Uniqueness – The Bane of Fundraising

I have seen this time and again. Someone uses their brainpower to come up with a cutting-edge idea for real estate investment. It is a niche (a “Power Niche” as I call it), or a way of looking at real estate that no one has done before. It seems pretty cool, but the lament is that “investors won’t go for it”, so, alas it is just not viable.

If the fundraiser doesn’t just throw in the towel at this point, the next question is whether the fundraiser should “tweak” the business model (or maybe in other words ruin the cool and cutting-edge part of it) so it will look like other investments and thereby become appealing to the target investors; or stick to his guns and try to find investors, even though most prospective investors will not be willing to take the plunge. That sounds kind of terrible too – like the sheepherder throwing in the towel and just deciding to follow the sheep.

As an aside, I don’t mean to imply that the investors who reject the new ideas are foolish. They are not dumb at all. Indeed, the prospective investors are smart to avoid the newfangled investment idea for the simple reason that if they all stick together and perform in an “average” manner, they will remain employed and their lives will continue on (probably happily) as they were before. If, however, they take on the risk of the new idea (and all new ideas have enhanced risk as well as enhanced reward), and it goes poorly, they may be out of a job.

I had been noticing and thinking of this irony – or paradox – for years, but then Todd Zenger wrote a really interesting article in The Harvard Business Review called The Uniqueness Challenge, which explains this conundrum in a very readable and understandable manner. He calls it the “Uniqueness Challenge” and that does describe it very well, as it is always a “challenge” to be “unique”.

I note that my law firm took this Uniqueness Challenge by making the determination to be The Pure Play in Real Estate Law®, thereby taking the enormous downside risk of being different (and unique). We “burned the ships” with this strategy and, fortunately, it worked out exceptionally well. At the time we did it, we were very nervous about it, but now looking at where we stand in the marketplace it seems so obvious – what were we worrying about?

So hats off to Mr. Zenger for his article – it is well worth reading.

Now we have this conundrum—this irony—this paradox. The question is how to solve it. Here is my best shot at it:

At the outset, I wouldn’t tweak (i.e. ruin) the business idea to appeal to investors. That is just like the sheepherder throwing in the towel to follow the sheep – and, in this case, even the sheep would (sheepishly) maybe admit privately that they don’t disagree with the strategy – they just don’t want to take a risk where the risk/reward isn’t to their benefit.

I will – very reluctantly – admit that tweaking/ruining the strategy’s novelty might be the optimal short-term economic strategy, and may result in more immediate fund-raising success. But where is the fun in that? What is the point? Where is the break-out upside? It isn’t there. You are just conforming to be like everyone else.

However, I wouldn’t waste a lot of time on a strategy that is doomed to failure either. If you know that the main investor group just can’t invest in your idea, probably for the reasons I outlined above, don’t spend two years with a fruitless private placement memo trying and failing to raise a billion dollar fund that is doomed to failure or, worse yet, that a Blackstone-type party will do itself if they like the idea. Nor would I use a straight-down-the-middle fund-raising advisor either, as such an advisor would advocate you soliciting the mainstream investors who will likely not be able to say “yes” for the reasons outlined above. Overall, the odds are stacked against you and you could waste two or more years of your life being essentially jerked around and come up empty.

What I would do is approach those who are outside the normal channels, i.e. instead of pension funds, insurance companies, endowments, and similar parties, I would look towards high net worth individuals, family offices, and investment funds that make it their bread and butter to seek alternative investments and that are deliberately set up to not follow the herd. There are a lot fewer of these parties, and the way forward will be tortured, like following a narrow bending path up a mountain; however, I think the chances of success are much higher.

As an outgrowth of this strategy, I would also dial down my fund-raising size dramatically. Instead of visions of billion dollar funds dancing in your head, consider a fund of, say, $25,000,000. All you would want is the bare minimum for a “proof of concept” and an amount you can invest quickly to confirm the strategy is doable. Once you have that, it will likely be a very different story when you go back to the mainstream investors. They will likely change from skittish to eager very quickly.

If you follow this strategy, the only thing you can be sure of is that you don’t know what will happen. However, a strategy where you don’t know what will happen is a lot better than a strategy that is likely doomed to failure (as is the straight-down-the-middle strategy), so mathematically, this strategy is optimal. Also, if things go badly, you will spend a lot less time and money failing.

By the way, if “you” mainstream investors are reading this when you are visited with a Uniqueness Challenge, consider giving the guy presenting to you a break. Maybe this is your big chance to stand out from the herd yourself. Maybe this is a time for you to take a chance too…

If you are a reader of The Real Estate Philosopher and have thoughts on this, feel free to email your thoughts to me and maybe I will put them out in the next article as a follow-up piece.

Finally, if you have an outside-the-box idea in the real estate world that perhaps rises to the level of a Uniqueness Challenge, I hope you will give me a call or shoot me an email. There is nothing I like better than trying to figure out how to make unusual, different and unique ideas successful.

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.

Yuk!!!

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.