There are a lot of talks these days about inflation, interest rates, and recession.
» Will prices for real estate come down? (Yes)
» By how much? (Unknowable? Perhaps not)
» For how long? (Only time will tell)
So what is a buyer to do in these conditions? Many people have decided to take a wait-and-see approach. Others are signalling that they are priced out of their market and will be permanent renters. While waiting to make a decision can pay off, decisiveness always wins the day. Nobody makes money in real estate (or anything) by being on the sidelines.
When determining the value of real estate, there are 3 key approaches:
Income Approach: How much rent can I generate from this property?
Replacement Cost: How much would it cost to build this property today?
Land Value: The value of the property to a developer who chose to tear down and start again.
A value investor will always try to buy on replacement costs because income and land values are speculative by nature. You can make all the projections you want into the future, and you may be right some of the time, but eventually, you will get it wrong.
Conversely, replacement cost is based on historical data; it is knowable because it has already happened. You want to buy at or below replacement cost because it typically represents the lowest of the three indicators. It functions as the bottom of the bandwidth, our best guess of how low a product can go before it naturally starts to rise again.
The mechanism for this is supply and demand; as prices fall, the number of willing buyers increases. If the price for a good drops below replacement cost, no more units can be produced at this price, so supply will taper off. Eventually, all of the supply will be absorbed, and the price will be forced to start climbing again above the replacement cost in order to facilitate more product.
So while it is possible for prices to fall below replacement cost, if there is ongoing demand by users, it is unlikely for it to drop much below replacement cost for any extended period of time. Eventually, the supply will be outstripped by the increased demand, and prices will begin to rise. Simultaneously, inflation is increasing the cost of construction, pushing up the replacement cost making it more difficult for developers to increase supply. They will have to wait until the existing supply is absorbed to a high enough point that prices rise above an ever higher inflated replacement cost. The consequence will be a bumpy road ahead for the industry, but, you have a choice as an investor. You can either sit on the sidelines and wait, or you can look for value, which is very hard to find in a fast pace high-growth market.
QUALITY & QUANTITY
In today’s market, there are many opportunities to buy product below replacement cost. So how to choose? Pick something you actually want to own, for a long time, perhaps forever.
Example: There are currently 295 listings on MLS for condos in Surrey City Centre. 156 of these are listed for less than $820 per land foot. That is less than the replacement cost in today’s dollars.
If someone were to buy one today, it is not guaranteed to be worth more tomorrow. It could drop further and may have to in order to clear the inventory and push prices back up.
However, buying below the replacement cost today is likely to be worth more in the medium to long term. This is because, in order for more product to be produced, the prices will need to go up to offset construction costs and other development fees. Should you go and buy one of these units? Perhaps, but only if you intend to own it for a long time. In today’s market, prices are definitely moving in one direction and it isn’t up, so buying speculatively is a fools’ errand.
If you buy one of these properties and move in, it will become your home. You could live there for 5-10 years, at which point we will be well past this challenging moment.
If you buy one of these properties and rent it out to someone, it will become their home, and you could hold the property well past this challenging moment, and so on.
The key is to operate with some clear purpose with a long-term outlook. If you are a family buying your first home, go out and find something you can afford and buy it. Build a life and make a home.
If you are an investor looking for an asset that will fight against inflation, find an income-producing asset that you can afford and buy it. Start building out a portfolio that will help you achieve your retirement goals.
If you are a developer, don’t stop buying, 2 years from now, you will be kicking yourself that you don’t have product to build.
This exercise is designed to help us remember that markets operate within bandwidths. When they slow down, they are running near the bottom, replacement cost. They may fall further, but only for a short period, as supply will get constrained, pushing prices back up above replacement cost.
Unlike when the market is running towards a new peak, and achieving new benchmarks, don’t try to buy for instant gratification and a quick flip. It will not work. But, it is equally foolish to wait for things to improve as by that point, prices will be rising, and the number of value opportunities will start to decline.
We know we are near the bottom when people are willing to sell for less than what it would cost to build, and the farther the prices drop, the faster they will likely rebound due to the need for the market to push beyond the replacement cost.
And as long as we are operating with a clear purpose, we should never stop looking for an opportunity as it is always out there. You will find it; you might have to look for a while; for how long? Time will tell.
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