From the desk:Large Multifamily (Institutional)

Why is "below replacement cost" a selling point?

Studying for the license and one of the brokers at the office let me sit in on a 180 unit listing. The offering memorandum leads with $172,000 per unit against a "replacement cost of $240,000 per unit" and the whole first page is built around that gap.

What I understand: it costs more to build the thing than to buy it. What I don't understand is why a buyer cares. The rent is the rent either way. If I can buy a building for less than it costs to build one, doesn't that just mean the building isn't worth much, because if it were worth more somebody would build one?

The broker said something about competition and I nodded like I understood.

The part actually in front of me is small. I'm going to be on the call with two prospective buyers next week and I'd rather not be the person in the room who can't explain the first line of the marketing. Where does that number even come from, and who decides what replacement cost is?

Answer

1stephen_ok9CO2CPRO6

You're closer than you think. The reason it matters is future competition.

A developer builds when the rent they can charge supports the cost of building. If it costs $240,000 a unit to deliver and rents only support $172,000 of value, nobody builds. So for however long that gap lasts, the buyer at $172,000 has an asset that new supply can't undercut, because new supply can't get financed. That protects rent growth.

The number comes from land, hard construction costs, soft costs like architecture and permits, and the interest carried during construction. Any of those can be pushed around, so ask whoever wrote the OM where the $240,000 came from. If it's a real local builder quote it means something. If it's a national average it means less.

3 replies

2chriswalton8CC1CPRO8

Adding the piece that makes it a live topic right now. Construction costs went up a lot since 2020, roughly 39 percent, while apartment values fell 20 to 30 percent from their 2022 peak because a huge wave of new supply hit at the same time as financing got expensive. So the gap between what things sell for and what they cost to build is wider than it's been in over a decade.

That's why the OM leads with it. It's the argument of the moment.

The counterargument, and you should be ready for a buyer to say it, is that the gap exists for a reason. Values are down because rents are soft in markets that overbuilt. Buying below replacement cost doesn't help you if there are still 3,000 units in lease-up two miles away giving away two months free.

5sonia_alvarez Get yoursPRO6

Also be ready for someone on the call to ignore the whole framing and ask what the going-in yield is on the actual current income with taxes and insurance re-set to what a new buyer would pay. Replacement cost doesn't pay debt service. If the answer to that question is bad, no amount of gap talk fixes it, and the buyers who move at institutional size will get there in about ninety seconds.