My dad carries patents for several things he has invented. He has told me most of his new ideas end in one of two ways, though. Either no one has pursued the idea because it’s not practical, or it’s a great idea and someone has beat him to it. You need a good idea before someone else. That inventor’s dilemma has played out often through history. Many inventions like the light bulb, combustion engine, and radio were being pursued by several people simultaneously. Some ended up in virtual foot races to the patent office.
Building projects are nothing as revolutionary as the radio. But they are created in an ever-repeating loop of events that bears a striking resemblance to the inventor’s story. This loop is known in the industry as “the cycle.” Here’s how it might play out:
One day you’re having lunch with business friends. They start complaining about how they can’t find office space in an up-and-coming area. “Prices are skyrocketing because there’s no supply, and the spaces that do exist aren’t even that great.” You have just stumbled upon great insider information. There’s demand but no supply. So you set out to develop new space in this up-and-coming district.
Finding a reasonably priced piece of land takes several months. It takes another six months to have the space designed by an architect, financed by a bank, and approved by the city. As you finally begin putting up fences around the site to break ground, you notice several other sites are doing the same thing. A few have even have signs with renderings of massive office buildings coming soon. What’s happened?
As you were working on your plan, others were doing the same. And now, because it has taken so long, a major shortage of office supply could turn into a glut of office supply. If too much space hits the market, a price war will start, and that will drive down the revenue you need to create value. So now there’s a race to finish construction and bring your building online. If the other buildings get all the tenants, you could be left with an empty building and no way to pay the bills.
Developers don’t work in a vacuum. Others also have their ears open, trying to hear what spaces are popular and in short supply. But it takes a long time to bring buildings online. And developers try to do so as secretively as possible. As a result, real estate is prone to “cycles” of boom and bust. This means that the same building, on the same parcel, can be a goldmine or a money pit, depending on your timing.
The cycle encompasses several industries. For example, during a slump, construction companies are desperate to find new projects. This means they will give you great pricing. The cost for the raw materials also drops. By getting the same rental revenue with these lower construction costs, the spread between your hypothetical $1 and $1.12 widens. But once other developers have seen the opportunity, construction workers get busy too. And because there are greater demands on their time, and on materials, prices go up. That reduces the amount of value you can create.
In truth, there are actually multiple real estate cycles playing out, at the same time, across the country. During good economic times, big cities see development earlier than smaller ones, which means they are often “later in the cycle.” Maybe there are too many apartments in Chicago but not enough in Springfield. Even more importantly, the different kinds of real estate have their own cycles. There may be too much Class A, luxury office space in Los Angeles but not enough Class B, cheaper office space. One market research firm has even taken to showing cities on a clock, depending on where they are in the cycle.
What’s the lesson of cycles? If you can predict what peoples’ space needs will be, and build such spaces before others do, you can build cheaper. This also decreases the chance tenants will have alternatives. Both factors increase your return. On the other hand, if you try to guess what the future holds, and do so incorrectly, you might create a building that never fills up. Maybe a kind of space doesn’t exist in an area for a reason. Either way, you’ll have to convince your investors and lenders to jump in with you to make it possible. And that’s where it gets tricky.
In the next chapter:
Because creating new buildings requires significant capital, even wealthy developers need investors to make it possible. Those investors must first be convinced to invest in real estate in general. Then they must be won over for your building project in particular. In the next chapter, we’ll meet the investors and begin learning about their own “cycle.”
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