Entrepreneurial Profit in the Cost Approach

[LifetimeStudent]

I've gone down the rabbit hole... in researching what cost source to use I was reading what is included and what is not included in the costs as provided by Marshall and Swift. Entrepreneurial Profit (not the contractor's profit) is not included. I have a Master of Real Estate Degree and real world experience developing property (including building homes) and both the classroom and the real world support the fact that nothing gets built unless the developer (not just the contractor) earns a profit for the risk (including opportunity cost) they are taking in developing the property, be it a house or a commercial property. In the 1004 or UAD where is this entrepreneurial profit included? It appears as though I have been doing it wrong all along and need to add at least 10-15% in entrepreneurial profit to the Cost Approach. What am I missing?

The Cost Approach is defined as follows in the Dictionary of Real Estate Appraisal, 6th Edition.

cost approach. A set of procedures
through which a value indication is
derived for the fee simple estate by estimating
the current cost to construct
a reproduction of (or replacement for)
the existing structure, including an
entrepreneurial incentive or profit;
deducting depreciation from the total
cost; and adding the estimated land
value. Adjustments may then be made
to the indicated value of the fee simple
estate in the subject property to reflect
the value of the property interest being
appraised.

The Entrepreneurial Incentive is defined as follows in the Dictionary of Real Estate Appraisal, 6th Edition.

entrepreneurial incentive. The amount an
entrepreneur expects to receive for
his or her contribution to a project.
Entrepreneurial incentive may be distinguished
from entrepreneurial profit
(often called developer’s profit) in that
it is the expectation of future profit as
opposed to the profit actually earned
on a development or improvement.
The amount of entrepreneurial incentive
required for a project represents
the economic reward sufficient to
motivate an entrepreneur to accept
the risk of the project and to invest the
time and money necessary in seeing
the project through to completion. See
also entrepreneurial profit.

The Entrepreneurial Profit is defined as follows in the Dictionary of Real Estate Appraisal, 6th Edition.

entrepreneurial profit
1. A market-derived figure that represents
the amount an entrepreneur
receives for his or her contribution to
a project and risk; the difference be-
tween the total cost of a property (cost
of development) and its market value
(property value after completion),
which represents the entrepreneur’s
compensation for the risk and expertise
associated with development. An
entrepreneur is motivated by the prospect
of future value enhancement (i.e.,
the entrepreneurial incentive). An
entrepreneur who successfully creates
value through new development, expansion,
renovation, or an innovative
change of use is rewarded by entrepreneurial
profit. Entrepreneurs may
also fail and suffer losses.
2. In economics, the actual return on
successful management practices,
often identified with coordination, the
fourth factor of production following
land, labor, and capital; also called entrepreneurial
return or entrepreneurial
reward.
See also entrepreneurial incentive.

 

[CANative]

CA over and over and over again. Start with 15% of total cost and see where you end up. If the MV indication is much higher, you've got a market where demand exceeds supply and vice versa the other way. In a down market, no one is building because there is no EP when sold. Yet we have to make a cost approach even when no building is going on. The EI (incentive vs. profit) must factor in. But it may require an adjustment for external obsolescence created by current market conditions. Incurable but possibly temporary.

EI should be a separate cost. Report it in "other" costs section on the GSE forms.

 

[George Hatch]

The cost approach summary on the 1004 is an abbreviated format wherein the price/sf figure includes all the indirects as well as the investor/developer profit. That's why appraisers using Marshall and Swift and other cost databases need to understand what those costs do and don't include, and then to adjust them as necessary to reflect the situation at hand.

The analysis in the 71b (4-pg multifamily) form has a couple more lines, but the analysis in the 8-pg 71a form runs an entire legal-sized page and has the additional lines it takes to readily add these elements. There's also a land sale grid. The commercial appraisal report forms use longer Cost Approach formats. The format I use for (simple) multi-family and commercial runs 2 pages, one for site value and another for the cost analysis itself and includes separate lines for indirects and profit/loss. More complicated situations require more written analyses and explanation.

 

[Joe Flacco]

Things do get built with no profit. It just means there is depreciation. Agree with George the reporting format in the 1004 is at a minimum awkward.

You could add the ei as a separate line item or you could reflect it in the multiple and say that it includes ei. When you add the ei as a separate line item and market conditions are so that there is no profit or what is built is not in the ideal improvement range then need subtract it out as depreciation.

 

[Joe Flacco]

What i observe is that in neighborhoods where there is a lot of build on your lot activity but no spec activity, it is because there is no profit or not enough profit. Doesn't stop people from building on their lot though.

 

[Joe Flacco]

Actually, I don't think the 1004 cost approach format is that awkward. It makes total sense. It's just commercial appraisers that don't like the format because they report non residential properties other ways

 

[J Grant]

entrepreneurial incentive. The amount an entrepreneur expects to receive for his or her contribution to a project.
Entrepreneurial incentive distinguished from entrepreneurial profit (often called developer’s profit) in that it is the expectation of future profit as opposed to the profit actually earned

Spec builder buys a lot and plans to build a house, on that start date they EXPECT to receive 15% (AI)

entrepreneurial profit
1. A market-derived figure that represents the amount an entrepreneur receives for his or her contribution to
a project and risk; the difference between the total cost of a property (cost of development) and its market value (property value after completion),

10 months later, house is completed and goes on the market. Now the market will determine ( market derived ) the ACTUAL profit (what they receive after cost/expenses)
10 months have passed since start. If market is stable, builder earned expected 15% . If market declined, they earned 2% If market increased, they earned 30% In all 3 cases it is EP

 

[J Grant]

It appears as though I have been doing it wrong all along and need to add at least 10-15% in entrepreneurial profit to the Cost Approach. What am I missing?

My post 7 gives examples hows how it works, no you are not doing it wrong and you do not rote add 10-15% EP- because EP comes from the market and can be anything- from a loss to 200%. The EI is usually more fixed /rote for an area ( most builders expect 20% in area, for example ). If a builder expected 20% and instead suffers a loss of 5% then result is was no EP, there was depreciation. That is when we see builders abandon a house part way though construction and walk.

 

[Michigan CG]

Actually, I don't think the 1004 cost approach format is that awkward. It makes total sense. It's just commercial appraisers that don't like the format because they report non residential properties other ways

You have it wrong here. There are basically three types of commercial appraisers. The first segment is those with a license that allows them to do commercial work but they don't do any commercial work and most likely are not really qualified (anymore) to do that type of work. I have two in my county that haven't appraised a commercial property in many years, if ever.

The second group of appraisers with commercial licenses do a mixture of commercial and residential work. I am in that category; right now I have five commercial assignments to complete and about 15 residential. I can remember doing a cost approach for a commercial property only once in the last decade. My commercial reports have a SCA and an income approach; like residential, most reports do not warrant a cost approach.

Then there are the appraisers that have a commercial license that ONLY do commercial work and haven't seen a 1004 form in years. Those guys can do some pretty complex cost approaches that I would have a hard time duplicating.

 

[Joe Flacco]

You have it wrong here. There are basically three types of commercial appraisers. The first segment is those with a license that allows them to do commercial work but they don't do any commercial work and most likely are not really qualified (anymore) to do that type of work. I have two in my county that haven't appraised a commercial property in many years, if ever.

The second group of appraisers with commercial licenses do a mixture of commercial and residential work. I am in that category; right now I have five commercial assignments to complete and about 15 residential. I can remember doing a cost approach for a commercial property only once in the last decade. My commercial reports have a SCA and an income approach; like residential, most reports do not warrant a cost approach.

Then there are the appraisers that have a commercial license that ONLY do commercial work and haven't seen a 1004 form in years. Those guys can do some pretty complex cost approaches that I would have a hard time duplicating.

So what are your thoughts on the cost approach reporting format in the 1004?

I think it could have a couple more blank lines that we could use but overall I think it is fine. George keeps saying "real" cost approach is not reported that way but the reporting format it's fine for single family new construction. I think it is fine because the way most residential construction is done, a land developer takes land and develops/subdivides the land into sites, then sells the sites to builders. Which is probably the rationale for the 1004 cost approach having "site value" + construction costs and not land value + soft costs + hard costs. It makes sense to me.