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McNellis: Buying it Right

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Making it in Real Estate (Part Eleven): Buying it Right

By John McNellis

McNellis
McNellis
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 only sell 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 ten million dollars for a great property worth seven million, you have a dilemma: Do you tie the property up at his price and then gently attempt to educate him about the property’s true value (in slightly more pejorative terms, renegotiate your deal) or let a competitor charge that particular hill, await his demise and come in as the second or even the third buyer once the seller has accepted reality? Both strategies entail risk: If you go in first, you’re likely to be the first messenger shot; but if you let someone else go first, he just may succeed with his bait-and-switch strategy.

When confronted with an unrealistic seller, we usually advise his broker that teaching market values to a seller is not our business and that we will wait until he learns this from someone else. Thus, we occasionally lose deals.

Far worse though is to win an over-priced deal. If you chase that seven million dollar deal for which the seller will only take ten and you fall in love with the property or become too invested in closing the deal—you obtain equity commitments from which it would be embarrassing to walk away—and the seller hangs tough and you talk yourself into meeting him half-way and paying eight and half million, you will spend the next three years of your life working for the seller. You handed him your future profits on day one.

If there isn’t a country western song that sobs, “Don’t fall in love with nothin’ that can’t fall in love with you,” there should be. If you’re looking for love, at least fall for the numbers and not the property. One astute friend ties up properties sight-unseen, not even visiting a property until he is in contract at a price he loves. He doesn’t want a building’s ocean views or historic charm to soften his yield requirements.

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” is the timeless adage. Had you done so in 2009, you would have made a fortune. Market timing is, however, a rare talent and buying into disaster requires not only a cast-iron stomach and a prophet’s certainty of the future, but the ability to raise patient money when few others can. It might be easier to buy and sell on an established pattern, say, 2 to 3 deals a year and then sticking with it like a farmer with his annual plantings. By way of example, we have averaged about two new deals over the past thirty-five years, some years not buying anything, others as many as four properties. Schedules and goals aside, it’s critical to have the discipline to sit it out when prices make no sense to you.

Often the best deals come with the worst contracts. Loan servicers who have foreclosed upon choice properties often employ the most obnoxious lawyers who delight in preparing wickedly one-sided agreements. My advice? If the price, contingencies and closing date are right, don’t worry about the fifty pages of crap in the contract. Agree to buy the property as-is, to indemnify the seller, to whatever ridiculous terms the seller insists upon, but—as a counter-weight—be exceptionally careful with your own due diligence.

In particular, insist upon an estoppel letter from every tenant. And never let a seller convince you to accept his estoppel in lieu of estoppels from the tenants. Why? Because if the seller’s substitute estoppel is wrong and the tenant happens to have a valid offset against rent or the right to terminate or the right to extend the lease for free, all you have is an expensive lawsuit against a seller who already has your money.

As an aside, if there’s any way a seller will meet you, do it; become his new best friend. Even if he’s tighter than a clam, you will learn something merely by visiting him at his office. And if your closing is subject to anything remotely out of your control—entitlements or new leasing—then the more contact you have with the seller, the more you keep him honestly apprised of what’s going on, the better your chances will be of getting the closing date extensions you need to make the deal happen.

Finally, even if you’re going to lose fifty thousand in due diligence costs, walk away from deals that turn out to be worm-holed. This is easy advice to give and hard to follow, but to succeed, you have to learn when to leave your ante on the table.

John E. McNellis is a Principal at McNellis Partners in Palo Alto, Calif.