Entrepreneurial Profit And Construction Duration

[Brian P. Coker]

Let's say required minimum entrepreneurial incentive = 8%, external obsolescence = 0% and extra-minimum entrepreneurial incentive = 1% for a total entrepreneurial profit of 9%.

I believe you then need to account for construction time.

"Entrepreneurial incentive typically reflects the opportunity cost—or the lost profits—to the taxpayer during the hypothetical property replacement or reproduction period." – Institute for Professionals in Taxation, Property Taxation, 4th Edition, p. 539

If it took 2 years to build a hotel, would you multiply 9% x 2 years and add 18% to your cost approach? If so, is there any reference guide for average construction duration by building type and size? Or do you just have to call around and speak to builders?

 

[Deleted member 152047]

If you truly want to extract the appropriate entrepreneurial profit, see if you can find comparable projects and find out what the builder's profit expectation is. The construction duration is a factor in the overall cost and the $ profit number will increase as time goes on.

In other words, we don't allocate the entrepreneurial profit by line item as that is not how an entrepreneur would do it.

If project A is a hotel that costs $10,000,000 to construct and it takes 12 months, the profit might be 15% and result in $1,500,000 in profit ($125,000/month).

Project B is a hotel that costs $50,000,000 to construct and takes 36 months, the profit might be 15% and result in $7,500,000 in profit ($208,333/month).

Its all relative, unless you have extraordinary governmental barriers to entry, which would be another case entirely and might drive up EP.

 

[Brian P. Coker]

I see. That's an interesting way to look at it. It makes sense. Thank you

 

[Gobears81]

I took an AI class called Advanced Sales Comparison and Cost Approach about 6-7 years ago, which I don't believe is taught anymore. They had some good commentary on this very subject. There was a good example in the course handbook about handling EI in the cost approach during leaseup, in which EI was obviously recognized on the net costs prior to completion. But in the interim leaseup period EI was calculated based on:

(TIs + leasing fees + operating expenses + yield) less income earned during that period. In this case, yield was defined as compound interest on the net costs incurred prior to completion, IN ADDITION to compound interest on EI previously recognized.

Your question wasn't not in reference to leaseup of course, but the above does relate to lost profit, so a similar multiple period model could be developed to illustrate the opportunity cost

 

[leasedfee]

"Entrepreneurial incentive typically reflects the opportunity cost—or the lost profits—to the taxpayer during the hypothetical property replacement or reproduction period." – Institute for Professionals in Taxation, Property Taxation, 4th Edition, p. 539

This is a different definition that what the Appraisal Institute uses, and the different is significant.

If it took 2 years to build a hotel, would you multiply 9% x 2 years and add 18% to your cost approach? If so, is there any reference guide for average construction duration by building type and size?

No.

Or do you just have to call around and speak to builders?

No.

If you truly want to extract the appropriate entrepreneurial profit, see if you can find comparable projects and find out what the builder's profit expectation is. The construction duration is a factor in the overall cost and the $ profit number will increase as time goes on.

No.
Builder's profit is not the same as entrepreneurial incentive to the developer. There are some detailed threads on this topic on the forum, and it is worth looking for. Everyone makes a profit in developing a building. The trucking company, the appraisal company, the cement company, the lumber company, the nail company. These are generally hidden or lodged within a cost bid. Likewise, the builder (GC) is just another vendor whether directly or separately line-itemed into the hard costs. But they're not the developer who needs to make their own profit. Go read some older threads on AF and I go into detailed about what developer's profit is and why it is earned.

You pay property taxes, insurance, and holding costs during the construction period. Longer periods becomes notable. You are also looking for what the late E. Nelson Bowes, MAI, PE, rest in peace, called "fill up" cost. Fill-up cost to the anticipated loss in rents, expenses, or economic utility that is built into stabilizing a building. He describes this in detail in his In Defense of the Cost Approach: A Journey into Commercial Depreciation and he also taught it as the author of AI's Cost Approach course. Fill-up cost becomes pronounced with large projects as it is a necessary hurdle rate that makes these larger projects economic infeasible. Rents have to become high enough and absorption fast enough. Fill-up (anticipated absorption loss) is part of the reason there are numerous horizontal multi-phased suburban office buildings totaling 1,000,000 sf and very few 1,000,000 sf vertical skyscrapers.

 

[Deleted member 152047]

Right, developers profit and entrepreneurial profit are different. As are entrepreneurial incentive and entrepreneurial profit. My builder profit comment is referring to the investors position. Semantics.

That said, you can call a developer (within a space that they are active) and typically get a good idea of what kind of profit they expect. As long as the project is not unique.

 

[Meandering]

Holding costs over,
permitting process
construction
(lease-up (fill-up) time weighted against projected market slow down or demand increase) = time value of money
are factors that impact expected EP and have to be projected and addressed on the front end before applying a percentage.

.

 

[Michael P Jacobs MAI]

Profit is earned on sale (value) not on cost. There is no profit in Y1 of a multi-year project without a sale of something.

 

[Terrel L. Shields]

ill-up cost becomes pronounced with large projects as it is a necessary hurdle rate that makes these larger projects economic infeasible. Rents have to become high enough and absorption fast enough. Fill-up (anticipated absorption loss) is part of the reason there are numerous horizontal multi-phased suburban office buildings totaling 1,000,000 sf and very few 1,000,000 sf vertical skyscrapers.

Same issue as a poultry farm. We have a lot of new ones here. These are typically built by the owner, so the EI is built into the construction. The owner is the one who has to endure the period of time between commencement of the construction and the first integrator check of the farm, which is typically near a year, rarely shorter than nine months. Even if completed in six months, the farmer now has to get the birds into the barn and grow them out, so his first check may be two months away, but the utilities go on, etc. So you often see offers on new construction with the first or second batch of birds that is markedly higher than the total "cost" of the project, which would cover the time value of the money borrowed, the insurance paid, etc.