Sufficiency Of Cost Approach?

[Peter LeQuire]

I understand - really. But a builder who buys a lot, builds a house and sells it, the builder is the entrepreneur. (The developer/entrepreneur gets his EI/profit from the sale of the lot.) If the builder is also the developer, he makes a profit on the sale of lots (whether he builds houses on them or sells them to others who will) probably accounts for his profit on lots and the sale of completed houses differently. His EI for the development is in the value/prices of the lots; his EI in the sale of completed houses is in the value of the lot and the profit on the cost of building the house.

Which is immaterial. I understand EI. The responses to my saying that EI is included in #6 of the M&S is what was questioned. Whether M&S includes entrepreneurial incentive in its square foot method estimates of costs is the question, isn't it? I believe that it is, and would welcome knowing if that is not the case.

 

[gregb]

Example of a "development fee"-

http://www.chicagobusiness.com/real...o-developers-face-lawsuit-from-former-partner

 

[hastalavista]

I understand - really. But a builder who buys a lot, builds a house and sells it, the builder is the entrepreneur. (The developer/entrepreneur gets his EI/profit from the sale of the lot.) If the builder is also the developer, he makes a profit on the sale of lots (whether he builds houses on them or sells them to others who will) probably accounts for his profit on lots and the sale of completed houses differently. His EI for the development is in the value/prices of the lots; his EI in the sale of completed houses is in the value of the lot and the profit on the cost of building the house.

Which is immaterial. I understand EI. The responses to my saying that EI is included in #6 of the M&S is what was questioned. Whether M&S includes entrepreneurial incentive in its square foot method estimates of costs is the question, isn't it? I believe that it is, and would welcome knowing if that is not the case.

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 presentaiton (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 then 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.

 

[Peter LeQuire]

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?

 

[Mark K]

In this area, the system doesn't work the way Denis describes, hence the questionable need for EI in all cases.

Here, a developer will develop a 40 ac. field into building lots. 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. The developer makes the money on the lot sales, the builder on the houses. 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. Or have it built for the same $385K - $390K +/-. No additional EI anywhere in the equation.

 

[hastalavista]

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).

 

[hastalavista]

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.

 

[Howard Klahr]

M&S includes entrepreneurial incentive in its square foot method estimates of costs is the question, isn't it?

Marshall Valuation Service cost manual specifically does NOT include EI in the cost information they provide. Contractor profit is NOT the same as EI, two totally different components in the cost approach.

 

[Mark K]

My example refers to custom homes built either as a spec or built as a contract for an owner.

In my example the hard cost for the home is $350K. I can subcontract out the house myself and have it built for $350K, saving $35K. Or I can hire a builder to do it for $385K. In either case, its the same house.

Are you saying that the builders profit of $35K is the same as EI or maybe the $35K is made up of two components, profit and EI?

When I quote a lot value I don't break out the EI or profit even though I know one or the other (maybe both?) exists.

M&S comes reasonably close on new construction in this area when no additional EI is added.

 

[hastalavista]

My example refers to custom homes built either as a spec or built as a contract for an owner.

In my example the hard cost for the home is $350K. I can subcontract out the house myself and have it built for $350K, saving $35K. Or I can hire a builder to do it for $385K. In either case, its the same house.

Yeah- if it is the same house, but if it costs you $350k to build or $385k to purchase, when it is done, it is worth $385k. So either you have paid another developer $35k EI or you have taken on the risk yourself and have pocketed $35k.

Are you saying that the builders profit of $35K is the same as EI or maybe the $35K is made up of two components, profit and EI?

I don't fully understand what you are asking. "Builder's profit" is the amount a contractor will charge to build the house over and above the costs of material and labor it must expend. That is not EI.
EI is what it would require a developer to spend $350k in costs and make a profit. In your example, there is a $35k difference between cost and sale price (value); we are assuming the house will sell at market); that is a 10% difference which is likely EI, but if the incentive is lower, then it is part EI and part EP. But none of it is "contractor's profit" because that is part of the direct (hard) costs.

When I quote a lot value I don't break out the EI or profit even though I know one or the other (maybe both?) exists.

In the cost approach, land is valued as a site, ready for development at its highest and best use. So, there is no specific "EI" in the site value estimate. However, many developers will base their EI figure on the total cost (land + cost to build): so they may factor that as part of the cost to which they calculate their EI.
According to the theory, it isn't so important how the EI is allocated (on improvements only or on land + improvements); the amount will be the same.

M&S comes reasonably close on new construction in this area when no additional EI is added. The MS numbers contain the builder profit.

What can I tell you? EI is part of the cost approach model and I would submit it exists. You mentioned (and I agree with you) that there may be exceptions to the rule (the most common exception I hear is special-use properties, but even with those, there is a strong argument that EI is part of the equation).
There is no doubt it is difficult to discern sometimes. The recognized text tells us this along with our own experience. I would say that EI likely exists in all your cases. I would also say that any approach's reliability is based on (a) the quality of the data and (b) the correct application of the methodology.
Since EI is hard to "nail down" in most cases, this becomes a quality of data issue and it is one reason (possibly) why reliance on the indicated value by cost approach should play second fiddle to another approach (presumably the SCA which, most of the time, has superior quality data).

It all boils down to the example I give in my class: Will an entity take on all the risk to develop a site for no profit? Will an entity not purchase the same exact property, ready to go vs. a property that they will have to develop themselves with no additional incentive to do so?
Common sense says they won't; and economic theory says they definitely will not... at least not the "typical" market participant.

And, that's why, in my CA class, I advise the participants:

"You need to consider EI and state how you account for it in the analysis."