Construction cost inflation has been nearly 70% higher than consumer inflation over the last 4.5 years. This has sparked increasing commentary around ‘replacement costs’. Below we examine what this means and the opportunity it presents investors.

Construction Cost Inflation v CPI

Source: ABS

Replacement cost vs Market value

The market value and replacement cost of a building are not the same thing. They are distinctly different concepts that are estimated using different criteria.

Replacement cost is the estimated cost to construct, at current prices, the same property. The major components of replacement cost are:

• Land value
• Construction costs – which includes both materials and labour
• Professional fees
• Financing costs
• Leasing costs
• Development profit

Market value is the estimated price at which a property would be sold on the open market between a willing buyer and seller in the prevailing market. The major drivers are:

• Rents
• Capitalisation rate – which works the same way as bond yields with a lower cap rate equating to a higher price, and vice versa

Real estate has a reputation as a hedge against inflation because its intrinsic value is linked to construction costs. If market values fall behind replacement costs, then new development will be curtailed. The resulting undersupply triggers a spurt of rental growth sufficient to bring market values back in line with replacement costs.

Over the last 18 months a substantial mismatch has emerged. Rising interest rates have triggered a correction in real estate values. Simultaneously, construction costs have risen due to supply chain disruption, higher land costs, higher material costs, higher labour costs, higher financing costs, the difficulty of finding a builder, competition from infrastructure projects and a repricing of development margins to reflect the risks above.

CBRE Research have published a paper on this topic which states: 

there’s a sizeable gap between current average value/rent and replacement costs across almost every aspect of Australian real estate. In most cases, the gap is around 30-40%.¹

Fund features

The Dexus Wholesale Australian Property Fund (DWAPF) was started back in 1985 and has continued to improve the design of the fund while delivering an average return to investors of 7.9%. The Fund is widely available and offers market leading features, some of which have been recently introduced. Here is a summary:

• Availability – the Fund is available for direct investment or via leading platforms including North, Panorama, Asgard, Macquarie Wrap, Expand Extra, FirstWrap, Netwealth, Xplore, Hub24, Dash, Praemium, FNZ and Mason Stevens.
• Deceased estates / Legal disability – a legal disability withdrawal mechanism has been introduced that may facilitate monthly redemptions for investors that have passed away or have suffered other forms of ‘legal disability’ and meet the conditions. This is available up to $500,000 subject to conditions.
• Secondary sale of units – Dexus has partnered with PrimaryMarkets, enabling the Fund’s investors the potential to list for sale their units and gain liquidity at a price nominated by them (if a buyer is available) through a facilitated secondary market at a 2.5% fee payable to PrimaryMarkets (note, the Fund does not charge a sell spread). This arrangement is designed to provide a potential alternative liquidity pathway if the primary way of exiting the Fund is not practical. Alternatively, eligible purchasers can potentially take advantage of an immediate uplift in the holding value of their investment if they complete a purchase of units through the PrimaryMarkets platform at a discount to the Fund’s prevailing unit price.
• Recontributions – if investors need to technically redeem and re-invest to facilitate a recontribution strategy, this can be facilitated.
• Switching – if investors need to transfer between platforms or onto/off platform or on a super-to-super basis or super-to-pension basis, this can be facilitated.
• Bonus Units – direct investors who choose to activate the Distribution Reinvestment Plan are eligible for 2% bonus units.
• SIV Compliant – the Fund is ‘complying’ for the purpose of meeting the Significant Investor Visa requirements.
• Ratings – Lonsec and Zenith Investment Partners both rate the Fund.

The Fund continues to offer one of the most competitive liquidity and fee structures amongst comparable unlisted managed property funds. Currently, monthly withdrawal payments are being made based on redemptions lodged 12 months prior.