What does it take to be a successful real estate developer? Author John McNellis tells you how, sharing practical tips and advice from his wealth of experience over 35 years in real estate development. Like meeting with a mentor over coffee, McNellis entertains with witty anecdotes, and wisdom on how to take advantage of opportunities and avoid pitfalls. Offering humorous insights, the book covers the ins and outs of how to get financing, working with architects, brokers, and other professionals, how to make a good deal, and win approval for your project.
|Publisher:||Urban Land Institute|
|Product dimensions:||5.90(w) x 8.70(h) x 0.30(d)|
About the Author
John McNellis is a principal with McNellis Partners, a commercial development firm he cofounded in the mid-1980s in northern California. After graduating from the University of California, Berkeley, and the University of California Hastings College of the Law, McNellis began his career as a lawyer in 1976 in San Francisco. Always more interested in business than in law, he started fixing up houses in his spare time and gradually worked his way to more complicated projects. At 28, he formed a partnership with an older client and began his career as a retail developer. Cobbling together the equity from friends and family, they built and opened their first shopping center in 1983, by which time McNellis was no longer practicing law—except on behalf of his own projects. Within a few years, he formed McNellis Partners with Beth Walter and Mike Powers. They continue to be partners more than 30 years later. In recent years, the company has begun developing mixed-use projects and, in an effort to diversify, investing in small Silicon Valley office buildings.
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Making It in Real Estate
Starting Out as a Developer
By John McNellis
Urban Land InstituteCopyright © 2016 Urban Land Institute
All rights reserved.
Quit Your Job?
Over a beer, a young friend recounted his progress with a retail development firm. I was surprised to hear how much he had learned and how much responsibility he already had. When he explained his lead role on a mixed-use project, I asked how profitable the development would be for the company. He guessed about $10 million. I asked if he had a profit share. Reluctantly, he explained that he had been promised a percentage in the deal but that his employer, a man of infinite wealth, had gone silent on the issue. With nothing in writing and the project's final entitlements days away, he could only hope his boss would honor his word.
It could be that this jillionaire simply has a lot on his mind — which jet to use for the St. Tropez trip can be a consuming decision — or it could be that no amount of wealth will ever make him do the right thing.
Business has few certainties, but one is this: employees are seldom paid more than "go money." That is, companies large and small, public and private, will pay enough to keep their key employees from going elsewhere. The publics blame their parsimony on their duty to their shareholders, and the privates blame their silent but surprisingly stingy partners.
If your dissatisfaction is with the job itself — and not your income — you should quit. That is, if you can afford the cash flow hit. If you're an entrepreneur at heart and the only decision you're making at work is where to park in the morning, quit. If you can cobble together a year's worth of living expenses and go into business and fail, what's your downside? Merely the salary loss from your crappy job. And if you have to white-flag it back to the corporate world, you will be more valuable because of your experience. Potential employers will know you are ambitious, that you have an owner's perspective, and that — let's face it — you're unlikely to bolt again.
It's a different story if it's all about the money. If you love your job and your hunger is only for wealth, then ask yourself when you're sober — or better yet, badly hung over — if you're really worth more than go money. If you still think so, explain to your boss how valuable you are, ask for a big raise, and then listen hard to the reply. He's your boss for a reason. He has more experience than you do, and it's even theoretically possible that he is smarter than you or at least a tad better in business (these are two entirely different things: many of the smartest people I know are terrible at business). And if your boss says your compensation is fair, he may be right. In my experience, those who start a business just to get rich almost never succeed. The ones who make it are those who love what they're doing and start their own companies only because they have no choice (no one will hire them), because they want to be their own boss, or because they think they can do it better on their own. They believe they will be more productive — and have more fun — if they can peel away the corporate bureaucracy, the weekly team conference calls, the Sisyphean reporting requirements, the multiple sign-offs needed for deals, and even the mandatory company socializing.
I asked George Marcus, one of the most successful men in American real estate, what he thought about starting a company for the money. "Anyone dreaming of going into business just to get rich is fooling himself. You start a business because you have a passion to improve a business strategy or an industry." George knows what he's talking about. At 25, he started Marcus & Millichap and finally took it public in 2013 (the stock price has since doubled). He is also the founder and principal shareholder of another public company, Essex Property Trust, arguably the country's best-performing real estate investment trust over the past 20 years.
Mervin Morris, a giant in the retail industry and founder of the Mervyn's department store chain, told me simply, "I went into business for myself because I wanted to be my own boss and make a comfortable living." Personally, I switched from real estate law to development because it seemed to me that developers have a lot more fun than lawyers do (I was right). My sole financial ambition at the time was to make as much as a developer as I would have as a lawyer.
Turning Gordon Gekko's aphorism on its head, greed is not good enough.
Where does all this leave my young friend who loves his job and its challenges but who will likely end up unhappy with his compensation? (By the way, if you can succeed at running your own business, you will always be unhappy with your compensation.) If, like George, he thinks he can do it better on his own or, like Merv, he wants to be his own boss, or if he simply wants to have more fun, then he should consider setting up shop.
But to paraphrase the teachings of Siddhartha, there is a "middle way" that we will explore in the next chapter.CHAPTER 2
Doing It on the Side
ARE WE IN THE WRONG BUSINESS?
On the "Best Jobs in America" lists, a career in real estate rates lower than carjacking. In fact, commercial real estate doesn't rate at all on these ubiquitous lists. The closest we come is "real estate agent," a distant #89 on U.S. News & World Report's Top 100 Jobs list, lapped by such swell careers as "substance abuse counselor" (#36), "bill collector" (#57), and "exterminator" (#61).
And at $80,000 a year, "real estate brokers" earn #159 among the Top 300 Highest Paying Jobs published by Myplan.com. That list's top 20 paying jobs, by the way, are all physicians, starting with anesthesiologists at $233,000 and ending with general practitioners at $181,000.
Should we be applying to med school, or is it possible these data don't tell the whole story? Misreading data is a common failing — "Son, you got four F's and a D. What's that tell you?" the father asks. "That I'm spending too much time on one subject, Daddy?" To deduce that one should elect a career in exterminating rather than real estate courtesy of U.S. News is likely such a mistake.
What best-jobs data will never reveal is one of real estate's greatest strengths — that is, that one can amass a considerable fortune by doing it on the side. What other part-time work or avocation is so lucrative? You could probably work part time as an exterminator or perhaps even as an anesthesiologist, but as long as you are working by the hour — as long as you're working and your capital isn't — you will be stuck in the economic middle class.
If you love your day job but are unhappy with its compensation — the dilemma posed in chapter 1 — you don't have to quit. You just need to start a new hobby: give up fantasy football and while away your free time on a dilapidated house. And if you take the long view — you should, real estate is the classic get-rich-slow business — you will do well.
My late father-in-law was a bright man who came home from World War II devastated by his experiences as a combat medic in the South Pacific. As with many veterans, Bill found solace in the bottle, and by the time he was in his mid-30s he was an alcoholic — drinking a six-pack of beer and a bottle of vodka every day. Yet Bill somehow found the fortitude to quit drinking and start life over at 45. With no savings, no formal education beyond high school, and no marketable skills other than a talent for sales, Bill slowly amassed a small collection of San Francisco Bay Area real estate — a couple of houses, a few promissory notes, a duplex or two, and a five-unit building — worth several million dollars at the time of his death 40 years later. More important, his real estate allowed him to retire in his late 60s with a secure income of $150,000 a year.
How did he do it? One small building at a time. Bill made his living by day but his fortune by night, buying a property every year or two, fixing it up, sometimes selling it, sometimes keeping it. His properties were never pretty — they probably lost money at first — but 25 years later when it was time to retire, he had paid off their mortgages and his cash flow was as free and clear as a Sierra stream.
And it's really that simple.
If you love your job or find the prospect of going out on your own — of working without a net — overwhelming, and yet you still want a future independent of a corporate pension, buy a neglected house in a quiet town and get started. If you can cobble together enough of a down payment — perhaps with family and friends' money (the topic of a later chapter) — so that you at least break even after paying your expenses, you're set. Even if your rents never increase a cent, you will eventually pay off the mortgage and all that cash flow will be yours. If you can pull this off a few times, you can retire as comfortably as my father-in-law did.CHAPTER 3
Playing Small Ball
"I HIT BIG OR I MISS BIG. I like to live as big as I can." A winning formula for the greatest baseball player ever, but unless you're determined to become real estate's Babe Ruth, you might consider following in someone else's spikes. Mortals make the Hall of Fame by hitting singles. The late Tony Gwynn was dearly remembered as a better person than a hitter, and he was the greatest hitter of his generation. Tony hit singles. Derek Jeter will make the Hall hitting singles.
And so can you. But this is where the baseball metaphor strikes out — players make the Hall of Fame batting .300. You won't. Unless you're making money on eight out of every ten deals, you'll enter a different hall, the one where you file Chapter 11.
Don Kuemmeler, a founding partner of Pacific Coast Capital Partners, is more precise. Don says PCCP, a $6.5 billion real estate management firm, has to bat .850 on its equity deals and .990 on its debt placements to maintain its targeted profitability.
How should you choose real estate investments? The same way you take a lion's temperature — very carefully. Hitting those numbers isn't easy — $6.5 billion firms are few and far between for a reason — because sooner or later, everyone loses money in real estate.
Even when you are careful you will hit a rough patch (especially if you persist in thinking of a second home as an investment). If you bought anything in the 2004–2007 bubble, you lost big. But this is the point: if you didn't have to sell, your losses were merely on paper. And if you could afford to wait long enough, you actually turned a profit. If, however, you were forced to sell bubble-era acquisitions in 2009–2011, you lost, somewhere between a lot and everything. What three factors force one to sell into a terrible market? Debt, debt, and debt. The other "D's" — death, divorce, and disaster — are far easier to ignore than a foreclosure notice nailed to your door.
In baseball, the difference between a single and a home run is how hard you swing the bat; in real estate, it's how much leverage you use.
In a rising market, leverage turns singles into home runs. Let's say you bought a $5 million property with a million dollars in equity and a $4 million loan and that two years later it's worth $6 million. You would have achieved a 100 percent return on your million-dollar investment. Home run. If you had instead purchased the same property with no debt, your return would be 20 percent (a million dollar profit on a $5 million cash investment). Single.
Note that we're simply measuring the return on your equity investment to determine your level of success.
If, however, the property had lost 20 percent of its value, the leveraged buyer would be tapioca — the equity gone and the property too when the loan matures. On the other hand, the cash buyer has a 20 percent loss on paper, but nothing else changes. Assuming the drop in value is systemic (e.g., the Great Recession), the property's cash flow remains the same: if you were making $300,000 a year when the property was worth $5 million, you're still making $300,000 when it's worth $4 million. Bob Hughes, one of the most original thinkers in our business, drawled in the depths of the recession, "John, my net worth's gone down by half, but my cash flow's the same." And since net worth is meaningless (see chapter 17), since ultimately it's all about cash flow, nothing changed for the talented Mr. Hughes. Nor will it for you if you are prudent with leverage.
It's hard to hit a home run paying all cash, but it's also impossible to strike out, and since even the best in our business lose money, you might seriously consider small ball. By the way, the Bambino himself agreed with this philosophy: "If I'd tried for them dinking singles, I could've batted around .800." And so can you.
Finally, if you're truly going out on your own, take this last bit of advice from the Babe to heart: "Never let the fear of striking out get in your way."CHAPTER 4
Specialize or Die
A recent college graduate wrote, asking for advice. Mentioning how thrilled he was to be accepted into Marcus & Millichap's training program, he wanted to know which area he should specialize in: land, apartments, or industrial. I told him it didn't matter as long as he picked one and stuck with it. Yet to spend his first day in real estate, this fellow had already figured out a truth that eludes many: if you don't specialize, your specialty will be failure.
In small towns noted more for alfalfa than economic opportunities, a broker can be a grammar school teacher — that is, he can know just enough about half a dozen subjects to be one step ahead of his clients and sell anything that walks in the door, from ranches to diners to mobile homes. In a city of size, the competent broker is more of a high school teacher, sticking with one broad subject, selling, say, only industrial properties. And in major markets, top brokers are more akin to university professors, focusing on narrow niches within their specialty — an office leasing agent who represents only law firms.
But which specialty matters little and which niche almost not at all because each product type will have its days in the sun over the years. What you do doesn't matter that much, but where you do it is huge. To paraphrase Warren Buffett, I'd rather be a mediocre developer in a brilliant city than a brilliant developer in Lancaster, California. My advice? If you're stuck in my hometown or any other city with Lancaster's dim prospects, move.
Like every other clueless neophyte, we started out in apartments, but, as profitable as they are for many, they didn't work for us. Richer in experience but little else, we soon decided we had no wish to own buildings where anyone slept. Waving farewell to our tenants — some of whom were arguably sane — we shifted into the fast lane, the glamour world of suburban industrial. How hard could industrial be, we asked ourselves. Within months of buying our first pair of warehouses, we began learning about our new business (experience is something you acquire just after you need it). It belatedly dawned on us that when the biggest player in town not only owns a Pangaea of free land but a construction company that must be kept busy, he is going to stop building warehouses the week after we rescind the Louisiana Purchase. And rents are never going to rise. Ten years later, we cracked the Dom Perignon when we managed to sell our warehouses for exactly what we paid for them. This time we waved bye-bye to tenants who, as always, were merrily melting our parking lot with their cleaning solvents and oil changing.
In short, rather than being apartment and industrial moguls, we might have more profitably spent our time as forest fire lookouts. But all was not lost. Somewhere during our ten years in the industrial wilderness, we fell into a retail deal and developed a shopping center in Healdsburg, California. That project — we still own it — became the template for everything we've developed ever since, namely, neighborhood shopping centers in cities that fight development as if it were contagious. The degree to which we specialize is worth stressing. Within the high school subject of retail, our professor's niche is this: our development projects are "necessity retail" (supermarkets, drug stores, and discount department stores); they range from 25,000 to 150,000 square feet; and they are located within a two-hour drive of San Francisco. Within that narrow range, we can often be competitive with larger, better-known developers, challenging their superior capital with local knowledge and an ability to act quickly.
Our geographic limitation — that two-hour drive time — isn't based purely on laziness. If a project is no more than two hours away, we can drive there, have the meeting with the city, get our hats handed to us, and still get back to the office to deal with other challenges.
By the way, specializing doesn't mean that you shouldn't move on once the tin mine is played out. When it finally sputters, you need to pick a new specialty (and then stick with that) or a new area.
Excerpted from Making It in Real Estate by John McNellis. Copyright © 2016 Urban Land Institute. Excerpted by permission of Urban Land Institute.
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Table of Contents
1 Quit Your Job? 3
2 Doing It on the Side 6
3 Playing Small Ball 9
4 Specialize or Die 12
5 Bromancing the Deal 15
6 Size Matters 18
7 Buying It Right 21
8 Desperately Chasing Yield 24
9 Liquid Assets 27
10 A Little Help from My Friends 30
11 Fickle Shades of Green 33
12 Autographing the Deal 36
13 The Politics of It All 39
14 Decked by City Hall? 42
15 Sell versus Hold 46
16 Lies, Damn Lies, and the IRR 49
17 Working without a Net Worth 52
18 Monogamy and Its Downside 55
19 Let Us Now Praise Famous Architects 58
20 Developers and Contractors: General Relativity 61
21 Sex, Lies, and Off-Market Deals 64
22 Do As I Say 67
23 The Back of a Napkin 70
24 No Partners, No Problems 73
25 The "NTM" 77
26 Postscript 81
Glossary: Real Estate Jargon Demystified 83