Why Buying Below Replacement Costs is Key to your Real Estate Success. Making informed decisions helps tip the scale of success to your favor. When it comes to investments, knowing what you’re getting into––and investing your money on––is crucial to avoiding costly mistakes and improving your return on investments.
One of the first things my mentor taught me was “Whatever you do, make sure you buy below replacement costs.”
What are replacement costs?
“Replacement cost” is the cost to build a similar building you are acquiring, only brand new. In other words, it is the cost that in the event your property gets damaged to the point of no return and renovation is not possible. Replacing the building and the cost to do so is your “replacement cost.” It’s also referred to the cost of building new.
Understanding Replacement Costs in Real Estate
When I first started in real estate, there wasn’t much to compare to. There were not a lot of new rental purpose multifamily buildings being built in the early 2000s, but around 2008. There was an increase of new construction. A major factor that contributed to a rise of new construction were the demand from two generations who were ok to pay a premium for rent; millennials and the baby boomers.
Millennials have been all too happy to pay for a higher-quality product and are willing to pay, $200-$300 more than an older building. Boomers are driving this demand mainly due to downsizing or moving out of the suburbs and into the city.
While the goal for Boomers is to reduce their cost and out of the suburbs, they are only willing to do so if they live/rent in a place similar to what they currently own or better. New multifamily rentals is their choice.
Buying below replacement cost or a brand new building ultimately means you can charge lower rent while still being able to achieve a good ROI. For example, a brand-new wood-framed building costs $200,000/suite to build. If the cap rate is 5%, the monthly rental rate would be rounded up to about $1,167/month.
If you were to buy a similar building only orders, with similar floor space, that has the purchase price of $120,000, a cap rate of 5 % would mean that a monthly rate of $833/month.
That’s a 40% difference. Which means you have some flexibility in the rental price and a wider market to attract given a more competitive rental rate. Even if there is a need for renovation of your older building, adding say $15,000/suite in renovation (which is plenty) would still allow you some room to be more competitive than a new building, with now a renovated suite and likely a higher rent as a result of the renovation.
The Inherent Values of Buying Below Replacement Cost
The advice given to me early allowed us to grow our company and maintain higher occupancy. Even during recession periods or when vacancies increased. It helped us with having a competitive product and the flexibility to charge a more competitive rate while still achieving a good rate of return.
We hope you enjoyed reading this article “ Why Buying Below Replacement Costs is Key to your Real Estate Success” and should you have any questions or if you’d like to speak to one of our consultants you can contact us.