Cost Estimation: Reproduction, Replacement, and Profit

Chapter Title: Cost Estimation: Reproduction, Replacement, and Profit

Introduction

This chapter delves into the critical aspects of cost estimation within the cost approach to real estate valuation. Specifically, we will examine reproduction cost, replacement cost, and the essential component of entrepreneurial profit/incentive. Understanding these concepts is fundamental for real estate professionals seeking to accurately estimate the value of a property based on the cost of creating a similar or substitute improvement.

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

The cost approach centers on the principle that a rational buyer will pay no more for a property than the cost to acquire a similar site and construct a substitute property without undue delay. The cost of the improvements can be estimated using either reproduction cost or replacement cost.

1.1 Reproduction Cost

• Definition: Reproduction cost is the estimated cost to construct an exact duplicate or replica of the building being appraised as of the effective appraisal date. This includes utilizing the same materials, construction standards, design, layout, and quality of workmanship. Crucially, it also embodies all deficiencies, superadequacies, and obsolescence present in the existing improvements.

• Theoretical Basis: Reproduction cost serves as the theoretical cornerstone and traditional starting point for the cost approach.

• Challenges: Estimating reproduction cost can be challenging due to:

  • Obsolete Materials: Some original materials may no longer be available or may be prohibitively expensive.
  • Outdated Construction Standards: Building codes and construction practices evolve over time, making it difficult to replicate original construction precisely.
  • Increased Cost: The cost of reproducing older materials using older practices is frequently very expensive.
  • Significant research may be required to source the materials and expertise required.

• When to Use: Reproduction cost is most appropriate when precise replication is necessary or when a detailed depreciation analysis is required to isolate and quantify all forms of depreciation. This is less frequently used due to its complexity and the time/cost involved.

1.2 Replacement Cost

• Definition: Replacement cost is the estimated cost to construct a substitute for the building being appraised as of the effective appraisal date, using contemporary materials, standards, design, and layout. This approach allows for the curing of some existing obsolescence in the property.

• Practicality: Replacement cost is more commonly used in practice because it is often easier to obtain and can simplify depreciation analysis.

• Advantages:

  • Modern Materials and Techniques: Utilizing modern construction methods and materials typically results in lower costs compared to reproduction.
  • Functional Obsolescence Mitigation: Replacement cost inherently addresses some forms of functional obsolescence, such as superadequacies or poor design features.
  • Simplified Depreciation: Estimating depreciation can be less complex when starting with a replacement cost basis.

• Disadvantages:

  • Loss of Historical Accuracy: If the original structure has historical significance, replacement cost may not accurately reflect its true value.

• When to Use: Replacement cost is suitable when an exact replica is not required, and when some functional obsolescence can be cured through the construction of a modern substitute. This is especially helpful when the structure is very old or unique.

1.3 Mathematical Representation

Let:

• CR = Reproduction Cost
• CP = Replacement Cost
• D = Accrued Depreciation
• V = Indicated Value

Ideally, the value indication should be the same whether using reproduction or replacement cost:

V = CR - D_R = CP - D_P

Where D_R is the depreciation when using reproduction cost and D_P is depreciation when using replacement cost.

1.4 Example

Consider an older warehouse building with inefficient floor layout and outdated electrical systems.

• Reproduction Cost: Estimating the cost to rebuild the warehouse exactly as it exists, using the same materials and layout, even though the layout is inefficient and the electrical system is obsolete.
• Replacement Cost: Estimating the cost to build a modern warehouse with an efficient layout and modern electrical systems, even though it may not be an exact replica of the original.

The replacement cost will likely be lower due to modern construction techniques and materials. Also, the replacement cost will remove the need to depreciate the electrical system and layout issues (functional obsolescence).

2. Direct Costs (Hard Costs) vs. Indirect Costs (Soft Costs)

Developing accurate cost estimates requires considering both direct and indirect costs.

2.1 Direct Costs (Hard Costs)

• Definition: Direct costs are the costs directly attributable to the physical construction of the improvement. They are often detailed in the contractor’s bid.

• Components:

  • Materials: Cost of all building materials (lumber, concrete, steel, roofing, etc.).
  • Labor: Wages and benefits for all construction workers involved in the project.
  • Equipment: Costs associated with construction equipment (rental, depreciation, fuel, maintenance).
  • Contractor’s Overhead and Profit: General contractor’s and subcontractors’ overhead (office expenses, insurance) and profit margin.
  • Security during construction
  • Material storage and transportation costs
  • Power line installation and utility costs

2.2 Indirect Costs (Soft Costs)

• Definition: Indirect costs are expenditures or allowances necessary for construction but are not typically included in the construction contract.

• Components:

  • Architectural and Engineering Fees: Costs for design, blueprints, and engineering services.
  • Permitting and Legal Fees: Costs associated with obtaining building permits and legal services.
  • Financing Costs: Loan origination fees, interest payments during construction, and other financing-related expenses.
  • Insurance and Taxes: Property insurance and property taxes incurred during construction.
  • Appraisal fees
  • Marketing and Leasing Costs: Expenses related to marketing the property and securing tenants (if applicable).
  • Developer’s Overhead and Profit: Compensation for the developer’s time, expertise, and risk-taking.
  • Environmental Studies
  • Supplemental capital investment in tenant improvements and leasing commissions

2.3 Mathematical Representation

Let:

• TC = Total Cost
• DC = Direct Costs
• IC = Indirect Costs

Then:

TC = DC + IC

2.4 Practical Application

When using cost estimating services or data, it’s essential to identify which costs are already included in the estimates and which need to be added. For example, a cost estimating service might provide a base cost per square foot that includes direct costs, but excludes indirect costs like architectural fees or financing costs. The appraiser must add these indirect costs to arrive at a complete cost estimate.

3. Entrepreneurial Incentive and Profit

A critical component of the cost approach is the inclusion of entrepreneurial incentive or profit.

3.1 Definitions

• Entrepreneurial Incentive: The amount an entrepreneur expects or wants to receive as compensation for providing coordination and expertise and assuming the risks associated with the development of a project. It’s the anticipated profit.

• Entrepreneurial Profit: The difference between the total cost of development and marketing and the market value of a property after completion and achievement of stabilized occupancy and income. It’s the realized profit.

3.2 Importance

Entrepreneurial incentive is crucial because it motivates developers and investors to undertake construction projects. Without the expectation of a reasonable profit, new buildings will not be built. This profit is as integral to the cost approach as the cost of building materials and labor.

3.3 Factors Influencing Entrepreneurial Incentive

• Market Conditions: Strong demand and limited supply can justify higher profit margins.
• Project Risk: Riskier projects (e.g., complex developments, speculative ventures) require higher entrepreneurial incentives.
• Complexity of the Project
• Uniqueness of Opportunity
• Expertise Required
• Capital Needed
• Stage of Development: The stage of development, and the different levels of risk and expertise that may be required at different stages, can affect the amount of entrepreneurial profit earned.

3.4 Estimating Entrepreneurial Incentive

• Market Research: Interview developers, investors, and other market participants to determine typical profit margins for similar projects.
• Comparable Sales Analysis: Analyze recent sales of newly constructed properties to determine the difference between the sale price and the total cost of development.
• Published Surveys: Consult industry surveys and reports that provide data on developer profit margins.

3.5 Mathematical Representation

Let:

• MV = Market Value
• TCD = Total Cost of Development (including land value)
• EP = Entrepreneurial Profit

Then:

MV = TCD + EP

Therefore:

EP = MV - TCD

3.6 Contributions of Entrepreneur, Developer, and Contractor

In analyzing the components of reward, appraisers may choose to further distinguish between project profit, entrepreneurial 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.
• Developer’s profit represents compensation for the time, energy, and expertise of an individual other than the original entrepreneur.
• Contractor’s profit is essentially a portion of the project’s overhead and is not usually reflected in the entrepreneurial reward.

3.7 Example

Suppose a developer builds a new office building at a total cost (including land) of $10 million. After completion and stabilized occupancy, the building is sold for $12 million. The entrepreneurial profit is $2 million ($12 million - $10 million). The appropriate percentage to add to the cost would be 20% ($2million/$10 million).

4. Conclusion

Accurate cost estimation, including the appropriate application of reproduction cost or replacement cost, and the inclusion of entrepreneurial profit, is essential for a reliable cost approach. By understanding the nuances of each cost component and applying sound valuation principles, real estate professionals can develop credible value opinions.