Cost Estimation and Entrepreneurial Incentive

Chapter: Cost Estimation and Entrepreneurial Incentive

Introduction:

This chapter delves into the critical aspects of cost estimation within the cost approach to real estate valuation, with a particular focus on the concept of entrepreneurial incentive. Accurate cost estimation is paramount to the reliable application of the cost approach. Furthermore, understanding and quantifying entrepreneurial incentive is crucial for determining the overall economic viability and market value of a property development project.

1. Reproduction Cost vs. Replacement Cost: Theoretical and Practical Implications

The cost approach hinges on estimating the cost to create a new improvement, which can be approached in two primary ways: reproduction cost and replacement cost.

1.1. Reproduction Cost: The Idealized Starting Point

• Definition: Reproduction cost is the estimated cost to construct an exact duplicate or replica of the existing building, as of the effective appraisal date. This includes using the same materials, construction standards, design, layout, and quality of workmanship. Critically, it also embodies all the deficiencies, superadequacies, and obsolescence present in the subject improvements.
• Theoretical Basis: Reproduction cost represents the classic, theoretically pure starting point for the cost approach. It aims to precisely replicate the original structure.
• Challenges: Estimating reproduction cost can be difficult, especially for older structures, as materials may no longer be available, and construction standards may have changed significantly.

• Application: Reproduction cost is useful for measuring depreciation from all causes when that sort of measurement is necessary.
  1.2. Replacement Cost: A Pragmatic Alternative

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

• Practical Advantages: Replacement cost is often easier to obtain than reproduction cost, as it involves readily available materials and construction techniques. It also simplifies depreciation analysis.
• Obsolescence Considerations: Replacement cost inherently cures some forms of functional obsolescence, such as superadequacies and poor design.
• Application: Replacement cost is suitable when reproduction cost is impractical or when some degree of obsolescence cure is desired.

1.3. Consistency and Avoiding Double-Counting

• Importance: Regardless of whether reproduction cost or replacement cost is used, it is critical to apply the chosen cost basis consistently throughout the cost approach.
• Risk of Error: Inconsistent application can lead to double-counting of depreciation items and other errors, resulting in an inaccurate value opinion.
• Transparency: The cost basis selected should be clearly identified in the appraisal report.

2. Direct Costs (Hard Costs): Tangible Construction Expenses

Direct costs encompass all expenses directly related to the physical construction of the improvement.

2.1. Components of Direct Costs

• Materials: The cost of all construction materials (lumber, concrete, steel, etc.).
• Labor: Wages and benefits for all construction workers.
• Equipment: Costs associated with construction equipment, including rental fees, depreciation, and operating expenses.
• Contractor’s Profit: The profit margin earned by the general contractor for overseeing the project.
• Contractor’s Overhead: Expenses incurred by the contractor in running the business, such as office rent, insurance, and salaries of administrative staff.
• Construction Contingency: Allowance for unforeseen costs during construction.
• Security during construction: Cost to secure the construction site.
• Material storage facilities and transportation costs
• Power line installation and utility costs
• Contractor’s shack and temporary fencing

2.2. Mathematical Representation

Total Direct Costs = ∑ (Material Costs) + ∑ (Labor Costs) + ∑ (Equipment Costs) + Contractor’s Profit + Contractor’s Overhead + Construction Contingency

2.3. Factors Influencing Direct Costs

• Quality of Materials: Higher-quality materials generally result in higher direct costs.
• Complexity of Design: Intricate designs and specialized construction techniques can increase labor and material costs.
• Market Conditions: Supply and demand dynamics in the construction industry can affect material prices and labor rates.
• Geographic Location: Construction costs vary significantly depending on the location due to differences in labor rates, material availability, and regulatory requirements.

3. Indirect Costs (Soft Costs): Supporting Expenses Beyond Construction

Indirect costs encompass expenditures necessary for the construction project but are not directly part of the construction contract.

3.1. Components of Indirect Costs

• Architectural and Engineering Fees: Costs for design, planning, and engineering services.
• Permit Fees: Fees charged by local governments for building permits.
• Loan Origination Fees: Fees charged by lenders for providing construction financing.
• Carrying Costs During Construction: Interest payments, property taxes, and insurance premiums incurred during the construction period.
• Appraisal and Legal Fees: Costs for appraisal services, legal counsel, and title insurance.
• Leasing and Marketing Costs: Expenses associated with attracting tenants or buyers to the completed property.
• Developer’s Overhead: Administrative and operational expenses incurred by the developer.
• Local government development levies
• All-risk insurance expense and ad valorem taxes during construction.
• The cost of carrying the investment in the 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
• Building permits
• Appraisal, consulting, accounting, and legal fees
• Performance bonds

3.2. Mathematical Representation

Total Indirect Costs = ∑ (Architectural Fees) + ∑ (Permit Fees) + ∑ (Loan Fees) + ∑ (Carrying Costs) + ∑ (Appraisal Fees) + ∑ (Marketing Costs) + Developer’s Overhead

3.3. Estimating Indirect Costs

• Percentage of Direct Costs: Some indirect costs, such as architectural fees, are often estimated as a percentage of direct costs.
• Market Research: Leasing and sales commissions are related to the property type and prevailing market practices.
• Specific Analyses: Fees for appraisals and environmental studies depend on the time and complexity required.

4. Entrepreneurial Incentive: Rewarding Risk and Coordination

Entrepreneurial incentive is the economic reward required to motivate an entrepreneur to undertake a real estate development project. It represents the profit expected for providing coordination, expertise, and assuming risks.

4.1. Distinguishing Entrepreneurial Incentive from Entrepreneurial Profit

• Entrepreneurial Incentive: The anticipated or expected reward for entrepreneurial efforts. This is a forecast.
• Entrepreneurial Profit: The actual profit realized after the project is completed and stabilized. This is a historical result.

4.2. The Importance of Entrepreneurial Incentive

• Project Viability: Without adequate entrepreneurial incentive, new construction will not occur.
• Market Value: Entrepreneurial incentive is an essential component of value in the cost approach.
• Economic Equilibrium: It bridges the gap between the cost of development and the market value of the completed property.

4.3. Factors Influencing Entrepreneurial Incentive

• Market Risk: Higher-risk projects demand greater entrepreneurial incentive.
• Complexity: Complex or unique projects require more specialized expertise and coordination, warranting a higher reward.
• Market Conditions: Strong market demand can support higher entrepreneurial incentives.
• Opportunity Cost: The entrepreneur’s alternative investment opportunities influence the required return.
• Competitive situation: The competitive situation in the local market can also affect cost estimates.
• Creative concepts, greater risk, or unique opportunities have market acceptance

4.4. Estimating Entrepreneurial Incentive

• Market Research: Interviews with developers, investors, and other market participants to determine typical profit margins.
• Comparable Projects: Analyzing the profitability of similar development projects in the area.
• Discounted Cash Flow Analysis: Projecting future cash flows and discounting them to present value to determine the required rate of return.
• Percentage of Total Costs: Expressing entrepreneurial incentive as a percentage of total development costs (land, direct costs, and indirect costs).
• Example: If the total cost of development is \$1,000,000 and the market requires a 15% entrepreneurial incentive, the incentive would be \$150,000.
• Total Cost of Development + Entrepreneurial Incentive = Market Value
• MV = TDC + EI

4.5. Mathematical Representation

Entrepreneurial Incentive = Market Value - Total Cost of Development

EI = MV - TDC

Where:

EI = Entrepreneurial Incentive

MV = Market Value

TDC = Total Cost of Development (Land Value + Direct Costs + Indirect Costs)

4.6. Separating Project profit, entrepreneurial profit, developer’s profit, and contractor’s profit

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.

5. Special Considerations

5.1. Owner-Occupied Properties:

For owner-occupied properties, the concept of entrepreneurial incentive may be less straightforward. The owner-occupant may consider additional operating profit, long-term control, or ownership pride or prestige to be an adequate incentive to develop and occupy that property. Appraisers need to consider these non-monetary incentives in their analysis.

5.2. Specially Built Properties:

In the case of specialized private owner-occupied improvements, entrepreneurial incentive is as much a part of the construction as the building materials used in the improvements. However, the reality is that in properties that are constructed for owner occupancy as opposed to economic returns, the entrepreneurial incentive may be the first cost lost in value if those properties are not constructed similar to the ideal improvement.

6. Practical Applications and Experiments

6.1. Case Study: Estimating Entrepreneurial Incentive for a New Office Building

• Scenario: A developer is considering building a new office building in a suburban market.
• Data Collection: The appraiser interviews several developers and investors in the area to determine the typical entrepreneurial incentive for similar projects. The data indicates a range of 12% to 18% of total development costs.
• Analysis: Based on the market data and the specific risks associated with the project (e.g., lease-up period, competition from existing buildings), the appraiser estimates a reasonable entrepreneurial incentive of 15%.
• Calculation: If the total cost of development is \$5,000,000, the entrepreneurial incentive would be \$750,000.

6.2. Experiment: Sensitivity Analysis of Entrepreneurial Incentive

• Objective: To assess the impact of different entrepreneurial incentive levels on the estimated market value of a property.
• Procedure: The appraiser performs multiple cost approach analyses, varying the entrepreneurial incentive percentage from 10% to 20%.
• Results: The experiment reveals that the estimated market value is highly sensitive to changes in entrepreneurial incentive. A 1% increase in entrepreneurial incentive results in a corresponding increase in the estimated market value.
• Conclusion: This experiment demonstrates the importance of accurately estimating entrepreneurial incentive.

Conclusion:

Accurate cost estimation, encompassing both direct and indirect costs, is fundamental to the reliable application of the cost approach. Furthermore, understanding and quantifying entrepreneurial incentive is essential for determining the overall economic viability and market value of a property development project. By carefully considering the factors that influence entrepreneurial incentive and employing appropriate estimation techniques, appraisers can provide credible and supportable value opinions.