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.
What Percentage of Hard Costs are Soft Costs?
Technically speaking, no percentage of hard costs are soft costs. In many cases, about 70-80% of a project’s budget will be allocated toward hard costs that deal directly with the physical construction of the building or structure, while the other 20-30% will be utilized for soft costs. It is important to remember that costs involving physical labor, such as repairs, maintenance, and landscaping, can also be soft costs, but only when they occur after construction is complete.
Are Financing Costs Soft Costs?
Yes, because they are not directly related to the physical construction of a building or structure, and are typically incurred in the planning and development phase before construction begins, financing costs are considered soft costs.
What Soft Costs Can be Capitalized?
As briefly discussed earlier, some costs related to a real estate development project can be capitalized, allowing investors to strategically segregate costs based on their ability to generate revenue over time. Through the critical process of cost segregation, the overall cost basis (value) of a development as reflected in a balance sheet can be significantly increased.
Although determining exactly which soft costs to capitalize can be complicated, the majority of soft costs related to a real estate development can usually be capitalized. This includes architectural and design fees, contractor and legal fees, permits, and real estate taxes. Generally speaking, soft costs that should not be capitalized typically include those associated with the financing of loans, whether related to the construction or acquisition of a property or development. Again, while cost segregation is important, it can be a complicated and sometimes confusing process, and investors should consult with professionals to be sure that they have a sound legal basis for capitalizing any cost.
What are Soft Costs in Business?
In business, soft costs are often referred to as “indirect costs,” and are typically expenses that do not directly relate to the day-to-day processes or operation of the business. And while indirect costs in the context of a business won’t necessarily be similar to soft costs related to a real estate development project, the general principle can be carried over.
For example, hard costs in a business setting are any fixed costs related to operations, such as employee salaries or regular fees paid to a vendor for services. Soft costs, on the other hand, are those that are not fixed and therefore harder to anticipate, such as individualized marketing campaigns and variable tax obligations.
Is Salary a Soft Cost?
No, because it is a fixed payment in direct relation to the physical construction of a building or structure, a salary is not considered a hard cost in the context of a real estate development project. Legal fees, by contrast, are considered soft costs, because they do not directly relate to the physical construction of a building or structure and are not a fixed expense, making them more difficult to anticipate.
Funding a real estate development project is an ambitious and exciting way to invest in real estate, but it is also significantly more complex than merely acquiring a property to eventually resell. Investors who hope to be successful in this space must first understand the full spectrum of associated expenses, which includes being able to make the critical distinction between hard and soft costs.
To briefly recap, hard costs are fixed expenses directly related to the physical construction of a building or structure, whereas soft costs are expenses that are typically not fixed and are not directly related to physical construction. Hard costs include expenses such as labor, materials and utilities, and soft costs are variable costs that include expenses such as architectural and design fees, legal fees, taxes, and maintenance and repair costs that occur after construction is complete.
It is also important to remember that while hard costs can be estimated with relative ease, soft costs are often more difficult to anticipate. Additionally, soft costs will be incurred throughout the entire lifecycle of a real estate development project, whereas hard costs will only be incurred during construction.
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