Making it in Real Estate (Part Twelve): Selling vs. Holding
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 his new tattoo is considerably harder. Among the hardest 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 trans-generational asset?
To answer this question, a newly-minted developer might consider taking a deep breath and first asking herself where she wants to be in twenty 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 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.
Over-simplifying 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.
The classic build-to-sell approach, merchant building has two principal advantages over its counterpart: The ability to do many more deals and to profit much sooner. Merchants can do more deals because their required returns on cost are lower than those of investors. They typically charge greater fees for the acquisition and construction of their projects and sell them as soon as they are finished. Merchants are about fees and sale proceeds now; merchants are ordinary income. (In real estate, now is a relative term; even the swiftest projects take at least two years before you can cash in and more likely a minimum of three to five from the moment you first see a property to the day you sell.)
The stodgier strategy, investment building is the build-to-hold approach. In order to keep a property long-term, an investment builder needs a going-in return well in excess of the merchant’s. He charges his project little in the way of front-end fees. Investors are about cash flow later; investors are capital gains. Turning an old expression on its head, investors mortgage the present for the sake of the future.
Merchants typically seek an overall return on cost of about one hundred basis points—i.e. one percent—greater than the cap rate at which they expect to sell the property. Thus, if she anticipates a cap rate on sale of six percent, the merchant will develop for a seven percent return on total cost. As long as prices remain steady or rise, the merchant will profit handsomely on the sale, but—here’s the point—not so handsomely as to enable her to keep her project for the long-term. To do so, she would have to leave too much equity, earning too little return, in the deal. In short, she is forced to sell.
For a similar project, investors will require a return on cost two hundred basis points—two percent—greater than the expected sale cap rate, an eight percent return on cost if cap rates are six. If you wish to be an investment builder, this higher 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. (The video linked above, Making it in Real Estate: The Sell Hold Decision, analyses the going-in yield’s effect on the ability to retain a property long-term).
In short, unless your return on a project’s total cost is roughly two percent higher (or more) than the cap rate at which you can sell the property, you will be economically compelled to sell it. You will have no sell vs. hold decision to make.
To bring this point home, it may be worth summarizing our firm’s strategy: We’re more interested in having fewer, higher-quality properties with lower debt than we are in amassing a portfolio to pay overhead. And we never intentionally develop a property with a merchant approach, that is, one for which the only exit strategy is a sale. Why? Simply put, we think it’s too risky. Merchant building works great in good times, but the moment it hits the fan—and it will—that 100 basis point spread can evaporate overnight. While the investment builder isn’t impervious to loss in a down market—everyone loses money sooner or later—he’s on far safer ground.
We try to always develop to investor yield standards—that 200 point spread—but we still sell about two-thirds of the projects we develop. Why? In the beginning, we had to, we needed to eat and, because it takes five to seven years to start building meaningful cash flow on a pure investment build approach, one can easily starve as an investor. We continue selling today for the simple reason that many properties are at their best on day-one.
When do we choose to sell? We sell if, despite our best efforts, our return on cost comes in too low (either because of construction cost overruns or our failure to achieve anticipated rents). We sell when the barriers-to-entry for our project’s future competitors are low or when we have concerns about either our tenants’ longevity or the quality of our location. And conversely, we keep our high-yielding properties in competition-constrained environments.
If you want to run a big development firm, become a merchant builder. If you want the luxury of deciding which deals to keep forever (in real estate, forever means more than ten years) and slowly building your cash flow, consider investment building. But if you go the investor route, choose the properties you keep carefully—many do have their finest hour at the ribbon cutting.
John E. McNellis is a Principal at McNellis Partners in Palo Alto, Calif.
