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Analyzing "unearned" entrepreneurial profit.

Entrepreneurs require an incentive to purchase distressed real estate. This incentive represents a monetary reward for the risks associated with purchases of this type of real estate and is termed "unearned" entrepreneurial profit. In this article, the reasoning and rationale for analyzing unearned entrepreneurial profit are demonstrated.

Commercial real estate has components of cost and value that include

* Construction

* Occupancy

* Financing

* Land

* Entrepreneurial profit

These components comprise the four agents of production, specifically land, labor, capital, and entrepreneurial profit. The potential to satisfy the first three agents of production (i.e., land, labor, and capital) as well as earn a profit is what motivates entrepreneurs to purchase real estate. The amount

allocated to profit, the residual component, determines the relative economic feasibility of a real estate investment.

The opportunity to earn entrepreneurial profit involves both skill and risk taking. Skill is required to introduce the right mix and timing of the three other agents of production, and risk taking is required to encounter unforeseen construction, marketing, and financial conditions.

The Dictionary of Real Estate Appraisal, second edition, defines entrepreneurial profit as:

A market-derived figure that represents the amount an entrepreneur expects to receive in addition to costs; the difference between total cost and market value. Also called entrepreneurial reward.[1]

Provisions for entrepreneurial profit should be recognized in all real estate valuations. The conclusions of numerous appraisals, however, indicate entrepreneurial profit is often ignored in real estate valuations prepared on distressed real estate. The result is flawed market value estimates.

Entrepreneurial profit and unearned entrepreneurial profit are essentially synonymous. The term unearned entrepreneurial profit, as used in this article, specifically refers to the remaining profit required to compensate a purchaser for buying a distressed real estate property, specifically one in its "as is" condition.


Various issues must be considered when analyzing and quantifying entrepreneurial profit and unearned entrepreneurial profit projections because of problems arising from the subjective nature of this component. This section identifies and discusses some of these issues.

Anticipated profit is a difficult component to quantify because no cost manuals or periodically published data are available to document actual or expected profit. Historical profit is easier to quantify based on analysis of the sale prices of comparable sales and associated costs of comparable sales. The difference between the sale prices and the associated costs represents the indicated entrepreneurial profit. The process of forecasting unearned entrepreneurial profit thus involves comparing future profit expectations with pure historical profit trend analysis.

Forecasting entrepreneurial profit requires both judgment and probability analysis of what incentive is necessary to entice an entrepreneur to buy a distressed real estate property. The remaining amount of unearned entrepreneurial reward is not always obvious; moreover, the amount of profit an entrepreneur requires will vary from project to project depending on the relative bargaining power of market participants, tempered with any remaining perceived risks for that property.

A natural extension of an appraiser's function is the determination of what profit levels can be obtained on a real estate development at any point in time. In his article, "Estimating Entrepreneurial Reward," Brian Chester observes that "Appraisers are often apprehensive about making subjective estimates for entrepreneurial profit without adequate market support and documentation."[2] Chester later notes, "From a practical standpoint, however, the same argument regarding subjectivity can be made regarding other methodologies for estimating the market value of almost any property interest in real estate."[3]

Appraisers should remember not to construe rent loss calculations as forecasts of unearned entrepreneurial profit. Rent loss represents an opportunity cost as a result of foregone income that has yet to be established at a particular point of ownership, while unearned entrepreneurial profit represents the reward for the risks associated with a particular investment.

It should be remembered as well that entrepreneurial profit to the original developer or to the seller of a property is not necessarily always present. Initial profit projections may be eliminated once various problems associated with construction, marketing, or financing conditions are taken into account. Purchasers of distressed properties, however, will require compensation for the skills and risks involved in purchasing such properties; thus, purchasers will make a deduction for unearned entrepreneurial profit from the price offered.

The dollar amount, as opposed to the percentage amount, is of primary importance to an entrepreneur in any estimate of unearned entrepreneurial profit. For example, a 30% profit may not be sufficient on a small project where the dollar amount of profit is calculated to be $50,000; in other words, the $50,000 figure, regardless of the percentage it represents, may not be sufficient to entice an entrepreneur to undertake the risks associated with a given property. Conversely, a profit percentage below 10% may be more than enough on a large project where the indicated dollar allocation is sufficient to entice an entrepreneur to undertake the necessary risk.


With the advent of overbuilt markets and a corresponding abundance of distressed properties, appraisers are frequently asked to report as is market value estimates. In "Contemporary Applications of Valuation Analysis," William Pittenger presents the following succinct as is market value definition:

... the price at which a third-party purchaser could acquire the property in its as is condition and then cover all the remaining costs associated with completing construction, sellout, or lease-up and earn a market-based level of profit for doing so.[4]

This definition acknowledges that entrepreneurs demand compensation to purchase distressed real estate.


Appraisers historically have advocated an as is market value derived by deducting rent loss, leasing commissions, and property/tenant improvement costs from the "as stabilized" market value. These traditional methods fail to account for the compensation required to entice an entrepreneur to purchase a property in its as is condition. A properly supported as stabilized market value estimate, however, recognizes a market-based level of profit for an entrepreneur. As such, an additional deduction from the as stabilized value is needed to entice an entrepreneur to purchase a property in its as is condition.

The time-line graph shown in Figure 1 best illustrates a property's value creation, specifically the process of deducting for unearned entrepreneurial reward. Figure 1 depicts various points in time when value is either created, maintained, or lost. The graph shows that entrepreneurial profit was initially earned upon the successful completion of the development process (Figure 1, line A1). The graph further indicates that a value diminution later occurred as a result of an adverse condition (Figure 1, line A2).

Figure 1 subsequently reveals that this property can successfully achieve a higher value when a sustainable level of long-term occupancy is reattained. This process involves an entrepreneur's coordination effort similar to the efforts required in the initial value creation process (see Figure 1, line A3).

In fact, the coordination required in the redevelopment stage can be extremely complex because of potential "stigma" problems associated with an existing property. The expected profit required to entice an entrepreneur to purchase an existing distressed real estate property in its as is condition may thus be even greater than the projected profit levels sought in the same project's initial development.

Consider, for example, Figure 2 and Figure 3, which illustrate the traditional as is market valuation method and the suggested as is market valuation method outlined in this article, respectively.

As is market valuation methods that fail to provide incentive for entrepreneurs are flawed and result in unsupported, overstated market value estimates (see point C on Figure 2).

On the other hand, the method suggested in Figure 3 provides incentive for an entrepreneur and for the other associated lease-up costs; the result is a market-supported as is value estimate. The value indicated through this method is shown as point D in Figure 3.

To illustrate, consider the situation of a person who buys a house for $20,000 and invests an additional $10,000 to improve the residence. This person would then anticipate receiving in excess of $30,000 for the house, say $33,000, to reflect a reward for the effort and risk expended to make the improvements. Conversely, if the person knew that only $30,000 could be received upon completion of all improvements, and $10,000 worth of improvements were required, the person would pay less than $20,000 for the house in its as is condition--perhaps $17,000. (To simplify this example, the figure for improvement costs of $10,000 is assumed to include both the opportunity--i.e., capital costs--and the actual repair costs.)


Consider the following case study. A property operating at stabilized occupancy sells for $8,800,000. The land value is $3,000,000; total hard and soft development costs are $5,150,000. The remainder is allocated to profit. In this example, profit would represent $650,000, or roughly 12.6% of the construction cost.

Entrepreneurial profit estimate Sale price $8,800,000 Less: land value - $3,000,000 Contributory value of improvements $5,800,000 Less: development costs - $5,150,000 Indicated profit $ 650,000

Assume, however, that this property was nearing completion and is not fully leased. The appraiser subsequently documents the following results. The present value of the rent loss, from the as is value date to the date of projected stabilized occupancy, is $200,000; leasing commission costs are projected at $50,000; and remaining unfinished tenant improvement costs are documented at $100,000. The costs indicated to bring the property into production, exclusive of entrepreneurial profit, are summarized as follows.

Estimated costs to bring into production Present value of rent $200,000 loss Leasing/marketing costs $ 50,000 Tenant improvement $100,000 costs Indicated costs $350,000

Traditional appraisal methods would suggest only a $350,000 deduction from the $8,800,000 as stabilized value to derive the as is market value as follows.

Value at stabilization $8,800,000 Less: costs to bring into production (neglecting provisions for profit) -$350,000 As is value indication $8,450,000

Recognizing that entrepreneurs require compensation to undertake risks, the $8,450,000 as is value indication is overstated; the value estimate did not provide an incentive for the risks associated with this property. In the previous example, the first three requirements for production (i.e., land, labor, and capital) are satisfied at $8,150,000.

Land value $3,000,000 Labor and capital costs incurred $5,150,000 Three factors of production $8,150,000

If the purchaser were to pay the previously indicated $8,450,000 as is market value figure, the seller would be permitted to receive the full profit amount of $400,000.

As is value (exclusive of profit) $8,450,000 Less: indicated costs

of three factors of production - $8,050,000* Residual to profit $ 400,000

* $100,000 worth of tenant improvement costs had yet to be expended; thus, the three agents of production would in actuality be $8,150,000 less $100,000 in unfinished tenant improvement cost.

A prudent purchaser would not pay $8, 450,000. A prudent seller, however, would demand more than $8,050,000; the seller would want to be rewarded for the value created until that time. In this example, the property is essentially completed (98%, or $5,050,000/ $5,150,000) and well occupied (only $200,000 rent loss until stabilization).

The remaining unearned entrepreneurial profit must be treated as a deduction from the as stabilized market value estimate in addition to the other associated costs (e.g., rent loss, leasing commissions, tenant improvements, advertising) to derive the appropriate as is market value. In the previous example, the two parties would need to allocate the $400,000 profit based on the market participants' relative bargaining power tempered with future perceived risks. Assuming the profit was estimated equally among the two parties, the appropriate as is value indication would be as follows.

Value at stabilization $8,800,000 Less: total cost to bring into production: Present value of rent loss ($ 200,000) Leasing commissions ($ 50,000) Tenant improvements ($ 100,000) Unearned entrepreneurial profit ($ 200,000) Indicated as is market value $8,250,000


The second case study demonstrates three methods for estimating unearned entrepreneurial reward. The first two methods specifically apply to discounted cash flow (DCF) analysis, while the third method applies to direct capitalization.

In the two DCF methods, the market-derived discount rates are adjusted. The market-derived discount rate prior to adjustment would not provide for an entrepreneur's risks associated with a particular property. The adjustments are

* A simple add-on to the discount rate throughout the entire projection

* A split-rate discount calculation

DCF analysis is an appropriate method with which to derive as is market value estimates for existing distressed real estate properties. This is because DCF analysis best simulates the volatile cash flows that characterize these types of properties. In DCF analysis, a market-derived discount rate is used to reflect a present value of the projected cash flows over an estimated applicable holding period. The function of this exercise, however, is to demonstrate various methods to derive unearned entrepreneurial profit. The specific inputs necessary to derive the cash flows are thus not discussed.

An existing 15-year-old, 234,823-square-foot office building is 53% occupied. The highest and best use conclusion is that the property can be successfully redeveloped. [TABULAR DATA OMITTED]

First, an initial cash flow run is prepared that establishes the value prior to provisions for unearned entrepreneurial reward. The market-derived discount rate prior to adjustment is estimated at 12%. A ten-year cash flow period is used. Table 1 illustrates the initial cash flow run. This analysis indicates an as is value of $27,400,000 prior to addressing the issue of the incentive required for an entrepreneur. [TABULAR DATA OMITTED]

Method 1--incremental increase to discount rate

A premium of 1% was applied to the base discount rate to forecast an estimate of unearned entrepreneurial reward. This premium inherently reflects risks associated with subsequent lease renewals; further, the property in most cases will have already suffered an adverse influence and could be subjected to the same adverse influence in the future. For instance, a class A office building may become a class B office building and subsequently suffer adverse influences. While an extensive remodernization. [TABULAR DATA OMITTED]

program could improve the property back to a class A property, ten years hence the property could again revert and suffer similar adverse influences. [TABULAR DATA OMITTED]

The use of a higher discount rate reflects the increased risks associated with this property. (See Table 2.) Specific discount rates for distressed properties are excellently reported by Peter F. Korpacz and Associates, Inc., in its quarterly survey.[5] The particular discount rate chosen will be tempered by the risks associated with the property and the reasonableness of the amount of unearned entrepreneurial profit estimated. This method has merit, because risks to an entrepreneur will occur during the remarketing of the property as well as throughout the subsequent investment holding period. [TABULAR DATA OMITTED]

A $25,800,000 as is market value was estimated under this method. The resulting unearned entrepreneural estimate is determined as follows: Base example value

indication $27,400,000

Less: method 1 value

indication -$25,800,000



estimate $ 1,600,000

Method 2--split-rate discount

In Table 3, a split-rate discount method is employed. This method is useful because greater risks are associated with the lease-up or absorption period. Further, to the extent that a property can reattain a sustainable level of long-term occupancy, it should be analyzed like other comparable stabilized-occupancy properties.

Controversy surrounds the use of the split-rate discount method. The logic of a higher initial discount rate is questionable because the income received during the lease-up period reflects the income that is least at risk. In the example, the income received from the occupied 123,823 square feet is at least risk because this rent is quantified with documented leases. Further arguments against the split-rate discount method relate to the question of support for the quantified increment applied to the discount rate throughout the projected absorption period.

Under method 2, a high initial discount rate of 25% is used throughout the lease-up period; however, upon attainment of a stabilized occupancy the discount rate is adjusted back to the base 12% discount rate. The high initial discount rate would be comparable to other high-risk investments available to an entrepreneur.

As is the case with method 1, the particular initial discount rate chosen will be tempered by the remaining risks associated with the property and the reasonableness of the estimated amount of unearned entrepreneurial profit.

According to method 2, an as is market value of $26,500,000 is indicated. The resulting unearned entrepreneurial estimate is determined as follows:

Base example value

indication $27,400,000

Less: method 2 value

indication $26,500,000



estimate $ 900,000

While the initial 25% discount rate appears excessive, the impact on the subsequent as is market value is significantly less than the impact on value indicated by method 1, in which only a 1% increment is applied to the base discount rate of 12%.

Method 3--line-item deduction

A line-item deduction represents a simple calculation that is easily demonstrated and can be applied when using direct capitalization. To properly derive the necessary profit projection and subsequently determine the applicable profit allocation with this method is difficult, however. For demonstration purposes, a $3,000,000 total profit is projected for this property.

At this point, an allocation of the remaining unearned entrepreneurial profit should be estimated. The amount of unearned entrepreneurial profit to be allocated is a function of the relative bargaining power of the market participants, taking into account associated risks of this particular real estate property. The example property is a 53%-occupied office building. A four-year absorption period is projected. The allocation is based on the fact that substantial coordination efforts still remain, and while the property is over 50% occupied, considerable risks thus remain.

To entice an entrepreneur to undertake the risks associated with this property, an estimate of 50% of the profit projection was estimated, or $1,500,000. The remaining associated risks must be considered to derive a reasonable market-supported unearned entrepreneurial reward estimate.


The following three methods of estimating unearned entrepreneurial reward are presented in this article.
Method Employed Reward Estimate

1. Incremental

discount rate

increase $1,600,000

2. Split-rate

discount $ 900,000

3. Line-item

deduction $1,500,000

A range of $900,000 to $1,600,000 is indicated. The question is whether this dollar amount range is sufficient to entice an entrepreneur to undertake the risks associated with this property. If so, deducting this unearned entrepreneurial reward estimate range would indicate an as is market value range from $25,800,000 to $26,500,000.


The amount of unearned entrepreneurial profit varies from property to property depending on the negotiating ability of market participants and the market conditions. Subjectively, as in the whole appraisal process, is involved in the estimation of unearned entrepreneurial profit. If based on proper analysis, however, the adjustment applied for unearned entrepreneurial profit will be consistent with the marketplace.

[1]. American Inst. of Real Estate Appraisers, The Dictionary of Real Estate Appraisal, 2d ed. (Chicago: American Inst. of Real Estate Appraisers, 1989), 104.

[2]. Brian A. Chester, "Estimating Entrepreneurial Reward," The Appraisal Journal (April 1990): 255.

[3]. Ibid., 256.

[4]. William L. Pittenger, "Contemporary Applications of Valuation Analysis," 1990 seminar in Atlanta, Georgia.
COPYRIGHT 1992 The Appraisal Institute
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1992 Gale, Cengage Learning. All rights reserved.

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Author:Anglyn, William Ted
Publication:Appraisal Journal
Date:Jul 1, 1992
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