Your First Deal
Not too long ago, I took a call from a reporter at the Los Angeles Times who was doing a story on a session at which Donald Trump, the ultimate real estate salesman, was speaking. The writer later wrote, in essence, that Donald Trump said you can make it quickly, whereas Bill Poorvu, the Harvard Business School professor, said, “Not so fast; go more slowly.”
I realize that some people approach the real estate industry the same way they approach the stock market: looking for the quick hit. They hang on the words of a (self-described) billionaire. And of course, Donald Trump wasn’t, and isn’t, dumb. He was getting free publicity for a session in which he was getting paid a big fee. Meanwhile, I was giving an interview for nothing.
Still, I’ll hold my ground. Because real estate is not like the stock market, the same answers don’t apply. When you dabble in stocks, you can buy an index, such as the S&P 500, and be certain that your performance will mimic the averages, with low transaction costs. Buying individual real estate is much more complicated, and there is much more to learn, in part because it is a less-efficient market with much higher transaction costs.
You hope your first deal will be a financial success. In truth, however, it’s more likely to be a good learning experience, in which you discover how the process actually works.
For example, it isn’t just about gaining control of a property and sitting on it. Most people who succeed in real estate find a way to take a property from a less valuable use to a more valuable one. You can add value in many ways, some of which are listed here:
- Repositioning (that is, changing the use, condition, or pricing).
- Using excess land for new or extended purposes, especially if most of the initial cost can be allocated to the primary use.
- Adding new uses to existing development, such as a shopping center next to a residential subdivision.
- Buying properties at auctions, whether from lenders or distressed sellers, at prices that reflect a lack of liquidity in the financial markets rather than a permanent loss of value.
- Building on one’s own tenancy. For example, your retail firm may anchor a shopping center. Your occupancy may fill an office building. In both cases, why not own the building? It is your lease that is creating much of the value of that property.
- Leasing rather than buying land, which is a way of reducing your up-front cash requirements.
- Pre-leasing, which means filling a vacant building with suitable tenants either before or soon after you acquire or construct it.
- Financing/leveraging. As noted, using other people’s money is a necessity for most of us. The availability and cost of money will affect your cash flow, big time.
- Design/construction. Creative architecture, efficient layouts, cost control, and on-time delivery are keys to good execution.
- Customer service. Understanding and satisfying your existing tenants needs leads to higher occupancy and lower turnover.
Here’s an important point to keep in mind, as you think about deals: Strictly in terms of a percentage return, the greatest increase in a property’s value often comes in the early stages of owning that property, when your influence or specialized knowledge has its greatest impact.
For example, if you can make a $100,000 purchase that is worth $150,000 after a year, that first-year gain is 50 percent. After the property is repositioned, stabilized, and financed, it’s unlikely that the annual return will be anything like that in subsequent years. We’ve already talked about the idea of buying at distressed prices. The corollary is to sell in times when the risk is lower, there is an overabundance of money anxious to come into the market, and the capitalization rate is more favorable.1
The example is made even more compelling if you assume that you only had to put up $10,000 of the initial $100,000, and could borrow the rest. If you sold the building for $150,000, your return on sale would be $50,000 on your $10,000: a very satisfying 500 percent return! You have bought wholesale and sold at retail.
But what if you don’t sell at that point? Going forward, if you assume you have, after the first year, a theoretical equity of $60,000—that is, your $10,000 initial cash plus the $50,000 potential gain—you won’t make anything like that kind of annual return on the higher equity. You will likely only receive an annual cash flow of $5,000 or $6,000 on that $60,000.
So selling, especially early in your career, may make good sense. You might be in a lower-income tax bracket, and taxes might not be a huge issue if you sell the property. In addition, you’re likely to need to sell your first property to have the cash to do your second deal. You’ll read in subsequent parts of this book that in later stages of your career, holding the property may be the best long-term strategy. But, what you do starting out may be very different from what you do later on.
The downside in all this is that your risk level goes up as a result of your greater dependency on short-term activities—whether those risks are market related, the result of cost overruns on renovations, or whatever. You may assume that the interest rate is less important because you see yourself selling or refinancing the property in the near future. If you are heavily leveraged, you might need larger reserves to cover higher financing costs.2 If it takes longer than you projected to generate revenues, you can quickly find yourself in deep trouble.