Q1-10 Situation Analysis
Measure of Competitiveness
At the same rent, a new building will lure tenants away from an older one, so a used property must charge lower rents. It must be priced below the cost of new construction.
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In this sense, replacement cost is a proxy for competitive margin, and as such, it is a necessary consideration in any commercial real estate (“CRE”) investment: necessary, but not sufficient, because when demand is low — when occupancy and rent are falling, as they have been during our present downturn — there will be almost no new construction.
Without demand for new construction, what relevance does replacement cost have? As a measure of competitiveness, it asserts a fallacy. Competition today occurs among existing properties, not against new ones. In fact, the competitive benchmark right now is foreclosure, so instead of “replacement cost ratio,” we should be thinking in terms of “foreclosure price ratio.” This will remain the case until demand for new product makes construction feasible again1.
When will that be? First, the excess supply of CRE must be absorbed. We might all wish that this could occur through economic growth, more employment, higher wages, greater retail sales, increased production, and so forth.
Absorption: Good, Bad & Ugly
Unfortunately, given the devastated CRE landscape, absorption will not begin with increased demand, but with diminished supply. Falling rents cause mortgage defaults, but even before that happens, they will impair property maintenance, operation and occupancy. With lack of revenue, CRE typically accelerates toward the end of its useful life, the most obsolescent property first. Renovation in these cases will often be economically infeasible2. For investors in such properties, the fact that they had been priced below replacement cost will be of no consolation.
For the market at large, however, the depletion of supply will be a good thing. As buildings go out of service with little or no replacement, demand will begin to strengthen, and net rental income will stabilize. However, true CRE recovery will only occur with a substantial improvement in the general economy, especially in wages and employment3. Economists don’t agree on when this may occur, but those who foresee a time earlier than 2016 are in the minority. Whenever expansion does occur, it will finally lead to new CRE construction, and this is when replacement cost will become significant again.
Replacement Cost and Replacement Kind
Here, however, it must be noted that replacement cost is subject to another type of fallacy — the fallacy of like-kind replacement. During the long construction hiatus between now and 2016, a number of qualitative changes will be germinating. Among the most important, green technology will substantially improve in that time frame. Public policy will drive innovation in this area; consumer preference will do the same; and building codes will incorporate the advances into law.
New buildings will be easier to market, cheaper to operate, favored by tax-incentives and other enactments.
Anticipating this environment, if the concept of replacement cost ratio is to be meaningful, it must include more than mere restoration, but also retrofit. Building owners who do not allow for the cost of true modernization will find that their replacement cost ratio was inadequate to assess their actual competitive risk.
A comparative cost ratio remains highly relevant to any CRE investor. Typically this has been structured as a replacement cost ratio:
newcost ÷ usedcost
In today’s market, however, we must recognize that this traditional formula is misleading and that the following formula is far more pertinent to our current situation:
newkindcost ÷ (foreclosureprice + retrofit)
- The specter of foreclosure will hang over CRE-pricing for a while. U.S. Treasury policy is for banks to “blend and extend” whenever possible, that is, to negotiate terms of under-collateralized mortgages in order to avoid or delay foreclosure. The policy reduces pressure on the Fed, but it also obscures the CRE price-bottom, slows absorption of excess CRE, and delays the reemergence of new construction lending.
- There are always some exceptions, of course, as when government grants are available for housing rehabilitation, or when unique advantages of price, location or permitted use are in question. In those cases, investors must have a carefully conceived rehabilitation budget and ample funds to execute it, or they will be unable to hold their own.
- Higher wages indicate demand for labor, which ultimately leads to demand for office and industrial space. Wages support retail sales and thus store rentals. Obviously, wages determine the level of housing consumption and apartment rents.