February 12, 2022

JF2720: 4 Things to Know Before Your First Development Deal ft. John McNellis #SituationSaturday


Are you interested in entering the commercial real estate development space but have no idea what to expect on your first deal? Return guest John McNellis walks us through different financial scenarios you might encounter on your first deal, their outcomes, and how to best set yourself up for financial success.

John McNellis | Real Estate Background


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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 with today’s guest, John McNellis. John is joining us from Palo Alto, California. He was a previous guest on a number of episodes. If you Google Joe Fairless and John McNellis, those episodes will pop up. John, we’re glad to have you back. Thanks for joining us and how are you today?

John McNellis: Ash, I’m great. I’m absolutely great.

Ash Patel: Thank you.

John McNellis: Omicron here in Palo Alto seems to finally be going away. It turns out it didn’t seem like it was that big a deal. Life seems to be returning to normal.

Ash Patel: Glad to hear that. Today is Saturday. Best Ever listeners, I hope you’re having a great weekend so far. Because it is Saturday, we are going to do a Situation Saturday show, where we discuss a specific situation our guest has encountered. The goal is to give you the knowledge should you encounter a similar situation. John is a principal at McNellis Partners and has been involved in over 80 development projects. John, before we get into your particular skill set, can you give us a little bit more about your background and what you’re focused on now?

John McNellis: Sure. I went to school here in the Bay Area, I went to Berkeley, I went to a fancy law firm in San Francisco in the mid-70s, and quickly decided that I needed to practice law. I was in a real estate commercial practice and managed, with let’s say a lot of effort, to gradually shift out of law into business. I teamed up with an older partner who was a shopping center developer. For the last 40 years, we have been primarily shopping center developers. Our focus has been in Northern California; basically, it’s like a two-hour drive from San Francisco in all directions, except maybe West. The centers tend to be, give or take 100,000 feet, give or take 10 acres, supermarket anchored, Walmart anchored, all single stories, surface part… And I didn’t realize how brilliant that was, and it certainly wasn’t a strategy until two years ago when COVID hit. Then I learned somehow that we were essential retail. Unlike the big boxes that you see and the enclosed malls, our portfolio and that of all my competitors in the same niche, that is supermarket anchored neighborhood centers, came out essentially unscathed. We had to give up rent for our small tenants in 2020 and continuing to 2021, and even still today a little bit… But a vast bulk of our tenants, 75% to 80% of the supermarkets, drive-throughs in particular, did fine. Also, just to round it out, we had to do a little bit of investing in Silicon Valley, office buildings, and sort of high-end small residential projects.

Ash Patel: What do you want to talk about today, John? We’ve covered so much in our past conversations… What would give our audience some value today?

John McNellis: Okay, I’m assuming, Ash, that our audience are young guys like you that want to get into the development business… So what I want to talk about is that first deal, for the first couple of deals where let’s say you’re a broker, let’s say your attorney, a banker, whatever it is, but you hanker to become a developer. You find a deal, and oh my God, it is so good. And I’m going to give you, slightly disguised, a specific deal that good friends were involved in, so this is a real thing.

You find a deal, let’s say it’s $15 million dollars – it was – and let’s just say you’re absolutely certain Ash that in a year you can make it worth 20. It’s an existing project, it doesn’t matter whether it’s an office building or a shopping center, but single tenant. The lease is coming up, the sellers are old, they’re nervous, they decided to sell it at a discount. You know that if you can extend that lease for 10 years, you can turn around and have a value of $20 million. So you want to keep as much of that as possible.

Then just this background, and… It’s in my book. But typically, this is what I call a paint and petunias deal, where the project is leased or unleased, there’s no construction risk, there’s no entitlement risk; essentially, there’s a leasing risk. On a deal like that, in my experience, the best you could hope for as the equity partner, or the young developer, is maybe an 80/20 split, sometimes even 90/10. Sometimes, if you don’t have enough control, the financial partner kind of muscles you aside and says, “Okay, kid, we’ll give you an extra point or two on the commission, but you’re out of the deal.” Let’s say 80/20. But you think this is such a great deal that you want to get a better deal than that, and you want to get 60/40. And it’s a good enough deal, so you go to your financial partner and you say, “This is a killer deal. There’s $5 million on the table. All we have to do is buy it, lease it, sell it or refinance it.” The natural partner agrees and he says, “Whoa, you’re right. This is a good deal. The chance of getting this thing leased – 100%.” He says, “Here’s the deal, kid. 80/20, 8% preferred return on the money.” You guys all know how this works. First, there’s the 8%, then there’s the repayment of the capital, and then it’s the 80/20 split. You counter and say “No, this is such a good deal. I want 60/40.” The money guy says, “60/40 – you’re really pushing it. I tell you what, if you’re that convinced that you can get in and out in a year, I’ll do it. But I want the high end of the financial partner preferred returns, I want an 18% preferred return.” So that’s your dilemma as a young developer, do you take 60/40 after an 18% return, or 80/20 after an 8% return? With me so far?

Ash Patel: I am.

John McNellis: Okay. Any questions so far?

Ash Patel: No. I have a deal that’s very similar to this. We’re doing an 18% preferred return and a 70/30 split. So I’m really intrigued to learn more.

John McNellis: Oh, so you should have watched this episode…

Ash Patel: Before I did the deal. Yes. [laughs]

John McNellis: That’s one of my favorite lines, experience is something you acquire just after you need it. Anyway, so 80/20, 8%, 60/40, 18%. So let’s just walk through the numbers, and I think I can do this in my head. Let’s first do it. And then you tentatively say to the guy, “I think I want to go the 60/40 route.” He says, “Well, work through the math.” So a year out, 18% on 15 million, and let’s assume this is a last-minute deal; you’re going to sell or refinance it, so there’s no debt, it’s just all equity. So 18% on 15 million is 2.7 million. So a year out, 2.7 million; that leaves 2.3 million in profit. What’s 40% of 2.3 million Ash, tell me that?

Ash Patel: Roughly a million.

John McNellis: I actually wrote it down. It’s more roughly 920,000 on your deal if you hit your marks. Now let’s go the other route. In the 80/20 deal with the 8% return. 8% on 15 million is 1.2 million, which leaves a $3.8 million profit. 20% of that is how much? 760,000. So if you can get in and get out on that one year, you’re 160,000 to the good on the aggressive 60/40 after 18% deal; you’re 100% to the good. I was actually thinking about this… I know you’re well versed in IRR or internal rate of return, and I’m guessing most of your audiences is as well, if they’re going to listen to this technical real estate stuff. And as I was thinking about our talk, I think you know already, we have zero faith in the IRR. It’s a silly metric, but it’s one that all the financial guys use. So they say “We want an 18% IRR and then you get your money.” But it occurred to me that IRR could stand for “I ruin rookies.” [laughs] Keep that in mind. In fact, I think I’ll put that in a newsletter.

Ash Patel: It’s a t-shirt.

John McNellis: It’s a t-shirt, I Ruin Rookies. Alright, so we just walked through the math. At one year, the aggressive approach works great. But this is real estate folks – let’s just say there’s a delay. What happens on that same deal at 18 months? It looks like there’s a six-month delay; you can work through the math, but add another six months at 18%. Suddenly, you’re at 4,050,000 of preferred return; there’s only 950,000 left to split. 40% of that is 380,000. If you’ve gone the other way, if you’ve taken the 80/20 deal, the 8% is, again, at 18 months, that’s up to 1,800,000, there’s 3,200,000 left to split, so suddenly you’re at 600,000. So that’s the point – let me underscore that, folks. If you hit your marks exactly and you’re in and out one year, you’re way ahead. If you only have a six-month delay, you’re behind. You’d net 600,000 on the more conservative way, 380k on the 60/40; you’re up 220,000. If you carry this out to the next level, a one-year delay – at a one-year delay, the developer’s out of money. 2,700,000 times two is 5,400,000; that’s all the profit in the deal goes to the financial partner.

Ash, you may say, “Well, John, has that ever happened to you?” I’d say “Yes. It has.” Not quite so dramatically and not where I had a choice. But simply where, in the early days we would do a deal at a 10% preferred return, a development deal. It would turn out well, but not perfect, and we’d be producing a 9% return on the investment. The preferred return was 10%, so each year we’d fall behind 1%, and then next year 1.2%, and so on. Have we done deals that only benefited the financial partner? Yes, about three or four. I think we’ve talked about this before, it’s kind of off the topic, but that’s one of the reasons we decided once we were able to, to no longer have financial partners; to just do small deals on our own and not get ourselves behind this snowball.

Now, the situation that I’m personally aware of – the young developers chose the 60/40, 18%, and here’s what happens. They were really smart guys, really competent; everything that they had said that was going to happen actually did happen. But delays occurred in getting the lease extended, and then COVID occurred. Suddenly, things were jammed and, sure enough, they ended up out of the money entirely. Had they gone with the more conservative approach, they would have made at least a couple hundred thousand dollars. So you can draw from that what you want. You can say, “Gee, I think I’ll take the conservative approach and make a little less money maybe if everything goes great, but I’ll cover my bets.”

Break: [00:14:47][00:16:56]

Ash Patel: That makes a lot of sense, and we’re doing the exact same thing. You don’t know this, but our story is exactly what you said. It’s 18% preferred return to our investors, and it’s a 70/30 split, 30% goes to the LPs, 70 to the GPs. And it’s the same thing, it’s a $5 million strip center, that we have two LOIs on leases to lease up the remaining vacancy. If all goes well, it should be a huge win.

John McNellis: I hope it will.

Ash Patel: If all goes well. [laughs]

John McNellis: If all goes well. California is the home of delays. Is that in Ohio?

Ash Patel: It’s in Ohio. One of the delays is one of the tenants coming in is Ace Hardware. They have a six-month delay in getting shelving for new stores. We knew that going in. The other reason we’re confident about this deal is the operating capital is enough to pay the investors preferred return. Sorry, the operating income and the profit.

John McNellis: You bought it at a current 18%? return?

Ash Patel: Correct.

John McNellis: Okay; then you’re not going to suffer the same way. As long as you can keep it current, that’s great. In this case, the one that I mentioned, that wasn’t the case.

Ash Patel: Okay. This is pretty conservatively underwritten. We won’t make any money if we just maintain the center as it is. But the upside will add a tremendous amount of value.

John McNellis: Well, that’s great. And there’s a bigger picture – as a young guy starting out, even if you don’t make money, if the financial partner does and the financial partner likes you, it’s on your portfolio; it’s another stripe or another battle ribbon. For your next deal, you can say “Yeah, we did this shopping center. We bought it for four and sold it for five.” It adds to your credibility, and of course, it adds to your experience.

I guarantee you’re not going to make money, to listeners out there, on every single deal. We have certainly lost money more than once. But even on the losers, you gain something, you gain a lot of valuable experience. And again, what I used to call “kiss sisters,” but it’s no longer a happy term, I guess… It’s where you’re absolutely breakeven; again, that works out okay in the long run.

Ash Patel: I agree. If the investors make a killing on this, awesome. Have you ever done deals where it’s a combination of development and buying existing, standing structures, so expanding a shopping center?

John McNellis: Oh, sure.

Ash Patel: The underwriting for that, how was that? How do you underwrite that for investors?

John McNellis: Well, again, we don’t use investors anymore, but we underwrite it for ourselves. I’ll give you an example – two recessions ago, if we say that COVID caused a small one… So in 2010, we bought a little shopping center, a 50,000-foot center in Modesto, California, out of foreclosure. Let me think about this. It was 70% vacant, and 30% leased. What was vacant was the anchor, the 30,000-foot-anchor, just to simplify things, and there were 20,000 feet of shops. Ash, what we liked about what we saw was the shops have been there forever and they were paying for Modesto with very low rent. We bought it on a 5% immediate cash on cash return. So kind of like what you just described, I said to myself — and remember, banks then were just like banks today, they were paying thumb and forefinger interest. It wasn’t that much, it was a couple of million dollars. So I said, “Guys, we can buy this, we have an immediate 5% return, which is okay. Cap rates weren’t that far, they were maybe six or seven then. And we have 70% of vacant spaces upside.” So if you go in where you’re at breakeven and there’s a big upside, I love doing deals like that.

Ash Patel: So those scare me, because if I see a vacant anchor, my assumption is one by one the rest of the tenants are going to leave when their leases are up. Is that not the case?

John McNellis: Good point. As a general rule, yes. But what intrigued us about this site was the little tenants, the coffee shop, the insurance, the pizza place, the nail salon, and so on – they had been there for years and years, and the anchor had been vacant for years. So they had survived just fine without the anchor. So we were pretty sure we weren’t going to lose them. Also, it was such a strong location.

One of my friends likes to say the two-word key to success in real estate is supply constrained; you want to be in an area where the competition can’t come in and build a better mousetrap. But in this particular location, a mile in all directions was totally built out, so we knew there wasn’t going to be another shopping center coming in.

And the other thing – I don’t know how many people have pools in Ohio, but pools in California are a good indicator of nice solid income, at least middle income, maybe a little better. And what indicates pools in a neighborhood? Leslie’s Pools, or one of the pool supply companies. We had Leslie’s in some of our other centers, so I called them and I said, “How are you doing here?” They said, “We do just fine.” So I liked that as kind of a bellwether or canary in the coal mine telling us, “Yeah, this is a good location.”

Ash Patel: Can I pick your brain on a couple of deals that I’m working on?

John McNellis: Sure.

Ash Patel: If you go back to that one example, would you subdivide that giant, vacant space from the previous anchor? Or would you just try to find another big-box anchor?

John McNellis: Actually, I simplified it a little bit; I went the other way. I had 25,000 feet vacant, and as it turned out, it was 25,000 feet of one space that was vacant, and there were another 5000 feet in line that was vacant. So Walmart came along, and we have worked a lot with Walmart in the last 30 years. Walmart’s been great, by the way; they’re a great business partner. They came along and said, “We need 30,000 feet.” It was complicated. I’d move one tenant, build him a new space, and then when he moved, we had to move another tenant into that space; when that tenant moved out, then we could build out the 30,000 feet for Walmart.

Ash Patel:  That’s a huge win.

John McNellis: Yeah, it turned out. We still own it 10 years later and it’s a good property for us.

Ash Patel: Best Ever listeners, forgive me for asking this question. It’s on a property that I own, but hopefully, you get some value out of this as well. John, that $5 million strip center, 100,000 square feet, it has a giant parking lot that we don’t need all of. Building an out-lot, in a conversation with a broker right now, he’s convincing me to just sell the out-lot, versus trying to build something and collect rent on it. What are your thoughts on that? Across the street, there’s McDonald’s, Burger King, Taco Bell, everyone’s there.

John McNellis: Did you pay 5 million all cash?

Ash Patel: No, a million cash, it was 20% down.

John McNellis: 20% down. So it’s just a million that’s getting the 18% return, correct?

Ash Patel: That’s correct.

John McNellis: And then you’ve got a $4 million loan at three, four, or five percent?

Ash Patel: Four and a quarter.

John McNellis: Four and a quarter. Okay. We do that a lot, actually. We’ll buy a shopping center — because, again, that’s our primary business, or a piece of land, we’ll subdivide it, and then we’ll sell off almost immediately one or two parcels in order to bring our basis down on the balance, and then we’ll keep that. We like having very little debt. So what that would enable you to do — a pad here in California, like what you’re talking about, would probably sell for close to a million dollars. Let’s just say you could sell for a million dollars; in all good conscience and honesty, you can allocate. Because you just bought the center for five, this year, [unintelligible [00:25:01].05] months, you can immediately turn around and sell that one pad for a million and you can allocate a million dollars as a basis to that. You can say to the IRS, “Look, guys. We didn’t do anything. We just bought this and we sold this for a million. Clearly, that part was worth a million.” Then you allocate that, so you can pull that million out, essentially, without attacks, you hand the million to your financial partner, no more 18% return on your end for 70/30 on all the cash flow. I love that idea.

Ash Patel: Okay. So sell it, versus trying to become a developer and build on it.

John McNellis: You can go either way. They’re a little tricky. We did a Super Walmart in another town and we ended up with four pads, after we did the 18-acre Super Walmart. We developed one for 711, we’re selling another to a Starbucks developer, and we’re ground leasing a third to an oil changer. So basically, all three options – build a [unintelligible [00:26:02], ground lease, sale. Usually, you don’t have the luxury of choices. Do you guys have In-N-Out Burger?

Ash Patel: No, unfortunately.

John McNellis: Okay. In-N-Out Burger always says, “We’re buying. Otherwise, we’re out.” They’re the flavor of the month, everybody loves In-N-Out Burger. In-N-Out Burger always insists on buying. Chick-fil-A, another darling in fast food, is happy to ground lease. So it all depends. Chances are that the tenants will dictate, but all three options work fine.

Ash Patel: Okay. That helps a lot. Awesome. John, thank you so much for being on our podcast again. It’s been a pleasure. I learn a lot every time we have you on here. How can the Best Ever listeners reach out to you?

John McNellis: Probably the easiest way is on LinkedIn. I’m there, John McNellis; you’ll find me there.

Ash Patel: You’re not going to plug your book but I am. This is the most gifted product I’ve ever purchased. I’ve bought dozens of these. It’s called Making it in Real Estate: Starting Out as a Developer by John McNellis. A phenomenal book; in my opinion, and one of the few incredible commercial real estate books. Thank you for that, it’s been a great resource.

John McNellis: Thank you, delighted you like it.

Ash Patel: Best Ever listeners, thank you so much for joining us. If you enjoyed this episode, please leave us a five-star review, share the podcast with someone who you think will benefit from it, follow, subscribe, and have a Best Ever day.

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