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McNellis: The Politics of it All

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McNellis Partners, Palo Alto

Making it in Real Estate (Part Nine): The Politics of it All

By John McNellis

McNellis Partners Palo Alto
McNellis

Rents and occupancy rates are tumbling today in North Dakota because shale oil is mud in a $35 dollar a barrel world. Once the hottest real estate market in America, a Northerly is now blowing across the prairies, and landlords are scarcely better insulated than shale’s jobless roughnecks. This turnabout is not unique to the Badlands. Properly viewed, the lords of real estate are always bit players, mere vendors to the stars who make economies twinkle. As long as a gold rush rampages, we do well renting tents and cabins. But, sooner or later, mines peter out.

If real estate is no more resilient than its surrounding economy—it isn’t—and if all economies eventually falter—they do—how does a prudent investor protect herself, particularly if she is buying into a bull market’s heat?

The best way to protect yourself from the next correction requires a skill few possess; namely, the ability to call your shot, to time the market perfectly and sell at its peak.  If you happen to have this rare talent, forget real estate and go straight to Wall Street. (By the way, a correction occurs when others get creamed, a crash when you do.)

For less far-sighted mortals, buying with all equity—using little or no debt—is a fair if timid strategy. It works well enough for the rich, but is a poor option for someone starting out. If you can convince your investors to put up 100 percent of a purchase price, leaving you risk-free, they will convince you to give them 100 percent of the profits, leaving you profit-free.

The second-best way to protect yourself against loss is to create so much value you will still be afloat when the tide bottoms out. Combined with a conservative level of debt (say 50-60 percent), this is also the best way to make a lasting fortune. While it is sometimes true that value can be created through a brilliant purchase, stealing property—despite what you may hear at conferences—is hard. By and large, sellers tend to be smart enough and, when they are dumb, their stupidity more often lies in mulishly overvaluing their holdings than in wanting to give them away.

Doing something—anything—to a property can create value. But the easier the make-over, or the more obvious it is, the less value you will create. If you buy an empty building, paint it, re-landscape it and lease it out, you may have created lasting value or you may have simply caught the leasing market’s next wave. Unless the building’s vacancy was truly a result of inept ownership (as your broker will swear) rather than market conditions, your paint & petunias may have left the property’s shortcomings unresolved. Consider selling it.

If instead you demolish that building and build a new project in its place—or build fresh on an empty lot—you will have created lasting value, but the question will be for whom. If the property was already zoned to permit your new project or, if it’s in a town where rezoning is easier than skateboarding (basically, Everywhere-You-Would-Never-Live, USA), then chances are your dumb seller baked most of your eventual profit into his asking price. And, if you pay his price, you could end up spending a couple years of your life having effectively worked for him, leaving you with a shiny-new project worth about what it cost to build.

Once in a great while you can do something to a property that no one else has thought of and hit it big. The first guy to tie up a major luxury apartment complex at apartment prices, convert it into condominiums and then sell it off at condo prices made enough to retire the national debt. The second guy not so much. Why? Because it took the dumb sellers five seconds to add the downstream condo profit to every other apartment building on the market once the play was public.

And that leads us to an excellent way of either creating lasting value or, if you don’t get the votes, losing the sitting part of your anatomy: Rezoning property in first-class towns, where it’s a lot harder than skateboarding. Smart guys—particularly smart guys who have enough money—will tell you to never buy unzoned property. They will insist that you only close after you have your final city approvals. This great advice is comparatively easy to follow in down markets or fly-over cities, but if you’re going to develop in the best locations, sooner or later you will be buying—or handing over so much option money you might as well be buying—unzoned property. And praying for votes at city hall.

We have arrived—at last—at politics. The next installment of this series will give you a few hard-learned lessons in the art of rezoning in recalcitrant cities. But before getting to those, it may be worth leaving you with something to ponder, namely, the politicians’ view of their relationship with developers. The legendary Jesse Unruh, czar of California’s Assembly in the 60’s, nailed it when he opined, “If you can’t eat their food, drink their booze, screw their women, take their money and then vote against them, you’ve got no business being up here.”

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