Value Characteristics and Principles of Valuation

Understanding real estate value is the core of the real estate appraisal process and the foundation for all professional analyses and conclusions. This chapter, “Value Characteristics and Valuation Principles,” from the course “Fundamentals of Real Estate Value: From Theory to Application,” will deeply address the concept of value in the context of real estate, exploring the fundamental factors that determine and influence it. Familiarity with these characteristics and principles is essential for accurate and reliable valuations.

This chapter connects basic economic concepts related to value with their practical applications in the real estate market, explaining how market forces like supply and demand interact with unique property characteristics to determine value. It highlights the relationship between value, price, and cost, clarifying the distinctions between these concepts.

The chapter aims to provide participants with the knowledge and understanding to:

1. Identify and explain the four characteristics of value: utility, scarcity, transferability, and effective demand.
2. Distinguish between value, price, and cost.
3. Apply real estate valuation principles, such as supply and demand, competition, substitution, change, and highest and best use.
4. Understand the relationship between the market and value, including the impact of supply and demand conditions.
5. Analyze the impact of different costs on value, including direct and indirect costs, development and construction costs, and replacement and reproduction costs.

Value Characteristics & Valuation Principles

Introduction:

Understanding “value” is central to real estate appraisal. The chapter explores the concept of value, its essential characteristics, and the principles governing its estimation in the market. It discusses value-related terms and differentiates them from “price” and “cost,” covering the theories and scientific principles underlying real estate appraisal with practical examples and applications.

Four Characteristics of Value:

Value is dynamic, influenced by external forces. The conditions creating value are:

1. Utility: The ability to satisfy a need or want. Real estate has utility as building sites, for agricultural and mineral production, or recreation. Example: A lot in a residential subdivision is suitable for building a house.
2. scarcity❓: A thing must be limited in supply. Air is essential for breathing but not economically valuable due to its abundance. Scarcity is fundamental to the theory that value depends on supply and demand. When supply exceeds demand, value diminishes. Example: Waterfront properties are more expensive due to scarcity.
3. Transferability: The ability to transfer ownership through inheritance, lease, gift, or sale. Value assumes an exchange (real or theoretical). Example: National parks are not for sale; therefore, they do not have “value” in the economic sense.
4. Effective Demand: A combination of desire and purchasing power. Buyers must desire to own the item. Real estate is desirable when seen as useful. Desire alone is insufficient; it must be coupled with the ability to pay. Purchasing power is measured by economic conditions like inflation, unemployment, and wage levels, impacting real estate values. Example: Properties in cities with strong job markets and high wages have value due to effective demand.

Value vs. Price vs. Cost:

• Value: What a property is theoretically worth under specific conditions.
• Price: The actual amount asked, offered, or paid for a property in a transaction. Value is a concept; price is a fact.
• Cost: The amount required to “create, produce, or obtain a property,” including labor, materials, and services.

Value is the “anticipated price” under a set of assumptions. Example: A buyer purchases a home for $100,000 with seller financing at below-market interest. The $100,000 is the price. The value may be lower than $100,000 because part of the buyer’s payment is for the favorable interest rate. An appraiser cannot determine value based on price alone.

Cost refers to the production of a good. In real estate, cost is the total money to develop and/or build improvements on the land. Example: A homeowner pays $20,000 for an outdoor pool in an area with a short swimming season. The $20,000 is the cost. The value will likely be far less because the improvement has very limited utility.

Costs are classified as:

• Direct Costs: Labor and materials for building an improvement.
• Indirect Costs: Other costs incurred during construction, such as contractor overhead, architectural fees, financing costs (interest), and permit fees.

Appraisers distinguish between:

• Development Cost: The cost of creating a project, such as a residential subdivision.
• Construction Cost: The cost of building an improvement, such as a house. Development cost may include the construction costs of the individual improvements that are part of the development, such as all the homes in the development.

Example: Costs associated with a single-family residential property:

• Raw land: $30,000
• On-site utilities, clearing, grading: $12,000
• Architectural fees: $7,000
• House construction: $80,000
• Construction loan interest: $4,000

The construction cost of the dwelling is $80,000. The cost to develop the project is $133,000.

Development time❓ affects how long the developer’s capital is tied up, plus the direct cost of interest on borrowed capital.

For appraisal purposes, a distinction is made between:

• Replacement Cost: The cost to create a substitute building with equivalent function and utility, using current methods, materials, and techniques.
• Reproduction Cost: The cost to create an exact replica of the building, using the same design, materials, and construction methods including the building’s deficiencies, superadequacies, and obsolescence.

Valuation Principles (Economic Value):

Appraisal is based on economic principles of value, also referred to as valuation principles, principles of value, economic principles, or simply principles. Value requires utility, scarcity, transferability, and effective demand.

Principles of Value: A series of statements or rules describing how value is created in the real estate market. Examples include supply and demand, type of property, location, productivity, etc. These principles are guidelines for estimating value.

The market refers to the interaction of buyers and sellers to exchange money or assets. The market is defined in terms of a product or service being bought and sold for money (or other assets) within a geographic area. In real estate, the market is for a specific type of property in a specific location, area, or region. Example: market for “ranch-style homes priced between $150,000 and $180,000, located within 5 miles of the city center”.

Principle of Supply and Demand:

• Supply: The quantity of a property type offered for sale in a market at a given price.
• Demand: The quantity of the same property type desired or purchased by buyers in a market at a given price.

The relationship between supply and demand is generally inverse:

• Increased Demand, Constant Supply: Prices tend to rise.
• Increased Supply, Constant Demand: Prices tend to fall.

This can be represented graphically with quantity (Q) on the x-axis and price (P) on the y-axis.

Conclusion:

The chapter provides a foundation for understanding the characteristics of value and the principles that govern real estate appraisal. Understanding these concepts allows the real estate appraiser to perform more accurate and reliable appraisals.