One of my bigger failures as a 20 year real estate developer
As I enter a new stage of my life I am looking back at what I did right, and what I did wrong.  For now I will stick to the failures.  I am going to write a few of these, as time allows.  May you learn from my mistakes.  


Year is 2003 or 04.  I live in a very rural area so my numbers on a national basis are MUCH cheaper than what you're used to.  NAFTA and international trade has decimated manufacturing in rural Pennsylvania.  As a result lots of towns/small cities have had their local manufacturer close shop and their real estate is coming up for sale everywhere.  These buildings are anywhere from 50,000 - 200,000 square feet but are 30-75 years old and most often in terrible condition.  The business owners were striving to make payroll, they weren't concerned a toilet broke or the roof was leaking.  


They would come on the market for sale and no one would buy them because they were in terrible condition.  I would wait and pounce until the price had dropped and was paying less than $5/sft.  (This part I did right, with 1 or maybe 2 exceptions I never overpaid).  The name of the game here was simply patience.    


After my company bought it (I had 2 partners), we would remodel the whole thing.  Painting it white and putting in new lights would make the inside look fantastic, usually for around $3/sft.  Of course we would have to do the garage doors, bathrooms, lunchrooms, heat, etc... These improvements cost another $10/sft and the roof would be about $4/sft.   So usually we had a like new building with a new roof, painted, new lights, heat and loading docks for between $15-$20/sft.  This was at a time when building that building new would usually be between $30-$40/sft.    


We never would put them up for sale, just lease them usually for between $2.50-$3.00/sft net. Our cash on cash return would average between 15-20%.  We would sign a lease almost immediately.  Go to the bank and borrow the full cost of the building based on the lease income.  Now we had no cash in the property.  Pre-2008 you could borrow the full cost.    


Now you have the number side of the business.  Starting around 2003 we do our first project, it's around 50,000 sft, with the numbers I mention above, and almost immediately rented.  So we do this every 6 months.  never selling a building.  By 2006, I would estimate we had done 750,000 square feet of these projects and cash flow was amazing.  So 2006 one of our main tenants comes to us and asks us to do a $5M build to suit.  Of course!  They are in the plumbing industry and home building is booming and their financials are amazing.  We move them in 2007 and backfill their old space almost immediately.   2007 we do another 250,000 sft.  So now we are up to 1,000,000+ sft plus of this product and then we have this huge new build to suit project that the rent needs to be more like $5/sft, double what we get everywhere else.    


I had only done retail and office leasing prior to this and I was basically in charge of the leases.  I could basically agree on the terms of the leases without anyone else's approval.  I was definitely the most knowledgeable person on the team, but it turns out I wasn't that knowledgeable.    


You see, as I was writing the leases, I got to pick the terms.  1 year lease?  Sure, no problem, you're a public company of course we can do that for your VP.  Small business, don't know the future, 3 year lease? No problem!    


So while I was building this 1,000,000 sft portfolio of like new but old industrial real estate all the lease terms were 1-3 years.  Now 2008 hits.  We all know what happened then.    


To cut off my long story - by 2010, the plumber that we had done the $5M build to suit for had gone bankrupt and our occupancy dropped from 100% to 40%.  I think every single lease that expired except 1 the tenant declined to renew the lease.   I would estimate we were losing $100,000 per month at one point and that went on for a few years.  Thankfully we had the reserves to pay them and never missed a loan payment.  We basically put it all up for sale and anyone that would buy anything vacant we would sell it.  We didn't really get creamed in any of the sales because we bought right.  Definitely lost low 6 figures on a few though.   I'm sure we breached some of our loan covenants but banks didn't want the property back and recognized we were making payments so they didn't really give us a hard time.   By 2012-3 we had fully recovered the business but it was much smaller and we were much more selective in our leases.    


Moral of the story is short term leases (&lt;3 years) are almost worthless other than for nice short term cash flow.  If you're signing a short term lease understand what can and does happen.  Have the reserves to carry the property  through the bad times.  For industrial leases like that I only endorse 5 year or longer terms.  Alternatively it can have a landlord kick out clause.  Sure I'll rent it to you for 1 year but I am going to keep the property on the market and kick you out when I do rent it to someone more serious.
[{"id": "goip4v3", "text": "Thank you for that insight", "replies": [], "depth": 1}, {"id": "goip6qi", "text": "Good info. I\u2019ve been in CRE for 16 years.", "replies": [], "depth": 1}, {"id": "goip6x5", "text": "Appreciate the write up!", "replies": [], "depth": 1}, {"id": "goipxo1", "text": "It sounds like you went to towns that lost their economic prosperity then tried to fix a few places up. Why choose those locations?", "replies": [{"id": "goir0xb", "text": "Mostly because that's where I lived.  I didn't know any better.  While your statement is definitely true, even today that portfolio does well - with an expectation when the bottom drops it will collapse there.    \n\n\nThe same model would work in any city, just have to adjust the numbers.  Add a zero or two LOL.", "replies": [{"id": "gojdzl4", "text": "Nothing wrong with sentimental value", "replies": [], "depth": 3}, {"id": "gojtyed", "text": "Industrial commercial space is interesting. My experience is you find a good tenant and your Golden but that can be hard. The headache is not worth it for me.", "replies": [], "depth": 3}], "depth": 2}, {"id": "gomfn88", "text": "Economic development departments in these locations can be helpful, too.   Mayors/councils of these cities want a new employer to brag about and increase the tax base.", "replies": [], "depth": 2}], "depth": 1}, {"id": "goirkrp", "text": "This is very useful information - thanks for posting this. I look forward to more stories and anecdotes!", "replies": [], "depth": 1}, {"id": "goitx54", "text": "What a wild ride.  Thank you for sharing.", "replies": [], "depth": 1}, {"id": "goiui7f", "text": "How many of those businesses do you think would have survived and kept paying rent if you'd had longer leases?\n\nDo you think you'd've been able to keep the properties or would it have merely kicked the can down the road a couple years?", "replies": [{"id": "goiupwr", "text": "The only one that went out of business was the plumbing supply.  By far the bigger problem was companies cut inventory (my tenants were mostly using them as warehouses), and less inventory, less need for warehouses.  \n\nSo to answer your question virtually all of them.", "replies": [{"id": "gol3pl6", "text": "But inventory cuts are generally part of later stage bull markets/early stage recession..\nSo according to your experience, what is the alternative? Smaller warehouses only? Or staying away from them, all together? \ud83d\ude0a\n\nThanks for a cool post", "replies": [], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "goiuzb9", "text": "I\u2019m sorta *mad* for you. No one told you? *No one told you?* Really? *Really?* No one told you? This is unbelievable to me, but I must be living in fantasy land based on the comments profusely thanking you for this nugget of wisdom. \n\nCan we get a crowd going please? Everyone clap to the beat! *Industrial! Leases! Don\u2019t mean anything! With Short Term Leases!* Gotta hear it from the folks all the way in the back! *Industrial! Leases! Don\u2019t mean anything! With Short Term Leases!*", "replies": [{"id": "goiwjt5", "text": "Yea I mean I think in my analyst training class the first thing they teach you is industrial is a long WALT game, no one buys it with lease terms under like 5-7 years remaining....", "replies": [{"id": "goiyjll", "text": "This was a family business that had been fairly successful with one office tenant.  I had done 10-15 office lease build to suits for that tenant (they are Aa3 rated today by Moody's  \n\n\nSo you do one thing, you think you can do another.  I was the only one with a college degree (in engineering).  Basically the complete opposite of NYC type deals.  I got trapped by the fallacy of 15% cash on cash returns then financing them for 100% cash out.    \n\n\nMaybe someone did tell me or warn me.  It would've had to have been the bank.  I don't remember them doing so.  There was no one watching over my shoulder to tell me.  It was very frustrating because our market was so small that it couldn't support a single decent industrial/commercial broker.  My tenants had to find me.", "replies": [{"id": "goj6158", "text": "Don't listen to those dudes.  You were growing your small biz and regardless of what the 'right' answer was, you were feeling it out.  08 f'd everyone.  I'd say half the industry never dealt with it....Covid is bad, but 08 was worse.", "replies": [], "depth": 4}, {"id": "gojg92b", "text": "You \"got trapped by the fallacy of 15% cash on cash returns then financing them for 100% cash out\".  Why fallacy?  That did actually happen, didn't it?  Not a fallacy.", "replies": [], "depth": 4}], "depth": 3}, {"id": "gol8ojt", "text": "please tell me what WALT stands for.", "replies": [{"id": "gome78l", "text": "Weighted average lease term. Industrial and NNN are financial engineering plays, you need a ton of term in order to max it out.", "replies": [], "depth": 4}], "depth": 3}], "depth": 2}, {"id": "gojmo3c", "text": "Why is WALT more important for industrial versus other asset classes?", "replies": [{"id": "gomeclz", "text": "Because industrial and NNN are largely financial engineering plays when you have a ton of term to help max out value.", "replies": [], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "goizhyj", "text": "When you get other than bank financing - IE life company, cmbs, etc, then the lease term(s) need to be beyond or close to the lease term of tenants. Or you need at least to hit a 1.0x dscr with long term tenants so there isn't a hangout with coverage. Banks care less because they get full recourse.", "replies": [], "depth": 1}, {"id": "gojgo8s", "text": "You mentioned that short term leases were the problem. But was it really?  \n\nIf the lease to that big tenant was a longer term, it doesn't seem like that would've mattered.  They still went bankrupt.  Whether 10 year lease or 1 year lease.", "replies": [{"id": "gok5qi9", "text": "True, it would not matter for a tenant who declares bankruptcy and liquidates. Landlords are unsecured creditors and usually get almost nothing. However, it would have mattered with all the other leases that got non-renewed.", "replies": [], "depth": 2}], "depth": 1}, {"id": "gojoe20", "text": "Great and valuable insight from a successful developer that highlights the importance that things don\u2019t always go well! Other then lease extensions beyond 3 years, would you suggest reducing your debit to income on the commercial mortgages for the sake of a safety net for when shit hits the fan?\n\nI\u2019m 2 weeks away from acquiring a 4 million dollar commercial property for my business - 90% debt with a 10% deposit over 25 years- \n\nCurious to know if we should prioritize the monthly payment and pay more then the minimum amount or enjoy the 2.8% interest rate we are getting and ride it out", "replies": [{"id": "golz3ss", "text": "I care about my debt to equity ratio overall, not on any individual property.  Currently I am around 38%.  I would more decide what ratio are you comfortable at?   \n\nThe higher the ratio, the less prepared you are if the $hit hits the fan.  But, OTOH, you'll build vastly more wealth at a higher ratio because your percent return on your cash will be higher.  I can give you some examples if you want, but really you should have your own calculator or spreadsheet so you understand it better.  Play around with it.  \n\n2.8% interest is practically free when you calculate in the tax deduction of the interest, then it's between 1.5-2.0% net.  I would ride it out, but I am assuming you have significant assets outside of this one building.  \n\nSome of my assets I have leveraged as high as 60 or 65% but basically that number is diluted by other's which I own outright and have no leverage.  So if the 60% asset goes bad, I should be able to ride it out with the other ones.", "replies": [{"id": "goq532v", "text": "The \"Right\" leverage ratio is all about asset class and rent credit.  We buy and operate Section 8 properties, which have 20 year rent assistance contracts with the government, or LIHTC properties, which have below market rents and huge demand.  We lever up to 85-90% of value, because the risk of a loan default is really low.  \n\nOn the other hand I advise a HNW on an office investment he made and the leverage ratio there is around 75% of value.  \n\nIn the original scenario look at the debt service coverage ratio and make your choice there.  These low interest rates are leading to odd pairings of high leverage and low DSCR.  High leverage is only a problem if it means a low DSCR or if you will need to sell sometime soon.  If your 90% leverage equals 1.4 DSCR then you're probably going to weather the storm.", "replies": [{"id": "goq76sv", "text": "That's an excellent point.  I figured by posting I would learn something, and BAM, here it is.  \n\nWhat kind of market are you operating in?  Meaning, city, MSA, tertiary?  In my old home area you could probably crush it.  I have a friend who buys really cheap, remodels (and does an excellent job), and averages 20% cash on cash.  He refuses to get a loan and only grows with internal cash flow.  His market is mostly section 8.", "replies": [{"id": "goq9y7m", "text": "I'll PM you", "replies": [], "depth": 5}], "depth": 4}], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "gojx4yf", "text": "Thanks for your story, very interesting.  Would you take less $ per sf if the lease is going to be a long term, say 10+ years?", "replies": [{"id": "golimp7", "text": "Hell yes.  \n\nIn my experience with GOOD credit tenants 1-3 year leases are worth 12-15% CAP's and some are not sellable at all.  5 year or greater leases are worth 9% CAP or greater, could be up to a 6% CAP.  \n\nOne of my properties I still own I have a good public company as a tenant.  I have never gotten more than a 3 year lease.  I can't sell the building.  On the other hand, they keep resigning the lease for 1-3 years at a time since 2010.  So I've paid for the building almost twice over and cash flow is amazing.  On the other hand I can't sell the property.  \n\nIn the end I will ALWAYS take less money for a 5-10 year lease.  Just so I can sell if I wanted to.\n\nEdit:  my buildings are in terrible markets the REIT's laugh at, and most aren't even in industrial parks and most have 15-20' ceilings.  Basically, the opposite of what the best buyers are looking for.", "replies": [{"id": "gomfxfh", "text": "That's one of the great things about real estate.  You can specialize in something the big boys ignore.  Most of us can't compete on Wall Street, but there 20 thousand Main Streets.", "replies": [], "depth": 3}, {"id": "gon6j5d", "text": "&gt; my buildings are in terrible markets the REIT's laugh at,\n\nMy favorite kind of asset.  Orphans :)", "replies": [], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "gojyibu", "text": "Thanks for sharing. This is basically me (distressed industrial reposition) except I'm only a few years in with \\~250k sq ft right now. The other metrics are basically the same with some inflation. Man I struggle to get term from my big tenants. Doesn't matter if they've been in the building 10+ years etc they just won't do much term. Makes re-financing difficult. \n\nI'm now struggling with, do I kick one out and re-tenant for term while market is hot? They don't have extension options. Or limp along to keep the cash flow, knowing that when things get rough a tenant could break the lease or renegotiate anyway?\n\nIts likely I could re-tenant, have had inquiries, but it is a larger space in a smaller market so there is vacancy risk. \n\n2020 was a real eye-opener on how quickly things can change. Luckily all my tenants kept paying rent. I did end up selling off a big chunk of the industrial portfolio this past fall to harvest gains and diversify. Industrial is so hot right now, I feel like the distressed reposition play is now overpriced for the remainder of this cycle.", "replies": [{"id": "gol0m88", "text": "How large is your typical building size? Are you in primary/secondary markets? This is probably the time where not having term may work in your favor! You could certainly be more selective and push for more term with your better credit tenants and keep marking rents to market with the less creditworthy ones. I get that if you\u2019re working with 10K-25K SF buildings you may not exactly be dealing with Amazon and Walmart.\n\nWith all the capital that\u2019s flooded class A product I think there\u2019s still runway for the pricing to increase for ClassB/C product. Even with how cap rates have compressed the spreads over the 10 year are still like double where they were in \u201808. Supply, demand, and e-commerce fundamentals are still strong. \n\nI work for a bulk warehouse developer but it\u2019s interesting to see how the smaller building market dynamics are going. Hell you\u2019ve probably seen better cap rate compression that a lot of the big players getting into the distressed market years ago!", "replies": [{"id": "gol7glc", "text": "This one is tertiary, one hour outside of a growing top ten metro so definitely feeling the growth potential. The inquiries we get are users exiting the large market. Units are ~50-75k ft and the one in question is a credit tenant. With the small market, pro/con of large units: No one else has them, there's zero vacancy, but also there's no leasing volume. If the economy drops out they'll definitely sit vacant a long time. \nPart of the issue is the existing rent is a significant chunk of my cash flow (75/250k ft) and potentially losing it to find a longer term tenant adds risk. There's a bit of brinkmanship in negotiation but I haven't decided if I want to take it all the way.", "replies": [{"id": "golajzj", "text": "Definitely a different dynamic that a primary or secondary market, I guess what\u2019s working in your favor as certain tenants get priced out of the core market the leasing volume should theoretically increase.\n\nWhat would you diversify into as you sell off industrial?", "replies": [{"id": "golm8jk", "text": "That's the hope.\n\nI live in a smaller/desirable mountain town that is seeing a big surge in growth, which I think will continue post-COVID. So I put the proceeds into raw land in the path of development (residential). Reduced my cash flow but also debt.  Will have to lever back up once we get through entitlement, if I build it myself. \n\nI enjoy the distressed industrial game, very straightforward IMO, but I'm trying to stay flexible and go where the opportunities are.", "replies": [{"id": "golr2pv", "text": "Good luck! Sounds along the lines of what I want to be doing in a few years. Yeah obviously industrial might be super saturated in a few years but think there will still be opportunities to capitalize on other logistics related real estate like truck terminals and parking, especially in tertiary markets.", "replies": [], "depth": 6}], "depth": 5}], "depth": 4}], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "gon6c7s", "text": "Love your stories...I'm following you.\n\nI'm curious why you put so much emphasis on the 1 - 3 years lease issue as to 2008, et al.....I'm not seeing how a 5 year with several 5 year options in that time frame would have fared you any better?\n\nIf they failed...they aren't gonna care about the time they signed for.", "replies": [{"id": "gon6d2e", "text": "I love you both", "replies": [], "depth": 2}], "depth": 1}, {"id": "gonxgub", "text": "i started writing a reply to this that took on a life of its own so i'm gonna take a risk and post it separately so as not to seem like i'm\nhijacking your thread :) thanks for sharing your story ... maybe you will have some advice for me ?", "replies": [], "depth": 1}, {"id": "gonzhm2", "text": "Useful information, great post!\n\nKnowing what you know now, what would you have done differently? And what are you doing differently now? Diversifying a bit?", "replies": [], "depth": 1}, {"id": "gpiqk37", "text": "Was this your whole basket? We're you diversified at all? My thought process is 1/3 real estate 1/3 fixed income and 1/3 stocks.", "replies": [], "depth": 1}, {"id": "gpiqty5", "text": "I am new to commercial real estate and the rules are much different than residential. I am educating myself but some local and county governments are barriers to entry. Wanting ridiculous items like water retention ponds, surveys, soil samples etc. All of this due diligence has to be done to protect yourself but then you get close to closing and some other big ticket item comes up. \nAnyone have thoughts on dealing with government.", "replies": [{"id": "gpldozo", "text": "Lol no.  Pay to play is the name of the game.  Budget for it.", "replies": [], "depth": 2}], "depth": 1}, {"id": "gypdyjg", "text": "I started looking for a 2 acre commercial property in February 2021. I made an off on the 15th of February and I still have not purchased the land. Today is 5-19-21 and I need a land survey to move forward. That will take 3 weeks to complete. 3 months of waiting, paperwork and city council decisions. Is this a normal process for most commercial deals?", "replies": [{"id": "gypep4f", "text": "Lol yes.  \n\nI just did a storage deal.  I was brought in as the build partner.  My partners were experienced storage guys.\nWe sold it, it was a home run deal.  \n\nMy partners told me they would\u2019ve quit, a year before approvals.  It took 18 months to put all the paperwork in place.  4 months to build it.", "replies": [{"id": "i3fmiom", "text": "I ended up going in the county and had zero problem with the powers in the county. So refreshing", "replies": [], "depth": 3}], "depth": 2}], "depth": 1}]