Cost Estimation: Reproduction, Replacement, and Entrepreneurial Incentive

Chapter Title: Cost Estimation: Reproduction, Replacement, and Entrepreneurial Incentive

Introduction

This chapter delves into the critical aspects of cost estimation within the Cost Approach to valuation, focusing on reproduction cost, replacement cost, and the essential role of entrepreneurial incentive. Accurate cost estimation is fundamental to the reliability of the Cost Approach, and a thorough understanding of these concepts is vital for real estate professionals.

1. Reproduction Cost vs. Replacement Cost: A Scientific Comparison

The Cost Approach hinges on estimating the cost to create a substitute property and then adjusting for accrued depreciation. Two primary methods are used to derive this cost: reproduction cost and replacement cost. While both aim to quantify the expense of constructing a similar improvement, they differ significantly in their underlying assumptions and practical application.

• 1.1 Reproduction Cost: The Like-for-Like Replication

  • Definition: Reproduction cost is the estimated cost to construct an exact duplicate or replica of the subject building as of the effective appraisal date. This entails utilizing the same materials, construction standards, design, layout, quality of workmanship, and incorporating all existing deficiencies, superadequacies, and obsolescence.
  • Theoretical Basis: Reproduction cost serves as the classic starting point for the Cost Approach, grounding the valuation in a precise reconstruction scenario.
  • Practical Challenges: Estimating reproduction cost can be exceedingly complex, particularly for older buildings. Materials may no longer be available, construction standards may have evolved, and building codes may have been updated, necessitating extensive research and potentially hypothetical cost calculations.
  • Application and Depreciation: Reproduction cost provides a superior foundation for measuring depreciation from all sources – physical deterioration, functional obsolescence, and external obsolescence – because it acknowledges all existing elements of the subject property.

  • Formulaic Representation:

    Total Cost = Σ (Quantity of Material * Unit Cost of Material) + Σ (Labor Hours * Labor Rate) + Equipment Costs + Other Direct Costs

    • Where:
      • Total Cost is the sum of all direct costs to reproduce
      • Quantity of Material = Amount of material used
      • Unit Cost of Material = Cost of individual amount of material
      • Labor Hours = Amount of labor hours needed
      • Labor Rate = Wage given

• 1.2 Replacement Cost: Constructing a Modern Equivalent

  • Definition: Replacement cost is the estimated cost to construct a substitute for the subject building as of the effective appraisal date, utilizing contemporary materials, standards, design, and layout. This approach implicitly cures certain forms of obsolescence, particularly those related to outdated design and superadequacies.
  • Practical Advantages: Replacement cost is often easier to obtain than reproduction cost, as it relies on current construction practices and readily available materials.
  • Obsolescence Mitigation: The use of replacement cost eliminates the need to explicitly measure some forms of functional obsolescence, such as superadequacies and poor design, since the replacement structure reflects modern standards.
  • Cost Efficiency: Replacement structures are typically less expensive than identical reproductions because they incorporate more modern, readily available, and less expensive materials and techniques. Correcting existing deficiencies can further reduce costs.

  • Formulaic Representation:

    Total Cost = Σ (Quantity of Material * Unit Cost of Material) + Σ (Labor Hours * Labor Rate) + Equipment Costs + Other Direct Costs

    • Where:
      • Total Cost is the sum of all direct costs to reproduce
      • Quantity of Material = Amount of material used
      • Unit Cost of Material = Cost of individual amount of material
      • Labor Hours = Amount of labor hours needed
      • Labor Rate = Wage given
      • The individual materials may be less costly, while the labor hours may be shorter than reproduction costs

• 1.3 Experimental Application: Comparing Reproduction and Replacement Cost Estimates

  • Experiment Design: Select a sample of diverse properties (e.g., residential, commercial, industrial) with varying ages and degrees of obsolescence. For each property, independently estimate both the reproduction cost and the replacement cost.
  • Data Collection: Use reputable cost estimating services, contractor quotes, and market data to support the cost estimates. Document all assumptions and methodologies employed.
  • Analysis: Compare the resulting reproduction and replacement cost estimates for each property. Quantify the differences in cost and analyze the factors contributing to these differences (e.g., material substitutions, design modifications, efficiency gains).
  • Results Interpretation: The experiment will demonstrate the divergence between reproduction and replacement cost, highlighting the impact of obsolescence and technological advancements on cost estimation. It will also provide empirical evidence to support the selection of the most appropriate cost basis for specific valuation scenarios.

2. Direct Costs (Hard Costs) and Indirect Costs (Soft Costs): A Comprehensive Breakdown

Accurate cost estimation necessitates a thorough consideration of both direct and indirect costs. Direct costs are directly attributable to the physical construction of the improvement, while indirect costs encompass expenditures necessary for the project but not directly part of the construction contract.

• 2.1 Direct Costs (Hard Costs): The Building Blocks

  • Definition: Direct costs encompass all expenses directly related to the physical construction of the improvement.
  • Components:
    • Materials, products, and equipment
    • Labor used in construction
    • Equipment used in construction and depreciation of equipment during construction
    • Security during construction
    • Contractor’s shack and temporary fencing
    • Material storage facilities and transportation costs
    • Power line installation and utility costs
    • Contractor’s profit and overhead, including job supervision, coordination and management (when appropriate), worker’s compensation, and fire, liability, and unemployment insurance
    • Performance bonds
  • Cost Influences: The quality of materials and labor significantly affects direct costs. Over-insulation, thicker slabs, and specialized features can substantially increase costs.
  • Market Dynamics: Competitive conditions in the local market can influence contractor bids. Contractors operating at capacity may submit higher bids, while those seeking work may offer lower figures.

• 2.2 Indirect Costs (Soft Costs): The Enabling Infrastructure

  • Definition: Indirect costs are expenditures or allowances necessary for construction but not typically part of the construction contract.
  • Components:
    • Building permits
    • Architectural and engineering fees for plans, plan checks, surveys to establish building lines and grades, and environmental studies
    • Appraisal, consulting, accounting, and legal fees
    • All-risk insurance expense and ad valorem taxes during construction
    • The cost of carrying the investment in land and contract payments during construction*
    • The cost of carrying the investment in the property after construction is complete but before stabilization is achieved (if leased fee valuation)
    • Supplemental capital investment in tenant improvements and leasing commissions
    • Marketing costs, sales commissions, and any applicable holding costs to achieve stabilized occupancy in a normal market (if leased fee valuation)
    • Administrative expenses of the developer
    • Local government development levies
    • *If construction financing is required, the points, fees or service charges, and interest on construction loans are indirect costs.
  • Cost Drivers: Indirect costs are influenced by project size, complexity, property type, market practices, and the time and resources required for specific tasks (e.g., appraisals, environmental studies).
  • Estimation Methods: While some indirect costs (e.g., architectural fees) can be estimated as a percentage of direct costs, others (e.g., leasing commissions) are tied to the type of property or market practice. Detailed analysis is often warranted.

• 2.3 Contingency: Accounting for the Unexpected

  • While not a soft cost, construction contingency should be included as a hard cost to estimate unforeseen costs.

3. Entrepreneurial Incentive: Rewarding Risk and Expertise

Entrepreneurial incentive is a critical component of the Cost Approach, representing the economic reward necessary to motivate an entrepreneur to undertake a development project. It acknowledges the risk, coordination, and expertise required for successful real estate development.

• 3.1 Conceptual Foundation:
  • Market-Driven Profit: Entrepreneurs (developers, contractors, investors) operate in a competitive marketplace. Building projects must offer sufficient economic reward (beyond direct and indirect costs) to attract entrepreneurial investment.
  • Market Value vs. Total Cost: The difference between the market value of a completed project and the total cost of development (land value + direct costs + indirect costs) represents the profit (or loss) realized by the entrepreneur.
  • Formulaic Representation:
    Market Value – Total Cost of Development = Profit (or Loss)
• 3.2 Incentive vs. Profit:
  • Entrepreneurial Incentive: The amount an entrepreneur expects or wants to receive as compensation for coordination, expertise, and risk assumption. It is an anticipated reward.
  • Entrepreneurial Profit: The actual difference between the total cost of development and marketing and the market value of the property after completion and stabilized occupancy. It is an earned reward.
• 3.3 Market Research and Data Analysis:
  • Data Sources: Estimating entrepreneurial profit requires thorough market research, typically involving interviews with developers and other market participants to determine anticipated, acceptable, and actual profit levels.
  • Factors Influencing Profit: Profit margins vary depending on the type of structure, the nature and scale of the project, the level of risk, and the uniqueness of the opportunity.
• 3.4 Stages of Development:
  • Phased Rewards: Entrepreneurial rewards can accrue throughout the development process, increasing as land is acquired, plans are drawn up, permits are approved, financing is secured, contracts are signed, construction is completed, and units are sold or leased.
  • Risk Mitigation: As the project advances and risk is mitigated, the lender may require interim values that reflect financing costs and taxes during the construction and leasing phases.

• 3.5 Experimentation and Evaluation:

  • Market Analysis: Select a specific property type (e.g., office buildings, retail centers, residential subdivisions) in a defined market area.
  • Comparable Project Data: Gather data on recently completed development projects of similar type, including land costs, construction costs (direct and indirect), marketing expenses, and achieved sale prices or rental rates.
  • Profit Calculation: Calculate the entrepreneurial profit realized on each comparable project by subtracting the total development cost from the market value.
  • Statistical Analysis: Analyze the distribution of entrepreneurial profits, calculating measures of central tendency (e.g., mean, median) and dispersion (e.g., standard deviation, range). This analysis provides insights into the typical profit margins achieved by developers in the market.
  • Regression Analysis: Conduct regression analysis to identify factors that significantly influence entrepreneurial profit. Independent variables might include project size, location, construction quality, market conditions, and developer experience. The regression model can be used to predict the entrepreneurial profit for the subject property based on its characteristics and market conditions.

4. Contributions of the Entrepreneur, Developer, and Contractor

The measure of profit used in the cost approach is the amount required to entice an entrepreneur to take on the project. In analyzing the components of reward and compensation actually received (or anticipated) by an entrepreneur, appraisers may choose to further distinguish between the concepts of project profit, entre- preneurial profit, developer’s profit, and contractor’s profit:

• Project profit is the total amount of reward for entrepreneurial coordination and risk.
• Entrepreneurial profit refers to the portion of project profit attributable to the efforts of the entrepreneur, distinct from the efforts of the developer, if one is present. In projects in which the entrepreneur and the developer are the same person, the entrepreneurial profit comprises distinct cost items for the different roles served by the individual, with the sum of those items equivalent to total project profit.
• Developer’s profit represents compensation for the time, energy, and expertise of an individual other than the original entrepreneur—usually, in large projects, the person responsible for managing the overall devel- opment process.
• Contractor’s profit (including subcontractors’ fees) is essentially a portion of the project’s overhead and is not usually reflected in the entrepreneurial reward.
• The measure of project profit used in cost approach calculations usually includes both a developer’s profit and an entrepreneurial profit. The profit a contractor receives is often already reflected in the fee a contractor charges and would therefore be included in the direct costs.

Conclusion

This chapter has provided a comprehensive overview of cost estimation within the Cost Approach, emphasizing the distinction between reproduction cost and replacement cost, the importance of considering both direct and indirect costs, and the crucial role of entrepreneurial incentive. By understanding these concepts and applying appropriate estimation techniques, real estate professionals can develop reliable and defensible value opinions using the Cost Approach.