In valuing any property in the course of development, one must add entrepreneurial profit. The cost approach is used and entrepreneurial incentive is an important element of this valuation method. It is the incentive an investor has for coordinating the construction of a new project. Few investors would accept less than an amount necessary to account for the trouble they spent coordinating the construction of a new building.
The Dictionary of Real Estate Appraisal defines entrepreneurial profit as (1) a market-derived figure that represents the amount an entrepreneur receives for his or her contribution to a project and risk; the difference between the total cost of a property (cost of development) and its market value (property after completion), which represents the entrepreneur’s compensation for the risk and expertise associated with development; or (2) in economics, the actual return on successful management practices, often identified with coordination, the fourth factor of production following land, labor, and capital; also called entrepreneurial return or entrepreneurial reward. See Appraisal Institute, The Dictionary of Real Estate Appraisal, 4th ed. (Chicago: Appraisal Institute, 2002), 96. For a discussion of the related concepts of entrepreneurial incentive, developer’s profit, contractor’s profit, profit, and project profit, See Appraisal Institute, The Appraisal of Real Estate, 13th ed. (Chicago: Appraisal Institute, 2008), 388-391.
Entrepreneurial incentive is “a market-derived figure that represents the amount an entrepreneur expects to receive for his or her contribution to a project and risk.” See The Dictionary of Real Estate Appraisal, 4th ed., 96; and the Appraisal of Real Estate, 13th ed., 389.
Entrepreneurs have expectations of profits, even when their projects fail. Profits do not always materialize, but the expectation of a profit remains. If profits decline somewhat, the entrepreneur may still be motivated to develop. If profits decline significantly, there may still be an accounting profit, but the accounting profit may not be sufficient to motivate the entrepreneur. The minimum profit/incentive required to motivate an entrepreneur is requirement of development. As a requirement, it is not eliminated even when accounting profits are low or less than zero.
An example, a five-acre parcel of vacant land has one value, but if the owner spent years pursuing a wetland permit which enables construction, it has a much higher value when sold. In the construction of a shopping center, for example, years go by before construction can even begin. A knowledgeable real estate person has to devote time and money utilizing his or her skill to make it happen.
Some of the activities that may be necessary include:
- Site assemblage
- Tenant buyout
- Tenant relocation
- Financing and refinancing
- Market analysis
- Exploration of alternative uses of the property
- Geological investigations
- Building design
- Construction means and methodology
- Property management
If property is condemned while in the course of development, the owner is entitled to be compensated for all its efforts. Entrepreneurial profit is the incentive an investor has for coordinating the construction of a new project. The theory is that few investors would accept less than an amount necessary to account for the trouble they spent coordinating the construction of a new building.
Many urban appraisers use a 15% to 30% entrepreneurial profit to the sum of the cost approach.