Land Investing Versus Real Estate Development: Which Is More Profitable?
BATTLECALL GUEST EXPERT: Robert J. Abalos, Esq.,
InvestingInLand.com
Land investment and real estate development are two related subjects but they
do not have to be. Most books or treatises on buying land or developing real
estate projects link to the two subjects by placing them in the same continuum
of tasks related to development but I deliberately break that chain for an
important reason.
Land investment is inherently profitable. Real estate development
quite often is not.
This may seem like a bold statement but it is not. Of course both activities
can be EXTREMELY profitable and money can be made hand over fist both buying and
selling land and also developing it. But the larger issue is the efficiency of
the business models of each activity and without a doubt land investing is a far
superior enterprise to traditional real estate development.
Designing The Ideal Business
If you were going to design the perfect business model, it likely would have
the following attributes:
- Low capital requirements
- High return on capital
- Quick cash-to-cash inventory cycle
- Fast potential profits
- Few or no employees
- Low overhead and fixed costs
- Diversification across many product lines or services
There could be many others but this list certainly includes the most
important qualities of any ideal business model. Two important facts need to be
realized at this point.
Land investing has them ALL. Real estate development has
NONE.
Let's examine each criteria one at a time.
Capital Requirements And Return
Real estate development is an extremely capital intensive activity. Even if
you own the land you are building on free-and-clear, the process of putting up a
building, shopping mall, or office tower takes huge amounts of money, often
borrowed money that must be obtained from equity partners and debt instruments
that further increase the cost of any project. Contractors need to be hired,
materials purchased, soft costs paid, permits applied for and granted, the list
of capital obligations goes on and on and on.
Land investing, on the other hand, is not capital intensive. It does not
require a whole lot of money relatively speaking to buy or option land. Most
earnest money deposits and option premiums can be small borrowed sums even on
large tracts of land. It is also much easier to get purchase money financing for
a land transaction than construction financing on a project using land already
pledged as collateral on another note.
Obviously if you are very wealthy, capital requirements are irrelevant. But
most investors and developers are not and capital shortages drive most
developers at some point to or over the brink of bankruptcy. And even the most
well-heeled developer has to concentrate their capital into a small number of
projects, increasing the risk on each, rather than diversifying across many
investments as the land investor can.
Not only are capital requirements higher for the developer, but the return on
their capital is lower for them as well. The MINIMUM return I urge for investors
is 24% per year or a doubling of invested capital over the course of three
years. This is a floor on profits and quite often triple digit yields are
possible using leverage. But even the base yield of 24% is a dream for
developers who are lucky to return 10% or so on their total capital beyond
costs. While developers can certainly invest more money and therefore increase
their net return in dollar amounts, they cannot approach the extremely high
yields of the land investor. All things being equal, I would rather pay cash for
a $50,000 business earning 20% on its capital than a $50 million business
earning 5%. Yes, the first business would only earn me $10,000 per year versus
the $2.5 million of the second. But the relative capital invested for the return
generated is the key consideration here. This also applies to land investment
versus development. Developers can earn more net dollars on a project but have
to invest far more capital and at lower absolute rates of return to earn it.
Diversification is sacrificed in capital intensive business models. You have
to build one large factory or produce one product in huge quantities or like the
real estate developer, build a small number of projects (often just one) at a
time. Land investing allows for a larger inventory of holdings which permits
diversification and less risk per investment. In uncertain market conditions,
diversification is not a benefit that should be overlooked. There is much truth
in not putting all your eggs in one basket, especially when walking across a
very slippery floor.
Quick Inventory Cycle
A good business wants to turn its inventory from cash to product and back to
cash quickly. The faster, the better. Having cash available for investment is
good, having capital tied up in unsold inventory not so good.
Land investing is a fast business. You can buy land on a Tuesday and sell it
on a Wednesday. That's how any successful investment business should operate.
FAST. Take your profit and run to the next deal as quickly as you can find it.
If you buy right like I teach, you can sell fast and easy.
Real estate development is a slow business. If you are building a 100-unit
condominium complex, how long will it take to sell each and every unit? Just
getting the approvals and beginning construction can take months, perhaps a year
or more----IF EVER. This means the developer has HUGE amounts of capital tied up
in inventory and subject to all the uncertainty of the business cycle. What if
condos are hot when the complex is planned but not so hot when they are ready
for sale?
The best deals I get as an investor is buying excess inventories of land and
other improved real estate from financially distressed developers. There is a
reason for that. They have holding costs on unsold inventory as well as dead
capital tied up in that inventory. As a land investor who sells whatever I
acquire quickly, I don't.
The notion of fast profits also is important another way. The key
to building great wealth is to earn the highest return-on-equity possible on the
largest pool of equity possible. Making money fast means
pyramiding your equity fast. Land investing permits that option. Real estate
development does not. Larger real dollar returns are certainly possible but each
payoff comes slower in a less predictable fashion. Real estate development is a
great way to PERPETUATE wealth, in other words to make rich people richer, but
it is not an ideal way to GENERATE wealth, or take ordinary people and make them
rich from the start.
Few Employees and Low Overhead
Employees cost money. Each one not only requires a salary and benefits but
all the other hidden costs of having someone on the payroll. You have to pay for
office space where they work, liability insurance, and workman's compensation
costs. Every single one is a potential wrongful termination or sexual harassment
lawsuit. Each one is a potential thief, troublemaker, or spy for your
competitor. If this sounds jaded to you, I bet you don't have employees on your
payroll. Yes, there are many great employees. I know, I have a bunch working for
me. But there are many awful ones too and the more people you employ, the higher
your chances of getting some bad apples that can ruin a business from the inside
out.
The rule here is simple and really common sense. The fewer employees a
business has to successfully operate, the lower the costs, the higher the
profits.
Land investing does not require any employees, or just a small number to
process paper if necessary. Real estate development is employee intensive. Think
how many employees even a small development firm requires. Realize I'm not
talking about the employees of the contractors and their subs but all the
project managers, receptionists, personal assistants, and so on. Even a tiny
development company with five employees has four more than the smallest land
investment firm requires.
Development Profits the Right Way
You may think that I'm against real estate development because I don't like
the business model. You would be totally wrong. I just think there are better
ways to profit from real estate development than becoming a developer
oneself.
The way to profit from development is to allow others to develop your land
for you. They use their capital, their employees, pay all the fixed and variable
costs of development, and do all the hard work while you sit back and reap a
percentage of the profits for just contributing your land, either outright as
part of a joint venture agreement or through a land lease where the land is
rented to the developer and end user. Either way, no additional capital beyond
the money used to purchase the land is required to earn a return on the
development of that land.
This is a lesson straight from John Jacob Astor, history's greatest real
estate investor of all-time, who bought land and let others pay to improve his
properties and made BILLIONS OF DOLLARS doing just this. His lessons of land
investing success are so important and relevant for today's investors.
The bottom line is simple. If you are trying to make money fast, stick to
land investing. If you are rich and want to become richer, mix land investing
with real estate development. But if you are rich and want to become richer in a
hurry, invest in land and let others develop all your land for you. This way you
earn a profit while others work, spend, sweat, and invest to earn it for
you.
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