Sufficiency Of Cost Approach?

[BarrySW1963]

The EI conversation is fascinating and illuminating, but also discouraging. Pardon me while I wrap my head around this.

Seems like we are discussing this basic scenario:

I own a lot, and can either hire a GC to build on it, in which case M&S numbers should provide the RCN.

OR

I own a lot, and can hire someone else to turnaround and hire a GC to build on it, in which case what I end up paying is the M&S numbers (RCN) plus what I have to pay the guy to hire a GC for me (EI).

I don't see why the EI should be on the cost approach because it isn't really a cost in what it seems "cost" should be for the purposes of the URAR. It's yet another another haircut for someone else, above the actual RCN.

Maybe someone might want that insight on top of the cost approach, but it should be "above and beyond" what is required for the cost approach to be sufficient.

Yea? Nay?

 

[Mark K]

If I'm reading this right, in your area, its typical for a "developer" to purchase land, have it developed into into separate building lots, hire a "builder" to build all the houses, and then the "developer" sells the house and lot as a package, adding his EI onto his total costs (lot and building).

That is not the typical business model in this area and I think the source of the confusion.

Here, a "land developer" develops the land into lots, sells lots to builders, and the builders sell the package to a buyer. Or, alternatively, the developer sells the lots to individuals and they contract their own builder.

The first scenario would be very rare in this area, likely because there's enough competition from the second scenario to prevent a 'developer' from adding another layer of profit or EI onto the price and remain competitive in the local market.

Keep in mind that in my market I can go out tomorrow and buy a new home from Pulte or another national builder for about $100-$110/s.f. including the lot. There's not a lot of room for an additional layer of EI.

 

[Peter LeQuire]

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)

p. 264

p. 272
Some definitions (p. 265)

Looking at the sources you refer to, and looking at The Appraisal of Real Estate those terms (EI & EP) seem to appear only in the context of developments and projects. For the appraisal of a SF residence, there is no developer's EI or EP in play: the proportional share of the developer's EP is accounted for in the purchase/value of the lot. Is not the "contractor's profit and overhead" referred to above the builder's profit?

 

[hastalavista]

Seems like we are discussing this basic scenario:

I own a lot, and can either hire a GC to build on it, in which case M&S numbers should provide the RCN.

OR

I own a lot, and can hire someone else to turnaround and hire a GC to build on it, in which case what I end up paying is the M&S numbers (RCN) plus what I have to pay the guy to hire a GC for me (EI).

No, what you describe is not the either/or proposition.

Here is the proposition:

A house is worth $390k in the market. Do you want to build it yourself or do you want to buy it already built at $390k?
If you want to build it yourself, are you willing to do it when all the costs equal $390k, or would you rather buy the exact same house, ready-to-go, for $390k?
I'll assume you'd rather buy the house ready to go at $390k and then build it yourself for $390k.

So then the question becomes, if you can buy a house at $390k (which is what it is worth in the market), what would it take you to forego buying that house ready to go and develop it yourself?
$380k?... $370K?...$360k?, etc.?

Next, do you think a developer will develop a house at a cost of $390k anticipating it can be sold for $390k?
I'll assume you'd say, "No, a sane developer would not do that because they are not making any money!"

You and the developer need to be motivated to take on the project yourself rather than purchase the alternative already to go. That motivation (what it takes for you to take on the risk and develop it yourself rather than buy the house ready to go) is EI. You either pay the developer to develop the house or you do it yourself and get rewarded for the risk.

I don't see why the EI should be on the cost approach because it isn't really a cost in what it seems "cost" should be for the purposes of the URAR. It's yet another another haircut for someone else, above the actual RCN.

Real estate fundamentals are based on economic principles. Again, ask yourself: Will the typical person be willing to take on the risk of developing a project at a cost that is equal to what that project can be purchased for in the market? Or, would the typical person require an incentive to do so?
The answer is always, the typical person would require an incentive to develop it themselves when they can purchase the same project in the market at a price equal to the cost. That is why EI is part of the equation. Period.

Maybe someone might want that insight on top of the cost approach, but it should be "above and beyond" what is required for the cost approach to be sufficient.
Yea? Nay?

Think about what you are saying. I've quoted the recognized text and gave the page citations so you (and anyone else) can look it up.
What you are saying (as I interpret it) is, "the methodology asks for EI, but I don't think it is really relevant or necessary. So, why don't we get rid of that from the methodology, and if someone wants that, they can get it above/beyond RCN + site value."
EI is part of the economic model of how the cost approach works. You can see that it makes common and economic sense. How reliable would the methodology be if, for ease of analysis, a fundamental component required for analysis of market value is excluded?

Trust me, you are not alone in feeling "resistant" to the concept of EI... especially in residential scenarios.

 

[Peter LeQuire]

Is not the SF scenario different? A builder buys a site, builds a house, and sells it, anticipating a profit. The builder does not have the risks/costs of project development. Does it resolve the problem to call the builder's anticipated profit her entrepreneurial incentive?

 

[CANative]

I own a lot, and can hire someone else to turnaround and hire a GC to build on it, in which case what I end up paying is the M&S numbers (RCN) plus what I have to pay the guy to hire a GC for me (EI).

Yes. If you develop it yourself your EP is the amenity you're getting instead of the profit an entrepreneur would expect. The entrepreneur doesn't get to live in the house he built.

 

[CANative]

Is not the SF scenario different? A builder buys a site, builds a house, and sells it, anticipating a profit. The builder does not have the risks/costs of project development. Does it resolve the problem to call the builder's anticipated profit her entrepreneurial incentive?

The costs in the handbooks are for the builder and his profit. They don't recognize the entrepreneurial component of the problem.

 

[hastalavista]

Looking at the sources you refer to, and looking at The Appraisal of Real Estate those terms (EI & EP) seem to appear only in the context of developments and projects. For the appraisal of a SF residence, there is no developer's EI or EP in play: the proportional share of the developer's EP is accounted for in the purchase/value of the lot. Is not the "contractor's profit and overhead" referred to above the builder's profit?

EI is factored into the price one is willing to pay for the lot.
That is why a developer who requires a lower EI can afford to pay a lower price for the site than another who requires a higher EI. But it still must be accounted for in the Cost Approach Analysis. And I'll demonstrate it here:

Say a person requires 15% to incent them to develop the project themselves vs. buying it on the market. Say the price is $390 in the market and the costs (hard & soft, not land) are $275k. How much will the developer pay for the land?
The answer: $64,130.

Now, if the developer purchases the land for $64,130 and development costs are $275,000 that means the land + construction costs are $339,130.
So, the cost approach indicates a value of $339,130. But I said the price in the market is $390k. Where is the missing component? It is in the EI, which affected the value of the land, but needs to be accounted for in the cost approach.
$339,130 + 15% EI = $390,000.

A developer who is willing to require less EI can spend more on the land. A developer who wants more EI will spend less on the land. EI affects land value, for sure, but it still needs to be considered in the CA calculation because (ding, ding, ding) that is where it is achieved.
And while individual developers (or owner-users) may have differences in their required EI (just as individual buyers of finished homes have slightly different motivations and one might pay more and another pay less for the same house), we are charged with opining a market EI factor. We regularly do this in the SCA: if you did paired sales analysis, you may find that one property's GLA adjustment calculates to $100, another to $80, and another to $75; an appraiser might pick $85/sf, and apply that to all homes. EI is the same. As is a cap rate (they are rarely the same; the appraiser picks one as concludes that is the market rate).

Let's assume EI in the market is 15%, and our subject's site value is $64,130. I purchase it for that. Then, I sell it to you. Nothing has changed in the market and you are going to build the same house I was (which I outlined above). Assuming you need a 15% EI, how much will you pay for the parcel? You will pay $64,130. You will pay the same as I did. I haven't taken any risk with the vacant land that is ready for development. I should develop it "now". So if I don't develop it, you are not going to pay any extra for it because I haven't done anything to it. You are going to do your thing to it and you need to be incented to do that thing. If I tried to charge you more, you wouldn't purchase the site.

Re-read the citations I quoted (or, quote them where you think I'm misinterpreting them). EI is a component in the cost approach. The EI requirement will impact the value of the land, but it has to be identified in the cost approach because without identifying it, there is a missing component (which goes to alintx's point).

 

[hastalavista]

The costs in the handbooks are for the builder and his profit. They don't recognize the entrepreneurial component of the problem.

About time you chimed in. You were the one that brought EI up!

 

[hastalavista]

Is not the SF scenario different? A builder buys a site, builds a house, and sells it, anticipating a profit. The builder does not have the risks/costs of project development. Does it resolve the problem to call the builder's anticipated profit her entrepreneurial incentive?

Peter-
In what you describe, the builder has two hats (which is common): Builder/contractor and developer.
In your scenario, the builder has all the risks that a developer has.
Again, here is the question (common sense and economic):
A contractor has a choice-
1. The contractor can get hired to build a house. In that building contract, the contractor has a profit line. It doesn't matter what the house sells for, the contractor gets his profit as outlined in the contract. The developer pays the contract. If the developer cannot recoup his/her costs, the developer loses, but the contractor is whole.
2. The contractor can buy the site and build the house him/herself (be the contractor and developer). The contractor now has risk. The contractor could hire another contractor to do the work (for which, our developer/contractor would have to pay the outside-contractor's profit which is built-into the building contract) or the contractor could decide to assume all the risk him/herself. If you decide to do it yourself and cannot recoup your costs, you lose.

If you are the contractor, would you
A. Require the same profit level in option#1 (you have no risk) as in Option #2? Or, would you want a higher level of reward for Option#2 (i.e., an incentive to take on the risk)?
B. If you hired another contractor to build the house (and that contractor's profit is built into his/her construction contract) would you need an incentive for the risk you took as the developer, or when you sold the property would you be fine with price being the cost of the land + the cost to build (which, for the other contractor, includes his/her contractor's profit)?

I think it is reasonable to say that if the contractor is going to take on the developer's risk, the contractor is going to require a incentive (call it a higher level of profit if you like) to do so than it would in bidding a job, earning the contractor's profit, and not taking any risk.
Likewise, I don't think a contractor would purchase a site, hire another contractor to build the home (and that other contractor is getting paid his/her contractor's profit) and then be willing to sell the property for the cost of the land + the building contract.

In both scenarios, the contractor-developer is going to want an incentive to take on the developer risk. That incentive is EI.