How increasing replacement costs imply a widening investment moat

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.

Unsolicited advice for owners of non-RSO buildings

Owners of non-rent stabilized apartment buildings in Los Angeles with rents below market (eg most of them) ought to be considering their options in light of the likely repeal of Costa-Hawkins.
Two obvious courses of action:
  1. Sell now, while the market continues to (mistakenly, in my view) place a premium on non-RSO buildings; or
  2. Immediately bring rents to market (likely via some kind of re-positioning strategy) in order to avoid being “trapped” with low rents when rent control is inevitably extended to post 1978 structures

To fail to do either of the above is malpractice.

A good podcast

Have been spending my morning commute listening to a podcast I think you guys would love.

It’s call The Private Equity Funcast.

The hosts are two of the partners in a new private equity shop in Chicago called Parker Gale.

They have a small (for private equity!) fund of about $200MM which they’re using to buy lower-mid-market technology companies (so, like $20-40MM deals).

The thing I love about the podcast is that it goes far, far into the weeds on how you start a small private equity shop, including fund raising, deal sourcing, etc.

Many of you know that Jon and I are 100% self-taught… we didn’t work at other firms, our parents didn’t do this, etc. So this kind of nuts-and-bolts information is incredibly valuable to us.

Think you’ll like it, too!

Where our deals come from

Spent some time this morning looking back at all the deals we’ve done to see if I could learn anything about how we have historically sourced.

Here are the numbers:

Total deals done (as a buyer myself or as part of our fee-for-service business): 81

Of the total, number that were brokered: 74

Total number of different agents representing those sellers: 65

Agents who sold us three deals: 1

Agents who sold us two deals: 6

The above is a pretty surprising result, right?

While there are extraordinarily active agents working in our markets, almost all of our deals were done with agents who only ever sold us that one deal.

If I wanted to do a ton of work, I could look up each of those agents on the MLS to see how many deals they’ve done. I suspect I’d find that the vast majority of them very rarely sell apartment buildings.

What does this mean for our deal sourcing efforts? Well, it turns out that we should probably not spend our time focusing on the most active agents in our markets. They get tons of listings, but, because they’re sophisticated, their deals end up selling at prices we would not pay.

Instead, we need to figure out how best to reach those one-off agents, the ones who only get an apartment deal once in a blue moon. That’s where the bargains are.

The numbers are out of whack

Our business model allows us to generate yields which are consistently 200 basis points in excess of “market”.

In other words, if any random ding dong can buy a 4% cap, then we can reliably create a 6% by doing what we do.

But, right now, a 6% isn’t that great.


Well, interest rates for multifamily loans are ~4.5% / year.

So, if you borrow $2MM, you’re looking at annual debt service (inclusive of principal pay-down) of ~$121,150.

$121,150 / $2,000,000 = 6.1%.

That means, the more you borrow against your 6% yield, the worse the cash-on-cash yield gets. Ouch.

We really need to be making 6.5% yield deals to make the math work… but prices right now make that hard to achieve.

Eventually, if interest rates keep rising, prices are going to come down, which will allow us to make higher yield deals and bring the math back into alignment.

But you can wait a long time for an irrational market to come to its senses!