Risky Business

how real estate can get extra expensive

There are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns—the ones we don't know we don't know.

Donald Rumsfeld

I once found myself at a Chuck E. Cheese. A horrid place - with all the clanging and masked despair of a budget casino - but filled with screaming kids instead of sullen geriatrics. It was a place I knew should be avoided, but my son needed a ride home from a birthday party and he was ten years shy of driving himself.

After pleasantries with the oddball host parents, I went to fetch my child. If you’ve ever seen someone trying to gather a chicken, that was the scene. Even my stern voice couldn’t corral him and he scurried behind and over the climbing set and leapt into the ball pit.

His giggling kept pace with my rising annoyance and I just missed grabbing his ankle as he made it to the hamster tubes criss-crossing the ceiling. I twisted myself into the tube intent on his immediate removal and as I squeezed to the top I got a view of the entire tube. And I’ll never be the same.

Imagine the open sewers of Mumbai’s Dharavi slums. What I saw was an attempted re-creation, but in suburban Atlanta.

My son sat at the far end of the tube and, suppressing my nausea, I coaxed him back over the discarded diapers that littered the tube.

I assume cleaning the tubes is on a checklist somewhere, handled with skillful neglect by an angst-ridden teenage shift manager. I didn’t even think to consider that somehow freedom-seeking children would use the indoor playground as a place to remove their diapers.

Unknown unknowns.

Risk lies in the unknowns.

The known unknowns can be mitigated with any number of tools: things like interest rate caps, title insurance, phase 2 environmental inspections, and guaranteed max construction contracts. But they’re not foolproof.

I once participated in a development located in an area of Kentucky known to have underground caves. In an abundance of caution, our geotechnical engineer suggested 200 borings to make sure it was safe to build on, and fortunately no caves were identified.

Unfortunately, a D9 bulldozer plummeted into a 20' hole when site work began. No one was hurt (except my share of a profit) and with further testing we later determined a cave system snaked its way under the property avoiding each and every one of the 200 soil borings. We learned absence of evidence is not evidence of absence, but this was a known unknown. We knew caves could be present, although it took some excitement to find them.

The unknown unknowns, however, are what make the real estateur’s life interesting:

• An Atlanta property manager spent years making clandestine short term loans, using rent collections to fund the loans and collecting the principal and pocketing the interest before closing the books each month, creating an unknown unknown risk for his clients.

• We purchased a long-vacant urban property only to learn later the sewer line didn’t connect to the city’s main sewer line.

• A friend granted a developer the right to attempt a rezoning on his family’s property. A lawsuit later ensued between the developer and the local municipality, and a change in the law allowed the municipality to downzone the property to a far less favorable classification, resulting in a value that was 40% of where the exercise started.

• A local shopping center operator, at odds with his out-of-state partners and miffed because the financial structure kept him from sharing in the cash flow, set up a booting operation, handcuffing cars and collecting over $300k per year in cash. The partners never knew - all they saw was a dwindling rent roll and poor tenant sales.

• A partner of ours with a wonderful home in San Francisco’s Pacific Heights returned home to find the giant Monterey Cypress trees that lined his back fence had gone missing. The dramatic loss of value was due to his tech-zillionaire neighbor deciding to improve his view of the bay by taking a “sue me” approach.

Risk is a nasty pickpocket waiting to pounce. It takes all sorts of forms - like the unidentified corrugated metal pipe rusting under the building foundation, or the unknown encroaching plume of perchloroethylene from the closed dry cleaner around the corner.

There's obsolescence risk: two screen movie theaters became eight screens and then 24 screens and then dine-in and then, irrelevant.

There's re-tenanting risk - tenants come and go and the law firm may decide they want the groovy creative office and not the traditional high rise - and then no office at all. Chick Fil-A now wants larger suburban land sites, Microsoft now wants less sites.

Like demand, tenant credit changes and carries a risk - think of the "conservative" investor who purchased (prior to the Great Financial Crisis) a Canary Wharf office building leased to Lehman Brothers, and for full belt and suspenders protection, also purchased a separate lease guarantee policy provided by AIG.

Real estate ownership entities carry risk - we’re betting our partners behave as expected and our lender does what they've agreed. Lawsuits happen - slip & falls, falling trees, any reason, no reason. Insurance helps but there's still holes where the money slips out.

We create detailed financial models to quantify our odds on revenue, expenses, and capital expenditures, but there's not a line item for pandemics or war or rising water levels or loss of water.

Then there's the second order risks - maybe we allowed for ‘work from home’ but did we also allow for the lost retail sales at the lobby sandwich shop?

The unknown unknowns are real, but there's also risk in not taking risk - sideline sitting can be expensive. Screwy things happen; the real estateur embraces that idea - recognizing known and unknown risks and being structured both stay alive and thrive with the unexpected. Risk is real and everywhere, becoming hard to kill allows us to benefit from it.

If you’re reading this, you’re probably interested in real estate.

If you’re interested in creating wonderful places, and how those places can increase surrounding real estate values, consider joining the Tacos & Patios Workshop - a free online gathering where we unpack the how and why behind unique mixed-use developments.

Join now and get a recording of the last meeting, a workshop with Casey Lynch, CEO of Roundhouse, one of our country’s most talented multifamily developers, where we discuss how a singular pizza shop changed the trajectory of his company.

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