Chapter: cost estimation❓ Methods and Entrepreneurial Incentive

Introduction

In real estate, accurate cost estimation is paramount for making sound investment decisions. This chapter delves into the various cost estimation methods employed in real estate appraisal and development, highlighting their strengths and weaknesses. Furthermore, it will explore the critical role of entrepreneurial incentive in these estimations, examining how it influences project feasibility and investment returns.

1. Cost Estimation Methods

Cost estimation involves predicting the expenses associated with a real estate project, whether it’s new construction, renovation, or development. Several methods exist, each with varying levels of detail and complexity. The choice of method depends on the project’s nature, the available data, and the required accuracy.

1.1 Comparative-Unit Method (or Calculator Method)

• Description: This is the most commonly used method due to its simplicity and reliance on readily available data. It involves multiplying the building area (e.g., square footage) by a cost per unit (e.g., cost per square foot).
• Data Sources: Cost-estimating services such as Marshall & Swift/Boeckh, RSMeans, or McGraw-Hill Construction Dodge are primary data sources. These services compile cost data from actual construction projects across the country. This cost data is based on winning bids from builders, architects, and contractors.
• Calculation:
  • Base Cost: Found using the cost-estimating services based on national averages.
  • Location Adjustment: Apply a location multiplier to adjust for regional cost variations. For instance, construction costs in New York City will be different from those in rural Kansas.
  • Time Adjustment: Apply a time multiplier to account for inflation and changes in material and labor costs over time.
  • Total Estimated Cost = Base Cost × Location Multiplier × Time Multiplier
• Example: If the national average cost for industrial space is $50.00 per square foot, the local multiplier is 1.05, and the current multiplier is 1.03, then the cost estimate would be $54.08 ($50.00 × 1.03 × 1.05).
• Advantages: Quick, easy to use, and widely accepted.
• Disadvantages: Lacks detail and may not accurately reflect unique project features. Prone to inaccuracies if the comparable data is not truly comparable.

1.2 Unit-in-Place Method

• Description: This method breaks down the building into individual components (e.g., walls, roof, foundation) and estimates the cost of each unit based on its installed cost (material + labor).
• Calculation:
  1. Identify the building components.
  2. Determine the quantity of each component (e.g., square footage of walls, number of doors).
  3. Estimate the “unit-in-place” cost for each component (cost of materials and labor to install it).
  4. Multiply the quantity of each component by its unit-in-place cost.
  5. Sum the costs of all components to arrive at the total estimated cost.
• Example: Estimating the cost of a wall:
  • Material Costs: Lumber, insulation, drywall, paint.
  • Labor Costs: Framing, insulation installation, drywall installation, painting.
  • Unit-in-Place Cost = Material Costs + Labor Costs (expressed per square foot of wall).
• Advantages: More detailed than the comparative-unit method, allowing for better customization based on specific project characteristics.
• Disadvantages: Time-consuming and requires specialized knowledge of construction practices and costs.

1.3 Quantity Survey Method (or Segregated Cost Method)

• Description: The most detailed and accurate method, it involves quantifying every single component of the building and estimating its individual cost.
• Process:
  1. Complete and detailed take-off of all materials and labor required for the project, down to the smallest detail (e.g., individual nails, screws).
  2. Pricing of each item based on current market rates.
  3. Summing up all individual costs to arrive at the total cost.
• Advantages: Highest level of accuracy and allows for precise cost control.
• Disadvantages: Extremely time-consuming, expensive, and requires highly skilled estimators. Typically used by contractors for bidding purposes, not appraisers.

1.4 Cost Index Trending

• Description: This method involves adjusting historical construction costs using cost indexes to estimate current costs. Cost services also provide data that allows appraisers to update the historical cost of construction.
• Calculation:
  • Current Cost = Historical Cost × (Current Index / Historical Index)
• Example:
  • Cost of a small retail property in the spring of 2012 was $189,000.
  • Cost index (as calculated from the cost manual) is 1.859.
  • Current Cost Estimate = $189,000 × 1.859 = $351,351
• Advantages: Simple to use and can be helpful for updating costs over short periods.
• Disadvantages: Accuracy decreases as the time between the historical cost and the current date increases. Subject to errors if the cost index does not accurately reflect the specific type of construction being estimated.

2. Entrepreneurial Incentive (Profit)

2.1 Definition

Entrepreneurial incentive, also known as entrepreneurial profit or developer’s profit, represents the compensation required by a developer or investor for taking on the risks and responsibilities associated with a real estate project. It is the profit necessary to motivate an entrepreneur to undertake a project.

2.2 The Role of Risk and Reward

The level of entrepreneurial incentive is directly related to the perceived risk of the project. Higher risk projects require a higher profit margin to attract investors. Risks can include:

• Market Risk: Uncertainty about demand, occupancy rates, and rental rates.
• Construction Risk: Potential cost overruns, delays, and unforeseen site conditions.
• Financing Risk: Difficulty obtaining financing, high interest rates, and restrictive loan terms.
• Regulatory Risk: Changes in zoning laws, building codes, and environmental regulations.

2.3 Inclusion in Cost Estimates

• Cost services base their numbers on national averages of “winning bids” for construction projects around the country. Cost estimate figures include entrepreneurial profit on residential properties but do not include entrepreneurial profit on nonresidential properties.
• Appraisers have to add this amount to cost service estimates to determine what the market will pay.
• To estimate entrepreneurial incentive accurately, research the market for the subject property type and determine how much profit will attract a risk taker to the deal.
• Estimating this amount can be difficult because developers often do not know or cannot quantify the risk. It is very difficult to extract this amount from sales comparables.

2.4 Methods for Estimating Entrepreneurial Incentive

• Market Surveys: Asking developers, investors, and lenders about their required profit margins for similar projects in the same market. This is the most common and reliable method.
• Extraction from Sales Comparables: Analyzing sales of recently completed and stabilized projects to determine the difference between the sale price and the total cost (including land, construction, and soft costs).
• Percentage of Cost: Estimating entrepreneurial incentive as a percentage of hard costs, hard costs plus soft costs, or hard and soft costs plus land value. It is essential to define the cost basis used when discussing percentages.

2.5 Formula

Entrepreneurial Incentive = (Sale Price - Total Cost) / Total Cost

Where:
* Sale Price = The price at which the new building was sold after being stabilizied.
* Total Cost = The combined Hard Costs, Soft Costs, and Land Value.

2.6 Practical Application

Let’s assume a developer builds an apartment complex. The costs involved are as follows:

• Land Cost = $1,000,000
• Hard Costs = $4,000,000
• Soft Costs = $500,000
  Total Cost = $5,500,000

The developer manages to sell the property after stabilization for $6,500,000. We can calculate the Entrepreneurial Incentive with the formula:
Entrepreneurial Incentive = ($6,500,000-$5,500,000)/$5,500,000 = 0.1818 or 18.18%.

2.7 Considerations

• Market Conditions: Entrepreneurial incentive will fluctuate based on market conditions. In a strong market with high demand, developers may accept lower profit margins. In a weak market, higher profit margins will be necessary to attract investment.
• Project Complexity: Complex projects with unique challenges will require higher entrepreneurial incentive than simple, straightforward projects.
• Location: Prime locations with high barriers to entry may justify lower profit margins due to the reduced risk.
• Owner Occupants: Owner-occupants do not realize a profit, nor do they expect this amount at resale. Their risks are in the operation of the business rather than in ownership of the real estate.

3. Depreciation and Appreciation

Depreciation and appreciation play a significant role in the financial analysis of real estate investments and must be considered when evaluating entrepreneurial incentive. The table provided in the supplied pdf shows depreciation and appreciation values to calculate the capital gains income to be taxed.

3.1 Depreciation

Depreciation is the reduction in the value of an asset over time due to wear and tear, obsolescence, or other factors. In real estate, depreciation can be claimed as a tax deduction, which can improve the overall investment returns.

Depreciation = (Asset cost – Salvage Value) / Useful Life

Where:
* Asset cost = Original Cost of the Asset
* Salvage Value = The estimated value of the asset at the end of its useful life
* Useful Life = How long the asset is expected to be used

3.2 Appreciation

Appreciation is the increase in the value of an asset over time due to market demand, inflation, or other factors. Real estate often appreciates in value, which can generate significant returns for investors.

Appreciation = (Current Value – Original Value) / Original Value

3.3 Depreciation and Appreciation Combined

The tables in the pdf shows an example where the annual depreciation is 2.56% and the annual appreciation is 2%. Depreciation is being taken out of what it costs and appreciation is being added to the market value. This is how the book value and the market value is being derived.

3.4 Capital Gains and Tax Implications

The difference between the asset’s book value (cost less accumulated depreciation) and its market value can be taxed at different rates. This is because the taxes on capital gains will be assessed at different rates than earned income and the taxes are deferred at least until the property is sold.

Conclusion

Accurate cost estimation is crucial for successful real estate ventures. By understanding the various cost estimation methods and the importance of entrepreneurial incentive, investors and developers can make informed decisions, mitigate risks, and maximize returns. The interplay between cost estimation, depreciation, and appreciation further refines the financial analysis and influences the ultimate profitability of a real estate project. Always consult with qualified professionals, such as appraisers and accountants, to ensure accurate and reliable cost estimates and tax planning.