How increasing replacement costs imply a widening investment moat

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Experienced real estate investors know to keep an eye on replacement cost when considering rehab deals.

The idea is to try to ensure your property will have a cost advantage vs. its neighbors.

The thought process is pretty simple: When considering doing a project, you want to look at what it would cost a competitor to buy a lot nearby and build a building from scratch to compete with you. You want to try to ensure that your all-in cost, on a per square foot basis, will be lower than your competitor.

Here’s an example of the calculation:

  1. Assume you’re looking at a 10,000 sq ft, 10 unit building you want to buy and rehab
  2. Say you’ll be all in for $3,500,000, which equates to $350 / sq ft
  3. Assume further that the lot next door is zoned for, say, five units, and similar lots have sold for $1,000,000 (eg $200,000 / unit of land)
  4. Assume that building a 5,000 sq ft, 5 unit building ground up on that lot would cost $300 / sq ft, or $1,500,000

To come in and compete with you, someone would need to spend $2,500,000 ($1,000,000 for the lot, then $1,500,000 to build). So, for his 5,000 sq ft building, he would be all-in for $2,500,000 / 5,000 = $500 / sq ft.

To carry the calculation to its conclusion:

  1. Assume you can each get $3,000 / month for your units ($36,000 / unit / year) and that expenses will equal $10,000 / unit / year, implying net operating income per unit of $36,000-$10,000 = $26,000
  2. On your 10 unit building, you have invested $3,500,000 to get $26,000 x 10 = $260,000 of net operating income, or a yield of $260,000 / $3,500,000 = 7.4% (awesome!)
  3. Your competitor would be looking at investing $2,500,000 to get $26,000 x 5 = $130,000, or a yield of 5.2% (a terrible outcome)

 

Obviously, the higher the cost to compete with you goes, the lower the yield a competitor can expect. And the lower the yield he can expect, the less likely he is to come in and compete with you.  Less supply means more pricing power for existing suppliers, implying higher rents and, therefore, net operating income and free cashflow.

What we have here is a naturally-occurring investment moat (for more on the concept, you go read Warren Buffett), one which works to protect and enhance your return over time.

Want to end by sharing a few implications of the above:

  1. If the city wants the market to supply more apartments, it desperately needs to reduce the cost of doing so. Most of the conversation in this area lately has been about up-zoning, which in theory ought to reduce the per unit cost of land. Much more attention needs to be paid to construction costs, which, after all, make up a much large portion of the total cost of building ground up.
  2. As construction costs have gone through the roof over the past few years, the moat protecting existing owners has widened.

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