In a period when capital is a commodity and real estate investment opportunities are scarce, the pricing of core real estate has increased substantially—and in some markets, these valuations are pushing beyond replacement cost.
While valuation theory suggests that investors should never pay more for an asset than the cost to build new, investors in gateway markets are rapidly approaching and exceeding replacement cost in some cases. While replacement cost is but one valuation metric, this emerging trend is cause for concern as investors could experience painful losses in their portfolios, placing downward pressure on real estate returns.
Replacement cost is broadly defined as the cost to acquire land, design and construct a new building, incentivize the developer, and finance the construction in the same area as the investment considered for purchase. Investors compare the prospective purchase price of a building to what it would cost to construct a similar structure in the same area. While this tends to be a hypothetical scenario, it is also possible for replacement cost calculations to be based on recently developed buildings.
The relationship between the acquisition price of an asset and its replacement cost is a measure of risk; the closer the acquisition price is to the cost to build new, the less safety the investor has from the effects of new supply. Acquiring an asset at a price that is a sizable discount to its replacement cost allows investors to charge lower rental rates while still receiving returns similar to those achieveable with new construction because their investment basis is less than the cost of new construction.
For example, if an investor purchases an office building for $180 per square foot, and the net rental rate for the property is $20 per square foot, the yield is 11.11 percent. If the cost to construct a similar structure in the same submarket as the investment being considered is $250 per square foot, the developer would have to charge a net rent of $27.75 per square foot to maintain the same yield. This allows the investor to be more competitive on rental rates than the developer of a new building.
New development is typically considered when existing product is absorbed to the point that rental rates start to rise and approach replacement cost rents. In the case of the previous example, the rental rate of existing product would need to rise to approximately $27.75 per square foot before development should be considered. If the investor would pay $240 per square foot versus $180, however, the investor would need rents of $26.66 per square foot to maintain yield, which is of negligible difference to new development. Tenants might be willing to pay the additional rent to be in a new building, which illustrates the concern associated with asset pricing that starts to approach replacement cost.
Replacement cost continues to be a challenging metric to use, and it is often misunderstood. To understand why replacement cost is complicated and why some investors seem to be acquiring assets for prices at or above this metric and the possible implications, one must understand the influences of land value and the prevalence of capital in the system.
The Land Conundrum
Land is a factor of production, serving as a necessary input to obtain the output of a physical building and the creation of other products and services. The value of a piece of land is entirely based on its location compared with parcels in more desirable locations, which command higher prices, and those in less desirable locations, which command lower prices. Typically, land in the center of a city is expected to be worth more than land in the suburbs because, theoretically, a consumer is willing to pay more for it because he or she would incur lower transportation costs.
Theory aside, ascertaining the true value of a comparable land parcel can be the largest stumbling block in accurately calculating replacement cost. Investors in gateway markets such as New York City and San Francisco tend to have the most difficult time ascertaining replacement cost because suitable land parcels at comparable locations may be very difficult to identify, or such a parcel may not have been traded recently, so benchmarking the land value is difficult. Other influences, such as zoning and the presence of historic districts, further complicate the equation.
Times Square in Manhattan presents a classic example of this difficulty in determining land value. Times Square is an irreplaceable location that has not seen a land transaction in decades. While there are many examples of similarly irreplaceable locations throughout the country, many real estate investors view these as the minority of cases, even within major markets. Submarkets of New York City, such as the Williamsburg neighborhood of Brooklyn, have seen a significant increase in investor interest in multifamily investments, and many buildings have been acquired with the intent to tear down the improvements and build new multifamily product. These transactions are evidence that calculating the land value within a replacement cost context is possible even in markets such as New York City and would not be much different in similar submarkets across the country that are not irreplaceable. The land conundrum dissipates more in markets such as those throughout the Southwest, where land is available and recent transactions are observable.
Since most investor interest over the last several years has been in gateway markets—particularly within dense urban centers—land within these locations has been painted with the broad brush of being irreplaceable. This has led to the faulty belief that the replacement cost metric is moot because it is difficult or potentially impossible to replicate the land. An interesting test case of the difficulty in assessing land value in such locations will occur on Madison Avenue in New York City with office buildings on ground leases that will reset over the next several years. Assessing the fair market value of the rent for the ground lease will directly relate to the value of the land.
Too Much Capital
Another area of concern is the significant amount of capital available in the financial system due to the Federal Reserve’s stimulatory monetary policies. At the same time, there are too few high-quality investment opportunities for this capital. The Fed’s three rounds of quantitative easing essentially created money out of thin air and have resulted in the Fed’s assets nearing $4 trillion. Despite the decision to begin tapering its bond buying program this past December, there is little belief that the Fed will eliminate its accommodative policies anytime soon. Capital flows to areas of opportunity and real estate have provided solid returns over the recent years, which has encouraged more investors to enter the market. Yield-seeking investors, in particular, have been heavy investors in real estate due to the attractive cash flow component of real estate returns. Moreover, some of the most active capital sources have been market buyers who want to invest in product throughout all phases of the real estate cycle, which has created fierce competition for the highest-quality product in the best markets, pushing real estate prices higher.
The outcome of this investment behavior is difficult to ascertain. The simplest scenario is that new buildings are developed at lower costs. As the markets go through their respective cycles, those investors who overpaid will suffer, and development will have to wait until the underlying supply-and-demand fundamentals turn favorable. Some developers who acquired land at a prior point in the cycle and for a lower price per square foot may also decide to commence development on the land, only enhancing the impact for those who paid record pricing. Interest rates are likely to increase, which will add upward pressure on capitalization rates (both going in and exiting). Assuming no outsized rental rate growth, these investors could experience very painful mark-to-market losses in their portfolios, placing downward pressure on real estate returns.
Regardless of the outcome, when interest rates begin to rise, investors need an accurate understanding of the risk they are taking with real estate investments and the relationship between purchase prices and replacement cost. While replacement cost is one metric to consider as part of the investment analysis, it must be thoughtfully considered in an environment such as this when investment pricing is aggressive and downside risk is particularly high.
Matthew Cypher is director of the Real Estate Finance Initiative at Georgetown University’s McDonough School of Business.