Question regarding Cost Approach!

[jay trotta]

of the readings done over time and what used to be in Insurance;

1) 30 years ago we used - 10% OH & 10% Profit

2) Nationally, 80% of builders do not survive the business longer than 6-8 years, typical reason for leaving.....lack of profit

3) In general a builder needs to net 40% profit continually to survive for the long haul

4) In order to capture that net, I believe they need soewhere in the vacinity of 65% gross

To attain survival, this should relate to somwhere in the 15% OH & 15% Profit range - building to day requires more than it ever did to become sucessful today. Book Costs are different from survival costs and therein lies a problem. Small Builder - small OH / Big builder big OH, M&S cannot dictate costs they have no idea about -OH - Insurance Costs & Estimates should be calculated by the Insurer - has anyone ever reviewed "Blue Book" ? and I don't mean a simple simon version; I mean bought the book and reviewd it ? It is the old Insurance book we used eons ago and is still available today.
Be careful, if you Buy It - you will become knowledgeable about an incredible amount of information regarding the Insurance Industry and therefore, you may need to get a "License" with regards to Inurance Work.

The CA offers to many diversions to accuracy - and has never been reliable because one cannot "estimate" EP, and EP offers to many variables that do not have a solid basis; if you have no idea of what one's OH costs are, how can you note any reliability ??

 

[Terrel L. Shields]

and has never been reliable because one cannot "estimate" EP,

actually it never existed as such prior to 1973....and it is an intangible expense to management, and should never be included in cost to begin with. It was the so-called movers and shakers at AI who siezed upon the idea. Never mind they did not appraise anything, only talk about it and teach it, it became "fact"...worse than worthless fact at that.

stephen - the only time i have read much on the subject, it appears that EP is discussed the most by a very few academics and it my memory (faulty at best) which ties Kinnard to it. Perhaps I am targeting the wrong guy, maybe he was just editor at the time or something. I also recall that there have been from time to time articles which points out the weakness of applying EP in the cost approach.

As the strict interpreter that you are, i agree that USPAP doesn't 'require' the 3 approaches but...when applied on a practical level (that is, in front of a state board), application of any deviation from their own engrained methodologies will raise their eyebrows. I would hate to take a DCF only approach (which may well be justified in certain income properties) before a board. I think you would have a hard sell to make. Likewise, for allocation, ground rents, or any other non-sales method of valuing vacant land. I recall all too well when one person informed me that I could expect grief if I did not do a cost approach on a parcel of bare agricultural ground......They [therefore USPAP] required [according to her] all three approaches. Her argument being that the various classes of land, valued by the segregation and summation of those individual land values was the "summation" method and thus was the cost approach.

 

[Fred]

Sorry for the long post, Terry

As the strict interpreter that you are, i agree that USPAP doesn't 'require' the 3 approaches but...when applied on a practical level (that is, in front of a state board), application of any deviation from their own engrained methodologies will raise their eyebrows. I would hate to take a DCF only approach (which may well be justified in certain income properties) before a board.

Oh, the old-chestnut renegade-state-board argument. I would always rather be standing anywhere having done the right thing.

I always wondered why your renegade-board argument never works out that you are the one running an extraordinary risk instead of me. Over the years, I have looked at various state board sanctions and have seen quite a bit of what I thought was likely nit-picking an irrelevant cost approach, unaccompanied by a statement of whether the approach was even relied on and any logic of how the alleged discrepancy was a “substantial error of …commission” that had a “significant effect” on the credibility of the results. On the other hand, I never saw a board sanction based on the omission of the cost approach creating a “substantial error of omission” that had a “significant effect.” I can show you threads right in here that include board members and others, using the ‘if it’s in there, it has to be done right’ attitude. And all of that, indicates that in addition to being USPAP-correct in strict "interpretation" and economically correct in recognizing the irrelevance of the cost approach, that my modus operandi is also the safest course, even in confronting renegade peer review. Enough for that tangent.

actually it never existed as such prior to 1973....

Actually, “it” (EI) existed as long as far back as there were people engaging in barter. EI is just the natural human instinct to say – what’s in it for me? That’s why I keep saying; you can find the profit rate (in rents and reversions) in investor properties. However, in user properties, what’s in it for them is the use itself, not cash on real estate per se.

Do you know the context for EI in economic books? I see two key elements.
1. There is a producer (entrepreneur/developer) making decisions about, as I recall - what to produce, for whom to produce, and how much to produce. This is part of a larger body of knowledge about the protocols of producer decisions, separate from the protocols about consumer decisions.
2. There is the idea that in addition to actual cash outlays (what appraisers call hard and soft costs), producers incur non-cash opportunity “costs” that are, well, “costs.”

I’ll apply the two key elements.
1. An investor in completed properties and property users - a home buyer, or someone engaging in commerce looking for a place to operate a business from - are “consumers,” not “producers.” This is why I don’t see how anyone is ever to demonstrate relevance, by applying producer protocols to consumer decisions. That is, it is no coincidence that the done-right cost approach has never emerged.
2. Analyzing from a production standpoint, treating the opportunity costs the same way as the cash outlays (hard and soft costs) is more of an “accounting premise” than anything and there is another obvious premise that produces the same result. Suppose a developer counts up 800k in actual cash outlays (hard and soft costs) and counts 200k in time, management, foregone return on the 800k, and required profit (opportunity costs, called EI or EP by real estate appraisers).
A. Using the traditional micro-economic decision model, the developer counts the total “cost” of the investments as $1 mil. If the completed value is expected to be $1 mil or more, the costs are covered and it’s a go (produce). If the completed value is only 900k, it doesn’t cover cost and it’s a no-go (don’t produce).
B. Using a more typical “accounting” decision model, the develop would look at the $200k as a minimum “gross profit contribution.” At $1 mil, there is a sufficient gross profit (so produce), and at $900k, there is insufficient gross profit (don’t produce).

Some conclusions
1. The AI is harping on EI because it is in economic texts, as production costs, and they need to create the impression that they are promulgating something within the mainstream of economic thought (which the CA isn't) by avoiding the criticism that costs used by appraisers don't even include oppurtunity costs.
2. As to your observation that it (EI) doesn’t exist – of course the $200k exists. It’s part of the decision process.
3. As to your observation that EI would ruin the cost approach, you’d still have to show that “done right” version, to show why EI messes it up.
4. The point about the cost approach confusing the protocols of a production decision with a consumer's decision, begins to shine a light on the way CA "theory" takes the underlying economic principles are turns them around. That is, CA theory is the cost sets value (upper limit), but that isn't true because the $900k or $1 mil values in my examples are set by short-run market forces.
5. It is because cost doesn't set value, that the question of how this "newly" discovered (in your view) cost (the $200k in my example) fits into a market value appraisal, has no clearcut answer. Production cost does not set market prices - and that is neither production cost with incentive or raw production costs (cash outlays only) without incentive.

 

[Mike Boyd]

Its an old wives tale, and still told by some CE providers that need to hang it up.

If economic depreciation is utilized properly, it should be as accurate as it ever was......not that it ever was accurate.