Danny Kattan is the Managing Partner, Capital Markets at PIA Residential.
In real estate investment, the cost of acquiring a property (price per unit, price per square foot, or “price per pound”) should be the key factor in deciding to invest.
But while it’s common sense to buy a good property for less, I find many in the market often overlook this by focusing on financial returns. However, as I like to say, “cost basis is permanent, financing is temporary”—and this is more relevant today than ever.
Purchasing properties below their replacement cost, especially in inflationary environments, can help secure a competitive edge, mitigate risks and create value.
The Importance Of Buying Below Replacement Cost
Competitive advantage. Purchasing property below its replacement cost gives you a significant edge over new entrants who face higher construction costs.
De-risking the project. When you buy a property below replacement cost, you create a buffer against market downturns, helping to ensure your property holds value even during volatility.
Creating alpha through value addition. Value-added properties allow investors to increase property value through improvements and efficient management. With a lower cost basis, there’s more flexibility to enhance the property without overextending.
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Increasing rents, improving occupancy rates and reducing inefficiencies are all ways to boost net operating income (NOI) and property value after buying below replacement cost. Overall, I find this strategy not only conservative but also sustainable, protecting against short-term volatility while ensuring long-term growth. It aligns with the principles of value investing by focusing on acquiring undervalued assets with significant potential for appreciation.
Inflation, Construction Costs And Land Scarcity
For many U.S. investors, inflation wasn’t a major concern until more recently. Inflation erodes purchasing power, so returns need to outpace inflation for an investment to be worthwhile.
This is critical as construction costs have historically risen faster than inflation due to labor shortages, supply chain issues and demand. From 2013 to 2020, residential construction costs increased at an average annual rate of 5.3% versus the calculated overall 2.77% inflation during the same period. Even though cost inflation has stabilized somewhat, it’s still a key consideration.
On top of this, it is important to note how land, especially in growing cities and suburbs, is a finite resource. As demand for housing increases, land prices tend to rise, often faster than construction inflation. Historically, land in desirable locations has appreciated faster than the costs of building materials.
Replacement Cost Theory
Replacement cost theory suggests that a property’s future sale value should be comparable to the cost of constructing a similar property at that future date, adjusted for age and type. When evaluating older properties, the discount to replacement cost should be significantly larger than for newer properties.
Applying Replacement Cost Theory
When planning an exit strategy, it’s essential to ensure that the exit cap rate aligns with replacement costs. Investors typically estimate future sale prices by projecting net operating income and dividing it by an expected cap rate.
However, I think this needs to be considered in relation to the price per unit at exit, which should be at a discount to future replacement costs. This ensures competitiveness relative to new construction.
Incorporating Replacement Cost Theory In Underwriting
Applying replacement cost theory to underwriting requires a careful analysis of current and projected costs:
• Acquisition analysis. Compare the acquisition cost per unit to current construction costs. A significant discount signals a potentially advantageous investment.
• Future projections. Estimate future construction costs based on inflation trends to forecast replacement costs.
• Exit strategy. Develop an exit price per unit that remains competitive relative to future replacement costs, mitigating the risk of overvaluation and ensuring the property can be sold at an attractive price.
Practical Example Of Replacement Cost Advantage
You want to consider current construction costs, sale price to investors, inflation (and future costs) and an exit strategy when considering the replacement cost. Consider a scenario where it costs $275,000 per unit to build a new property today. Developers might sell such a property for $300,000 per unit, factoring in a profit margin.
With an annual inflation rate of 5%, the cost to build the same property in five years would be about $350,000 per unit. By planning an exit price of $285,000 per unit, you could offer a property priced well below future replacement costs, making it more competitive in the market.
Conclusion
Investing in real estate with a focus on cost basis and replacement costs can help provide a strategic advantage and significantly enhanced returns. This approach grounds investments in economic fundamentals, creating a solid foundation for long-term success.
With financing conditions subject to change, the chance to acquire assets at a historically low-cost basis won’t last forever. By embracing the permanence of cost basis and recognizing that financing is temporary, I believe investors can increase their opportunities to achieve robust and sustainable success.
The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.
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