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Should You Consider Replacement Value When You Buy Investment Real Estate

A question...

If you can buy investment real estate at below replacement cost, is that a good deal?

In fact, is the cost to replace a building that you are considering purchasing even relevant?

All too often I see real estate being marketed at "below replacement cost" as if this was some type of windfall that only happens once in a blue moon. The fact is, the replacement cost of a property is for the most part only relevant for insurance purposes. If the building is destroyed by a fire for example, you need to know what it would cost (in today's dollars) to rebuild. But as a method of determining market value when you are looking to buy investment real estate, it has little worth.

Now, if you ever have an appraisal done on commercial real estate, you will see the "Cost Approach" typically included as one of the three valuation methods employed by the appraiser. But the reality is, the value of most real estate (both commercial and residential) is usually derived from a "Sales Comparison Approach" or an "Income Approach".

Let's take it one step further. You are considering buying an older house. The one down the street that was almost identical (in age, size etc.) sold for $300,000. But the asking price on the house you are looking at is $350,000. The selling agent reassures you that at $350,000 you would be getting a great deal because the cost to replace the house would be $400,000.

Would you pay $350,000 for a house that based on comparable sales is only worth $300,000. Of course not. The fact that it would cost $400,000 to replace the home is irrelevant.

When you are looking to buy investment real estate, the only value that matters to you is today's market value. Figure that out first, and then aim to negotiate a price well below that. If you can't, it is probably time to move on to the next deal. 

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