As a baseline, everything that is done in FE can currently be done as a mod in FE. You can add new units, models, factions, terraintypes, maps, stamps (pieces of maps used for random maps), buildings, quests and much, much more.

If you wish to alter mechanics (more than tweaking their numbers) or introduce new mechanics that is significantly more difficult, and in most cases you won't be able to do that. We have no access to scripts/code and changing the UI can only be done in meaningless ways. Worst of all, the AI is completely boxed up, and we can only indirectly influence its behaviour through circumstantial priority tags.

To get a good idea of what can be done through XML, I would suggest you familiarize yourself with the data/english folder which contains the data for the game. Also check out https://forums.elementalgame.com/436142/page/1/ for guides on various topics (by no means all-encompassing).

I played Lords of Magic a lot, mostly as Earth. By editing the xml you could create a game quite similar to LoM. Creating new races isn't that difficult. Some FE mechanics you would have to keep though, like settling cities and turn based combat. You could add in the humanoid units easily by locking unit designs down, ie by creating elven stafffmen and making them none editable. Also while adding new models isn't a problem you will need to find some if you want to replace all the LoM monsters.