The Importance of Investing at a Discount to Replacement Cost
As the real estate market increasingly looks to be heading closer to a recession, more investors are considering defensive strategies. At Paladin, we have a multi-pronged approach geared toward capital preservation. One of the most important defensive attributes of our strategy—indeed, what gives us a unique competitive advantage in this market—is the steep discount the cost of our properties has to replacement cost relative to new construction.
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Understanding Replacement Cost
A common estate valuation technique used by real estate appraisers is the “replacement cost method.” Replacement cost refers to the price that it would cost to replace an existing asset with a similar asset at the current market price.
Determining a property’s replacement costs requires gathering construction-related estimates including:
- Hard (construction) costs including labor and materials;
- Soft costs including permits, fees, architects, engineers, and other consultants;
- Contingency estimates for unforeseen circumstances;
- Developer fees and profit;
- Marketing and leasing costs; and
To the above costs of construction, land cost will be added to determine the total replacement cost of a new project with the same quality and use as an existing building on a similar site.
Replacement cost will vary by market depending on the region’s land costs, ease of permitting, labor and material costs of construction (e.g., union vs. non-union labor), and more. Due largely to land, entitlement and labor costs, replacement costs in low-density secondary markets like Phoenix or Dallas are often half that of gateway cities like Los Angeles.
A smart strategy is to buy apartment buildings when prices fall below their replacement costs and develop new apartment building when their values rise above replacement cost. Generally, until values for new development rise above the cost of new development, it would not be economically rational to engage in new construction.
However, during periods of heightened economic activity, investors often lose discipline. When capital is a commodity and real estate investment opportunities are scare, the pricing of real estate can increase substantially. Some investors end up buying properties at prices well above their replacement costs based on future potential growth. And developers, projecting higher future values on completion, continue to develop new buildings. This trend can result in over-supplied markets and poor investments when projected growth in demand and rents doesn’t materialize.
Investing at a Discount to Replacement Costs
Instead, our strategy is to acquire existing apartment properties at a substantial discount to replacement cost. This strategy provides tremendous insulation during economic downturns.
Of course, few markets offer these buying opportunities. In fact, Southern California is one of the only areas where we can do this at scale.
This is because the SoCal multifamily market has unique attributes that set it apart from other gateway cities.
The first pertains to the unique evolution of L.A.’s rental housing stock. Most apartment buildings were built just after World War II when land was plentiful and cheap and construction costs were low. This resulted in the construction of low-density buildings. Today, roughly 85% of L.A.’s rental housing has 50 units or less—a stark contrast to the newer 300- to 400-unit apartment buildings that typify other markets like Phoenix, Dallas or Atlanta.
These are also older assets. More than 90% of the rental housing stock in L.A. is more than 20 years old. Therefore, these building are generally classified as Class B or Class C assets.
Small Class B/C properties don’t typically attract interest from large institutional investors, who are looking for scale – an ability to invest a lot of capital efficiently. An institutional investor would need to acquire four or five times as many properties in L.A. to achieve the same scale they could achieve through a single purchase in a secondary market like Phoenix. The spread-out location of these properties within the metro area and their need for extensive renovations also makes them too operationally intensive and inefficient for most institutional buyers.
Absent substantial institutional investment, most of SoCal’s apartment buildings are owned by smaller, less sophisticated “mom and pop” investors. These are typically family-owned businesses in which the properties have been handed down from one generation to the next. Many are operated by owners with little to no real estate experience. In turn, the buildings are rundown and poorly performing. Some owners may not even realize that their assets are underperforming the market. Those who do may not have the knowledge or resources needed to invest in the requisite capital improvements. Instead, they look to keep rents low to minimize unit turnover, which keeps monthly cash flow steady.
Indeed, this is rational objective for most long-time mom and pop investors. They can effectively operate their properties like ATM machines for current cash flow and little or no large maintenance expenses or capital improvements.
Of course, this strategy translates into significant deferred maintenance. It also means that rents are often 20 to 30% below market average, a “loss to lease” factor that investors like Paladin seek when acquiring these properties.
At the same time, redeveloping these properties is almost always a non-starter for mom and pop owners. It is extremely costly, time-intensive, and risky to try to tear down an asset and build something new. There are costs associated with relocating tenants, a lengthy permitting process, and often years of delay caused by expensive lawsuits if the new project is to be larger than the existing building. Building a high-rise apartment building, even if permitting such an improvement were possible, is prohibitively expensive and out of reach for most small investors—even if the existing asset is not the highest and best use for this land if the land were vacant.
In other words, these existing Class B/C assets are truly irreplaceable, which is reflected in their pricing.
This means that the older Class B/C assets we target generally trade at substantial discounts to their replacement cost. Often, we buy and renovate these assets at a 40% to 50% or more discount to replacement cost – i.e. the cost of a new building of similar use and quality.
Another way to say this is that we are buying apartments where, after renovation and stabilization, the cost per unit is 40% to 50% less than what it would cost to build new.
This discount is truly unparalleled in the vast majority of markets in the U.S., and as a result, gives our investors downside protection that cannot be replicated in other markets where ownership of assets is broadly owned by institutional investors. In those markets, institutional investors are quick to capture any loss to lease and, in turn, the discount to replacement costs narrows.
This strategy, where we buy assets at a significant discount to replacement cost, allows us to charge pro forma rents for renovated units that are about half of what Class A rents are in Los Angeles. This provides a tremendous cost advantage, particularly during a market downturn when cost-conscious renters downgrade from pricier Class A units to our more affordable, renovated Class B/C properties. In fact, we often find that our occupancy rises during downturns as we provide relatively affordable housing compared to renters’ other options.
Over the past 30 years, Paladin has invested in numerous major metro areas across the United States. During this time, we have been unable to find such a substantial discount to replacement cost in any other major U.S. market – particularly when those markets are dominated by institutional owners. This is one of the reasons we are so acutely focused on our SoCal investment strategy. The downside protection is simply unparalleled.