Buying "Below Replacement Cost"

Associate 1 in RE - Comm

Hey WSO - So value investors buy below replacement cost. Right?

The story goes if you can buy cheaper than a competitor can build, say, right next door, you're protected from such product as you can charge lower rents and still achieve an acceptable yield. Maybe people don't build because rents wont support the total cost. Build when prices are above replacement cost, you'll get a better yield with the same rents. OK. Got it. Not complicated if we're talking about buildings that are 3 years old.

But what about in a city like NYC where could easily pay $850psf for a 1920's office building? Is this below replacement cost because a new shiny tower in its exact location will run you $1,250psf? Is the true "replacement cost" some cheap build that gets you to a quality equivalent to a 100 year old building? This is where I'm lost.

Thoughts?

Comments (9)

Most Helpful
Jan 15, 2020

Obviously the most land constrained and sought after market in the country makes this particular generalism a little complicated.

I'm not really sure how to answer your questions but outside of small loft "techy" buildings, 100 year old buildings are not "quality" in midtown or downtown Manhattan. Building systems are a fucking mess in old buildings, column spacings are completely fucked. Take a look at floorplans for 230 Park ave. Yes the building is beautiful but the column spacing make modern office build outs impossible. Need suplemental AC in a very old building? Theres a good chance you'll have to use up a window to air intake, new buildings have plenty of fresh air circulation in the core to ameliorate that.

Large tenants dont want old buildings, his is why Hudson Yards is the new spot to be and Grand Central is a tough place to lease space.

Some here will say replacement cost doesn't mean anything in NYC but today we see people buying Park Ave buildings to tear them down and build new office buildings (not just condos). Replacement cost is certainly less of a factor in NYC but something to take into consideration if you're working on a building that has only a few tenants

Anyways this was a bit of a rant because I have no idea what your questions actually is.

Edit: replacement cost in general is a weird metric in major markets today considering where land values have gone so quickly. For example land for industrial in NNJ is like $200 PSF in the meadowlands where a year ago it was maybe $150 and the year before that under $100. So what is replacement cost today? If I buy a warehouse for $300 PSF, but today it costs me 125 + 200 in land to build is that a "value" under replacement cost buy? Technically yes today but for how long? What if its an obsolete building with legacy tenant.

wow too much coffee too early in the day

    • 2
Jan 15, 2020
SHB:

wow too much coffee too early in the day

I lol'd, and it made this even funnier:

SHB:

Anyways this was a bit of a rant because I have no idea what your questions actually is.

Jan 15, 2020

Construction costs have gone up a good amount higher than inflation over multiple decades so in major metros I'd expect there to be a lot of buildings sold below replacement cost. However that is really a false sense of security - rates will go up at some point and crater values regardless. Also markets like Sf have a gigantic bubble in demand from dot com bubble 2.0 companies and workers that will eventually blow up. Meanwhile retail is permanently fucked even though when the Amazon web services accounting fraud is discovered most subsidized free shipping will disappear.

Jan 15, 2020

accounting Fraud?

Jan 15, 2020

Second that^^. Dude what? is this some r/wsb conspiracy theory?

Array

Jan 15, 2020

Yes like worldcom or Netflix

Jan 15, 2020

Buying below replacement costs usually works best in a distressed market where others can't get financing and there is pent up demand, that will force new supply in the future.

This is essentially Sam Zell's strategy. It's one of the reasons he's moved away from real estate and is buying up oil/natural gas assets right now. He knows that there will be demand in the future for these commodities, but nobody can get financing right now because the industry is distressed and nobody can get financing.

When they changed the laws on depreciation and selling tax credits in the Tax Reform Act of 1986, banks stopped lending on commercial properties, because they were in free fall. One could buy anything well below replacement cost and make money, especially if you know there would be lack of office space/industrial or whatever in the future.

    • 1
Jan 15, 2020

You can't value a property correctly with only one method. Compare with market comps, see if it is in line with cap rates, and maybe do a DCF with sensitivity.

After you have multiple values, it's up to the investor's judgement now.

And if you still don't think it makes sense, be a contrarian - real estate is illiquid and inefficient, and there is room for beating the market.

Jan 15, 2020
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