BUILDING ECONOMICS:THEORY AND PRACTICE

BUILDING ECONOMICS:THEORY AND PRACTICE

Rosalie T. Rueggand

Harold E. Marshall

~ Springer Science+Business Media, LLC

Copyright © 1990 by Springer Science+Business Media New YorkLibrary of Congress Catalog Card Number 90-33143Originally published by VanNostrand Reinhold in 1990.Softcover reprint ofthe hardcover 1st edition 1990.

ISBN 978-1-4757-4690-7 ISBN 978-1-4757-4688-4 (eBook)DOI 10.1007/978-1-4757-4688-4

All rights reserved. No part of this work covered by thecopyright hereon may be reproduced or used in any form orby any means-graphie, electronie, or mechanical , includingphotocopying, recording, taping, or information storage andretrieval systems-without written permission of thepublisher.

16 15 14 13 12 11 10 9 8 7 6 5 4 3 2

Llbrary of Congress Cataloging-in-Publication Data

Ruegg, Rosalie T.Building economics: theory and practice / Rosalie T. Ruegg and

Harold E. MarshalI.p. cm.

Includes bibliographieal references .

I. Building-Economic aspects.11. Tide.TH437.R88 1990332.63'243-dc20

I. MarshalI, Harold E.

90-33143CIP

ToBill Ruegg

andJanet, Casey, and Brian Marshall

Contents

ForewordPreface

ixxi

PART 1

METHODS OF ECONOMIC EVALUATION

Chapter 1. Building Economics at a Glance 3Chapter 2. Life-Cycle Cost (LCC) 16Chapter 3. Net Benefit (NB) and Net Savings (NS) 34Chapter 4. Benefit-to-Cost Ratio (BCR) and Savings-to-Investrnent

Ratio (SIR) 48Chapter 5. Internal Rate of Return (IRR) 67Chapter 6. Overall Rate of Return (ORR) 79Chapter 7. Payback (PB) 92

PART 2

WHAT VOU NEED TO KNOW TO APPLV THE METHODS

Chapter 8. Adjusting Dollar Amounts for Time of Occurrence 107Chapter 9. Treatment of Price Changes 134Chapter 10. Setting the Study Period 147Chapter 11. Selecting a Discount Rate or MARR 153Chapter 12. Estimating Costs and Benefits 168Chapter 13. Accounting for Taxes and Financing 186

PART 3

TECHNIQUES FOR TREATING UNCERTAINTV AND RISK

Chapter 14. Risk Exposure and Risk Attitude 203Chapter 15. Conservative Estimating, Breakeven Analysis, and

Sensitivity Analysis 216

vii

viii Contents

Chapter 16. Risk-Adjusted Discount Rate and Certainty EquivalentTechniques 226

Chapter 17. Decision Analysis, Simulation, and Other Techniques 233Chapter 18. Selecting the Best Technique 251

PART 4

APPLICATIONS OF ECONOMIC EVALUATION METHODS AND RISKANALYSIS TECHNIQUES

Chapter 19. Selection of Building Designs and Building Components 257Chapter 20. Decision to Accept or Reject a Project 269Chapter 21. Decisions on Building Location 315Chapter 22 . Lease or Buy Decisions 324Chapter 23 . Economic Size of Building Components 335Chapter 24. Allocating Limited Budgets Among Competing Projects 346Chapter 25. Decisions on Timing of Equipment Replacements 354Chapter 26 . Selecting Combinations of Interdependent Systems 361

APPENDIXES

A. GlossaryB. Worksheets and Supporting Reference Tables

for Computing Life-Cycle Costs, Net Savings,Savings-to-Investment Ratio, and Payback

C. Graphs for Converting SPB to DPBD. Computer ProgramsE. Derivation of a Utility FunctionF. Guide to Published Sources of DataG. Discount Factor Tables

Subject

371

380428433440444447

INDEX

475

Foreword

We no longer build buildings like we used to nor do we pay for them in thesame way. Buildings today are no longer only shelter but are also life supportsystems, communication terminals, data manufacturing centers, and much more.Buildings are incredibly expensive tools that must be constantly adjusted tofunction efficiently. The economics of building has become as complex as itsdesign.

When buildings were shelter they lasted longer than their builders. The av­erage gothic master mason lived 35 or 40 years. Cathedrals took 3 or 4 hundredyears to build . Cost estimates were verified by great great grandchildren of theoriginal designer.

Today, creative economics has become as important as creative design andcreative building. The dient brings builder, contractor, architect , and facilitiesmanager to account in their life time . The cost of building can therefore nolonger be left to chance or act of god.

Solutions are no longer as ingeniously simple as those proposed by a Flor­entine builder early in the 15th century. He proposed to center the dome of S.Maria deI Fiore on a great mound of earth mixed with pennies. When the jobwas done street urchins would carry away the dirt in their search for the pennies.This was a serious suggestion offered by an early construction manager beforeBrunelleschi solved the problem more sensibly .

When OPEC increased oil prices fourfold in the early 1970s and then doubledthem again in 1979, dirt and penny economics went out the window. Buildingcosts became serious stuff. The cost of energy did more to improve the basicdesign and cost procedures for architecture than eclecticism, modern architec­ture, post modern architecture, and deconstructivism combined.

During the troubled years following the oil embargo architects, designers,builders, and students were aided in their search for understanding of the neweconomic conditions by aseries of small books, research reports, and journalarticles written by Ms. Rosalie Ruegg and Dr. Harold Marshall.

I was privileged to work with these two-economists so thoroughly familiarwith their mysterious science that they could make it comprehensible to build-

ix

x Foreword

ers, engineers, and architects . They made it not only understandable, but inter­esting and often fascinating.

You will find in this book the distillation of two decades of national andinternational experience in the field of building economics. They have carriedthe crusade of understandable economics to architects, builders , engineers, realestate developers, facilities planners, managers, and building economiststhroughout the U.S. and Europe.

This book is based on real world problems and solid experience. You do nothave to be an economist or an accountant to understand it. The approach issystematic , practical problem solving. All design and building decisions areweighed against cost and value. All the tools you might need are here.

Anyone, from economists to those who never bothered their head about thematter before, can use the book and will find it fascinating . A knowledge ofbuilding is helpful but not essential. The techniques apply to any investmentdecision even though the focus is on building and building systems. The bookwill add to your knowledge if you have some to begin with or can be a goodbeginning.

Try it-you willlike it.

Preface

WHY BUILDING ECONOMICS?

This book will show you how to apply the concepts and methods of economicsto decisions about the location , design, engineering, construction, management,operation, rehabilitation, and disposition of buildings. Use of these tools canlower costs and increase profits from buildings.

WHO NEEDS THIS BOOK?

This book is for people concemed with the economic efficiency of buildings :

• For practicing architects, engineers, real estate developers, facilities plan­ners and managers, building economists , and other professionals who makedecisions about buildings , it is a comprehensive, readable reference guide.

• For professors and students of advanced undergraduate and graduatecourses in schools of architecture, engineering, economics , quantity sur­veying, and business administration, it is an educational textbook withtheory demonstrated in many examples.

• For those designing and attending short training courses and workshops inbuilding economics and life-cycle cost analysis, it is a source book.

• For engineers and architects preparing for professional exam boards, it isa valuable study aid.

• For researchers and analysts who evaluate the potential of new buildingtechnologies and provide analyses in support of public policies affectingbuildings, it is a concise, practical guide.

This book assumes neither that you are an economist nor that you aspire tobecome an economist. It does assurne that you are interested in improving theeconomy of your buildings.

No specialized background in mathematics or statistics is required. Basic al-

xi

xii Preface

gebra and elementary statistics are sufficient for understanding the concepts andfor applying most of the methods and techniques .

WHY THIS BOOK?

There are few books which combine economic concepts with building technol­ogy, and most of them tend to be theoretical and macro-oriented; i.e ., directedtowards general analysis rather than particular building decisions. Most do notdescribe economic methods to evaluate building investments or provide help infinding appropriate data for evaluations. This book fills the void with a practicalguide grounded in theory.

WHY WE WROTE IT

Extensive first-hand experience with day-to-day real-world problems enabledus to develop practical approaches to building evaluation, which we bring tothis book. Our active involvement with professional groups gave us a broadawareness of current practices and needs in the field both in the United Statesand throughout the world, and enabled us to provide you with state-of-the-artmethods and techniques which are sound and well accepted. As a result of yearsofworking at the intersection of theory and practice , we have attempted to bringto you a unique book, solid in theory and rich in practical application.

Over the past 10 years , we have taught building economics in short coursesto more than 1,000 building professionals in the United States, Europe, andAsia . Their enthusiastic response and favorable comments convinced us of theneed for a book like this which meets the special needs of the building com­munity. Our consulting and research experience helped us focus on those spe­cial needs.

We worked extensively with state and federal government agencies to de­velop economic guidelines for making building decisions . For example, wedeveloped guidelines for the V .S . Department of Energy for use by all federalagencies in evaluating energy conservation decisions in more than 400,000 fed­eral buildings. We also developed training courses and audiovisual training filmsin building economics for the V. S. Department of Energy, as well as coursesfor the V .S. General Services Administration and the Army Corps of Engineers.

We worked for many years with standards-writing groups and professionalsocieties to formulate building economics methods and standards. These groupsinclude the American Society for Testing and Materials (ASTM), with its morethan 30,000 members from industry , government, and academia; the AmericanAssociation of Cost Engineers (AACE); the American Society of Heating, Re-

Preface xiii

frigerating and Air-Conditioning Engineers (ASHRAE); the American Con­sulting Engineers Council (ACEC); the International Energy Agency (lEA); theInternational Council for Building Research , Studies, and Documentation (CIß),which sponsors a Building Economics Working Commission with members from50 countries; and the Architectural Research Centers Consortium (ARCC) Panelon Building Economics and Industry Studies .

We also provided economic consulting for engineers and architects on indi­vidual building projects, and for researchers and analysts investigating ad­vanced building technologies.

ABOUT THE CONTENTS

The book is weIl balanced between the theoretical and practical issues of build­ing economics . It has four major parts: Part 1 presents six methods of economicevaluation and shows how and how not to use them. The methods covered arelife-cycle costing, net benefits (net savings), benefit-to-cost (savings-to-invest­ment) ratio, internal rate of return , overall rate of return, and payback. Simpleproblems illustrate the methods .

Part 2 explains what you need to know to apply the methods. For those whodo not understand the time value of money and discounting , it provides a tu­torial. It also explains how to perforrn evaluations in the face of inflation, howto adjust for tax effects, and how to find and use necessary data .

Part 3 presents techniques for dealing with uncertainty and risk. Techniquescovered are conservative benefit and cost estimating, breakeven analyses, sen­sitivity analysis, risk-adjusted discount rate, certainty equivalent technique , in­put estimation using expected values, mean-variance criterion and coefficientof variation, decision analysis, simulation , mathematical/analytical technique,portfolio analysis , and the capital asset pricing model.

Part 4 demonstrates how to apply the methods of economic evaluation andtechniques for dealing with uncertainty and risk to solve real-world problems .Quick reference guides direct you to case studies which use particular methodsand techniques and show you where to find cases applicable to special topics,such as energy conservation, equipment replacement, and leasing versus buy­ing. The case studies are in a separate part rather than in Parts 1 and 3 for tworeasons. First, the case studies illustrate combinations of economic methods andrisk analysis techniques. Second, the case studies are sufficiently comprehen­sive and complex that they deserve a focused presentation.

The case studies breathe life into the theory, helping the novice understandfundamentals and the seasoned professional see new problem-solving capabil­ities. They are taken from business , government, nonprofit organizations, and

xiv Preface

homeowners. The cases demonstrate how to use the methods presented in Partland the techniques presented in Part 3 to make decisions such as the follow­ing:

• Which alternative building design and size to select? Which mechanicalsystem? Which furnishings?

• Where to locate a building?• Whether to lease or buy equipment and buildings?• What size building investment to make?• Which projects to select when funds are limited?• What combination of interdependent building systems to use?• Whether to invest in a new building technology?

We designed the case studies for instructional use, presenting them in a con­sistent, step-by-step format. They are more comprehensive and realistic thantypical textbook problems, and are logically and systematically formulated andsolved. The essential logic is first given in words, followed by quantitativeanalysis .

By walking through the problem formulations and solutions, practitioners cangain confidence in their ability to solve their own problems . Professors will findthe cases appropriate for take-horne exam questions and for special projects .

Seven appendixes provide a glossary, data and data sources, an annotated listof computer programs, worksheets, and other supporting information .

HOW TO PROCEED

If you come to the book with no prior experience or training in building eco­nomics, you may want to read Parts I through 3 completely before going to theexamples in Part 4. Alternatively, as you read about each method in Part landeach technique in Part 3, you may wish to have a look at the specific caseillustrations of that method or technique in Part 4. The best way to learn howto use the methods and techniques is first to study them, next master the materialin Part 2, and then work through the sample problems .

If you are already knowledgeable about the economic methods and risk anal­ysis techniques, you may wish to proceed directly to those case studies in Part4 which hold special interest for you.

We welcome your comments and suggestions for improvements.

ACKNOWLEDGMENTS

A number of people influenced, supported, and encouraged the preparation ofthe book. Deserving special thanks for their valuable technical reviews are Dr.

Preface xv

Tung Au, professor in the Department of Civil Engineering of Camegie MellonUniversity; Dr . Ranko Bon, associate professorofbuilding economics and tech­nology in the School of Architecture and Planning of the Massachusetts Instituteof Technology; Dr . Carol Rawie , economist at the U.S. Environmental Protec­tion Agency; and Dr. Amrik Rakhra , economist at the National Research Coun­eil of Canada. In addition , we thank Ms. Ida Wooten Tripp , writer, who pro­vided helpful editorial suggestions.