Sufficiency Of Cost Approach?

[Peter LeQuire]

I have to go look at a house and will return to this manana.

 

[hastalavista]

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.

Hey, Mark-

I don't know if you are referring to me/my markets in the above, but I think the answer I posted to Peter (post #50) would address your question to me (if it is to me) as well.

And, if you are telling me that your markets don't account for EI in a lot of scenarios, I won't argue with you (you know your markets! ) but I have a hard time reconciling that because it doesn't fit the model, which is pretty well vetted.

Lastly, it could be that we are describing the same thing using different terms. That has happened more than once (I gave the residential cost approach to a group of very seasoned appraisers; one of the participants is an appraiser that is also an instructor and he, going into the presentation, vehemently disagreed that there was EI in residential cost approach analysis. After I was done, he agreed with me and the initial difference was due to us not fully understanding what the other was saying. But, I may convince no one in this thread! ).

 

[Mr Rex]

Any unaccounted for revenue in the cost approach is EI. Ask Greg.

 

[CANative]

EI/EP is a real cost factor and the cost approach to market value demands it. Just because an appraisers cost approach works without it doesn't mean it's not there. It probably means that the appraiser is over or understating depreciation. And don't forget that EI is also subject to depreciation according to some texts.

I'm finishing up a real hair shirt of an appraisal. Old(er) house in an area of generally low values with the most awesome view of of Clear Lake (in Lake County CA) I've ever seen (almost). Client didn't care about the cost approach so I'm not doing it. But they do want the land value. Really hard because all the good view lots were developed 50 to 100 years ago. I was almost sickened by the lot value I was getting from the meager land comps I could find. $25,000 at a stretch. I finished the SA. But the land value bugged me and the improved comps were crappy and hard to come by. But I got a pretty even bottom line.

So I wanted to say that I at least considered cost analysis so I ran a quick building-cost.net on the property, added 10% EI and took about 35% depreciation based on my guestimate of effective age.

Yep... about $8,000 more than the SA on a $190k to $200k home.

One of my "theories" about the CA came to me about 10 years ago while getting flak from the forum. It seemed like it was mostly appraisers in the flyover states (the center of the country) that had a problem with it. I was thinking that RE pricing there wasn't as volatile as it was on the coasts and that since the risks and rewards were lower that might mean that EI was probably pretty low too, maybe enough to be hidden in the margin of market error.

 

[CANative]

Any unaccounted for revenue in the cost approach is EI. Ask Greg.

1. The Dictionary of Real Estate Appraisal defines entrepreneurial profit as (1) a market-derived figure that represents
the amount an entrepreneur receives for his or her contribution to a project and 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; or (2) in economics, the
actual return on successful management practices, often identified with coordination, the fourth factor of production
following land, labor, and capital; also called entrepreneurial return or entrepreneurial reward. See Appraisal
Institute, The Dictionary of Real Estate Appraisal, 4th ed. (Chicago: Appraisal Institute, 2002), 96. For a discussion
of the related concepts of entrepreneurial incentive, developer’s profit, contractor’s profit, profit, and project profit,
see Appraisal Institute, The Appraisal of Real Estate, 13th ed. (Chicago: Appraisal Institute, 2008), 388–391.

2. Entrepreneurial incentive is “a market-derived figure that represents the amount an entrepreneur expects to
receive for his or her contribution to a project and risk.” See The Dictionary of Real Estate Appraisal, 4th ed.,
96; and The Appraisal of Real Estate, 13th ed., 389.

3. External obsolescence is “an element of depreciation; a defect, usually incurable, caused by negative influences
outside a site and generally incurable on the part of the owner, landlord, or tenant.” The Dictionary of Real Estate
Appraisal, 4th ed., 106. It is also sometimes referred to as economic obsolescence or locational obsolescence.

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

 

[CANative]

Any unaccounted for revenue in the cost approach is EI. Ask Greg.

http://federalappraisal.com/wp-cont...eneurial-Profit-and-External-Obsolescence.pdf

 

[CANative]

Any unaccounted for revenue in the cost approach is EI. Ask Greg.

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.


Include 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.

 

[CANative]

Any unaccounted for revenue in the cost approach is EI. Ask Greg.

VALID COMPONENTS OF COST
AH 501 discusses the concept that costs, for appraisal purposes, may be thought of as "full
economic costs."20 In general, full economic costs are the payments that must be made to secure
the supply of all of the agents necessary for production. Full economic costs consist of all
expenditures necessary to place the completed property in the hands of the buyer or ultimate
consumer. Full economic costs necessary to construct real property and ready it for its intended
use include (1) direct costs, (2) indirect costs, and (3) entrepreneurial profit.

CA BOE Assessors Handbook 502 - ADVANCED APPRAISAL

 

[Peter LeQuire]

A builder who is not the developer of a subdivision has only to deal with the cost of the lot, the cost of labor and materials, the cost of marketing and holding, and the opportunity costs of the capital tied up in the building the house, and her own profit expectations (entrepreneurial incentive by another name).

Ex. A builder/contractor determines that a certain subdivision supports prices of (arbitrarily) $300M; she determines that her profit (gross, after all costs) has to be 20%, her cost point is $240,000, which must pay for the site, labor and materials, construction loan interest, marketing, loan expense, etc. That 20% is her profit expectation (entrepreneurial incentive), which is included in the M&S cost figures. M&S does not contemplate development expense or entrepreneurial incentive/profit to the development.

The methodological construct that makes identifying EI/EP separately is irrelevant to the use of a building cost information source IF the builder's/contractor's profit is included in that source's cost. If it were necessary to isolate builder's/contractor's profit (entrepreneurial incentive by another name) in order to to be methodologically pure, it would have to be backed out of the cost given by the cost source (M&S in the current discussion). Otherwise, the cost approach would double the profit/EI portion of the costs, creating a total cost higher than the actual cost: which, I suppose, would have to be accounted for as a functional disutility/overimprovement.

I am not arguing that EI/EP is irrelevant or that they need not be accounted for: I am saying that M&S allows for the profit (entrepreneurial) incentive in its cost figures in its Residential Cost Handbook. (I use the term "builder" rather than "developer" as it is more consistent with what happens with the bringing of a SF house to market, the term "developer" generally referring to the entity that develops the building sites.) I think the insertion of a "developer" into the cost structure of a single family house as an additional profit-requiring entity is not consistent with the way most house building is done, and is not contemplated by the M&S costs.

 

[gregb]

Should one consider the Toll Brothers or Kaufman & Broad to be "developers"?