Making it in Real Estate (Part Fourteen): The Back of a Napkin

If you begin analyzing sales packages, you will soon encounter properties with numbers so flat, returns so anemic and projections of future values so clownishly optimistic that you may despair of ever finding a decent deal.


A great deal is rarely great on the first day it is offered to you; no one consciously gives anything away in business. Because great deals are made, not born, you must analyze many properties that make little sense at their asking prices. Why? Because things have a way of changing. If his property languishes long enough on the market, a frustrated seller may become reasonable. In that hope, you underwrite his nonsensical deal today. You decide that at his ten million dollar asking price, the seller should be institutionalized for delusional insanity, but that at six million, the property might work. And then you wait. And wait. More often than not, the seller will pull his property or someone will outbid you, but if you bait enough hooks, a fish will come along.

Work listed properties, but ignore the asking prices and decide for yourself their actual values. Then follow their progress on the market, checking in with their brokers every few weeks for updates. You can, by the way, minimize luck’s outsized role in hitting the seller at exactly the right moment by staying in close contact with his broker.

If being diligent and dogged in the pursuit of deals is the yin, the yang is this: If a deal doesn’t work on the back of a napkin, it doesn’t work. If you can’t make sense of those flat numbers and anemic returns with a simple calculator, you should move on. You need only middle school arithmetic and a dash of algebra to figure out whether a deal works. If you require a quant to get you there, if you need someone to start running net present values to justify the price you want to pay today, you’re cooked.

The old trope, “Figures don’t lie and liars don’t figure,” is about half-right and the right half is about half-misleading. Liars do figure; it’s that most are spectacularly bad at it, only plotting a move or two in advance when ten are required. Numbers are honest in their way—faithfully performing whatever mathematical gymnastics you wish—but they can, when underpinned by negligent or fraudulent assumptions, tell the most convincing lies. Figures may not lie, but their assumptions do.

Bad assumptions are myriad, but real estate has its perennial favorites: A listed property’s rents will rise by say five percent a year in the future while its expenses remain fixed; a buyer will be able to terminate a below-market, long-term lease for nearly nothing; space that hasn’t been occupied since the French Revolution will rent within six months after closing; and, because of the property’s unique characteristics, it will out-perform its overall market’s vacancy and rental rates.

One false assumption seems at first blush not only benign but reasonable: namely, that land has an intrinsic value. It doesn’t. This is worth remembering well: Whether raw or improved, land has no innate value. Rather, it has a cost. Even with an empty field, you reap property taxes, liability insurance and periodic fire prevention measures. Land’s only economic value is the income it receives after the costs required to produce that income are paid. If your development pro forma starts out with the seller’s value for his land, you may get there, but likely only by accident. As likely, your equation won’t work because that land value will drive your return through the floor.

Properly viewed, the land value is what you are solving for with your pro forma. You could show a seller that all of the other variables in your equation—save one—are third-party, verifiable costs not subject to much negotiation. If you’re going to build a project on the farmer’s favorite corner, you know what your construction, financing, permit and leasing costs will be and you should know the rents you will achieve. The one variable subject to negotiation is the return on investment you are seeking. If, after some back and forth, the farmer ultimately concedes that your return should be fair and let’s say seven percent (I have yet to meet such a farmer), then his land value will follow automatically when you plug in the other variables in your formula. Whether the farmer himself follows is another question.

Coincidentally, this last point is a great advertisement for dealing with smart, sophisticated sellers, better yet, with developers themselves. As tough as they may be—you will never steal a property from them—they understand math and the realities of real estate development and they will ultimately acquiesce to a fair deal. Farmers, trust fund babies, and school boards do not have this understanding. Instead, they know an acre across town sold for thirty dollars a square foot five years ago, and they want thirty dollars a square foot for their twenty acres now.

In sum, pursue deals hard, but keep them on a napkin.