Introduction
In this paper, I will share my philosophy on the real estate business and on how to successfully invest in this sector. As I see it, we may meaningfully distinguish between three archetypes of real estate business, although, in practice, specific real estate projects might be seen as combinations of these. The three archetypes are (1) doing so-called green-field developments, (2) retrofitting or rehabilitating existing buildings, and, finally, (3) investing in specific properties for rental purposes or for later sale. But before we discuss each of the archetypes in more detail, let me first outline a few useful philosophies pertaining to the property business.
Basic Philosophy
I recommend four basic philosophies when it comes to investing in the real estate sector:
Restructuring. Is it possible to undertake some sort of restructuring regarding the use of a specific real estate property and thereby increase its commercial value? Examples might be rezoning land from agricultural use to commercial use or renovating/rehabilitating/retrofitting buildings to achieve some sort of upgrade (either homes or commercial for later sale or rental).
Location, location, location. This timeless principle is, of course, a cliché, but I find that it remains valid. Let me share a misjudgment that I made regarding location, which I believe turned out to be a key determinant for this project’s lack of success. This was an investment in a vacation home project in Bulgaria, on the Black Sea, where we miscalculated the importance of being located close enough to the beach. Unfortunately, to this day, about one-third of these units are still unsold!
Long-term view. Unless you are a speculator, most real estate projects tend to have returns more found in the long term, and often, the cash flow returns come relatively late in a project’s life. Real estate investments therefore complement other asset classes, where returns and losses are more immediate, such as in the stock market.
Network organization. Each real estate project tends to be unique, often calling for an array of experts in each given case: architects, various construction experts, consultants (such as for environmental impact efforts), legal, financial, and so on. From my experience, it is important to satisfy myself that a given project can be implemented in such a way that the best competences might be drawn on for the project, such as in a networked approach. The contrast would be to develop your own in-house capabilities. While many such companies are also successful, I find it more important that the real estate operator has the sufficient know-how to choose the best expertise to make a given project a success.
Five Basic Factors
Now that we have dealt with some of the basic philosophies of the real estate business, I would like to discuss the following five factors, which I find critical to assess when undertaking real estate investments:
The economic outlook. Where are we in the relevant economic cycle? Do we expect increasing growth or a slowdown? It is, of course, always difficult to make accurate assessments, but as a heuristic, two underlying factors are perhaps particularly important to monitor: Continuing productivity increases in an economy; Increases in labor force availability. It should finally be noted that while most of these assessments might be made for given national economies, where a real estate project is located, there are occasionally also examples of national economic developments with cross-effects. For instance, with regard to the Bulgarian vacation home referred to earlier, the specific developments of Norway’s economy are critical in addition to the Bulgarian economy, because, in this case, the bulk of the vacation home-buyers (actual and prospective) come from Norway.
Interest rate development. The cost of financing tends to be critical in many real estate development projects. Most of these projects have to be relatively heavily leveraged with debt financing (see also section 4. Financing, below) to be commercially viable. Interest rates thus tend to be critical, and increasing interest rates might be a real “killer.” It should be noted that with the exceptionally low interest costs we have seen in most of the world’s economies, this affordable funding has led to a surge in real estate project start-ups and to some examples of excessive real estate speculation.
Inflation. Inflation plays an important role in real estate. With growing inflation, the values of real estate assets tend to go up accordingly. Thus, in this case, inflation would not be all that critical. Very often, debt repayment becomes easier. In contrast, deflation might imply significant potential problems for the continued viability of many real estate projects, especially when heavily geared.
Financing. The availability of financing, shall, of course, always be an issue in real estate, especially considering that such projects typically tend to be capital intensive. Relatively heavy borrowing is typically required to realize projects (particularly today, as the cost of land has increased in many places). Available bank financing is key. But here again, one’s outlook regarding the availability of credit is also important. Actions by nations’ central banks might have a significant impact on the world’s real estate markets in terms of monetary easing or the tightening of its credit policy.
Supply/demand. It is of course important to make an assessment of future real estate supply (residential buildings, offices, etc.) relative to what might be in demand. New-building activities are perhaps relatively easy to forecast; for instance, residential homes. Assessing the impact from finished unsold units on the market, such as from “overhang” from prior excessive construction, might be harder to do. How, for instance, might the vacation home market in Spain be expected to develop?
Let me emphasize that all the above factors tend to be important, equally critical, and heavily interrelated.
With our introductory discussion now completed, let us turn to the three major archetypes of real estate business:
Green-field real estate projects
These types of projects typically involve securing a plot of undeveloped land to build on. Acquiring a plot of land can entail a considerable amount of rezoning before one is in the position to build on it. This rezoning process, by the way, is often time-consuming (it may take ten years or more!). From my perspective, two factors seem to be particularly key to successfully implementing this type of real estate business.
1) Permitting
Obtaining the necessary permits from the public sector to actually build (to rezone or to renovate) is a key milestone for this type of real estate. These considerations seem particularly relevant:
One’s ability to come up with a proposal/plan that entails a win–win for all parties is important. Full transparency and adherence to all existing laws/regulations is of course, a prerequisite.
The quality of the proposed plan should be comprehensive and accurate, including appropriate environmental impact reports, ideally from outside consultants.
The proposer’s reputation and image is typically important as well. A strong reputation is built up over time. As such, not much can be done regarding this in the context of a given application. However, any real estate developer will know that reputation tends to be easily damaged and thus typically will try to avoid submitting “light” proposals.
Having a reputable partner might be key. For instance, with one of our real estate investments, a large land-rezoning project outside Oslo, Norway, it was an honor to have the late Mr. Ingvar Kamprad as a 50% partner, not in the least due to his position as having built one of the world´s largest companies, IKEA. His reputation definitely enhanced the reputation of our firm as well.
Retrofitting and upgrading
This real estate archetype’s primary focus is based on the reconstruction of existing properties to enhance them (homes and/or commercial spaces).
When the construction phase is reached, at least two considerations should be taken into account:
Is the construction budget, including proper financing during the construction period, realistic?
Could selling a certain number of new units before the actual construction would start partly diminish the burden of having working capital during the construction phase and diminish the actual risk exposure? After all, the full end-of-the-project profits tend to be realized only when all units have been sold!
Lastly, many of the same factors discussed for the archetype above tend to apply here. For example, would the physical conditions of a particular property be good enough to allow for realistic renovating/upgrading? This assessment might include examining the ground conditions (soil mechanics) and the structural features of the original building. Having proper competences for these inspections available as a part of one’s network would be key.
Purchase and sale of existing buildings (rent or speculation)
This third archetype of the real estate business would call for the purchase of certain properties—typically with dwellings/commercial real estate business already on the property—for rental purposes or for later sale without making substantial improvements to the properties. The strategy here would be exclusively to “buy low” and then later “sell high.” We have already discussed three critical success factors in this regard:
The state of the business cycle. Are we expecting further growth?
The outlook for future demand. Are we expecting increased prices?
The availability of financing. Are we expecting the same availability of financing for this project?
At the moment, however, we are not engaged in this type of real estate.
Conclusions
In this essay, I have discussed how we might conceptualize the real estate business:
What would be our basic business philosophy when it comes to real estate? We have discussed four such philosophies that apply to my approach to this business.
What would be the key critical forecasts/assessments made? We have identified five such areas to pay particular attention to.
What would be the major ways to approach the real estate business? We have identified three such archetypes in this paper.
In conclusion, I want to add that a plethora of specific approaches are viable in real estate, I have just covered what I deem to be the main and most important ones here. Furthermore, from my perspective, I find it important to remember that real estate projects often entail a long-term time horizon. To achieve relatively quick profits on one’s investments in this sector might not be that easy!
PS. I am very much looking forward to reading about some interesting real estate projects on our Deal Wall soon!
Discussion questions from the Lorange Network team
Which approach to real estate do you follow and recommend?
Do you consider the real estate market in your country to be in a bubble? Do you see any risks on the downside?
What role does real estate play in your portfolio?
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