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Real estate and scalability
Growth is about returns on incremental capital, not passive capital appreciation.
Please indulge me—again—as I use a couple of homespun analogies to explain my thinking about a business problem.
Imagine, for a moment, you’re running a lemonade stand. You’ve got the perfect spot, a tried-and-true recipe, and loyal customers. Your lemonade stand makes you a decent profit, enough to keep you in pocket money and ice pops all summer long. But what if you want to earn more?
To make more money, you need more lemonade stands, and each new stand costs you money – to get the supplies, and to hire someone to look after it for you. Not to mention that each new stand may not be as profitable as the original, especially if you hire an unmotivated helper or the new spot is in an area where people don’t like lemonade as much. It could work, but there’s a risk you’re reinvesting your earnings at lower returns than you want, and the risk to your day job means it probably isn’t worthwhile.
You end up doing pretty well at your day job. But your entrepreneurial drive means you keep looking for investment opportunities, and you hear that real estate is a good option for stable returns. You decide to buy a second property, and it gives you a rental income. So far, so good. But let’s ask ourselves the same question as before: what if you want to earn more? Well, you’ll need to buy more properties. Each new property requires a hefty capital investment, and there’s no guarantee the new properties will yield the same return as your first one. Sounds a lot like our lemonade stand situation.
This is the crux of both problems. Real estate has mediocre returns on capital, meaning the income you get relative to the amount invested is rarely exciting compared to other types of investments. When it comes to returns on incremental capital – the return on the additional money you put in – capital intensive investments, like real estate, often fall short and become riskier than they seem.
Picture a bustling restaurant in the heart of the city. It’s thriving, with customers lining up every night to get a table. The owner sees this demand and decides to open a second location in the suburbs, expecting it to be just as successful. But once it opens, it barely gets half the traffic of the original restaurant.
The owner has invested significant capital in this new venture — securing a lease, renovating the space, hiring staff, buying supplies — but the return from the new restaurant isn’t matching up to the money poured in. Here, the additional money spent to open the second restaurant is the incremental capital, and any extra income from the second restaurant is the return on that incremental capital.
As this example illustrates, the returns on incremental capital can be drastically different from the initial investment. It’s not just about having the money to expand; it’s about what kind of returns that expansion will bring.
The WD-40 Company provides a good example. They have historically produced their well-known degreasing fluid in a factory not much bigger than the average school assembly hall. It’s a popular product and the company produces higher than average returns on capital. But it can’t grow beyond that. Incremental capital doesn’t produce the same high returns on its current capital, so rather than reinvest earnings, the management distributes excess cash flow back to shareholders through dividends and stock buybacks.
Warren Buffet once said that best business is the one that earns a high return on capital and that keeps using lots of capital at those high returns. So, in our restaurant scenario, if the owner could open new branches with high customer traffic similar to the original, then the restaurant would indeed be a compounding machine. Or, in WD-40’s case, the business can’t compound precisely because a new “branch” wouldn’t add to its bottom line.
In the world of real estate, similarly, opening new “branches” or buying more properties often doesn’t yield the same returns, making it less effective as a business model than a business that can scale itself well with incremental capital. This notion of scalability is an essential dynamic when considering real estate as a long-term investment strategy.
To contrast with real estate and our restaurant example, let’s consider a software company with a highly desirable product that has an excellent return on incremental capital.
Imagine a company that creates an innovative app. They’ve spent their initial capital developing the app and marketing it to attract their user base. After the app becomes a hit, they find that they can make significant profits by adding new users, and here’s the twist: attracting additional users does not cost them much more.
Each new user requires a negligible amount of data storage and server capacity—a tiny fraction compared to the money the user brings in through subscription fees or in-app purchases. This is the key to their great returns on incremental capital. The capital required to bring in each additional user—the incremental capital—is small, but the return—the money made from that user—is high.
This is a prime example of a business with excellent returns on incremental capital. They can continue to grow and increase their profits without proportionally increasing their capital investment. Unlike our restaurant owner or the real estate investor, the software company is able to scale easily with new capital.
These scenarios highlight the importance of understanding the dynamics of returns on capital and incremental capital when deciding where to invest. Some businesses, like this software company, have the potential for high returns on incremental capital, making them potent vehicles for long-term wealth creation.
It’s not all doom and gloom. Real estate can have a place in a diversified portfolio. It can offer a regular income stream and price appreciation over time. But it’s essential to be aware of the hidden costs and the often-overlooked poor returns on capital and incremental capital.
The next time you’re tempted by the lure of bricks and mortar, remember our lemonade stand. Ask yourself, how much is each new stand—or in this case, property—going to cost you, and what return can you realistically expect? The answer may not be as sweet as you think.