Book Summary: Making it in Real Estate

Starting out as a (real estate) developer

Real estate development is a cross-disciplinary field where you need to orchestrate various professionals to build infrastructure and buildings. This book provides strategic advice for becoming an effective real estate developer.

The author, John McNellis, founded and led a commercial development firm focused on retail and shopping centers since the 1980s.

This book has two parts. The first has 40 chapters and focuses on lessons learned in real estate development. The second, chapters 41 to 46, are about philosophy and life decisions. The second part was nice, but it seems out of context. I rather read Alain de Botton or Seneca instead if I want life advice.

The following is John’s advice I liked most:

Starting Out

New developers typically need to pull off their first deal playing every instrument in the orchestra: investment broker, contractor, day laborer, property manager, janitor, lawyer, accountant, leasing, mortgage broker, etc. There is a benefit to this extra effort: just as a conductor of an orchestra must know how all his musicians should sound, a developer should understand what your service providers do, and doing it yourself is a quick way to get it.

New developers should ask themselves where they want to be in 20 years. Would you want to be a media darling running a big company and doing the splashiest deals in town? Or would you prefer smaller projects that help you slowly build assets and increase free cash flow?

You’re better off deciding the big picture question before your first deal because you might be unable to make the right decisions without a defined strategy to guide you. In other words, unless you plan ahead, the sell or hold decision may be a luxury you cannot afford. The fastest projects take at least two years before you can cash in and more likely three to five years from when you saw a property to the day you sell.

If we oversimplify, there are two types of real estate developers: investment builders and merchant builders. Investment builders build to hold assets for the long term as a portfolio investment, while merchant builders build to sell; they do more deals and profit much sooner.

If you want to run a giant 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. If you go the investor route, choose the properties you keep carefully: many have their finest hour when inaugurated.

The best, but uninspiring strategy, might be the build to hold approach.

Choosing a Focus

If you don’t specialize, your specialty will be failure.

“We started in apartments like almost all new developers, but they didn’t work for us. Richer in experience but little else, we decided we had no wish to own buildings where anyone slept. Since, we have developed neighborhood shopping centers in cities that fight new developments, thus limiting supply.”

John’s development projects are “necessity retail” (supermarkets, drugstores, and discount department stores); they range from 25,000 ft² (2,300 m²) to 150,000 ft² (14,000 m²), located within a two-hour drive of San Francisco.

John’s firm’s strategy: accumulate fewer but higher-quality properties with lower debt rather than amassing a portfolio that requires a big overhead.

Growth

Grow your deal size slowly.

The big-picture risk management for developers is the classic tactic of using other people’s money, taking fees upfront, and never signing recourse (personal guarantees).

The long-term investment approach is investing enough equity to survive any recession and avoid building speculative projects. Spec buildings are those with a build it, and they will come mentality—without having sold to a customer.

It’s hard to hit a home run paying all cash, but it’s also impossible to strike out, and since even the best in our business lose money, you might seriously consider being conservative. Slow and steady wins the race.

Market 

What you do doesn’t matter as much as where you do it.

As Warren Buffett said, “I’d rather be a mediocre developer in a high-growth city than a brilliant developer in a mediocre city.”

Market timing is a scarce talent. Buying in a down market requires a cast-iron stomach and a prophet’s certainty of the future, and the ability to raise patient money 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.

Challenges of Retail

Overbuilding

According to Forbes, the United States have roughly 50 ft² (4.6 m²) of retail space per capita, while Europe has just 2.5 ft² (0.23 m²).

Inexperienced developers often talk themselves out of acknowledging market conditions.

E-commerce

The internet has driven some merchants and retail categories out of business. Its most significant effect has been to reduce retailers’ overall profitability and shrink their store sizes. They’re doing so to pursue a combination of physical and online strategies. This is a major concern for commercial developers because their clients need less space.

Until e-commerce and bricks&mortar finally merge, retail will be suffering from a debilitating, but not deadly, internet-spawned flu.

Private Equity

“Since the end of the Great Recession, retailer after retailer has been similarly killed. Payless Shoes, Toys’ R’ Us, PetSmart, Gymboree, Sears, Mattress Firm, and Radio Shack—all companies owned by private equity—have gone bankrupt since 2012. Debtwire, a financial news service, calculates that about 40% of all U.S. retail bankruptcies in recent years were private-equity backed.”

How do private equity firms do it? Simple: the Leveraged Buyout (LBO). An LBO is the acquisition of another company using a significant amount of borrowed money (bonds or loans) to meet the cost of acquisition. The assets of the company being acquired are often used as collateral for the loans, along with the acquiring company’s assets.

The LBO 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 little equity and a lot of debt using the retailer’s assets as collateral. The private equity then improves the company’s profitability through excessive cost-cutting and rewards itself with a significant dividend, often recovering their entire initial investment and a substantial profit. Then they let the companies drown in debt.

Private equity has a toxic effect on retail. An episode of The Sopranos is a perfect illustration of how private equity destroys retailers.

“Bust Out” (season 2, episode 10)

Mobster Tony’s boyhood friend, Davey, borrows money from him to pay gambling losses. He didn’t repay Tony. In retaliation, Tony takes over Davey’s sporting goods store. Knowing he will never pay a single bill, Tony orders ten times the store’s inventory and then sells it all at a discount for cash–which he keeps. Consequently destroying Davey’s credit and forcing him into bankruptcy.

The Retailers

Wall street force retailers to grow or die. When a company has slow growth, private equity goes for the jugular. The company will be bought and chopped up for parts, the CEO and his management team will lose their jobs, and the new real estate managers will receive big bonuses.

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 being killed by private equity? You diversify: develop multitenant properties in which the loss of a single-tenant is merely painful, not lethal.

Retail is a tricky business. The threats from e-commerce, changing tastes, and ever-more-nimble competitors are real.

Retail’s safe harbor against those headwinds is what we now call essential retail—goods and services people cannot do without, even during a societal shutdown.

Should you consider retail development? Only if you start with an established company that knows the business and devote yourself full time to it. It is a highly specialized area of development that punishes those who merely wet their feet.

Finding Deals

Finding great deals among existing buildings is much more complicated than starting with undeveloped land.

“The bad deals came early in our career, the good deals came late. Why? Because great deals usually start with a great purchase. And how do you pull that off? You pay cash and use an escrow account—a tactic beyond a beginner’s reach.”

Veteran developers advise 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.

There’s no such thing as bad real estate, only bad pricing. Maybe it works for you at some number.

Deal Structure

Manage risk by investing a lot of equity and little debt, growing your portfolio slowly, and using the classic structure for developments: use other people’s money, take fees upfront and never give a personal guarantee to a bank (non-recourse loans).

Suppose your partner invests 90% of the equity (the usual arrangement) into a partnership in which you have no personal liability and that partnership’s external borrowing is also non-recourse. In that case, you can make real money while having minimal risk.

For example, you will develop a project that costs $10 million and will be worth $13 million on completion. It requires $4 million in equity. A bank will lend your partnership the remaining $6 million on a non-recourse basis. Your partner puts up $3.6 million, and you write a check for $400,000, a mere 4% of the total project cost. If the project tanks—some do—your loss is only $400,000, but truth be told, you probably charged that much in development fees during construction. Even as a loser, you’re home free.

Why would you develop with your own money? Because with no outside partners, you control your decisions. You can personally decide to keep a property as long as you like or sell it overnight on a hunch. You also avoid quarterly reports and explanations to investors.

“No Partners, fewer problems, more control.”

It is reasonable to forgo the glamour of owning a little equity in a high-rise and instead buy a corner store of your own. Having control over your life might outweigh the benefits of financial partners.

“We left the financial partner world in the early 1990s, moving from large deals in joint ventures to projects one-10th the size without financial partners, using our limited capital. That decision has worked out.”

“Over time, we have averaged a couple of projects a year. We have typically sold two out of three completed properties to generate capital for our next project. To our surprise, we found we had netted as much from these small, 100% owned projects as from joint ventures. But with much fewer headaches.”

Always calculate every deal’s “Net To Me” (NTM). An entrepreneur, someone who risks what little capital they have and years of their life on a project, should know what they earn if the deal works out.

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? In doing so, ponder the advice a sage contractor gave a homeowner about her idea to remodel: “It will cost twice as much and take three times as long as you initially believe.”

We have heard many times easily anticipated disappointments in career-launching projects. The typical problem is that the profit share was not well structured from the beginning. You can mitigate this risk by calculating the NTM before making the deal. Make sure the prize is worth the effort.

Team Building

If you desire to tackle big projects, you will need help with the skills you lack. The question is, should your help come from consultants, employees, or partners?

As long as you can rent any profession—legal, architectural, engineering, etc.—and still get first-rate work on the day you need it, you will be better off renting rather than buying. Outsource everything you can. Nothing runs up a tab like employees.

To get the highest-quality output from consultants, hire the most experienced person you can afford who will do the work themselves. Remember, you are always hiring an individual, not their company or firm. Hiring the fanciest firm in town does you no good if a junior associate is assigned your work. A fantastic hack is to hire well-seasoned solo practitioners.

You need two at least two providers for each service—two contractors, two architects, two engineers, etc. And they should know about one another. Why? Because you want them to compete, and it is healthy to have a backup plan. Eventually, your favorite consultant will be unavailable to you.

We 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.

The partnership of a skilled developer and a top architect may prove wonderful, often producing glorious offspring: a building, an entire neighborhood that fits well with its surroundings, is embraced by its community, and is profitable from the beginning.

Construction

You can handle construction in three different ways:

  1. Bid to three contractors: If you decide to bid out your project to multiple general contractors, be careful of low outlier bids. Dishonest contractors will bid low intending to make it up in change orders (especially if you are perceived as inexperienced). If three bids are close to one another at $10 million while a fourth is $8 million, and you accept the lower bid, you will likely be buying yourself more than $2 million’s worth of trouble.
  2. Build yourself: Once developers reach a certain size, they are tempted to align vertically and take construction in-house. Fee-driven merchant builders have a higher incentive to control the entire construction process to keep the contractor’s fees. Developers ignore a thousand ways a contractor can go broke and ask themselves, “How hard can it be?” And jump into the construction business. Developers that do everything in-house—from entitlements to architecture to construction—are often successful in bull markets. In a recession, they can’t keep up with overhead, consequently forced to lay off workers or go broke.
  3. Work from the start with one contractor: This means choosing a contractor from the moment a deal seems real and sticking with them to the end. Having a practical contractor early helps prevent your architect from designing a monument for themselves. The contractor is the yin to the architect’s yang: they will point to what part of your architect’s vision can be optimized. For example, that curved lines in buildings are more expensive than right angles or that there can be such a thing as too much glass in a building. In short, the value engineering—the reality check—a contractor provides to your design early on can be invaluable, especially if you’re new to the game. The downside to this approach is losing the ability to bid out the project. If this is a concern, you can still select your preferred contractor at the outset but agree that you will pay him a fair “walk away” fee if they don’t win.

Thick contracts won’t help with a crooked or inept general contractor. A handshake suffices 90% of the time with an honest, competent one. The contract is just a reminder of everyone’s responsibilities.

We stopped bidding out our projects nearly 20 years ago, relying on a couple of top contractors with whom we do business almost every year, making them part of our team.

Our general contractors work with us from day one—before anyone knows if a project will 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 is the right way to relate with general contractors.

Consider not issuing insurance construction bonds. They are expensive, and you will learn that insurance companies pay off infrequently if you ever do claim them. It is better just to verify that your contractor is “bondable.”

Buying

Whenever someone pitches you a deal, an excellent question is: “Why are they selling?” Be extra skeptical if the answer doesn’t involve a compelling need to sell (e.g., death, disaster, dissolution, or divorce).

The best time to find a motivated and realistic seller is when no one else is buying. “Buy when there’s blood in the streets.”

When confronted with an unrealistic seller, we usually advise the broker that teaching market values to a seller is not our business. Thus, we lose deals.

Try to meet the seller and become their new best friend. You will learn a lot only by visiting them at their office.

Vast land and easy approvals lead to overbuilding. The doom formula is:

easy zoning + easy money + many developers = death spiral of overbuilding

Smart money loves core properties because developers are more likely to generate cash in central locations where all the land is already built out. The best defense is to own properties where the zoning and approval process is challenging.

Sellers tend to be smart enough, and when they are dumb, their stupidity more often lies in overvaluing their holdings than in wanting to give them away.

Never buy unzoned property.

Actual off-market property may be a worthy prize, but brokers are seldom involved because principals deal directly with other principals.

A great deal is rarely great on the first day it is offered to you; no one consciously gives anything away in business.

If a property stays on the market for a long time, a frustrated seller may become reasonable. You don’t want a building at a $10 million asking price, but at $6 million, the property might work. And then you wait…and wait. The seller will pull his property off the market, or someone will outbid you. But if you bait enough hooks, a fish will come along.

Financing

If you develop or invest in property, you’re in the business of borrowing money.

The Family & Friends (F&F) profit-sharing formula: The equity gets a preferred return a few percentage points higher than Treasury bills from the project’s free cash flow. Once that’s paid, any remaining cash is split 50/50 between equity holders and the developer.

Two basic loans predominate in real estate: 

  1. Permanent loans: They are for stabilized assets like a leased office building. They have a lower risk and usually have a long-term duration (> 10 years).
  2. Construction loans: They are for constructions like building a new high-rise. They have a higher risk and usually have a low-term duration (~ 2 years).

It is impossible to predict real estate prices ten years from now. Be careful with those long-term proformas.

High-end sales brochures and investment committee reports routinely contain impressive Argus (commercial real estate software) spreadsheets that magically produce the IRR the buyer or investment committee desires. The magic is easy; keep raising the anticipated 10th-year sales price until you hit the desired IRR. Who will be around in 10 years to tell the analyst they were wrong?

Alternative interpretations of the Internal Rate of Return (IRR) are “Inflated Rate of Return” or “I Rationalize Risk” should come to the mind of anyone confronted with spreadsheets predicting rising rents, falling expenses, and zero vacancies.

There are two kinds of lenders: those who’ll admit they’re not lending a dime and those who pretend they are.

A banker is a successful developer’s best friend. But beware because your banker will want a committed, monogamous relationship.

Despite the best intentions, your banker is only as good as the last loan she committed to you. She may even become a friend. Eventually, she will be on vacation, quit, retires, or be in the hospital the week you 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 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.

Appraisals

Valuing property is subjective. Think about it: appraisers use three different approaches to evaluate a commercial property:

  1. Replacement cost.
  2. Comparable sales.
  3. Income capitalization.

Appraising is still as much art as science.

Selling

We sell if:

  • Our return on cost is too low either because our construction costs went over budget or we failed to achieve anticipated rents.
  • The barriers to entry for our project’s future competitors are low.
  • We have concerns about our tenants’ longevity or the quality of our location.

We keep our high-yielding properties in competition-constrained environments.

Brokers

Wise principals spend quality time with their favorite brokers. Why? Because they are genuinely friends, and it doesn’t hurt when it comes to getting the “first call, last look” on deals.

Beyond treating agents with respect, choosing the right one matters because the best agents are as specialized as the best principals.


This book is written under the Urban Land Institute (ULI) umbrella in the U.S. The ULI comprises real estate developers and related professionals who share best practices.


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