When evaluating a commercial real estate asset for a potential purpose, it is common for investors to spend a significant amount of time researching the property’s location and market. In an ideal market, there is a steady influx of new residents and businesses, along with the construction of new real estate to support their needs. While this can be a great situation to invest into, it also represents a risk—replacement risk—that all commercial property investors should be aware of.
What is Replacement Risk?
Simply, replacement risk is the risk that any given commercial property will become functionally or economically obsolete due to the arrival of newer options with similar rental prices.
The theory behind replacement risk is that, if given the choice, a tenant would prefer to lease space in a newer, more energy efficient and technologically advanced property if the price is the same or similar to an older property. So, in a fast growing market with rising rents, there is a risk that the economics could favor the construction of new properties to meet demand, making the older properties less desirable.
This risk underscores the need to understand a property’s replacement cost before making an investment.
What is Replacement Cost and Why Does It Matter?
Replacement cost is the theoretical price that would have to be paid to replace an existing asset with a new one at the current market price.
In a commercial real estate investment, it matters because it will provide insight into whether it is economically feasible to build a new property that could potentially take tenants from the investment property. For example, suppose that an investor is considering the purchase of a 20-year-old office building. It is in a high-growth market that has recently seen a dramatic increase in rental rates. If those same rates make it profitable for a developer to build a new office building, it is a safe bet that they will do so. Once complete, that brand new space will lease for the same rate as the 20-year old space. And, given a choice, it is also a safe bet that tenants will prefer the newer space.
For the older property, the arrival of newer competition at the same price likely means a necessary investment in renovations to meet the same level of finish and energy efficiency.
Calculating Replacement Cost
Calculating the replacement cost of a property can be a complex endeavor, but the most common method for doing so is using the “cost approach.” According to the Appraisal Institute, “…the cost approach is based on the understanding that market participants relate value to cost. In the cost approach, the value of a property is derived by adding the estimated value of the land to the current cost of constructing a reproduction or replacement for the improvements and then subtracting the amount of depreciation in the structures from all causes.“
The Appraisal Institute goes on to state that “…the current cost to construct the improvements can be obtained from cost estimators, cost manuals, builders, and contractors…“
In other words, it will likely be necessary to work with experts such as contractors and estimators to determine the replacement cost of a property. These experts will look at similar buildings of comparable quality to obtain current capitalization rates, as well as consider other factors such as the current building code, market conditions, and the building materials used in construction to develop a comprehensive cost estimate.
What is the Difference Between Market Value and Replacement Cost?
A property’s replacement cost should not be confused with its market value. They are separate and distinct concepts.
As discussed above, the replacement cost is the estimated cost of constructing a building that is similar to the building being evaluated using current prices for building materials and labor.
Fundamentally, the fair market value of the property is the price that a buyer is willing to pay given the current and projected cash flow. There are several methods by which a market valuation can be determined, but the most common include a net present value analysis, discounted cash flow (DCF) analysis, and/or the income capitalization approach.
In a fast growing market, it is feasible for there to be a significant difference between the market value and replacement cost.
Mitigating Replacement Risk
There are two keys to mitigating replacement risk: awareness and a plan.
The first idea necessitates that investors recognize where this risk lies in the transaction. If they are purchasing a property in a real estate market with rising rents and limited supply of inventory, it is a safe bet that new buildings will eventually appear and threaten to offer a more attractive product at the same rental rate. Recognizing this as a potential risk is the first step to mitigating it.
Next, investors should actively develop a plan for how to keep tenants and business owners from leasing space in the new property. Often, this involves things like property renovations and lease incentives to make the offering commensurate with the new property.
Summary and Conclusions
Replacement risk is the risk that a property will become functionally or economically obsolete due to the arrival of newer properties with a better offering at the same or similar rental prices. This is particularly prevalent in fast growing markets with rising rents. To understand the scope of replacement risk, investors should have a good understanding of a property’s replacement cost.
Replacement cost is the amount of money that it would take to rebuild a similar building using current prices for building material, land, and labor. This is distinctly different from the property’s market value, which is the amount of money an arm’s length buyer would be willing to pay to acquire the asset in the open market.
Mitigating replacement risk requires two things: an awareness that it exists, and a plan to retain tenants by keeping the property competitive with newer offerings. Often, this means investing in renovations/physical improvements or offering existing tenants lease incentives to stay put.
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If you are an Accredited Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or email@example.com for more information.