Entrepreneurial Profit in the Cost Approach

[CANative]

The EI/EP for an owner/builder is the amenity benefit, not the profit on sale.

 

[Joe Flacco]

I think it could/would be both in neighborhoods where there is a lot of spec activity. You get what you want and you also get it for less.

 

[CANative]

The other option would be to exclude the EI factor and explain that market conditions, at this time, do not allow for sufficient developer profit. A lack of new construction starts would bear this out.

My area was ravaged by 3.5 years of wildfires that destroyed many thousands of houses. Does rebuilding them count as new construction and is there a profit motive?

 

[NachoPerito]

Like you say the incentive is not always dollars. For for-profit developers it is always dollars.

Just because you build your own house doesn't mean demand is outpacing supply in the area. I would think that nobody going spec in the area is probably a sign of lack of demand for the product or at least risk is not in balance with the reward. Maybe some EP is realized on resale, it just might not be what is needed for a developer to go spec. If it does then developers might start going spec in the area.

You are right that there are many reasons why people may not be building new homes in the area. It is too much to assume there is build up demand.

 

[NachoPerito]

The other option would be to exclude the EI factor and explain that market conditions, at this time, do not allow for sufficient developer profit. A lack of new construction starts would bear this out.

My area was ravaged by 3.5 years of wildfires that destroyed many thousands of houses. Does rebuilding them count as new construction and is there a profit motive?

Assume 15% unless evidence points you in this direction.

 

[J Grant]

This is very wrong. If there is no EI then nothing every will get built. It is the expected profit, not the actual profit. Any spec home includes profit or it won't get built.

Please re read my post, I said no EP ( I did not make that comment about EI)

Where did I say there is no EI...I said EP from the market can be zero , and that EI on CA can be more fixed (rote) such as builders or speculators tend to expect 15 % or 20 % in X area.
EP is the actual profit regardless of what the EI was. I agree there has to be EI or builders don't build ( there are periods of years where that is the case ) But sometimes a builder times it wrong, they start a project or spec house in a good market and midway through or near completion the market stalls or drops and they take a loss. They started with expectation of EI but the market did not return it

 

[CANative]

Assume 15% unless evidence points you in this direction.

That's what I do and then work sideways. The CA, done properly, is a terrific thermometer of the market.

 

[NachoPerito]

? Where did I say there is no EI? I said EI is often more fixed (rote) such as builders or speculators tend to expect 15 % or 20 % in X area.
EP is the actual profit regardless of what the EI was. I agree there has to be EI or builders don't build ( there are periods of years where that is the case ) But sometimes a builder times it wrong, they start a project or spec house in a good market and midway through or near completion the market stalls or drops and they take a loss. They started with expectation of EI but the market did not return it

Apologies, I misunderstood your prior comment

 

[NachoPerito]

In the end, you can test in your market how the cost approach compares to sales in the area.

In my market I need to add in these other costs because M&S is very low without it. No brainer around here.

But maybe in other markets M&S overestimates the replacement cost.

 

[CANative]

"Although entrepreneurial profit (after this EP) has only recently been formally recognized as a separate item of cost (The appraisal of RE, 1983) in the cost approach, it is evident that it has been recognized by appraisers in developing their reproduction or replacement cost estimates. If appraisers had historically omitted this important element of cost, their estimates of market value developed by the cost approach would have been consistently lower than their estimates of market value by the sales comparison and income capitalization approaches to value. This has not been the case. The only logical explanation is that appraisers have incorporated EP into their coast approach estimates by either including it in their reproduction cost estimates or underestimating depreciation to account for it. Either way, it has been included in their estimates. If it had not, their value estimates by the cost approach would have always been low, which is certainly not the case.



Including a separate cost item for EP is obviously a more desirable, and technically correct, methodology. However, appraisers must recognize that, historically, they may have built this cost factor into their estimates of value by the cost approach. Thus, they may need to adjust their methods of estimating reproduction and/or depreciation so as not to count this item of cost twice."



J.D. Eaton, MAI, SRA – Real Estate Valuation in Litigation – Appraisal Institute.