For decades, one of real estate’s “three sacred ways” to value property has been replacement cost — the idea that a rational market values assets as a function of the cost to rebuild them. But in practice, replacement cost has rarely anchored real-world investment decisions. It's been more of a rhetorical tool used to either rationalize why we did not want to increase a bid on an asset at auction, or as a post-sale brag when we acquired a property for “below replacement cost.” That de-emphasizing of replacement cost is now validated by data. New research that finds replacement cost has little explanatory relationship to property values, and the decoupling is growing.

The research shows that in some markets, often coastal, the link between construction costs and value has frayed to the point of irrelevance in the single-family-home market. If that’s true for housing — the biggest real-asset market in existence — it casts a shadow on one of the core valuation crutches of commercial real estate.

Although building costs on average account for 60% to 70% “of the full cost of bringing a new house to market in a land-unconstrained area,” the table below indicates other factors are moving housing prices. The purple and the yellow lines below are two different measures of house prices, the blue and green are two measures of building costs, and — depressingly — the magenta is tracking inflation, well below all the other lines.

Construction costs have outpaced inflation for decades, which is true across commercial and residential development alike. One culprit is a near total lack of productivity growth in the sector “relative to the rest of the economy post-1970.” 1970! Still: “Cumulative house price growth using the FHFA index outpaced building costs by over 60%” since 1975; “the difference using the Shiller housing index is 80%.”

So what do construction costs actually tell us? Nationally, almost nothing: they have explained (statistically) less than 5% of the movement in housing prices since 1995. But some metros still play by the old rules. Dallas, Houston, Atlanta, and Phoenix — cities that build freely — show tighter alignment between cost and price. By contrast, the coasts and constrained markets have rewritten the relationship. In Miami, new-home prices run 98% above what local construction costs would predict. Seattle, Boston, Colorado’s Front Range and California metros show similar gaps.

An interesting aside, RSMeans during 2007 began separating material (e.g. lumber, finishes, drywall, concrete, etc.) and installation costs. Installation outpaced materials early in the 2010s; by the late 2010s, the trend reversed. Then COVID hit and materials inflation spiked more than 8% from 2020-2024 while installation costs grew 3% during that time, reflecting supply-chain bottlenecks and a global goods price shock. Still, even that surge barely nudged the fraying statistical connection between cost growth and home-price growth.

This low correlation between prices and replacement cost can lead to some funky - and misleading - charts. Here’s one showing median house prices in 2024 in each market mapped against the cost to rebuild those houses–an eye-opener for anyone who still thinks the market is tightly anchored to replacement value.

The market is no doubt more efficient than what the graph indicates, especially for those markets on the top right where apparently you can build a house for $350,000 and sell it for more than $1,000,000. Regulatory and soft costs, and of course land prices drive up the construction basis. But the real value drivers - supply constraints, demographic changes, economic growth - move home prices farther and faster. So if you zoom out, the table actually tells a compelling story: The market is not highly efficient, meaning there are cities in which value really is significantly higher than replacement cost.

And that drives the two-sided takeaway for institutional investors: First, “replacement cost” is volatile, market-specific and no longer a reliable anchor of an asset’s value. Second, this widening decoupling indicates opportunity: in markets where cost and price have drifted apart, disciplined developers and investors can still find arbitrage—real value hiding in the inefficiency.

Markets may look efficient from 30,000 ft, but they’re stitched together from local irrationalities. Replacement cost is just a part of the story we tell ourselves to make sense of them.

We often wonder how people in the US on average feel about their financial situation, and our assumption has been that things were generally tough and most people would say they were struggling economically. But that’s not the case: In October 2024 nearly three in four Americans told the Federal Reserve they were “living comfortably” or “doing okay,” and that figure has been fairly stable over the last decade. The study broke down responses by education, race and whether you’re a parent.

link: https://usafacts.org/articles/how-are-americans-doing-financially/

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