Entrepreneurial Profit Is Not A Cost

[Deleted member 126639]

I think EP should be depreciated along with direct and indirect costs. As the building ages, or other forms of obsolescence appear, it makes no sense to keep EP constant. The OP indicates $130,000 in EP as new. If a building is now 50 percent depreciated, how can there still be $130,000 EP? Make it more extreme, with 80 percent physical, functional and external depreciation/obsolescence due to neglect and changed market conditions. Do you still think there is $130k in EP? I say as the property ages, the neighborhood changes or standard designs change, the EP needs to be depreciated the same as the cost estimate.

The problem is that same argument can be applied to labor, which is a substantial component of the overall cost.

Let us think of other more common examples of deprecation: cars.

The new price of a car includes the parts, labor, and profit to the company that manufactured the car. Do we separate those costs? No.

Why should be any different for real estate?

 

[J Grant]

The problem is that same argument can be applied to labor, which is a substantial component of the overall cost.

Let us think of other more common examples of deprecation: cars.
The new price of a car includes the parts, labor, and profit to the company that manufactured the car. Do we separate those costs? No.
Why should be any different for real estate?

It's not really different-if one were appraising a car..

A car cost to build from factory, and depreciation, including profit to factory owner as the EP.

But it also has EP, (which should be separate) Cost from factory for car is is 20k. Dealer sells it for 24k to first owner. EP to dealer is $4000. First owner sells it two months later for 21k, a loss, no EI. Six years later, 2nd owner sells car for 10k .which reflects depreciation. The 3rd owner does not drive car, puts it in storage. 60 years later the car is a collector's item, sells for 60k. The 3rd owner got EI of 50k.

My dad was an auto wholesaler and made his $ between buy and sell no matter what a car cost. Sometimes he lost $ ...

 

[Deleted member 126639]

It's not really different-if one were appraising a car..

A car cost to build from factory, and depreciation, including profit to factory owner as the EP.

But it also has EI, (which should be separate) Cost from factory for car is is 20k. Dealer sells it for 24k to first owner. EI to dealer is $4000. First owner sells it two months later for 21k, a loss, no EI. Six years later, 2nd owner sells car for 10k .which reflects depreciation. The 3rd owner does not drive car, puts it in storage. 60 years later the car is a collector's item, sells for 60k. The 3rd owner got EI of 50k.

My dad was an auto wholesaler and made his $ between buy and sell no matter what a car cost. Sometimes he lost $ ...

Your response makes no sense.

The value of a new of a car is what someone pays at a dealer. Period. It does not matter how the profit is segmented between the dealer and the manufacturer. It is irrelevant. Everything else you have written is totally irrelevant.

 

[Gobears81]

It's not really different-if one were appraising a car..

A car cost to build from factory, and depreciation, including profit to factory owner as the EP.

But it also has EI, (which should be separate) Cost from factory for car is is 20k. Dealer sells it for 24k to first owner. EI to dealer is $4000. First owner sells it two months later for 21k, a loss, no EI. Six years later, 2nd owner sells car for 10k .which reflects depreciation. The 3rd owner does not drive car, puts it in storage. 60 years later the car is a collector's item, sells for 60k. The 3rd owner got EI of 50k.

My dad was an auto wholesaler and made his $ between buy and sell no matter what a car cost. Sometimes he lost $ ...

Project costs plus forwards-looking EI to the developer are what depreciation is determined from. If the initial projection from the developer (or car company) is $24k, then EI projections equal EP if the customer buys for $24k. Cars are a bad example because as soon as you drive off the lot, it loses value, whereas real property does not always lose value from the initial purchase to the following. But, assuming that the $21k is market value at the time of sale and market conditions have not changed, depreciation is 12.5% for the second sale two months later, which could be broken out as $2,500 to the "project costs" and $500 in depreciation to EI. But there is still EI, only it is now $3,500.

 

[hastalavista]

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 looked and could not find the article; what year was it published?

As someone else pointed out, there is a difference between EI and EP.

EP is not a factor in the cost approach; although it might coincidentally match EI.

Ei is a cost and it gets depreciated along with the improvements. Think about it; if one didn't depreciate it, then in the example you cite (#3), when the improvements contributed only $1, the EI would be $130,000 for a depreciated value of $131,001.
Would anyone buy the improvement for $130,000 over its contributory value of one dollar?

 

[jay trotta]

Steven;
http://federalappraisal.com/wp-cont...eneurial-Profit-and-External-Obsolescence.pdf

Found this in the Lum Library, perhaps it may assist, I do not get involved in Commercial, but the Question was interesting, as I deal in New Construction Residential.

 

[Deleted member 126639]

Steven;
http://federalappraisal.com/wp-cont...eneurial-Profit-and-External-Obsolescence.pdf

Found this in the Lum Library, perhaps it may assist, I do not get involved in Commercial, but the Question was interesting, as I deal in New Construction Residential.

Mark is a really smart guy. I would put a lot of weight on this article alone for that reason. Nice find.

 

[hastalavista]

From "In Defense of the Cost Approach: A Journey into Commercial Depreciation" (Nelson Bowes, MAI, AI) (my bold for emphasis)

Entrepreneurial incentive is what is required for an entrepreneur to get up in the morning, go to the office, find land, hire an architect, find money partners, arrange for financing, and so on. Hundreds (or thousands of tasks must be performed , and many months (or years) are required to complete them. no one, whether an individual, a corporation, an LLC, or any other entity, would (or should) take on those tasks without the possibility of making money....
Do not confuse entrepreneurial incentive with entrepreneurial profit either. Entrepreneurial profit is the amount that the entrepreneur actually makes when the property sells. That is a good number to know but is not the number we need. We need to know what is a sufficient incentive to entice an entrepreneur to go out and do a development....
The incentive is a cost, and this cost is just as real as the cost for bricks, concrete, or anything else.

EI is a cost; a cost component of the development. As a cost, it gets depreciated. While one could argue that it may depreciate at a different rate, there really is no basis for this argument as EI is associated with each factor of the development. It is applied to the entire cost; since it is applied to the entire cost, it depreciates along with the cost. Once the improvement is 100% depreciated, there is no residual EI.

 

[Howard Klahr]

If you do the breakdown method of depreciation, the allocation of profit associated with each short live component is actually depreciated at a faster rate when compared to that of the long lived items resulting in a higher cumulative overall depreciation.

Also if depreciation is extracted from the market the rate of deprecition applicable to the various components is inherent in the indicated rates

 

[leasedfee]

From "In Defense of the Cost Approach: A Journey into Commercial Depreciation" (Nelson Bowes, MAI, AI) (my bold for emphasis)

Nelson's paragraph is lovely. I took three classes with him, and occasionally chat at the AI Chapter meetings. A book titled, "Go or No Go!" boils down the essence of the entrepreneurial spirit. The risk is all-in with no retreat and the stakes are high as the entrepreneur. There is no compensation for the owner of capital until completed. Even if the entrepreneur/developer is large enough to pay him or herself a salary it is still contingent on successful completion. They must have access to fungible and liquid capital. Time is also the enemy: the slow drip of entropy; supercilious fashions of market needs; the decay of the dollar; the conducting of a symphony of experts, vendors and laborers; the return on and of your capital. This is why it is not equivalent with the wages of a laborer. EI is a Factor of Production.

Instead of thinking of it as the "Cost Approach", it should be thought of as the Factor of Production approach. Labor (of which materials are labor already performed) + Land + EI (called "capital" by the classical thinkers). I therefore have to disagree with Mr. Bowes about calling EI a "cost"; EI is not a cost in the formal sense of a check written with an contractual outcome, but EI is definitely required.