Sufficiency Of Cost Approach?

[BarrySW1963]

lol... It took Denis to sell you and not me?

Thank you!

 

[Peter LeQuire]

Sorry, Peter- I don't mean to ignore you, but I'm unsure if this is a question or a statement?

Mebbe both?

 

[BarrySW1963]

....From your comments, I infer it that you don't consider the contractor/builder the risk taking profit center, and that, in M&S the risk taking profit center is separate from the contractor doing the work and that the contractors included to in M&S's itemization are sub-contractors to the profit center (your developer?). I don't think that's the way M&S's square foot method is set up: it does not anticipate a user going backward to recapture EP from some earlier stage of development, nor does it anticipate another party being introduced into the process to generate additional EP....

That is my take on it as well. So, EI then becomes an additional layer on top of the M&S numbers if we're going to do it as Denis suggests.

So what remains is: what is a straightforward, reliable, reproducible way to determine (and support) EI outside of being the company that takes on the risk (and then you can substantiate with your own numbers)?

• Will mass builders cough it up? (no)
• Will individual sources put it in writing? (no)
• Will a reviewer/board accept that some of your support is from contracts for custom builds from other assignments (confidential information for one assignment not to be distributed or referenced in another, but IS part of your knowledge/experience base)?

I've read though the last 50+ disciplinary actions from the state board and in the majority of them they nailed the appraiser on deficiencies in the cost approach. It is clearly the go-to to make a complaint stick, and likely ruined each appraiser's career (at least for mortgage lending). Makes me wonder if they're in the pockets of the purveyors of AVMs who will benefit from a reduction in the number of appraisers.

Given the assertion that EI is necessary, and that EI support is elusive, what is an individual appraiser to do, specifically to close this gap?

And clearly its a gap given the volume of discussion here.

 

[Joe Flacco]

Denis has a gift of explaining complex things in a easy to understand logical way.

 

[hastalavista]

Mebbe both?

Ok, I'll take it as a question...

I am of the opinion that consideration of EI is a necessary component of a credible cost approach. That should be indisputable; it is in all the literature.
I recognize that EI is difficult (but not impossible) to extract.

When I review, and a report (in its cost approach analysis) fails to comment on how it considered EI or apply it in the report, I consider that a deficiency.
Depending on the how critical the cost approach is in the final value reconciliation, it may or may not impact the credibility of the report itself. The cost approach conclusions being critical in the reconciliation and overall value conclusion-credibility is rare in the reports I review, but it has happened.

If a report stated that it attempted to extract EI from the market but did not find sufficient information to do so (a common scenario) but either (a) allocated a reasonable percentage and stated it or (b) indicated that it therefore made no allocation for it and said this is a weakness of the quality of data and therefore reduces the reliability of the CA value indication, I would consider that adequate (and concur with the report's finding that it is a weakness of the the approach)... assuming that the CA is not the primary method it relied upon to form its final opinion of value.

In the case where no comment or analysis of EI is present, that would indicate to me that the CA application does not follow the prescribed methodology. That is a deficiency.
In the case where EI is acknowledged and the report explains how it dealt with it, that would indicate that the report is applying the prescribed methodology; if the report tells me how reliable its EI analysis is (reliability in terms of the quality of data it has to conclude an EI factor), I consider that an appropriate application (indeed, I consider that a "uptick" on the overall quality rating of the report).

In the case where a report indicated that EI is included in MVS contractor's profit, I would disagree with that conclusion (for all the reasons already stated). But I would acknowledge that the report considered EI.

In the case where a report made an argument that EI was not applicable, I would most likely disagree with that conclusion (I say "most likely" because I need to leave open the possibility that the report could persuade me it is correct). But I would acknowledge that the report considered EI.

In the end, as the reviewer (and, BTW, in my review function, I don't conclude my own opinion of value, I form an opinion of the quality of the report under review and state if the methodology is correct and meets the requirements of the client), I weigh all the components of the report in a final determination of the report's acceptability for my client's lending-requirements. The three most common deficiencies in the residential reports I review are:
A. Failure to adequately summarize the H&BU analysis
B. Failure to adequately summarize the subject's zoning
C. Failure to adequately summarize the analysis in the cost approach

Those failures do not necessarily lead to a "rejection" of the report for my client's use, but they are noted as quality deficiencies in my review.
That may sound counter-intuitive, but it isn't. Most of the residential reports I review are straightforward enough. Most of the time, the reports do a very good job of completing the sales comparison approach (the primary valuation method) and the conclusions are reasonable. Sometimes, I need to get clarification on the zoning and H&BU to confirm that the report's conclusions are reasonable; and almost all the time, with clarification, the report's conclusions are affirmed.

My review SOW is to form an opinion of the application of methodology and USPAP compliance. Parts of the report can be deficient and yet the overall credibility of the findings are reasonable.

Interestingly enough, that portion of the review is similar to the kind of audit a state regulator (or, at least my state regulator) completes: Compliance and methodology. In my capacity as a lender's reviewer, chances are good a report that is deficient in an area is still credible for the intended use. A state regulator is more black & white and a deficiency is a deficiency. Failing to consider EI in the cost approach is probably not going to get someone sanctioned; but a number of failures/deficiencies may tip the scale, and why risk it since it is low-hanging fruit (acknowledge it/consider it, and explain how it was considered). That is why, in my CE courses, I stress that while these things may seem penny ante in terms of typical lender work, they are of substance and can make a difference in how the report is evaluated.

 

[Howard Klahr]

I'm either wrong or we're not using the terms "contractor" or "builder" in the same way.

Bingo - Now you're starting to get it. Contractor profit is what the contractors receive for performing their individual service, such as the plumbing contractor, electrical contract, hvac contractor, roofing contractor, etc.

The developer/builder has their own profit called entrepreneurial incentive. As the entity that takes on the overall project risk for developing/building the house from conception, thru execution then selling the completed property with the new improvements, the developer/builder receives the amount between the actual development costs and the retail sale price of the home to the end buyer. That differential is entrepreneurial incentive/profit and is not part of the cost numbers in cost manuals. It is separate component of the overall costs t develop real estate.

So what remains is: what is a straightforward, reliable, reproducible way to determine (and support) EI outside of being the company that takes on the risk (and then you can substantiate with your own numbers)?

See Post #14

Will mass builders cough it up? (no)

And yes, the information from the publicly traded national and regional builders is available in analyzing their financial statements

 

[BarrySW1963]

...

See Post #14

And yes, the information from the publicly traded national and regional builders is available in analyzing their financial statements

Can you pick one and walk us through how you would digest and utilize the information from the financial statements for supporting statements for EI?

 

[gregb]

There is a local developer here in Santa Barbara that needs a lump sum EI of $1,000,000 before she will take on a project, unrelated to the number of single family homes involved. Most of her projects range between 20 and 50 homes. She is a licensed architect and contractor.

 

[BarrySW1963]

Denis - can you spot check my updated Opinion of Site Value Methodology, to make sure it's all in the right order?

"Opinion of Site Value Extraction Methodology: for each comparable closed sale, determine replacement cost of improvements new (RCN) minus depreciation (from a recognized source, Marshall & Swift), add in EI (Entreprenurial Incentive) and as-is value of site improvements (that are not otherwise accounted for in the RCN), subtract from sales price to get site value, divide site value by site size to get value per square foot for the site. Reconcile across comps for a price per square foot of the site and use that to determine and support the opinion of value for the subject's site."

 

[hastalavista]

Denis - can you spot check my updated Opinion of Site Value Methodology, to make sure it's all in the right order?

"Opinion of Site Value Extraction Methodology: for each comparable closed sale, determine replacement cost of improvements new (RCN) minus depreciation (from a recognized source, Marshall & Swift), add in EI (Entreprenurial Incentive) and as-is value of site improvements (that are not otherwise accounted for in the RCN), subtract from sales price to get site value, divide site value by site size to get value per square foot for the site. Reconcile across comps for a price per square foot of the site and use that to determine and support the opinion of value for the subject's site."

Alin-

I think that is an excellent summary and would certainly meet (from my review experience, far exceeds) the minimum standards for a typical residential assignment.

I'll add one more thing to consider in the valuation of the site; and this may be market-specific....

Assume you have 3 sales and the sites are 10,000sf, 13,000sf, and 9,500sf. It would not be surprising or unusual if, after your analysis, you find the residual (the value that remains and is attributed to the site) of a smaller site to be more than the value of a larger site. The reason is simple: Site value by extraction, as any other analysis, has a degree of uncertainty. We don't know everything, we cannot estimate depreciation precisely (our estimates can, however, be reasonable) and there is always the specific motivations of the individual buyer and seller which affect the sale price.
So, as a consequence, in the example above, the smaller site may have the highest indicated value. Don't let that freak you out.

Assume that the $/sf analysis works out like this:
9,500sf = $15/sf = $142,500
13,000sf = $10/sf = $130,000
10,000sf = $12/sf = $120,000

The average (all indicated prices divided the total lot sf) is $12/sf. Your site area is 12,500/sf.
What's reasonable for a site value?
$12 x 12,500 = $150,000. Your lot may be worth more than the others. I would submit, however, that the "sites" don't trade on a straight $/sf basis. The primary value of a home site is to support the house that is built on it. Assuming all the homes are similar to the subject, another way to value your site is not to do it on the $/sf basis (which is a unit of value) but to consider the total values of the sites. In other words, site values for sites similar to yours range from $120k to $142.5k per site. It would be very reasonable to make that conclusion and then to pick a specific value for your site (say, $130k).

Like I said, the best method depends on the market. In many of my markets, a typical lot size may be 8,000sf and the site value could very well be $800,000 ($100/sf, if we use the $/sf unit of value). In that same neighborhood, my subject may be on a 11,000sf site. Using the $/sf unit of value, my site would calculate out at $1,100,000. It is not likely that the incremental value difference for site utility between the typical lot size of 8,000sf vs. my specific subject at 11,000 sf is worth $300,000k.
More likely, I'll find site sizes ranging from 7,500sf to 12,000sf with values ranging from $800k to $875k. The incremental value difference in site utility is probably closer $50k.

Again, it all depends on your market. And some appraisers believe that site size difference should be based on the $/sf unit of value and not a more nebulous "utility/lump-sum" unit of value. It is up to you to determine what works best for your market and situation; just make sure that once you do your site calculation and conclude a value indication, it makes "sense" in the market.
And don't be afraid to modify the calculated answer/indicator with your appraiser's judgment. The math can take us only so far; it is your judgment which takes the data and synthesizes it to a reasonable/specific point. But it is the math and analysis which makes the process "credible".
Correct methodology/analysis = credibility
Competent appraiser judgment = reasonableness
Combine the two and you should never have a review-issue!

Good luck!