The replacement cost barrier

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As we seek to deploy our current pool of capital at a time of generally high prices, we are running up against the issue of replacement cost.

Here’s the problem: As a repositioner, you don’t really want to be in the position of spending more to buy and renovate a building than it would cost to build the same building from scratch.

The reasons are pretty obvious:

  1. All things being equal, you’d obviously prefer to have a brand-new, non-rent control building over an older (albeit totally-renovated) rent control building; and
  2. If someone can buy the property next door and construct an identical, brand-new, non-rent control building for less than you’re all-in for, then they should always be willing to under-price you on rents, assuming you’re both targeting the same yield.

Why is this coming up now?

It’s harder and harder to get our raw material (eg unrenovated buildings) at reasonable prices, because the market is hot. To compensate for the high prices, from a yield perspective, we can use the tricks we have developed over time to achieve high rents. But those tricks cost money, which drives up our all-in cost.

So, because I generally refuse to be all-in for materially more than replacement, we’re passing on some deals which have yields which would otherwise make them marginal “go’s”.

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