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22nd Apr, 2013 Commercial Real Estate

Monopoly Not A Good Analogy To Real Estate

Monopoly is a board game that allows you to step into the shoes of a property mogul.

From the moment you roll the dice, you have the ability to purchase a railway station, utility company or even a street. The pressure to close deals, negotiate a joint venture or agree to a property swap is always thick in the air.

Monopoly is an excellent tool to teach younger players the manner in which assets may generate income streams and the importance of cash flow. Sadly, the game is not a good analogy to real estate. In fact, Monopoly is guilty of oversimplifying, misrepresenting or even ignoring many challenges that a real estate investor must face. In this blog, we will question several Monopoly truisms that don’t stack up.

Building Houses Is Not Always the Optimal Strategy

Monopoly is centred around the theme “buy, monopolise and build”. In the game, building houses is one of the most important strategies to undertake in order to collect higher rents and advance your position.

In the real world, before any developer commits to a multi-family residential development he/she must understand the risks and opportunities. Understanding the economy is the first step that a developer will undertake even before considering site selection. The axiom that “timing is everything” is particularly applicable to real estate development. Picking the wrong time in the economic cycle may mean being exposed to a tightening in monetary policy and, in turn, higher financing costs combined with a sudden drop in demand. Bad timing has the potential to cause a developer financial distress. The variable mortgage rates of the late 1980’s, which peaked at 17%, are a bleak memory for most Australian developers.

Assuming a developer can synchronise their development efforts with the economic cycle, a project feasibility will be undertaken before any site acquisition is made. Residential developers are always interested in the yield of a site. The yield is concerned with the number of apartments that may be built on a site. This number is derived from architectural drawings, which in turn is informed by local planning controls. The feasibility model will project revenues based on the yield and the expected sale price for the product, along with other ancillary income. On the expense side, the model will incorporate the cost of acquiring the site, construction and other hard costs along with soft costs including legal, architecture, engineering and other consultant fees as well as the finance costs. If the development does not work following such an analysis, a developer will not proceed.

Recently, Trident Real Estate Capital evaluated whether a residential development would be feasible on a portfolio asset. Following the production of a concept design by our architect, it was determined that a yield of only 19 apartments would be possible for the 1,600 square meter site.  Our feasibility model allowed us to conclude that the profit from selling the pre-capital gains tax portfolio asset was far more attractive than the risk adjusted rate of return of a residential development.  Building houses, therefore, may not always be the optimal strategy on a developer’s Monopoly tile.

Property Management

In Monopoly, a player will incur costs if he/she lands on a tile and is required to pay rent or tax, or in the event that a card is pulled that requires the payment of miscellaneous expenses. The game completely ignores property management.

A real estate investor’s ability to manage real estate not only involves repairing a faulty air conditioner or a leaking roof, but also extends to leasing activities and tenant relations. Many landlords interact with their tenants in a superficial manner, perhaps to issue a tax invoice for monthly rentals. Trident Real Estate Capital treats its tenants as partners. In fact, some of our tenants have built their businesses in our buildings, growing from two person start-ups to employing over 400 individuals, in one case. It is also not uncommon for our tenants to visit our office and enjoy lunch or a coffee.

Tenants are very much like a VIP customer, their loyalty needs to be earned and, if successful, a landlord is rewarded with high occupancy rates and a rich and rewarding relationship that will forever be mutually dependent.

Location, Location, Location

To win a game of Monopoly, a player must acquire multiple sets of properties which preferably are located all around the board to maximise cash flow. Professional Monopoly players always aim to purchase the orange properties on the second side of the board as they rank second out of ten in visitation frequency and first in pay off percentage. This is closely followed by the red properties on the third side of the board.

Unlike Monopoly, where decisions about what properties to acquire can be definitively based on statistics relating to visitation frequency and pay off percentages, for developers, all real estate is local and knowing the market is critical before venturing into any project. Local knowledge of an area allows a developer to understand the dynamics of the neighbourhood, the existing and anticipated patterns of development, the particular rents and yield that a local property may achieve, and to identify good value for money.

Recently, Trident Real Estate Capital received an information memorandum summarising an investment opportunity in connection with a commercial property on Botany Road in South Sydney. The information memorandum was more detailed than most, which was useful as it informed Trident Real Estate Capital that the vendor was a motivated seller. Unfortunately, the comparables that were disclosed in the memorandum were misleading as the document identified local properties that either had a residential development potential or more favourable planning controls. Additionally, the rental potential disclosed was inflated by at least 25%. A newcomer to the South Sydney area would, unfortunately, not understand or identify the misrepresentations in the memorandum. A newcomer, without working in the area for at least six to twelve months, can not fully appreciate the relevant factors impacting price. Accordingly, local investors are at a distinct advantage and are much less likely to invest in a lemon.

Real estate development and investment is an exciting yet tough field. Not only must successful investors identify the small window of opportunity in the economic cycle, but they must also become familiar with the local submarket and find a suitable property at a reasonable price that satisfies their financial feasibility model. As the old saying goes, “The quickest way to make a small fortune in real estate is to begin with a large fortune.”