Pricing the gap to replacement cost as downside protection deserves more scrutiny than it usually gets

The phrase appears in nearly every offering memorandum and in none of the operative documents. There is no covenant anywhere that says a sponsor may not overpay if the cost approach supports it. So whatever work the comparison does, it does in the reader's head and in the committee memo, not in anything enforceable. That doesn't make it wrong. It means the only person testing it is the investor.

That $258k needs to be split before it means anything. How much 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 a gap of $77k a door has $40k sitting in land plus interest carry, a rate move and a motivated land seller closes most of the gap without a single stick of lumber getting cheaper. Break the $77k into the pieces that can compress and the pieces that can't before drawing conclusions.

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 is time before a new lease-up opens across the street and prices flat for six quarters. The right move is converting 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 rent growth over the hold is protected in years two through four and exposed in year five. That is a real modeling input. What should not happen is putting it in the exit cap. Every attempt 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.

@dpatel_re that framing is the first version of this argument that is actually followable. Delivery years are legible. Basis points of exit cap never really are to most of the people reading the deck. Sponsor decks routinely lead with the cost gap on slide four, and plenty of limited partners nod along at it without knowing what they are nodding at.

The lender view is worth settling before the philosophy. Appraisals on stabilized garden product lean on income and on sales, and the cost approach usually carries almost no weight, so a gap to replacement cost does nothing for loan sizing. That leaves it as an equity story, and it should be underwritten as one.

@raj_mehta14 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.

@gregpowell66 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 @hannah_west29 asked. Some of what inflated replacement cost since 2020 is impact fees, insurance during construction, and code changes, and the 2004 asset will carry the insurance and the fees too, just in different line items. The pattern in 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 the question to run is total expense per unit at the 2004 asset against what a new build pro forma carries. If it comes in $1,100 a door higher on insurance and turnover, capitalize that at the going in yield and take it straight off the gap.

Worth putting next to that: it is not unusual right now for an interior renovation package to bid about 6 percent under what the same scope cost eighteen months ago, with the GC volunteering that his crews are sitting. That is labor availability rather than a full build cost stack, and it moves in the direction @gregpowell66 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.

@aliyah_b that is 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 in writing what the lender's scope of work actually requires instead of assuming. The gap does not size the loan. It shows up indirectly, because a lender who believes new supply is finished gets more comfortable with the 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.

@ryanmck27 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. @gregpowell66 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.