Cost Estimation: Reproduction, Replacement, and Profit

Chapter 29: Cost Estimation: Reproduction, Replacement, and Profit

Introduction

This chapter delves into the core principles of cost estimation within the cost approach to real estate valuation. We will explore the critical distinctions between reproduction cost and replacement cost, analyze the components of direct and indirect costs, and examine the crucial role of entrepreneurial incentive and profit. The cost approach, fundamentally, relies on the principle of substitution, suggesting that a rational buyer will pay no more for a property than the cost to acquire an equivalent substitute. This chapter provides a scientific framework for understanding and applying this principle.

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

1.1 Theoretical Basis

The cost approach posits that the value of a property can be derived by estimating the cost of creating a substitute property, adjusting for depreciation. Two primary cost estimation methods exist:

1.1.1 Reproduction Cost: This method estimates the cost of constructing an exact replica of the existing improvement, utilizing the same materials, construction techniques, design, and quality of workmanship, while also incorporating all existing deficiencies, superadequacies, and obsolescence. The theoretical foundation of the cost approach rests on reproduction cost, providing a comprehensive assessment.

1.1.2 Replacement Cost: This approach estimates the cost of constructing a substitute improvement with equivalent utility, employing modern materials, current standards, contemporary design, and layout. Replacement cost may cure certain forms of obsolescence, such as superadequacies or poor design. It acknowledges technological advancements and current market preferences.

1.2 Scientific Principles

The choice between reproduction and replacement cost is influenced by the property’s age, uniqueness, and any disparity between its original intended use and its current highest and best use. While theoretically, both methods should converge on a similar value indication after thorough application, inconsistent use can lead to double-counting of depreciation or other errors.

1.3 Practical Applications

1.3.1 Older Structures: For historic or architecturally significant buildings, reproduction cost may be necessary to accurately capture their unique characteristics and value.

1.3.2 Modern Structures: Replacement cost is generally more suitable for newer buildings, as it reflects the cost of constructing a functionally equivalent substitute using current materials and methods.

1.4 Mathematical Representation

Let:

• V = Value
• CLR = Cost of Land (assumed vacant)
• RCR = Reproduction Cost
• RCRep = Replacement Cost
• D = Depreciation (total)

Then:

• V = CLR + (RCR - D) (Reproduction Cost Approach)
• V = CLR + (RCRep - D) (Replacement Cost Approach)

1.5 Experiment Example

Consider a 50-year-old building with outdated electrical systems. Estimating the reproduction cost would involve researching and costing the exact type of wiring, conduit, and panels used 50 years ago, which are likely obsolete and expensive to source. Estimating the replacement cost would involve costing modern, energy-efficient electrical systems that meet current codes, potentially resulting in a lower cost and improved functionality. Comparing the final value after depreciation using both costs gives a better understanding of the difference.

2. Direct Costs (Hard Costs): The Building Blocks

2.1 Definition

Direct costs, also known as hard costs, are the expenses directly attributable to the physical construction of the improvement. These costs are typically part of the construction contract.

2.2 Components

2.2.1 Materials: Costs of all raw materials, components, and equipment incorporated into the building (e.g., concrete, steel, lumber, roofing, HVAC systems). Material quality is critical. Over-insulating walls and windows increases costs.

2.2.2 Labor: Wages, salaries, and benefits paid to construction workers, including skilled tradespeople and general laborers.

2.2.3 Contractor’s Profit and Overhead: The contractor’s compensation for managing the construction process, including general overhead, administrative expenses, insurance, and profit margin.

2.2.4 Construction Contingency: A reserve to cover unforeseen expenses or changes during construction.

2.3 Formula

Total Direct Costs = Materials + Labor + Equipment + Contractor’s Profit + Contingency

3. Indirect Costs (Soft Costs): Supporting the Project

3.1 Definition

Indirect costs, also known as soft costs, are expenses necessary for the project but not directly related to physical construction. These costs are incurred before, during, and sometimes after the construction phase.

3.2 Components

3.2.1 Architectural and Engineering Fees: Costs for design, blueprints, structural engineering, and other professional services. Usually a percentage of direct costs.

3.2.2 Permits and Fees: Expenses for building permits, zoning approvals, and other regulatory requirements.

3.2.3 Financing Costs: Interest, loan origination fees, and other expenses associated with construction financing. These are calculated based on loan terms and construction timelines.

3.2.4 Insurance and Taxes: Costs for property insurance and property taxes during the construction period.

3.2.5 Marketing and Leasing Costs: Expenses for marketing the property, attracting tenants, and paying leasing commissions.

3.2.6 Legal and Appraisal Fees: Costs for legal services, appraisals, and other professional consulting.

3.3 Formula

Total Indirect Costs = Architectural/Engineering + Permits/Fees + Financing + Insurance/Taxes + Marketing/Leasing + Legal/Appraisal + Developer Overhead

4. Entrepreneurial Incentive and Profit: The Driving Force

4.1 Definitions

4.1.1 Entrepreneurial Incentive: The expected reward that an entrepreneur anticipates receiving for coordinating a project, providing expertise, and bearing the risks associated with development. This is anticipated profit.

4.1.2 Entrepreneurial Profit: The actual difference between the total cost of development (including land, direct and indirect costs, and entrepreneurial incentive) and the market value of the completed property. This is realized profit.

4.2 Scientific Principles

Entrepreneurs require a profit to compensate for the risks undertaken and the expertise provided. If the perceived risk-adjusted return is insufficient, the project will not proceed.

4.3 Market-Derived Estimation

4.3.1 Comparative Analysis: Analyzing recent developments of similar properties to determine the typical profit margins achieved in the market. Requires thorough interviews with developers.

4.3.2 Surveying: Interviewing developers and investors to determine acceptable risk-adjusted returns.

4.4 Factors Influencing Entrepreneurial Incentive

4.4.1 Project Complexity: More complex projects with higher risks generally require a higher entrepreneurial incentive.

4.4.2 Market Conditions: Strong markets with high demand may allow for higher profit margins.

4.4.3 Developer Reputation: A developer with a proven track record may command a higher profit margin.

4.4.4 Unique Project Features: Creative designs, innovative technologies, or unique locations may justify a higher incentive.

4.5 Formula

Entrepreneurial Profit = Market Value - (Land Cost + Direct Costs + Indirect Costs + Entrepreneurial Incentive)

Where:

• Market Value is determined by sales comparison or income capitalization approaches.
• Entrepreneurial Incentive is often expressed as a percentage of total costs (e.g., 10-20% of total development costs).

4.6 Experiment Example

A developer proposes a new apartment complex in a growing suburban market. The land cost is \$1,000,000. Direct costs are estimated at \$5,000,000, and indirect costs are \$1,000,000. The developer requires a 15% entrepreneurial incentive on total costs.

1. Calculate Total Costs (excluding incentive): Land + Direct + Indirect = \$1,000,000 + \$5,000,000 + \$1,000,000 = \$7,000,000
2. Calculate Entrepreneurial Incentive: 0.15 * \$7,000,000 = \$1,050,000
3. Calculate Total Development Cost (including incentive): \$7,000,000 + \$1,050,000 = \$8,050,000

For the project to be viable, the market value of the completed apartment complex must exceed \$8,050,000. If a comparable apartment complex sold for \$9,000,000, the entrepreneurial profit would be \$9,000,000 - \$8,050,000 = \$950,000.

5. Refinements on Entrepreneurial 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. 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 development 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.

Conclusion

Accurate cost estimation is crucial for sound real estate valuation using the cost approach. Understanding the nuances of reproduction cost versus replacement cost, carefully accounting for direct and indirect costs, and accurately estimating entrepreneurial incentive and profit are essential components of this process. By applying the scientific principles and methodologies outlined in this chapter, real estate professionals can develop credible and defensible value opinions.