Learn about the fundamental concept of replacement cost and how it relates to analysis.
- [Instructor] There's a commonly accepted rule in valuation theory that states that investors should never pay more for an existing asset, than the cost to build a new comparable one. Now this leads to a very important concept in commercial real estate called the replacement cost. That is, how the prospective sale price compares to the cost of construction of a new, similar structure in the same market. Factoring in the cost of land, design and engineering, construction, and even financing.
The all in cost, right. So if by comparing it to the sale price, we're able to measure the attractiveness and risk of an existing property. So how does that work? Well, if the sale price is greater than the replacement cost, right. Now this is typically happening during expansion cycles where there's frenzy bidding from buyers and their bidding properties values up during sales.
What happens in this case is that basically buyers are going to be taking on greater risk of investment losses right. Because new competition can come into the market at lower rents because they're able to provide new products at lower cost bases by building brand new equivalent ones without having to buy the existing ones right. This is common during peaks in market cycles. So, the other is where the sale price is less than the replacement costs.
And the greater the discount of the sale price is to the replacement cost, the greater the safety margin for the investor. Essentially, the investor can charge lower rents and still achieve attractive returns right. And you'll see this scenario much more common during down turns in the market cycle. So let's look at an example. Let's say there's an existing warehouse where the purchase price is $100 per square foot and achieves a net rental rate of $12 per square foot.
So the yield is 12 divided by 100 or 12%. Now if new construction replacement cost is $150 per square foot, then to achieve the same 12% yield, this developer has to charge $18 a square foot. To get that same 12% because their cost spaces is higher now. They have to charge 50% higher rents, just to achieve the same yield right.
So, their $18 per square foot is also known at the replacement rent. And this is the rent that is needed to achieve the same yields at the replacement costs. So an investor buyer has a competitive advantage if, they are able to acquire the existing warehouse at much lower than the replacement costs that a developer of a new product, new and comparable product in the same market would have to pay.
Let's look at the opposite scenario. Right so same warehouse, but let's say it cost $140 per square foot, and so to achieve 12% yield investor now much charge $16 and 80 cents per square foot. So going back to the new construction's replacement cost $150 now it was at $18 to get the 12% yield right? So in this case the replacement cost is only slightly lower than, or slightly higher than the sale price.
Now as the difference narrows an investor might be more willing to build something new, right. Even if the replacement cost is still a little bit higher, they might be willing to pay the replacement cost for a new one because maybe, they think that with a newer product maybe there are tenants that are willing to pay higher rents. So that might justify it, and they might see a better long term potential in the market with a newer product than buying an old one that might need some very expensive renovations in the near future anyway.
So, now related concept is the true cost of land. Now the cost of land is usually included in the sale price of a property right. But how do we separate the value of land? Now in very tight markets for example like New York or San Francisco, it's very very difficult to determine what the actual value of the land component is compared to the value of the improvements or the property itself, right? So the result is that a lot of investors will just ignore this altogether and potentially risk overpaying for the product right.
So in a climate like today where capital is plentiful, you know many investors are actually ignoring the calculation of the replacement cost entirely. But if there is going to be a down turn, those who end up actually overpaying will suffer the most. So let's take a look at how replacement cost differs across markets if we look at the same product. Now here's are some numbers that are from JLL, this is back in 2016.
But, it's a good way to compare the replacement cost of Grade A office buildings right. In central business districts this CBD here and if we compare 4 different markets we see that, the replacement cost is higher for Grade B classes in Sidney and Singapore than it is to buy just existing Grade A right.
So, where as in markets like Tokyo and Hong Kong, it's much more expensive to buy then it is to replace something comparable. So, there yah go. Even the same product at the same time in different markets we're going to see some very distinct differences in the replacement cost because well the local supply and demand is different, availability of land, and you know the amount of space is different, the cost to build is very different.
So a lot of the local dynamics is going to really impact the actual replacement cost calculations in different markets.
- Types and elements of commercial leases
- Replacement cost
- Highest and best use
- Retail, office, and warehouse asset classes
- Operating assets
- Case studies for industrial warehouses, medical offices, parking garages, and more