Hard costs vs. Soft costs  - A guide for real estate investors

Investing in real estate can be a wise use of money because of the consistent demand for various types of properties. However, it's not always a guaranteed success, especially in real estate development where projects can be complex. It's crucial for investors to be aware of the costs involved, including construction, maintenance, and legal fees. To navigate these expenses effectively, investors often categorize them as hard costs (construction) and soft costs (legal fees). Distinguishing between these helps with budgeting, risk assessment, and determining overall profitability. Understanding these categories is essential for success in real estate development.

## **What is the cost in real estate development?**

Real estate development extends beyond property purchase, focusing on purposeful construction aligned with a specific investment strategy. Projects vary from single houses to connected complexes like housing or apartment units. Costs are influenced by project scope and intended use, encompassing expenses such as land purchase, permits, construction, labor, maintenance, and legal fees.

In addition to these visible costs, real estate development involves various expenses in both the preliminary and subsequent stages. This includes research and marketing efforts related to the project's overall business strategy. Moreover, complex management and legal obligations arise in connection to the development's intended use, adding layers of intricacy to the process. Developers need to carefully consider and plan for these diverse costs throughout the entire lifecycle of a real estate development project.

## **Why should investors know about these costs?**

Real estate investors need to consider all costs associated with a development project due to their direct impact on returns. Developers may highlight market favorability or potential business profitability, but understanding expenses is crucial. High development costs can lead to years of operating at a loss before any profit is realized, affecting an investor's portfolio or risk tolerance.

Effective budgeting is key for long-term profitability. While not all development costs are losses, savvy investors use budgeting to anticipate future gains. For instance, investing in technology for an office building can be seen as an asset, enhancing business operations and future revenue generation. This approach, known as capitalization, ensures that investors recognize expenses crucial for generating future profits, preventing a misleading balance sheet that only reflects losses and overlooks potential gains.

## **Types of cost**

In the realm of real estate development, costs can be broadly categorized into two main types: hard costs and soft costs.

**Hard costs**

Hard costs are tangible and directly tied to the physical construction of a building or structure. They include expenses like materials, labor, equipment, and interior fixtures.

**Soft costs**

Soft costs are indirect or intangible expenses that are not directly related to physical construction. They encompass planning, administration, insurance, legal fees, real estate, and property management. Soft costs often extend beyond the construction phase and contribute to the overall project development.

## **What is included in hard costs?**

Hard costs in real estate development cover all construction-related expenses, including initial landscaping work such as tree planting and installing sculptures. However, ongoing landscaping expenses, like regular upkeep and maintenance after construction, are not classified as hard costs due to their occurrence post-completion and increased difficulty in anticipation.

## **Some examples of a hard cost**

Examples of hard costs include:

**Materials:** The raw materials required for construction, such as concrete, steel, wood, and other building components.

**Labor:** The cost of construction professionals and workers involved in the building process, including plumbers, carpenters, and electricians.

**Equipment:** Expenses related to acquiring or renting machinery and tools necessary for construction, such as heavy machinery and safety equipment.

**Interior fixtures:** Costs associated with permanent elements of a building's interior design, like appliances, cabinets, and furnishings.

## **What is included in soft costs?**

Soft costs encompass all expenses not directly tied to the physical construction of a building and are incurred before, during, and after completion. These costs persist throughout the project's entire lifecycle. Unlike hard costs, soft costs are not fixed and may include unpredictable expenses, like repairs due to unforeseen damages or legal fees arising from unexpected lawsuits or permit violations.

## **Some examples of a soft cost**

**Planning:** Expenses related to the planning and research phase, including market research, environmental surveys, and blueprint development.

**Administration:** Operating costs that ensure the project's organization and compliance, such as business software, office staff salaries, and accounting assistance.

**Insurance:** Ongoing costs for various insurance types, including builder's risk, general liability, and property insurance.

**Legal fees:** Expenses associated with legal considerations, such as inspection fees, construction permits, and attorney retainer fees.

**Real estate:** Land-related expenses, such as purchasing land or leasing space for the construction project.

**Property management:** Costs incurred for managing and maintaining the property after construction, including advertising, repairs, and renovations.

## **Difference between hard costs and soft costs in real estate development**

Hard costs in a construction project are expenses directly tied to physical construction. Examples include raw materials like concrete and steel, construction labor (plumbing, carpentry), equipment (heavy machine rentals, safety gear), and interior fixtures (appliances, cabinets). These costs are crucial for building the project.

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On the other hand, soft costs are indirect or intangible expenses that don't impact the actual construction but are still essential. Examples are planning costs (market research, blueprint development), administration (business software, salaries), insurance (builder's risk, liability), legal fees (permits, attorney fees), real estate expenses (land purchase, leasing), and property management (advertising, repairs). Soft costs support the overall project and often continue after construction ends.

## **Frequently asked questions (FAQs)**

**How can I estimate soft costs?**

One can estimate soft costs by considering planning, administration, insurance, legal fees, and ongoing expenses throughout the project's lifecycle.

**Is salary a soft cost?**

Yes, salary is often considered a soft cost, falling under administrative expenses.

**What are soft costs in management?**

Soft costs in management encompass expenses like planning, administration, legal fees, and ongoing operational costs.

**What percentage of hard costs are soft costs?**

The percentage of soft costs varies but typically ranges from 15% to 30% of hard costs in a construction project.

**What soft costs can be capitalized?**

Soft costs that can be capitalized include expenses directly contributing to future revenue, like architectural and design fees.

**What are the most common hard construction costs for multifamily developers?**

Common hard construction costs for multifamily developers include materials, labor, equipment, and interior fixtures.

**How can multifamily developers reduce their hard and soft construction costs?**

Multifamily developers can reduce costs by optimizing project planning, negotiating with contractors, and implementing cost-effective design strategies.

Explore the dynamics of real estate investment, focusing on the essential understanding of development costs. Distinguish between hard costs, directly linked to construction like materials and labor, and soft costs, encompassing planning and legal fees crucial for project success. Learn about the types of costs, the difference between hard and soft costs, and their pivotal role in budgeting for long-term profitability. Gain insights into why investors must grasp these costs, from market considerations to overall business strategy. Delve into FAQs covering estimating, categorizing, and capitalizing on costs in real estate development.

Hard costs vs. Soft costs - A guide for real estate investors

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