In a recent American Express Open Forum interview, the noted business guru Jim Collins made a great point about preparing your business for all conditions:
“As soon as you can—before you grow really big—your first priority is to have enough cash that you could go a whole year without revenues if you had to,” says Collins. “Because someday, you might have to.”
In other words, plan for zero.
In practice that’s the type of advice that most people hear, nod their head yes, and then promptly ignore. We know it makes imminent sense, but carrying it out is hard. When revenue grows to exceed the immediate demands of the moment the natural instinct is to use it for growth, or more investments, or a vacation.
The thought of hoarding cash for bad times is a downer by nature, mostly because we delude ourselves into thinking there won’t be any bad times now that we’ve “mastered” the business. Please observe that the road to bankruptcy court is paved with delusions.
How does this apply to real estate? For many years I’ve used a “worst-case break-even” as the deciding factor in valuation calculations, and to devise appropriate deal structures.
To explain, when I look at a property for acquisition I must have the most recent 12 months operating statement available, preferably a trailing twelve from the most recently completed month, along with the current rent roll.
Multiple Projections for Multiple Uses
I normalize the NOI by removing (or adding) anything from the historical statement that is not property related, or adjust for how I will operate the property, and my proposed deal structure. Using the current rent roll and appropriate expense inflators I construct a baseline projection of the first year of operation. This is the “do nothing” scenario. (It’s also the basis for valuation, but that’s another post.)
Then I do a “best case” projection, which includes improvements from the property investment plan, expansion, new lease-up, whatever… with the assumption that everything goes right. I know it won’t, but I want to know what it looks like.
Last is the “worst case” projection. This reflect is if all hell breaks loose, e.g. higher than normal tenant turnover; long re-leasing periods with heavy TI expense ( very common in retail and office properties);, improvements come in late and over budget; and any other possible problems for the project.
That third scenario becomes the litmus test as to whether I do the deal. What I’m looking for is what I call a “worst-case break-even” projection. That means just what it says… if all hell does break loose, then my worst case is I don’t make money that year, but any losses should be minor.
Reserves are the Key to Survival
This is the only way to play intelligently in the distressed property space and maintain a margin of safety to avoid excessive risk. I’ve acquired numerous properties purposely structured on a break-even scenario when the due diligence supports an investment plan that meets my 3-year return criteria. Using the “plan for zero” mindset, I budget for the improvements and reserves up front, and avoid the nasty surprises that sink projects.