Highest and Best Use of Capital Part One: Investing for Profit

Early on in learning about real estate investing, I was exposed to a beautiful and powerful concept: highest and best use.

The idea is often explained with an example, so here’s a classic: There’s a growing town. In that town you may find a neighborhood that is transforming over time. A number of old, obsolete buildings are being replaced one by one with beautiful new buildings, each new building meeting the growing needs of the community - rental housing, retail stores, etc. A real estate investor is eying another aging, vacant building in that neighborhood, and evaluates many different development ideas before determining the one that seems to be most in demand, and therefore can command the highest income via rent payments.

Now as real estate investors, identifying the highest and best use of a particular property is powerful. It shows you how to maximize the (gross) income of any particular parcel of land.

But that’s not actually the game we’re playing as real estate investors.

Maximizing investment returns requires an investor to compare one property to another, inclusive of the current state and potential highest and best use, discount by the time and cost of achieving it, and then compare all the potential deals to one another. That means comparing not only different parcels in the same neighborhood, but zooming out and realizing what other properties, or even non-real estate investments, can be executed with the same money.

The game as an investor is to identify and achieve the highest and best use of capital.

Investing for profit

Discovering the highest and best use for just one particular property is no easy feat. It requires information that’s not always easy to come by, models you can run that information through, access that may take time to unlock, and a level of intuition that not everyone possesses.

Informed math

One of the necessary skills for investing for profit is purely analytical - developing a financial pro forma model that accurately represents the expected financial outcomes of a deal. The meat of this work is determining the bottom-line “inside” the deal, the Net Operating Income (“NOI”). This considers the potential gross income (revenue) that can be generated from paying tenants, subtracting contra-revenue items like vacancy, as well as the necessary property expenses to operate the asset. Both income and expenses are highly dependent on the property’s location and physical characteristics. Knowing the math is not enough - it takes both math as well as a trained eye that has seen enough deals play out to determine proper model assumptions. The pro forma NOI then becomes the lynchpin of the rest of the deal setup.

Active network

Having deals to underwrite at all takes a very different skill: cultivating relationships that can lead to deal opportunities. Succeeding at this part of the equation takes both energy and soft skills. I’m not saying everyone who is great at business development has some sky high emotional intelligence - you’d be surprised how many people in this business have pretty low emotional intelligence when it comes down to it. EQ is one of the soft skills, but there are other important soft skills including clear verbal communication and confidence.

An active, engaged, growing network of contacts in the real estate industry including other investors, sales brokers, capital markets brokers, and others can lead to an increased amount of deal opportunities, including the coveted “off-market” deals.

Soft skilled or not, the energy component here means you are simply staying active and touching these relationships frequently enough that they remember you and what you are looking for. It’s amazing how often those who follow up beat those who are smarter.

Intuition

Investing isn’t all math and opportunities, though. Intuition plays a key role as well.

This is how great investors find and maximize opportunities that are not obvious to others. Rather than copying an existing plan, intuition helps an investor generate ideas for novel uses and amenities for properties that resonate with tenants, creating a premium rental price, or quickly identify the pairing of a deal with the right partner without having to work through every underwriting scenario. As a matter of fact, it’s rare for good investors to underwrite every potential scenario for a property; it’s not feasible to run a full analysis about everything, everywhere, every time. Intuition both guides what to analyze, and interprets its results.

This intuition isn’t something you're born with, but rather something that's developed over time, and is honed through experience. This is why having experience in the market or having experienced partners can be invaluable in identifying the right opportunities and navigating potential pitfalls.

The scarcest resource

To find the most profitable return on capital, it requires making timely decisions with limited information and cultivating access in the right places ahead of time.

While it may seem like the most scarce resource in this game is capital, in reality the scarce resource is really time.

Therefore, activities that increase your efficiency must be evaluated in addition to pursuing the investment opportunities themselves. You can’t make time, but you can maximize your time.

That’s why in part two of this series I’ll dive into building your investment machine to drive efficiency - so you can increase your return on time invested.