Below replacement cost is one of the most quoted lines in a real estate investment memo. Built properly, it gives two discounts and a test of how far rents must rise before anyone builds competing supply.
Discount to replacement cost is 1 minus the purchase price divided by the full cost of creating the same building today: land, hard costs, soft costs, construction finance, lease-up and the developer's profit. For an illustrative 240-unit apartment building bought at 225,000 per unit, replacement cost new is 363,729 per unit, a 38.1 per cent discount; against a depreciated replacement cost for a 12-year-old building it is 21.3 per cent. Net operating income would have to rise 40.6 per cent before a developer could build competing supply and earn its 12 per cent profit.
Worked in full in Private Equity Real Estate by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
"Buying below replacement cost" appears in almost every value-add and opportunistic investment memo, usually as a single percentage with no working. It is a useful argument when it is built properly, because it says something a cap rate cannot: how far the market would have to move before new buildings compete with yours. Built carelessly, it can overstate the margin of safety by 17 points or suggest there is none.
| Input | Value |
|---|---|
| Units | 240 |
| Gross building area per unit, sq ft | 1,050 |
| Purchase price | 54,000,000 |
| Going-in cap rate | 5.0% |
| Land, per unit | 40,000 |
| Hard costs, per sq ft of gross area | 210 |
| Soft costs, share of hard costs | 20% |
| Construction loan, share of cost; average drawn | 60%; 50% |
| Construction interest rate; build period, years | 7%; 2.5 |
| Lease-up losses and concessions | 1,000,000 |
| Developer profit on cost | 12% |
| Building age; useful life, years | 12; 50 |
Replacement cost new = land + hard + soft + construction finance + lease-up + developer profit
Construction finance = average drawn × loan-to-cost × (land + hard + soft) × rate × build years
Discount = 1 − price ÷ replacement cost
Finance here is 50% × 60% × 73,104,000 × 7% × 2.5 = 3,837,960. In Excel, with the cost lines in B2:B7: =1-54000000/SUM(B2:B7).
| Line | Total | Per unit | Per sq ft |
|---|---|---|---|
| Land | 9,600,000 | 40,000 | 38.10 |
| Hard costs | 52,920,000 | 220,500 | 210.00 |
| Soft costs | 10,584,000 | 44,100 | 42.00 |
| Construction finance | 3,837,960 | 15,992 | 15.23 |
| Lease-up | 1,000,000 | 4,167 | 3.97 |
| Total cost | 77,941,960 | 324,758 | 309.29 |
| Developer profit | 9,353,035 | 38,971 | 37.12 |
| Replacement cost new | 87,294,995 | 363,729 | 346.41 |
The price of 225,000 per unit, 214.29 per sq ft, is 61.9 per cent of replacement cost new: a discount of 38.1 per cent. Leaving out the developer's profit would give 30.7 per cent. It belongs in the figure, because the alternative to buying this building is buying a new one from a developer, and the developer prices in a profit.
The subject is 12 years old, so it is not equivalent to a new building: systems are part-way through their lives and the specification is a decade behind. A simple straight-line charge over a 50-year life takes 24 per cent off everything except land.
Depreciated replacement cost = land + (replacement cost new − land) × (1 − age ÷ life)
Per unit: 40,000 + 323,729 × 76% = 286,034. Discount = 1 − 225,000 ÷ 286,034 = 21.3 per cent.
Both numbers are true, and they answer different questions. The 38.1 per cent says what a buyer saves against a new building; the 21.3 per cent says what it saves against the building it is actually getting. A memo should show both.
The useful consequence of a discount is that nobody builds until rents rise. At a 5.0 per cent cap rate the subject's NOI is 2,700,000, 11,250 per unit. Assume a new building would let at a 15 per cent premium, so 3,105,000. On a total cost of 77,941,960 that is a yield on cost of 3.98 per cent. A developer builds when the finished building is worth its full replacement cost, profit included. Valued at the same 5.0 per cent cap rate, that needs NOI of 4,364,750, 18,186 per unit, a yield on cost of 5.60 per cent: the cap rate grossed up by the 12 per cent profit on cost.
NOI would have to rise 40.6 per cent before new construction pencils: 8.7 years of 4 per cent growth, or 11.5 years at 3 per cent, with construction costs and cap rates held flat. If operating costs rise in line with rents, rents must rise by the same 40.6 per cent; if costs lag, a little less. That is the margin of safety the phrase "below replacement cost" is really pointing to. It is only a margin if construction costs do not fall and the subject's rents can grow without competition.
| Hard cost per sq ft | Land 30,000 per unit | Land 40,000 per unit | Land 50,000 per unit |
|---|---|---|---|
| 190 | 30.2% | 32.6% | 34.9% |
| 210 | 36.1% | 38.1% | 40.1% |
| 230 | 41.0% | 42.8% | 44.5% |
Over these ranges hard costs move the answer more than land. At 190 per sq ft replacement cost new falls to 334,023 per unit and the NOI rise needed for new supply to 29.1 per cent; at 230 it is 393,435 per unit and 52.1 per cent. A cost estimate from a quantity surveyor or contractor for the specific location is worth more than any precision in the other lines.
The first is comparing price per sq ft with hard cost per sq ft. At 214.29 against 210, the purchase looks only 2.0 per cent above construction cost, as if there were no discount at all. Hard cost is less than two thirds of what a new building actually costs. The second runs the other way: quoting the 38.1 per cent discount to a new building for a 12-year-old asset, which overstates the margin by almost 17 points. The yield-on-cost test behind Step 3 is worked separately in how to calculate yield on cost, and the profit a developer needs is set against IRR in what IRR a 20 per cent profit on cost gives.
Build replacement cost from all six lines, including developer profit, then depreciate it for the asset's age and show both discounts: 38.1 and 21.3 per cent here. Then convert the discount into the NOI growth new supply would need, 40.6 per cent, which is what makes the argument useful. Private Equity Real Estate covers value-add and opportunistic strategies and the capital stack behind them, and the free workbooks for the book include the capital stack and return models used to test a deal like this one.
Yes, because no developer builds without it, so the price a buyer would otherwise pay for an equivalent new building includes it. In the illustrative case a 12 per cent profit on cost adds 38,971 per unit, taking replacement cost new from 324,758 to 363,729 per unit and the discount from 30.7 per cent to 38.1 per cent.
Because an older building is not a new one. A 12-year-old asset, depreciated straight line over a 50-year life, has used 24 per cent of its building cost. Its depreciated replacement cost in the illustrative case is 286,034 per unit, so the true discount on a 225,000 purchase is 21.3 per cent, not the 38.1 per cent against a new build.
That new competing supply is unlikely until rents rise. In the illustrative case, a new building would yield 3.98 per cent on cost at today's rents plus a 15 per cent premium for new space, against the 5.60 per cent needed for it to be worth its full replacement cost at a 5.0 per cent cap rate, so NOI must rise 40.6 per cent first: about 8.7 years at 4 per cent a year.
This article is one calculation from Private Equity Real Estate. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
Get the book on Amazon →Free companion files
Also on Amazon UK · Amazon Germany · Amazon France · Amazon Canada
Reading guide: real estate investing, finance and fund management → · All 1614 articles →
If this book helped, or didn’t, a few lines on Amazon are worth more than they look: they are what the next reader goes on. Write a review. The workbook stays free either way.