Making it in Real Estate (Part Fifteen): 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 else’s money. As a novice, you have financial partners by necessity. Should you 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 ninety 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 non-recourse, 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 a non-recourse basis. Your partner puts up $3.6 million and you write a check for $400,000, a mere 4 percent 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 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 (35-50 percent after repayment of all capital), you make about a million plus those fees.
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 ten projects, 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 quarterly reports and semi-annual trips to New York or Cleveland (yes, Cleveland) to explain the fate of your partner’s money. Far more importantly, 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 two billion dollars 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 non-recourse language you love in your partnership agreement works both ways—the money has no liability if it 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 apologetically hangs up.
If you were to receive this call—we did—you might decide to revise your investment strategy. You might decide that in the future you will forego the glamor of owning a deceptively small interest in a sleek high-rise and instead buy a corner gas station on your own. You might decide that having a measure of control over your life outweighs the benefits of big-time financial partners. 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 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 Theresa could jointly decide on day-one that you will hold your project for ten 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, a Texan, 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 nineties, moving from large deals in joint ventures to projects a tenth the size without money partners, using our own limited capital. That decision has worked out. Over time, we have averaged a couple projects a year and, in order 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 netted as much from these small, 100 percent owned projects than we would have in splitting profits multiple ways in big-city joint ventures. And with far fewer headaches.
For what it’s worth, we have consistently found that the constraint—or bottleneck, if you will—in successful development is not the lack of capital, but of quality projects. Great deals are truly few and far between. And therein lies the flaw in the assumption in the ramped-up production model described above—you cannot find ten good deals as readily as one. Rather than diversifying your risks, pushing deal quotas intensifies them.
A more accurate, but less catchy title for this article might be “No Partners, More Control”. For as my canny Irish mother liked to say, “If you don’t have any problems, you don’t have any business.” She may have been the worst cook in Los Angeles County, but she knew her way around running a small company.
John E. McNellis is a Principal at McNellis Partners in Palo Alto, Calif.