants are bluffing at least half the time when they threaten a store closure if

not dependent on screwing you out of as much rent as possible. Dealing with

their demands are not met. But that means that sometimes they aren’t. In this

one of these boiler-room operations—imagine the sales floor in Glengarry

context, you might do well to recall that “Go ahead and shoot” are purportedly

Glen Ross—is different. This person will threaten you with store closures,

the last words most often uttered just before dying.

misrepresent sales and profitability, and cajole, pester, and badger you until

Rather than swear or slam the phone down, the prudent owner should

you cave in. If you get such a call, hang up—again without swearing—and

listen, remain calm, and then ask the retailer for evidence to back up its

call the retailer’s real estate department and insist that the only way you will

poverty claims. Specifically, you should request not only the store’s gross

consider any sort of lease restructuring is in conversations directly with the

sales for the preceding five years, but also a store-specific profit-and-loss

company itself.

statement (P&L). The retailer’s response will be that it never divulges P&Ls. Your rejoinder should be that you never grant hardship requests without proof of hardship. With minimal tussling, the retailer will give you the store’s sales history and, with a little effort, you should be able to determine on your own whether its sales warrant a rent break. Another way to do this is to call a competing retailer, someone who understands the tenant’s business, and ask him what he thinks of the poverty plea. If, at the end of the day, you satisfy yourself that your tenant is still making money, just say no. If you think its situation warrants a reduction, ask yourself what your plan B would be if the tenant bolted. If you have no obvious substitute tenant, make the deal. As my brother used to say about a different but analogous situation, “When there’s only one train in the station, you better get on it.” While the practice of renegotiating rent is older than selling Thanksgiving turkeys as loss leaders, there is a relatively new, ugly wrinkle to the game. A commission-based cottage industry has sprung up in these

96

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

GAME OF PHONES 97

32

Winter Is Coming

In mid-December 2018, the S&P 500 was down 2.33 percent for the year. Like a dead rat in the basement, everyone could smell the next recession, everyone knew it was coming, but no one knew when. Nobody. The clever pundits gave its commencement the same wide berth they would accord that moldering rat. One acquaintance, however, rushed in where economists feared to tread and called it, proclaiming March 2020 as the next recession’s kickoff. As it happened, he was right. I thought it might be useful to consider how a real estate professional might survive a financial winter.

Suggestion 1: Keep your job. As truisms go, “Now is always the right time to get into real estate” isn’t bad. It has a nice ring to it; it even makes some sense. But there are better and worse times to ditch your day job for the joys of working without a net. Today is one of those worse times. With the economy having baked longer than one of my mother’s unfortunate Christmas hams, the percentage play would be to keep your paycheck over the next several years. The time to BASE jump is at the depth of the recession—when you’re closer to the ground—not the week before it starts. 98

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

Suggestion 2: Sell. Whether you own a single duplex or a portfolio you take your shoes off to count, ask yourself a simple question: should I sell before the snow flies? Benjamin Franklin observed, “There are three faithful friends—an old wife, an old dog, and ready money.” It takes decades to earn an old wife, but you can achieve ready money with one quick sale. What should you sell? Your sitting ducks—your projects leased at top-of-market rents, those rented to marginal tenants, and those most susceptible to future competition (i.e., located where land is cheap and zoning codes broken more often than not). And your overleveraged properties. What happens to your project if commercial values plunge 20 percent or more (they tanked 40 percent in the Great Recession) and you need to refinance in the next five years? Would you have any equity left? Would you be able to refinance at all? By year-end 2018, we had sold five small, single-tenant properties, were in escrow to sell two more, and were dickering with a potential buyer on an eighth. We had no need to sell any of these properties; rather, we thought it was a good time to harvest profits and deploy the cash elsewhere. Against this wave of selling, we traded several of these properties into one much larger asset—a well-located, supermarket-anchored shopping center.

Suggestion 3: Pay down debt and finance long. How did we use the cash that didn’t go into the trade? Simple: we paid down debt and, in one case, bought out an equity partner. Our company goal has always been to carry as little debt as possible at a fixed interest rate with the longest term we can obtain. Yes, this strategy is too conservative in good times and acts like a drag chute on new deals, and, yes, you can feel dumb when everyone else is doing five deals to your one. But you will feel much smarter, if not downright smug, when the recession deep-freezes the markets and your bankers will still buy you lunch. These suggestions are easy enough to swallow. Staying put is a piece of cake, selling can be fun, and repaying debt is kind of like going to Sunday Mass: it can be a little painful but you feel better afterward.

WINTER IS COMING 99

32

Winter Is Coming

In mid-December 2018, the S&P 500 was down 2.33 percent for the year. Like a dead rat in the basement, everyone could smell the next recession, everyone knew it was coming, but no one knew when. Nobody. The clever pundits gave its commencement the same wide berth they would accord that moldering rat. One acquaintance, however, rushed in where economists feared to tread and called it, proclaiming March 2020 as the next recession’s kickoff. As it happened, he was right. I thought it might be useful to consider how a real estate professional might survive a financial winter.

Suggestion 1: Keep your job. As truisms go, “Now is always the right time to get into real estate” isn’t bad. It has a nice ring to it; it even makes some sense. But there are better and worse times to ditch your day job for the joys of working without a net. Today is one of those worse times. With the economy having baked longer than one of my mother’s unfortunate Christmas hams, the percentage play would be to keep your paycheck over the next several years. The time to BASE jump is at the depth of the recession—when you’re closer to the ground—not the week before it starts. 98

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

Suggestion 2: Sell. Whether you own a single duplex or a portfolio you take your shoes off to count, ask yourself a simple question: should I sell before the snow flies? Benjamin Franklin observed, “There are three faithful friends—an old wife, an old dog, and ready money.” It takes decades to earn an old wife, but you can achieve ready money with one quick sale. What should you sell? Your sitting ducks—your projects leased at top-of-market rents, those rented to marginal tenants, and those most susceptible to future competition (i.e., located where land is cheap and zoning codes broken more often than not). And your overleveraged properties. What happens to your project if commercial values plunge 20 percent or more (they tanked 40 percent in the Great Recession) and you need to refinance in the next five years? Would you have any equity left? Would you be able to refinance at all? By year-end 2018, we had sold five small, single-tenant properties, were in escrow to sell two more, and were dickering with a potential buyer on an eighth. We had no need to sell any of these properties; rather, we thought it was a good time to harvest profits and deploy the cash elsewhere. Against this wave of selling, we traded several of these properties into one much larger asset—a well-located, supermarket-anchored shopping center.

Suggestion 3: Pay down debt and finance long. How did we use the cash that didn’t go into the trade? Simple: we paid down debt and, in one case, bought out an equity partner. Our company goal has always been to carry as little debt as possible at a fixed interest rate with the longest term we can obtain. Yes, this strategy is too conservative in good times and acts like a drag chute on new deals, and, yes, you can feel dumb when everyone else is doing five deals to your one. But you will feel much smarter, if not downright smug, when the recession deep-freezes the markets and your bankers will still buy you lunch. These suggestions are easy enough to swallow. Staying put is a piece of cake, selling can be fun, and repaying debt is kind of like going to Sunday Mass: it can be a little painful but you feel better afterward.

WINTER IS COMING 99

Suggestion 4: Drop marginal projects. Harder to accept is this: if you’re not already under construction, reevaluate your project and ask yourself whether it still makes sense. If your numbers look skinny, sell it or mothball it. Newton’s first law of motion—objects in motion tend to stay in motion—has claimed many victims; you have no wish to be one. Also known as inertia, this law is a major factor in the high rate of divorce: the bride figured out her fiancé was a bum long before the rehearsal dinner, but her family had already sent out the invitations and rented the hall. Inertia also drives a world of bad deals. You’re halfway through your permitting process when you notice the first frost on your pro forma—leasing has slowed, lenders are edgy, and contractors insouciant—but you push on with lower pre-leasing and perhaps a second-tier, more expensive lender. And then, if you somehow missed the news beforehand, you discover just how much construction costs have soared in the last couple of years. Yet you persist, marching down the aisle, telling yourself the project’s financials will look better on completion. They won’t. One major apartment builder in Northern California told me that construction costs here are rising 1 percent a month (yes, 12 percent a year) and that if you factor in the rental concessions his company is now giving away, his company is not meeting its targeted returns on investment. He also said some smaller developers are already giving up the ghost on their new apartment projects, irretrievably buried beneath the preferred returns due their financial partners, destined to make nothing on their developments. The strategies that work so well in a bull market can take you down in a recession. When it freezes, animals adapt. Bears hibernate, birds fly south, and bees live off their summer honey. Time to think about adapting.

33

Winter Is Here

recession n. A period of temporary economic decline during which trade and industrial activity are reduced, generally identified by a fall in GDP in two successive quarters. Gross domestic product dropped 4.8 percent in the first quarter of 2020, the biggest contraction since 2008—but a fall resembling an infant’s stumble when compared with the second quarter’s 32.9 percent Acapulco cliff dive. As of May 2020, 33 million workers had lost their jobs due to the coronavirus shutdown. That we’re in the midst of a recession is undeniable. How long it lasts beyond the definitional two quarters is simply a guess. If you’re one of the millions of unemployed, your waking thoughts are consumed with finding a job. If you’re lucky, however, if you’re still employed and working at home (no longer an oxymoron), you might find time—hell, a lot of time—to contemplate your life and how you might come out of this economic winter a step ahead. To that end, I asked a half dozen

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101

Suggestion 4: Drop marginal projects. Harder to accept is this: if you’re not already under construction, reevaluate your project and ask yourself whether it still makes sense. If your numbers look skinny, sell it or mothball it. Newton’s first law of motion—objects in motion tend to stay in motion—has claimed many victims; you have no wish to be one. Also known as inertia, this law is a major factor in the high rate of divorce: the bride figured out her fiancé was a bum long before the rehearsal dinner, but her family had already sent out the invitations and rented the hall. Inertia also drives a world of bad deals. You’re halfway through your permitting process when you notice the first frost on your pro forma—leasing has slowed, lenders are edgy, and contractors insouciant—but you push on with lower pre-leasing and perhaps a second-tier, more expensive lender. And then, if you somehow missed the news beforehand, you discover just how much construction costs have soared in the last couple of years. Yet you persist, marching down the aisle, telling yourself the project’s financials will look better on completion. They won’t. One major apartment builder in Northern California told me that construction costs here are rising 1 percent a month (yes, 12 percent a year) and that if you factor in the rental concessions his company is now giving away, his company is not meeting its targeted returns on investment. He also said some smaller developers are already giving up the ghost on their new apartment projects, irretrievably buried beneath the preferred returns due their financial partners, destined to make nothing on their developments. The strategies that work so well in a bull market can take you down in a recession. When it freezes, animals adapt. Bears hibernate, birds fly south, and bees live off their summer honey. Time to think about adapting.

33

Winter Is Here

recession n. A period of temporary economic decline during which trade and industrial activity are reduced, generally identified by a fall in GDP in two successive quarters. Gross domestic product dropped 4.8 percent in the first quarter of 2020, the biggest contraction since 2008—but a fall resembling an infant’s stumble when compared with the second quarter’s 32.9 percent Acapulco cliff dive. As of May 2020, 33 million workers had lost their jobs due to the coronavirus shutdown. That we’re in the midst of a recession is undeniable. How long it lasts beyond the definitional two quarters is simply a guess. If you’re one of the millions of unemployed, your waking thoughts are consumed with finding a job. If you’re lucky, however, if you’re still employed and working at home (no longer an oxymoron), you might find time—hell, a lot of time—to contemplate your life and how you might come out of this economic winter a step ahead. To that end, I asked a half dozen

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101

friends, successful entrepreneurs, what advice they’d give themselves today

“Use this downtime to vet your personal situation. Ask yourself, am I

if they were 27 years old—that is, if they were reasonably well-employed, but

with the right organization? If you’re not, move. The best companies hire in

ambitious and longing to succeed.

downturns; they know they can pick off top talent.”

Their answers skittered across the board, from the practical (never

One good friend took it up to 30,000 feet. He said, “Now’s a great time

underestimate the practical) to the near mystic. The following quotes are

to ask yourself what you want out of life. Are you that motivated by financial

paraphrased, but accurate. In no particular order, they opined:

success? Are you really all about money? Could you be happier living a quieter,

“If you’re already in a contract you can terminate without penalty, drop it.

less stressful life—taking a job, say, as a schoolteacher and having more time

And then, if you really want the asset, chisel.” (One apartment builder told his

for living a good life? But if you’re bent on becoming an entrepreneur, do this:

seller he would only close with a 25 percent price reduction. He got it.)

find a guy who knows how to make money—doesn’t matter what industry he’s

“Marry—or stay married to—a spouse with a steady income. That

in, it’s all about the individual, not the business—a guy who’s willing to pay

stability will let you go out on your own and take the risks you need to get to

attention to you and who isn’t a jerk, and go to work for him. Make him teach

the next level.”

you what he knows.”

“I’d go on with my life exactly as I would have done had there been no virus.”

And there you have it. On to 2020 real estate: a couple of observations and a couple of

“I wouldn’t bet all I have on a chance to win all the gold in Fort Knox. I know I can’t live without what I’ve got, and I’m doing just fine without all that gold.”

conclusions. First, this recession will play out more like 2009 than 1992—that is, don’t look for a bumper crop of fat deals. Why? Real estate ownership is more

“What do I care if the economy drops 10 percent? That’s where it was two years ago and I was doing just fine then.” “Do the work. Just because you heard the owner has said no to everyone

concentrated today than ever, and most of the vulnerable little guys have long since been flushed out. There are literally trillions of dollars in opportunity funds sitting on the sidelines waiting to pounce on the first underpriced

in town, knock on his door, make sure he hasn’t changed his mind. Get him to

portfolio that hits the market (and thus jack the price). And, let’s face it: no one

say no to you. Look for the neighborhoods that will bounce back first. Now’s

wants to sell in a down market. Everyone who can sit tight will. That said, the

the time to wear out a pair of shoes.”

four D’s—death, divorce, dissolution, and disaster—inexorably cross the stage

“If you think the world’s dependence on oil isn’t going away, start your

even when the audience is forced to stay home. Some owners will have to sell.

own little private equity fund. Use your friends’ and family’s money to buy

There may not be a flood, but there will be more than a trickle of great deals.

stock—a basket of oil companies and oil service providers. When oil hits $50 a barrel, you’ll look like a genius.” “You gotta be able to fail the whole thing.” (Yes, dear reader, my friends are not in complete agreement). “Timing is critically important. Success is all about entry points and exit

Making it more difficult, and at the same time more enticing, is today’s lending market. As of this writing, real estate has two kinds of lenders: those who’ll admit they’re not lending a dime and those who pretend they are. A real estate market without debt is like a car with a broken oil pan: it seizes up a couple of miles down the road—which means those 4-D sellers must

points.” (He meant when to buy and when to sell. As an aside, the when-to-

become reasonable. A clever, forthright buyer will structure her offer with

buy part is a lot easier than the when-to-sell.)

either long-term seller financing or at least a two-year bridge-loan carryback.

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friends, successful entrepreneurs, what advice they’d give themselves today

“Use this downtime to vet your personal situation. Ask yourself, am I

if they were 27 years old—that is, if they were reasonably well-employed, but

with the right organization? If you’re not, move. The best companies hire in

ambitious and longing to succeed.

downturns; they know they can pick off top talent.”

Their answers skittered across the board, from the practical (never

One good friend took it up to 30,000 feet. He said, “Now’s a great time

underestimate the practical) to the near mystic. The following quotes are

to ask yourself what you want out of life. Are you that motivated by financial

paraphrased, but accurate. In no particular order, they opined:

success? Are you really all about money? Could you be happier living a quieter,

“If you’re already in a contract you can terminate without penalty, drop it.

less stressful life—taking a job, say, as a schoolteacher and having more time

And then, if you really want the asset, chisel.” (One apartment builder told his

for living a good life? But if you’re bent on becoming an entrepreneur, do this:

seller he would only close with a 25 percent price reduction. He got it.)

find a guy who knows how to make money—doesn’t matter what industry he’s

“Marry—or stay married to—a spouse with a steady income. That

in, it’s all about the individual, not the business—a guy who’s willing to pay

stability will let you go out on your own and take the risks you need to get to

attention to you and who isn’t a jerk, and go to work for him. Make him teach

the next level.”

you what he knows.”

“I’d go on with my life exactly as I would have done had there been no virus.”

And there you have it. On to 2020 real estate: a couple of observations and a couple of

“I wouldn’t bet all I have on a chance to win all the gold in Fort Knox. I know I can’t live without what I’ve got, and I’m doing just fine without all that gold.”

conclusions. First, this recession will play out more like 2009 than 1992—that is, don’t look for a bumper crop of fat deals. Why? Real estate ownership is more

“What do I care if the economy drops 10 percent? That’s where it was two years ago and I was doing just fine then.” “Do the work. Just because you heard the owner has said no to everyone

concentrated today than ever, and most of the vulnerable little guys have long since been flushed out. There are literally trillions of dollars in opportunity funds sitting on the sidelines waiting to pounce on the first underpriced

in town, knock on his door, make sure he hasn’t changed his mind. Get him to

portfolio that hits the market (and thus jack the price). And, let’s face it: no one

say no to you. Look for the neighborhoods that will bounce back first. Now’s

wants to sell in a down market. Everyone who can sit tight will. That said, the

the time to wear out a pair of shoes.”

four D’s—death, divorce, dissolution, and disaster—inexorably cross the stage

“If you think the world’s dependence on oil isn’t going away, start your

even when the audience is forced to stay home. Some owners will have to sell.

own little private equity fund. Use your friends’ and family’s money to buy

There may not be a flood, but there will be more than a trickle of great deals.

stock—a basket of oil companies and oil service providers. When oil hits $50 a barrel, you’ll look like a genius.” “You gotta be able to fail the whole thing.” (Yes, dear reader, my friends are not in complete agreement). “Timing is critically important. Success is all about entry points and exit

Making it more difficult, and at the same time more enticing, is today’s lending market. As of this writing, real estate has two kinds of lenders: those who’ll admit they’re not lending a dime and those who pretend they are. A real estate market without debt is like a car with a broken oil pan: it seizes up a couple of miles down the road—which means those 4-D sellers must

points.” (He meant when to buy and when to sell. As an aside, the when-to-

become reasonable. A clever, forthright buyer will structure her offer with

buy part is a lot easier than the when-to-sell.)

either long-term seller financing or at least a two-year bridge-loan carryback.

102

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More devious buyers will offer to purchase, subject to obtaining conventional financing, and then seek to retrade at the financing deadline, forcing the hapless seller to carry the loan on onerous terms. Clever sellers, however, already know any offer dependent on outside financing is dead on arrival. There will be deals. Go find one.

34

There’s No Place Like Home

If idle hands are the devil’s workshop—they are—idle money is surely his pied-à-terre. When left with little to do, small boys play with matches, older ones play with hearts, and truly old boys start wars. Money is no different. When ignored, when left alone to pile up, when shackled in bonds, it begins to sulk and scheme, warping its owner’s better instincts, demanding to be set free, demanding to be wildly risked. This story of wild risk began in Palo Alto in 1998. One day, I was standing in a longish line at my local café. The conversations two deep in front of me and behind had to do with 15-year-olds making billions in startup companies. With the queue moving slowly, I had little choice but to listen to detail after detail of valuations—if not profits—rising to the sky. The coup de grâce came when the barista himself announced he was leaving his honest job to join a startup, with a fortune sure to follow. Already beyond old enough to know better, and despite having espoused that wonderful maxim “Invest in what you know” countless times, I was seduced by this siren song of easy money, resenting my plodding career in real estate. To justify the abandonment of my better senses, I convinced myself

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105

More devious buyers will offer to purchase, subject to obtaining conventional financing, and then seek to retrade at the financing deadline, forcing the hapless seller to carry the loan on onerous terms. Clever sellers, however, already know any offer dependent on outside financing is dead on arrival. There will be deals. Go find one.

34

There’s No Place Like Home

If idle hands are the devil’s workshop—they are—idle money is surely his pied-à-terre. When left with little to do, small boys play with matches, older ones play with hearts, and truly old boys start wars. Money is no different. When ignored, when left alone to pile up, when shackled in bonds, it begins to sulk and scheme, warping its owner’s better instincts, demanding to be set free, demanding to be wildly risked. This story of wild risk began in Palo Alto in 1998. One day, I was standing in a longish line at my local café. The conversations two deep in front of me and behind had to do with 15-year-olds making billions in startup companies. With the queue moving slowly, I had little choice but to listen to detail after detail of valuations—if not profits—rising to the sky. The coup de grâce came when the barista himself announced he was leaving his honest job to join a startup, with a fortune sure to follow. Already beyond old enough to know better, and despite having espoused that wonderful maxim “Invest in what you know” countless times, I was seduced by this siren song of easy money, resenting my plodding career in real estate. To justify the abandonment of my better senses, I convinced myself

104

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

105

of a need to diversify. By the way, the term diversify may have an innocent

■

And, finally a Marin-based software company that had a sweet idea—

meaning, but it can connote diverting your money away from your bank

namely, doing well by doing good. It developed a software program that

account into a speculative venture that you will never fully understand.

enabled large organizations to encourage—and keep close track of—all

Thus, over the course of a half dozen fateful years, I invested in a handful of emerging companies near and far: ■

■

their employees’ charitable works. The economic driver was simple: by having data showing that, say, 7,500 of its employees spend an average of

A Portland-based heating/air conditioning company that, with its

10 hours a year giving back to the community, a participating company

revolutionary technology, promised to let homeowners seamlessly

could vastly improve its public image. Free PR on the backs of its civic-

maintain individual rooms at varying and separate temperatures—68

minded employees. This one actually worked, but at nowhere near its

degrees in the living room, 72 in the kitchen, 78 in Grandma’s room, and

hoped-for level. In comparison to the others, this deal went deep—410

so on. The system worked—your correspondent is nobody’s fool—but

feet over the center field wall. But judged against more standard

as it turned out, it did so only under optimal conditions and not at a

benchmarks, it ended up a “kissed sister”: my investment back plus a

cost anyone beyond a well-off, retired engineering geek would consider

passbook rate of return.

paying. Financial result: total write-off.

Like Dorothy, I awoke at last from the Silicon Valley Dream about 10

A Palo Alto–based tech company that developed software to allow large

years ago and—though not surrounded by the Tin Man, Scarecrow, and

organizations to stream one-way, extremely high-resolution video from,

Cowardly Lion—I, too, repeated that wisdom I had known all along, “There’s

say, its CEO to 10,000 employees at once: think the president of Exxon

no place like home.”

Mobil addressing his managers. Why this one failed, becoming yet more

And I went back to bricks and mortar.

roadkill, I have no idea.* As they say, it seemed like a good idea at the time. But I can tell you that when faced with the choice of participating in a “down round” on this investment—doubling down on my original investment or watching my stake in the company evaporate—I did manage to swallow hard and walk away. ■

A Swedish biotech company with a drug for which it had high hopes of treating rheumatoid arthritis. For a guy whose only science experiment ever was trying to make a geyser with Diet Coke and Mentos, this investment was admittedly a stretch. But it did provide this insight: forget the right answers; if you have no idea what the right questions are, run for the exit. As it happened, the drug worked well enough on lab rats, but somewhere between them and its human subjects, the drug, like my Diet Coke experiment, fizzled.

* Probably because it was 20 years before its time: in essence, it was Zoom’s forerunner.

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THERE'S NO PLACE LIKE HOME 107

of a need to diversify. By the way, the term diversify may have an innocent

■

And, finally a Marin-based software company that had a sweet idea—

meaning, but it can connote diverting your money away from your bank

namely, doing well by doing good. It developed a software program that

account into a speculative venture that you will never fully understand.

enabled large organizations to encourage—and keep close track of—all

Thus, over the course of a half dozen fateful years, I invested in a handful of emerging companies near and far: ■

■

their employees’ charitable works. The economic driver was simple: by having data showing that, say, 7,500 of its employees spend an average of

A Portland-based heating/air conditioning company that, with its

10 hours a year giving back to the community, a participating company

revolutionary technology, promised to let homeowners seamlessly

could vastly improve its public image. Free PR on the backs of its civic-

maintain individual rooms at varying and separate temperatures—68

minded employees. This one actually worked, but at nowhere near its

degrees in the living room, 72 in the kitchen, 78 in Grandma’s room, and

hoped-for level. In comparison to the others, this deal went deep—410

so on. The system worked—your correspondent is nobody’s fool—but

feet over the center field wall. But judged against more standard

as it turned out, it did so only under optimal conditions and not at a

benchmarks, it ended up a “kissed sister”: my investment back plus a

cost anyone beyond a well-off, retired engineering geek would consider

passbook rate of return.

paying. Financial result: total write-off.

Like Dorothy, I awoke at last from the Silicon Valley Dream about 10

A Palo Alto–based tech company that developed software to allow large

years ago and—though not surrounded by the Tin Man, Scarecrow, and

organizations to stream one-way, extremely high-resolution video from,

Cowardly Lion—I, too, repeated that wisdom I had known all along, “There’s

say, its CEO to 10,000 employees at once: think the president of Exxon

no place like home.”

Mobil addressing his managers. Why this one failed, becoming yet more

And I went back to bricks and mortar.

roadkill, I have no idea.* As they say, it seemed like a good idea at the time. But I can tell you that when faced with the choice of participating in a “down round” on this investment—doubling down on my original investment or watching my stake in the company evaporate—I did manage to swallow hard and walk away. ■

A Swedish biotech company with a drug for which it had high hopes of treating rheumatoid arthritis. For a guy whose only science experiment ever was trying to make a geyser with Diet Coke and Mentos, this investment was admittedly a stretch. But it did provide this insight: forget the right answers; if you have no idea what the right questions are, run for the exit. As it happened, the drug worked well enough on lab rats, but somewhere between them and its human subjects, the drug, like my Diet Coke experiment, fizzled.

* Probably because it was 20 years before its time: in essence, it was Zoom’s forerunner.

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THERE'S NO PLACE LIKE HOME 107

35

Investing in Accidental Assets

investment ever. If you put away $30 for 35 years and get $500 back, you have a 1,567 percent return. Or, if you drink this liquid asset all by yourself, one lordly hangover. And even if you do quaff it, it’s still not a bad investment. As we were toasting one another, someone suggested we could sell the empty ’82 bottles online for hundreds of dollars. We checked, and so you can. The folks at Freakonomics attribute the brisk business in empty vintage bottles to the burgeoning market in fraudulent wine. In short, scam artists buy an empty bottle that retails for $1,000 when full, put 78 cents worth of fortified Kool-Aid in it, and have themselves quite a business. This essay is intended neither to praise nor bury the wine market, but to consider that perhaps buying what you love, investing almost by accident—or at least having enjoyment of the asset as your principal motivation—may not be the worst way to go. In other words, going for the chocolate cake instead of prudently investing in the asparagus of indexed mutual funds. Many years ago I knew an older man who, immediately after marrying a New York heiress, had promptly retired and spent the rest of his long life

Casting about in the cluttered basementthe night before our firm’s annual Christmas lunch, I happened across a couple of bottles of wine, survivors from a purchase made more than 30 years ago. The wine was a French Bordeaux from the fabled harvest of 1982—more specifically, a Grand Vin de Leoville du Marquis de Las Cases Saint-Julien. If that name means anything to you, you know more about wine than I do. But friends who can declaim—and decant—with the snootiest of sommeliers announced way back then that they were going long on 1982 Bordeaux futures. With their kind help, I bought a couple of cases of assorted ’82 Bordeaux at an average cost of around $30 a bottle. As we were driving to the city the next day for the lunch, a partner asked about the bottle, and we Googled it. It happens that the ’82 Leoville is available at such a bewildering array of prices—from $500 to $1,360 a bottle—that one questions not only the efficiency but also the integrity of the wine resale market. Even using the low-end price, however, this wine had to be my best

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mismanaging his wife’s portfolio, making the proverbial small fortune out of a larger one. He did, however, make one purchase that turned out so spectacularly it put Bordeaux to shame. He bought a Malibu beach house for $80,000 in the 1960s because he loved the views and the sand at his feet. When decades later he was no longer able to visit his bungalow, he reluctantly sold it for around $5,250,000. A 6,567 percent return. To this same point, an acquaintance recently showed me his collection of vintage Formula 1 racing cars. In explaining why, in addition to the great joy the cars have brought him, they have proved to be such lucrative investments, he said, “The world is awash with cash: trillions of dollars are sloshing around the globe trolling for investments. The stock market is overvalued, real estate is selling at all-time-high prices, and commodities are worth no more than tomorrow’s demand. Where can the money go? The best way to invest long term is in beauty—in unique, one-of-a-kind, irreplaceable beauty, whether that beauty is a Monet hanging on the wall or a vintage Ferrari in the garage.”

INVESTING IN ACCIDENTAL ASSETS 109

35

Investing in Accidental Assets

investment ever. If you put away $30 for 35 years and get $500 back, you have a 1,567 percent return. Or, if you drink this liquid asset all by yourself, one lordly hangover. And even if you do quaff it, it’s still not a bad investment. As we were toasting one another, someone suggested we could sell the empty ’82 bottles online for hundreds of dollars. We checked, and so you can. The folks at Freakonomics attribute the brisk business in empty vintage bottles to the burgeoning market in fraudulent wine. In short, scam artists buy an empty bottle that retails for $1,000 when full, put 78 cents worth of fortified Kool-Aid in it, and have themselves quite a business. This essay is intended neither to praise nor bury the wine market, but to consider that perhaps buying what you love, investing almost by accident—or at least having enjoyment of the asset as your principal motivation—may not be the worst way to go. In other words, going for the chocolate cake instead of prudently investing in the asparagus of indexed mutual funds. Many years ago I knew an older man who, immediately after marrying a New York heiress, had promptly retired and spent the rest of his long life

Casting about in the cluttered basementthe night before our firm’s annual Christmas lunch, I happened across a couple of bottles of wine, survivors from a purchase made more than 30 years ago. The wine was a French Bordeaux from the fabled harvest of 1982—more specifically, a Grand Vin de Leoville du Marquis de Las Cases Saint-Julien. If that name means anything to you, you know more about wine than I do. But friends who can declaim—and decant—with the snootiest of sommeliers announced way back then that they were going long on 1982 Bordeaux futures. With their kind help, I bought a couple of cases of assorted ’82 Bordeaux at an average cost of around $30 a bottle. As we were driving to the city the next day for the lunch, a partner asked about the bottle, and we Googled it. It happens that the ’82 Leoville is available at such a bewildering array of prices—from $500 to $1,360 a bottle—that one questions not only the efficiency but also the integrity of the wine resale market. Even using the low-end price, however, this wine had to be my best

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mismanaging his wife’s portfolio, making the proverbial small fortune out of a larger one. He did, however, make one purchase that turned out so spectacularly it put Bordeaux to shame. He bought a Malibu beach house for $80,000 in the 1960s because he loved the views and the sand at his feet. When decades later he was no longer able to visit his bungalow, he reluctantly sold it for around $5,250,000. A 6,567 percent return. To this same point, an acquaintance recently showed me his collection of vintage Formula 1 racing cars. In explaining why, in addition to the great joy the cars have brought him, they have proved to be such lucrative investments, he said, “The world is awash with cash: trillions of dollars are sloshing around the globe trolling for investments. The stock market is overvalued, real estate is selling at all-time-high prices, and commodities are worth no more than tomorrow’s demand. Where can the money go? The best way to invest long term is in beauty—in unique, one-of-a-kind, irreplaceable beauty, whether that beauty is a Monet hanging on the wall or a vintage Ferrari in the garage.”

INVESTING IN ACCIDENTAL ASSETS 109

He also pointed out that anything that can be endlessly reproduced, no

36

matter what its quality or desirability, has limited intrinsic value. By way of example, he mentioned the collapse of used private jet prices. (According to the Financial Times, second-hand jets have dropped 35 percent in value over the past three years.) Unless one is advising the first 25 employees of Facebook, suggesting the purchase of irreplaceable beach views or cars that Steve McQueen once raced at Le Mans is of little value. There is value, however, in suggesting that if you take great enjoyment in owning something, if you find it beautiful or

Retail’s Wholesale Risks

soul-satisfying, and if playing it or working it or restoring it or just looking at it makes you happy, perhaps it will more than hold its value as it ultimately brings the same joy to its next owner.

Had my livelihood been in another real estate discipline— say, industrial—I might be giving you specific suggestions about needed freeway proximity, clear heights, and truck docks for your projects. As it happens, I’ve devoted my career to retail—the development of neighborhood shopping centers. Thus, in following the adage “Write about what you know,” I will focus on the major challenges facing retail and briefly touch on its opportunities for the young developer as well. In short, four major headwinds are buffeting retail today: overbuilding, the internet, private equity, and the retailers themselves. Retail’s safe harbor against those headwinds is what we now call essential retail—that is, goods and services people cannot do without, even in the midst of a societal shutdown.

Overbuilding Far and away, the biggest problem confronting retail is excess capacity. In 2015, Forbes noted, “Since 1995, the number of shopping centers in the U.S. has grown by more than 23 percent and the total gross leasable area by almost 30 percent, while the population has grown by less than 14 percent.” According to Forbes, we have roughly 50 square feet of retail space per capita 110

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

111

He also pointed out that anything that can be endlessly reproduced, no

36

matter what its quality or desirability, has limited intrinsic value. By way of example, he mentioned the collapse of used private jet prices. (According to the Financial Times, second-hand jets have dropped 35 percent in value over the past three years.) Unless one is advising the first 25 employees of Facebook, suggesting the purchase of irreplaceable beach views or cars that Steve McQueen once raced at Le Mans is of little value. There is value, however, in suggesting that if you take great enjoyment in owning something, if you find it beautiful or

Retail’s Wholesale Risks

soul-satisfying, and if playing it or working it or restoring it or just looking at it makes you happy, perhaps it will more than hold its value as it ultimately brings the same joy to its next owner.

Had my livelihood been in another real estate discipline— say, industrial—I might be giving you specific suggestions about needed freeway proximity, clear heights, and truck docks for your projects. As it happens, I’ve devoted my career to retail—the development of neighborhood shopping centers. Thus, in following the adage “Write about what you know,” I will focus on the major challenges facing retail and briefly touch on its opportunities for the young developer as well. In short, four major headwinds are buffeting retail today: overbuilding, the internet, private equity, and the retailers themselves. Retail’s safe harbor against those headwinds is what we now call essential retail—that is, goods and services people cannot do without, even in the midst of a societal shutdown.

Overbuilding Far and away, the biggest problem confronting retail is excess capacity. In 2015, Forbes noted, “Since 1995, the number of shopping centers in the U.S. has grown by more than 23 percent and the total gross leasable area by almost 30 percent, while the population has grown by less than 14 percent.” According to Forbes, we have roughly 50 square feet of retail space per capita 110

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

111

in the United States while Europe has just 2.5 square feet. We have too many stores selling the same—let’s call it “stuff”—in every city in the country. Citing CoStar Group’s research, Bloomberg used Greater Cleveland to demonstrate how wildly developers have overbuilt. In Northeast Ohio, 21 million square feet of new retail had been thrown up in the 17 years since 2000 while buying power—a jobs/income formula—declined by 26 percent. You don’t need me to tell you any of this. That retail is overbuilt is obvious to anyone who has ever driven 20 miles in any direction in America. Less obvious is the why of overbuilding. For the beginning developer, this is worth considering. Putting aside a crude joke about dogs that illustrates the point perfectly, developers build in sagging areas because they can. Away from the coasts, all towns great and small are begging for development, for investment in their communities. We approached one remote town in northernmost California and inquired whether we could build a supermarket. “When can you start construction?” came the official response, and permits were issued forthwith. We built the market almost overnight, put it up for sale, and six months later without a single offer, we were reminded of the downside of ignoring location. Upon reflection, several reasons for “overdeveloping” come to mind. The first applies to that class of developers known as merchant builders; the second is more applicable to the naive or amateur developer; and the third involves the retailers themselves (explored below). Merchant builders build to sell, to get out of a project as swiftly as possible, often using other people’s money to do so. If these builders are large enough, they avail themselves of the public markets and use their stockholders’ equity. If not, they are typically funded by aggressive “hot money” sources that want to churn their capital even faster than the builders do. Thus, all a merchant builder needs to build in Northeast Ohio is the conviction that someone will buy her project on completion. Her go/no-go bar is practically on the ground: will there be a buyer around in 18 months? With such a stunted horizon, merchant builders often care little about an area’s longer-term prospects or whether they might be adding kindling to a retail pyre.

The inexperienced developer may build in the wrong places for less cynical reasons but ultimately to the same effect. Have you ever heard a homeowner dismiss comparable sales that undercut his own home’s value? “Yes, but mine has a hot tub.” Just as the homeowner blinds himself to the reality that houses sell at a surprisingly efficient price per square foot, inexperienced developers often talk themselves out of acknowledging market conditions. Despite a looming slowdown, they insist their project’s amenities are unique (they’re not), their lineup of tenants is special (it’s not), and that their project will thrive (it won’t). Groucho Marx famously remarked that he would refuse to join a club that would have him as a member. If you’re thinking of developing in an area that has scant prospects for growth, you might ignore the charming surface contradiction of Groucho’s comment and ponder his underlying point.

112

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MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

E-Commerce Retail’s other principal challenge is the internet. While the national press has been predicting retail’s death at the hands of e-commerce for years, the reality is more nuanced. Yes, the internet has driven some merchants out of business and some retail categories to the brink, but its biggest effect has been to reduce retailers’ overall profitability and, notably, to cause many merchants to shrink their store sizes. They’re doing so to pursue a joint bricks-and-mortar/online selling strategy. This last effect—shrinking stores—is a major concern: the landlord ends up with a 40,000-square-foot building he built for a tenant that now only needs half the space. But fortunately for bricks-and-mortar retail, e-commerce can only do so much harm. Why? It simply isn’t profitable: its siege against bricks-andmortar isn’t sustainable in the long run. In an homage to Amazon titled “E-Commerce Is a Bear,” Andy Dunn, the founder and CEO of Bonobos, points out that no other retail company has a chance online: “E-commerce is great. Only three problems: no IPOs, no Mergers and Acquisitions, no EBITDA” (earnings before interest, taxes, depreciation, and amortization— accountant-speak for profit). Putting aside FedEx and UPS, no one is making money in online retail. Why? Among other reasons, the last-mile delivery conundrum.

in the United States while Europe has just 2.5 square feet. We have too many stores selling the same—let’s call it “stuff”—in every city in the country. Citing CoStar Group’s research, Bloomberg used Greater Cleveland to demonstrate how wildly developers have overbuilt. In Northeast Ohio, 21 million square feet of new retail had been thrown up in the 17 years since 2000 while buying power—a jobs/income formula—declined by 26 percent. You don’t need me to tell you any of this. That retail is overbuilt is obvious to anyone who has ever driven 20 miles in any direction in America. Less obvious is the why of overbuilding. For the beginning developer, this is worth considering. Putting aside a crude joke about dogs that illustrates the point perfectly, developers build in sagging areas because they can. Away from the coasts, all towns great and small are begging for development, for investment in their communities. We approached one remote town in northernmost California and inquired whether we could build a supermarket. “When can you start construction?” came the official response, and permits were issued forthwith. We built the market almost overnight, put it up for sale, and six months later without a single offer, we were reminded of the downside of ignoring location. Upon reflection, several reasons for “overdeveloping” come to mind. The first applies to that class of developers known as merchant builders; the second is more applicable to the naive or amateur developer; and the third involves the retailers themselves (explored below). Merchant builders build to sell, to get out of a project as swiftly as possible, often using other people’s money to do so. If these builders are large enough, they avail themselves of the public markets and use their stockholders’ equity. If not, they are typically funded by aggressive “hot money” sources that want to churn their capital even faster than the builders do. Thus, all a merchant builder needs to build in Northeast Ohio is the conviction that someone will buy her project on completion. Her go/no-go bar is practically on the ground: will there be a buyer around in 18 months? With such a stunted horizon, merchant builders often care little about an area’s longer-term prospects or whether they might be adding kindling to a retail pyre.

The inexperienced developer may build in the wrong places for less cynical reasons but ultimately to the same effect. Have you ever heard a homeowner dismiss comparable sales that undercut his own home’s value? “Yes, but mine has a hot tub.” Just as the homeowner blinds himself to the reality that houses sell at a surprisingly efficient price per square foot, inexperienced developers often talk themselves out of acknowledging market conditions. Despite a looming slowdown, they insist their project’s amenities are unique (they’re not), their lineup of tenants is special (it’s not), and that their project will thrive (it won’t). Groucho Marx famously remarked that he would refuse to join a club that would have him as a member. If you’re thinking of developing in an area that has scant prospects for growth, you might ignore the charming surface contradiction of Groucho’s comment and ponder his underlying point.

112

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MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

E-Commerce Retail’s other principal challenge is the internet. While the national press has been predicting retail’s death at the hands of e-commerce for years, the reality is more nuanced. Yes, the internet has driven some merchants out of business and some retail categories to the brink, but its biggest effect has been to reduce retailers’ overall profitability and, notably, to cause many merchants to shrink their store sizes. They’re doing so to pursue a joint bricks-and-mortar/online selling strategy. This last effect—shrinking stores—is a major concern: the landlord ends up with a 40,000-square-foot building he built for a tenant that now only needs half the space. But fortunately for bricks-and-mortar retail, e-commerce can only do so much harm. Why? It simply isn’t profitable: its siege against bricks-andmortar isn’t sustainable in the long run. In an homage to Amazon titled “E-Commerce Is a Bear,” Andy Dunn, the founder and CEO of Bonobos, points out that no other retail company has a chance online: “E-commerce is great. Only three problems: no IPOs, no Mergers and Acquisitions, no EBITDA” (earnings before interest, taxes, depreciation, and amortization— accountant-speak for profit). Putting aside FedEx and UPS, no one is making money in online retail. Why? Among other reasons, the last-mile delivery conundrum.

According to the Wall Street Journal, UPS charged $8.31 per package delivered in 2018. You will buy your $40 worth of books online as long as Amazon eats that last-mile delivery cost. The moment it attempts to charge the $8.31, many of us will buy them elsewhere. Amazon understands this financial catch-22. The clever company will ultimately solve its last-mile dilemma by forcing you to drive it. This is why Amazon purchased the 431-store Whole Foods chain, has opened 24 bookstores to date, and made numerous proclamations about opening several thousand food markets. It knows it needs a physical presence within easy driving distance of 90 percent of its customers in order to compete with retail’s other great winner, Wal-Mart. In sum, e-commerce operates like a surface filter on retail’s Olympic swimming pool: it’s constantly skimming off the top, draining away the profits that would enable the bricks crowd to open new stores and expand and renovate their old ones. Until e-commerce and bricks-and-mortar finally merge (they will), retail will be suffering from a debilitating, but not deadly, internet-spawned flu.

Private Equity When Debenhams, a 200-year-old British department store chain, died, the coroner trotted out the usual suspects: the internet, the oversupply of retail, rising rents, tighter margins, and, at the end of the dreary lineup, private equity. As it happened, Debenhams had been purchased by a private equity consortium in 2003. That group paid £1.8 billion for the company, using £600 million in equity and £1.2 billion in debt it forced Debenhams to assume. The private equiteers promptly began selling off assets, dramatically cutting costs (store refurbishments dropped 77 percent), and awarding themselves large dividends for their efforts. And, no surprise, consumers lost interest in the fraying stores. Since the end of the Great Recession, retailer after retailer has been similarly gutted. Payless Shoes, Toys ’R’ Us, PetSmart, Gymboree, Sears, Mattress Firm, and Radio Shack—all companies owned by private equity— have filed Chapter 11 since 2012. In fact, Debtwire, a financial news service, calculates that about 40 percent of all U.S. retail bankruptcies in recent years were private-equity backed.

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How do the private equiteers do it? Simple: the leveraged buyout. The LBO is the financial world’s pick-and-roll—that is, a highly effective play that is difficult to counter. In short, the private equity firm pays top dollar for a given retailer, often even overpaying, but using as little equity and as much debt as it possibly can. It then improves the company’s profitability through unconscionable cost-cutting and then rewards itself with a major dividend, often recovering not only its entire initial investment, but a substantial profit to boot. A private equity firm may be acting in good faith. It may actually use its best efforts—and to be fair, equiteers sometimes succeed with their retail acquisitions—but even under the best of circumstances, retail is a difficult business. The threats from e-commerce, changing tastes, and ever-morenimble competitors are all too real. Here’s private equity’s ethical challenge: if you’ve already got your investment plus a fat profit out of a company, how hard are you going to continue to work on bailing it out, especially when you’ve crushed its bottom line beneath a wrecking ball of expensive debt? Because volumes have been written about private equity’s insidious effect on retail to no apparent effect, it may be time to try a different tack. If a picture is worth a thousand words, an episode of The Sopranos is good for an encyclopedia on the topic of destroying retailers. In “Bust Out” (season 2, episode 10), Davey Scatino, an old boyhood friend of Tony’s, borrows money from the gangster to pay back gambling losses. Unable to repay his debt, Davey watches helplessly as Tony and Richie Aprile take over his sporting goods store. Knowing they will never pay a single bill, the mobsters order 10 times the store’s normal inventory, sell it all at a discount for cash, and pocket the proceeds, destroying first Davey’s credit, forcing him into bankruptcy, then his life. Sadly, this is a perfect illustration of private equity. If you decide to develop retail, if you make creating locations for even top-notch retailers your career, you will likely wake up one morning to read in the Journal that your AA credit–rated tenant has been purchased by a private equity firm and that the great credit you relied on to build your center is gone, lost in the junk-bond financing the equiteers used to buy the retailer. This has happened to us a number of times. What can you do about it? Nothing. Except perhaps remind yourself never to fall in love with retailers. If you must love

RETAIL'S WHOLESALE RISKS 115

According to the Wall Street Journal, UPS charged $8.31 per package delivered in 2018. You will buy your $40 worth of books online as long as Amazon eats that last-mile delivery cost. The moment it attempts to charge the $8.31, many of us will buy them elsewhere. Amazon understands this financial catch-22. The clever company will ultimately solve its last-mile dilemma by forcing you to drive it. This is why Amazon purchased the 431-store Whole Foods chain, has opened 24 bookstores to date, and made numerous proclamations about opening several thousand food markets. It knows it needs a physical presence within easy driving distance of 90 percent of its customers in order to compete with retail’s other great winner, Wal-Mart. In sum, e-commerce operates like a surface filter on retail’s Olympic swimming pool: it’s constantly skimming off the top, draining away the profits that would enable the bricks crowd to open new stores and expand and renovate their old ones. Until e-commerce and bricks-and-mortar finally merge (they will), retail will be suffering from a debilitating, but not deadly, internet-spawned flu.

Private Equity When Debenhams, a 200-year-old British department store chain, died, the coroner trotted out the usual suspects: the internet, the oversupply of retail, rising rents, tighter margins, and, at the end of the dreary lineup, private equity. As it happened, Debenhams had been purchased by a private equity consortium in 2003. That group paid £1.8 billion for the company, using £600 million in equity and £1.2 billion in debt it forced Debenhams to assume. The private equiteers promptly began selling off assets, dramatically cutting costs (store refurbishments dropped 77 percent), and awarding themselves large dividends for their efforts. And, no surprise, consumers lost interest in the fraying stores. Since the end of the Great Recession, retailer after retailer has been similarly gutted. Payless Shoes, Toys ’R’ Us, PetSmart, Gymboree, Sears, Mattress Firm, and Radio Shack—all companies owned by private equity— have filed Chapter 11 since 2012. In fact, Debtwire, a financial news service, calculates that about 40 percent of all U.S. retail bankruptcies in recent years were private-equity backed.

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How do the private equiteers do it? Simple: the leveraged buyout. The LBO is the financial world’s pick-and-roll—that is, a highly effective play that is difficult to counter. In short, the private equity firm pays top dollar for a given retailer, often even overpaying, but using as little equity and as much debt as it possibly can. It then improves the company’s profitability through unconscionable cost-cutting and then rewards itself with a major dividend, often recovering not only its entire initial investment, but a substantial profit to boot. A private equity firm may be acting in good faith. It may actually use its best efforts—and to be fair, equiteers sometimes succeed with their retail acquisitions—but even under the best of circumstances, retail is a difficult business. The threats from e-commerce, changing tastes, and ever-morenimble competitors are all too real. Here’s private equity’s ethical challenge: if you’ve already got your investment plus a fat profit out of a company, how hard are you going to continue to work on bailing it out, especially when you’ve crushed its bottom line beneath a wrecking ball of expensive debt? Because volumes have been written about private equity’s insidious effect on retail to no apparent effect, it may be time to try a different tack. If a picture is worth a thousand words, an episode of The Sopranos is good for an encyclopedia on the topic of destroying retailers. In “Bust Out” (season 2, episode 10), Davey Scatino, an old boyhood friend of Tony’s, borrows money from the gangster to pay back gambling losses. Unable to repay his debt, Davey watches helplessly as Tony and Richie Aprile take over his sporting goods store. Knowing they will never pay a single bill, the mobsters order 10 times the store’s normal inventory, sell it all at a discount for cash, and pocket the proceeds, destroying first Davey’s credit, forcing him into bankruptcy, then his life. Sadly, this is a perfect illustration of private equity. If you decide to develop retail, if you make creating locations for even top-notch retailers your career, you will likely wake up one morning to read in the Journal that your AA credit–rated tenant has been purchased by a private equity firm and that the great credit you relied on to build your center is gone, lost in the junk-bond financing the equiteers used to buy the retailer. This has happened to us a number of times. What can you do about it? Nothing. Except perhaps remind yourself never to fall in love with retailers. If you must love

RETAIL'S WHOLESALE RISKS 115

something inanimate, love your location. Tenants come and go; locations are constant.

The Retailers And, finally, the retailers. Enslaved to Wall Street, retailers must grow or die. It’s that simple. The moment a company’s growth falters, private equity goes for the jugular. The company will be bought and chopped up for parts, the CEO and his cronies will lose their jobs, and the real estate managers will wave aloha to their bonuses. To avoid this fate, all too many retailers force their growth into wherever it can go—say, into oversaturated areas like Northeast Ohio. Mattress Firm, the nation’s largest mattress retailer, is a great example. The company filed Chapter 11 bankruptcy in late 2018. Why did it go bankrupt? Simple: the company had far more stores—more than 3,600 nationwide at its 2016 peak—than could ever possibly be profitable. The intriguing question was, how did MF end up with too many stores? A bit of background. Sophisticated retailers research what the “total addressable market” is for their product—that is, if they managed to capture every single buyer in the country, what would that total number be? And then—this is where hubris or bungling can arise—they decide how much market share they can capture from their competitors. If four equally strong companies are selling a given product, an individual company’s market share might reasonably be 25 percent. If there are 20 competitors, one’s share might be 5 percent. You get the picture. And when everyone and their mother are selling mattresses (they are), your realistic market share should be lower than your height, particularly since consumers only buy a new mattress once every seven to 10 years. Everyone at MF knew this; everyone knew that you cannot stack mattresses to the sky. In fact, they publicly stated that the company wanted a population of 50,000 in a trade area as a condition to locating a store there. They also knew, however, that you can’t create big value for your shareholders and, more important, yourself if you fail to meet Wall Street’s insatiable demand for growth. Until 2016, MF grew like a sunlit jungle vine by rolling up one regional mattress chain after another under its flag and opening hundreds of new stores. Senior management could only have justified this runaway expansion 116

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

to its board of directors and Wall Street by inflating its probable market share. How much did it over-expand? If it takes 50,000 people to support one successful mattress store, then, at 3,600 outlets, the company had stores for more than 180 million people—about half the U.S. population—meaning it had to capture an enormous share to succeed. It didn’t. And maybe it never really intended to. When MF bought a local Northern California chain in 2014, it acquired an outlet in our shopping center in Petaluma. A town of 60,000, Petaluma had six separate mattress shops and a number of home furnishings stores that sold beds. Since this meant the town had more mattress stores than 7-Elevens, we were sure MF would close our location to protect its existing store 300 yards away. Wrong. When it opened in our center, I asked our local partner, “How can four mattress stores at the same freeway off-ramp possibly survive?” He mumbled something about MF’s drive for market share and “four-squaring” a location—controlling every corner to capture all available consumer dollars. MF’s approach to Petaluma was not unique. Rather, its nationwide market oversaturation was so obvious that conspiracy theories abounded. Outraged landlords wondered whether MF had long ago hatched an evil plot to pin down all the best locations and then reject the also-rans as part of an eventual bankruptcy. This suspicion squared with the company’s reorganization plan: it shuttered 700 stores, 200 immediately, and then—here’s the fun part—it pitted its remaining loser-landlords against one another to see which would save their locations by cutting rent the most. We were among the 200 owners who lost their stores immediately. It took us two years to lease the space that MF left in our center. The point? You can do everything right in retail and still lose because of conditions beyond your control. How do you mitigate the risk of a tenant’s bankruptcy or gutting by private equity? You diversify: you develop multitenant properties in which the loss of a single tenant is merely painful. MF had a 5,000-square-foot space in our center of about 160,000 square feet. Thus, its loss raised our overall vacancy rate by a bit less than 3 percent. Had we owned a freestanding MF store that closed, our vacancy would have been 100 percent. ***

RETAIL'S WHOLESALE RISKS 117

something inanimate, love your location. Tenants come and go; locations are constant.

The Retailers And, finally, the retailers. Enslaved to Wall Street, retailers must grow or die. It’s that simple. The moment a company’s growth falters, private equity goes for the jugular. The company will be bought and chopped up for parts, the CEO and his cronies will lose their jobs, and the real estate managers will wave aloha to their bonuses. To avoid this fate, all too many retailers force their growth into wherever it can go—say, into oversaturated areas like Northeast Ohio. Mattress Firm, the nation’s largest mattress retailer, is a great example. The company filed Chapter 11 bankruptcy in late 2018. Why did it go bankrupt? Simple: the company had far more stores—more than 3,600 nationwide at its 2016 peak—than could ever possibly be profitable. The intriguing question was, how did MF end up with too many stores? A bit of background. Sophisticated retailers research what the “total addressable market” is for their product—that is, if they managed to capture every single buyer in the country, what would that total number be? And then—this is where hubris or bungling can arise—they decide how much market share they can capture from their competitors. If four equally strong companies are selling a given product, an individual company’s market share might reasonably be 25 percent. If there are 20 competitors, one’s share might be 5 percent. You get the picture. And when everyone and their mother are selling mattresses (they are), your realistic market share should be lower than your height, particularly since consumers only buy a new mattress once every seven to 10 years. Everyone at MF knew this; everyone knew that you cannot stack mattresses to the sky. In fact, they publicly stated that the company wanted a population of 50,000 in a trade area as a condition to locating a store there. They also knew, however, that you can’t create big value for your shareholders and, more important, yourself if you fail to meet Wall Street’s insatiable demand for growth. Until 2016, MF grew like a sunlit jungle vine by rolling up one regional mattress chain after another under its flag and opening hundreds of new stores. Senior management could only have justified this runaway expansion 116

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

to its board of directors and Wall Street by inflating its probable market share. How much did it over-expand? If it takes 50,000 people to support one successful mattress store, then, at 3,600 outlets, the company had stores for more than 180 million people—about half the U.S. population—meaning it had to capture an enormous share to succeed. It didn’t. And maybe it never really intended to. When MF bought a local Northern California chain in 2014, it acquired an outlet in our shopping center in Petaluma. A town of 60,000, Petaluma had six separate mattress shops and a number of home furnishings stores that sold beds. Since this meant the town had more mattress stores than 7-Elevens, we were sure MF would close our location to protect its existing store 300 yards away. Wrong. When it opened in our center, I asked our local partner, “How can four mattress stores at the same freeway off-ramp possibly survive?” He mumbled something about MF’s drive for market share and “four-squaring” a location—controlling every corner to capture all available consumer dollars. MF’s approach to Petaluma was not unique. Rather, its nationwide market oversaturation was so obvious that conspiracy theories abounded. Outraged landlords wondered whether MF had long ago hatched an evil plot to pin down all the best locations and then reject the also-rans as part of an eventual bankruptcy. This suspicion squared with the company’s reorganization plan: it shuttered 700 stores, 200 immediately, and then—here’s the fun part—it pitted its remaining loser-landlords against one another to see which would save their locations by cutting rent the most. We were among the 200 owners who lost their stores immediately. It took us two years to lease the space that MF left in our center. The point? You can do everything right in retail and still lose because of conditions beyond your control. How do you mitigate the risk of a tenant’s bankruptcy or gutting by private equity? You diversify: you develop multitenant properties in which the loss of a single tenant is merely painful. MF had a 5,000-square-foot space in our center of about 160,000 square feet. Thus, its loss raised our overall vacancy rate by a bit less than 3 percent. Had we owned a freestanding MF store that closed, our vacancy would have been 100 percent. ***

RETAIL'S WHOLESALE RISKS 117

Should you consider retail development? Only if you start with an established company that knows the business—and you devote yourself full time to it. It is a highly specialized area of development that punishes those who merely dabble in it. As to its challenges, you can get past the vast oversupply issue by focusing on areas with high population growth, particularly in new or emerging cities. You can get past e-commerce by focusing on internet-proof tenants (e.g., supermarkets, nail salons, gas stations, and pizza parlors). You cannot, however, insulate yourself from your tenants’ follies or the greed of Wall Street.

37

Environmental Contamination: Hazardous to Your Health?

One truth that bears learning is this: news is seldom as good—or as bad—as it first appears. If you exult over making a fistful of money, you will soon recall that half goes to the government; when you lose your shirt, your accountant will remind you of its deductibility and the government’s share in your folly. A good way to lose that shirt is to fail to take environmental issues seriously. We bought a Rite Aid drugstore in Northern California. Then, we decided to replace our acquisition financing with long-term debt. As with every lender in the country, ours required a Phase I environmental report to verify that the property was free of hazardous materials. Because suburban shopping centers are typically constructed on raw fields or farmland, only two types of underground contaminants tend to bedevil them, gasoline and dry-cleaning

118

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

119

Should you consider retail development? Only if you start with an established company that knows the business—and you devote yourself full time to it. It is a highly specialized area of development that punishes those who merely dabble in it. As to its challenges, you can get past the vast oversupply issue by focusing on areas with high population growth, particularly in new or emerging cities. You can get past e-commerce by focusing on internet-proof tenants (e.g., supermarkets, nail salons, gas stations, and pizza parlors). You cannot, however, insulate yourself from your tenants’ follies or the greed of Wall Street.

37

Environmental Contamination: Hazardous to Your Health?

One truth that bears learning is this: news is seldom as good—or as bad—as it first appears. If you exult over making a fistful of money, you will soon recall that half goes to the government; when you lose your shirt, your accountant will remind you of its deductibility and the government’s share in your folly. A good way to lose that shirt is to fail to take environmental issues seriously. We bought a Rite Aid drugstore in Northern California. Then, we decided to replace our acquisition financing with long-term debt. As with every lender in the country, ours required a Phase I environmental report to verify that the property was free of hazardous materials. Because suburban shopping centers are typically constructed on raw fields or farmland, only two types of underground contaminants tend to bedevil them, gasoline and dry-cleaning

118

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

119

solvents. That is to say, contamination of retail centers almost invariably comes from within—from their own leaking gas stations and dry cleaners. From this common knowledge, veteran retail buyers work off a rough

In 2001, we were in escrow to buy a broken-down Bay Area shopping center. As our due diligence unfolded, we discovered the center’s dry cleaner had leaked a minute amount of the dry cleaning fluid tetrachloroethylene

syllogism along these lines: almost all old dry cleaners leak, my center has

(commonly, PERC) into the soil below. The leak had occurred in the distant

an old dry cleaner, I sure as hell better have mine tested. Conversely, even

past—the dry cleaner had long since ceased using the solvent—and whatever

the most prudent buyer will be relatively unconcerned with contaminants

contamination remained had stabilized. Because the groundwater beneath

if her property went from farm to drugstore, if neither it nor its neighboring

the site was not potable, the contamination barely above detectable, and the

properties ever housed a gas station or dry cleaner, and if no toxic spill

seller willing to remain responsible for ongoing monitoring and cleanup, we

or environmental cleanup has ever been reported in the surrounding

purchased the center.

neighborhood. This was the precise situation with our Rite Aid: we weren’t at all

At the time, the environmental consultants assured us—and no doubt the seller—that a few more quarters of monitoring at a modest cost were

concerned about contamination issues. But we still needed a Phase I

all that was needed to obtain the closure letter necessary for a clean bill of

environmental report. A Phase I is simply a research paper that sets forth

environmental health. Nineteen years and nearly $600,000 later, the Regional

a given site’s historical uses and whether any contaminants are known or

Water Quality Board remains unsatisfied and the environmental consultants

suspected to be affecting it. If a site has no history of uses giving rise to

still whistle the same tuneless refrain: a few more quarters of monitoring.

the possibility of contamination and nothing in the public record suggests

Though the center has been a success for us, it’s in a sort of commercial

contamination from a nearby source, the Phase I concludes that no further

purgatory: we can neither sell it nor refinance it with anyone but the existing

action is required. Given our site’s history, the bank’s environmental

lender. Absent that final closure letter, few would dare come into the chain of

consultants should have given it a clean bill of health. Instead, they found

title. If we needed to unload the center in a hurry, the discount to its true value

that the presence of a dry cleaner (one with no known history of spills or

would be enormous.

contamination) two parcels away from ours was enough to warrant drilling

Environmental consultants are well intentioned—after all, they’re

our property. This conclusion could have blown the loan and caused us a

engineers, the most decent and sincere professionals in real estate—but

small world of grief. Fortunately, our lenders were the best in the business,

economic incentive is a powerful force. And with “cost plus” contracts the

and they concluded that, rather than drilling our property, we should boot

industry norm, where is their economic incentive to ever have a closure letter

that consultant.

issued? Does the local environmental authority ever want to sign one? Both

The second consultant was less persnickety than the first, concluding that

sides can busy themselves forever testing trace amounts of chemicals deep

there was no reasonable basis to deduce the presence of contamination. We

below the surface that cannot, even under the most zealous approach to

were able to complete our refinancing and place the property in our portfolio

safeguarding public health, be considered a realistic threat to society.

for a long-term hold. The obvious advice from our experience? Be serious

This vignette might have little appeal beyond our offices were it not for

about potential contamination but, like a cancer diagnosis, seek a second

the fact that the same story is played daily out thousands of times across the

opinion if there is any doubt at all.

country. We’ve been buying and renovating worn-out shopping centers for

It hasn’t always worked out so neatly for us.

120

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

35 years, and every old gas station and dry cleaner we’ve ever tested leaked.

ENVIRONMENTAL CONTAMINATION: HAZARDOUS TO YOUR HEALTH? 121

solvents. That is to say, contamination of retail centers almost invariably comes from within—from their own leaking gas stations and dry cleaners. From this common knowledge, veteran retail buyers work off a rough

In 2001, we were in escrow to buy a broken-down Bay Area shopping center. As our due diligence unfolded, we discovered the center’s dry cleaner had leaked a minute amount of the dry cleaning fluid tetrachloroethylene

syllogism along these lines: almost all old dry cleaners leak, my center has

(commonly, PERC) into the soil below. The leak had occurred in the distant

an old dry cleaner, I sure as hell better have mine tested. Conversely, even

past—the dry cleaner had long since ceased using the solvent—and whatever

the most prudent buyer will be relatively unconcerned with contaminants

contamination remained had stabilized. Because the groundwater beneath

if her property went from farm to drugstore, if neither it nor its neighboring

the site was not potable, the contamination barely above detectable, and the

properties ever housed a gas station or dry cleaner, and if no toxic spill

seller willing to remain responsible for ongoing monitoring and cleanup, we

or environmental cleanup has ever been reported in the surrounding

purchased the center.

neighborhood. This was the precise situation with our Rite Aid: we weren’t at all

At the time, the environmental consultants assured us—and no doubt the seller—that a few more quarters of monitoring at a modest cost were

concerned about contamination issues. But we still needed a Phase I

all that was needed to obtain the closure letter necessary for a clean bill of

environmental report. A Phase I is simply a research paper that sets forth

environmental health. Nineteen years and nearly $600,000 later, the Regional

a given site’s historical uses and whether any contaminants are known or

Water Quality Board remains unsatisfied and the environmental consultants

suspected to be affecting it. If a site has no history of uses giving rise to

still whistle the same tuneless refrain: a few more quarters of monitoring.

the possibility of contamination and nothing in the public record suggests

Though the center has been a success for us, it’s in a sort of commercial

contamination from a nearby source, the Phase I concludes that no further

purgatory: we can neither sell it nor refinance it with anyone but the existing

action is required. Given our site’s history, the bank’s environmental

lender. Absent that final closure letter, few would dare come into the chain of

consultants should have given it a clean bill of health. Instead, they found

title. If we needed to unload the center in a hurry, the discount to its true value

that the presence of a dry cleaner (one with no known history of spills or

would be enormous.

contamination) two parcels away from ours was enough to warrant drilling

Environmental consultants are well intentioned—after all, they’re

our property. This conclusion could have blown the loan and caused us a

engineers, the most decent and sincere professionals in real estate—but

small world of grief. Fortunately, our lenders were the best in the business,

economic incentive is a powerful force. And with “cost plus” contracts the

and they concluded that, rather than drilling our property, we should boot

industry norm, where is their economic incentive to ever have a closure letter

that consultant.

issued? Does the local environmental authority ever want to sign one? Both

The second consultant was less persnickety than the first, concluding that

sides can busy themselves forever testing trace amounts of chemicals deep

there was no reasonable basis to deduce the presence of contamination. We

below the surface that cannot, even under the most zealous approach to

were able to complete our refinancing and place the property in our portfolio

safeguarding public health, be considered a realistic threat to society.

for a long-term hold. The obvious advice from our experience? Be serious

This vignette might have little appeal beyond our offices were it not for

about potential contamination but, like a cancer diagnosis, seek a second

the fact that the same story is played daily out thousands of times across the

opinion if there is any doubt at all.

country. We’ve been buying and renovating worn-out shopping centers for

It hasn’t always worked out so neatly for us.

120

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

35 years, and every old gas station and dry cleaner we’ve ever tested leaked.

ENVIRONMENTAL CONTAMINATION: HAZARDOUS TO YOUR HEALTH? 121

Either we are the unluckiest developers in America or it’s fair to assume this

environmental risks involved. Run from properties that are, say, polluting

government-mandated digging of holes and then refilling them is pandemic.

groundwater, but fight conclusions or directives that make no sense to you

While PERC has yet to be proven to cause cancer (the National Toxicology Program’s most recent Report on Carcinogens states, “. . . it is reasonably

and your own consultants. In 1984, we were forced to bring in space suit–clad workers to remediate

anticipated to be a human carcinogen”), one should assume that in sufficiently

a trace amount of asbestos from a small San Francisco office building we’d

high doses, it would. Even drinking plain water can be fatal if the quantity

purchased. I likened that expensive madness then to the goldfish-swallowing

imbibed is prodigious. As Alice observed in her Adventures in Wonderland,

craze of the 1920s—silly, but a swiftly passing fad.

“Better read it first, for if one drinks much from a bottle marked ‘poison,’ it’s

As so often the case, I was wrong. This fad isn’t passing.

almost certain to disagree with one sooner or later.” Conversely, in minuscule doses, the deadliest poisons often prove to be without harmful effect. “The dose makes the poison” has been a dictum in the medical world for hundreds of years. From a layman’s standpoint, this seems to be the issue bedeviling environmental cleanups today: there is too little recognition of what “dosage” is actually injurious. When it comes to toxic cleanups, we’re too often forced to perform heart surgery for nosebleeds. Which landowner would dispute her obligation to remediate contamination that might affect drinking water? But does any owner of a gas station thinks it’s worth a small fortune to eradicate a thimble-full of gasoline residue 20 feet below an impermeable asphalt surface? It’s fair to say the goal of most governmental regulations is well intended, even high-minded. For the sake of argument, you might even concede that the majority of regulations—e.g., requiring hard hats on construction sites—are good rules. Protecting the public from known cancer risks is a noble aspiration. It is in the implementation of this goal, deep down in the bureaucratic trenches, where needless economic tragedy occurs. If the devil is in the regulation, hell is in its interpretation, especially where bureaucrats have little understanding of the business they’re regulating. Do deals blow up because of overly cautious environmental reports? Every day. Are properties cast into economic limbo by requiring remediation of a spill that everyone save the regulators considers inconsequential? To quote Ringo Starr, I’m certain that it happens all the time. The trick, if there is one, is to take potential contamination of a site seriously while, at the same time, keeping your perspective about the real 122

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

ENVIRONMENTAL CONTAMINATION: HAZARDOUS TO YOUR HEALTH? 123

Either we are the unluckiest developers in America or it’s fair to assume this

environmental risks involved. Run from properties that are, say, polluting

government-mandated digging of holes and then refilling them is pandemic.

groundwater, but fight conclusions or directives that make no sense to you

While PERC has yet to be proven to cause cancer (the National Toxicology Program’s most recent Report on Carcinogens states, “. . . it is reasonably

and your own consultants. In 1984, we were forced to bring in space suit–clad workers to remediate

anticipated to be a human carcinogen”), one should assume that in sufficiently

a trace amount of asbestos from a small San Francisco office building we’d

high doses, it would. Even drinking plain water can be fatal if the quantity

purchased. I likened that expensive madness then to the goldfish-swallowing

imbibed is prodigious. As Alice observed in her Adventures in Wonderland,

craze of the 1920s—silly, but a swiftly passing fad.

“Better read it first, for if one drinks much from a bottle marked ‘poison,’ it’s

As so often the case, I was wrong. This fad isn’t passing.

almost certain to disagree with one sooner or later.” Conversely, in minuscule doses, the deadliest poisons often prove to be without harmful effect. “The dose makes the poison” has been a dictum in the medical world for hundreds of years. From a layman’s standpoint, this seems to be the issue bedeviling environmental cleanups today: there is too little recognition of what “dosage” is actually injurious. When it comes to toxic cleanups, we’re too often forced to perform heart surgery for nosebleeds. Which landowner would dispute her obligation to remediate contamination that might affect drinking water? But does any owner of a gas station thinks it’s worth a small fortune to eradicate a thimble-full of gasoline residue 20 feet below an impermeable asphalt surface? It’s fair to say the goal of most governmental regulations is well intended, even high-minded. For the sake of argument, you might even concede that the majority of regulations—e.g., requiring hard hats on construction sites—are good rules. Protecting the public from known cancer risks is a noble aspiration. It is in the implementation of this goal, deep down in the bureaucratic trenches, where needless economic tragedy occurs. If the devil is in the regulation, hell is in its interpretation, especially where bureaucrats have little understanding of the business they’re regulating. Do deals blow up because of overly cautious environmental reports? Every day. Are properties cast into economic limbo by requiring remediation of a spill that everyone save the regulators considers inconsequential? To quote Ringo Starr, I’m certain that it happens all the time. The trick, if there is one, is to take potential contamination of a site seriously while, at the same time, keeping your perspective about the real 122

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

ENVIRONMENTAL CONTAMINATION: HAZARDOUS TO YOUR HEALTH? 123

38

A Sod Roof Too Far

Triage may be worth considering today in real estate development, not so much from the developer’s perspective, but the public’s. That no proposed development can afford to provide an infinite number of public benefits is axiomatic, at least to its developers. And given that the number and cost of city exactions imposed on new projects increase annually, a fair question might be, would society profit by reexamining the usefulness of its exactions and deciding to forgo some in favor of addressing other, more pressing public needs? This isn’t a call to save developers money. On the contrary, let’s assume that any given project can—without breaking the economic camel’s back— afford to add 10 percent to its total construction costs to provide public benefits. Let’s further assume a civic-minded developer accepts this 10 percent cost, but would like to see her money well spent and is therefore willing to suspend or at least further dilute the already watery “nexus” requirement (i.e., the exaction must offset a project impact). And finally, let’s assume that the city in which her project is located is suffering from poor public schools,

trē-'äzh n.

police and fire cutbacks, a dearth of low-income housing, and crumbling

1. A process for sorting injured people into groups based on their need for or likely benefit from immediate medical treatment. 2. A system used to allocate a scarce commodity, such as food, only to those capable of deriving the greatest benefit from it. 3. A process in which things are ranked in terms of importance or priority. In addition to sounding charmingly continental, the word triage embodies a reasonable concept. If you’re running out of blood transfusions, give them to those who still have a heartbeat. In an emergency context—say, a plane crash—everyone agrees this is the only possible approach. Anywhere else, triage is problematic. Triage should apply brilliantly to medical care during a time of limited means (now). The concept is logical, rational, and fair . . . until your mother is the one left untreated while her roommate is wheeled into surgery.

infrastructure (i.e., virtually Any City, USA). With these pressing public needs, should we, as cities, be requiring developers to put in drinking fountains for dogs, public “art” that is (thankfully for almost everyone concerned) seldom noticed, unneeded community rooms, or closet-sized public parks the public couldn’t find with a map? But instead of focusing on these relatively minor exactions, let’s step right into it and question “green.” Yes, no sane person questions that mankind is contributing heavily to climate change, but cannot one posit that the effect a new green building would have on global warming would be infinitesimal? Basically zero? When one considers that LEED compliance can add 1 to 10 percent to a building’s hard cost (depending on the LEED level adopted), is it callous to wonder whether that money might be better spent on more palpable public needs? If a city had the choice between devoting $1 million in fees toward low-income housing or having a developer spend that same $1 million on green mandates,

124

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

A SOD ROOF TOO FAR 125

38

A Sod Roof Too Far

Triage may be worth considering today in real estate development, not so much from the developer’s perspective, but the public’s. That no proposed development can afford to provide an infinite number of public benefits is axiomatic, at least to its developers. And given that the number and cost of city exactions imposed on new projects increase annually, a fair question might be, would society profit by reexamining the usefulness of its exactions and deciding to forgo some in favor of addressing other, more pressing public needs? This isn’t a call to save developers money. On the contrary, let’s assume that any given project can—without breaking the economic camel’s back— afford to add 10 percent to its total construction costs to provide public benefits. Let’s further assume a civic-minded developer accepts this 10 percent cost, but would like to see her money well spent and is therefore willing to suspend or at least further dilute the already watery “nexus” requirement (i.e., the exaction must offset a project impact). And finally, let’s assume that the city in which her project is located is suffering from poor public schools,

trē-'äzh n.

police and fire cutbacks, a dearth of low-income housing, and crumbling

1. A process for sorting injured people into groups based on their need for or likely benefit from immediate medical treatment. 2. A system used to allocate a scarce commodity, such as food, only to those capable of deriving the greatest benefit from it. 3. A process in which things are ranked in terms of importance or priority. In addition to sounding charmingly continental, the word triage embodies a reasonable concept. If you’re running out of blood transfusions, give them to those who still have a heartbeat. In an emergency context—say, a plane crash—everyone agrees this is the only possible approach. Anywhere else, triage is problematic. Triage should apply brilliantly to medical care during a time of limited means (now). The concept is logical, rational, and fair . . . until your mother is the one left untreated while her roommate is wheeled into surgery.

infrastructure (i.e., virtually Any City, USA). With these pressing public needs, should we, as cities, be requiring developers to put in drinking fountains for dogs, public “art” that is (thankfully for almost everyone concerned) seldom noticed, unneeded community rooms, or closet-sized public parks the public couldn’t find with a map? But instead of focusing on these relatively minor exactions, let’s step right into it and question “green.” Yes, no sane person questions that mankind is contributing heavily to climate change, but cannot one posit that the effect a new green building would have on global warming would be infinitesimal? Basically zero? When one considers that LEED compliance can add 1 to 10 percent to a building’s hard cost (depending on the LEED level adopted), is it callous to wonder whether that money might be better spent on more palpable public needs? If a city had the choice between devoting $1 million in fees toward low-income housing or having a developer spend that same $1 million on green mandates,

124

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

A SOD ROOF TOO FAR 125

is the city really better off with a new building with a sod roof and 10 electric car–charging stations? Other exactions are now so entrenched in the minds of all—even developers—as to go unrecognized as public benefits at all. In the name of public safety, building codes grow increasingly complex and costly every year. To offer just one, perhaps not perfect example: how much have we as a society actually benefited from the billions that have been spent seismically upgrading buildings? Sixty-three people died in the 1989 Loma Prieta earthquake. This means we averaged about half a death a year in Northern California due to earthquakes in the past 114 years. Western heat waves, northern black ice, and southeastern hurricanes kill more every single year. Yet we spend billions earthquake-proofing old buildings. What does this chapter tell you? That if you’re trying to get a project approved at city hall, you should gracefully acquiesce to the city’s demands for public benefits, but negotiate for an overall cap on their cost. If your total construction costs are, say, $10 million, you could seek to limit your public benefits to $500,000, or 5 percent. Then, once you and the city agree on a total cost, you could attempt to negotiate for public benefits that address a more pressing need of the city, that truly benefit the public. For instance, if you’re in Northern California, you might urge that your funds be spent on hiring schoolteachers rather than seismically retrofitting a building that has already withstood two major earthquakes. By the way, this will not be easy.

39 Money

If you’ve managed to read this far, you likely have the persistence needed to succeed as a developer. If you do prosper, your triumph will no doubt arise from your own hard work—your tenacity and determination. But when you summit your Olympus, you might do well to remember that you’ve had a tailwind your whole life. If you concede that America is the best place in the world to do business, then just being American puts you in the top 4 percent for business globally (328 million Americans/7.8 billion global population). Parse our lot down to the 11 percent with advanced degrees, and you’re in the top half of 1 percent worldwide. This means you’re starting miles closer to business’s finish line than everyone else in its marathon. While your success will still be yours (most flounder despite this great advantage), acknowledging luck’s role in your achievements might keep you from the arrogance and churlishness that often blights the successful. And if you acknowledge your good fortune, it might be easier to enjoy one of the fruits of your success—money—rather than be poisoned by it.

126

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

127

is the city really better off with a new building with a sod roof and 10 electric car–charging stations? Other exactions are now so entrenched in the minds of all—even developers—as to go unrecognized as public benefits at all. In the name of public safety, building codes grow increasingly complex and costly every year. To offer just one, perhaps not perfect example: how much have we as a society actually benefited from the billions that have been spent seismically upgrading buildings? Sixty-three people died in the 1989 Loma Prieta earthquake. This means we averaged about half a death a year in Northern California due to earthquakes in the past 114 years. Western heat waves, northern black ice, and southeastern hurricanes kill more every single year. Yet we spend billions earthquake-proofing old buildings. What does this chapter tell you? That if you’re trying to get a project approved at city hall, you should gracefully acquiesce to the city’s demands for public benefits, but negotiate for an overall cap on their cost. If your total construction costs are, say, $10 million, you could seek to limit your public benefits to $500,000, or 5 percent. Then, once you and the city agree on a total cost, you could attempt to negotiate for public benefits that address a more pressing need of the city, that truly benefit the public. For instance, if you’re in Northern California, you might urge that your funds be spent on hiring schoolteachers rather than seismically retrofitting a building that has already withstood two major earthquakes. By the way, this will not be easy.

39 Money

If you’ve managed to read this far, you likely have the persistence needed to succeed as a developer. If you do prosper, your triumph will no doubt arise from your own hard work—your tenacity and determination. But when you summit your Olympus, you might do well to remember that you’ve had a tailwind your whole life. If you concede that America is the best place in the world to do business, then just being American puts you in the top 4 percent for business globally (328 million Americans/7.8 billion global population). Parse our lot down to the 11 percent with advanced degrees, and you’re in the top half of 1 percent worldwide. This means you’re starting miles closer to business’s finish line than everyone else in its marathon. While your success will still be yours (most flounder despite this great advantage), acknowledging luck’s role in your achievements might keep you from the arrogance and churlishness that often blights the successful. And if you acknowledge your good fortune, it might be easier to enjoy one of the fruits of your success—money—rather than be poisoned by it.

126

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

127

Decades after reading The Lord of the Rings, it occurred to me that, with their impossibility of being controlled and unlimited capacity to corrupt,

have obtained your full maturity before you can do something truly stupid with your money.

Tolkien’s Rings of Power could be an allegory for money. The Dark Lord

Your options will be straightforward.

Sauron gave nine rings to several leaders of men who “became ‘mighty in their

You could spend it all. You could spend it all on yourself—hell, it’s your

day, kings, sorcerers, and warriors of old.’ Giving them glory and great wealth,

money—and why not? Because—back to Tolkien—total self-indulgence may

the rings also gave them an unending long life, yet it became unendurable

cause you to become someone you’d rather not be.

to them. . . . One by one, they fell to the power of the One Ring, and before

You could hoard every penny, pull off every tax avoidance trick known

the end of the Second Age, all nine had been turned into ring-wraiths—the

to man, and leave it all to your heirs. This Gollum approach has its downsides

Nazgûl.” (Wikipedia).

as well. One potential flaw is that your offspring could toast your life savings.

Like the One Ring, money seems to have its own evil volition,

Give a young adult a small fortune all at once and, as often as not, he’ll act

intentionally slipping away from one temporary owner after another,

like a rock star living on borrowed time. A more likely outcome is that your

running toward its true masters, the dark lords of Wall Street. How many

fortune will simply undermine your heirs. Put your estate in a bulletproof

tabloid stories have you read of working-class lives ruined by winning

trust fund, dole out a kindergarten teacher’s annual salary to your children,

the lottery? Or about millions of dollars in individual pension funds that

and you’ll give them the opportunity to try to find themselves . . . forever. Or,

evaporated in a stock market collapse? Or exposés about sports stars who

if your kids are spendthrifts, you can skip their generation and leave it your

burned through their fortunes? According to Sports Illustrated, 60 percent

grandchildren. That presupposes, however, that your grandchildren will be

of former NBA players go bankrupt within five years of retirement. Even the

better with money—a coin-flip call at best.

rich are not immune to money’s whimsy: turnover on the Forbes 400 list is remarkable—25 percent over three years, 60 percent over 12 years. Like the rings of Middle Earth, money corrupts. People will seemingly do

You could leave it all to your favorite charities. This is a great way to acknowledge your good fortune—your lifelong tailwind—but the truth is that charities and nonprofits come and go, their missions change, their values

anything to acquire it and even more to keep it. Poor, they steal with a gun;

drift, the people you love and trust retire, and your hard-earned money will be

rich, with a pen and a smile.

in the hands of strangers to whom your name is just a name—strangers who

But here’s where the Tolkien analogy falls apart: unlike with elfin rings, drugs, or alcohol, you can’t cold-turkey money. There’s no getting away from it; you must struggle with it every day. You either master it or, like a spouse from hell, it will ruin you and then desert you. This is where real estate has an advantage over sports stars, lottery

will have no compunction about substituting their charitable values for yours when the time comes. Rather than have it pass into an uncertain charitable future, you might consider giving away large chunks while you’re alive and thriving. And rather than give to it an endowment (for the record, I hate endowments for

winners, and, oh, the whole tech industry. Ours is a get-rich-slow industry.

the reasons set forth above), have your charity spend it immediately on some

It typically takes about five years before you see any meaningful cash flow

project or endeavor that you love.

from one of your developments and, say, 30 years before your portfolio is large

Finally, with apologies for applying Buddhist principles to money, you

enough to encounter the problem of what to do with your money. You will

could consider trying the Middle Way—that is, balancing it out among

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MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

Decades after reading The Lord of the Rings, it occurred to me that, with their impossibility of being controlled and unlimited capacity to corrupt,

have obtained your full maturity before you can do something truly stupid with your money.

Tolkien’s Rings of Power could be an allegory for money. The Dark Lord

Your options will be straightforward.

Sauron gave nine rings to several leaders of men who “became ‘mighty in their

You could spend it all. You could spend it all on yourself—hell, it’s your

day, kings, sorcerers, and warriors of old.’ Giving them glory and great wealth,

money—and why not? Because—back to Tolkien—total self-indulgence may

the rings also gave them an unending long life, yet it became unendurable

cause you to become someone you’d rather not be.

to them. . . . One by one, they fell to the power of the One Ring, and before

You could hoard every penny, pull off every tax avoidance trick known

the end of the Second Age, all nine had been turned into ring-wraiths—the

to man, and leave it all to your heirs. This Gollum approach has its downsides

Nazgûl.” (Wikipedia).

as well. One potential flaw is that your offspring could toast your life savings.

Like the One Ring, money seems to have its own evil volition,

Give a young adult a small fortune all at once and, as often as not, he’ll act

intentionally slipping away from one temporary owner after another,

like a rock star living on borrowed time. A more likely outcome is that your

running toward its true masters, the dark lords of Wall Street. How many

fortune will simply undermine your heirs. Put your estate in a bulletproof

tabloid stories have you read of working-class lives ruined by winning

trust fund, dole out a kindergarten teacher’s annual salary to your children,

the lottery? Or about millions of dollars in individual pension funds that

and you’ll give them the opportunity to try to find themselves . . . forever. Or,

evaporated in a stock market collapse? Or exposés about sports stars who

if your kids are spendthrifts, you can skip their generation and leave it your

burned through their fortunes? According to Sports Illustrated, 60 percent

grandchildren. That presupposes, however, that your grandchildren will be

of former NBA players go bankrupt within five years of retirement. Even the

better with money—a coin-flip call at best.

rich are not immune to money’s whimsy: turnover on the Forbes 400 list is remarkable—25 percent over three years, 60 percent over 12 years. Like the rings of Middle Earth, money corrupts. People will seemingly do

You could leave it all to your favorite charities. This is a great way to acknowledge your good fortune—your lifelong tailwind—but the truth is that charities and nonprofits come and go, their missions change, their values

anything to acquire it and even more to keep it. Poor, they steal with a gun;

drift, the people you love and trust retire, and your hard-earned money will be

rich, with a pen and a smile.

in the hands of strangers to whom your name is just a name—strangers who

But here’s where the Tolkien analogy falls apart: unlike with elfin rings, drugs, or alcohol, you can’t cold-turkey money. There’s no getting away from it; you must struggle with it every day. You either master it or, like a spouse from hell, it will ruin you and then desert you. This is where real estate has an advantage over sports stars, lottery

will have no compunction about substituting their charitable values for yours when the time comes. Rather than have it pass into an uncertain charitable future, you might consider giving away large chunks while you’re alive and thriving. And rather than give to it an endowment (for the record, I hate endowments for

winners, and, oh, the whole tech industry. Ours is a get-rich-slow industry.

the reasons set forth above), have your charity spend it immediately on some

It typically takes about five years before you see any meaningful cash flow

project or endeavor that you love.

from one of your developments and, say, 30 years before your portfolio is large

Finally, with apologies for applying Buddhist principles to money, you

enough to encounter the problem of what to do with your money. You will

could consider trying the Middle Way—that is, balancing it out among

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MONEY 129

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

spending on yourself, your heirs, and your favorite charities. There is no single right answer; no one has this truly figured out. In short, money is a bitch. One final note on lavishing it all on yourself: Frank Lloyd Wright famously opined, “The rich are in constant danger of becoming janitors to their possessions.”

40

Abandon All Hope

Hollywood has it wrong. Even the winners in lawsuits often come away scorched. (They’re called trials for a reason.) I was reminded of this sad truth yet again when an old friend, Steve, stopped by to postmortem a lawsuit that had consumed him for several years. From a litigator’s perspective, Steve’s had been nearly a perfect claim. He had purchased a strip center in Southern California with the aid of a broker who had expressly assumed responsibility for all pre-closing due diligence. (Having the broker do this fact-checking for you is, by the way, another recipe for disaster.) In the course of that due diligence, his broker had either defrauded Steve or been obscenely negligent. The broker had either hidden or, as he later claimed, inexplicably overlooked a key document he’d received from the seller—one that dramatically lowered the property’s value. As a result, Steve suffered an enormous loss the moment he closed on the purchase. When the document was discovered, Steve demanded the broker make him whole. The broker refused, leaving Steve no choice but to sue. Then,

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MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

131

spending on yourself, your heirs, and your favorite charities. There is no single right answer; no one has this truly figured out. In short, money is a bitch. One final note on lavishing it all on yourself: Frank Lloyd Wright famously opined, “The rich are in constant danger of becoming janitors to their possessions.”

40

Abandon All Hope

Hollywood has it wrong. Even the winners in lawsuits often come away scorched. (They’re called trials for a reason.) I was reminded of this sad truth yet again when an old friend, Steve, stopped by to postmortem a lawsuit that had consumed him for several years. From a litigator’s perspective, Steve’s had been nearly a perfect claim. He had purchased a strip center in Southern California with the aid of a broker who had expressly assumed responsibility for all pre-closing due diligence. (Having the broker do this fact-checking for you is, by the way, another recipe for disaster.) In the course of that due diligence, his broker had either defrauded Steve or been obscenely negligent. The broker had either hidden or, as he later claimed, inexplicably overlooked a key document he’d received from the seller—one that dramatically lowered the property’s value. As a result, Steve suffered an enormous loss the moment he closed on the purchase. When the document was discovered, Steve demanded the broker make him whole. The broker refused, leaving Steve no choice but to sue. Then,

130

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

131

when Steve had a chance to settle for not quite enough money, it was his turn

sued. After two years in court, they were vindicated: they won $5,000. But

to refuse; he wanted to punish the broker for his perfidy.

their lawyer billed them $200,000 in legal fees.

The case dragged on, culminating in a six-week trial. Steve had no idea of

There is an old Mexican curse: “May you have a lawsuit in which you truly

how thoroughly this lawsuit would wreck his everyday life. For weeks before

believe.” These three plaintiffs were so cursed. They had all been wronged;

and throughout the trial itself Steve had to be present 10 to 12 hours a day,

each had every right to truly believe in his lawsuit. And so they did. They

seven days a week, occasionally as a witness, but mostly either an observer—

also believed in that American myth, that wrongs can be completely righted

essentially, a potted plant—or as yet another assistant to his demanding

in court. Whether a moral universe exists may be open to question, but not

trial attorneys.

whether it can be found in a courthouse.

The action settled only after the soul-crushing drudgery was over—while

Lawyers are partly to blame for litigation that enriches no one but

the jury was in the midst of deliberating its verdict. Even though the broker

themselves. But the fault is not theirs alone. While some litigators may fail to

agreed at last to pay 100 percent of the lost property value, Steve still suffered

adequately warn clients of the financial and emotional costs of taking a case

staggering losses. Why? Because he had to pay his own attorneys’ fees and

to trial, many do issue such warnings. Some clients listen; others don’t. The

costs. Those fees and costs added up to 85 percent—yes, 85 percent—of the

client’s typical response: “I don’t care what it costs. It’s the principle of the

settlement, leaving Steve with a pittance, less than he could have settled for

thing. That guy screwed me, and I want justice.”

much earlier without any of the trial’s agony. (Imagine yourself slow roasted on the witness stand for three days running or hearing your character impugned by one lying witness after another.) Steve’s unhappy story reminded me of a San Francisco broker who had

But, in the end, what clients really want is money, and, despite their protestations, they care a ton about the cost. The most famous litigation in the English-speaking world is Jarndyce v. Jarndyce, the centerpiece of Charles Dickens’s novel Bleak House. In Jarndyce,

his leasing agreement wrongfully terminated when his clients sold their

a vast fortune is the impetus for a case involving a contested will that spans

office building. This broker demanded $1 million in compensation; the new

generations of woebegone claimants and wicked lawyers—a case of such

owner offered him $250,000 to walk away. The broker sued and, after years of

epic proportions and record-setting duration that it is only settled when the

grinding, a jury did indeed award him his $1 million. But his law firm billed

lawyers have bled every last dime from the estate. Dickens might have been

him $2 million in fees and, when the outraged broker refused to pay, his own

writing nonfiction.

lawyers sued him to recover their fees. The broker spent another $200,000 defending himself in the second lawsuit, but he still lost. Thus, instead of walking away with a “bad” settlement of $250,000, the broker spent the better part of a decade embroiled in two lawsuits that cost him $1.2 million. Because cautionary tales often come in threes, here’s a final one. Friends of mine came home one day after a weekend trip to discover that their privacy hedge (located on their side of the property line) had been hacked down by their next-door neighbors in a quest for more sunlight. The outraged couple

132

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

ABANDON ALL HOPE 133

when Steve had a chance to settle for not quite enough money, it was his turn

sued. After two years in court, they were vindicated: they won $5,000. But

to refuse; he wanted to punish the broker for his perfidy.

their lawyer billed them $200,000 in legal fees.

The case dragged on, culminating in a six-week trial. Steve had no idea of

There is an old Mexican curse: “May you have a lawsuit in which you truly

how thoroughly this lawsuit would wreck his everyday life. For weeks before

believe.” These three plaintiffs were so cursed. They had all been wronged;

and throughout the trial itself Steve had to be present 10 to 12 hours a day,

each had every right to truly believe in his lawsuit. And so they did. They

seven days a week, occasionally as a witness, but mostly either an observer—

also believed in that American myth, that wrongs can be completely righted

essentially, a potted plant—or as yet another assistant to his demanding

in court. Whether a moral universe exists may be open to question, but not

trial attorneys.

whether it can be found in a courthouse.

The action settled only after the soul-crushing drudgery was over—while

Lawyers are partly to blame for litigation that enriches no one but

the jury was in the midst of deliberating its verdict. Even though the broker

themselves. But the fault is not theirs alone. While some litigators may fail to

agreed at last to pay 100 percent of the lost property value, Steve still suffered

adequately warn clients of the financial and emotional costs of taking a case

staggering losses. Why? Because he had to pay his own attorneys’ fees and

to trial, many do issue such warnings. Some clients listen; others don’t. The

costs. Those fees and costs added up to 85 percent—yes, 85 percent—of the

client’s typical response: “I don’t care what it costs. It’s the principle of the

settlement, leaving Steve with a pittance, less than he could have settled for

thing. That guy screwed me, and I want justice.”

much earlier without any of the trial’s agony. (Imagine yourself slow roasted on the witness stand for three days running or hearing your character impugned by one lying witness after another.) Steve’s unhappy story reminded me of a San Francisco broker who had

But, in the end, what clients really want is money, and, despite their protestations, they care a ton about the cost. The most famous litigation in the English-speaking world is Jarndyce v. Jarndyce, the centerpiece of Charles Dickens’s novel Bleak House. In Jarndyce,

his leasing agreement wrongfully terminated when his clients sold their

a vast fortune is the impetus for a case involving a contested will that spans

office building. This broker demanded $1 million in compensation; the new

generations of woebegone claimants and wicked lawyers—a case of such

owner offered him $250,000 to walk away. The broker sued and, after years of

epic proportions and record-setting duration that it is only settled when the

grinding, a jury did indeed award him his $1 million. But his law firm billed

lawyers have bled every last dime from the estate. Dickens might have been

him $2 million in fees and, when the outraged broker refused to pay, his own

writing nonfiction.

lawyers sued him to recover their fees. The broker spent another $200,000 defending himself in the second lawsuit, but he still lost. Thus, instead of walking away with a “bad” settlement of $250,000, the broker spent the better part of a decade embroiled in two lawsuits that cost him $1.2 million. Because cautionary tales often come in threes, here’s a final one. Friends of mine came home one day after a weekend trip to discover that their privacy hedge (located on their side of the property line) had been hacked down by their next-door neighbors in a quest for more sunlight. The outraged couple

132

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

ABANDON ALL HOPE 133

Part 2:

Making It in Life

135

Part 2:

Making It in Life

135

41

How to Keep Friends and Influence No One

We all want friends. We all want to be liked.Most of us wish we were better liked. I recently read, finally, a book about making friends that I’d been putting off for 50 years: How to Win Friends and Influence People by Dale Carnegie. One of the most famous American books ever—the headwaters of all self-help books—it was first published in 1936, has sold more than 15 million copies, and is still selling today. It is number 15 on Amazon’s all-time nonfiction list. I had shied away from Friends decades ago—when it might have done me some good—mostly because of the title. Winning friends and influencing people sounded sketchy, bordering on manipulative. And Carnegie’s whole premise smacked of that Chamber of Commerce power of positive thinking that can drive even the remotely self-aware to drink. In reading the book, I focused on the section that deals with making friends. While Carnegie’s language is homespun and his examples archaic, his suggestions ring true. If you were looking for a New Year’s resolution that would likely produce more lasting happiness than losing five pounds or

137

41

How to Keep Friends and Influence No One

We all want friends. We all want to be liked.Most of us wish we were better liked. I recently read, finally, a book about making friends that I’d been putting off for 50 years: How to Win Friends and Influence People by Dale Carnegie. One of the most famous American books ever—the headwaters of all self-help books—it was first published in 1936, has sold more than 15 million copies, and is still selling today. It is number 15 on Amazon’s all-time nonfiction list. I had shied away from Friends decades ago—when it might have done me some good—mostly because of the title. Winning friends and influencing people sounded sketchy, bordering on manipulative. And Carnegie’s whole premise smacked of that Chamber of Commerce power of positive thinking that can drive even the remotely self-aware to drink. In reading the book, I focused on the section that deals with making friends. While Carnegie’s language is homespun and his examples archaic, his suggestions ring true. If you were looking for a New Year’s resolution that would likely produce more lasting happiness than losing five pounds or

137

beating last year’s numbers by 10 percent, you could do worse than studying his precepts. You can study these in detail in his book, or get a fair overview on

These are all solid, commonsense suggestions—great ways to make new friends—yet somehow in contemplating them, Woody Allen comes to mind. “Eighty percent of success is showing up” is no doubt Allen’s most

Wikipedia. If followed, his suggestions would no doubt make winning new

beloved quotation (particularly among the lazy). But it has been so universally

friends far easier. Doing them scant justice—and freely quoting Carnegie—

misunderstood that Allen had to clarify it years later: “My observation was

here are his six rules for making yourself more likeable.

that once a person actually completed a play or a novel he was well on his way

1. Become genuinely interested in other people. “You can make more

to getting it produced or published, as opposed to a vast majority of people

friends in two months by being interested in them, than in two years

who tell me their ambition is to write, but who strike out on the very first level

by making them interested in you.”

and indeed never write the play or book.” In other words, Allen meant that 80

2. Smile. Carnegie wants you to smile all the time, contending that all it takes to bring a little joy into others’ lives is a sincere smile—that we all love smilers. 3. Remember your listener’s name and use it. “The average person

percent of success is doing the work—neither funny nor quotable, but true. In a way, Carnegie makes the same mistake as the believers in the showup-and-succeed strategy: he implies that lasting friendship is found among his rules for winning friends. His rules may be a great start—there’s a good reason

is more interested in his own name than in all the other names in

his book still sells—but smiles, names, listening, and even the most genuine

the world put together.” This suggestion works. In the late 1970s,

interest are not 80 percent of friendship.

I met Quentin Kopp, then president of San Francisco’s Board of

Like success, lasting friendship is built on doing the work. The work of

Supervisors. I was a total nobody and he the second-most-powerful

understanding, of forgiving, of knowing you’re as flawed as your friends, of

man in the city. I didn’t see Quentin again for 20 years, ran into him

listening to their same stories and jokes again and again, of sharing fears,

at some event, and he said, “Hey, John, how’s it going?” I was stunned

hopes, and desires, of apologizing when you screw up and freely forgiving

at his memory. I couldn’t help but like the guy.

when they do. To put a Woody Allen spin on it, 80 percent of friendship

4. Be a good listener. Carnegie equates being a good conversationalist with being a good listener. He suggests you encourage others to

is kindness. My deepest gratitude to my understanding, forgiving friends.

talk about themselves, contending that most people just want someone who will listen to them. (This is the reason even mediocre psychologists stay in business.) 5. Talk to people about what they’re interested in. “If we talk to others about their interests, they will feel valued and value us in return.” 6. Make your listener feel important. “People will talk for hours if we allow them to talk about themselves. If we can make people feel important in a sincere and appreciative way, then we will win all the friends we could ever dream of.”

138

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

HOW TO KEEP FRIENDS AND INFLUENCE NO ONE 139

beating last year’s numbers by 10 percent, you could do worse than studying his precepts. You can study these in detail in his book, or get a fair overview on

These are all solid, commonsense suggestions—great ways to make new friends—yet somehow in contemplating them, Woody Allen comes to mind. “Eighty percent of success is showing up” is no doubt Allen’s most

Wikipedia. If followed, his suggestions would no doubt make winning new

beloved quotation (particularly among the lazy). But it has been so universally

friends far easier. Doing them scant justice—and freely quoting Carnegie—

misunderstood that Allen had to clarify it years later: “My observation was

here are his six rules for making yourself more likeable.

that once a person actually completed a play or a novel he was well on his way

1. Become genuinely interested in other people. “You can make more

to getting it produced or published, as opposed to a vast majority of people

friends in two months by being interested in them, than in two years

who tell me their ambition is to write, but who strike out on the very first level

by making them interested in you.”

and indeed never write the play or book.” In other words, Allen meant that 80

2. Smile. Carnegie wants you to smile all the time, contending that all it takes to bring a little joy into others’ lives is a sincere smile—that we all love smilers. 3. Remember your listener’s name and use it. “The average person

percent of success is doing the work—neither funny nor quotable, but true. In a way, Carnegie makes the same mistake as the believers in the showup-and-succeed strategy: he implies that lasting friendship is found among his rules for winning friends. His rules may be a great start—there’s a good reason

is more interested in his own name than in all the other names in

his book still sells—but smiles, names, listening, and even the most genuine

the world put together.” This suggestion works. In the late 1970s,

interest are not 80 percent of friendship.

I met Quentin Kopp, then president of San Francisco’s Board of

Like success, lasting friendship is built on doing the work. The work of

Supervisors. I was a total nobody and he the second-most-powerful

understanding, of forgiving, of knowing you’re as flawed as your friends, of

man in the city. I didn’t see Quentin again for 20 years, ran into him

listening to their same stories and jokes again and again, of sharing fears,

at some event, and he said, “Hey, John, how’s it going?” I was stunned

hopes, and desires, of apologizing when you screw up and freely forgiving

at his memory. I couldn’t help but like the guy.

when they do. To put a Woody Allen spin on it, 80 percent of friendship

4. Be a good listener. Carnegie equates being a good conversationalist with being a good listener. He suggests you encourage others to

is kindness. My deepest gratitude to my understanding, forgiving friends.

talk about themselves, contending that most people just want someone who will listen to them. (This is the reason even mediocre psychologists stay in business.) 5. Talk to people about what they’re interested in. “If we talk to others about their interests, they will feel valued and value us in return.” 6. Make your listener feel important. “People will talk for hours if we allow them to talk about themselves. If we can make people feel important in a sincere and appreciative way, then we will win all the friends we could ever dream of.”

138

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

HOW TO KEEP FRIENDS AND INFLUENCE NO ONE 139

42

Commencement Address

“Even if all your desires and wishes were fulfilled, you still wouldn’t be happy . . .” —Alan Watts Because there were few commencement exercises in the plague year of 2020, there were few commencement speeches. While some may think that was one of the virus’s few upsides, I thought I’d rough out the address I’d have given at Antelope Valley Community College (had its dean invited me). As with so many clichés, commencement speeches often begin with Shakespeare, more specifically with Polonius’s advice to his son Laertes in Hamlet, advice that begins, “Give thy thoughts no tongue.” My beloved high school English teacher Albert Guzman thought Polonius’s advice incomparable—a true north for living a good life—and read it aloud annually to his classes, imploring one and all to take it to heart. A few years later, a noted Shakespeare scholar had a more nuanced view. Professor Hugh Richmond informed my university class that Shakespeare was not a genius for nothing and that, the apparent soundness of his advice aside, Polonius was often interpreted as a meddling windbag, his big scene usually played for laughs, his listeners—Laertes, Ophelia, and Hamlet—according the

yourself. Whatever its other merits, truer words have yet to be uttered on friendship. Warming to the idea of recycling the advice of others, I asked successful friends for the single suggestion they would give someone starting out. “Do what you love” was the runaway favorite. Fine advice indeed if you love being a brain surgeon or a civil engineer, but Hollywood is full of 40-year-old baristas who still adore acting and are certain they are one audition away from hitting it big. Perhaps what you love should be your avocation rather than your career. A more useful suggestion might be, “Pick your job based on whether you like the people at the company.” Instead of trying to nail your lifelong career next month, go someplace where you will be treated with kindness and respect. After all, the chances of staying at your first job forever are almost nil and, more likely, you will switch careers at least once. Remember the aphorism, “It’s the journey, not the destination.” And the trip is more fun if you like your traveling companions. Another friend suggested asking yourself, “Where do I want to be in 20 years?” when making career decisions today. Adopting this long view may cause you to rethink your decision to take a year off to work as a lift-line operator for the sake of the skiing. You should tattoo “Never be afraid to ask” on the back of your hand and consider “Always take the high road” a wonderful aspiration. Easier for some of us, this one applies to all facets of your life: “Surround yourself with people who are better than you are.” A slight variation suggested was, “Work with people you wish to emulate.” Another: “The least convenient and least pleasant choice is usually the right thing to do.” Turning to more palpable suggestions, my best one-word bit of advice is this: “Over-tip.” You will benefit more than the delighted servers, car washers, and Uber drivers you encounter. The best two-word bit of advice, often mistakenly attributed to Kurt Vonnegut, is this: “Wear sunscreen.” Sticking with the commonplace:

old gentleman mock reverence. Read the passage (act 1, scene 3) and decide for

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COMMENCEMENT ADDRESS 141

42

Commencement Address

“Even if all your desires and wishes were fulfilled, you still wouldn’t be happy . . .” —Alan Watts Because there were few commencement exercises in the plague year of 2020, there were few commencement speeches. While some may think that was one of the virus’s few upsides, I thought I’d rough out the address I’d have given at Antelope Valley Community College (had its dean invited me). As with so many clichés, commencement speeches often begin with Shakespeare, more specifically with Polonius’s advice to his son Laertes in Hamlet, advice that begins, “Give thy thoughts no tongue.” My beloved high school English teacher Albert Guzman thought Polonius’s advice incomparable—a true north for living a good life—and read it aloud annually to his classes, imploring one and all to take it to heart. A few years later, a noted Shakespeare scholar had a more nuanced view. Professor Hugh Richmond informed my university class that Shakespeare was not a genius for nothing and that, the apparent soundness of his advice aside, Polonius was often interpreted as a meddling windbag, his big scene usually played for laughs, his listeners—Laertes, Ophelia, and Hamlet—according the

yourself. Whatever its other merits, truer words have yet to be uttered on friendship. Warming to the idea of recycling the advice of others, I asked successful friends for the single suggestion they would give someone starting out. “Do what you love” was the runaway favorite. Fine advice indeed if you love being a brain surgeon or a civil engineer, but Hollywood is full of 40-year-old baristas who still adore acting and are certain they are one audition away from hitting it big. Perhaps what you love should be your avocation rather than your career. A more useful suggestion might be, “Pick your job based on whether you like the people at the company.” Instead of trying to nail your lifelong career next month, go someplace where you will be treated with kindness and respect. After all, the chances of staying at your first job forever are almost nil and, more likely, you will switch careers at least once. Remember the aphorism, “It’s the journey, not the destination.” And the trip is more fun if you like your traveling companions. Another friend suggested asking yourself, “Where do I want to be in 20 years?” when making career decisions today. Adopting this long view may cause you to rethink your decision to take a year off to work as a lift-line operator for the sake of the skiing. You should tattoo “Never be afraid to ask” on the back of your hand and consider “Always take the high road” a wonderful aspiration. Easier for some of us, this one applies to all facets of your life: “Surround yourself with people who are better than you are.” A slight variation suggested was, “Work with people you wish to emulate.” Another: “The least convenient and least pleasant choice is usually the right thing to do.” Turning to more palpable suggestions, my best one-word bit of advice is this: “Over-tip.” You will benefit more than the delighted servers, car washers, and Uber drivers you encounter. The best two-word bit of advice, often mistakenly attributed to Kurt Vonnegut, is this: “Wear sunscreen.” Sticking with the commonplace:

old gentleman mock reverence. Read the passage (act 1, scene 3) and decide for

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COMMENCEMENT ADDRESS 141

“Five minutes early is 10 minutes late” may be OCD-ish, but it makes the point. Successful people do what they say they will do: they show up on time.

treat themselves to even the most quotidian of luxuries. Despite their vast differences in outlook and temperament, they still answer, “It depends.” Good

“Call your mother every Sunday and visit her at least twice a year.”

with numbers, these gentlemen point out that some are content with $100,000

“Floss.”

a year while $100 million beggars others. “How often is he going to get

“Procrastination is where dreams go to die.”

divorced? Does he need a vineyard or a jet or a ballclub, or does he collect art?

“If you want a callback, leave your phone number twice.”

You can blow $50 million on a painting and still feel like a piker.”

“Never buy a timeshare.” “Wipe down the machines at the gym before you use them.” “Treat everyone with respect.” If you wish to divine a person’s true

I would press: “When is the additional money irrelevant? When are you working just to keep score?” Again, it depends. I finally decided that “How much is enough?” is the wrong question. The

character, observe how she treats those whom she considers socially or

right one is, “Why are you working so hard?” While they may not admit it, the

economically inferior.

answer is, because it’s fun or, for those incapable of fun, it’s fulfilling. More

This one is hard: “If you are going to indulge in charitable acts, wean yourself of your need for gratitude.” Gratitude is often in short supply, and

fun—or fulfilling—than travel, golf, tennis, sailing, or drinking at noon. Some couldn’t spend their existing wealth if they were to live another 100

unless your acts of kindness are done for their own sake, you will be ever

years—they act like they intend to—but they plod on, the newly earned money

troubled.

almost a disincentive because they have to figure out what to do with it when

This next advice came from a dear friend in a letter written years ago: “There is nothing to be gained by trying to be the perfect human being, the

they’re gone. (By the way, no one seems to have that one knocked.) Dear Graduate, this then is the good and bad news: if you were born with

perfect father, or the perfect husband, or the perfect businessman. The good-

the mercantile gene, if you were meant to be successful in business (possibly,

enough human being, the good-enough father, and the good-enough husband

as opposed to life), you’re unlikely to ever stop working. Rather than haunt

are just that: good enough. Unless you are willing to join Mother Teresa, send

the country club for the last 20 years of your life, you’ll be carried out of your

your check and steer clear of great causes.”

office on your laptop. You’ll do it not for the money, but because you love it. If,

Changing gears slightly, I have yet to meet a self-made rich man who has

on the other hand, you cannot wait to retire rich, if you crave a life full of fun

stopped working. Self-made men in their 70s are still working harder than

and adventure unfettered by responsibility and obligation, I suggest you invest

busboys. Why? Because it’s not about the money. I’ve made a cottage industry

in lottery tickets because business is highly unlikely to put you on the beach at

out of asking rich guys how much is enough and have yet to hear a number.

30. Chasing wealth is like chasing your tail.

“It depends,” is the invariable answer. It’s not that they are being

Tacking slightly, I once had a money conversation with a wealthy man

particularly cagey. (It is true, however, that those with money would rather

that turned contemplative. In weighing life and its challenges, he mused, “If

discuss anything else.) It’s that the successful do not view their career as a

it can be fixed by money, it isn’t a real problem.” For a moment the remark

financial Denali—something one summits at, say, $20 million and calls it

seemed flawless in its simple brilliance. Money is helpless against some of the

a day.

most heartbreaking problems—say, incurable cancer (a case can be made that

I have asked this question both of cinematic spenders—owners of

it merely prolongs the agony) or a loved one’s depression or addiction. But as

private jets, boats that throttle the imagination, and homes you need two

I pondered it, I concluded the rich are just as myopic as everyone else. Money

hands to count—and financial hoarders, those psychologically unable to

solves a lot of real problems if you’re poor or even middle class. Money can

142

COMMENCEMENT ADDRESS 143

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

“Five minutes early is 10 minutes late” may be OCD-ish, but it makes the point. Successful people do what they say they will do: they show up on time.

treat themselves to even the most quotidian of luxuries. Despite their vast differences in outlook and temperament, they still answer, “It depends.” Good

“Call your mother every Sunday and visit her at least twice a year.”

with numbers, these gentlemen point out that some are content with $100,000

“Floss.”

a year while $100 million beggars others. “How often is he going to get

“Procrastination is where dreams go to die.”

divorced? Does he need a vineyard or a jet or a ballclub, or does he collect art?

“If you want a callback, leave your phone number twice.”

You can blow $50 million on a painting and still feel like a piker.”

“Never buy a timeshare.” “Wipe down the machines at the gym before you use them.” “Treat everyone with respect.” If you wish to divine a person’s true

I would press: “When is the additional money irrelevant? When are you working just to keep score?” Again, it depends. I finally decided that “How much is enough?” is the wrong question. The

character, observe how she treats those whom she considers socially or

right one is, “Why are you working so hard?” While they may not admit it, the

economically inferior.

answer is, because it’s fun or, for those incapable of fun, it’s fulfilling. More

This one is hard: “If you are going to indulge in charitable acts, wean yourself of your need for gratitude.” Gratitude is often in short supply, and

fun—or fulfilling—than travel, golf, tennis, sailing, or drinking at noon. Some couldn’t spend their existing wealth if they were to live another 100

unless your acts of kindness are done for their own sake, you will be ever

years—they act like they intend to—but they plod on, the newly earned money

troubled.

almost a disincentive because they have to figure out what to do with it when

This next advice came from a dear friend in a letter written years ago: “There is nothing to be gained by trying to be the perfect human being, the

they’re gone. (By the way, no one seems to have that one knocked.) Dear Graduate, this then is the good and bad news: if you were born with

perfect father, or the perfect husband, or the perfect businessman. The good-

the mercantile gene, if you were meant to be successful in business (possibly,

enough human being, the good-enough father, and the good-enough husband

as opposed to life), you’re unlikely to ever stop working. Rather than haunt

are just that: good enough. Unless you are willing to join Mother Teresa, send

the country club for the last 20 years of your life, you’ll be carried out of your

your check and steer clear of great causes.”

office on your laptop. You’ll do it not for the money, but because you love it. If,

Changing gears slightly, I have yet to meet a self-made rich man who has

on the other hand, you cannot wait to retire rich, if you crave a life full of fun

stopped working. Self-made men in their 70s are still working harder than

and adventure unfettered by responsibility and obligation, I suggest you invest

busboys. Why? Because it’s not about the money. I’ve made a cottage industry

in lottery tickets because business is highly unlikely to put you on the beach at

out of asking rich guys how much is enough and have yet to hear a number.

30. Chasing wealth is like chasing your tail.

“It depends,” is the invariable answer. It’s not that they are being

Tacking slightly, I once had a money conversation with a wealthy man

particularly cagey. (It is true, however, that those with money would rather

that turned contemplative. In weighing life and its challenges, he mused, “If

discuss anything else.) It’s that the successful do not view their career as a

it can be fixed by money, it isn’t a real problem.” For a moment the remark

financial Denali—something one summits at, say, $20 million and calls it

seemed flawless in its simple brilliance. Money is helpless against some of the

a day.

most heartbreaking problems—say, incurable cancer (a case can be made that

I have asked this question both of cinematic spenders—owners of

it merely prolongs the agony) or a loved one’s depression or addiction. But as

private jets, boats that throttle the imagination, and homes you need two

I pondered it, I concluded the rich are just as myopic as everyone else. Money

hands to count—and financial hoarders, those psychologically unable to

solves a lot of real problems if you’re poor or even middle class. Money can

142

COMMENCEMENT ADDRESS 143

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

fix your roof, pay your utility bills, and get your kids’ teeth fixed. It solves

43

serious problems. Had my friend added a floor to his thesis below which money is allimportant, he would have been right. Over a certain annual income, money’s power to make an individual happier or more content seems to attenuate rapidly. What is that number? Again, it depends. Lefty economists, those in favor of taxing the rich, are certain that additional happiness stops at $75,000 a year—that is to say, you will be no

Your Obituary

happier at $250,000 a year than you were at $75,000. The world weary might point out that one transatlantic flight sitting in coach might cause you to question that lower number, but so they claim. Righty economists, the handmaidens of the rich, shake the bones over similar data and conclude that happiness is on the same glide path as wealth— that the richer you are, the happier you are. Not surprisingly, they opine that it would be unfair to take away the happiness of the ultra-wealthy. Happier? I don’t think so, but definitely more comfortable. My personal take, dear Graduate, is that people are just about as happy as they want to be, and, ultimately, above that uncertain threshold, it has little to do with money.

Instead of your annual New Year’s resolution, you might consider another way of possibly improving yourself. Rather than resolving to lose weight, drink less, or read a new book every week, you might take the long view and ponder your own obituary. It’s been said before but is worth repeating: if you want to lead a good life, start with your obituary and work backward. Like paying attention to our doctors’ advice, sooner or later many of us start perusing obituaries. Some begin earlier than most, especially those—like your correspondent—of Irish descent. (It is no accident that obits are called the Irish sports page.) The last stronghold of newspapers, paid obituaries are growing daily in number, length, photos, and grandiosity as the boomers, the greatest selfabsorbed generation, begin to move on. By the way, obituaries have nothing to do with journalism: unless you had a good deal more than 15 minutes of fame in your lifetime, no professional writer or editor or, more important, factchecker will ever see your obituary before it’s printed. Obits are written by the

144

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

145

fix your roof, pay your utility bills, and get your kids’ teeth fixed. It solves

43

serious problems. Had my friend added a floor to his thesis below which money is allimportant, he would have been right. Over a certain annual income, money’s power to make an individual happier or more content seems to attenuate rapidly. What is that number? Again, it depends. Lefty economists, those in favor of taxing the rich, are certain that additional happiness stops at $75,000 a year—that is to say, you will be no

Your Obituary

happier at $250,000 a year than you were at $75,000. The world weary might point out that one transatlantic flight sitting in coach might cause you to question that lower number, but so they claim. Righty economists, the handmaidens of the rich, shake the bones over similar data and conclude that happiness is on the same glide path as wealth— that the richer you are, the happier you are. Not surprisingly, they opine that it would be unfair to take away the happiness of the ultra-wealthy. Happier? I don’t think so, but definitely more comfortable. My personal take, dear Graduate, is that people are just about as happy as they want to be, and, ultimately, above that uncertain threshold, it has little to do with money.

Instead of your annual New Year’s resolution, you might consider another way of possibly improving yourself. Rather than resolving to lose weight, drink less, or read a new book every week, you might take the long view and ponder your own obituary. It’s been said before but is worth repeating: if you want to lead a good life, start with your obituary and work backward. Like paying attention to our doctors’ advice, sooner or later many of us start perusing obituaries. Some begin earlier than most, especially those—like your correspondent—of Irish descent. (It is no accident that obits are called the Irish sports page.) The last stronghold of newspapers, paid obituaries are growing daily in number, length, photos, and grandiosity as the boomers, the greatest selfabsorbed generation, begin to move on. By the way, obituaries have nothing to do with journalism: unless you had a good deal more than 15 minutes of fame in your lifetime, no professional writer or editor or, more important, factchecker will ever see your obituary before it’s printed. Obits are written by the

144

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

145

next of kin—those invariably adored wives, husbands, and children

clubs you managed to join. Skip the tales of self-aggrandizing adventure:

left behind.

even a whiff of that goes a very long way in an obit. (“Big deal. So he tried

Written by the grieving with the noblest intentions, lies that would make a sociopath blush are printed every day in every newspaper in America. These falsehoods are not limited to praise for the deceased’s previously unremarked qualities and accomplishments. Because, as the saying goes, winners write the

skydiving.”) Write instead about how you helped others—perhaps how you managed to be of use to someone other than your travel agent. Write it the way you want to be remembered, and then—what the hell— try to live up to it.

history books, familial biographers often take liberties with their own roles in the decedent’s life. One cold wife refused to interrupt her Caribbean bridge cruise when informed of her husband’s passing in San Francisco. Even though she directed the mortuary to stack the body on ice for a couple of weeks and await her scheduled return, her tribute praised her own loving bedside vigil. Let’s put aside the eternal question as to whether one gets to smile down upon (or, in the case of developers, grimace up at) the bereaved after exiting the stage. Even if you’ll never know, might you prefer that an accurate record of your life be published rather than a half-invented mythology your heirs cook up over a couple of bottles of wine? Your answer may depend on the life you believe you will have led. Fortunately for us all, life is graded on a forgiving curve and few, if any, approach that curve’s saintly end. A better measure of a good life might be one of simple utility: was your life useful to others? A life spent sloshed at a country club or—conversely—in cloistered prayer is of little use to anyone else, whereas a lifetime of serving schoolchildren as a crosswalk guard is of inestimable benefit. In short, viewed as a whole and with a gentle eye toward your foibles, will your life have been one that would cause a stranger to think kindly of you upon reading your obituary? If you desire those posthumous kind thoughts, here’s a suggestion: write your own obituary now. If you do, try to limit your factual latitude to résuméwriting standards—that is, you can nudge your class standing a bit but can’t award yourself degrees. Touch lightly on how much you and your family adored one another and how many promotions you received. And forget about how you loved travel (every stiff, it seems, loved to travel) or how many

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MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

YOUR OBITUARY 147

next of kin—those invariably adored wives, husbands, and children

clubs you managed to join. Skip the tales of self-aggrandizing adventure:

left behind.

even a whiff of that goes a very long way in an obit. (“Big deal. So he tried

Written by the grieving with the noblest intentions, lies that would make a sociopath blush are printed every day in every newspaper in America. These falsehoods are not limited to praise for the deceased’s previously unremarked qualities and accomplishments. Because, as the saying goes, winners write the

skydiving.”) Write instead about how you helped others—perhaps how you managed to be of use to someone other than your travel agent. Write it the way you want to be remembered, and then—what the hell— try to live up to it.

history books, familial biographers often take liberties with their own roles in the decedent’s life. One cold wife refused to interrupt her Caribbean bridge cruise when informed of her husband’s passing in San Francisco. Even though she directed the mortuary to stack the body on ice for a couple of weeks and await her scheduled return, her tribute praised her own loving bedside vigil. Let’s put aside the eternal question as to whether one gets to smile down upon (or, in the case of developers, grimace up at) the bereaved after exiting the stage. Even if you’ll never know, might you prefer that an accurate record of your life be published rather than a half-invented mythology your heirs cook up over a couple of bottles of wine? Your answer may depend on the life you believe you will have led. Fortunately for us all, life is graded on a forgiving curve and few, if any, approach that curve’s saintly end. A better measure of a good life might be one of simple utility: was your life useful to others? A life spent sloshed at a country club or—conversely—in cloistered prayer is of little use to anyone else, whereas a lifetime of serving schoolchildren as a crosswalk guard is of inestimable benefit. In short, viewed as a whole and with a gentle eye toward your foibles, will your life have been one that would cause a stranger to think kindly of you upon reading your obituary? If you desire those posthumous kind thoughts, here’s a suggestion: write your own obituary now. If you do, try to limit your factual latitude to résuméwriting standards—that is, you can nudge your class standing a bit but can’t award yourself degrees. Touch lightly on how much you and your family adored one another and how many promotions you received. And forget about how you loved travel (every stiff, it seems, loved to travel) or how many

146

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

YOUR OBITUARY 147

44

Seeing the Forest for the Trees

view—a view decidedly more positive than the Armageddon of the day—your correspondent is unaware of it. This is why even recovering optimists should read Steven Pinker. While his 2018 book Enlightenment Now may remind one of that old writer’s saw, “If I had more time, I could have made it shorter,” it is nevertheless important. The book is a corrugated tin roof against the daily monsoon of bad news. It is a clear and convincing reminder of all the good that is happening in the world, of the amazing progress mankind has made and is continuing to make in virtually every aspect of life. If your attention span runs more to postcards than tomes, you might consider instead a simple chart published by Our World in Data that shows six measures of life’s dramatic improvement over the past 200 years: only 10 percent of the world now lives in extreme poverty, compared with 94 percent two centuries ago; 85 percent of the global population is now literate; 86 percent has a basic education; 56 percent of the world population lives in a democracy; 86 percent of the world population is now vaccinated against diphtheria, whooping cough, and tetanus; and, finally, the child mortality rate

If you are an entrepreneur, you are an optimist. You have to be. And, Pollyanna aside, it is no simple trick remaining optimistic. It grows harder by the day, particularly if you focus on the daily news instead of much longerterm events—if you focus on history’s weather rather than its climate. Have you ever found yourself depressed after reading the New York Times? A recent Sunday edition ran a front-page article on the perils of quitting antidepressants while the Review section was plastered with the death of democracy, the rise of fascism, and the inequalities of our college admission system. And if those failed to ruin your day, the editors ran the usual hit piece on how everything you love to consume—fat, salt, sugar, even Diet Coke—will kill you, this time by feeding the bad microbes within your digestive tract. In the American media’s production of the Hundred Acre Wood, the Times has sewn up the role of Eeyore, but it has thousands of understudies. In fact, if there is a credible publication that consistently takes the longer

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MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

has plummeted from 43 percent of children failing to survive their first five years of life to only 4 percent. Pinker makes these points and more in Enlightenment Now. Instead of the 40-year life expectancy of 200 years ago, it is now 71.4 years globally. And death from famine has been all but eradicated in every part of the world save Africa; even there it has been declining precipitously thanks to the Green Revolution—genetically modified crops and scientific, high-tech farming. You already knew most of this stuff, if not as a result of study, then unconsciously; these facts tend to bubble to the surface like crude in an oil patch. What is less obvious, what bears closer inspection, and what Pinker does an excellent job of explicating is the street reality of relative prosperity. A day rarely goes by without some pundit—usually in the Times— predicting the death of civilization as a result of income inequality. In his chapter “Inequality” (alone worth the book’s price), Pinker puts poverty into economic perspective, writing, “When poverty is defined in terms of

SEEING THE FOREST FOR THE TREES 149

44

Seeing the Forest for the Trees

view—a view decidedly more positive than the Armageddon of the day—your correspondent is unaware of it. This is why even recovering optimists should read Steven Pinker. While his 2018 book Enlightenment Now may remind one of that old writer’s saw, “If I had more time, I could have made it shorter,” it is nevertheless important. The book is a corrugated tin roof against the daily monsoon of bad news. It is a clear and convincing reminder of all the good that is happening in the world, of the amazing progress mankind has made and is continuing to make in virtually every aspect of life. If your attention span runs more to postcards than tomes, you might consider instead a simple chart published by Our World in Data that shows six measures of life’s dramatic improvement over the past 200 years: only 10 percent of the world now lives in extreme poverty, compared with 94 percent two centuries ago; 85 percent of the global population is now literate; 86 percent has a basic education; 56 percent of the world population lives in a democracy; 86 percent of the world population is now vaccinated against diphtheria, whooping cough, and tetanus; and, finally, the child mortality rate

If you are an entrepreneur, you are an optimist. You have to be. And, Pollyanna aside, it is no simple trick remaining optimistic. It grows harder by the day, particularly if you focus on the daily news instead of much longerterm events—if you focus on history’s weather rather than its climate. Have you ever found yourself depressed after reading the New York Times? A recent Sunday edition ran a front-page article on the perils of quitting antidepressants while the Review section was plastered with the death of democracy, the rise of fascism, and the inequalities of our college admission system. And if those failed to ruin your day, the editors ran the usual hit piece on how everything you love to consume—fat, salt, sugar, even Diet Coke—will kill you, this time by feeding the bad microbes within your digestive tract. In the American media’s production of the Hundred Acre Wood, the Times has sewn up the role of Eeyore, but it has thousands of understudies. In fact, if there is a credible publication that consistently takes the longer

148

MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

has plummeted from 43 percent of children failing to survive their first five years of life to only 4 percent. Pinker makes these points and more in Enlightenment Now. Instead of the 40-year life expectancy of 200 years ago, it is now 71.4 years globally. And death from famine has been all but eradicated in every part of the world save Africa; even there it has been declining precipitously thanks to the Green Revolution—genetically modified crops and scientific, high-tech farming. You already knew most of this stuff, if not as a result of study, then unconsciously; these facts tend to bubble to the surface like crude in an oil patch. What is less obvious, what bears closer inspection, and what Pinker does an excellent job of explicating is the street reality of relative prosperity. A day rarely goes by without some pundit—usually in the Times— predicting the death of civilization as a result of income inequality. In his chapter “Inequality” (alone worth the book’s price), Pinker puts poverty into economic perspective, writing, “When poverty is defined in terms of

SEEING THE FOREST FOR THE TREES 149

what people consume rather than what they earn, we find that the American

45

poverty rate has declined by 90 percent since 1960, from 30 percent of the population to just 3 percent. . . . In 2011, more than 95 percent of American households below the poverty line had electricity, running water, flush toilets, a refrigerator, a stove, and a color TV. (A century and a half before, the Rothschilds, Astors, and Vanderbilts had none of these things.)” This overall rise in standard of living is not unique to the United States. Pinker’s data show that in 2008, the world’s entire population (then 6.7 billion)

In Memoriam: James J. Curtis III

had an average income equal to that of western Europe’s in 1964. While conceding that the rich are becoming disproportionally richer, Pinker points out that the poor are getting richer as well. In fact, their economic well-being has risen more dramatically than that of the rich (driving a worn-out Toyota is closer to driving a Ferrari than it is to walking). The mistake that nearly everyone makes is in thinking that wealth is finite, that if the rich get a dollar more, the poor get a dollar less. In fact, global wealth is effectively without limit and, according to Pinker, has “grown almost a hundredfold since the Industrial Revolution was in place in 1820.” As a result of near-continuous wealth creation, global GDP has risen from almost

I delivered the following eulogy on August 9, 2019, at St. Dominic’s Catholic Church in San Francisco at a Mass commemorating the remarkable life of

nothing to $15,600 per capita in 2015. The poor are still on the bottom rung,

Jim Curtis.

but that lowest rung on the global ladder is considerably higher than it has

I first met Jim Curtis 40 years ago—in 1979—when we were both

ever been for 90 percent of mankind. Pinker’s central thesis, for which he supplies reams of documentation, is simple: while far from perfect and in need of vast improvement, the world is a better place today than it has ever been and is gradually, perhaps inevitably, getting better and better. If you need an optimism fix, read the book.

starting out. He was the real estate guy and I was his lawyer. From the first, I knew Curtis was the smartest guy in the room and, truth be told, I knew nothing about real estate law. But rather than tell me he was the smartest, Curtis showed me he was the kindest, explaining his deals with patience, giving me a chance to catch on. Curtis was so generous with his praise of his friends and his family it was sometimes embarrassing. If you were his friend, he would introduce you to others as the greatest banker in the world, the best broker on the West Coast, or the most talented architect ever. Your deals were the best. And he believed it. With his great generosity of spirit, Curtis really thought you were the best.

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MAKING IT IN REAL ESTATE: STARTING OUT AS A DEVELOPER

151

what people consume rather than what they earn, we find that the American

45

poverty rate has declined by 90 percent since 1960, from 30 percent of the population to just 3 percent. . . . In 2011, more than 95 percent of American households below the poverty line had electricity, running water, flush toilets, a refrigerator, a stove, and a color TV. (A century and a half before, the Rothschilds, Astors, and Vanderbilts had none of these things.)” This overall rise in standard of living is not unique to the United States. Pinker’s data show that in 2008, the world’s entire population (then 6.7 billion)

In Memoriam: James J. Curtis III

had an average income equal to that of western Europe’s in 1964. While conceding that the rich are becoming disproportionally richer, Pinker points out that the poor are getting richer as well. In fact, their economic well-being has risen more dramatically than that of the rich (driving a worn-out Toyota is closer to driving a Ferrari than it is to walking). The mistake that nearly everyone makes is in thinking that wealth is finite, that if the rich get a dollar more, the poor get a dollar less. In fact, global wealth is effectively without limit and, according to Pinker, has “grown almost a hundredfold since the Industrial Revolution was in place in 1820.” As a result of near-continuous wealth creation, global GDP has risen from almost

I delivered the following eulogy on August 9, 2019, at St. Dominic’s Catholic Church in San Francisco at a Mass commemorating the remarkable life of

nothing to $15,600 per capita in 2015. The poor are still on the bottom rung,

Jim Curtis.

but that lowest rung on the global ladder is considerably higher than it has

I first met Jim Curtis 40 years ago—in 1979—when we were both

ever been for 90 percent of mankind. Pinker’s central thesis, for which he supplies reams of documentation, is simple: while far from perfect and in need of vast improvement, the world is a better place today than it has ever been and is gradually, perhaps inevitably, getting better and better. If you need an optimism fix, read the book.

starting out. He was the real estate guy and I was his lawyer. From the first, I knew Curtis was the smartest guy in the room and, truth be told, I knew nothing about real estate law. But rather than tell me he was the smartest, Curtis showed me he was the kindest, explaining his deals with patience, giving me a chance to catch on. Curtis was so generous with his praise of his friends and his family it was sometimes embarrassing. If you were his friend, he would introduce you to others as the greatest banker in the world, the best broker on the West Coast, or the most talented architect ever. Your deals were the best. And he believed it. With his great generosity of spirit, Curtis really thought you were the best.

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151

But who was truly best? Curtis. Together with Jeff Kott, he built the

In short, Curtis was a great success as a friend, as a son, as a sibling, as

Bristol Group, one of the preeminent real estate investment firms in

a partner, as a husband, and in everything else he did. And that is why we’re

the country.

here today, why we’re celebrating the life of our great friend Jim Curtis.

His love for real estate went far beyond his own company. His great

In Matthew 19:24, Jesus says, “And again, I say unto you, it is easier for

passion was the Urban Land Institute, the ULI. Curtis believed that America

a camel to pass through the eye of a needle than for a rich man to enter the

itself has been enriched through the ULI, that cities all across the country have

kingdom of God.”

been revitalized thanks to the struggle, sweat, and determination of committed

How do you thread that camel through a needle? How do you fill a great

ULI members. He knew the ULI’s sharing of best practices had its members

church with mourners who truly grieve your passing and who will never

building better projects, more thoughtful developments, more environmentally

forget you? You do it through kindness, generosity, and compassion.

sensitive buildings. Because of his great love for it, Curtis volunteered countless

How do you thread that camel? You live your life like Jim Curtis.

hours to the ULI, serving in every possible capacity year after year for nearly four decades, doing everything asked of him. Curtis even took two years away from his company—yes, two whole years—to serve as the full-time volunteer chair of the ULI Foundation. His dedicated service to the Foundation came at no small personal expense to Curtis and the Bristol Group. While he loved the ULI, Curtis saw it clearly. Once when describing how to run a council meeting, he insisted the most important part was giving everyone a chance to talk. He said, “ULI members have just two modes of communication: talking and waiting to talk.” And that was Curtis. He called it the way he saw it. He didn’t mince words or sugarcoat his opinions. One time, in the early 1980s, Curtis addressed an ICSC conference, a room full of shopping center developers. He wasn’t quite 30—he looked 15—and he told these titans of industry twice his age that they were full of a substance one doesn’t mention in church, that they were overbuilding the market, and that they were going to take a big fall. They were outraged, but he was right. Yes, Curtis freely gave away his opinions, but he also freely gave away his time, his money, and his love. He gave away his time to anyone seeking advice or needing his help. He gave away millions to the most deserving of charities. And he gave away his love to his friends; his family; his mother, Clare; his father, Jim; his sisters and brothers—Mary, Kelly, Anne, Rob, and Tom; and most of all to his beloved wife, Melodie.

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IN MEMORIAM: JAMES J. CURTIS III 153

But who was truly best? Curtis. Together with Jeff Kott, he built the

In short, Curtis was a great success as a friend, as a son, as a sibling, as

Bristol Group, one of the preeminent real estate investment firms in

a partner, as a husband, and in everything else he did. And that is why we’re

the country.

here today, why we’re celebrating the life of our great friend Jim Curtis.

His love for real estate went far beyond his own company. His great

In Matthew 19:24, Jesus says, “And again, I say unto you, it is easier for

passion was the Urban Land Institute, the ULI. Curtis believed that America

a camel to pass through the eye of a needle than for a rich man to enter the

itself has been enriched through the ULI, that cities all across the country have

kingdom of God.”

been revitalized thanks to the struggle, sweat, and determination of committed

How do you thread that camel through a needle? How do you fill a great

ULI members. He knew the ULI’s sharing of best practices had its members

church with mourners who truly grieve your passing and who will never

building better projects, more thoughtful developments, more environmentally

forget you? You do it through kindness, generosity, and compassion.

sensitive buildings. Because of his great love for it, Curtis volunteered countless

How do you thread that camel? You live your life like Jim Curtis.

hours to the ULI, serving in every possible capacity year after year for nearly four decades, doing everything asked of him. Curtis even took two years away from his company—yes, two whole years—to serve as the full-time volunteer chair of the ULI Foundation. His dedicated service to the Foundation came at no small personal expense to Curtis and the Bristol Group. While he loved the ULI, Curtis saw it clearly. Once when describing how to run a council meeting, he insisted the most important part was giving everyone a chance to talk. He said, “ULI members have just two modes of communication: talking and waiting to talk.” And that was Curtis. He called it the way he saw it. He didn’t mince words or sugarcoat his opinions. One time, in the early 1980s, Curtis addressed an ICSC conference, a room full of shopping center developers. He wasn’t quite 30—he looked 15—and he told these titans of industry twice his age that they were full of a substance one doesn’t mention in church, that they were overbuilding the market, and that they were going to take a big fall. They were outraged, but he was right. Yes, Curtis freely gave away his opinions, but he also freely gave away his time, his money, and his love. He gave away his time to anyone seeking advice or needing his help. He gave away millions to the most deserving of charities. And he gave away his love to his friends; his family; his mother, Clare; his father, Jim; his sisters and brothers—Mary, Kelly, Anne, Rob, and Tom; and most of all to his beloved wife, Melodie.

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IN MEMORIAM: JAMES J. CURTIS III 153

46 Postscript

about philanthropy than business. Much of what I learned about real estate came from listening to Jim Curtis, Bob Hughes, Dan Petrocchi, and Mark Kroll at ULI gatherings. And from my formative years as a young lawyer desperate to be a developer, I would like to acknowledge the patient and amused guidance of Bruce Hyman, Kent Colwell, and Alexander Maisin. And finally, from my days as a bored teenager sitting on open houses for her residential brokerage business, my mother, Mary M. McNellis.

I suggested in the prefacethat my principal theme was one of risk management, of urging you to calibrate and limit your risks—even at the cost of potential profits—as a way to weather development’s storm-tossed peaks and troughs. In hindsight, a more personal and equally important theme seems to have emerged from these pages: choose your crew and fellow travelers wisely, treat them with friendship, dignity, and respect, and take the long view. A great career—and reputation—is built over decades on dozens and dozens of deals and thousands of daily decisions. While there may be no moral universe and it may sometimes appear that the unscrupulous and dishonest go unpunished in our world, you will find that, if not its own reward, fair dealing will prove its own satisfaction. I’m going to conclude with the thought that if you’ve made it this far, you will likely take the path less traveled and become a developer. I wish you the best of luck and can do no better than to repeat George Herman Ruth’s immortal advice: “Never let the fear of striking out get in your way.” I would like to acknowledge a few of the many people from whom I have learned about both real estate and life. First and foremost, my wife, Michele, for everything; and my partners, Beth Walter and Mike Powers, without whom my career would have surely fizzled. George Marcus taught me more

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POSTSCRIPT 155

46 Postscript

about philanthropy than business. Much of what I learned about real estate came from listening to Jim Curtis, Bob Hughes, Dan Petrocchi, and Mark Kroll at ULI gatherings. And from my formative years as a young lawyer desperate to be a developer, I would like to acknowledge the patient and amused guidance of Bruce Hyman, Kent Colwell, and Alexander Maisin. And finally, from my days as a bored teenager sitting on open houses for her residential brokerage business, my mother, Mary M. McNellis.

I suggested in the prefacethat my principal theme was one of risk management, of urging you to calibrate and limit your risks—even at the cost of potential profits—as a way to weather development’s storm-tossed peaks and troughs. In hindsight, a more personal and equally important theme seems to have emerged from these pages: choose your crew and fellow travelers wisely, treat them with friendship, dignity, and respect, and take the long view. A great career—and reputation—is built over decades on dozens and dozens of deals and thousands of daily decisions. While there may be no moral universe and it may sometimes appear that the unscrupulous and dishonest go unpunished in our world, you will find that, if not its own reward, fair dealing will prove its own satisfaction. I’m going to conclude with the thought that if you’ve made it this far, you will likely take the path less traveled and become a developer. I wish you the best of luck and can do no better than to repeat George Herman Ruth’s immortal advice: “Never let the fear of striking out get in your way.” I would like to acknowledge a few of the many people from whom I have learned about both real estate and life. First and foremost, my wife, Michele, for everything; and my partners, Beth Walter and Mike Powers, without whom my career would have surely fizzled. George Marcus taught me more

154

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POSTSCRIPT 155

Glossary: Real Estate Jargon Demystified

Whether a lawyer, architect, engineer, or broker,a young professional in real estate often hears expressions—some slang, others simply arcane—that neither the finest education nor the thickest dictionary is likely to illuminate. And the professional must solemnly nod, as if understanding came with sunlight, when his client invokes acronyms and mathematical formulas to brag about the steal she made in buying a property. A combination of years deducing meaning from context and gradual insight serves to answer most questions, but some have to be asked. And asking questions one fears to be stunningly basic can prove awkward while billing hundreds an hour. This informal guide to some of these uncommon terms will answer a few of the questions and, I hope, spare a little of the beginner’s inevitable anxiety.

Economic Terms Capitalization rate, or cap rate, or simply cap (as in, “The property capped out at an 8.”). A capitalization rate is a shorthand way of stating the yield a buyer would receive by purchasing a certain property. Or, to turn it around, the cap rate expresses the initial return on investment a buyer requires before buying.

157

Glossary: Real Estate Jargon Demystified

Whether a lawyer, architect, engineer, or broker,a young professional in real estate often hears expressions—some slang, others simply arcane—that neither the finest education nor the thickest dictionary is likely to illuminate. And the professional must solemnly nod, as if understanding came with sunlight, when his client invokes acronyms and mathematical formulas to brag about the steal she made in buying a property. A combination of years deducing meaning from context and gradual insight serves to answer most questions, but some have to be asked. And asking questions one fears to be stunningly basic can prove awkward while billing hundreds an hour. This informal guide to some of these uncommon terms will answer a few of the questions and, I hope, spare a little of the beginner’s inevitable anxiety.

Economic Terms Capitalization rate, or cap rate, or simply cap (as in, “The property capped out at an 8.”). A capitalization rate is a shorthand way of stating the yield a buyer would receive by purchasing a certain property. Or, to turn it around, the cap rate expresses the initial return on investment a buyer requires before buying.

157

Example: If you have $1 million to invest and wish to earn a 6 percent return on your investment, then you would have to buy at a 6 cap or higher. If a property is selling at a 7 cap, its buyer would receive a 7 percent return on his money. If it is selling at a 5 cap, the buyer would receive a 5 percent return, and so on. Cap rates vary because of many factors, ranging from the attributes of the property itself (its location, vacancy rate, the creditworthiness of its tenants, the age of its roof, and so on) to the economy as a whole (interest rates, Treasury bill rates, and what product types are in favor at the moment with the buying crowd). The mathematical formula is simple, but it’s easy to trip over because the relationship between the purchase price and the cap rate is inverted. The price rises when the cap rate is lowered and falls when the cap rate is raised. The formula is this: purchase price equals net operating income (NOI) divided by cap rate (expressed as decimal). Example: Assume NOI is $200,000. If the cap rate is 8, then the purchase

gross $90,000 a year and the gross multiplier is 12, the price will be $1.08 million ($90,000 × 12 = $1,080,000). Internal rate of return, or IRR. The IRR is—in a perfect world—a method to determine an investor’s total return from a property during his period of ownership, including both its annual cash flow and its ultimate sales proceeds. The calculation is neither simple nor without breathtaking guesswork. One takes the projected annual cash flow an investor hopes to receive from a property for a given holding period—usually 10 years—and adds to that the property’s estimated sale value in the 10th year. The IRR is the percentage required to discount this combined sum back to zero on the date the property is purchased. Example: If a property produces 5 percent in annual cash flow over 10 years and then sells at the end of that 10th year for twice what the investor originally paid for it, the IRR would be—trust me—10.98 percent; that is, in order to get all that cash dribbling in over the next 10 years to have a net present value of zero today, you would have to discount it at 10.98 percent.

price equals $2.5 million ($200,000 ÷ 0.08). If the cap rate is 12, then the

Framed positively, this means you would have received a total return on your

purchase price equals $1,666,666. Extreme examples underscore the inverse

investment of 10.98 percent. Since this highly speculative 10.98 percent sounds

relationship between cap rate and price: if the cap rate is 1 and the NOI is still

much better than the 5 percent return you know you’re getting from day one,

$200,000, the purchase price would be $20 million. Conversely, if the cap rate

the IRR is wildly popular.

is 25, the purchase price would be $800,000. Note: Historically, this concept was a bit more confusing to beginners

The fallacy behind every IRR analysis ever prepared is obvious: it requires one to predict the unpredictable—cash flows years into the future and the

because at a once-standard cap rate of 10 percent (unheard of in the modern

selling price of a property 10 years from now. The IRR calculation assumes

era), the relationship between price and cap appears to be direct: a property

one can predict highly complex and interrelated financial conditions—interest

with $1 million in NOI sells for $10 million; a property with $100,000 in NOI

rates, capitalization rates, tenant demand, new competition, population

sells for $1 million, and so on. This is the case only because 10 is the number—

growth, personal income shifts, and so on, long into the future. Predicting

and the only number—at which the teeter-totter of rising price and falling cap

what a given property will sell for 10 years hence is likely to be as accurate as

is exactly balanced.

predicting today how much rainfall the city in which the property is located

Gross multiplier. Another, far simpler method for arriving at price is used in

will receive in that 10th year.

the sale of small apartment buildings. One takes the property’s annual gross income and multiplies it by the agreed-on gross multiplier. If the apartments 158

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159 GLOSSARY: REAL ESTATE JARGON DEMYSTIFIED 159

Example: If you have $1 million to invest and wish to earn a 6 percent return on your investment, then you would have to buy at a 6 cap or higher. If a property is selling at a 7 cap, its buyer would receive a 7 percent return on his money. If it is selling at a 5 cap, the buyer would receive a 5 percent return, and so on. Cap rates vary because of many factors, ranging from the attributes of the property itself (its location, vacancy rate, the creditworthiness of its tenants, the age of its roof, and so on) to the economy as a whole (interest rates, Treasury bill rates, and what product types are in favor at the moment with the buying crowd). The mathematical formula is simple, but it’s easy to trip over because the relationship between the purchase price and the cap rate is inverted. The price rises when the cap rate is lowered and falls when the cap rate is raised. The formula is this: purchase price equals net operating income (NOI) divided by cap rate (expressed as decimal). Example: Assume NOI is $200,000. If the cap rate is 8, then the purchase

gross $90,000 a year and the gross multiplier is 12, the price will be $1.08 million ($90,000 × 12 = $1,080,000). Internal rate of return, or IRR. The IRR is—in a perfect world—a method to determine an investor’s total return from a property during his period of ownership, including both its annual cash flow and its ultimate sales proceeds. The calculation is neither simple nor without breathtaking guesswork. One takes the projected annual cash flow an investor hopes to receive from a property for a given holding period—usually 10 years—and adds to that the property’s estimated sale value in the 10th year. The IRR is the percentage required to discount this combined sum back to zero on the date the property is purchased. Example: If a property produces 5 percent in annual cash flow over 10 years and then sells at the end of that 10th year for twice what the investor originally paid for it, the IRR would be—trust me—10.98 percent; that is, in order to get all that cash dribbling in over the next 10 years to have a net present value of zero today, you would have to discount it at 10.98 percent.

price equals $2.5 million ($200,000 ÷ 0.08). If the cap rate is 12, then the

Framed positively, this means you would have received a total return on your

purchase price equals $1,666,666. Extreme examples underscore the inverse

investment of 10.98 percent. Since this highly speculative 10.98 percent sounds

relationship between cap rate and price: if the cap rate is 1 and the NOI is still

much better than the 5 percent return you know you’re getting from day one,

$200,000, the purchase price would be $20 million. Conversely, if the cap rate

the IRR is wildly popular.

is 25, the purchase price would be $800,000. Note: Historically, this concept was a bit more confusing to beginners

The fallacy behind every IRR analysis ever prepared is obvious: it requires one to predict the unpredictable—cash flows years into the future and the

because at a once-standard cap rate of 10 percent (unheard of in the modern

selling price of a property 10 years from now. The IRR calculation assumes

era), the relationship between price and cap appears to be direct: a property

one can predict highly complex and interrelated financial conditions—interest

with $1 million in NOI sells for $10 million; a property with $100,000 in NOI

rates, capitalization rates, tenant demand, new competition, population

sells for $1 million, and so on. This is the case only because 10 is the number—

growth, personal income shifts, and so on, long into the future. Predicting

and the only number—at which the teeter-totter of rising price and falling cap

what a given property will sell for 10 years hence is likely to be as accurate as

is exactly balanced.

predicting today how much rainfall the city in which the property is located

Gross multiplier. Another, far simpler method for arriving at price is used in

will receive in that 10th year.

the sale of small apartment buildings. One takes the property’s annual gross income and multiplies it by the agreed-on gross multiplier. If the apartments 158

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159 GLOSSARY: REAL ESTATE JARGON DEMYSTIFIED 159

Net operating income, or NOI. NOI has a widely held general meaning,

Bollard. A short, sturdy post used to prevent vehicle access or to protect an

but because it is the cornerstone of a property’s value, its definition is

object (e.g., an outdoor electrical panel box) from traffic.

subject to arm wrestling. Simply put, NOI is a property’s annual gross rental income minus the property’s—not the owner’s—expenses attributable to the same period. The definition of gross rental income has relatively few pitfalls—whether

Clear span. A building or tenant space constructed so as to be free of interior columns. This is important in retail buildings because of merchandising requirements and sight lines.

to include one-time payments (a lease termination fee) or bank interest on

CMB. The abbreviation for concrete masonry block. The term describes a type

deposits or a tenant’s repayment of over-standard tenant improvements.

of exterior wall construction. (“Is it a tilt-up?” “No, CMB. “)

Sellers invariably consider tenant improvement repayments to be rent, while buyers view them as loan payments and thus not part of gross income. The definition of expenses can be more problematic. For purposes of

Cornice. A projecting (or overhanging) continuous horizontal feature at the top of a building.

defining NOI, expenses never include the owner’s debt service or depreciation.

Curtain wall. The outer “skin” of an office building, usually glass, hung from

In other words, the property is viewed as being free and clear of mortgages

a steel frame. This is a common construction method for high-rises.

and the tax situation is put aside. The debate begins after that: what the management fee and vacancy factor should be; whether and how much to include for reserves for future tenant improvements and leasing commissions, structural maintenance reserves, and roof replacement reserves; how to handle capital repairs or improvements; and so on. Note to young lawyers: If possible, avoid a purchase contract in which your

Dock high. A term indicating that the floor of a building’s loading docks are flush with a delivery truck’s floor so that goods can be rolled off the truck on a level plane. This is usually accomplished by lowering the outside loading area where the trucks park. Elevation. A drawing of a building’s exterior wall viewed as if one were

buyer is paying a floating price dependent on an NOI formula. (This usually

standing in front of it. The elevation is the stylish drawing with which the

occurs where the sale is agreed on before the property is fully leased.) The

architect impresses the city council and to which the finished building

contract has yet to be drawn that can save a buyer from being screwed by a

sometimes bears a passing resemblance.

desperate developer whose new building is failing to meet his rosy pro forma.

Architecture and Construction Terms Alligatored. A term describing a parking lot in the midst of failure (after the first cracks but before the potholes). The term refers to the bumpy, cracked asphalt surface that does indeed resemble an alligator’s back. Note: A simple seal or slurry coat will not solve this problem despite

End cap. The space at the end of a row of shops nearest the street (hence, usually the most visible and desirable of the shop spaces). Facade. The front of a building; the architectural treatment, hopefully impressive, of a building’s principal elevation. The terms cornice and parapet tend to be used loosely (and interchangeably) as meaning the architectural treatment at the top of the facade.

whatever contrary advice your client may receive.

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161 GLOSSARY: REAL ESTATE JARGON DEMYSTIFIED 161

Net operating income, or NOI. NOI has a widely held general meaning,

Bollard. A short, sturdy post used to prevent vehicle access or to protect an

but because it is the cornerstone of a property’s value, its definition is

object (e.g., an outdoor electrical panel box) from traffic.

subject to arm wrestling. Simply put, NOI is a property’s annual gross rental income minus the property’s—not the owner’s—expenses attributable to the same period. The definition of gross rental income has relatively few pitfalls—whether

Clear span. A building or tenant space constructed so as to be free of interior columns. This is important in retail buildings because of merchandising requirements and sight lines.

to include one-time payments (a lease termination fee) or bank interest on

CMB. The abbreviation for concrete masonry block. The term describes a type

deposits or a tenant’s repayment of over-standard tenant improvements.

of exterior wall construction. (“Is it a tilt-up?” “No, CMB. “)

Sellers invariably consider tenant improvement repayments to be rent, while buyers view them as loan payments and thus not part of gross income. The definition of expenses can be more problematic. For purposes of

Cornice. A projecting (or overhanging) continuous horizontal feature at the top of a building.

defining NOI, expenses never include the owner’s debt service or depreciation.

Curtain wall. The outer “skin” of an office building, usually glass, hung from

In other words, the property is viewed as being free and clear of mortgages

a steel frame. This is a common construction method for high-rises.

and the tax situation is put aside. The debate begins after that: what the management fee and vacancy factor should be; whether and how much to include for reserves for future tenant improvements and leasing commissions, structural maintenance reserves, and roof replacement reserves; how to handle capital repairs or improvements; and so on. Note to young lawyers: If possible, avoid a purchase contract in which your

Dock high. A term indicating that the floor of a building’s loading docks are flush with a delivery truck’s floor so that goods can be rolled off the truck on a level plane. This is usually accomplished by lowering the outside loading area where the trucks park. Elevation. A drawing of a building’s exterior wall viewed as if one were

buyer is paying a floating price dependent on an NOI formula. (This usually

standing in front of it. The elevation is the stylish drawing with which the

occurs where the sale is agreed on before the property is fully leased.) The

architect impresses the city council and to which the finished building

contract has yet to be drawn that can save a buyer from being screwed by a

sometimes bears a passing resemblance.

desperate developer whose new building is failing to meet his rosy pro forma.

Architecture and Construction Terms Alligatored. A term describing a parking lot in the midst of failure (after the first cracks but before the potholes). The term refers to the bumpy, cracked asphalt surface that does indeed resemble an alligator’s back. Note: A simple seal or slurry coat will not solve this problem despite

End cap. The space at the end of a row of shops nearest the street (hence, usually the most visible and desirable of the shop spaces). Facade. The front of a building; the architectural treatment, hopefully impressive, of a building’s principal elevation. The terms cornice and parapet tend to be used loosely (and interchangeably) as meaning the architectural treatment at the top of the facade.

whatever contrary advice your client may receive.

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161 GLOSSARY: REAL ESTATE JARGON DEMYSTIFIED 161

Fascia. The flat portion of a building’s front or principal elevation, just above

In other words, every hillock and declivity is calculated. This is essential for

the tops of the doors and windows. Also called the sign-band, the fascia is

planning the parcel’s site work, its drainage, and whether earth needs to be

typically where building signage is placed.

removed or imported.

Footprint. The exterior or perimeter dimensions of a building. Building footprints are typically found on site or leasing plans. Mullion. The vertical element that separates window panes. Note: One can roughly calculate an office’s size in an office building by counting its mullions and the acoustical tile squares in its drop ceiling. Mullions are typically spaced 4 feet apart and ceiling tiles are usually either 2 feet by 4 feet or 2 feet by 2 feet. Pad. The land area for a small building (a McDonald’s) on the perimeter of a shopping center. The small building itself is also often referred to as a pad. Parapet. A vertical wall, usually extending above a roof line. In addition to making buildings appear larger, parapets hide rooftop equipment and exterior walls (a fire wall between two buildings).

Note: If a site is too low and needs earth or fill, the fill will be expensive. If, on the other hand, excess earth must be trucked away, the hauling costs will be ruinous and the dirt brokers will tell you no one is buying fill at the moment. Geotech. A geotechnical survey (the third step in the preconstruction process), prepared by a soils engineer and evaluating the quality and consistency of a parcel’s substrata through soil borings. Knowing whether earth is predominantly sandy or claylike or rocky is critical to the building’s structural design. A geotech report could kill a deal if, for example, a solid layer of granite were encountered beneath the surface. As-built. The survey prepared by a licensed surveyor when construction is complete, showing the exact location of the buildings and site improvements (e.g., light poles and fire hydrants). The as-built serves as the basis for a subsequent ALTA (American Land Title Association) boundary survey. To

Plenum. The enclosed space between the acoustical tile ceiling (the drop

the as-built, the ALTA adds easements, encroachments, and anything else the

ceiling) and the underside of the roof structure or, in the case of a multistory

lender’s counsel is fretting over.

building, the floor above.

Surveys and Plans

Site plan. A less formal document, sometimes simply sketched by the project architect, showing the proposed layout of the new building and the site improvements (the parking lot and landscaping). The site plan is often,

Surveys, site plans, leasing plans, plot plans, and so on—the when and why of

but not always, based on a boundary survey (it can be prepared from the

these various drawings can be confusing.

assessor’s map attached to the preliminary title report) and is used for initial

Boundary survey. A formal survey prepared by a licensed surveyor of a parcel’s exterior dimensions. (If not already in existence, this is the first step in developing a parcel.) Topo. A topographic survey (the second step in the preconstruction process),

presentation to planning staffs, neighbors, and so on. Typically, site plans go through numerous revisions as comments are encountered. When the size, shape, and location of the buildings are finally agreed on, the architect or civil engineer uses the site plan as the rough basis for the working drawings for the site work. The term plot plan is a less frequently used synonym.

prepared by a civil engineer and detailing all changes in a parcel’s altitudes.

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163 GLOSSARY: REAL ESTATE JARGON DEMYSTIFIED 163

Fascia. The flat portion of a building’s front or principal elevation, just above

In other words, every hillock and declivity is calculated. This is essential for

the tops of the doors and windows. Also called the sign-band, the fascia is

planning the parcel’s site work, its drainage, and whether earth needs to be

typically where building signage is placed.

removed or imported.

Footprint. The exterior or perimeter dimensions of a building. Building footprints are typically found on site or leasing plans. Mullion. The vertical element that separates window panes. Note: One can roughly calculate an office’s size in an office building by counting its mullions and the acoustical tile squares in its drop ceiling. Mullions are typically spaced 4 feet apart and ceiling tiles are usually either 2 feet by 4 feet or 2 feet by 2 feet. Pad. The land area for a small building (a McDonald’s) on the perimeter of a shopping center. The small building itself is also often referred to as a pad. Parapet. A vertical wall, usually extending above a roof line. In addition to making buildings appear larger, parapets hide rooftop equipment and exterior walls (a fire wall between two buildings).

Note: If a site is too low and needs earth or fill, the fill will be expensive. If, on the other hand, excess earth must be trucked away, the hauling costs will be ruinous and the dirt brokers will tell you no one is buying fill at the moment. Geotech. A geotechnical survey (the third step in the preconstruction process), prepared by a soils engineer and evaluating the quality and consistency of a parcel’s substrata through soil borings. Knowing whether earth is predominantly sandy or claylike or rocky is critical to the building’s structural design. A geotech report could kill a deal if, for example, a solid layer of granite were encountered beneath the surface. As-built. The survey prepared by a licensed surveyor when construction is complete, showing the exact location of the buildings and site improvements (e.g., light poles and fire hydrants). The as-built serves as the basis for a subsequent ALTA (American Land Title Association) boundary survey. To

Plenum. The enclosed space between the acoustical tile ceiling (the drop

the as-built, the ALTA adds easements, encroachments, and anything else the

ceiling) and the underside of the roof structure or, in the case of a multistory

lender’s counsel is fretting over.

building, the floor above.

Surveys and Plans

Site plan. A less formal document, sometimes simply sketched by the project architect, showing the proposed layout of the new building and the site improvements (the parking lot and landscaping). The site plan is often,

Surveys, site plans, leasing plans, plot plans, and so on—the when and why of

but not always, based on a boundary survey (it can be prepared from the

these various drawings can be confusing.

assessor’s map attached to the preliminary title report) and is used for initial

Boundary survey. A formal survey prepared by a licensed surveyor of a parcel’s exterior dimensions. (If not already in existence, this is the first step in developing a parcel.) Topo. A topographic survey (the second step in the preconstruction process),

presentation to planning staffs, neighbors, and so on. Typically, site plans go through numerous revisions as comments are encountered. When the size, shape, and location of the buildings are finally agreed on, the architect or civil engineer uses the site plan as the rough basis for the working drawings for the site work. The term plot plan is a less frequently used synonym.

prepared by a civil engineer and detailing all changes in a parcel’s altitudes.

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Leasing plan. A site plan that delineates the proposed dimensions of the spaces the developer wishes to lease. The leasing plan is what developers and their brokers huddle over with potential tenants. Tilt-up. A method of construction so common to warehouses that the buildings themselves are referred to as tilt-ups. With tilt-up construction, the form (or mold) for the exterior wall is assembled on the ground next to where the wall will stand, the concrete is poured into the form, and, when it dries, the wall is tilted up into its permanent vertical position. Because this is perhaps the cheapest means of construction, the term tilt-up is sometimes used derisively. Truss. The wooden or metal horizontal support for a roof; the roof’s understructure. It is often prefabricated. Wood-frame or stick construction. Shorthand ways of referring to a building constructed of wood framing and an applied exterior, usually stucco or wood siding.

Lease Terms Absolutely net. What a landlord strives for in a ground lease—the tenant paying absolutely all of a property’s expenses. Note: Even with an absolutely net lease, the landlord will typically have some unreimbursed expenses—for example, his partnership’s tax preparation fees, the cost of excess umbrella liability insurance, and so on. Base year. The year in which the landlord’s share of a building’s expenses vis-à-vis a particular tenant is established—usually the calendar year in which a lease commences or the 12-month period beginning when that tenant opens for business. In a base year lease, the tenant pays costs but only to the extent

Definitions of Area Because money is more important than math in the definition of a tenant’s leased premises, the industry standards are subject to negotiation, and one can appear foolish insisting on a particular definition as if it were an inalienable right. A Manhattan developer once said that there are more interpretations of net rentable area than languages spoken in New York. Gross leasable area, or GLA. The standard for retail leasing, which, as often as not, connotes “outside wall to outside wall,” meaning the GLA is the entire building or space with no deductions. Occasionally, the measurements are from the inside—and sometimes, the midpoint—of the perimeter walls. Industrial buildings are also often leased on a gross square footage basis. Net rentable area. An office leasing term and, assuming one is leasing an entire floor of a building, the standard for the leased premises. It is generally understood to be the total floor area less “vertical penetrations”—elevators, utility ducts, and staircases being the most readily agreed upon, while the janitor’s closet and light wells are sometimes debated. Net rentable area includes all of what would be the floor’s common areas if the floor contains more than one tenant—in other words, the elevator lobby, hallways, and restrooms. Net usable area. The calculation usually applied to multitenant floors in an office building. Net usable area is the net rentable area minus the common areas. Each tenant leases its pro rata share of the net usable area and a pro rata share of the deducted common areas; this is called a load factor. Depending on the efficiency of the floor plate (in English, the floor) and the relative bargaining strength of landlord and tenant, the load factor can vary wildly, but an average load runs about 10 to 12 percent. Above 15 percent, tenants scream; below 5 percent is unheard of.

they exceed base year costs. Note: Establishing a fair base year is tricky with new or underleased buildings. 164

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Leasing plan. A site plan that delineates the proposed dimensions of the spaces the developer wishes to lease. The leasing plan is what developers and their brokers huddle over with potential tenants. Tilt-up. A method of construction so common to warehouses that the buildings themselves are referred to as tilt-ups. With tilt-up construction, the form (or mold) for the exterior wall is assembled on the ground next to where the wall will stand, the concrete is poured into the form, and, when it dries, the wall is tilted up into its permanent vertical position. Because this is perhaps the cheapest means of construction, the term tilt-up is sometimes used derisively. Truss. The wooden or metal horizontal support for a roof; the roof’s understructure. It is often prefabricated. Wood-frame or stick construction. Shorthand ways of referring to a building constructed of wood framing and an applied exterior, usually stucco or wood siding.

Lease Terms Absolutely net. What a landlord strives for in a ground lease—the tenant paying absolutely all of a property’s expenses. Note: Even with an absolutely net lease, the landlord will typically have some unreimbursed expenses—for example, his partnership’s tax preparation fees, the cost of excess umbrella liability insurance, and so on. Base year. The year in which the landlord’s share of a building’s expenses vis-à-vis a particular tenant is established—usually the calendar year in which a lease commences or the 12-month period beginning when that tenant opens for business. In a base year lease, the tenant pays costs but only to the extent

Definitions of Area Because money is more important than math in the definition of a tenant’s leased premises, the industry standards are subject to negotiation, and one can appear foolish insisting on a particular definition as if it were an inalienable right. A Manhattan developer once said that there are more interpretations of net rentable area than languages spoken in New York. Gross leasable area, or GLA. The standard for retail leasing, which, as often as not, connotes “outside wall to outside wall,” meaning the GLA is the entire building or space with no deductions. Occasionally, the measurements are from the inside—and sometimes, the midpoint—of the perimeter walls. Industrial buildings are also often leased on a gross square footage basis. Net rentable area. An office leasing term and, assuming one is leasing an entire floor of a building, the standard for the leased premises. It is generally understood to be the total floor area less “vertical penetrations”—elevators, utility ducts, and staircases being the most readily agreed upon, while the janitor’s closet and light wells are sometimes debated. Net rentable area includes all of what would be the floor’s common areas if the floor contains more than one tenant—in other words, the elevator lobby, hallways, and restrooms. Net usable area. The calculation usually applied to multitenant floors in an office building. Net usable area is the net rentable area minus the common areas. Each tenant leases its pro rata share of the net usable area and a pro rata share of the deducted common areas; this is called a load factor. Depending on the efficiency of the floor plate (in English, the floor) and the relative bargaining strength of landlord and tenant, the load factor can vary wildly, but an average load runs about 10 to 12 percent. Above 15 percent, tenants scream; below 5 percent is unheard of.

they exceed base year costs. Note: Establishing a fair base year is tricky with new or underleased buildings. 164

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Expense stop, or stated expense stop. A variation to the base year approach

Percentage rent is determined by dividing the tenant’s fixed rent by the

found in office leasing in which the tenant pays the building costs above an

percentage rent factor (expressed as a decimal). The resulting sum is the

agreed-on maximum level. For example, if the expense stop were $10 per

tenant’s break point or natural break point or breaker. When the tenant’s

square foot and the building expenses rose to $12, the tenant would pay $2 per

annual gross sales exceed the break point, the tenant pays the landlord the

square foot as its share of building expenses.

agreed-on rate of percentage rent on the excess sales only.

Full service or gross. A lease under which the landlord pays all costs (including janitorial and utilities) without reimbursement from the tenant.

Example: A supermarket agrees to pay $500,000 a year in fixed rent and 1 percent in percentage rent. Thus, this supermarket will pay 1 percent of its annual sales in excess of $50 million ($500,000 ÷ 0.01 = $50,000,000).

Go dark. The closing of a business. In retail, powerful tenants insist on the

Put another way, it will not pay any percentage rent until its sales reach $50

right to go dark at any time (without, however, terminating the lease or any of

million. If, for example, a Mexican restaurant agrees to pay $220,000 in fixed

their other obligations). Once-burned landlords insist on the right to recapture

rent and 5 percent in percentage rent, the restaurant will then pay 5 percent

the space if the tenant goes dark.

of its sales but only to the extent its sales exceed $4.4 million ($220,000 ÷ 0.05

Industrial-gross. A typical lease format for industrial buildings wherein the tenant pays for maintenance, utilities, and increases, if any, in the landlord’s taxes over those payable in the first year of the lease. The landlord pays for base year taxes and insurance. Kick-out. A clause through which retail tenants can terminate the lease upon the occurrence of some event, usually the tenant’s failure to reach an agreedon minimum level of sales. Tenants often try for a kick-out clause in addition to a go-dark provision. Percentage rent. If a retail tenant is compelled to grant rent increases, all but the most successful prefer it to be in the form of percentage rent. The rate or percentage varies depending on the tenant’s particular business. High-salesvolume, low-profit-margin tenants (supermarkets) typically pay no more than 1 percent in percentage rent; a discount department store may pay 2 to 3 percent while a fast-food restaurant may pay as much as 6 percent of sales or more.

= $4,400,000). An artificial break point or breaker occurs when the parties agree that, the formula aside, percentage rent will be payable on sales above an agreed-on dollar amount. If the supermarket from the foregoing example agreed that percentage rent would commence above $40 million, then the artificial break point would be $40 million. An observation: Because they are efficient at keeping fixed rent high, landlords rarely receive percentage rent. Typically, only very old leases or exceptionally successful tenants pay percentage rent. Triple net. Although the most basic of lease terms, triple net means many things to many people. It usually means a tenant is required to pay its pro rata share of taxes, insurance, and maintenance, and that the landlord is responsible for maintenance of the roof and bearing walls. The term leaves open for debate a host of lesser issues, such as who pays for capital improvements or replacements (the parking lot), who pays the increase in property taxes upon the building’s sale, who pays for insurance the tenant views as excessive or frivolous (a $25 million liability policy or earthquake insurance).

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Expense stop, or stated expense stop. A variation to the base year approach

Percentage rent is determined by dividing the tenant’s fixed rent by the

found in office leasing in which the tenant pays the building costs above an

percentage rent factor (expressed as a decimal). The resulting sum is the

agreed-on maximum level. For example, if the expense stop were $10 per

tenant’s break point or natural break point or breaker. When the tenant’s

square foot and the building expenses rose to $12, the tenant would pay $2 per

annual gross sales exceed the break point, the tenant pays the landlord the

square foot as its share of building expenses.

agreed-on rate of percentage rent on the excess sales only.

Full service or gross. A lease under which the landlord pays all costs (including janitorial and utilities) without reimbursement from the tenant.

Example: A supermarket agrees to pay $500,000 a year in fixed rent and 1 percent in percentage rent. Thus, this supermarket will pay 1 percent of its annual sales in excess of $50 million ($500,000 ÷ 0.01 = $50,000,000).

Go dark. The closing of a business. In retail, powerful tenants insist on the

Put another way, it will not pay any percentage rent until its sales reach $50

right to go dark at any time (without, however, terminating the lease or any of

million. If, for example, a Mexican restaurant agrees to pay $220,000 in fixed

their other obligations). Once-burned landlords insist on the right to recapture

rent and 5 percent in percentage rent, the restaurant will then pay 5 percent

the space if the tenant goes dark.

of its sales but only to the extent its sales exceed $4.4 million ($220,000 ÷ 0.05

Industrial-gross. A typical lease format for industrial buildings wherein the tenant pays for maintenance, utilities, and increases, if any, in the landlord’s taxes over those payable in the first year of the lease. The landlord pays for base year taxes and insurance. Kick-out. A clause through which retail tenants can terminate the lease upon the occurrence of some event, usually the tenant’s failure to reach an agreedon minimum level of sales. Tenants often try for a kick-out clause in addition to a go-dark provision. Percentage rent. If a retail tenant is compelled to grant rent increases, all but the most successful prefer it to be in the form of percentage rent. The rate or percentage varies depending on the tenant’s particular business. High-salesvolume, low-profit-margin tenants (supermarkets) typically pay no more than 1 percent in percentage rent; a discount department store may pay 2 to 3 percent while a fast-food restaurant may pay as much as 6 percent of sales or more.

= $4,400,000). An artificial break point or breaker occurs when the parties agree that, the formula aside, percentage rent will be payable on sales above an agreed-on dollar amount. If the supermarket from the foregoing example agreed that percentage rent would commence above $40 million, then the artificial break point would be $40 million. An observation: Because they are efficient at keeping fixed rent high, landlords rarely receive percentage rent. Typically, only very old leases or exceptionally successful tenants pay percentage rent. Triple net. Although the most basic of lease terms, triple net means many things to many people. It usually means a tenant is required to pay its pro rata share of taxes, insurance, and maintenance, and that the landlord is responsible for maintenance of the roof and bearing walls. The term leaves open for debate a host of lesser issues, such as who pays for capital improvements or replacements (the parking lot), who pays the increase in property taxes upon the building’s sale, who pays for insurance the tenant views as excessive or frivolous (a $25 million liability policy or earthquake insurance).

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Loan Terms Ammo. Slang for principal amortization or amortization schedule, as in “What’s the ammo?” Basis point. One-hundredth of 1 percent. For example, 25 basis points are one-quarter of 1 percent, and so on. Thus, to impress you, your client will crow about saving 100 basis points on a new loan when he might simply have said 1 percent. Basis points are often called bips. Constant. The fixed payment of both principal and interest due under an amortizing loan, expressed as a percentage of the outstanding loan balance. In other words, the constant is determined by taking the total monthly debt service, multiplying it by 12, and then dividing that sum by the outstanding loan balance. The greater (or swifter) the principal amortization, the larger the constant. Older loans may have an attractive interest rate, but because so much of the fixed payment is principal, the cash flow–conscious buyer will object to the constant. Example: A $1 million loan payable in 30 years with interest at 8 percent has a constant of 8.8 percent in the first year. In the 15th year of the same loan, the constant has risen to 11.5 percent (the payments are unchanged but are higher in proportion to the then-remaining loan balance of $767,700). Debt coverage ratio, or coverage. The ratio that a property’s NOI bears to the annual principal and interest payments (or debt service) due under its loan. To obtain the coverage ratio for an existing loan, one simply divides the NOI by the debt service. If a property has NOI of $125,000 and debt service of $100,000, the coverage is called “1.25.” If the NOI were unchanged but the debt service fell to $60,000, the coverage would be “2.08.” The higher the coverage, the more conservative the loan. To determine the maximum new loan for a property, obtain the probable lender’s coverage requirement and the new loan’s constant, divide

Example: NOI is $327,000, the coverage is 1.15, and the constant is 8.8. Thus, ($327,000 ÷ 1.15 = $284,348) ÷ 0.088 = $3,231,225 maximum loan.  Note: It is easy to forget this is a two-step process. Leverage. A property is leveraged when it has debt on it. A 50 percent leverage means a property is encumbered with a loan for 50 percent of its value. Being completely leveraged means the owner has no cash investment in the property. Investors love leverage because it can exponentially increase their returns. If a buyer pays $1 million all-cash for a property that then appreciates $50,000 a year in value, he makes 5 percent a year on his $1 million investment (on paper at least). If the buyer instead puts down $100,000 and borrows $900,000 from the bank, the $50,000 annual appreciation becomes a 50 percent return on his $100,000 investment. This is how the audacious become wealthy in a rising market. Turning this example upside down illustrates what happens to the audacious in a falling market. If instead of appreciating, the property depreciates by $50,000 a year, the all-cash buyer will suffer mild discomfort while the leveraged buyer will wear out kneepads in meetings with his lender. Positive leverage. If the interest rate on the mortgage is lower than the cap rate, the buyer enjoys positive leverage. Example: If she buys a hotel for $1 million all-cash at a 7 cap rate, she will net $70,000 a year (a 7 percent return on her $1 million investment). If rather than paying all cash she instead borrows $750,000, payable at 5 percent interest with a 30-year amortization schedule, she will pay $48,113 in annual principal and interest, but her cash investment will be reduced to $250,000. After her debt service payments, she will be left with a net cash flow of $21,886—an 8.75 percent return on her $250,000 investment. And she will benefit from annual principal amortization starting at $13,113 (and increasing yearly after that). If one counts principal amortization as part of one’s return—one should—then her overall return would be 14 percent. Quite positive.

the property’s NOI by the coverage ratio, and then divide that result by the constant (expressed as a decimal).  168

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Loan Terms Ammo. Slang for principal amortization or amortization schedule, as in “What’s the ammo?” Basis point. One-hundredth of 1 percent. For example, 25 basis points are one-quarter of 1 percent, and so on. Thus, to impress you, your client will crow about saving 100 basis points on a new loan when he might simply have said 1 percent. Basis points are often called bips. Constant. The fixed payment of both principal and interest due under an amortizing loan, expressed as a percentage of the outstanding loan balance. In other words, the constant is determined by taking the total monthly debt service, multiplying it by 12, and then dividing that sum by the outstanding loan balance. The greater (or swifter) the principal amortization, the larger the constant. Older loans may have an attractive interest rate, but because so much of the fixed payment is principal, the cash flow–conscious buyer will object to the constant. Example: A $1 million loan payable in 30 years with interest at 8 percent has a constant of 8.8 percent in the first year. In the 15th year of the same loan, the constant has risen to 11.5 percent (the payments are unchanged but are higher in proportion to the then-remaining loan balance of $767,700). Debt coverage ratio, or coverage. The ratio that a property’s NOI bears to the annual principal and interest payments (or debt service) due under its loan. To obtain the coverage ratio for an existing loan, one simply divides the NOI by the debt service. If a property has NOI of $125,000 and debt service of $100,000, the coverage is called “1.25.” If the NOI were unchanged but the debt service fell to $60,000, the coverage would be “2.08.” The higher the coverage, the more conservative the loan. To determine the maximum new loan for a property, obtain the probable lender’s coverage requirement and the new loan’s constant, divide

Example: NOI is $327,000, the coverage is 1.15, and the constant is 8.8. Thus, ($327,000 ÷ 1.15 = $284,348) ÷ 0.088 = $3,231,225 maximum loan.  Note: It is easy to forget this is a two-step process. Leverage. A property is leveraged when it has debt on it. A 50 percent leverage means a property is encumbered with a loan for 50 percent of its value. Being completely leveraged means the owner has no cash investment in the property. Investors love leverage because it can exponentially increase their returns. If a buyer pays $1 million all-cash for a property that then appreciates $50,000 a year in value, he makes 5 percent a year on his $1 million investment (on paper at least). If the buyer instead puts down $100,000 and borrows $900,000 from the bank, the $50,000 annual appreciation becomes a 50 percent return on his $100,000 investment. This is how the audacious become wealthy in a rising market. Turning this example upside down illustrates what happens to the audacious in a falling market. If instead of appreciating, the property depreciates by $50,000 a year, the all-cash buyer will suffer mild discomfort while the leveraged buyer will wear out kneepads in meetings with his lender. Positive leverage. If the interest rate on the mortgage is lower than the cap rate, the buyer enjoys positive leverage. Example: If she buys a hotel for $1 million all-cash at a 7 cap rate, she will net $70,000 a year (a 7 percent return on her $1 million investment). If rather than paying all cash she instead borrows $750,000, payable at 5 percent interest with a 30-year amortization schedule, she will pay $48,113 in annual principal and interest, but her cash investment will be reduced to $250,000. After her debt service payments, she will be left with a net cash flow of $21,886—an 8.75 percent return on her $250,000 investment. And she will benefit from annual principal amortization starting at $13,113 (and increasing yearly after that). If one counts principal amortization as part of one’s return—one should—then her overall return would be 14 percent. Quite positive.

the property’s NOI by the coverage ratio, and then divide that result by the constant (expressed as a decimal).  168

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Negative leverage. This is the reverse. It occurs when the interest rate on the loan is higher than the cap rate on the purchase price. If our buyer bought that hotel at a 4 cap, the NOI of $70,000 would be unchanged, but her purchase price would have soared to $1.75 million. If the buyer has the same loan, she will still have $21,886 in net cash flow, but instead of an 8.75 percent return on investment, she will receive 2.19 percent ($21,886 cash flow ÷ $1,000,000 equity). Buying at a 4 cap but getting 2.2 percent in cash flow is distinctly negative leverage.

Miscellaneous Terms FF&E. A hotel term meaning “furniture, fixtures, and equipment.” Flip. A verb meaning to sell a property at the same time one is purchasing it. With a signed purchase contract and a sufficiently long escrow, a buyer of a property may, in a hot market, raise the price and secretly market it for resale before he closes escrow. The property is usually flipped (or double-escrowed or double-clutched) to the second buyer at the same moment as the flipper’s purchase, with the second buyer’s money the only funds in escrow. Rack rate. A hotel term meaning the average nightly room rental rate.

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