Entrepreneurial Profit Is Not A Cost

[Stephen J. Vertin MAI]

Looking for some highly theoretical answers. I just read an article from the Lum Library called "Entrepreneurial Profit Is not a Cost" by Max J. Derbes, Jr., SREA, MM, CRE. Max effectively argues that EP are not costs. This is fairly reasonable because they are above and beyond the actual construction costs and are profits to the builder or entrepreneur. So if they are not a cost would they be depreciated like a cost and why? Example:

EP is 13%, improvements are 20% deprecated. Which is a correct methodology (if EPs are required to be extracted)? I know this is a strange question but it is of great importance in something I am working on:

Cost $1,000,000 x 1.13 = $1,130,000 less 20% depreciation = $904,000
First answer $904,000 x 1.13 = $1,021,520 ($1,021,520 -$904,000 the EP extracted is $117,520)

Cost $1,000,000 x 1.13 = $1,130,000 less 20% depreciation = $904,000
Second answer $904,000/.87 = $1,039,080 ($1,039,080 - $904,000 the EP extracted is $135,080)

Cost $1,000,000 x 1.13 = $1,130,000 less 20% depreciation = $904,000
Third answer $1,130,000 less $1,000,000 the EP extracted is $130,000

The first and second answers are based on the fact EP is depreciated at the same rate as cost, the methods performed are simply different. The third answer is based on the fact EPs are not costs and were collected after completion of construction and the property selling. The money given to the EP does not change and since they are not a cost are not depreciated.




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[timd354]

Looking for some highly theoretical answers. I just read an article from the Lum Library called "Entrepreneurial Profit Is not a Cost" by Max J. Derbes, Jr., SREA, MM, CRE. Max effectively argues that EP are not costs. This is fairly reasonable because they are above and beyond the actual construction costs and are profits to the builder or entrepreneur. So if they are not a cost would they be depreciated like a cost and why? Example:

EP is 13%, improvements are 20% deprecated. Which is a correct methodology (if EPs are required to be extracted)? I know this is a strange question but it is of great importance in something I am working on:

Cost $1,000,000 x 1.13 = $1,130,000 less 20% depreciation = $904,000
First answer $904,000 x 1.13 = $1,021,520 ($1,021,520 -$904,000 the EP extracted is $117,520)

Cost $1,000,000 x 1.13 = $1,130,000 less 20% depreciation = $904,000
Second answer $904,000/.87 = $1,039,080 ($1,039,080 - $904,000 the EP extracted is $135,080)

Cost $1,000,000 x 1.13 = $1,130,000 less 20% depreciation = $904,000
Third answer $1,130,000 less $1,000,000 the EP extracted is $130,000

The first and second answers are based on the fact EP is depreciated at the same rate as cost, the methods performed are simply different. The third answer is based on the fact EPs are not costs and were collected after completion of construction and the property selling. The money given to the EP does not change and since they are not a cost are not depreciated.

I just don't accept the premise that EP is not a cost. Good luck finding a builder or developer willing to build a building or develop a project for zero anticipated profit.

 

[Stephen J. Vertin MAI]

Thank you for your response. I am not sure that is what Max is saying. He is not saying EP is not part of the cost approach. He is saying it is a profit and not a cost. Land value is part of the cost approach but it is not the cost to construct (nor is it depreciated the same as cost). What I am trying to figure out, is should EP be treated the same. Does EP warrant depreciation at the rate of cost since they are different elements within the same process?

 

[timd354]

Thank you for your response. I am not sure that is what Max is saying. He is not saying EP is not part of the cost approach. He is saying it is a profit and not a cost. Land value is part of the cost approach but it is not the cost to construct (nor is it depreciated the same as cost). What I am trying to figure out, is should EP be treated the same. Does EP warrant depreciation at the rate of cost since they are different elements within the same process?

I will have to see if I can get my hands on that article and see exactly what is argument is, but I will say that if I hire a builder to build house (or any other type of structure) as an alternative to buying an existing house, I don't see how the builder's profit is not a cost to me since that is part of what I am going to have to pay in order to get the builder to build the house. Whether EP should be depreciated at the same rate as the other elements of the cost to construct is an interesting question. Along those lines, the other elements that are included in cost are (broadly) the cost of labor and the cost of the building materials...if we are going to depreciate EP at a different rate than the other costs, should not the cost of labor be depreciated differently from the cost of materials - By the way, I don't know the answer. I am just posing the question and maybe it is a silly question.

 

[Deleted member 126639]

I will have to see if I can get my hands on that article and see exactly what is argument is, but I will say that if I hire a builder to build house (or any other type of structure) as an alternative to buying an existing house, I don't see how the builder's profit is not a cost to me since that is part of what I am going to have to pay in order to get the builder to build the house. Whether EP should be depreciated at the same rate as the other elements of the cost to construct is an interesting question. Along those lines, the other elements that are included in cost are (broadly) the cost of labor and the cost of the building materials...if we are going to depreciate EP at a different rate than the other costs, should not the cost of labor be depreciated differently from the cost of materials - By the way, I don't know the answer. I am just posing the question and maybe it is a silly question.

I think this is the right answer. Labor costs should be treated the same way, if the theory is right. Clearly, we can't do that without a lot of time and a lot of independent surveys.

For smaller projects, I tend to think that the traditional method of appraisers is fine. But the reality is for anything complex, developers don't even think about it this way. They look at the overall equity return to the project, which is something appraisers never do.

 

[Gobears81]

Stephen-I didn't read that article, but here's my initial thoughts:

In your example, here's my opinion of how entrepreneurial incentive should be extracted:

$1,000,000 cost new w/ 13% EI = $1,130,000 value without land
20% depreciation indicates $904,000 value, but $104,000 in EI

The last part of your initial post acknowledges entrepreneurial profit as effectively being retroactive. I agree. Which is why we do not include EP in the cost approach, we include entrepreneurial incentive, which is the expectation of what it would sell for. EI is forward-looking, EP is backward-looking. Entrepreneurial profit may end up being equal to 13% of project costs, maybe more, maybe less, but it is an inappropriate item to include in the cost approach as we are projecting in the future.

Entrepreneurial incentive is depreciated at the same rate as project costs from a consideration of the highest and best use/ building life cycle. In your example, when depreciation goes from 99% to 100%, the depreciated EI drops to $0, but the building improvements have no value. The value is effectively synonymous with land, and perhaps a new developer is then weighing his options of what to build on the site and whether the EI for said new project is sufficient (or to hold for future development when there are no feasible projects with sufficient EI). But I see no compelling reason for not depreciating EI at the same rate as the other building/site improvement costs.

 

[Joe Flacco]

My opinion is that EP is depreciated at the same rate as other costs.

I don't understand in answers one and two, why the depreciated cost of the improvement is multiplied by 1.13 or divided by .87 when the depreciated cost already includes EP.

 

[Joe Flacco]

Stephen-I didn't read that article, but here's my initial thoughts:

In your example, here's my opinion of how entrepreneurial incentive should be extracted:

$1,000,000 cost new w/ 13% EI = $1,130,000 value without land
20% depreciation indicates $904,000 value, but $104,000 in EI

The last part of your initial post acknowledges entrepreneurial profit as effectively being retroactive. I agree. Which is why we do not include EP in the cost approach, we include entrepreneurial incentive, which is the expectation of what it would sell for. EI is forward-looking, EP is backward-looking. Entrepreneurial profit may end up being equal to 13% of project costs, maybe more, maybe less, but it is an inappropriate item to include in the cost approach as we are projecting in the future.

Entrepreneurial incentive is depreciated at the same rate as project costs from a highest and best use/ building life cycle. In your example, when depreciation goes from 99% to 100%, the depreciated EI drops to $0, but the building improvements have no value. The value is effectively synonymous with land, and perhaps a new developer is then weighing his options of what to build on the site and whether the EI for said new project is sufficient (or to hold for future development when there are no feasible projects with sufficient EI). But I see no compelling reason for not depreciating EI at the same rate as the other building/site improvement costs.

That's what I get. $104,000 contribution of EI to depreciated cost. $130,000 * .8 = $104,000.

 

[Michigan CG]

My opinion is that EP is depreciated at the same rate as other costs.

I think you are right in a typical market BUT (thee is always that BUT) in the recession hard costs did not go down (lumber, light switches, cement, shingles) but no one could build a house because the COST was greater than the market would return. EI/EP was eliminated when the principal of substitution took over in 2008.

EI was 20% in 2006, down to 10% in 2007, nothing in 2008 and by 2009 it was NEGATIVE 20% in my market.

It is my opinion that in a typical market EI is a cost and depreciates similar to the remainder of the cost but in an atypical market EI can vanish in a short period of time.

 

[Joe Flacco]

I don't know if this is the article Stephen is talking about but it is Max Derbes discussing the topic.

https://professional.sauder.ubc.ca/.../content/330/11_Derbes - Rebuttal to Mann.pdf