McNellis: Liquid Assets

By John McNellis

I always wanted to make the front page of the Wall Street Journal…until I did. Today’s WSJ shows our Healdsburg shopping center doing an excellent imitation of McCovey Cove during a Giants game, replete with canoers and kayakers. This picturesque scene of course made the happy-talk news on local television (see video above). I wish I could say we were delighted to add a bit of levity to the storm that battered Northern California.

Lake McNellis will be short-lived, but unless repaired, its damage will be permanent. Parking lots fail beneath oceanic weight, landscaping is washed away and drowned. Shops are ruined, inventory destroyed and the drying process is long and expensive.

Even in drought-wracked California, rivers flood. And when a town is built on a river bank, as Healdsburg is on the Russian River, all of the storm drains, culverts and flood prevention measures one can muster are merely a lesson in futility—if not humility—when the almost perfect storm rolls in.

We cannot prevent floods or earthquakes or fires, riots, terrorists or even little greasy kitchen fires that inevitably cause either more damage than one has insurance for or not enough to cover the deductible.

In this time of breathtaking prices for real estate (see Desperately Seeking Yield April 2013), it may be appropriate to put the flood question more broadly and ask if any building is as truly safe as so many buyers would love to believe.

Yes, it’s possible to own a building or two for even a very long time without suffering casualty losses. But a whole portfolio over an extended career? That’s not statistically possible. Yet, if an owner is truly prudent in buying insurance, it will cover most of her direct losses arising from an accident.

As it happens, we do have flood insurance for Healdsburg, but we also have a five figure deductible—we will definitely pay for the pleasure of helping the WSJ sell newspapers. And we will have indirect losses. One of our Healdsburg tenants informed us yesterday morning that he had neither flood insurance nor the money to rebuild his shop and that his sales were so bad he would simply shut down if it flooded. Thus far, it hasn’t.

Let’s leave the world of cinematic losses that seldom occur and consider a more common way to watch values evaporate: no-holds-barred competition. We might call this “Houston Roulette” because, along with big hair, Houston’s laissez-faire approach to zoning is one of Texas’s lasting charms. Actually, it’s far more laissez than faire; Houston has no zoning at all. Subject to a building permit alone, developers are free to build anything they like, anywhere they like: hospitals next to dumps, oil refineries side-by-side with mansions or office towers all the way to the sky. This approach works surprisingly well from a land use standpoint—dollars rather than politics or neighbors wind up dictating that noxious industrial uses huddle with other industrial uses and so on.

But live by the dollar, die by it. Houston’s free-for-all means no project is ever safe from competition. If you build a 75 story high-rise and advertise the finest views in Texas, your ex-partner can build 100 stories out of spite tomorrow and tout even better views. You build a supermarket at the best intersection in town and overnight your competitor assembles three parcels across the street and throws up an even snazzier market. One of you dies.

Where land is plentiful and zoning more of a suggestion than a commandment, economic obsolescence—and breathtaking loss—requires no more than an idiot with a pot of money and a dream of a new building next to yours. The formula of doom is as simple as the Pythagorean Theorem: developer + money + easy zoning = death-spiral overbuilding.

This is exactly why smart money loves core properties. Since developers can somehow always come up with the money (let’s face it, that’s what they do), the best defense is to own properties in the handful of coastal cities in which the zoning process makes water-boarding appear humane.

Yet even a building as safe as kindergarten loses value every year through what too many view as merely a tax benefit—depreciation. Rather than simply a happy paper loss on April 15th, depreciation is real—buildings eventually wear out. The IRS has decreed that 39 ½ years is the standard useful life for buildings and allows a 2 ½ percent deduction for depreciation every year.  This also means—since the IRS has it about right—that your building is cooked when your depreciation burns off. Your children can either scrape your worn-out building and start fresh or go the more expensive route of gutting and rebuilding it.

Either way all you have left is your residual land value. If you have chosen your land carefully—i.e. on high ground yet within walking distance of big water (maybe a little farther than our shopping center)—your land appreciation should more than offset your building loss. If not, you might be reminded of the old joke: How do you make a small fortune in real estate? Start with a large one.

John E. McNellis is a Principal at McNellis Partners in Palo Alto, Calif.

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