With the emergence of single-family rental homes as an institutional asset class, the concept of replacement cost has received a lot of attention lately. We are proposing a set of definitions to bring clarity to the term replacement cost, which means different things to different people and can thus be misconstrued in the market.
To see how important it is to define replacement cost, take a look at the graph below, which shows two things:
- The change in costs over time, including how much costs can rise in good times and fall in tough times
- The significance of certain line items, all or some of which are included in some people’s definitions of replacement cost and not in others
Based on this graph, a client could reasonably interpret replacement cost in any of the following ways:
- One client would say that the replacement cost is $196,000 today (essentially the minimum price needed for a builder to be willing to start construction).
- Another client would say that the replacement cost is $121,000 today (the cost of construction including the finished lot at the trough of the market, depreciated for 10 years).
- A third client would say that the replacement cost is $111,000 (today’s direct cost of construction only)
All of these numbers have merit but are obviously very different. We propose two new industry terms to bring clarity to the issue:
- New home replacement cost (NHRC), a definition of replacement cost that varies throughout the cycle. It comprises all of the costs to build a home, including finished lot purchase and builder profit.
- Trough depreciated replacement cost (TDRC), a definition of replacement cost that is static. It is meant to represent the lowest value that a home can achieve without a buyer selling under duress or some other extreme change in the market. This would be an estimate of replacement cost when all of the costs (land, labor, soft costs, and materials) are at their cheapest and also includes a depreciation factor for the age of the homes that are being evaluated for investment.
Calculating purchase price as a percentage of both replacement cost estimates will help clarify any analysis. In the example below (detailed assumptions are available to clients), a 10-year old home purchased for $130,000 would be:
- $9,000 above the TDRC of $121,000, so the buyer would know that there is very little risk that the price could fall much more than $9,000 for an extended period of time
- $65,000 below the $195,000 NHRC, so the buyer would know that there is very little risk of new home supply in the area unless home values rise significantly
If you are comparing purchase price to replacement cost, remember to clearly define replacement cost and what your definition represents—this will help you articulate the value proposition and risks to your investors. And feel free to use our definitions.