Investing in real estate can be a smart use of capital. For one thing, there’s usually a considerable demand for property types of all kinds and for a variety of purposes. This means that real estate is often one of the most reliable, diverse, and accessible industries to potential investors. This does not mean, however, that investing in real estate will always be a slam dunk, and it’s important to remember that some real estate investments will be more challenging and complex to navigate than others.
For example, many beginner investors fail to realize that real estate investing can consist of much more than purchasing an existing property to be sold for profit at a later date, and in fact frequently involves the coordinated development of a property (or multiple properties) from the ground up. This is called real estate development, and as one of the most popular and potentially lucrative opportunities in real estate investing, there is a lot that investors need to know and understand in order to be successful.
Perhaps most importantly, investors need to understand that real estate development projects have a lot of associated costs. Between the actual construction of a property, ongoing maintenance, and myriad legal fees and obligations, there are a variety of expenses that will need to be accounted for throughout the entire process. And in order to make an informed decision about whether a project is worthwhile, investors have no choice but to organize and consider each of these costs in exhausting detail.
Fortunately, as complicated and demanding as this process can be, real estate investors have developed reliable strategies and methods for navigating the evaluation of development costs. One such method is to divide all expenses at the outset into two distinct categories: hard costs and soft costs. By making this distinction as early and accurately as possible, real estate investors can significantly improve their chances for success, through everything from more effective budgeting and a better understanding of a project’s risk profile, to an enhanced ability to capitalize on costs and determine the overall potential profitability of an investment.
But what exactly are hard and soft costs, and why is distinguishing between the two so important in real estate development? Let’s take a closer look at what goes into a real estate development project, and why properly categorizing all associated costs is always critical for investors.
What is the Cost in Real Estate Development?
As stated previously, real estate development does not consist of the mere purchasing of a property, and instead involves building a property with a particular purpose and investment strategy in mind. A real estate development project could relate to a single property, such as a house or an office building, or a series of connected properties such as a housing or apartment complex.
The cost of a particular real estate development project will depend largely on the scope of the project and the intended use of the resulting property, but generally real estate investors can expect to encounter many of the same costs throughout any project’s lifecycle. Some of the most common costs that almost any developer will encounter include the purchase of land and building permits, construction and labor, initial and ongoing maintenance, and legal fees.
However, these relatively obvious costs are often just the tip of the iceberg, and real estate development projects typically also include a number of costs in both the preliminary and subsequent stages of construction. These can include anything from research and marketing efforts related to the overall business strategy of the project, to complex management and legal obligations that arise in connection to the development’s intended use.
Why Should Investors Know About These Costs?
Real estate investors should be aware of all costs associated with a development project for a number of reasons. First of all, when the deal is pitched, developers will often be inclined to focus on the more enticing aspects of the project, such as the apparent favorability of the market, or the potential profitability of the business that results from the development. But before investors can make money, they need to spend it, and how money is spent before, during, and after the development process will have a direct impact on an investor’s return. Expenses related to development, for example, could be so high that investors will need to operate at a loss for years before realizing a profit, and such an arrangement might not be agreeable to a particular investor’s portfolio or risk appetite.
Additionally, effective budgeting can be a strategic step toward long-term profitability. Not all costs related to development will constitute an objective loss, and in fact most smart investors will view a budgeting sheet as a comprehensive playbook for potential future gains. For example, the development of an office building might include the purchase and installment of technology, such as computers and IT infrastructure. From the perspective of the business, this purchase can be viewed as an asset rather than an expense on the balance sheet, as the use of the technology will ultimately become a tool for generating profit. This is called capitalization, and it allows investors to identify and record all expenses that they anticipate will be instrumental in generating future revenue. Capitalization is a critical aspect of the budgeting process, and without it investors end up with a misleading balance sheet that reflects only losses and ignores potential gains.
Now that we’ve touched on the importance of costs in real estate development, let’s talk more about the distinction between hard and soft costs.
What is an Example of a Hard Cost?
A hard cost is any cost directly related to the physical construction of a building or structure. Hard costs are sometimes referred to as “brick & mortar” costs, and they include any expense that goes into the initial construction process, from manual labor, materials, utilities, HVAC systems, cement, and even landscaping. They are called hard costs because they are fixed, tangible expenses, which makes them much easier to identify and anticipate than soft costs.
What is Included in Hard Costs?
Importantly, hard costs include all costs related to the construction of a building or structure throughout but not after the project is complete. For example, initial landscaping work such as planting trees, laying down grass and fertilizer, or even installing a sculpture on the front lawn, are all considered hard costs. However, other landscaping costs, such as regular and seasonal upkeep, or as-needed maintenance on a sprinkler system, are not considered hard costs because they occur after construction and are more difficult to anticipate.
What is an Example of a Soft Cost?
A soft cost is any cost that is not directly related to the physical construction of a building or structure. Soft costs will typically include architectural design and engineering fees, environmental research, marketing, repair and maintenance, insurance, legal fees and permits. They are called soft costs because they are generally not fixed, and relate to more intangible assets that tend to be more difficult to anticipate.
What is Included in Soft Costs?
Importantly, soft costs include all costs not directly related to the physical construction of a building or structure and that are generally incurred before, during, and after construction is complete. In other words, soft costs will occur throughout every phase in the lifecycle of the overall project or investment. Additionally, while soft costs are not fixed like hard costs, some soft costs will be more difficult to anticipate than others, such as repairs resulting from unforeseeable damages, or legal fees related to an unanticipated lawsuit or permit violation.
