NachoPerito
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Like I always say, two wrongs always make a right
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Entrepreneurial Profit in the Cost Approach
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Like I always say, two wrongs always make a right
CANative
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A treatise to me from our friend Denis D. We have discussed EP/EI for many, many years now.
Peter-
I know you understand EI, but the question you raise is one I get a lot when I do a CA presentation. Here's an example of what I use in my presentation (which also addresses the notion that an individual user doesn't need an incentive...EI... to take on the job him/herself):
I pick a person in the class and ask them,
"You have the opportunity to buy a house, and you can buy it 2-ways:
A. You can purchase the house ready to go. Ready to go, it is worth $300k, and your willing to pay that.
Or
B. You can purchase the site and build the house yourself. The cost to do that is $300k, which is what it will be worth in the market. Assume for this example that there are no holding costs.
Both homes will be exactly the same with no differences in quality, condition, site, or location.
Which one would you buy and why?"
Inevitably, the answer is something like this,
"What, are you an idiot? I'd buy the one that is ready to go. Why would I want to go through the hassle of developing it myself for the same cost?"
Then, I ask,
"OK. Then would you do it yourself if, say, it only cost you $295k but it was worth $300k in the market?"
The answer is, again, "no", but you can see where this is going. I may get down to a level of around $260k cost, value $300k, before the individual says,
"Yeah. At that stage, I'd do it, if I can save $40k."
That savings of $40k for the owner-user is the EI it is necessary for that particular owner-user to incent the individual to develop the project him/herself rather than buying one that is ready to go. The $40k in this example is the EI. Now, a professional developer might not require $40k (which is 15% of the projected cost of $260k). A professional developer does this for a living and may be willing to take less. If the professional developer is willing to take less, then the professional developer will bid more for the land and get the deal done.
Contractor's profit is a direct cost. Even if a contractor is the developer, cost is cost and if the contractor didn't do the work him/herself, then he/she would have to bid out the project to a contractor that would require a profit to do the work.
Entrepreneurial Incentive is the amount necessary for a rationale person to take on the risk of developing the project. It can be thought of as the amount necessary to get someone off the couch and to begin the development project.
M&S and most other costing services include contractor's profit in their estimates.
Contractor's profit is not EI. EI is necessary, otherwise no developer would make any profit and all homes (or any improvement) would be owner-user developed & financed because there would be no incentive for anyone else to develop properties.
Now, there is a difference between EI and EP. EI is what it takes to incent a person to take on the development of the project him/herself. EP (Entrepreneurial Profit) is what the developer actually makes, and may be much different than their necessary EI. This is also different from contractor's profit. A contractor has his/her profit locked into the construction cost. They (presumably) will make their profit regardless if the house sells for above or below its cost. They have no "risk" (at least, not in the CA model).
The developer has risk; the easiest one to think about is market risk. The market may change from the time the developer decides to take on the project to the time when the house is finished. If the market goes down, the developer will not realize his/her EI and may take a loss. On the other hand, if the market goes up, the developer will not only achieve his/her EI but also get a profit on top of that (EP).
Regardless if the developer makes or loses money, the developer will only take on the project if he/she believes the EI is achievable. It is the minimum required, and therefore it is always present in the CA calculation.
In times when a project is not financially feasible, EI is still present in the calculation. No developer is going to give it up (although they may be willing to reduce it). This is the scenario where one can purchase an improved property at a price less than what it would cost to create (after accounting for all forms of depreciation): that gap, the difference between the costs to create + EI and the value in the market would be attributable to economic obsolescence.
Like I said, you may know this, but this is a topic that I spend a fair amount of time on when giving a CA class, so I thought it was worth emphasizing.
So, if I do a cost approach for a GSE appraisal, and use the M&S square foot method, I do it improperly if I do not make some allowance/separate entry for entrepreneurial incentive?
Your asking me if you do the cost approach improperly if you don't make an allowance for EI. I'll tell you what I tell the participants in my class:
"You need to consider EI and state how you account for it in the analysis."
Here's some advice from Appraising Residential Properties, 4th Edition (AI), a recognized text on the matter:
pg. 82 (there are 8 steps, I'm only going to cite step #3)
The cost approach is based on the premise that a property value is indicated by the current cost to construct a new improvement minus depreciation plus the value of the site. The cost approach is applied in the following steps:
1. ...
3. Estimate an appropriate entrepreneurial incentive or profit from analysis of the market.
4. ...
p. 264
Entrepreneurial incentive is a market-derived figure that represents the amount an entrepreneur (i.e., the developer) expects to receive in addition to direct and indirect costs as compensation for providing coordination and expertise and assuming risk. Entrepreneurial profit is the difference between actual total costs of development and the market value of the property...
[Denis note: There is a discussion on EI from page 264 through 266 and ends with the following...]
Although it may be difficult to estimate precisely, entrepreneurial incentive or profit is an essential development cost and should therefore be recognized in the cost approach.
p. 272
Estimated of entrepreneurial incentive or profit are rarely, if ever, provided by cost services. Appraisers estimate these costs separately and add them to the reproduction or replacement costs derived from published cost data, if appropriate. An appraiser will need to interview developers to estimate entrepreneurial incentive. Developers have three levels of incentive. One is the price they would like to recieve for their risk. The second is what would make them continue with the project. The last is the amount they must have to do the project. The appraiser must be sure which level of incentive thee developer is quoting. Interviewing local contractors and developers also provides an appraiser with additional support for the cost source information included in an appraisal assignment.
Some definitions (p. 265)
entrepreneurial incentive. A market-derived figure that represents the amount an entrepreneur expects to receive for his or her contribution to a project and risk.
entrepreneurial profit. A market-derived figure that represents the amount an entrepreneur receives for his or her contribution to a project and for risk; the difference between 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.
entrepreneurial coordination. One of the four agents of production in economic theory (i.e., land, labor, capital, and entrepreneurial coordination).
Peter-
I know you understand EI, but the question you raise is one I get a lot when I do a CA presentation. Here's an example of what I use in my presentation (which also addresses the notion that an individual user doesn't need an incentive...EI... to take on the job him/herself):
I pick a person in the class and ask them,
"You have the opportunity to buy a house, and you can buy it 2-ways:
A. You can purchase the house ready to go. Ready to go, it is worth $300k, and your willing to pay that.
Or
B. You can purchase the site and build the house yourself. The cost to do that is $300k, which is what it will be worth in the market. Assume for this example that there are no holding costs.
Both homes will be exactly the same with no differences in quality, condition, site, or location.
Which one would you buy and why?"
Inevitably, the answer is something like this,
"What, are you an idiot? I'd buy the one that is ready to go. Why would I want to go through the hassle of developing it myself for the same cost?"
Then, I ask,
"OK. Then would you do it yourself if, say, it only cost you $295k but it was worth $300k in the market?"
The answer is, again, "no", but you can see where this is going. I may get down to a level of around $260k cost, value $300k, before the individual says,
"Yeah. At that stage, I'd do it, if I can save $40k."
That savings of $40k for the owner-user is the EI it is necessary for that particular owner-user to incent the individual to develop the project him/herself rather than buying one that is ready to go. The $40k in this example is the EI. Now, a professional developer might not require $40k (which is 15% of the projected cost of $260k). A professional developer does this for a living and may be willing to take less. If the professional developer is willing to take less, then the professional developer will bid more for the land and get the deal done.
Contractor's profit is a direct cost. Even if a contractor is the developer, cost is cost and if the contractor didn't do the work him/herself, then he/she would have to bid out the project to a contractor that would require a profit to do the work.
Entrepreneurial Incentive is the amount necessary for a rationale person to take on the risk of developing the project. It can be thought of as the amount necessary to get someone off the couch and to begin the development project.
M&S and most other costing services include contractor's profit in their estimates.
Contractor's profit is not EI. EI is necessary, otherwise no developer would make any profit and all homes (or any improvement) would be owner-user developed & financed because there would be no incentive for anyone else to develop properties.
Now, there is a difference between EI and EP. EI is what it takes to incent a person to take on the development of the project him/herself. EP (Entrepreneurial Profit) is what the developer actually makes, and may be much different than their necessary EI. This is also different from contractor's profit. A contractor has his/her profit locked into the construction cost. They (presumably) will make their profit regardless if the house sells for above or below its cost. They have no "risk" (at least, not in the CA model).
The developer has risk; the easiest one to think about is market risk. The market may change from the time the developer decides to take on the project to the time when the house is finished. If the market goes down, the developer will not realize his/her EI and may take a loss. On the other hand, if the market goes up, the developer will not only achieve his/her EI but also get a profit on top of that (EP).
Regardless if the developer makes or loses money, the developer will only take on the project if he/she believes the EI is achievable. It is the minimum required, and therefore it is always present in the CA calculation.
In times when a project is not financially feasible, EI is still present in the calculation. No developer is going to give it up (although they may be willing to reduce it). This is the scenario where one can purchase an improved property at a price less than what it would cost to create (after accounting for all forms of depreciation): that gap, the difference between the costs to create + EI and the value in the market would be attributable to economic obsolescence.
Like I said, you may know this, but this is a topic that I spend a fair amount of time on when giving a CA class, so I thought it was worth emphasizing.
So, if I do a cost approach for a GSE appraisal, and use the M&S square foot method, I do it improperly if I do not make some allowance/separate entry for entrepreneurial incentive?
Your asking me if you do the cost approach improperly if you don't make an allowance for EI. I'll tell you what I tell the participants in my class:
"You need to consider EI and state how you account for it in the analysis."
Here's some advice from Appraising Residential Properties, 4th Edition (AI), a recognized text on the matter:
pg. 82 (there are 8 steps, I'm only going to cite step #3)
The cost approach is based on the premise that a property value is indicated by the current cost to construct a new improvement minus depreciation plus the value of the site. The cost approach is applied in the following steps:
1. ...
3. Estimate an appropriate entrepreneurial incentive or profit from analysis of the market.
4. ...
p. 264
Entrepreneurial incentive is a market-derived figure that represents the amount an entrepreneur (i.e., the developer) expects to receive in addition to direct and indirect costs as compensation for providing coordination and expertise and assuming risk. Entrepreneurial profit is the difference between actual total costs of development and the market value of the property...
[Denis note: There is a discussion on EI from page 264 through 266 and ends with the following...]
Although it may be difficult to estimate precisely, entrepreneurial incentive or profit is an essential development cost and should therefore be recognized in the cost approach.
p. 272
Estimated of entrepreneurial incentive or profit are rarely, if ever, provided by cost services. Appraisers estimate these costs separately and add them to the reproduction or replacement costs derived from published cost data, if appropriate. An appraiser will need to interview developers to estimate entrepreneurial incentive. Developers have three levels of incentive. One is the price they would like to recieve for their risk. The second is what would make them continue with the project. The last is the amount they must have to do the project. The appraiser must be sure which level of incentive thee developer is quoting. Interviewing local contractors and developers also provides an appraiser with additional support for the cost source information included in an appraisal assignment.
Some definitions (p. 265)
entrepreneurial incentive. A market-derived figure that represents the amount an entrepreneur expects to receive for his or her contribution to a project and risk.
entrepreneurial profit. A market-derived figure that represents the amount an entrepreneur receives for his or her contribution to a project and for risk; the difference between 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.
entrepreneurial coordination. One of the four agents of production in economic theory (i.e., land, labor, capital, and entrepreneurial coordination).
CANative
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Continued...
-----
Mark K said: ↑
In this area, the system doesn't work the way Denis describes, hence the questionable need for EI in all cases.
Mark-
There can always be an exceptions, but no matter where along the timeline you describe is there not a need for EI.
Here, a developer will develop a 40 ac. field into building lots.
EI exists in this component (which you point out in the quote below, which I have truncated)
The builders (production or custom) will then buy the lots, sometimes one at a time, sometimes an entire section of 20-30 lots at once... Only rarely will the homebuilder develop the subdivision from raw land and if so, they get to keep the lot profit in addition to the house profit.
Typical for this area is a profit of about 10% for the builder, custom homes. Spec home $350K hard cost including lot, $399K list price, sells for $385-$390K.
EI in this component; but the next example isn't the same.
Or have it built for the same $385K - $390K +/-. No additional EI anywhere in the equation.
Here is where I think the example runs into trouble. Remember we are comparing identical houses. They have to be the same in every respect. In the quote about speculative homes (or custom.. I am not sure if you are differentiating) you cite an EI of 10% and a selling price of $385k to $390k. In the immediate quote above, you are saying you can have a home built for $385k to $390k. But, if they are the same house, then it would cost $350k to build and be worth $390k+/- in the market. There is a $40k EP there (some of which is EI).
Or, the custom home that is built for and worth $390k+/- is not the same house as the one that is built for $350k. It is either one or the other.
This is another point which people raise in the class:
"Well, if I was going to build my own home, I'd customize it and spend that $40k difference on updates. I'd have a better quality house."
No doubt, but then (a) you are not replicating the house that costs $350k, (b) you would expect that the house you are building is worth more than the house that cost $350k since you are putting in $390k, or (c) you've over-improved your house.
EI would be a component in the above example, and would explain the over-improvement.
-----
Mark K said: ↑
In this area, the system doesn't work the way Denis describes, hence the questionable need for EI in all cases.
Mark-
There can always be an exceptions, but no matter where along the timeline you describe is there not a need for EI.
Here, a developer will develop a 40 ac. field into building lots.
EI exists in this component (which you point out in the quote below, which I have truncated)
The builders (production or custom) will then buy the lots, sometimes one at a time, sometimes an entire section of 20-30 lots at once... Only rarely will the homebuilder develop the subdivision from raw land and if so, they get to keep the lot profit in addition to the house profit.
Typical for this area is a profit of about 10% for the builder, custom homes. Spec home $350K hard cost including lot, $399K list price, sells for $385-$390K.
EI in this component; but the next example isn't the same.
Or have it built for the same $385K - $390K +/-. No additional EI anywhere in the equation.
Here is where I think the example runs into trouble. Remember we are comparing identical houses. They have to be the same in every respect. In the quote about speculative homes (or custom.. I am not sure if you are differentiating) you cite an EI of 10% and a selling price of $385k to $390k. In the immediate quote above, you are saying you can have a home built for $385k to $390k. But, if they are the same house, then it would cost $350k to build and be worth $390k+/- in the market. There is a $40k EP there (some of which is EI).
Or, the custom home that is built for and worth $390k+/- is not the same house as the one that is built for $350k. It is either one or the other.
This is another point which people raise in the class:
"Well, if I was going to build my own home, I'd customize it and spend that $40k difference on updates. I'd have a better quality house."
No doubt, but then (a) you are not replicating the house that costs $350k, (b) you would expect that the house you are building is worth more than the house that cost $350k since you are putting in $390k, or (c) you've over-improved your house.
EI would be a component in the above example, and would explain the over-improvement.
CANative
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mike32716
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Most of the literature looks at real world development costs over time, and what happens as time changes. The longer the time, the greater the risk that the market might change, and the higher the Entrepreneurial Incentive (EI). But that is not what we do with the cost approach. We are applying a deconstructed economic theory to the CA. We take today's cost data as of the effective date, and build a house that is ready to occupy today as a substitute to the subject property (assume subject is new, no depreciation).
Under this theory the cost data is high (it includes financing carrying costs over the project time of 3-4 months+), and the EI is also high as the only real carrying risk to building a house in a day is that the market tanks that same day. This is why I would argue that for SFR housing simply using the base costs (no EI) is more appropriate as the "developer" is not needed to take that risk. The buyer is not managing anything. In theory they are saying to the contractor, "build the subject house" exactly as it is, and call me tonight so we can close." There are no choices to make for the buyer.
If you think there should be a time component, and therefore increased carrying risk, then should you not also be using the cost data from 3-4+ months ago plus EI to arrive at the cost at what it would be today? As an aside I do believe that the EI is fairly constant. If the EI isn't there it doesn't get built, and if nothing gets built then labor and material prices drop until it does make sense to build it.
IMHO two of the major weaknesses of the CA are the assumption of time, and the application of depreciation (how do you build a depreciated house).
Under this theory the cost data is high (it includes financing carrying costs over the project time of 3-4 months+), and the EI is also high as the only real carrying risk to building a house in a day is that the market tanks that same day. This is why I would argue that for SFR housing simply using the base costs (no EI) is more appropriate as the "developer" is not needed to take that risk. The buyer is not managing anything. In theory they are saying to the contractor, "build the subject house" exactly as it is, and call me tonight so we can close." There are no choices to make for the buyer.
If you think there should be a time component, and therefore increased carrying risk, then should you not also be using the cost data from 3-4+ months ago plus EI to arrive at the cost at what it would be today? As an aside I do believe that the EI is fairly constant. If the EI isn't there it doesn't get built, and if nothing gets built then labor and material prices drop until it does make sense to build it.
IMHO two of the major weaknesses of the CA are the assumption of time, and the application of depreciation (how do you build a depreciated house).
Last edited:
George Hatch
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Some construction projects lose money. If you can make money on a project you can also lose money on a project.
And although the way we commonly discuss the issue here is in term of SFRs, the CA is applicable to other types of properties as well, sometimes moreso than with SFRs. Once you see examples of the process functioning with some of these other property types - which unlike SFRs, don't have serve emotional needs that sometimes drive the SFR market - it becomes a lot harder to say the CA doesn't work.
I've had assignments where all 3 approaches to value concluded to the same number all by themselves due to the homogeneity of the site, rental and sales data.
And although the way we commonly discuss the issue here is in term of SFRs, the CA is applicable to other types of properties as well, sometimes moreso than with SFRs. Once you see examples of the process functioning with some of these other property types - which unlike SFRs, don't have serve emotional needs that sometimes drive the SFR market - it becomes a lot harder to say the CA doesn't work.
I've had assignments where all 3 approaches to value concluded to the same number all by themselves due to the homogeneity of the site, rental and sales data.
CANative
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Then why are my CA's so consistently similar to the SA, particularly when I have good land sale comps and make good judgements as to the quality and specifics of the property under appraisal?
One of the things I suspect of appraisers is not including the many components a property might have, particularly rural property.
One of the things I suspect of appraisers is not including the many components a property might have, particularly rural property.
CANative
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When I argued Gas Station/C-store properties, the CA was the primary valuation method.
bnmappraisal
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Thanks for sharing that CAN
I always highly respected his opinion(s) and expertise. I miss his posts on here, but have saved the one you shared.
This is an interesting topic to me
LifetimeStudent
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We are talking about the market value of the subject property though. The premise of the cost approach, like sales comparison approach is the market value of the home under a typical market situation. The situation doesn't change if it is a refinance or a sale, does your sales comparison approach change somehow?
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