Greed may not kill, but it does have a way of clouding one’s judgment.
By John E. McNellis, at real estate developer McNellis Partners:
This is a true story.
A well-to-do investor—let’s call him Sam—owns a charming three-story brick office building in a city that was once the envy of America. His building is in an elegant quarter that has suffered less than the forlorn city itself, but a restoration to its former grandeur is some years off. Meanwhile, this neighborhood’s rents have plummeted.
Sam is well versed in real estate, but he’s an old man, halfway through his eighties, and this building is his biggest and best asset. And like a proud but deluded tract homeowner, Sam is sure it’s superior to the other commercial buildings in his neighborhood.
25 years ago, Sam leased his ground floor to a small, but elegant bistro. The rent was high then—the restauranteur Umberto was dying for the space—and rose ever higher with annual increases. The rent peaked last year at $140,000 for the 2,000-foot restaurant ($70 per square foot a year). But like all things, good and bad, the bistro’s lease term came to end. Actually, it didn’t quite end. Umberto had an option to extend his term for five years at current fair market rent. And, as leases typically do, his provided that the new rent would be determined by arbitration if Sam and Umberto were unable to agree upon it.
Umberto exercised his option and asked Sam for his thoughts on market rent. Sam insisted upon $60 a foot ($120,000 a year). A genius in the kitchen, but largely ignorant of real estate, Umberto nevertheless thought this sounded crazy and asked one of his best customers—a savvy leasing broker—about market rents. After checking recent comps, she assured Umberto that his rent should be no more than $20 a foot ($40,000 a year). In other words, a financial gulf as wide as the Mississippi lay between landlord and tenant.
Your correspondent saw this broker’s comps, concluded she was right and, as chance would have it, had a couple dispiriting conversations with Sam about their import. While sharp as a prosecutor on other topics, Sam went stone deaf upon hearing something he didn’t like. He wouldn’t listen to the facts; instead, he countered with nonsense in support of his $60 stance.
Not a hard man and as wary of litigation as immigrants can be, Umberto offered to meet Sam more than half way, suggesting he could live with $45 a foot as his new rent. Sam said no. Months dragged on, the parties lobbed market data at one another, but still Sam wouldn’t budge a dollar. At last, they went to binding arbitration and—to no one’s surprise—Sam lost, the arbitrator setting the rent at $20 a foot.
Putting aside the thousands he spent on legal fees in this battle, Sam lost $50,000 a year in rent by failing to accept Umberto’s compromise. Capitalize that $50,000 by five percent and Sam’s obstinacy cost his building a million dollars in value. Greed may not kill, but it does have a way of clouding one’s judgment.
It’s been a dozen years since this column railed against litigation as a way of solving business disputes. Arbitration is no better. While quicker than an old-fashioned lawsuit—there’s less lingering on death row—it can be, well, arbitrary. Yes, the result with Sam’s proceeding was correct, but it could have gone the other way, or the arbitrator could have done the Solomon split, that milquetoast practice of which arbitrators are all too frequently accused.
Win or lose, one spends a minor fortune on lawyers in any legal proceeding and often far more in anxiety and emotional capital.
To sum this up, two old sayings come to mind. The first—a bad settlement beats a good lawsuit—should be a forearm tattoo. The second is actually a sorcerer’s curse that comes to us by way of Mexico: “May you have a lawsuit in which you truly believe.” McNellis is the author of Making it in Real Estate: Starting Out as a Developer
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…always good to hear from Mr.McNellis. May I reprise another tag-end quote?:
“…self-deception is the root of all evil…” – rob’t a. heinlein
may we all find a better day.
Not only facts and good information can be found at WolfStreet, but wisdom as well.
Fun read, thanks
Well told!
Brings back my law days in which I saw many litigants with stars in their eyes go off similar cliffs. Sometimes a lawyer would have the same affliction, taking a contingent fee case, years and many gray hairs (not to mention advanced expenses, never to be collected from a deadbeat client), to nowhere.
Never seen a lawsuit that treats all parties fairly. It’s usually an ego driven thing that results in someone getting hurt.
At a minimum, a lawsuit will involve at least 2 lawyers and 2 litigants. The number of interested parties can only go up from there. Even with only 4 people though, the odds of at least one of them being irrational and thereby making the lawsuit intractable is extraordinarily high. It probably isn’t a surprise, but the lawyers are just as likely to be irrational as the clients.
Arbitration, especially securities arbitration, can be hazardous to your wealth. The qualify of justice is deceptive. I have participated in it for almost 50 years.
Kinda surprised to hear that after the lease term ends, the end result can be a *default* to arbitration – had basically always assumed that the property would simply revert to owner and he/she/REIT would simply put it back on the market again.
I’m guessing that the CRE agreements are more-or-less like any other contract – pretty close to being infinitely customizable, with occasional exceptions (and, admittedly, RE does tend to have a few more difficult-to-draft-around constraints).
But, that said, I’m still guessing that landowners have to agree upfront to this “going to arbitration” language in the first place…and I’m not sure why they would do that.
My perception is that, historically at least, the land owners had more negotiation leverage, so I’m fairly unclear on why they would ever agree to a provision that could ultimately take decision-making control out of their hands (arbitration if negotiation fails).
Can anybody opine on the ubiquity/rationale for the “going to arbitration” clause if lease extension negotiations fail? Still pretty shocked to hear about it.
I used to call that kind of thinking “Stupid Greedy”. It always ends up badly. For example, 20% of something is always better than 50% of nothing.
Thanks for this instructive anecdote. As a wiser man than me once said, “what can’t continue won’t continue” …
Delusional for sure. Landlords and tenants not a problem until things head south or north . Usually not a happy medium when ones livelihood depends on the outcome . Thanks for the information I have seldom seen a situation that warrants a lawsuit.
The legal system in our country is severely dysfunctional. There are any number of reasons for this.
If you are not rich, entitled and powerful it is not available to you as a form of redress. Subsequently and increasingly litigation is and will be conducted in the streets.
“Subsequently and increasingly litigation is and will be conducted in the streets.”
Mofo,in the hills of New England folks mention how your lawyer should be obese,reason is so they can take a bullet for ya’s.
Pigs get fat and hogs get slaughtered…
This has always been a memorable phrase…but the actual, precise meaning has always puzzled me a bit.
“Pigs get fat” – Suggests that greedy mindset tends to be successful
“But Hogs get slaughtered” – But too greedy (how greedy?) tends to lead to worse outcome.
Or does it actually mean that *the grift/graft* has to be *spread around* if disaster is to be avoided?
Considering the Wall Street origins of the phrase, I tend to assume the latter.
I’ve always heard it as “bulls make money, bears make money, pigs gets slaughtered”
In reality, both bulls and pigs get slaughtered. Bears might die of old age or get run over by a truck or something and sometimes they get shot.
Great story, thanks for sharing. I second Bob’s comment!
John,
Interesting anecdote. Though I agree entirely with your overarching point, I’d contend there was likely nothing “arbitrary” about the result of the arbitration.
Properly authored and lawyered leases don’t contain weak or ambiguous language or arbitration clauses. This lease sounds like it stipulated the parties submit to baseball arbitration, which is fairly common and designed to encourage good faith negotiation. The fact that the landlord foolishly submitted an absurd estimate of FMV because he was greedy guaranteed the tenant would prevail. A properly-authored clause would have absolutely limited the percentage in which FMV estimates could differ in order to result in a split of the difference.
Money spent on having an experienced attorney review lease terms prior to signing is some of the smartest money you will ever spend.
This at least partially addresses some of my questions above (Why agree to default binding arbitration in the first place?).
“To encourage good faith negotiation” (Okay – but somebody needs to tell CRE edge-lord Trump…)
“Percent by which submitted FMV estimates may differ” – Reminds me vaguely of the process by which Disney is allowed to buy-out its Hulu partners.
All said and done, I’m still a bit surprised that RE owners (who I perceived held the whip-hand for decades and decades) would ever ultimately agree to *binding* arbitration if lease extension negotiations failed.
Like bankers and employers, I thought RE owners tended to have more of a “my way or the highway” attitude when negotiations irritated/disappointed them a bit too much.
And that they would *never* surrender that power up front.
The law would be a good application area for AI.
There are mountains of data to train on.
All the AI engines out there start with a Large Language Model (LLM).
If you have a dispute, each party pays $100 at a website, submits their “Facts” and get a judgement in seconds.
Of course parsing out the “facts” part of it will be tricky, but solvable as long and the lawyers dont get involved.