Cost Estimation & Entrepreneurial Profit

Chapter X: Cost Estimation & Entrepreneurial Profit

Introduction

This chapter delves into the critical aspects of cost estimation and entrepreneurial profit within the cost approach to real estate valuation. A thorough understanding of these components is essential for accurately determining the value of a property based on the cost of creating a similar or identical one. We will explore the scientific principles underpinning cost estimation, the distinct roles of reproduction cost and replacement cost, the various direct and indirect costs involved, and the crucial element of entrepreneurial profit.

1. Reproduction Cost vs. Replacement Cost

The cost approach begins with estimating either the reproduction cost or the replacement cost of the improvement. Both approaches aim to quantify the cost to construct an equivalent improvement as of the effective appraisal date, but they differ significantly in their underlying assumptions.

• Reproduction Cost: This is the estimated cost to construct an exact duplicate or replica of the existing building, using the same materials, construction standards, design, layout, and quality of workmanship. It includes all deficiencies, superadequacies, and obsolescence present in the original structure. The theoretical basis of the cost approach lies on reproduction cost.

  • Theoretical Foundation: The concept is rooted in the principle of substitution. A rational buyer would not pay more for an existing property than the cost to reproduce it, assuming no undue delay. This serves as an upper limit to value.

  • Challenges: Estimating reproduction cost can be complex, especially for older buildings, as materials and construction techniques may no longer be available. Furthermore, adherence to obsolete codes and inefficient designs might inflate the cost without contributing to the property’s value.

• Replacement Cost: This is the estimated cost to construct a substitute building with equivalent utility, using contemporary materials, standards, design, and layout. This approach allows for curing some obsolescence and superadequacies. It’s the most commonly used because is easier to obtain and can reduce the complexity of depreciation analysis.

  • Modernization: Replacement cost reflects current construction practices, often resulting in lower costs compared to reproduction cost. It effectively addresses functional obsolescence arising from outdated design or materials.

  • Considerations: Even when using replacement cost, it’s crucial to account for any remaining functional obsolescence that persists in the hypothetical replacement structure.

The following example highlights the difference:

Example: Imagine a warehouse built in 1950 with a low ceiling height by today’s standards.

• Reproduction Cost: Would involve finding and using similar materials and construction techniques from 1950, and replicating the low ceiling height.
• Replacement Cost: Would involve constructing a warehouse with modern materials, design, and a standard ceiling height, addressing the functional obsolescence of the original structure.

Mathematical Analogy:

Let:

• RC_r = Reproduction Cost
• RC_p = Replacement Cost
• C_ob = Cost of Obsolescence (cost to cure functional obsolescence)
• C_mod = Cost of Modernization (cost savings from using modern materials and techniques)

Then:

RC_r = RC_p + C_ob - C_mod

Ideally, after depreciation adjustments, both reproduction and replacement cost approaches should yield similar value indications. Inconsistencies may lead to double-counting of depreciation or other errors.

2. Direct and Indirect Costs

Accurate cost estimation requires considering both direct and indirect costs.

• Direct Costs (Hard Costs): These are directly attributable to the physical construction of the improvement. They are usually part of the construction contract.

  • Materials: Includes all construction materials, such as concrete, steel, lumber, roofing, etc.
  • Labor: Includes wages, benefits, and insurance for all construction workers.
  • Equipment: Includes the cost of renting or leasing construction equipment, as well as depreciation on owned equipment.
  • Contractor’s Profit and Overhead: This encompasses the general contractor’s profit margin, supervisory expenses, coordination, and management fees. This also includes worker’s compensation, and fire, liability, and unemployment insurance
  • Contingency: Allowance for unforeseen issues and unexpected costs. This is a hard cost.

• Indirect Costs (Soft Costs): These are expenditures necessary for the project but not directly tied to physical construction.

  • Architectural and Engineering Fees: Costs for design, blueprints, structural analysis, and environmental studies.
  • Permits and Fees: Costs associated with obtaining building permits, impact fees, and other regulatory approvals.
  • Financing Costs: Includes loan origination fees, interest payments during construction, and other financing charges.
  • Insurance and Taxes: Includes property insurance and ad valorem taxes during the construction period.
  • Legal and Accounting Fees: Costs associated with legal counsel, accounting services, and appraisal fees.
  • Marketing and Leasing Costs: Expenses for advertising, marketing, and leasing activities.
  • Developer’s Overhead and Anticipated Profit: Compensation for the developer’s expertise, coordination, and risk-taking.
  • Carrying Costs: Costs of holding the land during construction.

Mathematical Representation:

Total Cost = Direct Costs + Indirect Costs

TC = DC + IC

Where:

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

Practical Applications and Examples:

• Direct Costs: When estimating the labor cost, appraisers can look at prevailing wage rates for different trades (e.g., electrician, plumber, carpenter). They should also factor in productivity levels and the complexity of the project.
• Indirect Costs: Architectural fees are often calculated as a percentage of direct costs. Appraisers should research typical percentage ranges based on the size and complexity of the project. Carrying costs are calculated based on the land value and the interest rate during the construction period.

3. Entrepreneurial Profit (Incentive)

Entrepreneurial profit represents the economic reward required to incentivize an entrepreneur to undertake a real estate development project. It is the difference between the market value of the completed project and the total cost of development, above and beyond direct and indirect costs.

• Economic Principles: This concept is linked to the principles of supply and demand. In competitive markets, entrepreneurial profit is necessary to attract capital and resources to new development projects. Without the expectation of a sufficient return, entrepreneurs will allocate their resources to alternative investments.

• Market-Driven Figure: The estimated entrepreneurial profit should reflect prevailing market conditions and the risk associated with the specific project. Higher-risk projects or those with unique concepts may require a greater profit incentive.

• Incentive vs. Realized Profit: Entrepreneurial incentive refers to the anticipated profit that entrepreneurs expect to receive at the project’s completion. Entrepreneurial profit refers to 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.

Distinguishing Roles: Appraisers may distinguish between project profit, entrepreneurial profit, developer’s profit, and contractor’s profit.
* Project profit is the total reward for risk and entrepreneurial coordination
* Entrepreneurial profit is the portion of project profit attributed to the entrepreneur
* Developer’s profit represents compensation for the time, expertise, and energy of the person responsible for managing the overall development process
* Contractor’s profit is a portion of the projects overhead

Factors Affecting Entrepreneurial Profit:

• Market Conditions: Strong demand and limited supply can support higher profit margins. Overbuilt markets may reduce or eliminate entrepreneurial profit.
• Project Risk: Complex or innovative projects with higher risks command higher profit incentives.
• Competition: The level of competition among developers influences the expected profit margins.
• Location: Prime locations may command higher values and, therefore, greater profit potential.

Estimation Methods:

• Market Extraction: Analyze recent comparable development projects to extract the entrepreneurial profit component. This involves comparing the sale price of the completed project to the total cost of development.
• Surveys and Interviews: Consult with local developers, investors, and market experts to gather insights into typical profit expectations for similar projects.
• Financial Modeling: Develop a pro forma financial model to estimate the project’s potential profitability based on various scenarios.

Mathematical Formula:

Entrepreneurial Profit = Market Value - Total Cost of Development

EP = MV - TC

Where:

• EP = Entrepreneurial Profit
• MV = Market Value
• TC = Total Cost of Development (including land, direct costs, and indirect costs)

Example: A developer builds a new office building. The market value of the building upon completion is estimated at $10 million. The total cost of development, including land, construction, and soft costs, is $8 million. The entrepreneurial profit is $2 million.

Experiments/Practical Considerations:

• Sensitivity Analysis: Conduct a sensitivity analysis to assess how changes in key variables (e.g., construction costs, rental rates, vacancy rates) affect the entrepreneurial profit. This helps to identify the most critical factors driving the project’s profitability.
• Risk Assessment: Evaluate the potential risks associated with the project, such as construction delays, cost overruns, and market fluctuations. Incorporate a risk premium into the required entrepreneurial profit to compensate for these risks.

Conclusion

Accurate cost estimation and a realistic assessment of entrepreneurial profit are crucial for the successful application of the cost approach in real estate valuation. By carefully considering the various direct and indirect costs, and by analyzing market conditions to determine an appropriate entrepreneurial profit, appraisers can provide reliable value opinions that reflect the true cost of creating a comparable property. Understanding the interplay between reproduction and replacement costs, along with the underlying economic principles of entrepreneurial profit, enables appraisers to provide robust and defensible value conclusions.