Transferred Value: A Concept in Explaining Project Feasibility

Project feasibility is the concept that if costs exceed the increase in value to whatever asset is being developed, then the project should not be undertaken. This concept applies to many different aspects of business, however, this blog focuses on project feasibility in the context of land development.

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In land development, it is sometimes difficult to understand how real estate value is not always directly correlated with cost. With this situation in mind, it is important to define what price, value, and cost actually represent.

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Price is what any individual is willing to pay.

 

This is based on their own personal criteria and is not necessarily influenced by external factors.

In real estate terminology, price is synonymous with investment value.

It essentially states that there are personal factors which lead to an investment making sense for an individual person.

 

Price is rarely 100% consistent with value.

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Value is essentially an average of prices.

Therefore, value is highly theoretical and is more appropriately expressed as a range of

potential prices.

 

My job as an appraiser is to determine the most probable price of a property – essentially a weighted average of similar sales or metrics and their relevancy as it pertains to any property I’m appraising. The sign of a good appraiser is the act of identifying which property metrics are the most relevant drivers of value and giving those metrics more weight in a process known as reconciliation.

 

Simply put, the value of a thing is the most probable price it will bring.

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Unlike value, cost is a fact. Costs change based on contractor workload, availability of raw materials, or inflation; however, it is tangible and measurable, unlike value. [1]

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The difference between cost and price is the value created by the project to an individual, not the overall market. The market value created by a project does not always equal or exceed cost for a number of reasons. So, if project costs exceed the incremental real estate market value increase, it wouldn’t be prudent to start the project, right?

Wrong (sometimes).

 

It’s wrong because of a concept known as transferred value – a term coined by a colleague,

Ted Whitmer, and often difficult to explain to interested parties in land development.

So, here is my shot at it...

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Transferred value is a theory of sorts that states that there are intangible considerations outside of the real estate which need to be identified and quantified to determine feasibility. Commercial and industrial real estate exist to house a business need. Therefore, it follows that project feasibility should not only be quantified based on incremental real estate value, but also how much intangible business value is being created as part of the project. The difficulty, of course, is quantifying the incremental increase in the intangible asset, as well.

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Common examples of traditionally financially infeasible projects with the presence of transferred value theory include home improvements to enhance quality of life, church development for the benefit of its congregation, and corporate headquarters to enhance employee morale and corporate image (reducing perception of risk to shareholders). Last, and maybe most relatable, is essentially any public project as its intention is to increase the safety and/or quality of life for the community its benefitting with that same community sharing the pro rata cost of each project via tax dollars (libraries, highways, etc.). These types of projects are rarely financially feasible in real estate terms, but include intangible benefits that may offset or exceed the actual project costs.

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In my line of work, I’m often asked to appraise proposed improvements for prospective owner-occupants. Whether it be an addition, an alteration or renovation, or brand-new vertical development altogether. We typically receive a budget from a contractor and are asked to value the property as of a future date when construction is expected to be complete. Many times, the change in property value as a result of the project is less than the cost to complete the project.

 

In this case, a contractor or owner might question the analysis with a statement similar to: “How can the market value only be enhanced by 70% of cost?”

 

While it’s not my job to discuss value with borrowers or owners unless they’re my client (typically a bank is my client in this scenario), it’s important in this moment to explain to them that this deviation should not suggest the project is ill-advised.

 

This is where appraisers or contractors can add value by explaining to them exactly what is happening: they’re accepting a physical risk (real estate development) in order to benefit from an intangible asset (enhanced business value).

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Communication may break down because we lose the words to clearly explain to the developer or prospective owner occupant what is happening. Sometimes, the project isn’t foolish, it’s that the deviation between real estate value and cost to construct is the risk they have to accept to grow their company or intangible asset.

 

For example, by increasing production capacity in an industrial property via an addition, the increase in real estate value may not be 100% correlated with cost.  But, in conjunction with increased real estate value, the increased capacity may enhance the intangible value of the occupying business to total a value increase equal to or greater than the cost of the project.

 

Therefore, project feasibility can be understood based on the following formula:

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Project Feasibility = Increase in tangible value + Increase in intangible value - Project Cost

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If this concept is communicated in such a way that the client understands the defined risks and what’s actually happening, it may increase the likelihood of starting a project despite the appraisal being a hurdle in the process. Most importantly, the understanding may give the borrower or client a sense of peace and may end up bringing them to the table regardless of the real estate-related financial implications.

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As always, I encourage everyone to engage with this post to help myself and others learn from your experiences!