Many techniques have been used to convince investors to buy real estate. Buying income property at a discount to replacement cost has been a popular one. It conveys a feel-good aura. When you remove the ego and the promotional hype, however, the reality is that a real estate market with sale prices below replacement costs is not a healthy sign.

How many times have you heard someone say: “I bought it at a 50% discount to replacement cost.” Or “Considering the price I paid and today’s construction costs, there’s a built-in 50% profit.” Or “They can’t replace it for the price I paid for it.” If we believe that all these buyers paid prices that were one-half of the market value, then we have to believe there are a lot of inexperienced, ill-advised sellers of real estate. Quite frankly, if there is a bias in one direction, history shows us that it lies with the buyers and their expectations, not the sellers.

The following are causes for markets with sale prices below replacement costs and the reasons why these markets are not positive:

1. Rents have been driven down by an excess of supply over demand.

There are many reasons why a marketplace has more real estate than it needs.

When lenders have a loose policy toward developers.
When developers can offer tax incentives as part of their investor’s return.
When there is an economic downturn in the local economy.
When a major employer closes its business.
When there is an increase in local crime.
When the infrastructure has deteriorated.
When the educational system declines.

These factors will cause an excess of real estate. In the first two instances, the reason is the construction of non-economic (unnecessary) real estate. In the remaining cases, there is excess real estate because less is needed or desired. In all cases, the real estate’s net operating income (NOI) will remain even or turn down while construction costs continue to rise. The result: You can buy the income property at a discount to replacement cost.

Investors who purchase real estate to make a profit have a chance for success when the real estate’s NOI rises. But how much impact will these problems have on the real estate’s future NOI?

2. The costs of construction are rising at a faster rate than rents.

This imbalance between costs and potential income indicates inflation. The various commodities that go into the manufacture of real estate are directly tied to the rate of inflation, whereas rents are affected by the relationship of supply and demand. Many of the operating and capital expenses on real estate’s profit-and-loss statements are also tied to the rate of inflation. Thus, during an inflationary period, the real estate’s financial state could turn into a classic profit margin squeeze if the supply/demand relationship is unfavorable. In other words, when expenses are increasing at a faster rate than the rents, the NOI will be reduced. The result, you can buy the income property at a discount to replacement cost.

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