More Thoughts About Value Creation – Melding Narrow and Broad Thinking

This is going to get really philosophical (even for the Real Estate Philosopher) so please stay with me – it is mercifully short, but very important…..

In earlier articles I have argued the value of trying to “own” a smaller niche in order to have the ability to create value within that niche. The value is created by the “power” you obtain within your niche by the confluence of knowledge, intellectual capital, experience, expertise and, of critical importance, relationships with key players in the niche. I have been recently calling these niches “Power Niches” to elucidate the “power” that comes from working in this manner.

Anyway, the “power” in the Power Niche comes from the small-size of the niche and your ability to achieve ownership within it. This makes evident that narrowing the focus is the key to success. However, as I think (philosophize) I have concluded that this is not the whole story and indeed focusing only narrowly can be self-limiting.

My thinking has evolved by adding to the mix that your ability to think of new and creative – even brilliant – ideas within your Power Niche is enhanced if you become exposed to the creative and brilliant ideas that others have thought of in other niches. This creates the optimal mixture of narrow and broad thinking that is critical for the genesis of ideas to create value.

I have noticed this in just The Real Estate Philosopher itself. Indeed, the great thinker Peter Drucker is not really known that much in the real estate industry, or the law industry in which I practice; however, he has given me numerous ideas for my law business and this publication. And other great thinkers I read about outside the industry regularly give me ideas as well. So does reading Fortune, which often profiles the reasons that some companies are great successes – or great failures. Indeed, it is one of the easiest ways to become more knowledgeable and “powerful” within your Power Niche by reading, learning and thinking outside the Power Niche.

This is very true in the legal industry. My close friend for many years, Jay Bernstein, is a real estate capital markets lawyer at the magic circle law firm Clifford Chance. He is known for creative outside-the-box solutions to client problems that have never been solved before. Part of Jay’s (secret?) is that he calls not only on his own brain but also on the brains of colleagues in different disciplines at Clifford Chance. Putting these different areas of expertise together often yields a creative solution that no one within a specific discipline could have found alone.

And I see it myself, in that my eclectic legal career history – that includes bankruptcy, litigation, securitization, corporate M&A, leveraged buyouts, entertainment and movie law, and much more – often enables me to approach legal problems in the real estate world that I would not otherwise be able to solve.

All of this somewhat contradicts my earlier writings that the best way to be successful is to be the top dog in a small niche. I acknowledge this by saying the following to sum up my (somewhat revised) hypothesis:

Optimal value creation – in the real estate world, and in other worlds as well – is achieved by obtaining ownership of a Power Niche (which is a narrow focus), and then augmenting the power of the Power Niche by gaining knowledge of as many disparate different disciplines as possible (which is a broad focus) and applying what you learn into the Power Niche. So “narrow and broad” together is the magic formula.

Ultimately, knowledge of disparate areas permits outside-the-box thinking in the area you are trying to think in.

Could it be proved that I am right here? I don’t know. It “feels” right to me and I keep seeing evidence of it. However, I guess you can’t prove something like this. But it certainly has been working for me.

Three Words That Might Change How You Look At The Real Estate World

I will get right to it – here are the three words:

“Competition is Evil”

Competition is a truly horrible and terrible thing and should be avoided at all costs! All competition does is destroy your profitability, as we all no doubt remember from our first year economics course in college. Indeed theoretical “perfect competition” reduces everyone’s profits to zero.

The goal in a real estate business – indeed in any business – should not be to “compete” with your “competition” but to do something different.

I didn’t make this up. This comes from just about every deep thinker in the business world:

Peter Thiel, who started PayPal and is now a Stanford professor, gets credit for coining the above phrase – and I heartily recommend his book Zero to One, which delves deeper into his thinking.

The late Peter Drucker, who I mentioned in my first article, and will no doubt quote again as he is one of my personal heroes, says one of the two most critical things for a business to do is to “innovate”, which is the essence of avoiding competition, as the whole concept of innovation is something new and different.

Michael Porter, the Harvard Professor and guru of competitive analysis, says that the biggest mistake businesses make is “trying to be the best” and beating their competition. Instead, he advises, the goal should be to create something new and therefore create value for your business. Indeed, as Porter points out, if you become “better” than your competition, all this (usually) means is that your customers, employees or other parties in the industry benefit, as opposed to your business benefiting. His definition of competitive advantage is instructive:

“Competitive advantage depends on offering a unique value proposition delivered by a tailored value chain, involving trade-offs different from those of rivals, and where there is a fit among numerous activities that become mutually reinforcing.”

Note the key words “unique” and “tailored value chain” and “trade-offs different from those of rivals”.

Seth Godin, who is a more eclectic, but in my view also a brilliant thinker, writes an excellent and easy-to-read book called Purple Cow, which emphasizes a different variant of the same thing; namely, how important it is to STAND OUT, like a purple cow would stand out, as opposed to fitting in and being forgotten.

And there are other books I have read as well by brilliant and creative thinkers. They all say versions of the same thing; namely, that it is more critical to be different than it is to be better.

So I urge you to sit down – with a bottle of single malt scotch (if you have my taste in liquor) – have a couple of snifters – turn off your iPhone or other machinery – and have a good look around at what you are doing in the real estate world. Consider:

  • Are you doing what others are doing?

  • Is your day spent trying to figure out how to be “better” than others?

  • Is what you are doing “different” than others somehow – possibly in the way you do business, the way you treat and incentivize employees, in what you offer to customers, in how you build your product, in how you use technology, in how you lend out money, in how you invest money, or in any other way? Or is your entire business exactly like someone else’s?

  • How much of your time spent on analyzing your business strategy is spent on thinking about macro things that are really in the nature of trying to time the market or the cycle with your crystal ball?

  • How much of your free time is spent thinking about how to be different?

  • Have you read any of the books I have mentioned above?

If the answers to the above questions lead you to the view that you aren’t really trying to be different and instead you are trying to do things better, then my guess is that on a risk-adjusted basis, your returns are more like to be average than to out-perform.

Gorging on Leverage Always A Dumb Idea?

Heresy – according to a dictionary I found on-line, is a word that means

Any belief or theory that is strongly at variance with established beliefs, customs, etc.

I think it has become heresy to advocate a lot of leverage – at least for “conservative investors” in investment funds. But I am going to do exactly that, at least in part.

Hopefully you will at least hear me out before you stop reading. By the way, many years ago, I was a math major although I admit I can’t remember anything about it.

This article has two parts. First, there is the kind-of obvious part of my analysis, for which I suspect most people will agree with me. And second there is the more subtle thinking, which I suspect is more thought-provoking and subject to more disagreement.

First – the obvious thought process:

Let’s say you bought a property about three years ago for $50,000,000 and it is now worth $75,000,000.

Let’s say that when you bought it you took out “conservative” 60% leverage of $30,000,000. This means you wrote a check for $20,000,000.

Let’s say the property is in a stable type of asset – e.g. multifamily – where the cash flow is unlikely to be lumpy over a long period of time.

Let’s say that you intend to hold the property for a total of roughly 5 to 7 years and you are hoping for future additional appreciation.

Let’s say that there is long-term debt (e.g. 10 years or even 30 years) available at historically low fixed interest rates – and in some instances 85% (and maybe even 90%) leverage is also available.

Let’s say you are a conservative investor type who generally believes leverage over 60% is “too much”.

In this instance, I think the conclusion that leverage should be limited to 60% should be challenged. Please consider the risk/reward of taking the following action:

Right now, leverage up the investment to 85%.

This returns to you $63,750,000 (less the $30,000,000 you borrowed) = $33,750,000.

You invested $20,000,000 at the beginning so you now have all your capital back plus $13,750,000.

You now still own the asset – albeit with high leverage on it – but at a low interest rate – and your debt doesn’t come due for a long time. My belief (explained below) is that, for an asset without lumpy cash flow, lower leverage with a shorter maturity is actually more risky than higher leverage with a longer maturity – so you have actually lowered your risk by the foregoing actions. But either way this is relatively moot since you just took out all the money you invested anyway.

You might be concerned about prepayment penalties for long-term debt; however, if interest rates rise prepayment penalty risk is not really that big a concern – and if interest rates fall then you will probably obtain more upside from property appreciation than you will lose from a prepayment penalty. Also, you can – and should – mitigate the prepayment risk by negotiating assumability for the loan and the ability for the buyer to put on mezz debt or preferred equity (admittedly difficult to negotiate at times), so hopefully there will not be a need to prepay in the first place.

If all this can be done, then isn’t this too good to be true? Shouldn’t you in fact take the long-term cheap money and the highest leverage possible as long as this market anomaly (i.e. interest rates below long-term norms) exists?

Of course I made up these numbers, but even if the numbers are a lot worse, it would seem that if your asset is of the type that permits long-term leverage on these terms you might consider the above proposition and run the numbers. I already admitted (above) that I can’t do the math myself anymore; however, my former-math-major brain believes that this will enhance your IRR’s quite a bit in some situations.

Second – the more subtle thinking:

Now let’s continue to assume you are a “conservative” investor, i.e. someone who wants to be “conservative” in the use of leverage. Let’s play around with what this means.

Generally, this means that you don’t use a lot of leverage right? But why not? In the not-sorecent-any-more Global Financial Crisis, what happened? My general view is the following:

Those who were conservative in the years leading up to the Financial Crisis did worse than those who were aggressive. This is because those who were aggressive (obtaining, say, 90% leverage), by definition, made more upside as the market rose than those who were conservative (obtaining say 65% leverage).

Then when the Financial Crisis hit property values generally dropping – in the short run – anecdotally about 35% or even more. And even math-challenged people know what this means – it means, alas, that both the conservative guy and risk-prone gunslinger were wiped out. Sadly, in the end there was no reward given to those who were more conservative. Each ended up with nothing.

But look at my preceding paragraph – there are two words there that I deliberately didn’t emphasize but I think tell the real story. Those are the words “short run”! What happened after the “short run” ended? After the short run ended prices bounced back up and in only a few years for many asset classes prices had risen to the same, or even a higher level, than before the Financial Crisis.

What does this tell us? I will tell you what it tells me. It is that (for non-lumpy cash flow assets) there is a lot more “risk” in short-term debt than there is in high loan to value ratios. Those who had long-term debt in place before the Financial Crisis had only “paper losses” and if they waited a year or two or three were just fine. Those who had short term debt, and unforgiving lenders, faced disaster.

So if I am not crazy – which of course I myself cannot be sure about – it looks to me that investors looking to manage their risk in the context of leverage should be looking at maturity at least as much, and maybe more, than loan to value.

To conclude:

I am probably overstating my points here a bit to make a point, but my points are as follows:

If you own significantly appreciated property — with non-lumpy cash flow – with high leverage available – that can be long-term in nature, then take out as much as you can, and negotiate to preserve your ability to (i) transfer the property subject to the debt and (ii) put mezzanine debt or preferred equity in place.

If you are buying new property, don’t limit yourself to a “rule” that you “always” have to limit leverage to, say, 65% of loan to cost; instead, for property that does not have lumpy cash flow, consider raising the percentage of leverage and lengthening the maturity and, again, negotiate to preserve your ability to (i) transfer the property subject to the debt and (ii) put mezzanine debt or preferred equity in place.

None of us has an actual crystal ball of course; however, my sense is that the above courses of action are destined to increase your likelihood of obtaining higher IRR’s in markets that go up and down with frequency.

Finally, if you think I am missing something in this analysis I would certainly like to hear about it.

Porter’s Five Forces in the Real Estate World

Michael Porter is a professor at Harvard Business School. He has spent his long career analyzing strategy and competition. His analysis is exceptional and probably just about everyone in the business world knows all about him; however, I have never seen his theories applied to the real estate world.

The most interesting thing about Porter’s work, at least to me, was his admonition that the goal should “not” be to “compete” with one’s competitors, as all this really does is give away your upside to your customers, employees, suppliers and other parties (e.g., competing on price just helps the customer). Instead, the smartest thing is to do something “different” from your competitors. Indeed, asked what the biggest mistake companies (and those leading them) make, Porter’s response is exactly that: Companies trying to beat their competition when the goal should instead be to extract as much “value” as they can out of their industry.

Porter, after many years of thought and analysis, concluded that there are five forces that dictate the competitive situation in an industry. In a nutshell, and generally speaking, when these forces are strong, it is kind of rough to be a player in the industry, and when these forces are weak, it is great times.

As the managing partner of a New York real estate law firm, I have performed this analysis for my firm and have found it to be quite helpful. Indeed, the sine qua non of my law firm is to try to be different from other law firms by becoming a top player in the real estate niche, rather than trying to be all things to all people. Instead, my firm focuses “only” on real estate; hence, our brand as The Pure Play in Real Estate Law.

I am now going to do my best to illustrate how one might do this for an “industry” that is part of the real estate world.

Also, I would like to emphasize that this is not pointless philosophizing, as I would think that anyone considering entering an area within the real estate industry, or considering a project in an area of the real estate industry, should logically do exactly this analysis.

Before one can get to an analysis of the five forces within an “industry”, one has to define what “industry” it is that one is analyzing, and that is not as easy as it might seem. I mean, is the industry to be analyzed:

All real estate in the world?

Of course not. Is it then:

All real estate in, say, New York City?

Still kind of too broad, so maybe:

Building housing in New York City?

I think still too broad, so how about

Building condominiums in New York City?

Even that may be too broad as most people think there are three submarkets consisting of relatively affordable, medium range, and super high-end luxury, so how about:

Building super high-end luxury condominiums in New York City?

That sounds kind of reasonable to me as an industry for analysis, so let’s go with that for purposes of this article; however, as I hope is relatively obvious, an “industry” could consist of innumerable concepts including those based on geography, product type, way of doing business (locally, nationally or internationally), deal structure, new economy, etc. There are always innumerable ways to define the industry one is analyzing and it is easy to get bollixed up and diverted or to fool yourself in this analysis; however, for the conclusions to have any use this is critical to do. I deliberately picked a relatively easy industry concept for purposes of this article.

So now let us embark on our analysis of the Five Forces as applied to the industry that is the building and selling of super high-end luxury condominiums in New York City.

If you have been wondering, here are the Five Forces, which I will go through one by one to reach a conclusion as to whether the competitive forces are low, medium or high:

  • Competitive Rivalry

  • Threat of New Entrants

  • Threat of Substitutes

  • Bargaining Power of Buyers

  • Bargaining Power of Suppliers

Competitive Rivalry: This one seems to be quite high. There is a ton of competitive rivalry right now. There are quite a few players building and selling super high-end luxury condominiums in New York City.

Threat of New Entrants: This one seems to be relatively low or at best medium. It is not so easy for someone to just go out and build a super high-end luxury condominium in New York City. There are innumerable regulations and other obligations to be dealt with. Plus the reputation of the party building the condominiums has a great deal to do with a project’s success, which is a further barrier to a new entrant. Accordingly, a new player will have a great deal of trouble just moving into this industry.

Threat of Substitutes: This one seems to be quite low. It is difficult to come up with a substitute to this product as there is only one New York City. One could argue that living in Brooklyn is a “substitute”, and there is a slight element of that; however, overall I would say this threat is a low one in view of how we have defined the industry. Another possible “substitute” could be renting instead of buying; however, that also doesn’t seem quite applicable at the top end of the luxury market.

Bargaining Power of Buyers: Of course this fluctuates, but right now the bargaining power of buyers seems pretty high as there seems to be more super high-end luxury condominiums than buyers. The obvious difficulty in analyzing an industry such as building and selling super highend luxury condominiums, that makes the risk/reward perspective so much worse, is that you are not selling your product right now but in the future when you don’t know what the bargaining power of buyers will be. To be safe, even in a time of a shortage of luxury high-end apartments, you would have to assume the bargaining power of buyers is high even at times when it isn’t.

Bargaining Power of Suppliers: This one seems to be very high as well since one of the problems in making a profit in this market is it is taking longer to obtain the necessary supplies, plus the pricing has risen for these supplies. Indeed, workers, to my mind, are also technically suppliers too; and, due to the construction boom, the cost of workers is much higher.

So to sum up:

Competitive Rivalry: High
Threat of New Entrants: Low/Medium
Threat of Substitutes: Low
Bargaining Power of Buyers: High
Bargaining Power of Suppliers: High

Looking at the above it seems that overall the Five Forces are pretty strong in the super high-end luxury condominium industry in New York City. This would mean that it is (probably?) not the best industry to go into right now because it will be more difficult to make a profit

So this is a very quick and dirty analysis of how one might apply Porter’s Five Forces to the real estate world. I did it very fast here and without a ton of depth as my goal was to illustrate rather than dive into a deep analysis.

To sum up, and hopefully make this article useful to you in your real estate business, the way to apply Porter’s Five Forces is as follows:

First – figure out what “industry” you are in or are you would like to move into. This should not be quick and dirty. You really want to spend a lot of time on this as there are many subtleties and you can end up with the right or wrong results just by how you define the industry. It is actually the most difficult part of the analysis. For example, is Ford Motor Company in the “car business” or is it in the business of “transporting people.” And are you in the business of building buildings for people in a certain market or in the business of providing a lifestyle for people. You could see a lot of difference in analysis and results depending on this.

Second – go through the five forces and analyze each one as it applies to your industry.

Third – be honest with yourself about the application of these Five Forces to your plans and take these Five Forces into account in planning your actions. Of course, this is not the whole story, and a possible problem for Porter’s analysis is likely the cyclical nature of the real estate markets that you have to adjust for (i.e. the Five Forces may change a great deal from the day you start a project until the day it is ready to be sold). However, overall the goal with the Five Forces is to permit you to make a more informed decision whether to go into a market deeper or possibly to get out.

In my next article, I am going to work further with Professor Porter’s works and apply his definition of competitive advantage to the real estate world. To get you excited about my next article, I will give you his definition, which I find incredibly insightful:

Competitive advantage depends on offering a unique value proposition delivered by a tailored value chain, involving trade-offs different from those of rivals, and where there is a fit among numerous activities that become mutually reinforcing.

A Special Idea to Create Value in Real Estate

I was going to have this article be about applying Porter’s Five Forces to the real estate world. That will be a great article when I write it; however, A very interesting value-creating idea just struck me this beautiful afternoon in New Jersey, and I thought I would sneak this idea in first through this (very short) article.

If you will hearken back to my first article:

Using Drucker to “create” customers by marketing and innovation.

And then my second article:

Creating value by amassing intellectual capital in, and ownership of, small-sized niches.

As an outgrowth of both of these articles, I suggest that a great untapped market for creating value in real estate is through developing expertise in operating businesses that have real estate as a major component.

There are obvious candidates such as hotels, retailers that own real estate (and spin it off and turn it into REIT’s), and things of that nature. These are easy and obvious examples. And these are of course fields well-plowed so I doubt you can do what I advocate here. If you are a hotel expert, you are hardly unique enough anymore. What I urge here is picking smaller niches and using the theories I espoused in my prior two articles to create special real estate value in these niches in which you develop significant intellectual capital.

Some examples – I could think of off the top of my head — are: amusement parks (small and large), garages, restaurants (and other related things like beer gardens), retail space that is just too large and could be turned into operating businesses (consider bazaars, farmers markets, specialty markets, pop-up stores), co-working space (a perfect example of this), shopping center owners with multiple locations creating almost private label brands by backing start-up retailers, urban for-profit schools, etc. There are probably an almost infinite number of ideas here.

Then follow the thinking outlined in my prior articles to create the necessary intellectual capital by learning everything possible about the operating business. Once you have achieved this, you have a powerful competitive advantage as you are the only one (yes, the only one!) who now understands both real estate and the subject operating business. As we all know, knowledge is power, and this power gives you a great advantage in buying, investing, operating, selling, financing and – of course – creating value.

Is this easy? Of course not. But what choice does everyone have? One thing that the internet has done is taken away the easy pickings, since everyone knows everything at the same time. Anything that is simple isn’t going to be a value creator because everyone will see the same things and bid the price to a point where the risk and reward equilibrate, so the best you can do is perform “average”. The goal now has to be to create intellectual capital that only you have and the only way to do that is by creating that capital between your own ears by learning and thinking and creating.

Creating Value in the Real Estate World

In my wanderings and discussions with clients and other friends in the real estate world, I hear many different plans from many different people. Many plans are of course brilliant and well executed; however, I do see a perennial fundamental flaw in many plans that I would like to talk about. Here is my thinking……

I believe that in just about every really promising real estate deal – or real estate platform – there is a party that “creates value.” Obviously this is more pronounced and obvious in a project that is architecturally and aesthetically beautiful and different or in a cutting edge project in a different location, but it is also true in the most mundane of transactions as well. There is someone that has brought some “value” to the deal or to the process. The trick in a good business plan (for a deal or a company) is to be that person on a consistent basis.

I don’t know if others look at things this way; however, I get a sense that typically lenders, fund managers, insurance companies, sovereign wealth funds, family offices and other providers of capital (collectively, “Capital Providers”) give this “value creation” away to developers, owners, sponsors and brokers (collectively, “Sponsor Parties”) without really thinking about this concept. Also, my sense is the Sponsor Parties sometimes go into business without thinking deeply about how they might set themselves up to really create value that they can bring to Capital Providers.

Consider what typically happens vis a vis the Capital Providers. Toby (a metaphor), who works for the Capital Provider sits in his/her office and waits for possible deals to roll in. Toby is a great marketer and knows how to create deal flow. He knows that the key rule is to get out and about with people, build relationships, and try to make deals work and do great and careful underwriting. But there is one thing Toby is not (typically) doing, which is “creating” the “value” in the deal. Instead, he is in the “reactive” seat, and waiting for the “proactive” Sponsor Parties to create the deals to be sent to Toby for evaluation.

Why is he doing that? I don’t think there is a good reason. I think it happens this way largely due to inertia, and the fact that that is just the way everyone typically does business. But, I think that there is really no reason why Toby can’t create deal value himself. Let me give an outline of an idea:

Let’s say you are the CEO of a Capital Provider (say, “Smith Capital”) which is a $1B opportunity private equity fund that invests in deals of all types in the U.S. Sponsor Parties solicit Smith Capital with deals it might invest in and Smith Capital analyzes hundreds of these deals every year, does solid underwriting, and then narrows them down to about twenty deals it tries to do, of which let’s say five actually close.

In all of these deals – alas – Smith Capital has competition from other Capital Providers. Maybe these other Capital Providers are more eager – or dumber – or whatever – so they offer better terms than Smith Capital is willing to offer so Smith Capital doesn’t get the deal or its pricing (and hence its risk/reward) gets worse. Of course this will likely end up being the case since the Sponsor Providers have provided the “value” that Smith Capital and its competition are bidding for.

How about instead you ask your acquisitions guy – Toby – to pick a specialty area to become a major expert in? And I don’t mean a big area that is in the typical real estate food groups (like retail, multifamily, etc.) but a much smaller niche, like, say, garages, golf courses, co-working space, or another much smaller niche — the thinking here being that the niche has to be small enough that Smith Capital can dominate it.

As an aside, the niche should be somewhat creative. For example, a purely geographic niche sounds interesting but doesn’t last very long. As soon as others realize a location is undervalued, the prices get bid up. Of course, the first player can do well, but usually it is very hard to be sure that when you get in on the ground floor in a geographic location whether the overall market will really rise or not; accordingly, the risk/reward is not necessarily easy to evaluate.

As a metaphor for this niche idea for Smith Capital and Toby, let’s pick parking garages as the example.

Now, what Toby does is the following: He reads everything possible about garages. He finds out who are the major players, costs, advantages, disadvantages, and little known facts (like what local fire departments say about different garage types). He has a gaggle of Google alerts from all sorts of angles on garages. He gets the garage trade publications. He tells everyone about it – both internally at Smith Capital – and externally too. He then ramps it up by going to garage conferences. He goes out and meets the owners and developers of garage companies. After just a few months Toby is Toby the Parking Garage Man! He knows everyone and everything. He has relationships. He has strong and coherent ideas about how to invest – including what to avoid — and is now able to apply this knowledge to create “value” in deals. He knows the REIT issues that pertain to garages – he knows the operational issues – he knows (personally) all the good operators – and most importantly he knows the risks.

His presence now is an upgrade to the “value” that Smith Capital can provide because third parties start thinking that if there is a garage as a significant portion of their deal then maybe Smith Capital should be called to be involved, as they could provide some “value’ due to the intellectual capital that Toby has developed pertaining to garages.

Maybe lenders will like Smith Capital in the deal, since lenders are more concerned nowadays than ever about the talent in the equity that they lend to. Indeed, possibly (dare I say), the lender might even recommend to the Sponsor Provider that Smith Capital would be a great co-investor in the deal due to its expertise. Maybe even the Sponsor Party (who usually struts around, since he holds the “value” cards) isn’t quite as cool anymore because Smith Capital can enhance the upside of the deal pertaining to the garage adjunct. Also, maybe Smith Capital has relationships that can be mined to help the garage part of the deal get better.

Eventually Smith Capital starts to be a major player in the garage space. They know everyone and everything. Everyone comes to them for advice and they are the first stop – and the last stop – for proposed deals that have garages in them.

To end the story, instead of Smith Capital giving away the value creation to the Sponsor, it is Smith Capital now creating at least part of the value and upside, which means that Smith Capital can negotiate much better terms with the Sponsor Party.

By the way, I know I directed this article at Capital Providers; however, that is just serendipitous, since my thinking is exactly the same for Sponsor Parties. In order to be able to demand good and strong terms, Sponsor Parties should do the exact same thing; namely, develop niche-type expertise that they can use to create value.

So I hope I have made my point here. To conclude:

If you are a Sponsor Party or a Capital Provider, I propose that the name of the game is figuring out where the value will be created in the real estate deals you are seeking, and then set yourself to really “proactively” create that value, rather than “reactively” wait for someone else to create it and bring it to you. And the way to do that is by using your assets – the brains of your team – to create intellectual capital in small-sized niches that you can own.

Peter Drucker: Creating Customers

Peter Drucker – one of the great intellectual thinkers of the twentieth and twenty-first centuries – asks a question: “What is the purpose of a business?”

Have you ever stopped to ask yourself that question? Or, perhaps more importantly, have you ever asked yourself what is the purpose of “your” business?

As I was reading Drucker, I stopped to think and see if I could answer this question myself for my law firm. The obvious answers seemed to be: to make a profit, to build a brand, to serve society or maybe to do good things for my employees or to make my customers happy or something like that.

Drucker; however, says simply:

“To create a customer (emphasis added)”

Wow – when you hear that, it zings doesn’t it – you aren’t just going out to get customers – you are creating them……and that is your true purpose!!!

Drucker goes on to say that there are only two things that every business MUST do. Everything else is white noise. If you do these two things you have a chance at great success and if you don’t, then most of the time the converse.

Can you think of what they are? I couldn’t till he told me – the two things are very simple:

To innovate
And to market

I remember reading all of this and feeling like I had been struck. Of course!!!!

If you don’t innovate, then you are selling what everyone else is selling and you have no pricing power. By the laws of perfect competition, your pricing power erodes as you are effectively selling a commodity.

And if you don’t market the product, then people not only don’t know about it but they also don’t know why they should want it.

If you really spend a moment and think about all of this it is both exciting and liberating at the same time – it is so simple – to succeed in the business world you just keep in mind that the “purpose” of your business is to “create” customers and the way you do this is by “innovating” and “marketing”.

That’s the whole ballgame.

Heady stuff isn’t it – this Drucker guy?

Consider Apple for a moment. What would Wozniak have done without Jobs? He would have tinkered and tinkered till someone stole or used what he did, or employed him, or until the industry just moved past him.

And what would Jobs have done without Wozniak? What would he have had to sell? Nothing at all.

They were the ultimate people in innovating and marketing.

And talk about creating customers. No one did that better than Jobs. I truly love his incredible statement:

“Don’t give the customers what they want – show the customers what they should want!”

So – as you read this – I ask you – do you have as your purpose “creating” customers – and are you “innovating and marketing” to do it?

Let me take you a little deeper and try to apply this to the real estate world.

I will start with applying this thinking to my (lawyer/law firm) business and then applying it to your (real estate) business.

My law firm is a 70 lawyer law firm in midtown Manhattan, which focuses on real estate.

If I were trying to attract a client to my firm I could say we are really good lawyers – I could even say we were really great lawyers – but would that do much to attract a client to my firm? I sincerely doubt it. People would nod off since they have all have heard that before. Indeed I have met many people before, who say things like “Don’t give me the usual stuff – tell me how you are different”.

So what if I said instead that we are a pure play in real estate law – unlike all other law firms, shunning other lines of business – in order to achieve the top status in our niche? And we have a mission statement to add value to our clients by doing more than just legal work – instead, we also work to build their businesses by making connections and thinking of ideas and structures for them – and that our clients simply love this as it really helps them in ways other law firms cannot and do not.

So am I creating customers here? I think I am. It used to be that clients went to lawyers just for legal advice and assistance in closing deals or handling litigations. Did they think they needed a law firm with a mission to help clients build their businesses? I don’t think they knew that. I think my clients know that now and they really love the special value we create for them because they tell us this flat out all the time. I think we created customers here.

So now let’s apply this thinking to the real estate business.

Imagine a row of buildings with identical products for rent – i.e. a row of gleaming “new” office buildings along the street – all the same – and all beautiful and pristine.


It’s all beautiful – and it’s all perfect – and it’s all the “same” as everything else. No customers are “created”. They are everyone’s customers just shopping among identical products. And all an intelligent customer has to do is walk down the street and ask each landlord who will rent them space for the lowest price. And pretty soon someone will put that on the internet and they won’t even have to walk down the street.

So the only thing helping – or hurting – the landlord is the market going up or down. And good luck trying to time the market. Sometimes you nail it and sometimes you don’t. I would hate to be in a business that the only thing separating me from success or failure is my crystal ball that tells me that the future demand for rental space in New York will go up or down.

So now let me give you an innovation I have thought of that I think, if properly marketed, could create some real live customers. I admit that this topic was the subject of one of my speeches a few years ago, and if you heard that, hopefully you won’t mind too much.

I picked office leasing, probably for the reason that it is sometimes maybe thought of as one of the less innovative parts of the real estate world (I don’t agree with that thought by the way). My reason is to make a point that innovations can come up anywhere.

It seems like until about five-ish years ago landlords just leased space to tenants and relied upon tried and true things like:

The location of the property – of course
The niceness of the building

And, then, all of the sudden, all these cool ideas blasted onto the scene. Things like: picking one (cool) tenant like Google to attract other tech companies to be nearby – shared space for multiple parties – exchanges where people of all kinds integrate – incubators – temporary space – co- working facilities — popup stores – and all sorts of “stuff” started to happen. The landlords who were at the head of these trends – i.e. the innovators – took a part of the city that was kind of humdrum (Park Avenue South) and turned it into the hottest part of the city. Rents went up – and the landlords there cleaned up.

And the industry was transformed and continues to transform around us. So here is a thought that might further transform.

It starts out in the mind of the customer – i.e. the tenant – and asks what does a tenant really want? Of course there are a lot of things, but one thing that many tenants want is the ability to cram as many people as possible into a location, but in a manner in which they can work productively, happily and successfully. Indeed, a lot of us law firms think about this a lot. Rent is our second biggest expense – and boy would we like to be able to cram a lot of lawyers into our space without bumming them out.

So how about this – instead of leasing space by rent per square foot – instead start leasing space by Productive Employees Per Square Foot?

Think this through with me for a moment and let’s do some math. If you ask me to take 50,000 square feet of space at $50 per square foot then I am paying $2,500,000 per year. If I can comfortably fit 100 lawyers “productively” into the space then my law firm can achieve a certain level of profitability in that space. As the managing partner of my law firm, that is how I would judge things, i.e. every lawyer I get in the space can bill X hours times Y billing rate, etc.

But if you lease me 40,000 feet at the same rent (i.e. $50 per square foot) and I get the same number of lawyers in the space I achieve the same level of profitability – don’t I? But now I achieve that profitability for $2,000,000 a year, which is $500,000 a year less. Suddenly my business is $500,000 a year more profitable isn’t it? Just because you – the landlord – made it so…..

And you (if you are a landlord) just gave up $500,000 to me – as your tenant – for free!!! You didn’t take anything for it if you just are sticking with the old rules of measurement, i.e. by the square foot.

To achieve this idea all you would have to do is this:

“Innovate” – be creative in how to set up space so that more lawyers can comfortably work in it.

“Market” the idea to law firm tenants like me that I should pay more for this kind of space or, in other words, that I should evaluate the value of the space I am renting by this new metric.

Then you have “created a customer” (i.e. me) who will purchase office space based on Productive Employees Per Square Foot.

This would mean you ignore the “market” and what everyone is doing and what everyone wants. Instead – just like Steve Jobs – you are telling the market, and your customers, what they should want!

And suddenly you have created customers who buy their space based on Productive Employees Per Square Foot.

If this is marketed successfully, then you are possibly making a lot more money from the same office building.