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McNellis: The “NTM”

McNellis Partners, Palo Alto, Silicon Valley

Making it in Real Estate (Part Sixteen): The “NTM”

By John McNellis

John McNellis Partners Making it in Real Estate Palo Alto commercial real estate advice how to be a developer advice lessons

Properly constructed, primers should be sequenced in terms of importance, the first chapter containing the writer’s best advice, the next, his second best and so on. Turning this time-honored rule upside down, we arrive at 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 are considering a deal, taking a job or entering a partnership. If asked and answered, it will detour you away from countless financial cul-de-sacs.

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 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 quickly 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 gentleman had a penchant for young wives who refused to sign pre-nuptial 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 upon knowing how much profit actually trickles all the way to the sea. You learn 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 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, modest or otherwise) 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 above, 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. 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 twenty 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 feeling for your hourly rate and avoid the heartache and hard feelings that inevitably accompany unpleasant financial surprises.

A salaried employee knows his NTM like his drive home from work—he sees it every two weeks on his pay stub. An entrepreneur, on the other hand, someone who risks what little capital she has and a couple years of her life on a project should know what she can earn if the deal works out. She should 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—particularly if one is not stressing out over a job offer or a deal closing—I’m underscoring it heavily as my final point. 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 which, in our view, could have been anticipated from miles off—the profit share was suspect from the beginning—and which might have been avoided altogether by a judicious application of the NTM.

In sum, make sure the prize is worth the leap.

Best of luck.

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