I don’t come from a business background. My dad is a soil scientist and I spent the first ten years of my career as a theologian. But there is an illustration which has helped me grasp the entirety of what business, and thereby real estate, is all about. It goes like this:
If I was to offer you $1.12 for every $1.00 you gave me, how many times would you want to make that trade? Hopefully your answer will be “as many times as possible.” That’s because, in the trade, you get your dollar back (a return of your capital). And for the trouble of doing the exchange, you get twelve cents on top of that (a return on your capital).
Let’s say you’ve got a thousand dollars to trade. That means you could stand to make $120. But why stop there? If you could be guaranteed to earn this $1.12 for every $1 you traded me, it would make sense to borrow as much as possible, to continue trading.
What if there were transaction costs and expenses incurred to borrow the money and make these trades? As long as there was still more than $1 left after you paid all the expenses, you would have still gained on the trade.
Every business, from a child’s lemonade stand to a commercial airline, operates on this principle. The principle is called various things, but most often “creating value.” By engaging in the trade, you are literally creating value which didn’t exist when you were holding the $1 by itself. How? People are willing to pay you more for the thing you have created, or service you have offered, than it cost you to produce it. The desire to conceive and bring into existence a new building must start with this motive as well. Why are buildings conceived? Because they create value. People are willing to pay more to use them than it costs us to create them.
There’s a very understandable aversion to this rationale for creating buildings, and it goes something like this:
Maybe you are creating a building to make money. But nobler people in your business pursue other goals: improving society, helping the underprivileged, creating beauty, and the like.
As someone who very nearly studied architecture or urban planning, I can relate to this reaction. So for the sake of discussion, let’s consider a building project freed from such focus on creating value.
You’ve planned a building which will help the underprivileged, create beauty, and make you the darling of the local news. And every year, it will generate enough revenue to cover your expenses and 75% of your mortgage. That means each year, before you’ve paid yourself or your investors, you’ll have to cover a mortgage payment shortfall. This shortfall will cost thousands, or hundreds of thousands, of dollars. And the funds to cover it must come out of your pocket, since the building isn’t producing enough income on its own.
How many buildings like this a person could create? And what lenders and investors would line up to help them do it? I hope you will agree that no one, with any motive, can afford to create buildings that lose money month after month. You might choose to do so using your personal fortune. But your personal fortune will dry up. And when you finally you go bankrupt, the bank will just sell the buildings to someone who can create value with them.
Does this mean that developers must be like the industrial capitalists of the 19th century? Must they squeeze every cent out of a project and exploit people to do so? No, but it is impossible to create buildings, and keep them, if they don’t create value. In this way, development is like so many forms of art: it is subject to creative constraints. We can do more than create financial value, but we have to create financial value first. So how does one do that in real estate? Let’s consider a few different ways it happens.
In the next chapter:
Creating value in a building project isn’t just a mathematical exercise. It requires finding a particular site, at a particular moment in history, and putting a particular kind of building on it. It also requires partnering with some people, in competition with others, to make it happen. So creating a good project is as much like solving a mystery novel as it is like solving an equation. In the next chapter, I’ll introduce you to a story known by many as “the cycle.” Every individual building’s story is a part of, and is influenced by, that larger story.