This post is ultimately going to be about real estate, but bear with me for a minute. In Warren Buffet's 1989 letter to shareholders, he describes something that he refers to as the "cigar butt" approach to investing. This has been talked about a lot since this letter, but the general idea is that if you buy a company cheap enough, it doesn't matter that there may only be "one puff left." Your low cost basis will make that puff all profit.

This has a logic to it, but Buffet goes on, in this same letter, to call this a "bargain-purchase folly." You may think you're getting a good deal and an enviable discount to market, but if the company sucks, you're likely in for a rough ride at some point. This lesson learned is what resulted in his famous adage that it's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.

Now, let's consider something that Howard Marks wrote in the memo that I cited yesterday. He calls it one of his guiding investment principles and goes like this:

"There's no asset so good that it can't be overpriced and thus dangerous, and there are few assets so bad that they can't get cheap enough to be a bargain."

Interesting. I agree with the first piece. It doesn't matter how good an asset may be -- and we can now start to turn our minds to real estate -- there's of course a way to pay too much. But is this second part entirely or at least mostly true? I'm not so sure. It might be a cigar butt.

One of my own rules for real estate is that just because an asset is cheaper than it was before, it doesn't necessarily mean that you're getting a good price. And that's because I have seen "bargain prices" drop even further. In fact, when it comes to real estate, including development land, sometimes the value that you should be willing to pay might even be negative or less than zero.

What this means is that someone would need to pay a rational market participant in order to take on the asset or development project (usually this comes in the form of a subsidy and it means the market isn't functioning on its own).

"Buying below market" and "buying below replacement cost" are commonly sought after features in the real estate industry. And indeed, buying well is critically important. But I do think that it's important to be just as worried about overpaying as you are about buying a shitty asset. Buying too cheap can also be a problem, assuming the market is pricing the asset accurately. It means you probably don't want to own it.

Cover photo by Simone Hutsch on Unsplash

As many of you will know, I very much enjoy reading the investing memos of Howard Marks. And buried somewhere in one of them is an analogy about the kind of investors who try and time the market and/or who constantly chase the next hot thing (whatever asset class that may be).

It goes something like this: If you're trying to catch a bus and you're running from bus stop to bus stop trying to perfectly time the arrival of the next one, there's a chance that you might never catch a bus. But if you patiently wait at one stop, eventually a bus will come and eventually you'll be able to get on it.

I like this analogy because you see this jumping around in every industry. In tech, a lot of people have moved from the crypto bus stop to the AI bus stop and, in real estate, we've seen it, and are seeing it, with industrial, student housing, and other in-demand asset classes. Capital wants its yield.

Now, it's obviously important not to ignore macroeconomic shifts and fundamental changes to your sector. If your bus route has been cancelled or rerouted, you don't want to be waiting patiently at that stop. You want to be on the move.

But if the long-term fundamentals in your sector haven't changed and everyone else is distracted by what's new and shiny, hanging out can be a powerful strategy. And this brings me to something that Marks recently wrote about in a memo called "On Bubble Watch." In it, he talks about the three stages of a bull market.

Here's how he describes stage one:

The first stage usually comes on the heels of a market decline or crash that has left most investors licking their wounds and highly dispirited. At this point, only a few unusually insightful people are capable of imagining that there could be improvement ahead.

In my view, this is broadly the stage we are at in the commercial real estate industry. It's tough out there. But at some point in the future, we will move past this stage and go from "a few unusually insightful people" to "most people" and then finally "everyone." These are the exact words used in his 3 stages.

But here's the thing.

There's lots of opportunity if you can be among the "few unusually insightful people." It gives you the chance at being right about something that "most people" are overlooking. But that means you need to hang out at the bus stop that you have high-conviction around, which can be hard if everyone has left you in search of another one.

As we have talked about many times before, the best answer to this question is that it's worth whatever money is left in your pro forma once you've accounted for everything else. This is what is called the "residual claimant" in a development model. And it means you start with your revenue, you deduct all project costs, including whatever profit you and your investors need to make in order to take on the risk of the development, and then whatever is left can go to pay for the land.

This is the most prudent way to value development land; but of course, in practice, it doesn't always work this way. In a bull market, the correct answer to my question might be, "whatever most market participants are willing to pay." And sometimes/oftentimes, this number will be greater than what your model is telling you, meaning you'll need to be more aggressive on your assumptions if you too want to participate. (Not development advice.)

Given that determining the value of land starts with revenue, one way to do a very crude gut check is to look at the relationship between land cost and revenue. This is sometimes called a land-to-revenue ratio. And historically, for new condominiums in Toronto, you wanted a ratio that was no greater than 10%. Meaning, if the most you could sell condominiums for was $1,000 psf, then the most you could afford to pay for land was $100 per buildable square foot.

However, this is, again, a very crude rule of thumb. I would say that it's only really interesting to look at this after the fact. Because in reality, things never work this cleanly. For one thing, there is always a cost floor. Don't, for example, think you can buy land in Toronto for $80 pbsf and sell condominiums for $800 psf, because this will not be enough to cover all of your costs. You will lose money.

Secondly, there are countless variables that have a huge impact on the value of development land. Things like a high required parking ratio, development charges and other city fees, inclusionary zoning, and so on. All of these items are real costs in a development model, and so they will need to be paid for somehow.

Typically this happens by way of higher revenues (in a rising market), a lower land cost (in a sinking market), or some combination of the two. But in all of these cases, it means your land-to-revenue ratio must come down to maintain project feasibility. This is why suburban development sites typically have a lower ratio -- too much loss-leading parking, among other things.

Of course, there are also instances where the correct answer could be a land-to-revenue ratio approaching zero, or even a negative number. In this latter case, it means your projected revenues aren't enough to cover all of your other costs, excluding land. For anyone to build, they will require some form of subsidy. And this is basically the case with every affordable housing project. They don't pencil on their own. (For a concrete example of this, look to the US and their Low-Income Housing Tax Credits.)

So once again, the moral of this story is that the best way to think about the value of development land is to think of it as "whatever money is left in the pro forma once you've accounted for everything else." Because sometimes there will be money there, and sometimes there won't be.

Photo by Jannes Glas on Unsplash