Jan 2025
“I’m easy. Very easy. I’ll tell you why I am easy. If someone is no good, I get rid of them. It is no good being tough on somebody who can’t do the job. If he can do the job, then there is no point in being tough with him. I fire very little because I try to be very careful when I select people. If you know how to select, you don’t fire often.”
– Harry Triguboff
“The only reason a person doesn’t like what he’s doing is because he doesn’t know what he’s doing. He isn’t winning, and that’s because there’s something that he doesn’t know. The doctor who can’t save lives won’t like being a doctor. The teacher who can’t get her students to learn will sooner or later become disenchanted with teaching. A salesman who can’t close deals won’t like selling. Therein lies the only reason you would not like being a salesperson. When you don’t understand something, you aren’t in control, and when you aren’t in control, you aren’t going to like what you are doing!”
– Grant Cardone
I’m often asked how to invest in real estate effectively. But what they’re subtly asking without realising is how exactly do you determine property value and what is making it go up and down over time and how to project forward to see what an individual property is going to do in the future. I’ve written previously about the macroeconomics of real estate value, this essay is going to be the microeconomics of real estate value.
There are a lot of different valuation models in real estate but this is the one I like best and what I use for everything. How I think about an individual property is pretty simple, how much does it cost to replace this property asset? This is usually a good shorthand for value. Because a property is a whole is greater than the sum of its parts problem. You can break down the individual parts or components of a property and then see where those numbers end up, then piece it back together again.
There is of course a level of granularity that you don’t need here. You for example don’t need to measure how much concrete or bricks are in a house and the cost of concrete or bricks. But all of that would fall under the big umbrella of construction cost which kind of includes everything required to build the home: materials, labour and time.
The main components of a house if you broke it down are construction materials + land value + cost of capital + risk profit margin = property value. That’s what you need to replace a property.
So a simple formula for determining a properties replacement value in laymens terms is: what is the land worth today + construction cost today of rebuilding the property + how much does capital cost to hold all the debt (the interest rate X 2 years or 10%) + developer profit margin to offset the risk of developing it (10% -20%) = what the property should be worth.
Let’s unpack those individual components.
Land Value
What is land value? That’s an easy one, a house has to be physically located somewhere and the patch of Earth it’s located on is land. How much the land costs to buy in an area is the land value. Some areas have expensive land and some areas have cheap land. Even within an area there can sometimes be a broad range of land values. Because some blocks of land are better than others.
For example, land right next to a highway or under a power line or that is on a flood plane can be undesirable. Conversely land next to a school or park or shopping centre can be quite desirable. Land surrounded by greenery and restaurants are good. Land with big slopes and lots of crime are bad. Land where more people want to live than there is physical land available, like close to the city is good, whereas land where there is more land available than people to buy it all, like rural farms, is bad. Natural light is good, darkness and shadows from other buildings is bad.
I once looked at a block of land I was interested to buy that I thought was quite cheap only to find out that it was both on a flood plane and was right next to a tiger snake habitat protection zone, one of the most poisonous snakes in the worlds. Literally tens of thousands of tiger snakes live nearby. The land was cheap because periodically it floods and also gets a lot of tiger snakes coming onto it. And people don’t like sharing their home with tiger snakes, especially in a flood. At least nobody sane. And you can’t even remove the tiger snakes because it’s their protected habitat area. I don’t know who ended up buying that site but I wish them the best of luck with their biblical nightmare of snake floods.
I bet the person who ended up buying it didn’t even know what they were getting themselves into because they didn’t do enough research to understand the risks. They probably saw what I saw which is a good looking site at a cheap price and didn’t realise there were reasons why it was so cheap. A lot of people do this and it’s a big mistake. They only look at location, size and price for land but don’t research anything else. This is an important lesson in itself. Make sure to thoroughly and comprehensively research land and everything around it before you buy it because it is the only thing you cannot change about a house. Or else it will start flooding snakes on you.
My personal favourite type of land is a north facing corner block in a good family area with lots of mature adult trees in a quiet neighbourhood near schools, shopping centres and parks. That’s about the bluest chip a block of land can get. I’ve additionally had a lot of success buying these blocks near where someone is spending a billion dollars upgrading a shopping centre or making a new building or upgrading infrastructure.
My theory is if you own the highest quality block of land in an area with a lot of capital upgrades or growth, the waterfall effect on value from so much capital being injected into a location at one time waterfalls onto all the surrounding nearby properties and they all benefit from that investment with land price growth. This is why it’s important to know what’s coming in an area that is large and out of your control.
Conversely you can have the opposite happen where a high quality block of land randomly gets a highway built next to it and that reduces land values. Richmond, a high quality location in inner Melbourne had very expensive land value until the government opened a safe space for injectable heroin for addicts to go for medical care and safe usage of their drugs. The idea was to provide medical care to reduce drug deaths. If people are going to do drugs, they may as well do so in a safe area. But what that also did was skyrocket the amount of crime in the area and land values fell as a result. Lots of people lost a lot of money there because of this.
Construction Cost
The next component is construction cost. If you had to build this exact house again, what would it cost to do? Construction costs generally only increase, they almost never go down. Because it takes so long to build a home and materials and labour costs are only ever rising, it’s fairly straightforward to predict and figure out what it would cost. It’s as simple as taking the number of square metres within a house and multiplying it by the cost of construction.
In Australia, over my career alone, it used to be about $2,000 per square metre to build a home before the Covid pandemic. Now it’s about $3,000 per square metre. Soon it’ll be $4,000 per square metre and the trajectory is only upwards. This is for a large high quality luxury home built to a high standard and free of defects. What tends to happen with construction costs is they stay flat for long periods of time then randomly go up rapidly and sharply and it takes people by surprise.
What that looks like in practice is a trade such as a carpenter who for a long time charges $20,000 for some work then decides that work should now cost $30,000. That becomes the price for a long time. Then he might decide in another few years the work should now cost $40,000 and so on. The builder of the house passes all those costs along to the client who is the person engaging the builder to build the house. That phenomena plays out across the board in all trades at the same time. It surprises lots of people because a month ago the cost of the same work could have been 30% less. But that’s just how it goes.
You can pretty easily call up any builder and ask them how much per square metre they’re building at and is a good approximation for the construction market. They’ll usually be within striking distance of each other. But there can be a big difference in quality of work and cost to produce that work. A word of caution, stay clear of very cheap builders. There’s a good saying I like, the most expensive thing you can do is engage a cheap builder.
Remember, construction is a craft. It’s an art. Very good builders are artists. Don’t try to screw down the price of high quality art because all that happens is you screw up the art, in this case the house. Houses built with lots of problems are very hard to fix and very bad quality builds almost need to be knocked down completely and started from scratch again.
Something about houses that I’ve never understood and seen often is a lot of people will pay top dollar for the best block of land but then try to cut corners to save costs on construction. I think this is a huge mistake. You can have the best located land imaginable but if the house sucks, people aren’t going to enjoy living there and pay lots of money to buy the house. I can’t tell you the number of times I’ve seen a person spend over a million dollars on land only to buy their joinery from IKEA or try to do a lot of the trades themselves to save money.
Personally a good rule of thumb I like when budgeting for a project is 1/3rd land value, 2/3rds construction cost. Budgeting enough money to build with is the best way to get a high quality product and work with the best builders. It gives them enough money to build a high quality end product and not have to worry about where they need to compromise the quality of their craftmenship.
You’ll often find the best builders are the ones who are the most communicative and best at fixing the defects within their builds because they care the most about the quality of the work and the quality of their art. If a builder is hard to contact and isn’t eager to improve or fix their work, then they’re not a true artist and you should stay away from them. Fundamentally, all a builder is is a professional communicator, project manager and problem solver. They plan and liaise all the trades to do each work in sequence to get a home made and fix all the problems that emerge along the way.
Cost of Capital
Houses are incredibly expensive to build. So expensive that almost nobody has the amount of money that it costs to build a house in cash. So what they do is borrow it, usually from a bank. But the bank also has to make a profit lending the money to people to build their houses. The way the bank profits is by themselves borrowing money from the government or depositers, then lending it at a higher rate to customers. That’s why whatever the interest rate is, banks are always lending that money out at a higher interest rate, usually by a few percent.
What people are doing when they borrow money to build a house is they’re borrowing a lifetime of money from the future and bringing it into the present to spend on building this house. Then they pay back the future money over the remainder of their life. The bank that lent them this money charges them the interest rate to rent the money from them until it’s all paid back and takes the house as security via a mortgage in case the customer defaults on the loan and can’t pay it back. But most people always pay back the bank loan, it just takes them the rest of their lives, especially after tax.
This is a beautiful system when you think about it. Because it lets the person live in their dream house right now and for the rest of their lives even though they didn’t have the money to build it with right now. If a person had to build a house from their savings, most people wouldn’t get their dream home till they’re 60 years old, which is around the time most people have fully paid off their home loans by. It’s a system where everybody wins. The bank wins because they make a profit. The customer wins because they built their dream home with money they didn’t have and can live in it now. The builder wins because they charge a profit margin on building the home.
But the money the bank lends to the customer isn’t free. The tradeoff is over a lifetime, the interest paid on the loan ends up being a lot and is why it’s referred to as the cost of capital or the holding costs for the debt. Because it has a very real cost that everyone has to pay. This is why it’s an important part of the value calculation. You can’t buy land or build anything without getting capital to do it with.
With long term interest rates around 5% in Australia and a home taking 12 – 24 months to build, I always like to use the broad figure of 10% for the cost of capital. Mainly because it’s nice and simple to add on whereas the land value and construction costs components are more complicated to figure out. But also because it shoots a bit high to include all the fees and lawyers and brokers and financial advice and random extra bits that you might pay for when you borrow money.
Developer Margin
The last part of the formula is the risk. Construction can be a dangerous game with many risks involved. There’s land risks I highlighted above where the land value can go down. There are construction risks where the builder goes bankrupt midway through a build or it costs a lot more to build than everyone thought or the home is so full of defects that it costs a lot to fix.
There’s life risks where the customer loses their job and can no longer pay the loan to the bank. Or the customer gets divorced or dies midway through a build and stops paying for it. The whole build could get hit by a fire or a flood or some other natural disaster. Builds that are meant to take 12 months can blow out over time and over budget. There are a lot of risks and problems that can occur.
Most end customers don’t actually want to go through this whole process, they just want to buy an existing built new home that has most of what they like and want already in it. They don’t want to take on the risk to do that work themselves where they have to take responsibility for whatever could go wrong. But property developers professionally take on those risks and their talent is in making high quality decisions and reducing the impact of problems that emerge.
Most of the problems that occur are unknown unknowns to people who have never done it before. But for a developer they are known knowns because they’ve done it before and they know what processes or systems have to be in place to get it right. In property development, prevention of problems is the best source of keeping costs down because when problems do happen they tend to be outrageously expensive.
Developers are experts in navigating this complicated web. But to do that they have to make a profit. Because from buying a block of land to having a finished house to sell might take 1 year of work but 2 years of their lives. They have to make money to spend that time and expertise doing it. Those risks are generally baked into the developer profit margin which is the margin a developer makes by going through the exercise of buying land, taking a bank loan, constructing a house and then selling it to customers on the market.
That profit margin is usually 10% – 20% of the final selling value. When a person buys a built new house, they’re almost always paying 10% – 20% of that value to the developer as their profit margin to bring that product to the market. This is why you have to factor that in as it’s an important component of the property valuation formula because it accounts for all the risk and expertise involved to make this house happen. If you do the work yourself, you make that developer margin instead.
Market Timing
There’s probably an extra final component to property value which is market timing or sentiment. But I don’t really include this in the formula. Sometimes markets are bubbly with lots of irrational property interest with people prepared to overpay for property and sometimes markets are docile with everyone unlikely to buy or sell anything. You can usually tell from looking at the news or general economy the timing of the market. If you’re in a recession or growth period, that can change market sentiments about what happens to property.
The problem about market timing is that it’s really hard to do well. In fact almost everyone I’ve ever heard say they are good at it, if you look at their investment returns, you find actually they are mediocre at best. It’s because when front page news is saying it’s a good time to buy property, it usually isn’t. But you just don’t realise that. To take advantage of timing a market, you generally want to be counter cyclical.
So for example when front page news is saying markets are great and property is growing and you should buy property, what you actually want to be doing here is selling property. And when front page news is saying markets are bad and property is falling and you should sell property, what you actually want to be doing here is buying property. Buying in a bad market and selling in a good market is an easy way of getting force multiplication on your investment returns but is impossible to quantify exactly how or by how much.
But this is easier said than done. It is very hard to spend a lifetime’s amount of money to buy an asset when everyone around you; your friends, your colleagues, your family are all telling you what an idiot you are for doing it because they read on the news or heard from their friend that it’s a bad idea. Or everyone you know is telling you you’re missing out on a great investment by not buying a house when they all are. Social cues are probably the reason many people have not been able to time the market while thinking to themselves that they are timing it.
I don’t know why the property market is like that but it is. That’s about as good as an approximation for the wisdom of crowds not being very wise as you can get. Whenever I’ve found in my life that there has been a consensus of everyone thinking something is a bad idea at the same time. But I think it’s a good idea, I’m usually right. Consensus forms when everyone isn’t really thinking for themselves but are parroting back ideas they’ve internalised but heard elsewhere. If you follow the hearsay train back to where it came from, you almost always find it’s the news.
Uniqueness of Supply
Another piece that can provide a tailwind to real estate value but is practically impossible to quantify is the uniqueness of the house you’re building and how it fits within the dreams of someone who wants it or not. A good way to think about this is the same way a startup might achieve product market fit which allows it to grow rapidly, you might build a house that is so perfect for a specific group of people that they fall so deeply in love with this one specific house that they’re prepared to pay a lot for it.
When you’re building a house you can in a sense manufacture this phenomenon if you’re skilled enough. Most property developers aim for the middle, they design something very conventional to aim for the largest cohort of potenital buyers and try not to do anything too different or unique that might turn people off their product. The thought being that the competition between those people in the middle will be enough to create the price premium.
But you can do the opposite of that, make something that is so unique that the market has no choice but to buy it from you and overpay you for the privilige of doing so. Adding so much character and so much uniqueness that you can bring the product to the market at any price and the buyer has nowhere else to go to get this exact house because it is 1 of 1. It fits their needs just so perfectly.
You could builid a house in a very religious area and design the best prayer room within it, something a very devout family may fall in love with. Or you could spec a kitchen with professional restaurant grade high end appliances, something a person who cooks to a high standard might love. You could put a professional grade cinema or gym, something cinephiles or body builders will love. You could build a house that has a beautiful shopfront on the ground for a family that runs a business from their home.
But you need to be wary when trying this. Do it right and you get spectacular returns because you’ve made something so unique they have no choice. Do it wrong and you basically have no buyers for your product. There’s a thin line between unique and weird. The former is desirable, the latter is a turn off for purchasers. Many people have lost fortunes trying to design and build something too unique that frankly there was just no market for ever.
Personally, I think a good idea is to push the envelope on uniqueness in ways that appeal to everyone and that are hard not to love. A straightforward way of doing that is taking things people love and then just making them bigger and nicer. For example by making bedrooms and living spaces and kitchens much larger than average dimensions. Nobody has ever complained that their bedroom or kitchen was too big. Or by installing the latest technology or items so useful that nobody has ever considered the utility of it before until they see or use it for the first time.
Fundamentally this micro scale unique investing for higher returns is what a developer is trying to do. They’re trying to for example spend $100,000 on a pool to get a buyer to come along and pay $300,000 more for the property because it has a pool. Getting individual market returns on individual dollars spent. For example, a developer intuitively knows if they buy a cheap $1,000 Ariston oven, someone isn’t as likely to pay more for that kitchen as if they buy a $10,000 Gaggenau oven. That individual curation and micro investing on this level is how to get really good at the game of property developing.
Many people have tried to buy the cheapest appliances and make the cheapest kitchen they can, only for nobody to want to buy that house because of that kitchen. Conversely many people have spent absolute fortunes on designing kitchens with the very best technology and appliances, only for a buyer to come along and pay 2 or 3 times what they spent for that house because of that kitchen. There’s not real rulebook for this, it comes from experience and intuition.
If you got very granular, you could say that the developer is investing $100,000 into a very good kitchen or pool or other itme to then get a 200% return on those dollars invested. But this is as much art as science. If you asked a professional to quantify it heuristically, I bet most of the time they can’t put it into words why one oven provides a better investment return on home value than another oven. But actually that’s exactly how it works, for pretty much every item selected in a house.
Because it’s a matter of understanding the relationship between taste and value, something inherently qualitative, it’s extremely hard to explain why it works exactly. A beautiful home isn’t appealing to logic, it’s appealing to emotion. If someone loves something, they pay more for it. So if you can manufacture that love, you make more money. Which is what’s happening and the developer is trying to do, they’re attempting to manufacture love through the intersection of craftsmentship, applied micro investing and artistic taste to achieve above average investment returns.
Putting it all Together
So if you put the formula in action you start to get a valuation heuristic that is extremely useful and here’s how it goes:
You might see a house that is 250 square metres in size for sale for $1 million dollars. When you break that into it’s components you see that the land value is $300,000. The construction cost at $2,000 per square metre X 250 square metres is $500,000. Adding both of those and you get a total of $800,000 for land value and construction cost. Then 10% for the holding cost of capital is $80,000, then 10% – 20% for the developers margin is another $80,000 – $160,000. Putting that all together gives you a total of $960,000 – $1,040,000.
So you can see that a sale price of $1 million dollars is about right for this property. Because that’s the value of the sum of the parts of this property and the cost you would incur to replace this property today. It’s always a range because the part you can never be sure of exactly is the exact margin the developer is making.
But what if the property was selling for $800,000? Remember, the formula doesn’t care about the sale price, just the underlying value. Well then you would know that you’re buying the property for less than what the parts are worth and what will likely happen in the future is the property will grow in value to between $960,000 – $1,040,000 and you’ll make a profitable investment. As the property value catches up to what the individual parts are worth to replace it today.
But what if the property was selling for $1,200,000? Then you’d know that the property is selling for more than what the parts are worth and you’d be overpaying for this property. Because the replacement value is less than what you would be paying. It means that you can go buy land and build this exact same house literally next door to this house and it would cost you less than what this house is selling for. This is the axiom for why the formula works. If a property is selling for too much, you can just build it next door for a lot less.
It’s not necessarily a bad thing if you want to overpay for property to get it right now instead of in the future if you needed to build it. Eventually the cost of construction and the land value will grow to equal this amount. So if you really love the house and are happy overpaying, you can. But at least you know why. In this scenario, you may be paying a developer margin of 40% because you can infer and know what that developer has paid for land value and construction cost and cost of capital. So the developer piece is the only piece missing so if a price of a property is abnormally high, that’s where the delta is going. You can decide if you wish to compensate that developer or not by buying it.
When you buy property you’ll almost always be paying $1 for every $1 of land value. You’ll also almost always be paying $1 for every $1 of construction value. But where you start to really make money is by figuring out properties where you can pay less than $1 for each $1 of land value or construction cost. Because those are undervalued assets and the market will eventually reprice them back to $1 for $1. What you really don’t want to be doing is paying $2 for $1 of land value or construction cost because the market will reprice them down or they’ll take a long time to grow.
You can also see areas where maybe the land value is growing faster than normal or construction is more expensive than normal. So in those locations a house will also grow faster. In some areas land may be growing at 5% per year while in others it might be 15% per year. That allows you to project out in time in a location. Construction costs might go up by a lot in a year so if you buy a property right before then, in all likelihood it will grow too. Because it takes time for markets to reprice.
This is what happened right after the Covid pandemic. Randomly construction costs jumped about 30% all around the world. Then somehow people were surprised when property prices also grew about 20%. But it’s the construction component of the property price that was growing because if you tried to replace that part today, it would be 30% more expensive. Lots of people made huge returns and thought they were investment geniuses without understanding why or what the components of the growth was made of or the mechanism for why it happened.
What also happened during the Covid pandemic is the cost of capital was cheap at 2% as governments tried to stimulate their economies. So that 10% I usually use in the equation for cost of capital, it was temporarily much less. Then when interest rates went back up to 7% from 2%, people were somehow surprised when property prices grew a lot as a result. I was telling anyone who would listen in 2020 to borrow as much money as they could and to buy as much property as they could because the cost of capital was so cheap. It was a once in a lifetime cost of capital in fact.
When interest rates would go back up, the property values would have to go up too in line with that repricing of the cost of capital. But everyone told me I was an idiot because all the newspapers were talking about huge property price collapses, most of which didn’t happen anywhere near to the degree they were catastrophised about in the news, except maybe in commercial offices. It just so happened there were a lot of other tailwinds that you couldn’t see coming but it fundamentally had sound economics.
All of property as an asset class I think follows these sort of economics. If a property is selling for more or less than the value of the sum of its parts. It will eventually reprice to what the sum of the parts equals, the problem is you just have no idea when. So if you’re prepared to hold long enough the returns will eventually arrive but you don’t know when. That’s the lens at a microeconomic level through which I look at and think about real estate value.