Tuesday, August 9, 2016

What is Replacement Cost?

What is Replacement Cost?

Replacement cost is a metric often used by commercial real estate professionals as a way to measure whether an asset is under or overvalued. The actual replacement cost of a property is what it would cost to rebuild the property and then what you would need to spend in order to re-tenant it. If a property's value is below its replacement cost, that's generally a sign that it's not overvalued.

For example, let's assume we're analyzing an existing 20,000 square foot office building in Downtown San Francisco that's valued at $700 PSF. Here's a spreadsheet showing an example of calculating a replacement cost for the target property. In the spreadsheet I've assumed it would cost $300 PSF for land, $400 PSF for hard costs (actual cost to purchase building materials and construct it), $100 PSF for soft costs (architectural, city, permitting, entitlement fees, etc... necessary to get the building constructed), $100 PSF for tenant improvement allowances (what the landlord is expected to provide a prospective tenant in that market) and a leasing commission of $20 PSF. Based on these assumptions, it would cost $920 PSF to recreate the target property.

So what does this mean exactly? Are we getting a screaming deal because we have the opportunity to buy the building for $700 PSF? That's what brokers would have you believe, but it's only a half truth.

Go to the download page to download a more polished replacement cost spreadsheet or click this button:

Replacement Cost is a Tool to Measure Development Risk

Commercial real estate is subject to the same laws of supply and demand as every other good. Supply outpacing demand will decrease prices and supply not keeping up with demand will increase prices. In commercial real estate, the supply side of the equation is determined by development of new buildings and redevelopment of existing building (changing their use to a different use--re-purposing a building from retail to general office, for example, increases the supply of general office in that market while reducing the supply of retail). Clearly, when making a multi-million dollar investment, it's important to understand what is happening on the supply side in the market as that will have a big impact on the value of the investment.

In our San Francisco example let's assume there are no buildings currently being constructed and no buildings being planned for construction. Why would that be? Well, it's because, based on our replacement cost calculation above, it's actually cheaper to buy existing buildings as an investment than it is to build a new one. Also consider that there is substantial risk attached to developing a new building from raw dirt, implying there's an additional risk premium associated with developing a new building versus buying an existing one.

What replacement cost really tells you is whether or not your property is subject to development risk in the near future or not. In our example, we're buying the building at a 25% discount to replacement cost. This implies rents would have to increase an additional 25% while the cost of developing a replacement building remains static in order to justify developing a new, competing building (or cap rates compress). In theory that threshold where asset prices are higher than replacement cost shouldn't happen for a good amount of time. The subject property should be in good shape on the supply side for the foreseeable future.

If the opposite were true, i.e. asset values were higher than replacement cost on a PSF basis, then you need to be worried about new buildings being developed and competing with the subject property. That parking lot kitty corner to your building--that could become a shiny new building that steals all your tenants. You better make sure there's enough demand from tenants to sustain additional square footage in the market or your property has some unique feature / competitive advantage that will help it maintain its occupancy and rents.

Replacement Cost has a catch...

The interesting thing about replacement cost is that it is sort of a proxy for how healthy a market is. In the real world, San Francisco has gone through a huge construction boom over the last few years due to crazy demand from the booming tech sector. Clearly asset values have gone well above replacement cost and developers are taking advantage of it. A similar phenomenon is happening in Seattle where it seems like a new skyscraper is being built on every street corner right now.

In spite of this massive construction boom, the demand has been so strong that the markets have soaked up all the new supply and rental rates / occupancy have held strong. Imagine you own an office building in Downtown Seattle. During this construction frenzy, a developer builds a huge office building across the street from you with class A retail on the first floor. At first you're scared, but then Amazon comes in and pre-leases the entire building and a premier restaurateur plans on opening a high-end steakhouse on the ground floor. Then, another block over, a hotel developer builds a brand new luxury hotel. Imagine how much more valuable your building is now. It's across the street from a big Amazon campus--many tech tenants will want close proximity to Amazon and will pay good money to be in your building--it's across the street from one of the city's newest and best restaurants, and there's a brand new luxury hotel a block away that will substantially increase the amenity base in the immediate area.

These are the kinds of things that are happening right now in these cities. If you're a property owner there, yes, there's supply side risk, but as in the example above, as that new supply is soaked up the entire area is transformed, increasing the value of your property. While replacement cost can be a worrisome indicator for the near term, in some ways you want own property in a city that will get more development in the future.

Let's take an example from the opposite end of the spectrum: Detroit. Unfortunately over the past few decades, Detroit has gone from one of America's premier cities to one of its worst in terms of crime, property values, population growth and economic growth. Subsequently, there has been little to no new construction over the past few decades. There's just no need to build another skyscraper in Downtown Detroit when so many of the existing buildings are likely struggling as is. I don't have exact numbers, but I would guess buildings in Downtown Detroit are well, well below replacement cost. That's great and all, there's probably no near term supply risk, but it's also a bad indicator for the future health of that market.

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