Marshall And Swift Cost Service

[The Nightfly]

EI is what I need as a developer to go into the project (or, as a homeowner, what I would need to forgo purchasing the same house, ready-to-occupy).

Great post. But how does one measure or extract a market-based EI? If we are looking at closed sales, isn't that just indicating EP, not EI (which could have been more or less than EP)? Or, if we are getting consistent indications of EP is that a logical conclusion of EI?

 

[J Grant]

EP is present when a developer or spec builder/investor constructs a property. (unless they sell at a loss or break even). But their goal is to profit, so assuming they meet that goal in a stable or increasing market, then the gap between what it cost them to build and what they sell for is the EP .

Whereas the hypothetical owner occupant who would construct an individual home does not realize EP, since they plan to live in it upon completion, not sell it on completion. Therefore, the EI belongs to the contractor ( and is part of the cost figures in MS or similar services)

Developers/professional builders who can command EP are their own market segment, because it will cost them less to build an individual house, since they employ crews, buy bulk material wholesale/cheaper , and buy larger tracts of land they subdivide up for the individual site. They did not have to go and buy an individual site as a owner occupant buyer. Therefore, since builder actual costs of construction and land are different and not available to average owner , the market returns EP to a developer, but not to an owner who builds to occupy. The EI contractor expects to do business is baked into costs they charge ( in M and S costs)

The more cash down, wait time and headaches and possible cost over runs to avg buyer constructing a house is why far fewer do it. They usually have to invest more cash, to buy the land, for a draw construction loan etc, vs if they bought the same house with 10% down conventional financing. I might disagree with Denis that an incentive for an owner occupant buyer is to realize some EI. Imo (usually, or at least in my market ), they choose the more intensive, and perhaps expensive, option of building new vs buying an existing home, either because they want to build their dream home, are architects or designers themselves, or they want a certain kind of home on a site location that is unavailable with existing homes...such as they might buy a 1950's dated but usable home in a fully built out beach side area, tear it down, and build a replica of a bungalow but with modern conveniences...what I call a "vanity house"..... The purchase and cost makes no economic sense but that is not the point, they have the money and EI is not an expectation...they may even lose money building their dream home (at least initially, they might profit later if it's a cool house or values go up)

 

[hastalavista]

Great post. But how does one measure or extract a market-based EI? If we are looking at closed sales, isn't that just indicating EP, not EI (which could have been more or less than EP)? Or, if we are getting consistent indications of EP is that a logical conclusion of EI?

Extracting EI is difficult for the reason you identify: Is it EP or EI?
I'm fortunate in that a lot of development-appraisals (single family as well as multifamily) come across my desk and I originate those kinds of assignments myself. Sometimes the developers have it in a line-item in their construction costs. Other times I have to interview them to get it. When the developer is also the contractor, that can throw an additional twist; she has her contractor profit and her developer profit rolled into one.

My general experience is this: I don't think I've seen anyone say they'd do it for less than 10% and only a few, rare situations (very high end/spec homes) have I seen it much above 20% (I think 22% was the highest I've seen).
I have the data, so an estimate within that range is very reasonable and I can support it. Some might say that spread is too wide... I don't consider it too wide. We do adjustments in the grid where it can reasonably be somewhere between 10-20% all the time without much hesitation. EI is just something that many appraisers (unless they are doing a lot of proposed construction) don't have an opportunity to drill down on.

I teach a Cost Approach CE class. One of the things I advise the participants is that when they have an opportunity to ask a builder/contractor or developer the question, to ask it:

• "After all costs are paid, what is the minimum profit you'd take to go forward with the project" (I say use the word "profit" because Entrepreneurial Incentive is more of an appraiser thing than a builder/developer thing)
• "Do you base that percentage on the land acquisition + building costs or on the building costs only?"

You have to ask if their target % includes acquisition costs as well as building costs.

10% of total (land + building costs) of $400k house where the site costs $100k would equal is $40k. In this case, the cost approach would equal: Land value + construction costs + EI = $100k + $300k + $40k = $440k.
However, if the target % is building costs only, in the example above it would be 13% ($300K x 13% = $39k). The cost approach would be: $100k + $300k + $39k = $440k (rounded).
The point is that the profit target likely doesn't change: $40k is the target. But how the the response is given will impact to which number it is based on.

Of course, another way to ask is this:
Appraiser: "It costs you $100k to buy the land and your hard and soft costs are $300k: so you are in for $400k. What is the minimum you'd need to make before taking on this project?"
Developer: "I wouldn't do this unless I was sure I could walk away with at least $40k after all is said and done!"

 

[hastalavista]

I might disagree with Denis that an incentive for an owner occupant buyer is to realize some EI. Imo (usually, or at least in my market ), they choose the more intensive, and perhaps expensive, option of building new vs buying an existing home, either because they want to build their dream home, are architects or designers themselves, or they want a certain kind of home on a site location that is unavailable with existing homes...such as they might buy a 1950's dated but usable home in a fully built out beach side area, tear it down, and build a replica of a bungalow but with modern conveniences...what I call a "vanity house"..... The purchase and cost makes no economic sense but that is not the point, they have the money and EI is not an expectation...they may even lose money building their dream home (at least initially, they might profit later if it's a cool house or values go up)

I'm quoting you here because this is the common path (in my opinion) where many appraisers get sidetracked on the concept of EI.
In your example, you state that an owner-user may go over-the-top to build something for themselves. That is very true.
But (and again for the last time in this thread) plug your over-the-top owner into the position of:
A. Buying an over-the-top home that just happens to be his ideal/perfect custom home
or
B. Building it himself with all the risks, etc.

If he can buy it for the same price as he can build it himself, he will buy it rather than build it.
If he can bu it for slightly more than he can build it himself, he will buy it rather than build it.
Only when it gets to the point that he can build it for less than what it would cost him to buy it ready to go, and at a point where he determines its worth his hassle (risk) to manage it himself, will he opt to do it himself.

The cost approach requires apples for apples: It is the exact same house: build-it-yourself or have it ready-made. In the cost approach, one cannot put extra money into the one you build-yourself without updating the ready made one to the similar degree.
It really is that simple:
Two homes exactly alike in all regards.
I can buy one for $X and move in.
I can build the same one for the same cost of buying its twin already to go. But if I build it myself, I'm taking on the risk associated with the project and spending the time to do so. When I'm done, it will be exactly like the ready-built home and cost me the same as-if I purchased the ready-built home.

There is no differences in the two choices as far as quality and condition/configuration. They are identical.
There is no difference in the price to acquire and the value of the home: They are identical.
The only difference is for one, it is ready to go without any development risk and waiting. The other one must wait and take on risk of something changing during the construction.
Which one does the rational buyer choose?

Like I said, it isn't that difficult (at least, as far as I'm concerned).

 

[Mark K]

Would you build the same house at a cost of $500k, taking 6-9 months to do so, carrying all the risk associated with the project during that time or would you buy my house for $500k which is exactly what you want?

.

I think this boils it down pretty well and is the heart of the issue. The answer is 'yes', I'd pay a bit more for the EXACT same house today rather than go thru what is always a PITA of building and waiting.

The only problem with this scenario is that it doesn't exist; the exact same custom house never exists. A $500K new construction home is about 4X the average sales price in this area. By a large majority, people that will spend $500K on a house want EXACTLY what THEY want, not what some other guy wants, the guy that had his house painted to match his (bad) taste and built to his dream-house floor plan.

For the most part, people that are forced to sell their custom homes shortly after moving in (big promotion, out of state move) nearly always lose money to the tune of 5% or so of the cost. Is this because its depreciated 5% in the first 3 months (unlikely) or because most people are willing to wait for their dream house? Possibly the answer is that it takes a 5%+/- discount as an incentive for someone to buy someone else's dream house; they'll settle for nearly exactly what they want for the right price.

In any case, I appreciate the thought provoking explanation and I will think more about it, maybe after a shot or two of Blanton's. That always helps. Cheers!

 

[hastalavista]

In any case, I appreciate the thought provoking explanation and I will think more about it, maybe after a shot or two of Blanton's. That always helps. Cheers!

 

[J Grant]

Denis" "But (and again for the last time in this thread) plug your over-the-top owner into the position of:
A. Buying an over-the-top home that just happens to be his ideal/perfect custom home
orB. Building it himself with all the risks, etc.
If he can buy it for the same price as he can build it himself, he will buy it rather than build it.

The reason buyers build spec/custom or over the top homes is they either can not buy it , for any price /or same price as an existing home in the location, or for their own reasons, they prefer to build new. As for buyers looking at an ordinary home ...unless in an area of cheap land and easy to find contractors, few buyers would go to the trouble of building an ordinary home, since ordinary homes are easy to find both existing used or new from developers where the developer builds it and buyer just signs the contract and picks out options.

Not arguing...putting forth my point of view on the topic.

If he can buy it for slightly more than he can build it himself, he will buy it rather than build it.
Only when it gets to the point that he can build it for less than what it would cost him to buy it ready to go, and at a point where he determines its worth his hassle (risk) to manage it himself, will he opt to do it himself.

The above makes sense as theory, but not applicable in most cases. Assuming same location and similar construction quality, why would it cost less to build a new home than a used one? It would seldom cost less to build new unless the owner is a contractor/skilled enough to do a lot of the work themselves) Which is not the typical homeowner.

Building new usually takes more cash, and more wait time. Yet we see people pay more to build new, not less, therefore the motivation to build new is rarely about saving money or getting it cheaper (for typical owner occupant buyer)

The EI in a new home cost approach is the contractor profit as part of their cost charges to build a home and make a reasonable profit, aka what Marshall and Swift uses).

Whereas any additional market based IE or EP added by appraiser would be attributable to a developer or investor who constructs for profit /sale...the developer or spec home builder who buys a lot of tract of land and then builds or offers homes to be built for sale, takes on more risk and personal expense and marketing effort etc, than a contractor simply being paid to build a house on a site the buyer owns.

 

[Howard Klahr]

The EI in a new home cost approach is the contractor profit as part of their cost charges to build a home and make a reasonable profit, aka what Marshall and Swift uses).

Wrong, wrong, wrong. Contractor profit is contractor profit. It is the component of cost associated with the contractor making a profit in running their business. Contractor profit has absolutely nothing to do with profit associated with developing the real estate. Many contractors operate on what is known as a cost plus model and the "plus" is the contractor overhead and profit.

Entrepreneurial profit/incentive is a cost of development associated with real estate projects, all real estate projects. It is an economic concept explained by the costs of production. In the instances where market conditions do not support Entrepreneurial profit/incentive, this allowance is reduced and/or eliminated due to market condition through external/economic obsolescence.

 

[hastalavista]

Entrepreneurial profit/incentive is a cost of development associated with real estate projects, all real estate projects. It is an economic concept explained by the costs of production. In the instances where market conditions do not support Entrepreneurial profit/incentive, this allowance is reduced and/or eliminated due to market condition through external/economic obsolescence.

Couldn't have said it better myself!

(and don't say, "Of course you couldn't!" )

 

[CANative]

In a relatively stable market I would say EI is about 10%-15% of total project cost. If it is way less than that or non existent then supply probably exceeds demand. If it is way more than that then demand probably exceeds supply. EI tells the appraiser a lot more about the market than many other things I see appraisers post about.

The cost approach is not an approach until EI is accounted for. With the exception of Jimmy Carter, developers don't take on a development project unless there is a profit to be made.

"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.

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Defining and Supporting Entrepreneurial Profit, Entrepreneurial Incentive, and External Obsolescence.
by Mark Pomykacz, MAI

"Estimating entrepreneurial profit, entrepreneurial incentive, and external obsolescence continues to be a contentious issue. Those appraisers who incorporate estimates of entrepreneurial profit, entrepreneurial incentive, and external obsolescence find the task of empirically supporting their estimates to be problematic. This in turn adds support to opponents’ view that entrepreneurial profit, entrepreneurial incentive, and external obsolescence are not as measured or are not applicable concepts. This often leaves users of appraisals, such as those involved in legal disputes, with irreconcilable value differences.

This article employs macroeconomic data to demonstrate that entrepreneurial profit, entrepreneurial incentive, and external obsolescence are real phenomena. Further, the article uses this data to reveal that there is an inverse relationship between any entrepreneurial profit and incentive and any external obsolescence, and that these are cyclical in nature. The article also demonstrates that certain incentives are required even when there is obsolescence. Finally, the article suggests that appraisers ought to revise their concepts of and terminology relating to entrepreneurial profit, entrepreneurial incentive, and external obsolescence to better reflect the actuality and to better communicate their opinions."

http://federalappraisal.com/resources/library/profit-incentive-external-obsolescence/