I priced the gap to replacement cost as protection, and I'm no longer sure that's honest

The phrase appears in every offering memorandum I've read this year and in none of the operative documents. There is no covenant anywhere that says the sponsor may not overpay if the cost approach supports it. So whatever work it does, it does it in your head and in the committee memo, not in anything enforceable. That doesn't make it wrong. It means the only person testing it is you.

Your $258k needs to be split before it means anything. How much of it is hard cost, how much is land, how much is soft cost and carry at today's rates? Land and carry are the volatile parts and they're also the parts a merchant builder can wait out. If your gap is $77k a door and $40k of it is land plus interest carry, then a rate move and a motivated land seller closes most of the gap without a single stick of lumber getting cheaper. I'd want the $77k broken into the pieces that can compress and the pieces that can't.

I don't underwrite replacement cost at all on my stuff, but at your size the only version of it I'd trust is a phone call. Who owns the dirt within two miles, is it entitled, and what does the local builder say his yield on cost pencils at. Everything else is a spreadsheet arguing with itself.

You can price it, but only through the pipeline, not directly. What the gap buys you is time before a new lease-up opens across the street and prices you flat for six quarters. So I convert it into delivery years. If nothing in the submarket can start until costs and rents cross, and the earliest realistic start is 2027 with delivery in 2029, then my hold period rent growth is protected in years 2 through 4 and exposed in year 5. That's a real modeling input.

What I will not do is put it in the exit cap. Every attempt I've seen to justify a lower exit cap because of the cost gap is just the entry cap wearing a hat. The stabilized buyer is running income capitalization, and the appraiser will give the cost approach almost no weight on a 2004 garden property.

@sextant that framing is the first version of this I can actually follow. Delivery years I understand. Basis points of exit cap I never did. On the LP side the pitch decks I've been shown lead with the cost gap on slide four and I've been nodding at it without knowing what I was nodding at.

Does a lender look at any of this? If the appraisal gives the cost approach almost no weight, then the gap doesn't help the loan sizing at all, which makes it purely an equity story. Correct me if I've got that backwards.

@vellum mostly right, and it's why I stopped taking the sentence seriously in isolation. What I do in diligence now is pull entitled but unstarted projects in the submarket from the planning department, count the units, and assume half of them find capital if rents recover 10 percent. That number, not the cost gap, is what tells me whether girder's moat is two years wide or six.

@girder the other check is who your seller is. If a 2021 buyer is exiting at $181k because their bridge matured, your basis is real. If a merchant builder is exiting a 2023 lease-up at $181k, that's a cost number too and it's telling you something less flattering about the submarket.

Pull apart the $258k one more layer than @ledger asked. Some of what inflated replacement cost since 2020 is impact fees, insurance during construction, and code changes, and you're going to pay the insurance and the fees on the 2004 asset too, just in a different line item. My own experience buying older garden product is that the operating expense line has caught up faster than the rent line, so part of the discount to replacement cost is compensation for a worse expense ratio rather than a free option on supply.

So I'd ask what your total expense per unit is at the 2004 asset versus what a new build pro forma carries. If yours is $1,100 a door higher on insurance and turnover, capitalize that at your going in yield and take it straight off the gap.

For what it's worth, the last two interior renovation packages I bid came back about 6 percent under what the same scope cost me eighteen months ago, and one GC volunteered that his crews were sitting. That's not a full build cost, it's just labor availability, and it's moving the direction @girder is worried about.

Reading this from way down the ladder. Is the whole idea just that nobody builds a competitor while it's cheaper to buy one? If so it seems like the thing to track is starts in the submarket rather than costs anywhere.

@tally that's most of it. On the debt side the cost approach gets very little weight on stabilized apartments, and appraisal practice varies by state and by lender anyway, so confirm what your lender's scope of work actually requires in writing rather than assuming. The gap doesn't size your loan. It shows up indirectly, because a lender who believes new supply is done is more comfortable with your rent growth assumption in years 3 and 4.

Plain question. If values are 20 to 30 percent below the 2022 peak in a lot of markets, isn't buying below replacement cost just the normal condition right now rather than a selling point? Feels like saying the water is wet.

@halyard that's roughly where I landed too. If every deal in the market clears below replacement cost, the discount can't be the reason to pick one of them. @girder your submarket detail about employment inside four miles seems like the part actually doing the work, and it's the part you spent one line on.