Real estate value investors believe that real estate assets have an underlying intrinsic value that can be determined by analysis and evaluation. Opportunities for profitable investments become present when the purchase price of the asset is below the underlying intrinsic value of that asset.
Value investors evaluate an opportunity in an investment by understanding the relationship between value and price. Thus, the essential task of a successful value investor is to determine the intrinsic value to capitalize on inefficient market mispricing.
In determining the intrinsic value of investment assets, there are two generally accepted practices used by fundamental investors today. The first is to determine the replacement cost of the investment asset to assess a general valuation. Adjustments are then made to the general valuation for the impact of depreciation on an older asset relative to new construction. In addition, an adjustment must be made for replacement rents versus new development rents. The end result is the intrinsic value of the investment asset.
Replacement cost numbers are typically generated on rough estimates of cost per square foot suggested by development and contractor organizations. When assessing replacement cost on an investment asset, contact two or three reputable developers or contractors, familiar with your market and product type, to obtain replacement cost estimates. Make sure your estimates are an apples-to-apples comparison that include standard costs such as:
- Hard Costs (Site, building, parking)
- Soft Costs (Third party consultants, permits & fees)
- Contingency Costs
- Land Cost
- Fees (Developer, construction, profit)
- Marketing & Leasing Costs
- Financing Costs
Finding a property’s intrinsic value using the replacement cost approach is used most often in the industry. The current industry replacement cost for a particular market and product type gives investors a baseline for valuation purposes. For example, let’s look at a typical cycle.
The economy is coming out of a recession, and demand for residential and commercial real estate is increasing. The increase necessitates the need for more housing units and commercial space to accommodate the growth. A house that cost $100,000 to build and that sells to a buyer for $120,000 creates a profit of $20,000. As the economy continues to expand and grow, replacement cost may increase to $110,000 (increase in land and building costs) and selling prices may increase to $150,000, creating a $40,000 profit.
As the economy overheats and demand starts to fall, fewer buyers are available to purchase, causing home prices to fall. We enter a recession and the market is flooded with homeowners and home builders trying to sell their huge inventory of homes to fewer buyers, causing home prices to fall even farther. The replacement cost of a home now drops to $90,000 (lower land prices and cheaper commodities) and selling prices have dropped to $70,000. When the economy begins to pick up again, home prices increase as the large inventory of homes for sale decreases.
The best time to be a buyer of homes is when the replacement cost to build a home is above the selling price. Buyers can buy homes lower than it cost to build a new home creating value. If a buyer bought a home for $70,000 and the replacement cost (intrinsic value) is $90,000, then the buyer has captured, at least, $20,000 of value. When the economy picks back up, home prices need to get above $90,000 (the cost to build a home) to make a profit.
The rule of thumb is to be a buyer when prices fall below replacement cost, and a builder when prices get above replacement cost. Therefore, replacement cost is the line in the sand (baseline). As a real estate value investor, you dream of the days when prices fall below replacement cost because value opportunities are everywhere.