First Principles of Real Estate
“First principles thinking requires you to break down previous assumptions. In contrast, reasoning by analogy is solving problems based on prior assumptions.”
Whether you admire him or not, agree with his politics or not or like what Twitter has become (X), Elon Musk is very much in the news these days because he is not only (usually) the richest person on the planet but also a visionary entrepreneur known for his unique approach to problem-solving.
At the heart of his methodology lies the concept of first principles thinking.
Rather than relying on analogies or conventional wisdom, Musk is thought to dissect issues down to their fundamental truths, building solutions from the ground up.
This approach has empowered him to revolutionize multiple industries, from electric vehicles with Tesla to space exploration through SpaceX. Some people even say that Musk's commitment to first principles has reshaped both the technological and business landscapes. That’s because first principles applied to a number of problems allow us to break free from conventional wisdom and think independently. By examining problems from the ground up, we can uncover new insights. At its best, first principles thinking can liberate us from the constraints of existing knowledge and pave the way for breakthroughs. That’s because first principles thinking encourages us to question deeply ingrained assumptions and dissect problems differently.
Around now, you might be thinking “what the heck does this have to do with real estate?” So, without further adieu…..
FIRST PRINCIPLES OF REAL ESTATE
Let’s reconstruct real estate from the ground up and ask what are the fundamental truths in residential housing.
EVERYONE LIVES SOMEWHERE
With the unfortunate exception of the unhoused, everyone lives somewhere. Some people own their own homes, others rent. Some have roommates and others live in their parent’s basement. The vast majority of people in this country are housed and have a roof over their head. And people need a place to live whether mortgage rates are high or low, whether the economy is good or bad or the stock market is up or down. Consider the fact that we all need a roof over our heads a first principle of real estate.
Now this doesn’t mean that everyone has to or should be a homeowner. Many people will rent for their entire life. Nothing wrong with that and the reason isn’t always economic. I know many wealthy people who have been life long renters for whatever their personal reasons are. But, except as noted, we all live somewhere.
Let’s couple that with another thought.
SUITABLE HOUSING MAY NOT ALWAYS BE AVAILABLE
You need or want a place to live but not everyone can always find a home where and when they want it. Let’s consider that another first principle. In fact, in the US right now, there has been a shortage of available housing in many markets for over 10 years. Put simply, that’s because building has not kept up with population growth.
In 2000 the population of the United States was around 282 million. In 2024 we are standing at over 330 million in the US.
From 2000 through 2023, the United States experienced a significant surge in housing unit construction, reflecting the nation's growing population and evolving housing needs. But not enough to keep up with population growth.
Housing construction in the United States plummeted between 2006 and 2010, followed by a gradual increase until 2022. The number of new building permits reached the highest value since 2006 in December 2021, followed by a decline in the following years. That consequently affected the construction pipeline, leading to a declining number of home construction starts.
As of August 2023, the 12-month rolling number of new privately owned housing units completed amounted to almost 1.4 million. Inflation, the increase in material costs, and the overall economic uncertainty were some of the reasons for construction slowing.
SUPPY AND DEMAND
So what happens when there is not enough supply to meet demand?
Prices stabilize - or go up.
People don’t move.
Renters don’t become home owners.
Another first principle of real estate is that supply and demand determine cost.
The reason home prices and rents have climbed fairly steadily is because there have not been enough homes to satisfy demand. Well at least in places that people want to live.
Realistically, the odds of building our way out of the current housing shortage is unlikley.
ECONOMIC OPPORTUNITY DEFINE POPULATION CENTERS
Most people want to live reasonably close to where they work. Yes, since the pandemic there are many more remote workers who never go into an office but some of those jobs are transitioning to hybrid as more firms require their workers to be in the office at least a few days a week.
And even if you are one of those who can work from home, you most likely need good internet and cell connectivity to do so as well as proximity to the services we all need for daily living.
So whether you are a farmer and living very close to where you work, a tech entrepreneur who can work from anywhere, or a retiree looking for a slower pace, let’s write down as a first principle that jobs / lifestyle create housing needs.
CLIMATE LIMITS HOUSING CHOICES
I’m not wading into the global warming debate here - but am referencing that no one is living in either Death Valley or the North Pole. It is worth noting that wildfires in California, hurricanes in Florida, and flooding just about everywhere has led to many insurance companies leaving certain markets or making homeowner’s insurance unaffordable. As another first principle, let’s consider that the entire planet is not habitable. So there are certain limitations as to where housing is even a possibility.
GOVERNMENT REGULATION STIFLES DEVELOPMENT
Some cities, counties and states are more accommodative than others but with laws, regulations and zoning on multiple levels - and all trying to comply with certain national laws, building simply isn’t an easy proposition.
The first principle here - at least as it applies to the US, is regulation slows progress.
CHANGE IS INEVITABLE
The lifecycle of family formation, babies, divorce, job loss, promotions, relocation, down sizing, disease and death continues no matter what the economy is. That means that there’s always a segment of the population making changes to their living situations and on the move. Doesn’t matter if rents or mortgage rates or high or low or there’s a lot of homes on the market or low inventory. The first principle here is that your housing needs will change during your life. If you’re the person reading this who is living in the home you were born in, you are definitely the exception and not the rule.
APPLYING FIRST PRINCIPLE THINKING TO REAL ESTATE
Let’s start by defining the problem I’m applying first principles to: housing availability and affordability.
The first question I ask is why are the major cities located where they are?
In many examples it has to do with ports, rivers, or rail lines. In other words commerce. Would we build the major US cities where they are today of we were starting with a blank slate? I’m going to guess probably not.
Is there an Elon Musk out there who would create an entirely new city in the US? Its possible. Look at Las Vegas as an example. Urban legend has it that the mobster, Bugsy Siegel created Vegas. And once there were casinos, there were jobs.
To successfully create a new city, jobs may be necessary. But what if there was just a small city built primarily for remote workers? Of course you would need to have some percentage of the work force attached to physical jobs in the city such as police, firemen, medical, teachers, restaurant workers etc.
Even better, applying the concept of “anchor tenants” like at the mall (remember those?), possibly some large employers can be brought in as well. (Company towns anyone?)
As to where it would be, I’m sure there is some state with ample land and an attractive climate that would love to increase their tax base.
So, yeah, like building an electric car industry from the ground up, maybe we can build some new cities with affordable and desirable housing from the ground up.
Applying first principle thinking to real estate here’s another question I would ask.
Are we thinking about “housing” wrong. By that I mean that for many people the 3 bedroom, 2 bath Single Family Residence on a 5,000 Sq Ft lot has been the gold standard for a very long time. Maybe we need to think differently as in repurposing existing commercial structures as housing.
In many places, old factory buildings have been reimagined as lofts. And not only in NYC. It’s happening in downtown LA and the Arts District too. Well we may have to go beyond factories to office buildings and malls or other structures originally built for retail.
And then there’s entirely different kinds of structures. For example. shipping containers have been repurposed as housing. Really. Google it.
But stopping a lot of this is the zoning and other regulations I spoke about.
And for the last question challenging the status quo, I have to ask about the form of ownership. Today, many homeowners have mortgages, some may own their home outright and the others are renters.
But just like cryptocurrency has redefined the concept on paper money as an asset, what is the next form of home ownership?
Well I don’t have an answer for that one. Where’s Elon when we need him?