Cost Components: Reproduction vs. Replacement & Entrepreneurial Incentive

Chapter [Chapter Number]: Cost Components: Reproduction vs. Replacement & Entrepreneurial Incentive

This chapter delves into the critical cost components within the Cost Approach to real estate valuation. Specifically, we will examine the distinction between Reproduction Cost and Replacement Cost, and the significance of Entrepreneurial Incentive. A thorough understanding of these elements is crucial for accurate cost estimation and subsequent value indication.

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

2. 1 Definitions and Theoretical Basis

   • Reproduction Cost: The estimated cost to construct an exact duplicate or replica of the existing building, as of the effective appraisal date, using the same materials, construction standards, design, layout, and quality of workmanship. This includes all the existing deficiencies, superadequacies, and obsolescence of the subject improvements.
   • Replacement Cost: 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 cost basis allows for the curing of some existing obsolescence.
   • Theoretical Base: Reproduction cost is theoretically the foundational starting point for the cost approach, reflecting the idealized recreation of the subject property. However, practical considerations often lead to the use of replacement cost.

3. 2 Practical Considerations and Application

   • Age and Uniqueness: The decision to use reproduction or replacement cost is often influenced by the age of the structure, its uniqueness, and any divergence between its original intended use and its current highest and best use.
   • Data Availability: Replacement cost data is generally more readily available and easier to obtain than reproduction cost data. Modern building materials and techniques are more widely documented and priced.
   • Obsolescence Treatment: Replacement cost allows for the mitigation of certain forms of functional obsolescence (e.g., superadequacies, poor design). A replacement structure, built with contemporary designs, materials and systems, typically costs less than a reproduction because it will use available cost effective methods.
   • Consistency: Regardless of the chosen approach, consistency is paramount. Inconsistent application of reproduction or replacement cost can lead to double-counting of depreciation and other errors, resulting in an inaccurate value opinion.

4. 3 Measurement and Depreciation Considerations

   • Reproduction Cost and Depreciation: Reproduction cost often provides a more comprehensive basis for measuring depreciation from all causes (physical deterioration, functional obsolescence, and external obsolescence).
   • Replacement Cost and Depreciation: When using replacement cost, it is essential to recognize that some forms of functional obsolescence may already be addressed by the modern design and materials. However, if any functional problems persist in the hypothetical replacement structure, appropriate deductions must still be applied.

5. 4 Mathematical Representation of Cost Approach:

Value = Land Value + (Cost New - Depreciation) + Entrepreneurial Incentive

Where:

• Cost New can be either Reproduction Cost New or Replacement Cost New
• Depreciation encompasses physical deterioration, functional obsolescence, and external obsolescence.

Example Scenario:
Assume an old warehouse is being appraised. Using Reproduction Cost would mean estimating the cost to rebuild the warehouse exactly as it is, with outdated materials and design. Using Replacement Cost would involve estimating the cost to build a new warehouse with modern materials, efficient layout, and up-to-date technology. The choice depends on whether the appraiser needs to explicitly measure all forms of depreciation (reproduction) or can account for some obsolescence within the cost estimate (replacement).

1. 5 Potential Errors

The biggest risk when choosing between reproduction or replacement cost is incorrectly assessing depreciation or double counting depreciation. Depreciation, from any source, should only be applied one time. The cost basis selected for a particular appraisal should be clearly identified in the report to avoid misunderstanding and must be applied consistently throughout the cost approach to avoid errors in developing an opinion of value.

2. Direct Costs vs. Indirect Costs

To develop cost estimates for the total building, appraisers must consider direct costs (also known as hard costs) and indirect costs (also known as soft costs). Both direct and indirect costs are essential to a reliable cost estimate. (The traditional data sources and appraisal techniques used to estimate building costs are discussed in Chapter 30.) Direct construction costs include the costs of material and labor as well as the contractor’s profit required to construct the improvement on the effective appraisal date. The entrepreneurial incentive or profit is separate and apart from the contractor’s or developer’s profit. The overhead and profit of the general contractor and various subcontractors are usually part of the construction contract and therefore are direct costs that should always be included in the cost estimate. In more complex projects, where multiple contractors, construction staging, or other complications are involved, a management fee may be required. Indirect costs are expenditures or allowances that are necessary for construction but are not typically part of the construction contract. These costs can include, but are not limited to, the cost of architectural and engineering services, loan origination fees, carrying costs during construction, title insurance fees, appraisal and legal fees, leasing and marketing costs, and developer’s overhead and anticipated profit.

2. Entrepreneurial Incentive: The Engine of Development

3. 1 Definition and Significance

   • Entrepreneurial Incentive: The amount an entrepreneur expects or wants to receive as compensation for providing coordination, expertise, and assuming the risks associated with developing a project. It is the profit anticipated before the project is undertaken.
   • Entrepreneurial Profit: The difference between the total cost of development and marketing and the market value of the property after completion and achievement of stabilized occupancy and income. This is the profit realized after the project is complete.
   • Importance: Entrepreneurial incentive is crucial because it is the motivating factor that drives developers to undertake new construction projects. Without the expectation of a reasonable return, development would cease. This profit is as essential to the indication of value in the application of the cost approach as the costs of building materials and labor.

4. 2 Market-Driven Estimates

   • Data Reliance: Estimates of entrepreneurial profit/incentive are only as reliable as the available market data. When little market data exists, like in years following an economic downturn, it is difficult to forecast.
   • Market Research: Appraisers must conduct thorough market research, including interviews with developers and other market participants, to determine anticipated, acceptable, and actual profit levels in the specific market.
   • Risk and Reward: The level of entrepreneurial incentive should correlate with the risk involved in the project. Higher risk projects (e.g., a unique development in a suburban market) will demand a higher incentive compared to standard projects (e.g., a residential subdivision in an area with strong population growth).

5. 3 Mathematical Representation

Entrepreneurial Incentive = Market Value - Total Cost of Development

Where:

• Total Cost of Development = Land Value + Direct Costs + Indirect Costs

Example Calculation:
A developer is planning to build an office building. The land value is estimated at $1,000,000, direct costs at $5,000,000, and indirect costs at $500,000. The developer anticipates the completed building will have a market value of $7,000,000.

Entrepreneurial Incentive = $7,000,000 - ($1,000,000 + $5,000,000 + $500,000) = $500,000

The Entrepreneurial Incentive represents 7.14% of the total costs.

6. 4 Influencing Factors

   • Market Conditions: A seller’s market may result in sale prices exceeding development costs, potentially leading to higher entrepreneurial profits.
   • Property Amenities: Unique or desirable property amenities can increase sale prices and, consequently, entrepreneurial profit.
   • Build-to-Suit Properties: In owner-occupied properties, the entrepreneurial incentive might manifest as operational efficiencies or long-term value appreciation rather than immediate profit.
   • Specialized Properties: Governmental or religious properties may not be developed with the same profit motive as commercial developments. The appraiser needs to carefully consider these situations and adjust their incentive calculation accordingly.

7. 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, 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, 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 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. The profit a contractor receives is often already reflected in the fee a contractor charges and would therefore be included in the direct costs.

3. Conclusion

Understanding the nuances of Reproduction Cost, Replacement Cost, and Entrepreneurial Incentive is vital for real estate professionals utilizing the Cost Approach. Accurate cost estimation requires careful consideration of these components, leading to a more reliable indication of value. By following the guidance and principles outlined in this chapter, appraisers can improve the accuracy and defensibility of their cost approach analyses.