June 7, 2021

JF2470: How to Develop Shopping Centers with John McNellis

John McNellis started as a journalism major headed to law school because he did not know what else to do. While practicing business law, he was drawn to business operations and shifted to become a developer. At 29 he started shopping center development and now has over 80 projects in development. More than half of those projects are complete tear-down and renovations. Listen in to hear his advice on the need to specialize in shopping centers, start with tenants, and how to avoid over-leveraging.

John McNellis Real Estate Background:

  • Partner at McNellis Partners
  • Very active in CREI for 40 years
  • Portfolio consists of 80+ projects
  • Based in Palo Alto, CA
  • Say hi to him at: https://mcnellis.com/
  • Best Ever Book: Psychology of Money

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Ash Patel: Hello Best Ever listeners. Welcome to the Best Real Estate Investing Advice Ever Show. I’m Ash Patel and I’m here with today’s guest, John McNellis. John is joining us from Palo Alto, California. John, how are you today?

John McNellis: I’m great. Thanks.

Ash Patel: Fantastic. Thank you for joining us. John is a partner in McNellis Partners and has been very active in real estate for 40 years. He has built over 80 projects. John, before we get started, can you tell us a little bit more about your background and what you’re focused on now?

John McNellis: Sure. The deep background – I was a journalism major in college. I ended up in law school because I didn’t know what to do with my life and I didn’t want to be a newspaper reporter. I got out of law school and discovered quickly that I hated the practice of law. It just happened by sheer luck to be working for a law firm that had a real estate practice. I shifted over to becoming a business lawyer. After a few years of doing that, I decided, whoa, it’s a lot more fun being the business guy than the lawyer. Gradually, over the course of seven or eight years, I shifted from practicing real estate law to becoming a full-time developer. Again, sheer luck or coincidence, I had an older partner who is an accomplished shopping center developer. I started when I was about 29 in the shopping center development business. That’s what I’ve been for quite a while.

Ash Patel: John, here it says 80 projects. What are projects?

John McNellis: Great question. First, we only build here in Northern California within about a two-hour drive. Somebody called me a [unintelligible [00:02:33].25] developer, meaning that wouldn’t drive more than two miles. For us, the projects are 10 acres of dirt in the path of growth in a new town, and on that 10 acres we’ll build roughly 100,000 foot shopping center, Safeway or Albertsons, Longs or CVS, McDonald’s, bank… Typically what we call a barbell shopping center that has a big anchor on one end, a thin row of shops, and then an anchor on the other. The other thing – because here in Northern California, obtaining entitlements is difficult. That’s good and bad news. It’s bad if you’re trying to get something built, it’s good if you own something because the drawbridge is up.

One of the things we figured out 30 years ago was it’s a lot easier to get entitlements or permits if you were tearing down an old broken-down shopping center and replacing it. So probably more than half of our projects were tear-downs and renovations as opposed to the greenfield development.

Ash Patel: You’re in an elusive world that not many people know about, so I’m excited to have this conversation. Where do you start when you want to build 100,000 square foot shopping center? Let’s take the land one first. How do you identify land that you could build on?

John McNellis: Sure. Retail is a very tricky business actually, like hotels. It’s not something you can really dabble in, you really need to specialize in it. The best way to start is to become friends with a major tenant. If you’re just starting out, I think you’d become friends with say 7-Eleven or a Dutch Bros here in Northern California or a little regional small tenant. You befriend them and you say, “Gee, 7-Eleven, I’d like to work with you here in Northern California. Where would you like to go?” If they like you and they think you’re competent, they’ll say, “Well Ash, we’d really like to be in Middletown.” You say okay, and then you run around and you find a site. As you’re tying it up, you call the tenant back and say “Okay, I found the site at Thurston Main, how does this look?” They say, “Yeah, actually it works for us.” Half the time and more they say “No, that doesn’t work,” because of something.

But in my world, you’re getting the tenant at the same time you’re getting land. What we don’t do, we don’t buy a piece of dirt on spec with no prospects on it. That’s a good way to go broke in my business. I started when I was in my late 20s I had an older partner. He was about 15 years older and he was an accomplished developer. He had a relationship with Safeway in the case of our first shopping center. The first [unintelligible [00:05:11].02] adult project I did, we knew Safeway wanted to be on this site. That’s how we did it. That’s pretty much always the case.’

But the great part about retail as opposed to pretty much any other real estate discipline is you work with the same people over and over again. The real estate reps in a given area – they may change, they may go from Starbucks to Safeway to Walmart, but they don’t tend to leave the area, because their value to the tenants is in their geographic knowledge.

It’s hard to go from Palo Alto to Cincinnati. If you plop me down there, it would take me a while to get my bearings to figure out where the good corners were to build a grocery store. So people tend to stay in the same place. The benefit there is you do repeat deals over and over again. So there’s, if not collegiality, there’s certainly a familiarity. The more deals you do, the easier it gets.

Ash Patel: John, I’ve always wondered, why don’t these companies from the smallest 7-Eleven to as large as a Kroger Safeway, why don’t they just hire you and bring you in-house and capitalize on their real estate upside?

John McNellis: The answer is that I wouldn’t do it. They do that, actually. But if you’re really good as a developer, why would you ever take –I’ll make up numbers– 200,000 a year or 150,000 a year, when, with just a little bit of luck, you can make 10 times that if you’re a principal? The best guys –guys who are really good at this– would never consider doing that, they would never consider working as a consultant. The mediocre guys, the ones who failed as a developer, they’re happy to take that job. But there’s a reason that they’re mediocre and there’s a reason they fail. They’re not that good at it. But over and over again, tenants, let’s say 7-Eleven, if the developer is buying the dirt, building it, and selling it instantly and that there’s a fair bit of profit in that.

A company like 7-Eleven could say, “Gee, we should do that ourselves and keep the profit.” But real estate development is tough, it is really hard, and it takes a lot of perseverance, a lot of effort. The companies usually figure out it’s not worth it. They usually say “Screw it. Let Ash or John make the profit on the deal. It’s too much brain damage. We just want shovel-ready stores.”

Ash Patel: Alright. It’s people like you that make this look easy. I have to ask you, you said that you don’t do spec deals. Why not take a high-traffic road where you could see the development coming to a particular corner? Why not just buy it on spec and then shop it out to a whole bunch of different retailers?

John McNellis: If your audience is starting out, don’t do that. That is too risky.

Ash Patel: It looks easy, though.

John McNellis: If you’re in my position, and let’s say you’re playing with the house’s money, he said “We don’t care, we’ll park a couple million a year on this dirt. We know something good is going to happen.” You’re right, you make more money that way. If you’re running with a tenant the way I described earlier, they’re going to expect that you give them a much better deal. If on the other hand, you step up and you buy the corner of No and Brainer and you own it, then you can write your own ticket. But the problem, Ash, if you have loose cash sitting around, we’re all getting put your thumb and forefinger together, we’re getting 0% in the bank. Everybody does. So you can say “Well screw it. I’ve got this cash sitting here, I’ll buy this dirt.”

First you’ve got to pay property taxes, then you have to pay it pretty much –I’m sure it’s true in Ohio, as well as California– to have a dist, or the weeds cut a couple of times a year, or the fire department comes after you, you have to buy liability insurance. If you can pay all cash, let’s say it’s a million-dollar piece of property, you’ve got a million cash sitting there earning zero, and you don’t need that million to eat, and you can take the risk, sure, that’s not a bad thing to do. We have done that and we’ve done quite well with that approach. But that’s not a rookie play. You’ve got to work your way up out of rookie ball, single-A double-A, maybe double-A triple-A before you start doing that kind of stuff. Because it can go wrong on you. You may not get the zoning.

I feel a lot more comfortable about that if I had two tenants that I knew really liked the site. If you only have one, then if you own it, they know you own it, and they know particularly if you borrowed money. Here’s a takeaway for your audience, never borrow money to buy raw land. We bought a piece of raw land just the way you described it in 2012, coming out of the last downturn. We bought it as a foreclosed property from a bank. It took us eight and a half years to build a shopping center there. Now we paid all cash for it, it didn’t matter. But a young developer, who has a financial partner and has a big loan on it, would have been taken under by the eight and a half years of interest carry on the loan, or with a financial partner.

Ash Patel: That’s valuable advice. Because I think a lot of us, we see that corner that was undeveloped. All of a sudden there’s a for sale sign and somebody buys it. Then there’s a Starbucks, Chipotle, and a Walgreens there, and you think, “Man, why didn’t I do that?”

John McNellis: Sometimes they go really well, and sometimes not so well.

Ash Patel: Thank you, because you probably just saved me from making some mistakes. Again, it just seemed like an easy thing to do. So you talked about the new development. What about redeveloping old shopping centers? Is that typically a tear-down, or a facade improvement?

John McNellis: Great question. When I was a kid, the supermarkets were 25 to 30,000 feet, and there were any number of shops. There was a floral shop, there was Chinese restaurant, there was a bank, a ton of little shops. What’s happened across the country is that supermarkets have grown and grown and grown. You know this, they have an in-house bakery, in-house bank, in-house Starbucks, in a house Chinese restaurant… So there are fewer tenants out there. Back to that barbell shopping center, let’s say it’s 100,000 feet – the old center might have a 30,000-foot market, 30,000 feet or 40,000 feet of shops, and then a drugstore. If it’s worn out, you can’t fill up all those shops. You couldn’t before the 2009 crash. You couldn’t before the virus. The number of shops out there are getting fewer and fewer.

What we were doing was buying old-fashioned, old-school shopping centers with lots of shops and replacing them with, say, a Walmart. So no shops. We bought an 18-acre site, 180,000 feet of mom-and-pop shops, and a few anchors. We tore the whole thing down and built a Walmart on the whole site. We’ve done that, I don’t know, a dozen times. Knocking out smaller buildings and putting in larger ones. We just had a grand opening of a shopping center on this dirt that we owned for eight and a half years. Six and a half acres, in the old days, that that would have been a 30,000-foot market and 30,000 feet of shops. The one we literally opened this week, 65,000-foot market and one 6000-foot shop building with just two tenants, Chase Bank and Pete’s coffee, an original coffee player here. There are these title shifts to business that you have to be part of. You say “Okay, how can I modernize this?”

But again, the good news about a rehab deal is that unless you’re in a particularly difficult city, the city planning departments will say, “Oh, you’re going to put $10 million into this old wreck? Great. When can you start?” You don’t have to go through two years of public hearings and everything else.

Break: [00:13:01][00:15:03]

Ash Patel: John, with the Walmart deals, I’m assuming Walmart was already interested in that tract of land?

John McNellis: Yup. Back to the great advantage of doing retail, we’ve been working with Walmart, my firm, since they first came to California in 92. Maybe we’ve done 15 Walmart deals, so we have a strong relationship with them. In probably each of those deals that we bought, we knew that Walmart was interested in advance, and they confirmed it. They said, “Sure, John. We like you. We like working with you. You tie this side up, we’ll do a deal with you.” It’s good to have a tenant in your pocket if you’re going to do this stuff.

Ash Patel: Good to know that. Those strip malls where there’s an anchor, and a whole L-shaped line of other retailers – going forward, is that not what they’re building? That’s not what’s in right now?

John McNellis: That’s right, what’s being built right now are far fewer shops.

Ash Patel: Is that because of people’s attention spans a little bit? Because if you’re going to JC Penney and there’s a hobby store over there – we’ll swing by and check it out. But now it seems like everybody wants things now, attention spans are short, we’re in and out of there. We’re not going to interior malls. We want to drive up, go in the store, come back out and leave. Is that part of it, the attention spans? What’s happening why those are no longer in favor?

John McNellis: A lot of things are happening right now. But you and I, in order to go to a mall, we have to say, “Well, if I just need a new t-shirt, or a sweater, or a pair of shoes, I can order online. So I’m going to go to the mall because there are nice restaurants there.” There was this whole shift toward experiential malls, which worked really well until the virus came down. But if the mall has an ice-skating rink, if the mall has a big gym, if the mall has trampolines, the mall has some vitality to it at work. But if it’s just a straight-up hard goods, soft goods, Sears, a lot of these old tenants, unfortunately, they were roadkill before the virus, and they were roadkill before the 2009 collapse; they’re still around, but they’re going down, because there’s no reason to go to them.

Fortunately for us — it’s only half a joke… I discovered we were in the essential retail business about a year ago, because our centers are supermarkets, drugstores, drive-throughs, gas stations, and banks; in fact, probably 75% of our holdings are comprised of those categories. They all did as well if not better in the downturn. The downturn, the COVID downturn, has accelerated the existing trends. The tenants that were on life support before the virus are definitely not coming back. It just kind of accelerated that. I wouldn’t want to be in the business today of building big boxes for hard and soft goods tenants right now… Because again, too easy to get on the internet.

Ash Patel: So with the vacant Sears, the vacant JC Penney’s, do you think those will be teardowns, or other any opportunities for investors to buy and repurpose them effectively?

John McNellis: Yeah, the question is, you walk outside your front door in the town that you’re thinking about buying a mall, and if there’s no dirt anywhere… Here in Palo Alto, I’m sure most of your listeners know, it is the brains if not the heart of Silicon Valley; we’re on this peninsula, there’s basically no land available. So if you can find an old mall here, you can easily repurpose it. You can add a hotel, you can add multifamily housing, you can add for-sale housing, you can take a 40 acre 400,000-foot center, cut it down to 10 acres of 100,000 feet of retail and then add all these other uses.

If on the other hand – not to pick on my hometown, but it’s a dump. If you’re in Southern California in some woe begotten desert town and you look out the front door and all you see are millions of acres of raw land – there’s nothing you can do with those old malls, because it’s cheaper by far to build fresh than it is to go into one of those old malls and tear it down. Because even if I give you the mall, Ash, it’s expensive to tear those things down and then you may have toxic issues and everything else.

So I don’t know what the answer is for a lot of them. The B and C malls in B and C cities, I don’t know, maybe the city takes them over for government offices, or their community colleges take them over, or the hospitals, but I would not recommend that anybody get in there and try and retool them as retail.

Ash Patel: Interesting. Often, they require multi-million-dollar roofs, because they’ve been neglected for so many years as well.

John McNellis: The other problem with enclosed malls is the operating costs are so expensive. Open-air – you don’t have to heat it, you don’t have to air-condition it, you don’t have to have janitors policing the areas. Again, the retailers don’t care whether it’s rent or operating expenses, all they care is what their gross monthly amount is. So the extent that you can deliver a retail setting without all those extra costs, you can make it up in rent.

Ash Patel: With COVID, what do you think about these suburban downtowns? My opinion is, people during COVID did not go to city centers, but they went down the street to their neighborhood downtown where there are local restaurants and bars. Do you think those areas will continue to thrive?

John McNellis: Yeah, I think you’re absolutely right. I think the biggest loser in the virus is the elevator. I’m serious. Salesforce tower is a building that looks like it’s been downtown San Francisco. It looks like it’s half again taller than any other building in town, and the elevators aren’t that large. So if we’re on the 80th floor or whatever, and we have to do a five minute ride every day, do we really want to do that? I think you’re right. The work-at-home phenomenon, I think, is overplayed; people will go back to the office. But if you and I own a company and we could have 10,000 feet in Salesforce tower on a 40,000-foot floor plates, so that our employees are sharing bathrooms with three other tenants, common bathrooms, or, back to your point, we could have a 10,000-foot building, a two-story walk-up in a downtown where there are no elevators and where we can control the health protocols… Where are we going to sign a lease? Because we do own suburban office as well, and I made a, let’s just say, educated guess…

Ash Patel: Killing.

John McNellis: Not a killing, but they we’re betting that these suburban downtowns, like Palo Alto, will do fine. People still need to congregate in offices, but I don’t think they want to go into the CBDs. Because then, how am I going to get there? Gee, I’ve got to ride the subway or the bus, and then I have to ride this elevator up. Now, it could be that the vaccinations solved everything and that’s no longer an issue. But I think there’s always going to be a lingering fear here. What happens five years from now when the next virus rolls down the pipe? We’re in a small office here in downtown Palo Alto, it’s just us. So when the governor mandated that shelter in place, we revised that slightly to shelter in office. We’re here, my partners and I, we’ve been here the whole time. But Ash, had we been in a high-rise office building, we would have been locked out of our offices for this last year. People aren’t going to forget that.

Ash Patel: That’s a good point. John, you’ve given us a pretty good idea of the retail, the malls, the high-end retail scenario. What about the downtown suburban office buildings? Do you think they’ll be repurposed into apartments, live-work play centers, co-working centers? Or do you think there’s just not much of a future for those?

John McNellis: No, actually, I think they’re just the opposite. I think there’s a pretty good future for vibrant suburban areas. You pick it in Ohio, I could pick it here… Essentially, just outside of the major CBDs, any of these towns. I think those suburban offices has people move out of the cities; I think they’ll be fine. So I don’t think they need to be repurposed. I think they’ll be used as offices. I think big companies will say, “Okay, the back of the house guys, the accountants, or the software engineers, they can work from home. But some of the accounting department has to get together, HR has to get together, the marketing guys, the sales guys, they definitely have to get together.” So I think, rather than have this huge floor played in the CBD, they’ll say, “Okay, this division, this group of ours will work in this small town in this walk-up building that we control.”

Ash Patel: But downtown Cincinnati, the high rises down there, you don’t see them getting repurposed anytime soon?

John McNellis: What I think happens ultimately, and this may take five or seven years, as people flee the downtowns, it’s absolutely happening in San Francisco. Rents have dropped, real rents, forget what you’re reading in the papers. Rents have really dropped on the order of 40%. Once rents drop low enough so it becomes a value proposition, then back to Ash and John running a company… We’ll say “Screw it. It is too good a deal.” And then it’ll happen like New York kind of went off the tracks in the 70’s. When things get low enough so that the fun, artsy people, the artists, the writers, the actors, the waiters, –and rents have dropped here, 20% to 25%– when office rents and apartment rents drop low enough, you get the gentrification effect. People will move back to the downtown’s, because they’ll say “Okay, it’s actually cheaper here than out in the suburbs.” So tide goes in, tide goes out. I don’t know anything about Cincinnati, other than it’s close to Kentucky.

Ash Patel: But it’s not going to be an apocalypse. It’s going to come back at some point.

John McNellis: It is. Again, I think the work-from-home was maybe 5% before the virus and maybe it settles at 15% or 20%. But you can’t get promoted from home.

Ash Patel: From a Zoom meeting.

John McNellis: From a Zoom meeting. You can’t meet the love of your life, you can’t go hang out and have beers with your friends, or play on the team basketball league. I think people come back. Working at home, it’s fine for certain people and for certain age cohorts, like it’s fine for us; but if you’re 25 and ambitious, working from home isn’t going to cut it.

Ash Patel: That’s a great point. What about those Class B and C shopping centers that don’t have anchor tenants, they just have mom-and-pop tenants, and there are four to six spots, in there in suburban areas?

John McNellis: We call those strip centers, where it’s maybe five or 10,000 feet and it’s a nail salon, it’s a barbecue pickup place, it’s a hair… They’re all fine. The personal services in my world were wiped out. Dry cleaners, hair salons, nail salons, legitimate massage – they were all just totally shut down. But they are also though internet bulletproof. You can’t get a manicure online, you can’t get your hair colored online. Those little strip centers, if they’re well located, they’ll be fine. Now, the landlords probably lost a year’s worth of rent on some of them, because they’re essentially wonderful, hard-working immigrants that run those little shops. They didn’t have any money to pay us. We just let them sit there. There was no other demand for it. But once they’re back, once everybody’s getting a haircut again, they’ll be back. I’m not worried about the little strip centers. The large enclosed B and C malls – those are dead malls walking. They’re a problem.

Ash Patel: Yeah. I’d love to hear your take on restaurants, both chains, and the mom-and-pops.

John McNellis: Sure, I have a few opinions on that. The thing I love about business is it’s always different. It’s like a kaleidoscope. All of the little pieces are there, but you shake a kaleidoscope each time it comes up different. In prior recessions, we kind of all went down together and all went up together in retail. This time, there have been these runaway winners – home improvements, Home Depot, Lowe’s, killing it; everybody in the country’s adding a bedroom. The supermarket is killing it. But restaurants – you have to parse it even finer. Drive-through restaurants are absolutely golden, Ash. We have a Jack in The Box in one of our centers, they recported sales up 50% year over year. The tenants who are out there looking for new deals that we’re talking to, all want a drive through. McDonald’s is killing it, Carl’s Jr. Do you have Carl’s Jr. in Cincinnati?

Ash Patel: We don’t.

John McNellis: Okay. It’s a sort of national chain. They have a lease that’s coming up for renewal, not this year, not next year, three years out, and they’re doing so well that they want to renew their lease. So they’re fine. Pizza. If you think about it, ask yourself if… The good part about retail is that we’re all consumers, we all shop, so we all have a pretty innate working understanding of retail. So pizza, you can pick up or have delivered, and it tastes the same at home as it does… Maybe you throw it in the microwave for 10 seconds, but it tastes the same. Chinese food, pretty good that way. Mexican food, not so much. The restaurants that lend themselves to take out, they are doing well.

Where they’ve been hurt, for us and others, the fancy restaurants. Particularly those without any outdoor seating, they’re crushed and a lot of them aren’t coming back. If you’re crazy enough to go to a fancy French restaurant, order the food, you get at home 45 minutes later, it tastes like Chef Boyardee. The tastes are too subtle, the flavors are too nuanced, and it just all kind of collapses in on itself after a little while.

Ash Patel: All the emulsifications are gone.

John McNellis: Exactly. And the other thing, frankly – and this is true of all of retail but particularly true of restaurants, we just have too damn many of them. We probably, before the pandemic 10 years ago, I think we have on the order of 25 feet of retail space for every man woman child in the country, whereas Europe has about two feet. We just have so much retail space, we are just wildly overbuilt. So each time something comes along, whether it’s a downturn, or whether it’s the depredations of the internet, or the virus, a little more retail goes away. But it should go away, we just have too much of it.

Ash Patel: It’s a bit of a reckoning? Understand.

John McNellis: Exactly.

Break: [00:29:16][00:29:52]

Ash Patel: I know this isn’t your area of expertise, but what about single-family housing and the crazy prices, lumber prices, what is your take on that?

John McNellis: We’re in the middle of a bubble right now; people fleeing the CBD of Cincinnati or San Francisco or wherever, getting out of apartments, getting out of condos… Back to the elevator, “I don’t want to ride that elevator anymore. I want a three-bedroom house. Four bedrooms, actually.” That fourth bedroom, at least here in California, has gone from optional to mandatory, because people want an office. I think it lasts for a while. So our suburban single-family homes are on fire, I assume yours are as well. I am tired of hearing about Austin and Boise. Everybody from California is allegedly fleeing for those states. It’ll settle out in a while. But the fact is that we are building several hundred thousand if not close to a million too few units a year of housing units. So if you’re going to get into to real estate development to start, I would probably go into either apartments or single-family housing. I guess it’s probably the safest, because the demand is so strong and the supply is pretty limited.

Ash Patel: Do you think the bubbles are on the verge of busting? My thought is no, because you have companies like Zillow and Blackstone just buying single-family homes as fast as they can. So do you think this will continue to last for a while?

John McNellis: For a while. I have just the world’s worst crystal ball, so I try to just stick with the present. When we buy properties, it’s not “Gee, it’ll be great in 10 years.” If it doesn’t work on day one, or say we buy it, and then it’ll take us –I’ll make this up– a year to get it titled, a year to build, and another six months to have it fully leased… If we can’t see those two and a half years from now based on today’s rent, it makes sense, we won’t do it. You’ll see a lot of guys, particularly these huge fancy projects, where they say, “Well, in 10 years, it’ll be a great deal.” Well, they use the IRR. We think that’s a big mistake.

Ash Patel: Just like the developer that bought the land that had to sit on it for eight years, and the holding costs… John, what is your best real estate investing advice ever?

John McNellis: Don’t over leverage; we’ve lost money in real estate. If anyone ever tells you they’ve done more than a half a dozen deals and they haven’t lost money in real estate, they’re lying. Real estate is just too hard. No matter how smart you are, something like the virus comes along. So all the guys who thought they were brilliant, like say with malls, and you took out the old Pennies or K-Mart and put in an ice skating rink because it was experiential… Well, that was a brilliant move until a year ago and then they lost money because of the virus. The best way to lose money is to over-leverage. I think Warren Buffett said it’s almost impossible to lose money in real estate if you don’t have any debt. Now, that’s probably true. You can’t do that starting out. If you start out as I did with zero money, you need to have debt, you need to have financial partners. But my best advice is to be careful with your leverage.

Ash Patel: Great. Advice. Go ahead, please.

John McNellis: The other thing is, you know that old saw, if at first you don’t succeed, try and try again. That’s not a good mantra for development. If at first you don’t succeed, if the neighborhood hates the 7-Eleven that you want to put on the corner, you better pivot and try something else. Another good way to lose money is to be a little too stubborn about what you want to do.

Ash Patel: John, with your 40 years of experience, would you recommend new people go into development or just investing in existing assets?

John McNellis: When people say, “Gee, John. I want to be like you and have a big development company” I say, “Okay, well then start as I did.” I started with a duplex when I was 24, that cost maybe $26,000, and I put a couple thousand down. Residential is the easiest, Ash, because the vacancy factor is pretty much always zero. You can always clear an apartment, you can rent it for something. All the other disciplines – industrial, office, retail, hotel, and so on, they all have vacancy factors and you can get caught. So my advice is always if you want to do it, buy the worst house on the best block you can possibly afford, in the best neighborhood. Buy something for 200,000 in a block that selling around 400,000, if you can find it, put 100,000 in and you made $100,000 profit. That’s the way to start.

With mine, I think –this is trying my memory– I put down 2000 to 3000 at most, I got lucky on an upturn. The one that I bought for 25k I sold for 60k a year later. And then with that 60k, so then I had like 30k to 32k, I bought a fourplex for 60k, and again, a year later sold that for 120k. That initial two or $3,000 of my capital became $90,000. Just for the record, I’ve never done a deal since then with that kind of return on capital, but that’s how it starts. I start out small and actually, I’d keep my day job and do it on the side.

Ash Patel: Great advice. Let’s take it a step further. Let’s say you build a bit of a portfolio, a bit of a nest egg, and you then have the opportunity to continue to buy value-add, or existing strip centers, or develop your own. Where would you recommend people turn to? Development or just buying existing assets?

John McNellis: One of the reasons we’re talking today is I’ve written a book. In fact, I just finished the second edition of it. That question came up in a talk I gave, and the kid just stopped me, and I had to admit, we don’t have a strategy. It’s when it’s come along. And then I went back and looked at our portfolio. About 75% of the time, we built ground-up, and about 25% of the time we took advantage of let’s call them opportunistic buys. Then I parsed that a little finer, and said, “Well, what was my win-loss record?” Oddly enough, it turned out to be about the same. That would tell you, “Gee, then I ought to just buy existing stuff.” The problem is, it’s very hard to find existing deals because everybody’s out there competing for them, that are really strong deals.

As much trouble as developing is, it’s a lot harder, there’s a lot less competition, the returns are significantly higher if you do it right. So I’m happy to buy existing, and we’ve done essentially just as well with existing. I’d say case by case. The old saw is in a really hot market, when everything is selling for well over replacement cost, you have to build. In a down market when everything is just tumbling, and you can buy for less than replacement cost, why would you build? Buy something that’s existing.

Ash Patel: That’s a great metric. John, you’ve written a book, tell me more about that.

John McNellis: I write a monthly column for the San Francisco Business Times. At some point along the way, over the last 10 years, or seven years ago, someone said to me, “John, go and make a book out of this.” So I wrote a book called Making It In Real Estate: Starting Out As A Developer. Basically, starting out with that duplex I mentioned and how you can grow that carefully, slowly, conservatively, over years, into a large development company. The book has done, much to my surprise and gratification, quite well. In fact, it was my publisher’s best seller.

A year ago, in January, they said, “Hey, how about writing another book?” I said, “No.” Back to the question you asked me about to buy versus develop. I said, “A lot of issues have come up, I’ll rewrite the book. I’ll add chapters to it.” So we came out with a second edition in the late fall, and it’s selling really well. It’s now required reading Cornell, Georgetown, University of Cincinnati, Cal Vanderbilt. I spoke virtually at Vanderbilt, it’s done really quite well. Whatever it costs, six or 10 bucks, I think there’s more than that worth of advice in it.

Ash Patel: If it’s anything like this conversation, it’s an amazing book, I’m sure. I will definitely get that.

John McNellis: The guys who love it say, “Gee, John. I like it because the chapters are short.” Because they started out as newspaper essays and each one has pretty much a single point in there. I think it’s quite useful and I’d be delighted to have your listeners take a look at it.

Ash Patel: That is great, because what I found for commercial real estate books are either very dry outdated textbooks, or books written by beginners that just want to get published. So having something like this, I think would be amazing. I will definitely get that.

John McNellis: Yeah, the difference is, I actually did it. I’m not a journalist writing a book; I’m talking about real-world experience over 40 years. It’s tough. I point out in the book, I think, unfortunately, the vast majority of people who try to become developers fail at it. It is a hard business. But there are a lot of ways you can reduce that risk. Again, back to my earlier point, don’t over-leverage your properties.

Ash Patel: John, are you ready for the lightning round?

John McNellis: Yeah. Sure. Shoot.

Ash Patel: Let’s do it. John, what’s the Best Ever book you recently read?

John McNellis: I knew you’re going to ask that. It’s called The Psychology of Money by a guy named Morgan Housel. I think he’s a genius, because everything he says is what I agree with. It’s not a real estate book, it’s an investing book. It’s an investing book about taking the very long term. He makes the point that Warren Buffett isn’t year by year the world’s best investor, it’s that Warren Buffett has been investing for 70 years from the time he was 15 and now he’s in his mid-80s. Just by investing and staying in the market, like a farmer, year in year out just planning the crops, he’s produced these fabulous returns. Anyway, a very interesting book for somebody starting out.

Ash Patel: That is great. John, what’s the Best Ever way you like to give back?

John McNellis: Locally, we give back a ton. I have found that charity, just like electricity, tends to attenuate the farther it is away from you. If you’re sending money to Africa, that’s nice; but you just don’t know how it’s going to get some bad weather, it’s going to get intercepted. If you can get involved yourself with local charities in every town, whether it’s Cincinnati or Palo Alto or New York City, it doesn’t matter. Every town, there are plenty of local charities that need help. If you can get involved personally, get on the board, show up, give more than just your check… Checks are great, but the more you get involved, the more you understand, the better use your money can be put to. Somebody pointed out it is just as hard to give away money well as it is to earn it, and there’s a lot of truth in that.

Ash Patel: That is great advice. John, how can the Best Ever listeners get a hold of you?

John McNellis: I’m at LinkedIn, John McNellis, or my email address is john@mcnellis.com. Unless you happen to be a Nigerian prince offering 20 million dollars, I’ll respond to your emails.

Ash Patel: John, I can’t thank you enough for all of your advice today. We started out with simply talking about developing strip centers and we pretty much hit every commercial asset out there. We got your outlook on what the future holds. Just an amazing episode. You’re one of the godfathers of commercial real estate with all of your experience. Thank you so much for sharing all of that with us today.

John McNellis: My pleasure. It’s been fun.

Ash Patel: Have a Best Ever day.

John McNellis: Okay. Thank you.

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