Entrepreneurial Profit

[MNRural]

This has been an ongoing discussion before. Many appraisers and assessors think that real estate just can't be developed somehow without someone making a profit off the end costs. They claim the owner/developer's time is worth something, end of discussion.

Owners put up buildings all the time without the expectation of a 'profit' from selling their real estate. Come out to a rural area or a market where it is amost NEVER financially feasible to build.

Go back to the basics. Appraisers in all their theories and methodologies sometimes forget the end reason they are engaged, "the most probable price which a property should bring............................

 

[Lost Cause]

Fascinating discussion... EP/EI always brings out interesting arguments. Though I have not believed that there is a cost approach to value for a long time, it is interesting to consider the theories behind the concept. I agree with Terrel that EP is a flawed concept, in that it originated in appraiser's attempts to explain why the Cost Approach wasn't working.

Theoretically, it seems undeniable that a developer requires a return to undertake a project. And clearly, market conditions will dictate how much of a developer's anticipated profit may be realized. The inability to objectively track and record such potential profits makes use of the theory problematic.

Profit in every form is reversionary .... they are not realized until there is a sale ...

I mostly agree with PE on this. However, it should be noted that properties that generate cash flows to the owner may well include an element of profit in those cahs flows. Just as with a reversion, market conditions will significantly impact the realiziation of that profit. I agree with PE to the extent that the vast majority of profit is reversionary.

Terrel's point that owner-user developed properties can confuse EP with business profit is interesting. As others have noted here, many feel that owner-user properties received EP in the form of the owner-user's rent advantage.

 

[stefan olafson]

Back to the OP's original questions.

They (the assessors office I believe) claim that in order to be compliant with USPAP that they must add for entrepreneurial profit. Is that even true? Simple answer is FALSE


Should you add for entrepreneurial profit in an owner-occupied situation? or in any situation where there is not necessarily a developer involved whose motivation is to build then sell as soon as possible? Answer is in my opinion no, not when there is clear evidence that a developer includes that in their plans on development and it is something that actually shows up. Too often developers develop because that is what they do, always thinking that the next upturn is just around the corner and those that develop and guess wrong lose out in the end. External Depreciation oftentimes swallows up EP and then some.

My 2 cents!

 

[Lost Cause]

They (the assessors office I believe) claim that in order to be compliant with USPAP that they must add for entrepreneurial profit. Is that even true? Simple answer is FALSE

I would agree that USPAP does not specifically require that EP (or really EI) be added when developing a Cost Approach. However, USPAP is generally non-specific on detailing how an appraisal may be developed. As we all know, Standards Rule 1-1 (a) states that "In developing a real property appraisal, an appraiser must ... employ those recognized methods and techniques that are necessary to produce a credible appraisal." If one agrees that including Ei is a recognized technique necessary for a credible appraisal, one could well argue that SR 1-1(a) does require the use of EI.

 

[Scott Lanz]

By definition via the Dictionary of Real Estate, EI and EP are not the same. In short, Incentive is anticipated and profit is earned. According to the theory taught by the AI, EI needs to be included as one of the components just like the land, sticks and bricks.

It may be wiped clean in the cost approach.

The AI materials in the advanced cost approach have about seven pages on this issue, definitions, how to measure, etc.

Ultimately, the entire section requires that all of these issues must be based on market evidence via market data or interviews.

There is a section discussing whether owner-occupied or special-use properties earn an EI. The last statement reads, “The profession has not reached a consensus on this issue”.

This is what makes real estate appraising fun. I took a class from well-known instructor and he said something along the lines of “as long as we continue to disagree, we will have jobs”.

 

[Tar Heel]

I will both agree and disagree with Terrell on this one. A small disagreement in that I don't believe EI is a flawed concept. I believe it is an essential part of the cost approach. That said, EI can certainly be zero in certain property types in certain markets. As an aside, I don't think EI can be less than zero as obsolescence wholly explains the difference between cost with zero EI and market value.

Just like discount rates, EI varies across property types and just like discount rates it has to be measured as the incentive that will cause the buyer to make the purchase and not by analyzing what happens after the fact. If you attempt to arrive at a market EI by measuring EP from a property which was purchased and subsequently resold, that's two different measures. EP could be much higher or much lower than what was anticipated at the time of the original purchase for any number of reasons and the anticipated return is what drove the investment.

Just like Terrell, I find that farmers will construct ag buildings with zero EI, so the EI in my appraisals for those property types is zero. Another property type in my area with no EI is churches. The common denominator between the two is that these property types in my area are almost without exception built for owner occupancy.

If you find a property type in a market where at least some of the properties are built for investment purposes and not owner occupancy, that property type in that market, regardless of whether a particular property is built for investment or owner occupancy, is extremely likely to have EI greater than zero as most investors like to see a return on their investment as a general rule.

 

[Terrel L. Shields]

EI can be less than zero

The basis of my post(s) remains that of the referenced articles..

Specifically, from a ."..Defense of the Land Residual ...."

Abstract. The temptation is strong for arguing that property values can be broken down into land, improvements and business value, as only land and improvements are subject to property tax. As sympathetic as the authors are to this motivation, the notion of a long-run business value component for retail property is refuted and the land residual value theory reasserted, while at the same time admitting the possibility of first owner entrepreneurial or development-based value creation. It is argued that any excess property productivity will eventually become attached to the land, and last that option values are an important aspect of land values that would be affected when suggesting that the appropriate value of a given property is the cost of substituting adjacent property.​

The tie between BEV and EP/EI is indisputable.​

http://www.federalappraisal.com/Pomykacz,%20Defining%20and%20Supporting%20Entrepreneurial%20Profit%20and%20External%20Obsolescence.pdf​

Pomykacz indicates that External obsolescence is the negative of EP but EI is the anticipation of a profit (whether it occurs or not.) ​

This theory forms the basis of feasibility measurement: a project is feasible
when the value minus total costs, including adjustments for entrepreneurial incentive and external obsolescence, is greater than zero. ​

Graaskamp wrestled with the problems thus created. He implies that EP has made the cost and sales approaches more difficult and less reliable.

..it [the entrepreneurial profit] is not earned with construction nor is it even a tangible asset. It is the present value of income attributable to the ability of management to exploit market shortages in order to arbitrage opportunities between market tiers or to obtain nonmarket financing. Therefore, it is a return to management [editors note: the current term is coordination], a goodwill factor in defining intangible assets of the enterprise. If the market approach and the cost approach are increasingly unreliable, then the income approach might be necessary, which brings the essay face to face with the problem of attributing income to real estate. (From Graaskamp on Real Estate, the Urban Land Institute, 1991)

Now isn't that a fine howdy doody...but let's fall back on the "bible". I don't have the latest addition, but the 12th Ed. of "The Appraisal of Real Estate" , pg. 360-363 thoroughly discussed EI and EP.

Some appraisers observe that in owner-built, owner-occupied properties, entrepreneurial profit often represents an intangible. [EP] is realized only when the property is first sold, even if the sale takes place years after the property was built. Over time, [EP] becomes obscured by the appreciation in property value. , pg 361)

That "intangible" is the BEV not the Real Estate Value. If you apply EP to the poultry barn example I give using the cost approach then you are in danger of doing what TARE describes as

The appraiser must scrutinize the cost data...to determrine whether or not an allowance for [EP] has already been made. - pg. 362

(double dipping)
The reality is that at most the EP in a poultry barn would be the cost of time value of money and the delay in creating the barn (about 6 mo. "loss of income"?)....but "new" barns do not sell. In part, because integrators wised up and will not transfer a contract with the person building a new barn because they got burned with experienced growers selling near new operations to neophyte growers who underperformed the contract. In fact, integrators sign 5 -7 year contracts only because the banks and lenders require it as a condition of lending. After 7 years, the contract is a batch to batch contract that favors the integrator while the farmer is at the mercy of the grower and his own performance where he/she is pitted against other growers. 50% make less than average contract, 50% over average contract. Again, all this relates to the value of the contract.

That "first sale" to capture "appreciation" almost always captures "depreciation" instead suggesting that the external obsolescence in the barns is high from DAY ONE... no EP.

If we assume that EP must be "considered"...then we can "consider" that it is not applicable to the REAL ESTATE but rather is a contribution to an intangible business value thus has no place in the owner-operated, owner-constructed building, rather, if it exists, does so in the OVERALL PROPERTY VALUE, not the REAL ESTATE VALUE...

And that, in my mind, goes a long way towards explaining why, when I was on the Board of Equalization, I never saw a single INDUSTRIAL PROPERTY [owner occupied business] that sold for anywhere close to what it was APPRAISED for by the county...they simply were capturing the intangible value of the business without considering that in a transfer, that industrial building likely would have to be modified for the new owner and thus contained a huge amount of external obsolescence that negated any EP that might have existed...and if it existed it was immeasurable... how can we value something no one can measure?

 

[Tar Heel]

Terrell,
That was an interesting article written by Pomycacz. There are some things in the article I agree with and other things I don’t agree with. There were some very broad assumptions in the analysis for one. He also states that EI and obsolescence are inversely related. While I definitely believe that EP and obsolescence are inversely related, I don’t buy that EI and obsolescence are inversely related. I do believe that a change in EI will result in a change in obsolescence, but a change in obsolescence does not in and of itself change the return the investor would require to develop the property.

Further, I really disagree with what he refers to as extra-minimum entrepreneurial incentive. He defines this as the portion of EI above the required minimum EI. In my opinion, if the investor is willing to go forward with the development at a given EI, then there is no EI above the minimum. If your construction costs plus EI plus land value is less than the value of the property, then there is a mistake somewhere in your inputs.

I’ll give you an example. The appraiser estimates land value at $300,000, the construction costs are $1,000,000, and EI is 15%. His cost approach is coming up to $1,450,000. He has concrete evidence that the value of the property is $1,500,000. If that’s the case, one of his cost approach inputs is incorrect. Assuming for the purposes of this discussion that his costs of construction and EI are absolutely correct, we can then arrive at the value of the land by deducting costs of construction plus EI from the property value. In this case, the value of the land should be $350,000 rather than $300,000. The reason this is true is that the investor is requiring a 15% EI to move forward with the development, meaning that he is willing to pay $350,000 to buy the land for this project given all of the other inputs and realize his required return.

Rather than taking a second look at the cost approach inputs, Pomycacz is simply assigning the difference based on the original inputs as “extra-minimum entrepreneurial incentive”. I just don’t buy it. Do you?

Back to the relationship between EI and obsolescence for a moment. Given those same numbers as in the previous example, a $350,000 land value, $1,000,000, and a 15% entrepreneurial profit, you arrive at a value of $1,500,000. Let’s assume that the property value drops 5% to $1,425,000. If none of our remaining inputs change, the property is experiencing $75,000 in obsolescence. Note the investors requirements haven’t changed as a result of the obsolescence. They still require 15% EI to move forward with a development and if they can’t get it, there will be no new development.

So obsolescence does not necessarily have an impact on EI. At the same time, if the investors lower their EI requirement to 7.5%, the obsolescence then disappears as the lower EI requirement has offset the loss in value. So obsolescence is absolutely influenced by EI, but EI is not necessarily influenced by obsolescence.

 

[Terrel L. Shields]

I just don’t buy it. Do you?

It doesn't matter if I "buy it" or not. What is the body of knowledge in appraising? Is it peer reviewed and published papers and books? or my personal opinions? I don't agree with Kinnard on EP/BEV, but nevertheless I would be amiss to simply dismiss all of "EP" and "BEV" as nonsense and ignore the fact that these concepts are part of the "techniques" that USPAP says I must "consider"... my opinion does not count no matter that I think such concepts to be flawed in valuing "REAL" estate.

Again, my argument remains, that that body of knowledge is muddled and unclear over the issue of the "owner-operated" specialized building whether farm or commercial. It's value is in use, a business value, not a tangible value in the market. It's value in the market is whatever the BUYER can decide to use if for...and short of buying the enterprise (entire franchise/contract/blue sky business value) if will not transfer to the next buyer.

How a developer exploits the risk that exists between a concept and the finished condo/mall/subdivision is the arbitrage that defines "EP". That is a "project" not an individual building designed explicitly for an individual use. So where is the EP in a poultry barn, independent retail store, or real estate office? It does not exist in the REAL ESTATE, rather exists in the BUSINESS ENTERPRISE...

In your rather precise example above, I can only question this.... Most commercial bids I see have a contingency...usually 5-10%. How do you handle that? Assume they miscalcluate? Ignore it but then use 5-10% for EP?....

The builder certainly doesn't make it.
The contractor doesn't make it.
The owner of the building is making his money on his business, not the building.
If you ask a farmer how much he anticipates to make on his "Entrepreneurial Profit" he would look at you like you fell off the turnip truck onto your head. He doesn't have a clue what you are talking about.
And finally, that "first sale" only occurs when the building has been outgrown, depleted or the owners business fails or is closed for whatever reason.
That "first buyer" has no dog in the original owner's fight in many cases. He will use the building for a new purpose and modify it accordingly...or he will have to negotiate a new contract with the poultry company in that case ...and again, in that situation, the new poultry company will require "updates" to meet their specs 10 out of 9 times (i never recall an instance where they did not.) A motel built with a 20 yr anticipated life and resold will likely be rebranded to another franchise, and again, that "franchise value (cost)" dictates the BEV which again is business value not real estate value.

So like the old lady said years ago..."Where's the Beef?" Where is that magic EP? How can you possibly measure it in an owner-occupied building?..and the short answer is that you cannot - because you cannot predict the future "first sale" with which to measure it. Yes, you can and should apply EP, if we are talking about developing a retail mall, a condo, a subdivision...EP is merely the intangible (as Graaskamp described it) BEV of development and that only exists when the building is the object of the profit, not the ancillary item necessary to run the business.

Again, whether I agree with the written peer-reviewed papers or not, they are what USPAP describes as the "techniques", etc. we as appraisers are supposed to be aware of and apply. I don't wander off on my own because I disagree with EP or BEV...I do "consider" them even when I oft consider them nonsense.

 

[Tar Heel]

Terrell,
You absolutely should consider different techniques, but you’re also supposed to analyze the relevance of the techniques and not simply use a technique with which you disagree and can reasonably explain why. I have analyzed it and can explain my position.

Again, EP from an investment can be calculated at the first sale. EI cannot be calculated by a sale because it’s anticipated, not actual. It seems that these terms are being used interchangeably at times during this discussion when in fact they are two distinct terms.

EI is a relationship between land, cost, and value. When that relationship reaches a certain level, it acts as a trigger to cause the developer to move forward with the project. You can call it whatever you want, but the relationship doesn’t change.

Further, EI is only for purposes of making a decision as to whether or not to develop. Once the decision has been made, it is my opinion that the incentive no longer exist (how can it because there is no decision left to be incentivized?) and is absorbed into the value of the building.

Maybe that’s where we are agreeing, but speaking in different terms. I’m solely talking about EI as is relates to making the decision to build as part of the cost approach. You seem to be talking about value, which is obviously different from cost. In my opinion, the only reason EI comes into play in a cost approach for a building which isn’t new is that we have to calculate RCN and EI is part of that calculation. The developer is not selling EI when he sells the property. He’s selling the land and improvements and their corresponding utility and/or anticipated income potential. The EI is no longer there and no longer necessary because the development decision was made long ago.

Further, I completely agree with you in regards to farm buildings and said so in my original post and I get the idea from reading your post that you might have missed that part of my original post. I said that EI can be zero and in fact that I see no EI in farm buildings in my area and use zero EI in my appraisals for these property types. As an aside, like some others on this forum, I was actually a farmer in a previous life myself, so I have some experience in this area beyond the appraisals I’ve performed, as I assume you do as well.