Entrepreneurial Profit

[HornedFrog08]

This is my first post on this forum. I am a tax consultant so this is for ad valorem tax purposes. My client's properties are owner-occupied C stores and/or fast foods and the appraisal district insists on adding 10% entrepreneurial profit to the replacement cost. They claim that in order to be compliant with USPAP that they must add for entrepreneurial profit. Is that even true? 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? How many spec McDonalds or gas stations are out there? none. I need some opinions.

 

[CANative]

Owner occupant or owner builder? An owner occupant would have had to buy the property from the developer who built it and that developer would require a profit for his participation. An owner builder just traded his profit for the amenity of using the property himself. The EP is still there. You have to include EP in a cost approach.

But, EP is subject to depreciation. Market conditions are one cause and that's probably what you have going on.

 

[Pittsburgh Pete]

Doesn't matter whether it is owner occupied or to be leased, entrepreneurial profit is a realistic consideration. If there is no profit to the developer/owner, why develop. That said, in the current environment we don't see any room for entrepreneurial profit in most sectors of our market. The profit cannot be realized which is why no one is building.

Market data will determine whether profit is realizable or not. While assessors tend to focus on cost, for most appraisers it is the tertiary approach. Greater reliance would be given to a SCA or possibly the IA.

P.S. Welcome to the Big East you Horned Frogs.

 

[stefan olafson]

You have to understand what EP is in the first place.

From The Dictionary of Real Estate - EP is a market-derived figure that represents the amount an entrepreneur expects to receive for his or her contribution to a project; the difference between the total cost of a property (cost of development) and its market value (property value after completion), which represents the entrepreneur'scompensation for the risk and expertise associated with development. In the cost approach, expected profit is reflected as entrepreneurial profit.

If the assessor is using the cost approach to value the properties you have described, the assessor must then look at the market to see if there is entrepreneurial profit in building this type of property. It has nothing to do with the present use of the structure at all.

 

[CANative]

While assessors tend to focus on cost, for most appraisers it is the tertiary approach. Greater reliance would be given to a SCA or possibly the IA.

I was working on a large hotel and the assessor wanted to argue based on cost. I sent a LoopNet summary of about 100 listings of hotels from all over country with agent comments: "Listed at less than replacement cost."

They stipulated to a lower value a couple of days later.

 

[CANative]

You have to understand what EP is in the first place.

From The Dictionary of Real Estate - EP is a market-derived figure that represents the amount an entrepreneur expects to receive for his or her contribution to a project; the difference between the total cost of a property (cost of development) and its market value (property value after completion), which represents the entrepreneur'scompensation for the risk and expertise associated with development. In the cost approach, expected profit is reflected as entrepreneurial profit.

If the assessor is using the cost approach to value the properties you have described, the assessor must then look at the market to see if there is entrepreneurial profit in building this type of property. It has nothing to do with the present use of the structure at all.

Until someone changes my mind I've always considered it more technically correct to include a reasonable EP (could be based on historical information) and then back it out or increase it based on market conditions. The building would not be there if the developer perceived no profit in building it in the first place.

 

[Terrel L. Shields]

You have to include EP in a cost approach.

no you don't...imho.

The building would not be there if the developer perceived no profit in building it in the first place.

hmmm. are you sure? If the owner is building a building to house his business (say he manufactures the King Size Klunge) then the building is a necessary business expense but as an expense, is not a fungible asset that can be resold and capture that "EP" unless they sell the patent to the Klunge as well,..so where would he could ever recapture that EP? Never in the building, rather his anticipation of future profits of the business...EP is thusly better described as a part of the Business Enterprise Value and is not a tangible asset of the land/building.

Same with a poultry barn or dairy parlor. The value is in the poultry growing contract not the building. The barn costs X dollars. EP was applied on some barns back 10 years ago when an influx of Hmong buyers (inexperienced and eagar mullets) bought farms and paid a premium to the folks who actually built the barns....guess what. The barns are selling for a bundle less now. So how secure was that EP? It wasn't...in fact, only a fool paid it. too bad. Now you have a tax to add to the crippling disability of paying too much for property.

EP is a fairy tale made of fairy dust and there is an excellent argument that any such value is a land residual value, not a BEV contribution...and I bet in that case, your building "EP" is less than zero.
There is a discussion of both EP and Ent. Incentive in 12th ed. of The Appraisal of Real Estate... it is long on vague conjecture about the difficulty in calculating EP and suggests that you best be careful that you haven't accounted for EP twice... I suggest that if you are planning on making the profit off the intangible business model pursued as an owner-operator, it is a mistake to add EP for the building as well. Again, the "Bible" of appraisers the aforementioned App. of RE, suggests that

Entrepeneurial profit 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..

....and obscured by the depreciation in value as well...and if so, then how in the *&^% do you calculate it..and I argue that you cannot. Commercial properties SELL for whatever the best available buyer will pay for the building which will be modified for that person's business model...that is why I have long observed that in my home county I have never seen a commercial property sell for as much as the county valued the enterprise....it is always a lower price than the assessed market value.

, 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.

from http://business.fullerton.edu/finance/Journal/papers/pdf/past/vol10n02/v10p203.pdf
also
http://www.aptcnet.com/articles/2005/Separating_Business_Siegel.htm
http://www.dev-res.com/newsarticles/RealEstateFinanceJournal_Spring2008.pdf
http://www.oft.gov.uk/shared_oft/reports/comp_policy/oft1020o.pdf
http://www.businessinsider.com/mba-mondays-enterprise-value-and-market-value-2010-8

 

[CANative]

If the owner is building a building to house his business (say he manufactures the King Size Klunge) then the building is a necessary business expense

That squares with my post where I said...

An owner builder just traded his profit for the amenity of using the property himself.

hence...

The EP is still there.

Call it something else if you like but it's still there. He was motivated by his planned occupancy instead of a profit on sale.

Entrepeneurial profit is realized only when the property is first sold,

Okay. So let's call it Entrepreneurial Incentive instead of Entrepreneurial Profit.

Every text I've read states that EP/EI has to be included in the CA and that appraisers alway have included it or else the CA would not reconcile with the SA.

 

[Michigan CG]

EI/EP is a Cost no matter who builds the structure and arguing that it isn't is a kin to someone protesting a management fee in an apartment appraisal income approach because the owner is going to manage it. That dog don't hunt.

 

[Pittsburgh Pete]

While the EP is still there for the owner/user, it is not a function of the real estate but rather his business.

EP is not always included in the Cost Approach--only included if the market indicates it is present. Currently, most cost approaches we do (with or without an estimate of EP) tend to be higher than the SCA or the IA (in most but not all areas of our market)--proof that external obsolescence exists which tends to whittle away at or totally eradicate EP.