Replacement Cost

Our firm uses CoStar to do a very crude replacement cost analysis for our acquisitions. We are finding that the analysis they provide is very generic and in many instances, far off in value. What are some of the services you guys use at your firms?

 

Typically we will either speak with a builder or at the very least, a broker. Our firm is vertically integrated so our development team is able to connect us with builders to get a range for hard costs and provide a general idea of soft costs based on experience.

 

Agreed. Marshall & Swift very pricey sanity check. We talk to developers, maybe we've looked at some developments in the area.

I'm actually working a commentary about why replacement cost is not useful in MOST situations. The definition varies, the land contribution can be miles apart, etc. It is useful as a sanity check but I f'n hate losing deals because we're 10% over "replacement cost".

 
PF_CRE:

Agreed. Marshall & Swift very pricey sanity check. We talk to developers, maybe we've looked at some developments in the area.

I'm actually working a commentary about why replacement cost is not useful in MOST situations. The definition varies, the land contribution can be miles apart, etc. It is useful as a sanity check but I f'n hate losing deals because we're 10% over "replacement cost".

You shouldn't be losing deals b/c your slightly over replacement cost. The acquisitions vs. development horizon varies dramatically and after taking into consideration construction cost fluctuations, the cost to build now could be very different by the time construction begins (or you get a GMP). I have seen hard costs PSF (which could be considered the backbone of development proforma) increase by 35% for the same project since 2008.

Checking the general range is a great idea, but if I'm looking at an acquisition and its pricing 10-20% above replacement cost, I wouldn't consider this deterimental by any way shape or form (assuming the investment meets my return metrics). After all, every property that you buy from a merchant developer is going to have development fees built into the cost and a large back-end profit, none of these guys work for free.

 

I know this won't go over very well with a lot of people and I don't feel like explaining myself in the appropriate level of detail right now, but my entire firm and I refuse to accept replacement cost as an appropriate method of valuation. "Trading below replacement cost" is enough for me to consider having someone shot.

I hate victims who respect their executioners
 

That is pretty awesome. At my firm we put in this completely incorrect number and use it as a “reference point”. Luckily no deal has EVER been killed due to replacement cost. My worry is we will use a more accurate method as you guys have mentioned (thanks for the input by the way!) and suddenly replacement cost will become more of an issue.

 
Best Response

Different things.

Replacement cost is what it costs to build the same building again. REPE firms love touting that they only buy below replacement cost (read old buildings). If you buy a new stabilized building it will be above replacement cost (otherwise the developer wouldn't make a profit and sell it to you). Basically REPE guys think guys that buy new buildings "core buyers" are dumb as shit. And core buyers think that REPE firms buy dog shit buildings. Understand that is generallizing because not all REPE firms and core buyers do this but you get the point. TIP TIP Know where you're interviewing and say the right things.

Expense recovery relates to what happens to the landlord when a tenant pays rent and what their lease structure is. For commercial real estate there are 4 common types of lease structures 1). Net / absolute net - tenant pays all expenses for the property. 2). NNN landlord pays expense and gets reimbursed by the tenants. 3). Modified gross / base year stop - the tenant only reimburses for expense over the base year. 4). Gross - tenant does not pay for any expenses.....the most common is NNN followed by modified gross. Absolute net is really only used for single tenant retail and gross is mostly only on very old and not nice office and industrial buildings.

 

Step 1: Open model Step 2: Delete recoveries Step 3: Look at value Step 4: Understand the significance of recoveries

They can be straightforward, but can get complicated too. Certain expenses are sometimes capped or floored at various levels. Other times, the tenant could just pay a fixed amount per year on some expenses (sucks when you have large unexpected expense hit). Pro rata share for each tenant can be calculated obnoxiously at times, too. Sometimes on the entire GLA, other times on part of the GLA (which can be defined in an infinite amount of ways). The WORST is when you have retail or office resting on multiple parcels. Tenants' leases will usually be structured so that their pro rata share and expense pools only applies to their parcel (sometimes not). It's a pain to model from scratch. Anyways, moral of the story is that recoveries enhances your NOI, and negotiating favorable structures is an art (usually LL and tenant go back and forth on rent and recoveries). You screw it up, and you're stuck with it until the tenant renews or leaves.

For replacement cost, I will add that your property insurance figure is in some way tied to it. If you're externally appraising your property every so often, you can get a good idea of what that figure is, and then pass it along to the poor soul who is cranking away at those insurance numbers each year.

 

Replacement cost is mostly useless because it's not directly tied to the cash flow a property can generate in any way, shape, or form. In my opinion, it's only use is in determining if you're overpaying for something, not to say you're getting a deal.

Here's a half-baked example: it might cost you $300 psf to rebuild Office Tower X that you're buying at a $100 psf discount to replacement cost because it's 70% occupied, but if it's in west Las Vegas, good luck getting your cash out, because the market blows and you will still be in the deal at the wrong basis. You won't sign new leases at rents that justify your purchase price.*

Self-storage is a good example of an asset type where replacement cost can be worth considering. It's fast and cheap to construct. If you're looking at a self-storage deal, analyzing it based on the cash flows and market, without regard for replacement cost, you might be in trouble. If your target is in a well-occupied market with low barriers to entry, and someone can build new product for roughly the same price as your existing product, that is going to happen, and it will negatively impact your property's performance.

*I pulled these numbers directly out of my ass with little thought to their accuracy.

 

If your looking at a similar investment horizon and you have the capacity (Cash/expertise) and opportunity (site availability) to build or buy... this is surely a metric you will need to know.

If you know the property types you work in, this should not be difficult to calculate on a napkin. Ask a local GC what the hard costs PSF, add in a rough soft cost number (i.e. 25% of HC's), plus your land. Its not rocket science but any nerd thats on a wallstreet real estate forum should be able to do this fairly easily.

 

I've looked at replacement cost before, but more as a sanity check. It can be a sign that something could be an asset play, but it's far from a sure thing.The assets in question may have seen their future productivity decline.

For example, you own a timber farm and the price of timber falls (let's assume this is a permanent decline and the cost of land is not impacted by the decline in the price of timber). It still costs the same amount to grow a tree. But the land's future cash flows are impaired. And let's say you were a high cost producer - it might no longer even make sense to be in the timber business. In other words, given the capital and opportunity to buy those same assets, you would not.

 

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